Barel Karsan

A Random Walk Down Wall Street: Chapter 4

sajid.karsan@barelkarsan.com (Saj Karsan) — Sat, 21 Nov 2009 11:42:00 +0000

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Having poked holes in the "Castle In The Air" approach to investing, Malkiel now discusses the Firm Foundation approach. (Both of these approaches were introduced in Chapter 1.) The author discusses what he considers to be the four key determinants used to value stocks using the intrinsic value approach:

1) The expected growth rate

2) The expected dividend payout

3) The degree of risk

4) Market interest rates

Malkiel references or shows evidence that each of these factors do play a role in determining prices. At the same time, however, the willingness of investors to pay for each of these factors can change drastically in relatively short periods of time. For example, while the market always pays more for "growth" stocks, during bouts of market optimism (pessimism) the market is willing to pay a high (low) premium relative to the broad market.

Part of the reason for this fluctuation is that items like the future growth rate cannot be known for certain, and so expectations fluctuate wildly based on the market's overall sentiment. From the words of an analyst who tried to determine the intrinsic value of IBM a few decades ago:

"I began by forecasting growth in earnings per share. This was a little under the average for the previous ten years...I forecast at 16% growth rate for 10 years, followed by indefinite growth at 2%...When I put all these numbers into the formula, I got an intrinsic value of $172.94, about half of the current market value. It doesn't really seem sensible to predict only 10 years of above average growth for IBM, so I extended my 16% growth forecast to 20 years."

Despite the tendency to fall prey to biases/sentiment and the fact that the inputs are to the model are so uncertain, analysts/investors treat their estimates as being certain, and rely on precise calculations in forming their decisions. Unfortunately, when the inputs are so uncertain, precision can hardly be expected in the results.

Investor Traps

sajid.karsan@barelkarsan.com (Saj Karsan) — Fri, 20 Nov 2009 11:07:00 +0000

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 few weeks ago 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.

Party Like It's Early 2008

sajid.karsan@barelkarsan.com (Saj Karsan) — Thu, 19 Nov 2009 11:19:00 +0000

Wall Street is entirely too focused on current earnings, as noted by Ben Graham. So when a company shows declining earnings on declining revenues, the stock price will take a hit, even if the declines are purely cyclical. For example, consider the quarter-by-quarter revenue chart for KSW Inc. (KSW) below:

As a result of this decline, Mr. Market's valuation of this company offers great opportunities for value investors. The company trades for just $20 million despite having a net cash position (cash minus debt) of over $14 million. Before the credit crisis caused the cancellation of many of the company's jobs, the company was earning profits of around $4 million per year!

Because the company's cost structure is flexible (as discussed here), the company has also avoided losses during this recession despite the harsh drop in revenue.

But how can one be sure that the company is only undergoing a cyclical decline, and is not instead getting battered by stronger competition? A leap of faith is not required. Consider the company's backlog below:

Some of the company's cancelled projects have been brought back online, and the company has expanded its reach. As a result, the company's backlog has not been this high since the early part of 2008! Investors don't have to wait long, as it appears the company will soon be returning to business as usual. Considering the company's cash balance, however, investors are only paying for a couple of years worth of earnings.

Disclosure: Author has a long position in shares of KSW

You Might Think You're Copying Buffett...

sajid.karsan@barelkarsan.com (Saj Karsan) — Wed, 18 Nov 2009 11:44:00 +0000

Recently, Berkshire filed its mandatory disclosures detailing its positions in various securities. As a result, you will undoubtedly see headlines beginning "Buffet Buys X Stock" and "Buffett Sells Y Stock". And when word gets out that Buffett has bought a particular stock, its shares jump immediately. After all, if the Oracle of Omaha wants into a company, surely it has a bright future, right? Unfortunately, determining whether Buffett has actually bought a company is not so easy.

Buffett is not the only portfolio manager at Berkshire. But don't take my word for it, as this statement comes from Buffett himself:

"The media continue to report that "Buffett buys" this or that stock. Statements like these are almost always based on filings Berkshire makes with the SEC and are therefore wrong. As I’ve said before, the stories should say "Berkshire buys."...Even then, it is typically not I who make the buying decisions. Lou Simpson manages about $2½ billion of equities that are held by GEICO, and it is his transactions that Berkshire is usually reporting."

As an example, shares in CarMax rose 7.5% on the day a filing from Berkshire indicated it had taken a position. Presumably investors assumed Buffett had seen something in the valuation that the market hadn't. However, Alex Taylor refutes the fact that KMX was a Buffett purchase in a well-written article here.

So even though you know how to access Berkshire's filings, you may not know the buyer behind the buys. Your best defense is to do your own homework and to know yourself what you're buying.

Market and Book Value Arbitrage

noreply@blogger.com (Guest Authors) — Tue, 17 Nov 2009 11:22:00 +0000

The following is a guest post by Garrett Chan, a private investor who is currently raising capital to start his own firm. He may be contacted by e-mail for those who would like more information or who have questions about the article.

In its purest form, value investing is simply an arbitrage between price and intrinsic value. In other words, we see opportunity when, through careful analysis, we determine there exists a spread between the going price of an asset and its intrinsic value.

Likewise, Melcor has been discussed several times here as an investment based on its large discount to book value. However, it was also noted that real estate assets on its books are recorded at historical cost. Given that Melcor acquired assets as far back as the 70’s, it should come as no surprise that historical cost is a poor proxy for determining intrinsic value. In this case, real estate assets are materially understated and can be uncovered by the enterprising investor.

So how can we determine the market value of these assets if management does not tell us outright? Management is obviously aware of these true values as they state “net realizable value exceeds the carrying cost”. Actually, they do tell us, however indirectly it may be.

Like any other asset, the value of a building is the sum of discounted cash flows received over its lifetime. Therefore, we can roughly value the properties using the income Melcor receives.

Instead of using a full blown discounted cash flow analysis. We can use a popular tool used in the real estate industry called the “capitalization rate”.

Cap rate = Net Operating Income / Market Value

To find market value we can rearrange it to read:

Market Value = Net Operating Income / Cap rate

Melcor’s Investment Properties’ NOI totaled about $20M for 2008.

The average downtown office, suburban office, and retail property had a cap rate of 7% in the fourth quarter of 2008. This holds true in most major Canadian cities. The properties have a lease rate of 96% so these are not subpar assets. Melcor’s investment portfolio should then be worth roughly $286M at current market rates. These properties are valued at $158M on the books so the difference is $128M. This is material as shareholder’s equity is only $310M.
Even though management states net realizable value of land inventory is greater than its cost, we will leave the rest of Melcor’s balance sheet at book value since land inventory does not earn a regular stream of cash flows and cannot be reliably valued like the buildings.

Even so, after we add the “hidden” $128M, Melcor’s new book value becomes $438M. With 30M shares outstanding, this is $14.60; an increase of 41% over the $10.33 historical book value. Consider that the 52 week low of this stock was $3.25…

Also consider that management has grown historical book value at over 12% compounded annually for the last 14 years and was, until recently, a member of the Dividend Aristocrat Index.

Who says value investors can’t get quality companies on the cheap?

Disclosure: Garrett Chan has a long position in shares of MRD

The Right P/E For The S&P 500

sajid.karsan@barelkarsan.com (Saj Karsan) — Mon, 16 Nov 2009 11:50:00 +0000

As the market has continued to soar while corporate profits have continued to plummet, many market observers have noted that the P/E level of the S&P 500 has risen to such an extent that an overvalued market is now upon us. Indeed, Standard and Poor's reports a P/E for the S&P 500 of 122, which is clearly well above the index's historical range. Does this constitute a clear signal to value investors to stay away? Not on its own.

The problem with this measure of the market's valuation is that, at times, earnings may be temporarily depressed. During recessions, unanticipated drops in revenue occur which catch companies off-guard. Companies cut their costs in reaction to these revenue shocks, but there is a lag. To demonstrate this, consider the following chart depicting the profit margin level of the S&P 500 in the aggregate:

In every recession, profit margins temporarily shrink. Therefore, to justify what appears to be a ridiculously high P/E, we do not presume incredible growth in sales or returns on capital as was the norm in the late 90s. Instead, we consider what the earnings would look like when the write-downs and impairments are complete, and companies have returned to a more normal operating environment.

(As an aside, notice how strong profit margins were in particular during the expansion that preceeded this recession. This could be due to the growth that occurred in the financial industry, where margins tend to be higher as we saw here.)

Based on the above chart, the average historical profit margin for the S&P 500 appears to be around 5-6%. Using this number to determine the normalized earnings level of the index gives the S&P 500 a P/E of around 20. While this number is still a few points above the historical P/E for the index, notice how profit margins over the last business cycle have been higher than the historical norm. Investors expecting this trend to continue would estimate an even lower current P/E ratio using normalized earnings.

Though this method of calculating the market's P/E is preferred from the perspective of a long-term investor, this still does not suggest the market is cheap. Earnings are determined by multiplying profit margins with sales; with high unemployment and tighter lending standards, the sales level of the index (which is somewhat, but not completely, related to GDP) may shrink further from this level, reducing earnings further.

While the method described above can help estimate future earnings, determining the earnings level of the entire index with any degree of certainty is a difficult task indeed. It is much easier for the investor to focus on individual companies, and the performance of individual companies within the index will show high variability; many companies will be unable to handle the depressed earnings environment (due to debt or other fixed obligations) and will therefore fail. But companies with flexible cost structures will be able to return to profit margin levels commensurate with their histories, and investors should focus on identifying these companies in order to achieve returns that outperform the index.

* Source: Thanks to William Hester of Hussman Funds for the profit margin chart.

A Random Walk Down Wall Street: Chapter 3

sajid.karsan@barelkarsan.com (Saj Karsan) — Sun, 15 Nov 2009 11:10:00 +0000

Considering the madness of crowds as described in the previous chapter, many investors believe it prudent to attempt to grow their savings and wealth using professional money managers. While professional/institutional money management has grown tremendously in the last few decades (in 1960, only half of all trades were from institutional managers, while today closer to 90% of trades are institutional), Malkiel attempts to show that such managers fall prey to the same vagaries as do individual investors.

Starting from when he first started working on Wall Street in 1959, Malkiel walks the reader through several crazes Wall Street went through over the years that cost investors dearly:

1) The "Tronics" Boom of the early 1960s

Investors were hungry for growth stocks, and the market provided them, as 1959-1962 saw more issues than at any other period. IPOs would trade at several multiples of their prices only weeks after the fact, and regular companies would add a "tronics" suffix to their names in order to boost their stock prices. In 1962, the party ended, with "growth" stocks suffering far more than the general market.

2) The Conglomerate Boom

Two plus two equals five for these acquirers of the mid-1960s. Companies in totally unrelated industries were merging and "creating value" for shareholders with back-end "synergies". Companies trading at high multiples would buy companies trading at lower multiples and thus show earnings per share growth. The combined company would then trade at the multiple of the acquiring company, thereby increasing value like magic! Not only did multiples not drop after such acquisitions, but they would actually rise, seemingly due to the earnings per share "growth" that was occurring. The bottom fell out in 1969 when multiples for conglomerates came crashing back down to earth.

3) Concept Stocks

In the late 1960s, a focus on near-term stock returns led to a boom in concept stocks. These were stocks of companies with little to no revenue, but with compelling stories. Fund managers did not even have to believe the stories, they just had to believe that other fund managers would believe, and that would be enough to buy in, with the hope of selling to a 'greater fool'. The pros lost a lot of money for their clients when the bear market of 1969-1971 destroyed the prices of these dream stocks.

4) The Nifty Fifty

With the silly fads that had taken place in the 60s, Wall Street pros began the 70s with an eye towards quality companies. These companies were big caps (and were thus "proven") and had great returns on capital, and therefore the thinking was that even if prices were temporarily high, the earnings would eventually catch up since the companies were so great. The P/E's of companies like Sony, Polaroid, McDonald's and International Flavors traded above 80, but they would all trade at fractions of this level some years later.

5) The Roaring 80s

A return of the appetite for "growth" companies saw investor demand for new issues once again overwhelm prices. Where electronics companies commanded ridiculous multiples in the 60s, it was biotechnology companies that were favoured by investors in the 80s. Malkiel discusses a few individual stocks to demonstrate how insane even the institutional investor can become.

6) The Nervy 90s

The 90s saw huge bubbles in both internet stocks and Japanese real estate. There was no doubt that the internet would be a game changer, but Wall Street's overzealous demand for internet securities led to ridiculous valuations where companies with no earnings could sell for 350 times their revenues!

While anomalies such as the ones described in this chapter do occur every once in a while, Malkiel takes care to note that in each case, even if it took years, the markets eventually corrected. Therefore, he argues that in the long-term markets are efficient.

A Random Walk Down Wall Street: Chapter 2

sajid.karsan@barelkarsan.com (Saj Karsan) — Sat, 14 Nov 2009 11:21:00 +0000

This chapter contains a discussion of asset price bubbles throughout history, and the psychology behind them. Malkiel discusses the Tulip Bulb Craze, The South Sea Bubble, The Florida Real Estate Craze (the one in the 1920s...the book's writing preceded the one last year!) and the crash on Wall Street of 1929.

Of interesting note is the fact that it is obviously very difficult to sit on the sidelines and see one's friends and neighbours profit from a bubble. Therefore, even though many of the participating "investors" recognize that prices are irrational, they are willing to part with their money anyway, hoping for a "greater fool" to sell to later.

Another commonality of these bubbles is the fact that there are always groups of people who can rationalize the price no matter how high a level is achieved. Even after the bubble pops, such people will maintain that the high prices were rational, only this time their opinions are considered foolish, whereas during the bubble they were considered reasonable.

Even Isaac Newton fell victim to one of the bubbles described in the book. He is quoted as grumbling, "I can calculate the motions of heavenly bodies, but not the madness of people."

While unsustainable prices can persist for years, eventually they succumb to gravity. The larger the bubble, the more dramatic the reversal and the longer the resulting hangover. Few of the builders of the "castles in the air" (a reference from Chapter 1) can anticipate the reversals in time to realize their paper profits. Malkiel concludes by arguing that it is not difficult to make money in the market, but one of the easiest ways to become a loser is to be constantly swept up in the latest bubble.

The ETF Advantage

sajid.karsan@barelkarsan.com (Saj Karsan) — Fri, 13 Nov 2009 11:26:00 +0000

For those investors who recognize that professional money managers rarely beat the index, investing in passive funds (that basically spread the pooled investments across the index) makes a lot of sense. Investing in mutual funds that track the index used to be the best way to perform this task, but several years ago, ETFs were born, and offer a cheaper way (i.e. lower management fees) to invest in an index. How exactly do they do this?

When you buy a mutual fund, the mutual fund manager issues you shares of the mutual fund and takes your cash investment. But now he has to keep the cash around, which drags the whole fund's return, or he has to incur transaction costs buying shares of the underlying index. The same thing happens when you redeem your shares; the manager has to keep cash around to return your money (which drags on returns) or he has to incur transaction costs by selling stock to provide you with cash.

The first ETF was a financial product innovation that started in Canada and has now spread through the world like wild fire due to its advantages. ETFs don't have to incur transaction costs or keep pools of cash around for when individuals buy and sell shares, because these shares are issued in large blocks and are traded in the secondary market (meaning when you buy/sell a share, you're buying/selling an existing share, which doesn't require the issuing/redemption of a new one).

Shares in large blocks can be issued or redeemed from time to time as needed, but most of the time they are in the hands of dealers who make money off the bid/ask spread of the ETF (like a regular stock). The dealers compete with each other for volume, however, so the bid/ask spreads are kept competitive for liquid ETFs (just like regular stocks). Unlike closed-end funds, however, which can trade at huge discounts or premiums to their underlying assets as we saw here, ETF shares can indeed be redeemed if there are arbitrage opportunities. For example, if the ETF trades at a discount to the underlying assets, traders can buy the ETF and redeem it for a profit, which results in ETFs trading fairly close to their Net Asset Values.

If you're an index investor who owns mutual funds, consider checking if an ETF exists that invests in the same index...you will likely increase your returns by almost 1% per year due to the management fee cost savings.

Leisure Suit Lawsuit

sajid.karsan@barelkarsan.com (Saj Karsan) — Thu, 12 Nov 2009 11:48:00 +0000

Ben Graham noted that stocks of companies with some lingering uncertainties tend to have their valuations over-punished by the stock market. A pending lawsuit is one such example of a "lingering uncertainty". For this reason, many companies would rather settle legal claims that cast a shadow over the company's valuation even if they think they can win them. However, in such uncertain situations, no liability is recognized on the balance sheet. Nevertheless, investors who take the time and effort to read the legal proceedings that the company discloses put themselves in a position to reduce - or even eliminate - the financial uncertainties.

Consider Adams Golf (ADGF), a designer and distributor of golf clubs. Two days ago, the company reported the settlement of an old claim; the company will be out $5 million as a result. For a company with a market cap of just $19 million, this is a material cash outflow. But for investors, this should come as no surprise. A careful reading of the company's previous notes to its financial statements would have revealed, among other things, the following:

1) The company was insured for exactly this type of infraction for up to $50 million

2) One of the insurers, which was to cover $5 million of the $50 million, claimed a breach of contract and was unwilling to pay

When we previously discussed this stock as a potential value investment two months ago, an astute commenter raised the subject of this lawsuit. The answer a few comments later was that in all likelihood the lawsuit would cost the company $5 million. As such, the company's disclosure two days ago that it would take a $5 million charge to settle this lawsuit came as no surprise. By factoring in this cost before it was even recognized by the company, a more educated decision could be made by the investor as to whether the company was indeed undervalued.

Of course, surprises are still going to occur. Not every event, legal or otherwise, can be foreseen. But by doing their research (by reading the company's disclosures and its notes to the financial statements), investors can minimize risk and reduce uncertainty. In doing so, they can improve their accuracy in determining a company's value.

Disclosure: Author has a long position in shares of ADGF

Housing Completions

sajid.karsan@barelkarsan.com (Saj Karsan) — Wed, 11 Nov 2009 11:15:00 +0000

It's common to hear that the housing industry is in a depression, and that this type of collapse is unprecedented in American history. When one looks at house prices, which we did here, one can see why. There was a huge run-up in prices, and a huge collapse as a result. Those who bought in at the height of the market are suffering now. But for the housing industry itself, the construction pattern is actually very familiar. Here's a look at US housing completions since 1968 (note that 2009 is an estimate through September):

The boom and bust phenomenon in housing construction is common throughout history! But it just hasn't happened for a while, which may have fooled people into thinking this is not a highly cyclical industry. Notice that for whatever reason (e.g. cheap credit, low supply due to the fact that there was no preceding boom), there was no bust in the last recession in 2002. But current reductions in construction have caused panic levels to soar, allowing investors the option to purchase assets at great discounts.

While the current low levels of construction are taking a big bite out of GDP, this is necessary in order for existing inventories to be absorbed. Once supplies have been sufficiently reduced, this industry will be back. When that is, is anybody's guess, but when the market is fearful, one can find companies in unfavoured industries that trade at discounts to their assets, which is what value investors try to do.

Earnings Revert To The Mean

sajid.karsan@barelkarsan.com (Saj Karsan) — Tue, 10 Nov 2009 11:28:00 +0000

When calculating a company's P/E or projecting a company's earnings power, rather than using a company's current earnings, value investors prefer to use average earnings from several years past. Ben Graham has written about this idea, and we've also discussed how writedowns, asset sales, and other infrequent items can affect current earnings; but when using an average over several periods, one gets a much better idea of a company's earnings power.

But there's another more subtle reason why "average earnings" is far more useful than current (or forward) earnings: in a free market, companies with undifferentiated products will tend to see their earnings naturally revert to the mean. This occurs because when profits are high, new competitors enter the market, old competitors ramp up production and customers seek out substitutes, until profits are driven to normal levels. When profits are low or negative, the weakest competitors are forced to close their doors and no new competitors enter the market, improving conditions for the companies that stick around.

Depending on the industry, this process will vary in the amount of time that passes between peaks (we discussed this process for the oil industry here). But Wall Street's obsession with current earnings (as discussed here by Ben Graham and David Dodd) provides opportunities to value investors when earnings are simply at the lower end of the cycle.

An important caveat is that one must be sure that earnings are low due to a cyclical effect, not a secular effect (the newspaper industry is often cited as an example of an industry in secular decline, thanks to the world wide web and other forms of media). Furthermore, one must only purchase the companies with little to no debt and low cost levels, as these are the companies that will survive the downturn. Adjustments must also be made for companies that have increased their book values substantially (either by retaining earnings, or issuing new shares); the earning power of such companies should be higher than they have been in the past, though this is not always the case.

The bottom line is, average earnings are a much more useful gauge of a company's earnings power than current or oft-cited expected future earnings, which are based on only one period and could be affected by infrequent items or the industry's current position in its business cycle.

Imation

sajid.karsan@barelkarsan.com (Saj Karsan) — Mon, 09 Nov 2009 11:33:00 +0000

Imation (IMN) is a 1996 spin-off of the innovative 3M Company (MMM) that produces storage media from DVDs to backup tapes. It owns the #1 brand/sales position in many of the segments in which it competes. Unfortunately, it doesn't generate returns on equity anywhere near 3M, but on the other hand it doesn't trade at a massive premium to its book value either. Imation has equity of over $900 million but trades for just over $300 million.

With some noted exceptions, companies trading with such low price to book ratios are not likely to be profitable or they wouldn't trade at such low levels. Imation is no anomaly in this regard. Due to various restructuring, pension, asset impairment and litigation charges, along with the current recession, Imation hasn't been profitable for the better part of three years. But last quarter, even including the charges, Imation managed to eek out a small profit, which could suggest they are making progress in aligning costs with revenues.

The company's storage solutions are offered to large customers, many of which are financial institutions. As these companies have been drastically cutting costs, Imation experienced a revenue shock. But as the company eventually aligns its costs with a lower revenue environment, it should be able to generate returns commensurate with its historical average.

And what offers investors protection while this company attempts to return to profitability is the fact that Imation has no debt, and has a cash buffer of $80 million (after subtracting upcoming payments for a recent litigation settlement). Furthermore, its net current asset value (current assets less all liabilities) is $400 million, well over the company's market cap.

Disclosure: Author has a long position in shares of IMN

A Random Walk Down Wall Street: Chapter 1

sajid.karsan@barelkarsan.com (Saj Karsan) — Sun, 08 Nov 2009 11:47:00 +0000

Malkiel starts the book off by arguing that individual investors can indeed outperform the so-called "experts" on Wall Street by following the principles of the book. The term "random walk" in the title refers to the fact that future steps or directions in the stock market cannot be predicted. Malkiel argues that earnings predictions and chart patterns are useless.

One of the largest threats to investor portfolios is inflation, and while it has been tame in recent decades, Malkiel warns that it may not continue to be so. As the economy continues to become more service-based, Malkiel believes that productivity improvements will be harder to come by, which will drive up prices.

In the rest of the chapter, Malkiel describes and discusses the two approaches used on Wall Street to value assets:

1) The Firm Foundation

Each investment has an intrinsic value. When the price of the investment falls below that value, a buying opportunity exist. Malkiel argues that the logic of this theory is respectable, but that in practice it is very difficult to correctly value a security, because the future is so uncertain.

2) The Castle-In-The-Air

With this method, investors attempt to determine which securities will be popular in the future, and thereby buy before the crowd does. Malkiel also calls this the "Greater Fool" theory, since it suggests that it's allright to pay three times what something is worth as long as later on you can find someone else to pay five times what its worth.

The Little Book That Beats The Market: Appendix

sajid.karsan@barelkarsan.com (Saj Karsan) — Sat, 07 Nov 2009 11:34:00 +0000

Joel Greenblatt, the book's author, is a value investor extraordinaire and a professor at Columbia's business school. In the book, Greenblatt discusses and justifies the "Magic Formula", a stock selection method that allows individual investors to beat the market using value investing.

For those convinced that the investment strategy encouraged by the book is a good one to follow, Greenblatt offers step by step instructions at the end of the book.

1) Go to magicformulainvesting.com

2) Follow the instructions for company size

3) Follow the instructions for a list of top-ranked magic formula companies

4) Buy 5-7 companies.

5) Repeat steps 1 to 4 every 2-3 months, which should give you 20-30 stocks for the year.

6) Sell each stock after holding for one year

7) Continue for many years. It's important to stick to the strategy, otherwise you may quit before it gets a chance to work.

Greenblatt ends the appendix with a discussion of the efficient market hypothesis, which suggests that the market is priced efficiently. While many studies have shown that various different strategies can beat the market, they have often suffered criticism for overlooking various aspects, such as increased risk, survivorship or look-ahead bias. Greenblatt asserts that the magic formula does not suffer from any of these biases, and works well for both large and small stocks.

The Inventory ADDvantange

sajid.karsan@barelkarsan.com (Saj Karsan) — Fri, 06 Nov 2009 11:27:00 +0000

A company that makes for a good investment for one value investor does not necessarily make for a good investment for another value investor. How can this be? A company may appear cheap on an earnings or asset basis, but future earnings may not live up to current earnings and assets may be written down. Therefore, only when a company falls within an investor's circle of competence can he ascertain whether a stock is trading at a discount.

Consider ADDvantage Technologies (AEY), a hardware provider for the cable television industry. The company is cheap on many metrics, trading near its net current asset value with a P/B of 0.75 and a P/E of 6. Though sales have fallen dramatically through this downturn, the company has maintained profitability.

Of importance is the company's strategy, however. The company does not manufacture much of the equipment it sells, but is instead a distributor, servicer and value-added reseller to cable companies. One of the major ways in which it adds value for its customers is with its large inventory, allowing for fast delivery of large orders. But the amount of inventory the company carries is far from trivial: it represents 90% of the company's current assets, two-thirds of the company's total assets, and is greater than the company's total equity.

For value investors, the company's strategic decision carry so much inventory has important implications. From one vantage point, the large inventory may represent a margin of safety, as investors are currently afforded the opportunity to purchase this company for less than its inventory. From another point of view, however, the inventory carries a major risk of obsolescence.

Confidence can be placed in the value of inventories of durable goods in slow-changing industries. For example, $30 million worth of screws, nuts and bolts can probably hold their value. But $30 million worth of laptop computers will eventually have to be written down. In which category does the inventory of AEY fall? That depends on the investor's circle of competence.

It is not enough to be able to interpret management's comments on the current value of the company's inventory. Carrying such a large inventory is a major part of the company's strategy going forward, and so cash received from customers will be pumped back into inventory on an ongoing basis. As such, the investor will be constantly subject to the risk of obsolescence. Therefore, only an investor who understands the nature of AEY's products and the speed at which the technology changes can value the company's inventory to some degree of certainty. For everybody else, an investment in this company contains an element of speculation.

Disclosure: None

Buffett vs Value Investing

sajid.karsan@barelkarsan.com (Saj Karsan) — Thu, 05 Nov 2009 11:49:00 +0000

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 this week 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.

Don't Be Fooled By High P/E Values

sajid.karsan@barelkarsan.com (Saj Karsan) — Wed, 04 Nov 2009 11:56:00 +0000

As the market has risen throughout most of this year, many market observers have noted that P/E values are looking rather inflated from a historical standpoint. But of course, earnings are lower than usual this year due to reduced revenue that was caused by financial shocks. So as investors, should we be willing to pay a higher P/E for now, on the assumption that earnings will soon pick up?

When considering the market in the aggregate, this is a very difficult question to answer. Some companies will have cost structures that prove too rigid, and will therefore be unable to adapt to a lower revenue environment. Other companies, on the other hand, will have flexible cost structures or will see revenue continue to grow, despite the downturn. But to determine which of these forces will exert more pull on the market's earnings in the coming quarters is not only extremely difficult, but unnecessary: unless you're trying to value the entire index, you don't have to answer this question for the market in the aggregate. Instead, you can try to answer this question for individual securities, which are much easier to understand.

For example, consider Key Tronic (KTCC), a manufacturer of electronic devices. The company has a P/E of 23, which makes it appear overvalued. But earnings are down because year-over-year quarterly revenue is down 15%. However, the company has little in the way of debt, and has the vast majority of its operating leases coming due in the near-term, giving it further flexibility in reducing its costs. Operating expenses are down 17% this year, and the company sees sales starting to rebound in January of 2010. In fact, based on KTCC's past margins and returns on assets (which it should be able to return to by continuing to cut costs and with a modest recovery in revenues in the years to come), it appears to trade at a normalized P/E much, much lower than the 23 that stock screeners currently display. (KTCC is a stock we've previously discussed here.)

Determining whether the market is over- or under-valued is a difficult exercise indeed. But by focusing only on those companies for which it is easier to compute earnings (circle of competence), and ensuring that companies trade at discounts to those earnings (margin of safety), investors put themselves in positions to profit in the long-term whether the aggregate market offers potential or not.

Disclosure: Author has a long position in shares of KTCC

Increases In Consumer Spending Do Not Make Us Better Off

sajid.karsan@barelkarsan.com (Saj Karsan) — Tue, 03 Nov 2009 11:19:00 +0000

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.)

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:

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, 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.

Earnings Pops

sajid.karsan@barelkarsan.com (Saj Karsan) — Mon, 02 Nov 2009 11:59:00 +0000

For companies with high fixed costs, earnings are particularly sensitive to drops in revenue. As a result, we have seen many such companies show negative earnings over the last few quarters. But while reported revenue figures have continued to decline, some backlog numbers have started to tick up, suggesting that for some, higher revenue is on the way. This higher revenue can translate into much higher earnings for companies with fixed costs. For such companies that currently trade at low earnings multiples, strong price appreciation potential exists.

For example, consider Canam (CAM), a company that specializes in designing and building heavy-construction components. Year-over-year quarterly revenue is down over 30%, resulting in a reduction to operating income of over 60%. Despite the revenue shocks, the company has managed to eek out small profits every quarter, and now trades at a P/E multiple under 10 using earnings over the last four quarters.

But these are trough earnings for a company with high fixed costs. Consider the company's backlog over the last several quarters, shown below:

It would appear that revenues will soon be on the mend. Furthermore, subsequent to the end of the Q3 2009 quarter, the company was awarded a $100+ million contract to help build the new roof for BC Place Stadium in Vancouver, which is not included in the above chart.

In addition to the fact that Canam trades at a cheap multiple to trough earnings, Canam has no net debt, and management has recently signaled that it will be buying back and canceling shares. For value investors looking to buy good businesses at attractive prices, Canam may offer such an opportunity.

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Disclosure: Author has a long position in shares of CAM

The Little Book That Beats The Market: Chapter 13

sajid.karsan@barelkarsan.com (Saj Karsan) — Sun, 01 Nov 2009 11:34:00 +0000

While he cannot guarantee the results of the magic formula going forward, Greenblatt does believe that using it over the long-term will provide investors with excellent returns. But despite the money that can be accrued following this technique, Greenblatt doesn't believe this type of investing adds any value to society.

While the stock market does provide a valuable service, creating a secondary market that allows the primary market to raise capital for companies that need it to grow, Greenblatt believes that 95% of the trades out there are completely unnecessary to serve this purpose. For this reason, Greenblatt makes the case that investors who profit from this formula should use some of those profits for purposes that do benefit society.

In particular, Greenblatt argues that the education system needs help. Education is the foundation for the high-level work force that helps the economy thrive. But much potential is wasted. In every major US city, only half of public school ninth graders end up graduating from high school.

In a capitalist system, capital moves from poor businesses to productive businesses, and that's what helps the economy thrive. In the school system, however, it is very difficult to close poorly performing schools and stop paying teachers that can't get the job done, in order to divert capital to better performing schools/teachers. Greenblatt argues that this issue needs to be addressed, and provides the reader with some means to do so.

The Little Book That Beats The Market: Chapter 12

sajid.karsan@barelkarsan.com (Saj Karsan) — Sat, 31 Oct 2009 10:05:00 +0000

In this chapter, Greenblatt warns about the pitfalls of following some of the other investment options that are available to individual investors.

First off, individuals may get direct stock advice from stockbrokers. While stockbrokers can help explain some elements of investing and probably do want you to succeed in the long term, investors must keep in mind that brokers make their money by selling something to the investor, not by the long term success of the investor.

Rather than relying on a broker, mutual funds or hedge funds offer a better alternative, because they are motivated by track record to a larger extent. Nevertheless, these funds make more money by becoming larger and larger (so they can charge fees for the size of the assets under management), which makes it more and more difficult to maintain strong levels of performance. Furthermore, after fees, most of these funds are bested by the market.

While there are good managers out there that can beat the market, there are many more who will not. Just as the magic formula can lose to the market in three-year periods, so too can good money managers. In the same way, poor managers can beat the markets over periods of such length. As such, it very difficult to identify a fund manager with whom one should invest.

Investing in index funds is therefore an option which allows investors to closely match the market's return. But that's all the investor can do with such funds: match the market. To beat the market, investor's should use the magic formula.

How Efficient Is Management?

sajid.karsan@barelkarsan.com (Saj Karsan) — Fri, 30 Oct 2009 10:45:00 +0000

One of the most important factors in determining whether a company is worth an investment is the quality of its management. Unfortunately, this assessment can at times be highly subjective. Reading interviews or comments from management can often be of little value. After all, management may have great communication or oratory skills, but that doesn't necessarily translate into good business execution. In fact, many value investors even prefer not to meet managements to avoid being influenced by factors unrelated to execution.

So how then to evaluate management? One way is to simply evaluate the financial results of their companies. Unfortunately, certain factors which manifest themselves in the financials may be out of management control. For example, competition in an industry and/or time period might be fierce, or a company may be at a brand disadvantage - not necessarily the fault of current management, so how do we differentiate across managements?

One method analysts like to use is to evaluate the number of days inventory a company has on hand. The lower the number, the more efficient management is (as cash is freed for other purposes, like paying shareholders)...as long as there are no stock-outs hurting revenues! The number of days of inventory a company has on hand can be estimated with the following formula:

inventory * 365 / COGS = days of inventory on hand

This number can be compared to that of competitors or the industry, with the caveat that differences in product mix must be taken into account. Below are average days of inventory for several industries as per the IRS:

A high days inventory doesn't necessarily mean bad management, however. But this concept can be extended to a company's days receivable and days payable. This can offer a clue as to how effective management is at running an efficient operation, which can translate into other facets of the business.

Conn's Inc.

sajid.karsan@barelkarsan.com (Saj Karsan) — Thu, 29 Oct 2009 10:13:00 +0000

When Circuit City declared bankruptcy near the beginning of the recession, opportunities were created for other electronics retailers. One company that aggressively stepped forward to fill the void is Conn's Inc. (CONN), a home appliance and electronics retailer. Conn's even took over some of Circuit City's previous locations on its quest of aggressively growing its market share.

A quick look at the financial statements shows that Conn's has indeed been successful at grabbing consumers, with flat year-over-year sales (in an otherwise negative environment for consumer electronics) and decent profitability. In the last four quarters, Conn's has earned operating income of almost $40 million while the company trades for just $150 million on the market. The numbers are enticing until you consider how the company is making its sales: on credit.

Indeed, the company's "receivables" balance has increased from $30 million to $140 million in the last year, as the company counts the increase as sales and then subsequently counts on consumers to pay that money back (using repossession as an incentive). In the past, the company has sold these receivables to an off-balance sheet qualifying special purpose entity (QSPE) to fund these consumer financings, but the QSPE's funding is currently near its limit, requiring the company to show the difference on its balance sheet.

In principle, there is nothing wrong with a business that lends money to consumers to finance purchases. But investors must recognize that this is not a simple business: this is partly a retailer, and partly a bank, and therefore contains risks inherent to both industries. From a bank-type risk point of view, the company has had to take on $130 million in debt to fund these receivables; if consumers have trouble paying their bills, this spells trouble. From a retail-type risk point of view, the company has over $150 million in operating lease commitments; if the company can't find enough consumers that pay cash or that have good credit, this also spells trouble.

Reported sales numbers don't always tell the story. In this case, past sales numbers, however accurate they may have been at the time, may be covering for the fact buyers can't actually afford items they purchased on credit. On the other hand, it's entirely possible that the company is extremely accurate with its credit scoring system and its strategy will pay off in the long run. Either way, to avoid being surprised by the downside risk, investors must be aware that they cannot simply evaluate this company as a retailer alone, but must take into account the risks that are inherent in investing in banks as well.

Disclosure: None

What Does The Index Really Tell You?

sajid.karsan@barelkarsan.com (Saj Karsan) — Wed, 28 Oct 2009 10:50:00 +0000

We looked here at the Dow Jones Industrial Average, and saw why it's not a great measure of US stock performance, despite being a favourite index when it comes to media coverage. The S&P 500 is a much better barometer for the health of US stocks, though an understanding of its calculation methodology is important in order to understand the limits to its usefulness.

The S&P 500 is essentially a market-value weighted index*, meaning a company's influence on the index is proportional to its size. This much different than how the Dow Jones Industrial Average is calculated. Also unlike the Dow, the 500 stocks that comprise the index are chosen such that the index proportionally represents the economy's various industries. As such, the S&P 500 is not just the 500 largest companies. One interesting note is that despite being larger than almost every company in the index, Berkshire Hathaway is not a component of the S&P 500.

What does this mean for you? Basically if you invest in an index fund that mimics the S&P 500, most of your money is invested in the largest companies, thanks to the index's market-value weighting*. For example, the top 10 companies of the S&P 500 make up 20% of its value!

If you're a value investor like we are, and find more value in small companies than in large (for reasons discussed here), the S&P 500 neither looks like a good place to invest, nor does it provide a decent basis against which to compare one's returns, as it rises and falls with the largest companies.

While the S&P 500 is a useful indicator of the perceived health of the US economy, its usefulness as an investing and comparison tool is limited.

(*)Since 2005, this statement is only approximately true; Standard and Poors switched to only counting shares in its index that are available for public trading (as opposed to all outstanding shares).