Monday, June 30, 2008

M / I Homes: A Diamond in the Rough

We saw here that the market values of home builders track reasonably well with their book values, and we saw here that currently most builders are trading at a discount to their book values. M/I Homes (MHO) is one such company on that list, trading at a healthy discount of 58% to its book value. MHO's debt to capital level sits at just 30%, while others on that list are flirting with much higher debt levels. On the surface, MHO appears as though it could be a value play, and warrants a closer look.

Upon further inspection, it turns out that not all shareholder equity is owned by the common shareholders. A good chunk of it is in preferred shares, which trade as separate securities (MHO-A). If we back out the value of the preferreds, the discount to book value changes from 58% to just under 49%, which still remains relatively attractive.

But the question of future writedowns remains a concern for this industry, as we discussed here. MHO is not as geographically diversified as many other home builders, and has a large percentage of its business in Florida, one of the hardest hit areas of the housing crash. In fact, the vast majority of MHO's $22 million in writedowns in Q1 took place in Florida.

But even if MHO requires writedowns of the same magnitude as what they had last quarter ($22 million) for the next four quarters, they would still be trading at a 35% discount to book value for common shareholders. At their slow sales pace of last quarter, they would get through their inventory in about one and a half years.

As an aside, I am a little bit concerned about management excesses. During the real-estate bubble, it seems they went out and bought a rather large airplane. To lower costs, they traded down to a smaller plane last quarter, picking up $9.5 million in the trade. It's a move in the right direction, but nevertheless it seems rather strange that a $500 million home builder requires its own airplane, but perhaps I'm just too nitpicky.

Overall, however, this company appears to have been over-punished by the markets, and as such offers a margin of safety. I would recommend this stock be owned as part of a long-term, well diversified, value portfolio.

Disclosure: None

Sunday, June 29, 2008

Bicycling and Value Investing

I decided to go for a bike ride out in the country this afternoon since I knew that I would be getting an extra dose of calories during dinner at my mother in-laws later this evening. I set off enthusiastically after doing the requisite research with Google maps to ensure that my planned route actually had roads to travel on. As I turned the pedals on my mountain bike I kept my brain active by establishing parallels between two of my favourite activities, bicycle riding and value-investing.

Cycling away from the city towards the country had the pleasant effect of taking me away from automobile traffic. This distinctly contrarian action allowed me to take more than my fair share of the road, as there were absolutely no cars following me once I had gone around 5 km out of the city limits. Similar to my observation of the benefits of low traffic on country roads, if you invest in sound companies that are not popular or are currently out of favor, you have an opportunity to obtain more shares for your dollars then when a stock is popular. Combined with an informed understanding of a company’s intrinsic value, the industry it competes in and any competitive advantages that it might possess, I believe you can obtain excellent investing results as other great value investors have done before us.

I turned left on Ranger Rd. and shortly thereafter watched in horror as the largest Rottweiler I have ever seen tried to intercept my course with an extremely aggressive sprint in a near-perfect diagonal run that would have bested any in this year’s Euro Cup. The loose “beast” must have picked up early sounds (or scent) of my approach.

My recent MBA degree from the Richard Ivey School of Business was put to quick work. Operationally I should have the advantage on a bike as long as I maxed out on acceleration immediately. Financially it made sense to speed up since the time value of money dictated that I should get home asap to start on another company intrinsic valuation. Economically I was on solid ground as Adam Smith would advocate self-preservation and the invisible hand would take care of the rest. Strategy was a no-brainer, I needed to implement this plan or I was dead. Almost instinctively I put everything into accelerating the bike and just barely avoided the savage onrush. Even as I was cycling for dear life ahead of the massive dog, it relentlessly pursued me, testing my reserves and only giving in when I had a sizable distance opened up between us.

My parallel to investing became obvious. I needed enough reserve energy to survive this encounter and companies need enough cash flow to survive unexpected events. During a speech by Walter Schloss, I learned that this great value investor avoids companies with “high” leverage because he doesn't want to take the risk that they will be unable to have enough cash to weather unforeseen “business storms”. This is an important lesson for value investors and Walter’s impressive track record is a good reason to take heed of his advice.

George Soros came to mind shortly after a second attack on my life was launched by a German Shepherd. Luckily on this day I had enough energy reserves to survive the test. George’s famous “sore back” comes on when the flaw(s) in his investments are not known to him. My bike-ride flaw was travelling on unknown roads without a stun gun. When you invest in companies you should think critically of the things that can go wrong in the industry, the company, with customers, with management and so on. It is only after careful consideration of the facts that an overall assessment of the investment appeal can be made. This is why Benjamin Graham’s “margin of safety” is such a valuable tool to apply to the intrinsic value estimation of a company. After diligently calculating the intrinsic value of a business, methodically apply a discount factor to this value to reach an entry price for the company’s stock. The margin of safety gives you some extra assurance that you are getting a good purchase price for the stock. After all, as with cycling, you can never be certain of precisely all the events that will transpire and affect a business.

Asbury Automotive On Dangerous Ground

At first glance, Asbury Automotive (ABG) looks like it could be a value play. It trades at a discount to its book value, has a P/E of 7, and pays a dividend of almost 7%!

Asbury also does not have it's own financing arm, and is therefore relatively shielded from the current situation in credit markets. Its presence in the luxury car segment should also help protect it to some extent from the current downturn, and its largest profits come from vehicle repairs, which consumers require no matter what the state of the economy.

So what's wrong with this company...isn't it a clear buy? Well there are a few areas of concern.

To me, their problems stem from their debt levels. Their operating income is only 2 times interest expense for one thing, yet they payout roughly half their net income in dividends. If things were to turn south, they have very little protection to be able to make these payments.

It looks like debt holders have recognized this, and are wary. They have placed covenants such that Asbury has a ceiling on what it's allowed to pay shareholders (in share purchases or dividends), and this ceiling only grows at 50% of net income (as it's accrued), minus payouts. At the present time, that ceiling stands at just $13.2 million, which is just about 40 cents a share! Imagine a company so restricted, it's not allowed to pay it's owners even half of the cash it has on hand!

Nevertheless, the company continues to pursue acquisitions, which seems a little strange, considering their return on assets (less than 5%) and return on equity (less than 10%) are nothing to write home about, despite leveraging to the hilt! And they don't seem intent on paying off their debt, as they continue to make sale-leasebacks, where they sell off their properties, but now have to pay rent on them!

As long as the company makes its sales numbers, it will be fine. But any unexpected hitch, however small, can cause great damage to the small portion of equity that is left after debt obligations are satisfied, making this company not worth the risk.

Disclosure: None

Saturday, June 28, 2008

Copy-cat Investing

Most people take comfort in buying stocks that others have. After all, if other people think a stock is good, there must be something there, right? So it should come at no surprise that people love to know what star investors are buying. Not only do they like to know, but it makes them want to buy. For example, shares of CarMax rose 7.5% on the day it was released that Berkshire-Hathaway was buying in.

To fill this investor need for knowing what other investors are buying, a plethora of websites exist that track what large funds are buying. Can these be useful in guiding your own portfolio decisions? Unfortunately, a number of challenges exist which make it difficult to gain from this knowledge.

Investment companies only have to disclose their transactions at the end of each quarter. As a result, if you base your decisions on what these fund managers do, you could be trading on old news. Under certain circumstances, the SEC will grant funds the right to delay disclosing their purchases, which makes copying these funds' investments even harder.

There is also the case of mistaken identity. Just because a particular company bought a stock, does not mean the manager you were interested in did. Warren Buffett has griped about this issue in the past:

"The media continue to report that "Buffett buys" this or that stock. Statements like these are almost always based on filings Berkshire makes with the SEC and are therefore wrong. As I’ve said before, the stories should say "Berkshire buys."...Even then, it is typically not I who make the buying decisions. Lou Simpson manages about $2½ billion of equities that are held by GEICO, and it is his transactions that Berkshire is usually reporting."

Stocks the market bought after an erroneous "Buffett buys..." have subsequently fallen back to their previous levels once the market realized its error.

Blindly following the reported investments of fund managers can be detrimental to your portfolio. Nothing beats buying a company for its fundamentals, rather than because others are buying.

Friday, June 27, 2008

Insiders Are Buying...Should I?

We constantly hear reports from the media about insider buys, signalling that its time to jump into such and such company. The idea is as follows: if managers and directors are buying (selling) the company's stock, it's probably because they know something the rest of us don't. Since they know more about the company than anybody else, we should see this buying (selling) as an indicator of where the stock is going.

The Brooks Ratio was developed to measure this very phenomenon. The equation is simple:

(Insider Sales $) / (Total Insider Trades $) = Brooks Ratio

If the Brooks Ratio is less than 40%, this signals that insiders are buying. If the ratio is greater than 60%, beware, insiders are selling!

Unfortunately, research by Market Profile Theorem, an independent research firm, suggests that although this works to an extent on individual stocks, its best application is on the market in the aggregate. The reason this doesn't work so well with a small sample (i.e. at the individual stock level) is because there are so many reasons why insider buying or selling may not be a clear signal in either direction.

First of all, managers and directors have their own lives to worry about. They may be buying a house, may be looking to diversify, or may have just come into some money from salary/bonus or otherwise. Just because they are buying or selling does not mean they are particularly bullish or bearish about the company.

Even if managers are buying (selling) because they think the stock will go up (down), it doesn't mean they're right! For example, home builders were buying their own stock in droves when things turned soft last year...only later did they reverse course and believe in the downturn the public saw first.

Finally, managers and directors are often paid in stock options. Simply exercising these options is officially a buy transaction, but this signals nothing about the stock, as these managers are simply cashing their bonus or salary cheques.

Thursday, June 26, 2008

Fed Model Says S&P Undervalued: Does It Matter?

Before we get into the details of the so-called Fed Model, we should make it clear that the US Federal Reserve (or for that matter, any other central bank we know of) does not endorse this model. Nevertheless, it was named as such and so we are stuck with the confusion.

The idea behind the model is that stock returns should approximate returns on treasury yields. If they do not, the theory goes that stocks are either over or undervalued. Let's illustrate with an example.

If treasury yields are 5%, but the S&P returns 10% (on an earnings basis), the theory goes that the S&P 500 is undervalued (since its returns are more attractive). Investors should thus buy the S&P 500, bidding it up until its yield becomes 5%. The opposite is also true: investors should sell if the S&P yield is low compared to treasuries, resulting in a lower S&P 500, but a higher yield.

Obviously, there are a couple of key assumptions made by this model. First of all, there is no risk premium added for owning stocks over government treasuries. The government is able to print money to pay its obligations, hence its risk is considered low. Corporations can do no such thing, therefore a higher yield should exist on the S&P 500 to pay investors for this risk.

Second, corporations can actually grow their returns, compared to the fixed payments of the treasuries. Consider a company that earns 10% on its assets. If they improve their processes or become more efficient between now and next year, perhaps they can earn more than 10% next year. It's important to note that "growth" here excludes any growth the company has experienced thanks to retained earnings, since they're only making that money because they never paid it out. An investor who is paid out can go and earn that "growth" himself by investing elsewhere.

Also note that the future payments from the treasury are known and fixed. Such is not the case with stocks. The best we can do is use analysts' forward estimates, which are prone to inaccuracies as we discuss here.

This is what the forward earnings yield for the S&P 500 and the 10-year treasury bond have looked like since 1962:


There is clearly some relationship between the yields of these two entities. However, it is clearly wrong to think you should buy the S&P 500 any time it pays a higher yield than the 10-yr, as there are many periods where bond yields have changed drastically. Consider the late 60s and early 80s for example. If you were blindly buying the S&P 500 because its yield was higher, you would have gotten burned as treasury yields soon spiked...making your returns not-so-attractive anymore.

Right now we can see S&P 500 returns are higher than the treasuries. Once again, though, be careful. If treasury yields rise, you don't want to be left holding the bag (of S&P 500 stocks).

Wednesday, June 25, 2008

When P/E fluctuates...is it Price or Earnings?

We saw here that although the P/E average for the S&P 500 over the last 100+ years is around 15, the P/E actually fluctuates quite a bit, ranging from 5 all the way to 35. But what's actually happening? Is investor sentiment so fickle that it creates buying opportunities for those who wait for the market to drop? Or do earnings fluctuate based on economic conditions, with prices staying rather stable?

Here's the P/E of the S&P 500 since 1990 split into its two components:

We see that both price and earnings fluctuate, providing for the volatile P/E chart we saw here. Obviously, timing the market is not as simple as buying when P/E's are low, since for all one knows, earnings could drop and actually make P/E's high, leaving the investor holding the bag.

Therefore, other models have been developed that try to determine whether the market is over/undervalued. The Fed model, described here, uses interest rates along with earnings to determine what the market value of the S&P 500 should be. A model developped by Steve Foerster tries to determine when the business cycle hits its peaks and troughs, so that investors can determine when they should buy and when they should sell.

Rather than trying to time the market, value investors try to value individual companies within the stock market, to determine if they sell at discounts to their intrinsic values.

Tuesday, June 24, 2008

S&P 500 historical P/E vs today's P/E

There are several factors that go into the stock market's current valuation: investor confidence, interest rates, expectations for inflation (as we've discussed here) and more. But perhaps the most important driver of the stock market is earnings. After all, though people speculate and trade on momentum, in the end they are buying the right to the future earnings of the company. Here's a look at the Price to Earnings ratio for the S&P 500 since the year 1900:




Note that I use 12-month trailing earnings, with a two month delay on price data (since it takes some time before earnings are released to the market). The average P/E over this time period is 15, but note that we are very rarely actually at the average! But we are close to that average right now.


It's interesting to note various bull and bear markets throughout the past. We see the most irrational bout of exuberance taking place in the late 90s and early 2000s. We also see the bear market of the 70s when inflation was high and pessimism was rampant. Stocks were trading at P/E multiples well below 10. This looks like a dream come true for value investors.


But it's not just in the 70s where we see compressed P/E values. For those who are patient, we can see that the market rewarded them many times with large dips in P/E, rewarding those who carried cash into those periods. Although the S&P 500 has been below 10 seven times since 1900 (and stayed there for a while on several of those occasions), it hasn't happened since the early 80s. With inflation on its way up, might we be headed back there?

Monday, June 23, 2008

Francis Chou

Francis Chou is of a different background than the other value investors we've profiled here. He didn't have a lot of money to invest, and didn't have the chance to get a university education. As an immigrant to Canada from India, he had a Grade 12 education and was working as a telephone repair man when he discovered Security Analysis by Graham and Dodd. He started an investment club with 6 others and turned $50K into $1.5 million in the next five years. He has since gone on to turn that fund into a mutual fund and achieve %14 annual returns over the following 20 years.

What's most amazing about this record is that at most times, Chou isn't afraid to keep a great deal of his portfolio in cash. Like other value investors, Chou focuses on capital preservation, and at the same time wants to be able to take advantage of opportunities when they become available.

Again like other value investors, Chou won't invest in commodities, likely because the future prices of these companies' products are too difficult to determine.

Unlike standard mutual fund companies, which seem to be more like marketing companies than investment companies, Chou relies on word of mouth to find clients. That probably suits him just fine, as growing too large would probably hurt his returns.

For those interested in learning more about value investing, read The Intelligent Investor (Graham) and/or Security Analysis (Graham and Dodd).

Sunday, June 22, 2008

How Does Inflation Affect Stock Prices?

As we discussed here, despite the fact that price increases should shield corporations from the effects of inflation, they actually end up eating up much of the profits in asset requirements. But this cash requirement of the business is hidden from investors, who continue to see rising earnings. Therefore, what happens to stock prices during inflationary times? Do they continue to rise along with earnings? The answer is no.

They key to understanding the argument below is to recognize that as inflation increases, central banks increase interest rates to reduce the money supply and slow inflation down: When interest rates are high, people find it expensive to borrow, and therefore there is less money floating around. With interest rates are high, people require higher returns on stocks. Well, its not so easy to just increase earnings for a stock, so its price has to adjust downward.

Consider a stock that sells at $10 with earnings of $1, a 10% return. When government bonds pay 5%, an investor may be willing to buy this stock for the extra 5% return. However, if interest rates were to rise, to say 15%, who would pay for this 10% return, when they could get 15% risk-free by buying the bonds? Therefore, the stock may drop to $5. With earnings of $1, this now generates a 20% return and is once again at a price where an investor might be willing to take the risk on this stock for the extra 5%.

As we can see, inflation compresses P/E values, which can be a painful adjustment for anyone holding stocks.

Saturday, June 21, 2008

Are Home Prices Still Too High?

We discussed here that under normal financial/housing conditions, existing home sales would probably be around 5.8 million per year, compared to the 4.9 million pace we're on right now. What about home prices? We know they rose to extreme levels for most of this decade, but we also know they've come down from those levels. We might get a clue as to what home prices will be once things stabilize if we knew, based on income and demographics, what would home prices be right now if we hadn't gone through this bubble?

Here's a look at the S&P/Case-Shiller US National Home Price Index since 1987:
The way Case-Shiller determines the index is quite interesting. The index considers individual homes that have been sold twice, and considers the price appreciation between those sales.

Based on the exponential trend line added below, we see that home prices may be close to normal levels. That doesn't mean they don't have further to fall, however. As long as confidence is low, and the economy is bad, home prices my continue to fall. But for those who have the ability to wait the housing market out until things stabilize, they should be able to realize prices slightly higher than what they are now, presuming the demographic factors that fuelled this trend line continue into the future.

Friday, June 20, 2008

Homebuilders Ranked By Discount and By Debt

We saw here that there are home builders trading at huge discounts to their book values. Could some of these offer a chance to buy land at a big discount? It's worth taking a deeper look at some of these issues. If they are leveraged to the hilt, they might not be as attractive as they seem. So here's a second look at this list, but this time including each company's debt to capital ratio:


Clearly, many of these companies are leveraged to the hilt. I don't think it was their original intentions to have so much debt, but recent writedowns have probably forced them into this situation.

Notice Cavco (CVCO) has no debt on its books. A company in this condition is able to weather cyclical downturns fairly easily, and that's one of the reasons we prefer companies with little debt. Notice, however, that it's trading to a 73% premium to book value, so it's not immediately obvious whether its trading at a discount to its intrinsic value.

The companies that look somewhat appealing in this chart are M/I Homes (MHO), followed by Lennar (LEN). They trade at significant discounts to book, with debt to capital in the 30% range. Might be time for a closer look!

Thursday, June 19, 2008

What Should Home Sales Numbers Be?

We constantly hear reports about home sales being far lower than they were at the peak of the housing boom. But under normal economic conditions, should we expect a rebound in home sales, or are they still higher than we can support on a sustainable basis?

It's difficult to determine exactly what home sales should be (assuming normal conditions), but maybe we can consider some of the factors that contribute to sales. One such factor is surely population. Here's a look at annual home sales per 100,000 people:

Based on this graph, it would seem that despite the fact that annual home sales are far lower than they have been, they are still above average (of 1.49 sales / 100,000 people) for the last 40 years. However, the average may be a bit deceiving, as the trend line over the last 40 years appears positive. Obviously, it cannot continue to be positive forever, as that would mean that at some point in the future, we would all be moving every month. However, some demographic factors (smaller families, more affluency etc.) suggest that we probably move more often now than we did 40 years ago.

Therefore, a more reasonable proxy for what home sales would be under normal conditions may be the years just prior to the housing boom, where they hovered around 1.9 sales / 100,000 people. A better model for predicting existing home sales may include other variables, but based on this analysis, whenever it is that financial conditions stabilize (credit returns to normal, house prices stabilize), we may expect home sales to approach 1.9 per 100,000 people, which is about 5.8 million sales per year, higher than the current 4.9 million sales per year pace we're on for 2008.

Wednesday, June 18, 2008

ITB: A Play on Real-Estate?

We saw here that several home builders are trading at large discounts to their book values. However, for those who are unable take the time and go through individual builders, or who want to diversify across several builders, an ETF that tracks the S&P Homebuilder Index exists (symbol: XHB). Unfortunately, because of XHB's holdings, as we discussed here, this is hardly a good play on the discounts to book value.

But there is a better alternative. iShares has an ETF with symbol ITB with holdings closer to that which you would expect out of a home builder ETF. Although it's a bit better than XHB, 20% of the underlying stocks still have exposure to mortgage financing (Standard Pacific, Ryland, NVR, and MDC Holdings), with another 5% (Skyline) has exposure to recreational vehicles, and one company, Champion, has exposure to Canada and England as well as other segments like steel prison construction. The other 70% of the ETF is devoted to pure home builders, with the following discounts to book:


Cavco (CVCO) actually managed a profit last quarter, which may help to explain their premium to book. The rest of the builders could offer some value, if markets have indeed overreacted to the downside (which we know they are prone to do, from this article).

Tuesday, June 17, 2008

Inflation Dimensions Keep Changing!

Every month, the Bureau of Labor and Statistics (BLS) releases their CPI number, which tells us the change in consumer prices from the month before. The CPI has been extensively used to index price increases for contracts (such as union management bargaining agreements). But according to many, the way it was calculated actually overestimated inflation. Since the 1990s, however, various changes have been made to the CPI (and still are being made) that have had the effect of reducing its reported numbers.

Unfortunately, these changes have invited criticisms from the opposite side...that inflation is now underestimated. The government controls how inflation is calculated, but it has a vested interest in keeping CPI low for several reasons. For example, a low CPI reduces Social Security obligations (which are tied to CPI). A low CPI also makes the real GDP figure higher than otherwise, which makes voters happy with the government.

Traditionally, the CPI was calculated by looking at changes in prices for a fixed basket of goods. Simple enough, right? But this doesn't take into account the fact that consumers are able to buy higher quality products for a given price. A laptop you can buy today for $3000 for example, is far superior than one you could buy 5 years ago for the same price. CPI calculations now include what they called "hedonistic pricing" to capture gains in quality, thus reducing the CPI number.

Recent CPI calculations also account for product substitution. This means the basket of goods can change because of price. If oranges become expensive, it's expected that people will buy more apples instead. In the CPI calculation, a smaller weighting will therefore be placed on oranges. Again, this has a dampening effect on the CPI number. Critics argue this substitution facility has the CPI measuring a declining standard of living. If steaks become too expensive, you may buy more hamburger meat, and the CPI says your costs are the same, despite your having a lower standard of living.

Currently, the BLS also releases what they call a chained CPI. This isn't the widely reported number in the media (yet), but it includes even more substitution, and is therefore generally lower than regular CPI.

The bottom line: Be careful of the headline CPI number. It's constantly evolving. To truly understand inflation you must look beyond the headline number to understand what is being measured.

Monday, June 16, 2008

Is Inflation Higher Than Reported?

CPI is an index that measures the average price a household pays for goods and services. By its very definition, close to half of the population will actually be paying more for their goods than the CPI suggests, since it's an average. Furthermore, if a certain category of goods, let's say gas for example, has a sharp rise in price, people who spend more than average on gas will be hurt disproportionately. This may explain why we are currently constantly hearing reports that inflation is actually higher than the CPI reports.

Since gas only makes up a small part of CPI, its wide swings in price will be devastating to those living in freezing climates in larger houses who commute two hours a day in their SUVs, but has little effect on those in milder areas who walk or bike to work.

In fact, here's a look at gasoline prices and total CPI on the same chart, showing how someone overly reliant on gas will be feeling harsh effects, but how others are barely affected:

Economic theory suggests people will change their behaviour in response to the high gas prices, and shift into lower cost alternatives (living closer to work, alternative transportation, better fuel efficiency, alternative energies etc.), but often these changes take time, which makes the present situation no less painful for the affected groups.

Sunday, June 15, 2008

Favourite Articles

Here's a list of the some of this site's most popular articles:

Do we only hear about the lucky value investors?

Certain writers have taken exception to my stipulations about the successes of individual value investors. One such article, written by Frank Voisin, is listed here. In essence, he argues that of the thousands or millions of value investors who try their hand at investing, statistically there will surely be some winners...but that doesn't mean this (or any other) breed of investing works. But those arguments don't consider that there is a particular school of investors that does outclass the rest.

The argument stipulated by those who believe in efficient markets goes something like this: If 50 million people flip a coin twenty times, and get paid $1000 for every "head", there could be around 50 people that will have rolled "heads" all twenty times. Are such people particularly skilled? Should we copy their methods? Upon first glance, probably not.

But what if such coin flippers lived in the same neighbourhood? Or what if they all learnt how to flip from the same person? Wouldn't it be worthwhile to determine whether this group has some knowledge or skill which is allowing them to profit?

Warren Buffett makes such an argument in his article The Superinvestors of Graham and Doddsville. He shows us the investment returns of the people who studied with him under Ben Graham, demonstrating that the returns derived from this method of investing are no fluke. Below are the returns Buffett references from the investors he has personally worked with (despite the fact that there is little overlap between the stocks owned by these investors). I encourage you to read the full article here.

Saturday, June 14, 2008

Value In Action

There's no better way to learn about value investing than by studying successful value investments of the past. Here is some discussion of investment opportunities that astute value investors may have taken advantage of:

Income Opportunity Realty - 2/2014
Lakeland Industries - 1/2014

Nortech Systems - 11/2013
InfoSonics - 10/2013
Best Buy - 10/2013
Urbana - 9/2013
Surge Components - 8/2013
Lexmark - 8/2013
Coast Distribution - 8/2013
Alco Stores - 7/2013
Aastra - 7/2013
iGo - 7/2013
PMC Commercial Trust - 7/2013
Microsoft - 5/2013
Manhattan Bridge Capital - 5/2013
Cisco - 5/2013
Ridley - 4/2013
Canam - 4/2013
GameStop - 4/2013
G Willi-Food - 3/2013
Dell - 2/2013
Artio - 2/2013
TAT Technologies - 2/2013

H Paulin - 12/2012
Dorel - 11/2012
New Frontier Media - 10/2012
Asta Funding - 10/2012
Acme United - 10/2012
Tempur-Pedic - 9/2012
Janus - 8/2012
Paulson Capital - 5/2012
GTSI Corp - 5/2012
Bassett Furniture - 4/2012
Alpha Pro Tech - 3/2012
InfoSonics - 2/2012
OfficeMax - 2/2012
L.S. Starrett - 1/2012

Envirostar - 11/2011
hhgregg - 11/2011
Parlux - 10/2011
KSW - 6/2011
Jewett Cameron - 4/2011
H&R Block - 4/2011
Kirkland's - 2/2011
Envoy Capital Group - 2/2011
Imation - 2/2011

TSRI Corp - 12/2010
Acorn...Again - 10/2010
Nu Horizons - 09/2010
ADDvantage Tech - 08/2010
Blonder Tongue - 08/2010
Quest Capital - 07/2010
Adams Golf - 05/2010
Hardinge - 02/2010
LCA Double-Vision - 02/2010
Key Tronic - 01/2010

Goodfellow - 12/2009
Melcor...Encore - 10/2009
Acorn International - 10/2009
LCA Vision - 10/2009
Twin Disc - 08/2009
Spartan Motors - 07/2009
Office Depot - 05/2009
Hammond Power...Again - 05/2009
AM Castle - 03/2009

H Paulin - 09/2008
The Finish Line - 09/2008
Hammond Power Solutions - 06/2007
Phoenix Canada Oil - 12/2005
Melcor - 12/2005
Dundee Corp - 04/2003
Charlie Munger And Belridge Oil - 07/1980

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How does inflation affect stock owners?

Today's business news media is rife with articles suggesting inflation is here to stay. Were that to happen, what does it mean for equity holders? Upon first reflection, it would seem that in inflationary times, companies can charge more for their products, and thus should have a natural hedge against inflation. Unfortunately, companies in such times are forced to invest their profits in the companies JUST to keep returns at ordinary levels, resulting in real costs to equity holders.

Consider a numerical example for a given company. For simplicity, we will consider total assets (e.g. A/R, inventory, fixed assets) at $1000, and annual sales at $2000/year. Assuming profit margins of 5%, this level of annual sales translates to $100 in profits.

At zero inflation (to keep the example simple), that profit of $100 can pay shareholders, or can be re-invested in the company to generate further returns the following year.

At 10% inflation, presumably sales increase to $2200 / year. Margins stay at 5% since costs increase as well, resulting in profits of $110. Sounds fine, right? Profits have increased along with inflation, resulting in no loss for the equity holder. Unfortunately, this isn't the end of the story.

We've implicitly assumed asset turnover (sales / assets) will increase with inflation. But there is no reason to believe this. Inflationary increases in dollar amounts for assets such as A/R, inventories, and fixed assets will be required to service these inflationary increases in sales. We had assets at $1000. With our 10% inflation, asset requirements become $1100, eating up almost all of the $110 in profits. What's the value of a company that needs to re-invest all its profits just to maintain its earnings? Very little.

The numbers were made up, but the principle of this argument will persist no matter what numbers are chosen. Inflation eats up profits. If inflation is high, equity values will suffer.

Book Summaries

Constantly educating oneself is a neccessity for every value investor. Here are links to the book summaries we have discussed on this site. Enjoy!

Security Analysis by Graham and Dodd

Predictably Irrational by Dan Ariely
The Upside Of Irrationality by Dan Ariely
Super Crunchers by Ian Ayres
It's Not Rocket Science by Tom Bradley
The New Buffettology by Mary Buffett
Buffett Partnership Letters by Warren Buffett
The Innovator's Dilemma by Clayton Christensen
Influence by Robert Cialdini
The Little Book That Builds Wealth by Pat Dorsey
You Can Be A Stock Market Genius by Joel Greenblatt
Competition Demystified by Bruce Greenwald
The Warren Buffett Way by Robert Hagstrom
Even Buffett Isn't Perfect by Vahan Janjigian
The Investment Zoo by Stephen Jarislowski
Thinking, Fast and Slow by Daniel Kahneman
Margin Of Safety by Seth Klarman
Freakonomics by Levitt and Dubner
SuperFreakonomics by Levitt and Dubner
A Random Walk Down Wall Street by Burton Malkiel
Boombustology by Vikram Mansharamani
The Most Important Thing by Howard Marks
The Psychology Of Human Misjudgement by Charlie Munger
Quality of Earnings by Thornton O'Glove
The Dhandho Investor by Mohnish Pabrai
The Halo Effect by Phil Rosenzweig
The Snowball: Warren Buffett by Alice Schroeder
Irrational Exuberance by Robert Shiller
Fooled By Randomness by Nassim Taleb

Friday, June 13, 2008

Ben Graham's Intellectual Property Lives On

On what would have been Ben Graham's 100th birthday, a few of his former proteges (Buffett, Schloss and others) participated in an event titled "A Tribute to Ben Graham". They all agreed that Graham had changed their lives by teaching them the principles that were the foundation for their ultra-successful careers in investing.


Here's a summary of some of the wisdom they claimed they learned from Ben, with brackets around who said it:

1) Look at stocks as part ownership of a business (Buffett)

2) Make market fluctuations (Mr. Market) your friend...volatility is GOOD, not bad (Buffett)

3) Margin of safety - building a 15,000 pound bridge if you're going to be driving 10,000 pounds across it (Buffett)

4) You don't have to do anything ridiculously complicated to find undervalued companies...assets don't lie (Buffett)

5) Stocks are easier to deal with than people...they don't argue with you, they don't have emotional problems, you don't have to hold their hands (Schloss, who prefers not to talk to managements of the companies he buys, as he's not confident he can judge them accurately and without bias)

6) Companies with high debt get punished during bad times...the best companies to own aren't leveraged (Schloss)

7) Always have an open mind...that's what allowed Graham to build his great model (Irving Kahn)

Thursday, June 12, 2008

Charles Brandes

Charles Brandes is yet another value investor who has broken the bank (so to speak), having market beating returns since 1978 with Brandes Investment Partners.

Brandes doesn't worry about short term returns, as long as the underlying value of the business hasn't changed. He cites Freddie Mac who he bought in at $100, saw it go to $30, and finally sold when it had turned around up to $160. He's seen many 50%+ drops in many good companies that he has purchased. But beware, if you bought into a too rosy outlook, a 50% drop might reflect the real value of a company!

He also doesn't subscribe to market timing, another common theme among value investors we've looked at. "As long as you're prepared for declines and don't sell into them, they can't hurt you," he says.


Brandes tends to put little emphasis on earnings, but instead focus on cash flows. This strategy served him well with Latin American telecom companies. In 1994, Telebras (Brazil) was one of his favourites. It had lines in ground, which were hurting earnings due to their depreciation. But it traded at only five times cash flow, as the company benefitted from having infrastructure already in the ground. There are numerous examples of other industries where earnings can look bad because of fixed cost purchases in the past...but those purchases that have already been made can now generate cash flows in excess of earnings as a result!

Wednesday, June 11, 2008

How Much Is Inventory Worth?

Sometimes a company's inventory can be a large component of its assets. Therefore, when valuing a company, determining how much the inventory is worth becomes an important issue.

Companies will list their inventory at the lower of:
1) what they think they can sell it for
2) what it cost them to make it

What it cost them (#2) can include the raw materials they required, the labour costs, energy costs, and anything else that might have contributed to the end product.

But this listing of the lower of these two components is a little bit conservative. Sometimes, inventory is worth a whole lot more than what is shown on the financials.


Consider an oil company currently pumping oil out of the ground. It may not be costing them much to pull the oil out (resulting in a low inventory value on their balance sheet), but the value of their inventory could be astronomical. So where prices fluctuate (common for commodities), you have to keep an eye out and make sure you understand the underlying value of the inventory.


Another example where inventory is understated is when a company has particularly high gross profits. Consider Harley-Davidson throughout the late 90's. They had waiting lists for their vehicles, resulting in people willing to pay a lot more for the vehicles than the raw materials and labour required to put them together. As a result, the value of their inventory was actually a lot more than you would think if you just looked at the balance sheet.

When comparing inventories across companies, you also have to keep in mind different methods companies use to calculate their ending inventories. The two most common methods are FIFO and LIFO; a good article describing them is listed here, therefore I won't get into it here.

Tuesday, June 10, 2008

GDP not negative, but GDP per capita is

Lately there has been a lot of banter about the state of the US economy. Many (including Warren Buffett) have argued that for all intents and purposes, we're in a recession. Officially, however, a recession is defined as two consecutive quarters of negative, real (i.e. inflation adjusted) GDP growth. When you consider the fact that GDP is not adjusted for population growth, you realize this definition is pretty meaningless.

Consider country Happy, with a population of 1 million and GDP of $1 billion. If next year their GDP grows by 2.5%, pundits in the media will proclaim the economy is strong. During that same year, if the population increases by 5%, GDP per capita will have actually dropped from $1000 to $976. The standard of living of the average Happonian drop as a result, while the official numbers tell them growth is strong!

What is it we're trying to measure when it comes to GDP? Currently, the government and media seem most interested in how much the country as a whole produces (see some arguments here about why we're not in a recession). I would argue that what we should be interested in is how the people within that country are doing, to truly understand what is occurring in a given economy.

In the US, population growth is expected to be 1.2% in 2008. This suggests that if GDP growth for the country as a whole is below this, the standard of living of the average American will be lower this year. Real US GDP for the last two quarters has been (annualized) .6% and .9%. This IS a recession for all intents and purposes. The GDP for the entire country as a whole is useless without thinking about it and applying it to the population within that country.


Monday, June 9, 2008

XHB: Not A Real-Estate Play

We've seen here that certain home builders are showing large discounts to their book values right now. But some of these companies might actually be in trouble. For those who don't have the time to dig through each individual builder's finances, or for those who prefer a diversification strategy, a home builder ETF exists called XHB that tracks a whole slew of builders.

However, a closer examination of the underlying securities of XHB reveals this ETF not to be exactly what it purports to be.

First of all, it has quite a bit of exposure to retail. Home Depot and Lowe's make up almost 10% of its portfolio! Another problem is that three of the companies in XHB (Standard Pac, MDC, and Ryland) are heavily involved in mortgage financing. So you thought you were making a play on real-estate, but you end up owning mortgages you know nothing about, for another 10% of your portfolio!

Third, this ETF has another 25% of its holdings not in homebuilders, but in home accessories! With companies like Tempur-pedic (mattresses!), Sherwin-Williams (paint!), and other companies involved in furniture, carpets, and interior decorating, beware! I'm not saying that these companies don't have some correlations to the housing market, but by no means are these real-estate plays!

Finally, the builders we looked at which have the largest discounts to their book values (rankings here), do not even appear in XHB. It's possible they're too small for the ETF to hold without affecting their values.

In any case, if you're looking to benefit from the discounts to book values that home builders are trading at, XHB is not for you. Its exposure to retail, mortgage financing and various other sectors (adding up to almost half the portfolio) combined with the fact that even its home builders are not the cheapest ones out there, mean that if you want to take advantage of the discount to book values that are out there, the best strategy is to buy the individual securities yourself!

Sunday, June 8, 2008

Homebuilders Ranked By Discount to Book Value

We saw that market values tend to rotate around book values for home builders here. We also saw that markets tend to overreact both to the upside and the downside here, creating buy opportunities. Currently, most home builders are trading well below book value. Could this be a buying opportunity? Here they are, ranked by biggest discount to book:

Why such a spread between the top of the list (discounts in excess of 75% book values) and the bottom (barely any discounts!)? It could be that investors believe there are way more writedowns coming for those at the top. Investors may also have more confidence in certain managements' abilities to navigate through these difficult times.

Upon closer examination, notice the largest builders tend to have the smallest discounts. If we take a look at the discounts relative to the sizes of the companies, we get a chart that looks like this:

Notice how the largest discounts to book value (in excess of 50%) are for companies smaller than $250M. Also note that the largest companies tend to have the smallest discounts. Could it be that managements for the smaller companies are worse, or that they are more risky, or have higher debt levels? It's possible. Another reason could be that the stock market is less efficient for those smaller companies as we've discussed here (hence we see more variation among the discounts for the smaller companies), since they are too small for many institutions to buy.

It's worth taking a closer look at the companies with the largest discounts to book to see if they offer large margins of safety!

Saturday, June 7, 2008

Homebuilder Values Overshot to the Downside?

We saw here with Orleans Homebuilding that markets can be fairly adept at figuring out whether book values will increase or decrease, but that they tend to overshoot their marks, offering buy opportunities when they overshoot to the downside. But was Orleans a one-off? Let's look at a few more builders to see if there's a common theme emerging.

Here's a look at Dominion Homes, operating in 3 states in the US:
We do see here once again several occasions where the market predicts the direction of book values before they occur (1994, 1996, 2001,2006). However, we do see occasions where the market is wrong as well, with a big drop in 1998 and 2002. Once again, we also see that on almost each of these occasions, the market overshoots, offering dramatic buy opportunities in 1996, 2000, and possibly today?

The next chart is of California Coastal Communities:

This one is a bit perplexing, with market values taking a huge plunge in the early nineties. Market value continues to underperform book throughout the 2000s (until a bout of irrational exuberance in 2004), suggesting for some reason investors were turned off by this company. I'd be interested to dig into why this was trading at such a sharp discount.

The last chart is of Meritage Homes:
This is a bit more typical from what we saw earlier, with markets correctly predicting directions of book value, while nevertheless overshooting both to the downside and upside, providing opportunities when market values are much less than book values.

Friday, June 6, 2008

Can the Market Predict Land Values?

Although rarely exactly equal, we've seen how market values tend to track the book values of home builders over time here and here. Here's an example of a particularly volatile home builder when it comes to its price to book over time. Orleans Homebuilders (OHB) operates in 14 markets across the US:

But what is causing this volatility? Is the market price bouncing around all over the place, or is the book value constantly changing, or some combination thereof? Here's a look at the price and book values separated out to see how they've moved over the same period:

Clearly, market values are more volatile than book values, suggesting one can take advantage of the situation by buying when market values are low and selling when they're high.

However, we do see the market having some ability to predict the direction of the book value. In the late 80s, we notice market values are lower than book values, correctly predicting that book values are about to fall (which it appears they do for this company throughout the late 80s). Again in the early 2000s we see the market correctly predict book values are about to shoot up, and soon enough, book values shoot up thereafter.

At the same time, despite the market's accuracy in predicting the direction of book values, it overshoots its mark almost every time. Once again, this is clearest in the late 80s where markets are far below book values ever reach (creating a buying opportunity) and again in the early 2000s where markets clearly overshoot the top.

Most recently we've correctly seen markets punish home builders (with OHB being no exception) in advance of the drop in book values. The question is, at what point will it have overshot its mark? By having enough of a margin of safety between the market and book value, you can protect your downside. Here we calculate how well that would work.

Thursday, June 5, 2008

Small Homebuilders Are A Bargain vs Book Value

In this post, we saw that home builders' market values track decently well with their book values. But those were the largest of home builders. Here, we look at Price to Book values for the smallest cap builders. All of these companies (Brookfield, Comstock, Meritage, Orleans, California Coastal, and Tousa) have market caps under $500 million, so they may present opportunities that the large builders don't, as we've discussed here in our discussion about why small caps are better investments.

Once again, we see periods of fear as well as exuberance for these stocks. In the early 90s, there is some tremendous opportunity to buy these companies for presumably much less than the land they own! It takes several years, but eventually by the mid to late 90s, those investors got rewarded.

In the first half of this decade, we see clear evidence that the market is extremely optimistic on land values, as investors are willing to pay more than 3 times book value for many of these companies.

Today, we see some possibilities for some great opportunities. Many of these small companies are trading for much less than their book values! Of course, P/B is just a screening tool. One still has to dig into the financial statements of these companies and make sure there is value there to be had. But if this screen is any indication, there may be an opportunity to buy real estate at bargain prices through these companies, presuming there is a margin of safety to cover any write downs!

Wednesday, June 4, 2008

What's Book Value Worth?

Do people care about price to book value when they buy a stock? For a given stock on Google Finance, you won't find the price to book value shown anywhere on the page. On Yahoo's finance site, you have to scroll down the 12th page of info (titled 'Statistics') to find the P/B. It would seem P/B is not an important measure in investor's minds.

For companies like Microsoft and Accenture, book value won't help you figure out the intrinsic value of the company. Their assets are knowledge based. But are there some companies out there where book value is an appropriate measure for intrinsic value?

Consider land developers. They acquire land for the purpose of development, and for the most part try to sell those developments as soon as they can. I would argue that book value is a pretty decent approximation of the intrinsic value of those companies. Sure, it's not perfect. In some cases, land could have been purchased years ago, and is therefore underestimated at strictly book value. So you still have to dig into the financial statements of the company to figure out what the properties are worth, but as a screening tool, looking for a low P/B ratio can be useful.

Here's the price to book ratio since 1985 for several large US homebuilders (Centex, Hovnanian, Lennar, Toll, DR Horton, Beazer):

A couple of interesting things going on here. We do see some irrational exuberance at times, where companies are trading for 3 or more times book value, but they come crashing back down when times aren't so great. In the 1980s we may be seeing the high inflationary times drive up the appetite for hard assets such as real-estate. In the early 2000s we see the runup in valuations of pretty much every builder.

We can also see times when it looks like these stocks are great bargains. During the 1991 recession, they're all trading below book value, and in many cases with large margins of safety!

Today, we see these stocks trading near the bottom of their P/B range. Could this be a buying opportunity? This chart clearly shows there currently aren't huge expectations built into these stocks. But there could still be more writedowns to come, which would reduce book value. Therefore, you'll want to look for a healthy margin of safety before jumping in.

Also consider that these are the largest, most famous US homebuilders. Smaller builders may have less analyst coverage and so may represent bigger bargains!

Tuesday, June 3, 2008

Let's get rid of Sundry Assets!

Considering the cool weather we've been having to this point, you must think I'm insane for wanting to get rid of something that sounds so warm and fuzzy. Who couldn't like something called Sundry right? Unfortunately, Sundry Assets do nothing to warm the hearts of those who wade through corporate financial statements.

When a company has a Balance Sheet entry titled "Sundry Assets", it's totally unclear what's included in that account. Sundry literally means 'various or diverse'...so what gets included under Sundry Assets? Anything and everything that management doesn't want to provide a separate line item for. Since investors have no idea what's in there, it becomes almost impossible to value.


Some companies throw expenses in there that they haven't used up. For example, if a company bought $500 of wood to knock on (following rosy statements), but only wore out $400 worth, they can stuff Sundry with the extra $100 (with the expectation of expensing it later). For small items such as this, it's not such a big deal. However, companies have also stuffed this account with items like private investments in other companies.

Usually, Sundry accounts are small and so aren't worth bothering about. But I recently encountered a company whereby the contents of those assets would make a valuation difference...if only I knew what they were! Such accounting reeks of management hiding information from shareholders, and is a signal to stay away!

Monday, June 2, 2008

Directional Hedge Funds

Hedge funds can be broadly classified into three categories:

1) Relative Value
2) Event-Driven
3) Directional

I've discussed the first two here and here. Directional funds are the most risky of the lot, as they involve taking massive bets on the direction of the market. Why do I call them massive bets as opposed to regular bets? Because they often involved a large amount of leverage, which magnifies both gains and losses.

As an example, if you invest $10 and achieve a 10% return, you'll have $11. However, if instead of just investing $10, you borrowed another $10, well that same 10% return would net you $12 (after paying the lender back), a return of 20% on your original $10. This amplifying of your gains will do the same for your losses as well.

Such hedge funds will take large long or short bets on equities, bonds, indexes, currencies or any derivatives. Many hedge funds of this nature also focus on emerging markets, as they are often less efficient due to lack of investor interest and information flow.

Sunday, June 1, 2008

A Company's Losses Can Be Valuable

Yes, a company can certainly learn from its mistakes, but that's not the kind of value in losses that I'm talking about. Companies that lose money can actually apply those losses against income from other years, thus lowering their tax bill. A profitable company we recently analyzed, which had a market cap of under $1 billion, was carrying $500 million in future tax assets from such losses...and not showing a penny of it on the balance sheet! This could be hidden value...but how much are those tax assets really worth?

For a company that lost money this year but that has had profits in the past, it is relatively straightforward to calculate what those tax assets are worth. Simply apply the company's losses against the past profits (assuming they are larger than the losses), and the government now owes the company an amount equal to the difference between what they paid and what they should have paid in retrospect of these losses. Generally, companies can apply these losses on profits of the past three years.

But in this company's case, they had run out of past profits to apply these losses to. They can, however, apply these losses to future profits, but now their value becomes uncertain. Companies are now required to recognize (i.e. show on their balance sheet) such future tax assets "when it is more likely than not that the asset will be realized". This requires some estimates of future profits up until the expiry of these loss carryforwards.

Whatever value the company recognizes today, however, still has to be adjusted to present value due to the time value of money. Therefore, any tax asset shown on the balance sheet will often be an overstatement of the present value of that asset.

Further complicating matters, firms with losses they can't use up right away can prove to be acquisition targets for firms with higher absolute profits, as means to shield profits from taxes. However, the government has put in measures to prevent companies from buying losers just to shield themselves from taxes, but where there's a will, there's a loophole!


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