Thursday, April 30, 2009

King Of The Castle

For all intents and purposes, AM Castle (CAS) is a volatile stock. The stock is down 70% in the last year, but is also up 100% in the last two months. It is not unusual for this stock's value to fluctuate by more than 5% in a given day. As such, this stock would be considered risky by industry standards

But is it? CAS has current assets of $520 million (using FIFO inventory) and total liabilities of $310 million, for a difference of $210 million. At the same time, the company only trades for $210 million as well, giving investors downside risk protection in the form of inventory and A/R. After buying current assets minus all liabilites at their book values, current investors are also acquiring the company's fixed assets and future earnings for free!

While this stock gets ignored by the mainstream finance industry, it appears to offer value investors the opportunity to buy in at a cheap price. As Warren Buffett told us when we met with him last year, he loves volatility as that's what allows him to profit from mispricings in the market!

Last week, CAS cut its dividend and reported profits lower than expected, resulting in a 20% drop in its stock price. With its flexible cost structure and net tangible assets greater than its current market value, this may represent another opportunity for value investors looking to take advantage of this stock's volatility.

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

Disclosure: Author has a long position in shares of CAS

Wednesday, April 29, 2009

Take On Taxes

When the returns of various funds, fund managers, or ETFs are bandied about, the discussion is usually centered around pretax rates of return. While this measure makes sense for retirement accounts, pensions, charities and endowments, regular investors have to pay significant taxes on their returns and therefore consideration to tax minimisation must be given.

For these investors, pretax rates of return across funds are not comparable, since investment income can come in many forms including interest, dividends, and capital gains. Complicating matters for investors is the fact that tax rates can vary (sometimes dramatically) across all of these categories, making investment comparisons across categories non-trivial. 

Furthermore, tax regimes vary by jurisdiction: while Americans may be subject to lower tax rates on capital gains versus interest income, Colombians face just the opposite situation, with heavy taxes on capital gains and favourable rates on interest income. Knowing the tax regime of your country will help you compare investment possibilities on an after-tax rather than a pretax basis.

For almost all jurisdictions, however, capital gain taxes can be deferred as long as the investment is not sold. The longer this deferral is prolonged (i.e. the longer the investor holds the security), the lower the effective tax rate on the gains becomes. This would seem to suggest that a buy and hold strategy is the most tax efficient, which just happens to be the preferred method of choice for value investors. 

However, tax efficiency is no substitute for the value of superior returns: even a highly taxed investment will outperform a poor investment, even if it should be tax-exempt. The point is not to base investment decisions on their tax treatment, but rather to compare investments on an apples-to-apples after-tax basis, and so the reported pretax returns that are the industry norm just don't do the trick.

Tuesday, April 28, 2009

Too Big To Fail IS Failure

What makes capitalism work is competition among firms. Firms that can deliver value replace firms that can't, resulting in increases in worker productivity, which is the basis for increases in our standard of living. But when governments bail out poorly managed firms, productivity stagnates, with Japan being a leading example. Knowing that when push comes to shove, governments will be unable to avoid the political pressure to save large firms, we must take steps to ensure that in the future, no firm is too big to fail!

While regulations which keep firms from growing after they have reached a certain size may seem like socialist actions, they are actually firmly grounded in capitalism. Monopolies and oligopolies are the least competitive market forms, leading to inefficiencies and below-average productivity levels. Furthermore, if a monopoly goes bust, it has to be bailed out or every company/individual relying on its product will be affected. If several firms are in competition, the industry can better adjust to the loss of the most badly managed firms.

Don't take my word for it though: the break-up of institutions deemed "too big to fail" was advocated by some of the top economists in the world last week, for the simple reason that bailouts pervert the incentive system that has made capitalism so successful.

Of course, even if we get to the point where there is no one company deemed too big to fail, political pressure during recessions may still persuade governments to bail out entire industries. For example, subsidies that encourage home sales along with bailouts of certain players in the auto industry (despite no shortage of excellent auto manufacturers headquartered outside North America) could occur on a larger scale. Unfortunately, that appears to be a risk we have to take, as, debt-wise, we cannot afford a repeat of the firm bailouts we have seen next time the business cycle bottoms.

Monday, April 27, 2009

RVs Losing Speed

Makers of big-ticket items and luxury goods suffer the most during times like these, as consumers delay large purchases and reduce their expenses. Companies that recognize that they are in cyclical industries can put themselves in positions to outlast downturns and thereby emerge from them with fewer competitors. 

Nowhere is this more apparent than in the RV business, where sales have seemingly dropped off a cliff. For for two leading RV manufacturers, Monaco Coach and Thor Industries, sales have dropped over 60% from what they were four quarters ago.

However, one of these companies has positioned itself to survive this downturn, while the other over-leveraged when times were good. We discussed Monaco Coach's (MCOAQ) lavish spending habits on this site a few months ago. They recently filed for bankruptcy, and shareholders will be left with virtually nothing. 

Thor Industries (THO), on the other hand, while it is going through hard times, has a cash position of $200 million and no debt, which will allow it to emerge from this recession not only with its own market share intact, but also with a large chunk of the share formerly occupied by Monaco.

Value investors must always consider the cost structures of the companies in which they are considering investing, enabling them to invest in companies that will thrive in the long term at the expense of companies that take excessive risks.

Disclosure: None

Sunday, April 26, 2009

Margin Of Safety: Chapter 5

In the previous four chapters, Klarman focused on describing how investors go wrong. Chapter 5 is an introduction to the second part of the book, where Klarman describes the philosophy of value investing.

Klarman quotes Buffett's first two rules of value investing:

1) Don't Lose Money
2) Never Forget Rule #1

While it is easy to say these rules, Klarman said by themselves they don't help investors. Klarman seeks to make it clear that the future is uncertain. Future GDP growth rates, inflation rates, and other relevant factors to stock price returns are always unknown. Furthermore, stocks are junior securities to debt and other firm obligations, making their future values even more uncertain. Stocks are certainly not risk free, but in the following chapters, Klarman seeks to describe strategies investors can follow that will help them follow the above rules.

Saturday, April 25, 2009

Margin Of Safety: Chapter 4

In this chapter, Klarman examines the junk bond market in depth to illustrate how Wall Street can create investment fads, only to leave investors much poorer when the tide goes out.

In the early to mid-1980's, Wall Street firms pushed junk bonds on investors, touting the positive historical results of high-yield debt. However, Klarman notes major differences between the debts of fallen angels versus newly issued bonds from fragile companies. 

Since debt from fallen angels trades at a discount to par, downside risk is reduced. At the same time, the potential for capital appreciation is large. Newly issued debt from marginal companies does not share in these characteristics, but that didn't stop Wall Street from pushing this form of debt, nor did it stop investors from ponying up and falling victim to these issues.

The number and size of junk bond issues grew, despite the fact that this asset class was untested by an economic downturn, which should have made investors cautious. Investors were happy to gobble up zero coupon bonds (where the interest accrues to the issuer but is not paid out until the bond comes due) despite the clear risks! It took the downturn of the early nineties to wipe out those who were too eager to pay for assets that were risky.

One way investors were prodded into purchasing such securities were valuation measures based on EBITDA. Rather than considering cash flow or earnings, companies were valued using this accounting measure which doesn't include depreciation expenses. Klarman argues that a company paying its debts from EBITDA is slowly liquidating itself (as it can't make capital expenditures) and leaving itself susceptible to a credit crunch. 

Klarman warns that such fads will undoubtedly occur in the future, and those who are able to avoid them will do well.

Friday, April 24, 2009

Companies Faking It

In order to determine whether a company is worthy of an investment, it is important to understand exactly how it makes money. Only then can one understand a firm's business and financial risks. Often, however, the only way to do this is to dig deep into a company's financial statements, as firms are often not very forthcoming on the surface. 

For example, Daxor Corporation (DXR) describes itself as a manufacturer of medical devices and provider of biotech services. Investors may believe they are buying a company with a competitive advantage, as DXR's flagship product, an FDA-approved blood-volume analyzer, appears to save hospitals time and money, and no competing products appear on the horizon. Unfortunately, investors who dig deeper into this company will find that this firm's financial results are barely - if at all - related to its blood-volume analyzer!

Instead, the company appears to be a heavy trader in securities of unrelated companies! And it doesn't just take long positions: last year, the company made $5.3 million alone on its short positions, compared to operating revenue of only $1.7 million! Furthermore, the company both buys and sells call and put options. To put its investment income in perspective, here is the company's investment income compared to its operating revenues over the last five years:

Clearly, this company does not appear to be a medical device manufacturing play! Even if its flagship product were to take off (or die off), the company's financial results would hinge on how its traders have performed! Investors who take the time to determine how companies actually make money are in a better position to gauge its risks.

Disclosure: None

Thursday, April 23, 2009

Fixed Costs Not So Fixed

We have always advocated that investors seek out future operating lease payments that a company has agreed to. Under ordinary circumstances, these payments are fixed obligations, like debt payments, and should be treated as such. (For a discussion of why this is the case, see here.) Under the exceptional economic malaise with which we are currently afflicted, however, lessors appear willing to allow lessees to re-negotiate these contracts, even for financially healthy lessees!

Consider Build-A-Bear (BBW), the make-your-own-stuffed-animal retailer. In February, the company announced it had been able to improve store lease terms. In its recently released 10-K, we got to see the magnitude of that reduction. Here's a graph depicting the dollar reduction in future lease obligations from what they were last year:

By my calculations, this changes BBW's debt to total capital from 64% to 57%, and reduces its lease payments for 2009 by an amount greater than BBW's entire net income for 2008! 

If these had been debt payments instead of lease payments, would BBW have been able to reduce the amounts so drastically? Unlikely, as this is not a company in dire straights: assuming even a catastrophic shortfall in revenues in the near future, it currently has enough cash on hand to cover lease payments for the next year. 

It appears that owners of assets (e.g. land/building/mall owners) are willing to share the pain of this recession with even healthy tenants, perhaps to build goodwill or for competitive reasons. Investors should be on the lookout for companies that have been able to reduce their cost structures, even when it appears that those costs are fixed!

Disclosure: None

Wednesday, April 22, 2009

Blind Faith In Capitalism

When the rest of the market panics and a wild sell-off ensues, value investors calmly increase their market holdings. As the unemployment rate increases and more investors panic, value investors become giddy as they swallow up stocks at even more attractive prices. Is it blind faith? Where does this faith come from? As Buffett has said many times over the years...

"In the 20th Century alone, we dealt with two great wars; a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25%."

Although there have been cyclical downturns in the past, how do we know that it's not "different this time", as doom and gloomers will assert in each and every downturn? Quite simply, it is an understanding of the effectiveness of the incentive system that is the basis of capitalism. As Buffett puts it in his 2008 letter to shareholders:

"Our economic system has worked extraordinarily well over time. It has unleased human potential as no other system has, and it will continue to do so. America's best days lie ahead."

Investors who study various economic measures through the course of history will find many of the recurring themes which make Buffett so positive. One is the positive effects that lower borrowing costs have on the economy. Another is the adaptive ability of businesses which react to shocks by eventually bringing supply and demand back in line with each other. Another is growth in productivity, as innovation drives increases in efficiency which allows workers to produce more per hour and thus become more valuable and thereby increase their standard of living.

While certain political leaders call for an end to capitalism, it is important to retain some perspective and consider how valuable this economic system has been and how valuable it will be in continuing to drive increases in our standard of living.

Tuesday, April 21, 2009

Site Update: 400

Perceptive readers may have noticed that this site recently crossed the 400 plateau in terms of feed subscribers. For those of you who don't know what that means (and you could have counted me as a member of this group a mere 12 months ago), there are 400 individuals who receive our posts either via e-mail or automatically onto a personalized "favourites" web page. If you are a frequent visitor of this site, you might want to consider subscribing to save yourself a trip to the site each time! (To do so, just follow the "RSS" or "E-mail" links at the top of the right frame. To read more about it, see here.)

Readers will also notice that the subscriber count is well over 400, as rather than tiptoe across that mark, we blew by it in the course of a few days. The reason for this is simple: a site with a readership which shares similar values to the readers of our site recently posted a guest article advertising our site. We have had occasion to advertise our site in this manner three times, and all three times we have added to our subscriber base significantly.

As such, we will look for opportunities to continue to trade guest articles with sites similar to ours. Our readers should benefit by getting the opportunity to hear from more authors who think and act like value investors, and our site should benefit from the increased viewership by way of higher advertising revenue.

If any of you read other blogs or sites with subject matter of a similar disposition to ours that you feel would make an ideal candidate for a guest post, feel free to let us know by commenting on this post. Conversely, if you are a publisher with similar content interested in sharing guest articles, also let us know!

The sites with which we have previously arranged guest posts (perhaps you came to our site from one of these sources!) are as follows:

As always, do let us know if you have any suggestions going forward!

Monday, April 20, 2009

Best Buy And The Efficient Market

In an "efficient market", all stocks are fairly priced by the market. If the US stock markets are efficient, and many finance industry professionals believe this to be the case, one cannot generate index-beating returns except through luck. However, if we were in an efficient market, it seems hard to believe that stock prices for even the most stable of companies should fluctuate so drastically from year to year and even from week to week. Yet that is exactly what happens. 

Consider Best Buy (BBY), a US-based multi-national electronics retailer. It has generated consistent returns year after year, and has a low debt to equity ratio resulting in minimal financial risk. Yet it's stock price has fluctuated dramatically, offering astute investors the opportunity to achieve enormous returns.

Below is a chart depicting Best Buy's annual return on invested capital (ROIC) contrasted with its stock price:

While ROIC has been predictable and consistently range bound for the last several years, the stock price has been anything but. It seems hard to believe that the market is efficiently pricing this security when its price can fluctuate wildly in relatively short periods of time while the company itself generates predictable earnings on capital. For example, if the company is worth X amount in early 2000, how does it become worth just one quarter of this amount 3 months later, and then three times this amount six months after that?

More recently, three months ago the market valued Best Buy at $7 billion, but now values it at $16 billion! Investors who recognized the mispricing have seen returns of over 100% in a 3 month period!

We've also seen other examples of this phenomenon: we've looked at graphs illustrating wild fluctuations in the historical P/E ratios of Coke and Walgreen, for example, which have allowed value investors to buy in at tremendous discounts.

Value investors willing to put psychological bias aside and instead invest at the height of the market's fear can indeed achieve above average returns.

Disclosure: Author owns a long position in shares of BBY

Sunday, April 19, 2009

Margin Of Safety: Chapter 3

In this chapter, Klarman discusses how the investment world has changed over the last several decades, and how understanding these changes allows investors to earn superior returns. From 1950 to 1990, the institutional share of the market rose from 8% to 45%, and institutions comprise 75% of market trading volume. But the institutions are hampered by a short-term mindset, and Klarman attempts to explain why.

First of all, money managers tend to be rewarded not on what they return to clients, but rather as a percentage of their assets under management. But a larger base of cash actually makes it more difficult to generate returns, thus there is a conflict between what's best for the manager and what's best for the investor.

Institutional investors are also "locked into a short-term relative performance dirby". Frequent comparative rankings among institutional investors forces a short-term mindset, as a long-term view can quickly send a manager to the unemployment line. As a result, these managers act as speculators rather than investors: they try to guess what other managers will do, and try to do it first!

Klarman argues that only the brokers, who benefit from frequent trading, win this derby, as he believes that short-term market fluctuations are random. Institutional investors are also constantly compared (and comparing themselves) to index benchmarks. Due to this relative comparison, they tend to prefer being close to 100% invested, even if things don't look cheap on an absolutely basis, which hurts investors when stocks are expensive.

Klarman also points out that money managers rarely invest their funds along with their clients, making it clear that it's the management firm that wins the conflicts of interest. Klarman would prefer to see the situation as that described by economist Paul Rosenstein:

"In the build­ing practices of ancient Rome, when scaffolding was removed from a completed Roman arch, the Roman engineer stood beneath. If the arch came crashing down, he was the first to know. Thus his concern for the quality of the arch was intensely personal, and it is not surprising that so many Roman arches have survived."

Saturday, April 18, 2009

Margin Of Safety: Chapter 2

What's good for Wall Street is not necessarily good for investors, according to Klarman. Because of how Wall Street does business, it has a very short-term focus. For example, Wall Street makes money up-front on commissions (not from long-term performance), therefore the Street will always push for churn and will always push "hot" investments.

Klarman argues that there is nothing fundamentally wrong with this business model. After all, many professionals (consultants, lawyers, doctors) make money in this manner without being responsible for the long-term results. But what's important is that investors recognize this Wall Street bias, or they will be robbed blind.

This business model also encourages very short-term thinking, and a bullish bias. If stocks are going up, Wall Street is able to make more in the form of commissions. Klarman sees evidence of this bullish bias in the percentage of stocks that are recommended by analysts versus those that are deemed "sells".

Klarman provides many examples of Wall Street's short-term bullishness that props up prices of various securities, but where those prices eventually fall dramatically. He advises investors to keep Wall Street's biases in mind when dealing with the Street, and to avoid depending on the Street for advice.

Friday, April 17, 2009

Value Investing Arbitrage?

This article originally appeared on The Div Net on April 8th, 2009.

Occasionally, an investor may believe a stock to be undervalued based on his estimate of the business' underlying value. If his estimate is correct, he should generate excellent returns over the next several years if the stock price converges to the underlying business' value. Sometimes, however, an announced merger transaction will allow this investor to buy this stock at an even cheaper price! Consider TAT Technologies (TATTF), which we've discussed as a potential value play

TATTF already owns 60% of Limco-Piedmont (LIMC), an aircraft maintenance provider with a market cap of $30 million, no debt, and cash of $32 million! TATTF now wants to own the other 40% of Limco-Piedmont, and has offered LIMC shareholders 1 TATTF share for every two LIMC shares.

With TATTF's share price at $4.90, and Limco-Piedmont's at $2.24, investors are offered the opportunity to acquire TATTF's stock at an additional 10% off! (An investor looking to make a quick buck could purchase two LIMC shares and short-sell one TATTF share for a handsome profit margin.)

Of course, nothing is a sure thing. Although TATTF controls Limco-Piedmont and therefore the merger should be quick and easy, unknown factors could come along that derail the transaction. As such, investors should ensure they understand LIMC and are comfortable with the investment as is. However, since LIMC is already fully consolidated as part of TATTF (due to its controlling interest), a share of TATTF represents a significant interest in LIMC already, and therefore shareholders of TATTF should already know the acquisition target well.

Disclosure: Author has a long position in shares of TATTF

Thursday, April 16, 2009

Inventories Falling

It is important for value investors to understand the cyclical nature of the economy so that they can make objective investment decisions at all times, rather than fall prey to the psychological biases that overcome the market during periods of recession and exuberance. Economists believe most recessions are caused by temporary drops in demand. Until businesses reduce output, this results in increased inventories. Businesses react by cutting output to a point that reduces inventories such that they are in line with the now reduced demand. Once this process is complete, the economy is once again ready for expansion, as barring another reduction in demand, businesses will no longer have a need to reduce output.

While the economy has not yet reached that point, it appears businesses have now cut output to a point that inventories are being depleted. The following chart illustrates the US business inventory to sales ratio over the last business cycle as reported by the US Census Bureau:

While the inventory to sales ratio is still high (meaning firms will still try to cut output, which does not bode well for employment rates), it appears that businesses are now selling more than they are making, as the inventory to sales ratio has started to drop. Firms can enjoy these cash inflows for the time being, but obviously this is not sustainable. Eventually inventories will have to be replenished, and that is when we will see GDP expansion return.

Clearly, this same phenomenon occurred in the last recession, and the peak inventory to sales ratio is remarkably similar. What is different this time is the ferocity with which demand appears to have waned, causing a large spike in the graph in late 2008, which resulted in large output cuts which manifested itself in some of the staggering country GDP drops observed in the last quarter, such as that of Japan.

When the inventory to sales ratio changes, which is more dominant, changes in sales or changes in inventory? It actually depends on which part of the business cycle we are in. In a future post, we'll break this graph down into its two components to better understand exactly what takes place.

Wednesday, April 15, 2009

Intersegment Sales Tell The Tale

A couple of weeks ago, we looked at a company which operated two segments going in very different directions. Summed together, the segments (and as a result, the company) were just breaking even, but the thinking was that if the company reduces or eliminates its exposure to the poorly performing segment, shareholders will be left with a good business (from the remaining segment) at a cheap price.

A reader brought up an interesting question, however. Since the manufacturing segment actually sells to the distributing segment, is it really possible to just cut one segment off and operate the other as if nothing has happened? The answer lies in the company's disclosure of intersegment sales, in the notes to the financial statements.

While the company had $110 million worth of sales in its distribution business in 2008, it had only $8 million worth of intersegment sales. They don't tell us whether the manufacturing segment bought from the distribution segment or vice versa, but even if we assume the distribution business did all the buying, this represents only 7% of its sales. Furthermore, this percentage dropped from 9% in the previous year, suggesting the company is able to reduce its exposure to the manufacturing segment while still growing its distribution business. Intersegment sales are reported at fair values.

As we've discussed many times for various reasons, it is essential that value investors read the notes that accompany a firm's financial statements, as it is a necessary requirement to truly fully understanding a business.

Tuesday, April 14, 2009

Sources Of Volatility

Many finance professionals believe the stock market is basically efficient. That is, prices of stocks are fairly priced, and therefore the only way to generate higher returns is by taking more risks. This group also believes that risk is defined by price volatility, so the more volatile the stock, the higher its risk.

Value investors, of course, not only reject the fact that the market is efficient (for a terrific essay on the subject by Warren Buffett, see here), but also find flaw with the definition of risk. To value investors, risk represents the potential that the underlying business is or becomes worth less than anticipated, and this is often times completely unrelated to a stock price's volatility. Value investors believe volatility could be caused by the market's general level of fear, supply/demand characteristics of various securities at particular points in time, and other psychological factors unrelated to the underlying business.

A study by Richard Roll has attempted to quantify the various components that comprise a given stock's volatility. His findings are depicted in the chart below:

According to Roll, company specific risks play only a very small role in a stock's volatility. If this information is accepted, it seems ludicrous to believe a stock's volatility - rather than the fundamental business/financial risk of the underlying company itself - is what governs an investment's risk level. Investor confidence, interest rates, and the stage of the business cycle all play far larger roles when it comes to volatility!

Value investors who take advantage of volatility, rather than fear it by equating it with risk, position themselves for market beating returns!

Monday, April 13, 2009

For Value Investors, Smaller Is Better

Value investors are always looking for inefficiently priced stocks. Such stocks are often found among smaller cap issues, since these securities are not worth the time and the effort of analysts and institutions catering to billion dollar funds. Empirical evidence also supports the fact that small caps have the potential for greater returns, but outstanding returns only come to those willing to seek out value among the thousands of issues available.

Consider a stock such as Limco-Piedmont (LIMC), a maintenance, repair and parts and services supplier to the aviation industry. Limco trades for $30 million in the market, but consider the following balance sheet items:

Cash + Securities: $33 million
Accounts Receivable: $12 million
Inventory: $19 million
Total Liabilities: $10 million

With those balance sheet numbers, you would expect that the company is losing money hand over fist to have a market cap of just $30 million. But this is not the case. The company has contracts in place with several customers, including Fokker, KLM, Lufthansa, Boeing and Bombardier, resulting in a 4th quarter profit along with net income for 2008 of $2.7 million.

As an added incentive for investors, Limco is also the subject of a takeover offer which is 20% higher than its current price. A group of Limco's investors are pushing for a higher takeover price, but even if the deal falls through, buyers at this price appear to be purchasing at a discount based on Limco's cash position.

Rest assured, you will not find such a situation among well-followed large-cap stocks. It is near impossible to find a large company trading at a discount to its cash on hand, and if one can be found in such a state, you can rest assured it is because its debt load and negative earnings have the company in dire straights with doubts as to its future. Limco's debt level: $0.

Disclosure: None

Sunday, April 12, 2009

Margin Of Safety, By Seth Klarman: Chapter 1

In the next few weeks, we'll be doing a chapter-by-chapter run-down of Seth Klarman's sought after book, Margin Of Safety. We've discussed Klarman on the site before, as he has consistently demonstrated an ability to generate market beating returns over a long period of time. You can find Klarman's limited edition book selling on ebay for hundreds of dollars.

Chapter 1

Klarman starts out by distinguishing investing from speculating. He uses a Mark Twain quote to illustrate the two times in life when one shouldn't speculate: "when you can't afford it, and when you can!". Speculators buy in the hopes or assumptions that others will want to buy the same asset (be it a painting, a baseball card, or a stock) later, while investors buy the cash flow the investment returns to its owner. (As such, a painting can never be an investment by this definition!)

Examples are provided which describe various speculative bubbles, discussing the faulty logic that first propells speculators to bid up prices followed by the inevitable bursting which destroys the wealth of many.

Klarman suggests that what determines whether an investor will make money in the market or not is his psychological make-up. If he does his own stock analysis and views the prices offered by Mr. Market as an opportunity to buy low and sell high, he will do fine. If Mr. Market's offering prices guide the investor's outlook of what the stock price should be, he should get someone else to manage his money!

Klarman argues that most market fluctuations are the result of day-to-day distortions between supply and demand of particular stocks, not of changes in fundamentals. Investors who take advantage of these distortions by focusing on the fundamentals will be successful. Those who invest with their emotions are sure to fail in the long-run.

Saturday, April 11, 2009

The Snowball: Warren Buffett And The Business Of Life

If you've enjoyed some of the value investing book summaries we have featured on this site, you may also enjoy a summary of The Snowball: Warren Buffett And The Business Of Life, the only biography of Buffett that he has authorized himself.

The book describes Buffett's principles and the type of thinking that has made him the investor he is known for today. It was written by Alice Schroeder in 2008 with the co-operation of Buffett, whose advice to Schroeder as he provided information for the book was: "Whenever my version is different from somebody else's...use the less flattering version."

The summary of this book is available for free to our readers, but in the interest of disclosure, it should be noted that we receive a fee for each reader we send who reads the summary. Therefore, your learning from Warren Buffett will hopefully make us both rich! ;)

Friday, April 10, 2009

Even Buffett Isn't Perfect: Foreword By Steve Forbes

In the last few weeks we've had a chapter-by-chapter look at this book. Today we finish at the start, by examining the foreword by Steve Forbes.

Vahan Janjigian's book about Warren Buffett is advertised as neither a love-letter nor a put down of the world's greatest investor. But the foreword by Steve Forbes, perhaps best-known for running for US President on a "flat tax" platform, is critical of several of the national policies that Buffett advocates.

Forbes goes after Buffett on his tax policy, calling it "shortsighted". While Buffett believes the rich should have a higher tax burden since they can afford it, Forbes argues this is a disincentive for the most productive earners. While Forbes' conclusion is grounded in accepted economic theory, his arguments are unconvincing, as he makes weak links in history between tax cuts and economic growth, when in actuality there are many factors at play which determine economic growth.

Forbes also calls Buffett "obtuse" on the subject of death taxes. While Buffett argues for taxing rich, dead people over taxing the living, Forbes argues such people will find ways to setup trusts to avoid death taxes anyway. Forbes also argues that a death tax punishes frugality, since there's no point saving up if there's a big tax at the end; however, he then goes on to argue that the children of the rich end up spending their inheritance anyway, helping to recycle that money. This seems to be an incongruent argument since a death tax would encourage the rich to spend that money, thereby recycling it quicker than having to wait a generation for the children to do so.

Forbes argues that the information in this book is worth three books on investing, making this book an undervalued asset. However, the book is only 200 or so pages. Though one shouldn't judge a book by its number of pages, it was difficult not to negatively judge this book based on its foreword.

Thursday, April 9, 2009

Taking Advantage Of Mr. Market

Value investors tend to be net buyers of securities when Mr. Market's risk appetite is low, and tend to hold cash when Mr. Market is in a gambling mood. This process does not take place as a result of these investors timing the market's risk appetite, but rather as a result of a disconnect between security prices and their underlying values. Nevertheless, by gauging the market's risk level, one can get an idea of what kind of discount (if any) the market is offering on security prices. One method of gauging the market's risk appetite is by looking at credit spreads.

The TED spread measures the difference between the interest rates at which banks are willing to lend to each other and US treasury yields. A wide difference between these yields indicates that banks are risk averse, as they require much higher returns than those offered on US government debt, which is considered virtually risk free. A small difference in these yields indicates banks are willing to take risks, asking for little yield in return for investing in assets with risks attached to them.

Here's a look at the TED spread over the last several years:

Clearly, one can see the stark contrast in risk tolerances for banks between the boom years of 2005-2007 and the more recent recessionary times. When economists and government officials sounded alarms of a "credit crunch" in 2008, we can get a good idea of why they might have thought so. Spreads spiked to alarming levels, pushing up financing costs for businesses and consumers alike.

Currently, the spread sits at 100 basis points (1 percentage point), which is certainly better than it was for much of 2008, but certainly not near the pre-recession years of 2005 to mid-2007. Governments around the globe are battling to implement measures to restore the confidence required to reduce spreads so that credit flows again. In the meantime, the market's aversion to risk is likely offering value investors great opportunities to buy securities at discounts to their underlying values.

Data Source: Bloomberg

Wednesday, April 8, 2009

Williams Sonoma Continues To Show Value

This article originally appeared on The Div Net on April 1st, 2009.

Back in January, we discussed Williams Sonoma (WSM), a specialty retailer of home products, as a possible value investment. Since then, the stock is up some 20% while the company's latest results indicate that it does indeed have the ability to weather the economic storm.

Sales in Q4 2008 fell almost 27%, which would be enough to send many companies deep into the red. With WSM's relatively flexible cost structure, however, it managed to eek out a profit. With a drop in sales of that magnitude, one would ordinarily expect a battered gross margin and ballooning SG&A costs as a percentage of sales. The company has managed to cut its costs drastically however, showing a gross margin of 34% and SG&A costs as a percentage of sales only 1.5 points higher than last year (after backing out impairment charges).

Many of the company's cost cutting initiatives won't be seen until next year's results, however. As the company gets its cost structure in line with depressed demand (including by renegotiating certain of its operating leases), it expects be able to derive profits between $1 and $2 per share for 2009. Not a bad return when you consider the share price of $10 and the minimal downside risk considering WSM's balance sheet strength, with some select items shown below:

Cash: 150 million
Inventory: 570 million
Current Assets: 940 million
Debt: 24 million
Market Cap: 1.1 billion

Disclosure: Author has a long position in WSM

Tuesday, April 7, 2009

Painful Inventory Levels

The Japanese economy has been particularly hard-hit by the current recession. One of the main reasons for this is the proportion of Japan's economy that is reliant on some of the hardest hit sectors of this recession, including autos, IT equipment, and advanced machinery manufacturing. Because of the sheer magnitude of Japan's output drop, we are offered the ability to examine the inner workings of the "business cycle" by looking at Japanese economic data.

Economists believe most recessions are caused by temporary drops in demand (as opposed to drops in supply). As such, when demand drops, firms cut inventories to maintain sales-to-inventory levels, and thus output (which GDP attempts to measure) is cut more drastically than demand sagged to begin with.

Consider the chart below depicting Japanese inventory and output levels:

We see that inventory (pink) was trudging along just fine until August 2008 when it started to increase as confidence waned and customers stopped buying products. Inventories increased only slightly, but inventory-to-sales ratios (dotted) rose dramatically. Firms responded with an equally dramatic cut to output (blue), which resulted in the poor GDP numbers.

So when will output start to increase again? Once inventory-to-sales ratios stabilize, firms will no longer have the need to cut output. In the last recession (2001), output increased five months after inventories peaked. From the chart above, inventories appear to have peaked in December of 2008. However, the severity of this recession appears deeper than it was in the previous recession, and so stabilizing inventory-to-sales ratios may take longer.

For investors, it's important to note that business cycle fluctuations are normal, and they should take advantage of such fluctuations by buying when confidence is low and selling when confidence is high!

Data Source: IMF Staff Position Note, March 18, 2009

Monday, April 6, 2009

Paulin Puts The Brakes On Manufacturing

H Paulin (PAP.A) trades at a discount to its net current asset value, meaning its current assets minus all its liabilities equal more than its market cap. This was a favourite screening tool for Ben Graham, long considered the father of value investing, and serves as a good starting point for finding value stocks.

But it's never a good idea to invest simply on this basis. As we've seen before, a company can even trade at a discount to its cash, but if it's burning through that cash, it's not likely to make for a worthy investment. As it turns out, H Paulin lost 22 cents per share in 2008, meaning its balance sheet position has deteriorated. But a closer examination of the company reveals that it holds the potential to be a terrific value investment.

The company has two main segments: manufacturing and distribution. The manufacturing segment lost $6.7 million in 2008, while the distribution segment had operating profits of $6.2 million! Paulin is basically made up of two companies, one on the verge of collapse, and one exhibiting strong revenue and market share growth!

The key to look out for in this type of situation is whether management is throwing good money after bad: is the manufacturing segment going to continue to hamper this company going forward, or will investors start to reap the benefits from the distribution business? 

Looking at the numbers, the answer appears to be the latter. The company has stated its intention to reduce its exposure to its manufacturing segment, and it has backed up its words with actions: manufacturing capex in the last two years has been just $1.2 million, compared to depreciation of $5.3 million. Also included in the loss for 2008 are charges (all to the manufacturing division) of $3 million for severance, inventory obsolescence, and asset impairments, suggesting exposure to this segment has been drastically reduced going forward.

Value investing is all about finding hidden gems. While the headline numbers of this unfollowed small-cap result in market disinterest, those willing to take a closer look may reap the rewards over the long term.

Disclosure: Author has a long position in PAP.A

Sunday, April 5, 2009

Even Buffett Isn't Perfect: Chapter 10

In this the final chapter, a discussion takes place about whether management should give earnings guidance. Buffett's position on this matter is made clear. He believes that when managers give quarterly guidance (i.e. tell analysts what the next quarter's earnings are expected to be), it inappropriately encourages managers to focus on short-run profits rather than the business in the long-run.

It should be noted that providing guidance is not mandatory, but certain firms do so voluntarily. While Janjigian agrees that short-run earnings management is a bad idea, and that the best way to manage is with a long-term horizon in mind, he doesn't believe guidance is what causes short-term thinking. Janjigian argues that analysts will form expectations regardless of whether management offers guidance, and therefore the incentive to manage in the short-term is present whether management offers guidance or not.

The author argues that investors want to avoid price volatility and that is why these investors are against guidance. (However, it should be noted that when we met with Buffett, he was very clear that he likes volatility, because that's what allows him to profit by buying low!) Janjigian argues that volatility is higher for companies that don't offer guidance, since management is in the best position to offer the best forecast of the next period's earnings.

Finally, the author cites studies that suggest stocks drop after managements announce they will no longer offer guidance. The authors of the studies believe dropping guidance sends a signal to investors of bad news ahead, which causes the stocks to drop.

Saturday, April 4, 2009

Even Buffett Isn't Perfect: Chapter 9

The author goes on a full scale attack of Buffett's position on taxes.

To set the background, Buffett believes the rich should pay a higher percentage of their income in taxes. He argues this because they can afford it, while others who are less well off can really make use of the money they pay in taxes. Buffett also believes in high estate taxes. Why tax living people, who could use the money to improve their lives, when you can tax those who can no longer gain from their material wealth?

Janjigian attacks Buffett on the death tax issue by pointing to the fact that Buffett is giving most of his estate away, and therefore will not pay much of a death tax himself. It seems strange to attack Buffett's own activities: even though Buffett is arguing for higher estate taxes, surely he can make his own decisions within the rules that currently exist. The author also quotes a couple of economists that believe a higher estate tax is unfair and would cause wasteful spending.

The chapter is surprisingly lacking a discussion of the standard economic argument for flat taxes (where the rich pay a similar percentage to the poor) which is incentive driven. By allowing workers to keep more of what they earn, the most productive workers are encouraged to work more, which benefits the entire society due to their value add. Of course, this leads to a higher disparity between the rich and the poor which is unpopular politically.

Friday, April 3, 2009

Cost Structure Is Key

The number one rule of value investing is: Don't Lose Money.

While nobody can predict the future with any level of certainty, a primary concern for every value investment is the downside risk of the business under consideration. With that in mind, it is of the utmost importance that investors consider the cost structure of every business under consideration.

To see how important cost structures are, consider the following chart depicting the share by industry of the US advertising market:

A naive glance at the chart above would seem to suggest that even if newspaper advertising revenue were to decrease for the next several years, newspapers themselves should manage to throw off tons of cash flow in the meantime. But a look at newspapers around the country reveal a very different reality.

Newspapers are burdened with fixed costs (e.g. printing, delivery, content), none of which can be cut without significant reductions in the quality of service. Contrast this with a law firm or consulting firm that can easily reduce headcount to better match costs with revenues.

Another important element that impacts costs is a company's debt level from cash advances and other loans. Debt payments are fairly fixed, and so a company with a large debt load has a rigid cost structure and high downside risk. This is one of the main reasons value investors prefer low debt to equity levels. For example, even if newspapers could reduce their costs and profitably serve only a few areas, their debt loads would not shrink along with them, creating a large burden.

When evaluating a company's downside risk, be sure to give strong consideration to its cost structure.

Data Source: IAB Internet Ad Revenue Report; PricewaterhouseCoopers Global Entertainment and Media Outlook

Thursday, April 2, 2009

Governing Governance

In a previous post, we discussed the potential pitfalls of investing in companies with poor corporate governance structures. But how can an investor protect himself? There are two basic ways. First of all, the investor can become knowledgeable about what makes for good corporate governance, and then study up on each company in which he is interested in order to make sure it follows practices in accordance with sound corporate governance. The second method is to take advantage of the information published by the companies that specialize in rating and reporting on the governance practices of public companies.

A full discussion of what makes for good corporate governance is beyond the scope of what can be provided in this one article, and we have covered some of the basic points in previous articles on corporate governance. Therefore, this article will focus on what's available for those interested in pursuing the second method.

Governance Metrics International (GMI) is a company that has developed a proprietary corporate governance rating model that it has applied to over 4000 companies. The premise behind the company is that firms with superior corporate governance practices generate superior returns. GMI can be contacted for those who wish to receive a sample report.

Standard and Poor's also produces a Corporate Governance Score (CGS), based on the following criteria:

  1. Ownership structure
  2. Shareholder rights
  3. Transparency and disclosure
  4. Board effectiveness
Based on how a company is rated in the above four factors, it is given a CGS rating between 1 and 10. A sample report of S&P governance can be viewed here.

While it's easy to gloss over corporate governance elements, the wisest investors always keep them top of mind. With the first rule of value investing being "Never Lose Money", ensuring sound corporate governance practices can increase the likelihood of being able to follow that rule successfully.

Wednesday, April 1, 2009

Goodfellow Toughs It Out

As a manufacturer and distributor of lumber and hardwood flooring, Goodfellow (GDL) is currently in a tough industry. The collapse of the US housing market has drastically reduced demand for products in this industry, and Goodfellow correspondingly showed a year-over-year sales decline of 8% in the last quarter. In that same time period, however, the stock price has dropped some 40%, possibly offering long-term investors an attractive price.

The company trades for about $50 million, but an examination of its balance sheet reveals some downside protection for investors. The company shows A/R of $51 million, inventories of $63 million, and total liabilities of $50 million. As such, Mr. Market is offering the investor a 20% discount on inventory, with the company's fixed assets, customer relationships (of which there are 7,000) and manufacturing know-how thrown in for free!

The company has also remained profitable each quarter throughout this downturn, although this is slightly misleading. The company had an operating loss of $800 thousand in its most recent quarter, but due to a one-time gain it showed a net profit of over $2 million. Nevertheless, the company has cut its costs by over 10% in most of its divisions (compare this to the year-over-year sales drop of 8%). Furthermore, the seasonality of the company is worth noting, as the summer quarters generally result in operating profit figures which dwarf those of the winter months.

A recovery in housing may not be on the horizon for a while. However, for investors looking for minimal downside risk with the potential for capital appreciation, companies like Goodfellow may offer such opportunities.

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

Disclosure: Author has a long position in GDL