Category Archives: Valuation Techniques

More on the Capital Cycle

FMQ for blog

We last left off here: follow-the-capital-cycle-as-a-contrarian

Gold and the capital cycle_2 Edward Chancellor discusses the fall-off in supply in precious metals which bodes well for FUTURE profits for miners.

The future turn in oil prices: http://www.resilience.org/stories/2016-01-12/arthur-berman-why-the-price-of-oil-must-rise

Over or mal-investment in the commodity cycle: Commodity Crash due to Monetary Supernova_Stockman

Buy disappointment and sell popularity  Don’t do this reflexively but place into context.

Peabody from hero to zero_case_resolution_fictconsulting

FCX_AR_2014 Note the increase in the rapid increase in assets before the stock price collapse. Note the research on how rapid asset growth usually precedes declines in future profitability  Robin Greenwood Investment and Ship Prices and asset_growth

Contrarian Investing (Part II)

swimming-against-tide-one-man-figure-walking-contrary-to-group-crowd-walking-wooden-figures-people-d-rendering-white-35054169

“Bull markets are born on pessimism,” he declared, they“grow on skepticism, mature on optimism, and die on euphoria.” –John Templeton

John Templeton paid attention to the emotion of the stock market. The first half of his philosophy was “The time of maximum pessimism is the best time to buy.” When everyone else was selling, he bought low during the Depression and in 1939 at the onset of World War II . . . and he made millions.

The second half of his philosophy was “the time of maximum optimism is the best time to sell.” He sold high during the Dot.com boom when everyone else was still buying. Founded in the 1950s, his Templeton Growth Fund averaged 13.8% annual returns between 1954 and 2004, consistently beating the S&P 500.

I think there are a few ways to make many times (10x to 100x +) your money over a long period of time.   The first would be to own emerging growth companies that have owner-operators who are both excellent operators and capital allocators who grow the company profitably at a high rate over decades.   The business generates high returns on capital while being able to deploy capital into further growth. Think of owning Wal-Mart in the early 1970s or Amazon after its IPO or 2001.   There will be a post on 100 to 1 baggers soon. I prefer this approach.

Wal-Mart 50 Year Chart_SRC

The second way would be to buy distressed assets and then improve those assets or create efficiencies by creating economies of scale. Carlos Slim, Mexican Billionaire, would be an example of this type of investor. Think activist investing. Note that Carlos Slim has operated at times as a monopolist in a government protected market.  Most of us do not have his options.

The third way would be to buy deeply-distressed, out of favor, cyclical assets and then resell upon the top of the next cycle. Gold mining is a difficult, boom/bust business, for example–see Barrons Gold Mining Index below. All businesses are somewhat cyclical, but commodity producers are hugely cyclical with long multi-year cycles due to the nature of mining-it takes years and high expense to reopen a mine and even if I gave you $2 billion and several years, you and your expert team may not be able to find an economic deposit. Note the five-to-ten year cycles below.

gold mining bgmi

We are focusing on the third way, but in no way do I suggest that this is for you. You need to be your own judge.  There is a big catch in this approach, you need to choose quality assets and/or companies with managements that do not over-leverage their firms during good times or overpay for acquisitions during the booms (or you could choose leveraged firms but be aware of the added risk and size accordingly becasue when a turn occurs, the leveraged firms rise the most). You also need to seek out a period of MAXIMUM pessimism which is difficult to do. How do you know that the market has FULLY discounted the bad news?  Finally, YOU must be prepared to invest with a five-to-ten year horizon while expecting declines of over 50%. That concept alone will make you unique.   Probably most will turn away from such requirements.

We pick up from http://csinvesting.org/2015/12/14/contrarian-dream-or-nightmare/.  Before we delve into the technical aspects of valuing cyclical companies, think about what it FEELS like to have the CONVICTION.  Here is an example:

We last studied Dave Iben, a global contrarian investor, in this post: http://csinvesting.org/tag/david-iben/.   You should read, Its Still Rock and Roll To Me at http://kopernikglobal.com/content/news-views and listen to the last few conference calls at the right side of the web-page.   Note Mr. Iben’s philosophy, approach, and Holdings. His portfolio is vastly different than most money managers or indexers. But being an contrarian takes fortitude and patience. Kopernik Global performance since inception:

koper spy

Next preview the readings below.

First you need to understand Austrian Business Cycle Theory to grasp how massive mal-investment occurs. Why does China have newly built ghost cities? Distortion of interest rates causes mal-investment (the boom) then the inevitable correction because the boom was not financed out of real savings.

Why is the bust so severe for mining/commodity producers?   Read Skousen’s book on the structure of production.  Think of a swing fifty feet off the ground and 200 feet long.   If you are sitting near the center of the swing’s fulcrum (nearest the consumer), then the ups and downs are much less than being on the end of the swing furthest from the consumer (the miners and commodity producers).

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Even if you are an expert in valuation, investing in a cyclical company can be lethal: Vale: Go Where it is darkest (Damodaran)

ValeBig Vale

Then Throwing in the towel on Vale. I am not picking on Prof. Damordaran because we all make mistakes, and he graciously has provided a case study for us.  Study the posts and the comments.

Can you think of several research errors he made (BEFORE) he invested?

Remember in the prior post, the long-term chart of the CRB index showing commodities at 41-year lows since the CRB Index is below 175 or back to 1975 prices?  Then why, if gold is a commodity,  doesn’t gold trade at $200 or at least down to $500 to $700 as the gold chart from that time shows?monthly_dollar

Why, if gold is money, doesn’t gold trade in US Dollars at $15,000 or the estimated price to back US Dollars by 100% in gold?  You can change the amount to $10,000 or $20,000, but you get the idea.gold monetary base

 

Gold during the boom of 1980 rel. to Financial Assets in 1980 the price of gold at $800 per ounce allowed for the US gold holdings to back each US dollar then outstanding.

Try thinking through those questions.  Can we use what we learned from gold to value oil?

I will continue with Part III once readers have had several days to digest the readings and at least three readers try to answer at least one question.  Until then……………………….be a contrarian not contrary.

Update on 21/Dec. 2015 http://fortune.com/2015/12/21/oil-prices-low/

Avoiding the Death Zone–the Four Horsemen and the Nifty-Fifty

everest-top

Climbers say that when you are over 24,000 feet, you enter the “Death Zone. Mistakes become lethal.

The death zone is the name used by mountain climbers for high altitude where there is not enough oxygen for humans to breathe. This is usually above 8,000 metres (26,247 feet).[1] Most of the 200+ climbers who have died on Mount Everest have died in the death zone.[1] Due to the inverse relationship of air pressure to altitude, at the top of Mount Everest the average person takes in about 30% of the oxygen in the air that he or she would take in at sea level; a human used to breathing air at sea level could only be there for a few minutes before they became unconscious.[1] Most climbers have to carry oxygen bottles to be able to reach the top. Visitors become weak and have inability to think straight and struggle making decisions, especially under stress. WIKI

So what does this have to do with investing?  When you pay too much for growth or quality, you may never recover. VALUATIONS MATTER ALWAYS!

First review the Nifty-Fifty Era when fifty stocks were “must own” for institutions in the 1970s due to their growth and quality.  Money managers herded into them similar to this: Money Managers Herding Video.

valuing-growth-stocks-revisiting-the-nifty-fifty  (Note page 22, you as an investor would have eventually broke even, but almost no one would have been able to seat through the 1980’s UNDER-PERFORMING a declining stock market!

Nifty Fifty   Ignore the second half of these notes.

Now think about how the pattern repeated in the Internet years of 1996 to 2000 when MSFT and INTC were the must own stocks of their era.

MSFT Monthly

INTC monthly

Congratulations! If you bought back in 1999/2000 when the press was lauding these “must own” stock for the future, you are now in the black.

Even if you pay too much for stable, high quality companies, you can lose even as the companies grow sales, cash flows and earnings year after year after year. Note: KO_VL_Jan 2013 (See P/E ratio as a proxy for investor enthusiasm and compare to financial metrics).   What is not to like?  So why did the price go sideways for almost a decade after 1998?   Investors adjusted their expectations.

Sun MicroSystems Case Study

One thing to never forget is that the market is mostly efficient but not ALWAYS efficient or correct. 2 plus 2 equals 4 not 10.   The last Internet frenzy gives a perfect case study in Sun Microsystems (SUN).

Sun Microsystems has always intrigued me. For a number of years, it seemed as if the company could do no wrong. During the early 1990′s, Sun occupied the top position in high performance computer workstations, a category of computing that has since virtually disappeared thanks to advances in PC hardware. Despite desperate attempts to unseat it from its leadership position by worthy competitors like HP, DEC, and IBM, Sun was able to prevail.

If you had purchased Sun stock in May of 1994, you’d have seen it skyrocket to nearly 100 times its value by August of 2000, just 6 years later. Had you kept it at the historical high price of $253/share, you’d have seen your investment lose more than 98% of its value when it came back down to just $3.17 a share by October 2008.

SUNW/JAVA stock price meteoric 100x rise and fall

Sunmicro

It is easy to pull out a historical chart and say, “Look at the bubble popping.”  But note what the CEO had to say about the price of his company’s stock in 2002:

Q: Sun’s stock hit a high of $64 or adjusted in the chart above of $250. Did you think what tech stocks were doing two years ago was too good to be true?   (Date of the interview was March 2002).

A: No, she trained me well, and the stock made a nice move since we got married. But two years ago (2000) we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

Now, the same music is playing but the players have changed. 
New Four Horsemen1


New Four Horsemen

Are now driving the performance of the general stock indexes:

Fab Five

The Fab Five are “NEED TO OWN” stocks for money managers who wish to NOT underperform in the short-term.

  1. AMZN VL
  2. Goog_VL
  3. FB_VL
  4. MSFT VL
  5. GE_VL   certainly the the financial metrics, growth, and rising stocks prices make these easy “one-decision” stocks.

Let’s take AMZN because this company has a dominant position in retail that seems to be growing.

Amazon Key Stats

  • Trailing PE: 950.63
  • Forward PE:  117.65
  • Market Cap: $311.04 billion
  • Book Value: $26.50 per share
  • Share Price: $663.54
  • Price/Book: 24.27

Read more at How Amazons Long Game Yielded a Retail Juggernaut. Can’t you see many Americans becoming addicted to Amazon’s Prime service? Poor Wal-Mart and other retailers. However, IF AMZN doubles in market cap over the next 10yrs or a 7% annual return, and ends up trading at 21.9x earnings (current SPX p/e) in 2025, it needs to grow net income 55%/yr! Since 1973, 0.28% of companies have grown earnings at 55% for 10 years (Source: O’Shaughnessy). Do you like those odds?  Or are you so smart that you can tell that AMZN will win the lottery?

While valuation augur for CAUTION for stocks IN GENERAL:

GMO 7-Year 2015-11

The Bubble Right in Front of Our Faces

The True Contrarian

A MUST-READ ARTICLE:  The Nifty Fifty Becomes the Feb Five

Because when you enter the death zone you need to remember:

avalanche

Have a great weekend and Thanksgiving for those in the USA!   How is your analysis of Valeant progressing? I hear crickets.

Update: The top 10 stocks in the S&P 500 are +13.9%. The other 490 are -5.8%. Largest spread since the late 1990s. Can you hear the bells ringing?

Research on a Cyclical Business; The bubble in front of our faces

debt fueled buybacks

commodities pct below all time high

1-Incrementum-Inflation-Signal

Repeat after me: All markets are cyclical, all markets are cyclical, all markets are cyclical.

xau spx

A good example of research for a simple, cyclical business

JAC_Simple Digressions Oct 25 2015 46 cents ENERGOLD

More here: http://prostedywagacje.blogspot.com/2015/10/impact-silver-cheap-stocks-but.html

Perspective on the mining market and gold: Van Eck Joe Foster Gold-Public-Monthly-Commentary-2015-10

And be careful, The Bubble in front of our faces………http://hussmanfunds.com/wmc/wmc151116.htm

The Valeant Saga, Part III; Master Class in Deep Value Investing by Icahn

ackman

Part II on Valeant  Let’s pretend you are asked to evaluate the situation for Mr. Ackman.  He is in deep #$%^& and has brought in fresh eyes to advise him. Pershing Square has had to install two hotlines–Hotline 1: for investor suicide calls and Hotline 2: for investors who wish to phone-in death threats.

image002

All bad joking aside, you have a huge pile of information to present the critical issues.  Do you advise Mr. Ackman to buy more, sell immediately, sell down to a “more reasonable amount,” or hold?  Use reason not opinion or emotion to guide you.

Step back and ask what are the important issues?  What is Valeant worth? Can you know that?   Pretend you are an investigative journalist trying to uncover the story.

You can start here with company documents:

What does Valeant do?  Does Valeant have assets or a business method that gives the company a higher sustainable return on capital?   What roll-ups/acquisition firms have been very successful in the past and how was success achieved?

Then you can read all the rumours and commentary swirling around Valeant, but be quick to focus on what you determine to be important.  There are several links in the documents for you to follow further.

If anyone has other information to share please post in the comment section.

Also follow the links to the prior posts on Valeant to read the comment sections.

In a week, we will go through this exercise.   Now YOU have the chance to do the work.

Good luck and have a great weekend!

Excellent Video of Carl Icahn below.

http://greenbackd.com/2015/11/05/icahns-masterclass-on-deep-value-and-activism/

Valeant Case Study in Progress

wisdom

There is an ongoing battle over Valeant’s (VRX) valuation and business model between short-sellers and investors.   This opportunity allows us to improve our analysis skills and understanding of business models.  Also, how will Sequoia, an owner of over 20% of Valeant’s equity, handle their portfolio?

My first question is whether Valeant is a franchise with durable competitive advantages or a roll-up of commodity products dressed-up in a fancy industry (Pharma)?   We should use this case to learn how experienced analysts present their opposing views.

First: What’s not to like?  Valeant has rapid growth with huge profit margins? Of course, the PERFECT investment is a company that has high returns on capital and can constantly redeploy its capital at the same high returns.  The classic case would be the early (pre-2000) history of Wal-Mart (WMT) as the high returns generated from its stores could be redeployed into new stores on the borders of their regions which had economies of scale in administration, advertising, and management costs per unit of sales.  WMT did not have, for example, advantages in gross margins, but net profit margins. See WMT_50 Year SRC Chart.

What would be the source of Valeant’s high returns and competitive advantages?

Sequoia (a well-known value fund with an excellent long-term record) saw strong competitive advantages.  See their recent investor transcript:

Sequoia-Fund-Transcript-2015-August  Note the date of the transcript and the questions regarding Valeant concerning Philador and Sequoia’s 20% concentration.

Other investors (Charlie Munger, Citron) disagreed:

April 2, 2015 from www.fool.com

…..Recently, during a shareholders meeting for the Daily Journal Corporation, a newspaper where he serves as Chairman, Munger had this to say about Valeant Pharmaceuticals Intl Inc. (TSX:VRX)(NYSE:VRX): “Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time.”

What exactly does Munger mean by this?

A little history lesson

Who exactly was Harold Geneen? And what did he do at ITT that’s so infamous?

Geneen took over ITT Corp in 1959 when it was still mostly a telegraph and telephone company. After being blocked by the FCC in an attempt to buy the ABC television network in 1963, Geneen decided to diversify away from the company’s traditional business and completed more than 300 acquisitions during the decade in areas such as hotels, insurance, for-profit education, and the company that made Wonder Bread.

Geneen used cheap debt to finance these acquisitions, which later proved to be the company’s downfall. After Geneen’s retirement as CEO in 1977, subsequent CEOs spent much of the next two decades paying off the debt by selling most of Geneen’s acquisitions.

Is Valeant really comparable?

On the surface, Valeant looks like it could be pretty comparable to ITT. Since merging with Biovail in 2010, Valeant has made more than 30 different acquisitions, most of which were paid for with debt or by issuing shares.

Since the end of 2010, Valeant’s debt has skyrocketed from US$3.6 billion to US$15.3 billion. Shares outstanding have also gone up considerably from 196 million to 335 million. It’s obvious that Munger is onto something.

But on the other hand, I’m not sure Valeant is anywhere close to being as bad as ITT was. For one thing, all of the company’s acquisitions are at least in the same sector. ITT was buying up hotels and car dealerships, while Valeant is buying up pharmaceutical companies. Valeant’s efforts scale up a whole lot better than ITT’s ever did.

There’s also a bit of hypocrisy coming from Munger on this issue. Munger is actively involved in a company that does pretty much the same thing as ITT did back in the 1960s. Sure, Berkshire doesn’t use much debt or engage in hostile takeovers, but Berkshire and ITT have more in common than Munger is willing to admit. Both attempted to dominate the business world using a roll-up acquisition strategy; Buffett and Munger were just a little more patient with their plan.

But just because Munger exaggerates how bad Valeant’s acquisition spree has been doesn’t mean the stock is necessarily a buy at these levels. The company had earnings of just $2.67 per share in 2014, putting the stock at a P/E ratio of nearly 100 times. Yes, earnings are expected to grow substantially in 2015, but the outlook is simple. For the stock to continue performing, the company must continue to make acquisitions.

After making more than 30 acquisitions in just a few years, it’s hard to keep finding deals that will not only be big enough to make a difference, but will also prove to be good long-term buys. There’s so much pressure on management to keep buying that a serious misstep could be coming. If that happens, this hyped stock could head down in a hurry.

Although I don’t buy Munger’s alarmist concerns about Valeant, I agree with him on one thing. The stock just isn’t attractive at current levels.

A potential acquisition target, Allergan, Inc., points out its worries over Valeant’s business model. investor-presentation-may-27-2014-1 on VRX

Citron, a short-seller, attacks with a report: Valeant-Part-II-final-b. Valeant is another “Enron.”  Use the search box on this blog and type in Enron and follow links to review that case.  Enron never showed the profit margins that Valeant is currently showing.   NEVER take another person’s statement on faith.  Check it out for yourself. 

Valeant today (October 26th, 2015) counters Citron and answers investors’ concerns with 10-26-15-Investor-presentation-Final4 Valeant and video presentation:  http://ir.valeant.com/investor-relations/Presentations/default.aspxeep.

Ok, so what is Valeant worth?   Can you make such an assessment?  How do you think Mr. Market will weigh-in?   If you owned a 20% stake in Valeant, how would you manage the position?   What are the main issues to focus on?

This may be too difficult to analyze for many of us but we have  or will have many documents and reports to provide insights.  Remember that there are two sides to every narrative. Can we move closer to reality or the “truth”?

Note www.whalewisdom.com and type in VRX.   What type of investor owns Valeant?   Will momentum investors stick and stay?

Your comments welcome.

Sign up for Whitney Tilson’s emails on investing.  Worth a look: leilajt2+investing@gmail.com

A Reader’s Question on Franchise vs. Asset-based Investing

Finland-winter

Greetings from Finland,

I have been a long-time reader of your blog as well as member of your Deep Value group. I am studying in a business school and I’ve been investing in stocks since I was 15 (now 23). I have read the basic Graham’s Intelligent Investor and Security Analysis and lately I have found the statistic, Deep Value approach very interesting.
 
For me it’s very hard to choose between franchise type investment strategy and more statistic, asset based valuation strategy. I acknowledge that my skills for identifying those Buffet- type-compounders at low prices are lacking but I also know that sticking with asset based strategy is mentally difficult. I have been trying to find asset-based valuation strategies from your blog and Deep Value group and wanting to be better at valuating businesses. I also found Tobias Carlisle’s books helpful and encouraging about finding great picks using quite simple ratios such as P/B or Acquirer’s multiple.
 
I believe my problem is quite common and you hear this quite often. I am really convinced about your knowledge and I find you to as a great teacher. I hope you could email me those books you took off from your blog because of the copyright reasons. And of course if you can give some tips and hints I would be very thankful.
My reply: Yes, your worries/problems are endemic and natural to anyone developing their investment process.  You have two major goals:
  1. How to value a business
  2. How to think about prices

Point 1: In valuing a business you have either an asset or a franchise (or franchise 2% to 5% of businesses or non-franchise) to value.  The terms are not important, but the concepts are.  If you pay over asset value for a business then growth will not bail you out.  Time is not on your side.   Therefore, step one in improving your results is do not mistake a non-franchise business for a franchise business.  You are in the death-zone where you risk a PERMANENT loss of capital.  See below, dead Russian soldier during WWII invasion of Finland.

main_1200

Examples would be swks vl.   There is almost no way in a competitive world that SWKS’ returns on capital will remain at those levels (20%+) over the next ten years–and that is what speculators (NOT investors) are betting on.

Buying net/nets and working capital bargains (buying at a discount to liquid working capital and paying nothing for fixed assets) is probably the safest type of investment IF done as a group.   For example, Energold, Inc. (EGDFF) is a working capital bargain with a decent balance sheet but if frontier drilling does not increase over the next five to ten years then it could go out of business. If you invest 10% in ten of those net/nets and working capital bargains, then the ODDS are with you. This is NOT a recommendation for Energold, inc. because it is just a fair business in a hugely cyclical industry, but it is cheap based on its balance sheet.

energold

The bottom-line is that you need to practice and DO valuation all the time.   Value a company every day or every week.   Go through a Moody’s manual or value-line (or the equivalent in Finland) and look at a lot of companies.  Reading about sex, or sky-diving or war is not the same as participating.  Yes, go ahead and read, but request annual reports from all the companies in Finland and start valuing them. If you have trouble, then set aside and come back later when you have more knowledge.  Don’t be afraid to call up the companies.   If you find a company that is really cheap, ask the CFO why doesn’t he sell his home to buy more stock?  The point is to be ACTIVELY valuing companies ALL THE TIME.   Practice, practice.

Take KO VL Last I looked Coke was trading at about 16 times EV-to-EBITDA while HNRG trades at 4 times EV-to-EBIDA (deduct $1 per share for subs.). Cheap!?  Well, hold on, for every dollar of sales Coke makes about 80 to 85 cents in free cash flow while for Hallador Energy (Coal Producer) every dollar of sales generates about 15 cents of free cash-flow right now. I expect that to rise to 20 cents but you can see that Mr. Market handicaps each business properly–usually (but not always).  Hallador has unused capacity and can grow profitably but to a certain limit.   I would characterize Hallador as a non-franchise but with quality assets compared to its competitors in the coal industry (second on cost curve behind Foresight Energy (FELP).

When you buy a franchise then you must expect that barriers to entry will hold-off regression to the mean. The strategy is almost opposite to buying assets where you expect regression to the mean to occur.

Point 2: How to think about prices.    This comes down to knowing yourself?  How do you think, how do you react under stress? Only YOU (not me or other “experts”).  Here is an example of a true value investor:

You have to keep a log of your investments and decisions.  What patterns do you see.  Are you patient?   How will you develop patience.  If you have $1,000 US dollars, then if you make 5 investments of $200 each, write-up each investment–its value, why you made the investment, what would cause you to sell and/or abandon the investment. Then keep meticulous journal entries.   You buy at $10 then the price rises to $15 then declines to $8.   Will you buy more?  Why or why not?   The famous Seth Klraman, sells some at $15 because he knows he will be too upset to buy at $10 or $8 if he hasn’t sold some of his stock. The point is that Mr. Klarman has found a method that fits HIS personality.

Spend more time in introspection and practicing investing.   Let me know your progress and GOOD LUCK.

Best,

John Chew

More readings

Strategies used by Munger Buffett and Davis to outperform

Has Buffett Lost the Midas Touch

Keynes

the-manual-of-ideas_josh-shores_2015-07

BEING WRONG (VALE)

Brazil EM

Friday, September 25, 2015

No Mas, No Mas! The Vale Chronicles (Continued)!

Some of my Brazilian readers seem to be upset that I used “No Mas”, Spanish words, rather than Portuguese ones, in the title. To be honest I was not thinking about language, but instead about a boxing match from decades ago, where Roberto Duran used these words to give up in his bout with Sugar Ray Leonard.

I have used Vale as an illustrative example in my applied corporate finance book, and as a global mining company, with Brazilian roots, it allows me to talk about how financial decisions (on where to invest, how much to borrow and how dividend payout) are affected by the ups and downs of the commodity business and the government’s presence as the governance table. In November 2014, I used it as one of two companies (Lukoil was the other one) that were trapped in a risk trifecta, with commodity, currency and country risk all spiraling out of control. In that post, I made a judgment that Vale looked significantly under valued and followed through on that judgment by buying its shares at $8.53/share. I revisited the company in April 2015, with the stock down to $6.15, revalued it, and concluded that while the value had dropped, it looked under valued at its prevailing price. The months since that post have not been good ones for the investment, either, and with the stock down to about $5.05, I think it is time to reassess the company again.

vale

John Chew: At least the author has a process to reassess his investment.  I believe the critical flaw in his analysis (easy to say in hindsight) was not noting the massive mal-investment due to distorted credit markets caused by central bank policies. To normalize iron ore prices you would need pre-distortion prices going back twenty-five years.

Read more: No Mas!

The Secret to Success: Being Ridiculed on Social Media; Hedge Fund Analyst Quiz; The End

Beards-1272x950

Jesse Felder, a Contrarian Trader   Listen to the podcast and explore The Felder Report

Hedge Fund Quiz

The only way to win a date is to become a hedge fund analyst.  Your interview process requires you to analyze a real estate/mining company.

You look first at the balance sheet (Thanks Mr. Graham).   You notice that this mining company bought claims under a ski resort (Park City, Utah) where it bought acres in 1907 at five dollars an acre.

Then you notice that the company issued 20-year corporate bonds when interest rates were 9% for AA corporates about fifteen years ago.  Now similar companies can issue bonds at 5%.

How would you conduct your analysis? Good luck.

Interest rate decline

The End

So how will it all end? Dollars are created by computer key stroke when the Fed buys bonds, but the dollar is backed only by bonds (and a tiny bit of gold) and the bonds are payable in Federal Reserves Notes (the dollar) or just another form of debt. So debt is created to buy debt which, in turn, is payable in debt. Whoa?! No way this could ever be a problem. It’s magic. One thing bothers me, though, why do we need legal tender laws TO FORCE people to use dollars? I got a bad feelin’ on this.

But WHAT if more and more debt creates less and less “GDP” (let’s pretend it means something–govt spending creates economic growth, Ha Ha.) until each dollar of debt creates 0 or negative GDP growth. The Fed has to print to pay interest on the debt or the tail consumes the tiger.

Hemingway: We go broke slowly, then suddenly!

Anyone using CPI to gauge reality needs a reality check. You are a fool to buy gold as an “investment against “CPI inflation.” You own gold as a form of money to store wealth IF you lack confidence in central planning. So when it all comes down is when gold goes into permanent BACKWARDATION in gold. Holders of gold go NO BID on dollars. But don’t worry, the dollar derivatives like the Yen and the Euro will be earlier casualties. Meanwhile hope that the dollar rises against in order to buy more ounces. For others, Pray.
Now those who read the above my disagree, but know exactly fiat currencies do NOT go to 0 (or NO BID).

Buffett’s Search and Analysis Techniques; Economic Fitness

investor-trait

Wise Thoughts from Buffett on Finding Stocks

  1. I started at page one [of these manuals-Moody’s and Value-Line] and went through every company that traded, from A to Z. When I was done I knew something about every company in the book.
  2. I like businesses that I can understand. Let’s start with that. That narrows it down by 90%. There are all types of things I don’t understand, but fortunately, there is enough I do understand. You have this big wide world out there and almost every company is publicly owned. So you have all American business practically available to you. So it makes sense to go with things you can understand.
  3. First, you need two piles. You have to segregate businesses you can understand and reasonably predict from those you don’t understand and can’t reasonably predict. An example is chewing gum versus software. You also have to recognize what you can and cannot know. Put everything you can’t understand or that is difficult to predict in one pile. That is the too-hard pile. Once you know the other pile, then it’s important to read a lot, learn about the industries, get background information, etc. on the companies in those piles. Read a lot of 10Ks and Qs, etc. Read about the competitors. I don’t want to know the price of the stock prior to my analysis. I want to do the work and estimate a value for the stock and then compare that to the current offering price. If I know the price in advance it may influence my analysis. We’re getting ready to make a $5 billion investment and this was the process I used.
  4. 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
  5. Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.
  6. I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.
  7. If we were to do it over again, we’d do it pretty much the same way. The world hasn’t changed that much. We’d read everything in sight about businesses and industries we think we’d understand. And, working with far less capital, our investment universe would be far broader than it is currently.

7 Gems from Buffet on Analyzing Stocks

  1. You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
  2. There’s nothing different, in my view, about analyzing securities today vs. 50 years ago.
  3. We favor businesses where we really think we know the answer. If we think the business’s competitive position is shaky, we won’t try to compensate with price. We want to buy a great business, defined as having a high return on capital for a long period of time, where we think management will treat us right. We like to buy at 40 cents on the dollar, but will pay a lot closer to $1 on the dollar for a great business.
  4. Munger: Margin of safety means getting more value than you’re paying. There are many ways to get value. It’s high school algebra; if you can’t do this, then don’t invest.
  5. If you’re going to buy a farm, you’d say, “I bought it to earn $X growing soybeans.” It wouldn’t be based on what you saw on TV or what a friend said. It’s the same with stocks. Take out a yellow pad and say, “If I’m going to buy GM at $30, it has 600 million shares, so I’m paying $18 billion,” and answer the question, why? If you can’t answer that, you’re not subjecting it to business tests.
  6. Capital-intensive industries outside the utility sector scare me more. We get decent returns on equity. You won’t get rich, but you won’t go broke either. You are better off in businesses that are not capital intensive.
  7. No formula in finance tells you that the moat is 28 feet wide and 16 feet deep. That’s what drives the academics crazy. They can compute standard deviations and betas, but they can’t understand moats. Maybe I’m being too hard on the academics.

7 Nuggets from Buffett on Valuing Stocks

  1. When Charlie and I buy stocks which we think of as small portions of businesses our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.
  2. In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.
  3. Intrinsic value is terribly important but very fuzzy. We try to work with businesses where we have fairly high probability of knowing what the future will hold. If you own a gas pipeline, not much is going to go wrong. Maybe a competitor enters forcing you to cut prices, but intrinsic value hasn’t gone down if you already factored this in. We looked at a pipeline recently that we think will come under pressure from other ways of delivering gas [to the area the pipeline serves]. We look at this differently from another pipeline that has the lowest costs [and does not face threats from alternative pipelines]. If you calculate intrinsic value properly, you factor in things like declining prices.
  4. Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.
  5. We use the same discount rate across all securities. We may be more conservative in estimating cash in some situations.
  6. Just because interest rates are at 1.5% doesn’t mean we like an investment that yields 2-3%. We have minimum thresholds in our mind that are a whole lot higher than government rates. When we’re looking at a business, we’re looking at holding it forever, so we don’t assume rates will always be this low.
  7. The appropriate multiple for a business compared to the S&P 500 depends on its return on equity and return on incremental invested capital. I wouldn’t look at a single valuation metric like relative P/E ratio. I don’t think price-to-earnings, price-to-book or price-to-sales ratios tell you very much. People want a formula, but it’s not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business’s economic characteristics.

More Reading

Most of these quotes came from Buffett FAQ which contains the Q&A from shareholder meetings and goes beyond what you’ll find in the annual letters.

Just from these small selection of quotes, you can see how Buffett manages to dance in zone 4.

Take his words to heart and let’s join him on the dance floor because the sweet spot is where we belong. Read more: http://www.oldschoolvalue.com/blog/investing-perspective/warren-buffett-analyze-value-stocks/#ixzz3iofOBNF9

Economic Review & Fitness

Boot Camp  A good resource for students

Consequence of ZIRP

What is money?

Economic Conversations

How the economy works by Ray Dalio

Sentiment

Crude-Oil-Returns

oil Sentiment

oil carnage

Oil headed to $10 a barrel

HAVE A GOOD WEEKEND!