Category Archives: Special Situations

Gift from Heaven: A Classic Guide to Special Situations Investing.

https://www.hightail.com/download/OGkOGNlYSs5RmJ2WnRVag

SPEC Sits

HAVE A HAPPY WEEKEND!

 

If you want more to study go here: http://aswathdamodaran.blogspot.com/

VACATION! Gold Mining Case Studies

SUMMER

Time has come to head to the beach because I might start to sell ALL my miners after a 20% to 80% rise from the depths of the five-year bear market.

It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine–that is, they made no real money out of it. Men who can both be right and sit tight are uncommon. –Edwin Lefevre in Reminiscences of a Stock Operator

Case Studies

Why don’t YOU have a crack at valuing these companies? I will provide supporting materials.

Royal Gold (RGLD)

Royal Gold Chart

http://www.royalgold.com/investors/why-invest-in-royal-gold/default.aspx

Video: http://youtu.be/znx74K1-qVg

Streamers: RGLD_VL and SLW_VL

How to value a net smelter return: http://www.goldroyalties.ca/how_to_value_a_NSR_NPI_mining_royalty.php and http://www.frickcpa.com/tvom/TVOM_PV_SS.asp

http://www.theaureport.com/pub/na/precious-metal-royalties-the-new-landscape

http://seekingalpha.com/article/1341411-gold-and-silver-royalty-companies-part-1-the-pros-and-cons-of-royalty-companies

http://seekingalpha.com/article/1367241-gold-and-silver-royalty-companies-part-4-royal-gold-inc

http://seekingalpha.com/article/1532432-clash-of-the-gold-titans-royal-gold-vs-franco-nevada

Romarco Minerals, Inc. (RTRAF) A pre-production gold miner (Speculative)

RTRAF

Brent Cook https://www.explorationinsights.com/. See his work on Yukon Gold http://www.youtube.com/user/ExplorationInsights. View the three videos

http://youtu.be/qwZeJjXmN1A Brent Cook of Exploration Insights discusses junior miners.

Doug Casey:8202013casey (21-minute Audio/Excellent!) on searching for opportunity/miners. His book recommendations : Economics_in_one_lesson and Liberty: The Market for Liberty. His suggestion: Read widely and ask a lot of questions.

Handbooks on valuing mining equities: book_excerpt Invest in Gold and Silver and GSA_2012_User_Guide and Profiting from the Dismal State of Gold miners and Explorers

RTRAF Excerpt: There is another company that I like, but it’s not in production yet. Romarco Minerals Inc. (R:TSX) doesn’t have a full permit, but I feel strongly that it will be able to get permitted. The mine is going to have about 91 million tons of ore at 1.6 grams per ton for a total of 4.8 Moz gold. You are essentially buying this thing for $50/oz at the current trading price of $0.39/share. I believe Romarco will get up and running, because its management knows a lot of large institutional shareholders who would be willing and able to front them some more cash. I believe the Haile project in South Carolina will be a mine in a couple of years.

TGR: How does that $50/oz compare to its peers?

HI: They range from $40/oz to almost $120/oz. It is definitely in the lower range, and it should be because it doesn’t have a permit. It is not as derisked as a producing mine.

TGR: How likely are those permits to come within the next year?

HI: If you asked me that question a year ago, I would have said about 75%. Today, I am going to give you the same answer. There is a very decent chance that the permits are going to come reasonably soon. The permitting process, especially in South Carolina where there are no real mines, is not easy. The company has to have constant discussions with the U.S. Army Corps of Engineers. Romarco claims to be making progress. I am inclined to believe that, but these things always take a lot longer than you would like.

TGR: Meanwhile, Romarco has increased its resource and it has brought in more experienced personnel. What institutional support does it have?

HI: Van Eck Global, BlackRock, Baker Steel Capital Managers, Oppenheimer & Co., Tocqueville Asset Management and so on, the usual suspects. Seventy percent of shares are institutionally owned. Those firms haven’t owned this and watched the stock sink in order to throw in the towel when it actually comes time to build a mine.

TGR: Can this management team get the permitting done?

HI: Yes, it should be able to do it.

Read more: http://seekingalpha.com/instablog/399928-the-gold-report/2024862-somethings-got-to-give-in-the-precious-metals-market-heiko-ihle

Romarco Minerals: http://www.romarco.com/Investors/default.aspx

Instructions: You have two ends of the investing spectrum: A major royalty company and a pre-production mining company–though not a pick and shovel exploration company.

Try to come up with reasonable values. If you can’t, pass. I will present my thoughts upon my return next week.

HAVE A GREAT WEEK/WEEKEND.

Search for Panic/Capitulation: Hui-Gold Index at 16.8

gold miners

Just as I seek panic and capitulation as a place to find value among the carnage, the Colonel loves the smell of napalm.

Geico Case Study; Klarman Sees Collapse

TALK SHOW SHEEP

As David Ricardo, a successful speculator who, in his early retirement, became one of the finest economists of the early nineteenth century, explained in 1817:

It has been my endeavor carefully to distinguish between a low value of money and a high value of corn, or any other commodity with which money may be compared. These have been generally considered as meaning the same thing; but it is evident that when corn rises from five to ten shillings a bushel, it may be owing either to a fall in the value of money or to a rise in the value of corn…..

The effects resulting from a high price of corn when  produced by the rise in the value of corn, and when cause by a fall in the value of money, are totally different. 

GEICO CASE STUDY

You can never read enough about a great business and the importance of HOLDING ON to reap the benefits of growth.  If you can combine patience with the knowledge of understanding the moat of a great business, then you will have an outstanding investment career.

Geico Case Study and  wedgewood partners second quarter 2013 client letter

Klarman’s Speech (Thanks to a reader)

His latest speech also includes a distinct tone of regret over where the current state of affairs is taking the U.S. He sounds positively saddened by how things are run in his country. In Klarman’s words:

“Like all of you, I am worried about our future, I am concerned about the prospect for upcoming generations to have the same opportunities that ours did, and I’m saddened that our generation was handed something unique, the stewardship of the greatest country in the history of the world– and we are far down the path of making it less great.”

Klarman Slams Myth Of Efficient Markets

Klarman said that the idea that financial markets are efficient is foolish, and he goes on to describe how that will always remain the case. Markets are governed by human emotions and they do not follow laws of physics—prices will unpredictably overshoot, therefore the academic concept of market efficiency is highly incorrect.

“Academics are deliberately blind to the fifty plus year track record of Warren Buffett as well as those of other accomplished investors, for if markets are efficient, how can Warren Buffett’s astonishing success possibly explained?”

In his speech Klarman mentioned value-investor Ben Graham’s explanation of markets, where he says that Mr. Market is to be perceived as an eccentric counter-party which should be taken advantage of, but one should not follow its emotional advice. He also agrees with Ben Graham’s idea that assets should be bought at a significant discount to keep your margin of safety.

“As when you build a bridge that can hold 30 trucks but only drive 10 trucks across it, you would never want your investment fortunes to be dependent upon everything going perfectly, every assumption proving accurate, every break going your way.”

Klarman said that the current economy is being built like a house of cards that will implode. Huge deficits, empty government promises, pretty pictures painted to ease voters and reliance on external markets to keep your currency afloat, have all disrupted the margin of safety in U.S. economy.

Klarman Encourages Going Against The Grain

He says that investors have become increasingly speculative and subject themselves to frenetic trading, even the holding period of 30-yr treasuries has fallen down to a mere couple of months. Investors increasingly rely on technology to judge their performance not merely on a monthly or quarterly basis—it has now become an hourly practice.

“The performance pressure drives investors to into an absurdly short-term orientation…. If your track record is going to be considered by investment committees every quarter, if you are going to lose clients and possibly your job because of poor short term performance, then the long term becomes almost completely irrelevant.”

Read more: http://www.valuewalk.com/2013/07/klarman-economy-house-of-cards/

The Research Process Part 2

Guitine

We discussed the research process in Part 1: http://wp.me/p2OaYY-22A

Research Process Part 2

Your research process is obviously part of your investment philosophy (search, value, portfolio management, risk and you). If you are buying a non-franchise then you must buy assets cheaply since growth won’t increase intrinsic value. Or another way of approaching the problem: time is not on your side. You are dependant upon the market closing the gap between price and value. When investing in a franchise you face the difficulty in accessing the company’s sustainability of competitive advantage and how much should you pay for future growth. Hint: Not much.

You will have to spend many weeks studying your first few companies and industries to practice finding answers to your questions while learning to be an efficient reader of annual reports and proxies.  As you gain experience, you can make better assessments.  For example, say you study the title insurance business or the funeral business.  The title insurance business shows tremendous stability in return on assets but no better than normal profitability. Only one national insurance company went bankrupt in over 100 years (in 2008).  So you can have a high degree of confidence in buying below asset value that those assets will not deteriorate. But why can’t the businesses grow much or develop higher profitability? Most of the value in a title transaction comes from the originator of that transaction—the real estate broker.   Title insurance is like a local monopoly. The same goes for the funeral business.  You will notice unique aspects to various industries as you cast your net widely.

Buffett’s advice:

The Story of Warren Buffett from Of Permanent Value by Andrew Kilpatrick

Buffett rarely gets ideas from talking with other people. He gets them alone by reading and thinking. Maybe Edward Gibbon had it right: “Conversation enriches the understanding, but solitude is the school of genius.”

 How to make money 

Once Bob Woodward asked Buffett a good way to make more money and Buffett suggested investing. Woodward told Buffett, “I don’t know anything about investing.”  “Yes, you do.” Buffett said, “All it is, is investigative reporting.”

Buffett told Woodward: “Investing is reporting. I told him to imagine an in-depth article about his own paper.  He’d ask a lot of questions and dig up a lot of facts. He knows The Washington Post. And that is all there is to it.”

Buffett continues, “Bob, why don’t you assign yourself a story, get up an hour early every morning and work on a story you have assigned yourself. Now a sensible story to assign yourself would be what is the WPO worth?  Now, if Ben Bradlee gave you that story to work on what would you do for the next week or two? You would go around and talk to people (in the television business). You would try to figure out what the key variables in valuing a TV station and you would look at the four that the Post has and apply those standards to that. You would do the same thing to newspapers. You would try to figure out how the competitive battle between the Star and the Post is going to come out and how much different the world would be if the Post won that war.  All of these things are a lot easier than the problems Woodward would usually be working on. Usually people would want to talk to him but on this subject they would be glad to talk to him and then I said when you get all through with that, add it up and divide by the number of shares outstanding. All he had to do was assign himself the right story, and I assign myself stories from time to time.”

More tips

Munger: “I think both Warren and I learn more  from the great business magazines than we do anywhere else…..I don’t think you can really be a really good investor over a broad range without doing a massive amount of reading.”

Buffett replied, “You might think about picking out 5 or 10 companies where you feel quite familiar with their products, but not necessarily so familiar with their financials…Then get lots of annual reports and all of the articles that have been written on those companies for 5 or 10 years…Just sort of immerse yourself.

“And when you get all through, ask yourself, ‘What do I know that I need to know?’  Many years ago, I would go around and talk to competitors where you feel quite familiar with their products, but not necessarily so familiar with their financials…Then get lots of annual reports and all of the articles that have been written on those companies for 5 or 10 years…Just sort of immerse yourself.

Search Strategy

Most mis-priced stocks tend to fall into two categories: Either they’re well-known but hated, or obscure and unknown.   Warren Buffett seems to agree.  At the Berkshire 1999 annual meeting, he said: “If I had $100,000 to invest, I would probably focus on smaller companies because there would be a greater chance that something was overlooked in that arena.”

“If you gave me a million dollars of capital to manage, I would pretty much almost guarantee that I will make 50% a year.  I think the reason he makes that statement is he would just make 100 percent doing special situations.

Question: According to a business week report published in 1999, you were quoted as saying “it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50′s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

Special Situations:

I am going to buy a dollar for 50 cents, and when it gets appraised at a dollar or 90 cents, I’m going to get rid of it.”  Now your returns are simply a function of how long it takes to get to convergence.  If you bought a dollar for 50 cents and sold it for a dollar and convergence took one year, you would generate a hundred percent return.  If convergence took two years, you would generate a 376% return.  If convergence took three years, you would generate a 26% return, and if convergence took four years, you would generate an 18 percent return.  So up to four years of convergence beats buy and hold.  This very simple math became obvious, and the fact is that buying great businesses is all good because you have a few more tax efficiencies and all of that.  But really the pop in terms of getting better returns on assets is first of all to sell fully priced—or nearly fully priced—assets, whether they’re special situation or net/nets and then go back and buy at 50 cents on the dollar.

To find special situations:

Let the game come to you.  You do nothing, just read and think, and occasionally, you read the paper and you will see something.

You are looking for market anomalies.  Whenever there is extreme fear in some sector, or whenever there is some big clouds over some companies, you are likely to get mis-pricing.  The question is, “Am I able to see through the clouds, and do I know the business well enough to be able to see beyond the temporary negativity of an industry or company and see what the value of the business is versus the price at which it’s being offered, and if it is enough of a delta, step in?”

The primary driver for buying the business was an ultra-cheap price and a huge discount to what it was worth.

Add your thoughts………….?

Precious Metal Mining Stocks May Be Making History Today

Gold Stocks Turn

 Gold always does what it should do…it just never does it when we think it should. –Richard Russell

gold stock bears

Past bear markets in precious metals miner stocks have been vicious since they are last in the production cycle as a commodity producer.

lundeen062511b

Past history of mining shares….

Unless these past three days are simply window dressing and short covering, then something meaningful may be occurring:

BIG GDX

Small GDX

The GDX represents several of the senior gold producing companies. The GDX has under-performed the gold price as represented by (GLD) for about 5 years and especially in the past two years.  Note the radical change in the past two days as gold, ironically, fell below the all-in cost to produce an ounce of gold for the majority of mining companies.

Change

Two days is just one sign, but a big one in my opinion. Until after the Fourth of July weekend, the true trend may be revealed since this is quarter end and before a long holiday next week. I am bullish for the long-term in SELECTED, WELL-CAPITALIZED companies.  Remember to do YOUR own thinking and correlation is not causation. I have been two to three months early and down 20% so far, but I sense a turn–finally?!  Prices are absurd.

Perhaps better to listen to an old pro (albeit biased)

Speaking toward what he’s seeing from the institutional investor community, Rick said, “This is the fourth time in my career that I’ve seen capitulation selling, and it get’s ugly and spasmodic…Last week I was on the East Coast of the United States visiting very large institutional investors, and the level of indecision I saw was absolutely classic of the period right before capitulation—andthis week, right on schedule, we’re getting it. [It's] truly ugly, but it’s the kind of cleansing the market needs.”   (Source: www.bullmarketthinking.com)

Hear interview: 6272013rule

 

Learn more:

http://www.kitco.com/ind/Trendsman/2013-06-28-Epic-Opportunity-in-Gold-Stocks.html

http://www.stentormedia.com/gold-mining-stocks-have-outperformed-the-dow-since-1920

http://www.fgmr.com/gold-mining-stocks-have-outperformed-the-djia.html

http://www.gold-eagle.com/editorials_08/lundeen062511.html

http://www.gold-speculator.com/mark-lundeen/77176-barron-s-gold-mining-index-gold-silver-1920-dollar-terms-they-re-cheap.html

HAVE A GREAT WEEKEND.

PS: if you have a question, please post it in the comments section–my emails are swallowed up.

A Contrarian’s Dream (CEF); The Buffetts’ Thoughts on Money

Bankers

Another conviction forced upon my mind, by the examination of long periods of history, was the exceedingly small part played by conscious thought in moulding the fate of men. At the moment of action the human being almost invariably obeys an instinct, like an animal; only after action has ceased does he reflect.” –Brooks Adams in The Law of Civilization and Decay (1897)

Perhaps the only reliable contrary thought one dares hold when monetary innovations are presented is simply one of doubt. Old-timers have confidence only in gold, whereas the younger and “newer” economists are unafraid to experiment with substitutes for what has been called our “barbaric metal.” A speaker contends that gold may be barbaric, “but it is no relic.”

A review of depressions reveals how in every cycle the crisis developed when money and credit became overextended. No answer to the monetary riddle is foreseeable so long as bankers, business-men and speculators act normally, which is that they will push for profits when, and as long as, there is capital gain to be made. They will leave the idealistic “distaste” for money and the power of money to the hippies. 

The trained contrarian recognizes the periods of monetary over-extension and guards against the inevitable “corrections.” He need not understand the riddle of money to avoid its perils.  –Humphrey B. Neill, The Ruminator

 Buy CEF or buying gold and silver bullion at a discount

CEF pricing history

Buy CEF

CEF Five Year

CEF is a closed-end fund that holds gold and silver bullion--currently trading at a 1.5% to 2% discount. Back in 2011, CEF traded at a 6% premium. The present discount is a function of HISTORICAL and UNPRECEDENTED bearishness by small speculators who are currently net short! If ever there was contrarian signal, this is one. Oh, I forgot one, Noureil Roubini, an economist, says that gold will go to $1,000 because the world is in recovery. See below:

Gold & Silver COT Small Specs Net Short

Gold & Silver Short Selling

Commercials at a thirteen year high in bullish positioning

http://www.321gold.com/editorials/mcclellan/mcclellan061713.html

Commercial Hedgers in Gold

In recent years, commercial gold futures traders have been continuously net short ever since late 2001, and so the game consists of evaluating their comparative net short position relative to recent readings.

The reason for this bias to the short side is that a lot of the commercial gold traders are gold producers, who sell their future production ahead of time in the futures markets, and who thus are short. Commercial traders of silver futures have been continuously net short to varying degrees going all the way back to the start of modern COT Report data back in 1986.

In the chart above, the current reading is the commercials’ lowest net short position (as a percentage of total open interest) since 2001, which was when gold prices were just starting a multi-year uptrend from below $300/oz. The message here is that commercial traders as a group are convinced that gold prices are heading higher. They usually get proven right, eventually, although sometimes we have to wait around longer than we might wish for “eventually” to get here.

 

http://www.cefconnect.com/Details/Summary.aspx?ticker=CEF. Now, you may not wish to own gold as a way to hold/store a portion of your savings, but if you are looking for a way to buy bullion, this might be an intelligent way. This writer’s understanding is that  gold is money (all else is credit–J.P. Morgan)–if it wasn’t, then gold’s U.S. dollar price would probably be 50% to 95% lower. Gold is not a currency due to our fiat currency laws (coercion), and gold is NOT an investment. Gold does not create wealth, but it represents wealth/savings. Finally, extreme bearishness may be a contrarian buy signal, but–as in all things pertaining to human action–prices may decline further for a while. No one knows future prices definitively.

However, with high bearishness among small specs in the leveraged paper market with strong commercial traders on the other side of the trade after a two-year decline of 30% to 50% in gold and silver prices, which side do you want to be on?  The theory of contrary opinion aims at avoiding Crowd opinions. That is a broad generality but the reason for avoiding the crowd in most matters is that the crowd is often wrong. A crowd is swayed by emotion and fear rather than by ruminating and reasoning.

Now, why own some gold? Gold is non-printed, non-government created money. If you believe that our current fiat currency/debt laden system is sustainable or that the Fed can “taper” and “exit,” with precision, perfect foresight, and without consequences then just hold paper dollars. If you do own CEF, pray that bullion declines in price because then the rest of your portfolio is probably prospering. Gold is not an investment but simply another form of money.

Warren and Howard Buffett’s Thoughts on Money and Gold

Now where are we today?

View the below videos for a discussion of some economic issues concerning massive debts and zero interest rate policy. The first video is 18 minutes while the next video is 55 minutes.

Arguments given for central planning interventionism and going off the “gold standard” are the periods of booms and busts during the 19th century–forgetting that 1880 to 1913 showed consistent 4% to 5% REAL economic growth while nominal prices declined. Of course, with FRACTIONAL RESERVE banking (Ponzi finance) and regardless of bank notes fully redeemable in gold, there would be booms and busts because credit could be extended through fractional reserves beyond true savings. In other words, money is still being created out of thin air and the currency is not fully-backed 100% by gold (representing true savings). Governments do not enforce a depositor’s property rights by suspending redemption in times of crisis because governments are dependent upon banks for some of their financing. You have to fix all the underlying problems.

Finally, a massive disconnect in reality: Paul Krugman, a nobel-prize winning “economist” says that higher regulatory burdens have NO NEGATIVE effects upon small businesses. How can any one person be so arrogant and ignorant? All he has to do is ASK an entrepreneur/”small” business person DIRECTLY.  If anyone can prove Krugman’s point to me, I  will gladly send you $1 million in gold coins.  As Chicago Slim says, “This will not end well.”

Update on a Reader’s Question About Investing; Greenblatt Offers Advice

Junk Food

A reader asks what to do with his $150,000: http://wp.me/p2OaYY-1TE. This post is a follow-up.

First, I would do nothing until you know what you are doing. As Jim Rogers said, “Don’t do anything until you see money laying in the street.” WAIT. You can’t ask other people to value companies for you. You either learn to do that yourself within your circle of competence (The Goal of CSinvesting.org) or you find a low-cost way to be in equities.

My advice: avoid high fees. That nixes most mutual funds, hedge funds and managed money. Read more:http://www.zerohedge.com/news/2013-04-29/wall-street-rentier-rip-index-funds-beat-996-managers-over-ten-years

Keep it simple.  There are four asset classes (Read The Permanent Portfolio)41f5oFGYTqL__SL160_PIsitb-sticker-arrow-dp,TopRight,12,-18_SH30_OU01_AA160_Equities, Bonds, Cash, and Gold

I love finding undervalued businesses, but we live in a world of monetary distortion of fiat currency wars (Japan), suppressed interest rates, hidden risks and massive debasement so I would have 5% up to 25% in gold as an insurance policy to maintain the purchasing power of my savings. Gold coins from a reputable dealer should be part of that.  Buying CEF at a discount would be another low cost way to own bullion. Gold is just a commodity money that holds its value over centuries and it can’t be printed nor does it have liabilities (counter-party risk) like fiat currencies.  Another way to approach it might be avoid oversupply (dollars) and buy undersupply (money that can’t be printed).  Don’t take my word for it. What did an oz of gold purchased 200 years ago, 100 years ago, 50 years ago and 20 years ago? Choose a man’s suit, a night at a decent hotel and a meal as items to consider.  Learn more here: http://www.garynorth.com/public/department32.cfm Follow the links to the free books and reports on gold, you will learn alot. 

Now, I own some gold coins but I don’t count investments like Seabridge Gold (SA) as an insurance policy, but as an investment in gold. I can own an oz in the ground for $10 in enterprise value per share. Of course, there are plenty of risks to get an oz of gold out of the ground, but I think there is some margin of error.  But I don’t recommend this strategy for others due to the need to diversify highly, know the industry, and the tremendous volatility.

Government bonds are a mass distortion on the short end and as long as other governments will hold our dollars this game can continue a long time. I would stay within a laddered bond portfolio of no more than seven years so WHEN interest rates rise, you can roll into higher yields. I would do this if you have to have cash in three to four years, and you are hedging your portfolio with this different asset class.  But I think of government bonds as return-free risk.  You take on risk for tiny returns. Welcome to financial repression. The Fed is punishing savers to fund the government. Corporate bonds require you to be able to read balance sheets so you are adequately paid for th credit risk.

If you are willing to do some work and have the temperament, then here is one way to invest in equities besides an index fund as Buffett has suggested:

The Eternal Secret of Successful Investing

A Little Wonderful Advice from Where Are The Customer’s Yachts? by Fred Schwed, Jr., 1940 (pages 180-182)

For no fee at all I am prepared to offer to any wealthy person an investment program which will last a lifetime and will not only preserve the estate but greatly increase it. Like other great ideas, this one is simple:

When there is a stock-market boom, and everyone is scrambling for common stocks, take all your common stocks and sell them. Take the proceeds and buy conservative bonds. No doubt the stocks you sold will go higher. Pay no attention to this—just wait for the depression which will come sooner or later. When this depression—or panic—becomes a national catastrophe, sell out the bonds (perhaps at a loss) and buy back the stocks. No doubt the stocks will go still lower. Again pay no attention. Wait for the next boom. Continue to repeat this operation as long as you live, and you will have the pleasure of dying rich.

A glance at financial history will show that there never was a generation for whom this advice would not have worked splendidly. But it distresses me to report that I have never enjoyed the social acquaintance of anyone who managed to do it. It looks as easy as rolling off a log, but it isn’t. The chief difficulties, of course, are psychological. It requires buying bonds when bonds are generally unpopular, and buying stocks when stocks are universally detested.

I suspect that there are actually a few people who do something like this, even though I have never had the pleasure of meeting them. I suspect it because someone must buy the stock that the suckers sell at those awful prices—a fact usually outside the consciousness of the public and of financial reporters.   An experienced reporter’s poetic account in the paper following a day of terrible panic reads this way:

Large selling was in evidence at the opening bell and gained steadily in volume and violence throughout the morning session. At noon a rally, dishearteningly brief, took place as a result of short covering. But a new selling wave soon threw the market into utter chaos, and during the final hour equities were thrown overboard in huge lots, without regard for price or value.

The public reads the papers, and reading the foregoing, it gets the impression that on that catastrophic day everyone sold and nobody bought, except that little band of shorts (who most likely didn’t exist).   Of course, there is just no truth in that at all. If on that day the terrific “selling” amounted to seven million, three hundred and sixty-five thousand shares, the volume of the buying can also be calculated.   In this case it was 7,365,000 shares.

CASE STUDY

How Mr. Womack Made a Killing by John Train (1978)

The man never had a loss on balance in 60 years.

His technique was the ultimate in simplicity. When during a bear market he would read in the papers that the market was down to new lows and the experts were predicting that it was sure to drop another 200 points in the Dow, the farmer would look through a S&P Stock Guide and select around 30 stocks that had fallen in price below $10—solid, profit making, unheard of companies (pecan growers, home furnishings, etc.) and paid dividends. He would come to Houston and buy a $25,000 “package” of them.

And then, one, two, three or four years later, when the stock market was bubbling and the prophets were talking about the Dow hitting 1500, he would come to town and sell his whole package. It was as simple as that.

He equated buying stocks with buying a truckload of pigs. The lower he could buy the pigs, when the pork market was depressed, the more profit he would make when the next seller’s market would come along. He claimed that he would rather buy stocks under such conditions than pigs because pigs did not pay a dividend. You must feed pigs.

He took “a farming” approach to the stock market in general. In rice farming, there is a planting season and a harvesting season, in his stock purchases and sales he strictly observed the seasons.

Mr. Womack never seemed to buy stock at its bottom or sell it at its top. He seemed happy to buy or sell in the bottom or top range of its fluctuations. He had no regard whatsoever for the cliché’—Never send Good Money After Bad—when he was buying. For example, when the bottom fell out of the market of 1970, he added another $25,000 to his previous bargain price positions and made a virtual killing on the whole package.

I suppose that a modern stock market technician could have found a lot of alphas, betas, contrary opinions and other theories in Mr. Womack’s simple approach to buying and selling stocks.   But none I know put the emphasis on “buy price” that he did.

I realize that many things determine if a stock is a wise buy. But I have learned that during a depressed stock market, if you can get a cost position in a stock’s bottom price range it will forgive a multitude of misjudgments later.

During a market rise, you can sell too soon and make a profit, sell at the top and make a very good profit. So, with so many profit probabilities in your favor, the best cost price possible is worth waiting for.

Knowing this is always comforting during a depressed market, when a “chartist” looks at you with alarm after you buy on his latest “sell signal.”

In sum, Mr. Womack didn’t make anything complicated out of the stock market.   He taught me that you can’t be buying stocks every day, week or month of the year and make a profit, any more than you could plant rice every day, week or month and make a crop. He changed my investing lifestyle and I have made a profit ever since.

Keep this a secret!

Of course after reading those pieces, you realize there is no secret to investing.   All the principles are laid out in Security Analysis and The Intelligent Investor by Benjamin Graham. The application and evolution of value investing principles are laid out each year in Mr. Buffett’s shareholder letters. The study, application and discipline are up to you, but then who would want it any other way?

JOEL GREENGreenblatt Offers Advice

The BIG SECRET for the Small Investor: A New Route to Long-Term Investment Success by Joel Greenblatt (2011)

When investors decide to invest in the stock market they can:

  1. Do it themselves
  2. Give it to professionals to invest.
  3. They can invest in traditional index fund
  4. Or they can invest in fundamentally constructed indexes (recommended)

If brains, dedication and MBA degrees won’t help you beat the market, what will?

The secret to beating the market is in learning just a few simple concepts that almost anyone can master. These concepts serve as a road map that most investors simply don’t have.

Most people CAN do it. It is just that most people won’t. Why?

Understand where the value of a business comes from, how markets work and what really happens on Wall Street will provide important conclusions.

The BIG SECRET to INVESTING:  Figure out the value of something—and then pay a lot less. Graham called this “investing with a margin of safety.”

In short, if we invest without understanding the value of what we are buying, we will have little chyance of making an intelligent investment.  The value of an investment comes from how much that business can earn over its entire lifetime. Discounted back to a value in today’s dollars.  Earnings over the next twenty or thirty years are where most of this value comes from. Earnings from next quarter or next year represent only a tiny portion of this value. Small changes in growth rates or our discount rate will lead to large swings in value.

Then there is relative value. What business is the company in? How much are other companies in similar businesses selling for? Looking at relative value makes complete sense and is an important and useful way to help value businesses. Unfortunately, there are times when this method doesn’t work well. The Internet bubble of the late 1990s, when almost any company associated with the Internet traded at incredibly high and unjustifiable prices. Comparing one Internet company to another wasn’t very helpful.

In the stock market this kind of relative mispricing happens. An entire industry, like oil or construction, may be in favor because prospects look particularly good over the near term.  Yet when an entire industry is misprices (like the capital goods sector during a boom), even the cheapest oil company or the least expensive construction company may bge massively overpriced!

There are other methods such as acquisition value, liquidation value, and sum of the parts, can also be used to help calculate a fair value.

By now you know it is not so easy to figure out the value of a company.  How in the world do we gho about estimating the next thirty-plus years of earnings and, on top of that, try to figure out what those earnings are worth today? The answer is actually simple: We don’t.

We start with the assumption that there are other alternatives for our money.   Say we can get 6%[1] for ten years from a government bond compared to a company paying a 10% earnings yield. One is guaranteed and the other is variable—which do we choose? That depends upon how confident we are in our estimates of future earnings from the company we valued or what other companies can offer us in return.

We first compare a potential investment against what we coulde earn risk-free with our money. If we have high confidence in our estimates and our investment appears to offer a significantly higher annual return over the long term than the risk free rate, we have passed the first hurdle. Next we compare our investment with our other investment alternatives.

If you can’t value a company or do not feel confident about your estimates, then skip that company and find an easier one to value.

In the stock market no one forces you to invest. Focus on those companies you can evaluate.

One way to win in the stock market game is to fly a little below the radar, to buy share in smaller companies where the big boys dimply can’t play.  So investing in smaller capitalization stocks is a game involving thousands of companies worldwide, and most institutions are too big to play.

So not having billions of dollars to invest is a great way to gain an edge over the big Wall Street firms. Also, find 6 to 10 companies where you have a high degree of condidence in the prospects for future earnings, growth rates, and new industry developments.

According to Buffett, “We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.”

Besides going small (small-cap), go off the beaten path. Special situations is a anrea where knowing where to look, rather than extraordinary talent, is the most important part of finding bargains in some of these less well followed areas.

Spinoffs.  The lack of research and following creates an even greater potential for mispricing of the new shares.

Stocks emerging from bankruptcy.  Again, unwanted and unanalyzed stocks create a greater chance for mispriced bargains.

Restructings, mergers, liquidations, asset sales, distributions, rights offerings, recapitalizations, options, smaller foreign securities, complex securities, and many more.

Investors who are willing to do a little work have plenty of ways to gain an advantage by simply changing the game.

If you can’t do it yourself then you can choose:

Actively or passively managed mutual funds.

Most actively managed mutual funds charge fees and expenses based on the size fo the fund, usually 1 to 2 percent of the total assets under management.

Invest in index funds. However, there are problems with index investing, and
congratulations to Greenblatt for developing and explaining these problems in
terms that most investors understand. As you read this book, you will come to
appreciate the difference between market-weighted (“capitalization” weighted)
funds, equally-weighted funds and “fundamentally-weighted” funds. The
differences are not trivial, yet most investors are unaware of them.

Use Greenblatt’s approach, developed and explained in his book. However, I will say that his “value-weighted” approach, which amounts to giving more weight to investments that appear more attractively priced (lower price/earnings ratios, etc.), makes sense for many investors.

Two stand-out ideas from the book: 1) value-weighted index investing and
2)always have a core position invested at all times, which based on your market
outlook you can add or subtract to it by a given amount on rare occasions (if
you have no idea what I’m talking about–Get This Book). If retail investors
were to follow this advice to the letter, they would see their returns and peace
of mind increase dramatically, the latter being more important to overall
well-being.   (Amazon reviews)


[1] Using 6 percent as a minimum threshold to beat, regardless of how low government rates go, should give us added confidence that we are making a good long term investment. (This should protect us if low government bond rates are not a permanent condition.)

END

 

Readers’ Questions

Flasher

In the second decade of the twenty-first century, America is faltering under the weight of a dual crisis. Its public sector teeters on the ragged edge of political dysfunction and fiscal collapse. At the same time, its private enterprise foundation has morphed into a speculative casino which swindles the masses and enriches the few. These lamentable conditions are the Janus-faces of crony capitalism–a mutant regime which now threatens to cripple the nation’s bedrock institutions of political democracy and the free market economy.

….Once the Fed plunged into the prosperity management business under Greenspan and Bernanke, however, the subordination of public policy to the pecuniary needs of Wall Street became inexorable. No other outcome was logically possible given Wall Street’s crucial role as a policy transmission mechanism and the predicate that rising stock prices would generate a wealth effect and thereby levitate the national economy. — David A. Stockman (former Budget Director under Reagan and a former Partner of Blackstone Group) from The Great Deformation, The Corruption of Capitalism in America.

READERS QUESTIONS

Reader Question #1:  What Accounting Books Do You Suggest? I want to improve my intermediate level of understanding so I am ready for my investment analyst internship.

My reply: http://www.barnesandnoble.com/s/?category_id=394924

Buy and work through the problem sets. Accounting problems must be done rather than reading texts because then the concepts will sink in.

Also, to combine that with analyzing financial statements, read http://seekingalpha.com/article/1019951-book-review-what-s-behind-the-numbers

Interview of the writer: http://www.businessinsider.com/whats-behind-the-numbers-a-chat-with-john-del-vecchio-2012-10

Companion website for the book: http://deljacobs.com/

Also, look at: http://www.footnoted.com/report

http://www.accountingobserver.com/PublicBlog/tabid/54/Default.aspx

http://www.offwallstreet.com/research.html Go download several research reports then obtain the particular annual report and study the numbers. Do you agree with the analyst’s report on the company? Study cases.

Financial Shenanigans by Schillit. His books are great for practicing your financial statement skills to undercover weaknesses and strengths.

Also, view short seller blogs like www.brontecapital.com

Reader Question #2: How to begin?

My reply: Investing for beginners:

Obtain a few of these books on the cheap to get a perspective. Then find an industry like beer, soda or trash hauling (one that you can easily understand) and order the annual reports, then pick a company and go through the numbers with your books at your side to look up what you don’t understand. Go back and forth and note your questions. Try to find answers for those questions.

http://www.fwallstreet.com/intro/

http://www.classicvalueinvestors.com/

Wall Street on Sale by Timothy Vick (A good book but perhaps out of print?)

The Little Book of Value Investing by Christopher Browne

The Little Book that Builds Wealth by Pat Dorsey (A good intro to franchises)

Reader’s Question #3: How Do you Invest in Gold Mining Stocks?

My reply: Very carefully………….

GOLD

Dr. Ron Paul was interviewed by Fox after the U.S. Federal Reserve confirmed it will continue its QE program highlights the importance of gold as money.

On July 13, 2011, when Dr. Paul was a U.S. Congressman he asked U.S. Fed Chairman, Ben Bernanke, “Do you think gold is money?” and Bernanke replied, “No, it’s a precious metal.”

Dr. Paul countered, “Even though it’s been used for 6,000 years?” But Bernanke denied gold was money and said, “No, it’s an asset. Just like T-Bill’s are not money.”

The Fox News interviewer then commented, “Cyprus has taught us that governments can confiscate money that you’ve earned or even paid taxes on. Rampant quantitative easing and price fixing by governments may prop up the stock markets but it doesn’t keep unemployment down. The U.S. Fed is going to continue its QE program which is good for gold.”

goldcore_bloomberg_chart4_21-03-13

First, I do not want this subsection to be more than 35% of my portfolio, then I want 12 to 15 companies for maximum specific company risk diversification, then I have a range of low cost producers like Yumana, Eldorado then Streamers (Royalty Companies) like Royal Gold and Silver Wheaton, then more obscure, smaller companies that are beginning their production.

I suggest visiting www.goldstockanalyst.com Listen to all the audios and videos. Read: GSA_2012_User_Guide and GSA_sanfranpresentation  

Also, a book, Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks by Adrian Day

Go to www.kitco.com and listen to the investors, miners and analysts of the mining industry.

From GSA:

Investors must choose from two major groups: Explorers, of which probably 1,000 are publicly owned and Producers, of which only about 50 trade in North American stock markets.

To this latter group, we can add near-Producers, miners that have taken a deposit through the bankable feasibility stage and an independent engineering firm’s analysis has shown that:

1)      drill holes are close-enough spaced to have high confidence about the ore grades in-between the holes and thus justify the Proven and Probable Reserves (P+P) classification, and

2)      that the capital investment required to put the site into production will yield a profit, or economic return. Just as an independent auditor’s sign-off on a company’s financial statement is critical for investors, so too is an independent engineering firm’s sign-off on the deposit’s economics, and it’s required by the US SEC for a miner to be able to call its ounces in the ground P+P Reserves.

Gold Stock Analyst only follows producers and near-producers as they are the only miners with data confirmed by 3rd parties and thus have solid numbers that can be analyzed.

The Gold mining industry is unique. All the miners produce exactly the same final output, ounces of Gold. Unlike Coke and Pepsi, they spend nothing trying to tell consumers that their Gold is the best. The miners simply accept the current Gold price when they sell. With all ounces the same, and selling for the same price, one might think the stock prices would reflect similar valuations for Miner A’s ounces versus Miner B’s ounces. But, in fact, the stock market is not efficient and the valuations can vary widely. This gives an opportunity for investors.

The gold stock analyst uses three filters:

  1. Market Cap/oz P + P Reserves
  2. Mkt.. Cap/Oz Production
  3. Operating Cash Flow Multiple

Essentially, you can use his filters to pick your own gold and silver stocks. I monitor some of the well-known gold and value investors like Sprott, First Eagle Fund, Van Eck, Tocqueville and note some of their holdings, then I run the numbers and compare. I want to buy the cheapest ozs of gold (producing or in the ground) that I can with management that has been successful before and with a decent balance sheet or highly probably access to the capital markets.  Many junior gold mining companies are going to go bust due to the prior boom creating over-capacity (too many mining promoters or two guys and a mule with pick and shovel) and to tight financing conditions today. Great conditions for those companies that survive.

By the way, here is one gold bug who will not hire MBAs:

http://www.kitco.com/news/video/show/on-the-spot/55/2012-10-25/There-Will-Be-Panic-Into-Gold-Casey-Research   (see 4 minute 30 second mark)

Interviewer: Do they need a good degree to work at your shop (www.caseyresearch.com)?

Doug Casey, “We don’t care if someone has an MBA or college. We don’t care whether they went to college. We ask, “Do they have good character, intelligence, diligence, are they hard working and do they want to improve themselves? I don’t see how a college degree has anything to do with that, especially what they are teaching today—gender studies, etc. If someone comes to work for us today with an MBA, we look at them and say, What’s going on in your head that you allocated $100,000 and two years of your life to get more theory instead of doing in the real world.

….be careful.

Reader’s Question on Arbitrage

Testtost

 Reader’s Question

Please post your question rather than email directly to me (unless you do not get a response within two days) because (1) Other readers probably have similar questions and (2) your email may go into spam or be overlooked.

Don’t be embarrassed. If you ask, “What is a balance sheet?” I won’t give you the answer but I will tell you where to look and how to learn on your own.

Question

I’ve mentioned this before but I’m an avid reader of the blog. I’m currently going through your old posts one by one and learning a lot. Yours is one of 2 or 3 other blogs that I am reading the archives.

My question is about arbitrage (tenders and merger arb). I’ve been reading through Buffett’s old letters and in the late 1980’s he had quite an impressive run with his arbitrage investments (I think in 1987 he made around 80% on his arb investments).

Both he and Graham seem to have had long time success for decades using merger arb and other arbitrage techniques. Buffett mentioned in one of his letters that during the 63 years that Graham, Buffett LTD, and Berkshire practiced arbitrage, they made 20% annually on that strategy.

I’m wondering how often you employ any of these strategies in your portfolio? I’m also wondering if it’s more valuable to spend time working on tradition valuations of companies before treading into this highly specialized area? I think you mentioned you look for liquidations when the market gets too high, which I would group into this special situations category. It seems like a specialized area, but also seems like an area that would add uncorrelated returns to the portfolio, and serve as a great substitute for cash when markets begin to become overvalued.

Would love to hear your thoughts on merger arb if you have time… Thanks

My Reply

First, you should learn about arbitrage because all investing involves some form of arbitrage. Typically, the average investor takes an immediate to 6 month view but value in equities must be measured over the company lifetime (equities are perpetual securities) so value investors use time arbitrage to benefit. Also, spin-offs are one area to find uneconomic selling. Pursue your studies.

Read Klarman’s book Margin of Safety, Greenblatt’s Genius Book, Berkshire’s letters and then look at past deals. Then go where you have the least competition–micro-caps going private, liquidations, etc.  Oddball Stocks is one blog and there are others to learn from.

I am opportunistic, but I have found over the past few years there has been so much money with low-to-zero interest rates competition that the spreads have been too narrow. Then when there were deals like Burlington Northern buyout from Berkshire back in 2009, the spreads were OK–18% annualized but at that time you could buy MMM at or under $50.

MMM

Pursuing merger arb depends upon your opportunity set. Also, don’t compete against the big trading desks on Wall Street–it isn’t worth the risk/reward.

I had a successful merger arb in Burlington Northern but I took my eye off ball in not investing more in the obvious. If I bought around $50 to $55 per share, today I would have a 5% growing dividend yield and a double plus tax deferral.

Today, I feel the environment for many stocks is like this:

However, there are sectors like small gold and silver mining stocks that are in a huge bear market–and for good reasons–but there are opportunities in the areas with the most hatred and plunging prices. Meanwhile the mania in cloud stocks like CRM continues.

There have been companies like NVDA and Intel that offer a more than fair price, but risks are higher than owning a NVR or SYK in the $50s.  My first goal is to find compounders–franchises that can compound capital over time (rare), then buy franchises at slight discounts (20% to maybe 30%) and sell when the margin of safety disappears like today with NVR.  Then I look for special situations or net/nets.

You have to be flexible and go where you find opportunity but understand the drawbacks of each approach and your own limitations.  So recently, I have few special situations in my portfolio but that shouldn’t stop you from pursuing special sits. Just know why you have an edge.

Good luck.