Wednesday, December 31, 2008

Fooled By Randomness: Conclusion

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Key Takeaways from Fooled by Randomness:

  • Recognize the role of randomness in your life. Err on the side of assuming your success is based on randomness, and always work diligently to reduce the variability of your strategies.
  • Recognize your own biases, and think critically about the conclusions you draw, rather than relying on common sense.
  • Ignore the noise, chase the signal. Determine what matters to you (in your decision making of a particular theme) and don’t pay attention to the madness of the markets or the popular opinion.
  • Remain skeptical of all of your long-held beliefs, lest you become married to a position and ignore its faults (surely to your own future detriment).
  • Set up both contingency and prophylactic systems to encourage your rational thinking in the face of emotional upset. These will protect you from the frustrations associated with making emotional decisions devoid of critical thought.
  • Conduct your affairs with personal elegance, because the only thing randomness cannot control is your behaviour. (If you get a chance, read pages 194 - 195 on personal elegance. They are superbly written and are of great value)

From The Mailbag: New York Times

Stock in The New York Times Company (NYT) has dropped 90% from its high and 60% in the last year. While the stock is undoubtedly trading for far cheaper than it was, this is a great example of a value trap.

While the company owns a stable of recognized brands (including part of the Boston Red Sox), its flagship newspaper business is clearly in secular decline. (You can see this by reading the company's "segment" disclosures on its annual reports.) Newspapers are no longer the stable city-wide monopolies or oligopolies they once were. Every year, more and more advertisers shift towards more targeted forms of advertising, and readers are migrating to news sources with faster distribution channels. While we often advocate estimating a company's earnings power based on an average of past earnings, this would result in an overestimation of the earnings power for a company in secular decline. This makes it very difficult to determine a floor for the earnings power of this company.

At the same time as its business is in decline, NYT is working with a burdensome debt load. This further adds to the uncertainty with respect to the company's future. While the company's debt to equity ratio above 140% would be just ok if the company still operated as a relative monopoly like it did in the decades before the internet, it has now become quite a burden. Operating earnings over the last 5 quarters have not even been sufficient to cover interest payments; therefore, it's difficult to see how shareholders are going to be able to reap much in the way of benefits.

While value investors like to buy companies with great brands and steady track records, one has to be on the lookout for signs of trouble ahead. For us, companies whose business models are out of date and which are further burdened by high debt loads are not worth the risk of investing in.

Other examples of value traps include GM and Ford of 2004, which we wrote about here. Value investors who were paying attention at that time would have seen a strong chance of the collapse which is currently taking place.

Tuesday, December 30, 2008

Off-Balance Sheet Contingencies

To fully grasp a company's position, its financial statements are not enough. Consider CVS Caremark (CVS), a provider of prescription and related health services in the US. Nowhere on its balance sheet (or any other of its financial statements) would you find its guarantees for certain former subsidiaries, but these guarantees have turned out to be very real. In its last quarter, the company took an $80 million charge that would have caught off-guard anyone who had not read the notes.

This is an excerpt from the notes to its 2007 financial statements that would have helped an investor willing to do his homework:

Between 1991 and 1997, the Company sold or spun off a number of subsidiaries, including Bob’s Stores, Linens ‘n Things, Marshalls, Kay-Bee Toys, Wilsons, This End Up and Footstar. In many cases, when a former subsidiary leased a store, the Company provided a guarantee of the store’s lease obligations. When the subsidiaries were disposed of, the Company’s guarantees remained in place, although each initial purchaser has indemnified the Company for any lease obligations the Company was required to satisfy. If any of the purchasers or any of the former subsidiaries were to become insolvent and failed to make the required payments under a store lease, the Company could be required to satisfy these obligations.

Since the writing of this note, Linens 'n Things has gone bankrupt. As such, CVS owes money as described by the note above. The payments CVS must now make will not bankrupt the company; however, the lesson is one that can apply across all companies in an investor's portfolio. As such, these guarantees must be factored into an investor's valuation.

Often, a company will have financial obligations for which it is difficult to determine the precise amount that will have to be paid. In many cases, such obligations are completely omitted from the financial statements, as we saw here with CVS. For this reason (and others that we've described here), it is imperative that investors read the mandatory notes that accompany a company's financial statements.

Monday, December 29, 2008

Fooled By Randomness: Chapters 13 and 14

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Recognize the dangers of becoming married to a position. If you have invested a great deal of time into formulating a position, or have held a position for a long time, then you will have built up a strong loyalty to that position which acts as a barrier to considering its faults. This is extremely dangerous as failure to reconsider things will prevent you from properly adapting as the situation changes.

The Japanese have a word for this - Kaizen - which is used often in their successful manufacturing process philosophies. It is the constant review of all processes, even those that are successful, always seeking a better process.

The reality of life is that we are dominated by odds. Randomness will occur. The best we can do is plan for contingencies so as to reduce our downside exposure.

Taleb closes by urging us to not abandon our emotion, but instead “Just listen while shaken by emotion but not with the coward’s imploration and complaints.” It is not wrong to have emotions, but it is wrong to follow the path that ignores probability and odds.

Shareholder Rights Or Wrongs?

Sometimes, managements will adopt so-called Shareholder Rights Plans that "protect" shareholders from hostile takeovers. Often, however, such plans have negative effects for shareholders. In such cases, these plans are designed to protect managements rather than shareholders. Consider recent events at LCA-Vision (LCAV), a stock we've discussed as a potential value play.

The founders of LCAV (who left the company a few years ago) have started buying up a significant number of shares, bringing their total to 11.4% of the company. Often, this type of activity suggests a takeover offer for the remaining shares may soon follow. In order to entice remaining shareholders to tender their shares, a takeover offer will ordinarily be at a price well above the current share price. Because the market anticipates an offer, the shares tend to trade higher than they otherwise would. Good for current shareholders, right? It was, until a "Shareholder Rights Plan" was adopted a couple of weeks ago by management (management's description of how the plan works is available here).

The plan makes it more difficult for a group to successfully bid for and acquire the company. But even if an offer is made, shareholders are under no obligation to accept it. If they deem the offer to be unfair, they have the option to reject it. So essentially management is eliminating that shareholder option, and forcing shareholders to wait until the next annual general meeting where shareholders will be able to vote the plan down.

In Security Analysis, Ben Graham asserts that shareholders do not protect themselves from managements as much as they should. This appears to be an example where management has protected itself at the expense of shareholders...how will shareholders respond?

Disclosure: None

Sunday, December 28, 2008

Housing Inventories Tell The Tale

While current home sales are a product of current prices and consumer confidence, in order to see where the future of housing is going, it's useful to look at home inventories. Here's a look at US home inventories in November over the last decade and a half:

We can see from the chart that the housing boom which preceded this bust may have been caused in part (alongside low interest rates) by low inventory levels. This caused prices on new homes to be bid up, resulting in a building boom (to capitalize on large profits) which pushed inventories up to abnormal levels.

Eventually, slowing demand led to a glut of new homes on the market, leaving a supply/demand imbalance that deflated the home construction industry. In the last couple of years, we see that much of this inventory has been worked through, but not without a lot of pain. Builders have had to slash prices and have abruptly cut new construction, which has hurt the economy.

We now see that housing inventories are currently at levels which appear to be 'normal', at least by historical standards; that's the good news. The bad news is that confidence is at such low levels that inventories will likely have to drop to abnormal levels before prices stabilize. What level is that exactly? Nobody knows. But as new home sales continue to outpace new construction, this inventory level will continue to fall, and prices will once again be bid up when this happens.

Saturday, December 27, 2008

Bailout: Shoe On The Other Foot

One issue which is largely ignored in the bailout vs no-bailout debates is the precedent being set on international trade. The US has consistently imposed tariffs when it has felt that international government subsidies for foreign companies have disadvantaged American companies. By bailing out domestic auto makers, does the US lose all credibility in this regard?

It would now seem quite hypocritical for the US to argue that free markets should decide which companies should survive. Just three months ago, the US threatened sanctions against China for export subsidies on textiles. If China can make a case which parallels the arguments the US uses to justify bailing out domestic auto makers (e.g. the threat of widespread unemployment, serious harm to the economy etc.), does the US have any moral authority anymore?

It would seem that it is now open season on bailouts. Any government that wishes to bail out certain industries or companies which are headquartered in its jurisdiction is now free to do so. Unfortunately, this strategy is harmful to overall productivity, which is the driving force behind our standard of living, as we discussed here. By sustaining the least profitable companies rather than allowing the superior companies to grow their market shares, we all lose in the long run.

Friday, December 26, 2008

Fooled By Randomness: Chapter 12

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Taleb admits to being just intelligent enough to understand that he, like all people has a predisposition to being fooled by randomness. However, he is neither smart enough, nor strong enough to cast away his emotions and deal with pure probabilities, nor does he suggest that you or I do so.

Gamblers’ ticks are those habits picked up by gamblers that are thought to bring them added luck, such as a lucky shirt, or a certain phrase. The problem is that many of these ticks are more severe in real life than lucky shirts - causing us to react to events in certain ways based on our past success with that kind of reaction.

The trick is to recognize your own ticks and set up systems to deal with them, such as preventing access to information which is filled with noise, rather than signal (e.g. the 24-hour financial news networks) if these cause you to react in a superstitious manner rather than a logical manner.

Curb Minimum Wage

For the US economy to start growing again, businesses must see new profit opportunities and must subsequently invest in these opportunities. One way to increase the number of available profit opportunities is to reduce or remove minimum wage requirements. While it may be a politically unpopular move, removing the minimum wage would encourage hiring, reduce unemployment and increase business profits (and thus incentives for expansion) through this downturn.

When minimum wage rates are set above what the market rates would ordinarily pay, costs per worker are held artificially high. This keeps businesses from hiring workers they otherwise would, thus reducing hiring and keeping unemployment levels at artificially high levels.

When costs are artificially higher than they otherwise would be, certain profitable projects are no longer profitable, and otherwise fruitful investments are not made as a result. The economy as a whole thus grows at a slower rate than it otherwise would.

While the benefits of removing minimum wage are felt by most of society, those who currently receive minimum wage (but would not otherwise) would feel pain in an immediate removal of minimum wage. A gradual announced phase-out of the minimum wage for workers who are currently employed at that rate is the best method of reducing the impact on these workers. This would allow current workers to plan ahead and would encourage them to increase their productive value through education, while at the same time allowing businesses and the unemployed to benefit from new hires at a market rate.

Thursday, December 25, 2008

Military Spending Out Of A Recession

Much has been made of the US Federal debt which currently stands at over $10 trillion. While this number continues to increase as the government tries to spend its way out of a recession, eventually the government will have to cut its spending. One of the largest components of the US budget is its military spend. Here's a chart depicting US military spend over the last three decades:

From the chart, we can see that if the US can wind down its wars, it can realistically return to an annual spend around $300 billion. Ignoring inflation and interest for the sake of simplicity, this would save $150 billion per year compared to the last eight years.

Over the next eight years, this would reduce outstanding debt by $1.2 trillion, which represents more than 10% of current debt outstanding. This is more than the fiscal stimulus checks issued earlier this year and the funds allocated to the current bank bailout combined! Getting along with the other cultures with whom we share this planet might not just be good for our health, but also our wallets.

Wednesday, December 24, 2008

Fooled By Randomness: Chapter 11

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

You are diagnosed with cancer, but have a 72% chance of surviving the next 5 years. You are overjoyed, but why? After all, you have a 28% chance of death. But people do not look at things this way. Our brains are wired to think of one state only. So rather than thinking of yourself as 72% alive and 28% dead, you think of yourself as 100% alive. We are probability blind which causes all of the biases we have discussed previously.

Taleb discusses the many biases that affect our ability to understand probability, including the difficulty in determining causality (and our likely use of the post hoc ergo propter hoc fallacy), and filtering out noise (rather choosing often to interpret the noise!).

As a great man GI Joe said, knowing is half the battle. By being aware of our biases, you can think critically about your decisions, interpret information more clearly, and formulate better decisions.

Goodfellow Or Greatfellow?

Goodfellow (GDL) is a wholesaler and distributor of wood products including flooring, exterior siding, and a broad range of other hardwood and softwood products. Because of the housing collapse, stocks in this industry have taken a beating. But Goodfellow has managed to cut costs and still turn a profit, including in its most recent quarter which ended November 30th. While many of its competitors deal with burdensome debt loads and reduced operations, Goodfellow stands to make market share gains.

But is the stock cheap? The company trades for $55 million. Let's compare this to some elements of GDL's latest balance sheet:

A/R: $75 million
Inventory: $47 million
All Liabilities: $53 million

Therefore, you're buying receivables and inventory for a 25% discount, ($69 million in net assets, on sale for $55 million) and you're getting the company's profitable operations and customer relationships for free!

Of special note for this company is that billionaire value investor Stephen Jarislowski is a substantial owner and Chairman of this company. Reyer has reviewed Jarislowski's book for this blog here.

Profitable small caps with low debt levels which operate in beaten up industries offer long-term investors the opportunity for great returns.

Disclosure: Author has a long position in shares of GDL

Tuesday, December 23, 2008

Newell Rubbermaid Revisited

A few months ago, Reyer looked at Newell Rubbermaid (NWL), the maker of several brand name products including Sharpie, Paper Mate, Parker, Rolodex, and Rubbermaid. At the time, NWL traded at $19 per share, and Reyer concluded that there was little value to be found in this stock.

Last week, however, the stock dropped over 25% in one day as the company reduced profit expectations for 2008 and 2009, and announced job cuts and temporary plant closures. As a result, the stock now trades at just $9.50 per share, a 50% discount to where it was when Reyer wrote about it just a few months ago, bringing the P/E to just 8 and the dividend above 8%.

Has the long-term value of the company's brands and earnings power changed that much in the last few months? It appears unlikely. There is no evidence to suggest the earnings reductions are related to anything more than the current downturn. The company's large diversified stable of products offers some protection against a permanent decline in any one product.

One risk the company does have is its debt level. Employing higher than normal debt/equity levels offers stable companies cheaper access to capital, and since NWL has traditionally been a very stable business, it has a D/E of 1.5. If this is a long and protracted downturn and the company is unable to reduce costs in line with revenues, this debt level will become a large burden. As part of a diversified portfolio, however, NWL now appears to offer great long-term value.

Disclosure: None

Monday, December 22, 2008

Fooled By Randomness: Chapters 9 and 10

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Taleb uses this chapter to illustrate the Survivorship Bias in several different common situations.
Two important things come from the examples in this chapter:

1. A large group of poor performers will eventually yield a few performers that appear to be quite skillful due to their success. This is simply volatility from the norm, but is often confused for skill.

2. Success is more greatly correlated with the number of people in the original pool than the skill of the players (since, the larger the pool, the longer the survivors had to survive, and the more successful they will appear as a result.)

Life is unfair in a nonlinear way. Small advantages often translate into disproportionately large payoffs, or simple randomness can lead to the same thing without any advantage at all.

Nonlinearity is the disproportionate result resulting from a proportionate increase in force. Adding sand to a sandcastle tower, growing at a linear rate, until suddenly one extra grain of sand causes it to all come crumbling down - that is the nonlinear result.

The reason life is nonlinear is that past success increases the probability of future success, due to a multitude of reasons (network externalities being one). Each step on our path is not independent

The nonlinearities of life cause us to confuse sucess with skill. Nonlinearities allow tiny amounts of randomness to build ever greater success (or failure), confusing us into thinking that the tiny amount of randomness was ineffectual.

Behind Build-A-Bear's Balance Sheet

On the surface, Build-A-Bear (BBW) appears to offer great value for the value investor. The stock has a market cap of just $75 million, but has earned an average of about $25 million in each of the last four years. Furthermore, its balance sheet shows a book value of $175 million, with $27 million of that in the form of cash.

As with many companies that sell non-essential items (and teddy bears, even the cutest among them, do fall in this category), this year has been a rough one. In the last two quarters, the company has lost a combined $11 million dollars. But if the company can outlast this downturn, it looks like a great deal for the long-term value investor. After all, if earnings ever return to pre-recession levels, buying in at this price would be a steal!

But the question is, how sure are you that the company can outlast this downturn of unknown length and magnitude? This is not an easy question to answer. The company's balance sheet shows no debt, but this is deceiving! After capitalizing operating leases, this company's debt to equity jumps to a staggering 167%. These represent fixed obligations owed to landlords. If revenues drop for several years, these fixed costs cannot be reduced (unlike variable costs).

If the economy rebounds in the next year, this company's stock will shoot up dramatically. But it is not set up to outlast a long and protracted downturn, and so it doesn't represent the "sure things" we usually like to swing for.

Sunday, December 21, 2008

The Special Economic Climate

Several months ago, the capital markets began to be gripped by fear. There is no doubt that this fear has (for whatever reason) now pervaded its way all the way to the end consumer. We are now seeing evidence that consumers are holding off on buying items they would normally keep buying.

Nowhere is this more evident than on last week's conference call for Gildan Activewear (GIL). Gildan sells non-fashion apparel like t-shirts, underwear and socks to mass retailers. One would expect this to be a steady business. Although their most recent quarter ended in early October, Gildan's management added some info about what they saw happen to sales after the quarter's end:

"Up until the end of September, [Gildan's] market was down 3%, so we have been in a recession...basically, we have always felt that we’re quite resistant to economic downturns, and that was reflective really in this year of 3%...In the month of October...business was actually quite normalized at probably at a clip of minus 3% through October 15...From October 15, there has been a shock of the credit system, customers watching their inventory, the customer end user watching their inventories, and just I think the whole philosophy, rethinking and people getting nervous looking at their net worth thinking, I guess shrinking. So, what has happened is that really – [Gildan's] market actually went down. In October, it was down 13%, but in the first two weeks we were actually pretty normalized, and the last two weeks we’re severely down, and that kept going through November."

Normally, one wouldn't expect large drops in demand for a company selling cheap t-shirts, socks and underwear. But clearly this is a fearful time. Gildan's stock dropped 27% following this call. The fear prevalent in the economy is creating buy situations for those (like Warren Buffett) who are bullish on the economy in the long term.

Disclosure: None

Saturday, December 20, 2008

More Conference Call Etiquette

When public companies release quarterly results, they will generally have a conference call to answer any questions the public may have. These conference calls are limited in length, however. Therefore, those who are selected to ask questions should keep their follow-up questions to a minimum so that everyone can have their questions answered. Unfortunately, this courteousness rarely takes place.

Last month, I waited my turn on the conference call for Abitibi-Bowater as certain analysts asked follow-up after follow-up. Unfortunately, we ran out of time before everyone could be heard from.

Recently, many companies have begun to take steps to fix this problem. On the Gildan Activewear (GIL) call last week, the company requested that questions be kept to two per person so that everyone would be heard from. Unfortunately, this still didn't stop certain analysts from hogging the floor. Sara O'Brien from RBC, the first analyst selected for a question, asked a question followed by four separate follow-ups! Pretty much every analyst that followed her also surpassed the two question request, prompting the Investor Relations Director to have to interject at one point during Mary Gilbert of Imperial Capital's fifth question with a:

"Sorry to interrupt, if you can maybe call us with follow up questions, we could give the opportunity for others to ask questions as well."

This call also ended with analysts still in the queue. Let's see a little courtesy!

For more conference call etiquette, see here.

Friday, December 19, 2008

Fooled By Randomness: Chapters 7 and 8

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

The problem of induction may be phrased as follows: “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.”

Recognize that inductive reasoning (statistics) is not perfect. Use it to make decisions, but do not use it to manage risks and exposure!!

The survivorship bias, as discussed earlier is the failure to consider those that followed the same path as the people we are analyzing, but failed to reach the same success (or be successful at all). It is extremely difficult to view these people, since history does not record them. To correct for this bias, we may want to adjust the success of those we are considering to take into account the effect of those that failed to survive.

We tend to mistake one realization among all possible random histories as the most representative one, forgetting that there may be others… The survivorship bias implies that the highest performing realization will be the most visible. Why? Because the losers do not show up.

Conclusion: Taleb’s point is that survivorship bias is a chronic syndrome affecting most people. We naturally ignore the data we do not see, so we must work hard to counter survivorship bias.

Power Up With Hammond

Six months ago, we responded to a "buy" recommendation on Hammond Power Solutions (HPS.A). At that time, we disputed the recommendation and suggested it had come far too late, as the company no longer appeared to be the steal it was in 2004 when it had no such recommendation.

Since July, however, the company's stock price has fallen 50%, and HPS now looks like a company trading with a large margin of safety. HPS makes custom electrical magnetics and dry type transformers for use in several industries including wind power, oil and gas, mining, waste, and water management, without being dependent on any single market. The company has been growing quickly, having doubled sales in the last four years, and now has a P/E under 5.

Since it is a relatively small company (with a market cap around $70 million), small investors have an advantage since it falls outside the range of the largest funds. For small investors who are paying attention, this company looks like it has a bright future. Even while the economy slows, this company has been growing its backlog (even organically - i.e. without acquisition). While it most certainly cannot completely escape the global spending slowdown, its backlog will certainly help smooth out this effect, and its low debt levels should keep it safe until government and central bank liquidity injections are felt throughout the economy.

Disclosure: Author owns a long position in HPS.A

Thursday, December 18, 2008

From The Mailbag: Canadian Tire

Canadian Tire (CTC.A) is a retailer and distributor of a wide range of products, from automotive parts to sportswear. Its stock price has fallen by over 50% in the last year, from $83 to $39. This gives it a P/E of 8 and a price to book value below 1. This is despite the fact that the company's profits appear to hold up relatively well even during downturns. Here's a look at operating margins over the last recession and through the first three quarters of this year:

Clearly, this company is not a cyclical one and therefore it can afford to take on a reasonable amount of debt without running the risk of insolvency.

But the company's P/E suggests the company is on the decline; but this is hardly the case. The company has embarked on a five-year plan to add more locations while improving profitability at existing locations. The company's full strategy is described in its annual information form available here.

But how can one determine whether management is credible and/or effective? Can they really deliver on their "bigger and better" strategy? One method on which to judge management is on its effectiveness at generating returns on the capital it has at its disposal:

In the early 2000s, management decided to convert many of its medium and small sized stores to large ones. Their plan has appeared to be beneficial to company stakeholders, as returns have improved over the last several years.

Remember, however, that this company is well-known and has national coverage across most of Canada. As such it is a well-followed stock and may not reach valuation levels that give it a discount to intrinsic value that can be found in some of the smaller companies we've discussed.

Wednesday, December 17, 2008

Fooled By Randomness: Chapter 6

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Median figures are not very valuable, because they mask all sorts of information. For example, the fact that the average patient lives 8 months is useless when you find out that those that live beyond 8 months tend to live a long and regular life, whereas those that live less than 8 months tend to die very quickly. This is asymmetry. Asymmetric outcomes mean that payoffs are not equal, and differ from the average by a wide margin.

Asymmetry can be countered by considering the expected values. This means multiplying the probability of an event by the value of its outcome to get the expected value of the event, and then adding up the total of the expected values. This will give you a figure which lets you know what you expect the entire scenario to result in. Usingthe patiente example above, it may show you that the expected lifespan with that illness is quite a bit longer than 8 months!

Taleb introduced the Rare Event Fallacy, which is the failure to account for extremely rare events. The problem is that such events are extremely difficult to detect. As we take more samples, we only very slowly learn about the relative infrequency of the rare event, however as soon as one happens, our knowledge improves quickly.

Goldman Sachs' Wonky Oil Predictions

Just eight months ago, with oil prices on their way up, Goldman Sachs boldly predicted an oil price of up to $200 per barrel. This raising of Goldman's target price for oil followed similar periodic target price raises as the price of oil had been climbing for years. A few days ago, in a sharp turnaround, a new Goldman report predicted the oil price would drop to $30 a barrel by next year.

Goldman Sachs is supposed to employ some of the most brilliant minds in the world. Yet their predictions give the appearance of a firm simply extrapolating the market's momentum. Is all this time, effort and money spent on short-term price predictions worthwhile? When we met with Warren Buffett a few months ago, he made it pretty clear that he doesn't think anyone can predict the short-term price of anything.

Many have raised the possibility that Goldman makes such periodic price predictions in order to manipulate markets so they can profit from trades. Whatever the case may be, relying on analyst predictions does not appear to be a fruitful method of generating profits.

In related posts on "analyst predictions gone bad", last month we looked at what analysts were saying about both Lehman Brothers, Fannie and Freddie, and Washington Mutual right before each of them went down.

Disclosure: None

Tuesday, December 16, 2008

Forbes Writer Responds

A few days ago, I wrote an article disagreeing with the economic proposals set forth in an article written on Forbes.com by Frank Beck. He responded to my arguments as follows:

"Actually, I believe we are experiencing the same devaluation, just over a longer period of time and it, like a pendulum, will likely swing further than what I proposed. You are right that cash gets “burned” (under either plan, or even under regular inflation). I just hope that those holding lots of cash, also own a home, some gold, and some other hard assets. That is how we position our clients, because the dollar is shrinking almost all of the time."

Many people have made the argument that this influx of cash will result in massive inflation in the future. When the economy picks up, inflation will indeed rear its head. But when the economy is strong, we can remove stimulus (i.e. by the Fed raising interest rates, and by the government switching to saving and paying down debt).

By maintaining a target inflation rate between 1% and 3%, we won't hurt the future practice of lending and we won't send those on fixed incomes to the poorhouse. If inflation is moderate and devaluation takes place over time (which is what has happened for the last 30 years), lenders do not lose purchasing power by making long-term loans.

Devaluing world currencies immediately would be irresponsible and would damage our future.

Monday, December 15, 2008

Fooled By Randomness: Chapters 4 and 5

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Chapter Four: Randomness, Nonsense, and the Scientific Intellectual
Simulators can create beautiful things that appeal to our senses (e.g. abstract artwork and poetry). Why is this important? What motivates us in some things (e.g. poetry) is not rational and scientific.

Conclusion: We do not need to be rational and scientific in all things - only in those that can harm us and threaten our survival. Taleb says that modern life invites us to do the opposite: become realistic and intellectual when it comes to matters such as religion and personal behaviour, yet irrational when it comes to markets and matters ruled by randomness.

Chapter Five: Survival of the Least Fit - Can Evolution be Fooled by Randomness?
In this chapter, Taleb discusses the characteristics that make someone a fool to randomness:

  1. An overestimation of the accuracy of their beliefs
  2. A tendency to get married to positions. Loyalty to ideas is not a good thing!
  3. The tendency to change their story.
  4. No precise game plan ahead of time as to what to do in negative events.
  5. Absence of critical thinking.
  6. Denial.

Arbitrage For The Retail Investor

Sometimes, a public company (say Company A) will own shares in another public company (say Company B). When Company A's ownership stake in Company B is worth more than the market cap of Company A, clearly the market has made a pricing mistake. When this occurs with large companies, investors enter the market and drive the prices to more reasonable levels. When this occurs with small companies, however, there is little return on investment for large funds, offering small investors a chance to profit.

Consider Glendale (GIN), which owns 43% (and control) of Firan Tech (FTG). FTG trades for $6.2 million, and so Glendale effectively owns $2.7 million worth of Firan...but Glendale itself is trading for only $2.6 million! In addition, Glendale owns cash, inventory and A/R of $15 million over and above all of its liabilities!

Even if you believe that Firan is overvalued in the market, you can take a short position in FTG along with a long position in GIN. No matter which direction the market values of these companies move, you neither profit nor lose. As long as GIN increases in value relative to FTG (which it should eventually), you have made an arbitrage profit, on a retail investor scale!

Sunday, December 14, 2008

Fooled By Randomness: Chapter 3

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Taleb uses this chapter to introduce Monte Carlo simulators which repeatedly run simulations of a scenario with the different variables changing based on their associated probabilities. By running these simulations millions of times, you can look at the characteristics of the set of results and generate incredibly useful inferences. For example, by considering the variability from the average result, you can determine the impact of randomness in the scenario being analyzed. The less variability, the more resistant the situation is to randomness.

Taleb suggests Monte Carlo simulators allow us to learn from the simulated future which is superior to learning from the past, because the past has a survivorship bias, and we also tend to denigrate the past by claiming misfortune had by others will not happen to us.

Conclusion: When considering things, think about the results of a Monte Carlo simulator - what result do you expect would occur after a million simulations and what level of variability? This will help ignore survivorship bias and prevent you from denigrating the past by saying misfortune won’t happen to you. The Monte Carlo simulator will help you clarify your thinking and make better choices.

Conference Call Etiquette

Every quarter, public companies are required to release their latest financial results. Along with their results, they hold conference calls and accept questions from the public. As we've discussed before, it's important for investors to listen to these calls to understand the challenges the company faces. Usually, analysts ask management about revenue outlooks for various products, margin expectations, overall strategy and other pertinent questions. Sometimes, however, analysts will feel the need to offer some "free" advice to management.

On the most recent conference call for Build-A-Bear (BBW), here's what Mike Smith of Kansas City Capital had to say when prompted for his question:

"Well, one comment first before I ask a question. I would suggest you don’t buy any stock back because people can postpone buying bears for a long time."

His opinion is one which is rampant throughout a finance industry currently gripped with fear. At a time when value investors are buying, stock analysts are against buying back shares at the cheapest prices in over a decade. (Of course, the value of analysts is not so clear when you consider their ratings of Lehman Brothers the day before it went down).

I'm not saying BBW should be buying back stock, but that option should most certainly not be automatically discarded: if management sees a certain level of cash flow that more than covers their fixed obligations, buy backs at cheap prices may very well be in order. Here's what BBW's founder, chairman and CEO had to say on the matter:

"We have to look at it week by week and we do. And I think that if there’s opportunities that present themselves because we can see that the cash is in excess of what we thought would need to operate our business in a normal basis. And we’re also trying to look and forecast into 2009 and how the economic issues will affect us there."

Free advice is worth its price!

Saturday, December 13, 2008

From the Mailbag: Mellanox Technologies

Mellanox Technologies, Ltd. (NASDAQ:MLNX) is a technology company that builds high speed data transmitting infrastructure interconnects for enterprise IT equipment, including servers, storage devices, and network gear. The company is headquartered in Yokneam, Israel.

MLNX is a small-cap stock with a market cap of $254.3 million based on the current stock price of $8.03 per share. The company does not pay a dividend and has no intention of paying dividends to shareholders in the future (from disclosure in their annual report). MLNX has a price to earnings ratio of 7.75 and a price to book ratio of 1.2.

The balance sheet for MLNX looks quite strong as current assets less all liabilities results in a per share price value of $6.32. The debt to capital ratio for the company is very low at 1%. The company does not appear to have any liquidity issues with a current ratio of over 12 times. The current assets are made up of primarily cash and short term investments.

While the balance sheet is very strong, Mellanox has a high concentration of customers with the top 4 customers comprising over 50% of their revenues. The company also has short track record of profitability having just become profitable in 2005. This is a highly competitive and quickly changing industry. For these reasons I believe Mellanox has high business risk. Mellanox's competitive positioning and ability to continue to innovate value-add technologies are keys to their future success.


Disclosure: The author has no shares in this company.

Gildan's Tax Avoidance

When we looked at Spark Networks' glowing P/E, we noticed that it was due in large part to a huge tax benefit due to past operating losses. Since this tax benefit would not occur in the future, the company's current net income had to be discounted by a tax rate in order to determine the company's true earning power going forward. For Gildan Activewear (GIL), we see similarly suspicious earnings after taxes:


Clearly, this is an unusual situation. So should we chop net income by a normal tax rate in order to determine a sustainable income going forward? Not without a closer look.

Further investigation reveals that the company's "low overall consolidated tax rate reflects the operating structure of the company under which all of our sales, marketing and manufacturing functions are carried out at low tax rate jurisdictions in the Caribbean basin and Central America, with only corporate head office functions based in Canada...As far as our tax rate, including our retail business, we are looking at an overall consolidated tax rate...of around 6%...And we are fully confident of sustaining our low tax rate for the period on an ongoing basis" (source: 2008 Q4 conference call)

By maintaining much of its operations in low tax jurisdictions, Gilden management has found a great way to add value for shareholders. Assuming a 35% tax rate, this corporate structure has increased the value of the company by nearly 50%, minus any extra costs associated with operating in those regions!

Friday, December 12, 2008

Fooled By Randomness: Chapter 2

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Taleb introduces the concept of Alternative Histories. When considering success, you must also consider the likelihood of success given the probability of a negative result having occurred. Failure to consider the potential for negative results and judging based only on the success witnessed is the survivorship bias, which my friends over at Barel Karsan have explored.

Consider Russian Roulette. If a wealthy man offered you $10 million to play Russian Roulette, you have one of six possible histories - one of which renders you dead, the other five render you $10 million wealthier. Only one of these histories actually occurs. If you live, and win the $10 million, you are more successful. Though you are successful only by dumb luck. If offered another $10 million to try again, you may again win, or you may die. The fact is, the success has nothing to do with you. Though external observers would see you getting $10 million richer until you are dead. Taleb argues that $10 million earned through Russian Roulette is not worth the same as $10 million earned through the diligent practice of dentistry. The first is devalued due to its dependence on randomness.

Now, in reality, there are thousands of chambers, and after we succeed past a few, we forget about the bullet, thinking we are protected by our skill (Taleb calls this the Black Swan Problem). We also tend to denigrate history by thinking the things that happen to others won’t happen to us. Additionally, most of us carry on without knowing the real odds of our demise, unlike in Russian Roulette.

Conclusion: Consider the probabilities associated with you arriving at your current post in life. Are you happy with where you are? If so, does the course you took have a high probability of leading you to where you are (considering the alternative histories!)? If you aren’t happy, then what are the probabilities things will change in the future? What are you doing to improve those odds?

Also, important for all people is the notion of embracing randomness. Consider all of the potential risks. When assessing your own success, always consider what would have resulted had things gone differently. Only when considering things in this light can you truly assess your own skills and the quality of your strategies.

Forbes Says Devalue Dollar

In undoubtedly the worst article I've ever read on Forbes.com (and there have been many candidates), writer Frank Beck suggests the world should instantaneously devalue all currencies by 30%, thereby increasing the dollar value of all assets. Debts then become manageable, and we all move forward with cleaner, leaner balance sheets. Right? Wrong!

Who in their right mind would ever lend money again? Knowing that in the next recession (yes, recessions will happen again) there is a high probability that the government will just devalue currencies, interest rates would permanently skyrocket: even the best businesses, of which are there many, would find it prohibitively expensive to expand, which hurts all of us.

Instead of focusing on business problems like improving productivity and improving value for the customer, businesses in the future will be chiefly concerned with expectations for inflation, which is what happens when future inflation rates are uncertain.

Beck calls himself "a national authority on retiree planning", but consider how this plan would affect retirees! Primarily reliant on fixed incomes, this group would see an instant, permanent skyrocketing of their costs, with no corresponding increase in income!

Even those who lent money with sound practices to good businesses would get burnt by this plan. Basically, it would reward those who speculated with risky loans and purchases of assets, while those who lent appropriately and those who saved cash for a rainy day would get burned. What a perverse incentive system...imagine the long-term repercussions!

I do agree with Beck on one point (you can read his article here, if you can find it between all the ads): we should not throw good money after bad businesses. The auto bailout talk should never have reached this far. The Fed needs to lower interest rates (as it's doing) so that businesses in general have lower costs, with the strongest of them being able to expand. Business taxes should be (if only temporarily) lowered, so that the most profitable businesses have incentives to keep their workers and grow, instead of taxing the most profitable businesses to give to the least productive.

These levers do take time to work themselves through the economy, however. But let's not go overboard by implementing a solution that's worse than the problem.

Thursday, December 11, 2008

Airline Passengers Hold Steady

As we've discussed before, the airline industry is a cyclical one. Due to the terrorist attacks in the last recession, that recession was particularly difficult for airlines. So far during this recession, however, passenger miles have held up. Here's a look at airline passenger miles over the last decade and a half:



While airline miles have tapered off, we see that there is nowhere near the drop-off one might expect from a cyclical industry. This chart suggests the airline industry is now a relatively stable industry. But that would be an errant conclusion.

Part of the reason passenger miles have been stable lies in the exceptional fuel price volatility that has occurred in recent years. As oil prices rose with the economy, growth in miles was tempered by high fuel costs (on the chart we see that miles did not grow much from 2005 to 2007 despite a strong economy). On the flip side, as the economy has tanked, dropping fuel prices have made tickets more affordable. This overall combination has resulted in the seemingly stable demand we see in the chart, when in fact this was caused by exceptional price volatility.

Of course, this apparent demand stability doesn't mean that airlines are not currently struggling (in fact, they often will as we discussed here). Value investors, however, should beware. Airlines do not make for safe or fruitful long-term investments, as we discussed here.

Wednesday, December 10, 2008

Fooled By Randomness: Chapter 1

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Part One: Solon’s Warning
Solon’s warning is “The uncertain future has yet to come, with all variety of future; and him only to whom the divinity has guaranteed continued happiness until the end we may call happy.” In other words, “it ain’t over til it’s over.”

Part one of the book discusses how the things which we have received by luck may be taken away by luck just as easily.

Chapter One: If You’re So Rich, Why Aren’t You So Smart?
Taleb introduces, by way of parable, the argument that we cannot judge a person’s success by their performance and wealth because of Solon’s warning: it ain’t over till it’s over. Just because you are successful now doesn’t mean that success wasn’t generated in an incredibly risky manner that is inherently inconsistent and will come crashing down at any moment.

Conclusion: Don’t let someone’s current success fool you into thinking they must be skilled at what they do. There is a decent chance they are the beneficiary of dumb luck, in which case their success is just as likely to disappear due to dumb luck! If you work hard and are consistent in your growth, be confident in what you do, even as others temporarily exceed you.

Miles Per Gallon On The Rise

When oil prices were out of control in the summer, we discussed how while in the short term oil demand is inelastic (i.e. can't change much), in the long-term demand would likely drop, leading to a tempered oil price in the long term. Historically, one reason oil demand has dropped when prices are high is an increased focus on developing and purchasing fuel efficient vehicles. Here's a look at fuel efficiency for the average new passenger vehicle over the last two decades.

Clearly, the high oil prices prevalent in the early 80s resulted in a surge in fuel efficient technologies which helped eventually reduce demand. On the other hand, low oil prices throughout the 90s and early 2000s led to a lack of innovation in this area.

Thanks to the recent high prices of the last several years, it is likely that we will once again see gradual fuel efficiency improvements take hold over the next several years. We see that this has already begun to some extent, with fuel efficiency over the last three years showing marked gains over the prior decade. More efficient vehicles combined with fewer miles driven per vehicle will likely be a major contributor to a drop in oil demand even after this recession.

Tuesday, December 9, 2008

Buffett on "Cigar-Butt" Investing

In the Essays of Warren Buffett, Warren describes some of his past investing mistakes. He notes that his first mistake was buying control of Berkshire, which at the time was involved primarily in the difficult textile manufacturing business. Warren admits that he bought the company simply because it looked cheap which was a mistake.

Buffett describes the cigar-butt style of investing as buying a company at a sufficiently low price and then waiting for a favorable "hiccup" in the companies fortunes that creates an opportunity to sell the stock at a profit. The comparison to a cigar-butt is made because the company in question usually has "one puff of smoke left". Buffett writes that "unless you are a liquidator, that kind of approach to buying businesses is foolish".

Buffett goes on to say that he had to learn the hard way, several times, to understand the principle that "time is the friend of a good business but the enemy of a mediocre business". He provides a clear example on this lesson with Hochschild, a department store company. Buffett bought the company at a large discount to book value and the deal included some hidden real estate value and a large LIFO inventory cushion. At the time Warren felt confident on the purchase, but three years later he felt fortunate to be able to exit the investment at a break-even.

Buffett comments that over 25 years, he has learned that it's best to avoid difficult business problems and not to try to solve them.

Margin Debt Tumbles

When the stock market rises, investors buy stocks on margin (i.e. borrow money to invest) in an attempt to get as vested as possible in the market in order to profit from its expected rise. At times like these, however, margin calls (i.e. requirements to pay back debts) cause investors to have to liquidate their margin positions. Here's a chart showing NYSE margin debt over the last year up to October of this year:

As far as indicators go, it does not appear as though investor sentiment can get much worse. This pattern is nothing new, however. When we looked at margin borrowing in the last recession, we saw a similar pattern to this one. This doesn't necessarily mean we're at a stock market bottom, but it does indicate that the worst of the selling may be over. After all, if there isn't much margin debt left, it can't drop by all that much.

Margin debt may be considered useful as a contrarian indicator for those who like to buy when others are fearful, and sell when others are greedy. For such contrarians, this indicator suggests now is a time to buy.

Monday, December 8, 2008

The Warren Buffett Way: Chp 8 : An Unreasonable Man

Hagstrom concludes that Buffett's approach to investing represents progress in the financial world. When Buffett invests, he evaluates the business. He is not striving to achieve superior quarterly performance results, but rather he is interested in achieving superior long term results. Buffett's approach is simplistic, logical and yet retains an incredible track record of success.

Buffett believes that investors and businesspersons should look at a company in the same way. A businessperson most often looks at how much cash can be generated from a company and investors should do the same. Buffett has told us that over time, the price of a company's stock will track to its underlying business economics. Therefore, study and understand a business thoroughly before deciding to invest.

Buffett has experience in operating businesses, and this is something he values greatly. Buffett said "one day on land is worth a thousand years of talking about it and one day running a business has exactly the same kind of value".

Another key aspect to Buffett's approach to investing is in evaluating management. We have seen with the Berkshire investments reviewed in this book, that Buffett invests in companies that possess shareholder-oriented managers. Other managerial qualities that Buffett respects include the ability to control and cut costs and resisting the institutional imperative of blindly following what others in the industry are doing.


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This concludes the review of the Warren Buffett Way.

The Role Of Randomness

Dr. Nassim Taleb is a writer and scholar who used to be a derivatives trader. In his work, he contends that society overestimates the value of patterns from the past and underestimates randomness in attempting to predict the future. This effect had a direct impact on him as a trader, where he found his peers would rely on past data while he could find profits in taking advantage of this phenomenon.

Here he is explaining how the banking crisis was caused by false confidences in quantitative risk management:



Here is an introduction to Taleb's book, Fooled by Randomness, written by Frank Voisin and re-printed here with permission:

Prologue
Taleb starts out with the point of the book - to explore luck “disguised and perceived as non-luck (that is, skills).” So many of the successful among us, he argues, are successful due to luck rather than reason. This is true in areas beyond business (e.g. Science, Politics), though it is more obvious in business.

Our inability to recognize the randomness and luck that had to do with making successful people successful is a direct result of our search for pattern. Taleb points to the importance of symbolism in our lives as an example of our unwillingness to accept randomness. We cling to biographies of great people in order to learn how to achieve greatness, and we relentlessly interpret the past in hopes of shaping our future.

Only recently has science produced probability theory, which helps embrace randomness. Though the use of probability theory in practice is almost nonexistent.

Taleb says the confusion between luck and skill is our inability to think critically. We enjoy presenting conjectures as truth and are not equipped to handle probabilities, so we attribute our success to skill rather than luck.

The book is organized into three parts:

  • Part One: Solon’s Warning
  • Part Two: Probability Biases
  • Part Three: Tricks To Help Ourselves

Sunday, December 7, 2008

The Intelligent Investor: Chapter 20

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

In this the final chapter, Graham distills the secret of successful investment into building a “Margin of Safety” into each and every investment. What is a margin of safety? It is coming up with a valuation of the underlying business, and then paying less! Warren Buffett describes this as building a bridge that can carry 30,000 pounds, and then only driving 10,000 pound trucks across it. Know the value, then pay less, and don’t cut it close!

How does one do this? Here are some key points:

  • Not overpaying for a security just because it is the latest market darling
  • Buying good companies that are undervalued
  • Diversifying across multiple companies and industries
  • Having a portfolio that is both bonds and stocks and reviewing the allocation at regular intervals (not every time the market seems to be throwing a fit)
  • Having the courage to buy even when the market is saying something else.
  • Having the courage to ignore the daily market fluctuations and hold on to the investment until the underlying fundamentals change
  • Recognizing that it is better to be safe and careful than to take risks in an effort to earn above-average returns

Preferred Shares Get Theirs

When lending standards toughen, companies work to improve their liquidity positions. One of the easiest ways to improve liquidity is by cutting dividend payments: unlike cutting marketing or research expenses, a company doesn't hurt its operations by saving money by way of stopping its dividend.

However, preferred stock dividends are often cumulative, meaning if payments are put on hold, they must eventually be paid out before common stockholders receive a dime. As such, it is important for investors of common stock to take into consideration the value of cumulative dividends owed. These will not show up as liabilities on the balance sheet, but for common stockholders they most certainly are liabilities! Therefore, they must be manually subtracted from an investor's valuation of a company, along with the value of the preferred shares themselves.

On the flip side, this represents an opportunity for investors willing to foray into the preferred stock space. As discussed in this chapter of Security Analysis, some healthy companies act conservatively and do not pay out preferred dividends for years at a time. As such, they have cumulative dividends owing. When the company is ready to pay common stockholders, these cumulative dividends in arrears have to be paid out first, to the current holders of the preferred shares. Therefore, purchasing preferred shares where large cumulative dividends are owed can represent great upside if the company's financials are sound.

Saturday, December 6, 2008

The Warren Buffett Way: Chp 7 Part 5: Equity Marketable Securities

Wells Fargo

Wells Fargo is a large U.S. based bank. In October of 1990, Berkshire announced that they had purchased 10% of the bank's common shares at an average price of $57.88 per share. This purchase occurred during a time of fear in the market, especially towards banks like Wells Fargo that had exposure to West coast commercial and residential mortgages. The fear emanated from a widespread belief that a recession would cause significant losses in the real estate market.

Berkshire had acquired 98% of Illinois National Bank in 1969 and therefore Buffett was familiar with the banking business. Buffett believes that banks are commodity-like businesses, and therefore management is the most important factor for a banks success.

Buffett wrote that "banks don't have to be bad businesses, but often are". He feels that mistakes by bankers, specifically the issuing of bad loans, is the most likely cause of banks' problems. Buffett also commented that "you don't have to be number one in the banking industry, what is important is how you manage your assets, liabilities and costs". According to Bufett, if a bank is well managed, "it can earn 20% on equity, which is better than the average of what most other businesses earn."

One important operating measure of a bank is how they control their costs. Buffett and Munger felt that the Wells Fargo managers, Carl Reichardt and Paul Hazen were the best in the banking business. Carl Reichardt in particular, was legendary in his ability to control costs. Munger commented that Berkshire's investment in Wells Fargo represented a bet on the management team.

Despite Buffett's claim that he "underestimated the severity of the California recession and real estate troubles", Berskhire's investment in Wells Fargo common shares rose in value to $137 per share by the end of 1993.

Doing Business With The Donald

Consider Donald Trump. Twice, his company Trump Entertainment (TRMP) has gone bankrupt, causing shareholders to lose their investments while personally he has done just fine. His public feuds with Martha Stewart, Rosie O'Donnell, Carolyn Kepcher and his nasty divorces with ex-wives Ivana and Marla Trump suggest an exceptional lack of good judgment and a strong willingness to throw business partners and companions under the bus.

It now appears that for a third time, Trump Entertainment will go bankrupt as it has recently missed a bond payment. As a result, its stock now trades at $0.24 cents a share, down from over $20.00 about a year and a half ago. Trump himself is not worried, claiming less than 1% of his net worth is tied up in TRMP.

In his last book, Trump brags that he loves to crush the other side, and mocked banks that had made loans to him that he has renegotiated down.

With this in mind, why would anyone want to do business with this man? Whoever does so, for publicity or other reasons, gets what they deserve. One such lender is finding that out the hard way, as this week Trump is suing Deutsche Bank (DB) for $3 billion, for trying to collect on a $40 million loan that Trump personally guaranteed on a real estate project that has gone bad. Trump is claiming that the current state of the economy is beyond his control, and that since the contract has a force majeur clause (normally reserved for fires/floods etc) allowing leniency for "any...event or circumstance not within the reasonable control of the borrower", his debt should not be payable.

Deutsche Bank's mistake was doing business with this man in the first place. When we met with Warrren Buffett earlier this year, he spoke of only doing business with managers with good character. He claims a big part of his success is due to the fact that he has a 90% success rate in choosing such managers. His method of filtering, however, relies on factors unrelated to the numbers in the deal. Instead, he uses body language and factors such as the things that person talks about, what that person considers important, what they laugh at, etc. Doing business with those without honour is asking for trouble.

Friday, December 5, 2008

The Warren Buffett Way: Chp 7 Part 4: Equity Marketable Securities

Guinness plc.

Guinness plc (known today as Diageo), is a manufacturer and distributor of premium alcoholic beverages. The company was Berkshire's first significant foreign investment. Buffett commented that he viewed Guinness plc as a company much in the same was as he viewed Coca-Cola and Gilette. Similar to Coca-Cola and Gilette, Guinness plc earns a substantial portion of its revenues internationally. Another parallel is that both Coca-Cola and Guinness plc have some of the best beverage brands in the world and were highly profitable companies.

At the time, Guinness plc was the most profitable alcoholic beverage company in the world and second only to Coca-Cola as most profitable beverage company in the world. Berkshire purchased common shares in Guinness plc in 1991, when the company's earnings growth rate was slowing from the previous 25% annual rate.

In 1991, if you assumed the company would grow earnings at 10% per year for ten years and then 5% thereafter, using a discount rate of 9%, the present value of the company would be around 21 billion British pounds. In 1991, Buffett bought shares of Guinness when the market cap of the company was around 9.4 billion British pounds. Buffett managed to buy the company at a 56% discount to the estimated value of the company.

Beware The Big Bath

It is usually in economic times like these, where earnings are generally poor, that managements will incur asset write-downs and/or restructuring charges. This phenomenon is known as the "big bath". When earnings are negative, a further reduction in current earnings changes little in the way of currently non-existent management bonuses, but sets the company up for artificial earnings gains later, when bigger and better bonuses are to be had as a result.

A simple example presents itself in the form of the acceleration of an asset's depreciation. By writing said asset down now, earnings become more negative, but in the future this asset no longer needs to be depreciated to the same extent, resulting in an artificial earnings boost in the future.

When analyzing a company that is undertaking such charges/write-downs, investors should distinguish between asset impairments (like that of the depreciation example above) and restructurings, where changes to operations are expected to incur additional costs (severance pay, etc.). In the former case, the impairment is only of an accounting nature and is therefore a write-down of of past cash flows, while in the latter, future cash flows are affected.

In this paper by Francis, Hanna and Vincent (1996), asset write-downs were found to result in poor stock market returns, suggesting the write-downs were caused by poor business conditions (no shock there!). Restructurings, however, resulted in positive stock returns, as the market's perception implied an expectation of an improved profit outlook as a result of the upcoming operational changes.

While Wall Street may fall victim to this type of manipulation due to its focus on current earnings (as discussed on this site many times, as well as in this chapter of Security Analysis by Ben Graham and David Dodd), investors can protect themselves to some extent by focusing on average earnings over a business cycle, thereby smoothing out the effect of any earnings manipulations that might be taking place.

Thursday, December 4, 2008

The Intelligent Investor: Chapter 19

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Graham is a big supporter of shareholder activism, urging shareholders to demand explanations for poor results, and to support the removal of poor managers.

Many shareholders fail to be active enough, but Graham says this is alright, because a new mechanism has been created to do the same thing. Graham is referring to the market for corporate control. Poor management leads to poor market prices, which paints a big red target sign on the company for potential acquirers. The price that is bid is generally the amount that the company would be worth if it had competent management. This has become increasingly important in today’s market, where highly capitalized hedge funds are ready to gobble up underperforming companies.

Conclusion: Companies with poor management may have poor valuations, which make them targets for acquisition. This is good for investors who will see a control premium added to their share price upon acquisition. But, going back to the AOL-Timewarner example, make sure the company acquiring is not trading its own overvalued shares for your undervalued shares, otherwise you may end up in an even worse situation.

Also recognize that, as a shareholder, you become an owner of the company. Act like you would if you were owning a small restaurant and had hired a manager to run. If that manager performed poorly, you would demand results. You would be vigilant in overseeing that manager. Don’t lose sight of your position as owner of the company.

H Paulin: Safety First

The first rule of value investing is to never lose money. An investment in H Paulin (PAP.A), a manufacturer and distributor of nuts, bolts and 75,000 other stock keeping units, appears to offer investors such an opportunity. The company's inventory and accounts receivable add up to $82 million, while all of its liabilities total just under $39 million, for a difference of $43 million. Meanwhile, the company trades for just $20 million on the market.

Therefore, even in a liquidation situation, investors are protected to a great extent. As a going-concern, one can look at this situation as akin to buying the inventory and receivables of this company for half price while still getting all the fixed assets and customer relationships for free!

A couple of days ago, we saw a similar situation to this when we looked at Shermag, which was burning through cash. However, this is not the case for Paulin: its operating income continues to be positive as its distribution business profits make up for its manufacturing losses.

As such, the fixed assets of this company may not be worth much (but remember, you're getting them free!), as the auto industry customers the company serves are going through a tremendous downturn. On the other hand, the customer relationships (another freebee!) appear very valuable: Paulin has managed to position itself as a supplier of choice to The Home Depot (HD).

As The Home Depot concentrates on consolidating its suppliers, Paulin has been a clear winner, having secured valuable sales contracts with this customer until at least 2011. As a result, despite slowing sales at Home Depot, Paulin's sales to Home Depot have increased year over year in the double digits thanks to market share gains within the stores.

As such, a big component of Paulin's sales and accounts receivable are from The Home Depot. Therefore, it's worthwhile ensuring HD is financially stable and able to pay its debts. As we looked at here, despite the exceptional downturn in HD's industry, it is in no danger of going away: interest coverage, cash flow, and liquidity appear strong enough to outlast even the most severe downturn.

There's no such thing as guarantees. H Paulin may make mistakes causing HD to cancel its contracts, or it may blow its profits on what turns out to be unprofitable ventures. But a portfolio of companies made up of "Paulins", trading at discounts to liquid assets and having positive earnings and cash flow, is sure to offer investors outstanding returns over the long term.

Disclosure: The author owns long positions in both PAP.A and HD.

Wednesday, December 3, 2008

The Warren Buffett Way: Chp 7 Part 3: Equity Marketable Securities

In 1990, General Dynamics (GD) was the second largest U.S. defence contractor in the United States. The company focused on building nuclear submarines and armored vehicles. In 1990, the Berlin Wall was brought down signalling the end of America's cold war. Soon after the event, General Dynamics CEO, William Anders, realized that the defense industry had significantly changed and decided to reorganize GD's business.

Anders started selling off GD's business units and assets that did not display franchise like characteristics. Ander's only wanted GD to be in businesses that were market leaders and that could achieve a balance between research and development and production capacity. With significant cash on hand generated from the rationalization of GD's assets, Anders declared the company would buy back 30% of its shares as way of a Dutch auction. Warren Buffett took an interest in GD after Anders' announcement of the company's intent to buy back its shares.

By July 1992, Berkshire had acquired 4.3 million shares of GD. Buffet explains that "seeing an arbitrage opportunity, I began buying the stock for Berkshire, expecting to tender our holdings for a small profit." Buffett explains that after studying the company more intently, he became very interested in holding onto the shares due to the rational strategy that Anders was executing and the sense of urgency that Anders displayed in executing his tasks. Buffett also liked the fact that Anders was shareholder friendly.

Berkshire invested in GD's common stock at $72 per share and within two years, received $52.60 of dividends for each share held and witnessed the share price rise to $103 per share. Anders' actions of divesting the company's underperforming assets and returning the excess cash to shareholders resulted in a tremendous increase in shareholder value.

Easy Win: Curb Rent Ceilings

For the US economy to start growing again, many believe the housing market must reach a bottom. Overbuilding coupled with a drop in demand has resulted in an oversupply in the housing market, causing a huge drop in construction. As we saw here, historically this type of construction boom and bust is nothing new to the housing market.

One easy way for certain cities to increase construction in the private sector is to abolish rent controls. Many US cities including New York, Los Angeles, and San Francisco currently have some form of rent control. While these controls are meant to protect tenants against rising housing costs, in the long-term they actually have the opposite effect, as housing supply is left artificially low since there is no incentive to build, and thus new tenants are forced to overpay for scarce supply.

While abolishing rent controls at the present time would cause certain tenants to have to move to more affordable housing, it would only do so where price ceilings are lower than rent market values. In such areas, the overall economy stands to benefit from an increased incentive for builders, resulting in a growing construction industry. The controls don't have to be abolished immediately, but instead implemented to phase out over time, which offers builders incentives to break ground now, while tenants are afforded time to adjust.

Tuesday, December 2, 2008

The Warren Buffett Way: Chp 7 Part 2: Equity Marketable Securities

Gilette is a company known to be a global leader in the manufacturing and distribution of razor blades and toiletries. The company has been a market leader in the shaving market since 1923.

In early 1974, a competitor, Bic, introduced a disposable shaving blade that quickly took 50% of the shaving market. Gilette swiftly countered with their own disposable blade but in the process they found themselves cutting into their own profit margins. Eventually Gilette realized that they would be better off focusing on the higher-end shaving market and thus they abandoned the disposable shaving blade market.

During the period when Gilette was offering a "disposable blade", the company appeared to be a mature, slow growing company and a potential takeover target. During this time, Gilette's CEO fought off multiple takeover attempts. It was at this time that Warren Buffett solicited a friend on Gillette's board to see if Gillette would be interested in a capital injection from Berkshire Hathaway. The board agreed to do a deal with Berkshire.

In 1989, Berkshire made a deal with Gilette for convertible preferred shares and soon after, Buffett joined Gilette's board of directors. Berkshire bought $600 million of Gilette's convertible preferred shares. Within two years, Berkshire converted their Gilette preferred shares into Gilette common shares, which were then worth $875 million.

Buffett understood Gilette's business economics and felt he could make a reasonable estimate about its future. In 1991, Buffett compared Gilette to Coca-Cola and said "Coca-Cola and Gilette are two of the best companies in the world", and "we expect their earnings to grow at hefty rates in the future". For this reason, Buffett, along with Munger, decided that Berkshire should hold onto Gilette's common shares.

All Net-Nets Not Created Equal

Ben Graham, oft considered the father of value investing, found that buying companies trading at a 33% discount to their Current Assets minus Total Liabilities offered investors great returns. The idea is that even at liquidation the investor will get more than his investment, but chances are things will turn around before that's required. For many years, stocks trading at such discounts were near impossible to find in North American markets. Today is a different story, however, as fear has driven the market to such levels that once again stocks such as these exist in droves.

But not all such companies are worth investing in. If the company is burning its assets due to floundering operations, well its liquidation value won't be worth much at all! Consider Shermag (SMG), a furniture manufacturer and distributor. Last year, it had current assets of $48 million and total liabilities of $36 million, yet it was trading at a market cap of just $6 million.

Great value? Hardly not. The company has lost about $15 million per year for the last three years. As it burns through its assets in this manner, it quickly erodes any balance sheet value it appears to have.

When looking through net-nets, be sure to keep in mind that not all of them offer great value. It takes patience and an understanding of the underlying business to ascertain whether you've found a diamond in the rough.

Monday, December 1, 2008

The Intelligent Investor: Chapter 18

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

This is a long and detailed chapter. To do it justice, I would have to reproduce great portions of it, and I think that is beyond the scope of this review. Instead, I will outline some of the key points from the comparisons, without getting into detail about the different pairs of companies.

Look for companies with long histories of dividend payments, prudent investing and moderate growth through conservative debt financing.

Stay away from conglomerates comprised of unrelated companies, that have achieved phenomenal growth through interesting financing methods.

Look for companies selling at a bargain compared to their asset backing (book value). Look for companies with comfortable working capital. Low multiplier companies tend to outperform high multiplier companies.

Be careful when looking at previous growth. Small companies are capable of growing at greater rates than large companies, and as these small companies grow, their growth curves will flatten out. The market may overreact to the previous growth and overvalue the company, believing such growth is sustainable, and this will destroy any bargain opportunities.

Graham’s general observations suggest that, while it is logical for companies with better growth records and higher profitability to command higher multiples of earnings, the intelligent investor must be careful in considering whether the specific differentials in earnings multiples are justified. In many cases, the market becomes overly optimistic and may ignore the underlying soundness of the company while pushing the price high on mere speculation alone.

Again, it is better for most investors to just focus on companies with low P/E multiples. This is a message Graham continuously repeats throughout the book. Zweig does a good job of summarizing this: “If you buy a stock purely because its price has been going up - instead of asking whether the underlying company’s value is increasing - then sooner or later you will be extremely sorry. That’s not a likelihood. It is a certainty.”

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