Value Idea: Japanese Net-Nets

Japan seems awfully cheap these days:

A study made under the authors’ direction (covering some 3,700 stocks traded on the Japanese exchanges), found 512 stocks selling for less than net current asset value (includes long-term investments) and 212 selling below ⅔ of net current asset value (Graham’s famous “66% net-net” threshold). Equally interesting, 763 of the businesses were selling for less than cash plus short and long term marketable securities. Suffice it to say, there are large parts of the Japanese market selling for extremely cheap.

Based on the studies previously referenced, we would anticipate this basket of cheap Japanese stocks to similarly outperform the market indices. If the 30 businesses were afforded a modest multiple (8-times earnings before interest and taxes) + net cash, similar to what businesses typically sell for in private-party transactions, the average valuation for the 30 businesses would be $191 million vs. a market-cap-inferred-price of $86 million. You’re theoretically getting $191 million worth of private-party businesses for the public market price of $86 million. This represents a tremendous upside potential when the market’s sentiments toward Japan become normal again– offering a handsome potential reward for those brave enough to test their resolve in the face of threatening headlines.

Individual securities can be attained through most brokerage houses without too much fuss. Although the trading costs can be steep (we’ve paid $100 per trade through one of the bigger name houses), we feel the potential upside justifies the transaction costs, depending on the size of your portfolio. For smaller amounts of money and certainly increased liquidity, WisdomTree’s Japan SmallCap Div Fd ETF (NYSE:DFJ) may be a good way to participate in Mr. Market’s mispricing of Japan. Although the DFJ is not as cheap as a readily-attainable basket of individual stocks (Price-to-Book of ~.77 vs. much less), the liquidity and diversification is quite attractive.

I like the idea of investing in Japan. It’s strongly within the econo-legal orbit of Western countries and Western attitudes toward law and commerce. There is definitely fraud and corruption, as there is anywhere in the world, but it’s probably less worrisome in Japan than it is in a place like neighboring China.

The challenges to investing in Japan are:

  1. Cost of trading
  2. Language barriers in studying company publications
  3. Convenient access to reliable market data

I am not sure how affected Japan will be by a China slowdown. I am not sure how much a person should worry about the fact that many of these Net-Nets appear to be in the engineering and construction consultancy business– this was an area that was a focus of corruption and overspending during the boom years in Japan and it’s questionable how many of these businesses are kept alive now or in the future by political connections.

Finally, at some point Japan is going to have a day of reckoning related to their massive government debts. For the average Japanese business with earning power and some growth prospects the implied inflationary solution to that problem seems like a tailwind. But for a Net-Net with no real exciting business prospects and a lot of cash on the balance sheet, that seems like it could destroy a lot of value, if anything.

Austrian economist Gary North insists that won’t happen, but I’m not sure what will take place instead.

The best strategy, were someone to attempt to take advantage of this scenario and these low prices relative to net current assets, would probably be to build some kind of a basket of the best of the best, as the author suggests.

I read a good article by Geoff Gannon on How to Pick Net-Nets, and he argues the main idea is to protect yourself from the downside, not to worry about the upside, when it comes to Net-Nets. He says the main risks to look out for are:

  1. Fraud
  2. Solvency
  3. Ownership dilution

I’m going to keep my eye on the Japanese NCAV situation, but for now it might be cheapest and easiest for me to find a few issues in the US, first. Meanwhile, I wonder what’s going on in Europe as far as Net-Nets go?

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Exercises In Imagination

A friend sends along the following video: http://www.youtube.com/watch?v=XKfuS6gfxPY

Ignoring the pitch for Ron Paul’s political campaign at the end of it, that’s about as good as a libertarian video comes. The key is the identification of one moral standard for all people. It is hypocritical to expect any other person or persons to appreciate a “foreign policy” that you yourself would not appreciate if applied to you.

Here’s another good video about libertarian philosophy from Stefan Molyneux: http://www.youtube.com/watch?v=Cd-SLRyuRq0&w=560&h=315

The reality of government financing is exploitation of its citizens. The people are not fully and fairly compensated for their labor as the exchange being made (via taxation) is not voluntary and deemed to be mutually beneficial.

I’d like to help produce more videos like these. I think YouTube is a powerful medium for spreading the message of individual liberty through the use of economies of scale.

Want To Lose Money In An Uninspired Way? Become A GM Investor

The UAW, which represents tens of thousands of GM hourly workers, has negotiated a base pay increase as well as an increased profit-sharing bonus, with the help of executive management (Bloomberg):

“When GM was struggling, our members shared in the sacrifice,” UAW Vice President Joe Ashton, who directs the union’s General Motors Department, said in a statement released last night. “Now that the company is posting profits again, our members want to share in the success.”

One Berkley “labor professor” (what the hell is that?) compared the compensation negotiations to economic stimulus:

“It’s an impressive agreement in a very tough economy,” said Shaiken, the Berkeley professor. “This agreement amounts to a stimulus package because it generates jobs and puts purchasing power into the economy.”

Question: why would anyone in their right mind want to be a GM shareholder?

Management has conspired with Marxist labor unions to increase hourly wages during a time period of general economic weakness, great challenges for the auto industry in particular and a near-death environment for GM specifically. Additionally, unionized factory employees are now being treated like they have capital-at-risk, when they do not. Factory employees don’t own or control GM capital and have nothing to do with intelligently or otherwise allocating that capital– it makes absolutely no sense that any entrepreneurial gains from the successful allocation of that capital should accrue to factory workers as some bargaining chip for securing their employment, especially when there are tens of millions of unemployed people looking for work in this country.

This is an odd inversion of the socialist principle of a divorce between costs and benefits.

To add insult to injury, the company has evidently become an auxiliary extension of the US government and its stimulus policy.

GM shareholders aren’t playing with fire, they’re standing outside the charred remains of a multistory apartment structure expecting to enjoy a high standard of living by moving in.

Abodeely: Discounting The Value Of Experience

JJ Abodeely, author of the Value Restoration Project blog, writes about a theme that deserves more attention– that experience isn’t always an advantage and may even be a disadvantage, particularly at times like today where there appears to be a paradigm shift underway:

Consider how many firms espouse the experience of their managers as a key selling trait. The idea that experience might actually be detrimental to returns is not one that the investment management industry is willing to promote. However, an intellectually honest assessment of the role of experience in driving investment decision-making and results is in the best interest of advisors, managers and clients alike.

Perhaps even more importantly, relying on experience often means relying on a cloudy, biased recollection where our “memory is not as much a factual recording of events as it is a perception of the physical and emotional experience,” as behavioral finance professor John Nofsinger teaches us. Focusing on exposure, on the other hand, frees us to think beyond what our experience allows for. Perhaps ironically, forsaking experience for exposure may allow for a greater respect for the rhythm of history with a more objective and long-term analysis.

In practical terms, most investors today are impaired by their experiences in the 1980s and 1990s. They lack a historical understanding of secular market cycles and valuation, the closest thing we have to a law of gravity in finance. Similarly, most economists, with their data-heavy analysis, lean almost exclusively on the post-war period when modeling how the economy should behave. Most economists, strategists, analysts and investors have not experienced debt-induced financial crises, de-leveraging global economies or the demographic headwinds we face today. Nor does anybody’s experience include the ways in which today’s world is unique from any other point in history and the ways in which tomorrow’s history is completely unwritten.

More Thoughts On Lone Ranger Investing, Informational Asymmetries And “Going Private”

A few days ago I linked to a post from Hedge Fund News in which the author expressed some deep skepticism and reservations about common stock investments in the present era. The primary concerns were that the market is “rigged” to a large extent via Fed front-running and black-box trading algorithms. Stock market investing is largely about an informational edge. Without friends in high places, an army of analysts and a mainframe computer, how is the little guy supposed to have an edge anymore?

First, a contrarian take on the contrarian take.

Front-running the Fed works, until it doesn’t. Many try to front-run the Fed without any real, personal insight into what’s going on there (aka, having a whisper network that’s tapped in to the Fed) and those people get steamrolled in periods like the one we just witnessed in August 2011, when many market participants hit the “Eject” button all at once and the Fed isn’t there with a trampoline to catch everyone. Some do have those networks and their front-running is largely successful (though you have to wonder what the hell happened at PIMCO over the last two months with Alan Greenspan on retainer) and to that I have no response besides to observe that “Life isn’t fair, deal with it.” Some people are born with a Golden FRN lodged between their butt cheeks and some aren’t. It’s obviously not the majority of the market because if it were that’d defeat the whole purpose of having that kind of informational advantage.

For the average, little guy investor, all the Fed does is introduce extreme volatility into the picture. And volatility isn’t risk. In fact, volatility provides true opportunities for the value investor that he otherwise might never have gotten as the inevitable panics that ensue tend to drag down the good companies with the bad. Then, you buy good companies cheaply.

I look at the black-box trading the same way. So what if there are black-boxes? They add volatility to markets. Volatility is opportunity, not risk. Use limit orders if you’re worried about getting manipulated by these robots putting out false bids.

The concern about informational asymmetries caused by institutionalism and hedge fund analyst armies is more substantive. But it still doesn’t mean doom for the little investor (or maybe better to call him the “lone ranger investor”, because he might have a few thousand or he might have a few million). I am going to paraphrase a few points from Jason Zweig’s commentary from chapter 8 of The Intelligent Investor:

  • Institutions (and hedge funds) have billions of dollars under management; this massive AUM forces them to gravitate towards the same large-cap stocks
  • Investors tend to pour money into institutional vehicles as markets rise, and pull it out as it falls; this forces these players to buy high and sell low
  • Many institutions are obsessed with relative benchmarks, the performance and composition of which shape their trading patterns and selections; their creativity and independence is stifled as a result
  • Many institutions box themselves in with an arbitrary mandate or theme which forces them to make their investment decisions within a confined space, often without regard to absolute value found elsewhere in the market place

Now, let’s flip each of these points around to see how the lone ranger investor is advantaged by each:

  • The lone ranger has comparatively little AUM so he has the flexibility to allocate his portfolio into nearly any stock he wants, from nano-cap to mega-cap
  • The lone ranger is in sole control of his buying and selling as he doesn’t face redemption requests or sudden influxes of hot money like institutions do
  • The lone ranger doesn’t have to compete with any benchmark if he doesn’t want to, instead he can just chase absolute returns and not worry about how he measures against a given index or benchmark over a given period of time
  • The lone ranger is free to choose any style, theme and type of investment strategy he likes and never has to worry about a regulation or outside investors having a problem with it

A video of Ray Dalio over at Credit Bubble Stocks features Dalio riffing on the high degree to which average hedge fund returns are correlated with the broader markets. The implication is that hedge funds aren’t being creative and independent in their strategies and trades. What good is an army of analysts, in other words, if you’ve got them looking at the same exact companies (AAPL, NFLX, BAC, etc.) that everyone else is looking at? What good is it to be a hedge fund when all this really means is you can hold more than 5% of your portfolio in something like AAPL and then lever the hell out of it and cross your fingers hoping Ben Bernanke’s got your back?

Informational advantages come in three flavors:

  1. Investments no one else is interested in, ensuring you have little to no competition for information (for example, a micro-cap with no institutional sponsorship and no analyst coverage)
  2. Investments in which you have a special relationship with insiders or other connected people, ensuring you have better quality information
  3. Investments in which you have a unique perspective or framework for understanding, ensuring that even if information is fairly distributed amongst all participants, only you will know what to do with it

Number two is damn near impossible (and extremely legally risky) to get in the current era of financial market regulation for most people. But there is nothing to stop the lone ranger investor from focusing on numbers one and three. In fact, this is where he should be focused.

The real risk, and this was suggested in the Hedge Fund News piece, is that number two might be so pervasive in particular situations that it overwhelms number one and number three. But for the most part, those situations are fairly obvious and can be avoided. For example, don’t buy AAPL if that’s what everyone is trading.

So, that’s some of the advantages the lone ranger has, in spite of it all. But the HFN piece wasn’t total fluff and he’s right to still be skeptical. I was particularly struck by his suggestions about corporate governance. This is a big problem as I see it.

Yesterday I spent some time listening to Albert Meyer talk about his experience with uncovering numerous well-publicized frauds and accounting shenanigans of the last decade ($KO, $TYC, Enron and the New Era Philanthropy Ponzi). The way Albert made it sound, corporate governance in this country is in shambles and a true embarrassment to the idea of free and honest markets.

Albert talked about the problem with option issuance overhang. Even though these items are now expensed following a FASB rules change, Meyer insists that the true costs of executive compensation for many (most?) companies listed on US exchanges is severely understated. He called into question the practice of huge stock buybacks by most companies, which he said is really just the way in which companies cover up the inevitable dilution that would otherwise occur from executive stock option exercising– and it all comes at the expense of shareholders and mutual fund investors whose mutual funds buy the new shares of recently exercised options. One example he gave was $EBAY, which he said reported income of $800M in a particular period but should’ve reported an $800M loss (a swing of $1.6B) once you had factored in the option issuance and subsequent buybacks to prevent dilution.

Albert said there were only 7 companies in the US that do not compensate executives with stock options. He cited numerous examples of Congressional and regulatory (SEC) corruption with regards to the protective relationship these cretins have with American corporate boards and C-level management teams and the stock option issuance scam. He said there is a lot less of it going on outside of the US which is yet another reason why he finds himself seeking out investment opportunities there.

I’m getting into a digression here when I don’t mean to be, but I assure you this is all related. The point is this: the predominating corporate structure for business in this country, specifically amongst publicly-listed companies with career professional management teams who are not also owner-operators of the company, creates a uniquely perverse set of incentives that truly pits the interests of shareholders (the actual owners of the company, its assets and cash flows) against management and even their own boards! The reality in many cases is that executives and obedient, captured boards work together the milk the wealth of the company for themselves with outsized compensation packages based primarily on stock option issuance, leaving shareholders with all the risks and none of the rewards.

And as the HFN piece points out, the entrepreneurial spirit is particularly absent in these kinds of arrangements because it must be. There is no real connection between the performance of the business (good or bad) and the compensation of the board and management. In the event that the company does well, the gains are secretly dissipated through executive stock option exercising and subsequent colossal buybacks. In the event that the company does poorly, management and the board issue themselves numerous stock options at rock-bottom prices with long duration expirations, virtually guaranteeing that should the business ever turn around they’ll be there to siphon off all the gains for themselves and leave shareholders with nothing.

In effect, it’s a game, and a dirty one that the lone ranger investor doesn’t have many tools besides selectivity that he can use to win. It’s such a widespread practice that you really have to either get in at the absolute bottom or find a company where the corporate governance is much more shareholder aligned (high percentage of insider ownership, predominance of cash compensation for executives without major options issuance, share buybacks that occur at market lows not at market highs when management is cashing in their chips and exercising options, low percentage of institutional sponsorship and a truly independent board where ideally executive management doesn’t have many or any seats) if you ever hope to win it.

That is why I’ve been thinking a lot about “going private.” By going private, I don’t mean taking companies that are public, private, though that might be a good start as I honestly think that in many ways having access to public financing is simply an excuse for poorly managed companies to engage in Ponzi finance without it looking like such.

Instead, what I am talking about is being an enterprising, entrepreneurial investor primarily within the private investment space. This means not only starting your own businesses, but making contacts and seeking out investment opportunities that are not party to the public capital markets. In many cases, it means investing locally and investing in what you know about. It also potentially means outsize returns via informational asymmetries and reduced competition (amongst yourself and other potential investors).

In that vein, I was struck by this comment from Mark Cuban that I saw quoted on Tim Ferriss’s 4 Hour Blog in a post about rethinking investing:

YM: Do you have any general saving and investing advice for young people?

CUBAN: Put it in the bank. The idiots that tell you to put your money in the market because eventually it will go up need to tell you that because they are trying to sell you something. The stock market is probably the worst investment vehicle out there. If you won’t put your money in the bank, NEVER put your money in something where you don’t have an information advantage. Why invest your money in something because a broker told you to? If the broker had a clue, he/she wouldn’t be a broker, they would be on a beach somewhere.

Cuban’s sentiment echoes my own here and I find myself sharing this perspective with friends and family members who ask me for investment advice or what to do with their 401k.

The first thing I tell people is, don’t put your money in your 401k if you don’t know what you want to do with it once it’s there. People get taken in by the idea of pre-tax investing and employer matching, but ultimately those advantages are wasted if you are just going to make clueless, doomed-to-fail investments with that money. What good is having 6% matching or investing with 35% more money because you don’t pay taxes on the principal when you put it in, if you’re just going to lose 100% of it anyway?

The second thing I ask them is, what kind of options do you have and what kind of informational advantages do you have when you put your money into your 401k or the stock market in general? Most don’t have a clue. That’s a warning sign! If you don’t know what your informational advantage is, you don’t have one and you’re basically investing blind. Meanwhile, your opponents not only aren’t blind, they’ve got Lasik. They will take your money and run the first chance they get.

The final recommendation I make is, instead of investing in the stock market or a 401k (which the person admittedly knows nothing about), I suggest they save up to start their own business or invest in the business of a friend or family member who they know, trust and have tangible proof of their success. It would be much better to make private arrangements to invest equity or loan money privately in a situation like that than it would be to dump their hard-earned wealth into a Wall Street rucksack and then wake up 20 years later wondering where it ran off to.

When I make those suggestions to others I start to wonder if we would all be better off if we did the same.

Gary North Says “NO!” To Hyperinflation

In case you missed his previous missive on the subject, entitled “Which Flation Will Get Us?“, Gary North came out today firmly against the idea of a hyperinflationary experience in the US or any other industrialized country with a privately owned central bank. Instead, North is predicting “mass inflation”, which he defines as 15-30% money supply growth per annum.

North bases his conclusion on four premises:

  1. The central banks control inflation, the central banks are owned by the banks, hyperinflation destroys banks who are borrowed short and lent long
  2. There is too much public awareness of the role the Fed plays in promoting inflation nowadays (primarily thanks to Ron Paul), so they will get blamed if something goes wrong
  3. People have become accustomed to the boom-bust cycle and the pattern of recessions following inflations, so the public will be more tolerant and forgiving of a recession and the “return to normalcy” than the destruction and reset of a hyperinflation
  4. Members of the Federal Reserve System participate in a lucrative employee pension system which primarily holds US stocks (53% of plan assets) and bonds (34% of plan assets), which will be made worthless by a hyperinflation, giving the employees of the Federal Reserve System a vested interest in preserving the system and averting hyperinflation

North calls hyperinflation a “policy choice”. He believes the only thing that could change this outcome would be if the Congress nationalized the Fed. Then, all bets are off.

It’s an interesting prediction. It makes a lot of sense. I am not sure how mass inflation will avoid some of the problematic items mentioned above though (particularly #2 and #4).

If North is right, this should be good for gold and not so good for people invested in stocks as consumer price increases will likely outpace increases in stock prices. Stock prices may even get hurt short-term because of increased commodity prices for many businesses.

UPDATE

Robert Wenzel of EconomicPolicyJournal.com fires back:

So don’t put me in the more unemployment camp or the mild inflation camp,or in the non-hyperinflation camp. Long term there are too many unknowns to be in any camp, especially when you have a machine known as the Fed that can shoot out billions trillions of dollars whenever it chooses. I just watch what the Fed is doing and adjust accordingly on a roughly six month basis. The constant adjustments are no way to live, but are necessary because of the fact that we do have a central bank, the Federal Reserve, that manipulates up and down the money supply. Right now, because of the new money accelerated growth that is occurring,  I anticipate that the climb in price inflation is going to escalate dramatically, where this spike in price inflation will stop, I have no idea. I just take it six months at a time.