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Posts Tagged ‘Value investing’

T2 Partners on BP, MSFT and BUD

Posted in About, Stocks, tagged on July 28, 2010| 1 Comment »

Market Folly has T2 Partners’ presentation to the 7th Annual Value Investing Seminar, in which they discuss three opportunities in BP, which I’ve discussed in the past, MSFT and BUD. Says Jay:

On Anheuser-Busch InBev, T2 Partners says, “you can currently buy BUD with an entry FCF yield of 10% for a business that can probably grow at GDP + inflation for a long time, giving you a long term IRR of at least 15% without any multiple expansion.” We’ve previously covered a separate and specific T2 Partners presentation on BUD worth checking out as well.

Secondly, Tilson and Tongue argue that Microsoft (MSFT) is undervalued. They write, “MSFT’s closing price on 7/12/10: $24.83, so assuming $2.40/share of FY 2011 earnings (midpoint of analysts’ estimates and our own), plus $4 share in cash, here are possible stock prices and returns (plus there’s a 2.1% dividend): 10x multiple = $28 stock = 13% return. 12x multiple = $33 stock = 33% return. 15x multiple = $40 stock = $61% return.” They highlight the company has $4.24 cash per share, shareholder friendly capital allocation (buybacks & dividend), as well as a new product cycle in tow (Microsoft Office, Windows 7, etc). T2 Partners says that the rumors of Microsoft’s demise are greatly exaggerated.

See the T2 presentation.

No positions.

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Grantham on the potential disadvantages of Graham-and-Dodd investing

Posted in About, Stocks, Value Investment, tagged , on April 26, 2010| 11 Comments »

Jeremy Grantham’s 2010 first quarter investor letter (.pdf) appends the first part of a speech he gave at the Annual Benjamin Graham and David Dodd Breakfast at Columbia University in October last year. The speech was titled Friends and Romans, I come to tease Graham and Dodd, not to praise them. In it Grantham discussed the “potential disadvantages of Graham and Dodd-type investing.” It seems to have struck a chord, as I’ve received it from several quarters. As one of the folks who forwarded it to me noted, we learn more from those who disagree with us.

Hat tip Toby, Raj and everyone else.

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One for the annals of behavioral finance

Posted in About, Behavioral economics, Value Investment, tagged , on April 23, 2010| 1 Comment »

Oh dear (Daily Reckoning via Guru Focus):

04/21/10 Gaithersburg, Maryland – Ken Heebner’s CGM Focus Fund was the best US stock fund of the past decade. It rose 18% a year, beating its nearest rival by more than three percentage points. Yet according to research by Morningstar, the typical investor in the fund lost 11% annually! How can that happen?

It happened because investors tended to take money out after a bad stretch and put it back in after a strong run. They sold low and bought high. Stories like this blow me away. Incredibly, these investors owned the best fund you could own over the last 10 years – and still managed to lose money.

…

Psychologically, it’s hard to do the right thing in investing, which often requires you to buy what has not done well of late so that you will do well in the future. We’re hard-wired to do the opposite.
I recently read James Montier’s Value Investing: Tools and Techniques for Intelligent Investment. It’s a meaty book that compiles a lot of research. Much of it shows how we are our own worst enemy.

One of my favorite chapters is called “Confused Contrarians and Dark Days for Deep Value.” Put simply, the main idea is that you can’t expect to outperform as an investor allthe time. In fact, the best investors often underperform over short periods of time. Montier cites research by the Brandes Institute that shows how, in any three-year period, the best investors find themselves among the worst performers about 40% of the time!

See the rest of the article here.

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Endangered Species 2001

Posted in About, Activist Investors, Audiovox Corporation (NASDAQ:VOXX), Catalysts, Dataram Corporation (NASDAQ:DRAM), Ditech Networks Inc (NASDAQ:DITC), Stocks, Value Investment, tagged , , , , , on April 14, 2010| 2 Comments »

In the Spring 1999 Piper Jaffray produced a research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy (see also Performance of Darwin’s Darlings). The premise of the report was that undervalued small capitalization stocks (those with a market capitalization between $50M and $250M) lacked a competitive auction for their shares and required the emergence of a catalyst in the form of a merger or buy-out to close the value gap.

In the first follow-up, Endangered species update: The extinct, the survivors, and the new watch list, from Summer 2000, Murphy and Buckley (Donoghue is not listed on the 2000 paper as an author) tested their original thesis and provided the “Darwin’s Darlings Class of 2000,” which was a list of what they viewed as “the most undervalued, yet profitable and growing small cap public companies” in 2000.

In the Fall of 2001, Donoghue, Murphy, Buckley and Danielle C. Kramer produced a further follow-up to the original report called Endangered Species 2001 (.pdf). Their thesis in the further follow up should be of particular interest to we value folk. Putting aside for one moment the purpose of the report (M&A research aimed at boards and management of Darwin’s darlings stocks to generate deal flow for the investment bank), it speaks to the very fertile environment for small capitalization value investing then in existence:

In the last few of years, many small public companies identified this [secular, small capitalization undervaluation] trend and agreed with the implications. Executives responded accordingly, and the number of strategic mergers and going-private transactions for small companies reached all-time highs. Shareholders of these companies were handsomely rewarded. The remaining companies, however, have watched their share prices stagnate.

Since the onset of the recent economic slowdown and the technology market correction, there has been much talk about a return to “value investing.” Many of our clients and industry contacts have even suggested that as investors search for more stable investments, they will uncover previously ignored small cap companies and these shareholders will finally be rewarded. We disagree and the data supports us:

Any recent increase in small-cap indices is misleading. Most of the smallest companies are still experiencing share price weakness and valuations continue to be well below their larger peers. We strongly believe that when the overall market rebounds, small-cap shareholders will experience significant underperformance unless their boards effect a change-of-control transaction.

In this report we review and refresh some of our original analyses from our previous publications. We also follow the actions and performance of companies that we identified over the past two years as some of the most attractive yet undervalued small-cap companies. Our findings confirm that companies that pursued a sale rewarded their shareholders with above-average returns, while the remaining companies continue to be largely ignored by the market. Finally, we conclude with our third annual list of the most attractive small-cap companies: Darwin’s Darlings Class of 2001.

Piper Jaffray’s data in support of their contention is as follows:

Looking back further than just the last 12 months, one finds that small-cap companies have severely lagged larger company indices for most periods. Exhibit II illustrates just how poorly the Russell 2000 compares to the S&P 500 during the longest bull market in history. In fact over the past five, seven and ten years, the Russell 2000 has underperformed the S&P 500. For the five, seven and 10 year periods, the S&P 500 rose 82.6 percent, 175.6 percent and 229.9 percent, respectively, while the Russell 2000 rose 47.9 percent, 113.4 percent, and 206.3 percent for the same periods.

The poor performance turned in by the Russell 2000 can be attributed to the share price performance of the smallest companies in the index. Our previous analysis has shown that the smallest companies in the index have generally underperformed the larger companies (see “Wall Streets Endangered Species,” Spring 1999). To understand the reasons for this differential, one must appreciate the breadth of the index. There is a tremendous gap in the market cap between the top 10 percent of the companies in the index, as ranked by market cap (“the first decile”) and the last 10 percent (“the bottom decile”). The median market capitalization of the first decile is $1.7 billion versus just $201.0 million for the bottom decile. There is almost an 8.0x difference between what can be considered a small cap company.

This distinction in size is important, because it is the smallest companies in the Russell 2000, and in the market as a whole, that have experienced the weakest share price performance and are the most undervalued. Exhibit III illustrates the valuation gap between the S&P 500 and the Russell 2000 indices. Even more noticeable is the discount experienced by the smallest companies. The bottom two deciles of the index are trading at nearly a 25 percent discount to the EBIT multiple of the S&P 500 and at nearly 40 percent below the PIE multiple on a trailing 12-month basis.

This valuation gap has been consistently present for the last several years, and we fully expect it to continue regardless of the direction of the overall market. This differential is being driven by a secular trend that is impacting the entire investing landscape. These changes are the result of:

• The increasing concentration of funds in the hands of institutional investors

• Institutional investors’ demand for companies with greater market capitalization and liquidity

• The shift by investment banks away from small cap-companies with respect to research coverage and trading

The authors concluded that the trends identified were “secular” and would continue, leading small capitalization stocks to face a future of chronic undervaluation:

Removing this discount and reviving shareholder value require a fundamental change in ownership structure. Equity must be transferred out of the hands of an unadoring and disinterested public and into those of either: 1) managers backed by private capital, or 2) larger companies that can capture strategic benefits. Either remedy breathes new life into these companies by providing cheaper sources of equity capital and shifting the focus away from quarterly EPS to long-term growth.

They recognized the implications for secular undervaluation which lead them to make an impressive early identification of the re-emergence of modern shareholder activism:

Unfortunately, many corporate executives continue to believe that if they stick to their business plan they will eventually be discovered by the financial community. Given the recent trends, this outcome is not likely. In fact, there is a growing trend toward shareholder activism to force these companies to seek strategic alternatives to unlock shareholder value. Corporate management is now facing a new peril – the dreaded proxy fight. Bouncing back from their lowest level in more than a decade, proxy fights have increased dramatically thus far in 2001 and are running at nearly twice the pace as they were last year, according to Institutional Shareholder Services. In fact, not since the late 1980s has there been such attention devoted to the shareholder activism movement.

As shown in our Darwin’s Darlings list in Exhibit XX, page 23, management ownership varies widely among the typical undervalued small cap. For those that were IPOs of family-held businesses, management stakes are generally high. In these instances in which a group effectively controls the company, there will be little noise from activist shareholders. However, companies with broad ownership (i.e., a spinoff from a larger parent) are more susceptible to unfriendly actions. In fact, widely held small caps frequently have blocks held by the growing number of small-cap investment funds focused on likely takeover targets.

Regardless of ownership structure, these companies typically have the customary defensive mechanisms in place. They are also protected because they are so thinly traded. In most cases it can take more than six months to accumulate a 5 percent position in the stock without impacting the share price. While we expect most of the successful acquisitions in this sector to be friendly, small-cap companies will have to increasingly worry about these unfriendly suitors.

There are several consistent factors that are driving the increased frustration among shareholders and, consequently, the increased pressure on Management and Boards. These factors include the aforementioned depressed share prices, lack of trading liquidity, and research coverage. But also included are bloated executive compensation packages that are not tied to share price performance and a feeling that corporate boards are staffed with management allies rather than independent-minded executives. Given the continuing malaise in the public markets, we believe this heightened proxy activity will continue into the foreseeable future. Companies with less than $250 million in market capitalization in low growth or cyclical markets are the most vulnerable to a potential proxy battle, particularly those companies whose shares are trading near their 52-week lows.

Here they describe what was a novelty at the time, but has since become the standard operating procedure for activist investors:

Given the growing acceptance of an aggressive strategy, we have noticed an increase in the number of groups willing to pursue a “non-friendly” investment strategy for small caps. Several funds have been formed to specifically identify a takeover target, invest significantly in the company, and force action by its own board. If an undervalued small cap chooses to ignore this possibility, it may soon find itself rushed into a defensive mode. Thwarting an unwanted takeover, answering to shareholders, and facing the distractions of the press may take precedence from the day-to-day actions of running the business.

So how did the companies perform? Here’s the chart:

Almost 90 percent of the 1999 class and about half of the 2000 class pursued some significant strategic alternative during the year. The results for the class of 1999 represent a two-year period so it is not surprising that this list generated significantly more activity than the 2000 list. This would indicate that we should see additional action from the class of 2000 in the coming year.

A significant percentage (23 percent of the total) pursued a sale or going-private transaction to provide immediate value to their shareholders. Others are attempting to “grow out of” their predicament by pursuing acquisitions and many are repurchasing shares. However, many of Darwin’s Darlings have yet to take any significant action. Presumably, these companies are ignoring their current share price and assuming that patient shareholders will eventually be rewarded through a reversal in institutional investing trends, or perhaps, in a liquidity event at some later date.

The actual activity was, in fact, even greater than our data suggests as there were many transactions that were announced but failed to be consummated, particularly in light of the current difficult financing market. Chase Industries, Lodgian, Mesaba Holdings, and Chromcraft Revington all had announced transactions fall through. In addition, a large number of companies announced a decision to evaluate strategic alternatives, including Royal Appliance, Coastcast, and Play by Play ‘Toys.

The authors make an interesting observation about the utility of buy-backs:

For many of Darwin’s Darlings and other small-cap companies, the share repurchase may still have been an astute move. While share price support may not be permanent, the ownership of the company was consolidated as a result of buying in shares. The remaining shareholders were, in effect, “accreted up” in their percentage ownership. When a future event occurs to unlock value, these shareholders will reap the benefits of the repurchase program. Furthermore, the Company may have accommodated sellers desiring to exit their investment, thereby eliminating potentially troublesome, dissenting shareholders. There are circumstances when a repurchase makes good sense, but it should not be considered a mechanism to permanently boost share prices.

Piper Jaffray’s Darwin’s Darlings Class of 2001, the third annual list of the most attractive small-cap companies, makes for compelling reading. Net net investors will recognize several of the names (for example, DITC, DRAM,  PMRY and VOXX) from Greenbackd and general lists of net nets in 2008 and 2009. It’s worth considering that these stocks were, in 2001, the most attractive small-capitalization firms identified by Piper Jaffray.

See the full Endangered Species 2001 (.pdf) report.

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Uncommon lessons from Phil Fisher

Posted in About, Behavioral economics, Contrarian investment, Stocks, Value Investment, tagged , , on March 18, 2010| 10 Comments »

In the Introduction to my 2003 copy of Philip A. Fisher’s Common Stocks and Uncommon Profits and Other Writings, his son, Kenneth L. Fisher, recounts a story about his father that has stuck with me since I first read it. For me, it speaks to Phil Fisher’s eclectic genius, and quirky sense of humor:

But one night in the early 1970’s, we were together in Monterey at one of the first elaborate dog-and-pony shows for technology stocks – then known as “The Monterey Conference” – put on by the American Electronics Association. At the Monterey Conference, Father exhibited another quality I never forgot. The conference announced a dinner contest. There was a card at each place setting, and each person was to write down what he or she thought the Dow Jones Industrials would do the next day, which is, of course, a silly exercise. The cards were collected. The person who came closest to the Dow’s change for the day would win a mini-color TV (which were hot new items then). The winner would be announced at lunch the next day, right after the market closed at one o’clock (Pacific time). Most folks, it turned out, did what I did – wrote down some small number, like down or up 5.57 points. I did that assuming that the market was unlikely to do anything particularly spectacular because most days it doesn’t. Now in those days, the Dow was at about 900, so 5 points was neither huge nor tiny. That night, back at the hotel room, I asked Father what he put down; and he said, “Up 30 points,” which would be more than 3 percent. I asked why. he said he had no idea at all what the market would do; and if you knew him, you knew that he never had a view of what the market would do on a given day. But he said that if he put down a number like I did and won, people would think he was just lucky – that winning at 5.57 meant beating out the guy that put down 5.5 or the other guy at 6.0. It would all be transparently seen as sheer luck. But if he won saying, “up 30 points,” people would think he knew something and was not just lucky. If he lost, which he was probable and he expected to, no one would know what number he had written down, and it would cost him nothing. Sure enough, the next day, the Dow was up 26 points, and Father won by 10 points.

When it was announced at lunch that Phil Fisher had won and how high his number was, there were discernable “Ooh” and “Ahhhh” sounds all over the few-hundred-person crowd. There was, of course, the news of the day, which attempted to explain the move; and for the rest of the conference, Father readily explained to people a rationale for why he had figured out all that news in advance, which was pure fiction and nothing but false showmanship. But I listened pretty carefully, and everyone he told all that to swallowed it hook, line, and sinker. Although he was socially ill at ease always, and insecure, I learned that day that my father was a much better showman than I had ever fathomed. And, oh, he didn’t want the mini-TV because he had no use at all for change in his personal life. So he gave it to me and I took it home and gave it to mother, and she used it for a very long time.

Common Stocks and Uncommon Profits and Other Writings is, of course, required reading for all value investors. I believe the Introduction to the 2003 edition, written by Kenneth Fisher, should also be regarded as required reading. There Kenneth [Edit:, an investment superstar in his own right,] shares intimate details about Phil from the perspective of a son working with the father. As the vignette above demonstrates, Phil understood human nature, but was socially awkward; he understood the folly of the narrative, but was prepared to provide a colorful one when it suited him; and he understood positively skewed risk:reward bets in all aspects of his life, and had the courage to take them, even if it meant standing apart from the crowd. What is most striking about this sketch of Phil Fisher is that it could just as easily be a discussion of Mike Burry or Warren Buffett. Perhaps great investors are like Leo Tolstoy’s happy families:

Happy families are all alike; every unhappy family is unhappy in its own way.

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Hunting endangered species

Posted in About, Activist Investors, Catalysts, Stocks, Value Investment, tagged , on March 11, 2010| 18 Comments »

Back in the spring of 1999, when the world was enamored of dot coms and not much else, three guys at Piper Jaffray, Daniel J. Donoghue, Michael R. Murphy and Mark Buckley*, produced a superb research report called Wall Street’s Endangered Species. The thesis of the paper was that there were a large number of undervalued companies with strong fundamentals and solid growth prospects in the small cap sector (defined as stocks with a market capitalization between $50M and $250M) lacking a competitive auction for their shares. Donoghue, Murphy and Buckley argued that the phenomenon was secular, and only mergers or buy-outs would “close their value gap:”

Management buy-outs can provide shareholders with the attractive control premiums currently experienced in the private M&A market. Alternatively, strategic mergers can immediately deliver large cap multiples to the small cap shareholder.

I believe that this phenomenon led to the emergence of activist investors in the small cap sector over the last decade. More on this in a moment.

Endangered species report

The document is drafted from the perspective of a M&A team selling corporate advisory services. Here’s the pitch:

Many well-run and profitable public companies in the $50-250 million market capitalization range are now trading at a significant discount to the rest of the stock market. Is this a temporary, cyclical weakness in small stocks that is likely to reverse soon? No, these stocks have been permanently impaired by a shift in the economics of small cap investing. This persistent under-valuation is sure to be followed by a rise in M&A activity in the sector. We have already seen an uptick in the number of “going private” transactions and strategic mergers involving these companies. Management teams that identify this trend, and respond to it, will thrive. The inactive face extinction.

Donoghue, Murphy and Buckley’s thesis was based on the then relative underperformance of the Russell 2000 to the S&P 500:

The accompanying graph, labeled Exhibit I, illustrates just how miserably the Russell 2000 lagged the S&P 500 not only last year but in 1996 and 1997 as well. Granted, small cap returns have tended to run in cycles. Since the Depression, there have been five periods during which small cap stocks have outperformed the S&P 500 (1932-37, 1940-45, 1963-68, 1975-83, and 1991-94). It is reasonable to believe that small caps, in general, will once again have their day in the sun.

They argued that the foregoing graph was a little misleading because the entirety of the Russell 2000 universe wasn’t underperforming, just the smallest members of the index:

However, a closer look at the smallest companies within the Russell 2000 reveals a secular decline in valuations that is not likely to be reversed. The table in Exhibit II divides the Russell 2000 into deciles according to market capitalization. Immediately noticeable is the disparity between the top decile, with a median market capitalization of $1.5 billion, and the tenth decile at less than $125 million. Even more striking is the comparison of compounded annual returns for the past ten years. The data clearly demonstrates that it is not the commonly tracked small cap universe as a whole that is plagued by poor stock performance but rather the smallest of the small: companies less than about $250 million in value.

Stocks trading at a discount to private company valuations

The underperformance led to these sub-$250M market cap companies trading at a discount to private company valuations:

Obscurity in the stock market translates into sub-par valuations. As shown in Exhibit IV, the smaller of the Russell 2000 companies significantly lag the S&P 500 in earnings and EBIT multiples. It is startling to find that with an average EBIT multiple of 9.0 times, many of these firms are valued below the acquisition prices of private companies.

And the punchline:

Reviving shareholder value requires a fundamental change in ownership structure. Equity must be transferred out of the hands of an unadoring public, and into those of either: 1) management backed by private capital, or 2) larger companies that can capture strategic benefits. Either remedy breathes new life into these companies by providing cheaper sources of capital, and by shifting the focus away from quarterly EPS to long-term growth.

Increasing M&A activity

The market had not entirely missed the value proposition. M&A in the small cap sector was increasing in terms of price and number of transactions:

Darwin’s Darlings

Donoghue, Murphy and Buckley argued that the value proposition presented by these good-but-orphaned companies, which they called “Darwin’s darlings,” presented an attractive opportunity, described as follows:

Despite the acceleration of orphaned public company acquisitions in 1997 and 1998, there remains a very large universe of attractive public small cap firms. We sifted through the public markets, focusing on the $50-250 million market capitalization range, to construct a list of the most appealing companies. We narrowed our search by eliminating certain non-industrial sectors and ended up with over 1500 companies.

We analyzed their valuations relative to the S&P 500. The disparity is so wide that the typical S&P 500 company could pay a 50% premium to acquire the average small cap in this group without incurring earnings dilution. Those dynamics appear to be exactly what is driving small cap takeover values. The median EBIT multiple paid for small caps in 1998 was roughly equal to where the typical S&P 500 trades.

We honed in on those companies with multiples that are positive, but even more deeply discounted at less than 50% of the S&P 500. Finally, we selected only those with compounded annual EBIT growth of over 10% for the past five years. As shown in Exhibit VII, these 110 companies,“Darwin’s Darlings,” have a median valuation of only 5.8 times EBIT despite a compounded annual growth rate in EBIT of over 30% for the past five years.

The emergence of activists

Donoghue, Murphy and Buckley identified the holders of many of these so-called “Darwin’s darlings” as “small cap investment funds focused on likely take-over targets:”

As detailed in the description of our “Darwin’s Darlings” in Exhibit VIII, management ownership varies widely among these companies. For recent IPOs of family-held businesses, management stakes are generally high. For those that were corporate spin-offs, management ownership tends to be low. We frequently find large blocks of these stocks held by small cap investment funds focused on likely take-over targets, leading to a surprisingly high percentage of total insider ownership (management plus holders of more than 5%).

Regardless of ownership structure, these companies typically have the customary defensive mechanisms in place. They are also protected by the fact that they are so thinly traded. In most cases it takes more than six months to accumulate a 5% position in the stock without moving the market. Hence, we expect virtually all acquisitions in this sector to be friendly. There is no question that some very attractive targets cannot be acquired on a friendly basis. However, coercing these companies into a change of control means being prepared to launch a full proxy fight and tender offer.

In When Wall Street Scorns Good Companies, a Fortune magazine article from October 2000, writer Geoffrey Colvin asked of Darwin’s darlings, “So why are all these firms still independent?”

The answer may lie in another fact about them: On average, insiders own half their shares. When the proportion is that high, the insiders are most likely founders; they have enough stock to fend off any hostile approach, and they haven’t sold because they aren’t ready to give up control. Not many outside investors want to go along for that ride. Thus, low prices.

But there’s still a logical problem. Since the companies are so cheap, why don’t managers buy the shares they don’t already own– take the company private at today’s crummy multiple, then sell the whole shebang at an almost guaranteed higher price? Going private has in fact become more popular than ever, but what seems most striking is how rare it remains. Of Piper Jaffray’s 1999 Darwin’s Darlings– 110 companies–only three went private in the following 12 months. That makes perfect sense if you figure that many of the outfits are run by owner-managers whose top priority is keeping control. Announce a going-private transaction and you put the company in play, and even a chummy board may feel obliged to honor its fiduciary duty if a higher bid comes along.

Thus we reach the somewhat ugly truth about Wall Street’s orphaned stars: Many of them (not all) like things the way they are–that is, they like staying in control. The outsider owners are typically a diffuse bunch in no position to put heat on the controlling insiders. The stock price may be lousy, but when the owner-managers decide to sell–that is, to get out of the way–it will almost certainly rise handsomely, as it did for the 19 of last year’s Darwin’s Darlings that have since sold.

So shed no tears for these scorned companies, and don’t buy their shares without a deep understanding of what the majority owners have in mind. In theory the spreading corporate governance movement ought to protect you; in practice the shareholder activists have bigger fish to fry. Such circumstances may keep share prices down, but that’s the owner-managers’ problem. At least, in this case, the market isn’t so mysterious after all.

I believe that the third paragraph above best describes the reason for the emergence of the activists in the small cap sector. Observing that stock prices rose dramatically when owner-managers of “Wall Street’s orphaned stars” decided to sell, and outside investors were “typically a diffuse bunch in no position to put heat on the controlling insiders,” activist investors saw the obvious value proposition and path to a catalyst and entered the fray. This led to a golden decade for activist investing in the small cap sector, one that I think is unlikely to be repeated in the next decade. Regardless, it’s an interesting strategy, and an obvious extension for an investor focussed on small capitalization stocks and activist targets.

*Donoghue, Murphy and Buckley in 2002 founded Discovery Group, a fund manager and M&A advisory that takes significant ownership stakes (up to 20%) in companies trading at a discount to “fundamental economic value.”

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Doctorin’ the Tractatus

Posted in About, Stocks, Value Investment, Warren Buffett, tagged , on March 8, 2010| 2 Comments »

When I started out investing I summarized Warren Buffett’s letters to shareholders into a document I jokingly called the “Tractatus Logico-Valere.” The title, Latin errors aside, was intended to be an homage to Ludwig Wittgenstein’s Tractatus Logico-Philosophicus (which, according to Wikipedia, may in turn have been an homage to the Tractatus Theologico-Politicus by Baruch Spinoza). The idea was to create a comprehensive summary of Buffett’s investment process set out in a succinct, logical fashion. I kept Wittgenstein’s seventh and final proposition – “Whereof one cannot speak, thereof one must be silent” – as my own and interpreted it to mean “where you can’t value something, don’t invest” or “stay in your circle of competence.” My Tractatus wasn’t very good, and I’m not Warren Buffett’s shoelace. Consequently, I didn’t do very well with it. (Wittgenstein was not similarly burdened with self-doubt. Wikipedia says that he concluded that with his Tractatus he had resolved all philosophical problems, and upon its publication retired to become a schoolteacher in Austria.) My abortive experience attempting to create a comprehensive guide to earnings and growth-based investing has given me a great appreciation for those who are able to successfully create such a document and live by it. One investor who has done so is setting out his process for the world to see at The Fallible Investor.

The author of The Fallible Investor is a private investor who has “previously worked for a private hedge fund in Bermuda and Bankers Trust in Sydney, Australia.” He calls himself The Fallible Investor because he “often makes errors when he invests, and says, “Recognising such a weakness is also useful. As Taleb says:

Soros… knew how to handle randomness, by keeping a critical open mind and changing his opinions with minimal shame… he walked around calling himself fallible, but was so potent because he knew it while others had loftier ideas about themselves. He understood Popper. He lived the Popperian life.

I have found particularly useful his elucidation of the linkage between return-on-invested-capital, market value, replacement value, and sustainable competitive advantage:

I define the replacement value of a business as what the business’s assets would be worth if it’s ROIC was equal to its cost of capital.

The market value of a business with a high ROIC and no sustainable competitive advantage should (assuming the market eventually prices a business at its intrinsic value[1]) fall to its replacement value. This should happen because if an incumbent business has a high ROIC, and no sustainable competitive advantage, other businesses will enter this industry, or expand within the industry, to seek these higher returns. These competitors will drive down the incumbent business’s profits until its ROIC declines to the average return of a commodity business. Once this occurs, the incumbent business can only be worth the cost of replacing the business’s assets.

Professor Greenwald has another way of describing this process. He points out that if an incumbent business, with no competitive advantage, has a replacement value of $100 million and its market value is $200 million[2], competitors will drive its market value down to $100 million. Competitors will calculate that by spending $100 million to reproduce the assets of that business they can also create an enterprise with a market value higher than $100 million. These competitors will think, correctly, there is no reason for why they should have a different economic experience from the incumbent because there is nothing it can do that they cannot. Remember the incumbent business has no sustainable competitive advantage. Competitors, by reproducing the assets of the incumbent business, will increase the supply of products or services in the industry. There will now be more competition for the same business. Either prices will fall or, for differentiated products, each producer will sell fewer units. In both cases, the incumbent’s profits will decline and the market value of its business will decline with them. This process, capacity continuing to expand, and the profits and the market value of the incumbent’s business falling, will continue until the incumbent’s market value falls to the replacement value of its assets ($100 million). Its competitors will suffer the same fate.

Greenwald points out that while this process does not happen smoothly or automatically it will eventually turn out this way. It happens because the incentives for businesspeople to take advantage of the market’s excessive valuation of the incumbent’s business are too powerful.[3]

The market value of a business with a sustainable competitive advantage can, by contrast, stay much higher than its replacement value simply because it can sustain a high ROIC.

[1] The intrinsic value of a business is what I think the business is worth to a rational businessperson.

[2] Assuming the business has a high market value because it has a high ROIC.

[3] P38, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.

The Fallible Investor has provided me with a full copy of his notes. I highly recommend following his posts as he sets out his investment process on the site.

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Seth Klarman’s Twenty Investment Lessons of 2008

Posted in About, Seth Klarman, Value Investment, tagged , on March 5, 2010| 2 Comments »

Seth Klarman’s teachings, which I’ve covered on this site on several occasions (see, for example, Klarman on calculating liquidation value, on identifying catalysts, and on investing in liquidations), are always worth reading. In his most recent investor letter Klarman has provided a list of twenty investment lessons of 2008 (via the always superb Zero Hedge):

  1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
  2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
  3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
  4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
  5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
  6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
  7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
  8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
  9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
  10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
  11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
  12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
  13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
  14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
  15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
  16. Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
  17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
  18. When a government official says a problem has been “contained,” pay no attention.
  19. The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
  20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

See also Klarman’s False Lessons of 2009.

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Dr. Michael Burry and The Greatest Trade Ever

Posted in About, Stocks, Value Investment, tagged , , on March 2, 2010| 12 Comments »

Michael Burry is a value investor notable for being one of the first, if not the first, to short sub-prime mortgage bonds in his fund, Scion Capital. He figures prominently in the Gregory Zuckerman’s book, The Greatest Trade Ever, and also in The Big Short, Michael Lewis’s contribution to the sub-prime mortgage bond market crash canon. In Betting on the Blind Side, Lewis excerpts The Big Short, which describes Burry’s short position in some detail, how he figured out that the bonds were mispriced, and how he bet against them (no small effort because the derivatives to do so didn’t exist when he started looking for them. He had to “prod the big Wall Street firms to create them.”).

Here Lewis describes Burry’s entry into value investing:

Late one night in November 1996, while on a cardiology rotation at Saint Thomas Hospital, in Nashville, Tennessee, he logged on to a hospital computer and went to a message board called techstocks.com. There he created a thread called “value investing.” Having read everything there was to read about investing, he decided to learn a bit more about “investing in the real world.” A mania for Internet stocks gripped the market. A site for the Silicon Valley investor, circa 1996, was not a natural home for a sober-minded value investor. Still, many came, all with opinions. A few people grumbled about the very idea of a doctor having anything useful to say about investments, but over time he came to dominate the discussion. Dr. Mike Burry—as he always signed himself—sensed that other people on the thread were taking his advice and making money with it.

Once he figured out he had nothing more to learn from the crowd on his thread, he quit it to create what later would be called a blog but at the time was just a weird form of communication. He was working 16-hour shifts at the hospital, confining his blogging mainly to the hours between midnight and three in the morning. On his blog he posted his stock-market trades and his arguments for making the trades. People found him. As a money manager at a big Philadelphia value fund said, “The first thing I wondered was: When is he doing this? The guy was a medical intern. I only saw the nonmedical part of his day, and it was simply awesome. He’s showing people his trades. And people are following it in real time. He’s doing value investing—in the middle of the dot-com bubble. He’s buying value stocks, which is what we’re doing. But we’re losing money. We’re losing clients. All of a sudden he goes on this tear. He’s up 50 percent. It’s uncanny. He’s uncanny. And we’re not the only ones watching it.”

Mike Burry couldn’t see exactly who was following his financial moves, but he could tell which domains they came from. In the beginning his readers came from EarthLink and AOL. Just random individuals. Pretty soon, however, they weren’t. People were coming to his site from mutual funds like Fidelity and big Wall Street investment banks like Morgan Stanley. One day he lit into Vanguard’s index funds and almost instantly received a cease-and-desist letter from Vanguard’s attorneys. Burry suspected that serious investors might even be acting on his blog posts, but he had no clear idea who they might be. “The market found him,” says the Philadelphia mutual-fund manager. “He was recognizing patterns no one else was seeing.”

Lewis discusses Burry’s perspective on value investing:

“The late 90s almost forced me to identify myself as a value investor, because I thought what everybody else was doing was insane,” he said. Formalized as an approach to financial markets during the Great Depression by Benjamin Graham, “value investing” required a tireless search for companies so unfashionable or misunderstood that they could be bought for less than their liquidation value. In its simplest form, value investing was a formula, but it had morphed into other things—one of them was whatever Warren Buffett, Benjamin Graham’s student and the most famous value investor, happened to be doing with his money.

Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied Buffett, the less he thought Buffett could be copied. Indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual. “If you are going to be a great investor, you have to fit the style to who you are,” Burry said. “At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules.… I also immediately internalized the idea that no school could teach someone how to be a great investor. If it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.”

Investing was something you had to learn how to do on your own, in your own peculiar way. Burry had no real money to invest, but he nevertheless dragged his obsession along with him through high school, college, and medical school. He’d reached Stanford Hospital without ever taking a class in finance or accounting, let alone working for any Wall Street firm. He had maybe $40,000 in cash, against $145,000 in student loans. He had spent the previous four years working medical-student hours. Nevertheless, he had found time to make himself a financial expert of sorts. “Time is a variable continuum,” he wrote to one of his e-mail friends one Sunday morning in 1999: “An afternoon can fly by or it can take 5 hours. Like you probably do, I productively fill the gaps that most people leave as dead time. My drive to be productive probably cost me my first marriage and a few days ago almost cost me my fiancée. Before I went to college the military had this ‘we do more before 9am than most people do all day’ and I used to think I do more than the military. As you know there are some select people that just find a drive in certain activities that supersedes everything else.” Thinking himself different, he didn’t find what happened to him when he collided with Wall Street nearly as bizarre as it was.

And I love this story about his fund:

In Dr. Mike Burry’s first year in business, he grappled briefly with the social dimension of running money. “Generally you don’t raise any money unless you have a good meeting with people,” he said, “and generally I don’t want to be around people. And people who are with me generally figure that out.” When he spoke to people in the flesh, he could never tell what had put them off, his message or his person. Buffett had had trouble with people, too, in his youth. He’d used a Dale Carnegie course to learn how to interact more profitably with his fellow human beings. Mike Burry came of age in a different money culture. The Internet had displaced Dale Carnegie. He didn’t need to meet people. He could explain himself online and wait for investors to find him. He could write up his elaborate thoughts and wait for people to read them and wire him their money to handle. “Buffett was too popular for me,” said Burry. “I won’t ever be a kindly grandfather figure.”

This method of attracting funds suited Mike Burry. More to the point, it worked. He’d started Scion Capital with a bit more than a million dollars—the money from his mother and brothers and his own million, after tax. Right from the start, Scion Capital was madly, almost comically successful. In his first full year, 2001, the S&P 500 fell 11.88 percent. Scion was up 55 percent. The next year, the S&P 500 fell again, by 22.1 percent, and yet Scion was up again: 16 percent. The next year, 2003, the stock market finally turned around and rose 28.69 percent, but Mike Burry beat it again—his investments rose by 50 percent. By the end of 2004, Mike Burry was managing $600 million and turning money away. “If he’d run his fund to maximize the amount he had under management, he’d have been running many, many billions of dollars,” says a New York hedge-fund manager who watched Burry’s performance with growing incredulity. “He designed Scion so it was bad for business but good for investing.”

Thus when Mike Burry went into business he disapproved of the typical hedge-fund manager’s deal. Taking 2 percent of assets off the top, as most did, meant the hedge-fund manager got paid simply for amassing vast amounts of other people’s money. Scion Capital charged investors only its actual expenses—which typically ran well below 1 percent of the assets. To make the first nickel for himself, he had to make investors’ money grow. “Think about the genesis of Scion,” says one of his early investors. “The guy has no money and he chooses to forgo a fee that any other hedge fund takes for granted. It was unheard of.”

Hat tip Bo.

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Why are we so clueless about the stock market?

Posted in About, Stocks, Value Investment, tagged on February 3, 2010| 1 Comment »

Mariusz Skonieczny is the founder and president of Classic Value Investors LLC and runs the Classic Value Investors website. He has provided me with a copy of his book Why Are We So Clueless about the Stock Market? Learn How to Invest Your Money, How to Pick Stocks, and How to Make Money in the Stock Market and has asked me to review it for the site. I am happy to do so.

Mariusz says that the purpose of this book is to “help readers understand the basics of stock market investing:”

Material covered includes the difference between stocks and businesses, what constitutes a good business, when to buy and sell stocks, and how to value individual stocks. The book also includes a chapter covering four case studies as well as a supplemental chapter on the pros and cons of real estate versus stock market investing.

The book discusses the basics of valuation through return on equity, how to identify a “good” businesses with sustainable competitive advantages (moats), diversification, how to understand the capital structure, and the implications of the economy for the business analyzed. Most usefully, Mariusz also discusses how to analyze an investment and provides several case studies discussing his methodology. In my opinion, the book is an excellent introduction to Buffett-style investing, and I would recommend it to investors seeking “wonderful companies at a fair price.”

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