I have been a long-time reader of your blog as well as member of your Deep Value group. I am studying in a business school and I’ve been investing in stocks since I was 15 (now 23). I have read the basic Graham’s Intelligent Investor and Security Analysis and lately I have found the statistic, Deep Value approach very interesting.
For me it’s very hard to choose between franchise type investment strategy and more statistic, asset based valuation strategy. I acknowledge that my skills for identifying those Buffet- type-compounders at low prices are lacking but I also know that sticking with asset based strategy is mentally difficult. I have been trying to find asset-based valuation strategies from your blog and Deep Value group and wanting to be better at valuating businesses. I also found Tobias Carlisle’s books helpful and encouraging about finding great picks using quite simple ratios such as P/B or Acquirer’s multiple.
I believe my problem is quite common and you hear this quite often. I am really convinced about your knowledge and I find you to as a great teacher. I hope you could email me those books you took off from your blog because of the copyright reasons. And of course if you can give some tips and hints I would be very thankful.
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My reply: Yes, your worries/problems are endemic and natural to anyone developing their investment process. You have two major goals:
How to value a business
How to think about prices
Point 1: In valuing a business you have either an asset or a franchise (or franchise 2% to 5% of businesses or non-franchise) to value. The terms are not important, but the concepts are. If you pay over asset value for a business then growth will not bail you out. Time is not on your side. Therefore, step one in improving your results is do not mistake a non-franchise business for a franchise business. You are in the death-zone where you risk a PERMANENT loss of capital. See below, dead Russian soldier during WWII invasion of Finland.
Examples would be swks vl. There is almost no way in a competitive world that SWKS’ returns on capital will remain at those levels (20%+) over the next ten years–and that is what speculators (NOT investors) are betting on.
Buying net/nets and working capital bargains (buying at a discount to liquid working capital and paying nothing for fixed assets) is probably the safest type of investment IF done as a group. For example, Energold, Inc. (EGDFF) is a working capital bargain with a decent balance sheet but if frontier drilling does not increase over the next five to ten years then it could go out of business. If you invest 10% in ten of those net/nets and working capital bargains, then the ODDS are with you. This is NOT a recommendation for Energold, inc. because it is just a fair business in a hugely cyclical industry, but it is cheap based on its balance sheet.
The bottom-line is that you need to practice and DO valuation all the time. Value a company every day or every week. Go through a Moody’s manual or value-line (or the equivalent in Finland) and look at a lot of companies. Reading about sex, or sky-diving or war is not the same as participating. Yes, go ahead and read, but request annual reports from all the companies in Finland and start valuing them. If you have trouble, then set aside and come back later when you have more knowledge. Don’t be afraid to call up the companies. If you find a company that is really cheap, ask the CFO why doesn’t he sell his home to buy more stock? The point is to be ACTIVELY valuing companies ALL THE TIME. Practice, practice.
Take KO VL Last I looked Coke was trading at about 16 times EV-to-EBITDA while HNRG trades at 4 times EV-to-EBIDA (deduct $1 per share for subs.). Cheap!? Well, hold on, for every dollar of sales Coke makes about 80 to 85 cents in free cash flow while for Hallador Energy (Coal Producer) every dollar of sales generates about 15 cents of free cash-flow right now. I expect that to rise to 20 cents but you can see that Mr. Market handicaps each business properly–usually (but not always). Hallador has unused capacity and can grow profitably but to a certain limit. I would characterize Hallador as a non-franchise but with quality assets compared to its competitors in the coal industry (second on cost curve behind Foresight Energy (FELP).
When you buy a franchise then you must expect that barriers to entry will hold-off regression to the mean. The strategy is almost opposite to buying assets where you expect regression to the mean to occur.
Point 2: How to think about prices. This comes down to knowing yourself? How do you think, how do you react under stress? Only YOU (not me or other “experts”). Here is an example of a true value investor:
You have to keep a log of your investments and decisions. What patterns do you see. Are you patient? How will you develop patience. If you have $1,000 US dollars, then if you make 5 investments of $200 each, write-up each investment–its value, why you made the investment, what would cause you to sell and/or abandon the investment. Then keep meticulous journal entries. You buy at $10 then the price rises to $15 then declines to $8. Will you buy more? Why or why not? The famous Seth Klraman, sells some at $15 because he knows he will be too upset to buy at $10 or $8 if he hasn’t sold some of his stock. The point is that Mr. Klarman has found a method that fits HIS personality.
Spend more time in introspection and practicing investing. Let me know your progress and GOOD LUCK.
Some of my Brazilian readers seem to be upset that I used “No Mas”, Spanish words, rather than Portuguese ones, in the title. To be honest I was not thinking about language, but instead about a boxing match from decades ago, where Roberto Duran used these words to give up in his bout with Sugar Ray Leonard.
I have used Vale as an illustrative example in my applied corporate finance book, and as a global mining company, with Brazilian roots, it allows me to talk about how financial decisions (on where to invest, how much to borrow and how dividend payout) are affected by the ups and downs of the commodity business and the government’s presence as the governance table. In November 2014, I used it as one of two companies (Lukoil was the other one) that were trapped in a risk trifecta, with commodity, currency and country risk all spiraling out of control. In that post, I made a judgment that Vale looked significantly under valued and followed through on that judgment by buying its shares at $8.53/share. I revisited the company in April 2015, with the stock down to $6.15, revalued it, and concluded that while the value had dropped, it looked under valued at its prevailing price. The months since that post have not been good ones for the investment, either, and with the stock down to about $5.05, I think it is time to reassess the company again.
John Chew: At least the author has a process to reassess his investment. I believe the critical flaw in his analysis (easy to say in hindsight) was not noting the massive mal-investment due to distorted credit markets caused by central bank policies. To normalize iron ore prices you would need pre-distortion prices going back twenty-five years.
For the millions of investors in buy and never sell strategies today who look at the values on their statements today, trusting that the Federal Reserve will always cut rates and always flood the system with more cheap debt as though this were some sacred rite of passage for the American investor, I can only say two words. Wake up! Read more: BMI_TheBigNastyDWordIsHere_Sept22.15
You may not wish to become a short-seller due to the asymmetrical risk and reward, but you can certainly improve as an analyst to become more skeptical by taking on the viewpoint of a short-seller. Riders on the Storm or Short Selling An overview and primer. The best book yet that I have found: For those who wish to learn what a REAL BEAR MARKET is like then:
If you want a cogent metaphor for the central bank enabled crack-up boom now underway on a global basis, look no further than today’s scheduled chapter 11 filling of met coal supplier Alpha Natural Resources (ANRZ). After becoming a public company in 2005, its market cap soared from practically nothing to $11 billion exactly four years ago. Now it’s back at the zero bound.
This article by David Stockman perfectly illustrates that capital DESTRUCTION or mal-investment occurs DURING the boom phase. The bust which is what Alpha and the entire coal industry are going through creates the healing process as assets are redeployed to their higher uses and supply is re-balanced to meet changed demand.
From 2006 to today during the greatest coal boom in history, Alpha has lost almost $5 billion for its shareholders. At the peak of its earnings, the market cap (not including debt) traded at 25 times and during the insanity at over 50 times. Investors were destroying their capital and the company was mis-allocating its shareholder’s capital DURING the boom phase. Now is the cleansing process. Ditto for many coal companies. So ask yourself why do reasonably intelligent management teams and Board of Directors make such a CLUSTER of errors and why do investors pay stupid multiples on peak earnings? A combination of central bank distortion and psychology and momentum chasing?
Yes, bankruptcies happen, and this is most surely a case of horrendous mismanagement. But the mismanagement at issue is that of the world’s central bank cartel.
The latter have insured that there will be thousands of such filings in the years ahead because since the mid-1990s the central banks has engulfed the global economy in an unsustainable credit based spending boom, while utterly disabling and falsifying the financial system that is supposed to price assets honestly, allocate capital efficiently and keep risk and greed in check.
Accordingly, the ANRZ stock bubble depicted above does not merely show that the boys, girls and robo-traders in the casino got way too rambunctious chasing the “BRICs will grow to the sky” tommyrot fed to them by Goldman Sachs. What was actually happening is that the central banks were feeding the world economy with so much phony liquidity and dirt cheap capital that for a time the physical economy seemed to be doing a veritable jack-and-the-beanstalk number.
In fact, the central banks generated a double-pumped boom——first in the form of a credit-fueled consumption spree in the DM economies that energized the great export machine of China and its satellite suppliers; and then after the DM consumption boom crashed in 2008-2009 and threatened to bring the export-mercantilism of China’s red capitalism crashing down on Beijing’s rulers, the PBOC unleashed an even more fantastic investment and infrastructure boom in China and the rest of the EM.
During the interval between 1992 and 1994 the world’s monetary system—–which had grown increasingly unstable since the destruction of Bretton Woods in 1971——took a decided turn for the worst. This was fueled by the bailout of the Wall Street banks during the Mexican peso crisis; Mr. Deng’s ignition of export mercantilism in China and his discovery that communist party power could better by maintained from the end of the central bank’s printing presses, rather than Mao’s proverbial gun; and Alan Greenspan’s 1994 panic when the bond vigilante’s dumped over-valued government bonds after the Fed finally let money market rates rise from the ridiculously low level where Greenspan had pegged them in the interest of re-electing George Bush Sr. in 1992.
From that inflection point onward, the global central banks were off to the races and what can only be described as a credit supernova exploded throughout the warp and woof of the world’s economy. To wit, there was about $40 trillion of debt outstanding in the worldwide economy during 1994, but this figure reached $85 trillion by the year 2000, and then erupted to $200 trillion by 2014. That is, in hardly two decades the world debt increased by 5X.
To be sure, in the interim a lot of phony GDP was created in the world economy. This came first in the credit-bloated housing and commercial real estate sectors of the DM economies through 2008; and then in the explosion of infrastructure and industrial asset investment in the EM world in the aftermath of the financial crisis and Great Recession. But even then, the growth of unsustainable debt fueled GDP was no match for the tsunami of debt itself.
At the 1994 inflection point, world GDP was about $25 trillion and its nominal value today is in the range of $70 trillion—-including the last gasp of credit fueled spending (fixed asset investment) that continues to deliver iron ore mines, container ships, earth-movers, utility power plants, deep sea drilling platforms and Chinese airports, highways and high rises which have negligible economic value. Still, even counting all the capital assets which were artificially delivered to the spending (GDP) accounts, and which will eventually be written-down or liquidated on balance sheets, GDP grew by only $45 trillion in the last two decades or by just 28% of the $160 trillion debt supernova.
Here is what sound money men have known for decades, if not centuries. Namely, that this kind of runaway credit growth feeds on itself by creating bloated, artificial demand for materials and industrial commodities that, in turn, generate shortages of capital assets like mines, ships, smelters, factories, ports and warehouses that require even more materials to construct. In a word, massive artificial credit sets the world digging, building, constructing, investing and gambling like there is no tomorrow.
In the case of Alpha Natural Resources, for example, the bloated demand for material took the form of met coal. And the price trend shown below is not at all surprising in light of what happened to steel capacity in China alone. At the 1994 inflection point met coal sold for about $35/ton, but at that point the Chinese steel industry amounted to only 100 million tons. By the time of the met coal peak in 2011, the Chinese industry was 11X larger and met coal prices had soared ten-fold to $340 per ton.
And here is where the self-feeding dynamic comes in. That is, how we get monumental waste and malinvestment from a credit boom. In a word, the initial explosion of demand for commodities generates capacity shortages and therefore soaring windfall profits on in-place capacity and resource reserves in the ground.
These false profits, in turn, lead speculators to believe that what are actually destructive and temporary economic rents represents permanent value streams that can be capitalized by equity owners.
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Jeremy Grantham points out the unusual increase in China’s coal demand:
After every historical major rally in commodity prices, there has been the predictable reaction whereby capacity is increased. Given the uncertainties of guessing other firms’ expansion plans, the usual result is a period of excess capacity and weaker prices as everyone expands simultaneously. The 2000 to 2008 price rally was the biggest in history, above even World War II. It was therefore not surprising that the reflex this time was the mother of all expansions and excess capacity. This was further exaggerated by a sustained slowdown in demand from China, which is still playing through. The most dramatic example of this was in China’s use of coal, which had grown from 4% of world use in 1970 to 8% in 1988 and to 50% in 2013, the world’s most remarkable expansion in the use of anything since time began. And yet this remarkable surge was followed in 2014 by a reduction in China’s use of coal! And that in a year in which China was still growing at over 6%. See:price-insensitive-sellers-and-ten-quick-topics-to-ruin-your-summer
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Continued…..But as shown below, eventually the credit bubble stops growing, materials demand flattens-out and begins to rollover, thereby causing windfall prices and profits to disappear. This happens slowly at first and then with a rush toward the drain.
ANRZ is thus rushing toward the drain because it got capitalized as if the insanely uneconomic met coal prices of 2011 would be permanent.
Needless to say, an honest equity market would never have mistaken the peak met coal price of $340/ton in early 2011 as indicative of the true economics of coking coal. After all, freshman engineering students know that the planet is blessed (cursed?) with virtually endless coal reserves including grades suitable for coking.
Yet in markets completely broken and falsified by central bank manipulation and repression, the fast money traders know nothing accept the short-run “price action” and chart points. In the case of ANZR, this led its peak free cash flow of $380 million in early 2011 to be valued at 29X.
Self-evidently, a company that had averaged $50 to $75 million of free cash flow in the already booming met coal market of 2005-2008 was hardly worth $1 billion. The subsequent surge of free cash flow was nothing more than windfall rents on ANZR’s existing reserves, and, accordingly, merited no increase in its market capitalization or trading multiple at all.
In fact, even superficial knowledge of the met coal supply curve and production economics at the time would have established that even prices of $100 per ton would be hard to sustain after the long-term capacity expansion than underway came to fruition.
This means that ANRZ’s sustainable free cash flow never exceeded about $80 million, and that at its peak 2011 capitalization of $11 billion it was being traded at 140X. In a word, that’s how falsified markets go completely haywire in a central bank driven credit boom.
As it happened, the full ANZR story is far worse. During the last 10 years it generated $3.2 billion in cash flow from operations——including the peak cycle profit windfalls embedded in its reported results. Yet it spent $5 billion on CapEx and acquisitions during the same period, while spending nearly another $750 million that it didn’t have on stock buybacks and dividends.
Yes, it was the magic elixir of debt that made ends appear to meet in its financial statements. Needless to say, the climb of its debt from $635 million in 2005 to $3.3 billion presently was reported in plain sight and made no sense whatsoever for a company dependent upon the volatile margins and cash flows inherent in the global met coal trade.
So when we insist that markets are broken and the equities have been consigned to the gambling casinos, look no farther than today’s filing by Alpha Natural Resources.
Markets which were this wrong on a prominent name like ANRZ at the center of the global credit boom did not make a one-time mistake; they are the mistake.
As it now happens, the global credit boom is over; DM consumers are stranded at peak debt; and the China/EM investment frenzy is winding down rapidly.
Now comes the tidal wave of global deflation. The $11 billion of bottled air that disappeared from the Wall Street casino this morning is just the poster boy—–the foreshock of the thundering collapse of inflated asset values the lies ahead. See: Pop Goes the Alpha Bubble.
So I have bought coal companies like FELP, CLD, HNRG, BTU because IF there exists a coal industry, the best reserves, lowest costs, and well-capitalized companies should thrive on the other side of this HEALTHY bust. Yes, BTU does have a heavy balance sheet but it does have world-class reserves, operations and low-cost structure. However, Austrian economics teaches that the bigger the boom, the greater the bust. The TIME and DEPTH of the depression in coal will probably be underestimated by all, including me. One has to keep your positions diversified and small enough to sleep at night. I don’t see a turn before the next 18 to 24 months at least. Cyclical stock require a five to seven year horizon, perhaps longer. But NO ONE really knows until well after the bust when it is over. We must live with uncertainty.
Where is the next BUST. Capital is BEING DESTROYED TODAY:
The same phenomenon that is driving Biotech to unsustainable valuations (ON THE WHOLE) is what has caused coal stocks to collapse:
It actually seems, at times, as though there is this mysteriously large buyer that suddenly appears whenever the equity market most “needs it”…and the subsequent buying is so aggressive and so desperate…not the style of the mostly steady “hands” I personally know. It just seems too good to be true and the Sortino Ratio numerically reflects that belief. Plus, we all know that the economic fundamentals are not as smooth as the weekly or monthly charts of the S&P 500 would suggest.
Remember that equities typically offer the most risk of any asset class…not the lowest risk as the above data set suggests. Nevertheless, Yellen and Bernanke must be “psyched” as their “wealth effect” model has been so effective…actually too effective as the market distortions grow ever larger…and more market bears become contorted “road-kill”.
To be sure these distorting effects may be entirely assigned to The Fed…the debt monetizing, interest rate suppressing “Masters of the Universe” who always get what they want while answering to nobody.
They’ve literally trounced and expectorated on the concept of “moral hazard” and, it seems, purposely reconfigured and redefined its meaning into: We have no economic moralsand this poses an enormous hazard to the performance of hedged money managers. The spoils go to the ignorant only – the Fed’s true heroes. What Risk?
he following quote from C. Edward Griffin tells the little known story how dollars are created.
The Mandrake Mechanism
The American dollar has no intrinsic value. It is a classic example of fiat money with no limit to the quantity that can be produced. Its primary value lies in the willingness of people to accept it and, to that end, legal tender laws require them to do so. It is true that our money is created out of nothing, but it is more accurate to say that it is based upon debt. In one sense, therefore, our money is created out of less than nothing. The entire money supply would vanish into bank vaults and computer chips if all debts are repaid. Under the present System, therefore, our leaders cannot allow a serious reduction in either the national or consumer debt. Charging interest on pretended loans is usury, and that has become institutionalized under the Federal Reserve System. The Mandrake Mechanism by which the Fed converts debt into money may seem complicated at first, but it is simple if one remembers that the process is not intended to be logical but to confuse and deceive. The end product of the Mechanism is artificial expansion of the money supply, which is the root cause of the hidden tax called inflation. The expansion then leads to contraction and, together, they produce the destructive boom-bust cycle that has plagued mankind throughout history wherever fiat money has existed.
