Barel Karsan

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.

Interested in an alternative perspective on Canam, or another stock of your choosing? One of our sponsors, INO.com, is offering our readers a free analysis of a stock of their choosing here.

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).

Short-Term Value Investing?

sajid.karsan@barelkarsan.com (Saj Karsan) — Tue, 27 Oct 2009 10:21:00 +0000

At times, value investing can feel like trading. While value investors should always purchase with the expectation that a stock will be a long-term holding, some stocks can be so volatile that they go from offering a margin of safety to offering a reasonable price and back again within the span of a few weeks! And as Warren Buffett told us when we met with him last year, volatility (shunned as an undesired property by the mainstream finance industry) is the friend of the value investor.

For example, earlier this month we discussed how LCAV may have appreciated to a conservative estimate of its intrinsic value. But just three weeks following that article, its price had fallen by 40%, offering investors the opportunity to buy back in at depressed values!

There is no question that the near-term outlook for this company is poor: this is not a great time to be selling expensive, elective services to battered consumers, who are focused on paying down debt, saving money, and securing jobs. But this company has the ability to survive, with a strong net cash position and positive cash flow from operations through the first two quarters of this year.

But from a long-term business perspective, we have a company selling for $80 million that earned a combined operating income of $120 million in the three years that preceded this recession. While economic conditions are not likely to allow a return to those profit levels any time soon, the bleak near-term outlook is just the sort of stuff value investments are made from.

In a so-called "efficient market", it's hard to believe that stock prices can fluctuate so wildly. But as Joel Greenblatt notes in his book, stock prices do fluctuate enormously even within the same year. If investors can accurately determine that a company is trading for a discount to its intrinsic value, this volatility offers opportunities for excellent returns, sometimes within short periods of time.

Disclosure: Author has a long position in shares of LCAV

Ridley Inc.

sajid.karsan@barelkarsan.com (Saj Karsan) — Mon, 26 Oct 2009 10:24:00 +0000

Ridley Inc. (RCL) manufactures and sells animal nutrition products to North American meat, milk and egg producers. As such, it operates in a fairly stable industry, as demand for many feed products tends to hold steady through recessions.

Despite the stability of this industry, and Ridley's role as one of the larger players with $600 million of annual sales, the company is conservatively capitalized with only $13 million of debt compared to equity of $150 million. Meanwhile, the company trades for just $100 million, while it has brought in combined operating cash flow of over $60 million over the last four years.

While the company may seem attractive at these levels, the stock is rather illiquid, meaning institutional investors cannot realistically participate in this opportunity. The company is not that small compared to some of the other stocks we've discussed on this site, but what keeps the stock volume low is the fact that more than 9 million of the company's 14 million shares outstanding are held by Fairfax Financial (FFH), one of the best value-oriented firms out there, as we've previously discussed.

Like Dorel, RCL appears to be utilizing the recession to make acquisitions. The acquisitions should add value for shareholders, considering the fact that a value firm like Fairfax is a majority owner. For example, RCL's latest acquisition should allow it to sell its existing products to new customers as well as sell the target's products to RCL's existing customers.

So while most investors apply valuation discounts for both 1) stock liquidity and 2) controlling shareholders, for value investors with long term outlooks this stock could represent ownership in a business at an attractive price where the principal shareholder's views on stock ownership are aligned with those of the individual investor.

Disclosure: Author has a long position in shares of RCL

The Little Book That Beats The Market: Chapter 11

sajid.karsan@barelkarsan.com (Saj Karsan) — Sun, 25 Oct 2009 10:43:00 +0000

Despite the fact that the magic formula beats the market handily, Greenblatt recognizes that there are those who will not be satisfied with simply buying the basket of 20-30 stocks the formula spits out. This chapter offers advice to those individual investors who can't help but to pick stocks on their own.

Greenblatt starts with a warning:

"Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot."

After the warning, Greenblatt goes on to discuss some of the weaknesses of the formula, and how investors who do know what they're doing can improve their results.

For one thing, the formula considers last year's earnings when computing both the earnings yield and the return on capital. But last year may not be indicative of the company's earnings power, due to unusual occurrences. Therefore, Greenblatt suggests that people who know what they are doing can calculate 'normal' earnings for a company, and use that as a basis for earnings yield and return on capital, rather than simply using last year's earnings.

Even though the concept is simple enough, Greenblatt argues that predicting normal earnings is very difficult, and only those who know what they are doing should try it. As it stands, the magic formula works just fine even though it uses last year's earnings. This suggests that last year's earnings are reasonably indicative of earnings when a large enough basket of stocks is employed.

But for those who are capable of understanding the businesses they research and determining normal earnings, Greenblatt recommends a much smaller basket of companies. In fact, Greenblatt advises a basket of just 5 to 8 companies (as opposed to the 20-30 recommended for those using the magic formula) for those who know what they are doing.

So far, that covers those who know what they are doing and those who do not. But Greenblatt also has advice for those who don't know if they know what they are doing, but still want to choose individual stocks! For this group, Greenblatt suggests choosing between 10 to 30 stocks from the top 100 companies produced by the magic formula (as opposed to just choosing the top 30 stocks).

The Little Book That Beats The Market: Chapter 10

sajid.karsan@barelkarsan.com (Saj Karsan) — Sat, 24 Oct 2009 10:40:00 +0000

Greenblatt discusses the risk and return of the magic portfolio over the 17 years of historical data that he looked at. In some years (about 1 out of every 4), the magic formula underperformed the market. Over two-year periods, however, the magic formula improved its odds for beating the market, as it only failed to do so about 1 in 6 times. Over three-year periods, the magic formula never lost money and outperformed the market 95% of the time.

For this reason, Greenblatt argues that the magic formula operates with a low level of risk from the perspective of long-term investors. He rejects other measures of risk commonly used in the finance industry (e.g. standard deviation of returns), and instead chooses to measure risk by answering the following two questions:

1) What is the risk of losing money in the long-term, following the strategy?

2) What is the risk that this strategy will perform worse than the alternative strategies?

While the logic of the magic formula has been discussed in previous chapters, Greenblatt feels it necessary to assure the reader that stock prices do converge to the values of the underlying businesses in the long-term. Most of the time, this convergence takes place within 2 or 3 years. Sometimes, it can take weeks or months, while other times it can take years.

Some of the reasons prices will eventually converge to their values are: firm buyouts, other investors who see value, share buybacks etc. Greenblatt argues that in the short-term, Mr. Market can be quite emotional and offer crazy prices, but in the long-term he is mostly right.

Understand These Biases

sajid.karsan@barelkarsan.com (Saj Karsan) — Fri, 23 Oct 2009 10:18:00 +0000

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:

Overconfidence

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

Hindsight

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

Overreaction

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.

Approaching Book Value

sajid.karsan@barelkarsan.com (Saj Karsan) — Thu, 22 Oct 2009 10:28:00 +0000

Over the last year, we have discussed many stocks that have appeared to trade at significant discounts to their intrinsic values. But lately, undoubtedly due in part to the market's rally, we find ourselves discussing previously downtrodden stocks that are actually approaching their intrinsic values. The latest example of this is Melcor (MRD), a property developer and property manager in the western part of North America.

This company operates primarily in Alberta, a province rich in oil. When oil prices are high (low), Alberta's economy is strong (weak). While energy prices are volatile, the market's (over)reaction to energy prices appears to be even more volatile, as we saw when we looked at Melcor's price to book over the last several years. At that time, Melcor traded at a 40% discount to its book value. While it's book value hasn't changed, the market value of the stock has almost doubled, bringing it to a level near its book value!

One wouldn't value Microsoft or Intel based on its book value, so why place so much emphasis on book value when it comes to Melcor? While land and property prices do fluctuate to some extent, their book values act as a reasonable proxy to market value, particularly if the land was purchased recently. This valuation metric can be used effectively to value homebuilders, for example.

For Melcor, the value of its assets is probably higher than its stated book value. This is due to the fact that some of Melcor's properties were purchased long ago and their prices have therefore appreciated. This makes it all the more surprising that this company can trade at such a large discount to its book value. Even if property prices in some of its areas were to drop by 20% or more, there is no reason why Melcor should trade at just half of its book value! Yet the market provided such an opportunity just a few months ago, and will likely do so again in the future.

But for now, since Melcor has risen to a level commensurate with its book value, much of the upside potential in the stock is now gone. As such, some investors may choose to sell and deploy the capital to situations where great upside potential still exists.

Disclosure: None

Trusting Analysts

sajid.karsan@barelkarsan.com (Saj Karsan) — Wed, 21 Oct 2009 10:30:00 +0000

The herd mentality is well-documented outside the investment world. While it is not given much thought within the investment world (exceptions include discussions on the topic from both Ben Graham and Stephen Jarislowsky), it plays a large role in the investment decision-making process: investors feel much more comfortable buying stocks when they believe that others are also piling in. To that end, investors often rely on analysts, who are expected to be "experts" in guiding investors on stock selection.

But just how good are analysts at predicting the directions of stocks? A decent paper (though dated) is available here which discusses the difficulties in truly evaluating analysts. However, at the very least, if analysts were at all useful, they should be able to tell the difference between a company that has value and one that is about to go bankrupt. Yet these two very different realities in a company's status continue to baffle these "experts".

Consider how wrong analysts have been with respect to the future of certain companies just days before they have gone bankrupt. As a famous example, consider the case of Lehman Brothers. Just before it went bankrupt, there was not a single "sell" rating from any of the 19 analysts covering the company, as discussed here.

In fairness to analysts (and conversely in unfairness to investors), analysts are often confronted with conflicts of interest that may be preventing them from extolling their true opinions of a stock. So analysts might actually be better at stock prediction than we think. However, this makes them no more useful for investors, who should put little stock in what analysts say, and should instead do their own homework, in the same way as they would for any investment outside of the stock market!

When investors buy property as an investment, they consider items like the property's ability to earn rent, and the risk factors with respect to that rent. Investors don't just heed the advice of 3rd party brokers and agents. The investor mindset with respect to stocks should be no different.

While most of the information we hear about particular stocks does come from analysts, there are other avenues investors can utilize. For example, Jonathan Goldberg's site now includes a forum where like-minded value investors can discuss various topics, including stocks. By discussing the aspects of companies which value investors find relevant (balance sheet strength, margins of safety, long-term earnings etc.), investors can avoid following the mainstream herd.

Apple's Soar Means Future Sores

sajid.karsan@barelkarsan.com (Saj Karsan) — Tue, 20 Oct 2009 10:47:00 +0000

Once again, Apple (AAPL) impressed investors with results that handily beat analyst expectations. The company continued to move iPods en masse, and sold a record number of Mac computers and iPhones, staunchly defying the drag on consumer spending that has been the bane of this economy.

There can be little doubt that Apple is a well-run, exceedingly competent company. That much can be determined with a quick look at the company's financial statements, where equity returns of around 25% are commonplace. What makes those returns even more impressive is the fact that no leverage is employed in garnering these exceptional returns: Apple has no debt!

While this means the company itself operates with very little risk, that does not automatically translate into a low risk investment. That's because it's important for investors to be able to separate a great company (which Apple clearly is) from a great stock. What makes a stock great is a price that allows investors to buy the business at a significant discount to its intrinsic value.

Is Apple a great stock? That will depend on the value of its business. For a company that grows sales and profits as quickly as Apple does, the value of its business is very difficult to determine with any degree of precision. There will be wide-ranging opinions on what earnings will be next quarter, let alone next year or the year after, making predictions of Apple's business value a difficult venture to say the least.

But what is clear is that as the stock price soars in reaction to near-term profit expectations (e.g. upcoming product launches, or increased distribution of existing products) or the expectation that near-term upward price momentum will continue, downside risks for the investor increase. Twice in 2008 (once in January, and once in the fall), Apple's stock fell by 40%. This was not an indictment of the company, but rather it highlights the risks of owning a company (no matter how great it is) at a price that makes it difficult to determine whether it is indeed under- or overvalued.

Large, institutional investment firms often have no choice: there are a limited number of large companies from which to choose, and often investments are made when it is far from certain that there is value to be had. For individual investors, however, there are far better investments available (from a value point of view), where downside risk is minimal and upside potential is strong.

There are many smaller companies out there that trade at discounts to their inventories, discounts to their receivables, or discounts to their land holdings. There are even more companies out there that trade at discounts to their earnings despite the fact that they are market leaders in their categories.

Apple's stock holds a special place in the heart of many individual investor accounts, not only due to the well-loved consumer products the company produces, but also due to the fact that it is a superior company that continues to defy expectations. But investors must keep in mind the fact that price and value are two different things: just because Apple's business value is high, does not mean one should be willing to pay anything for the stock. Investors are encouraged to put a business value on Apple, and if they cannot assert that they are buying the stock at a discount to that value, they should avoid the downside risk that may be present in the stock price by considering companies that appear to trade at discounts to their intrinsic values.

What Do They Actually Earn?

sajid.karsan@barelkarsan.com (Saj Karsan) — Mon, 19 Oct 2009 10:05:00 +0000

Companies are required to release their financial results according to GAAP. Often, however, companies will also release what they call "Pro Forma" statements, where certain "one-time" costs are often removed. These statements, managements say, better reflect the earnings power of the company. However, investors are urged not to take managements word, but rather to consider the "one-time" costs to make their own determinations as to whether these apply in the future.

For example, managements have often excluded early plant retirement costs or losses on the sales of equipment from pro forma statements. While these items may not occur annually, the investor must apply business sense to determine if these are likely to re-occur.

For example, does the company compete in an industry rife with technological change? If so, early plant retirements may be part of the cost of doing business. Does the company often have to sell equipment below book value? Management may be using a depreciation schedule that makes earnings look higher than they should be.

The best way to include non-recurring yet real business costs is to average out several years worth of earnings, as discussed in Chapter 37 of Security Analysis by Ben Graham and David Dodd.

As an aside, many companies have also used pro forma statements to exclude the expensing of stock options, which is now required by GAAP. As we discussed here, options have real value, and to avoid expensing them misleads investors about the true costs of operating the business.

The term "one-time costs" suggests investors need not concern themselves as these are unlikely to re-occur. Unfortunately, in many industries and companies, "one-time" costs are the norm rather than the exception. As such, investors need to strongly consider and account for the items that managements suggest should be ignored.

The Little Book That Beats The Market: Chapters 8 and 9

sajid.karsan@barelkarsan.com (Saj Karsan) — Sun, 18 Oct 2009 10:23:00 +0000

While the Magic Formula appears to work over the long-term, Greenblatt discusses reasons why it is not used by everybody. He considers it good news that the formula doesn't work in many periods, as this prevents people from exploiting it and thus reducing its returns.

For example, the formula is outperformed by the market in 5 months out of every 12 (for the 17 year period Greenblatt tested). It can even underperform for years in a row, as at one point in the simulation it underperformed for three years in a row. This makes it very difficult for fund managers to employ it consistently. Greenblatt cites examples of various value fund managers he knows who lost large chunks of clients or who even closed down shop after underperforming for years, only to eventually emerge with far superior returns in the long run. The pressure on fund managers not to underperform their peers forces them to make decisions that are not in the best interests of their funds in the long term.

But to be able to stick to the formula, Greenblatt argues that investors must understand why it works. The bottom line is that by employing the formula, investors are buying stocks with the best combination of returns on capital and earnings yield. High returns on capital suggest a business has an advantage or position which allows it to make abnormally high profits, and a high earnings yield means investors are paying relatively less to buy each dollar of earnings. This combination is logical, and so it makes sense that the formula would work in the long-term.

The Little Book That Beats The Market: Chapter 7

sajid.karsan@barelkarsan.com (Saj Karsan) — Sat, 17 Oct 2009 10:53:00 +0000

In this chapter, Greenblatt speaks to the skeptic who doesn't believe the formula described in the last chapter. To that end, Greenblatt identifies possible pitfalls of using the formula, and attempts to disprove them.

First, he uses the past data to ascertain whether these results could indeed have been realized. For example, if the formula only showed great results because the simulation model used prices of small, illiquid stocks, then it may not be very useful. But Greenblatt ran the formula against markets of all sizes, and found that it beats the markets handily even among large caps.

Second, Greenblatt discusses whether the formula could have been lucky. After all, one could use historical data to come up with several winning strategies, but that doesn't mean they will work going forward, as they could be the result of coincidence. Considering the size of the sample Greenblatt employed (number of stocks over number of years), he does not believe the formula to work as a result of luck.

Finally, another possibility is that the market could wise up going forward, and no longer offer the top 30 stocks (as ranked by the formula) at such a large discount. If those 30 are no longer available, is the formula useless? To counter this theory, Greenblatt divided the stock universe (in his study) into deciles. He found that the deciles outperformed each other exactly as expected. In other words, the 4th ranked decile outperformed the 5th ranked decile, the 5th ranked decile outperformed the 6th ranked decile etc. This suggests the formula works on the general market, and does not require a special group of 30 mispriced securities (which is considered the 1st decile).

Comebacks

sajid.karsan@barelkarsan.com (Saj Karsan) — Fri, 16 Oct 2009 10:49:00 +0000

In a previous post, we discussed how as a result of circumstance, companies can go through tough times and good times that don't correspond with the economic cycle. Companies that had difficulties turning a profit in the strong economic period that preceded this downturn could go in one of two directions:

1) they could become companies mired in secular decline, unable to adapt to the current business environment, or

2) they could find a way to adapt and emerge as stronger companies.

As an example of the latter, consider Audiovox (VOXX), which sells consumer electronics and accessories. Prior to the recession, Audiovox had some trouble turning a profit. This served as an early wake-up call, forcing the company to focus on cutting costs and exiting lower margin products. While this had the effect of reducing revenue, the intention was to become a healthier, more sustainable business.

When the recession hit, Audiovox was already in the process of cutting its fat, whereas other companies were only just beginning. As a result, while many of its competitors are currently still losing money, Audiovox has now turned a profit for two quarters in a row.

Amazingly, while the stock has almost quadrupled since its March lows, it still trades at a discount to its net current assets. By finance industry standards, the company is "risky" due its high beta above 2. But from a value investor's perspective, the company's business risks do not appear onerous. The company offers a diverse range of products, and sells these products to a relatively diverse group of customers.

In addition to the discount to net current assets at which the company trades, the investor is offered the company's equity investments, investment securities, land, and intangible assets for free! But don't take my word for it; interested in another perspective on VOXX, or another stock you have your eye on? One of our sponsors, INO.com, offers our readers a free analysis of a stock of their choosing here.

Disclosure: Author has a long position in shares of VOXX

S&P Price To Book

sajid.karsan@barelkarsan.com (Saj Karsan) — Thu, 15 Oct 2009 10:59:00 +0000

Investors will often look at the P/E ratio of the S&P 500 in order to gauge how expensive stocks are. Earnings, the denominator of that equation, are quite volatile, however. In a year like this one, where massive write-downs plague income statements, it is difficult to determine the market's true earning power.

Another method to gauge investor sentiment, though not nearly as popular, is the market's price to book ratio. Unlike earnings, book values are not nearly as volatile (unless of course, you are an over-leveraged bank), and therefore they can give us a decent indicator of how the market is valuing company assets. Courtesy of Comstock Partners, here is the price to book value of the S&P 500 over the last 30 years (original version here):

There are a couple of interesting observations to note in the above chart. First, on a price to book basis, during this recession the market did not fall to the depressed levels seen in the late 1970s. Second, the market's price to book value currently appears to be fairly close to its 30-year average (denoted by the horizontal blue line), despite the fact that the outlook for economic growth appears tepid.

Of course, there are a number of factors that make historical comparisons of price to book values difficult. Accounting methods of how book value is calculated have changed over the years, with an increasing trend towards making book value better reflect market value. Furthermore, there has been a shift when it comes to industries in the S&P 500, with manufacturing companies playing a decreasing role while knowledge-based companies (e.g. software, consulting, other services etc.), where hard-assets are not a determining factor, comprise a larger portion of the index.

For the above reasons, long-term comparisons of historical price to book ratios can be problematic. Nevertheless, investors can look at the price to book ratio over recent periods as a decent gauge of investor sentiment. Clearly, price to book ratios fell dramatically from their 2008 highs, but a large rally has resulted in a recovery of a significant portion of those losses. The above chart won't tell you where the price to book ratio will go, but it will tell you that investor sentiment has recovered to a large extent and that downside risks have increased as a result.

Borrowing To Buy Stocks

sajid.karsan@barelkarsan.com (Saj Karsan) — Wed, 14 Oct 2009 10:11:00 +0000

Margin debt on the NYSE can be a useful indicator of how Mr. Market is feeling. If optimism is high, people tend to borrow more to buy stocks. Previously, we've seen how margin debt through the last recession fell mightily and did not return to its previous highs for several years. Through last year and the first part of this year, it looked like margin debt would follow a similar path.

In the last six months, however, investor appetite for risk appears to have returned, with margin debt making a small comeback. Here is a look at the use of margin debt on the NYSE through August of 2009:

While margin debt is still well below its 2007 high, it has surprisingly not fallen to the lows seen in 2002. Indeed, margin debt levels are now at 2005 levels and appear poised to continue their ascent: these numbers are through August; as the market rose through September, it is likely that margin debt continued to increase further.

If we look at the ratio of margin debt to the index level of the S&P 500, we see that debt as a percentage of the market remains historically high, at least compared to what it was in the last recession:

The proliferation of hedge funds over the last decade is likely at least partially responsible for this increased willingness to purchase stocks with debt. Nevertheless, investors should take note that a relatively high proportion of the market's capitalization is currently financed by debt, suggesting that there is a significant amount of downside risk to the market if these debt positions are forced into liquidation.