Sunday, June 9, 2013

How I Invest Using Conglomerate Analysis Tools

I suspect we all go back to thought patterns that brought success to us earlier in life. As a junior analyst I was assigned to follow steel, farm equipment, electronics, auto parts, aerospace and broadcasting companies. As I matured as an analyst I realized that many other analysts preferred to follow companies that were within one industry and that complicated companies (particularly those that were essentially works in progress) were shunned by a large number of good analysts. Providing “sell-side” (brokerage research for institutional investors) was and is a highly competitive endeavor.

I have always been attracted to investments that have unrecognized opportunity and less competition. Thus I started to follow a limited number of multi-industry companies that combined manufacturing activities with a capability of making reasonably priced acquisitions. These companies normally had at least some important activities in defense work (electronics), broadcasting and original equipment auto parts manufacturing. Thus, I became one of the first analysts to specialize in what became to be called conglomerates. In order to handle the complexities of each of these quite different stocks I developed a number of what were for me, useful analytical approaches. In some respect a number of these approaches were looking at conglomerates as unrecognized and unregulated closed-end funds, typically selling at significant discounts.

Several of these approaches of dealing with complexity and under-appreciated investments are useful to me and to my clients as we invest in funds as well as individual financial services stocks.

Professor David Dodd taught me well

Most analysts start and in some cases end with the financial statements issued by a corporation. I had the advantage of taking the Securities Analysis course under Professor David Dodd of Graham and Dodd, the authors of the first main text on and titled Securities Analysis. One of the many lessons he taught me was not to accept the financial statements as published. He wanted us to soundly reconstruct the statements for their investment use as distinct from their creditor usage. In many cases this meant taking a skeptical eye as to the worth of various levels of inventories as well as not accepting cost as the measure of value. He wanted us to add to the liabilities side of the balance sheet any contingent or possible liabilities. Among other lessons he drilled into us that fixed assets were worth what they could be sold for, not cost less depreciation.

Advantages of being an entrepreneur

The second advantage that I have is that I have not only earned a reasonable living as an analyst, but I have been an entrepreneur operator of an analytical business dealing with many of the world’s major financial institutions. My third advantage is that I have bought and sold intellectual property companies.

These advantages became useful in understanding the differences between the factors that I used in gauging the success of my business and the financial statements prepared for us by our gifted accountant. The most important factors for me were our ability to help our institutional clients make money or avoid problems. I believe this capability was of great importance when it became time to sell the operating assets of the company. In addition, on a daily basis I kept an eye on our cash balances. This was the key to not only paying bills, but also the pace that we could invest in further development which was important to our future utility to our valued customers. In essence I feel that many and much larger companies are driven by the same motivations.

In application

Many market pundits and investment reports talk about the reasonableness of the current stock market levels and quote a historical average of market indexes or price/earnings ratios.  I believe that neither individual investors nor institutional investors are setting the current price level. With the large amount of money in private equity funds that is not invested, the buying power of potential raiders, and an excessive amount of cash overseas on corporate balance sheets, stock prices are being set by the absence of a wave of acquisitions. The main metric used by these professionals is not the price/earnings ratio but EBITDA (earnings before interest, taxes, depreciation and amortization). While not quite up to the standard that Professor Dodd would have wanted, it is a series of important steps in the direction of assessing the values of the underlying business. I prefer (when I can get the data) to use operating earnings over one or more cycles to approximate the financial value of a business. These calculations are only one side of the equation for a strategic acquisition to take place. A knowledgeable buyer who wants to be in the business most likely would focus on what it would cost to build an operation that would have the same or enhanced value to the customer base.

Using these tools to view your investments

Just as I examined my potential value to our institutional clients versus the perceived competition, one should conduct a similar analytic exercise in looking at a stock. The short to intermediate price level of a stock is a function of who owns and who does not own the stock. Dramatic price moves occur when there are insistent waves of buying and selling. For an owner of a security he/she is much more at risk to the actions of co-investors than the direct actions of the company or the central bank. The vehemence and direction of the wave will be based not on how the investor interprets the news or rumor, but how others react to it. Corporations with a relatively limited number of large, usually institutional investors can pivot more quickly than companies with stockholders that are widely dispersed. A small group of significant shareholders can make their views known quickly to management and/or a potential raider. A relatively under-owned stock that represents an opportunity is a believable “story” that happens to be true and if it can be substantiated, could be a good opportunity.

One of the reasons that my reports on a limited number of conglomerates proved to be useful, at least for awhile, was that my analyses made these companies more understandable to both thoughtful investors and to the financial news media.

The change in attitudes of both the investor and media communities made these stocks more acceptable. Speaking with bias as an owner/portfolio manager of financial services stocks, the same thing is gradually happening again. Particularly as some investors are looking for sound companies whose stocks are below their former peak levels with improving balance sheets.

Now what to do?

The lack of capital devoted to keeping stock prices stable is very small in part because there are at least 13 markets available to institutions who are interested in equities trading in the US. Thus, we could see sudden sharp multi 100 point moves of the Dow Jones Industrial Average. One possible impetus on the upside might be the perceived need of hedge funds to cover their increasingly short positions. As a long-term oriented investor I am always looking for investment opportunities. Most of these opportunities come about more due to changes in perception than hard facts. The other investment opportunity cluster occurs when prices plummet. The fear in a sharply declining market is that one does not know where the bottom is. Going back to my formal education as an investor sitting in Professor Dodd's classroom, at some level (probably not a great deal lower than today’s valuation) the ratio of EBITDA or better yet, operating earnings, will entice many value investors to build positions. The risk to these investors is that before this happens we could enter into a wildly speculative market the likes of which we have not seen in many years.

Please share with me what are you doing now and how are you positioned for the current market. 


Sunday night reports of opening in Asia markets have the Japanese markets up 3%. Also Chinese exports reporting a surprising low 1% gain instead of the expected 7%. (I wonder whether this report is being influenced by reactions to the stories of false or inflated export invoices.)

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