Category Archives: Risk Management

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

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

 

A Deep Value Investor in Cyclical Companies

staffimg_IbenDavid Iben is a deep value investor currently focused on highly cyclical industries like coal, uranium, and gold mining.  He has a mandate to go anywhere to invest in big or small companies. He seeks out value.   The world is now bifurcated between a highly valued U.S. stock market and the cheaper emerging markets.  Social media and Biotech stocks trade at rich valuations while depressed cyclical resource companies languish.

VALUATION

Value to us is a pre-requisite and thus we never pay more than a company’s estimated risk-adjusted intrinsic value. But, failing to think deeply and independently about what constitutes value and how best to derive it, can be harmful. Following in the footsteps of growth investors who had allowed themselves to become too formulaic or put in a box in the late 90s, some value investors were hurt by overly restrictive definitions of value in 2007 and 2008 (Price/Book and Price/Earnings, etc). We find it valuable to use many valuation metrics. Additionally, emphasis is placed on those metrics that are most appropriate to a certain industry. For example, asset heavy and/or cyclical companies often are tough to appraise using Price/Earnings or Price-to-Cash Flow. Price to book value, liquidation value, replacement value, land value, etc. usually prove helpful. These metrics often are not helpful for asset light companies, where Discounted Cash Flow scenario analysis is more useful. Applying these metrics across industries, countries, and regions helps illuminate mispricing. Looking at different industries through different lenses, through focused lenses, using industry appropriate metrics and qualitative factors is important. Barriers to entry are an important factor. Potential winners possess different key attributes. Supply and demand are extremely important detriments of margin sustainability. The investor herd has a strong tendency to use trend line analysis, assuming that past growth will lead to future growth. A more reasoned, independent assessment will often foretell margin collapses as industries overdo it, thereby sowing the seeds of their own self-destruction.

Currently, opportunities are being created when the establishment pays too little heed to supply growth. This fallacy extends to money. Many seem to believe that the Federal Reserve has succeeded in quintupling the supply of dollars without a loss of intrinsic value. That is impossible. Evidence of the loss of value is abundantly clear. Gold supply held by the U. S. Treasury has not increased. As economic theory would predict, the price of gold went up. Following 12 straight years of advance and apparently overshooting, the price has since corrected 40%. The trend followers have their rulers out again, confusing a correction in a supply/demand induced uptrend with a new counter-trend.

We view this as opportunity. At the same time, bonds are priced as if they were scarce rather than too abundant to be managed. It is no secret that this is due to open, market manipulation by the central banks. Intrinsic value must eventually be reflected in market prices. These are abnormally challenging times. Fortunately, we believe markets aren’t fully efficient.

If you listen to his conference calls and read his insights, you will have a great education in counter-cyclical investing. It is easy to know what to do but hard to do!

The Twilight Zone – Jan 2015

Value Investor Insight_3.31.14 Kopernik (Interview)

July 2014 The Contrarian Iben of Kopernik (Interview)

Kopernik Annual Report 10 31 14 – Web Ready

Kopernik Semi-Annual Report _4.30.2014_FINAL

When Doves Cry_Final

The Wizard of Oz Dec 2013

THE SADDLE RIDGE HOARD

2014 – 4th Q Call with DI – Transcript FINAL

A tutorial of Deep Value Investing in Highly Cyclical Assets/Companies

The trials, tribulations, and need for consistent approach.

http://kopernikglobal.com/content/news-and-views-iben-insights

http://kopernikglobal.com/content/news-and-views-news

I will be asking for your suggestions for the deep value course. I am collating one reader’s suggestions which I will post next.  Some of you may be quite experienced and advanced investors who tire of the theoretical course materials as well as the mechanical aspect of quantitative investing. We will discuss this next………….Thanks for your patience.

 

Enron Case Study Analysis. Ask Why? Why?

Enron3

Case-Study-So-What-is-It-Worth    Prior Post where students discussed the case.

Turn up the VOLUME: Don’t believe the …..?

Enron-Case-Study-So-What-is-It-Worth  My walk-through. I go straight to the balance sheet then calculate the returns on total capital in the business. These financial statements were easy to discard because of the size of the business and the poor returns. My estimate of $5 to $7 per share worth or 90% less than the current share price, was wrong. The company was worth $0.  This is more a case of institutional imperative and incentive-based bias. Wall Street was feeding at the financial trough to keep raising money for Enron (to keep the bad businesses afloat) so guess what the financial analysts (CFAs and MBAs) suggested? Buy!   I guess the market is not ALWAYS efficient.

Forget accounting scandals, this was a crappy business based on trading so no way to determine normalized earnings.   When I was in Brazil and saw Enron’s newly-built generating plant sitting idle, I asked why.   A project developer said he got paid by doing deals by their size not profitability, therefore, the bigger the white elephant, the better.  When I called mutual funds who owned Enron as it was trading $77 per share to ask the analyst if he/she was aware of Enron’s declining businesses coupled with absurd price, I was told to shut up. As one analyst (Morgan Stanley?) told me, “I only believe what I want to believe and disregard the rest.”

Enron Annual Report 2000  Ha, ha! and Is Enron Overpriced?

The above august panel never answered why anyone would give capital to Enron?  No one mentions the elephant in the room.  Sad.

What does the above case have to do with net/nets and our course. Everything! Look at the numbers, think for thyself, ignore Wall Street, and be aware of incentives.   Buying bad businesses at premium prices is a guarantee of financial death.

This is an aside, but based on the above Enron example, does value investing serve a SOCIAL purpose or benefit? Prof. Greenblatt doesn’t think so–you are just trading pieces of paper, but what do YOU think?

See these two venture capitalists explain the social purpose of their business:

See’s Candies, Sanborn Map, and Inflation Article

SeesA 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.Sees 2

The best investment article I have ever read of Buffett’s is:

Buffett & Inflation Highlighted plus if you wish to read all that Buffett has said about inflation then Buffett inflation file.

A key case for you to focus on is See’s_Candies_Case_Study. Combined with Buffett’s Inflation Swindles the Equity Investor (Fortune Article: Buffett – How Inflation Swindles the Equity Investor), you will see a leap in Buffett’s thinking. Both are important to understand and complementary to each other.

Finally, Sanborn_Map_Case_Study_BPLs is another case mentioned in Chapter 3 of Deep Value.

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

DEEP VALUE Videos on Net/Nets and Investing

Closing Arg

How is it possible that an issue with the splendid records of Tonopah Mining should sell at less than the company’s cash assets alone? Three explanations of this strange situation may be given. The company’s rich mines at Tonopah are known to be virtually exhausted. At the same time the strenuous efforts of the Exploration Department to develop new properties have met with but indifferent success. Finally, the drop in the price of silver last year has provided another bearish argument. It is this combination of unfavorable factors which has carried the price down from $7  1/8 in 1917 to its present low of $1  3/8 in 1923.

Granting that the operating outlook is uncertain, one must still marvel at the triumph of pessimism which refused to value the issue at even the amount of its cash and marketable investments; particularly since there is every reason to believe that the company’s holdings in the Tonopah and Goldfield railroad, are themselves intrinsically worth the present selling price. (Ben Graham on Investing)

VIDEOS

Marty Whitman criticizes Graham and Net Nets (3 minutes Must see!)

Marty Whitman: They Just Don’t Get it.  (23 minutes) Marty says many analysts on Wall Street do not understand credit analysis.   We will explore later in this course whether the quality of credit provides a better assessment of the true cost of capital for a firm rather than “beta.”

One investor’s experience investing in Net/Nets (3 minutes)

Net/nets as value traps (5 minutes)

Good advice on behavioral investing (3.5 minutes)

Prof. Greenwald on UGLY and Cheap or Graham’s Search Strategy (8 minutes)

Greenwald on the Balance Sheet (risk of financials) (10 minutes)

Reading Assignments; The Institutional Imperative

ThOdysseusAndSirensWaterhou

All Enrollees in the DEEP VALUE COURSE should have been emailed Security Analysis and The Intelligent Investor.

Please read Chapters 42 – 45 (on the Balance Sheet). Especially focus on Chapter 43, Significance of Current Asset Value in Security Analysis, (pages: 548-613)

Read Chapter 15 in the Intelligent Investor (pages 376-402)

Chapter 22, Graham’s Net-Nets: Outdated or Outstanding in Montier’s Value Investing,  (Pages 229-235)

Chapter 2, Contrarians at the Gate in Deep Value, (pages 19 -34)

Chapters 1 & 2 in Quantitative Value (pages 3 – 59)

A total of about 168 pages.   This is to give you an early start for next week.  If you are short on time, then just read Ch. 2 in DEEP VALUE. 

If you didn’t receive any of those books, then 1) check your spam folder, 2. email me at aldridge56@aol.com with the title BOOKS and what you are missing.  3. if you receive an email with material that you have already received, then ignore/delete.

The Institutional Imperative
Sometimes institutions get caught up in the moment as well.  A company I used to work for held the Fairholme fund in two separate strategies in 2010.  At the end of 2010 I was able to convince the group to completely sell out of the fund in the smaller strategy, but it remained in the larger strategy.  In 2011, the Fairholme fund lost about 32% when the S&P 500 was up 2%.

fairx

At the end of 2011 I (the author of this article, link below) was able to convince the group to add the Fairholme fund back to the smaller strategy, but was unable to convince them to even maintain its weighting in the larger one.  Instead the group decided to cut the allocation in the larger strategy in half, despite my objections.  The argument was that the volatility and amount of underperformance (What about Regression to the Mean?) was too great.  The amount of underperformance was one of the reasons to add it back to the smaller strategy and in my experience returns trump volatility as volatility can actually be your friend.  In 2012, Fairholme was up about 35% which almost beat the S&P 500 by 20%.  In the end it was the clients that were hurt as the investment group followed the herd, on the larger strategy at least, keeping a manager after great performance and selling them after poor performance.  Read more….

The institutional-imperative

Institutional Investors and Analysts tend to herd-like behavior by acting late after trends are established.

Goldman cuts oil outlook, so NOW you tell us! (Perhaps, a tad late on the ADVICE!)

Working at Goldman Sachs

 

How NOT to be a DEEP VALUE INVESTOR

Repetitio est mater studiorum,” says the Latin proverb – repetition is the mother of all learning.

Lessons for this post:

  1. Know what you are doing.
  2. Avoid paying massive premiums over net asset values.

Below is CUBA, a closed-end fund investing in companies that invest in Cuba or will benefit by an increase in business with Cuba. Note the spike upward on the announcement that Obama would allow a prisoner exchange and take Cuba off the US’s terror list opening up the possibility of the end of the US embargo.

large CUBA

Now go: CUBA NAV Summary  (Click on the button, since exception on the right side of the page, to see the history of price vs. Net Asset Value (“NAV”). Note the results last time “investors”/speculators or the confused paid in excess of 50% to the underlying stocks. We can argue about the intrinsic values of the underlying stocks but not the prices–because price is what it is. Mr. Market has spoken.

Here we are todaysmall cuba

Go back and click on CUBA NAV Summary and view the one year summary. Note that the price reached a 70% premium to the NAV AFTER the news event of “improving” US/Cuba relations.   Upon hearing the news:

My first post on CUBA (CEF) SELL!  Can I predict? No, just common-sense.

Where is the efficient market? Perhaps the unavailability of shares to borrow hindered arbitrageurs who could buy the underlying stocks and short the closed-end fund (“CEF”), CUBA.  But to pay such a premium is almost a guaranteed loss unless sold to a greater fool who will pay an even more absurd premium. That is speculating not investing. What is business-like about paying a 70% premium after a news event?

A closed-end fund sells a fixed number of shares to investors. For example, let’s pretend we start a closed-end fund to buy stocks, called the BS Fund. We sell 10 shares at $10 each for $100 in capital, then we buy 1 share of Company X at $50 and 2 shares of Company Y for $25 (ignoring commissions and fees). The net asset value (NAV) is ($50 times 1 share) + ($25 times 2 shares) = $100.   The net asset value per share is also $10.  So the price per share of the CEF ($10) trades at no premium (0) to the NAV per share $100/10 shares.  Now an investor wants to sell 3 of his BS (CEF shares) to an investor who bids for them at $9.00 per share.  Unless, the underlying share prices of Company X and Y change, then the discount is now 10%.  We, as the management, must institute a decision to buy back shares of the BS fund to close the discount or investors increase their demand for the shares.

Carl Icahn got his start as a closed end fund arbitrageur, who would force the managements of the closed-ends funds that traded at large discounts to NAV, to buy-back their shares.

Setting aside the emotional impact of the news announcement, the prisoner exchange and Obama’s reducing of sanctions doesn’t change much.  By the way, if sanctions and embargos don’t work (I agree) as Obama claims then why the sanctions on Russia? If the Russians didn’t surrender during Stalingrad, what are the odds now? Color me cynical.

The US is ALREADY one of the top ten trading partners with Cuba. Of course, the embargo is a farce, kept in place for political purposes. Congress still has to vote to remove the embargo, but even without the embargo Cuba lacks the production of goods and services to trade. Why? Cubans lack the capital to produce because they lack the security of property rights and the rule of law to acquire capital. No Habeas Corpus, no freedom of speech, and no rights. No tyranny generates LONG-TERM economic growth.

What returns will foreign investors require to invest in Cuba?  Say you whip out your spread-sheet and suggest 25% annual returns to build a new hotel in Cuba based on your projection of American tourists hitting the shores of Cuba like locusts.  Two years after the hotel is built, Raul Castro and his military cronies tears up your contract. Investment lost.  Without the rule of law and sanctity of contract, the rest means little. The first lesson is to know what you are doing.

Life in Cuba:

  1. Tengo Hambre A Cuban Says I AM HUNGRY!
  2. Life for Cuban Youth (Cuba with highest suicide rates in the Western Hemisphere.

The investor who buys CUBA would have to understand what the current changes mean for the companies in the fund. Anyone who spends time understanding the current economic conditions there would grasp how little the current announcement means for investment there.  Ask the Canadian investor rotting in a Cuban jail today Canadian investor rots in Cuban jail.

Speculators were willing to pay at 70% premium AFTER the price of the underlying companies had moved higher by 10% to 15% on the news.  A premium on top of a premium–a lesson of what NOT to do.   Questions?

If anyone in this class does that, then this awaits: No Excuse

Whacked on W A C C (Wgt. Avg. Cost of Capital)

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Whacked on WACC

A reader asked how Prof. Bruce Greenwald determined WACC.

You can use traditional finance techniques of applying Beta (see links below) but I prefer estimating what other investors would require to risk their equity capital in the particular business because you are forced to think about business, financial and management risks.  Don’t substitute models for your own thinking. 

I will quote Prof. Greenwald’s discussion of WACC in Value Investing, pages 95-98

After we have completed the first step in arriving at an EPV (earnings power value) which is to calculate distributable earnings (Think of after-tax owner earnings using true maintenance capex instead of depreciation) for the company. Now we need to determine the appropriate cost of capital to use in the equation of EPV = Adjusted earnings x 1/R, where R = WACC.

Professional finance calls for a calculation of the weighted average cost of capital, known affectionately as the WACC.

There are three steps:

  1. Establish the appropriate ratio between debt and equity financing for this firm.
  2. Estimate the interest cost that the firm will have to pay on its debt, after taxes, by comparing it with the interest costs paid by similar firms.
  3. Estimate the cost of equity. The approved academic method for this take involves using something called the capital asset pricing model (see link below), in which the crucial variable is the volatility of the share price of the firm in question relative to the volatility of the stock market as a whole, as represented by the S&P 500 . That measure is called beta, and as much as it is beloved by finance professors, it is viewed with skepticism by the value investors. (98) Value Investing (Greenwald).

CSInvesting: Why? Because price movement is not risk! Risk always has an adjective preceding it like business-risk, management-risk, financial risk, regulatory risk, etc.

An alternative approach is to begin with the definition of the cost of equity capital: what the firm must pay per dollar per year to induce equity investors voluntarily to provide funds. This definition makes determining the cost of equity equivalent to determining the cost of any other resource. The wage cost of labor, for example, is what employers must pay to attract that labor voluntarily. There is no need to be esoteric about how to calculate the cost of equity in practice. We could survey other fund raisers to learn what they feel they must pay to attract funds. Venture capitalist in the late 1990s told us that they believed they had to offer at least 18 percent to attract funding. Venture investments are clearly more risky than those in WD-40 (wdfc); it is understandable that potential investors would demand higher returns. Alternatively, we could estimate the total returns—dividend plus projected capital gains—that investors expect to obtain from companies with characteristics similar to WD-40.  This method, the details of which we avoid here, produces a cost of equity of around 10 percent. Because long-term equity yields are about 12 percent per year, and because WD has a much more stable earning history than the average equity investment, 10 percent meets the reasonability test.

Summary

I do not like the traditional financial approach that uses Beta or CAPM.  Beta is misleading, See Beta vs Margin of Safety_Mauboussin and Beta and Risk.

I prefer the Greenwald approach because it forces you to think about the business and financial risk of the particular company. Also, the CAPM that uses the lower cost of debt financing would lead you to a lower WACC if you had 99.9999% debt financing and .0001 equity financing. Obviously the financial risk would rise dramatically for equity holders.

Glenn Greenberg of Brave Warrior Capital uses a 15% rate of return.   If he can buy at a price which he feels will return 15% per year compounded, then he will buy.  So let’s say the market reprices upward the business where the stock price infers an 8% return in the future because the stock price rose due to positive expectations, and then he might sell and redeploy his capital–no wonder he has averaged 18% returns. The market reprices his stocks before his estimated time- frame.   The point is not to double discount. If you can buy a business at a price that implies your required return of 15 (in Glenn Greenberg’s case) then you would not try to wait for a 50% discount on top of that.

Joel Greenblatt in his special situation class in discussing American Express described WACC in terms of valuation this way: If I can buy Amex here at $45 I think it will be worth $60 in two years because pension funds will need to buy it to meet their 9% hurdle.  I am paraphrasing and I may be misquoting, but that is one way he approached valuation. I guess that is where the art form comes in. How would he know pension funds would use 9%? Experience?

I always stress fundamentals. Try to sit down with a Value-Line and go back over companies’ 12-year history and see what the implied WACCs were on the businesses over time. After going through 2,000 companies month after month, you will have a good feel for when to use 8% vs. 12%. But wait for the obvious fat pitch. If the investment is too close to call at 9% or 10% then pass.

Read more:Whacked on WACC

Compare to traditional finance:

WACC_tutorial

Weighted Average Cost of Capital Article A short summary

Evaluating Debt and WACC Damoradan  More than you would ever want to know! :)

CAPM Damordaran

Choose what works for you!

Value Traps; The Dollar Crisis; Depression of 1929

worse

I owe my early success as an investor not to brains or knowledge, because my mind was untrained and my ignorance was colossal, The game taught me the game, And didn’t spare the rod while teaching.  

Whenever I have lost money in the stock market I have always considered that I have learned something; that if I have lost money I have gained experience, so that the money really went for a tuition fee.  –Jessie Livermore

Mark Sellers and PRXI Value Trap

He put over 50% of his fund into MCF:

MCF

I added an update to yesterday’s micro-cap post. http://wp.me/p2OaYY-2tX.  The point is to try and understand prior investment successes or failures. Any lessons there?

An excellent book on the inflationary 1970s The-Dollar-Crisis by Percy Greaves

I just like the old photos to capture the spirit of the times: The-Stock-Market-Crash-of-1929

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I am still in shock over Brazil’s World Cup blow-out.

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A fat tail event?