In short, Maier is contending that advice Cramer was giving the public under the guise of helping them manage their savings (“SmartMoney“) was actually being driven by Cramer’s need to dump his own positions without cratering the market. When a trusting public acted on Jim’s tip and bought shares, he dumped his shares onto the public. The only lesson Cramer learned from the “four orphans” incident, Maier claims, was that he, Cramer, had the power to move stocks through the press.
I am a first year MBA student in XXXX. I am from a background of (being) a software engineer and an equity researcher in China. I was very interested in Value Investing and tried to apply it to personal investment in past 8 years. Currently, I am exploring career opportunities in the Investment Management area and see that you have been working and teaching in this area for a long time. I would learn more about your experience in this area and get some advice from you.
I would write-up investment ideas within your circle of competence to show fund managers your critical thinking skills and approach to investing. Or if you have a great understanding of a particular industry or company that is public you can present your ideas to the fund managers who own the company. Show your past investment results. Why did you make the decisions you made? Try to sell your ideas to the appropriate money managers. But only you can determine what your strengths particular interests. Your reports should meld your interests with your skills.
Our activist friend, Carl Icahn’s High River LP, Icahn Partners LP and Icahn Partners Master Fund LP collectively bought 6.6 million Chesapeake shares on March 11 at $14.15 each, bringing the investor’s total stake in the company to 11 percent, according to a filing on Monday. Prior to the purchases, Icahn controlled about 9.9 percent of Oklahoma City-based Chesapeake. That compares with an 11.11 percent stake owned by Southeastern Asset Management Inc. as of Dec. 31, the largest holding according to the latest filings.
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.
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.
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.
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.
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:and 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.
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).
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
Valuation of Western Insurance_2 (A reader, WAPO mentioned in the comments section of the Dempster Mill Post that Chapter 3 of Deep Valuedidn’t include Buffett’s other early investments like Western Insurance, Genesee Valley, Union Street Railway, American Fire Insurance, and Rockwood. Does anyone wish to dig these investments up from somewhere? Just post in the comments section and/or I can post your work for the readers.
In the Dempster Mill Post we learned that Buffett succeeded in this investment because he:
Most importantly and in deference to Graham, he bought well--he started paying $18 in 1956 for Dempster with its $70 per share of book value and $50 of net working capital per share. He bought right. Note in the video lecture above, Buffett mentions that he paid 1/3 of working capital for a windmill company (probably Dempster).
Then he was patient. This investment was held for at least seven years.
Finally, he had Harry Bottle to turn the business around.
Thanks for the intelligent and thoughtful comments on Dempster. We learn from the questions and thoughts of others.
Perhaps his success in Dempster Mills lured him to buy Berkshire Hathaway?(considered by Buffett to be his worst investment)
Next we will review See’s Candies, Sanborn Map. We will focus on Buffett’s writings in his shareholder letters on valuation. See the Essays of Warren Buffett above.
For new investors you may feel frustrated by the lack of clear rules. Net/nets depend upon reversion to the mean before total value destruction, but franchises manage to repel the forces of competitive entry for longer than investors expect. Early, fast growing franchise companies like Wal-Mart (in the 1970s) or Costco trade at what appear to be sky-high multiples of earnings (30+) yet the market is UNDER-pricing the profitable growth of those companies. There seem to be grey areas. Congratulations, we are making progress. And for experienced investors, we can never reread the writings of investment greats like Graham and Buffett as many times as we should, but it may seem like
Effective money managers do not go with the flow. They are loners, by and large. They are not joiners; they’re skeptics, cynics even. Whatever label you want to put on them, they trait they all share is that they don ‘t automatically trust that what the majority of people–especially the experts–are doing is necessarily correct or wise. If anything, they move in the opposite direction of the majority, or they at least seek out their own course.
Warren Buffett is the best example of this contrarian impulse. In the 1960s, when Buffett started out (An excellent recounting of that era is The Go-Go Years, The Drama and Crashing Finale of Wall Street’s Bullish 1960s by John Brookes, Good review of the book, the Go-Go Years) most money managers were investing in highly cyclical, heavily indebted and capital-intensive industrial giants like U.S. Steel (X). As a consequence, stock in those kinds of companies were overpriced in Buffett’s view, especially when compared to their earnings. Instead of following the majority and buying into that mini-bubble, he consciously sought out companies on the other end of the spectrum–businesses with lower capital expenditures and higher profit margins–and he wound up buying relatively cheap stocks in ad agencies and regional media companies like Capital Cities, Gannett, and the Washington Post. This was a complete departure from the consensus of the time, and it made Buffett a ridiculous amount of money. (Scott Rearon, Dead Companies Walking, 2015)
As we study Chapter 3 in Deep Value and Buffett’s early career, we should learn more about this tribe called value investors. Have they had success and why?
Below are four (4) articles you should read in sequence. Watch for what these investors do differently than the majority of institutional investors. Lessons we can use?
A Nor’easter is coming my way (up to two to three feet of snow with high winds) so I may be out of contact for two or three days. But push on we must. We continue to study Chapter 3, in Deep Value and Buffett’s investing career.
The best investment article I have ever read of Buffett’s is:
Hopefully, students will discuss in the comments section.
Time to bring out the snowshoes!
It’s not entirely clear what will happen in the near term, but the financial markets are already pushed to extremes by central-bank induced speculation. With speculators massively short the now steeply-depressed euro and yen, with equity margin debt still near record levels in a market valued at more than double its pre-bubble norms on historically reliable measures, and with several major European banks running at gross leverage ratios comparable to those of Bear Stearns and Lehman before the 2008 crisis, we’re seeing an abundance of what we call “leveraged mismatches” - a preponderance one-way bets, using borrowed money, that permeates the entire financial system. With market internals and credit spreads behaving badly, while Treasury yields, oil and industrial commodity prices slide in a manner consistent with abrupt weakening in global economic activity, we can hardly bear to watch.. John Hussman, Jan. 26, 2015 www.hussmanfunds.com
As previously discussed, we have read the Preface and Chapter 2, Contrarians at the Gate in Deep Value where we learned about Graham and liquidations and the great mean-reverting mystery of value investment. Klarman’s writings were also read (Margin of Safety) to learn about his approach to liquidation and valuation. Valuation is an imprecise art where value is no one precise number. Finally, Mr. Market is there to serve us not guide us. Therefore, think of all the pundits, experts, and CNBC commentators we can ignore for the rest of our investing careers.
If readers have questions or comments, do not hesitate to write. I try not to look at my emails but once a week. I neither have a cell phone nor a TV, but time is scarce so I can respond faster (or another student can to your questions) here in the comments section.
Now we transition into reading Chapter 3 of Deep Value, “Warren Buffett: Liquidator to Operator.” Buffett was Graham’s prized student who forged his own way. There are about ten books written on Buffett every year. We will now focus on his early career by going through his Complete_Buffett_partnership_letters-1957-70_in Sections
After Dempster, we will study Sanborn Map and then See’s Candies. Put on your thinking caps. Go the extra mile and find out more about these companies if you have the interest. Focus on how Buffett estimated the intrinsic value of Dempster Mills AND how he managed the investment over time. What made up his margin of safety BESIDES the price discount?
Reader Question: Do I know Toby Carlisle, and do I think his approach works?
Yes, I have had the pleasure of meeting Toby. A nice guy who seems like a Renaissance man similar to Graham but with a darker sense of humor. Toby taught me how to speak Australian English. You don’t thank your host for a delicious meal by saying, “That was excellent.!” You say, “What a belly-bust!” You don’t go out to drink beers, you go out to “rip down a frosty.” I am indebted for those tips. I learned during my working days in Cairns, Australia that fly-crawling was the national sport. If you could choose which fly could crawl the furthest along a wall or ceiling, you were the champ. The game had a huge element of randomness. I digress…
Since we haven’t finished our course of study on Deep Value Investing, I am no expert to comment upon his approach. But Deep Value investing can work since it does the opposite of a naive strategy. Hard-core contrarian-investing is difficult because buying what has been losing or is obscure, despised, and loathed goes against human nature. Are you more attracted to go into a full restaurant than one with cobwebs across the window? So far in our readings, net/nets seem more likely to be small, illiquid securities, so the investing approach may be more suited for individuals with a limited amount of capital who can go anywhere to find bargains.
Even the great Walter Schloss managed small amounts of money using his deep value approach. As his accounts grew, he would return capital to his partners, thus keeping the amounts of money he managed appropriate for the illiquidity of the names he bought and sold. He would also buy and sell scale down and up, I heard.
Why don’t you call him at his firm, Eyquem Investment Management LLC or visit www.greenbackd.com and find his email address. Ask for his record so far in managing accounts. What happens when there are only six or seven net/nets–does he concentrate into those?
-Are my instructions clear?
Addendum: Does Intuition Have a Role in Quantitative Investing?
At the ten minute mark Joel makes an amazing statement: 97% of the top quartile money managers from the decade of 2000-2010 (encompassing two big sell-offs) were in the bottom half of performance three years out of ten; 79% were in the bottom quartile and a whopping 47% were in the bottom decile (in tenth place!) in three of the ten years. Talk about fortitude and sticking to your strategy!
Joel Greenblatt’s Magic Formula for those unfamiliar with his approach.
Joel Greenblatt is the founder and a managing partner of Gotham Capital, a hedge fund (also called a private investment partnership). He is also an adjunct professor at the Columbia University Graduate School of Business, and holds a B.S. and an MBA from the Wharton School. According to Greenblatt’s “The Little Book that Beats the Market” (Wiley, 2005) learning to successfully invest in the stock market is simple. Greenblatt said that he wanted to write a book his children could read and learn from. The main point Greenblatt makes is that investors should buy good companies at bargain prices-businesses with high return on investment that are trading for less than they are worth. This is a classic value investing methodology that Benjamin Graham would have espoused.
Finding Undervalued Stocks
To those familiar with Benjamin Graham, Greenblatt’s approach is obvious: buy stocks at a lower price than their actual value. This assumes you are able to somewhat accurately estimate a company’s actual value based on future earnings potential. Greenblatt alleged that stock prices of a company can experience wild swings even as the value of the company does not change, or changes very little. He views these price fluctuations as opportunities to buy low and sell high.He follows Graham’s “margin of safety” philosophy to allow some room for estimation errors. Graham said that if you think a company is worth $70 and it is selling for $40, buy it. If you are wrong and the fair value is closer to $60 or even $50, you will still be purchasing the stock at a discount.
Finding Well Run Companies
Greenblatt believes that a company with the ability to invest in its business and receive a good return on that investment is usually a “well run” company. He uses the example of a company that can spend $400,000 on a new store and earn $200,000 in the next year. The return on investment will be 50%. He compares this to another company that also spends $400,000 on a new store, but makes only $10,000 in the next year. Its return on the investment is only 2.5%. He would expect you to pick the company with the higher expected return on investment.Companies that can earn a high return on capital (the return a company makes after investing in the business) over time generally have a special advantage that keeps competition from destroying it. This could be name recognition, a new product that is hard to duplicate or even a unique business model.
EBIT to Enterprise Value
Greenblatt compares a company’s ratio of EBIT (earnings before interest and taxes) to enterprise value against the risk-free rate. Enterprise value is a measure of company value that takes into consideration the company’s capital structure (debt versus equity). You could do a simple earnings yield calculation by dividing net earnings by the market value of the company’s stock, but Greenblatt has a different take. He divides earnings before interest and taxes by a stock’s enterprise value. A company’s enterprise value represents its economic value, which is the minimum value that would be paid to purchase the company outright. In keeping with value investment strategies, this is similar to book value.Enterprise value is equal to the market value of equity (including preferred stock) plus interest-bearing debt minus excess cash. Greenblatt uses enterprise value instead of just the market value of equity because it takes into account both the market price of equity and the debt used to generate earnings.Companies with debt must pay interest on the debt and eventually pay off the debt. This makes the debt’s true acquisition cost higher. Adding debt to market capitalization lowers the EBIT to enterprise value, making a company less attractive. Excess cash is subtracted from enterprise value because the un-needed cash reduces the overall cost of acquiring a business. If a company is holding $25 million in cash, the effective acquisition cost is reduced by that amount. Excess cash raises EBIT to enterprise value, making the company more attractively priced.EBIT to enterprise value helps to measure the earnings potential of a stock versus its value. If the EBIT-to-enterprise value is greater than the risk-free rate (typically the 10-year U.S. government bond rate is used as a benchmark), Greenblatt believes you may have a good investment opportunity-and the higher the ratio, the better.
Return on Invested CapitalReturn on capital, or return on invested capital (ROIC) is similar to return on equity (the ratio of earnings to outstanding shares) and return on assets (the ratio of earnings to a company’s assets), but Greenblatt makes a few changes. He calculates return on capital by dividing earnings before interest and taxes (EBIT) by tangible capital. Instead of using net income, return on invested capital emphasizes EBIT, also known as pretax operating earnings. Greenblatt uses this number because the focus is on profitability from operations as it relates to the cost of the assets used to produce those profits.Another difference is Greenblatt’s use of tangible capital in place of equity or assets. Debt levels and tax rates vary from company to company, which can cause distortions to both earnings and cash flows. Greenblatt believes tangible capital better captures the actual operating capital used.The equity value Greenblatt uses to calculate return on equity ignores assets financed via debt, and the total assets value used in the return on assets calculation includes intangible assets that may not be tied to the company’s primary operation. According to Greenblatt, the higher the return on capital, the better the investment.
Greenblatt’s Implementation of the Magic Formula
Greenblatt started his Magic Formula screen with a universe of the 3,500 largest exchange-traded stocks, based on market capitalization (shares outstanding multiplied by share price). He then ranked the stocks from one to 3,500 based on return on capital (the highest return on capital got a ranking of one; the lowest received a rating of 3,500). Next, he ranked the stocks based on their ratio of EBIT to enterprise value, with the highest ratio assigned a rank of one and the lowest assigned a rank of 3,500. Finally, he combined the rankings (if a company ranked 20 for return on capital and 10 for EBIT to enterprise value, the combined ranking was 30).For practical purposes, Greenblatt recommends investing in 20 to 30 stocks by purchasing five to seven every few months. The holding period he advises for each stock is one year. He believes this strategy will allow you to make changes on only a few stocks at a time as opposed to liquidating and repurchasing the entire portfolio at once.
Greenblatt tested his investing strategy over a 17-year period and earned an average annual return of 30.8%. He held 30 stocks at a time and held each stock for one year.In the book, Greenblatt devotes an entire chapter to explaining that the strategy is not a “magic bullet” that always works. During his test period, he found that, on average, five of every 12 months underperformed the market. Looking at full-year periods, once every four years the approach failed to beat the market.Sticking to a strategy that is not working in the short run even if it has a good long-term record can be difficult, Greenblatt says, but he believes you will be better off doing just that. Greenspan supposed that following the latest fad or short-term investment ideas will not yield market-beating results.
Narrowing the Stock Universe
The first step is to remove all over-the-counter stocks (OTC) and ADRs (shares of foreign companies trading on U.S. exchanges). Greenblatt’s initial database of stocks included only exchange-traded stocks. Next, all stocks in the financial and utility sectors are excluded due to their unique financial structures.
While Greenblatt’s original study included stocks with market capitalizations of $50 million or greater, he subsequently modified the minimum value for market capitalization between $50 million and $5 billion, depending upon on liquidity needs and risk aversion.
Return on Invested Capital
Return on capital measures the return a company achieves after investing in the business; the higher the return on capital, the better the investment.Tangible capital is defined as accounts receivable plus inventory plus cash minus accounts payable. This figure is based on the fact that a company needs to fund its receivables and inventory but does not have a cash outlay for accounts payable. For our screen, we require a return on invested capital greater than 25%, as specified in Greenblatt’s alternative screening suggestions.
EBIT to Enterprise Value
The ratio of EBIT to enterprise value helps to measure the earnings potential of a stock versus its value. To calculate, Greenblatt divides EBIT by enterprise value. For this screen, we use the EBIT-to-enterprise-value ratio to narrow the field to 30 stocks by choosing those with the highest ratio.
Like any stock screening strategy, blindly buying and selling stocks is never a good idea. Developing and implementing disciplined buy, sell and hold strategies is a better option. Greenblatt’s Magic Formula is not revolutionary, but does provide a new twist on the old value investing ideas. While his past record is impressive, it will be interesting to see how the screen holds up during this period of market turmoil and its aftermath.
Joel Greenblatt’s Magic Formula Criteria
Companies in the financial and utilities sectors are excluded
Over the counter stocks are eliminated
Non-US companies are excluded
Market capitalization is greater than $50 million
Return on capital is greater than 25%
Return on capital is found by dividing earnings before interest and taxes (EBIT) by tangible capital
EBIT = Pretax income + interest expense
Tangible capital = accounts receivable + inventory + cash – accounts payable + net fixed assets
Pick the 30 stocks with the highest earnings yield
Earnings yield = EBIT/ Enterprise value
Enterprise value = market value of equity (including preferred stock) + interest-bearing debt – excess cash