Tuesday, June 30, 2009

Identifying Cheap

Most (though surprisingly not all!) investors like the idea of buying a stock for less than it is worth. But it's the calculation/determination of what a company is worth that trips most investors up. For some securities, however, determining this value can be relatively easy. For example, if a large proportion of a company's assets have a liquid market (e.g. a mutual fund), the calculation can be asserted with much more certainty.

While real estate is not quite as liquid as most stocks and bonds, it is not far-fetched to say that a company whose assets consist mostly of real estate should trade near its book value.

While some adjustments to book value may need to made to better approximate the current market value of the real estate (e.g. if the land was purchased long ago and has since appreciated), one might expect real estate companies to trade near their book values.

Consider Melcor (MRD), a property development company in Western Canada. A large component of Melcor's balance sheet consists of raw land (purchased over the course of a few years) which it prepares and sells as lots to builders. Another large component of its balance sheet consists of commercial property which it has owned and leased for several years or, in some cases, decades.

The following chart depicts Melcor's price to book ratio over the last two decades:

Melcor is trading, relative to its assets, at levels not seen since the mid-1990s. Readers who are pessimistic regarding the outlook for real estate should note that an investment in Melcor does not require a bullish stance on real estate, since this investment constitutes a purchase of real estate at a discount of approximately 50%! The value of the property does not appear in jeopardy either, as while the pace of sales has slowed down, Melcor is still selling its lots at a gain.

When investor sentiment sours, those who take advantage of the situation by purchasing assets at a discount stand the chance to gain the most over the long term.

Interested in another perspective on MRD, or any other stock that's currently on your mind? One of our sponsors, MarketClub, has offered our readers a free analysis of a stock of their choosing.

Disclosure: Author owns a long position in shares of MRD

Monday, June 29, 2009

Copying The Best

Many people take comfort in buying stocks that others have as well. After all, if other people think a stock is good, there must be something to it, right? Therefore, it should come as no surprise that people love to know what star investors are buying, so that they can buy the same stocks. 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. (One of our favourites is marketfolly.com, which we've discussed here.) Can these be useful in guiding your own portfolio decisions? Absolutely, but only to a certain extent. 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 also 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. Knowing the purchases of managers you wish to emulate can be a useful starting point, but investors who also educate themselves put themselves in positions to make better decisions.

Sunday, June 28, 2009

The Psychology Of Human Misjudgement: Pain-Avoiding Denial

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

The perfectly sane mother of a soldier who had not been heard from since World War II refused to believe her son was not alive and well. In order to avoid the pain she would feel from acknowledging his death, she distorted the facts in her own mind. This is what Munger refers to as simple, pain-avoiding, psychological denial.

It is difficult to criticize an individual who has used this denial to shield themselves from pain, but Munger finds it an admirable trait that others prefer to live by a different creed: "It is not necessary to hope in order to persevere."

While Munger believes we all use this form of denial at various points in our lives, it is particularly visible when used by those who suffer from some form of chemical dependency. Those under the influence of addiction often believe themselves to be in respectable condition with good prospects, when this is clearly not the case.

Saturday, June 27, 2009

The Psychology of Human Misjudgement: Influence From Association

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Humans tend to form judgements based on factors that may be irrelevant. This tendency of humans to be influenced by association is well understood by advertisers. In this way, people can be tricked into believing things that are not true. For example, producers will sometimes charge a higher price for a product only because customers perceive its quality to be higher due to the higher price. The association can even be trivial: if a pretty girl is pictured on the product's packaging, this too can drive buyers to be influenced to purchase.

However, Munger argues that the ramifications of this tendency that are caused by advertising are relatively trivial. The most important miscalculations due to this tendency come from improper associations with past successes, and liking/disliking to the point of ignoring relevant factors.

For example, if a man has success at a casino, he will associate that success with particular behaviours, and believe that his success can be repeated. All too often, he will wager - and lose - far more than his initial gains. Traders who are blessed with early success will often believe they are superior speculators, only to fall victim to their overconfidence. Munger argues two antidotes to combat this improper association: 1) look for accidental, non-causative factors that led to the initial success, and 2) look for dangerous aspects in the new venture that were not present in the old.

When it comes to liking/disliking to the point of ignoring relevant factors, Munger uses the example of man's (un)willingness to listen to bad news. People who "blame the messenger" often find themselves living in realities void of bad news and also void of fact. Munger uses examples from Ancient Persia, two major oil companies, and CBS to illustrate the detriment of ignoring bad news. To counteract this tendency, Munger claims Berkshire has a policy of "Tell us the bad news promptly; the good news can wait."

Friday, June 26, 2009

News From 1930

All too often, investors either ignore or are unaware of historical precedents to today's economic issues. Whether it be the oft-repeated bullish proclamation "They're not making any more land!" (due to a lack of recognition of the repeated boom and bust nature of the housing industry), or beliefs that well-operated, efficient businesses will be quickly erased by emerging technologies, the lessons of history often go unheeded.

One site that offers temporary reprieve from the mentality that we are in uncharted waters is News From 1930. Each day, readers are given a summary of the news on this date in 1930! Following the stock market crash in 1929, investors in 1930 were in a similar position to investors today: is a recovery on the way, or is there more gloom on the horizon?

Of course, we know (or can find out) what happened in the years following 1930, and that doesn't help us determine what will happen tomorrow. However, by educating ourselves on the events that took place in prior recessions, we gain an understanding of where this recession fits (both in magnitude and in velocity) in a historical context, and what needs to take place before a recovery takes place.

Thursday, June 25, 2009

Site Update: 1 year and 600 subscribers!

Some of our regular readers may have noticed that this site recently celebrated its first birthday! We'd like to thank all our readers for making it a success. This is hopefully only the beginning of the value investing community that is being built here, and to that end there are some exciting new announcements coming up in the next few weeks!

This site also recently eclipsed the 600 subscriber plateau, but we can also tell that there are many visitors who are not subscribers. To subscribe (for free) to the site's content, visitors may click on the orange squares to the right of this post for either e-mail or RSS subscriptions. For an overview of what this entails, see here.

While we already have a link at the top of the page for readers to access the site's most popular articles, the nature of that page is such that the content does not change frequently. As such, we have decided to provide a list of articles in the last 3 months that readers have appeared to take an interest in by traffic and/or links. The articles are in chronological order. Enjoy!


Wednesday, June 24, 2009

Don't Just Buy Any Net-Net

During recessions, with this one being no exception, value investors usually rejoice at the opportunity to purchase stocks at discounts to their net current asset values. That is, stocks that trade for less than their current assets minus their entire liabilities. While purchasing an "index" of net-nets should result in above average profits (if history is any guide), further careful analysis can lead to even higher returns.

Not all net-nets are worth investing in. If the company is burning its assets due to floundering operations, its value (liquidation or otherwise) 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. 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. Today, it trades for $300,000, but the drop in value should have caught no one by surprise.

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.

Tuesday, June 23, 2009

It's About Returns, Not Profits

All too often, the media is concerned with a company's absolute profit level in determining how successful a company is. However, what's more important is the company's return on its invested capital, since that has a stronger effect on:

1) The cash flows to the shareholder, and
2) Whether the company has opportunities to grow going forward.

Let's say Company A and Company B both make $1000 / year, and have been growing their profits at 10% per year. Company A and Company B are in the same industry and are similar, except for the fact that Company A has assets worth $5000, while Company B has assets of $20,000. Assuming they were selling for the same price, which company would you rather own?

It may seem like Company B is more desirable. After all, who wouldn't want to own $20,000 worth of assets rather than $500? But actually, if you believe in the growth prospects of this industry, Company A is the better investment! It comes down to "return on assets" (which is sometimes substituted for it's cousin, return on invested capital), which is a measure of what kind of return an investor gets on his money.

For each dollar Company A invests in its assets, it gets $0.20 in earnings, while Company B only manages $0.05. If these companies were to grow their earnings by $100 this year, the owner of Company A would only have to invest $500 for that return, allowing the remaining amount to be paid as a dividend or to repurchase shares. On the other hand, the owner of Company B would have to invest $2000, which means he won't see any of that $1000 profit from last year, and the company would need further financing such as bank loans.

All too often, investors see growth in a company's future, but fail to consider the costs of that growth. All companies require investments in assets in order to support growth, whether it's in the form of fixed assets, working capital, or the acquisition of other firms. The companies with the best return on assets (or return on invested capital) are the ones that reward their investors with cash, not just paper profits.

Monday, June 22, 2009

When Customers Are Too Few

One of the most important risks facing a company is that demand for its products will drop. That risk is lessened if the company has a wide assortment of products that it sells to a large number of customers. Conversely, if customers are highly concentrated, the company faces additional risk.


Consider JAKKS Pacific (JAKK), maker of toys and related products. While the company enjoyed over $900 million of sales last year, consider the concentrated sources of that revenue:


While none of these companies is in imminent danger, they must be constantly monitored to ensure things stay that way. For example, consider how Magna International's sources of revenue went from a strength to a weakness in the course of a few years.

Of course, a customer's potential bankruptcy is not the only cause for concern when a company has a concentrated number of clients. The company under consideration is also subject to the whims of its customers, who can leverage the importance of the relationship to the company by pushing down profit margins. Wal-Mart, JAKK's largest customer, has a history of squeezing out every last penny from its suppliers, particularly those who are dependent on Wal-Mart for the bulk of their revenues.


By considering and understanding the sources of a company's revenue, investors can better shield themselves from being blindsided by downside risk.

Disclosure: None

Sunday, June 21, 2009

The Psychology Of Human Misjudgement: Reciprocation

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Humans, apes, monkeys, dogs, and other animals all share the tendency to reciprocate. When someone does something nice (mean) to you, you tend to do something nice (mean) to them as well. The tendency fosters cooperation within groups, and also protects groups from the ill-intentioned.

The power of this tendency is strong, and can drive individuals to perform brutal acts. For example, in wars sometimes prisoners are not taken (but rather killed) when one side believes the other side is treating its prisoners unfairly. Non-war examples of disfavourable actions as a result of this tendency are road rage and injury-causing temper tantrums on athletic fields.

Munger notes that, whether good or bad, humans are not programmed to turn-the-other-cheek. The best antitode to falling victim to disfavourable actions resulting from this tendency is to defer reaction. Munger quotes Tom Murphy, whom Buffett has often called one of the best managers alive, who frequently says, "You can always tell the man off tomorrow, if it's such a good idea."

Positive reciprocation is just as strong as well. Marriage and commercial trade are listed as examples where this reciprocation fosters strong relationships. Because it is often a subconscious behaviour, one's tendency to reciprocate can also be taken advantage of. For example, when an automobile salesman offers small favours, you are more likely to accept a final sale price that is $500 higher than otherwise. A man who is spending someone else's money (e.g. the manager of a company, a government employee) are more likely to fall into this trap, since he is not the one who has to foot the bill. Sam Walton (the man who started Walmart) recognized this tendency early, causing him to implement a policy disallowing purchase managers from receiving gifts of any kind from vendors.

Saturday, June 20, 2009

The Psychology Of Human Misjudgement: Envy

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Envy is fairly commonly understood by humans, yet one will not find it discussed in psychology texts. Munger believes Warren Buffett to be roughly correct when he says "It is not greed that drives the world, but envy." Yet the words 'envy' and 'jealousy' were often absent from the indexes of psychology textbooks Munger has studied.

Munger argues that the origins of envy are the result of a desire for man to acquire scarce resources, and then the feelings of conflict associated with seeing those resources in the hands of others. Munger also notes that jealousy is fiercest among siblings, particularly at younger ages. It is also exaggerated in myth, religion and literature, as in many of those accounts it triggers hatred and injury.

In modern life, jealousy is visible in many forms. University communities are driven to anger when it becomes known that an employee in money management or surgery is given annual compensation far above standard professorial salaries (in order to compete with what the employee could command in private employment). In order to avoid conflicts and hurt feelings, many large law firms will treat all senior partners alike, even if their contributions to the firm coffers are widely different.

Munger also believes this tendency to be a taboo topic, as labelling someone as jealous is considered to be an extreme insult. While this may be an explanation for why the term is absent from psychology textbooks, Munger believes it accounts for so much of man's behaviour that it should be regarded as an important topic.

Friday, June 19, 2009

Screening For Value

Google Finance is easy to use and provides useful glancing information across a vast plethora of individual stocks. Unfortunately, that's where its utility ends. As we've discussed before, it contains a great number of errors, some of which (e.g. dividend information) are systematic and therefore not simply specific to a particular stock.

We often get asked how we screen for value stocks. While Google Finance once again provides an intuitive and user-friendly tool in this regard, it falls far short of providing the necessary categories that a value investor requires. For the resourceful investor, however, there are other options!

One useful tool we have come across is provided by Financial Visualizations at finviz.com . In addition to being able to search across standard screens available on many other sites, investors are offered screening options above and beyond what one would normally expect. For example, should an investor be interested in all stocks with an expected 5-year EPS growth above 10%, ROE above 10%, debt-to-equity under 1, insider ownership above 10% of market cap, gross margins above 20%, a quick ratio above 3, that institutional investors are bearish on, this site will provide a list of stocks that match this criteria.

While sites such as these can be useful for screening purposes, it can never replace the diligence and careful analysis required to properly value each security in which an individual is interested in investing. The screening tool is the beginning, not the end, of the investment determination process.

Disclosure: None


Thursday, June 18, 2009

The Money Fortress

Fortress Paper (FTP) is not your average paper company. While many paper companies struggle with volatile pricing (thanks to the fact that paper is generally a commodity product), shrinking demand, and industry overcapacity, Fortress Paper has been printing money - literally.

The company supplies high-end security paper to central banks for the purposes of supplying currency. As central banks attempt to stimulate their economies by printing currency, Fortress Paper has benefitted, as its security-paper segment operates at full capacity.

Despite the strong outlook, the company trades with a P/E of just 6 and a P/B under 1. The company has managed to stay profitable throughout the economic downturn, and does so with a current cash balance of $19 million (compared to its $70 million market cap).

Growth mongers will love the fact that the company is considering tripling its capacity for security-paper, but value investors may see this as a reason to proceed with caution. An increase in capital expenditures of this magnitude is always a risk: large sums of cash are diverted away from shareholders in exchange for uncertain returns.

While the company does generate good returns on equity, it has a short record as a public company, having IPO'd in 2006. For those who believe strongly in its growth story, this represents a terrific buying opportunity. For those of us who would rather see a stronger track record along with a less uncertain future, Fortress Paper certainly qualifies as worthy of keeping an eye on.

Disclosure: None

Wednesday, June 17, 2009

Perverse Incentives

Much has been made of the $100 million salary of Chesapeake Energy (CHK) CEO Aubrey McClendon in 2008. This salary would be high even for a company providing phenomenal returns for its shareholders, but is particularly shocking considering that the company endured a 56% loss in market value during the year. Even more infuriating for shareholders is the fact that the company recently purchased McClendon's historical map collection for over $12 million. The most disturbing aspect of this situation, however, is how these transactions came to be and the resulting dangerous incentive system at Chesapeake which will likely cause the company material harm for years into the future.

As Charlie Munger has told us, "The most important rule in management is to get the incentives right." But Chesapeake's board appears to be transferring wealth from shareholders to McClendon in order to help offset losses which were the result of McClendon's own risk-taking: during 2008, McClendon purchased Chesapeake shares on margin, and was forced to sell these shares at a loss on October 10th. McClendon's $75 million bonus and the map collection purchase took place at the end of the year. While McClendon would likely have been the sole beneficiary of his margin position had Chesapeake stock soared, his downside risk appears to be subsidized by Chesapeake's shareholders!

A perverse incentive situation such as this encourages reckless and risky behaviour on the part of managers. Managers are more likely to take undue risks, due to the rewards that come with positive outcomes and the muted financial punishments that come with negative outcomes. It is also not surprising that the company had positive earnings of over $700 million for 2008 (showing strong results while it released the details of McClendon's compensation), but declared almost $10 billion in unusual expenses in the first quarter of 2009. You have to aggregate the company's earnings for the last 5 years in order for Chesapeake's earnings to top its CEO's 2008 compensation!

This is not the kind of company you want to own. But if you own the S&P 500 index, you do own this company.

Disclosure: None

Tuesday, June 16, 2009

The Best Indicator Of The Economy's Future

When sales drop, businesses respond by reducing their inventory levels, causing their suppliers' outputs to be cut. This reduced output level is what is measured by the government-released GDP data. As we've discussed previously, by following the level of business inventories, we can get a clue as to the future output level of the economy. Last week, the US Census Bureau released business inventory levels for April of this year. The following chart illustrates how current inventory levels relate to those of April's past (to avoid seasonal noise):


While we can see that inventory levels have not been this low since 2006, they are still high by historical standards. Of course, sales have also increased since 1992, and therefore this chart doesn't tell the whole story. A more normalized way to analyze inventories is by dividing them by sales numbers:

The problem with this chart, however, is that sales levels can be volatile (we saw an example of this when we looked at historical data for home inventories, specifically). So while sales to inventory levels could look low on this chart, if sales are unusually high and subsequently correct, there will be abrupt changes to this chart, as is the case in the latter half of 2008.

Taken together, however, the two charts suggest that while absolute inventory levels are going in the right direction (to lay the groundwork for future output to be required), demand is so low that sales to inventory levels are still high. Until this number reduces substantially, businesses will have no need to increase output, and thus the economy will remain stagnant. While the government attempts to spur demand to encourage output increases, it remains to be seen whether this effort will be substantial enough to have the desired effect. We may instead just have to wait for these inventory levels to come down before they can go back up.

Monday, June 15, 2009

Profiting From Inefficiencies

Compared to the mainstream finance industry, value investors tend to hold a lot of cash in their portfolios. This is due to the fact that:

1) Value investors are stingy and therefore only purchase when there are blatant mispricings, and

2) Mainstream finance professionals believe higher returns only come from higher risk; therefore to maximize returns it makes sense for them to be fully invested

During times of (often irrational) market exuberance, however, value investors look like chumps, as their cash holdings return far less than the risky holdings of their mainstream peers. When the market eventually crashes, however, their cash positions allow them to profit from pricing opportunities that have become available due to market fears.

The current recession has given many cash hoarding value investors the opportunity to pick up companies at bargain basement prices. On this site alone, during the market lows of late 2008 and early 2009, several companies were discovered as trading far below their intrinsic values: profitable companies with net tangible (and sometimes even liquid) assets in excess of their market values. For example, one such company we owned and liked (before it tripled in value) was Williams-Sonoma (WSM), which was in no danger of going bankrupt, yet traded below its liquidation value.

By avoiding being fully invested during bouts of market exuberance, investors are better able to take advantage of the stellar opportunities which present themselves from time to time in the market. But history has shown that few people can actually refrain from jumping on rising markets. Those that can, however, are in the best position to profit from the market's folly.

Disclosure: None

Sunday, June 14, 2009

The Psychology Of Human Misjudgement: Curiosity and Fairness Tendencies

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

While all mammals are curious, apes are abnormally more curious than other mammals, and humans are by far the most curious of them all. Munger argues that this curiosity can drive the advancement of knowledge, using examples from Ancient Greece, where much math and science was developed out of pure curiosity. Individuals who are more curious than others also benefit from added wisdom long after their formal education is complete.

Munger also argues that man displays and expects fairness to and from others. Man's tendency towards reciprocity is part of this fairness tendency: when someone does something nice for you, you feel like doing something nice for them.

Sometimes, an individual will do something nice for another even when he knows that person will not have occasion to repay them. Man will allow drivers in front of them on the highway and even allow others to advance when they don't have right-of-way. This behaviour pattern may have evolved due to the fact that it makes everybody better off when these acts of indirect reciprocity are performed.

Because fairness has come to be expected, much conflict arises when fairness is expected and not provided!

Saturday, June 13, 2009

The Psychology Of Human Misjudgement: Inconsistency Avoidance

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Man tends to resist all forms of change. Munger argues that this tendency is what leads to the fact that people have habits, be they good or bad. Furthermore, every man will carry many bad habits despite the fact that he knows that the habits are bad. Since man has this tendency to avoid change, in order to avoid bad habits, prevention is far more effective than cure (i.e. it is easier to prevent a habit than change it).

Also as a result of this tendency, man tends not to change his previous conclusions (even when facing convincing new information to the contrary), human loyalties, and role in civilization. Unfortunately, if a conclusion was reached quickly thanks to the "Doubt Avoidance" tendency previously discussed, this tendency to avoid change will lead to many errors in judgement!

Munger paraphrases from Lord Keynes who argued that it was not the fact that ideas were new that made them difficult to accept, but rather the fact that they were inconsistent with old ideas. In other words, people tend to accumulate a bunch of fixed conclusions over their lifetimes, and those conclusions and attitudes will not be reexamined or changed.

Munger argues that this tendency has also been useful to man in many areas. People are loyal to their roles in life as priests, physicians, solders, spouses etc. Unfortunately, when people learn dubious notions, they are also more prone to carry these notions for the rest of their lives. For this reason, Munger advocates that it is "important not to put one's brain in chains before one has come anywhere near his full potential as a rational person".

Friday, June 12, 2009

Market Folly

The following is a guest post by Jay, the author of MarketFolly.com: a site dedicated to tracking hedge fund movements through their portfolios.


We're currently in the midst of our ongoing hedge fund portfolio tracking series (Q1 2009 edition). We track these hedge fund portfolios to get a sense as to where they are putting their money and to gain any possible investing insight from their movements. And, since BarelKarsan is focused on value investing, we thought we would take an in-depth look at a faily well-known value investor: Whitney Tilson and his T2 Partners.

T2, as of the current filing, has $81 million invested on the long side of their value fund. The fund is run by Whitney Tilson and Glenn Tongue and they use deep value investing methodologies. In addition to running his fund, Tilson is very active in the value investing community, releasing hisValue Investor Insight newsletter and organizing the Value Investing Congress, which we typically try to cover. In the past, we've also noted Tilson's bullishness on Berkshire Hathaway (BRK-A).

Tilson launched his investment career in 1999. Taken from his Tilson Funds website, "Mr. Tilson received an MBA with High Distinction from the Harvard Business School, where he was elected a Baker Scholar (top 5% of class), and graduated magna cum laude from Harvard College, with a bachelor’s degree in Government. Mr. Tilson writes a regular column on value investing for theFinancial Times and Kiplinger's, has written for the Motley Fool and TheStreet.com, and teaches financial statement analysis and business valuation for the Dickie Group. He was one of five investors included in SmartMoney’s Power 30, and was named by Institutional Investor as one of 20 Rising Stars." With that in mind, let's dive into their portfolio to see what ideas they may have.

The following were T2's long equity, note, and options holdings as of March 31st, 2009 as filed with the SEC. We have not detailed the changes to every single position in this update, so keep in mind that we're just checking out the major moves. All holdings are common stock unless otherwise denoted.


Some New Positions (Brand new positions that they initiated in the last quarter):
Wells Fargo (WFC), General Electric (GE), General Growth Properties (GGWPQ), Microsoft (MSFT), Costco (COST), Laboratory Corp (LH), Sears Canada (SEARF), Chipotle (CMG), Apple (AAPL), Yahoo (YHOO), PF Chang's (PFCB), AllianceBernstein (AB), and Dominos (DPZ)


Some Increased Positions (A few positions they already owned but added shares to)
Berkshire Hathaway (BRK-B): Increased by 200%
Contango Oil & Gas (MCF): Increased by 180%
Wesco Financial (WSC): Increased by 117%
American Express (AXP): Increased by 98%
Linn Energy (LINE): Increased by 98%


Some Reduced Positions (Some positions they sold some shares of - note not all sales listed)
Odyssey Re Holdings (ORH): Decreased by 76%
Berkshire Hathaway (BRK-A): Decreased by 75%
Fairfax Financial (FFH): Decreased by 72%
Wendys/Arbys (WEN): Decreased by 49%


Removed Positions (Positions they sold out of completely)
McDonald's (MCD) Calls, Barnes & Noble (BKS), Johnson & Johnson (JNJ), Altria (MO), American Oriental Bioengineering (AOB), Lojack (LOJN), Equity Media (EMDAW) Warrants


Top 10 Holdings (by % of portfolio)
  1. Berkshire Hathaway (BRK-B): 12.64% of portfolio
  2. Huntsman (HUN): 9.3% of portfolio
  3. Delia's (DLIA): 5.86% of portfolio
  4. Resource America (REXI): 5.62% of portfolio
  5. Wendys/Arbys (WEN): 5.57% of portfolio
  6. American Express (AXP): 5.47% of portfolio
  7. Winn Dixie (WINN): 5.43% of portfolio
  8. Wells Fargo (WFC): 4.75% of portfolio
  9. Echostar (SATS): 4.3% of portfolio
  10. Contango Oil & Gas (MCF): 3.97% of portfolio

Overall, an interesting look inside his portfolio. The most notable move to us was his brand new purchase of Wells Fargo (WFC). Not only is this a notable move because it is the purchase of a financial, but also because T2 was previously short WFC. As they shorted it down, they started to recognize value and switched their bet. In addition to WFC, T2 was out adding to shares of AXP and WSC, other financial based firms. It will definitely be interesting to see if their entrance into the sector pays off down the road. One last thing we noted was their preference for Berkshire Hathaway 'B' shares over the 'A' shares. They were adding to the B shares but were selling the A shares, as they possibly have found some sort of arbitrage there.

Assets from the collective holdings reported to the SEC via 13F filing were $81 million this quarter compared to $89 million last quarter, so a slight decrease in assets listed on the long side of the portfolio. This is just one of the 40+ prominent funds that we'll be covering in our hedge fund Q1 2009 portfolio series. Check back each day as we cover new fund portfolios. We've already covered Andreas Halvorsen's Viking Global, John Paulson's hedge fund Paulson & Co, Stephen Mandel'sLone Pine Capital, Eric Mindich's Eton Park Capital, John Griffin's Blue Ridge Capital, and David Einhorn's Greenlight Capital, Seth Klarman's Baupost Group, Timothy Barakett's Atticus Capital, Lee Ainslie's Maverick Capital, Raj Rajaratnam's Galleon Group, Shumway Capital Partners (Chris Shumway), Bret Barakett's Tremblant Capital Group, and Boone Pickens' BP Capital Management.


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Thursday, June 11, 2009

Commodity Prices Lie

Commodity prices have been soaring since March. During a recession, it is unusual for commodity prices to rise to such relatively high levels, as demand usually drops, resulting in an overcapacity of supplies causing downward pressure on prices.

So why are prices rising this time? If supplies are currently inadequate, one would expect strong growth in supply production, which should help create employment in an otherwise poor job market.

Thanks to some terrific research by Macro Man, we can see one reason commodity prices have been rising: China is buying more than it needs. The following illustrates this phenomenon by showing China's volume imports for copper, iron ore, and coal over the last several years:



Macro Man's conclusion, which appears to be supported by the evidence above, is that China is stockpiling inventory at cheap prices (cheap relative to one year ago, that is). So while the run-up in prices may cause some to believe that demand is back, it may actually be a warning sign that future demand will drop even further, as the excess inventories China is building up will need to be worked through.

Conduct your forex trading at Forex Capital Markets and learn how investing in the currency exchange market could be a smart move for you.

Wednesday, June 10, 2009

Margin Debt

When the market panicked late last year and early this year, we saw a corresponding reduction in the use of margin debt on the NYSE. As investor sentiment soured, borrowers were forced to sell their positions to cover their debts, further exacerbating market prices. Now that market confidence appears to have returned to some extent, let's take another look at the use of margin debt on the NYSE up to the end of April 2009:

While it appears that the use of margin debt has stabilized, and even increased since its February lows, it is not neccessarily a sign of a market bottom. One only has to look at the use of margin debt over the last business cycle to see why. The chart clearly shows that there were many instances of upticks in the use of margin debt even as the trend continued lower throughout the early part of this decade.

Just because margin debt has stabilized at its current level for now does not mean it's on the way up (which would help buoy prices) or even that it will stay at current levels. Charts like these can help us determine where investor sentiment currently stands as compared to the last decade, not what sentiment is going to be like in the future. Investors who believe the market will quickly return to its former heights are not heeding the lessons of history.

Tuesday, June 9, 2009

GM's Reinvention

GM's new marketing campaign certifies that this is not GM's end, but rather its reinvention. Unfortunately for shareholders, however, this is the end, as the company's shares are virtually worthless. But shareholders should not have been caught off guard. As the following chart shows, for the last several years this company has not brought in earnings commensurate with its increasing debt:

Since 2004, GM has clearly been a company in trouble. Was GM in a position to best its competitors? Not likely! The following chart illustrates the reckless and risky nature in which this business was being run, as early as 2004: 

As we discussed a few months ago, GM and Ford are not value investments that have just gone wrong, as they made almost as little sense as investments then as they do now. While some bankruptices can catch shareholders off guard, this is not one such example - except for the shareholder who does not do his homework.

Disclosure: None

Monday, June 8, 2009

Don't Believe The Numbers

When considering companies for investment, it is easy to take a lazy approach by quickly scanning financial statements and forming conclusions based solely on the numbers. Unfortunately, companies make accounting choices which can drastically alter the meaning of their financial data.

One such choice concerns the accounting treatment of inventory: FIFO vs LIFO. While in the majority of cases this difference is not large enough to matter, it can make substantial differences in a handful of companies, and in the extreme case it could be the difference between a "buy" and a "don't buy"!

Consider A.M. Castle (CAS), a metals and plastics distributor. While it currently lists inventory at $232 million, it has made a conservative accounting choice (LIFO) that not many companies make; its inventory would actually be listed at $340 million were it to adopt the more prevalent FIFO method of inventory accounting.

While this may not seem like a noteworthy distinction (and in many cases, it isn't), consider how this affects the net current asset value of CAS compared to its market value:

Clearly, investors who took the time to evaluate the company's financials by digging deeper than what's on the surface could have found value that others had missed. For a discussion on A.M. Castle's suitability as a potential value investment, see this article.

Disclosure: Author has a long position in shares of CAS 

Sunday, June 7, 2009

The Psychology Of Human Misjudgement: Doubt Avoidance

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Because it has helped our ancestors survive, humans have a tendency to quickly eliminate doubt by reaching some decision. As an example, Munger notes that the worst thing an animal can do in the face of a predatory species is to take time to deliberate.

This tendency is so strong in humans (and other animals), that man must often force himself to be objective when his natural tendency is not to do so. Judges and jurors are forced to delay decisions exactly for this reason. By taking time to consider all issues, rather than following his gut feelings or initial instincts, man can better work through circumstances in an objective manner.

Munger attributes the success of religion in society to this doubt-avoidance tendency. He argues that although individuals may believe their own faith comes from revelation, this does not explain the seemingly inconsistent faiths of others.

Munger believes this doubt-avoidance tendency is triggered by some combination of puzzlement and stress. An unthreatened man, on the other hand, has no need to rush to a decision and is therefore not forced to remove doubt.

Saturday, June 6, 2009

The Psychology Of Human Misjudgement: Like and Dislike

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

The 2nd and 3rd tendencies Munger discusses are human tendencies to like and dislike. Certain triggers cause man (and other animals) to like and dislike others. For example, a baby goose will love and follow the first creature that is nice to it, whether it's its mother or a human being.

A consequence of these tendencies is that man will ignore faults of the object of their affection, favour people/products associated with that object, and distort facts to facilitate that love. Conversely, man will ignore virtues in the object of his dislike, dislike people/products associated with that object, and distort facts to facilitate hatred! Munger uses as an example the fact that mediations between Israelis and Palestinians are difficult because the facts on each side overlap very little.

Man also likes being liked, causing man to strive for the devotion and admiration of those around him. Munger also argues that an individual that loves admirable persons with a strong intensity has a great advantage in life. He says that both he and Warren Buffett are so inclined, and they both admired Warren's uncle Fred in this manner.

Friday, June 5, 2009

Time To Build?

Many more new homes are currently being purchased than they are being built. In fact, this process has been occurring for a span of almost two years now, as builders have slashed construction at a faster pace than buyers have reduced purchases. This has caused steadily decreasing housing inventories, as shown in the following chart:

Obviously, a continuation of this decrease in inventories is not sustainable, as eventually a scarcity of available homes will cause prices to rise and thus invite builders to ramp up construction, which is a bullish sign for the economy. However, that's not to say that such a turnaround is right around the corner. As we saw when we looked at new home inventories over the last two decades, the housing bubble caused a huge upsurge in inventories that buyers are still working their way through.

It is worth noting that the current inventory number still represents a full 10+ months of supply at the current pace of purchases vs just 7 months in January 2007. This is due to the fact that the number of purchases has dropped substantially, despite the now lower inventory level. However, housing demand does fluctuate dramatically; therefore, when judging the level of housing inventories from a long-term perspective, it is often more relevant to consider the absolute level (as shown in the above chart) rather than the months supply - the number often reported by the popular press. 

Thursday, June 4, 2009

Charlie Munger and Belridge Oil

Charlie Munger, Warren Buffett's long-time partner, is quoted as saying he made a big mistake several decades ago in not selling some of his assets to buy more shares of Belridge Oil*. By examining the events surrounding Belridge Oil at the time in question, perhaps we can apply some of the learnings from this incident to our current investment decisions.

While Munger did purchase 300 shares of the thinly traded stock of Belridge Oil for $115 in the late 1970s, he was offered 1500 more shares at this price but chose to pass it up. Despite recognizing that the stock was "ridiculously underpriced", he couldn't bring himself to sell any of his other holdings, even though he could have easily afforded to. That decision ended up costing him over $5 million, as Belridge Oil sold for $3700 per share just two years later!

Belridge Oil was selling for a market cap of about $110 million and a book value of $177 million when Munger declined to add to his holdings**. The real value in this company lay in its proven oil reserves, however. Underneath land it owned in California, it had assets of 380 million barrels of oil***. That means the market was valuing each barrel of oil at 29 cents per barrel, while the going rate was $5-6 per barrel! The value was realized two years later when Shell purchased the company for a price representing about $8/barrel.

Many elements of the teachings of value investors are embedded in this story. Firstly, one shouldn't be afraid to buy a small cap stock or a stock that is thinly traded if it is indeed undervalued (i.e. buy as if markets will be closed for the next several years). Second, companies deemed more undervalued than others should represent a larger holding in one's portfolio. Third, it's easy to get caught up in comparing companies by their earnings, but don't ignore the value of a company's assets. Fourth, the presence of an immediate catalyst is not always neccessary. By buying businesses that the market is undervaluing, superior returns will accrue over the long term.

*** Big Deal, by Bruce Wasserstein.

Wednesday, June 3, 2009

Reducing Risk

The mainstream finance industry defines a company's riskiness by its stock price's volatility. For value investors, there is no such short cut; a company's riskiness is defined by a slew of factors that can affect the business. A few weeks ago, we considered some items that can affect risk on the cost side. Today's post will discuss some items relevant to risk on the revenue side.

First of all, a company's revenue can have varying degrees of cyclicality. What this means is, during recessions, certain industries are hurt more than others. Conversely, these industries tend to do better when the economy is strong. Nevertheless, there is higher risk involved in a cyclical business, since poor conditions can persist and cause companies to be unable to meet their obligations. For a more detailed discussion of this topic, see this article.

Secondly, risk is lower when a company has a "moat" (as coined by Buffett) that essentially protects it from competition. In these instances, revenues are more stable, thereby reducing downside risk. Of course, companies with strong moats are hard to come by.

Revenue risk is also reduced when a company is not depedent on one product, as having multiple lines serve to diversify a company's risk should a competitor make inroads or should a product become obsolete. Having a diverse array of customers also helps, since that way a company's fortunes are not tied to the health of companies outside of its control. (This was an important factor when we answered a reader's question on auto parts suppliers a few months ago.)

Finally, it's important to understand how persistant current revenues are. Does the company need to keep innovating just to hold revenues steady, or has it already done most of the work? As an example, contrast Walmart with Apple. Apple's earnings are only as good as its latest products, and it must make sure to keep producing products that customers value, which won't be easy over the long-term. On the other hand, Walmart already has a presence where it can sell the products customers value, without having to innovate anew!

While it's impossible to predict the future, investors can better protect themselves from unforeseen events by choosing companies which are less susceptible to revenue declines. By considering the factors discussed above, downside risks can be reduced.

Tuesday, June 2, 2009

Small Cap Rap

Our regular readers have undoubtedly noticed that we have a tendency to discuss small cap stocks quite a bit on this site. Why? Because among the small cap universe some of the most inefficiently priced stocks can be found. They carry little in the way of name recognition for retail investors, and they don't move the dial enough for institutional investors. As such, for those who can read/interpret/understand financial statements, small cap stocks offer up some great opportunities.

But while we've discussed stock investment research sources for individual investors, most of these sources are focused on large caps, as that's where the traffic's at. One site, however, is devoted entirely to small caps: Agoracom is a site dedicated to providing information and promoting discussion of small cap stocks.

There is one caveat, however. Its business model derives revenue not from advertising, but from the small cap companies themselves. Many small caps struggle to get their names out there to investors, and so they are willing to pay Agoracom to discuss their companies. As such, it is unlikely you will find much in the way of negative information. Nevertheless, investors looking for info on small caps can find discussion forums, filings, quick facts and other useful information that could eventually lead to an investment decision. 

If you use or have other useful sources for small cap investing, please feel free to share them in the comments section below.

Monday, June 1, 2009

Channel Stuffing or Poor Predicting?

A reader recently pointed out the fact that LoJack (LOJN) appears to be "channel stuffing" its international sales. What exactly is "channel stuffing" and how does one detect whether it's taking place?

Channel stuffing is the practice of selling more products to one's customers than the customers can sell to their customers. (For a more detailed description, see here.) In the short-term, this can increase sales (and therefore profits), but it can't be sustained forever since the customer's inventories will continue to bloat until there is finally a day of reckoning.

To determine whether a company in which you are considering investing is stuffing its channels, the first stop is the revenue recognition note to the financial statements. For example, here is what LoJack has to say about how it recognizes revenues from international customers:

Revenue relating to sales to our third party installation partners is recognized upon shipment, which is prior to the installation of the related products in the consumer’s vehicle. Revenue from the sales of products and components of the LoJack System to international licensees is recognized upon shipment to the licensee or when payment becomes reasonably assured.

Basically, LoJack recognizes a sale once it has shipped the product to its international 'licensee', or customer. While this is not the most conservative method of accounting (since the product has not actually been installed in anyone's vehicle at the time the sale is recognized), it is not all that unusual.

The next step we would take is to compare the number of units shipped to the licensees over the years to the number of end-customer installations the licensees have actually performed. This would give us a good idea of what licensee inventory looks like, and we used a similar analysis to view the channel stuffing status of Harley-Davidson with respect to its dealer network. Unfortunately, LoJack does not provide such numbers.

But that doesn't mean our journey ends there. Another useful indicator of channel stuffing is whether the company's receivables account has been growing at a disproportionate rate. If the company is enticing customers to "purchase" products by offering generous financing (i.e. "Just accept delivery, you can worry about paying us later!"), it will show up here.

In LoJack's case, there is enough disclosure to determine that at least $22 million of its year-end 2008 A/R is owed by international licensees, compared to 2008 international sales of $64 million. This represents a long 128 days between when a customer receives the product and when it pays for it, compared to a much shorter 90 day period when using the comparable numbers from 2007.

While this may look like damning evidence, investors must keep in mind that international customers represented just 15% of last quarter's sales. Furthermore, this situation appears to be correcting already: as per LoJack's latest results, international sales fell 61% versus the year-ago period. It would appear that international customers are paring down inventory, as it is unlikely that end-consumer installations fell by such a large amount. Furthermore, we only have a snapshot of receivables at one point in time; if an abnormally large shipment was received in the days before the year-end, the numbers we use don't tell us the full story.

With the following line, LoJack also hints that poor predictions by its international customers had them ordering far more products than they needed:

Our international unit volume and revenue reflect...the effects of a build-up of inventory at the end of 2008 by certain licensees in anticipation of better economic conditions during 2009. The economic uncertainty in the international markets has impacted the buying patterns of our licensees, as they work to...minimize inventory.

The bottom line in all this? As usual, it's hard to know for sure. By objectively considering the issues discussed, investors should make up their own minds as to whether something fishy is going on, or whether the economic slowdown that occurred last quarter caught some customers off-guard. 

For a discussion of LoJack as a possible value investment, see this article.

Disclosure: Author has a long position in shares of LOJN

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