This chapter is about the various forms of accounting and their uses. The authors argue that accounting is the single most important tool in making sense of a business. It is the language of business, and investors who seek to understand companies must become fluent in it.
The distinctions between the following forms of accounting are discussed: cost accounting, tax accounting, and financial accounting. The authors argue that they each have their purpose, and noting the distinctions between them will help investors understand the limitations of financial accounting, which is the form of accounting used by investors.
For example, the authors argue that it is a misconception that the relative efficiencies of competing companies can be determined using financial accounting. There are too many assumptions that managements are free to make in financial accounting to allow for such direct comparison. To truly compare efficiencies between companies, one would have to have access to numerous internal (i.e. non-public) documents.
The authors also distinguish between financial accounting as used for corporate analysis and as used for market analysis. Market analysts focus on net income and earnings per share, on the expectation that changes to these numbers will lead to short-term changes to the stock price. Corporate analysts rely much more on financial position than current income numbers.
The authors also discuss circumstances where accounting describes the situation well, and where it doesn't. For example, financial statements are most useful when most profits are to come from the operations of a going-concern and there is heavy regulation limiting management leeway in the accounting assumptions. On the other hand, accounting is not so useful when a large portion of profits are to result from asset sales, imaginative financial techniques are employed, and managements throughout the industry make different accounting choices.
It's the last Friday of the month, so Frank (author of value site frankvoisin.com) and I are chatting messenger, where we discuss stories from the web that caught our interest:
Frank: Check out AGX. Tons of cash on hand. Sort of a weird conglomerate structure, but very little debt.
Saj: I've written about it here
Frank: Dammit, Saj, I swear you've looked at 98% of public companies.
Saj: Just the ones with high cash to debt balances...I'm no match for Cramer!
Frank: Can you imagine if you were on that show? Cramer would be screaming and making cow sound effects, and then they'd cut to you, and you'd be totally calm and say something about a company's fundamentals.
Saj: And I'd be off the show at the first commercial break. "Sorry, but when we cut to you, our ratings drop 50%"
Frank: "Yeah, can u at least 'moo' or something? Our research indicates animal noises raise viewer interest levels and strengthen our relationships with advertisers"
Saj: So salesforce.com is now trading at a P/E of 300!
Frank: Seems pretty fair.
Saj: Looks like the late 90's are back...any company with a "dot com" in the name is worth 5 times what it would otherwise be worth.
Frank: And another 5 times that that if they are related to "cloud computing" in any way.
Saj: To be fair, the guy in this video makes a pretty good case for owning shares at the current price.
Saj: Chinese reverse-takeover (RTO) stocks continue to take a beating.
Frank: HQS shows us you don't even need to be an RTO to have those problems, as an independent director resigned after claiming management was stalling him as he had "difficulties in verifying information relating to company accounts and customer positions".
Saj: That's pretty bad on the auditor, which is a fairly sizable firm, if "company accounts" are in question.
Frank: People are always saying the auditor can't prevent fraud, but at the very least can't they verify that the cash account is for real??
Saj: Seriously! It's like they spend all their time getting to really specific inventory numbers, or confirming whether the depreciation method conforms to GAAP, when what we'd really like to know is whether the bank balance exists!
Frank: "Are you straight line or accelerating your depreciation of that mirage?"
Saj: We should be allowed to ask auditors questions. "What is your process for verifying cash balances?"
Frank: As much as short sellers get a bad rap, thank God for them. If short-selling were outlawed, as my lawmakers would like, we'd still be thinking some of these stocks look like good value, because the SEC certainly wouldn't uncover these frauds.
Danier Leather (DL) is a vertically integrated designer, manufacturer and retailer of leather apparel and accessories. The company trades at a price to book value of about 0.75 and a P/E under 9 despite a healthy balance sheet.
Danier has a market capitalization of $60 million, but has generated more than $40 million of operating cash flow over the last four years. Because the company kept capital spending to less than $4 million in each of the last four years, most of this money accrued directly to shareholders.
Last year, the company spent more than $9 million buying back shares. This represents about 15% of the company's current market cap! In a particularly shrewd move, the company bought back a large number of shares via a Dutch Auction last year when the shares traded at about half their current level.
Currently, the company sits on $30 million worth of cash against no debt. The company should be eligible to buy back another 10% of its shares in just a few days, should it decide to continue along the path of buying back its shares, which would be consistent with its history of buybacks. This would have the effect of either pushing up the share price or lowering the company's P/E and P/B ratios even further.
But the perfect investment this is not, as there are some risks to the downside. For one thing, it has been a very profitable year for the company. While that's a good thing, investors should not rely solely on current earnings in calculating a company's earnings power. This was Danier's most profitable year since 2002, so counting on these profits as the new normal going forward may be a bit optimistic. Market forces (including competition, cost pressures etc.) could bring profits lower; they certainly have in the past.
Another potential drawback for shareholders is the company's dual-class share structure. This has allowed an ownership group to control the company without putting in the capital requisite with that level of influence. This structure results in a misalignment of incentives. It also makes it harder to oust management if it were to take actions that are not shareholder friendly.
Finally, this company has had quite an embattled history. It attempted and failed at a costly expansion plan, and managed to irk a few shareholders resulting in a costly lawsuit. While expensive, those incidents are now in the past and have already been paid for; but investors should note that the same management team is still in place, and so if they haven't learned any lessons, similar problems could cost shareholders in the future.
About one year ago, a company by the name of Jewett Cameron was brought up on this site as a potential value investment. At that time, the stock traded around $7/share, but over the last few weeks it has approached $11/share, offering investors the opportunity to exit at a return of approximately 50%.
Of course, there many stocks that have generated this kind of return (or more) in the last year. But what made Jewett a terrific investment was the limited downside risk to investors. That is, even if the economy or the market tanked, investors would likely have been protected. This is something you likely cannot say about the vast majority of securities that have returned 50% in the last year. If we look at some of the key elements that made Jewett's stock a low-risk, high-return type of investment, it can perhaps help us identify stocks that are undervalued right now:
1) Despite depressed earnings as a result of the recession, the company's P/E was under 10
ROE averaged 15% over the last 5 years
2) The company traded for its book value, despite strong ROE (above) and large land amounts carried at historical cost
3) Management had been in place for 25 years, and held a significant stake in the company relative to his salary
4) The company had no debt but lots of cash
Notably absent from these attributes is a "story" of why the shares should rise (predicting future market sentiment on a particular stock is practically impossible) and a known catalyst event that is expected to vault the stock upwards (if a catalyst is known, it's usually too late to buy the shares).
There's nothing overly complex about these attributes. All they signify is that the company was cheap and solvent, generated strong returns on capital, and had an experienced management team with incentives that were aligned with those of shareholders. And that's really all you need!
One and a half years ago, Orsus Xelent (ORS) was brought up on this site as a potential stock idea. Despite the numerous risks cited in that article, this author went ahead and invested good money in that company. The results were bad, as the stock has fallen by about 80% since that article. Perhaps by looking at what went wrong, it will be possible to avoid similar such mistakes in the future.
The first risk outlined in the article had to do with Orsus' customer concentration. Specifically, this distributor concentration led to a huge receivable balance on Orsus' balance sheet. The stock traded at a massive discount to net current assets, but this receivable balance was the largest component of the company's current assets. Unfortunately, this customer has been unable to make good on its obligations, and Orsus has now written down much of this balance.
Because of the size of the receivable due from this customer, Orsus did insure a large portion of it. Unfortunately, it did not insure enough of the receivable, as the write-down now brings the company to a negative equity position. In other words, the discount to net assets at which this company traded is not only gone, but the company's obligations now outnumber its assets! So while the margin of safety looked large numerically, it was in fact quite weak because it was dependent on the ability of a single customer to pay what it owed, and that didn't happen. Investors would do well to avoid companies heavily reliant on just one or two customers.
Another warning sign was that the company's former CEO was selling his shares at a rather frantic pace. Insider sales are often difficult to interpret, as insiders must often sell stock to lower their own risk (diversification) or to obtain/maintain the lavish lifestyles by which many managers are seduced. In this case, however, the pace of the sales was so strong (resulting in price pressure on the stock, which no seller would want to do unless he was very motivated) that maybe I should have gotten a clue.
But despite these adverse occurrences, I could have sold this stock for only a small loss. But I believe I instead fell victim to loss aversion bias, whereby I held out hope for a profit in order to avoid realizing a loss. Had I encountered this company a year after I did, I don't think I would have been interested in purchasing shares due to the company's inability to collect its receivables over this period. Nevertheless, I continued to hold the stock, which was a serious error in judgment that I believe is explained by this bias.
Unfortunately, knowing about this bias was not enough to prevent me from falling victim to it. Hopefully, having learned the lesson the hard way will save me from this error in the future. I hope this is a stock most readers avoided; and if they didn't, that they sold at a profit (which was possible) or at only a small loss.
Bassett Furniture (BSET) is a vertically integrated furniture company, as it imports, manufactures, wholesales and distributes a range of furniture. The company was profitable during the housing bubble, lost money for a while following the housing crash, and is now operating pretty close to break-even. But for value investors, it's not the earnings that are interesting, but the catalyst events surrounding some of the company's assets.
Bassett trades for $95 million, but has a deal in place (that is expected to close by the end of this month) to sell a company in which it has a minority interest for $74 million! This sale will produce a gain, which is subject to tax, but the company notes that it has "net operating loss carryforwards of [$18 million] that can be utilized to offset the taxes on the gain." In addition, the buyer will place $7 million in an escrow account that Bassett could receive over the next three years if no unexpected contingencies arise out of the company being sold.
In addition, Bassett has current assets of $83 million, long-term investments (money market and bonds) of $15 million, another minority investment carried at $5 million (equity method), and many tens of millions of dollars of retail real estate (including its own locations and locations it leases to licensees who are wholesale customers of Bassett), versus total liabilities of $83 million.
Of course, there are some risks with this type of investment. The most obvious is that the proposed deal may not close. But even if it doesn't, investors have a pretty good idea of what that minority investment is worth, which should act as a margin of safety.
But perhaps the biggest risk is what the company will do with all that money. Management didn't exactly narrow it down for shareholders when it stated it may use the money for "the retirement of debt and certain other long-term obligations, the settlement of various obligations related to closed stores and idle facilities, restructuring licensee debt, paying a dividend, judiciously funding expansion of our Company-owned store network, and/or funding stock buybacks and/or funding any potential future working capital needs."
While such a wide range of possibilities may be a bit scary for value investors, the company does have a history of paying out special dividends and buying back shares when it has extra cash. Unfortunately, management may only have done this because it had a gun to its head, thanks to activist shareholders who challenged the company's capital allocation. Management would probably rather grow the company than serve shareholders, as the company's CEO owns less than a million dollars worth of Bassett shares, but got paid almost half a million dollars last year.
On the other hand, management has not been taking wanton risks as of late to grow the company at the risk of profitability; the company has been closing the least profitable stores, and capex has been consistently below depreciation as the company has limited spending to store upgrades/refreshes rather than unjustified expansion. But management does appear to be pleased with the results of some new-concept stores it has been testing, so the possibility is there that management will use the bulk of this cash inflow to fund a growth program with uncertain results.
As Bassett shrinks down to its most profitable stores, it may be on the verge of returning to profitability. At the same time, it is likely to receive a major cash injection that the company may use to benefit shareholders. Value investors who believe this management team to be prudent may find this a stock worthy of investment, but those who don't will want to stay away.
The authors briefly discuss many of the disclosures public companies must release by SEC requirement, including financial statements and their notes. The usefulness of this paper trail of documents will vary by industry. For example, for a steady dividend-payer in a mature industry, more information will probably be released than the investor needs; however, for a miner or real estate company, GAAP financials are not as useful in determining a company's value.
For the investor to fully fathom the usefulness of these public disclosures, the authors argue it is useful to understand how they are created. For one thing, the lawyers and accountants who prepare many of the disclosure documents have no desire to risk their reputations on a third party (i.e. the company's management). As such, they are rather meticulous in making sure they disclose what they should, and are honest in doing so. Though frauds do occur, the authors believe they are few and far between, especially when compared with normal commercial transactions (where parties must always worry about the truthfulness of the party with which they are transacting).
Investors are also encouraged to obtain copies of the forms and mandated regulations required for filling them out. This will give investors a good idea of what those who fill out the disclosures must go through, and will therefore help the investor understand why a disclosure is laid out as such.
These disclosures also help identify which companies are not worthy of investment no matter what the price! Though many believe that every security is worth something at a low enough price, the authors argue against this line of thought. Some securities are too junior compared to the obligations of the company, and some managements are so egregious in their treatment of shareholders, that some securities should be discarded outright based on their disclosures.
Finally, it's important to recognize what's not contained in the disclosures. Internal budgets, management disagreements, marketing plans and other such matters in which shareholders might be interested are not normally disclosed. Often, projections, budgets and asset appraisals can be used for stock manipulation, so in some cases it is better that such "soft" details are left out. Nevertheless, the authors argue that in many cases these disclosures are so useful that they are all the investor will need to form an opinion of whether a security is worthy of investment.
The authors argue that there is risk in every investment. No amount of research can completely eliminate risk. Even if the investor does an absolutely thorough job analyzing a company, his analysis could be wrong, he could misappraise management, future unexpected events could occur, and/or the market may never recognize a company's true value. But using the techniques described in the book, investors should seek to tip the scales of the risk-reward ratio in their favour.
Most investors judge a stock's risk by the quality of the issuer. A well-known company, judged by others to be a quality issuer, is often considered a low-risk security by investors. The problem with this line of thinking, according to the authors, is that the fact that the company is a "quality issuer" would already be ingrained in the stock's price. As such, investors often pay a premium for such issues.
But what is considered a quality issuer changes over time. The authors describe a number of examples through the decades where quality companies have inevitably declined in prominence over time. These stocks in effect suffer a double-whammy of negative returns, as the companies decline in both earnings and in price multiples (e.g. their P/E ratios) as they lose their "quality" status.
Nevertheless, for investors will little knowledge of the market and a weak understanding of companies, a diversified quality-issue portfolio is likely appropriate. But for investors who are willing to take the time to understand a company, the authors argue that the issuer's quality is only one of three factors influencing risk, with the other two being price and financial position.
Smart investors with a deep understanding of a company seek to reduce risk by purchasing when the price is low (relative to the investor's estimate of the company's value). In this view of risk, risk actually reduces as upside potential increases. This is in contrast to the prevailing view in the finance industry, where conventional wisdom suggests that only by taking more risk can an investor achieve higher returns.
Finally, the third element of risk is financial position. Even the safest investment of all (e.g. US treasuries) can become a casino-style gamble if financed with 95% leverage. Some value investments can take years to play out, and therefore a strong financial position is important to be able to outlast the bad times.
The authors now take up the topic of modern portfolio theory, where it is assumed that prices properly reflect information relevant to a stock. The following passage from a textbook is critiqued:
"There are thousands of professional fundamental security analysts at work in the United States . . . As a result of the efforts of this army of professional fundamental analysts, the price of any publicly listed and traded security represents the best estimate available at that moment of the intrinsic value of that security. In fact, the fundamental analysts do such a good job, there is no reason for anyone who is not a full time professional to bother with fundamental analysis."
The authors flatly disagree with the above statement. They even go so far as to say that there aren't many competent analysts out there, certainly not enough to be able to render every security to its proper price. This is particularly true because many of the analysts out there are looking to determine where the stock price will go, rather than focusing on the fundamental value of the business.
The authors do argue that the market is efficient in some sense. For those who attempt to generate short-term returns, for example, empirical data suggest a "random walk" to prices. Furthermore, certain markets, such as the high-grade (low yield) corporate bond market are pretty efficient in the authors' opinions. However, the authors argue that it has not been proven that all investors interpret the public evidence correctly such that long-term gains in equities and other instruments cannot be realized due to market mis-pricings.
In a previous post, we saw how humans appear to have an overconfidence bias, and how that can play havoc on financial forecast estimations. What is not immediately clear, however, is the increasing role overconfidence plays the more knowledge one acquires. That is, as expertise rises, so does overconfidence, resulting in the fact that the people with the most knowledge are likely to be the most miscalibrated, which can result in detrimental effects.
But knowledge alone does not doom someone into being overconfident. James Montier argues that it's a lack of feedback that pushes people to be overconfident. To demonstrate this, Montier cites a study performed by Scott Plous that compares the calibration of weathermen against that of doctors. Weathermen were asked to predict the weather, while doctors were asked to diagnose patients (based on case notes). Both were asked to provide confidence intervals, so that their calibrations could be measured.
Interestingly, weatherman were well calibrated, while doctors were very poorly calibrated. Montier argues that this is because weather forecasters benefit from the fact that they receive immediate evidence of their abilities as forecasters, while doctors do not.
While one may be inclined to believe that financial analysts should be like weathermen in that they can see whether their forecasts came true, similar calibration tests appear to show that analysts are calibrated to a similar extent as doctors! As a result, the industry is glowing with overconfidence. Further testing confirmed the opening hypothesis: experts in finance are more overconfident than lay people, as they apply too narrow a band around their estimates as compared to the general public.
Hart Stores (HIS) is a department store retailer with 92 locations under the "Hart" and "Bargain Giant" banners. The retailer has maintained profitability throughout the economic downturn, and yet it trades for less than its net current assets. In Hart's last four fiscal years, the company has generated $16 million of operating income. But today, its market cap is just $20 million, giving it a price to book ratio of just over 0.4.
The problem with Hart is not so much its historical earnings but rather the trend of those earnings. Even before the recession, margins were on the decline, suggesting the company was having trouble competing with better assorted/priced other retailers. This has occurred despite the company's claims that it has "a dominant position in many of the communities it serves". Things have now deteriorated to the point where it is in doubt as to whether the company will have turned a profit last year; fourth quarter results should be out in a few days.
But the numbers likely underestimate the problems at this retailer, as the company has been able to benefit from a strong Canadian dollar. As the company procures a lot of its products from the US in US dollars, it sells its products to Canadians in strong Canadian dollars. This is likely helping profits, and yet the financials continue to deteriorate, suggesting the company is having a lot of difficulty competing. What would happen if the currency trend were to reverse?
Even though operations are on the decline, the company is pushing ahead with expansion plans. For many investors, this likely appears to be a risky strategy; normally, value investors like cheap companies that are growing, but only if they are growing profitably. Hart's strategy appears risky, considering that the company's existing stores already appear in trouble.
Unfortunately, investors really are outsiders when it comes to this company. For better of for worse, the Hart family controls the company. As discussed before, sometimes family business owners have different priorities than maximizing shareholder value. These priorities can sometimes lead to an imperative to grow/invest in a business even if the more prudent action might be to return cash to shareholders, who can then allocate capital to investments with better risk/reward profiles.
Of course, if the Harts (who as a team occupy the Chairman, CEO, President, and three board of director positions) can turn this thing around, shareholders will be greatly rewarded. Unfortunately, there is no indication (at least to outside shareholders) that this is either possible or plausible.
One of the most important determinants of whether a company makes for a good long-term investment is the industry within which it operates. We've discussed the boom and bust nature of the housing industry, the generous margins garnered by the soft-drink industry giants, and reasons why airlines make for poor long-term investments. But on the average, what do industry returns look like?
Harvard Professor Michael Porter, using data from Standard and Poor's as well as Compustat, has calculated the profitabilites of various industries over the 1992-2006 period, some of which are shown below:
Clearly, there is high variability in returns on capital by industry. Average industry ROIC in the US was calculated at 14.9% by Porter, demonstrating that some industries are clearly extremely profitable, while others destroy capital.
Does this mean you shouldn't own a company whose industry returns fall below the average ROIC? Absolutely not! Within industries, returns may also be highly variable, in the case where one or two companies have differentiated themselves or are low-cost producers that generate consistent industry-beating returns. Furthermore, even companies with meager returns can trade at such large discounts to book that returns on the market price of equity are quite high. But you may still want to stay away from the airline industry!
Last time Alpha Pro Tech was discussed on this site (about one year ago), investors were warned to be wary of the company's current earnings because of a one-time spike in revenue. Alpha Pro Tech (APT) makes a range of protective products, and demand for its face mask spiked last year as fears of an H1N1 breakout spread. Now that revenue has dropped back down to normal, however, it appears that the market may have overreacted to the downside, as the stock is down more than 60% since that article and more than 80% from its 2009 peak.
APT now trades at a price to book value of about 0.8, despite profits over the last business cycle that are reasonable compared to invested capital. This gives the investor solid downside protection, as the company approximately trades for its net current assets despite a history of positive net income.
The reason for the low stock price is likely due to low current earnings, as the company barely eked out a profit last quarter. In addition to having to deal with the drop in demand of face masks, the company was recently dealt a blow by its major distributor, which decided to compete with the company on certain products. This distributor represented almost 30% of sales in 2009 (this is a major risk, as previously discussed), but now represents only 14% of the company's sales, which should result in much more stability going forward.
The company also appears to be taking shareholder-friendly steps to get the company back on the right track. It sold its money-losing pet bed business two months ago for its inventory at cost plus Goodwill. When a company trading at a discount to its book value converts assets into cash, it usually reduces the investor's risk. APT has also been consolidating its manufacturing facilities in an attempt to cut costs. Furthermore, perhaps recognizing that the shares are cheap, the company recently increased its share buyback authorization.
But can the company get back to the level of profitability it has shown in the past? There are some reasons to be optimistic. The company's Building Supply segment has quadrupled in revenue since 2007 despite a very weak housing market, and contributed a record $2.4 million to the company's income in 2010. As a result of strong customer response to the company's roofing products, management has increased inventories for this segment in anticipation of even higher sales in 2011. If you slap a 10x multiple on the 2010 figure and add the company's cash balance, this gives a valuation of $29 million, which is what the entire company trades for! From this vantage point, the investor is receiving the other two segments (Infection Control and Protective Apparel), which are historically APT's most profitable segments, for free!
The investor's path to prosperity through this stock is not without risk, however. In many product lines, APT competes with several companies with larger scale and financial clout. Furthermore, management's bonus structure provides clear incentives to grow the company's operating income; attempts to grow profits are not always in the best interests of shareholders, as there is a risk that management will seek to enlarge the company at low rates of return on capital. At the current price, however, the market may be offering shareholders three profitable business lines for the price of one.
Disclosure: Author has a long position in shares of APT
In this chapter, the authors discuss the importance of price performance to an investor. An argument is made that too many market participants put too great an emphasis on price performance, and not enough emphasis on business performance. But there are a number of reasons why a company's short-term price and long-term business performance can diverge, including:
- changes in stock market levels
- changes in interest rates
- cyclical economic fluctuations
- quarterly (near-term) earnings performance
- dividend changes
The authors do, however, recognize that for some, price performance is of paramount importance. For example, traders who know nothing about the company's business but who focus only on price volatility, trading volumes and previous price movements have no choice but to rely 100% on a security's price movements in making their decisions. At the other extreme, those with a long-term outlook who have a deep knowledge and understanding of the underlying business' value wouldn't place much emphasis at all on the security's price performance, opting instead to rely on their own valuations.
The authors also take issue with the general consensus that has developed with respect to the value that money managers add based on their short-term performance. Because many managers are beaten by the market after fees, it is generally accepted that these managers are useless. But the authors make the point that most managers have requirements such that "beating the market" is not part of, or only a small part of, their mandates. For example, the money manager at an insurance company should not be trying to outperform a bull market, but rather protect his business from being under-capitalized. Furthermore, statistically, even terrific money managers will be beaten by the market over several periods.
The authors believe that successful activist investors, creditors and private owners share two common attitudes towards investing that regular investors would do well to internalize. The first concerns their perspective towards losses vs gains. The authors argue that the most successful activists first consider how much they can lose before asking the question of how much they can gain.
The second attitude concerns their perspective of risk. To successful activists, risk is not measured externally (e.g. as a function of price volatility), but rather internally as a function of the quality of the security and its financial position.
This leads the authors to describe a philosophy of investing that they believe leads to superior returns in the long-haul relative to the market. They call it the "Financial-Integrity Approach To Equity Investing". Under this approach, a security may only be considered for purchase if the following four tenets are met:
1) The underlying company has a strong financial position (more important than strong assets is the lack of significant obligations)
2) An honest management and control group
3) A reasonable amount of relevant information about the security is available
4) It is priced below the investor's estimate of net asset value
The authors take care to note that just because a security meets these requirements does not make it suitable for purchase; rather, it must meet all four criteria to be even considered for purchase.
Even though the authors believe an investor following this philosophy will do well, they note that it has several disadvantages. For one thing, it requires a lot of reading and understanding of numerous documents/filings. Furthermore, since the investor is not in a control position, he has no control of the timetable of when he will be in a position to buy/sell the security. Finally, there are only a small subset (many of which are illiquid!) of the market's securities that fit into these criteria.
Humans don't like ambiguity. This is demonstrated in the experiment Hersh Shefrin discusses where subjects are offered either a guaranteed $1000, or a 50/50 chance at $2000. Consistently, fewer than 50% of respondents prefer the gamble for $2000, even though the expected values (i.e. the average value of the result if it were conducted many times) of both offers are the same.
What if the 50/50 odds in the above experiment were instead unknown? This adds even further uncertainty to the situation, and results in even fewer people willing to gamble on the $2000.
Shefrin calls this phenomenon "aversion to ambiguity", and on Wall Street it results in downward pressure on the prices of securities with uncertain outlooks. In order to avoid uncertainty/ambiguity, humans will stay away, even if the odds are favourable (i.e. downside risk is low, upside potential is high).
In his book, Shefrin argues that this ambiguity aversion is the reason for government intervention, even when it is not needed. What would have happened had the government not bailed out the banks? Nobody really knows, but the fact that the outlook was uncertain made the government want to intervene, even at a high cost, in order to avoid the uncertain situation.
As Mohnish Pabrai notes in his book, risk is not the same as uncertainty. Uncertainty can drive down the prices of assets/securities, even if downside risk is low. By capitalizing on situations where uncertainty is high, but risk is low, the investor can put himself in a position to earn above-average returns.
Xyratex (XRTX) designs and manufactures digital storage solutions and storage process technology. The company can currently be purchased at a price not seen since 2004, when revenues were about one-third of what they are today. The company trades at a P/E of just 2.5, while sporting cash of $98 million against no debt.
The stock has fallen by 40% in just the last three months, as both the company's financial performance and its outlook have been below estimates. If the problems the business faces are short-term in nature, this is the kind of situation where value investors with a long-term view can generate strong returns.
In the early part of 2011, PC sales have been lower than expected, reducing demand for the company's products. One of Xyratex's two segments derives revenues in large part from the capex investments of storage firms, which results in heavy cyclicality (revenues in this segment can rise and fall significantly from period to period). When sales are softer than expected (as they have been so far this year), Xyratex's customers will of course be reluctant to invest in growth, resulting in quarterly revenue for Xyratex that has fallen dramatically.
Sales also fell because of component shortages resulting from the earthquake in Japan. Xyratex itself does not have operations in Japan, so there are no direct costs in that respect, but customers who can't procure core components from Japan are reluctant to purchase components from Xyratex that they can't assemble without the complementary parts from Japan.
One major owner appears to believe that the problems are short-term; the company is 12% owned by Royce and Associates, a firm focused on value investments. The company's board of directors appears to concur, as Xyratex recently authorized a buyback of $50 million. At today's stock price, this would represent more than 15% of the company's shares outstanding. Despite the buyback, management expects to finish the year with $100 million in cash, meaning management expects the company to generate another $50 million of cash from the business between now and the end of the year.
In its quest to earn more, the company also benefits from a very favourable tax environment. For this Bermuda-incorporated company domiciled in the UK with manufacturing operations in Malaysia, taxes are nowhere near US business rates. As a result, operating income has been a decent proxy for net income, allowing the company to keep more of what it earns.
Not all of the issues are short-term, however, as there are some potential problems that could hurt the company in the long run. Customer concentration is high, and continues to increase. Companies in the storage space have been consolidating, giving them greater resources to research and develop the products they currently buy from Xyratex, and the market power to lower Xyratex's margins.
Furthermore, as a player in the fast-evolving technology space, Xyratex is only as good as its newest products. There is the risk that the company will fall behind the competition as the cloud-computing world continues to evolve. Investors must ensure that they understand the competitive threats facing the company from not only continuously evolving specs, but potential disruptive technologies that can alter the competitive landscape.
Disclosure: No position
The following is a sponsored post, paid for by MCW Energy Group. Content was provided by MCW Energy Group. The site's author does not own any MCW Energy Group Securities.
MCW Energy Group (“MCW”, “the Company”) is a Canadian holding company with two principal portfolio companies, a fuel distributor based in Southern California, and a break-through oil sand recovery venture with operations in Utah. MCW is a public company trading on the on the Frankfurt exchange under the symbol MW4.
MCW’s oil sand recovery technology, a leader in the industry with respect to environmental safety and efficiency, has the potential to open vast U.S. oil sand reserves to production. The Company expects rapid growth, both from sales of crude oil recovered from Utah oil sands under lease, and through improved competitive positioning in its core fuel distribution business. MCW’s two primary operations are:
• McWhirter Distributing Co., a leading distributor of branded and unbranded gasoline and diesel in the West Coast of the United States, and
• MCW Oil Sands Recovery LLC (“MCWOSR”) which will produce and sell oil extracted from oil sand reserves under lease in Utah.
The Company combines a steadily-growing fuel distribution business with an emerging, oil sand technology and extraction business. Based on conservative projections of oil pricing as well as operating costs, MCW’s oil sand recovery economics are attractive. Management anticipates that the oil sand operation will add significantly to MCW’s projected revenue and EBITDA growth, beginning in 2011.
Beyond these positive economics is a key strategic rationale for combining the two businesses: fuel distribution is an intensely competitive industry. While MCW’s fuel distribution business has certain advantages over competitors, profit margins are thin and prospects for growth are essentially limited to the growth rate of the overall economy.
However, as a producer of oil MCW becomes a supplier to the integrated petroleum companies that wield significant power over the much smaller regional distribution companies, including McWhirter Distributing Company. By having steady access to a supply of oil and control over the pricing, MCW believes it will be able to negotiate contractual terms that provide advantages on the distribution side of the business.
Disclosure: The above is a sponsored post, paid for by MCW Energy Group. Content was provided by MCW Energy Group. The site's author does not own any MCW Energy Group Securities.
For the reasons outlined here, Genesis Land has been on this site's Stock Ideas page for about a year. Last week, the company received a buyout offer at a large premium, presenting a potential exit opportunity for investors who purchased the shares on the cheap. Unfortunately, based on the stock price reaction, the market doesn't believe the proposed deal will actually close.
While the offer was for $5.80 per share, shares closed at just $4.56/share yesterday. The press release disclosing the offer listed an intention to close the transaction by August 12th of this year, which is only four months away. As a result, the market is offering arbitrageurs the potential for an annualized rate of return of more than 80%!
Of course, that return is only realized if the transaction closes. Before that happens, a number of conditions must be satisfied, not the least of which is the fact that the buyer needs financing. The buyer is a brand new company with no operations, recently incorporated by a Calgary businessman named David Crombie. Crombie will now attempt to raise several hundred million dollars in just four months in order to complete this transaction, which would be a rather daunting task for most individuals.
So now that an offer has been made, should investors take their profits and sell, despite the large discount at which the stock trades to the buyout offer? That would be the safest thing to do, but may not be the wisest.
First of all, the buyout offer isn't at some pie-in-the-sky valuation whereby the stock will fall precipitously if the transaction fails. The stock is only up a few percent following the offer announcement, so the immediate downside does not appear large.
Furthermore, the company is now clearly in play, which could bring a competitor or strategic buyer to the forefront. The breakup fee on Genesis' side is only $500,000 (or just over a penny per share), which should act as little deterrent for a well-financed real-estate development company looking to grow their size and reach. Third-party appraisers have put the value of Genesis' land holdings much higher than its current price, which could entice a buyer to come to the forefront now that an offer is on the table.
Normally, I don't like to play the role of risk-arbitrageur. But in this case, the market's discount to the offer price coupled with the value of the firm's underlying assets suggest that the downside risk is low relative to the upside potential. As such, I'm sticking with it despite the significant chance of a price retreat in the event of a failure.
Disclosure: Author has a long position in shares of GDC
Six months ago, the bottom fell out from under the stock of H&R Block (HRB). Shares fell to a 10-year low, giving the stock a normalized P/E of around 7 despite a strong balance sheet. Investors who pounced on the opportunity have seen their shares appreciate by 70%, as the stock closed in on $18 last week. The lessons to be learned from this value play apply to a large number of current and future opportunities.
Many of the problems facing the company were short-term in nature. For one thing, there was a great deal of concern over whether H&R would be able to obtain bank financing for its RAL product in time for this year's tax season. (The product allows individuals expecting a refund to borrow against that anticipated refund.)
Furthermore, there were worries about H&R Block's potential liabilities on improper mortgages it may have issued. While the discovery of these liabilities could result in a large hit to current earnings, the company was capitalized such that it could afford to take a hit of more than 10 times the company's liability estimates and still easily survive, based on the stable, annual cash flows it receives in its core tax-return business.
Nevertheless, the market panic was very real, scaring away many investors. One comment I received after writing about the potential opportunity at the time was as follows:
"The price action of the stock today should say enough. Stay away for now. There are sellers all over the place ready to hit your bid."
The problem with this line of thinking is that it is very bad for portfolio performance! Investing with the crowd is not the way to outperform the market; it is contrarians who beat the market. As such, when everybody else is selling something, that's when your interest level should rise. (Conversely, when everyone else is buying, it's probably a good time to exit.)
What may be even more interesting is that over the last six months, these issues haven't really gone away. Mortgages can still be put back on the company, the company was not able to secure RAL funding, and the company continues to face headwinds with respect to its business model. And yet the multiple at which the company trades now is much more reasonable.
This reinforces the fact that its okay to buy companies with problems; every company faces some challenges, but the ones that make for good investments are cheap and have a financial position such that they can outlast the problems. Rather than focus on the short-term headwinds, therefore, investors should focus on the price they pay versus the long-term value they receive, irrespective of how the market is behaving.
Disclosure: No position
The first chapter discusses the authors' overall views of the market, and their intent with the book. The authors disagree with the way stocks are traditionally analyzed, whereby cookie cutter formulas are applied to securities of all types. Depending on the situation, different approaches should be utilized, and the book will attempt to discuss such approaches.
Furthermore, the authors dispute the accepted notion that risk reduction results in lower returns. The opposite view is taken. That is, minimizing downside risk actually tends to increase return.
The book is aimed at outside investors, i.e. those without access to more than public information and those who exert no influence or control over the company's operation. The authors stress the importance of understanding the business. That is, investors should be able to grasp the business' opportunities and potential pitfalls. That is not to say that investors need to understand the source of security price fluctuations and predict near-term macroeconomic activity; the authors believe there is very little predictive power in these pursuits.
The book is appropriate for the analysis of special situations as well as cash-return investing.
The final piece of advice from Fisher on the subject of avoiding frauds is for investors to do their own due diligence. He acknowledges that it is tempting to look for shortcuts. Many people make investment decisions by relying on friends or people in perceived positions of authority. But such people have increased the odds of getting duped by a rat. One of the reasons fraudsters target people belonging to affinity groups is that they are more likely to accept the recommendation from another member of the group and assume that the due diligence has already been done, rather than do their own.
In order to conduct due diligence, investors also need a fund that offers a decent level of transparency. For this reason, Fisher advises against investing in feeder funds or "funds of funds". Not only do these setups have a bunch of extra fees, but they also add a layer of obscurity, making the due diligence a lot more difficult.
SEC-registered firms are simpler to vet. These companies are required to disclose certain information, and are subject to random checks. However, SEC registration does not guarantee that a fund is not a fraud. The SEC staff is simply not equipped to be able to find all frauds before some investors get duped. Fisher gives the reader a rundown of the various forms investors should read and what they should be looking for.
Karsan Value Funds (KVF) is a value-oriented fund, as described here. Due to securities regulations, the fund is not open to the public at this time. Should that change in the future, there will be an announcement on this site.
For the first quarter ended March 31st, 2011, KVF earned $0.72 per share, bringing the value of each share to $13.77.
The market had yet another strong quarter. This will make the results of long-only funds look good, but it can also allow complacency to set in. A rising market results in a perception that risk is low, when the reality is that downside risk increases as prices rise. As such, the true test of whether this (or any other) fund is adding value will take place over a period of several years, through both rising and falling markets. So far, the fund has only been in existence for 1.75 years.
Gains in former fund holdings Imation (discussed here), Envoy (discussed here), and Kirkland's (discussed here) helped contribute to KVF's strong performance in the quarter.
These gains were offset by realized losses in Belzberg (discussed here). Over the course of the fund's ownership of shares in Belzberg, the company managed to lose a tremendous amount of value. But thanks to a very generous margin of safety offered by the market at the time of purchase, the fund was saved from more impacting losses.
Once again, currency markets continued their assault on the fund's performance. Had the USD/CAD exchange rate finished the quarter at the same level at which it started the quarter, earnings in the quarter would have been $0.19 higher. Despite taking some heavy currency losses over the course of the fund's young lifetime, the fund will not alter its strategy of not hedging its currency risk for the reasons outlined here.
Looking ahead, the market in the aggregate appears quite fully priced by a number of measures, not least of which is the PE 10. However, there nevertheless appear to remain a number of undervalued issues in certain areas of the market that the fund will attempt to exploit.
KVF's income statement and balance sheet are included below (click to enlarge). Note that securities are marked to market value, and amounts are in $CAD:
Chartwell Technologies (CWH) designs gaming applications (e.g. slot games, table games) for companies that operate online casinos. Its shares are at an all-time low, going as far back as 12 years ago. The shares are even some 70% lower than they were in March of 2009, which is a dubious distinction usually held by debt-laden companies with serious bankruptcy risk. But Chartwell has no debt against $15 million of cash; and yet it trades for just $11 million.
The company's current assets total $17.5 million against total liabilities of just $1.2 million, giving the company a large discount to its net current assets.
But how is the business doing? Pretty darn good, according to management. In the press release accompanying the company's latest quarterly results, its "highlights" section was comprised of just three bullet points, essentially stating the following:
1) The company expanded its client base
2) The new client has some of the most popular sites around
3) Four new slot games were released
When a company reports only good news and completely omits any financial details in its opening section, investors may read management as lacking candor. Investors who don't read any further than the company's highlights might think this was a growth company trading at a great price. Alas, despite the fact that there was only good news to be found in the "highlights", revenue decreased by 10% (due to the loss of a significant customer), and the company had to pay higher royalty fees such that it couldn't materially reduce costs commensurate with revenues. Furthermore, over the course of the quarter, the company managed to lose $2 million, representing a significant chunk of the company's margin of safety!
Nevertheless, the company is still quite cheap on an asset basis, so can value investors make money? Not without a lot of risk, due to management's rampant optimism. To get the company back to profitability, Chartwell's focus is on growing revenues rather than reducing costs. Both the marketing and sales department budgets have increased, as the company "is
working aggressively to replace the decline in revenue that occurred over the last year."
Chartwell management might very well succeed in its plan to restore revenues to previous levels. However, in so doing, it is risking all that cash that could otherwise be distributed and put towards less risky ventures. Clearly, not all net-nets make for low-risk value investments.
Disclosure: No position
Global Railway Industries (GBI) provides locomotive re-manufacture services to the railway industry. The company trades for just $20 million despite $12 million in cash, no debt and a history of profitability.
Rail traffic nosedived during the recession, causing overcapacity in the industry that reduced the need for the types of services Global Railway offers. But while the company lost $4.3 million in 2010 (excluding the gain from the sale), it did manage to earn $3.3 million in 2007. Because the market focuses current earnings, value investors can profit in cyclical industries when earnings are temporarily depressed and the company's financial position is strong enough to outlast the downturn. So far, this company has the makings of being such a situation.
But investors must not assume that a company in a cyclical industry will see its earnings go back to previous levels. Changes at the company (or its competition) could render past results rather useless in forecasting future earnings.
In Global Railway's case, it is no longer the same company it was a year ago. The company sold its instrumentation and track/signal segments in the last few months in order to pay off debt. So though the company now operates with a cash surplus, it has only its locomotive segment left.
As such, in estimating future earnings, investors would be better served focusing on the earnings derived by the locomotive segment over the last few years. The problem, however, is that the segments that the company sold were its most profitable! In fact, its locomotive segment has not made money since the company started breaking out its results separately some four years ago. As such, investors expecting this company to return to profitability as railway economics improve may be sorely mistaken!
Nevertheless, Global Railway does trade at a significant discount to its net current assets, and so some investors may be interested regardless of the company's past record with its only remaining segment. If the company is able to turn things around, shareholders would likely see a large payday.
Disclosure: No position
Closed-end funds can and do trade at significant differences to their net asset values. But do these situations offer value investors strong upside potential while employing minimal risk? It depends on the situation. For example, consider shares of Canadian World Fund (CWF), which trades at a 30% discount to the market value of its net assets.
There can be many reasons for a fund to trade at such a large discount to its net assets, some of them quite reasonable. Often, some of the companies or securities in which a fund has invested are not even listed on public exchanges. This reduces the level of confidence an investor can have in the actual value of the net assets. In CWF's case, 99% of the fund's investment portfolio is public. Investors in CWF with access to global stock markets could theoretically short these stocks to reduce their risk.
But owning shares of a fund is not the same thing as owning the shares of each individual company, and not just because of voting rights. Investors in the fund have to fork over a management fee for the right to hold those stocks. While the fee might seem trivial in relation to the discount (e.g. the fee might be in the range of 2%), the fee is annual, and therefore a better comparison of the fee to the discount involves calculating the fee's present value for a number of years out, and subtracting it from the fund's net asset value. In many cases, this exercise can reduce even a seemingly large discount to zero! CWF has a management expense ratio of around 2.5%, which will significantly eat into shareholder returns over a number of years.
Another item worthy of discussion for investors considering closed-end funds trading at large discounts is management's incentive structure. Does management want to grow the company and thereby grow in importance and salary, or does management want to maximize shareholder value? The answer to this question can go a long way in determining how a fund is likely to react in the face of a large discount. In the case of CWF, it is controlled by the same people who own the management company. As such, they are likely to want to grow the fund (and increase fees) rather than shrink through a buyback, even though shareholders would benefit greatly from the latter.
Of course, management's abilities are also important. A closed-end fund run by Warren Buffett, for example, would probably trade at a premium to its net assets, under the assumption that net assets would grow at a faster rate than the market. In CWF's case, however, the fund has seen its net asset value grow by 0.2% annually over the last ten years...before fees! The fund's prospectus notes that past performance does not necessarily indicate future performance; for the sake of CWF's shareholders, I hope it doesn't!
Finally, as strange as this may sound to bottom-up value investors, they may want to consider the level of the stock market as part of their analysis of a closed-end fund. Is the market priced for perfection (e.g. by using a long-term valuation tool such as the PE 10) ? This may give the investor an indication as to whether the company's net assets are likely to rise or fall in the coming years.
CWF does trade at a large discount to its publicly traded net assets. However, when considering management's fees and incentives, the discount no longer seems so grand. Furthermore, considering the market's PE 10 levels (which are approaching the mid-20s) along with CWF management's poor performance track record, CWF's net assets may be likely to fall over the long-term, which may reduce or eliminate any remaining discount in the eyes of value investors.
Disclosure: No Position
Isn't it crazy to avoid investing in energy stocks? After all, don't we all know that energy prices are going up in the long term? After all, as large, developing countries continue to grow, demand for oil is sure to sky-rocket. Furthermore, as a non-renewable resource, the world's oil supplies reduce every single day. Unfortunately, these stories don't tell the whole tale, and the reasons for value investors to stay away from investing in commodities like energy have never been stronger.
Energy prices are volatile, and the direction of price changes is hard to predict. While the factors described above (emerging economies, non-renewable resource) will play an important role in the future price of energy, they are over-emphasized by the media and those who are bullish on the price of oil. Under-emphasized, however, is the market reaction to the high (even relative to recent history) prices.
First of all, high oil prices result in increased exploration and increased production. But neither of these occur overnight. Instead, they take place over a period of several years, as labour and capital is shifted to the energy sector in order to derive strong returns. We saw this effect taking place in the early 1980s, and we are seeing it again.
Second, high oil prices result in consumer and business shifts towards conservation and the development of technologies that increase energy efficiency. As an example, consider the increase in energy efficiency of new American passenger vehicles sold in the last few years:
Note that the last time efficiency was jumping by this magnitude was in the early 1980s, when oil prices last spiked significantly. When oil prices were low, there was no need to purchase fuel-efficient cars and there was no need to invest in technologies that would increase efficiencies.
But once again, changes in efficiency don't happen overnight, which is why oil demand is relatively inelastic in the short term (e.g. one still has to fill up his car to get to work, no matter what the price) but elastic in the long term (e.g. the car-owner will consider fuel efficiency the next time he buys a car). Over the next several years, as higher efficiency vehicles replace older relatively inefficient vehicles, oil demand in this country will start to decline.
Will this offset emerging market growth and supply constraints? It is difficult to tell. This will depend on how fast developing countries grow, how quickly new supplies are found and at what cost, and the rate at which technologies that improve energy efficiency are brought to market. Simultaneously sorting through these variables to come up with a forecast is a difficult exercise riddled with traps.
The safest bet for the value investor is not to make one at all, since being wrong on the future price of oil is too easy to do. With the number one priority of value investing being "Never Lose Money", value investors should stay away from making investments that are heavily reliant on the price of energy, either on the cost or the revenue side. Instead, investors should focus on companies that face stable pricing of their products and have flexible cost structures.
Rather than focus on the strategy of the fund, fraudsters distract you with things that don't matter. This brings us to Fisher's fourth signal to look out for, that of a fancy facade.
Specifically, Fisher advises that investors be wary of claims of exclusivity. The manager should want your money; he should not make you feel like he is doing you a favour. Turning the tables on you like this is how a fraudster protects himself from an investor who seeks too many answers.
Fraudsters will also focus attention on their entertainment connections. Just because a manager hangs a picture in his office showing him spending time on the yacht of a professional athlete you recognize does not make him a manager worthy of your investment.
Political leanings and affiliations with affinity groups (e.g. religious groups) are also exploited by fraudsters. Avoid being swayed by irrelevant items such as these.
Fraudsters aren't really generating the returns they say they are, and therefore they can't come clean about their investment strategy. As a result, they use a lot of jargon in their strategy descriptions in an attempt to make the investor feel too stupid to ask questions. Investors must ignore the tendency to shy away from asking question, and only invest if they understand the strategy, and can compare the manager's historical returns to a benchmark that mimics the strategy.
A legitimate manager won't mind a potential client trying to get a better understanding of the investment strategy. That manager wants the investor's business, and is therefore willing to have someone explain the strategy very clearly, even to someone without a financial background.
But a fraudster doesn't have a strategy that he is willing to admit to publicly, so he will make the strategy sound complicated using a lot of mumbo-jumbo, or seem angry/insulted when asked for more details. For this reason, Fisher recommends that investors ask for a simpler interpretation of the investment strategy until it is clear enough for them to understand. If the manager can't do this, it's time to walk away.
Fisher describes the story of one potential investor in Madoff's fund who just couldn't get a coherent explanation of what Madoff's investment strategy entailed. Madoff couldn't, or wouldn't, and so the investor walked. Obviously, it saved him a lot of money. Fisher also gives other examples where fraudsters were vague about their strategy descriptions, for if they weren't, the public would be able to see that the historical returns being presented just weren't possible.
Netflix (NFLX) offers its customers both DVD and internet streaming of movie and television content. It is widely credited for the demise of Blockbuster, the movie rental company that went belly-up last year.
Shares of Netflix have been on a tear lately, having increased more than 700% since the beginning of 2009. Once the market has recognized a stock like this, it is a great time to jump in on the bandwagon!
Investing in Netflix is also a very low-risk venture, as the stock's beta is only 0.48. As such, even if the market falls dramatically, investors in Netflix will be relatively protected, as the stock will only fall by roughly half as much as the broader market.
There are many who argue that Netflix is overpriced, as its P/E now flirts with 80 despite new competition coming online, and the upcoming expiry (and much higher renewal costs) of some of Netflix's content distribution agreements. But as they say on CNBC, "price is truth", and so as Netflix recently closed above its 5-hour moving average it is poised to continue to rise.
Besides, at the company's current growth rate, its P/E is not high by any stretch. Netflix has more than tripled its profit over the last three years. Projecting that growth rate forward, its P/E would only be around 25 in three years, which is rather low for such a high-growth company. Considering Netflix's subscriber count is just 20 million versus the world's population which approaches 7 billion, there is still plenty of room to grow into its P/E.
Clearly, Netflix is offering strong upside potential with limited downside risk. Investors not part of the crowd that has already jumped into this stock should get in before it really rockets upward.
If you caught ten or more investing errors in the above article, you are probably a value investor!
Disclosure: Author is a customer of Netflix, but would not touch its shares at the current price