Saturday, July 31, 2010

Reminiscences of a Stock Operator: Chapters 3 & 4

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

Livermore was desperate to learn where he was going wrong in his legitimate trading, but having lost all his money he had no choice but to return home. But the bucket shops were closed to him, and were fewer in number as the authorities cracked down on them. He made some money trading through a friend in the bucket shops, but soon the bucket shops became wise to his friend as well.

By chance one day he ran into a friend of a friend who had an interest in a "legitimate" broker that could get faster execution than the New York firms Livermore had lost his money with. Livermore couldn't understand how this could be done, but realizing execution speed was the key to his success so far, he investigated. Livermore found a class of firms that were one level above bucket shops in that they did some legitimate trading, but they were mostly bucket shops and so they would give him immediate execution based on the latest available price. These firms would make money by simultaneously telegramming some clients to buy a certain stock and some clients to sell that same stock. The firm would buy a little bit of the stock for real so that the operation seemed legit, but in the end they would profit off of their clients' losses.

For Livermore, these companies offered a bucket shop environment (which is one in which he could succeed) and were willing to do business with him (since they were larger operations) and so he set to work. He opened an office and set up direct wires to five of these firms, and another wire to get the latest stock prices.

He made some money this way, but was under the distinct impression that some of these firms were trading against him, costing him earnings. As such, he often cheated to increase his earnings. He would place buy orders on a fairly illiquid stock (knowing that these firms aren't actually buying the stock for him), and place a real sell order through a legitimate firm, in effect driving down the price. As such, he would get a great price for his bucket trades. Later in the day he would close out his position by placing a sell order with the five firms, and a buy order with the legit firm, thus getting a great selling price for his bucket trades.

In so doing, Livermore saved up enough, despite a lavish lifestyle, to return to New York City to try his hand there for a third time.

Friday, July 30, 2010

EPS Shmee-PS

As earnings season continues, investors are keeping a watchful eye on their favourite companies' quarterly reports. Stocks become highly volatile during this period, moving several percentage points up or down based on a company's reported earnings per share (EPS) numbers. But too many investors blindly incorporate earnings per share (EPS) as a primary component of their valuations. EPS gets multiplied by a P/E multiple, or it is used as a base for growth rate multipliers to be discounted back to present value. However, for several reasons, investors must avoid using such short cuts in company valuations.

First of all, EPS can fluctuate wildly from year to year. Writedowns, abnormal business conditions, asset sale gains/losses and other unusual factors find their way into EPS quite often. Investors are urged to average EPS over a business cycle, as stressed in Security Analysis Chapter 37, in order to get a true picture of a company's earnings power.

EPS, averaged or otherwise, still does not provide adaquate information regarding a company's debt levels. Two companies could have the same EPS, but one could be capitalized with 99% debt while the other could have 0% debt. While the earnings to the shareholder is the same in both cases, one company is extremely risky and susceptible to bankruptcy should anything unexpected occur. To factor in debt levels, investors are encouraged to value a company based on its operating earnings (instead of its EPS) and subtract debt obligations from this value, and compare debt/equity values.

Finally, EPS does not give adaquate information regarding dilutive securities that have not yet been converted into common shares. "Diluted EPS" is a required reporting component of an income statement, but it only incorporates those options that are above water. For example, if a company has 100,000 shares that have averaged trading at $2.00/share, and 500,000 options outstanding at an exercise price of $2.01/share, not a single one of these options will be recognized in the diluted EPS calculation, despite the fact that these securities are potentially extremely dilutive! To avoid this trap, investors must subtract the value of options outstanding from the arrived at intrinsic value of the company.

EPS is a quick and easy way to refer to a company's earnings. It does not, however, serve as a replacement for prudent analysis of a company's true earnings power and obligations.

Thursday, July 29, 2010

For The Smaller Portfolios Out There

Warren Buffett has said many times that his annual returns would be higher (and they have been in the past) with a smaller portfolio. The universe of stocks in which he can invest is tiny, forcing him to accept returns that beat the market but are lower than his historical standard. Some of the most outrageously priced securities, however, are in the small-cap realm, allowing investors with smaller portfolios the ability to generate strong returns.

One stock that is too tiny for even a small-timer like myself (though it would have interested me a few years ago) is Xentel DM (XDM), a telemarketing company. The stock's P/E of 3 is likely so low because the company trades less than $1,000 worth of stock in an average day. For readers with decent-sized portfolios, this stock is of no use. For young, up-start readers with long-term outlooks and still budding portfolios, however, this company could offer long-term value.

The company operates off of 3-5 year contracts with its customers, and charges fees based on the hours spent telemarketing client products to consumers. This model makes for stable earnings, as the company can adjust costs easily such that they line up well with expected revenues. Indeed, despite the recession that has reduced the number of marketing dollars companies will spend, Xentel has been able to reduce costs at a faster rate than revenues declined and in the end actually increase profits.

The company does not come without risks, however. The company recently acquired another telemarketing company using Xentel's own shares; but if one is to share stock with a P/E of 3 in an acquisition, one better receive an outstanding valuation in return! At least shareholders can rest easy knowing management's interests are aligned with theirs, as both the company's chairman and its president each own 20% of the company. As such, the target company was likely another company that is trading at a low multiple of its earnings.

Xentel DM is cheap and has a flexible business model that should keep earnings relatively stable. Those with portfolios of a small enough size may benefit from this stock over the long term.

Disclosure: None

Wednesday, July 28, 2010

Tariffs Are Not The Answer

With the US unemployment rate holding near 10% for several months, there has been a great clamour for government-sponsored initiatives that will help spur job creation. One such crusade that has gained traction across several sectors of the manufacturing industry is the call for import tariffs. Those who support import tariffs are no doubt well-meaning (at least, towards their domestic citizenry they are), but their stance is helping hold America back from its more prosperous potential.

The logic behind import tariffs is simple enough: raise the price on foreign goods so that domestic producers can profit as a result, which allows domestic producers to maintain or grow the domestic workforce. The problem with this approach is that it assumes this action exists in a vacuum, whereas in reality it has a ripple effect which actually serves to harm the economy.

First, while import tariffs may (if only temporarily) save the jobs of a few Americans, it raises the cost of goods for the buyers of that product. As such, it reduces the profits (for a business) or the standard of living (for individuals) reliant on that product. The impact is spread out over a number of people, which can obscure the fact that there is an impact, but overall, the country is worse-off by protecting the industries which are least competitive at the expense of all of its other industries.

In addition, countries producing goods on which tariffs have been slapped may choose to retaliate by protecting their own weaker industries from their stronger American counterparts. This would harm America's successful businesses, which are the ones that should be encouraged to grow. In effect, the tariff is transferring jobs from successful businesses to businesses that are barely scraping by, which results in a poor overall result for the country. Even if the affected countries do not retaliate with formal tariffs, their businesses will end up poorer than they otherwise would have been, again lowering their abilities to increase their business with America's successes (Google ads, Apple smartphones, Boeing jets, pharma drugs etc.), which drive the high-paying American jobs that university graduates seek.

Finally, those who accept the aforementioned economic reasoning but who reject its application on compassionate grounds should consider which worker needs their help the most: the worker in the developing country who either works or starves, or the one in the developed country, who has access to temporary jobless benefits, worker re-training programs and welfare protection, should the transition to new employment take longer than expected.

If tariffs aren't the answer to increasing American jobs, then what is? Education.

Tuesday, July 27, 2010

Inventories Show Room For Continued Recovery

Last time we looked at US inventory levels, it was clear that production levels were going to be weak. Today, the inventory picture is dramatically different than it was one year ago. Compared to sales levels, inventories are at low levels, as seen by the chart below:

Low inventory levels (such as those shown on the above chart) suggest strong future GDP growth is in order, as production must be increased to return inventory levels to those commensurate with sales.

However, a few caveats are in order. It's important to note that inventory data takes a while to tabulate. As such, this data is already a few months old. Considering how quickly this chart can change (consider the speed at which the inventory to sales ratio both rose and fell in 2008 and 2009 respectively), we may be looking at stale data.

Furthermore, sales levels can also affect the above chart. If sales levels continue to falls, the inventory-to-sales ratio will rise without the need for further production, which suggests a weaker economic outlook.

Amidst these contradictory signs, what is the investor to do? Since macroeconomic variables are extremely difficult to interpret, the investor is well-advised to stick to buying easy-to-understand companies trading at discounts to their intrinsic values.

Monday, July 26, 2010

The Lower Rungs Of The Income Statement

NovaMed (NOVA) owns (in partnership with physicians) surgery centres throughout the US. It has 37 such centres under its purview, with a wide variety of offered services, but primarily focused on cataract operations. The company has a market cap of just $62 million, but generally generates after-tax earnings in excess of $6 million per quarter! On the surface, the market appears to be offering this company at an enormous discount, so what could be the problem?

The company does have debt of $110 million, could that be the problem? Well, it would seem that the company's services are of a non-discretionary nature (unlike some other cyclical health companies we have seen), since even during this recession operating cash flow remains rather stable. As a result, the company has paid down its debt by $17 million in the last four quarters from its operating cash flow, suggesting the situation is well under control.

Sixty-million dollars of that debt, however, is convertible into equity. Surely, this potential dilution is scaring investors off, right? Actually, this too does not appear to be that big a deal. At first glance, the conversion price of the convertibles is $6.37/share, which is below the stock's current price of $7.83. But when the company issued these convertibles, it also purchased call options on its own stock at $6.37 (and sold call options at $8.31), effectively raising the convertible price (from the company's perspective) to $8.31. Should it so choose, the company also has the option of paying cash, rather than shares, to the converters of the debt, to avoid dilution at a poor price.

So the debt, even the convertible debt, seems manageable. So why is the market offering up this company for so cheap? The answer lies in the lower rungs of the income statement, where few investors venture. While the company generates $6 million of earnings per quarter, it pays most of this to the physicians it has partnered with (as per the first line of this post). The "minority interests" are getting a majority of the profits in this situation!

A glance at the cash flow statement further illustrates that the economics of this company are not as neat as they first appear to be. While the company has earned net income of over $57 million over the last three years, it has paid out almost $50 million in "Distributions to minority interests", the doctors that are performing the surgeries.

The top of the income statement (revenues, COGS, SG&A) is its most popular section. But sometimes companies are structured in a way such that it is the bottom of the statement that affects the stock's intrinsic value the most. This company would appear to be a screaming steal to those who do not closely scrutinize the company's statement of earnings from its revenues all the way down to the shareholder's pocket.

Disclosure: None

Sunday, July 25, 2010

Reminiscences of a Stock Operator: Chapters 1 & 2

Reminiscences of a Stock Operator was originally written in 1922 as a first-person fictional account, but is now generally accepted as the biography of stock market whiz Jesse Livermore. The book is recommended to traders and value investors alike, for the lessons it teaches the reader in human behaviour as it pertains to securities trading and investing.

At the age of 14, Livermore got a job in a brokerage office updating the quotation board. The latest quotes would be shouted at him, and for hours on end (as long as the market was open) he would change the numbers on the board.

Since arithmetic came easy to him and he could remember numbers easily, Livermore eventually started to notice patterns in the quotes he would receive. He would start to make notes in a little book predicting market movements (based on the movements of their past prices) and then later check to see if he turned out to be right. He figured he was doing quite well, so he started to put his own money to work in bucket shops throughout his area.

Livermore made so much money off of the bucket shops that one by one they refused to deal with him anymore. He wouldn't win on every trade, but figures he made money about 6/10 times, and that it would have been 7/10 times, but for the fact that he would sometimes deviate from his method for psychological reasons. Not long after, he became famous around the country as "Boy Trader", and bucket shops were wise to him. As a result, he was forced into trading at legitimate brokers if he wanted to trade, and so he showed up in NYC in 1898 at the age of 21 with $2,500 ($70,000 in today's dollars) he had accumulated so far through bucket shop winnings.

Unfortunately, over a period of six months he lost it all and then some in stock speculation through legitimate brokers, due to some key differences between real trading and bucket shop operations. In real trading, you never knew the market price you were getting by the time your trade got to the floor. You might want to short something at $108 for example, but by the time your trade transacted the price might be $102, and you've lost your gains. Since the bucket shops were closed to him now, Livermore had to figure out how to make money with the new playing rules he had now encountered.

Saturday, July 24, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 17

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

In this the final chapter of the book, Dreman takes one last look at the Efficient Market Hypothesis (EMH) and notes its flaws for the reader. When considering the data that is often cited to provide evidence for EMH, readers should remember that correlation is not causation. In many studies, correlation is often shown, and causation is often assumed. To demonstrate this, Dreman discusses how, throughout the last several decades, skirt hemlines and Superbowl champions have correlated well with certain stock market returns, but that no serious investor would believe in a causal relationship.

The assumption that each individual investor behaves rationally is also a huge leap. Since investors have different goals, differing amounts of knowledge, and various opinions on how to interpret all the data that is available, an assumption that all investors behave in the same way is not practical.

Moreoever, Dreman takes apart the conclusions that were reached by various studies that are often cited by EMH proponents. For example, a study showing that stocks post-split show no excess returns is often used to show that markets are efficient. But Dreman digs into the data and finds that the researchers used the date of the split to measure post-split returns rather than the date of the split's announcement, which biases the results.

Other studies that show the market reacts immediately to earnings news or merger announcements are also used as evidence to show that markets are efficient. Dreman scoffs at this, noting that all the studies show is that markets react, not that they react correctly.

But the best argument against EMH in Dreman's opinion is the fact that there are several systematic methods to beat the market (including the low P/E, low P/B methods described in previous chapters). But the scientific paradigm that is EMH is so ingrained in academia that it continues to ignore the evidence against it. Until there is a new paradigm that can better explain stock market returns, Dreman doubts EMH will be abandoned. In the interim, those who employ contrarian approaches are afforded the opportunity to generate abnormally high returns.

Friday, July 23, 2010

Getting A Feel For The Market

To gauge how expensive the general market is, investors will often look at the market's overall P/E. Unfortunately for investors, however, the market's earnings can fluctuate dramatically. For example, S&P 500 earnings were 69 in 2007, 15 in 2008, and 51 in 2009. With earnings in a constant state of flux, how can the investor rely on the market's P/E when it is subject to such dramatic change?

In Security Analysis, Ben Graham and David Dodd advocated averaging earnings over several years to gauge a company's earnings power, and from that idea comes the concept of "PE 10", which is the P/E of the market using the current price in the numerator, and the average of the last 10 years of earnings for the index in the denominator.

Since 1880, the median and average P/E 10's of the S&P 500 have each been around 16. Currently, the S&P 500 trades at about 19 times its earnings over the last 10 years, which is well below the 44 times it reached in 1999.

One site,, is dedicated to providing a daily update of the market's P/E 10. Readers are encouraged to visit this site from time to time when they wish to determine the relative cheapness of the broad market, as it can serve as a useful anchor amidst the media noise that attempts to predict market movements using all sorts of various, often irrelevant, data.

Thursday, July 22, 2010

Envoy Capital Group

Envoy Capital Group (ECGI) trades at just $8 million, but has net current assets of $16 million. Most of the assets are in the form of cash and marketable securities, while debt sits at just $0.8 million, making Envoy Capital an interesting asset play. The company's stock has fallen drastically over the last year, despite improving operating results.

The company is a consumer and retail branding company, but with a seemingly unrelated investment arm on the side. Losses have been piling up on the branding side, as companies have cut their marketing spend as a result of the recession. As such, Envoy was left with losses as revenues dropped while costs stayed flat. But recently, the company enacted a restructuring plan to reduce fixed costs (e.g. it closed its Dubai office), and therefore the company showed a small operating profit in this unit in the most recent quarter post-restructuring.

What may be a little bit scary for the value investor is the fact that the investment arm of the company appears to operate with a momentum strategy. Mitigating this is the fact that the company appears to hold a number of put options on market indexes which likely reduce the downside risk of the portfolio. However, investors should note that the market has fallen some 10% since the company's latest financial statements, suggesting that Envoy's investing assets may not be as high as they currently appear.

The good news is that management appears willing to take matters into its own hands when it comes to reducing the discount between the stock price and the assets: the company bought back almost 7% of its outstanding shares in the last quarter alone, and has recently announced the intention to repurchase up to 10% more over the next 12 months. Motivating this action may be the fact that the company would be in danger of having to de-list from the NASDAQ if its share price were to spend too much time under the $1 mark. Unfortunately, neither management nor the Board (save for one member) owns a number of shares of any consequence, so there is a risk that capital will not continue to be deployed in an ideal manner for shareholders who buy in at the currently depressed price.

There is no question that the investor is afforded a company on the cheap here. But there also appear to be enough risks to keep many a value investor away. Each investor will have to make up his own mind as to whether this company fits within his strategy.

Disclosure: None

Wednesday, July 21, 2010

Openness Policies

As the financial news media has expounded Europe's emerging debt crisis, investors have shied away from companies with significant operations in Europe. Austerity measures are expected to hurt the economy, and so investors have looked elsewhere for opportunities. But is the European situation really that bad?

Companies operating in Europe are still free to only allocate capital to projects they expect will generate returns, which may seem obvious but appears to be something we take for granted. While the focus has been on Europe, severe economic problems in a country much closer to home (for North Americans, that is) have gone largely unnoticed. Venezuela has seen its economy contract 5.8% in just the first quarter of the year! While its economy is quite small compared to some of the European nations undergoing austerity measures, the effect can be much stronger for companies with interests in the small, Latin-American country due to the policy impositions of the government.

Consider a company that does business in both Europe and Venezuela. Audiovox (VOXX) derives a significant portion of its revenues from Europe, and a comparatively smaller amount from Venezuela. But consider how recent events in the different regions have affected operations and results.

Regarding Europe, the company notes that the economy is more tenuous than that of the US, and that the decline in the Euro will negatively affect results throughout the year. Nevertheless, the company sees business expanding in this region as the economies in Eastern Europe improve and exports to the region increase.

Quoting the company's CEO on the latest conference call, "Venezuela, on the other hand, is a different story." Sales were cut in half in the first quarter, as the government stepped in to control the exchange rate. Audiovox has been unable to convert Bolivars to USD (or any other currency, for that matter) so that it can procure materials to sell! Furthermore, customers are unable to obtain currency to even purchase from Audiovox.

Earlier this year, we discussed the importance of understanding the political regime under which a company's assets operate. Emerging markets can be a source of excellent investment opportunities, but not paying attention to government policy can result in a complete loss of principal, which isn't in keeping with the first rule of value investing.

While the problems in Europe are headline news, companies operating in Europe are at least free to shift capital and reduce labour to match costs with revenues and maintain margins in the long-term. But investments in companies with significant operations in countries with intrusive regimes represent substantially more risk to investors.

Disclosure: Author has a long position in shares of VOXX

Tuesday, July 20, 2010

It's Not A Job Shortage, It's A Worker Shortage!

Over the last several months, the US jobs report has indicated that private (i.e. non-government) hiring has turned positive, but remains at a low rate. Private payrolls increased by only 83,000 last month, which is rather insignificant in comparison to the fifteen million people classified as unemployed. However, what these headline numbers fail to expose is that a number of US corporations wish to hire, but cannot find workers with the sufficient skills.

To see this, consider the current unemployment rate for the following groups, separated by their educational attainment levels:

Note that the overall unemployment rate in 2007, when the American economy was booming, was 4.6%, which is higher than the current unemployment rate of 4.4% for those with Bachelor's degrees. This data suggests (although it does not prove) that there is a shortage of educated workers in the US.

I say the data does not prove a shortage because some may argue that the educated workers are just better equipped to take the limited jobs that are out there, and so there is no shortage at all. That conclusion is not borne out by the data, however. If the educated were simply taking jobs away from the uneducated, one would not expect to see the gap between the salaries of the educated and the uneducated continue to grow - but it has. Moreover, the average salary offered to current university graduates is around $48,000/year, which is well above median salary of the average worker with many years of experience.

Now consider the situation from the perspective of America's most innovative companies. The following companies generated returns on investment of over 15% over the last year:

  • 3M
  • Abbot Laboratories
  • Accenture
  • Alcon
  • Amazon
  • Apple
  • Bristol Myers Squibb
  • Ebay
  • Eli Lilly
  • Gilead Sciences
  • GlaxoSmithKline
  • Google
  • IBM
  • Johnson & Johnson
  • Merck
  • Microsoft

These companies are able to make products/services that the world desires, even during a recession. Because they are at the cutting-edge of their fields, they are able to provide value to their customers while at the same time generating hefty profit margins and investment returns. To continue to innovate and drive these returns, these and the plethora of other companies looking to grow to this size need educated workers, and they are willing to pay for them, as evidenced by their higher salaries and lower unemployment rates.

To improve America's prosperity, the emphasis should be on increasing its number of educated workers, as there is a shortage. On the other hand, there is an oversupply of uneducated workers, not only in America but around the world. As a result, developing countries will continue to steal market share in the production of the lowest-priced goods. America's advantage is in its ability to innovate and contribute to the creation of the world's highest-priced goods, however, from PC chips to OS software to smartphone designs to web software to jet technology to medical/pharmaceutical research. To continue to supply the world with the most advanced products in the world, America's companies are starved for workers with the ability to contribute. Measures that increase the number of educated workers are needed immediately, and can help shield the country from future economic hardship.

Monday, July 19, 2010

To Grow Or To Buy Shares?

Companies trading at large discounts to their net asset values have an additional decision to make when it comes to allocating their capital. Should they buy back shares, or focus on growing the business? Unless there are debt (or other immediate liability) concerns to worry about, value investors would generally prefer that a company return money to shareholders, as this is a lower risk method for generating a strong return for investors. But should value investors still be interested in a company that trades at a large discount to its net current assets even if management has no intentions of returning cash to shareholders?

This decision cannot be made in isolation, as several other factors play an important role in this determination. Investors should consider the nature of the intended investments, the company's ownership/control structure, the level of its management/board ownership, and management's abilities or track record.

As an example, consider Nu Horizons (NUHC), a company discussed on this site last week as one that trades at a discount to its net current assets but where management's intentions are to re-invest its capital in the business rather than return money to shareholders.

For Nu Horizons, these re-investments are not in the form of specialized fixed assets with uncertain returns. Instead, as Nu Horizons is a distributor of electronic components, these re-investments are in the form of inventory. The company is able to generate a gross margin on this inventory, and is currently profitable while simultaneously growing sales, suggesting the investments will earn immediate returns for shareholders.

Often, when management controls a company, it doesn't have to pay attention to shareholder returns and can instead focus on growing the size of its empire, whether shareholders benefit from that or not. In this case, however, management controls just 10% of the votes, leaving the company vulnerable to a takeover if returns are not adequate.

Nevertheless, the company's Chairman and COO own a combined $4.6 million of the company, so they do have a vested interest in seeing the company make decisions that are in the best interests of shareholders. Comments on the conference call confirm that the company is not making this decision to re-invest lightly:

"[Buying back shares is] something we talk about quite fairly, but we discussed it all on a number of occasions particularly in Board meetings, but if you look at the growth that we have in business today and you look at our new facilities that we have that Kurt talked about, then the truth is we are using our facility to fund the growth, which is our belief: that we have to fund the growth... And I think today that’s the right use of our cash. And I understand the concept of buying back stock and as I said, something we discussed on a regular basis."

It's certainly riskier for the value investor when management of a company trading at a large discount to its net current assets chooses to invest in the business rather than return money to shareholders. But under circumstances where management does not control the company's voting direction (and yet has a significant ownership position) and investments are not of a specialized or uncertain nature, a stock may still make for a great value investment. It will be interesting to see how this one turns out!

Disclosure: Author has a long position in shares of NUHC

Sunday, July 18, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 16

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

In this chapter, Dreman examines the irrationality of some investor behaviour, and how that irrationality often culminates in bubbles that end up costing investors dearly. Bubbles are not just formed by sub-average investors; instead, many of the sharpest minds become so enamoured with an idea that they will behave completely irrationally.

There are four elements to a bubble according to Dreman. First, an image of instant wealth is presented. This image drives some to dream rather than think, and therefore a crowd forms around the idea.

Second, a social reality is created. Opinions become "facts". Experiments have shown that in uncertain circumstances, we rely on the opinions of others in forming our own opinions. Often, we do it without even realizing that the opinions of others are altering our own. Dreman argues that the appropriate price of a stock, or a piece of real-estate, or a tulip bulb are excellent examples of things of which we are uncertain, causing us to rely on the opinion of experts.

Third, the opinion suddenly changes. Perceptions can change quickly in the market. Opinions that harden over years can turn out of favour in just a few short weeks or months. Overconfidence is then replaced with anxiety. Prices crash.

Fourth, the pattern repeats itself. Circumstances appear different, but they are not. Things seem "different this time", but that is part of the illusion. As an example, Dreman shows how the IPO market has fluctuated several times, becoming hot at several points (resulting in circumstances where, say, Netscape can trade at 375 times its earnings shortly after its IPO), resulting in big losses for investors at the top. Yet the pattern persists.

Saturday, July 17, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 15

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

In this chapter, Dreman takes apart some common stock market beliefs. He spends the most time critiquing the "small-cap effect". It's commonly believed in the investment world that small stocks outperform large ones. Some widely cited papers have even claimed the low P/E effect (where stocks with lower P/E's tend to outperform stocks with higher P/E's) does not exist when one takes into consideration the small-cap effect.

Dreman takes apart some of these claims by examining the data and pointing out the pitfalls of several such studies. The most important point to note about some of these studies is the liquidity issue of small-caps. Dreman demonstrates that because of large bid-ask spreads and commission costs of purchasing the small-caps cited in the studies (which go back to the 1930s, when bid-ask spreads for small caps were on the order of 40% of the stock price), the returns shown by the studies are theoretical and could never have been achieved in practice. Furthermore, small-caps don't trade enough for investors to have been able to scoop up enough shares, and purchases in these small issues would have changed the prices of the stocks considerably, none of which is captured in the data.

Dreman goes on to cite a subsequent study he performed which shows the P/E effect to be very much alive, and across all sizes of stocks. After dividing the universe of stocks into quintiles by size, Dreman shows that it's the P/E effect that drives the returns of small-caps as much as it does for large caps. Buying small stocks with high (low) P/E's provides similar returns to buying large stocks with high (low) P/E's.

Dreman also confirms these results using P/B and P/CF measures, suggesting that small-caps as a group perform only marginally better than large-caps, but that they do so because of the strong returns of the beaten down stocks (as measured by their earnings, book values, or cash flows).

Finally, Dreman offers some caveats for investors interested in small-caps. One of the most important items to note is that transaction costs are not simply equivalent to commission costs. Large bid-ask spreads represent very real transaction costs that are not captured by commissions. Investors must recognize this when making purchase decisions, or they may see their supposedly higher returns eroded, much to their surprise.

Friday, July 16, 2010

Completing Your Diligent Research

The importance of listening to the quarterly conference calls of the companies in which one is interested cannot be stressed enough. While press releases that accompany quarterly results do provide critical financial data, the qualitative commentary and outlook provided in these releases is less than adequate for a full understanding of the company's position.

In the conference calls, on the other hand, management's intentions for the company's cash balance will often be made clear, the company's revenue situation with respect to the current quarter (that is, the quarter following the one for which results are released) is often discussed, and other material facts related to the company are often disclosed. Often, none of these items are discussed in the company's press release or its written quarterly report.

As an example of how such items can increase one's understanding of a company, consider Nu Horizons' (NUHC) conference call last week. Nu Horizons is a company we have previously discussed as a potential value investment due to its large discount to its net current assets.

On the conference call, management was asked about the large discount and whether a share buyback would be done in an effort to reduce the discount. Management's answers suggest management intends to use its cash balance (and then some, using a line of credit) to invest in growing the business and not buying back shares, due to the opportunities it sees in its distribution markets. This isn't necessarily a bad use of cash, but for the value investor who sees this as a risky use of his funds, the message is clear: stay away.

The company also revealed that its distribution contract with Sun Microsystems (representing approximately 5% of Nu Horizons' revenue) will not be renewed due to Oracle's acquisition of Sun. To me, this information appears material, but for whatever reason it was not disclosed in the quarterly report, only in the conference call.

Finally, with the information management provided on the call along with the answers it gave to shareholders who prodded for more info, shareholders could actually piece together the company's profit outlook for the current quarter, even though management does not give quarterly guidance. Management discussed a revenue level that would be required to break-even in the quarter, and from bookings over the quarter, shareholders are able to estimate what the revenue number will be in the current quarter. The numbers suggest a modest profit for Nu Horizons, which is not a very common position for a company trading at a discount to its net current assets.

The more the investor knows about management's intentions and the current state of the business, the better the decision the investor can make. Listening to quarterly conference calls is a key component for the investor to fully understand where the business is going.

Disclosure: Author has a long position in shares of NUHC

Thursday, July 15, 2010

Completion of the Quest for Value

Many stocks trade at large discounts to their book values. Some are destined to trade at such levels (or below) for prolonged periods, while others show strong price appreciation in subsequent periods. How can investors distinguish between the beaten down stocks that are destined to remain beaten down, and those that are potential investment opportunities?

There are three important items to look for. The first thing is to determine how convertible the assets are into cash. Reliable receivables, land, and fast-moving inventories are all quickly convertible into cash compared to highly-specialized fixed equipment for example, where the book value may be nowhere near the realizable value.

Second, it's important to consider the debt level of the company. With debt, any estimation errors of the value of the assets (discussed in point 1) are magnified, as discussed in the third paragraph of this post. Furthermore, if debt obligations are due soon, the company is less likely to be able to sustain itself to get to a point to where it can reward shareholders.

Finally, management's intentions are worthy of consideration. If management is sitting on a boatload of cash, but wishes to spend it on new projects with uncertain outcomes, shareholder risk increases.

Exactly one year ago, we discussed Quest Capital (QCC) on this site as a potential value investment due to its massive discount to its book value. The company was in the business of issuing short-term (approximately 1-year), land-secured loans to finance builders looking to complete projects that were to be sold to various customers.

On all three of the points discussed above, Quest scored well, making for a rather safe investment with strong upside. The loans were due to convert into cash or the land could be seized and then sold by the company (of course, some loans had to be written down as some land values fell below loan values), debt levels were low (allowing for confidence in the net asset values), and management's intentions to take the steps necessary to reduce the discount to book value were very clear.

As a result, the stock generated returns of over 50%, and it did so with little in the way of downside risk. With yesterday's price increase, Quest's price is now within around 10% of its book value, offering investors the opportunity to exit at a price close to fair value and redeploy their funds to the next potential opportunity.

Disclosure: None

Wednesday, July 14, 2010

Roark, Rearden & Hamot

Many of this site's readers have contacted me to ask for advice on how to start their own investment funds. This post is for them. Ankit Gupta of Selected Financials provides this interview of Seth Hamot, who started his own fund 17 years ago, and has generated returns of 17% per year since then.

When did you launch your investment fund and what were you doing leading up to that?

RRH launched in the mid to late 90’s and prior to that, I was working with partners buying distressed and defaulted debt backed by real estate. I started doing that in 1989 and 1990. Prior to that, I was the President of College Pro Painters, a painting contracting company with a student labor force. I graduated college and since CPP was owned by a foreigner, and needed a local president and leadership, I was brought on board. It was going through financial distress, had no local leadership, and so I was brought in to turn it around. We went from $3 Million/year in revenue to $11 Million when I left. Shortly after, a real estate recession kicked and, and so I began looking for turnaround situations with distressed debt that could be bought. My partners from those ventures eventually retired and so I continued what I was doing into the public markets. We found poorly performing assets that were either too encumbered with too much debt or too little leadership, focusing on hard assets like real estate and mining assets.

Where did you get your first 5 investors for your fund and how many are still with you today?

College roommates, families of college roommates, friends, my own money, etc.

What were the first 5 years of your fund like? How many employees did you have and what were some of the larger challenges?

It was a small fund and so picking investments was the main challenge. It was just myself initially. We took a very large position in a liquidating insurance company that lasted 2-3 years, but was very profitable because the markets misunderstood it entirely. It took a little bit of activism and at the end of it, I met someone, who introduced me to his own limited partners, and that’s where I brought in some fresh capital. One of the joys there was that I met some great people who were also doing small cap value investing. Eventually I was introduced to a well-run fund of funds on the west coast. I was told that we made some great investments, but our documentation was on napkins and we used grid pads for calculations. We got a real lawyer, real documentation, put together information for investors, and then began to grow. From the original $2 Million that we started with, we had grown to somewhere around $15-20 Million, and then these guys came in. We’ve been successful in our performance with investors: Over the last decade, ended December 2009, we’ve returned 17% annualized, net of all fees.

How do you find your investments? Are they brought to you or do you screen for them?

We don’t use as many screens as our competitors – we look for situations of transition. We monitor a lot of announcements for spinoffs, acquisitions, divestitures, distributions and one-time dividends, etc. A good 1/3rd of our investments come from people who call about how they’ve lost a lot of money and they don’t understand why the equity is performing so poorly. They want information, but in another sense, they’re questioning whether an activist could help out. More often than not, present management and the board of directors will deal with the issues.

We don’t want to be activists, generally, but to the extent that we’re wrong that the CEO isn’t good, we have to do it. If it’s activism, it’s because the board or CEO is not reasonable.

When we are activists, we always say to CEO’s and board members that we see this (something specific) as a problem and that any reasonable businessman would see this as a problem. Reasonable owners, your shareholders, see this as a problem. “Why don’t you get in front of this and solve it?”

It’s only when they refuse to address the issue and completely ignore rational shareholders that we become activists. It’s not a case of them not being granted an opportunity to fix it.

Furthermore, when they stick to their actions – often to feather their own actions, they refuse to accept that we are the shareholders and owners of the business. Instead, they try to publicize that we are a “lesser class” of shareholder, a hedge fund.

One extreme example is a board that said they had a program in place to find new, more docile, shareholders. Instead of realizing value by spending time to follow suggestions, they were spending time on finding money and new bosses.

What is your fund’s underlying approach? What wrong do you right in the markets?

I want to find companies going through a transition. Eventually, that transition will translate into others seeing that the company will be worth more than they originally thought. It might be divesting a cash burning division, or new credit facility, or maybe the company just did a merger or acquisition allowing the business model to be leveraged, etc. The objective is to NOT be an activist in these situations. There are a lot of great opportunities because really great companies make errors, but they can move on. We enjoy dealing with smart businessmen on a daily basis. Often times though, managers slowly become content to have a larger span of control and more remuneration. They change by rationalizing their business to make themselves better focused and more efficient and effective.

What do you look for in an investment?

A perfect investment would be in a business that was once well covered by investors, analysts, raised a lot of money, etc. and then the company and industry went through a transformation and the stock trades very cheaply. Even after that, the underlying business itself makes sense and with some tough decisions, it can regain its value and it will right itself.

A simplistic example is a REIT that for some reason no longer pays its dividend, driving the stock price very low. It’s a hard asset business that won’t just disappear. If you can foresee the dividend coming back, it will get bought again for its yield eventually.

So if someone calls in and says, “I’ve got this REIT I want you to look at,” I’ll respond by asking, “Is it paying a dividend?” If the answer is yes, then I don’t care, but if the answer is no, then let’s talk!

How long do you typically hold an investment for?

Our average investment period is well over a year, probably closer to a couple of years. I’m the chairman at TEAM, chairman at ORNG, both of which we have owned for over 4 years. Some of our other big positions are in the 3rd year of our ownership. We’re not traders and our investors see it by the tax bill – we’re not paying short-term taxes nearly as much as others.

Some of your investments are in pharmaceuticals or biotechs along with energy, mortgage processors, etc., how are you doing this?

We’re generalists and start digging into anything. If the problem is product based, we don’t dig into that. We’re focused on the business. If the company has successful products, but is spending too much on R&D, it’s a question of capital allocation.

We avoid biotech companies without significant revenues because we don’t have a take on science. At the same time, we don’t have any problem in investing in a pharmaceutical spending a lot on biotech, but already has successful drugs in the marketplace.

If there is a mismatch between capitalization and value of drugs that are already in the market, there will be a major discount to the market value of the company. A big discount points out that investors don’t value the R&D pipeline even though the drugs are kicking off a lot of cash.

How much do you care about where the overall markets are and where they are headed?

We used to not care at all, and through 2008, a lot of my competitors and I started to care very greatly. I don’t really pay all that much attention to it though, because I’m investing longer term than most, 2-4 years, and if they can turn a business around in 2 years, any 1 days headlines today won’t be the headlines 2 years from now.

Do you take long positions only or short positions as well? Is any of this as a hedge or do you look for companies with something that is fundamentally wrong when taking a short position?

We do take short positions, but we’re not nearly as good at them as our longs. We look for bad business models, too much leverage, and companies generally run for the benefit of senior management and board members. Shorts tend to go against us because whenever any activity continues, the investment community rates it highly. We’re not too good at anything other than when the debt comes due causing the company to reorganize or hand over ownership to the debt holders.

Your firm seems to be okay with small cap positions. Do you ever worry about a complete lack of liquidity that small caps will see whenever there’s a downturn?

Yes, we worry about liquidity. We think about it more today than 2 or 3 years ago because it is an issue and with many stocks that we used to get involved in, we will no long get involved in.

How do you manage and define risk?

We define risk as leverage – certainly not beta. Our only use of leverage will be used to trade around positions. That said, liquidity is the first coward and when liquidity dries up, you just have to put up with the bumpy road. There’s a desire to avoid volatility at all costs. The flip side is that you’re paying for it in liquidity. Our 17% annualized return partly comes due to an illiquidity premium. Neither the auditor nor the IRS makes us give back our excess return due to that though!

Your fund has lived through 2 or 3 economic downturns – which one were you most prepared for?

2000 Internet crackup. In 2002, when the S&P500 fell 22%, we were up almost 10%. These crises are very good for us, eventually. They’re not so good short term because we go through hell too. Just after it though, we tend to double and show over 100% returns. Leading up to the recent troubles, we were short on homebuilders and held CDS’s at one point, however gave those up on suspicions that the markets were rigged.

Do you ever notice that it’s easier to be right than it is to know when you’ll be proven right?

Yes, very much so. It happens in real estate quite a bit. You can buy a property one minute and then in the next minute, you can come up with a number for what it’s worth. Sometimes, it takes longer, and sometimes it’s shorter. This applies to stocks too – you know what it’s worth when you buy it, you have to wait though. We were investing 3-4 years ago and are still waiting for the investments to complete. We see how they will, but the markets have not recognized it yet.

Historically, do you have any investments that you remember as amazing? Maybe an investment where you were just so darn right that it was memorable?

Yes, two in specific:

1. Nursing Homes

In the early parts of the last decade, nursing homes were providing elderly housing and elderly care. They were expanding the elderly care to provide ancillary types of procedures, like occupational therapy, breath therapy, etc. and all these things made tons of money. The underlying business was great, and then they issued a ton of debt, raised capital, etc. Shortly after, congress cut back funding. With that, the top lines and margins went through the floor, leveraged ones went bankrupt, and the industry in itself went through a transition.

The markets priced that as if nursing homes would go away. In reality, there would only be more elderly people given enough time. We were buying healthcare REITS, preferred shares with 20% yields, dividend-paying instruments for 50% of pay, etc. Lo and behold, the Internet stocks went to hell and these nursing homes were going through a change too. Even while they went through a change, they had to keep paying rent, and so the REIT dividends kept coming in. It was priced like a junk bond, but the yields were better and actual ratings were better too!

2. InVision Technologies

INVN, InVision Technologies. During the internet bust, you would hear tons of ideas that all began, “This company has so much cash on hand and is only burning this much per quarter.” We found INVN, which was a collection of venture ideas that were being commercialized. The CEO of this company, though, was committed to being profitable. Same sort of upside, but without the cash burn, as the Internet investments. The CEO basically said this: “They (our investments) turn positive NOW, not later on.” Meanwhile, I’m getting a ton of calls from people to buy 1 of 6 online pet food supplier stocks, they have a ton of cash and little burn – they don’t need money for two years! I heard that all day long and then went to buy Invision. I paid less than the cash they had and saw some upside on a logger product that was going to make logging much more efficient. They weren’t burning cash either, and that’s what made it attractive.

I went over just 1% of the company by September 10th, 2001. On the next morning, terrorists attack the country and so the markets don’t open for a while. Invision actually had technology that sniffs for bomb threats in airports. At this time, it was in beta testing at a few regional airports. I hadn’t paid attention to this part of INVN at all, but now it was a lot more important than all the other activity at the company. I had been buying the stock for $3 per share, less than net cash. It was a “net net.” As you know, the markets remained closed until September 17th, when it opened around $7.50. By that afternoon, it traded around $9. This is when all the value investors got out right away. Around this time, I said, “You know, if it’s a real business, and it’s up to $9 today, because it was installed as a beta test, the government will want hundreds and thousands of these in the recent future, these will be hot.” Eventually, I got out between $17-20. If you travel now and look behind the check in counter, those machines that they put your luggage through are Invision machines. I have no idea what happened to the log cutting advancements or anything else, I was following a CEO who wanted profitability even when everyone else had different ideas.

When dealing with small caps, do you ever think about why some of them are publicly traded to begin with?

All the time. If you actually understand the classical theory of public markets, they exist for raising initial capital. No one would actually give capital unless there’s an exit strategy, and the public markets allow that exit strategy to be a reality for small holders of stock.

Looking at your current positions, can you offer any insight as to some of the more interesting ones?

Aeropostale (ARO) – Aeropostale is the premier teen retailer in my estimation. When you compare the company’s fundamentals to the other large players, AEO and ANF, you see the superiority clearly. Yet, ARO is relatively cheaper than its competitors.

Let’s first look at the ability to drive same store sales. In 2009, arguably the worst year for retail in the last generation, ARO had year over year gains every month. Furthermore, if you consider the gains in total sales compared to the recent trimming of inventory – that’s right, the decline in inventory – you realize the increasing efficiencies that are driving huge cash flows at ARO. [Specifically, let’s take the summation of the last four quarters of “percentage yearly revenue gains” and subtract from that number the summation of the last four quarters of “percentage of yearly inventory gains,” the latest quarter being actually a reduction in inventory. ARO’s resulting number is 50.83 and accelerating. AEO’s is 21.88, and going in the wrong direction and ANF’s is 34.68 and also headed in the wrong direction.]

Analysts miss all this though. They are so wed to their bullish calls on ANF and AEO that they have conjured up a story that once the recession ends, all those customers who are moving to a lower price point by shopping at ARO are going to return to the competitors’ stores. Hence, ARO trades at 5.43x its LTM EBITDA, while ANF trades at 7.26x and AEO traded at 7.14x until it lost 35% of its value in the last quarter. Caught up in their past view of the world, they are missing one of the great retail stories around today, which continues to improve its business quarter over quarter.

Nabi (NABI) – this is a wonderful story. Nabi has a vaccine that helps with smoking sensations. Glaxo Smith Cline (GSK) actually put up $45 Million to partner with them on this drug. No one spends $45M on a drug that isn’t credible. That will probably move forward by the end of 2011. When I entered my position, I wasn’t paying more than cash and the NPV of royalties, probably lower and upper 3’s. GSK validated the vaccine and the ramifications of its approval are mind-boggling. You take 4-5 shots over 6-8 months and you can get over smoking. Our nation spends a lot of money on smoking and so there will be a lot of push behind this drug, you could make budgets balance if less people smoked. Even if you doubt it, the GSK guys have been looking at it for months and when they’re done with the next phase of development, GSK will pay NABI another $30 Million for the work they’re doing, and then the numbers get really crazy for royalty payments. When I was buying, I got in at prices where most of the story was for “free” because of where the stock price was trading.

BreitBurn Energy Partners (BBEP) – This company found they were overleveraged at one point last year and so they cut the dividend distribution, causing the stock to go down to $6. Dividend money went to cut down debt and now it’s at $15. We went from $6 to $15. Baupost is there and the interesting thing is that they got involved with a proxy contest with the largest shareholder. Quicksilver, the largest shareholder, went on the board and removed 2 guys – the chairman and CEO, the two folks whose name is in the company name itself. They became management employees.

Quicksilver (KWK) is overleveraged and owned 21 million shares of this company at one point, or about 40% of the company. They had a proxy contest and those 2 were removed. You have to take a step back and wonder what’s going on. If there is nothing going on, why would they bother to remove people from the board who will object and not be happy about the situation? There’s a possibility that managers were taken off the board of directors so that potential M&A activity could be kept segregated from the operations, which offers a potential exit strategy for Quicksilver. In the meantime, I got a 10% dividend and 37.5 cents per quarter per share, not too bad at all, and mostly tax-free.

How do you try and structure your portfolio? Your top holding is 15% of your invested portfolio and the top 5 make up 44% of your portfolio, even though you had 29 positions at the last 13F filing.

We tend to buy as much as 6-7% of the portfolio and will be pruning as it crosses the 10-15% threshold. We’re usually always pruning.

How do you deal with prices at which you are okay holding a stock, but not buying? Opportunity cost would say that if you aren’t willing to buy it at the current price, you shouldn’t be holding it, because by not selling, you’re effectively buying at the current price.

One of the pains is you buy stocks out of favor. Often times, they become in favor! Just because they’ve risen past fair value, and you saw that in InVision, where the fundamentals had markedly changed, you have to be patient and see it runs its course. By the same token, if I was buying for the log cutting machine software, and if it was done with the beta tests without much business activity, I would have found another investment to move onto. From my point of view, I can be patient.

Tuesday, July 13, 2010


As a large country undergoing tremendous GDP growth rates, China is abound with investment opportunities. But investors must also be extra careful in dealing with emerging market companies, as their legal and regulatory situations do not protect investors to the same extent as they do in developed markets. This can lead to fraud in some cases.

Ever noticed that many directors of otherwise domestically-focused Chinese companies have Anglo-Saxon names? In many cases, these directors may be legitimate executives appointed to improve a business' operations. But a recent exposé by CNN suggests that the presence of white people in Chinese businesses in many cases is purely for show, sometimes bordering on fraud.

Chinese companies will go so far as to hire actors from overseas in order to bolster their reputations. If there are foreigners around Chinese companies, these companies appear to have prestige, money and connections, which encourages companies to fake it.

Often times, these actors are just brought along to impress government officials or clients. But CNN interviewed a few actors who had been hired to claim they were Vice Presidents or senior executives! One company allegedly swindled investors, and the actor who was claimed to be "in charge" of the company was investigated for fraud!

Emerging markets present a ton of opportunities, due to their potential to grow the labour force and the productivity of that labour force at tremendous rates. Unfortunately, they also present a whole slew of new risks that developed market investors are not used to. As such, investors must be particularly diligent in assessing potential investments in emerging economies.

Monday, July 12, 2010

Price To Book In Action

We discuss the Price to Book values of various stocks quite often on this site, but how useful a metric is it? From a logical standpoint, as a purchaser of a business (which is how we view all our stock purchases), a prudent buyer ensures - barring certain exceptional circumstances - that he does not pay too much more for a company than the value of its assets. In this way, he receives downside protection to a certain extent. Though book value is not a perfect measure of the value of a company's net assets, it does provide at least some level of a proxy for it.

That's all well and good in theory, but does this practice actually hold up against empirical data? Do stocks with low P/B values indeed outperform the market? There have been several studies that suggest that historically, stocks with lower P/B values have in fact outperformed, however, there are certain caveats to keep in mind.

One study that has gained industry credence was carried out by Bauman, Conover, and Miller. The authors used an international sample of stocks and divided them into quartiles based on P/B. They observed over the ten-year period of their study that the quartile of the lowest P/B stocks had mean returns of 18.1%, while those of the highest P/B had mean returns of 12.4%, representing an annual spread of 5.7%. This is consistent with what other studies have found, including those conducted by David Dreman, discussed here.

Based on this data, buying a basket of low P/B stocks may get you outstanding returns, but you may do even better if you can determine which of the low P/B stocks are worth purchasing and which are about to go bankrupt: the standard deviation of the returns for the lowest P/B stocks was 70 as compared to 57 for the highest P/B quartile, suggesting the low P/B space contained some big winners along with some big losers.

This is why looking for companies with low debt and good liquidity among issues trading at discounts to their book values can present great investment opportunities, some of which we discuss here.

Sunday, July 11, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 14

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

This chapter discusses the topic of risk. Currently, the finance industry defines an investment's risk by its price volatility. The theory suggests that investors require compensation for taking on volatility, and therefore securities with higher volatilities have higher returns. Dreman takes issue with this simplistic definition.

First, he points to evidence that suggests volatility and returns are not correlated. This puts a hole in the theory that investors are indeed compensated for taking on more volatility.

Dreman also argues that semi-variance (as opposed to standard deviation) is a better measure of volatility (though still not perfect). After all, nobody would consider a stock that rises more than the market (i.e. that is volatile on the way up) to be risky, so only downside volatility should be considered.

But finally, volatility is only one of the risks investors face. The risks described in the previous chapter, taxes and inflation, should also be considered. The fact that T-Bills (the "risk-free asset" according to the finance industry) have actually lost money over time once inflation and taxes are taken into account suggests volatility does not adequately represent the risks facing investors.

Saturday, July 10, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 13

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Dreman compares the returns of stocks to those of bonds and T-bills over several historical periods. While stocks outperform bonds over long periods, the sheer magnitude of the relevant performance is not clear until the investor considers the effects of inflation and taxes.

Through most of the 19th and 20th centuries, inflation was benign. For example, in 1940 the dollar still had 88 cents of the purchasing power it did in 1802! But since World War II, inflation has been relatively strong; today's dollar only has 8% of the purchasing power it had in 1802!

Too much money chasing too few goods results in inflation, so why has inflation picked up over the last 70 years relative to the previous 150? Dreman argues that government deficits are a major contributor, as governments have tended to increase national debt levels to finance wars, entitlement programs, natural disasters, bail-outs and other events. Unfortunately, they don't run surpluses as much as they should when times are good. Furthermore, since WWII, wages have been made sticky on the way down. As such, prices rise easily but they do not come down when they should, from a supply/demand point of view.

Whatever the reasons, as long as inflation continues going forward, stocks should outperform bonds and T-Bills by an even larger margin. When the price level for goods changes, businesses can earn revenues at the higher price level, but bond holders get left receiving lower dollars amounts.

Conventional wisdom suggests diversification between stocks, bonds and T-bills, but based on the evidence presented in this chapter, Dreman argues that portfolios meant to last more than four or five years should be squarely invested in stocks. Dreman might be sued if he placed 90% of the assets of a pension plan (with a decades-long time horizon) in stocks, because it goes against the prevalent wisdom of the day, but due to inflation he believes this to be a position which will clearly outperform what are considered the more "conservative" allocations.

Friday, July 9, 2010

Karsan Value Funds: 2010 Q2 Results

For the second quarter ended June 30th, 2010, KVF earned $0.03 per share, bringing the value of each share to $11.76.

On an absolute basis, these results are uninspiring. But with most equity markets having fallen in the high single-digits or low double-digits this quarter (e.g. the S&P 500 is down 12% for the quarter), the fund's relative performance was strong. If KVF were to outperform the market by this margin every quarter, shareholders would realize exceptional returns. Unfortunately, as nice as it would be, it's unlikely that the magnitude of this relative out-performance can be sustained.

There were a few reasons for the positive results relative to the market. First, gains in currency this quarter helped somewhat reverse currency losses which have accumulated over the previous three quarters. Had the USD/CAD exchange rate finished the quarter at the same level at which it started the quarter, earnings would have been $0.26 lower than they were.

Second, as markets were strong last quarter, the fund became a net seller of securities and thus built up a cash position. As a result, as KVF's stock portfolio fell with the markets this quarter, that cash position helped stabilize the overall portfolio. Furthermore, as markets fell, new positions were added and some existing positions were increased. Some of these positions have bounced off their lows, thus having a positive effect on the portfolio.

Finally, there were some stocks in the portfolio that bucked the trend of the falling markets. Strong moves in stocks such as Adams Golf (discussed here) and Quest Capital (which has been discussed extensively now on this site) helped counteract the downward moves in the general market.

Looking forward, KVF is still capitalized such that it is in a position to take advantage if more market opportunities should present themselves, despite the fact that it was a net buyer this quarter. At the same time, KVF owns several stocks deemed to be undervalued.

KVF's income statement and balance sheet are included below. Note that securities are marked to market value, and amounts are in $CAD:

Thursday, July 8, 2010

Being Wary Of Retailers

The financial statements of various retailers can look very clean in some cases: decent cash balances, low debt levels, and dropping inventory levels acting as a source of cash in this tepid retail environment. In many cases, the stock prices of these retailers can seem like veritable bargains in relation to their financial statements. After all, what value investor wouldn't want to buy a company for half of what it owns in inventories alone?

However, when valuing company assets, retailers should not be placed on the same playing field as companies operating in a different space, even if the financial statements suggest two companies are identical. This is because of an accounting standard that does not require retailers to include on their financial statements a most material of liabilities: their operating leases.

Consider Trans World Entertainment (TWMC), a retailer with about 560 stores across the US. The company trades for just $60 million, even though it has current assets (mostly inventory) of around $280 million, and total liabilities of under $140 million, for a net current asset value of around $140 million.

If a manufacturing company had the types of numbers depicted above (and some do have similar), it would likely be a straight up steal, as the company could cut costs (reduce output/headcount/facilities) while sourcing cash from its inventory. Most retailers, on the other hand, are burdened with fixed operating leases that in some cases don't expire for years, reducing the ability to cut costs. While manufacturers can also have operating leases, the magnitude of these leases are normally not nearly as material as they are for retailers.

For example, Trans World has operating lease obligations of $160 million over the next five years or so. (Compare this to the company's market cap of $60 million!) Trans World lost $10 million last quarter, and it may continue to lose money (eating into its current assets) as its cost structure is not flexible enough to allow for a quick turnaround, thanks to these leases.

Not all retailers have such daunting operating leases, however. Some, like Office Depot (ODP), own land and buildings outright, which provided ODP some much-needed flexibility during a cash crunch last year. Furthermore, the expiration of operating leases can empower management with the ability to reduce costs: companies can cherry-pick which leases to renew based on store-by-store profitability, thus improving overall results. Finally, we've also seen how some companies (e.g. Build-A-Bear as described here) have been able to re-negotiate their lease requirements lower as the lessors would rather work with them rather than lose a valued client.

Nevertheless, when viewing the financials of a retailer, alarm bells should go off because of the fixed-cost nature of this industry: what is this company contractually obligated to pay in the future, and does it have the ability to make those payments? While a company may trade at a discount to its net current assets, that is no good to investors if it will continue to lose money. To avoid falling into the trap of buying such companies, it's important to consider the company's cost structure thoroughly, no matter what the financial statements say.

Wednesday, July 7, 2010

Debt And The Economy

Many economists project a slow recovery from this recession, as consumer spending, which makes up more than two thirds of the economy, is not expected to rebound any time soon. On what basis are economists making these projections? Mounting job losses are a major reason why consumer spending is not expected to be strong, and serves as a risk to the economy going forward as we discussed here. Another reason is that consumers have started to reduce their debt levels (i.e. rather than spending, they are saving).

Consumer debt levels have been falling since late 2008. But we are still nowhere near the debt levels we were at just 10 years ago. The following chart illustrates how the consumer has been focusing on paying off debt as of late, but also shows how debt levels still appear high relative to recent history:

Clearly, consumer debt levels are quite elevated in a historical context, despite the recent well-publicized reductions. This indicates that there could be more debt reductions in store, which would further reduce the consumer's ability to spend. Will consumer debt return to the levels that they were in the year 2000, when the last recession took place? Nobody really knows.

Furthermore, it's important to note that much of the consumer debt burden (which is on the decline) has been shifted to governments. As governments will be forced to cut back (which is starting to occur now in Europe) in order to reduce debt levels, this will further hurt economic growth as funds are pulled out of the economy for the purpose of debt reduction.

Investors bullish on the stock market should keep these figures in mind. Revenue growth will be hard to come by for many public companies. For most, profit growth will have to come from cost containment and productivity growth. Companies with flexible cost structures may be in the best position to see their earnings grow.

Tuesday, July 6, 2010

The Buyout Factor

Value investors can spend a lot of time evaluating the quality of a company's management. We look at management's track record, and attempt to gauge the level of management's candor in providing information to shareholders.

But when it comes to companies that trade at large discounts to their net assets, is this exercise worthwhile? Thanks to our capitalist system, managers who are not getting the most out of company assets will often be replaced, a process which can often serve as the catalyst that helps a stock's price converge with its intrinsic value. By avoiding the companies with poorly performing managers, shareholders may be missing out on the potential for large gains.

Consider RCM Technologies (RCMT), a company we discussed about a year ago as one that traded at a deep discount to its net assets despite a flexible cost structure and therefore a decent earnings outlook. Nevertheless, management's poor capital allocation decisions in the past and their seeming intentions to continue to "build empires" had us avoiding the company.

But those who were willing to take the plunge despite the management situation would be rewarded. The company recently received a buy-out offer at a price which is about twice that of what it was when we looked at it last August. This is a classic case of getting rewarded for buying assets for less than they are worth.

For companies expected/required to generate above-average returns on capital, the management team is likely a very important factor in determining whether the investment makes sense. But perhaps we place too much emphasis on the management team when it comes to companies trading at large discounts to their assets. After all, management teams can be replaced, and shareholders can get rewarded in the process. On the other hand, buyouts are difficult to predict and may not occur with enough frequency to remove every poorly performing management in a timely manner.

The right decision is not always clear, but investors should keep in mind that the importance placed on the management team in weighing an investment decision may change according to the type of investment (e.g. an earnings play vs an asset play) being made.

Disclosure: None

Monday, July 5, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 12

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

This chapter is dedicated to the topic of crisis investing. This is another form of contrarian investing which Dreman recommends, but with a few added caveats.

How will investors know the market is in crisis? The crisis, be it financial, a war or some other reason, will dominate the news headlines. Investors will sell down industries or markets by 50% or more in very short periods. Rather than discuss prices of companies in the context of their earnings power or balance sheets, there will be a selling stampede for the exits as investors are willing to sell at any price.

Dreman takes the reader through a few crises that have happened historically, and how the investor could have identified and profited from these opportunities. In particular, Dreman discusses his own actions in profiting from the meltdown of the financial and bond markets in the early 80's, and the pharmaceutical industry plunge that occurred a few years later.

Diversification is key to crisis investing. It is often difficult to tell which companies will survive, but by researching diligently, the investor can get a good idea of which group of stocks is likely to be able to outlast the downturn. By diversifying among these issues, the investor stands to profit greatly.

Emphasis should also be placed on balance sheet strength, especially a company's debt to equity ratio. The companies with strong financial positions should be able to outlast the downturns, and perhaps even profit from them.

Sunday, July 4, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 11

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Dreman's contention is that investors tend to overreact both to the positive and the negative (depending on the relative outlook towards a company or industry). He cites numerous bubbles to make his case, and also points out that the opposite of bubbles also tends to occur (situations where prices are well below where they should be).

Rather than rely on anecdotal data to make his case, however, Dreman describes a study he conducted with he believes proves that investors overreact. Once again he separated stocks into quintiles based on how cheap they were (this time by their Price to Book values). He then found that the operating performance (based on 5 factors including ROE and sales growth) over the subsequent five years of the lowest quintile group was much weaker than that of the highest quintile group. Despite this, the prices of the lowest quintile group showed remarkable gains both on an absolute basis and in comparison to the highest quintile group. As such, Dreman makes the point that while the market is able to determine which set of companies will have better operating metrics, it overvalues these companies and undervalues those which are expected to perform poorly.

Dreman ends by discussing how investors can profit off such overreactions in ways that go beyond simply following a low P/E (or low P/B or low P/CF or high dividend-yield) strategy. For one thing, junk bonds tend to show abnormally high returns over time, as default rates are over-estimated. However, Dreman suggests that investors deciding to enter this arena know what they are doing as rigorous financial analysis is required. On the other hand, Dreman argues an investor with little knowledge can likely do well by investing in junk bond mutual funds.

Earnings surprises are also a good source for finding overreactions from which the investor can profit. Often, a company missing estimates by a few million dollars (pennies per share) can see its market cap cut by billions of dollars. As traders overreact, such situations are ripe for finding bargains. Studies Dreman points to have also shown that stocks that drop the most in one period are more likely than other stocks to rise in the subsequent period, suggesting a strategy of buying beaten up stocks can also be successful.