Tag Archives: Damodaran

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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Boom/Bust Austrian business cycle theory.pdf
Damodaran Valuing Cyclical Commodity Companies.pdf
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Sorry: here is the Hooke book (chapter 19 on resource companies)

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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/

Valuation from a Strategic Perspective, Part 1: Shortcomings of the NPV Approach to Valuation

Review

For beginners and a review of Present Value—see these 10 minute videos: http://www.khanacademy.org/finance-economics/core-finance/v/introduction-to-present-value and  http://www.khanacademy.org/finance-economics/core-finance/v/present-value-2 and http://www.khanacademy.org/finance-economics/core-finance/v/present-value-3

and Discounted Present Value: http://www.khanacademy.org/finance-economics/core-finance/v/present-value-4–and-discounted-cash-flow

Prof. Damodaran’s Handout on NPV:DCF Basics by Damodaran

Prof. Greenwald Lecture Notes (See pages 10-13 on NPV Valuation):OVERVIEW Value_Investing_Slides

And The Dangers of Using DCF (Montier and Mauboussin)

CommonDCFErrors (Montier) and dangers-of-dcf (Mauboussin)

Part I: What are the three major shortcomings of using the Net Present Value Approach (“NPV”) to valuing companies?

The NPV approach has three fundamental shortcomings. First, it does not segregate reliable information from unreliable information when assessing the value of a project. A typical NPV model estimates net cash flows for several years into the future from the date at which the project is undertaken, incorporating the initial investment expenditures as negative cash flows. Five to ten years of cash flows are usually estimated explicitly. Cash flows beyond the last date are usually lumped together into something called a “terminal value.” A common method for calculating the terminal value is to derive the accounting earnings from the cash flows in the last explicitly estimated year and then to multiply those earning by a factor that represents an appropriate ratio of value to earnings (i.e., a P/E ratio). If the accounting earnings are estimated to be $12 million and the appropriate factor is a P/E ratio of 15 to 1, then the terminal value is $180 million.

How does one arrive at the appropriate factor, the proper price to earnings ratio? That depends on the characteristics of the business, whether a project or a company, a terminal date. It is usually selected by finding publicly traded companies whose current operating characteristics resemble those forecast for the enterprise in its terminal year, and then looking at how the securities markets value their earnings, meaning the P/E at which they trade. The important characteristics for selecting a similar company are growth rates, profitability, capital intensity, and riskiness.

This wide range of plausible value has unfortunate implications for the use of NPV calculations in making investment decisions. Experience indicates that, except for the simplest projects focused on cost reduction, it is the terminal values that typically account for by far the greatest portion of any project’s net present value. With these terminal value calculations so imprecise, the reliability of the overall NPV calculation is seriously compromised, as are the investment decisions based on these estimates.

The problem is not the method of calculating terminal values. No better methods exist. The problem is intrinsic to the NPV approach. A NPV calculation takes reliable information, usually near-term cash flow estimates, and combines that with unreliable information, which is the estimated cash flows from a distant future that make up the terminal value. Then after applying discount rates, it simply adds all these cash flows together. It is an axiom of engineering that combining good information with bad information does not produce information of average quality. The result is bad information, because the errors from the bad information dominate the whole calculation. A fundamental problem with the NPV approach is that it does not effectively segregate good from bad information about value of the project.

A second practical shortcoming of the NPV approach to valuation is one to which we have already alluded. A valuation procedure is a method from moving from assumptions about the future to a calculated value of a project which unfolds over the course of that future. Ideally, it should be based on assumptions about the future that can reliable and sensibly be made today. Otherwise, the value calculation will be of little use.

For example, a sensible opinion can be formed about whether the automobile industry will still be economically viable twenty years from today. We can also form reasonable views of whether Fort or any company in the industry is likely. Twenty years in the future, to enjoy significant competitive advantages over the other automobile manufacturers (not likely). For a company such as Microsoft, which does enjoy significant competitive advantages today, we can think reasonable about the chances that these advantages will survive the next twenty years, whether they will increase, decrease, or continue as is.

But it is hard to forecast exactly how fast Ford’s sales will grow over the next two decades, what its profit margins will be, or how much will be requires to invest per dollars of revenue. Likewise, for a company like MSFT, projecting sales growth and profit margins is difficult for its current products and even more difficult for the new products that it will introduce over that time. Yet these are the assumptions that have to be made to arrive at a value based on NPV analysis. (See page 10 of Greenwald notes-link on blog post).

It is possible to make strategic assumptions about competitive advantages with more confidence, but these are not readily incorporated into an NPV calculation. Taken together, the NPV approach ‘s reliance on assumptions that are difficult to make and its omission of assumptions that can be made with more certainty are a second major shortcoming.

A third difficulty with the NPV approach is that it discards much information that is relevant to the calculation of the economic value of a company. There are two parts to value creation. The first is three sources that are devoted to the value creation process, the assets that the company employs. The second part is the distributable cash flows that are created by these invested resources. The NPV approach focused exclusively on the cash flows. In a competitive environment, the two will be closely related. The assets will earn ordinary –the cost of capital—returns. Therefore, knowing the resource levels will tell a good deal about likely future cash flows.

But if the resources are not effectively, then the value of the cash flows they generate will fall short of the dollars invested. There will always be other firms that can do better with similar resources, and competition from these firms will inevitably produce losses for the inefficient user. Even firms efficient in their use of resource may not create excess value in their cash flows,  so long as competition from equally environment, resource requirements carry important implications about likely future cash flows, and the NPV approach takes no advantage of this information.

All these criticisms of NPV would be immaterial if there were no alternative approach to valuation that met these objections. But in fact there is such an alternative. It does segregate reliable from unreliable information; it does incorporate strategic judgments about the current and future state competition in the industry; it does pay attention to a company’s resources. Because this approach had been developed and applied by investors in marketable securities, starting with Ben Graham and continuing through Warren Buffett and a host of others, we will describe this alternative methodology in the context of valuing a company as a whole in Part II.

HAVE A GREAT WEEKEND

The University as a Failed Model for Learning. Free Valuation and Finance Courses-Damodaran

 Education is one of the few things a person is willing to pay for and not get.William Lowe Bryan (1860–1955) 10th president of Indiana University (1902 to 1937).

The University Business Model is Broken

http://aswathdamodaran.blogspot.com/2012/01/university-business-model-is-failure.html

On Jan. 25th, 2012 Professor Damordaran wrote, “My small challenge to the “university” business model.”

I am not a great fan of the university business model as a delivery mechanism for learning. The model can be traced back to the middle ages and is built around physical location and arbitrary requirements for graduation (that have less to do with learning and more to do with maximizing university revenues and faculty comfort). I know! I know! I am a beneficiary of the system and I gain from the low teaching loads and a tenure system that is indefensible. With four children, I am also a consumer of the same system and I am flabbergasted at how little accountability is built into it. How many classes have you taken (or your children taken) where you should have received your money back because of the quality of the learning experience? How often have you been able to get your money back?

For hundreds of years we (as consumers) have had no choice. Universities have operated with little competition and substantial collusion. There is no other way that you can explain how little variation there is in tuition fees across US universities and the rise in these fees over time. Outside the US, the fees may be subsidized by governments, but the quality of the learning experience is often worse, with the rationale being that if you paid little or nothing for your education, you should eat whatever crumbs fall of the table in you direction. But I think that the game is changing, as technology increasingly undercuts the barriers to entry to this business. I am not just talking about online universities (which, for the most part, have gone for the low hanging fruit) or the experiments in online learning from MIT, Stanford and other universities. These are evolutionary changes that build on the university system and don’t challenge it. I am talking about a whole group of young companies that have made their presence felt by offering new tools for delivering class content and learning. I am convinced that the education market is going to be upended in the next decade and that the new model is going to do to universities what Amazon has done to brick and mortar retailers.

To back up my point, I am running an experiment this semester with the classes that I am teaching at the Stern School of Business: Corporate Finance, a first-year MBA class, and Valuation, an elective. I have taught these classes for more than 25 years now and have tried to make the material and the lectures available to the rest of the world, but I have never formally tracked those taking these classes online. In fact, if you were not an MBA student in the class, taking the class online would have required you to forage through my website for materials and keep track of what’s going on. And I would have no idea that you even were taking the class… So, I want to change that..

Last semester, I used a company called Coursekit to package and organize my class and was impressed with their clean look and responsiveness to my requests. This semester, which starts in a few days, I have created a coursekit page for each class that is focused on just online students. I will use this page to deliver content (lecture notes, handouts and assignments that those who are in my physical class get), webcasts of lectures (though not in real-time, but the links should show up about an hour after the actual class ends ) and even the exams (you can take them and grade them yourself). The site also has a social media component, where you can start or join discussion topics, which I hope will provide the element of interaction that is missing when you do an online course. When you do get to the home page for Coursekit, you will notice my mugshot in the entry way. I promise you that I have zero financial interest in the company but I really want to see it succeed, because I think the education business needs to be shaken up.

The first session for both classes is on Monday, January 30. If you want to take these classes online, here is what you need to do:

  1. a.     Corporate finance class 
  2. b.    What is it? This is my “big picture” class about how financial principles govern how a business should be run. It looks at everything that a business does, through the lens of finance, and classifies them into investment, financing and dividend decisions.

Who can use it? I am biased but I think that everyone can use a corporate finance class: entrepreneurs starting new businesses, managers at established businesses and investors valuing these businesses.

How do you join? Go to the site (http://coursekit.com/finance). Enter RWHZYG as your code and you can then register for the class. Once you are registered, you will automatically be put into this page, every time you enter the site.

b. Valuation

What is it? This is a valuation class and it is about valuing any type of business: private or public, large or small and across markets. My focus is on providing the tools that will allow you to create your solution to valuation challenges, since new ones keep popping up.

Who can use it? While investors interested in valuing companies may be the obvious target, I teach the class more generally to be useful (I hope) to managers running the businesses and those who are just curious about value.

How do you join? Go to the site (http://coursekit.com/app#course/b40.3331.damodaran). Enter EH7WZN as your code and you can then register for the class. Once you are registered, you will automatically be put into this page, every time you enter the site.
Just to be clear, my first obligation is to the students in my MBA classes and I will not stint or compromise on that obligation, but I view delivering a great learning experience to those taking the class online as a close second. Note also that you will not get any credit from NYU for taking this class. While I will give you the grading templates to grade your own exams and evaluate your own assignments, I will not be able to give you direct feedback on your work. But then again, the price (at zero) is set right. So, these classes definitely come with a money back guarantee. In fact, the more the merrier… So, pass the message in this post on to any friends who may be interested. See you in cyber space on Monday.

Though I am not a fan of traditional finance courses, because of the heavy emphasis on math and models instead of deep thinking about businesses, you be the judge. Perhaps you might enjoy being part of the experiment.