Price and Book Volatility

Last week, we looked at the historical price to book value of Melcor, and noticed that it sells today near historic lows. While this may suggest a buying opportunity to some, many would argue that varying levels of price to book ratios are appropriate based on changing expectations for the value of Melcor's book value. For example, if real estate prices are expected to increase, price to book values should be higher, since the company will experience gains as it sells land for higher than it is booked. Conversely, if prices are expected to contract, writedowns to book value should be expected, and therefore investors should only purchase at a discount to book value.

By separating out the components of P/B, we can get a good idea of whether this is what's driving the dramatic changes in Melcor's P/B (values in $millions):

Clearly, whether times are good or bad, Melcor's book value does not change dramatically. Even through this most recent downturn, which hit Western Canadian real estate prices hard due to their local economic exposure to commodity prices, Melcor's book value retreated only marginally or stayed flat. Through the commodity and real estate price run up from 2004 to 2007, book values did increase more than normal (as gains were realized), but not nearly enough to justify the dramatic price increases which made this stock fiercely overpriced!

Indeed, it would appear that while the market appears able to predict the direction of book values, it overreacts both when book values are rising and when they are not. This theme is not specific to Melcor. As we saw when we looked at several major US homebuilders, during times like these the market will often offer real estate at large discounts which are more than enough to offset any upcoming writedowns.

Determining whether a company or industry is historically cheap by looking at P/B values is not limited to home builders. We have previously seen how the relative valuations of banks can also be judged on this basis.

Disclosure: Author has a long position in MRD

Benchmarking

Whether managing their own money, or having given it to a professional, investors want to know if the time/money/effort spent on security selection is worthwhile. To do that, a logical approach is to compare results with those of an appropriate benchmark. But what is an appropriate benchmark? The answer will vary by portfolio. For a small, value-oriented fund such as Karsan Value Funds (discussed here), the most appropriate benchmark may be the Russell 2000.

There are many sector-specific indexes for funds that operate within specific industries (for example, for portfolios that focus on alternative energy stocks, there's the S&P Clean Energy Index). There are few such indexes for funds that avoid certain sectors, however; but many value funds may tend to do just that, by staying away from commodities or financials or other sectors with high unpredictability.

As such, Karsan Value Funds may best be benchmarked against a general index. While indices that are covered often by the major media may make for the easiest comparisons, not every general index is appropriate. As we saw here, both the Dow Jones Industrials and the S&P 500 make for poor proxies, each for their own reasons.

The Russell 2000, on the other hand, is recognized enough for investors to find credible, yet it has a median market cap of just $325 million, which serves as an appropriate benchmark for a general fund that focuses on smaller companies.

Of course, even if an investor disagrees with the benchmark a fund manager has chosen, he is free to compare the fund's returns to a benchmark of his choosing. No matter what benchmark is chosen, however, an appropriate time frame must be applied (comparisons should be made over years, not months), whether results are negative or positive.

The Psychology Of Human Misjudgement: Deprival

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

The tendency that Munger describes as "deprival" is the human tendency to hate losing more than liking winning. For example, the loss of a ten dollar bill seems to hurt much more than a gain of ten dollars seems to help.

The problem with this tendency is that man misprioritizes his problems. For example, a man with a brokerage account containing $10 million will agonize over missing $100 from his wallet. This irrational tendency to be intensely focused on small losses, whether to property, friendship, territory, status or other valued items is quite normal.

Munger notes that this tendency has ghastly effects in labour relations. When a corporation is in trouble, workers find it very difficult to give up benefits they currently enjoy, even if it is in everyone's best interest to do so (to make the company more competitive). As a result, many companies go bust when, had rational thinking prevailed, the situation could have been corrected.

This tendency also causes the form of business failure that encourages otherwise wise men to use up good assets in fruitless attempts to rescue a venture gone bad. Munger also believes this tendency is what drives gamblers towards ruin: once he has suffered a loss, the gambler becomes obsessed with breaking even in order to recover that loss. Being cognizant of this tendency can help one focus on making rational decisions rather than throwing good money after bad.

The Psychology Of Human Misjudgement: Over-optimism

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

Munger starts his description of man's tendency to be over-optimistic by quoting the Greek orator Demosthenes, who said "What a man wishes, that also will he believe." In addition to psychologically denying when things are going badly, man will tend to be overly optimistic when things go well.

For evidence of this tendency, Munger points to people happily buying lottery tickets despite having the odds stacked against them. People also believe in new business ideas that are often poor substitutes for efficient, existing companies.

Munger believes that while this tendency has likely been helpful for evolutionary reasons, it is best to approach issues more objectively. To do so, individuals are encouraged to make more use of the simple, high-school level, probability math of Fermat and Pascal. Munger likens avoiding the antidote to this tendency (the antidote being habitual use of probabilities) to letting natural evolution determine one's golf grip rather than taking golf lessons.

The Psychology Of Human Misjudgment: Excessive Self-Regard

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies (without having to grab an online psychology degree), we better equip ourselves to avoid psychological biases when investing.

Ninety-percent of Swedish drivers believe themselves to be above average drivers. This is an example of the tendency of man to overrate his own abilities. This tendency can also be extended to man's possessions: once a man owns something, he places a higher value on its worth than he otherwise would.

The repercussions of this tendency are visible in various forms. Lotteries where gamblers can pick their own numbers (as opposed to being offered a random set) are bigger draws. Man will also strongly prefer people like himself. In a "lost-wallet" experiment, subjects were found to be more likely to return a wallet to a stranger when that stranger resembled the subject.

In business, excesses of self-regard can often cause poor hiring decisions. (The hirer believes in his superior ability to select a candidate in a face-to-face, and therefore ignores more objective measures of a candidate's value.) Munger actually points to the hiring of the well-spoken Carly Fiorina as CEO of Hewlett-Packard as an example of a mistake due to this tendency.

Munger argues that the best antidote to falling victim to this tendency is to try to think objectively about oneself, one's family and one's possessions. While this is not easy, it is far preferable than allowing one's psychological biases to control one's thoughts.

Doing Your Homework

Investors who buy stocks without reading the company's disclosures leave themselves open to risks of which they are not even aware. Consider Escalade (ESCA), a diversified producer of sporting goods and office equipment.

Escalade is cheap across a variety of metrics. It trades for just $10 million, despite having operating income exceeding $10 million in each of the years 2005, 2006 and 2007. Though the recession turned results negative in 2008, the company has cut costs aggressively and has a good chance of turning a profit in 2009. The company trades with a price to book value of just .12!

But the following tidbit from the company's annual report highlights a very important risk for shareholders:

"The Company is considering the potential for voluntary delisting of its common stock with NASDAQ".

Why might they be considering this?

"In complying with those reporting obligations and the additional requirements imposed upon public companies pursuant to the Sarbanes-Oxley Act of 2002, the Company incurs significant annual out-of-pocket costs. In addition, the time and attention required of management to comply with all such requirements is substantial."

Public companies usually have higher valuations than private companies, because the shares are more liquid, more accessible, and the reporting/compliance requirements instill a level of trust from the point of view of investors. Escalade's management doesn't appear too pleased with the current valuation, however:

"As a small public company, particularly in light of recent economic conditions, the Company has not been able to take full advantage of the potential benefits of being public yet must continue to satisfy all of the requirements to remain a public company."

The company ends this paragraph with a major understatement:

"No final decisions have been made in this regard, but such actions would have a material impact on stockholders if taken."

While the risk of delisting may not prevent some investors from being interested in a cheap-looking stock, for others this falls outside the bounds of what is considered an acceptable investment. As such, it is important that investors read a company's disclosures before deciding to invest, lest they be caught unaware of a potentially detrimental future event.

Disclosure: None

The Fund

I am pleased today to announce the launch of Karsan Value Funds (KVF), a long-term oriented, value investment fund that I will manage. The fund will take equity positions in public companies which trade at discounts to their intrinsic values and where downside risk is low compared to upside potential.

As it can take many years for such companies to return to trading at their intrinsic values, the investment horizon of the fund is of a long-term nature. To that end, investors will be discouraged from short-term dispositions of their securities. Investors will also be unable to sell securities to anyone other than the fund, since new investors may not fully understand the partnership's strategy, and there are certain legal restrictions.

Although the fund will report financial results every quarter, emphasis will be placed on long-term returns, not quarterly results. The fund will likely start out with a capitalization of approximately $400K. As such, using a registered dealer, registering as a dealer, or issuing a prospectus will be prohibitively expensive in the initial year(s). Therefore, the fund's shares are not currently available to the public.

We look forward to providing more information and publishing the first set of results in the near future. Of course, I am always looking for new ideas. If you have any stocks you favour that you believe may fit the investing profile of the fund described above, I'd be happy to hear about them in the comments section. Happy investing!