Berkshire: Part 2

Berkshire Graph

More commentary on the 2014 Berkshire Letter

Did-warren-buffett-move-the-goalposts-in-the-latest-letter

Berkshire-hathaway-2015-coverage

I enjoyed reading Berkshire -Past, Present and Future, pages 24-28 2014ltr

Mr. Buffett’s anger at Stanton’s chiseling cost dearly because he didn’t sell at the first puff of the “cigar-butt” (Berkshire’s Textile Division). Buffett suffered in a value trap.

Notably, Buffett’s cigar-butt strategy worked well when managing small sums–the best of Buffett’s life in terms of relative and absolute investment performance.  However, cigar-butt investing was not scalable or enduring with larger sums.  Buffett then turned towards buying wonderful businesses at fair prices or, in other words, franchises with honest and able management.

His investment in See’s Candies was a turning point because the company generated high returns on invested capital which Buffett could then redeploy into other businesses.  Note that See’s could only grow profitably within a defined region (Calif.?).  A powerful brand coupled with economies of scale makes for a great business.

Berkshire Today (page 29) provides a description of Conglomerates and the mania that occurred in the 1960s with ponzi-scheme pooling of interests accounting and ever-rising P/E multiples–until the game crashed.

Buffett points out the folly of spin-offs, whereby the owning company loses purported “control-value” without any compensating payment.  Investment bankers and private equity buccaneers were heartily savaged by Mr. Buffett’s pen.

Articles and Videos of Interest

25-old-investor-spurred-lumber  A short-sellers uncovers Lumber Liquidators.

shark-tank-the-speculators-guide-to-junior-mining-investment-session-1-with-rick-rule/  A series of talks on speculating in junior miners.

Back to Deep Value

Before we dig deeper into Chapter Five in Deep Value, I thought we should read Chapter 2 in Quantitative Value so as to not skip over several important points.  I will make sure new students receive a link to the books in the course.

Buffett’s 2014 Letter to Shareholders

buffett

Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”

Comments on the Berkshire Hathaway 2014 letter,  Part 1

Note the plug (page 6) for Where Are the Customers’ Yachts by Fred Schwed. That along with the Money Game by Adam Smith will teach you the ways of Wall Street. Also, see:

Intrinsic Value: Buffett reiterates that it is not a precise number for Berkshire nor, in fact for ANY stock.

GEICO delivers savings to its customers because it is a low-cost operation (source of structural competitive advantage).  The company’s low costs create a moat—an enduring one—that competitors are unable to cross.  Note Buffett’s comment on the animated gecko, a LOW-COST spokesperson.

TESCO

Here’s how he explained it:

“In 2013, I soured somewhat on the company’s then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior “thumb-sucking.” (Considering what my delay cost us, he is being kind.)

“During 2014, Tesco’s problems worsened by the month. The company’s market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.”

Buffett said the dawdling resulted in an after-tax loss of $444 million by the time Berkshire was no longer a Tesco shareholder. That, he added, is about 0.2% of Berkshire’s net worth. Only three times in 50 years has Berkshire recorded losses from a sale equal to more than 1% of its net worth.

Unfortunately, we don’t learn what exactly caused the loss. How did Buffett miscalculate intrinsic value?    Did management worsen, but if so, then how can an investor sidestep that?   I believe the economics changed as customers had more in-home deliveries and other choices coupled with poor store execution from Tesco.  I was disappointed with this explanation of the Tesco loss, but Buffett would reply that it was only 1/5 of 1%.

Nominal vs. Real Returns

During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13 cents in 1965 as measured by the CPI (Flawed or whats wrong with cpi)

I prefer measuring in gold grams, because gold is a store of value and market-based rather than concocted by Federal bureaucrats.DJIA-1900

There is an important message for investors in that disparate performance between stocks and dollars. Think back to our 2011 annual report, in which we defined investing as the transfer to others of purchasing power now with reasoned expectation of receiving more purchasing power–after taxes have been paid on nominal gains—in the future.”   (I wonder why Mr. Buffett makes no mention of the financial repression of ZIRP and NIRP?  It is the elephant in the room because of the devastating effect it has on savers and on calculating discount rates for investment.)

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities—Treasuries, for example—whose values have been tied to American currency. That was also true in the preceding half century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.  Buffett’s comments are backed up by history as shown here:Triumphand triumph_of_the_optimists

Stock prices will always be far more volatile than cash equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments—far riskier investments. Than widely –diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk.  Though this pedagogic assumption makes for easy teaching, it is dead wrong. Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing power terms) than leaving funds in cash-equivalents. That is relevant to certain investors-say, investment banks—whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can—and should—invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

Note the multi-decade horizon. Stocks were unchanged from 1964-1981, please see page 79: A Study of Market History through Graham Babson Buffett and Others.  Read what Buffett has to say about stock markets. Some say it is Time to exit because of high valuations for big-cap stocks in the U.S. market. So even if stocks decline for a decade but your holding period is MULTI-Decade, then hold tight.  Tough to do, but history seems to bear his thesis out: valuing-growth-stocks-revisiting-the-nifty-fifty.  I prefer to act like the pig farmer in A Study of Market History (see link above).

If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risk things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon (to panic) are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).

spx

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary to managers and advisors and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. ….Anything can happen anytime in markets. And no advisor, economist, or TV commentator–and definitely not Charlie nor I–can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.

A plug for Jack Bogle’s The Little Book of Common Sense Investing.  Basically, Buffett is saying keep it simple, think and hold L O N G – T E R M, avoid high fees and commissions, and don’t use leverage. 

Next, let’s look at Berkshire–Past, Present and Future in Part II

ROIC and Reversion to the Mean

Buffett-Indicator

Buffett-Indicator-with-Wilshire-5000

If women ran the world we wouldn’t have wars, just intense negotiations every 28 days. –Robin Williams

Return Measures by Damordaran 2007 (More on ROIC)

REGRESSION TO THE MEAN

This is a key concept to learn along with EV/EBITDA, MCX, and cheapness wins.

REGRESSION TO THE MEAN  A good read by an Australian Graham & Dodd-like Investor.

When an investor turns to the research on regression to the mean and investors overreacting to poor company performance/bad news in Richard Thaler research, he or she sees that prices of the winner and loser portfolios take three-to-seven years to revert.  See also The New Finance: The Case Against Efficient Markets by Robert A. Haugen and Inefficient Markets by Andrei Schleifer.

RTM vs EMT

Illustration by S of Reversion to the Mean

t is it a Goode value

We next progress to Chapter 5: A Clockwork Market, Mean Reversion and the Wheel of Fortune in Deep Value.

From there we will read chapters 3 and 4 in Quantitative Value.

DIA-2002

A Reader Shares Good News; Finishing up Ch. 4

Ego

I couldn’t repair your brakes, so I made your horn louder. –Steven Wright

A Reader shares good news.

Hi John,

Partly motivated by your blog and lectures on value investing, I decided to quit my dead-end Hedge Fund job, and open my own investment management firm, Apatheia Capital. Think Schloss, and early Greenblatt special situations.I intend to use the best from quant and value investing in terms of buying cheap special situation stocks consistently.

So far it has been fun, exciting and anxiety-ridden process, and few friends and family have been misguided to be infected by my optimism. Please keep up the good work!  I cannot stop thinking about my ideas (about ever-present fat tails in special situation value stocks). So far in the process, I have filed for state registrations etc. and finalized a mission document for the firm.

I wish you a great journey. Be flexible and patient. Use your small size to your advantage by going anywhere there is value. Keep good records of your investment journey and keep in touch!

Toby Carlisle Talk:

Recording of Webinar: Portfolio Construction, Concentration and Diversification for Value Investors

Footnotes for Chapter 4 (Deep Value)

Success-equation.com (Mauboussin’s Web-site)

The Relation Between The Enterprise Multiple and Avg Stock Returns 2010 more research on the efficacy of using the enterprise multiple as an indicator of value.  Remember to adjust for normalization because at the top of a cycle you will see low EV to EBITDA (like in housing circa 2005/06) or high EV/EBITDA (11 x) BTU VL Dec 2014 near a depressed cycle. Coal reserves are priced low and production doesn’t generate high enough cash flows for the industry to generate a normal return, so mines are being closed, production shuttered, mines consolidated. The cure for low prices is low prices.

Berkshire 1992 Letter on What is an attractive investment.

This post wraps up Chapter 4 in Deep Value so don’t hesitate to comment or ask questions.

My first date did not go well

Beating An Index or What Works on Wall Street

chimp

Chimps Managing  (30-second video) and Sales are down

Why can’t 70% of professional money managers beat chimps?

High fees/costs, index hugging, inconsistency, overconfidence in their ability to be above average, lovers of stories, herding, and the institutional imperative? Don’t forget incentives that differ from achieving performance like asset gathering. See the case study at the end of this post.

what works

We left off with a reader asking why do money managers do better or follow a deep value approach? http://wp.me/p2OaYY-2IZ

One goal of our Deep Value journey is to find a method that suits us. This method should have a large base case rate of beating an index over a long period of time, say fifty years.   The lesson learned so far—I hope—is that CHEAPNESS wins whether that is price to book value, price to sales, price to cash flow.  My recent reading of the most recent 4th Edition of What Works on Wall Street shows that high  EBITDA-to-EV has beaten out Price-to-Sales (3rd Edition) What Works on Wall Street, Third Edition as the best metric as a value factor.  However, combined with quality of earnings metrics, it performs even better or about 18% to 19% per year since 1964 to 2009.  Our goal is to put the odds on our side and CONSISTENTLY play the odds through thick and thin.  Our other edge is to realize how flawed our thinking is and thus we build protection against ourselves by developing a disciplined approach.

What Works: Notes from Joel Greenblatt’s class 2002:

Read: What Works on Wall Street by James P O’Shaughnessy.  He started a fund in 1996-1997 but he underperformed the market by 25% and after three years in business of underperforming he sold his company at the bottom of the cycle.   The guy who wrote the book quit his system!   It seems like it is easy to do, but it is not easy to do.

This book, What Works on Wall Street, has born out its wisdom. The two funds that are patented that follow his strategy have been phenomenal. HFCGX is the patented fund based on his top idea of Cornerstone Growth; over the last 5 years it has had an average return of 13.44% per year vs. the Vanguard 500’s -2.01% per year (6/1/00 through 5/31/05). HFCVX is the patented fund based on his 2nd to best idea of Cornerstone Value; over the last 5 years it has had an average return of 6.47% per year vs. the Vanguard 500’s -2.01% per year (6/1/00 through 5/31/05).

The most interesting point is that the author points out those investors often are too emotionally involved to have the discipline to see the strategy through. Not only did the first reviewer bash the book because he did like the returns strategy JUST one year after the book came out, but Mr. O’Shaughnessy sold the funds to Hennessy Funds at the end of 1999 after it failed to surpass the returns of the bubble that soon after collapsed. Seven years after it was published an investor would be much wealthier had they followed the books top strategy instead of the investors who dog-piled onto the stocks of the market’s bubble.

We are going to try to understand why it works. Why it has to work over time.  That is the only way you can stick it out.  The math never changes: 2 + 2 = 4.   That is the level of your understanding I want you to have by the time we are done.  If I get that right, forget all this other stuff and noise, I will get my money.  No genius required.  Concepts will make you great and your ability to STICK IT OUT.

There is a lot of experience involved in valuation work, but it doesn’t take a genius or high IQ points to know the basic concepts.  The basic concepts are what will make you the money in the long run.   We are all capable of doing the valuation work.

Notes from the 4th Edition of What Works on Wall Street

Why Indexing Works

Indexing works because it sidesteps flawed decision-making and automates the simple strategy of buying the big stocks that make up the S&P 500. The mighty S&P 500 consistently beat 70 percent of traditionally managed funds over the long-term by doing nothing more than making a disciplined bet on large capitalization stocks.

Money Management Performance

Past records of most traditional mangers cannot be predictive of future returns because their behavior is inconsistent.  You can’t make forecasts based on inconsistent behavior.

Common Sense Prevails

We now have the ability to empirically compare different investment strategies and their ongoing performance over time. What you will see in coming chapters is that almost all of them are deeply consistent with what common sense would tell you was true. Strategies that buy stocks that are selling at deep discounts to cash flow, sales, earnings , EBITDA-to-enterprise value (Yeah, but don’t forget MCX), and so on do extraordinary better than those that are willing to buy stocks with the richest valuation.  WE will be sensitive to data mining.

Does Complexity Imply Value  Simple works best–I suggest you read!

Systematic, structured investing is a hybrid of active and passive management that automated the buy and sell decisions. If a stock meets a particular criteria, it’s bought. If not, not. No personal, emotional judgments enter into the process.  Essentially, you are indexing a portfolio to a specific investment strategy and, by doing so, uniting the best of active and passive investing.  The disciplined implementation of active strategies is the key to performance. Traditional managers usually follow a hit-and-miss approach to investing. Their lack of discipline accounts for their inability to beat simple approaches that never vary from the underlying strategy.

The ONE thing that unites the best money managers is consistency.

Successful investing requires, at a minimum, a structured decision-making process that can be easily defined and a stated investment philosophy that is consistently applied.

Goeth said, “In the realm of ideas everything depends on enthusiasm; in the real world, all rests on perseverance.” While we may intellectually understand what we should do, we usually are overwhelmed by our nature, allowing the intensely emotional present to overpower our better judgment.

Human Judgment is limited

Why models beat humans

Models beat the human forecasters because they reliably and consistently apply the same criteria time after time. It is the total reliability of application of the model that accounts for its superior performance.

We are ALL above average.

Base rates are boring

We prefer gut reactions and stories to boring base rates.

Stocks with low PE ratios outperformed the market in 99 percent of all rolling 10-year periods between 1964 and 2009.

The best way to predict the future is to bet with the base rate that is derived from a large sample.

Base rates are boring while experience is vivid and fun.  Never mind that stocks with high P/E ratios beat the market less than 1 percent of the time over all rolling 10-year periods between 1964 and 2009.

Montier in his book, Value Investing writes: “One of the recurring themes of my research is that we just can’t forecast There isn’t a shred of evidence to suggest that we can.

We prefer the complex and artificial to the simple and unadorned.

Nowhere does history indulge in repetition so often or so uniformly as in Wall Street. When you read contemporary accounts of booms or panics, the one thing that strikes you most forcibly is how little either stock speculation or stock speculators today differ from yesterday. The game does not change and neither does human nature.—Edwin Lefevre.

Brain Research

Because of the interrelated nature of the emotional and rational centers of our brain, we will never be able to fully overcome our tendency to make irrational choices.  Simply being aware of this problem does not make it go away. To break from our human tendencies to chase performance and perceive patterns where there are none, we must find an investment strategy that removes subjective, human decision-making from the process and relies instead on smart, empirically proven systematic strategies. We can become wise by realizing how unwise we truly are.

Rules of the Game

It is amazing to reflect how little systematic knowledge Wall Street has to draw upon as regards the historical behavior of securities with defined characteristics. –Ben Graham

Richard Brealey, a respected data analysis, estimated that to make reasonable assumptions about a strategy’s validity (95% confidence level or statistically relevant) you would need 25 years of data.

Short periods are valueless

Consider the “soaring sixties” when the go-go growth managers of that era switched stocks so fast that they were called gunslingers. The go-go investors of the era focused on the most rapidly growing companies without even considering how much they were paying for every dollar of growth. Between Jan 1, 1964, and Dec. 31, 1968, $10,000 invested in a portfolio that annually bought the 50 stocks in the Compustat data base with the best annual growth in sales soared to $33,000 in value , a compound return of 27.34 % a year. That more than doubled the S&P 500’s 10.16% annual return, which saw $10,000 grow to just $16,200. Unfortunately, the strategy went on to lose 15.7% per year for the following five years compared to a gain of two percent for the S&P 500.

Had this same hapless investor had access to long-term returns, he would have seen that buying stocks based just on their annual growth of sales was a horrible way to invest—the strategy returns just 3.88 percent per year between 1964 and 2009.  Of course, the investor received similar results if he repeated the experiment between 1995 and 1999 and then the next five years.

EBITDA to EV was the best on an absolute basis for all the individual value factors we examine from 1964 to 2009 such as price to cash flow, price to earnings, etc.

EV/EBITDA in the lowest decile (the most EBITDA per EV) generated a 16.58% CAGR vs. 11.22% for the All Stocks universe with a standard deviation of returns of 17.71 percent, more than 1 percent below that of All stocks, 18.99 percent.  The worst five-year period for the metric was 2000 during the Internet Mania.  These ups and downs for a strategy are all part of the bargain you must strike with yourself as a strategic investor.  Pages 103 to 124 in What Works (4th Ed.) The EV/EBITDA in the highest decile (the most “expensive) did the worst of all the value metrics studied!

EV works well as a guide to under-and-over valuation when contrasted to EBITDA, SALES, and Free cash flow.

Price to book value ratios are a long-term winner with LONG periods of underperformance.

Accounting Ratios can help identify higher quality earnings:

  • Total accruals to total assets
  • Percentage change in net operating assets (NOA)
  • Total accruals to average asses.
  • Depreciation expense to capital expense.

We are looking for stocks with high earnings quality.

Accounting variables mater. How companies account for accruals, how quickly they depreciate capital expenses and their additions to debt all have a serious impact on the health of their stock price.

Successful investing relies heavily on buying stocks that have good prospects, but for which investors currently have low expectations. Stocks with great earnings gains and high net profit margins are basically high expectations stocks.

History shows that using high profit margins as the SOLE determinant for buying a stock leads to disappointing results.  The only lesson here is that it is best to avoid stocks with the lowest net profit margins.

A Case Study in Why Money Managers Lose Even With a Winning Hand

  • Winning Stock Picker’s Losing Fund

Value Line Research Service Has Beaten Market Handily, But Its Own Fund Suffered By Jeff D. Opdyke and Jane J. Kim Staff Reporters of THE WALL STREET JOURNAL Updated Sept. 16, 2004 12:01 a.m. ET

Value Line Investment Survey is one of the top independent stock-research services, touted for its remarkable record of identifying winners. Warren Buffett and Peter Lynch, among other professional investors, laud its system.

But the company also runs a mutual fund, and in one of Wall Street’s odder paradoxes, it has performed terribly. Investors following the Value Line approach to buying and selling stocks would have racked up cumulative gains of nearly 76% over the five years ended in December, according to the investment-research firm. That period includes the worst bear market in a generation.

Why the Fund Lagged

  • Past managers bought stocks that in some cases were well below the company’s top-rated choices, hurting performance.
  • Style drift: The fund has swung among small-, mid- and large-cap shares.
  • High turnover of fund managers meant little consistent investment discipline.

By contrast, the mutual fund — one of the nation’s oldest, having started in 1950 — lost a cumulative 19% over the same five years. The discrepancy has a lot to do with the fact that the Value Line fund, despite its name, hasn’t rigorously followed the weekly investment advice printed by its parent Value Line Publishing Inc. It also highlights the penalty investors often face when their mutual fund churns its management team and plays around with its investing style. In fact, late last night the person running the fund, Jack Dempsey, said that as of yesterday he had been reassigned and no longer had responsibility for managing the assets. Value Line couldn’t be reached to comment.

Most of all, the discrepancy between the performance of the fund and the stocks it touts shows that investors don’t always get what they think they’re buying in a mutual fund. For even though Value Line’s success is built around stocks ranked No. 1 by the company’s research arm, the fund’s managers have in recent years dipped into stocks rated as low as No. 3.

Ironically, even while Value Line’s own fund struggles to match the Value Line Investment Survey’s success, an independent fund company that licenses the Value Line name is doing much better with Value Line’s investment approach.

The First Trust Value Line 100 closed-end fund, run by Lisle, Ill.,-based First Trust Portfolios, adheres far more rigorously to Value Line’s investment principles, owning only the top-rated stocks.

Each Friday, First Trust managers log on to the Value Line site to download the week’s list of Value Line’s 100 most-timely stocks. During the next week, they sell the stocks that have fallen off the list and buy those that have been added. The result: Since its inception in June 2003, the First Trust Value Line fund’s net-asset value is up 12.4%, slightly better than the 11.6% gain the Standard & Poor’s 500-stock index posted in the same period.

Value Line’s own fund, meanwhile, gained 3.1% in that same time. Because the fund has been such a laggard in recent years, investors have been walking away. Assets in the fund — in the $500 million range as recently as 1999 — are now less than $200 million, though some of that stems from market losses.

Part of the underperformance stems from previous fund managers who didn’t rely entirely on Value Line’s proven model, opting instead to venture into lower-rated stocks, betting that active fund managers could unearth overlooked gems that one day would shine as top-rated stocks. Thus, investors who thought they were buying into Value Line’s winning investment strategy instead were buying into fund managers who thought they could outperform by second-guessing the company’s research — a tactic that didn’t work well.

Because the fund wasn’t performing well, the company changed managers frequently, searching for one who could post winning returns.

Value Line appeared to be moving back toward its roots in March, when it put Mr. Dempsey in charge of the fund. He isn’t the traditional mutual-fund manager; he’s a computer programmer who for a decade helped refine Value Line’s investment models. Value Line, which uses a team-managed approach, has had at least five lead fund managers since 1998, including Mr. Dempsey, according to Morningstar.

In an interview prior to his reassignment, Mr. Dempsey said he had been restructuring the fund to follow the ranking system “in a much more stringent fashion.” Today, about 95% of the stocks in the fund are rated No. 1. Mr. Dempsey said his goal was to liquidate within a week stocks that fell below Value Line’s No. 1 ranking.

The Value Line survey produces independent research on Wall Street stocks. The weekly view of 1,700 stocks, which costs $538 a year online (www.valueline.com) and nearly $600 in print form, is particularly popular with do-it-yourself investors and the abundance of investment clubs in the U.S. Value Line rates stocks in a variety of ways, but is especially known for its so-called timeliness rank. Stocks ranked No. 1 are timely and expected to outperform the market; those ranked No. 5 are expected to lag.

Instead of running an actively managed fund in which a manager cherry-picks the stocks the fund owns, Value Line could operate what amounts to an index fund that simply owns the highest-ranked stocks in the survey. However, active managers believe they can improve the performance of a fund.

“As a fund manager, you want to add value,” Mr. Dempsey said. Still, he acknowledged that “it’s hard to beat our quantitative system.” In the short time that Mr. Dempsey was in charge — a nearly six-month period in which he transformed the portfolio — he accumulated losses of about 2%, compared with losses of 0.2% at the S&P 500. However, he topped the First Trust fund, which is down about 2.5% in the same period. Under Mr. Dempsey, the fund accumulated significant positions in stocks such as Research In Motion Ltd. and added new positions in Yahoo Inc. and Arrow Electronics Inc., among other companies, according to Morningstar.

Value Line, based in New York, doesn’t detail the inner workings of its proprietary stock-picking model. By and large, though, the strategy is built around stocks displaying price and earnings momentum and posting earnings surprises, says John James, chairman of the Oak Group, a Chicago company that runs hedge funds, some of which try to anticipate changes in Value Line’s stock rankings and then invest based on which stocks will rise to No. 1 from No. 2.

However Value Line’s model works, there’s no question the company’s research produces winning choices. Value Line’s list of stocks ranked No. 1 produced cumulative gains of nearly 1,300% from Dec. 31, 1988 through June, 30, 2004, according to Value Line. The S&P 500, by comparison, posted cumulative gains of 311%.

Newbie investor meets a DEEP VALUE INVESTOR

 

Readers’ Links, Comments and Questions

DJIA-1900

A Reader’s Article on Value Traps

I found a very interesting piece of writing about Value Traps and Value investing

http://www.wyliemallory.com/blog/how-does-one-avoid-blowups-in-deep-value-investing/

I must say lot of valuable advice from a seasoned investor.  

I read the linked article, but I wonder if the folks here took away the key lesson(s)

OK, why was this investment a “Value Trap?”   What can we learn from this example or ignore in this article?   Are you investing when buying this bank?  What makes a bank very different from investing in a widget factory?  The article goes on to say you should wait for a catalyst.  Is there a flaw to that argument?   What about checklists?   Can checklists save you from faulty thinking?

A Frustrated Reader:

Moreover, I wonder if it would be possible to have an index or anything like that in order to program and coordinate all classes and materials.

I teach under the chaos-and-mayhem method to force you to choose what is important to you.  In a more serious light, we are going chapter-by-chapter in DEEP VALUE and it is supplement by Quantitative Value and other readings. 

Next, use the search box in the upper right corner of this blog to type in: Lesson 1 Deep Value.   Then scroll to the links and begin there. The blog supplements the readings. You should have already received a link to the book folder.   Much of the materials are supplementary.   For example, we read in Chapter 3 in Deep Value about Buffett’s career, so various case studies were linked in the various posts that correspond to the chapter like See’s Candies or Dempster Mills.  Also, the Essays of Warren Buffett were sent out, but that is up to you if you want to read further (I highly recommend that you do and reread every year).

A Reader provides links:

Was on reddit’s Security Analysis sub (www.reddit.com/r/securityanalysis) and stumbled upon these notes from some other readers, good supplementary reading:

II Notes: https://docs.google.com/document/d/106U79BVHzzeCiO5SjWD1eCz4Lp6nm3VJ0rYThUk1Shg/edit

Buffett Notes: https://drive.google.com/file/d/0B8B1Rxv9hy1oOGM4eFZfcjF2eVk/view

For reference, if you don’t have the Buffett Annual Letters: http://www.rbcpa.com/WEB_letters/WEB_Letters_pre_berkshire.html

A Reader with Good Questions

John,

While I agree completely with your analysis, I think its worth noting additionally that:

  1. Quant Value proponents (e.g. Graham, Greenblatt & Carlisle) are not arguing that any given filter (EV to EBIDTA for instance) accurately measures the intrinsic value of a given company.  Agreed
  2. But rather they argue that some filters (or combinations of filters) can capture mis-pricings in a basket of stocks.  Agreed
  3. And on average, over time the captured mis-pricings will deliver a return that dramatically exceeds the index and all but the most exceptional stock-pickers.  Agreed.  “Experts” may even degrade the results of a quant model!
  4. So while a given filter (EV to EBITDA for instance) may be just the beginning of the analysis for a stock-picker working a concentrated portfolio,
  5. that same filter alone may be enough for a Quant Value portfolio to outperform 99%+ of stock-pickers,
  6. and with far less work.

To the extent this finding is true and replicable in real time, it is a remarkable finding.  What puzzles me is this:

  • Given a huge economic opportunity–some screens deliver 2X market returns in back tests
  • Given the Quant Value idea has been around for 75+ years–since Graham described the Net Net idea in Security Analysis
  • And given the vast resources dedicated to optimizing portfolios

Why are there so few examples of this simple idea being executed effectively in real time?

The best answers I’ve heard to this question (most of which were mentioned by Greenblatt in TLBTBTM) are:

  • Quant Value strategies are difficult to stick with because they will under-perform the market for years at a time
  • Much of the excess return is found in small cap stocks so it cannot be run in a large portfolio
  • The stocks selected by the Quant Value screens are “ugly” stocks which are difficult to own and defend

While all these explanations make sense, it still appears to me that the lure of 2X market returns would be enough to overcome them.  So I am left with the puzzle: why is this opportunity not more widely exploited?  I would be interested to hear any thoughts from the group on this…

I will post tomorrow my thoughts on your other questions.

DJIA-1997

Questions on Chapter 4

ABOOK-Feb-2015-Buybacks (1)

The Acquirer’s Multiple Ch 4 in DEEP VALUE  is where we left off in discussing Chapter 4.

Imagine diligently watching those stocks each day as they do worse than the market average over the course of many months or even years….The magic formula portfolio fared poorly relative to the market average in five out of every 12 months tested. For full-year period…failed to beat the market average once every four years. Joel Greenblatt discusses the role that loss aversion plays in deterring investors from following his ‘magic formula’. (Montier)

A Summary

Greenblatt reinterpreted Buffett’s return on equity capital measure as RETURN ON CAPITAL, which he construed as the ratio of pre-tax operating earnings (earnings before interest and taxes, or EBIT or EBITDA-MCX or operating earnings that are sustainable) to tangible capital employed in the business (Net Working Capital + Net Fixed Assets) defined as:

Return on Capital = EBIT divided by (Net Working Capital (NWC) + Net Fixed Assets)

The use of EBIT makes the return on capital ratio comparable across different capital structures. EBIT makes an apples-to-apples comparison possible.

For tangible capital Greenblatt uses NWC + Net Fixed Assets rather than total assets to determine the amount of capital each company actually requires to conduct its business.

The higher the return on capital ratio, the more wonderful the company.

To determine a fair price, Greenblatt uses earnings yield, which he defines as follows:

Earnings Yield = EBIT divided by Enterprise Value (EV).

EV gives a more full picture of the actual price an acquirer must pay than market capitalization alone.  EBIT is agnostic to capital structure so we can compare companies on a like-for-like basis.

The higher operating earnings are in relation to enterprise value, the higher the earning yield, and the better the value.

Greenblatt has quantified Buffett’s wonderful company at a fair price strategy.

Enterprise Multiple (EV) = EBITDA divided by EV or (EBITDA – Maintenance Capital Expenditures) divided by EV.

BEWARE!

The EV to EBITDA ratio is useless without a discussion on asset lives, capital intensity, technological progress or revenue recognition.

EBITDA, or any of its derivatives (EBDIT, EBITDAR, etc.) is simply a crude measure of gross cash flow.

The gross cash flow margin is simply a measure of the capital intensity of the business.   A manufacturing business will have a significantly higher gross cash margin than, say, a retailer, because it needs to pay for the capital (via in the accounting sense the depreciation charge) of all its plant and equipment which consumes more of it than a superstore.

What matters is not gross cash flow but net of free cash flow, which is the amount of cash available after reinvestment.

Case Study:

In the heyday of the technology bubble, the EV to EBITDA ratio was a favorite among telecom analysts.   Sadly, as new entrants came into the system and pushed up the price of the UMTS licenses (the third generation of mobile networks) to insane levels, the cost of replacement went sky-rocketing; expected free cash flow plummeted, and the telecom shares got more and more ‘attractive’ on an EBITDA basis, which could not capture any of this.   Eventually, some went bankrupt, some had to undergo a debt rescheduling exercise or issue new capital, and all saw their share price collapse.

James Murray Wells, a 21-year-old law student in Bristol, UK, needed a pair of glasses, and was faced with a bill of 150 stg.   He found that the manufacturing cost off standard spectacles (frame and glasses) was less than 10 stg.   This prompted Mr. Murray Wells to set up an Internet-based company to challenge what he claimed was a lack of price competition among the four major high street opticians in England.  Three months into his venture, he was selling hundreds of pairs for as little as 15 stg to apparently delighted customers.

The replacement value of the asset, ‘making spectacles and selling them’ is rather low.   A 21-year old student with no expertise in the field is apparently able to replicate it from his student room, with a few thousand pounds borrowed from his father.   On the other hand, the market value is enormous because, as previously discussed, it equals the net present value of free cash flow discounted to infinity.

The market value is a direct function of the economic profitability of the asset in question and, in this example with a cost of goods sold at 10 and sales at $150, it is plain that economic value added is truly staggering.   Making spectacles and selling them has a high ROIC, and an equally impressive asset multiple—the ratio of market value to the replacement value of invested capital.

If the entrepreneur is successful in his venture, he will collapse the marginal return on capital invested of the industry by accepting a lower margin than his competitors.   The entrepreneur made an arbitrage between the market value of existing capacity and the replacement value of new capacity, which he found cheaper to create.

Investors in incumbent firms my find out that they have paid too much for the economic value of their asset in the belief that a very high economic return on capital invested was sustainable.   Investors who ignore the workings of the capital cycle, the ultimate driver of share prices, do so to their disadvantage.

Investment should just be a replication of the process of arbitrage between market value and replacement value. Good stock pickers are brilliant strategy analysts.   They understand the business case for the company. (TATOO that to your forehead!)

Questions:

Why is the EV so good at identifying undervalued stocks?

What drives the returns of the magic formula? What Metric?  What does this mean for us as Deep Value Investors?

Assuming you read the entire chapter, what two main points about investing did you learn?  Anything surprise you?

Supplementary Readings:

What Has Worked in Investing by Tweedy Browne   Why do low price-to-book, low price to cash flows, etc tend to generate higher returns than a market average?  What is the principle behind the returns?  Also, note the Richard Thaler link below for a hint.

When an investor turns to the research on regression to the mean and investors overreacting to poor company performance/bad news in Richard Thaler research, he or she sees that prices of the winner and loser portfolios take three-to-seven years to revert.  See also The New Finance: The Case Against Efficient Markets by Robert A. Haugen and Inefficient Markets by Andrei Schleifer.

Next, we will focus on Mean Reversion and ROIC.

Death Taxes and Reversion To The Mean (Mauboussin)

ROIC

Dale Wettlaufer on ROIC and MROIC  a series of Fool.com articles

EconomicModel of DFC_ROIC The author uses NOPAT (after-taxes). I placed this here for those who wanted to see how others determine value.

We will review the second half of the chapter next.

 

 

 

 

One more time: CS on Maint. Capex (IRDM)

male

 

A reader kindly shared:

Multiples

Also, to see cash flow analysis of different industries to START your analysis go to: http://scheller.gatech.edu/centers-initiatives/financial-analysis-lab/

Now on to Iridium (IRDM)

You just got hired as a junior analyst for a hedge fund. Your boss calls you in and asks for your opinion on whether he should buy IRDM.  He heard about it from a hedgie friend in New York who heard about it from another hedgie friend in New York  who heard about it from…….you get the picture–a daisy chain of independent-thinkers.

Your boss slaps this on your desk:

IRDM_10-K_Wrap_2013_

IRDM_VL Dec 2014   Check this first.

IRDM

 

You remember something about Buffett saying that the tooth fairy doesn’t pay for capex?  What will you tell your boss this afternoon?

If you want more clues (after trying hard) go to the search box on this blog and type in IRDM–follow the links.

Good luck!

PS: I will resend the book folder to new students and I will send value vault folders to the folks who have been asking for the past three weeks. I try only to check email once a day and I group the various email requests over time.

I will be next focusing on ROIC for Chapter Four in Deep Value because we already covered EBITDA and its use and ABUSE.  And EV/EBITDA multiples. Remember that multiples are simply a short-hand for cost of capital.  I remember when Blockbuster (US Video Chain) looked cheap in an EV/EBITDA analysis (from a broker report) but Blockbuster was being dis-intermediated by Netflix and planned to reinvest in its stores to sell popcorn and toys along with DVDs. How do you think that turned out?   Rear-view looking at past multiples may mean being entombed in a value trap.  When I heard of Blockbuster’s plan, I thought of entering a mule in a horse race–what are my chances?

A Blockbuster Video store - File / Photo: Justin Sullivan/Getty Images

 

 

 

 

 

 

 

Have faith but don’t be overconfident! Have a great weekend from sub-zero New England.

Reader’s Question: Cyclicals

Structure of production

 

What multiples and metrics to use for different industries? 

A reader struggles with how to value cyclical industries. First you have to understand the particular industry. How to do that–read the reports and financials of dozens of companies in that industry, then note what is important to value such a business.  Take several months.  If you are looking at highly-cyclical businesses, then you should read : Skousen-Structure-production.pdf

Note how long the cycles are in the gold mining industry.  A mine may take a year or two to close or years to open. From discovery of the deposit until extraction may take a decade or more. A gold miner is valued on production, reserves, cost to extract, etc.

Now if you have access to a Bloomberg (expensive!) or go to a library and look at Value-Line, Moody’s Manuals, or industry articles of the industry.   You can scrub around the Internet, but you have to grind through company reports to get a feel.  Obviously, “heavy industries” require analysis of tangible book, replacement value, capital costs, industry capacity and utilization–note what happened in the airline industry when capacity was taken off-line. Go to search box and read my post on CRR, Carbo-ceramics–below TBV and replacement value, for example.

gold
If I seem abrupt with your questions, here is the reason why.

Lesson 4: The Acquirer’s Multiple

End nearWhat happens if you get scared half to death twice?  –S. Wright

We were unable to discover any ‘magic’ qualities associated with stocks selling below liquidation value. — Joel Greenblatt (How the Small Investor Can Beat the Market)

Enterprise Multiple = Earnings before interest, taxes, and depreciation & amortization, (“EBITDA”) divided by Enterprise Value (“EV”).

We need to understand the use of EBITDA, Why we must use EV, and the requirement to use pre-tax owner’s earnings or EBITDA – maintenance capex (“MCX”).

Placing EBITDA into Perspective (from the prior post) Suggested reading

EV The Price of a Business  Understanding and calculating EV. Suggested reading

Beginning lesson on Enterprise Value for beginners (Video, Khan Academy)

Pop Quiz: Why do you include minority interests with EV?

Why you use Enterprise Value (Review)

Minority Interests (Review)

Chapter 9 EV Multiples  Only if you dare. Heavy reading. Voluntary.

Let’s tackle really grasping the use of EV, EBITDA, and EBITDA – MCX

I will also send out the Little Book via email as supplementary reading for this chapter.

Good luck.