Tuesday, November 30, 2010

Microsoft: The Dead PC Beckons From The Grave

For many years, Microsoft (MSFT) has been an investor favourite, making it an expensive purchase for value investors. Today, however, that is no longer the case. Consider the following chart depicting Microsoft's P/E over the last 25 years:

If you remove the company's net cash position of $33 billion from its market cap, the current P/E (based on the company's last 12 months of earnings) is about 9.

Despite efforts at product proliferation and diversification, Microsoft still makes most of its money from two main products, its Windows operating system and its Office family of applications. The stock's low P/E tells you that investors are rather bearish on the combined future of these two products, as well as Microsoft's future position in potential growth areas such as tablets and mobile phones.

On the Windows front, Microsoft continues to dominate share in PCs and maintain a healthy share in servers. But the use of tablet computers is expected to take a bite out of PC sales. Furthermore, continued market share gains by MacIntosh computers could be a threat to Windows' market share in the future.

With respect to Office, Microsoft now competes with a very high profile player in Google. Some enterprises are moving or have moved to Google Docs, having shunned the high fees associated with Office.

In other areas, Microsoft continues to profit from entertainment products/services such as the Xbox console and software, but these just barely make enough money to cover losses in the company's online division, as Microsoft is losing badly to Google in the area of online search.

While all of the above-mentioned challenges represent threats to Microsoft's future profits, it is extremely difficult to predict the future. For example, even if Microsoft loses share in both Windows and Office, has no success in tablets or mobile phones (or any other new products for that matter), and continues to lose money online, Microsoft's share of growth in global PC sales may more than offset any profit declines. For example, Gartner estimates PC shipment growth next year of 15.9% (the vast majority of which will likely run Windows and Office), despite "growing user interest in media tablets such as the iPad".

So while the future is extremely difficult to predict, Mr. Market is nevertheless making a bold prediction. At a P/E of 9, he appears to believe that Microsoft's profits are in decline. This is in stark contrast to the company's latest quarter, which saw earnings growth in the high teens on an apples-to-apples comparison with last year.

Like Cisco, which was discussed yesterday, Microsoft also returns a lot of money to shareholders in the form of buybacks. At the current P/E, further buybacks could turn out to be a terrific investment on behalf of shareholders.

When Mr. Market boldly predicts a high-return company's decline, investors are offered an opportunity to buy an asset for cheap. In the case of Microsoft, investors are offered a company with a dominant position in a growing field, at the price of a company in decline.

Disclosure: Author has a long position in shares of MSFT

Monday, November 29, 2010

Dominant and Cheap: Cisco Systems

Over the last 10 years, shares of Cisco Systems (CSCO) are down over 60%. But that's not because the company has been eroding shareholder value. Cisco earned $1.33 per diluted share in 2010, whereas it earned 36 cents per share in the year 2000. Yet the stock fell over this 10-year period because it had a P/E of 140 back then; today, Cisco has a P/E (adjusted for its net cash position) of just 10.

Companies with P/E ratios in the single digits or low double-digits usually generate low returns on capital as a result of having no competitive advantage. This is not the case with Cisco, as borne out by the following return* on invested capital (ROIC) data over the last few years:

Before panicking at the apparent downtrend, consider that 1) the absolute numbers are still high, and 2) numbers will be weaker during a recession. These high returns do suggest that Cisco has a moat. Further analysis of the company's core products reveals that Cisco dominates several product lines, in some cases delivering market share numbers north of 70% and even 80%. These kinds of numbers will help Cisco maintain and grow its moat, as it is able to spread R&D spend over a much larger number of units than are its competitors.

Sometimes, companies will also trade at low P/E's because a company's industry is in secular decline (e.g. the newspaper industry). This, too, is hardly the case for Cisco. In fact, it may be just the opposite. Networking needs continue to grow worldwide as populations continue to seek higher and higher bandwidth connectivity for a multitude of devices. Cisco is at the forefront of the network hardware architectures required to make this happen.

Finally, companies also trade at low P/E's because of negative short-term sentiment. That appears to be what's happening here. The company's latest quarterly guidance was below estimates, as Cisco expects just 3-5% year-over-year revenue growth next quarter due in part to government budget cuts, as state and local governments look to bring their fiscal houses in order. This caused the stock to fall some 20% over the last two weeks. But annual revenue growth is still expected to come in between 9 and 12%, suggesting the business is still sound, growing and undeserving of such a low P/E.

Cisco's board agrees, as it has now authorized the company to buy back almost 14% of its outstanding shares. A look at the company's cash flow statements shows that Cisco has been quite willing to return cash to shareholders in this manner, and recent management comments suggest this will continue:

"If you look at what we do, we always purchase the stock during periods when we see it sliding a little bit."

When a company with a sustainable and proven competitive advantage trades at a low P/E, opportunity knocks. Investors with an eye for the long term are likely to do well going long in such situations.

Disclosure: Author has a long position in shares of CSCO

* As there are many formulas to choose from when calculating ROIC, it should be noted that here, ROIC is calculated as OpIncome(1-tax)/(Debt+Equity-Cash)

Sunday, November 28, 2010

SuperFreakonomics: Chapter 5

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

This final chapter focuses on the issue of global warming, but draws on many of the other concepts discussed in the book. First, the book debunks many of the misleading and exaggerated facts disseminated by the media. There appears to be scientific consensus that the earth is warming, and that humans are contributing to this. But how humans are contributing appears to be wildly misunderstood. For example, ruminants contribute 50% more greenhouse gases than the entire transportation sector! If humans changed their diets from say beef to kangaroo, it would do far more to help the environment than if they all drove hybrids.

The authors stress that negative environmental effects are due to externalities. In theory, we could determine the negative environmental externalities associated with a particular activity, tax it, and use that money to pay the costs that others experience as a result of the activity. Unfortunately, the world's climate operates under such a complex system that the authors argue this is virtually impossible.

Others believe the problem of global warming can be solved by encouraging (or perhaps forcing) people to make sacrifices. But people are not philanthropic enough to make this happen (this topic was more fully discussed in a previous chapter) and therefore this is unlikely to work on a grand scale.

Instead, they believe the challenges of global warming can be met by the same force that has solved environmental issues of the past: technological innovation. The authors describe various attempts at solving the problem of global warming. Many of them are quite simple, yet still sound effective. For more on some of these solutions and the ensuing controversies that followed, see here.

Saturday, November 27, 2010

SuperFreakonomics: Chapter 4

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

This chapter discusses some of the simple solutions that have improved the lives of humanity over time, and contrasts them with some complex solutions that have actually done more harm than good. While people love to complain and refer to the good old days when everything was better, the authors argue that the reality is that our lives have consistently improved over the last 100 years.

The authors discuss a few examples of innovations that have improved our lives. One of these is the seat belt, a simple but effective solution to what used to be high traffic fatality rates. The authors argue that the seat belt has reduced the risk of driving fatalities by 70%.

One of the sub-themes of this chapter is the contrast between solutions from the private sector and those of the government. Because the private sector is focused on profit, their solutions to problems tend to be fairly simple, low-cost fixes. When governments get involved, however, the complexity rises and often results in unintended consequences that actually make the problem worse (e.g. the American Disabilities Act has reduced hires of the disabled because the disabled are harder to fire, protections for endangered species actually do more damage to endangered species because they encourage land owners to make their properties uninhabitable etc.)

The authors end with a look at a future innovation that may save the US billions of dollars worth of damage annually. A group of researchers is working on a relatively simple method of preventing hurricanes using a simple, low-cost, non-polluting device. More on this device, the man behind it, and some of his firm's other inventions are discussed here.

Friday, November 26, 2010

SuperFreakonomics: Chapter 3

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

This chapter is about altruism. In classical economics, the belief is that everyone is out for themselves and so people will make decisions only if it helps them out. However, recent studies and experiments (including the Dictator Game) have suggested that people are also altruistic to some degree, which has thrown a wrench into the idea that people are rational, self-interested beings who make decisions that are in their best interests.

The authors spend a fair bit of time debunking the idea that people are unselfishly altruistic. Yes, people will help out others, but they often do so for self-serving reasons, including reducing their own guilt, or because they hope to receive similar benefits when they are in need, or because someone is watching. The authors cite a few variants of the Dictator Game introduced by John List (the economist, not the mass murderer) that suggest people are not as altruistic as originally thought.

Though people may give money away in supervised games, outside of the laboratory the authors suggest the practical evidence suggests people are not all that altruistic (prompting the quip: "sure it may work in practice, but does it work in theory?")

One example the authors use to illustrate this has to do with organ donation. Would a stranger give another stranger one of his kidneys out of the goodness of his heart? To the detriment of those needing a transplant, US law prohibits monetary gain from organ donation. As a result, there are 80,000 people in need of a kidney in the US, but only 16,000 transplants will be performed this year. In Iran, where donors are paid, there is no such gap. While the authors recognize that Iran is not considered a forward-thinking country, it should receive some credit for recognizing that incentives, not altruism, are a more effective method in saving lives.

Thursday, November 25, 2010

SuperFreakonomics: Chapter 2

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

In this chapter, the authors describe several instances of how the use of data can be employed to make better decisions. The authors start by explaining some strange anomalies with respect to one's birth month. Those who believe in horoscopes can point to many cases where birth months appear to play an abnormal role in predicting an outcome; the authors delve into the data to explain why.

For example, babies born in a certain month of the year (for 2010, it would be May) are 20% more likely to have a learning disability. This is because of religious fasting during the month of Ramadan; when pregnant mothers fast, their children are more likely to have disorders.

In other examples, a US-born child is 50% more likely to play professional baseball if he is born in August (vs July), whereas a British-born child is far more likely to play pro soccer if he is born in January (vs December). This is because the cut-off dates for little league baseball and youth soccer are July 31st and December 31st respectively, and so kids that excel under that format are given the most encouragement, confidence and playing time. (That is, a four-year old born in August will be much more able than his teammate born almost a year later in July.)

The authors then detail how such data mining can be applied to help improve our lives. Mining medical records can help identify the best (and worst) doctors. Mining banking data can help identify terrorists.

Using outed terrorists as a guide, the authors sought to create a banking profile to help identify terrorists still living among us. This is a challenging exercise for many reasons, not the least of which is the fact that because there are so few terrorists, inaccuracies in prediction are liable to yield scores of false positives, the investigation of which would overburden authorities. The authors provide some examples of the behaviours of terrorists (and omit some, because of the top secret nature of this work), including the fact that terrorists do not buy life insurance, do not have savings accounts, and were unlikely to use an ATM on a Friday afternoon (potentially due to prayers). This work is ongoing, but the authors believe the progress and future potential of this work is strong.

Wednesday, November 24, 2010

Silverleaf Golden?

Silverleaf Resorts (SVLF) markets and operates timeshare resorts. The raw stats on Silverleaf are enough to excite any value investor. The company has a P/E under 5, a P/B of 0.2, and a P/S of around 0.15. Furthermore, the company continues to generate a profit throughout this downturn.

But it's no longer March of 2009, so a company trading at such a low price must be spooking investors in some way. In the case of Silverleaf, it is the company's high debt levels in relation to questionable receivables that worries investors. The company has tangible equity (mostly in the form of notes receivable from customers to which it has sold timeshares) of $200 million, and debt of $400 million.

The good news is, the debt owed is staggered in its maturity dates, and much of it isn't due for several years. The bad news is, the receivables are due over several years as well. Silverleaf takes about a 10% down payment from the would-be vacationer, and then spreads the remaining payment over the next 5-7 years.

As such, the situation is a bit of a black box for shareholders, as we don't know how well the customers are going to be able to make their payments, and the leverage employed further clouds the situation. In this way, Silverleaf operates a little bit like a bank, which makes it very difficult to value. It is a well-capitalized "bank", but it is also an un-diversified one, as it caters to just one group: low-end consumers willing to accept annual interest rates in the teens. This is a group that is particularly vulnerable in a weak economy. The loans to customers are, however, secured against the timeshare which can then be flipped to someone else, which does provide some protection to shareholders. (For further discussion of the company's customers, see here.)

With such a low stock price, the company might be better served sitting on its hands and collecting payments it is already due. But that is not what's going on. Perhaps due to vacancies at the company's properties (i.e. a high inventory number), management continues to push sales. But to market the company's inventory of timeshares, the company has to spend money now, while most of the cash from customers isn't received for many years. This situation dries up liquidity and explains why the company's debt position is not really improving, despite the paper profits.

So is management just trying to keep its job, or is there some scale to be achieved by filling up the company's properties? The answer to this question may lie in the company's proxy filing, which details who owns the company's shares. In this case, the CEO owns 25% of the company, suggesting his incentives are aligned with those of shareholders. Nevertheless, there is much uncertainty clouding this company's future due to the long-term nature of receivables, the customer groups Silverleaf sells to, and the leverage employed to finance these future receivables.

Disclosure: None

Tuesday, November 23, 2010

Harbinger Group: Cash At A Discount

Harbinger Group (HRG) is a holding company that hasn't held much of anything other than cash for the last several years. As such, it mostly traded at a market cap commensurate with its cash holdings. But that changed in the last couple months as the stock price dove, creating a potential opportunity for value investors.

HRG has agreed to issue new shares in return for a majority stake in another public company called Spectrum Brands (SPB). The opportunity arises because HRG's price does not appear to properly reflect its ownership in Spectrum Brands.

After the deal (which is scheduled to close this quarter), HRG will have less than 140 million shares outstanding. At its current price, that would give it a market cap of about $630 million. But it will own 27.8 million shares of Spectrum, which is worth $734 million at its current price of $26.40 per share. In addition to its future holdings of Spectrum, HRG currently has $140 million of cash and short-term investments, versus just $10 million worth of liabilities. This suggests that the market is valuing the $730+ million of Spectrum at just $490 million.

However, this does not necessarily mean that investors should jump onto HRG on the expectation that its price will appreciate. It could very well be that the divergent valuations of these two companies will converge as a result of a fall in Spectrum Brands' stock, rather than a rise in the price of HRG. As a result, one potential opportunity for investors who expect a price convergence would be to go long HRG while simultaneously shorting Spectrum. This would provide a profit for the investor as long as the prices of these companies converge, no matter whether HRG appreciates, Spectrum declines, or some combination of the two.

But there are risks even with this long/short strategy, as HRG is not done investing just yet. The company just issued $350 million worth of debt, as it continues to seek acquisitions. From the last quarterly report:

"The Company intends to use the net proceeds from the offering for general corporate purposes, which may include acquisitions and other investments...We intend to make investments in businesses that we consider to be undervalued and have potential for growth."

Whether these additional investments will add or subtract value is subject to uncertainty, which is further compounded by the use of a fair amount of leverage in the form of the company's newly issued 10%+ senior notes. More on this potential investment is available here.

Disclosure: None

Monday, November 22, 2010

Kirkland's: The Falling Knife

Conventional wisdom in the stock market dictates that investors should not try to "catch a falling knife". Mainstream investors consider catching a falling knife risky, and their mental panic buttons force them to sell stocks in this position. Value investors, on the other hand, can stomach short-term drops because they understand that a lower price equates to lower, not higher, risk. On Friday, Kirland's, a company previously discussed on this site as a potential value investment, (KIRK) served as a perfect example of this dynamic.

Shares in the home decor retailer fell 17% after the company lowered its outlook for the holiday period. For mainstream investors, this is a signal to stampede for the exits, at no matter what the price. For value investors, however, Kirkland's now represents a very compelling value opportunity.

Despite the company's lowered expectations for the year, the company is still very profitable, as return on equity should come in around 25%. Based on the current price and the company's earnings expectations for the year's final quarter, the stock trades at a P/E of just 8. After subtracting the company's $65 million cash balance (against no balance sheet debt), the P/E falls between 5 and 6. Furthermore, next time the company reports it will have approximately $20 million of cash more than it does now due to the fact that a good portion of its profits are generated during the holiday season.

It's worth noting some of the reasons for the lowered outlook to judge just how temporary the company's problems are. First, higher freight charges versus last year have increased costs and reduced margins. The company imports most of its products from overseas, so freight costs (which have since abated somewhat) can wreak havoc with margins a quarter or two after the fact.

Secondly, while traffic to the company's locations was up, the company saw a lower conversion rate (i.e. purchases per visitor was lower). Management believes its merchandising decisions are to blame for this and has identified the weak areas in which it needs to improve. It is refreshing to hear a management team make candid comments of this nature, rather than the standard approach of blaming the weak consumer environment or other factors beyond management's control.

This "falling knife" example also illustrates the importance of having a list of stocks as potential investments should prices become more favourable. Investors should keep up with stocks that are outside of their buy range so that when the opportunity presents itself, they are ready to take advantage of the situation.

Low P/E and high ROE stocks tend to outperform the market, as eloquently illustrated by Joel Greenblatt. Kirkland's holds a lot of potential in this regard.

Disclosure: Author has a long position in shares of KIRK

Sunday, November 21, 2010

SuperFreakonomics: Chapter 1

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

This chapter examines the economic forces that exist in the world's oldest profession. First, the authors contrast some main differences between prostitution today and one hundred years ago. Prices have fallen dramatically, despite a fewer per capita supply of prostitutes. Demand for sex is still high, so what has changed? Due to the acceptability of pre-marital sex in today's society, men are able to satisfy their demands without requiring a prostitute. (More than 20% of men 80 years ago lost their virginity to a prostitute while only 5% do so today, whereas 70% of men today have had sex before marriage, compared to just 33% previously.)

The way prostitution is dealt with by law enforcement serves to highlight the principal-agent problem we have discussed with respect to shareholders and management. Police chiefs (in this case, the principals) likely wish to see more arrests and fewer prostitutes, but there is a conflict of interest with the beat cops (agents). As it turns out, based on the data gathered by the authors and their associates, a prostitute is much more likely to have to give a freebie to a cop than be arrested by a cop.

The way law enforcement attempts to deal with illegal activities is also a problem. As in the drug trade, when law enforcement gets serious, it does so by stepping up its efforts at trying to curb the suppliers of illegal goods/services rather than the consumers. But this serves to increase the price of the product, thereby encouraging more suppliers to join the fray!

The authors also examine the effects of pimps, and compares their effects on prostitution to the effects of using real-estate agents to sell homes. Using data gathered from first-hand study, they find that the use of pimps, holding all other variables constant (including the same prostitutes in many cases), results in an increase in prostitute wages even after commissions, whereas real estate agents don't garner much in the way of benefits to home sellers (and may in fact be a net negative). The main reason for this, the authors conclude, is that pimps are able to market to clients in demographics and geographies that prostitutes are unable to reach. On the other hand, the internet has made it so that real estate agents are not adding much in the way of value for clients, so their value-add is low.

Finally, the authors profile a highly successful prostitute who employs economic techniques to improve her profits. She is a twice-divorced computer programmer who quit that job because it was boring and tedious. She enjoys the fact that she now works for herself, enjoys low overhead (markets by internet), employs price discrimination (higher rates for clients she doesn't enjoy as much), understands elasticity of demand (she can raise prices to certain levels without seeing a drop in demand), and understands market forces (she hopes prostitution stays illegal, because that's part of the reason she can charge such high rates).

Saturday, November 20, 2010

Buffett Partnership Letters: 1969

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

You Can't Time Your Returns

In the previous year, Buffett lamented that new ideas were hard to find and therefore he projected a future performance that could not match that of the past. However, 1968 had still turned out to be spectacular, yielding a portfolio gain of 58%! This was the result of the price performance of a security Buffett called "simple but sound" whose time had finally come. Buffett quips that "investment ideas, like women, are often more exciting than punctual".

Stick With Logic

Buffett quotes a few market observers with views dissimilar to his. One argues that a basket of securities can no longer be maintained over a period of weeks, as they must be studied minute-to-minute. Buffett finds this type of "investing" fascinating to watch, but in another sense appalling. Buffett also quotes an observer who writes that security analysts over 40 "know too much that isn't true". Buffett refuses to change his investing philosophy, however. He writes that an over-the-hill, overweight ballplayer with poor eyesight can hit a home-run every once in a while, but that doesn't mean you change your line-up because of it.

The conditions described above and in the previous year are party responsible for the following:

In his letter dated May of 1969, Buffett announces that he is retiring. It has become increasingly frustrating for him to invest over the years as speculation has slowly taken over the market. He argues that opportunities have disappeared, and the $100 million size of the fund now precludes him from investing in companies that are smaller than $100 million. Buffett does not know what he will be doing next. To redeem their partnership interests, Buffett offers investors cash and/or shares of Berkshire Hathaway, a company controlled by the fund. We know which turned out to be the better choice!

Friday, November 19, 2010

Don't Get Trapped

On this site, we have at times made fun of the findings of various stock market analysts. In the book Managing Investor Portfolios: A Dynamic Process, the esteemed authors discuss some of the traps analysts fall into when making their forecasts.

1) Anchoring trap. The mind gives a disproportionate amount of weight to the first information received on a topic. Keeping an open mind and avoiding premature conclusions is a way to avoid this trap.

2) Status quo trap. Forecasts tend to perpetuate recent observations. If inflation has been high, it is expected to remain high. It is a psychological risk to assume something different. The authors suggest rational analysis within decision-making to avoid falling into this trap.

3) Confirming evidence trap. Individuals give greater weight to information that supports an existing point of view. Being honest to oneself about one's motives, examining all evidence with equal rigor, and enlisting independent-minded people to argue against you are ways of mitigating this bias.

4) Overconfidence trap. Individuals overestimate the accuracy of their forecasts. Widening the range of expected possible outcomes is one way to mitigate this tendency.

5) Prudence trap. There is a tendency to temper forecasts that appear extreme. If a forecast turns out to be extreme and then wrong, it could be damaging to one's career. Therefore, sticking to the herd is safer. The authors again suggest widening the range of expected possible forecasts to avoid falling into this trap.

6) Recallability trap. Individuals are overly influenced by events that have left a strong impression on a person's memory. These events tend to be catastrophic or dramatic. To avoid falling into this trap, individuals should ground their conclusions in objective data rather than emotion or memories.

There is some overlap between these traps and the investor biases we discussed a while back and the psychological tendencies as described by Charlie Munger. The investor should get to know these traps so thoroughly that he recognizes and immediately mitigates when he is about to fall into one.

Thursday, November 18, 2010

ImmunoCellular Therapeutics

The below is a sponsored post placed by Executive Video

Value investing in the field of biotechnology is a difficult task indeed. Often, investors cannot rely on typical valuation metrics such as asset values and earnings. This is because biotech companies are about finding new products to treat unmet medical needs such as cancer, diabetes etc. As such, before investing in a biotech company, investors require an understanding of how well a company is progressing on its way to reaching its profitability goals.

The model for many biotech companies is to take a product through Phase I and Phase II testing, and then sell it to a company better equipped to take it to the next level. Sales prices for products with ready markets are often in the hundreds of millions of dollars. ImmunoCellular Therapeutics (IMUC) trades for just $25 million, but has made significant progress towards this goal.

The company is beginning Phase II trials for a product that fights aggressive brain tumours (like that of the late Senator Ted Kennedy) after a very successful Phase I trial. Only 10% of those afflicted with this form of cancer are disease-free after two years, whereas half of the patients under this trial are disease-free after two years.

Of course, the problem with this kind of company is that it needs to burn through cash for several quarters or sometimes years before completing its trials. The good news for ImmunoCellular is that it typically burns through less than $1 million per quarter, and has $7 million in the bank. Furthermore, management expects to raise another $10 million before the completion of Phase II trials.

For investors willing to take downside risk in return for very strong potential upside returns, ImmunoCellular may offer an enticing risk/reward scenario. Below are comments from the company's CEO:

Untitled from Executive Video on Vimeo.

Disclosure: The site's author does not own shares of IMUC

Wednesday, November 17, 2010

1-800-Flowers Trades Low

1-800-Flowers (FLWS) sells flowers and other gifts online, over the phone (as you might have garnered from its name) and at bricks and mortar retail locations. As consumers have cut back on superfluous spending, revenues at FLWS have fallen, but not nearly as much as the stock price. The stock is down more than 80% from its 2007 peak, when the company had operating income of $42 million. Today, the entire company trades for just $136 million.

The company does have a few items in its favour that put a floor under its earnings. Repeat business is high for FLWS; more than 60% of its sales are to previous customers, giving the company a good base from which to grow. The consumer portion of its basket business (1-800-Baskets) is also doing well, and management believes this business can grow to the size of its floral business.

Furthermore, management does have a significant stake in the company, so its interests are mostly aligned with those of shareholders. It should be noted, however, that the company does have a dual-class share structure which grants management more power than it actually owns. Also, the company does compensate its employees heavily with options, as there are 7 million options outstanding compared to just 64 million shares. But due to the stock price crash discussed above, many of these options are worthless, as the stock trades for well below some of their exercise prices.

What may be of concern for potential shareholders, however, is that the poor consumer environment does not totally explain some of the company's problems. FLWS has not performed up to potential in some of its businesses, resulting in market share losses that are compounding the losses due to the economy. Management is putting some practices into effect to reverse this trend, but it's far from clear as to whether they will do the trick. Outside of 2007 and 2008, the company has not been that profitable; low margins are the norm for this company (operating margins are well under 3% over the last business cycle), suggesting FLWS operates in a highly competitive business, despite the repeat customers that should serve as an advantage in this area.

Just before the recession, FLWS racked up a couple of blockbuster years that make the current stock price look extremely cheap. However, shareholders must decide whether those years were aberrations or whether the company is likely to be able to get back to those levels.

Disclosure: None

Tuesday, November 16, 2010

Kirkland's: Operational Excellence

Kirkland's (KIRK), a US retailer of home decor, has seen a dramatic operational turnaround in the last 3 years. As a result, the stock price moved from under a dollar in 2007 to $25 in April of this year! Since then, however, the soft retail environment and lower than expected results have cut the stock price in half. It now trades with a P/E under 6 after backing out the company's net cash balance, making it a potential value investment.

The company's turnaround is nothing short of amazing. Over a period of two years, it went from operating losses of $26 million during an otherwise strong economic period to operating profits of $47 million during a recession! Several changes were implemented by the management team that helped boost results:

- Underperforming stores were closed
- A major shift from mall-based to cheaper, larger and more productive off-mall locations
- Unique, differentiated items from competitors
- A focus on items over themes
- A more value-oriented price focus

As a result, the company now sits on $65 million in cash, compared to $5 million two and half years ago, while the company trades for $250 million. With the holiday season coming up, that cash position is likely to increase significantly, as Kirkland's currently expects similar results to those of last year.

It should be noted, however, that while the company has no balance sheet debt, its stores are financed by a large number of operating leases. While leasing costs have decreased due to the recession, should the competition figure out what Kirkland's is doing right or should some other factor cause the company's results to falter, the risk is there that the company will find it difficult to meet its obligations.

Until then, however, the race is on. Kirkland's plans to expand quickly and apply its now successful model to new locations. Capital expenditures will come in at around $25 million this year, which is well above the company's depreciation rate. As a result, shareholders may not see as much cash returned as they would like. On the other hand, management has recently shown that it has a formula for success; with an ROE north of 30%, shareholders may be better served with management deploying that capital to drive profits even higher.

Disclosure: None

Monday, November 15, 2010

Detrimental vs Non-Detrimental Debt

A company with a large debt load due within a short period of time can see its stock price take a hit, as investors perceive increased risk under such circumstances. But just because a debt load is high versus a company's current assets and ability to generate cash flow, does not mean the company is on the verge of bankruptcy.

Consider Genesis Land Corp (GDC), a residential real-estate developer in Alberta, Canada. The company has $46 million in debt due over the next few months, and it does not have the current assets to be able to cover that obligation. It is therefore reasonably within the realm of possibility that the company will be unable to cover the $46 million obligation with cash from operations.

But that doesn't signify the end of the company in this case. In other cases, such as those of Blockbuster, Rite-Aid, or TLC Vision, risk of default may be high. But for Genesis Land, the risk is not nearly as great, despite how the share price has reacted over the past few weeks and months.

To see this, it is important to consider the perspective of its lenders. They just want to get paid, quickly and easily. As a result, they have no interest in a drawn out and costly bankruptcy process; they would rather the company operate as a going concern so that it can sell its ample long-term assets in an orderly fashion to make the lenders whole. As a result, the likelihood of the company being able to refinance or alter the terms of its current debt to increase its maturity is very high. Companies without long-term assets are in a much more precarious situation.

Debt due within a short period of time can bankrupt a company. But sometimes a company's particular circumstances can make this a very remote possibility. Investors cognizant of the factors that contribute to a company's safety despite the presence of near-term debt maturities are in a position to capitalize on low share prices and thereby generate abnormal returns.

Disclosure: Author has a long position in shares of GDC

Sunday, November 14, 2010

Buffett Partnership Letters: 1968

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

The Index Matters

Buffett has repeatedly compared his performance against that of the Dow. As described earlier, one of the reasons the Dow was chosen as a measuring stick is because it is widely known. Unfortunately, as a price-weighted index, the Dow can be skewed by a few abnormal results. These abnormalities caused the Dow to underperform most actively managed funds during this period. Even investment management firms, who almost regularly underperform the market, were beating the Dow handily.

Beware Of Speculation

As terrific market returns became the norm, investors increased their willingness to risk their capital. The markets started to heat up. Buffett warns that chain-letter type stock-promotion practices are snow-balling, and he worries about the long-term effects these will have on the markets. In the short-term, however, they have caused stock prices to rise, which has allowed Buffett to sell many of his positions and sit on a pile of cash.

Stick To Your Strengths

While many funds were returning upwards of 100% during this speculative period, Buffett did not change his style. His standards remained the same, despite relative results (compared to new firms) that were unspectacular. He did not switch to this "new way" of investing, which was a form of speculation.

Saturday, November 13, 2010

Buffett Partnership Letters: 1967

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

Short-Term Results Can Conflict With Long-Term Results

Buffett discusses a security in which his fund invested that shows his temperament is quite different from that of his partners/investors. Even though Buffett's fund owned shares of this company, he hoped that the price of these securities would fall further. This would, of course, hurt short-term performance, but would allow him to purchase more shares at an even bigger discount. The shares ended up rising, which contributed significantly to results; but Buffett laments that had the price stayed lower, long-term results would have been much more pleasing.

Reporting Period Matters

Continuing on the theme of long-term investing, Buffett discusses the usefulness of more frequent reports (i.e. shorter reporting periods). Because some of his investments produce wild swings in price within short periods, shorter reporting periods would be more likely to capture these swings rather than the long-term trend. For this reason, Buffett calls frequent reporting "foolish and potentially misleading in a long-term oriented business."

Enjoy What You Do

In one 1967 letter, Buffett actually reduces his annual return goals. Instead of buying and selling businesses purely for profit, he seeks other, more satisfying objectives, even if they are not as profitable. For example, Buffett would prefer to use partnership funds "where I liked the people and the nature of the business" even though "more money would be made buying business at attractive prices, then reselling them."

Friday, November 12, 2010

Buffett's Methods vs Yours

Though he studied under Ben Graham and has adopted many of Graham's investing principles, the world's greatest investor is not your typical value investor. He speaks of margins of safety and of buying companies at discounts, but over the years Buffett has shown a willingness to buy businesses for what appears to be full price, at least on a P/E basis. What allows Buffett to do this and still generate excellent returns is his ability to understand economic "moats" better than anyone else.

For example, making headlines last year was Buffett's purchase of BNSF (BNI), a railway freight business. While most value investors are using this recession as an opportunity to gobble up companies trading for low P/E and P/B values, Buffett goes out and buys a company for a P/E of 16 (using peak 2008 earnings as the denominator!) and a P/B of 3. Ben Graham himself stated that purchasing companies with P/E ratios above 16 amounts to speculation, so what does Buffett do but make it his largest acquisition to date!

But flirting with high P/E's is nothing new for the Oracle of Omaha, as he has done so on several occasions. What all the high P/E acquisitions have in common, however, is a moat that allows each business to earn superior profits. For example, consider the return on equity (ROE) of BNSF over the last few years:

With the large size of Buffett's portfolio, his investment universe is fairly limited. While most of us have the benefit of being able to turn over every last rock to look for cheap companies, Buffett is limited to selecting from ocean-sized boulders. It is for this reason that BNSF offers an attractive investment opportunity for Buffett. With the ROE depicted above, Buffett will be able to allocate capital to this company (earnings from other businesses, insurance float etc.) and earn returns between 15% and 20%.

If it were this easy though, couldn't all large investors and insurers follow this formula? The advantage Buffett has over everybody else, however, is his superior ability to understand competitive advantages (or "moats"): he believes/knows that the ROE depicted above will continue for the foreseeable future. While he will be second-guessed (always has been, and always will be), his ability to predict moats has proven to be second to none.

Individual investors can certainly learn from Buffett, but are cautioned to avoid investing like him unless they know what they are doing. While Buffett likely benefits from having more information, more knowledge and a higher understanding of business than most investors, his major disadvantage is that his investing universe is so limited. Individuals are thus better off finding value in the analyst-ignored small cap universe where stock prices are the most inefficient and where companies trading at large discounts can be found.

Thursday, November 11, 2010

EarthLink: Low P/E, But Diverted Earnings

Earthlink (ELNK) is an Internet Service Provider that trades with a P/E under 4! In addition, the company has very little in the way of debt compared to its cash flow.

Companies will often trade at ridiculously low P/E's due to either a short-term or a long-term issue. Value investors love instances of the former, since it creates a long-term profit opportunity. Unfortunately, Earthlink appears to be an example of the latter, as its business is in secular decline. Nevertheless, the company's P/E is so low that some value investors may be compelled to invest despite the declining industry Earthlink's main business faces.

How can a company in the internet services industry be in decline? Well, Earthlink's major business line is dial-up internet access for US consumers. It doesn't take a clairvoyant investor to realize that broadband internet is rendering dial-up obsolete, at least in this part of the world. The company's revenues over the last four years bear out this problem, as they have steadily fallen from $1.3 billion in 2006 to just 724 million in 2009.

But the company has managed to cut costs in the face of this decline in revenue, as administrative costs have fallen from $770 million to $230 over this same period. Perhaps some value investors would be willing to overlook such declines when the asking price (a P/E of 4) is so low.

Unfortunately, most of the company's earnings are being diverted to other endeavours. While the company does pay a yield corresponding to 7% of its current stock price, that represents only a fraction of the company's earnings. Management appears intent on spending the rest of it on acquisitions that keep the company alive. Following what is effectively a $500 million acquisition (which is half of the company's market cap!), management had this to say on the company's latest conference call:

"After this transaction our company will still be highly unlevered. Our strong balance sheet and ongoing future cash flow will provide us an expanded set of organic and strategic alternatives."

That's fancy wording for "we're probably going to keep throwing good money after more acquisitions". Perhaps these acquisitions will be highly successful, or perhaps they will fail miserably. But value investors don't want even bets of this type. As such, there doesn't seem to be much reason for shareholders of such ilk to get involved, despite the extremely low P/E.

Disclosure: None

Wednesday, November 10, 2010

Hidden Cash

Liberty Acquisition (LIA) was formed with the intent of buying a business operation. As such, it is flush with cash. You wouldn't know it by looking at stock screeners, however: both Yahoo and Google Finance show the company as having just $7 million of cash. The reality, however, is that the company has over $1 billion in cash.

The reason for this discrepancy is the way the company classifies its cash: as a long-term asset, since it will be used to purchase a business. As a result, Yahoo has the billion dollars listed as "Property, Plant and Equipment" and Google has it listed as a vague "Other Long-Term Asset". For this reason, and others we have discussed, relying on these sites for company information is not a good idea.

Unfortunately, the company trades for $1.4 billion, despite a book value of just $700 million. As such, it is probably of little interest to value investors at this time, despite the huge cash balance. Nevertheless, it may be a useful company to watch in the future as a time may come when market sentiment turns negative on this stock. Furthermore, the knowledge that certain data on sites such as Yahoo Finance and Google Finance can be misleading should lead to improved investment processes on the part of investors.

Thanks to Ankit Gupta of Selected Financials for pointing this out, and for noting that a deal employing this company's cash may be very close to occurring.

Disclosure: None

Tuesday, November 9, 2010

Don't Focus On Consumer Spending

Contrary to popular belief, increases in aggregate spending (e.g. consumer spending) is not what leads us to a higher standard of living. Nevertheless, both in good times and bad, consumer spending is the gauge the media focuses on as a barometer of how we're doing; but consumer spending is only a measure of short-term demand. Increases in standard of living, however, come from our ability to do our jobs more efficiently.

For example, consider a plant that employs 1000 workers and makes one widget per day. Suppose one day the plant manager comes up with a new method of making that widget, and only requires 500 workers to do it. The remaining workers just got richer, because now the revenue from the widgets sold is spread over fewer workers. (In practice, of course, this process would take time, and the higher profits would be shared among owners and labourers through market forces. Furthermore, the 500 laid off workers would undergo short-term difficulties until they could join a company that's expanding, unless there is a market demand from the company to make 2 widgets per day.)

The aggregate nation-wide level of these efficiency improvements is referred to as productivity growth. Here's a look at US productivity growth (in percent) over the last 60 years:

Millions of tiny innovations (and some not so tiny, such as the wheel, the light bulb, and the internet) have contributed to human productivity growth over the ages. And millions more are on the way, if we are to see continued growth in our standard of living.

Productivity numbers are reported every quarter, but are not given the attention they deserve. Government policy should be geared towards encouraging productivity gains, which come from savings which leads to investment. Instead, governments often focus on increasing consumer spending through debt, which causes short-term pick-ups in demand (and therefore increases GDP and reduces unemployment in the short-term), but makes us no better off in the long-run.

Monday, November 8, 2010

Spread Too Thin

Integrated Electrical Services (IESC) provides wiring, power connection and related maintenance services to the industrial, commercial and residential markets. The company trades for $52 million, but has net current assets of $74 million.

As one might expect, revenues for this company are highly cyclical, as they are strongly correlated with new construction. Indeed, Integrated Electrical has seen its revenues drop 30% from year-ago levels as the recession has put construction projects on hold.

But considering the types of services the company renders, one would expect the company to be able to cut costs to adapt to a lower revenue environment. Providing electrical services should require a great deal in the way of variable costs such as labour and supplies, but likely doesn't require fixed costs such as factories and specialized equipment. True to form, the company only has $20 million of property and equipment (versus quarterly revenue of $120 million).

Despite this, the company has been unable to reduce costs in line with demand. In its last quarter, the company lost $6 million, following losses of $12 million the quarter before. Part of these losses are due to bad debt and restructuring charges, but the majority of these charges are cash losses. This is despite the fact that the company has cut costs, as administrative expenses are down 20% from the year-ago period.

So what gives? Why can't the company match its variable costs with its revenues to at least break-even, like other companies we have seen with variable cost structures? The answer may be that the company's operations are spread too thin.

The company serves 48 states from 89 locations. Closing locations would reduce revenues further. It would appear that the company has made a choice to keep capacity high, even though demand is presently weak. This is confirmed by the fact that management stated on its last conference call that operating leverage is significant as the market recovers.

While Integrated Electrical looks cheap based on its net current assets, investors have to allow for the fact that further significant losses may occur before the company returns to profitability. As new construction demand remains relatively weak, there is an oversupply of electrical service providers, resulting in competition that is lowering margins. Integrated Electrical's decision to remain in most of its markets and battle it out for business rather than shrink and focus on profitability increases the chances of further losses, which reduces the appeal of the company at its current price.


Sunday, November 7, 2010

Buffett Partnership Letters: 1966

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

You Can Be Too Big OR Too Small

This is the year Buffett closes the partnership to new members. He believes the size of the fund (at $46 million at the end of 1965) will now become a disadvantage in generating returns superior to those of the Dow. But he also believes the fund was large enough to take advantage of opportunities he couldn't have otherwise (i.e. control situations); as a result, if the fund were too small, he also doesn't believe it would have had the returns it has had to date.

Don't Over-Diversify

Buffett is willing to invest up to 40% of the partnership's capital in a single investment. While he would prefer that 50 investments exist of which he is extremely confident in generating excellent returns, he argues that the market just doesn't work like that. In response to those who argue that investors should diversify, he agrees in principle qualitatively, but he has yet to see a convincing argument of just how many stocks constitute proper diversification and why.

Don't Base Investment Decisions On Predictions For The General Market

When the market falls, Buffett gets calls from his investors suggesting he sell stocks until such time as the outlook becomes more clear. This idea sounds ludicrous to Buffett, since he believes one cannot tell in which direction the market is going and therefore it makes no sense to sell undervalued businesses based on some observer's guess. Buffett refers the reader to Ben Graham's The Intelligent Investor for more discussion of this topic.

Saturday, November 6, 2010

Buffett Partnership Letters: 1965

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

Group Think

In this letter, Buffett delves into some possible reasons for why the top investment management firms cannot beat the passive Dow Jones Industrial Average even as Buffett trounces it. Buffett doesn't believe it to be a lack of integrity or of intelligence at the top firms. He attributes their under-performance to, among other things, group decisions. His opinion is that "...it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions."

Relative Valuation Can Still Be Pricey

Buffett describes a growing portion of his portfolio where companies are not cheap by "private owner" standards, but rather on a relative basis compared to similar companies. For example, he may buy a company at a P/E of 12 while a similar company of lower quality sells for a P/E of 20. While he notes that this section of his portfolio is showing promise, he does worry about situations where the latter company gets revalued to a P/E of 10. Buffett does hint at this point that he is implementing a technique to reduce this risk.

Don't Let Taxes Stop You

Nobody likes taxes, but Buffett argues that more investment mistakes are committed in the name of tax considerations than from any other cause. Buffett quotes a friend who argues that a majority of life's errors are caused by forgetting what one is really trying to do. Paying the least amount of taxes is not the investor's goal; instead, the investor is trying to come away with the largest after-tax return. These are often not the same thing.

Friday, November 5, 2010

Timing The Market Timers

Many participants in the stock market base their buy and sell decisions on attempts to time the market. The idea is to buy into the market just before prices rise, and sell before they decline. Many studies have shown that it is very difficult to correctly time the market. But assuming you had superior foresight, how often would you have to be right in order to beat a buy and hold investor?

Chua, Woodward and To took an interesting approach to this question. Using a mean market return of 12.95% and a standard deviation of 18.30%, the authors ran 10,000 simulations of market years where an investor has an assigned probability of correctly determining a bull or bear market. If said investor guessed a bull market, he was credited with the market's return. If the investor guessed a bear market, he was given the T-Bill rate of return. The buy and hold investor always received the market return.

The results were surprising. In order for a market timer to beat the buy and hold investor on average, he had to correctly predict a bull or bear market a full 80% of the time! The reason for this is that the the cost of an investor missing out on a bull market was very high. Timers lost much ground in the years that the market did well where the timers incorrectly guessed a bear market.

However, the standard deviation between the timer and the holder was quite wide, suggesting that many market timers will indeed outperform the holders, and this is the case even at a 50% probability of a correct prediction. As such, timers who are successful will be promoted and we are sure to continue to hear about timers who have beaten the markets. Whether the outperformance as a result of timing is sustainable or simply the result of random distribution is another story. On average, being right 80% of the time would appear to be quite a stretch.

Thursday, November 4, 2010

Swank Inc.

Swank (SNKI) is a competitor of Tandy Brands, a company that has been discussed on this site. These companies produce and distribute (to retailers) belts, wallets and other accessories across a number of brand names. Where Tandy Brands has weaknesses as a potential value investment, Swank has strengths.

Swank trades for just $14 million despite net current assets of $23 million. Swank has also shown a capacity to earn, having generated operating income of approximately $30 million over the last four years. Unlike Tandy Brands, Swank is closely held, with management holding almost 50% of the outstanding shares, led by the company's CEO.

Swank's customer concentration is also much smaller than that of Tandy. While Swank's top customer (Macy's) accounts for 20% of Swank's sales, Tandy relies on Wal-Mart for almost half of its revenue.

Not everything is positive for Swank, however. Management salaries are high; in the last two years, the company's top three earners have made almost as much personally as the entire company has in net income. Nepotism also runs deep here, as the company CEO's daughter was hired and paid almost $300K per year over the last two years.

Since the entire industry is depressed, both of these stocks appear to trade for substantially less than they are worth. However, each individual stock has risks unique to each company that may sour its interest to value investors. Therefore, an investor wishing to take advantage of the depressed prices may wish to spread his investment across each of these companies, thereby lowering company-specific risks while at the same time gaining exposure to what appears to be an undervalued sector.

Disclosure: None

Wednesday, November 3, 2010

Where You Buy, Not What You Buy

We spend most of our time on this site discussing stocks from a bottom-up perspective. But sometimes the environment for business becomes more important than the business itself. When governments intervene between willing trading partners or property rights are not protected, the assumptions that underly bottom-up investing no longer apply. For this reason, even bottom-up investors must be cognizant of the business environment into which they are considering investing.

For those who disagree, consider Venezuela, which is run by an administration that abhors capitalism. Nevertheless, many American businesses still have significant operations there. Undoubtedly, some of these businesses are cheap enough to pique the interest of the value investor. But value investors should stay away.

The country has been on a nationalization rampage, and no business is safe. Recently, the country's leader Hugo Chavez announced that it would be taking over the Venezuelan operations of Owens-Illinois (OI), the glass container manufacturer.

While the company had no advance knowledge of its nationalization, it could hardly come as a surprise. As we've discussed on this site before, investors in Venezuela should be very careful. Yet the company announced that "we were surprised to learn of this decision and we are prepared to work with government officials to better understand the situation." What's to understand? Venezuela is not a free country.

Bottom-up investing works and it works well. But it only works because in most environments with which we are familiar, companies are free to buy, sell and allocate their resources towards their most productive uses. Investors must not take this for granted; where this paradigm does not exist (either by geography, industry or otherwise), investors should be wary of using methods that rely on its presence.

Tuesday, November 2, 2010

Biases You Must Defeat

Daniel Nevins is a managing director at SEI Investments. Not unlike Charlie Munger (whose discussion of human tendencies we have summarized), Nevins is a student of human biases which cause individuals to underperform as investors. In his paper titled Integrating Traditional and Behavioral Finance, Nevins notes the following biases:

Investors overestimate their ability to predict market events. This leads to overtrading and taking on too much risk.

People become honestly deceived when an event occurs, thinking that they had predicted such event even when they had not. This trait reinforces overconfidence.

The human mind looks for patterns. But sometimes events occur which are random or cannot be predicted. Nevertheless, investors over-interpret patters that are coincidental, leading to illogical behaviour.

Belief Perseverance
People are unlikely to change their opinions once they have been formed, for two reasons. First, people are reluctant to search for evidence that contradicts what they believe to be true. Second, even when faced with such evidence, it is treated with skepticism or not given the weight it merits.

Regret Avoidance
This is a tendency to avoid or postpone actions that create discomfort. For example, investors hold on to losing stocks, as selling them would be a confirmation of a poor prior decision, and this confirmation does not sit well. (Note that Belief Perseverance can also play a role in this action.)

By understanding these biases, investors put themselves in a position to avoid falling prey to them. By recognizing that such tendencies may be playing a role in investment decisions, individuals can take steps to mitigate them or implement procedures for decision-making that are more objective.

For those interested in reading more on the subject, the full paper is available here.

Monday, November 1, 2010

Making Money But Losing Value

L.S. Starrett (SCX), a company we have previously discussed as a potential value investment, recently returned to profitability having achieved sales and gross margin growth of 65% and 80% respectively in its fiscal fourth quarter. But despite the company's strong operating performance, the value of the company continued to fall. How can this be?

This occurs because not all company losses are shown on the income statement. Changes in the funded status (i.e. the difference between the pension plan's assets and the present value of what it owes) of a company's pension plan, for example, are not required to be immediately recognized as losses on the income statement. But to shareholders, a funding shortfall in a company pension plan is a very real liability that will have to be made up by future cash payments unless positive developments (e.g. strong returns from the plan's investments) occur that reduce the shortfall. But one cannot count on such positive developments!

For some companies, pension plan shortfalls are a drop in the bucket compared to the size of the company's operations. This is not the case with Starrett, as post-retirement plan shortfalls represent more than 1/3 of the company's market cap!

In order to properly estimate the intrinsic value of companies, shareholders should be sure to consider liabilities (such as pension shortfalls) that are not fully reflected on income statements. This requires subtracting funding shortfalls from company valuations based on their balance sheet values, or by following the progress of such shortfalls on the company's statement of comprehensive income.

Disclosure: Author has a long position in shares of SCX