Notes – Buffett Partnership Letters, 1957-1970

Recently I sank into my overstuffed armchair (in this situation, “sank” is used derisively to connote frustration and discomfort with regards to ideal reading conditions) with a copy of Buffett’s partnership letters from the 1957-1970 period in my hands. I found them on CSInvesting.org and had never taken the time to read them before, but figured it was about time as I was curious to consult a primary source on this period of Buffett’s investment career, having already read a 3rd-party recounting in The Snowball.

My interest was to read critically. Buffett’s letters have been read and analyzed and mulled over by thousands of investors and business people and have been discussed ad nauseum. But everyone seems to come away with the same lessons and the same pithy quotes that they throw up on their blogs when appropriate. I wanted to see if I could find anything original. From my own set of knowledge and understanding of Buffett and “how he did it”, I achieved my goal, but I can not guarantee creativity to anyone else who may be reading this. Somehow, somewhere in some overlooked nook of this vast interweb, I may have missed the discussion where someone went over these exact points.

Market timing, or the “value climate”

Amongst value investors, the sin of attempting to time the market is considered to be one of the greatest (for example, see the special note at the end of my recent review of The Intelligent Investor). Luminaries like Graham warn us that attempting to jump in and out of the markets according to their perceived price level being high or low is a speculative activity that will be rewarded as such, which is to say, it’ll eventually end in disaster.

However, while value gurus like Graham warned against market timing as a primary tool of analysis in an investment program, it’s also true that both Graham and Buffett were nonetheless intimately aware of market valuations and sentiment and both of them discussed the way their perception of market valuation influenced their portfolio orientation at any given time. For Graham and his intelligent investors, the response was to weight the portfolio toward bonds and away from stocks when the market was high and the opposite when the market was low. Similarly, Buffett advised in his 1957 letter:

If the general market were to return to an undervalued status our capital might be employed exclusively in general issues… if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio

This quote alone, along with many others just like it throughout the partnership letters, makes it clear the Buffett did not ignore broad market valuations. And not only did he not ignore them, he actively manipulated his portfolio in response to them. However, there are a few key things to note in terms of the heavily nuanced differences between what Buffett did and what the average market timer does:

  • Market timers are forecasters, they act on a perceived market level because of their anticipation about future market levels; Buffett refused to speculate about what the future of the market level might be and instead accepted it for what it was, changing what he owned and in what proportions, not whether he was invested or uninvested
  • Market timers are binary, choosing between “risk on” or “risk off”; Buffett responded to higher market levels by seeking to gain greater exposure to market neutral opportunities (special situations revolving around corporate action) while still continuing to make investments in individual undervalued businesses as he found them
  • Market timers always maintain the illusion of “full control” knowing they can always sell out or buy in any time they like in response to market valuations; Buffett acknowledged that many times he might desire to have greater market neutral exposure but that such opportunities might dry up in the late stages of a bull market, dashing his plans

The importance of relative performance

Another concept of Buffett’s money management style that stood out was his obsession with relative performance. I found this interesting again because the orthodox value investment wisdom is that it is not relative, but absolute, performance which matters– if you permanently lose a portion of your capital in a period, but your loss is smaller than your benchmark, you’ve still lost your capital and this is a bad thing.

Again, from the 1957 letter, Buffett turned this idea on its head:

I will be quite satisfied with a performance that is 10% per year better than the [Dow Jones Industrial] Averages

Because Buffett calculated that over the long-term the DJIA would return 5-7% to shareholders including dividends, Buffett was aiming for a 15-17% per annum performance target, or about 3x the performance of the Dow. But, as always, there was an important twist to this quest for relative out performance. In his 1962 letter, Buffett stated in no uncertain terms:

I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets. Preferably these should involve a substantial decline in the Dow. Our performance in the rather mild declines of 1957 and 1960 would confirm my hypothesis that we invest in an extremely conservative manner

He went on to say:

Our job is to pile up yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus. I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%

And he concluded by noting:

Our best years relative to the Dow are likely to be in declining or static markets. Therefore, the advantage we seek will probably come in sharply varying amounts. There are bound to be years when we are surpassed by the Dow, but if over a long period we can average ten percentage points per year better than it, I will feel the results have been satisfactory.

Specifically, if the market should be down 35% or 40% in a year (and I feel this has a high probability of occurring in one year in the next ten– no one knows which one), we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much

In his 1962 letter, he added further detailing, sharing:

Our target is an approximately 1/2% decline for each 1% decline in the Dow and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative

Why did Buffett focus so much on relative out performance in down years? Because, as a value investor, he was obsessed with permanent loss of capital. In a broad sense, making money in the market is somewhat easy as over long periods of time as the market has historically tended to rise higher and higher. Every now and then, however, it corrects sharply to the downside and it is in these moments when the average investor panics and sells out at a loss, thereby permanently impairing his capital.

Buffett believed that by buying at a discount and taking a more conservative approach to the investment problem from the outset, he would limit any losses he might sustain in the inevitable downturns in the market. This by itself would put him ahead of other market participants because he’d have more of his capital intact. The real power behind this strategy is what comes afterward, as then the just-as-inevitable recovery would continue the compounding process again– with more of his original capital than the other guy, Buffett would enjoy greater pure gain over time as he would have a relatively shallower hole to climb out of each time.

True Margin of Safety: two pillars of value

Fellow value investor Nate Tobik over at OddballStocks.com has talked repeatedly about one of Ben Graham’s concepts which he refers to as the “two pillars of value”, namely, that a company which represents a bargain both on the basis of a discount to net assets and a discount earnings is the most solid Margin of Safety one can possess because you’re not only protected two ways but you also have two ways to “win.”

Reading the Buffett partnership letters, it’s clear that the reason Buffett was knocking it out of the park in his early years was because he relied upon the same methodology. Buffett later was critical of his own early practices and many others have derided the investment style as akin to picking up soggy cigar butts and taking the last puff before discarding them, but there is no denying in studying several of the investments Buffett disclosed that Buffett was buying things which were “smack you over the head” cheap.

For example, in the 1958 letter, Buffett disclosed the partnerships’ investment in Commonwealth Trust Company of New Jersey, a small bank. Buffett claimed the company had a computed per share intrinsic value of $125, which was earning $10/share and trading for $50. This meant that Buffett bought the company for 40% of book value, or at a 60% margin of safety to indicated value. And, in two pillar tradition, he was also buying at a 5x multiple of net earnings– by any standards, an incredibly cheap value. If one were to look at the company as a bond and study it’s earnings yield, this company was offering a 20% coupon!

Making good buys, not good sales

In the example of Commonwealth Trust Co. discussed earlier, though Buffett calculated an intrinsic value of $125/share, he ultimately sold for only $80/share. He did not sell out near intrinsic value but rather far below it. Still, because he had originally bought at $50/share, he nonetheless earned a 60% return despite the company trading at a still-substantial discount to intrinsic value.

As Buffett chirped in his 1964 letter:

Our business is making excellent purchases– not making extraordinary sales

Why does Buffett harp on this idea so frequently? There are a few reasons.

One, an excellent purchase price implies a substantial discount to intrinsic value and earnings power, therefore there is a built-in margin of safety and the downside is covered, a principle of central importance to sound investing.

Two, an individual has 100% control over when they buy a security but relatively little control over when and in what conditions they sell, particularly if they use margin. You may not always get the price you want when you are ready to sell but you will always get the price you want when you buy because that decision is made entirely by you and doesn’t require the cooperation of anyone else. Buying at a discount ensures you “lock in” a profit up front.

Three, buying at a discount gives one optionality. If a better deal comes along, it is more likely you can get back out of your original investment at cost or better when you buy it cheap. When your original purchase price represents a substantial discount you have a better chance of finding a buyer for your shares because even at higher prices such a sale would probably still represent a bargain to another buyer meaning both parties can feel good about the exchange.

This last point was critical in Buffett’s Commonwealth situation. He was happy to sell at only $80/share despite a $125/share intrinsic value because he had found another opportunity that was even more compelling and because his original purchase price was so low, he still generated a 60% return. Meanwhile, the other party who took this large block off his hands was happy to provide the liquidity because they still had a 56% upside to look forward to at that $80/share price.

Early activism, the value of control

Another lesson from Buffett’s partnership letters is the importance and value of activism and control. From an activism standpoint, the examples of Sanborn Maps and Dempster Mills are well-known and don’t require further elaboration in this post (follow the links for extensive case study analysis at CSInvesting.org, or even read Buffett’s partnership letters yourself to see his explanation of how these operations worked).

But activism is something that is best accomplished with control, and often is its by-product. On the topic of control, Buffett said in his 1958 letter with regards to Commonwealth:

we became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal

By gaining a large ownership share in an undervalued company, an investor can play a more active role in ensuring that potential catalysts which might emerge serve to adequately reward shareholders. Similarly, time is money and when one has control,

this has substantial advantages many times in determining the length of time required to correct the undervaluation

An investment situation offering, say, a 30% return, offers a 30% annualized return if captured within a year, a 15% annualized return if gained after two years and only a 10% annualized return if it takes 3 years to realize value. Having control can often be the difference between a 30% and a 10% annualized return by allowing an investor to accelerate the pace at which they turn over their capital.

It is a myth, therefore, that Buffett only became a wholesale/control buyer as he employed greater amounts of capital in his later years. While many of his investments were passive, minority positions in the partnership years, Buffett never shied away from control and activism, even saying in his 1961 letter:

Sometimes, of course, we buy into a general with the thought that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen

In this sense, “value is its own catalyst” and something which is cheap and remains cheap for an extended period of time can actually be a unique opportunity to accumulate enough shares to acquire control, at which point the value can be unlocked through asset conversion, a sale or merger of the company or through a commandeering of the company’s earnings power.

Portfolio buckets: generals, work-outs and control

In his 1961 letter, as well as later letters, Buffett outlined the three primary types of investments that could be found in the partners’ portfolios, the approximate proportion of the portfolio to be involved with each and the basis upon which such investments should be chosen.

The “bread and butter” according to Buffett was his “generals”, businesses trading at substantial discounts to their intrinsic value which were purchased with the intent of eventually being resold at a price closer to the intrinsic value:

our largest category of investment… more money has been made here than in either of the other categories… We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen… Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price… individual margin of safety coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential… [we] are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner

While admitting that the particular and eventual catalyst was often not known with the average investment in a general security, Buffett also admitted in his 1963 “Ground Rules” letter section:

Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use

The next category was workouts:

our second largest category… ten or fifteen of these [at various stages of development]… I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior

The beauty of work-outs is that they relied on corporate action, not market action, to realize value. In this sense, they could provide a meaningful buffer to share price declines in generals during bear markets as their performance was largely “market neutral.” For example, in his 1963 (1962 being a bear market) letter Buffett said:

This performance is mainly the result of having a large portion of our money in controlled assets and workout situations rather than general market situations at a time when the Dow declined substantially

The final category was control, which started out as something of an after-thought or an accidental consequence of investing in certain generals which remained cheap, but later turned into an active category Buffett would search for opportunities in.

Buffett also mentioned the idea of the “two-way stretch” in control situations– if bought at a significant discount, there were generally two ways to profit from a control investment. Either the stock price remained low for a long period of time and control was acquired, in which case “the value of our investment is determined by the value of the enterprise,” or else the stock would move up in the process of consolidating a position in which case it could be sold at a higher level in the way one would normally “complete a successful general operation.”

Time horizons for performance

This particular point is more well-known but it bears repeating here. Buffett was obsessed with long-term performance and constantly advised his partners about appropriate timelines for judging investment performance, especially based-upon the particular type of investment being considered. For example, in his 1960 letter he said:

My own thinking is more geared to five year performance, preferably with tests of relative results in both strong and weak markets

In the 1961 letter, Buffett discussed “establishing yardsticks prior to the act” and again emphasized:

It is my feeling that three years is a very minimal test of performance, and the best test consists of a period at least that long where the terminal level of the Dow is reasonably close to the initial level

In other words, what did your performance look like after a three year period where the broad market index made no progress, or even reversed?

With control situations specifically, Buffett advised:

Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it

Diversification

It’s clear that Buffett had 15-21 “generals” or about 50-60% of his portfolio, with another 10-15 positions in workouts or another 15-30%, with the remainder in control situations. However, control situations could scale up to as much as 40% of the portfolio in an individual investment if the situation called for it in Buffett’s mind.

And while Buffett mentioned in an earlier letter of having approximately 40 positions in the portfolio in total, he later (around the time he started being influenced by Charlie Munger and other “quality over quantity” investment practitioners) became more critical of the idea of diversification. In the 1966 letter, Buffett lamented:

if anything, I should have concentrated slightly more than I have in the past

He also castigated “extreme diversification”:

The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has in the overall portfolio expectation

Buffett was learning the merits of “concentration” in areas outside the portfolio, as well. In discussing slight additions to the office space at Kiewit Plaza and the hiring of additional support personnel, Buffett added:

I think our present setup unquestionably lets me devote a higher percentage of my time to thinking about the investment process than virtually anyone else in the money management business

Of course, the results of this focus were obvious to all in time.

Sizing things up

Buffett dwelled on “the question of size” at length in his letters to partners. He made it clear that portfolio size and investment opportunity looked something like a continuum with small size on the left of the spectrum and large size on the right, with “generals” hanging near the left pole (size is a disadvantage), workouts inhabiting some kind of middle ground where they were neither benefitted nor impaired by size and control situations distinctly on the right where size was an enormous advantage.

Generals and control situations are, in this sense, almost opposites because Buffett warned that some generals were too small to buy meaningful stakes in for a large portfolio, whereas a small portfolio might never be able to acquire enough shares to gain control of certain investments.

Inflation-adjusting Buffett’s portfolio positions and capital at various points in time also gives important clues to the role size played in his operations. For example, Sanborn Maps was apparently around a $4.5M market cap when he mentioned the company in his letters. This would be about $35M or so in today’s dollars (this is not an endorsement of BLS/CPI measurement techniques, just a convenient rule-of-thumb), so clearly Buffett was hunting in a small/micro-cap space at least at this time.

In a similar vein, Buffett started with $105,000 in capital in 1956, which is about $893,000 in 2012. In his 1966 letter, he complained that the amount of capital being managed at the time, $43,645,000, was beginning to be burdensome in terms of size versus opportunities. This would be about $312,000,000 in 2012, to put it into perspective.

Apparently, the value investment framework Buffett created could work quite well even at a scale that we might consider to be decently large.

Serendipity: the reason for Buffett’s rise, and retirement

Few ever think to mention the incredible role serendipity played in Buffett’s early fortunes, but Buffett himself was well-aware. Not only did he begin his career at the outset of an astounding decade-long-plus bull market, but in 1952,

and for some years subsequently, there were substantial numbers of securities selling at well below the “value to a private owner” criterion we utilized for selection of general market investments

As the bull market started to grow gray hairs in the late 1960s and Buffett began contemplating an exit from the business, he similarly remarked in his 1967 letter:

Such statistical bargains have tended to disappear over the years. This may be due to the constant combing and recombing of investments that has occurred during the past twenty years, without an economic convulsion such as that of the ’30s to create a negative bias toward equities and spawn hundreds of new bargain securities

The comment on the aftermath of the 1930s bears repeating. The primary reason for the prevalence of bargain issues in the market around the time Buffett started investing was due to a massive psychological paradigm shift in attitudes about the stock market following the crash of 1929 and subsequent depression of the 1930s. By the late 1960s, a new inflationary thrust had managed to erase this psychology and great gains were actually made in sending it in the reverse direction. Buffett was convinced of

the virtual disappearance of the bargain issues determined quantitatively

the kind whose figures “should hit you over the head with a baseball bat”, which were being replaced by

speculation on an increasing scale

So how did Buffett respond to these new market conditions where his toolkit didn’t seem to work as well? Did he compromise his standards, or try to shape-shift his style into the “New Era” of investors and keep going? Well, anyone who has studied Buffett already knows the answer. Buffett knew his circle of competence and he knew what worked. When what he knew worked stopped working (because the opportunities weren’t available), he quit.

Despite writing in his 1968 letter that the answer to a potential phase out of the partnerships was “Definitely, no.” Buffett nonetheless in his 1969 letter suggested that “the quality and quantity of ideas is presently at an all time low” and that “opportunities for investment that are open to the analyst who stresses quantitative factors have virtually disappeared” and for this reason, he decided to close up shop.

There’s a lesson for all of us here. As Joel Greenblatt has argued, value investing doesn’t work all the time, which is why it works. We should respect this, just as Buffett did– when the deals dry up, we should go fishing (or at the very least, look for bargains in other markets that are in a different stage of psychology/sentiment/valuation). Trying to make great long-term returns when valuations won’t support it is a fools game and more likely to end in failure.

A few miscellaneous notes

In the 1968 letter, Buffett referred to 10-12% as “worthwhile overall returns on capital employed”.

With regards to dividends, although Buffett always described the return of the Dow for each annual period inclusive of dividends earned, and although when describing his investment in Commonwealth he specifically mentioned that the company was not paying dividends, and although we know from an anecdote in The Snowball that Buffett was receiving substantial dividend checks from his partnership portfolios because his wife Susie accidentally through a few away one time, I noticed that Buffett makes no specific mention in any of the letters of the importance of dividends nor that dividends impacted his investment decisions or philosophy.

16 Japanese Net-Nets I Put In My Portfolio

Listed below are the 16 Japanese companies that currently compose my “basket” (portfolio-within-the-portfolio) of Japanese net-nets, which I refer to as “JNets”. While most of my picks were classic Benjamin Graham-style companies trading for 2/3rds or less of their Net Current Asset Value (current assets minus total liabilities), some were selected on the basis of being a Net Cash Bargain (trading below the value of the company’s cash minus total liabilities) or as a Cash Bargain (profitable company with no debt trading for less than the cash on the balance sheet).

Strictly speaking, a Net Cash Bargain is a more conservative valuation than a Net Current Asset Value Bargain as there are more assets in front of the liabilities, while a Cash Bargain is a less conservative valuation (it may or may not be an NCAV Bargain) but typically you are getting a higher quality company with stronger earnings power as a result. As Graham noted, equities can be analyzed much like bonds and the true safety of a bond comes from the underlying company’s earnings power, not necessarily the asset values which are a worst-case fall back measure to protect against loss.

The figures in the list below are all in Yen, typically in millions of Yen besides the per share price. At the time of purchase, the approximate exchange value of the dollar against the Yen was 1 USD = 78 JPY. All figures and prices are the most recent available at time of purchase.

For comparative purposes, I summarize at the end of the list the metrics for the entire basket (as if it was a conglomeration of 100% of the equity of all companies included) as well as on an average basis as a representative for an individual company within the basket.

Links in the name of each company take you to their website, if available. Links in the symbol of each company take you to their Bloomberg business bio page, if available.

16 Japanese Bargain Shares (Net-Nets, Net Cash and Cash Value)

Name: Sakai Trading
Symbol: 9967
Industry/product: imports, exports, and wholesales chemical products, synthetic resins, and electronic materials
Market Cap (Ym): 2,210
Share price (Y): 235
Debt (Ym): 0
Cash (Ym): 2,851
EV/EBIT (10yr avg): 12.3x
NCAV (Ym): 4,973
 
Name: Shinko Shoji Co. Ltd
Symbol: 8141
Industry/product: sells electronic parts and equipment such as integrated circuits (IC) and semiconductor devices, liquid crystal (LC) display modules, condensers, ferrite cores, coils, power supplies, thin film transistor (TFT) thermal printers, head magnets, transformers, motors, sensors, and connectors
Market Cap (Ym): 16,905
Share price (Y): 625
Debt (Ym): 3,000
Cash (Ym): 10,610
EV/EBIT (10yr avg): 12x
NCAV (Ym): 41,899
 
Name: KSK Co Ltd
Symbol: 9687
Industry/product: develops computer software for various systems related to telecommunication and LSI (Large Scale Integration), provides data processing services for government and insurance group, sells OA (Office Automation) equipment and computer peripheral
Market Cap (Ym): 3,300
Share price (Y): 450
Debt (Ym): 0
Cash (Ym): 4,461
EV/EBIT (10yr avg): 1.6x
NCAV (Ym): 4,926
 
Name: Daichii Kensetsu
Symbol: 1799
Industry/product: constructs railways mainly for East Japan Railway, constructs infrastructure such as sewage facilities, tunnels, and waterways, builds commercial, institutional, and residential buildings
Market Cap (Ym): 15,124
Share price (Y): 685
Debt (Ym): 151
Cash (Ym): 17,230
EV/EBIT (10yr avg): 2.3x
NCAV (Ym): 19,099
 
Name: Choukeizai Sha
Symbol: 9476
Industry/product: publishes economics, finance, law, accounting, and tax related books and periodical magazines and business related books, operates a planning center which handles advertising on publishes, provides design & production services for sales promotion pamphlets
Market Cap (Ym): 1,434
Share price (Y): 326
Debt (Ym): 0
Cash (Ym): 2,501
EV/EBIT (10yr avg): -0.1x
NCAV (Ym): 2,933
 
Name: CLIP Corp
Symbol: 4705
Industry/product: operates a network of cram schools in Nagoya, operates soccer school and lunch box delivery services
Market Cap (Ym): 4,022
Share price (Y): 886
Debt (Ym): 0
Cash (Ym): 5,029
EV/EBIT (10yr avg): 0.1x
NCAV (Ym): 4,196
 
Name: Noda Screen
Symbol: 6790
Industry/product: processes electrical components such as plastic package substrates and printed circuits boards (PCBs), through a subsidiary, manufactures and sells screen stencils and fluoride chemical products
Market Cap (Ym): 2,849
Share price (Y): 27,000
Debt (Ym): 0
Cash (Ym): 3,641
EV/EBIT (10yr avg): -0.2x
NCAV (Ym): 4,146
 
Name: Kitakei Co Ltd
Symbol: 9872
Industry/product: wholesales housing materials and home furnishings based in the Kansai area, sells housing facility products such as bathroom units, wooden building materials, special wooden products, housing equipment, veneer boards, chemical products, and housing preservative agents
Market Cap (Ym): 2,963
Share price (Y): 296
Debt (Ym): 0
Cash (Ym): 5,045
EV/EBIT (10yr avg): 16.8x
NCAV (Ym): 5,133
 
Name: Ryosan Co Ltd
Symbol: 8140
Industry/product: distributes electronic components, such as integrated circuits (ICs), electronic tubes, semiconductor elements, and personal computers, manufactures heat sinks
Market Cap (Ym): 47,582
Share price (Y): 1,387
Debt (Ym): 172
Cash (Ym): 36,452
EV/EBIT (10yr avg): 7x
NCAV (Ym): 92,515
 
Name: Daiken Co
Symbol: 5900
Industry/product: manufactures and sells metal and other material parts for building construction and exterior products including curtain rails, exterior panels, garages, and bicycle parking units, provides installation of these products and real estate leasing service
Market Cap (Ym): 2,245
Share price (Y): 376
Debt (Ym): 0
Cash (Ym): 1,753
EV/EBIT (10yr avg): 5.4x
NCAV (Ym): 4,375
 
Name: Ryoyo Electro Corporation
Symbol: 8068
Industry/product: wholesales electronic components including semiconductors, sells workstations, personal computers, and printers, operates offices in Singapore and Hong Kong, trades semiconductors from Mitsubishi Electric
Market Cap (Ym): 22,205
Share price (Y): 771
Debt (Ym): 0
Cash (Ym): 28,443
EV/EBIT (10yr avg): 1.6x
NCAV (Ym): 54,847
 
Name: Nihon Dengi
Symbol: 1723
Industry/product: designs, constructs, and maintains integrated building management systems for air-conditioning, security, and electrical facilities, develops integrated production systems for industrial factories
Market Cap (Ym): 4,805
Share price (Y): 586
Debt (Ym): 0
Cash (Ym): 6,313
EV/EBIT (10yr avg): 4.3x
NCAV (Ym): 8,613
 
Name: Odawara Engineering
Symbol: 6149
Industry/product: manufactures automatic coil winding machines including micro motor, coreless motor, universal motor, and stepping motor type, provides reconstruction, repair, and parts replacement services for its winding machines
Market Cap (Ym): 4,154
Share price (Y): 650
Debt (Ym): 0
Cash (Ym): 5,411
EV/EBIT (10yr avg): 2x
NCAV (Ym): 6,423
 
Name: Natoco Co Ltd
Symbol: 4627
Industry/product: manufactures and sells various types of paints including paints for metals, building materials, and auto repair, manufactures high polymer compounds which are used as material for liquid crystal displays
Market Cap (Ym): 4,414
Share price (Y): 603
Debt (Ym): 0
Cash (Ym): 5,403
EV/EBIT (10yr avg): 5x
NCAV (Ym): 6,967
 
Name: Fuji Oozx
Symbol: 7299
Industry/product: manufactures automobile engine parts such as valves, valve adjusters and rotators, has subsidiaries in Korea, Taiwan, and the United States
Market Cap (Ym): 6,189
Share price (Y): 301
Debt (Ym): 0
Cash (Ym): 6,884
EV/EBIT (10yr avg): 1.6x
NCAV (Ym): 11,623
 
Name: Excel Co Ltd
Symbol: 7591
Industry/product: sells electronic products, such as liquid crystal devices (LCD), semiconductors, and integrated circuits (IC), including thin film transistor (TFT) modules, TFT-LCDs, cellular phones, car navigation systems
Market Cap (Ym): 6,208
Share price (Y): 683
Debt (Ym): 0
Cash (Ym): 6,679
EV/EBIT (10yr avg): 4.7x
NCAV (Ym): 18,574
 
Total Basket
Market Cap (Ym): 129,974
EV (Ym): -15,499
10yr avg EBIT (Ym): 27,046
Debt (Ym): 3,323
Cash (Ym): 148,796
NCAV (Ym): 291,244
EV/EBIT (10yr avg): -0.57x
P/NCAV: 0.45x
P/Net cash: 0.89x
P/Cash: 0.87x
EBIT yield (EBIT/Mkt Cap): 21%
 
Representative Company (Avg)
Market Cap (Ym): 8,123
EV (Ym): -969
10yr avg EBIT (Ym): 1,690
Debt (Ym): 208
Cash (Ym): 9,300
NCAV (Ym): 18,203

Geoff Gannon Digest #5 – A Compilation Of Ideas On Investing

Why I Concentrate On Clear Favorites And Soggy Cigar Butts

  • Graham and Schloss had >50 stocks in their portfolio for much of their career
  • They turned over their portfolios infrequently; probably added one position a month
  • To avoid running a portfolio that requires constant good ideas:
    • increase concentration
    • increase hold time
    • buy entire groups of stocks at once
  • With his JNets, Gannon purchased a “basket” because he could not easily discriminate between Japanese firms which were both:
    • profitable
    • selling for less than their net cash
  • Portfolio concentration when investing abroad is based upon:
    • which countries do I invest in?
    • how many cheap companies can I find in industries I understand?
    • how many family controlled companies can I find?
  • Interesting businesses are often unique

How Today’s Profits Fuel Tomorrow’s Growth

  • To elements to consider with any business’s returns:
    • How much can you make per dollar of sales?
    • How much can you sell per dollar of capital you tie up?
  • Quantitative check: Gross Profit/ ((Receivables + Inventory + PP&E) – (Payables + Accrued Expenses))
  • Once an industry matures, self-funding through retained earnings becomes a critical part of future growth; it’s the fuel that drives growth
  • A company with high ROIC isn’t just more profitable, it can more reliably grow its own business
  • Maintaining market share usually means increasing capital at the same rate at which the overall market is growing
  • Higher ROIC allows for the charting of a more reliable growth path
  • Industries where ROIC increases with market share present dangers to companies with low market share or low ROIC
  • The easiest place to get capital is from your own successful operations; tomorrow’s capital comes from today’s profits

Why Capital Turns Matter — And What Warren Buffett Means When He Talks About Them

  • Capital turns = Sales/Net Tangible Assets
  • Buffett nets tangible assets against A/P and accrued expenses; gives companies credit for these zero-interest liabilities, rather than assuming shareholders pay for all of a company’s assets
  • Buffett’s businesses tend to have higher sales per dollar of assets
  • Companies with higher sales per dollar of assets have higher ROIC than competitors even if they have the same margins
  • There’s more safety in a business in an industry with:
    • adequate gross margins
    • adequate capital turns
  • Industries dependent upon margins or turns open themselves to devastating attacks from the player who can maximize key variables you control:
    • price
    • cost
    • working capital management
    • etc.
  • Companies often compete on a specific trait; it has to be a trait that is variable and can be targeted for change

How to Lose Money in Stocks: Look Where Everyone Else Looks — Ignore Stocks Like These 15

  • It’s risky to act like everyone else, looking at the same stocks everyone else looks at, or by entering and exiting with the crowd
  • Don’t worry about which diet is best, worry about which diet you can stick to; find an adequate approach you can see through forever
  • Having Buffett-like success requires every day commitment
  • You should aim to earn 7% to 15% a year for the rest of your investing life if you aren’t going to fully commit like Buffett did
  • A good investment:
    • reliable history of past profitability
    • cheap in terms of EV/EBITDA
    • less analyst coverage
  • A list of such stocks:
    • The Eastern Company (EML)
    • Arden (ARDNA)
    • Weis Markets (WMK)
    • Oil-Dri (ODC)
    • Sauer-Danfoss (SHS)
    • Village Supermarket (VLGEA)
    • U.S. Lime (USLM)    
    • Daily Journal (DJCO)
    • Seaboard (SEB)
    • American Greetings (AM)
    • Ampco-Pittsburgh (AP)
    • International Wire (ITWG)
    • Terra Nitrogen (TNH)
    • Performed Line Products (PLPC)
    • GT Advanced Technologies (GTAT)

Notes – A Compilation Of Ideas On Investing

How To Think About Retained Earnings

  • Grab 15 years of data from EDGAR and compare receivables, inventory, PP&E, accounts payable and accrued expenses to sales, EBITDA, etc.; E.g., if receivables rise faster than sales, this is where “reinvestment” is going
  • For a quick comparison, look at:
    • Net income
    • FCF
    • Buybacks + dividends
  • Compare debt (total liabilities) between the start of the period and the end and subtract the difference to get growth in debt
  • Then, sum all dividends and buybacks over the period, and all net income over the period
  • Then, subtract the change in debt from dividends/buybacks; what is left is dividends/buybacks generated by the business, rather than growth in debt
  • Then, compare this to net income to see the ratio of earnings paid out to shareholders
  • You can compare the growth in net income to retained earnings to get your average return on retained earnings
  • Look at the change in net income and sales over 10 years and then the ratio of cumulative buybacks and dividends to cumulative reported earnings
  • You’re looking for the central tendency of return on retained earnings, whether it is approx:
    • 5%, bad business
    • 15%, good business
    • 30%, great business
  • Companies with single products easily generate high returns on retained earnings, but struggle to expand indefinitely

One Ratio to Rule Them All: EV/EBITDA

  • EV/EBITDA is the best ratio for understanding a business versus a corporate structure
  • Net income is not useful; FCF is complicated, telling you everything about a mature business but nothing about a growing one
  • General rule of thumb: a run of the mill business should trade around 8x EBITDA; a great business never should
  • Low P/E and low P/B can be misleading as it often results in companies with high leverage
  • P/E ratio punishes companies that don’t use leverage; they’re often worth more to a strategic buyer who could lever them up
  • The “DA” part of a financial statement is most likely to disguise interesting, odd situations; if you’re using P/E screens you miss out on companies with interesting notes on amortization
  • Control buyers read notes; why use screens that force you to ignore them?
  • FCF is safer than GAAP earnings or EBITDA because it’s more conservative and favors mature businesses
  • EBITDA misses the real expense in the “DA”, but FCF treats the portion of cap-ex that is an investment as expense, so they’re both flawed; investment is not expense
  • No single ratio works for all businesses in all industries; but to get started, EV/EBITDA is the best for screening
  • Example: cruise companies have huge “DA”, but no “T” as they pay no taxes
  • “Only you can calculate the one ratio that matters: price-to-value; there is no substitute for reading the 10-K”
  • Empirical evidence on ratios:

Blind Stock Valuation #2: Wal-Mart (WMT) – 1981

  • There is something wrong with believing a stock is never worth more than 15 times earnings
  • “Growth is best viewed as a qualitative rather than a quantitative factor.”
  • Buffett’s margin of safety in Coca-Cola was customer habit– repeatability
  • Buffett looks for:
    • Repeatable formula for success
    • Focus
    • Buybacks
  • “The first thing to do when you’re given a growth rate is not geometry. It’s biology. How is this happening? How can a company grow 43% a year over 10 years?”
  • Stable growth over a long period of time tells you a business has a reliable formula; look for businesses that behave like bacteria
  • Recognizing the value of changes after they happen is important, not predicting them ahead of time
  • You can’t post the kind of returns Wal-Mart did through the 1970s without a competitive advantage
  • Buffett gleans most of his info from SEC reports, things like 10-year records of gross margins, key industry performance metric comparisons, etc.

GTSI: Why Net-Net Investing Is So Hard

  • The challenge of net-nets is you often have no catalyst in sight and no wonderful future to visualize as you hold a bad business indefinitely
  • Graham’s MoS is integral– you can be off in your calculation of value by quite a bit but Mr. Market will often be off by even more
  • Focusing too much on time could be a problem in net-net investing
  • Two pieces of advice for net-net investing:
    • Put 100% of focus on buying and 0% on selling
    • Put 100% of focus on downside and 0% on upside
  • Money is made in net-nets not by the valuing but by the buying and holding
  • “You want to be there for the buyout.”
  • The hardest part of net-net investing: waiting
  • Graham and Schloss were successful likely because they built a basket, so they were always getting to buy something new that was cheap instead of worrying about selling
  • Focus on a process that keeps you finding new net-nets and minimizes your temptation to sell what you own

Can You Screen For Shareholder Composition? 30 Strange Stocks

  • Shareholder composition can help explain why a stock is cheap
  • A company’s shareholder base changes as the business itself changes; for example, a bankruptcy turns creditors into shareholders
  • Shareholders often become “lost” over the years, forgetting they own a company and therefore forgetting to trade it
  • Some companies go public as a PR ploy, so investors may be sleepy and inactive
  • Buffett understood this and understood that a stock could be a bargain even at 300% of its last trade price– National American Fire Insurance (NAFI) example
  • Buying a spin-off makes sense because many of the shareholders are stuck with a stock they never wanted
  • An interesting screen: oldest public companies with the lowest floats (in terms of shares outstanding); a lack of stock splits combined with high insider ownership is a recipe for disinterest in pleasing Wall St

How My Investing Philosophy Has Changed Over Time

  • Info about Geoff Gannon
    • high school dropout
    • bought first stock at 14
    • read [amazon text=Security Analysis (1940 Edition)&asin=007141228X] and [amazon text=The Intelligent Investor (1949 Edition)&asin=0060555661] at 14
    • over time, became more Buffett and less Graham
    • made most money buying and holding companies with strong competitive positions trading temporarily at 6, 10 or 12 times earnings
  • I like a reliable business with almost no history of losses and a market leading position in its niche
  • Geoff’s favorite book is Hidden Champions of the Twenty-First Century, which is part of a set of 3 he recommends to all investors:
    • You Can Be a Stock Market Genius (by Joel Greenblatt)
    • The Intelligent Investor (1949 Edition)
    • Hidden Champions of the Twenty-First Century
  • Everything you need to know to make money snowball in the stock market:
    • The Berkshire/Teledyne stories
    • Ben Graham’s Mr. Market metaphor
    • Ben Graham’s margin of safety principle
    • “Hidden Champions of the 21st Century”
  • Once you know this, if you just try to buy one stock a year, the best you can find, and then forget you own it for the next 3 years, you’ll do fine; over-activity is a major problem for most investors
  • Bubble thinking requires higher math, emotional intelligence, etc.; that’s why a young child with basic arithmetic would make a great value investor because they’d only understand a stock as a piece of a business and only be able to do the math from the SEC filings
  • There are always so many things that everyone is trying to figure out; in reality, there are so few things that matter to any one specific company
  • One key to successful investing: minimizing buy and sell decisions; it’s hard to screw up by holding something too long
  • Look for the most obvious opportunities: it’s hard to pass on a profitable business selling for less than its cash
  • Extreme concentration works, you can make a lot of money:
    • waiting for the buyout
    • having more than 25% of your portfolio in a stock when the buyout comes
  • I own 4-5 Buffett-type stocks (competitive position) bought at Graham-type P/E ratios
  • “There is a higher extinction rate in public companies than we are willing to admit.”
  • Most of my experience came through learning from actual investing; I wish I had been a little better at learning from other people’s mistakes

Review – F Wall Street

by Joe Ponzio, published 2009

“There’s Got To Be A Better Way!”

If you’ve ever managed your own retirement investment portfolio such as a 401k or spent any amount of time watching the talking boxes on Bubblevision, you’ve probably reached several conclusions almost simultaneously:

  • Even though we’re told investing in stocks is a surefire way to get rich over time, it never seems to work for the average person
  • Investment options in the average 401k seem best served to satisfy the needs and profitability of the Wall Street companies that peddle the products, not the investor who buys them
  • In general, the whole game seems rigged against you, from the annual expenses of mutual funds to the incentives those mutual funds have to trade to the regulatory burdens which virtually guarantee they’ll never be creative or contrarian enough to earn the kinds of out-sized returns necessary to make a killing in the markets over time
And according to author Joe Ponzio, who started his career working at several of these brokerages and mutual funds, you’d be correct to think that the whole system functions like a racket:
The Wall Street firms convince you to buy their “preferred” or “recommended” mutual funds;  then the mutual funds go out and buy the great, mediocre and bad investments from the brokerages.
In order to have access to the trillions of dollars the brokerages control, mutual funds buy “aggressive” investments, pay some of the brokerages’ expenses, and even offer them kickbacks every three months.

Now you’re thinking, “There’s got to be a better way!”

Luckily, there is.

F Wall Street

Enter Joe Ponzio’s inexpensive but thorough primer on Buffett-style value investing, F Wall Street. This book is truly one of the unsung heroes of the value investment classics library that I think should be one of the first titles an aspiring value investor should familiarize themselves with. The book is divided into several conceptual sections.

First, the basics: the market is not perfectly efficient; bonds are not just for old people and stocks are not just for young people and everyone, young or old, should be looking for good investments, not risky ones; mutual funds are essentially designed to fail the average investor; the true risk in the stock market is overpaying for the value available at the time; cash is king.

A bit more on the last part might be helpful. Ponzio defines the value of a business as its current net worth as well as the sum of its future cash flows. As a stock owner, you are essentially a silent partner in the business and silent partners are paid with cash, not profits. Businesses need cash to grow, to acquire other businesses, to service debt, to increase their net worth and to pay dividends to their investors. The superior business, and consequently the superior stock, is the one that can generate the most cash flows, not the biggest earnings.

Owner Earnings and Intrinsic Value

As Ponzio says, focusing on cash flows allows us to “peak inside” the firm and see what management sees. Furthermore, it implies looking at the business like an owner, rather than an accountant or IRS agent– net income/earnings do not represent cash available to the owners because they include a number of non-cash items and they do not account for necessary CAPEX spending to grow and maintain the business.

Owner Earnings represent actual cash flows attributable to the owners of the company in a given period and can be calculated fairly simply:

Owner Earnings = Net Income + Depreciation/Amortization + Non-Cash Charges – Average CAPEX

Average CAPEX should generally be taken over a period of the most recent 3-5 years, though you could use as many as 10 years if that’s how you prefer to look at a business’s history. Owner earnings tell you whether a business is generating enough cash to pay its bills without new infusions of debt or equity, as well as whether it is generating sufficient cash flows to continue to grow. Further, Ponzio states that “For extremely large, stable businesses, free cash flow usually approximates owner earnings.”

Intrinsic value is a related concept which considers the combined value of the current net worth of the business as well as the present value of all discounted future cash flows the business with generate. As a value investor, your goal is to buy businesses trading in the market at steep discounts to your calculated intrinsic value. The difference between intrinsic value and the market price is your “margin of safety” (note that if you pay more in the market than your calculated intrinsic value, this implies a “margin of dissafety” represented by the negative value you’d get from the equation).

To calculate the present value of future cash flows, Ponzio recommends using your desired investment return as the discount rate and sticking to it consistently (so, for example, if you want your investments to grow at 15%, use a 15% discount rate, but be wary that the higher your discount rate, the less conforming investment opportunities you will find). If you have Excel, calculating the value of discounted cash flows is simple. You can enter the following formula into any cell in your spreadsheet,

=PV(DISCOUNT_RATE, NUMBER_OF_DISCOUNT_PERIODS, AMOUNT_OF_ADDITIONAL_INVESTMENTS, FUTURE_VALUE)

By creating a matrix of future anticipated cash flows and then discounting them with the present value function, you can sum them up to get the total present value of present cash flows. When adding this to the business’s present net worth and comparing that amount to current market cap you can get an idea of whether or not the business is trading at a discount or premium to its intrinsic value.

Cash-yields, Buy-and-Hold, CROIC and “No-Brainers”

Ponzio suggests a few more ways to look at possible investments. One is the cash yield, which treats the stock like a bond for comparative purposes. Cash yield is defined as.

Cash Yield = Owner Earnings (or FCF) / Market Cap

Taking this yield, you can compare it to other investments, such as “risk free” government securities. Assuming the government securities are in fact “risk free”, if the cash yield is lower than the government securities the cash yield is telling you that you would likely be better off taking the “guaranteed” yield of the government security rather than assuming the capital risk of a stock. But if the cash yield is higher it could indicate a good investment opportunity, especially because that yield will typically improve over time as the denominator (your acquisition price) remains constant while the numerator (owner earnings/FCF) grows. But, as Ponzio states,

Cash-yield is not a make-or-break valuation; it is a quick and dirty “what’s this worth” number that applies more to slower-growth businesses than to rapidly growing ones.

Whereas cash-yield seeks to answer, “Is this cheap relative to other returns I could get?”, the Buy-and-Hold method seeks to answer “How much is it worth if I buy the entire business?” BAH is a more standard analysis and involves discounting future cash flows and adding them to the present net worth of the business, mentioned above.

A “no-brainer”, in Ponzio’s parlance, is an investment that leaps out at you as ridiculously undervalued– an excellent, growing business trading at a significant discount to its intrinsic value (net worth and discounted future cash flows). When searching for no-brainers, Ponzio suggests you stay in your sphere of confidence by sticking to what you know and asking yourself the following:

  • What does the company do?
  • How does it do it?
  • What is the market like for the company’s products or services?
  • Who is the company’s competition?
  • How well guarded is it from the competition?
  • Five and ten years from now, will this company be making more money than it is today? Why?

If you can’t answer any of those questions, you’re outside your sphere of confidence and probably won’t be able to identify a no-brainer.

There are many ways to identify growing businesses. Sticking to the theme of “watch the cash flows,” Ponzio’s favorite measurement is Cash Return on Invested Capital, or CROIC. CROIC is defined as,

CROIC = Owners Earnings / Invested Capital

(Ponzio suggests using long-term liabilities and shareholder’s equity to estimate IC– obviously if there was preferred equity or some other capital in the business like that, you might want to include it for a more accurate measurement.)

Ponzio recommends CROIC because it demonstrates management’s ability to generate owners earnings from each dollar of invested capital. The more efficient a management team is at generating owners earnings, the more resources it has to grow the business and pay shareholders. But be careful! An extremely high CROIC (such as 45%) is generally unsustainable. Look for anything above 10% as a good CROIC growth rate.

Portfolio Management Is All About The Percentages

You’ve found some great businesses. You know they’re growing and you know they’re trading at big discounts to intrinsic value, offering you your requisite margin of safety. Now you need to figure out how much of each you buy as you construct a portfolio.

A word of warning up front– there’s no science here, even though Ponzio refers to precise percentages. This aspect of investment management is even more art-vs.-science than judging which companies to buy in the first place. That being said, the principles themselves are sound and the truly important takeaway.

Ponzio divides stocks into three main categories:

  • Industry leaders: $10B+ market cap, demand 25% MoS, allocate 10-25% of your portfolio
  • Middlers: $1B-$10B market cap, demand 50% MoS, allocate up to 10% of your portfolio
  • Small fish: <$1B market cap, demand 50%+ MoS, allocate no more than 5% of your portfolio

The percentages are arbitrary but the idea is not. Industry leaders are companies that have proven track records when it comes to cash generation and cash flow sustainability through diverse business conditions. They won’t grow as much (they’re generally too big to do so) but if you can buy them at significant discounts to their intrinsic value, you will be rewarded. These are companies you can buy, read the annual report each year and otherwise sleep easy.

Middlers are companies that are in business limbo. They could grow quickly and become industry leaders, providing you with juicy returns, or they could be surpassed by smaller and larger competitors alike and shrink back to small fish size. Ponzio recommends keeping up with the quarterly reports on these companies and taking prompt action if you think you see any problems approaching.

Finally, small fish are capable of explosive growth… and spectacular failures. Many smaller businesses fail every year. Also, small businesses are often reliant or one or a few major customers for all of their business. If they lose that relationship, or a critical person dies or leaves the firm, their business can evaporate overnight. At the same time, because they are so small, the SF have the most room to grow and if you pick them right, they can turn into the magical “ten-baggers” of Peter Lynch lore. Ponzio recommends following every SEC filing and every news item on these companies as they can go belly up quickly if you aren’t careful.

The key thing to keep in mind is that, however you make your allocation decisions, you should always invest the most in the things you are most confident about. Diversification should be a consequence of your investing decisions, not an outright goal. You will make allocations as various opportunities arise. You don’t benefit yourself by being fully invested all the time, simply to keep your portfolio “balanced” amongst different business types.

Selling Is The Hardest Part

As the legendary Tom Petty once said, “the waiting is the hardest part” and while that’s certainly true of investing for some, what people consistently struggle with even more is knowing when to sell.

There are two times to sell:

  • when your investment has closely neared, met or exceeded your estimate of fair value
  • when the business you’ve invested in has developed some serious problems that will affect its present value and its future ability to generate cash flows

In the first situation, you must avoid getting greedy. If you had an estimate of intrinsic value when you bought the company (at a discount) and over time your forecast bore out, and if there is no completely new developments in the business which would cause you to drastically re-appraise upward the future value of the business, you sell. That’s it.

Similarly, if you make a forecast for the business’s prospects and you later realize you’ve made a big error in your conceptual understanding of the business and its value, you sell. Short term price volatility is not a “realization of your error”. Realization of your error would be the company generating significantly lower owner earnings than you had anticipated, or worse.

Finally, if you feel full of confusion and can’t sleep easily at night about your investment, tossing and turning trying to figure out what is going on, you sell. It’s not worth the stress and you won’t make good decisions in that state of mind. Just sell it and look for something you can understand a little easier.

And don’t be afraid to take a loss. You will not get every decision right. Luckily, you don’t need to– if you invest with a margin of safety, the reality of an occasional error is built in to the collective prices you pay for all your businesses. Never hesitate to sell simply because you want to avoid a loss. You will screw up now and then. Accept it, sell, and move on to your next opportunity.

F-ing Wall Street All Over The Place

There’s still more to this outstanding introduction to value investing but I don’t have the time or interest to go into all of it right now. In the rest of the book, Ponzio discusses arbitrage, workouts and other special investment scenarios and provides a great “how-to” on getting involved with these investments and taking your game to the next level. He also provides a short primer on bond investing and an exploration of the “different types of investors” ala Ben Graham’s conservative versus enterprising investor archetypes. Rounded out with an investor glossary and a short Q&A and this book is a true gem trading at a significant discount to intrinsic value.

More Warren Buffet than Ben Graham, Joe Ponzio’s F Wall Street is a classic and a great starting place for anyone who wants to jump into value investing head first.