Posts Tagged ‘Value Investment’

Yesterday I discussed Michael Mauboussin’s December 2007 Mauboussin on Strategy, “Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It,” (.pdf) about Mauboussin’s research on the tendency of return on invested capital (ROIC) to revert to the mean.

Mauboussin’s report has three broad conclusions, with significant implications for modelling:

  • Reversion to the mean is a powerful force. As has been well documented by numerous studies, ROIC reverts to the cost of capital over time. This finding is consistent with microeconomic theory, and is evident in all time periods researchers have studied. However, investors and executives should be careful not to over interpret this result because reversion to the mean is evident in any system with a great deal of randomness. We can explain much of the mean reversion series by recognizing the data are noisy.
  • Persistence does exist. Academic research shows that some companies do generate persistently good, or bad, economic returns. The challenge is finding explanations for that persistence, if they exist.
  • Explaining persistence. It’s not clear that we can explain much persistence beyond chance. But we investigated logical explanatory candidates, including growth, industry representation, and business models. Business model difference appears to be a promising explanatory factor.

How to identify ROIC persistence ex ante

The goal of the investor is to identify businesses with future, sustainable, high ROIC. Mauboussin explores three variables that might be predictive of such persistent high ROIC: corporate growth, the industry in which a company competes, and the company’s business model.

Corporate growth

Mauboussin identifies some correlation between growth and persistence, but cautions:
The bad news about growth, especially for modelers, is it is extremely difficult to forecast. While there is some evidence for sales persistence, the evidence for earnings growth persistence is scant. As some researchers recently summarized, “All in all, the evidence suggests that the odds of an investor successfully uncovering the next stellar growth stock are about the same as correctly calling coin tosses.” 16


Mauboussin finds that industries that are overrepresented in the highest return quintile throughout the measured period are also overrepresented in the lowest quintile. Those industries include pharmaceuticals/biotechnology and software. He concludes that positive, sustainable ROICs emerge from a good strategic position within a generally favorable industry.

Business model

This is perhaps the most useful and interesting variable considered by Mauboussin. He relates Michael Porter’s two sources of competitive advantage – differentiation and low-cost production – to ROIC by breaking ROIC into its two prime components, net operating profit after tax (NOPAT) margin and invested capital turnover (NOPAT margin equals NOPAT/sales, and invested capital turnover equals sales/invested capital. ROIC is the product of NOPAT margin and invested capital turnover.):

Generally speaking, differentiated companies with a consumer advantage generate attractive returns mostly via high margins and modest invested capital turnover. Consider the successful jewelry store that generates large profits per unit sold (high margins) but doesn’t sell in large volume (low turnover). In contrast, a low-cost company with a production advantage will generate relatively low margins and relatively high invested capital turnover. Think of a classic discount retailer, which doesn’t make much money per unit sold (low margins) but enjoys great inventory velocity (high turnover). Exhibit 8 consolidates these ideas in a simple matrix.

Mauboussin examined the 42 companies that stayed in the first quintile throughout the measured period to see whether they leaned more toward a consumer or production advantage:

Not surprisingly, this group outperformed the broader sample on both NOPAT margin and invested capital turnover, but the impact of margin differential (2.4 times the median) was greater on ROIC than the capital turnover differential (1.9 times). While equivocal, these results suggest the best companies may have a tilt toward consumer advantage.

An analysis of the poor performers reveals that they posted NOPAT margins and invested capital turnover “symmetrical” with the high-performing companies i.e. below the full sample’s median.

Mauboussin concludes:

Our search for factors that may help us anticipate persistently superior performance leaves us little to work with. We do know persistence exists, and that companies that sustain high returns over time start with high returns. Operating in a good industry with above-average growth prospects and some consumer advantage also appears correlated with persistence. Strategy experts Anita McGahan and Michael Porter sum it up: 22

It is impossible to infer the cause of persistence in performance from the fact that persistence occurs. Persistence may be due to fixed resources, consistent industry structure, financial anomalies, price controls, or many other factors that endure . . . In sum, reliable inferences about the cause of persistence cannot be generated from an analysis that only documents whether or not persistence occurred.

More to come.

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In Michael Mauboussin’s December 2007 Mauboussin on Strategy, “Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It,” (.pdf) Mauboussin provides a tour de force of data on the tendency of return on invested capital (ROIC) to revert to the mean. Much of my investing to date has been based on the naive assumption that the tendency is so powerful that companies with a high ROIC should be avoided because the high ROIC is not sustainable, but rather indicates a cyclical top in margins and earnings. This view is broadly supported by other research on mean reversion in earnings that I have discussed in the past, which has suggested, somewhat counter-intuitively, that in aggregate the earnings of low price-to-book value stocks grow faster than the earnings of high price-to-book value stocks. I usually cite this table from the Tweedy Browne What works in investing document:


In the four years after the date of selection, the earnings of the companies in the lowest price-to-book value quintile (average price-to-book value of 0.36) increase 24.4%, more than the companies in the highest price-to-book value quintile (average price-to-book value of 3.42), whose earnings increased only 8.2%. DeBondt and Thaler attribute the earnings outperformance of the companies in the lowest quintile to mean reversion, which Tweedy Browne described as the observation that “significant declines in earnings are followed by significant earnings increases, and that significant earnings increases are followed by slower rates of increase or declines.”

Mauboussin’s research seems to suggest that, while there exists a strong tendency towards mean reversion, some companies do “post persistently high or low returns beyond what chance dictates.” He has two caveats for those seeking the stocks with persistent high returns:

1. The “ROIC data incorporate much more randomness than most analysts realize.”

2. He “had little luck in identifying the factors behind sustainably high returns.”

That said, Mauboussin presents some striking data about “persistence” in high ROIC companies that suggests investing in high ROIC companies is not necessarily a short ride to the poor house, and might actually work as an investment strategy. (That was very difficult to write. It goes against every fiber of my being.) Here’s Mauboussin’s research:

Mauboussin’s report has three broad conclusions, with significant implications for modelling:

  • Reversion to the mean is a powerful force. As has been well documented by numerous studies, ROIC reverts to the cost of capital over time. This finding is consistent with microeconomic theory, and is evident in all time periods researchers have studied. However, investors and executives should be careful not to over interpret this result because reversion to the mean is evident in any system with a great deal of randomness. We can explain much of the mean reversion series by recognizing the data are noisy.
  • Persistence does exist. Academic research shows that some companies do generate persistently good, or bad, economic returns. The challenge is finding explanations for that persistence, if they exist.
  • Explaining persistence. It’s not clear that we can explain much persistence beyond chance. But we investigated logical explanatory candidates, including growth, industry  representation, and business models. Business model difference appears to be a promising explanatory factor.

ROIC mean reversion

Here Mauboussin charts the reversion-to-the-mean phenomenon using data from “1000 non-financial companies from 1997 to 2006.” The chart shows a clear trend towards nil economic profit, as you would expect:

We start by ranking companies into quintiles based on their 1997 ROIC. We then follow the median ROIC for the five cohorts through 2006. While all of the returns do not settle at the cost of capital (roughly eight percent) in 2006, they clearly migrate toward that level.

And another chart showing the change:

Mauboussin has this elegant interpretation of the results:

Any system that combines skill and luck will exhibit mean reversion over time. 7 Francis Galton demonstrated this point in his 1889 book, Natural Inheritance, using the heights of adults. 8 Galton showed, for example, that children of tall parents have a tendency to be tall, but are often not as tall as their parents. Likewise, children of short parents tend to be short, but not as short as their parents. Heredity plays a role, but over time adult heights revert to the mean.

The basic idea is outstanding performance combines strong skill and good luck. Abysmal performance, in contrast, reflects weak skill and bad luck. Even if skill persists in subsequent periods, luck evens out across the participants, pushing results closer to average. So it’s not that the standard deviation of the whole sample is shrinking; rather, luck’s role diminishes over time.

Separating the relative contributions of skill and luck is no easy task. Naturally, sample size is crucial because skill only surfaces with a large number of observations. For example, statistician Jim Albert estimates that a baseball player’s batting average over a full season is a fifty-fifty combination between skill and luck. Batting averages for 100 at-bats, in contrast, are 80 percent luck. 9

Persistence in ROIC Data

“Persistence” is the likelihood a company will sustain its ROIC. If the stocks are ranked on the basis of ROIC and then placed into quintiles, persistence is likliehood that a stock will remain in the same quintile throughout the measured time frame. Mauboussin then measures persistence by analysing “quintile migration:”

This exhibit shows where companies starting in one quintile (the vertical axis) ended up after nine years (the horizontal axis). Most of the percentages in the exhibit are unremarkable, but two stand out. First, a full 41 percent of the companies that started in the top quintile were there nine years later, while 39 percent of the companies in the cellar-dweller quintile ended up there. Independent studies of this persistence reveal a similar pattern. So it appears there is persistence with some subset of the best and worst companies. Academic research confirms that some companies do show persistent results. Studies also show that companies rarely go from very high to very low performance or vice versa. 13

These are striking findings. In Mauboussin’s data, there was a 64% chance that a company in the highest quintile at the start of the period was still in the first or second quintile at the end of the 10 year period. Further, it seems that there is a three-in-four chance that the high quintile stocks don’t fall into the lowest or second lowest quintiles after 10 years. It’s not all good news however.

Before going too far with this result, we need to consider two issues. First, this persistence analysis solely looks at where companies start and finish, without asking what happens in between. As it turns out, there is a lot of action in the intervening years. For example, less than half of the 41 percent of the companies that start and end in the first quintile stay in the quintile the whole time. This means that less than four percent of the total-company sample remains in the highest quintile of ROIC for the full nine years.

The second issue is serial correlation, the probability a company stays in the same ROIC quintile from year to year. As Exhibit 5 suggests, the highest serial correlations (over 80 percent) are in Q1 and Q5. The middle quintile, Q3, has the lowest correlation of roughly 60 percent, while Q2 and Q4 are similar at about 70 percent.

This result may seem counterintuitive at first, as it suggests results for really good and really bad companies (Q1 and Q5) are more likely to persist than for average companies (Q2, Q3, and Q4). But this outcome is a product of the methodology: since each year’s sample is broken into quintiles, and the sample is roughly normally distributed, the ROIC ranges are much narrower for the middle three quintiles than for the extreme quintiles. So, for instance, a small change in ROIC level can move a Q3 company into a neighboring quintile, whereas a larger absolute change is necessary to shift a Q1 and Q5 company. Having some sense of serial correlations by quintile, however, provides useful perspective for investors building company models.

So, in summary, better performed companies remain in the higher ROIC quintiles over time, although the better-performed quintiles will still suffer substantial ROIC attrition over time.

More to come.

Hat tip Fallible Investor.

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In March I highlighted an investment strategy I first read about in a Spring 1999 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, simply stated, is to identify undervalued small capitalization stocks lacking a competitive auction for their shares where a catalyst in the form of a merger or buy-out might emerge to close the value gap. I believe the strategy is a natural extension for Greenbackd, and so I’ve been exploring it over the last month.

Donoghue, Murphy and Buckley followed up their initial Wall Street’s Endangered Species research report with two updates, which I recalled were each called “Endangered Species Update” and discussed the returns from the strategy. While I initially believed that those follow-up reports were lost to the sands of time, I’ve been excavating my hard-copy files and found them, yellowed, and printed on papyrus with a dot matrix 9-pin stylus. I’ve now resurrected both, and I’ll be running them today and tomorrow.

In the first follow-up, Endangered species update: The extinct, the survivors, and the new watch list (.pdf), 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.

As for the original class of 1999, the authors concluded:

About half of the Darwin’s Darlings pursued some significant strategic alternative during the year. A significant percentage (19 of the companies) 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, about half of the 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, more likely, a liquidity event at some later date. The path chosen clearly had a significant impact on shareholder value.

Here’s the summary table:

There are several fascinating aspects to their analysis. First, they looked at the outstanding performance of the sellers:

The 19 companies that pursued a sale easily outperformed the Russell 2000 and achieved an average premium of 51.4% to their 4-week prior share price. The vast majority of transactions were sales to strategic buyers who were able to pay a handsome premium to the selling shareholders. In general, the acquirers were large cap public companies. By simply valuing the profits of a Darwin’s Darling at their own market multiple, these buyers delivered a valuation to selling shareholders that far exceeded any share price the company might have independently achieved. Note in the summary statistics below that the average deal was at an EBIT multiple greater than 10x.

Here’s the table:

Second, they considered the low proportion of sellers who went private, rather than sold out to a strategic acquirer, and likely causes:

Only three of the Darwin’s Darlings announced a going-private transaction. At first glance, this is a surprisingly small number given the group’s low trading multiples and ample debt capacity. With private equity firms expressing a very high level of interest in these transactions, one might have expected more activity.

Why isn’t the percentage higher? In our opinion, it is a mix of economic reality and an ironic impact of corporate governance requirements. The financial sponsors typically involved in taking a company private are constrained with respect to the price they can pay for a company. With limits on prudent debt levels and minimum hurdle rates for equity investments, the typical financial engineer quickly reaches a limit on the price he can pay for a company. As a result, several factors come into play:

• A Board will typically assume that if a “financial” buyer is willing to pay a certain price, a “strategic” buyer must exist that can pay more.

• Corporate governance rules are usually interpreted to mean that a Board must pursue the highest price possible if a transaction is being evaluated.

• Management is reluctant to initiate a going-private opportunity for fear of putting the Company “in play.”

• Financial buyers and management worry that an unwanted, strategic “interloper” can steal a transaction away from them when the Board fulfills its fiduciary duty.

In light of the final two considerations, which benefit only management, it’s not difficult to understand why activists considered this sector of the market ripe for picking, but I digress.

Third, they analyzed the performance of companies repurchasing shares:

To many of the Darwin’s Darlings, their undervaluation was perceived as a buying opportunity. Twenty companies announced a share repurchase, either through the open market, or through more formalized programs such as Dutch Auction tender offers (see our M&A Insights: “What About a Dutch Auction?” April 2000).

As we expected, these repurchases had little to no impact on the companies’ share prices. The signaling impact of their announcement was minimal, since few analysts or investors were listening, and the buying support to the share price was typically insignificant. Furthermore, the decrease in shares outstanding served only to exacerbate trading liquidity challenges. From announcement date to present, these 20 companies as a group have underperformed the Russell 2000 by 17.5%.

For many of the Darlings and other small cap companies the share repurchase may still have been an astute move. While share prices may not have increased, 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 should reap the benefit of the repurchase program. Furthermore, the Company may have accommodated sellers desiring to exit their investment, thereby eliminating potentially troublesome, dissenting shareholders.

One such company repurchasing shares will be familiar to anyone who has followed Greenbackd for a while: Chromcraft Revington, Inc., (CRC:AMEX), which I entered as a sickly net net and exited right before it went up five-fold. (It’s worth noting that Jon Heller of Cheap Stocks got CRC right, buying just after I sold and making out like a bandit. I guess you can’t win ’em all.) Murphy and Buckley cite CRC as an abject lesson in why buy-backs don’t work for Darwin’s Darlings:

I’m not entirely sure that the broader conclusion is a fair one. Companies shouldn’t repurchase shares to goose share prices, but to enhance underlying intrinsic value in the hands of the remaining shareholders. That said, in CRC’s case, the fact that it went on to raise capital at a share price of ~$0.50 in 2009 probably means that their conclusion in CRC’s case was the correct one.

And what of the remainder:

About half of the Darwin’s Darlings stayed the course and did not announce any significant event over the past year. Another 18 sought and consummated an acquisition of some significant size. While surely these acquisitions had several strategic reasons, they were presumably pursued in part to help these companies grow out of their small cap valuation problems. Larger firms will, in theory, gain more recognition, additional liquidity, and higher valuations. However, for both the acquirers and the firms without any deal activity, the result was largely the same: little benefit for shareholders was provided.

Management teams and directors of many small cap companies have viewed the last few years as an aberration in the markets. “Interest in small caps will return” is a common refrain. We disagree, and our statistics prove us right thus far. Without a major change, we believe the shares of these companies will continue to meander. For the 53 Darwin’s Darlings that did not pursue any major activity in the last year, 80% are still below their 1998 high and 60% have underperformed the Russell 2000 over the last year. These are results, keep in mind, for some of the most attractive small cap firms.

This is the fabled “two-tier” market beloved by value investors. While everyone else was chasing dot coms and large caps, small cap companies with excellent fundamentals were lying around waiting to be snapped up. The authors concluded:

The public markets continue to ignore companies with a market capitalization below $250 million. Most institutional investors have large amounts of capital to invest and manage, and small caps have become problematic due to their lack of analyst coverage and minimal public float. As a result, these “orphans” of the public markets are valued at a significant discount to the remainder of the market. We do not see this trend reversing, and therefore recommend an active approach to the directors and management teams at most small cap companies. Without serious consideration of a sale to a strategic or financial buyer, we believe these companies, despite their sound operating performance, will not be able to deliver value to their shareholders.

Tomorrow, the 2001 Endangered species update.

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In A Crisis In Quant Confidence*, Abnormal Returns has a superb post on Scott Patterson’s recounting in his book The Quants of the reactions of several quantitative fund managers to the massive reversal in 2007:

In 2007 everything seemed to go wrong for these quants, who up until this point in time, had been coining profits.

This inevitably led to some introspection on the part of these investors as they saw their funds take massive performance hits.  Nearly all were forced to reduce their positions and risks in light of this massive drawdown.  In short, these investors were looking at their models seeing where they went wrong.  Patterson writes:

Throttled quants everywhere were suddenly engaged in a prolonged bout of soul-searching, questioning whether all their brilliant strategies were an illusion, pure luck that happened to work during a period of dramatic growth, economic prosperity, and excessive leverage that lifted everyone’s boat.

Here Patterson puts his finger on the question that vexes anyone who has ever invested, made money for a time and then given some back: Does my strategy actually work or have I been lucky? It’s what I like to call The Fear, and there’s really no simple salve for it.

The complicating factor in the application of any investing strategy, and the basis for The Fear, is that even exceptionally well-performed strategies will both underperform the market and have negative periods that can extend for three, five or, on rare occasions, more years. Take, for example, the following back-test of a simple value strategy over the period 2002 to the present. The portfolio consisted of thirty stocks drawn from the Russell 3000 rebalanced daily and allowing 0.5% for slippage:

(Click to enlarge)

The simple value strategy returns a comically huge 2,450% over the 8 1/4 years, leaving the Russell 3000 Index in its wake (the Russell 3000 is up 9% for the entire period). 2,450% over the 8 1/4 years is an average annual compound return of 47%. That annual compound return figure is, however, misleading. It’s not a smooth upward ride at a 47% rate from 100 to 2,550. There are periods of huge returns, and, as the next chart shows, periods of substantial losses:

(Click to enlarge)

From January 2007 to December 2008, the simple value strategy lost 20% of its value, and was down 40% at its nadir. Taken from 2006, the strategy is square. That’s three years with no returns to show for it. It’s hard to believe that the two charts show the same strategy. If your investment experience starts in a down period like this, I’d suggest that you’re unlikely to use that strategy ever again. If you’re a professional investor and your fund launches into one of these periods, you’re driving trucks. Conversely, if you started in 2002 or 2009, your returns were excellent, and you’re genius. Neither conclusion is a fair one.

Abnormal Returns says of the correct conclusion to draw from performance:

An unexpectedly large drawdown may mark the failure of the model or may simply be the result of bad luck. The fact is that the decision will only be validated in hindsight. In either case it represents a chink in the armor of the human-free investment process. Ultimately every portfolio is run by a (fallible) human, whether they choose to admit it or not.

In this respect quantitative investing is not unlike discretionary investing. At some point every investor will face the choice of continuing to use their method despite losses or choosing to modify or replace the current methodology. So while quantitative investing may automate much of the investment process it still requires human input. In the end every quant model has a human with their hand on the power plug ready to pull it if things go badly wrong.

At an abstract, intellectual level, an adherence to a philosophy like value – with its focus on logic, discipline and character – alleviates some of the pain. Value answers the first part of the question above, “Does my strategy actually work?” Yes, I believe value works. The various academic studies that I’m so fond of quoting (for example, Value vs Glamour: A Global Phenomenon and Contrarian Investment, Extrapolation and Risk) confirm for me that value is a real phenomenon. I acknowledge, however, that that view is grounded in faith. We can call it logic and back-test it to an atomic level over an eon, but, ultimately, we have to accept that we’re value investors for reasons peculiar to our personalities, and not because we’re men and women of reason and rationality. It’s some comfort to know that greater minds have used the philosophy and profited. In my experience, however, abstract intellectualism doesn’t keep The Fear at bay at 3.00am. Neither does it answer the second part of the question, “Am I a value investor, or have I just been lucky?”

As an aside, whenever I see back-test results like the ones above (or like those in the Net current asset value and net net working capital back-test refined posts) I am reminded of Marcus Brutus’s oft-quoted line to Cassius in Shakespeare’s Julius Caesar:

There is a tide in the affairs of men,

Which, taken at the flood, leads on to fortune;

Omitted, all the voyage of their life

Is bound in shallows and in miseries.

As the first chart above shows, in 2002 or 2009, the simple value strategy was in flood, and lead on to fortune. Without those two periods, however, the strategy seems “bound in shallows and in miseries.” Brutus’s line seems apt, and it is, but not for the obvious reason. In the scene in Julius Caesar from which Brutus’s line is drawn, Brutus tries to persuade Cassius that they must act because the tide is at the flood (“On such a full sea are we now afloat; And we must take the current when it serves, Or lose our ventures.”). What goes unsaid, and what Brutus and Cassius discover soon enough, is that a sin of commission is deadlier than a sin of omission. The failure to take the tide at the flood leads to a life “bound in shallows and in miseries,” but taking the tide at the flood sometimes leads to death on a battlefield. It’s a stirring call to arms, and that’s why it’s quoted so often, but it’s worth remembering that Brutus and Cassius don’t see the play out.

* Yes, the link is to classic.abnormalreturns. I like my Abnormal Returns like I like my Coke.

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In a post in late November last year, Testing the performance of price-to-book value, I set up a hypothetical equally-weighted portfolio of the cheapest price-to-book stocks with a positive P/E ratio discovered using the Google Screener, which I called the “Greenbackd Contrarian Value Portfolio“. The portfolio has been operating for a little over 4 months, so I thought I’d check in and see how it’s going.

Here is the Tickerspy portfolio tracker for the Greenbackd Contrarian Value Portfolio showing how each individual stock is performing:

(Click to enlarge)

And the chart showing the performance of the portfolio against the S&P500:

[Full Disclosure:  No positions. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

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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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Yesterday I highlighted an investment strategy I first read about in a Spring 1999 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. The premise, simply stated, is to identify undervalued small capitalization stocks where a catalyst in the form of a merger or buy-out might emerge to close the value gap. I believe the strategy is a natural extension for Greenbackd, and so I’m going to explore it in some depth over the next few weeks.

The idea is reminiscent of “Super” Mario J. Gabelli’s Private Market Value with a Catalyst methodology, the premise of which is the value of a company “if it is acquired by an informed wealthy family, or by another private or public corporation, as opposed to the price it is trading at in the stock markets. Simply put, it is the intrinsic value of a company plus the control premium:”

To calculate PMV, Gabelli first takes into account the free cash flow (after allowing for depreciation), deducts debt and net options (stock options) and adds back the cash. To this, he then applies an ‘appropriate’ multiple to arrive at the PMV. It sounds simple enough, but where you can go completely wrong is the multiple. Gabelli says he either looks at recent valuations of similar acquisitions or applies an appropriate historical industry acquisition multiple to arrive at the PMV.

“Some of the factors that we look at while deciding multiples to apply are: what the business is going to be worth in five years from now, what kind of return on equity can we get over time, how much further debt can be put on the company, the tax rate and what the company would be worth if there was no growth or at some particular rate (4 or 8 per cent for instance),” he explains. Of course, the multiple – and the PMV – changes over time, as it is a function of interest rates, the capitalisation structure and taxes, all of which have an indirect impact on the value of the franchise.

Donoghue, Murphy and Buckley followed up their initial Wall Street’s Endangered Species research report with two updates, which I recall were each called “Endangered Species Update” and discussed the returns from the strategy. It seems that those follow-up reports are now lost to the sands of time. All that seems to remain is the press release of the final report:

For the last few years, Piper Jaffray has been reporting on the difficulties that small public companies face in today’s equity markets. Since the late 1990s many well run, profitable companies with a market capitalization of less than $250 million have watched their share prices underperform the rest of the stock market. With limited analyst coverage and low trading liquidity, many high-quality small companies are “lost in the shuffle” and trade at significantly lower valuation multiples than larger firms. Since our 1999 report “Wall Street’s Endangered Species,” we have held the position that:

This is a secular, not cyclical, trend and the undervaluation will continue. The best strategic move to increase shareholder value is to pursue a change-of-control transaction. Company management and the Board should either sell their company to a large strategic acquirer with the hope of gaining the buyer’s higher trading multiple, or take the company private.

In the last few of years, many small public companies identified this 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 did follow up the reports in a 2006 article called Is There a Renewed Prospect of Going-Private Transactions? Their conclusion:

Small-Cap Stocks Outperform

Small-cap stocks have experienced a dramatic resurgence over the past five years. With weak performances from large-cap stocks, small-caps have become more favorable investments with better returns and stronger trading multiples. Here is what we have seen:

  • Over the last one-, three- and five-year periods, companies in the Russell 2000 have offered average returns of 21%, 227% and 240%, respectively, compared to S&P 500 companies with average returns of 16%, 89% and 57%, respectively.
  • The valuation gap that we saw five years ago between the bottom two deciles of companies in the Russell 2000 and the S&P 500 no longer exists, with the last two deciles in the Russell trading at only a 3% discount to the median EBIT multiple of S&P 500 companies and a 9% premium over the median P/E multiple.

(Click to embiggen)

Despite the rebound in valuations, small-cap stocks continue to face the same capital market challenges:

  • For companies with market caps between the $50 million and $250 million range, there are approximately 1.3 analysts covering each stock versus 7.7 analysts for companies with market caps of more than $250 million.
  • Trading volumes are slightly higher, with the last three deciles trading an average 202,276, 176,092 and 223,599 shares, respectively, per day, but still significantly below the volume of S&P 500 companies, which trade an average of 4.0 million shares per day.

More to come.

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