Category Archives: YOU

I Passed on Berkshire at $97 per share

Thanks to David Hui Lai. Excellent!

In 1982, working as a 26-year-old money manager, I passed on Berkshire Hathaway, which was trading at $97, because I thought it was too expensive. The price represented a 50 percent price to earnings and price to book premium to the broad market. Had I made a different decision – at the time I was sitting on a large cash position from a successful real estate investment – I would now be smoking $10 cigars and hanging out with swell chicks. I’ll wait, I thought, until it hits $60. I’m still waiting. On Friday BRK.A closed at $217,000.

Although I was familiar with Warren Buffett’s investment record – he was widely regarded as one of the best investors of his generation, and I carefully read the Berkshire Hathaway annual report each year – he had not attained the prominence he now has. I mentioned this to Ian, and he suggested I might write about what I learned from passing on Berkshire Hathaway, and the years I worked as an investment analyst on Wall Street.

By way of background, I did not finish high school. I left home at the age of fifteen and hitchhiked up into Canada’s subarctic and worked fighting forest fires and then as a forest tower lookout. The loneliness was too much for me, so at the age of eighteen I became a real estate salesman. In my early twenties I sold hotels and nursing homes, and then met with some success as a real estate investor. I became fascinated by the stock market, and a full time investor in my mid-twenties. Within a couple of years I was managing money, specializing in mismanaged, undervalued companies. They ran the gamut from companies whose stock had declined significantly, had new management, heavy insider buying, to the bonds of bankrupt or distressed companies, to companies with substantial real estate holdings, low insider ownership and minimal or no profitability. I was fairly successful at this in Toronto, acquired some major clients in New York City and in my late twenties moved to the US and started an investment research firm serving institutional money managers and corporate acquirers. I did that for five years, made some money and retired to the Adirondack woods.

Overall, I was successful but my performance was extremely volatile including two years in a row down over 40 percent. Most of my investments lost money or broke even; the few winners were up so much that overall my portfolio averaged a thirty percent return. Among my clients were some of the most successful corporate acquirers of the day – Sam Zell, Richard Rainwater, Leucadia, Jay Jordan, and some of the most successful money managers of the day, Chuck Royce, Leon Levy, Michael Price, Seth Klarman, Fidelity’s Alan Leifer, Ernie Kiehne of Legg Mason (Bill Miller was Ernie’s assistant at the time), George Soros — about 100 money mangers paid my firm $20,000 a year in soft dollars for my “contrarian research.” They followed my work because I studied, in an in-depth way, companies not otherwise followed by analysts.

Much of what I learned I learned from watching extremely successful investors make and lose money. And from losing my own money.

What did I learn?

Lesson 1: The role of financial markets is to take money away from mediocre and underperforming companies and put it in stable, growing, high return on capital companies. Money has an almost metaphysical attraction to places where it is put to careful, good use. You can fight that trend, and invest in companies, for instance that are deeply undervalued and mismanaged – and some people are successful investing in the dregs – but very few over the long term. To use a whitewater kayaking analogy, freshwater seeks salt water, and you can fight that if you want, but paddling upstream eventually is likely to become highly problematic.

The approach that’s worked best in my experience is investing in high return on capital, low debt, growing companies that have the ability to reinvest earnings in the business and generate high returns on those reinvested earnings. The power of compound interest is so profound (mind-boggling really) that over time, returns in investments in those companies are enormous. The trick is finding companies that are compound interest machines. I remember Leon Levy, founder of Odyssey Partners, once telling me that John Paul Getty became the wealthiest man in the world by achieving a 17%percent compound rate of return, on average, over his career.

As in the case of Berkshire Hathaway, trying to invest in those companies based on an analysis of value is more likely to result in opportunities missed than it is make money. An approach that is much more likely to be successful – investing in high quality companies after a market decline of thirty percent, and retaining the liquidity to build positions in those companies after a fifty percent decline in the broad market averages. That takes extraordinary patience, which is a matter of personality.

Lesson 2: I’ve worked for two extremely successful investors who were experts in cyclical, commodity-dependent, capital intensive industries – real estate and mining – and learned that almost all of the real money made in those areas is made only by extremely patient investors who invest once every ten or twenty years, liquidate their holdings once a decade and spend long, long periods of time in cash.

One of those investors, Pat Sheridan, an owner of mines all over the world, once said to me that the classic business mistake was to be fully invested at the top of the market. The objective, he said, was to be liquid at the bottom because business cycles are primarily caused by the creation and destruction of debt. Those are functions of greed and fear, in other words of emotions. He built inventory (by buying mines) during times of low demand, and sold them during times of high demand, including one for $10 million in 2011. Managing cash is crucial to his strategy, he told me.

When oil or real estate prices increase, money flows in to take advantage of what appears to be above-average returns. Overcapacity results, prices decline, debt can’t be serviced and gets converted into equity or otherwise written off, capacity declines and within a few years commodity prices begin to recover. Then the whole cycle starts over again. The swings are unpredictable in terms of duration, but successful investors in those areas look for opportunities after a major (20 percent or more) capacity reduction in an industry, when the debt of the bottom thirty percent of companies in terms of quality of management and assets no longer exists and the debt of mediocre companies (the next ten or twenty percent of companies) trades at pennies on the dollar.

Three approaches, I’ve observed, work best over time: investing in the low cost producer with a durable cost advantage, investing in premium assets such as well-located real estate, and buying debt at pennies on the dollar after an industry wide collapse. All three strategies are most successful after a severe market decline when emotionally it is difficult to do.

The approach that almost always results in disaster – investing in cyclical stocks based on P/E ratios. Cyclical stocks are cheapest when, industry-wide, companies are losing money or have very low earnings, and most risky when they have low P/E and high price-to-book ratios.

Lesson 3: Most successful investors share some common personality characteristics.

They have superior analytical skills in at least one important area of investing. This results from an obsession with investing. They are students of the art. Ian, your commentary on this subject has helped me really focus on what I think I do better than most other investors. In your case Ian, I think that you have an important long term advantage in being willing to, and knowing how to, build relationships with management based on mutual trust and respect. In my case it is an ability to identify superior companies based on financial statement trends. I think. I hope. Only time will tell.

My skill evolved out of the realization that I could have avoided 90 percent of my disasters by spending a couple of hours with a company’s quarterly balance sheets and income statements. Instead, I would routinely fly thousands of miles, interview management, interview former executives and directors, especially those bearing grudges, visit company real estate and local appraisers, interview competitors, suppliers, and customers. I even, on occasion, would sit in a bar outside company factories and have a beer (or two) with workers coming off shifts. I studied accounting at night, read Ben Graham’s classic Security Analysis (twice) and spent twenty years running a business with customers, distributors, suppliers, employees and, as part of that, prepared financial statements once a month. I learned what fluctuations in twenty criteria including inventory, accounts payable and receivables and gross profit margin indicate about a company’s competitive position and prospects. That makes me uniquely qualified, I think, to analyze companies based on their financial statements. We’ll see.

Investing can be looked at as an emotional competition – your emotions and ability to control them versus the emotions of those you buy or sell securities from and to. A primary function of investment strategy is to counteract emotional impulses and thus survive (and take advantage of) adverse market developments. Investment performance is mostly determined by patience, risk management, a willingness to study, and what you do when things go differently than you anticipated. Those factors are personality driven.

In addition to having a clear concept of what their competitive advantage is over others, successful investors, I’ve learned, incorporate into their investment strategy clear concepts of acceptable risk, what constitutes an acceptable level of inactivity and length of holding period after funds are committed. And successful investors stick to their strategy. That strategy – for instance sitting on cash, sitting on losing positions, sitting on winning positions — must be based on self-knowledge. If the strategy is out of sync with the personality, it won’t work, no matter how well it has worked for others.

There are successful short and long term investors, but rarely are there successful investors who do both. A long-term investor must be a patient person. A short term trader who thrives on, perhaps needs, constant activity is likely to be an impatient person.

Regardless of short or long term investor/trader, risk management is crucial to survival and success. Once again, this is a personality issue. A successful investor’s strategy will anticipate adverse market developments – will assume that sooner or later they will be wrong and will lose money. Cash position versus invested capital is perhaps the single most important area of risk management, although acceptable debt levels (both in one’s own financial structure, and the companies in one’s portfolio) is also important. Does an investor have a cash management plan that fits with the other key elements of his or her investment strategy? Successful investors, in my experience, think their cash position through very, very carefully and they pursue a strategy that mitigates risk in what is otherwise a very risky field of endeavor – investing. Depending on the stage of the market cycle, very high or very low cash positions have a major impact on portfolio returns. And on investment survival.

Does and investor buy on strength or buy on weakness? Fluctuations in security prices are often determined by factors other than the underlying fundamentals of the companies involved. A stock can decline due to a major investor needing to raise cash, emotion, faulty analysis, and macro economic factors that do not affect the particular company in question. Is an investor a victim of those factors or a beneficiary? Does an investor know more about a particular company than the market? If yes, buying on weakness augments an investor’s returns. If not, returns are diminished by buying on weakness. Does an investor have the ability to admit when he or she is wrong and take action? Does an investor have the courage to buy during irrational price declines, when economic collapse is widely anticipated and discussed in the news media? Those factors impact long term returns, and they too are personality driven.

Ian, I find your belief that quality companies with market caps of under $30 million are more or less immune to general market declines because they have low institutional ownership very intriguing. Regardless, I strongly suspect that investing in quality companies that used to have market caps of over $100 million, and high institutional ownership, but now have market caps of under $30 million and no institutional ownership because the market is down 50%percent, is a lower risk variant on your strategy.

Whatever one’s position on that subject, an investment strategy needs to anticipate significant market declines, as well as declines in the securities in one’s portfolio, since declines have been a part of markets ever since markets were first created. Humans are emotional, therefore markets are emotional, debt results, markets collapse, and humans become more emotional. And master investors invest.

Or something like that.

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Among Analysts, A Herd Mentality Prevails

Goldman

By Lance Ignon (Investors’ Business Daily, 1998)

Today’s equity analysts are better educated (CFAs, MBAs, CPAs) better informed and command more computer muscle than ever.  What they lack, critics say, is courage.

Instead of leading clients to investment ideas, many analysts follow the crowed, churning out duplicative research reports that become part of a cacophony of timid group-speak.

“Too many analysts think alike; too few are willing to risk being wrong by taking a gusty, controversial stand,” according to a widely circulated report last month from market strategist Byron Wien at Morgan Stanley & Co.

Wien’s sentiments were echoed in interviews with other market strategists, mutual fund managers, research directors and analysts themselves.

Such complaints are not new, but they come at a time when research departments are slowly rebuilding their ranks following layoffs several years ago. These new analysts will be of little use, however, if they fall in with the herd and fail to produce ground-breaking research.

Critics say both analysts themselves and the incentives that drive the brokerage business are to blame for the group-think.

In a job where performance is measured every trading day by eights of a point, many analysts find security in mimicking their peers. If they are wrong, at least they don’t stand out. Yet, analysts’ opinions are most valuable when they are not only correct but also are in the minority.

If you’re always with the consensus, you probably won’t make much money, but you won’t get fired,” Wien said in an interview with Investor’s business Daily.

Stefan D. Abrams, managing director at Trust Co. of the West, argues that brokerage firms put too much emphasis on the morning call, when analysts announce their latest recommendations to their firm‘s brokers.

The practice may generate lots of trading commissions, but it also leads to a confusing fragmentation of information.

“Analysts are basically not doing the job of helping investors develop conviction in the long-term prospects for companies.” Abrams said.

“They’re too preoccupied with the morning call so they can spout some information that may not be that important. It’s a tidbit of information. Analysts are in the tidbit business.”

The very nature of the brokerage business also stunts the effectiveness of research.

CLIENTS’ INTEREST

An analysts’ purpose, after all, is to come up with winning investment ideas that will prompt their institutional clients to trade stocks through their firm’s brokers and generate commissions. But many of these clients are interested only in larger, more liquid stocks, so analysts tend to concentrate on these types of companies.

Often, “an analysts picks up a stock simply to attract trading calls, “ said Jonathan C. Schooler, a mutual fund manager for AIM Advisors Inc. in Houston.

The result is that dozens of analysts end up covering the same behemoth company. For example American Telephone and Telegraph Co. and NationsBank, the most widely covered U.S. companies , are followed by 59 analysts each. According to Nelson Publications Inc.

The 25 most widely watched U.S. companies have an average 52 analysts each.

By virtue of their size and number of shareholders, these companies deserve wide coverage. But each additional research report adds less value if, as is often the case, it resembles the reports it succeeded.

Moreover, this kind of duplicative effort leaves analysts less time to ferret out tomorrow’s AT&T or Microsoft Corp.

Of course, there are analysts who make a point of discovering companies early in their growth cycles and who are not afraid to cut their own path.

Oppenheimer & Co.’s Cecelia Brancato started following Cisco Systems Inc. in the summer of 1990. It has since increased 2,344%.

OTHER SIDE OF THE STREET

Brancato said she knew about Cisco even before its market debut, and recognized the potential for both the company and the entire computer networking industry. This gave her the conviction to ignore the periodic negative rumours that would temporarily weaken the stock.

“Typically, I am on the other side of the Street, whether it be on my opinion or my earnings estimates,” she said. “More often than not.”

ORIGINAL RESEARCH

Wien and others suggest, however, that analysts would build more credibility by conducting original research and developing maverick opinions that help clients make money.

Meantime, many institutional investors will continue to do their own research, they say, because too much of the information from Wall Street is stale.

“I throw those things out,” Art Bonnel (PM of MIM Stock Appreciation Fund) said, referring to most research reports. By the time it gets to me, everyone knows about it.”

—-

Coal Stocks Under Stress
Bus

Coal in a battle of “survival of the fittest,” Citigroup says

May 27 2015, 14:56 ET | By: Carl Surran, SA News Editor
  • A day after Credit Suisse warned that coal miners such as Arch Coal (NYSE:ACI) and Alpha Natural Resources (NYSE:ANR) were in “dire straits,” Citigroup analysts say it will be “survival of the fittest” for the world’s coal miners.
  • While Citi believes current coal prices are below sustainable long-run levels, it does not expect a return to prices anywhere near the levels seen a few years ago; the firm cuts its long-run thermal coal price forecast to $80/ton from $90 and its met coal price forecast to $125/ton from $170.
  • The firm sees China and India as the largest sources of downside risk to its long-run forecasts, particularly for met coal, where China could re-emerge as a net exporter.

The above “research” copy-cats an amazing insight of the obvious as coal company, ACI, declines from $78 to 49 cents:

ACI

 

Ask yourself what was the purpose of stating the obvious after the fact? The analyst should produce original work such as what has the market already discounted today? What about an industry-map showing production costs and sales per ton for each type of coal and where mines are located relative to domestic and export markets?  What are the dynamics affecting the market and what can change?  How much supply needs to be reduced? Who will and won’t benefit from consolidation? Do the companies have different management than the CEO’s and Boards of Directors who took on debt to make acquisitions at the top of the market in 2011? What drove management’s actions.  Can companies work together to merge and rationalize supply and return to profitability.

Reporting the obvious to mimic a competitor seems silly. What do YOU think?

A reader suggests a sub-group (off of the Deep-Value group at Google Groups) be formed to learn and study different concepts. I certainly encourage the idea. Let me know how I can help.

How Crazy is This?

What Chicago’s Fiscal Emergency says about the Quality of Credit Analysis in the Municipal Bond Market

Because it demands large-scale paradigm destruction and major shifts in the problems and techniques of normal science, the emergence of new theories is generally preceded by a period of pronounced professional insecurity. As one might expect, that insecurity is generated by the persistent failure of the puzzles of normal science to come out as they should. Failure of existing rules is the prelude to a search for new ones.

— Thomas Kuhn, The Structure of Scientific Revolutions

On May 12th, Moody’s Investors Service fired the shot heard around the world. The credit rating agency downgraded the City of Chicago and bonds issued by related tax districts to speculative (“junk”) status.

In a sense, Moody’s was only validating the bond market’s opinion of the city’s creditworthiness — the bonds had already been trading at junk levels for several months. This should have been a straightforward event for the chattering class to process intellectually. Rating actions tend to lag the market rather than lead it.

Oddly, however, Moody’s downgrade sparked a debate over whether Moody’s was being “fair” to Chicago. And with Chicago attempting to convert a portion of its variable rate debt to a fixed rate tomorrow, this debate has received considerable amounts of publicity. How could Moody’s cut the city to junk when the other rating agencies rate the city so much higher? (That has obviously never happened before in an era of ratings shopping and superdowngrades.) Wouldn’t having a diverse economy and large tax base cancel out the costs associated with machine politics? (It’s not like this is Chicago’s third fiscal crisis in the past century.)

This was probably the first instance in the history of the capital markets that a rating agency was accused of having too radical an attitude toward risk. How did we get here, folks?

A period of pronounced professional insecurity

Since the financial crisis, municipal bond market participants have been particularly defensive about the level of credit risk in the market as a whole. Commentary on any financially challenged issuer is reliably qualified with “the municipal market defies generalizations,” “these issuers are outliers,” or “remember that, historically, municipal defaults are small relative to corporate bonds.” But the parade of apologies for an issuer with Chicago’s level of financial dysfunction should signal that things have gone too far.

These observations began as a legitimate response to Meredith Whitney’s extremism. Whitney was never going to be correct — the amount of local defaults she predicted exceeded the amount of local government debt outstanding. It was mathematically impossible. It is still mathematically impossible. The financial media that turned her claims into clickbait have moved on to sensationalizing other sectors.

Five years later, however, many municipal market participants remain locked in an unproductive dialogue with an irrelevant personality. Consequently, they are now blind to the fact that what they are saying is no longer true. The market has more financially challenged issuers than can be counted on one hand. These governments are not outliers. They are a class, with similar characteristics and a universe of risks that differentiate them from other borrowers. And they are not small borrowers. It is a more meaningful trend that bondholders are receiving pennies on the dollar in court than it is that defaults remain rare.

There is a conversation to be had about how politics influences the perception of financial commitments and whether bond structures can further evolve to protect bondholders. If the general obligation pledge — absent a statutory lien, which few states have — lacks teeth in court, why isn’t it obsolete? Why is this bond structure still the foundation for credit analysis? Does the general obligation pledge allow governments to over-commit themselves financially in certain political contexts? I would submit to you that this is absolutely the case with Chicago.

None of these issues will be substantively explored so long as market participants remain in “move along, nothing to see here” mode. These are the first fiscal crises where pensions have been a factor at all. In previous fiscal crises, capital markets creditors had the luxury of control. That is no longer a given.

So municipal credit analysis has a lot of growing up to do. Essentially half the market was insured several years ago. As Kuhn noted regarding paradigm shifts in science, there will probably be “a period of pronounced professional insecurity” in the municipal market until new approaches emerge. Until then, there will be a lot of failures.

I will explain my own philosophy regarding financially challenged issuers at the end of this essay.

Rating divergence is actually the status quo — that’s not the story here

Shawn O’Leary at Nuveen Asset Management points out that this divergence is nothing new in Chicago’s Rating Split: Is Moody’s Out of Step?:

Before looking at rating divergence specific to Chicago, it’s helpful to look at the long-term trend of rating divergence between Moody’s Investors Service and Standard and Poor’s. In our opinion, the ratings of the two rating companies have been largely incongruous for several years …

While S&P upgraded 1.01 municipal ratings for each Moody’s upgrade from 2002 through 2007, that ratio ballooned to a whopping 6.66 S&P upgrades for each Moody’s upgrade from 2008 to 2014. And, as noted by the unemployment rate at the time, S&P’s drastic spike in the pace of upgrades occurred at the height of the Great Recession and continued through 2014. This was long after the recession’s effect on municipal finances became apparent to most market participants. While Moody’s pace of upgrades slowed in response to the recession, S&P behaved as though the recession never happened.

We believe this broader context is important to understanding how S&P could rate Chicago’s general obligation pledge at A+ (now A-) while Moody’s rates the same pledge at Ba1. Specific to Chicago, however, we find that not only has the market long treated Chicago’s debt as being at a speculative credit quality — but that it is also well-founded given the credit fundamentals.

Moreover, it is worth noting that the credit rating agencies have published rating methodologies. S&P’s US Local Government General Obligation Ratings Methodology and Assumptions (September 12, 2013 — stashed behind their paywall) includes overriding factors for liquidity and structural imbalance that the rating agency has long decided to ignore for Chicago. Those factors would have put a junk-level ceiling on Chicago’s ratings. In other words, S&P is arbitrarily holding Chicago to different standards than the other local governments the agency rates. And it is obvious why.

What financial risks does Chicago pose to investors?

Let’s examine Chicago’s credit profile and you can decide whether or not the city’s bonds are speculative investments.

Unfunded pension liabilities

The magnitude of Chicago’s unfunded pension liabilities receives considerable attention, and rightfully so. From Nuveen:

Chicago’s combined annual debt and pension costs are substantially higher than any [of the ten largest US cities] when these obligations are indexed to total governmental revenue. Chicago’s fiscal 2015 debt service and annual pension costs account for 44.8% of fiscal 2013 governmental revenue. San Jose is the next closest city at 27.8%. The nine cities other than Chicago averaged 22.4% of revenue.

Last Thursday’s Bloomberg Municipal Market Brief also provided some good comparisons (refer to the StoryChart):

The next 10 years will be the most difficult for Chicago, as current statutes require the city to increase contributions to its four pension plans by 135 percent in 2016, and 8 percent annually through 2021, according to Moody’s. Pension payments will rise 3 percent, on average, through 2026 and around 2 percent through 2032 …

The median per capita aggregate unfunded actuarial accrued pension liability for the largest US cities and Puerto Rico is $3,350. The City of Chicago’s is $7,149.

Most municipal market analysts assume that the city will address its unfunded pension liabilities and relatively high debt burden by increasing residents’ property taxes by nearly 50%.

Chicago officials have been unwilling to raise property taxes for at least a decade. Offering documents indicate that this attitude continues. The city iscurrently in negotiations with its police and fire unions to postpone transitioning from a system of arbitrary contributions to actuarial contributions (i.e., contributions that reflect the true cost of benefits).

If officials lack the political will to raise taxes when their bonds are trading at 300 basis points (3%) over the AAA benchmark, will there ever be a resolution short of insolvency? This is a material risk that should not be shrugged off.

Borrowing money in order to borrow money

Bloomberg also notes that Chicago has the second-highest general obligation debt per capita among US cities at $3,047, following New York City at $5,500.

According to offering documents (available here), the city won’t be able to afford to make debt service payments on its outstanding bonds from available funds until 2019. The city has been borrowing money on a long-term basis to make debt service payments since before the financial crisis:

Since 2007, proceeds from general obligation bonds in the range of $90 million to $170 million per year have been used to make the city’s general obligation debt service. The city expects to use approximately $220 million of proceeds of long-term general obligation bonds to fund general obligation debt service in levy year 2015 for debt service paid in 2016. The city currently plans to eliminate the use of general obligation bonds to pay general obligation debt service by 2019.

As I described at length in my earlier essay, How Chicago Has Used Financial Engineering to Paper Over its Massive Budget Gap, the city has also been using long-term debt to: (1) finance everyday expenses and maintenance; (2) finance judgments and settlements, including police brutality cases and retroactive wage increases and pension contributions for unionized employees; (3) restructure the city’s existing debt to extend the the maturities on its bonds far out into the future, in order to avoid having to pay the debt as it was coming due; and (4) provide slush funds for the city’s 50 aldermen to undertake projects in their respective areas (i.e., pork).

State and local governments typically only issue bonds to finance the construction of capital projects — buildings and infrastructure with long useful lives that will benefit residents for generations. Chicago has incurred literally billions of dollars of debt where residents have nothing to show for it.

Excessive reliance on short-term debt

Besides a sharp loss in population (as what happened in Detroit), excessive reliance on short-term debt is a solid indicator of financial stress. Chicago has essentially used its credit lines as permanent source of funding in the sense that they are usually carrying a large balance and have frequently been utilized for non-capital expenditures. The city recently expanded its short-term borrowing program to $1 billion. For the sake of comparison, the city’s general fund operating budget is in the neighborhood of $3.3 billion.

Forbearance agreements

Apparently the irony of assigning an investment grade rating to an issuer that is already in forbearance — i.e., its lenders and counterparties have conditionally agreed to delay declaring events of default and exercising their rights and remedies —has been lost on the rating agencies, let alone an issuer that has $2.2 billion worth of forbearance agreements for variable rate debt, short-term credit facilities, and interest rate swap agreements. Chicago’s offering documents contain six pages of triggered events of default. It would be understandable if the city simply needed to replace a deal participant, but having to take it all out at (presumably) much higher interest cost in short order?

Absent these forbearance agreements, that $2.2 billion would become due immediately. The city usually has less than $1 billion of liquidity. The municipal bond market has not seen a liquidity problem of this magnitude for a local government borrower since the financial crisis. And S&P calls this situation “short-term interference.”

Although a portion of these products will be addressed by the city’s offering this week, Chicago’s lenders and counterparties have imposed some strict conditions on the remaining amount. The agreements are for a short period of time and if the city’s credit continues to deteriorate, the standstill agreements will end and the remaining amount will come due.

A large and diverse tax base, but…

Many of the analysts arguing that Chicago should still be considered investment grade cite the city’s large and diverse tax base. Chicago is a transportation hub and home to a number of major corporations.

The city’s population has been declining in recent years and only grew by 82 residents last year. That is not a typo. According to the Chicago Tribune:

Chicago’s population grew by only 82 residents last year, giving it the dubious distinction of being the slowest-growing city among the top 10 US cities with one million or more residents.

With a population of 2,722,389 residents as of July 1, 2014, Chicago still easily holds its place as the nation’s third-largest city … But cities on both sides of it are gaining.

New York maintained its ranking as the nation’s largest city, gaining 52,700 residents last year, for a gain of 0.6 percent that pushed its population to 8,491,079. Los Angeles added 30,924 residents, up 0.8 percent and bringing its population to 3,928,864.

Sun Belt cities with more than 1 million residents — places like Houston, San Antonio, Dallas and Phoenix — all continued to see dramatic gains in new residents …

“The boom of Chicago in the 1990s was due to immigration,” said Rob Paral, a Chicago-based demographer who advises nonprofits and community groups. “You take away the catalyst of immigration, and you see what we have. They’re going to different parts of the country, and there much less immigration to the US than there was decades ago.

“Texas, as an example, has been a magnet for a lot of lower-paying jobs and has the benefit of lower housing costs. If you’re making $15 an hour, the difference between making it where a house costs $100,000 and $300,000 is great.”

This last point brings us to property taxes. Some have also pointed out that Chicago has the lowest effective tax rate in Cook County, which means the city can withstand a large tax increase. This is true. According to Bloomberg, Chicago’s effective tax rate on residential property is 1.8% versus Harvey’s 8.9%. On commercial property, Chicago is not the lowest, but its 4.9% effective tax rate is much lower than Harvey’s 15.1%.

Discussing the level of property taxes in absolute terms fails to capture residents’ calculus in deciding on where to live, however. Just because Chicago has a lower tax rate does not mean residents will stay in the city if or when tax rates are increased significantly. In other areas, higher taxes will translate into more government services, better schools, and so on. In Chicago, they will be used to offset the costs associated with meaningless debt and unfunded pensions from a decade of fiscal mismanagement. That’s a huge difference and something to take into account.

The city has few assets left to sell

Chicago has already blown through the reserves it established from the Skyway and lease of its parking meters. It could try to hawk Midway Airport, but that has already failed three times.

The city’s other tax districts have their own problems

The Chicago Board of Education is also heavily indebted and its recent downgrade likewise triggered events of default. These will force the school system to pay penalty interest rates ranging from 9% to 13.5% and make swap termination payments. The board has significant unfunded pension liabilities and a $1 billion deficit.

Bonds are legally and likely politically subordinated to pension benefits

Perhaps the greatest irony of the debate over Moody’s downgrade is the other municipal bond market news it obscured. Last week, with a 6-t0–1 vote, the San Bernardino city council approved a plan of adjustment that would keep pension beneficiaries whole and basically wipe out bondholders. San Bernardino would be the third in a series of bankrupt municipalities to do so.

Some rulings in federal bankruptcy cases suggest that Chapter 9 could potentially be used to adjust pension liabilities. For that to happen, however, the municipality would have to want to adjust its pension liabilities. So far, when capital markets creditors have gone toe-to-toe with pension beneficiaries in court, they have walked away with massive haircuts.

Why is this happening? I see two (largely ignored) things driving outcomes in municipal bankruptcy cases where pensions are involved. The first is that courts neglect to situate claims in larger public policy contexts. Perhaps this is because some of the judges and law firms involved have mostly corporate restructuring experience and do not fully understand how public policy works. Perhaps it is just impossible the way Chapter 9 was drafted. Whatever the reason, the vocabulary of sacrifice in Chapter 9 cases has become quite mangled. The second is that Chapter 9 provides subtle opportunities for political rebalancing in regions where machine politics prevails. Let’s discuss these in turn.

The treatment of other post-employment benefits (i.e. health care) has been a land mine for capital markets creditors in Chapter 9 cases, whether they realize it or not. Bankruptcy judges have agreed with the municipalities that pension beneficiaries are “making sacrifices” when a plan of adjustment strips them of their health care benefits but leaves their income benefits intact.

It has become something of a farce that the courts fail to recognize and quantify the other forms of government assistance available to retirees in determining the scope of their sacrifices. In a post-Affordable Care Act world, a municipality shedding OPEBs is not an economic sacrifice — it is tantamount to transferring those commitments from local taxpayers to state and federal taxpayers. It does seem like a sacrifice from a contract perspective, however, which allows locals to say, “See what we gave up? Now it is your turn.”

This is sufficient logic for capital markets creditors to receive haircuts, which then provide the resources required for the city to honor its pension commitments. To the extent that there are future Chapter 9 cases, expect OPEBs to be the starting point for crafting a plan of adjustment going forward. It’s just too easy.

If one looks at these insolvencies from the standpoint of local politics, it is not difficult to see how capital markets creditors can end up in the crossfire between different interest groups. Market observers tend to talk about organized labor as if it were a unified whole. In reality, large city governments can have dozens of labor groups with different perspectives and connections. This can be a very big deal with respect to pension politics. Cities can have several different pension plans depending on employees’ affiliations with funded levels that vary according to influence. Pension contributions are appropriations and appropriations are political.

If a municipality can keep its income benefits whole by making a token sacrifice that “frees up” funds that would have otherwise gone to investors, then policymakers can realign the political interests of all of these groups. They are all finally back on equal footing with respect to what they are due from the government. This keeps the machine working like a machine. Considering that governments can wander down this path (and in Detroit’s case, with open contempt for its investors) and still have some borrowing options, it is not surprising that Chapter 9 cases remain tethered to local politics.

That’s a bit of a digression, but it is still instructive with respect to Chicago. Chicago bondholders could potentially be subjected to the same destructive politics, but they would be in a worse situation legally if the city’s credit continued to deteriorate. Chicago is not eligible to file for Chapter 9, which means bondholders would have seek remedies in state courts with resistance from all of the other stakeholders (who are local). The Illinois Supreme Court has elegantly subordinated their claims to pensions through its interpretation of the state constitution and has expressed indifference about the financial impact. Absent Chapter 9, there isn’t even the possibility of sharing resources.

Regardless of what one thinks about ratings divergence, the divergence between the rating agencies and market participants with skin in the game makes perfect sense. Bondholders have been repeatedly hosed for giving municipalities the benefit of the doubt in these circumstances.

How I regard financially challenged governments

Chicago’s fiscal emergency is the confluence of two distinct, but related, problems: (1) the city has made extraordinarily bad decisions for over a decade about how to manage its resources; and (2) the city has made extraordinarily bad decisions for over a decade about which financial products to use in borrowing money. Both the city and its school system used excessive amounts of short-term debt, variable rate debt, and interest rate swaps. They have also waited until it is too late (expensive) to transition their debt portfolio to a more sustainable structure.

Ester Fuchs points out in Mayors and Money: Fiscal Policy in New York and Chicago, a classic text on fiscal crises, that municipalities can “afford” (i.e., financially survive) decades of mismanagement as long as the municipality can service its debt. While I agree with this observation (cynical as it is), I believe financial innovation has introduced some notable twists.

A municipality can “afford” either protracted fiscal mismanagement or an unconventional debt structure. Municipalities that are dealing with both, however, tend to be screwed. As its credit deteriorates, resources that would have cushioned the municipality against mismanagement are instead diverted to resolving broken debt structures (until they aren’t).

In Chicago’s case, the city is going to have to learn how to function without most of the gimmicks that have helped it through the last decade. Many market observers underestimate how difficult that will be, even with steep tax increases. They also seem to believe city officials are capable of becoming intellectually honest overnight.

Chicago is hardly exploring new territory here. All of the recent insolvencies in the municipal bond market have combined protracted fiscal mismanagement with a reliance on innovative financial products (e.g., interest rate swaps and pension obligation bonds). This epiphany continues to elude many market participants, especially those who believe credit analysis is as simple as financial ratios.

Perhaps Chicago will successfully navigate through this storm, but it is insane to disregard the risk involved.

The Wheel of Fortune: Mean Reversion (Part 1)

graves

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

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

As a value investor you are doing either:

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

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

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

Keynes discussed this phenomenon here:

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

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

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

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

Buffett Discusses Mean Reversion in the Stock Market

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

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

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

The growth illusion

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

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

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

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

High Growth Depresses Future Stock Returns

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

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

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

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

Mark Twain Falls for Silver Fever (A Study in Bubbles)

SilverStock_Certificate_1863

Silver FeverEvidence of bubbles has accelerated since the [2007-2009 financial] crisis.
~ Robert Shiller (“Irrational Exuberance,” 2015).The celebrated author and humorist Samuel Clemens (pen name Mark Twain) documented his experiences in the Nevada mining stock bubble, and his writings are one of the earliest (and certainly the most humorous) firsthand accounts of involvement in a speculative mania.

After a brief stint as a Confederate militiaman during the beginning of the U.S. Civil War, Clemens purchased stagecoach passage west, to Nevada, where his brother had been appointed Secretary of the Territory. In Nevada, Clemens began working as a reporter in Virginia City, in one of Nevada’s most productive silver- and gold-mining regions. He enviously watched prospecting parties departing into the wilderness, and he quickly became “smitten with the silver fever.”

Clemens and two friends soon went out in search of silver veins in the mountains. As Clemens tells it, they rapidly discovered and laid claim to a rich vein of silver called the Wide West mine. The night after they established their ownership, they were restless and unable to sleep, visited by fantasies of extravagant wealth: “No one can be so thoughtless as to suppose that we slept, that night. Higbie and I went to bed at midnight, but it was only to lie broad awake and think, dream, scheme.”

Clemens reported that in the excitement and confusion of the days following their discovery, he and his two partners failed to begin mining their claim. Under Nevada state law, a claim could be usurped if not worked within 10 days. As they scrambled, they didn’t start working, and they lost their claim to the mine.  His dreams of sudden wealth were momentarily set back.

But Clemens had a keen ear for rumors and new opportunities. Some prospectors who found rich ore veins were selling stock in New York City to raise capital for mining operations. In 1863, Clemens accumulated stocks in several such silver mines, sometimes as payment for working as a journalist. In order to lock in his anticipated gains from the stocks, he made a plan to sell his silver shares either when they reached $100,000 in total value or when Nevada voters approved a state constitution (which he thought would erode their long-term value).

In 1863, funded by his substantial (paper) stock wealth, Clemens retired from journalism. He traveled west to San Francisco to live the high life. He watched his silver mine stock price quotes in the newspaper, and he felt rich: “I lived at the best hotel, exhibited my clothes in the most conspicuous places, infested the opera. . . . I had longed to be a butterfly, and I was one at last.”

Yet after Nevada became a state, Clemens continued to hold on to his stocks, contrary to his plan. Suddenly, the gambling mania on silver stocks ended, and without warning, Clemens found himself virtually broke.

“I, the cheerful idiot that had been squandering money like water, and thought myself beyond the reach of misfortune, had not now as much as fifty dollars when I gathered together my various debts and paid them.”

Clemens was forced to return to journalism to pay his expenses. He lived on meager pay over the next several years. Even after his great literary and lecture-circuit success in the late nineteenth century, he continued to have difficulty investing wisely. In later life he had very public and large debts, and he was forced to work, often much harder than he wanted, to make ends meet for his family.

Clemens had made a plan to sell his silver stock shares when Nevada became a state. His rapid and large gains stoked a sense of invincibility. Soon he deviated from his stock sales plan, stopped paying attention to the market fundamentals, and found himself virtually broke.

Clemens was by no means the first or last person to succumb to mining stock excitement. The World’s Work, an investment periodical published decades later, in the early 1900s, was beset by letters from investors asking for advice on mining stocks. The magazine’s response to these letters was straightforward:  “Emotion plays too large a part in the business of mining stocks. Enthusiasm, lust for gain, gullibility are the real bases of this trading. The sober common sense of the intelligent businessman has no part in such investment.” (from Meir Statman)

While the focus of market manias changes – mining, biotech, Chinese stocks, housing, etc… – the outline of a speculative bubbles remains remarkably similar over the centuries.  Today’s newsletter examines the latest research into speculative bubbles and looks at how we can apply that knowledge, with examples of the recent booms (bubbles?) in Chinese stocks and Biotech.  This newsletter is much longer than usual letter, in part because the topic is both complex and important.  Skip ahead to the end for the Chinese and Biotech conclusions.  Speculative bubbles_2

nasdaq bubble

Hate Math

Poor future returns

 

Source: http://hussmanfunds.com/wmc/wmc150504.htm

Prof. Greenwald on Value Investing

OVERVIEW Value_Investing_Slides

Greenwald_2005_Inv_Process_Pres_Gabelli in London

Greenwald Overview of VI

A Value Investing Class in Three Minutes

sentiment_cycles
Buying High

Next Week

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

HAVE A GREAT WEEKEND!

Investment Checklists-Adapt Them for Yourself. GOODHAVEN

sacr

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

Investment Checklists 

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

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

The Quantitative Value Checklist

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

Below are several books on checklists.

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

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

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

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

goodx

The Problem with Investor Time-frames

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

holding-period

Shareholder_Message_1114 (Some investors run for the door)

2014_AR

2013_AR

HAVE A GREAT EASTER and WEEKEND!

fredgraphcreditmarketdebtgdp

Shareholder Maximization-The Dumbest Idea in the World; Is Skill Dead?

CRB 2015 long term

JM_The Worlds Dumbest Idea_1214

Video: http://eic.cfainstitute.org/2014/10/23/shareholder-value-maximization-the-dumbest-idea-in-the-world/

Excellent video on Austrian economics and entrepreneurship:

http://mises.org/library/entrepreneurship-austrian-economics-and-cryptorevolution

Advice

I am a first year MBA student in XXXX. I am from a background of (being) a software engineer and an equity researcher in China. I was very interested in Value Investing and tried to apply it to personal investment in past 8 years. Currently, I am exploring career opportunities in the Investment Management area and see that you have been working and teaching in this area for a long time. I would learn more about your experience in this area and get some advice from you.

I would write-up investment ideas within your circle of competence to show fund managers your critical thinking skills and approach to investing.  Or if you have a great understanding of a particular industry or company that is public you can present your ideas to the fund managers who own the company.   Show your past investment results. Why did you make the decisions you made?  Try to sell your ideas to the appropriate money managers.   But only you can determine what your strengths particular interests.   Your reports should meld your interests with your skills.

Icahn

Our activist friend, Carl Icahn’s High River LP, Icahn Partners LP and Icahn Partners Master Fund LP collectively bought 6.6 million Chesapeake shares on March 11 at $14.15 each, bringing the investor’s total stake in the company to 11 percent, according to a filing on Monday. Prior to the purchases, Icahn controlled about 9.9 percent of Oklahoma City-based Chesapeake. That compares with an 11.11 percent stake owned by Southeastern Asset Management Inc. as of Dec. 31, the largest holding according to the latest filings.

The Forgotten Depression (Video)

Forgotten-depression-1921-crash-cured-itself

Commodities Carnage; Reversion to the Mean and the Growth Illusion; Net/Nets

Reuters

CRBSearch Strategy: Go where the outlook is bleakest (John Templeton). Keep his wisdom by your side: Sixteen Rules for Investment Success_Templeton

Commodities (CRB Index) fall back to a 40-year support zone ($185/$205)

while:Commodities-Sentiment

As global commodities prices plummet, it’s incredibly convenient to pronounce the commodities super-cycle dead, isn’t it?  Yet banks from Goldman Sachs to Citigroup to Deutsche Bank are on record as saying it’s over.   http://www.wallstreetdaily.com/2014/12/08/jim-rogers-commodities-interview/

The point is not to follow the “experts” but search where there is carnage. I am looking at Templeton’s Russian and Eastern Europe Fund TRF Semi Annual Report because:

  • Hated Countries (Russia, Ukraine)
  • Currencies Down,
  • Commodity Exporters and
  • trading at a 10% discount so the 1.4% management fee is covered for six years.
  • Poor performance for the past few years

Things can and will probably get worse. So please don’t follow the blind (me) off the cliff. This is meant as an example of a SEARCH STRATEGY.

More on Reversion to the Mean and the Growth Illusion

We are beating this subject to death but you can’t understand how investing in bargains works without grasping these concepts.

Contrarian Strategy Extrapolation and Risk  Abstract: Value strategies yield higher returns because these strategies exploit the sub-optimal behavior of the typical investor and not because these strategies are fundamentally riskier.  Yes, this is an academic paper, but worth reading to understand WHY and HOW value (buying stocks with low expectations/and low price to business metrics like earnings, cash flow, EBITDA, etc.) provide better returns.

Growth Illusion

The Two Percent Dilution It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900–2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.

value-vs-glamour-a-global-phenomenon (Brandes Institute)

Thick as a Bric by Efficient Frontier

Does the Stock Market Over React

Discussion of Does the Stock Market Over React

Criticism of the Over Reaction Theory

The above is meant to supplement your reading in Deep Value Chapter 5, A Clockwork Market

 

Ben Graham’s Net-Net Strategy Revisited

Ben Graham Net Current Asset Values A Performance Update

Time-out: A Case Study in Pigeons

Pigeons-pigeons-27537154-741-1095

Case Study in Pigeon Investing

Times are hard.  Your family has been struggling to make the mortgage payments on your farm since the 50% decline in corn prices.

corn

Your lucky day! You get a call from a friend’s neighbor that he (The Pigeon King) desperately  needs breeders for his growing pigeon business. With a $125,000 investment financed with a second mortgage against your farm you can buy 360 pairs of pigeons at $165 a pair.  Then he offers to buy back the newly bred pigeons for $40 each (pigeons breed prolifically) with a ten-year contract.  He says these pigeons are for racing.  Then he gives you a list of five farmers in your state who are breeding pigeons for him.  Take your time and do your due-diligence, he says.

You check his credit ratings–all good.  No criminal or civil complaints. He owns his farm free and clear–he is a farmer like you!  After meeting with three of the pigeon farmers who confirm with check stubs that he has been paying them on time and as promised. The returns are good–in excess of 80% to 100% in terms of food and overhead to raise the chicks. Considering your time to look over your pigeons, you figure you can net a 50% pre-tax return on your capital. Plus, your contract allows you to sell whatever you produce at the stipulated price, so growth will be profitable.

Also, you hire an investigator to interview the Pigeon King. She sends you this video interview: Making Fowl into good fare—it this a good idea and A successful pigeon farmer

Times are hard. What do you do? Before you decide, you are inspired by

You gotta have dreams and the will to believe!

Pedgeon King

You remember what you learned as a deep value investor over at csinvesting.org and you_________? Why? What INVESTING/BUSINESS principles help you in your decision?

Please write them down now.  Then read on.

Many years later, you notice in the paper:

the-pigeon-king-and-the-ponzi-scheme-that-shook-canada.html

This article, The Pigeon King (same as the link above but with additional commentary for easier reading) is one of the most amazing stories–a farce, a tragedy, a comedy AND chock full of lessons for the investor.  You may think you are too smart to be a pigeon or a bird-brain (sorry!) but ANYONE can be blind.  What checklist items stop you (besides it’s too good to be true?).

What did YOU learn?

Money for nothing and your chicks for free

 

 

A Reader’s Suggestion for DEEP VALUE COURSE

I have recently received many suggestions to improve this course. There are almost 600 people in our group with many different backgrounds and experiences.  There may be advanced students who wish to discuss current case studies (Why is DLX, Deluxe, not a value trap like Radio Shack?) or potential investments or subjects into greater depth.  This course planned to follow Deep Value (book) while digging deeper into the footnotes without preconceived notions.  If, for example, we read about Buffett’s transition from net/nets to franchises, we will look at franchises but not focus on them. The point is to give students background to understand the distinctions. However, this may be too basic for many of you.

My goal is to make this a learning community. One idea would be to set up another blog (volunteers?) to discuss various ideas if there is enough interest. I won’t give out anybody’s email without their permission, but if a group of students wanted to dig deeper into various subjects, I am happy to provide a link to this new group or discussion area.  I will wait until I hear your feedback.

For example, a reader/student went into vast effort to provide feedback and suggestions.  Dr. K (my nickname for this reader) might be an excellent leader to develop a new discussion blog?  Below are Dr. K’s emails and links.  I will post your suggestions.

EMAIL 1

John; This is Dr. K following up from our phone conversation. So far I am very frustrated with the deep value course and in the following series of emails I will explain why.

Why I hate mechanical investing and problems with back-testing

  • First of all Seth Klarman in his book (Intro xvi, p.13, p.16-18, p.151, p.162) discusses the folly of searching for the holy grail “mechanical” formula for investing success. BG in The Intelligent Investor p.38-46 and p.194-195 also says mechanical formula investing is self-defeating. It contradictory that we are reading about mechanical formula (Toby Carlisle’s books). Mechanical formula (Toby Carlisle and Joel Greenblatt’s 2nd book) come off as lazy, naïve, and immature to me.
  •  Seth also is not a fan of Wide Moats (see p.32-34, p.93) but I guess that’s OK but it’s very confusing how we are jumping around from one investment ideology to another!! Seth also does not think much of EBITA (see p.71-78) while you seem to mention it on the front of your blog home page in a link at the top.
  •  Now go to http://falkenblog.blogspot.com and read as many past articles as you can. You should also get his first book: “Finding Alpha.” There is no need to read the rest of his books. In that book especially key in on p.115-116 “Geometric vs. Arithmetic Averaging”, p.116-117 “Survivorship Bias”, Ch. 6 p. 113-125 “Is the Equity Risk Premium Zero?” especially read p.121-123 “Transaction Costs” , p.47 “the Size Effect” and p.48 “Delisting bias.” These are just some of the many reasons why mechanical back testing is a dead-end path to investing success.
  •  And/or you can go to http://www.efalken.com and watch the Finding Alpha videos. This should take 8 hours but it’s good if you are short on time or you can do both. I also have many of the papers he has written or mentioned. I can send them to you upon request.
  • Next go to www.davidhbailey.com.Click on the Mathematical Investor blog and read all of the articles. Now see that attached papers he wrote along with Campbell Harvey.
  • Go to www.numeraire.com and read all of the links at the top. In the search site map section click on the article about why screening is not valuation.
  • Now go to www.numeraire.com/download.htm . Read every article in the Research Related Letter section. These are short but notice whom he is critical of. Now read all of the articles in the Research Notes section. Especially read “What is Circular Reasoning” which will explain why most stock screens and mechanical formulas (Toby Carlisle, Joel Greenblatt) are garbage! Make sure you click on or go to all of the links in this article. Notice the lists of various forms of logical errors. Notice the cross correlation with behavioral finance! These logical error list need to be studied in greater detail!! Also especially read “What is Economic Simultaneity?”, “A History of the Size Effect” and notice that on p.4-5 he lists some of the variables that are and are not circular!!, “Evolution of Stock Picking”, “Visual Detection of Circular Reasoning” (it’s vital you understand this) and finally “Fatal Summary.” (it’s vital you understand this also) Read all of the articles in Research Presentations and in Research papers (especially “Circling the Square” and notice on p.8 he gives the return formula and it’s vital you understand this).

You should a somewhat better idea of why mechanical investing is not scientific. You should not trust academic research as well as a lot of p-side research! I am not impressed with Toby Carlisle and Joel Greenblatt’s second book. I have a good feeling that many people in this course and google group are more advanced then you are aware of and feel the same way. I can tell you that I have been reading many academic papers over the years and would attach them when I tried to apply for a research job and never got any positive feedback from attaching them!! In addition Alpha Titans such as Seth Klarman, Peter Lynch, Warren Buffett, Ben Graham were not fan of this type of investing approach.

Let me know when you have read this stuff. I think you need to read and understand them otherwise you are not fully grasping how difficult value investing really is!! Keep in mind I don’t fully understand everything in this material but I know enough to not be impressed by mechanical investing research garbage studies!!

Most Factor Models that Explain Returns are False _ 1

Anamolies Don’t Do as Well after Publication

A Skeptical Appraisel of Asset-Pricing Tests _ 3

Backtest Overfitting

Significance Testing Issues for Empirical Finance 5

The Probability of Backtest Overfitting 6

Factor models to sensative to the time period tested 7

Email #2 about Net Nets.

You mentioned www.oldschoolvalue.comon your site in the resource section. I like this site for the free screens and the blog articles which do a good job of teaching quality investment theory. I am not too fond of his software program and he raised the price and his spreadsheets do not include critical off-balance sheet accounting adjustments (I will explain the New Constructs platform in a later email). Jae Jun thinks his spreadsheet program is better than it really is. (in my opinion).

Go to the -VeEV, NNWC and NCAV screens. Some of the stocks duplicate themselves. Now go to Ben Graham Net Net Stocks and a 7 Step Checklist to Make Money with Net Nets . Notice on p.7 Jae says 99% of Net Nets are useless and on p.9 he does not like Chinese ADRs. I think he also does no include financial companies, REITs, CEFs, Shells etc.

Now go to www.grahaminvestor.com.In the screens link at the top go to the NCAV Stocks (Shares Outstanding) screen. Notice it does include Shell companies and Chinese ADRs but only companies listed in the USA. (no Japanese, Canada, Australia, etc.) The next screen is NCAV Stocks (Float). I am not sure what the advantage of this screen is. It only seems to leverage the Current ratio. I have never seen anyone else mention using Float instead of Shares Outstanding instead. This site also gives: NCAV Stocks (Shares Outstanding, new) and NCAV Stocks (Shares Outstanding, new, no Chinese). I sent an email to the people that run this site about the screens but they never got back to me. I would not blindly trust that these companies are true Net Nets. You should verify the numbers yourself.

Go to http://www.netnethunter.com/my-ncav-investment-scorecard/. Does this guy give you the impression that he is a fan of running a mechanical screen and blindly following it?? Notice that he does analysis on the company’s “Burn rate.” Where did Toby Carlisle mention this?? Make sure you read all of the articles.

Now for the subscription. He does screens for Japan, Australia, Canada. The Japanese financials he gets are written in Japanese and gets the aggregated data from Business week.

A good assignment would be to figure out where for free or how you can screen for Japan, Australia, Canada or anywhere else other than the USA. Given the above two mentioned sites we could also for a day analyze (or for a week) every company of the list in greater detail and not do stupid mechanical investing like it has been suggested so far!!

I think I read that www.gurufocus.com has some Net-Net screens for a subscription rate but I don’t know if they are any good or not.

Another reason why Net Net studies and papers are flawed is that they don’t account for Survivorship bias and delisting bias in the historical database the study was conducted from. It’s quite possible that a company could be a “quality Net-Net” from financial standpoint but if the trading volume is too low then the NYSE could delist the company and then the stock loses 90% of its value as it goes from being a listed company to an unlisted (or OTC) company. Most of the deep value research does not discuss how to account for this and how to follow and trade these OTC companies!!

Here is email #3 about Wide Moat Investing.

You mentioned Pat Dorsey and his books. (see The Five Rules for Successful Stock Investing and The Little Book that Builds Wealth).

  1.  I met Pat Dorsey at a CFA Rochester, NY meeting while he was working for Morningstar. Morningstar has The Stock Investor newsletter which gives coverage of about 150 companies Morningstar believes are “Wide Moat” companies.
  2.  You mentioned Bruce Greenwald’s book and presentations about this subject.
  3. Now go to www.oldschoolvalue.com/blog/tutorial/this-is-how-buffett-interprets-financial-statements. This is a good summary article of the book “Warren Buffett and the Interpretation of Financial Statements” by Mary Buffett and David Clark. The authors also wrote “Buffettology” and a workbook about this book.
  4.  Also see What Gross Margins Can Tell You About a Company’s Economic Moat by Old School Value.

The assignment here is using these various books, articles and presentations someone subscribe to Morningstar’s Stock Investor newsletter, tell us the list of the 150 companies Morningstar list for “Wide Moats.” Then once we have this list we all go through each company and analyze and verify why these companies are indeed “Wide Moat” companies. In a presentation that you posted recently by WB he mentioned that there are no “Wide Moat” companies in Japan. I suppose we could locate “Wide Moat” companies in countries outside of the USA.

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This is email #4 about Special Situation investing. You mentioned Seth Klarman’s book. In the second half of that book he gives various “Special Situation” opportunities. Joel Greenblatt’s first book also was pretty good (but  now a little out of date while his second book was a bunch of mechanical garbage).

a. The absolute best and easiest site to locate “Special Situations” is Spinoff Monitor – Actionable Opportunities in Special Situations: Spinoffs, Bankruptcy, Restructurings . Notice on the right hand side a very easy list of all of the various situations!! I am very interested in exploring this area of Investing!! Their is no analysis on this site.
b. Other sites that list Special Situations include:
c. You mentioned www.distressed-debt-investing.com in your resource section on your blog. Someone also attached Stephen Moyer’s book about Distressed Debt investing. My advice here would be to stay far away from this area of investing until the investor has more experience under your belt in analyzing distresses equities first. That website and book is very complicated as it requires specialized knowledge of Bankruptcy law, Quant Credit Modeling and simulation. You should not really list this site on your blog unless you make it clear to people this area of investing is not for beginners! It’s for advanced investors!!!!!!!!!!!!!!!! These resources are not written in a way that is easy to learn or read!!
d. There are many sites on the web for following the Insiders. I think I read that www.gurufocus.com gives you coverage of Insiders. Many sites are for free. The absolute best book on Insider Buying is “Investment Intelligence from Insider Trading” by H.Nejat Seyhun. It should be noted that Seyhun’s database goes all the way back to 1975 while I have yet to see any website that goes back that far for a affordable price.
Now here is what I think is going on with Spinoffs. Suppose you have XYZ company with a consolidated financial statement consisting of three divisions: Division A, Division B, Division C. So Consolidated XYZ = [A + B + C]. Now suppose Division B will be Spunoff. Now we have two companies: Parent Company = [A + C] and the Spunoff Company = [B]. I think what is going on here is that when this proposal takes place it won’t occur for a 90 day period so therefore their is a 90 day period where these two companies’ financial statements won’t be in the various databases. Instead Consolidated XYZ = [A + B + C] will still be in the database. I THINK WHAT YOU NEED TO DO IS RECONSTRUCT THE FINANCIAL STATEMENTS SUCH THAT YOU CAN ANALYZE PARENT COMPANY = [A + C] AND SPUN COMPANY = [B] AS TWO SEPERATE COMPANIES. DO NOT ASSUME AS MECHICANICAL INVESTORS DO THAT THE SPUNOFF COMPANY IS THE GOOD DEAL AND THE PARENT COMPANY IS THE BAD DEAL. EVEN IN JOEL GREENBLATT’S FIRST BOOK SOMETIMES THE PARENT COMPANY IS WHAT HE PURCHASED AND SOMETHIMES THE SPUN OMPANY WAS THE BETTER DEAL. I think Joel did an OK of explaining what was going on in his first book but he was not always clear about the timeline of events for how to follow a typical Spinoff situation.
As for the various other types of Special Situations (except for Merge Arb) their is almost no analysis or coverage on how to follow these events!!

Email #5 about “Expectations Investing.”

  1. Go to www.expectationsinvesting.com. Make sure you read “Expectations Investing (2000)” by Alfred Rappaport and Mchael J. Mauboussin and “Creating Shareholder Value (1998)” by Alfred Rappaport. THESE ARE THE ABSOLUTE TWO BEST BOOKS I HAVE READ THAT CLEARLY EXPLAINED WHY CONVENTIONAL ACCOUNTING IS FLAWED AND THE DIFFERENCE BETWEEN ACCOUNTING VALUE AND ECONOMIC VALUE CREATION!! I can’t go into two much detail here but make sure you read and understand every Tutorial on the site!! In a recent post your blog about Enron I think you were trying to highlight the concept of Incremental Capital expenditure. This and Incremental Working Capital expenditure are clearly taught in these two books. These books also do a wonderful job of explaining the underlying drivers of Economic Value creation! You want to understand these spreadsheets in detail!

The assignment here is that New Constructs (See links below) does about 22 various off-balance sheet adjustments. Learn these adjustments and modify the Expectation Investing sample spreadsheets. Know how to do this for companies that New Constructs does not cover. (such as REITs, MLPs, Net Nets, Special Situations, Japan and non-USA stocks). In the case of non-USA companies the accounting conventions would need to be researched.

I think these spreadsheets do such a good teaching job of explaining things!!

(Not posted here-I couldn’t open the zip file)

  1. Michael’s 2nd book “More then you know” and his 3rd book “Think Twice” are gems that do a good job of summarizing what is going on in behavioral finance and must be read. I have many of the papers he mentioned from these books.

30-00 Part 2

The-Best-Primer-to-Valuation-Multiples Part 2

Trouble with Earnings & PEs

Cash Flow vs. NI

Counting what Counts

Financial Ratios

Financial Ratioswheres the bar ROIC

CommonErrors in DCF Models

Decoding Wall Street Propaganda ( A MUST READ!)

NewConstructs_in_DC

Do Investors see through Reported Earnings

Free-Sample-Company-Research-Report-HLS-2013-02-01

NewConstructsIntro_2013

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