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Archive for October, 2014

Earlier this week I did a Q&A withAbnormal Returns’ Tadas Viskanta about Deep Value. Tadas sees more finance and investing content than anyone else, so it’s always interesting to see what he takes away from a topic:

Activist investing is all the rage today. However you correctly note that activists, like Carl Icahn, have been at it for quite some time. What has led to the rise of activists of late?

Wall Street can be faddish. Like conglomerates in the 1960s, leveraged buy-outs in the 1980s, and venture capital in the 1990s, activism exploded in the early 2000s on the back of the success of a new breed of investors that included Edward Lampert, William Ackman, Daniel Loeb and David Einhorn. Activism, which is primarily driven by deep undervaluation, tends to be counter-cyclical, ebbing and flowing with equity valuations. In the wake of the dot-com bust in the early 2000s, there were a number who got started chasing the cashed-up failures of the information technology and communications boom. For the most part, those were the same guys who continued plying their trade through the 2009 low. The research shows that, in addition to undervaluation, activists seek cash-rich balance sheets, and over-diversified businesses, both of which are symptoms of the tension between managers who want larger fiefdoms, and shareholders who prefer that cash be distributed out to them when returns drop below a threshold. Looking at listed companies in the US now, following the rise in equity valuations and borrowing for buybacks, it would be hard to characterize the average stock as undervalued, or cash rich. More likely they are overvalued, and indebted. Brett Arends noted in an August 4 article for Marketwatch that U.S. non-financial corporations are carrying debts equal to 50 percent of their actual net worth, and that is “near record levels, and far above historic averages:”

In 1950 companies barely owed 20% of their net worth. In the early 1980s it was a little over 25%. Even in 2007 it was below 40%.

And this, note, is after years of record profits. Companies have used their profits, and their borrowings, to drive up their own stock prices.

Activists may be partly to blame, but mostly it’s due to very low interest rates and very high equity valuations, which are two sides of the same coin. The activist opportunity set is always going to be best at market lows: It was excellent in the early 2000s, and very good in 2009. Now it is poor. A correction in the market will improve the opportunity set because it will ameliorate one part of the problem, overvaluation, but we won’t see the systemic overcapitalization that we saw in the early 2000s. We are probably close to peak activism for this cycle, if we haven’t passed it already.

There are a number of references in the book of investors, or their analysts, manually combing through S&P tearsheets looking for candidates. How has the emergence of cheap and powerful databases and analytical tools changed value investing?

Logically, the simplest answer is that it must lead to a reduction in the number of mispriced opportunities, which is the value investor’s bread-and-butter. That will push value investors into special situations that don’t screen easily or at all. Empirically, it’s difficult to separate the cyclical drivers of mispricings–like plain, old stock market overvaluation–from the secular ones, like better, cheaper screening technology. Millennial Investor Patrick O’Shaughnessy shared the following chart that shows the proportion of non-financial U.S. companies with an inflation-adjusted market capitalization of at least $200 million trading on an enterprise multiple (EV/EBITDA) of less than 5, what I would characterize as deeply undervalued.

deepvalue 10142 579x420 Q&A with Tobias Carlisle author of Deep Value

Source: Patrick O’Shaughnessy, Searching for Deep Value Stocks, September 15, 2014

In mid-September just 3.2 percent of all stocks qualified as deeply undervalued, up slightly from the all-time low of 2.9 percent of all stocks reached in June this year. Whether it’s due to cyclical stock market overvaluation or better screening technology or some combination of both, I can’t say.

The counterpoint to this argument is that value investing is simple, but it’s not easy. It’s simple to understand, but behaviorally difficult to do. Though we know statistically that undervalued stocks with fundamental weakness outperform, it’s hard to buy falling stocks, and even more so when they have fundamental weakness. Screeners can help find good opportunities, but they can’t help buy them. To the extent that investors continue to be humans making cognitive errors, the opportunity will persist.

On a related note your write about the often ugly characteristics of stocks selected for a contrarian value strategy. Is this why it is important to use statistical models to build these types of portfolios?

Yes. Most deeply undervalued, fundamentally weak stocks are that way because their futures appear uncertain—they are losing money or marginally profitable—and, on an individual basis, don’t appear to be good candidates to buy. We know, however, that in aggregate they provide excellent returns, outperforming the market in the long run and suffering fewer down years than the market. This is an area in which our native intuition fails us. No matter how well trained we are, we tend to have difficulty with probabilistic, uncertain, and random processes. So the question becomes, “How can we trick or force ourselves to fill the portfolio with the right stock?”

Since the 1950s, social scientists have been comparing the predictive abilities of traditional experts, and what are known as “statistical prediction rules,” which are just simple models. The studies have found almost uniformly that that statistical prediction rules are more consistently accurate than the very best experts. This observation is now so well-accepted as to be known as The Golden Rule of Predictive Modeling. So why don’t we apply it to investment?

The reason is that most investors, like most experts in other fields, believe that it would be better to use the output from the statistical prediction rule, and retain the discretion to follow the rule’s output or not. There is some evidence to support this possibility. Traditional experts are shown to make better decisions when they are provided with the results of statistical prediction. The issue is that they continue to underperform the statistical prediction rule alone. The reason is known as the “broken leg” problem:

Suppose an actuarial formula accurately predicts an individual’s weekly movie attendance. If we know that the subject has a broken leg, it would be wise to discard the actuarial formula.

Statistical prediction rules get broken-leg problems incorrect because the particular case is so different from the base rate. If that is so, goes the argument, then surely these anomalous cases could benefit from an expert overriding the rule? The studies find that they do not. In fact, experts predict less reliably than they would have if they had just used the statistical prediction rule. The reason is that when experts are given statistical prediction rules along with permission to override them, the experts find more broken legs than there really are.

The contrarian value investment strategy is a good avenue for the application of statistical-prediction rules because all of the stocks have what appear to be broken legs. The intrinsic value in these stocks is uncertain because its discovery requires the anticipation of an event not obvious in the historical financial data—mean reversion. Rather we must rely on the statistical base case for undervalued, money-losing securities—that they will spontaneously mean revert toward a state of earning power commensurate with their assets.

The evidence is very strong that value (vs. glamour) works pretty consistently across time and markets. Can we chalk this up to “persistent cognitive errors” or is there something else going on?

Value investing works because it is about getting more value than you give up. But that begs the question, “Why doesn’t everyone just buy undervalued stocks, and pass on, or short, the overvalued, glamour stocks?” And the answer is that undervalued stocks tend to behaviorally difficult to buy, and glamour stocks appear attractive.

In Contrarian Investment, Extrapolation and Risk (1994), Lakonishok, Shleifer and Vishny demonstrate that value strategies outperform because they are “contrarian to ‘naive’ strategies followed by other investors:”

These naive strategies range from extrapolating past earnings growth too far into the future, to assuming a trend in stock prices, to overreacting to good or bad news, or to simply equating a good investment with a well-run company irrespective of price.

Lakonishok et al continue that investors get overly excited about stocks that have done well in the recent past and bid them up so that these “glamour” stocks become overpriced, and overreact to stocks that have done badly, oversell them, and these out-of-favor “value” stocks become undervalued. In both cases it is a failure to appreciate the impact of mean reversion, which is a cognitive error.

In pursuit of the idea that it is a failure to incorporate mean reversion into growth forecasts, Lakonishok et al undertake a really interesting examination of the data. They looked at two portfolios of value stocks trading on comparable multiples of price-to-earnings, cash flow, operating earnings, book value and sales, but with different historical rates of sales growth; one with a high rate of growth, the other low. They find that, even in the value portfolios, stocks with lower historical rates of growth outperform stocks with higher rates of growth. And the reason is that, in both cases, the extrapolated growth rates don’t materialize. Instead the fundamentals mean revert too.

Read the rest of the Abnormal Returns Q&A about Deep Value.

Buy Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook.

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Ken Faulkenberry of the Arbor Investment Planner has a review and summary of Deep Value on his Arbor Asset Allocation Model Portfolio (AAAMP) blog:

I must admit I was underwhelmed with my initial viewing of the book. Maybe it was because I thought the price was high given the size of the book. Maybe it was because I had such high expectations that my first thumb through just didn’t hit the right buttons; I don’t know.

What I do know is my first impressions were absolutely wrong. Tobias Carlisle totally lived up to his reputation as a great writer (you will find his blog at Greenbackd ). Carlisle may be a quantitative investor but the descriptions of his writing are qualitative (interesting, informative, educational, scholarly, revealing, etc).

The title of the book could have been: “Why Everyone Should Be a Value Investor”. I’m certainly not saying that would have been a better title for the book. My point is that Deep Value makes the case, chapter by chapter, that deep value investing works.

Who should read Deep Value?: Anyone who believes they are a value investor, might want be a value investor, or is a value investing skeptic. After reading, you will understand why you are a value investor AND you will be a better value investor. It’s worth every penny.

Read the rest of Ken’s review here: Deep Value by Tobias Carlisle – Review & Summary.

Buy Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook.

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Norman Rothery has an article in the Globe and Mail’s Strategy Lab The revenge of the market’s castoffs: Cigar-butt stocks get last laugh about Deep Value:

Carl Icahn is trying to squeeze a little more juice out of Apple. Late this week, he released what amounted to a love letter extolling the virtues of the company and urging it to repurchase more of its stock.

The move follows a similar push last year that saw the company return money to shareholders by raising its dividend and buying stock. This time around management appears to be a little less co-operative. But I wouldn’t count out Mr. Icahn quite yet. While he sometimes fails to get companies to follow his advice, he has a knack of walking away with piles of cash, nonetheless.

You can learn more about activists like Mr. Icahn by reading money manager Tobias Carlisle’s new book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations. It explores the modern development of value investing and uses the careers of famous activists to show how it has evolved.

Read the rest of The revenge of the market’s castoffs: Cigar-butt stocks get last laugh.

Buy Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook.

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My interview with Chuck Jaffe on the MoneyLife Show about Deep Value. We discuss net nets, Warren Buffett’s strategy, ETFs, mutual funds, and the Acquirer’s Multiple:

Buy Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook.

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The first ever Value Investing Educational Series is just 2 days away and spots are filling up fast.

The event will feature 5 notable value investors, sharing the investment strategies and ideas they are using to profit in the market.

Click here to secure your spot in Saturday’s event

The event will feature:

  • Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, presented by Tobias Carlisle, Managing Director of Eyquem Investment Management, LLC
  • Forward Thinking: Identifying Value Opportunities Before the Market Catches On, presented by Dave Waters, Founder of Alluvial Capital Management, LLC
  • Finding Oddball Stocks: Banks and Other Unusual Companies, Nate Tobik, Founder at CompleteBankData.com
  • Finding Value in an Expensive Market, Tim Melvin, Founder of Deep Value Letter and Banking on Profits
  • How Luxury Stocks Maintain Relevancy and Chase Market Shares, Kristin Bentz, President of Talented Blonde, LLC

So sign up now and sign in early.

Seating is limited and spaces are filling up fast.

Register for the Value Investing Educational Series Now

Look forward to seeing you in there.

PS – Can’t attend the live event? All registrants will receive the full recording.

Click here to register now

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Deep Value #1 Best Seller

Buy Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook.

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Over the past 90 years, there have been thousands of academic studies that all point to one conclusion: Over time, value investing outperforms the market.

That’s why the team at Marketfy have put together the first ever Value Investing Educational Series this Saturday, October 11th from 11am – 4pm ET.

See five value investing strategies presented by 5 value investors.

So, are you ready to learn the value investing strategies that have brought success to the likes of Warren Buffett, Benjamin Graham, and so many others?

Register for the Value Investing Educational Series + Recordings Now

The event will feature:

  • Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, presented by Tobias Carlisle, Managing Director of Eyquem Investment Management, LLC
  • Forward Thinking: Identifying Value Opportunities Before the Market Catches On, presented by Dave Waters, Founder of Alluvial Capital Management, LLC
  • Finding Oddball Stocks: Banks and Other Unusual Companies, Nate Tobik, Founder at CompleteBankData.com
  • Finding Value in an Expensive Market, Tim Melvin, Founder of Deep Value Letter and Banking on Profits
  • How Luxury Stocks Maintain Relevancy and Chase Market Shares, Kristin Bentz, President of Talented Blonde, LLC

Register for the Value Investing Educational Series Now

Don’t miss out on this rare opportunity to learn strategies proven to outperform the market.

PS – Can’t attend the live event? All registrants will receive the full recording.

Click here to register now

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Capital management is a little understood, yet critical, issue for shareholder value creation. The research is clear: Investors should seek the rare companies with a manager like Henry Singleton–described by Warren Buffett as having “the best operating and capital deployment record in American business”–at the helm, who only buy back shares at trough valuations, are miserly with options, and only issue shares when the share price exceeds the stock’s intrinsic value. A manager who buys back stock at a peak valuation destroys value as surely as the manager who issues shares at a trough valuation.

It is a perplexing statistic, but, in aggregate, managers tend to buy back more stock at market peaks than at market troughs. It seems the average manager prefers to goose an already overvalued stock with a buyback at shareholder’s cost. In one of his recent commentaries, John Hussman noted that buybacks ebb and flow with the equity markets: when the markets are up, so are buybacks, and vice versa:

Notice that heavy equity buybacks (negative values on the red line below) are regularly financed by the issuance of corporate debt (a mirror image of positive values on the black line). Those debt-financed equity buybacks have been heaviest at market peaks like 1999-2000, 2007, and today. Put simply, the history of corporate stock buybacks is a chronicle of corporations buying stock with borrowed money at market tops, and retreating from buybacks at the very points that stocks are most reasonably valued.

He shares the following chart to illustrate his point:

wmc140908c

Source: John Hussman, The Two Pillars of Full-Cycle Investing, September 8, 2014

This behavior turns the stomachs of value investors, but it’s par for the course for most managers. The Henry Singletons are few and far between. No manager focused on intrinsic value could behave this way.

These are sins of commission. Less visible, but equally impoverishing, are sins of omission: When undervalued, overcapitalized companies fail to grab a rare opportunity to buy back stock at a wide discount from intrinsic value. Where such unexploited opportunities exist, activists are incentivised to establish a position in the company and agitate to have management undertake a buyback. In Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (Wiley Finance, 2014), I examined one such example of an undervalued, overcapitalized company that failed to take its opportunity until two activists stepped up the pressure, and the outstanding returns that followed.

In early 2013 Carl Icahn began agitating to have Apple, Inc. use its enormous cash holding to buy back its very undervalued stock. Icahn would propose in an open letter to Tim Cook, Apple’s CEO, that Apple undertake a $150 billion buyback:

When we met, you agreed with us that the shares are undervalued. In our view, irrational undervaluation as dramatic as this is often a short-term anomaly. The timing for a larger buyback is still ripe, but the opportunity will not last forever. While the board’s actions to date ($60 billion share repurchase over three years) may seem like a large buyback, it is simply not large enough given that Apple currently holds $147 billion of cash on its balance sheet, and that it will generate $51 billion of EBIT next year (Wall Street consensus forecast).

With such an enormous valuation gap and such a massive amount of cash on the balance sheet, we find it difficult to imagine why the board would not move more aggressively to buy back stock by immediately announcing a $150 billion tender offer (financed with debt or a mix of debt and cash on the balance sheet).

Icahn believed that if Apple decided to borrow the full $150 billion at a 3 percent interest rate to undertake a tender at $525 per share, the result would be an immediate 33 percent boost to earnings per share and, assuming no multiple expansion, a commensurate 33 percent increase in the value of the shares. He saw the shares appreciating over the following three years from $525 to $1,250, assuming sustained 7.5 percent annual growth in Apple’s EBIT and an EBIT multiple of 11 from Apple’s 2013 EBIT multiple of 7. Icahn wasn’t the only activist to complain about Apple squandering an opportunity to buy back stock.

Around the same time Icahn sent his open letter to Cook, David Einhorn, speaking at the Ira W. Sohn Conference, also made an argument for Apple undertaking a buyback. Einhorn’s proposal was half the size of Icahn’s and didn’t require the company to take on debt. He noted that with close to $137 billion in cash on its balance sheet, Apple held more cash than “the market capitalization of all but 17 companies in the S&P 500,” the size of which “reveal[ed] a basic flaw in Apple’s capital allocation.” The problem with holding so much cash, according to Einhorn, was its opportunity cost. It earned only a small amount of interest, which meant a return below the rate of inflation. He likened it to “decaying inventory,” arguing that the real value of it declined a little bit every day:

Even worse, the return is far below the cost of capital. For companies with all-equity balance sheets, the cost of capital is particularly high, because expensive equity capital supports both the business and the foreign cash.

Finance theory suggests that an unlevered or net cash balance sheet should be rewarded with higher P/E multiples. In practice, the market assigns a discount for this level of overly conservative long-term capital management.

Not only does the cash earn a return below the cost of capital, it is evident that future profits will probably also be reinvested at a low return. As a result, the market not only discounts the cash sitting on the balance sheet, it also drives down the P/E multiple due to the anticipated suboptimal re-investment rate for future cash flows.

Einhorn argued that, at a 10 percent cost of capital, the cash represented an opportunity cost of close to $13.7 billion per year, or $14 in earnings per share.

Continue reading Buybacks: The Rationale and the Evidence article for the Manual of Ideas.

 

Buy Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook.

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Yesterday I chatted to Peter Switzer on Australia’s Sky News Business about Deep Value. It was a wide-ranging conversation canvassing some interesting ideas: Net nets, the Acquirer’s Multiple, and the validity of value investing:

Buy Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on Deep Value, or connect with me on Twitter, LinkedIn or Facebook.

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