Fooled By Randomness: Conclusion

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

Key Takeaways from Fooled by Randomness:

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

From The Mailbag: New York Times

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

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

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

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

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

Off-Balance Sheet Contingencies

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

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

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

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

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

Fooled By Randomness: Chapters 13 and 14

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

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

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

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

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

Shareholder Rights Or Wrongs?

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

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

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

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

Disclosure: None

Housing Inventories Tell The Tale

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

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

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

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

Bailout: Shoe On The Other Foot

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

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

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