Category Archives: Search Strategies

Checklists

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2015-06 ABBA Part I   Investing Checklist (Helpful)

2015-06 ABBA Part II – Bird in hand

Actual pre-flight checklists http://freechecklists.net/

Have a Great 4th of July Weekend!

Closed End Fund Arbitrage

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Closed End Fund Arbitrage and Hostile Takeovers

Our story begins with a closed end gold trust – GTU – that has been trading at a significant discount to its net asset value.   GTU, like its sister funds “CEF” (a mixed closed end gold and silver fund) and SBT.TO (a closed end silver trust), holds physical bullion in a Canadian vault.   Also, like its sister funds, it lacks a quality redemption feature – by which I mean: the ability to redeem units at their NAV (net asset value).   GTU’s redemption feature provides for redemption at roughly 90% of NAV.  Unlike an ETF,  a CEF (this might get confusing because we’re talking about Closed End Funds, but GTU’s sister fund actually has the ticker “CEF” also…) offers no way for market participants to create new shares: share creations must be done by the trust (they’d do an offering of shares and use the proceeds to buy bullion – if the units were trading above NAV).

When you account for the fact that GTU’s sector – precious metals ETFs/trusts/closed end funds – has been flooded with a variety of competing instruments which have superior redemption features, and that metals sentiment has been waning for a solid 2 years now, it’s not surprising that GTU had recently been trading at apersistent discount to NAV.

Enter:  Polar Securities, who purchased a stake in both GTU and SBT.TO, and then made an effort to get the Trusts to change their bylaws in such a way that would likely narrow the discounts to NAV that both trusts were suffering from.    Polar wrote a letter to unit-holders, and forced each board of directors to call a special meeting to vote on amending the bylaws.

None of this struck me as odd: this is something funds do all the time: buy cheap assets and try to unlock the value discounts that are present.   Amazingly, however, in goldbug-land, Polar Capital taking steps to try to close the massive discount to NAV that these two precious metals trusts were facing turned into cries of Polar attempting to “raid” the metal from the trusts.    While one might expect shareholders to be excited about the prospect of a narrowing of the massive NAV gap they’ve been languishing under, many instead rallied the wagons to fight this proposal!

GTU itself fought back, attacking the points of Polar’s proposal.  The GTU board of trustees noted that

1) Polar’s proposed redemption feature would be available to only a small number of holders, due to minimum size in the redemption requirement.   This is true, but largely irrelevant: all investors would benefit from a narrowing of the NAV discount if arbitrageurs came in to buy cheap GTU shares and redeem them to close the discount.  Although:

2) The board also noted the tax effects of redemptions, where the gains on sale of bullion would be taxable, and be borne by remaining shareholders.  This is true, but the effect would be miniscule compared to the massive discount to NAV that could be closed.

3) U.S. Mutual Funds may sell GTU to avoid these adverse tax consequences.  Reality suggests that GTU’s largest unit-holder, a U.S. based mutual fund, is eager to see the discount narrowed – but more on that later.

4) Polar’s proposal would increase GTU’s operating expenses.  Again, this is true, but we’re talking about matters of basis points – not percentage points that could be gained by the adoption of the proposal and closing of the massive NAV discounts.

So Polar replied with a PR of their own, repeating that the Trustees had no means of closing the discount and no plan to do so.  A common refrain you’ll hear from holders of GTU is something like: “when the price of gold is going down, GTU trades at a discount to NAV. When the price of gold goes back up, the discount will narrow.”

Well: *maybe* it will narrow – or maybe the market has been saturated with superior competing products that have equal “safety” and pareto-superior redemption features that can actually insure that discounts to NAV will be closed.  GTU lacks these features, and thus there is no reason why the discount must close if/when the price of gold rallies.  As I noted in a past post, just because a closed end fund traded at a premium in the past doesn’t mean it will/should trade at one again in the future, *especially* when there are a plethora of other ways to get the same exposure with other products.

Anyway, GTU responded to Polar’s latest PR quickly, noting:

1) Polar is not aligned with long term holders of GTU – I don’t know what this means: Polar wants the discount to NAV closed, which is exactly what the other holders should want.

2) Polar’s proposal is not “the answer” and the consequences of their proposal are real, explaining:

“In fact, Polar’s proposal can only be proven to eliminate the discount for the less than 1% of Unit-holders (including Polar) that could utilize Polar’s proposed physical redemption feature. The remaining 99% of Unit-holders are being asked to trust Polar’s opinion while Polar exits its position.”

That, of course, is nonsense.  Again: if I’m a GTU holder, I don’t care that I can’t buy and redeem enough units to get a gold bar: the act of others doing it will drive the price up and close the discount!  Yes, again we have that tax issue addressed above, if the redemptions actually happen – but more on that later….

3) etc etc etc

Amazingly, next, Institutional Shareholder Services, a proxy advisory firm, came out on the side of the Trust, and recommended that unit holders vote against Polar’s proposal! ISS wrote:

“Overall, the short-term and opportunistic nature of the dissident proposal constitutes a cause of concern for  long-term unit-holders. In addition, by just amending the trust’s Declaration of Trust and not providing a detailed business plan with new strategic initiatives on how to better manage the trust, the dissident’s request to replace the majority of the board appears overly demanding”

I was surprised by this, as there’s nothing “short-term” about a redemption feature that would protect all shareholders from future NAV dislocations.

Polar, of course, “disagreed” with the ISS recommendation, noting, among other things:

ISS displays lack of capital markets understanding” – which I completely agree with.

Polar added a few more bullet points, which I agree with:

 

  • ISS ignores peer comparisons, governance failures and needless value destruction
  • CGT discount to NAV could widen further without effective redemption feature
  • Polar has proposed the ONLY solution to eliminate the significant trading discount to NAV

This week, Polar figured they’d try to counter some of the GTU Board of Trustees responses that were off base, so they committed to not redeeming any GTU shares for the remainder of 2015.   Why did they do this?  Because again: they’re not interested in “raiding” GTU’s gold: they’re interested in capturing the NAV discount that should be remedied.   Polar knows that even if they don’t redeem, the discount is highly likely to close if a redemption feature is added.  Either the market will correctly price the units to reflect their NAV, or other arbitrageurs will come in an ensure that the price reflects the proper value – redeeming if necessary.

I’ll give you one guess what happened next:  GTU’s board responded again, in a PR titled “Polar’s Empty Promise To Delay Their Redemption Does Nothing to Correct the Fundamental Flaws in Their Proposal.”  Shockingly, GTU basically seems to be accusing Polar of lying about not redeeming, because GTU, like the ISS, seems to lack an understanding of how capital markets work.  GTU’s Special Committee Chairman added:

“…Such a delay does not level the playing field for the over 99% of Unit-holders who could not utilize their proposed physical redemption option, and who would be inheriting the increased cost and potential tax liability that come with it”

Again, this is ludicrous: GTU holders do not have the ability to redeem their shares at NAV.  Under Polar’s proposal, small shareholders would *still* not have this ability, but they’d be massive beneficiaries of the fact that others do have this ability.  Yes, again we have that tax issue, which is like complaining about pennies when someone is offering you dollars.

I already loved this story, as it was a back and forth between some guys who just wanted to help shareholders (and themselves, of course) realize the underlying value of their investment, but were being fought on all fronts by some shareholders and by the Trust itself.   But wait – today the drama kicked up a notch when none other than Sprott Asset Management jumped into the fray, making an unsolicited offer to exchange shares in GTU and SBT.TO for newly issued shares of its own physical bullion trusts: PHYS and PSLV.   Sprott (I’m using “Sprott” for “Sprott Asset Management” here, not to indicate “Eric Sprott”)  is basically proposing a takeover of the Central Trusts, where shareholders would receive shares of Sprott’s trusts instead, and Sprott would merge the underlying metal into their own trusts.

Brilliant!   I would expect that not a single goldbug site will write about Sprott trying to “raid” the Central Trusts, although that’s exactly what they’d be doing: piling the bullion under the Sprott umbrella so that Sprott Asset Management can get the management fees that Central Trust has been getting.  Never mind the fact that Sprott’s total fees are roughly 20 bps higher than Central Trust’s, or that when units are redeemed from Sprott’s trusts there are tax consequences like the ones Central Trust has been complaining about – if I were a GTU shareholder I’d be psyched for this offer! Well, we don’t know the exact terms of the offer yet – Sprott filed an SEC doc with some details, including that the exchange would be on a “NAV for NAV” basis, but I’d like to see the final details before blessing it.

Basically, though, I very much agree with Sprott’s CEO, John Wilson, who noted:

“It’s really just a very simple solution,” he said in an interview. “Why would you own that unit when you have opportunity to own a more liquid unit that does all the things you want and trades at its intrinsic value?”

Indeed!  I have been critical of Sprott on these blog pages in the past, but this one is a no-brainer for Sprott Asset Management, and probably for Central Trust unit-holders as well (side notable: Eric Sprott is no longer the man in charge – at least not officially – at Sprott Asset Management).   Sprott Asset Management knows – or perhaps GTU’s largest unit-holder, Pekin Singer Strauss, told them –  that while Canadian retail precious metals investors might be distrustful of some evil arbitrage fund trying to raid the metal from their trust, Canadian retail precious metals investors love and *trust* Sprott!  Hence, the beauty of this exchange offer, which, if successful,  would result in PHYS increasing its assets by roughly 50%!  You can do the math yourself, but Sprott Asset Management is looking at more than $ 3MM in additional annual management fees alone.  Synergies!

Of course, Polar already put their 2 cents in, issuing a PR that said that they welcomed the Sprott Exchange Offer– which, well, of course they do! The Sprott exchange offer, if it’s truly on a 100% NAV to NAV basis, will narrow the NAV discount that the Central Trusts are facing.

Nothing on this page should be construed as investment advice, which I couldn’t possibly give since we don’t know the details of the exchange offer anyway, but if I were a GTU shareholder, I’d be ecstatic about the Sprott Exchange offer’s preliminary details.   I can’t wait to see how the GTU board of Trustees reacts to this approach, especially since they’ve already pounded the table on the tax issue, while Sprott’s trusts face similar tax issues.   GTU’s board has also brought up management fees, but Sprott’s funds have significantly higher fees.   In other words, I think that it will be very hard for GTU’s board to deny the significant accretion that their unit-holders are likely to see under the Sprott exchange, but it’s also going to be odd to see them ignore the complaints they brought up multiple times in the back and forth with Polar.

Sprott’s CEO insinuated in a Bloomberg interview that it was GTU’s largest shareholder, Pekin Singer Strauss (probably nervous that Polar’s proposal was meeting resistance from GTU’s exceedingly naive shareholder base) who approached Sprott with this master win-win plan: “through that process some of those unit-holders reached out to us and thought we might offer a better solution” – I can’t wait to see how GTU’s Board reacts to this whole thing…

Stay tuned – this is pure gold for closed end fund geek drama…

-KD

I have no positions in GTU, SBT.TO, PHYS or PSLV

Valuing a Coal Company, Step 1: Will the Industry Survive?

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Is the Coal Industry Dead?

The key point is to try to disprove your thesis. Seek out the negatives and the counter-arguments, then make a reasoned decision to invest, not invest, short, stand-aside and wait, or dig further.

Lots of bad news hitting the coal industry: China slow-down, EPA Rules, falling natural gas prices, falling met and steam coal prices, President Obama says he will put coal out of business (supposedly)  http://www.washingtonpost.com/blogs/fact-checker/wp/2014/10/08/the-repeated-claim-that-obama-vow

HARD TIMES for US-coal-producers/

Coal five year

met coal

Nat Gas

2015 is the reckoning for coal: http://www.oilandenergydaily.com/2013/11/22/coal-2/

EPA Regulations Hit Economic Reality:  https://www.scribd.com/doc/266957890/Walker-May-2015-Letter

Will there be a coal industry over the next few decades in order to determine whether to use liquidation or going-concern value?

We seek to buy cyclical assets when there are NO REASONS to buy, the companies in the industry have depressed profits or large losses, and there seems to be no hope for the industry (Remember Airlines 9/11). However, we wish to avoid investing in Canal companies during the advent of the steam locomotive because then there is a permanent decline in asset value because long-term cash flows are driven by capacity constraints and customer demand changes.  Thus, we first try to answer this post’s question.

Let’s break down the energy producing statistics.

According to the Independent Statistics and Analysis Energy Information Administration, here’s how the nation’s electricity was generated in 2014:

  • ■ Coal: 38 percent
  • ■ Natural gas: 27 percent
  • ■ Nuclear: 19 percent
  • ■ Hydropower: 6 percent
  • ■ Other renewables: 7 percent, including
  •       — Biomass: 1.7 percent
  •       — Geothermal: 0.4 percent
  •       — Solar: 0.4 percent
  •       — Wind: 4.4 percent
  •       — Other gases: 1 percent

So let’s take the 38 percent of coal production out of the mix. Where’s the energy going to come from? It’s not. Therefore, we’re left with nothing but periods of darkness.

http://www.craigdailypress.com/news/2015/may/29/us-would-blackout-without-coal/

Global-coal-use-growing-faster-than-any-other-energy/

Books on the Coal Industry and Coal’s History

Big Coal

Long dismissed as a relic of a bygone era, coal is back — with a vengence. Coal is one of the nation’s biggest and most influential industries — Big Coal provides more than half the electricity consumed by Americans today (2006) — and its dominance is growing, driven by rising oil prices and calls for energy independence. Is coal the solution to America’s energy problems?

On close examination, the glowing promise of coal quickly turns to ash. Coal mining remains a deadly and environmentally destructive industry. Nearly forty percent of the carbon dioxide released into the atmosphere each year comes from coal-fired power plants. In the last two decades, air pollution from coal plants has killed more than half a million Americans. In this eye-opening call to action, Goodell explains the costs and consequences of America’s addiction to coal and discusses how we can kick the habit.

Coal WarsThe Moral Case for fossil fuels

We need fossil fuels

Current policies to supplant fossil fuels with inferior energy sources need to incorporate a deeper understanding of the transformative role of energy in human society lest they jettison the wellsprings of mankind’s greatest advance.

The thesis of this paper is that fossil fuels, as a necessary condition of the Industrial Revolution, made modern living standards possible and vastly improved living conditions across the world. Humanity’s use of fossil fuels has released whole populations from abject poverty. Throughout human history, elites, of course, have enjoyed comfortable wealth. No more than 200 years ago, however, the lives of the bulk of humanity were “poor, nasty, brutish and short,” in the words memorably used by Thomas Hobbes.

This paper aims to articulate and explain some startling, but rarely acknowledged, facts about the role of energy in human history. Energy is so intimately connected to life itself that it is almost equivalent to physical life. Virtually everything needed to sustain the life of a human individual—food, heat, clothing, shelter—depends upon access to and conversion of energy. Modern, prosperous nations now access a seemingly limitless supply of energy. This cornucopia, however, is a very recent advance in mankind’s history. Fossil fuels, methodically harnessed for the first time in the English Industrial Revolution, beginning in the 18th century and taking off in the 19th century, have been a necessary condition of prosperous societies and of fundamental improvements in human well-being.

Adequate treatment of this topic is a daunting task for anyone. The unprecedented stakes in today’s contentious energy policy debates about carbon, however, make it a morally necessary topic. As a former final decision-maker in a large environmental regulatory agency, I urge current officials and concerned citizens to reflect on energy policies within a broad but fundamental context: human history and the physics of material lives.

My research was initially inspired by a comprehensively researched monograph by Indur Goklany titled “Humanity Unbound.” His paper took me to a dozen books and twice as many academic papers. With gratitude, I acknowledge the books listed below as the most enlightening, persuasive guides on the topic. And I highly recommend them for more thorough analysis than allowed by the confines of this paper. May those policymakers entrusted with the authority to make binding decisions about energy consider these books as “a look before an unreflective leap” that could unravel mankind’s greatest achievement—
the potential enjoyment of long, comfortable, healthy lives without the gnawing hunger of subsistence poverty.

moral case for FF Epstein

CRITICS

Yes, fossil fuels have fueled our progress through the industrial revolution into the information age. But we have over-used them and fouled our nest. We could and can shift rapidly to renewables, but big oil greed obstructs us.  (Really?) As Pope Francis says, we have made the earth into “an immense pile of filth.” Own it.

The first big flaw that tragically happens to be the binding of the entire book (and in the title) is his thesis that fossil fuels is what causes human flourishing. No. INDUSTRIALIZATION is the underlying mechanism hat has created the exponential increase in human progress. Fossil fuels was just the first way of converting potential energy to mechanical energy. And it was a good one, but we need to move on to a more advance potential energy source. Luckily exponential growth in renewables and other advanced technologies has just started to gain heavy heavy steam.

By Donald Prothero on February 8, 2015

As an actual Ph.D. geoscientist who HAS WORKED for oil companies, written textbooks in geology of oil, and also done actual published research in climate change in peer-reviewed journals, I can say this work is pure garbage. Epstein cherry-picks climate data he doesn’t understand (as the review by Kathy Moyd pointed out), denies the conclusions of an entire scientific community who are NOT paid to shill for industry, and denies the obvious evidence of climate change going on worldwide. Then he distorts the benefits of fossil fuels and neglects or underplays the problems. The biggest problem of all is that (as all of us who are in the industry know so well), we’re past the peak of Hubbert’s curve and oil isn’t going to be cheap for the uses he brags about much longer.    (CSInvesting: Whether fact-based, true or untrue, all this critic asserts is not backed up with evidence–an assertion is not an argument.)  Appeal to authority argument–I’m in the industry and brilliant, you’re an idiot, so listen up!

Once the Saudis stop flooding the market with cheap oil to drive out the competition, it will pick up again to the levels of demand that anyone in the oil futures business knows so well, and we’ll be unable to use it for cheap plastics, fertilizers, pesticides, and all the other stuff that we wasted nearly all the planet’s oil heritage on. The moral case is clearly that we need to wean ourselves OFF of using up the last remaining oil so quickly before it reaches its true levels of scarcity, and it’s irresponsible to encourage people to use it up faster.
As all of my co-workers in the oil industry (and the students I trained who are now high in the business as well) know, oil is getting scarcer and scarcer, and the last thing we need to do is use it up faster and crash the global economy. Most of my colleagues in oil also agree that climate change is a serious problem–even though the bosses at ExxonMobil and Koch are bankrolling the climate denial lobby. Before you believe garbage by an industry hack with no actual training in the field, listen to those of us INSIDE the industry and INSIDE the climate science community. Our future is at stake when we make bad decisions based on crummy books like this!   (CSInvesting: I am an expert, therefore all my assertions are correct.   What’s to argue?  What better way to move to renewable energy than to let the free market decide to price oil at $1,000 a barrel–therefore making nuclear or hydro power more economic).

Environmentalists are evil: George Reisman-

Here’s David M. Graber, in his prominently featured Los Angeles Times book review of Bill McKibben’s The End of Nature: “McKibben is a biocentrist, and so am I (See video of debate below). We are not interested in the utility of a particular species or free-flowing river, or ecosystem, to mankind. They have intrinsic value, more value—to me—than another human body, or a billion of them.… It is cosmically unlikely that the developed world will choose to end its orgy of fossil-energy consumption, and the Third World its suicidal consumption of landscape. Until such time as Homo sapiens should decide to rejoin nature, some of us can only hope for the right virus to come along.”

And here’s Prince Philip of England (who for sixteen years was president of the World Wildlife Fund): “In the event that I am reincarnated, I would like to return as a deadly virus, in order to contribute something to solve overpopulation.” (A lengthy compilation of such statements, and worse, by prominent environmentalists can be found at Frightening Quotes from Environmentalists.)

There is no negative reaction from the environmental movement because what such statements express is nothing other than the actual philosophy of the movement. This is what the movement believes in. It’s what it agrees with. It’s what it desires. Environmentalists are no more prepared to attack the advocacy of mass destruction and death than Austrian economists are prepared to attack the advocacy of laissez-faire capitalism and economic progress. Mass destruction and death is the goal of environmentalists, just as laissez-faire capitalism and economic progress is the goal of Austrian economists.

And this is why I call environmentalism evil. It’s evil to the core. In the environmental movement, contemplating the mass death of people in general is no more shocking than it was in the Communist and Nazi movements to contemplate the mass death of capitalists or Jews in particular. All three are philosophies of death. The only difference is that environmentalism aims at death on a much larger scale.

Despite still being far from possessing full power in any country, the environmentalists are already responsible for approximately 96 million deaths from malaria across the world. These deaths are the result of the environmentalist-led ban on the use of DDT, which could easily have prevented them and, before its ban, was on the verge of wiping out malaria. The environmentalists brought about the ban because they deemed the survival of a species of vultures, to whom DDT was apparently poisonous, more important than the lives of millions of human beings.

The deaths that have already been caused by environmentalism approximate the combined number of deaths caused by the Nazis and Communists.

If and when the environmentalists take full power, and begin imposing and then progressively increasing the severity of such things as carbon taxes and carbon caps, in order to reach their goal of reducing carbon dioxide emissions by 90 percent, the number of deaths that will result will rise into the billions, which is in accord with the movement’s openly professed agenda of large-scale depopulation. (The policy will have little or no effect on global mean temperatures, the reduction of which is the rationalization for its adoption, but it will have a great effect on the size of human population.)

It is not at all accidental that environmentalism is evil and that its leading spokesmen hold or sanction ideas that are indistinguishable from those of sociopaths. Its evil springs from a fundamental philosophical doctrine that lies at the very core and deepest foundations of the movement, a doctrine that directly implies the movement’s destructiveness and hatred of the human race. This is the doctrine of the alleged intrinsic value of nature, i.e., that nature is valuable in and of itself, apart from all connection to human life and well being. This doctrine is accepted by the movement without any internal challenge, and, indeed, is the very basis of environmentalism’s existence.

As I wrote in Capitalism, “The idea of nature’s intrinsic value inexorably implies a desire to destroy man and his works because it implies a perception of man as the systematic destroyer of the good, and thus as the systematic doer of evil. Just as man perceives coyotes, wolves, and rattlesnakes as evil because they regularly destroy the cattle and sheep he values as sources of food and clothing, so on the premise of nature’s intrinsic value, the environmentalists view man as evil, because, in the pursuit of his well-being, man systematically destroys the wildlife, jungles, and rock formations that the environmentalists hold to be intrinsically valuable. Indeed, from the perspective of such alleged intrinsic values of nature, the degree of man’s alleged destructiveness and evil is directly in proportion to his loyalty to his essential nature. Man is the rational being. It is his application of his reason in the form of science, technology, and an industrial civilization that enables him to act on nature on the enormous scale on which he now does. Thus, it is his possession and use of reason—manifested in his technology and industry—for which he is hated.”

Thus these are the reasons that I think it is necessary for people never to describe themselves as environmentalists, that to do is comparable to describing oneself as a Communist or Nazi. Doing so marks one as a hater and enemy of the human race.

Climate Change Caused by Man? List_of_scientists_opposing_the_mainstream_scientific_assessment_of_global_warming

For and Against Fossil Fuels

Catch a Falling Knife

half full

We left off at Regression to the Mean Part II here:http://csinvesting.org/?p=10996

We skip Chapter Six (for now) and focus on Chapter 7 in DEEP VALUE: Catch a Falling Knife: The Anatomy of a Contrarian Value Strategy

In Search of Un-Excellence

The authors identified 36 publicly traded “excellent companies” on the basis of out-performance in six criteria, measured from 1961 to 1980.

  1. Asset growth
  2. Equity growth
  3. Return on total capital
  4. Return on equity
  5. Return on sales
  6. Market to book value

Then an investment analysts, Michelle Clayman, identified 39 publicly traded “un-excellent companies” which ranked in the bottom third of all Peters and Waterman’s criteria from 1976 to 1980.   These “in search of disaster” companies outperformed 24.4% pa over five years vs. 12.7% for the “excellent” companies.

The good companies under-perform because the market overestimates their future growth and future return on equity and, as a result, accords the stocks overvalued price-to-book ratios; the converse is true of the poor companies.

Over time, company results have a tendency to regress to the mean as underlying economic forces attract new entrants to attractive markets and encourage participants to leave low-return businesses. Because of this tendency, companies that have been good performers in the past may prove to be inferior investments, while poor companies frequently provide superior investment returns in the future.”

Note pages 128 to 136 in DEEP VALUE: Tables 7.1 to 7.9

Stocks in the Contrarian Value portfolios were cheaper than the comparable Glamour portfolios on every metric but on a Price-to-Earnings basis, possibly because the earnings in those portfolios were so weak.

First, valuation is more important than growth in constructing portfolios.

Cheap, low growth portfolios systematically outperform expensive, high-growth portfolios, and by wide margins.  It seems that the uglier the stock, the better the return, even when the valuations are comparable. Oppenheimer found in a study on Ben Graham Net/Nets that loss making and non-dividend paying net/nets outperform profitable, dividend-paying net/nets. Ben Graham Net Current Asset Values A Performance Update

In almost any study, the cheap, hated, ugly, least-admired, and poorly performing stock outperforms the high-growth, glamour stocks.

What these studies demonstrate is that mean reversion is a pervasive phenomenon, and one that we don’t intuitively recognize. Our untrained instinct is to pursue the glamorous stock, the high-growth stock, the story stock, the excellent stock, the admired stock, the A+ stock, or even the profitable net net, but study after study shows that this instinct leads us to under-perform. Buying well-run companies with good businesses at bargain prices seems to make even more sense. The research shows , however, that the better investment–rather than the better company–the value stock, the scorned, the unexcellent, the Ds, the loss-making net nets.  And the better value stock, according to Lakonishok, Shleifer, and Vishny’s research is the low-no-growth value stock, what they describe as “contrarian value,”

What is clear is that value investing in general, and deep value (buying the ugliest of ugly) in particular, is exceedingly behaviorally difficult. It is counter-intuitive and against instinct, which is why many investors shy away from it.

Lecture by Toby Carlisle on Deep Value Investing

Next Lesson:

We will finish up this chapter by covering The Broken-Leg Problem. Please give this chapter a close study–the conclusions are extremely COUNTER-INTUITIVE and the opposite of what most investors look for.  We are at the heart of deep value investing.

Mean Reversion Part II

roman-orgy-vasily-alexandrovich-kotarbinsky

Roman Orgy

Last post on Part 1:http://csinvesting.org/?p=10984

Why does high growth seem to depress stock market returns and low growth seem to generate high stock market returns? It is not the growth destroys returns, but that the market already recognizes the high-growth nation’s potential, and bids the price of its equities too high. Market participants become overly optimistic during periods of high growth, driving up the prices of stocks and lowering long-term returns, and become too pessimistic during busts, selling down stocks and creating the conditions for high long-term returns.   Jay Ritter says that irrationality generates volatility “and mean reversion over multi-year horizons.” Graham would agree (p. 88, DEEP VALUE).

The implications for mean reversion in stocks are counter-intuitive. Stocks with big market price gains and historically high rates of earnings growth tend to grow earnings more slowly in the future, and underperform the market. Stocks with big market prices losses and historically declining earnings tend to see their earnings grow faster, and out perform the market. Undervalued stocks with historically declining earnings grow earnings faster than overvalued stocks with rapidly increasing earnings. This is mean reversion, and, as Ben Graham said, it’s the phenonmenon that leads value strategies to beat the market.

The update to Lakonishok’s research Contrarian Investments Extrapolation and Risk demonstrates that, aside from short periods of under-performance, value stocks generate a consistent value premium, and beat both the market and glamour stocks over the long haul. ….Researchers believe the reasons are because they are contrarian to overreaction and naive extrapolation. Efficient market academics Eugene Fama and Ken French, counter that value strategies outperform because they are riskier.  However, Lakonishok found that while value strategies do disproportionately well in good times, its performance in bad times is also impressive.  Value strategies are also outperform during “bad” states for the world such as recession and extreme down markets.

When Lakonishok compared the growth rates implied by the market price to the actual growth rates appearing after the selection date, they found a remarkable result–one that supports Graham’s intuition–value stocks grow fundamentals faster than glamour stocks.  The high prices paid for glamour stocks imply that the market expects them to generate high rates of growth. Contrary to this expectation, however, the growth rates do not persist.  Growth stocks;s growth rates mean-revert from fast growth to slow growth.

SUMMARY

If you read all the links and research papers in the past two posts for this chapter in DEEP VALUE, you know that:

  • Out-of-favor value stocks beat glamour stocks because….
  • the actual growth rates of fundamental sales and earnings of glamour stocks relative to value stocks after selection are much lower than they were in the past, or as the multiples on those stocks indicate the market expects them to be.
  • Value strategies appear to be less risky than glamour strategies.

So why do investors persist in buying glamour? For behavioral reasons like anchoring and “overreaction bias.”   We will next explore chapter 6 in Deep Value.

BAD BUSINESSES

http://aswathdamodaran.blogspot.com/

Autos a Bad Business Damordaran Blog

HAVE A GREAT WEEKEND!

The Wheel of Fortune: Mean Reversion (Part 1)

graves

Last post on Chapter 4 in Quantitative Valuehttp://csinvesting.org/?p=10730 . Let’s get back to our course on Deep Value.

Let’s go back to DEEP VALUE, Chapter 5: A Clockwork Market: Mean reversion and the Wheel of Fortune.

As a value investor you are doing either:

  1. Buying a franchise, where barriers to entry allow for profitable growth, before mean reversion sets in or
  2. Buying assets where the normalized earnings’ power of those assets is below norm (Asset value = Earnings Power Value) and earnings’ power will mean revert to normal.

Therefore the concept of Regression to the Mean is powerful.  By putting the words, “Many shall be restored that now are fallend and many shall fall that now are in honor” on the facing page of Security Analysis, Graham gave the most prominent position in his seminal text to the idea that Fortuna’s wheel turns too for securities, lowering those that have risen and lifting those that have fallen.  The line, from Horace’s Ars Poetica, echoes the phrase spoken by the wise men of legend who boiled down the history of mortal affairs into the four words, “This too will pass.”  This is regression toward the mean. (p. 79).

The more extreme the initial price movement, the greater will be the subsequent adjustment in the opposite direction. There tends to be a price trend before reversal. The reasons are manifold, but the most obvious is that the trials aren’t independent—our own trading decisions are affected by the buying or selling preceding our trade.

Keynes discussed this phenomenon here:

https://www.marxists.org/reference/subject/economics/keynes/general-theory/ch12.htm or John Maynard Keynes and his life as an investor, Keynes as an investor

Two economists known for research into both market behavior and individual decision-making, Werner De Bondt and Richard Thaler, theorized that it is this overreaction to meaningless price movements that creates the conditions for mean reversion. Note page 800 in the link Does Stock Market Overreact—  the loser and winner portfolios.  Losers win out.

In a second study, Further Evidence of Inv Overreaction Thaler, Thaler and De Bondt revisited the research from a new perspective.  They hypothesized that the mean reversion they obserbed in stock prices in the first study might have been caused by investors focusing too much on the short-term. this fixation on the recent past and failure to look beyond the immediate future would cause investors to miscalculate future earnings by failing to account for mean reversion.  If earnings were also mean reversing, then extreme stock price increases and decreases might, paradoxically, be predictive of mean-reversion not just in stock prices, but in earnings too.  A stock price that has fallen a great deal becomes a good candidate for subsequent earnings growth, a vice versa for a stock price that has gone up a lot.  As you can see from the two research reports that the undervalued portfolio delivered better earnings and price performance.

The above research stand the conventional wisdom on its head and show compelling evidence for mean reversion in stocks in a variety of forms.

Buffett Discusses Mean Reversion in the Stock Market

Buffett_on_1999_Stock_Market_-_Fortune_Article & 2008 Market Call and a MUST READ: A Study of Market History through Graham Babson Buffett and Others

In the 1964 to 1981 period, Buffett wrote, U.S. GNP almost quintuples, rising 373 percent. The market, by contrast, went nowhere.

The evidence is that valuation, rather than economic growth, determines investment returns at the market and country level. Research suggests that chasing growth economies is akin to chasing overvalued stocks, and generates disappointing results. See

The growth illusion

Alas, this is not the case. Work done by Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School established this back in 2005. Over the 17 countries they studied, going back to 1900, there was actually a negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting.  In a second test, they took the five-year growth rates of the economies and divided them into quintiles. The quintle of countries with the highest growth rate over the previous five years, produced average returns over the following year of 6%; those in the slowest-growing quintile produced returns of 12%. In a third test, they looked at the countries and found no statistical link between one year’s GDP growth rate and the next year’s investment returns.

Why might this be? One likely explanation is that growth countries are like growth stocks; their potential is recognised and the price of their equities is bid up to stratospheric levels. The second is that a stockmarket does not precisely represent a country’s economy – it excludes unquoted companies and includes the foreign subsidiaries of domestic businesses. The third factor may be that growth is siphoned off by insiders – executives and the like – at the expense of shareholders.

Paul Marson, the chief investment officer of Lombard Odier, has extended this research to emerging markets. He found no correlation between GDP growth and stockmarket returns in developing countries over the period 1976-2005. A classic example is China; average nominal GDP growth since 1993 has been 15.6%, the compound stockmarket return over the same period has been minus 3.3%. In stodgy old Britain, nominal GDP growth has averaged just 4.9%, but investment returns have been 6.1% per annum, more than nine percentage points ahead of booming China.

What does work? Over the long run (but not the short), it is valuation; the higher the starting price-earnings ratio when you buy a market, the lower the return over the next 10 years. That is why buying shares back in 1999 and 2000 has provided to be such a bad deal.

High Growth Depresses Future Stock Returns

Why does high growth seem to depress stock market returns and low growth seem to generate high stock market returns?  The market ALREADY recognizes the high growth nation’s potential, and bids the price of its equities too high. Market participants become overly optimistic during periods of high growth, driving up the prices of stocks and lowering long term returns, and become too pessimistic during busts, selling down stocks and creating e conditions for high long-term returns.  More research on that here:

  1. Jay_Ritter_paper_14_August Economic Growth and Stock Returns
  2. value-vs-glamour-a-global-phenomenon
  3. Blinded by Growth

I will finish this chapter in the next post. If you do not have DEEP VALUE or Quantitative Value, then join the deep value group found here: http://csinvesting.org/2015/01/14/deep-value-group-at-google/ and I will send.

If you only understand one concept besides Margin of Safety in investing then let it be Reversion to the Mean.

Tim McElvaine: Kissing a lot of frogs to find a prince or Portrait of a Deep Value Investor

“Value investing is about praying on the emotions of the seller,” McElvaine said, noting that he loves to be a buyer of un-loved securities when their owners need out at any cost.

McElvaine pointed to a Globe and Mail headline about beat-up mining stocks being great tax-loss sale candidates this past December. He bought up shares in Sprott Resource Corp and Anglo American recently for trading at considerable discounts to NAV (more info at chat.ceo.ca/mcelvaine).

Six years into the global bull-market and McElvaine’s funds are about 25% in cash to provide an opportunity to buy assets if prices return to Tim’s liking.

Is the US bull-market over? McElvaine talked about what could go right in the United States, and suggested that a great way to stimulate the US Economy would be to wipe out student loan debt, which is $1 trillion of $1.3 trillion owned by the US Government, according to McElvaine. That move could put $1 trillion back in the hands of the most aggressive consumers.

There was a brief moment before Tim’s speech that my dad and I got to share a word with him, and I asked how do they know if a cheaply priced security represents a value gap, meaning it’s undervalued and going higher, or is it a value-trap, as so often cheap stocks get cheaper.

“You don’t know,” Dad and McElvaine agreed, which reminded me of something Tim taught me 6-7 years ago:

“You’ve got to kiss a lot of toads in this business to find your prince.”

Take the time to read his annual reports and transcripts, then go the extra mile and look at the annual reports of the companies he mentions–do you see what he sees?  For example, in the chat of his presentation for 2014 (see bold index and then the link) he mentions that Sprott Resource Corp is trading for about $1.00 Cdn while its NAV is above $3.00 or “It’s not pretty, but it’s cheap.”  Can you learn from his approach and analysis? What would you do differently? You have to be a contrarian with a calculator to buy what is hated.

Some reports below:

Buying dollar bills for fifty cents Recent talk on his investments.
2014-Transcript-of-May14-Annual-meeting

2013-Annual-Report and 2013-Partners-Confererence-Transcript

2012-Annual-Report and 2012-Transcript-Partners-Conference-website-version

Go deeper: http://mcelvaine.com/reports/

Tomorrow: I will post a reader’s list of great annual reports.

I love reading Warren Buffett’s letters and I love contrasting his words with his actions…I love how he criticizes hedge funds, yet he had the first hedge fund,” Mr. Loeb said. “He criticizes activists, he was the first activist. He criticizes financial services companies, yet he loves to invest in them. He thinks that we should all pay taxes, yet he avoids them himself.  – Business Insider LINK

http://investmentresearchdynamics.com/warren-buffet-is-the-definition-of-scumbag/     (A bit over the top but I like to present the contrasting view whether I agree or not).

Prof. Greenwald on Value Investing

OVERVIEW Value_Investing_Slides

Greenwald_2005_Inv_Process_Pres_Gabelli in London

Greenwald Overview of VI

A Value Investing Class in Three Minutes

sentiment_cycles
Buying High

Next Week

I have been too busy to do another lesson but be ready next week! For those attending the Berkshire Hathaway Meeting in Omaha enjoy the experience. Flash your Deep-Value Group card for up to 95% discounts.

HAVE A GREAT WEEKEND!

Investment Checklists-Adapt Them for Yourself. GOODHAVEN

sacr

Someone sent me a postcard picture of the earth.
On the back it said, “Wish you were here.” — Steven Wright

Investment Checklists 

We left-off here Last Lesson on Gross Profitability and Magic Formula and in that post, the next focus would be on investment checklists.  We have been reading Chapter 2: A Blueprint to a Better Quantitative Value Strategy in Quantitative Value (I will email the Book to new students if they are in the Deep-Value Group at GOOGLE. Go here: https://groups.google.com/forum/#!overview then type: DEEP-VALUE and ask to join.).

On pages 56 to 59 of this chapter the author discusses the case for a checklist. Atul Gawande in his book The Checklist Manifesto: How to Get Things Right argues for a broader implementation of checklists. The author believes that in many fields, the problem is not a lack of knowledge but in making sure we apply our knowledge consistently and correctly. 

The Quantitative Value Checklist

  1. Avoid Stocks that can cause a permanent loss of capital or avoid frauds and financial distress/bankruptcy.
  2. Find stocks with the cheapest quality.
  3. Find stocks with the cheapest prices.
  4. Find stocks with corroborative signals like insider buying, buyback announcements, etc.

Below are several books on checklists.

As students may know, I throw A LOT of information at you to force a choice on your part.   You have to focus on what material can be adapted to your needs. In the three books above, you will find many interesting ideas that may be helpful in learning how to build your own list.

The more experienced you are, then the shorter the checklist.  The point of a checklist is to be disciplined and not overlook the obvious while freeing up your mind for the big picture.   Yes, you check off if there is insider buying, but if insiders are absent, but the company has a strong franchise and the price is attractive, then those factors may be overwhelmingly positive.  You may ask, “Do I understand this business?” Then it may take weeks of industry reading to say yes or no.

Checklists are helpful, but only if you adapt them to your method.

Next, we will be reading Chapter 3, Eliminating Frauds in Quantitative Value. We are trying to improve our ability to build a margin of safety.

goodx

The Problem with Investor Time-frames

Note the dark line in the chart above representing the returns of the Goodhaven Fund. Two analysts/PMs split off from Fairholme and started in mid-2011. They had a big inflow in early 2014 and then some of their investors panicked as they vastly “underperformed the market.”  I don’t know if these managers are good or bad but making a decision on twelve to twenty-four months of data is absurd unless the managers completely changed their stripes (method of investing).  Therein lies opportunity for those with longer holding periods like five years or more.

holding-period

Shareholder_Message_1114 (Some investors run for the door)

2014_AR

2013_AR

HAVE A GREAT EASTER and WEEKEND!

fredgraphcreditmarketdebtgdp

R-T-M, Gross Profitability, Magic Formula

Our last lesson was in Mean Reversion (Chapter 5 in Deep Value) discussed http://wp.me/p2OaYY-2Ju  View this video on a very MEAN Reversion.

We must understand full cycles and reversion to the mean.  Let’s move on to reading Chapter 2: A Blueprint to a better Quantitative Value Strategy in Quantitative Value.

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas. -Warren Buffett, Shareholder Letter, 2000.

A WONDERFUL BUSINESS

Greenblatt defined Buffett’s definition of a good business as a high Return on Capital (ROC) – EBIT/Capital

Capital is defined as fixed asses + working capital (current assets minus current liabilities) minus excess cash.

ROC measures how efficiently management has used the capital employed in the business. The measure excludes excess cash and interest-bearing assets from this calculation to focus only on those assets actually used in the business to generate the return.

A BARGAIN PRICE

High earning yield = EBIT/TEV

TEV + Market Cap. + Total debt – minus excess cash + Preferred Stock + minority interests, and excess cash means cash + current assets – current liabilities.EBIT/TEV enables and apples-to-apples comparison of stock with different capital structures.

Improving on the Magic Formula?

ROC defined as Gross profitability to total assets.

GPA = (Revenue – Cost of Goods Sold)/Total Assets

GPA is the “cleanest” measure of true economic profitability.

See this study Gross Profitability a Better Metric and see pages 46-49 in Quant. Value. (the book was sent to deep-value group on Google)

The authors found GPA outperformed as a quality measure the magic formula.  Note on page 48, Table 2.3: Performance Stats for Common Quality Measures (1964 – 2011) that most simple quality measures do NOT provide any differentiation from the market!

FINDING PRICE, Academically–Book value/Market Price

The authors found that analyzing stocks along price and quality contours using the Magic Formula and its generic academic brother Quality and Price can produce market beating results 

The authors: “Our study demonstrates the utility of a quantitative approach to investing. Relentlessly pursuing a small edge over a long period of time, through booms and busts, good economies and bad, can lead to outstanding investment results.”

Ok, let’s come back to quality and avoiding value/death traps in the later chapters (3 and 4) in Quantitative Value.  We are just covering material in Chapter 2. 

INVESTORS BEHAVING BADLY

Investors and the Magic Formula

Adding Your Two Cents May Cost a Lot Over the Long Term by Joel Greenblatt
01-18-2012  (Full article: Adding Your Two Cents

Gotham Asset Management managing partner and Columbia professor Joel Greenblatt explains why investors who ‘self-managed’ his Magic Formula using pre-approved stocks underperformed the professionally managed systematic accounts.

So, what happened? Well, as it turns out, the self-managed accounts, where clients could choose their own stocks from the pre-approved list and then follow (or not) our guidelines for trading the stocks at fixed intervals didn’t do too badly. A compilation of all self-managed accounts for the two-year period showed a cumulative return of 59.4% after all expenses. Pretty darn good, right? Unfortunately, the S&P 500 during the same period was actually up 62.7%.

“Hmmm….that’s interesting”, you say (or I’ll say it for you, it works either way), “so how did the ‘professionally managed’ accounts do during the same period?” Well, a compilation of all the “professionally managed” accounts earned 84.1% after all expenses over the same two years, beating the “self managed” by almost 25% (and the S&P by well over 20%). For just a two-year period, that’s a huge difference! It’s especially huge since both “self-managed” and “professionally managed” chose investments from the same list of stocks and supposedly followed the same basic game plan.

Let’s put it another way: on average the people who “self-managed” their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some! How’d that happen?

1. Self-managed investors avoided buying many of the biggest winners.

How? Well, the market prices certain businesses cheaply for reasons that are usually very well-known (The market is a discounting mechanism). Whether you read the newspaper or follow the news in some other way, you’ll usually know what’s “wrong” with most stocks that appear at the top of the magic formula list. That’s part of the reason they’re available cheap in the first place! Most likely, the near future for a company might not look quite as bright as the recent past or there’s a great deal of uncertainty about the company for one reason or another. Buying stocks that appear cheap relative to trailing measures of cash flow or other measures (even if they’re still “good” businesses that earn high returns on capital), usually means you’re buying companies that are out of favor.

These types of companies are systematically avoided by both individuals and institutional investors. Most people and especially professional managers want to make money now. A company that may face short-term issues isn’t where most investors look for near term profits. Many self-managed investors just eliminate companies from the list that they just know from reading the newspaper face a near term problem or some uncertainty. But many of these companies turn out to be the biggest future winners.

2. Many self-managed investors changed their game plan after the strategy under-performed for a period of time.

Many self-managed investors got discouraged after the magic formula strategy under-performed the market for a period of time and simply sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis. It’s hard to stick with a strategy that’s not working for a little while. The best performing mutual fund for the decade of the 2000’s actually earned over 18% per year over a decade where the popular market averages were essentially flat. However, because of the capital movements of investors who bailed out during periods after the fund had underperformed for a while, the average investor (weighted by dollars invested) actually turned that 18% annual gain into an 11% LOSS per year during the same 10 year period.[2]

3. Many self-managed investors changed their game plan after the market and their self-managed portfolio declined (regardless of whether the self-managed strategy was outperforming or underperforming a declining market).

This is a similar story to #2 above. Investors don’t like to lose money. Beating the market by losing less than the market isn’t that comforting. Many self-managed investors sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis after the markets and their portfolio declined for a period of time. It didn’t matter whether the strategy was outperforming or underperforming over this same period. Investors in that best performing mutual fund of the decade that I mentioned above likely withdrew money after the fund declined regardless of whether it was outperforming a declining market during that same period.

4. Many self-managed investors bought more AFTER good periods of performance.

You get the idea. Most investors sell right AFTER bad performance and buy right AFTER good performance. This is a great way to lower long-term investment returns.

Luck-versus-skill-in-mutual-fund-performance by Fama

….We will finish the chapter with a study of checklists in the next post.

Interesting reading: The Crescent Fund (note reversion to the mean)  Oil Crash Pzena and http://aswathdamodaran.blogspot.com/

Go-where-it-is-darkest-when-company.html (Vale-Brazilian Iron Ore Producer).   Prof. Damordaran values Vale and Lukoil on Nov. 20, 2015.  I am looking at Vale because they have some of the lowest cost assets of Iron Ore in the world.  They have good odds of surviving the downturn but where the trough is–who knows. 

Valuing Cyclical Companies:

Valuing Cyclical Commodity Companies

CS on a Cyclical Business or Thinking About Cypress Stock

Letter to Cypress Shareholders about Price vs Value

download_t_j__rodgers__cdc_2002_keynote_presentation

CY_VL

39_studie_value_creation_in_chemical_industry

vale

I think the author at least knew of the risks, but underestimated the extent of the cycle due to massive distortions caused by the world’s central banks.  It did get darker..as iron prices fell another 10% and still falling. 

Month Price Iron Ore Change
Aug 2014 92.63
Sep 2014 82.27 -11.18 %
Oct 2014 80.09 -2.65 %
Nov 2014 73.13 -8.69 %
Dec 2014 68.80 -5.92 %
Jan 2015 67.39 -2.05 %
Feb 2015 62.69 -6.97

vale

Damodaran: I have not updated my valuation of Vale (as of Feb. 20th), but I have neither sold nor added to my position. It is unlikely that I will add to my position for a simple reason. I don’t like doubling down on bets, even if I feel strongly, because I feel like I am tempting fate. 

Prof. Damodaran is responding to a poster who is asking about Vale’s plummeting stock price.  If you are a long-term bull you want declining prices to bankrupt weak companies in the industry so as to rationalize supply.

HAVE A GREAT WEEKEND!