Sunday, May 29, 2011

Value Traps of Smart Value Investors

Smart investors, who try to buy low to sell high, look for what they perceive as bargains that the general market does not see. Originally under the founders and authors of their seminal text first published in 1934, Security Analysis, Graham & Dodd * focused on finding both bonds and stocks selling below their intrinsic value. In the early days this was focused on finding securities not only below their properly adjusted book value, but when possible below their “net-net” levels. “Net-net” was shrinking book value to just cash, and easily selling current assets versus all liabilities. While some of these opportunities do exist today, they are extremely rare in a world of so much electronically sorted published data. More often than not these opportunities are found in the distressed securities world when there are insistent sellers who must be out of the named issuer quickly.

(*) I took my securities analysis under Professor David Dodd.

With the disappearance of a large number of net-net opportunities, well trained investors looked for additional opportunities. These investors led by Ben Graham himself, Warren Buffet, and Irving Kahn, found additional ways to pick winning stocks. This coming Friday, Irving is to receive a Lifetime Achievement Award from the New York Society of Security Analysts, celebrating his 105 years of successful life and contributions. What these gentlemen did was to move the goal post forward from a current price/value relationship, to valuing a future price significantly above the current price. One of the keys to this analysis is that the future value was available today at a reasonable price. Thus, many value oriented managers today look for (future) growth at a reasonable price (GARP).

Reasonable price

There are two critical elements to the determination of reasonable price. The first is a high expectation that the future earnings will be realized. Usually this belief is based on some events happening that are anticipated to be positive for the stock in question. The chances that the good news will work are measured, in my mind, as execution risk. More on this risk later as part of the discussion on value traps.
The second critical element in determining reasonable price is: reasonable compared to what? In this case there are two approaches. The first, favored by leading value investors is relative to returns available currently from US Treasuries. If one expects, as I do, that interest rates on US Treasuries to rise to adjust for inflation and a decrease in the relative perceived safety of US paper compared with other assets, then a value stock buyer needs a substantially higher expected return than the current nominal rates. The second approach as to reasonable price is to examine the specific expected return compared with some concept of market. This relativistic approach believes that the market is mispricing the specific opportunity and will correct this undervaluation at the time of the expected sale.

Memorial Day vantage point

In the United States we celebrate Memorial Day on Monday. Our blog community includes members from at least 18 other countries, thus I need to avoid aiming all of my thinking on the US. This country, along with numerous other countries, looks back at least once a year to celebrate all of those who gave their lives, and I might add their innocent youths, to protect their country from those who wished to dominate them. On days like this I become a bit retrospective thinking not only of those we have lost, but also of their lost opportunities. As a confirmed investment addict, in time, my mind shifts to lost opportunities in stocks. I think about those who have fallen and in too many cases not to rise again. Just as our military leaders study the past battles to learn how to avoid the ensuing casualties, I look at the history of stocks to see what I can learn that is useful going forward.

Good Analysts/Portfolio Managers/Fund Selectors

William Shakespeare puts the words in the mouth of Marc Antony in describing the assassins of Julius Caesar who are standing before him, “So are they all, all honorable men...” Many good investment people have fallen into a way of thinking, that at least for some time has proven to be value traps. Since no one that I know has always had only winning positions, we all can learn from a retrospective look at our analytical skills with the hope of reducing the number of casualties in our portfolios.

Looking Back at Value Traps

Ford (truck sales), GM (slowing car buying economies in China and US plus a politically motivated seller), Sears (under-investment in desirable inventory), Intel (missing the switch to tablets), Microsoft (demand slowdowns in the developed world), Dell (adding new products and services without fixing the old and thus missing revenue estimates), Johnson & Johnson (not doing good enough in products and certain developing countries) is a brief list of what has proven to be value traps. Within the parenthesis after the company name is an extremely brief highlight of its perceived problem. In each case the companies are large with substantial assets, including well known names and reputations. Many have been followed for years by very bright analysts and portfolio managers who now have the responsibility for these stocks at current prices that don’t represent the values they perceived. In most cases, what they failed to weigh sufficiently was the execution risks imbedded in the names. Some of the problems were beyond management controls, e.g. the twin slowdowns in the economies of the two biggest car buying markets: China, (the largest) and the US. In a number of cases managements dropped the ball in not having the right products at the right prices. As not all investors fell into these traps, it is quite possible some were skeptical of the execution hurdles.

One of the recurring traps that people fell into was looking at the cash on the balance sheet and deducting it from the price of the shares and dividing the result by the earnings of the company to show how “cheap” the stock was priced. There are three reasons that this has proven in some cases to be a mistake. First in a number of instances a good bit of the cash is overseas and they do not account for the tax costs of bringing it back home. (In some cases the overseas cash has to stay put to satisfy various commercial and regulatory needs.) Second, we know from studying portfolio managers that carry large cash positions on the way down, through the bottom, and only recommit cash after a significant advance. In this example, cash is just too comfortable. Third, there is a risk that operating managements will make mistakes in the use of their hoarding, e.g. bad acquisitions of companies and/or securities.

Duration risk

In the standard analysis of future value, one needs to assign a period of time between the present and the recognition by the market of the enhanced value. Assume that today’s price is $5 and the expectation is that its future value is $ 10. If the recognition period is one year, the annual rate of return is 100%. Using the same metrics, but assuming that the duration of the recognition period is 100 years, the annual average rate of enhancement is 1% per year. What has proven to be the admitted problem for the believers is not that their expectations are misplaced, but it is just taking too long.

Now what?

While I am not an economist, I do have two very different observations of future actions. The first is to recognize that all of the listed value traps (and many others), are large market capitalization stocks. As a group, large capital stocks have risen less than small caps. As is my practice I will use mutual fund indices produced by my old firm. Through Friday, Small-Cap Growth funds were up +33.87% for the one year period, whereas Large-Cap Growth funds were up +24.5% and the Large-Cap Core funds +22.31% and Large-Cap Value funds +20.47%. Ever since the market hit bottom, large cap has not been as productive as small cap. In the current period of instability, I believe that there is more comfort in those required to be invested to own large caps. Thus, I would not treat this blog as a call to get out of what has been value traps, but to adjust the underlying analysis as to execution and duration risks.

The other approach on this Memorial Day weekend is to be thankful that we survived the past and to look at the new opportunities that are being created for us. Big winners come from successful big dreamers. I hope to find not those that restore value to their 2007 highs, but ones that see potential doubles and more from here. (If you have any of those, please share them with me.) I expect to find them in successful disrupters of current perceptions.


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Sunday, May 22, 2011

The Crowd Roared and Investors Cringed: Be Careful of Crowded Trades

Saturday night, my wife Ruth and I heard Mahler's Symphony No. 3, with the marvelous Jacques Lacombe conducting the New Jersey Symphony Orchestra in its concluding classical concert for the season. (Ruth is an indefatigable Co-chair of the NJSO.) When the last note was sounded, the nearly sold out audience at the New Jersey Performing Arts Center (NJPAC) exploded in a loud and enthusiastic roar of approval. (I am very pleased to see full houses at the NJPAC, where I am a trustee and chair an investment committee with very impressive co-members.) Though the Mahler symphony was composed over 100 years ago, being amidst Saturday night’s large and vocal crowd reminded me that one of the most valuable skills of some of the best investment managers that I have known and studied over the last half century, is to avoid crowds, especially early crowds.

Bond buyers and inflation

Last week bond buyers purchased between $40 to 50 billion dollars of securities, depending on which sources one used. Most of these issues were of high perceived quality and therefore relatively low yields. The yields were below many actuarial assumptions for pension plans, were below endowment fund expectations, and certainly did little to resurrect the retirement capital accounts of investors. Why the rush? The answer may well be that there is too much un-invested money sitting around earning next to nothing. The pressure to “do something” at times becomes unbearable. In the week, we saw the issuers take full advantage of the crowd; including Google raising $3 billion in addition to over $30 billion in cash on its balance sheets. Perhaps the buyers will be rewarded with interest rates dropping further (if that is possible) and therefore pushing bond prices up.

The two largest middle class populations outside of the US are in India and China. Both countries are experiencing reported and less-reported inflation at an accelerating rate. These populations are relatively unschooled in high finance, but are living through an inflationary experience and are acting smartly. Both are buying gold in all forms. In the first quarter of 2011, the purchase of gold by the Chinese was $40 billion, or about the same amount as its weekly bond buying surge. Often ordinary people are more correct than well-schooled experts, and therefore I am expecting an increase in the rate of inflation.

Gold buying is not the only defense against inflation. On Friday I attended the annual Investors’ Day for the Sequoia Fund, a mutual fund that has been held for many years by some of our investment advisory accounts. In discussing inflation, the president of the fund stated that ownership of well-managed corporations that have protected pricing power is an effective inflation-defensive strategy. I tend to agree.

Lack of Historic Perspective by Equity IPO Buyers

LinkedIn recorded a doubling of value on its first day of trading, a modern record. The key facts are: The company had no earnings, and at the initial prices it was selling at eleven times sales. By the end of the first day therefore, it was selling at more than twenty-two times sales. Assuming that full taxes are paid and that the after-tax operating margin is 50%, the potential price/earnings ratio would be a minimum of forty-four times earnings, if there were any earnings. When I was learning security analysis at a trust bank, there was a rule that senior investment management would not accept a terminal P/E valuation in excess of 25x. Further, there are very few companies that have a history of growing operating earnings with low double digit growth rates over a decade. A rare, exceptional company might be able to grow operating earnings in the mid to high teen range over a ten year period. I am not conscious of a company growing operating earnings 20%+ over ten years on a fully taxed basis. History would suggest that the first day closing price for LinkedIn was a function of undisciplined price behavior or aggressive shorting pushing up demand.

Lesson of The Week

Stand up and cheer great performances, but stay away from participating in crowded trades. This principle is applicable to bonds, stocks, or for that matter, anything that trades. Some of the biggest gains in the hedge fund that I manage have come from buying stock after an IPO price ran up, and subsequently collapsed well below the initial price. I doubt that I will buy into LinkedIn soon, (the stock, as distinct from the service). My early training at the bank requires publicly traded securities to have earnings.

Sharing Disciplines
What are the personal disciplines that have kept you out of investment trouble? Please share these disciplines with me via email; letting me know your choice whether to share them with the Blog community or for my use only.


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Sunday, May 15, 2011

Are You the Smartest Person in the Room?

Have you ever noticed that most of the time sellers know more about a trade than the buyers? As retail consumers purchasing a product or service, we normally approach a salesperson and ask them specific questions about what is being offered. Rarely do we get an exhaustive disclosure. Even when negatives or blemishes are mentioned, their number and importance are less emphasized than the headlined advantages. At times we may get lucky and feel that the seller is more knowledgeable, perhaps even truly professional. We carry the same attitude, some might say naively, over to purchasing securities, particularly fixed income securities.

Seller’s advantage

This last week, according to Karatash Abdullah of Natixis, the following bonds were issued at what has to be considered historically, very low interest rates: IBM, Xerox, Wesfarmers (Australian), Philip Morris, General Mills, Prudential, BBVA (Spanish), Standard Chartered, Nordea (a Nordic bank), Banco Bades (Uruguay), Banco Safra (Brazil), Energy Transfer Partners, Pacific Gas & Electric, IPALCO – AES, Southern California Edison, DTE (formerly Detroit Edison), Delphi, and MIT. I found this list fascinating for its length, breadth of issuer, and the timing of the offering. However, what caught my specific attention were the first and last names on the list.

When I was a young analyst, many thought that IBM was the smartest big company in the world. The company was not only deemed to be very smart, but rather opaque in terms of disclosure. Though I wanted to be an equity analyst, I had a discussion with the bond side of the house of the insurance company that provided the exclusive funding for what I believe was $100 million+, for 100 years, and this was the key: at 2%. I had assumed that as a very large powerful buyer, the insurance company would get frequent detailed disclosures similar to its loans to private companies. When I learned that the insurance company only got the normal disclosures of a public company, I became much less interested in working for the insurance company. Later on it became clear that this loan was one of the competitive strengths of IBM in building its absolutely critical computer leasing business, particularly outside the US. While the insurance company did have a rather modest equity position in the stock, it was clear which side of the private placement was the smartest in that trade.

The last named issuer was MIT (Massachusetts Institute of Technology) a truly wonderful university (for those who can not get into Caltech where I am a Trustee). All kidding aside, not only is MIT a great engineering school, it has a world renowned Economics and Finance faculty. They are clearly very smart. What fascinated me is that MIT issued $750 million in 100 year bonds. This issue was so successful in scooping up money from insurance companies that they canceled a planned 30 year bond offering. The interest rate for the 100 year bond was 5.623% and was rated AAA. The life insurance companies that bought this issue were using it to offset their actuarial risk of issuing life policies to some portion of the population that will die 100 years from now. What I find fascinating is that the smart guys are betting, I believe, that during some portion of the term of the bond and perhaps cumulatively, inflation will be above the long term (since 1926) rate of 3%, and thus the real cost of having money over time is less than 2.623%. All of these back of envelope calculations ignore the real power of interest on interest that will be earned by the insurance companies. If interest rates go up, as I believe they will, the payments by MIT can be invested at higher rates than the 5.623% on the issue. That is not a dumb bet, but my guess that the MIT will prove to be the most prudent if not the smartest player in the trade.

Translating government debt personally

Periodically one of the rituals of personal financial life is to draw up a personal balance sheet. Most often this exercise is done in the connection of some credit extension to us. Far less frequently the exercise is part of financial goal management. This exercise should be done for our own use at least once every year. On the right side of the balance sheet we aggregate all the debt that is outstanding in our name. We may even footnote any contingent debt that could be the result of guaranteed borrowings by others. After conducting this exercise we feel pretty good about our financial condition, particularly if our net worth is the largest number on the right side of the balance sheet. In these days of fiscal problems in Greece, Ireland, Iceland, Portugal and probably Spain and Italy, our personal debt profile is not complete without adding our share of the US government’s debt in addition to state and local debt. In his latest blog, Frank Holmes of US Global Investors displayed a screen shot from On the bottom line of the display is an entry entitled “liability per taxpayer” which was shown as $1,021,775, that minute’s calculation of the collective US government debt divided by the number of American taxpayers. We live in a “progressive” tax country, where the wealthy pay higher taxes than the less well off (only about half of the taxpayers pay federal income taxes). Considering the way politicians think, I would suggest that those of above average wealth, in reality will pay one way or another, a greater proportion of the debts as they become due than the average earning taxpayer. For planning purposes, I would suggest that for each additional $ 1 million in net worth, some 50% of the average debt per taxpayer be added to our total liabilities. Now before one decides quickly to leave the repayment problems to our heirs, remember in all the discussion about the exploding debts of the federal and local governments, no attention is being paid to the ultimate value of the assets on the various governments balance sheets. Much of what the government owns could be sold to the private sector that just might be better managers and still act both prudently and socially responsibly.

I would be happy to discuss the construction of your own personal balance sheet; please use the email link below to reach me.

Investment implications

With smart guys selling bonds and government debt structure exploding, one wonders why it is prudent to own debt. When interest rates rise, (note that I said “when” not “if”), I think we will see significant liquidation of high quality bonds and a sharp rise in money market funds and instruments.

What do you think?


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Sunday, May 8, 2011

What Can Hurt: Five Warnings/Concerns

As with other investment advisers, I report to our various clients on the progress of their accounts at least quarterly. The first quarter produced reasonable absolute returns, particularly if they were foolishly annualized. I said foolishly annualized, as historically the first quarter is often the best performing quarter of the year until a possible better fourth quarter.

In terms of expected interest rate raises, our conservatism cost us in terms of relative performance compared with other balanced accounts. Unlike other balanced managers who believe that they can trade out of higher rate, fixed-income paper before inflation drives interest rates higher, we have utilized much shorter investments, for example short-term treasuries of various nationalities, short-term bond funds and money market funds.

Any study of large losses should start with the price rise immediately before the major decline. At all times one should be wary of unexpected events, but I believe that this is particularly true now in a period of substantial double-digit recovery gains accompanied by both low volume and a general lack of enthusiasm. In my judgment, there are at least five legitimate concerns which should be viewed as warnings:

  1. China is critical to just about every major investment in the world; from dollars, US Treasuries, global merchandise imports, global raw materials, autos, KFC (Kentucky Fried Chicken, the subsidiary of Yum Brands for those who don’t have children or grandchildren), Apple, and General Motors (who sells more cars in China than in the US) among others showing way above-average growth. The potential for the rumor or the reality of social unrest can shake or break most markets around the world. In early May there was a plunge in commodity prices which went well beyond the sharp technical correction in silver. In almost every commodity whose price broke, China was the main swing buyer.

  2. In the first quarter, performance leadership was concentrated in industrials (often exporters to China), commodity producers and their transports sending materials to China and corporations that inhabit the Internet as the main part of their business. Apple was the leader of this pack. Technology is accelerating to the point that rumors of major government and societal issues can have sudden and dramatic impacts. Look how quickly the US Congress introduced legislation to prohibit tracking the location of children without the permission of their parents. Many will congratulate our society for its use of Internet technology for the capture of OBL. Others globally will recognize the intrusive power that has been unleashed by the Internet and will try, so to speak, to put the genie back into the bottle. Whenever a force becomes close to dominating, there are reactions to try curtail its power and growth. Any slowdown in the growth of the various Internet players will lead to sharply lower valuations.

  3. Small capitalization stocks and the funds that own them have been the performance leaders for some time. In the first quarter it was not unusual to see small caps up 10% or more while large caps were gaining at only half that rate. Substantial inflows, as usual followed high relative performance. At some point, history suggests that a reversal will occur, as those late performance followers stream out of small caps. I should have said attempt to leave as easily as they entered. The search for exit liquidity is likely to be painful. With the fragmentation of the market place into many different venues, but none with guaranteed liquidity that floor specialists used to provide, there is likely to be a very painful experience.

  4. Both US corporations and investors are increasingly sending money overseas to escape a perceived slow-growth economy with increasing deficits and a declining value of the dollar. These views are becoming almost universal, as traders crowd the exits. One should be very wary of charging crowds, for at some point there will be a significant event that will cause an abrupt reversal. Notice that in the week of the commodity price slump, the US dollar went up 2.5%, at least temporarily. In the current environment I would be careful to limit my foreign (non-US) exposure to 50% in terms of both foreign and multinational securities.

  5. One of the reasons I devoted twenty-five years of my life in building the data banks of Lipper Analytical Services was the observation that the use of bad data often leads to bad or sub-optimal decisions. Our country is awash with bad data. What is apparent now is that neither the White House nor any members of Congress had any accurate idea of the total long-term costs of what is now called Obamacare. Regularly many of our sharpest minds are substantially wrong as to the number of people employed economically and more importantly, not working. Notice none of the “official” data sources recognize that a significant portion of the cash economy tracks the so-called underground economy that is an essential element to much of our consumer spending. How many times have we heard that housing is turning on the basis of volatile, fragmented data that proves to be wrong the next month? We do not know the eventual size of our deficits. When a company reports results within the window of the analysts’ estimates, we celebrate the brilliance of my fellow analysts. As accounting is much more an art form than a precise science, is it possible that corporate managements, within the scope of the law, manage to their projected result and fail to appropriately recognize other factors that would lead to a surprise? Coming out of this recovery, I believe that more favorable results have been delayed compared with over-reporting the negatives. To an important degree as citizens and investors we are flying blind, as are our politicians.

For long-term investors that have both excess cash reserves and reasonable stock or stock fund positions, I would not rush to add to stocks now. I do not expect that all of my warnings or concerns will become operative soon. After one or more of these reverse expectations occur, I would hope to find some bargains.

Please let me know what you think.


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Sunday, May 1, 2011

Observations from Omaha

The annual meeting and "rally" of Berkshire Hathaway is probably the event most covered by the world’s financial press. The following observations are without the benefit of reading other people's impressions. Further, I should disclose that I have been a long-term shareholder of the company and the stock is also held in the private financial services fund that I manage.

Compliance awareness

I came away from the meeting with a concern that in terms of personal behavior, the company’s culture did not sufficiently produce an awareness of the potential violations of good corporate practice. I am pleased that the audit committee did conduct a careful review of the facts and concluded that there were a series of violations. What is not clear to me is whether any changes have been put in place in terms of appropriate conduct with investment bankers. In my judgment, one should not use investment bankers as, in effect, personal investment advisors. That senior operating officers earn very substantial compensation from the success of their specific operations does not appear to be enough of a constraint on their personal investment urges. I do not view what happened in connection with the acquisition of Lubrizol as a fatal flaw, but as an area for improvement.

Succession discount

There are a number of companies that are led by what are viewed as unique individuals, e.g. Apple. Long-term investors are concerned as to who will replace the great leader. This is particularly true with a CEO of eighty years young. The stock price of Berkshire, in my opinion, already reflected a discount for this uncertainty. The publicity around Mr. Sokol for the last two years through this weekend, has added to this discount. From a shareholder's viewpoint, this widening of the discount is a much bigger penalty than any short-term trading profits that have been forgone.

Earnings drivers

Berkshire-Hathaway has more than seventy different operating businesses that are wholly-owned and another one hundred forty that are partially-owned. However, the earnings, book value and thus the stock price, will be principally driven from three operating activities and Berkshire’s investment portfolio.

The largest operating activity is the insurance group. Due to a record amount of severity from natural disasters such as the recent tornadoes in the US, these activities are likely to break-even this year. Next year the severity of losses could very well be materially less. Often after a year such as the present, premiums are raised to restore the industry's balance sheet capacity. The second major earnings driver is likely to be the railroad, whose freight volume will probably increase as the economy rebounds. The railroad has significant operating leverage and because of the way Berkshire bought the company, it has some additional financial leverage. The third major operating driver is the utility group which is another high fixed-cost operation, with both financial and operating leverage. Both rail and utility activities have significant profit guarantees built into their pricing structures. Thus, in terms of certainty, these two drivers are almost like bonds. The combination throws off a prodigious amount of cash which allows and requires the investment portfolio to find attractive places to invest, which may well be overseas. Bottom line, I believe that the long-term value of the company will continue to grow faster than the global economy, as reflected in the S&P500.

Other observations

Often there is more wisdom in Charlie Munger's laconic answers than Warren's longer non-answers. To me, the silence was deafening on BYD, their investment in the Chinese battery maker and auto producer, even though BYD’s vehicles were on display. Finally from a biased point of view, for sometime in the future Berkshire Hathaway will have a significant investment in financials. Berkshire owns shares in Wells Fargo and US Bank and it admires Bob Wilmer of M&T Bank. The new internal investment manager comes from a background in financial services regulation; the last portfolio that I saw contained significant investments in some of the types of names in a typical financial services fund.

Other opinions

Some of our blog community were probably at the meeting and many others will have views of the meeting and the stock. Please share some of these with me via email.


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