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.

Notes – The Aggressive Conservative Investor

The Aggressive Conservative Investor

by Marty Whitman, published 1979, 2005

A seeming contradiction in terms

The following note outline was rescued from my personal document archive. The outline consists of a summary of Marty Whitman’s classic value investing tome, The Aggressive Conservative Investor.

Chapter 1, An Overview

  1. Two main types of investors
    1. passive, outsider investors
      1. no control over the management of their investments
      2. no knowledge of the investment other than what is publicly disclosed
    2. activist, insider investors
      1. have control over the management of the investments
      2. privvy to non-public information and disclosures
  2. Two major types of businesses which require two different kinds of analysis
    1. strict, going-concern
      1. large, stable institutions which tend to sell the same product and finance the selling of it in similar ways over time
    2. asset-conversion firms
      1. merger/acquisitions
      2. the purchase and sale of assets in bulk
      3. major financial restructurings or recapitalizations
      4. sales of control or contests for control
      5. creation of tax shelter entities
  3. Key emphasis is placed upon financial position
    1. ability to create liquidity (from cash or from liquid assets)
    2. ability to borrow
    3. ability to generate surplus cash from operations
    4. ability to market new equity securities
  4. In contrast, conventional fundamental analysis focuses on primacy of earnings
    1. reported earnings are a fundamental determinant of stock price
    2. this primacy of earnings theory is emphasized only in special circumstances where the company is a strict going concern or when its securities are being studied via day to day share price fluctuations
    3. most securities holders are not stock traders
    4. most businesses are not strict going concerns
    5. financial position reveals itself to be a better long-run determinant of valuation because it more fully represents the character of the underlying business
  5. Concerned with fundamental rather than technical analysis
  6. What is a security?
    1. investment vehicle which allows the holder to benefit from an inactive creditor or owner role
    2. examples: common stocks, preferred stocks, bonds, leasehold interests, limited partnership participations, savings-bank deposits and commercial paper
    3. example of a non-security: fast food franchise agreement which requires the owner to participate as manager as part of the agreement
  7. Understanding the underlying business becomes increasingly important as larger amounts of funds or increasing proportions of the individual’s resources are invested in a security
  8. Additionally, understanding the business is increasingly important with diminishing seniority within the security hierarchy, which exposes the investor to increasing risk
  9. The book takes a broad perspective on the strategies and perspectives of numerous types of investors because understanding the motives of others can highlight specific opportunities and risks for the individual investor himself
  10. Emphasis is on “business internals” rather than market and economic externals
    1. most individuals have little ability to predict the latter
    2. keen awareness of the former can remove a lot of the risk from the equation and protect the investor from mistakes made about the latter
  11. Disagree with modern capital theorists
    1. most markets and common-stock prices are in disequilibrium
    2. careful and thorough perusal of publicly available documents can guard the individual from unsystematic risk
  12. Underlying conviction that the value of a business has no necessary relationship to the price of its stock
  13. The primary determinant of future earnings and common-stock prices is financial position; quality and quantity of a business’s resources
  14. “Magic formula” for investment success is not arithmetic but grows out of:
    1. experience
    2. insight
    3. maturity of judgment
  15. Three general topics covered by the book:
    1. educate outside investors about the way insiders and deal promoters tend to think
    2. help the outsider to gain familiarity with the uses and limitations of required disclosures of the SEC
    3. attempt to impart understanding about the roles of the various players in the financial community and how they each participate in the investment process
  16. Focus on four types of investments to be made in commercial paper, corporate bonds, certain leases, preferred stock, limited partnership interests and common stocks:
    1. trading investments
    2. investments in the securities of emerging companies or industries
    3. workout and special-situation investments
    4. cash-return investments

Chapter 2, The Financial-Integrity Approach to Equity Investment

  1. Successful investors-activists prioritize their concerns as the potential issuer of a loan would:
    1. First, how much can I lose?
    2. Second, how much can I make?
  2. Strong financial positions generally translate to:
    1. less risk
    2. greater ability to expand business
    3. more attractive candidate for asset-conversion activities
  3. Attractive equity investments for outsiders should have the following characteristics:
    1. strong financial position, measured not so much by presence of assets as by the absence of significant encumbrances
    2. run by reasonably honest management and control groups that are aware of the interests of creditors and other security holders
    3. availability of a reasonable amount of relevant information, necessarily falling short of “full disclosure”
    4. price out to be below the investors reasonable estimate of net asset value
  4. Primary motivation for buying is that values are “good enough”, no search for bottoms in the short-run
  5. Shortcomings of the Financial-Integrity Approach
    1. requires an enormous amount of work; sifting through documents
    2. know-who is helpful and at times essential; special information discernible only from non-public relationships
    3. the most attractive securities uncovered by FIA tend to be in inactive markets, especially post-arbitrage
    4. risk aversion results in a severely limited selection of attractive securities which might be fully enjoyed by the less risk-averse
    5. securities issued by those believed to be “predators” should be avoided
    6. FIA approach is mostly useless in areas where sufficient public disclosure can not be obtained
    7. insiders sometimes pose a risk to outsiders and because of their ability to force-out outsiders and independently appraise values, some attractive opportunities will be avoided by the FIA adherent
  6. FIA view of risk
    1. quality of the issuer
    2. price of the security
    3. financial position of the holder

Chapter 3, The Significance of Market Performance

  1. Stock market value should be weighted differently for different individuals
    1. traders; 100% because they are trading for capital appreciation
    2. investors seeking secure income; 0%, because they may want to acquire a larger position over time at lower prices
    3. vast majority of people; somewhere considerably more than 0 and considerably less than 100
  2. Investors who do not weight stock prices as 100% important:
    1. investors who would benefit from low market valuations for estate tax or personal-property tax purposes
    2. investors primarily interested in maximizing cash return and/or are continually creating cash for new investment from non-investment sources
    3. investors seeking to accumulate large positions for control or to influence control shareholders
  3. One can not beat the market by trying to beat the market; instead, long-term performance comes from buying clear values and holding them in the absence of clear evidence that a mistake has been made
    1. evidence for this mistake comes in the results of the business, not the market’s valuation of the business
  4. Market performance is more important to a portfolio of fixed size or facing continued withdrawals of cash; less important to a portfolio which is a continual recipient of new cash and is thus a dollar-averager
    1. for the dollar-averager, good market perf results in less attractive terms for continued investment, bad market perf leads to more attractive terms for continued investment
    2. dollar averaging diminishes the need to beat inflation because changes in the value of money, in the long-run, will be offset by changes in the return on securities
    3. example; a well-run fire and casualty insurance company, which receives continuous cash injections from underwriting department
  5. An outside investor holding a completely marketable security should give a weighting of close to zero to market perfomance when:
    1. he knows has reason to believe that the security’s real worth is not close to the market price
    2. he knows he will not need to liquidate in the near future
    3. he knows he will not need to use the security as collateral for borrowings
  6. Important to remember that stock market prices are not business or corporate values but a realization price that will likely not hold in the event of a merger or acquisition; market price is a value of only part of the total outstanding, not all outstanding stock
  7. Comparative measures of portfolio performance are imprecise; a company can beat its industry benchmark but still have performed poorly in an absolute sense, or vice versa
  8. Professional money managers and beating the market
    1. some economists believe that the goal of professional money mgrs is to beat the market and they have failed if they don’t
    2. many professional mgrs have other concerns than simply beating the market:
      1. maintenance of cash income
      2. maintenance of cash principal
    3. for example, is it important that a strongly capitalized insurance company outperform the market when its net investment income is increasing at 10% annualized?
  9. Investors seeking “bailouts” from their investments might weight market performance low
    1. control of a company can allow for control over cash bailouts through dividend policy, mgmt of salaries and fees
    2. control of a company can allow for non-monetary bailouts via three P’s
      1. power
      2. prestige
      3. perquisites
  10. Three types of security holders who rate market performance highly, seeking “bailout” in the market:
    1. common stock holder with minority interest in which dividend income is insignificant or not part of the objectives
    2. control stockholder and company seeking to sell securities or issue them in merger and acquisition transactions
    3. holder without a strong financial position; someone who intends to borrow or has borrowed heavily to finance his portfolio

Chapter 4, Modern Capital Theory

  1. Description of MCT and efficient portfolios
    1. an individual knows how he reacts to risk and must choose from stocks, bonds and cash
    2. he evaluates each instrument accurately in terms of risk, expected return and relative valuation/price movement
    3. assuming all assumptions are accurate, the individual creates a portfolio that provides the largest expected return for a given level of risk
    4. this best describes the environment faced by the stock trader
    5. this theory fails to account for thin markets, price formation mechanisms, non-symmetric information and general equilibrium considerations
    6. this theory is not suitable for outside investors primarily interested in income, dollar averaging or special-situation investors who ignore timing considerations, as well as all activist investors
    7. MCT also assumes the avg outside investor and his adviser are capable and able to interpret information correctly; empirical evidence points to the opposite
  2. The computer and mathematical analysis
    1. the fatal flaw of mathematical analysis is the non-quantifiable variables or ugly facts that get left out of the models assumptions
  3. On systems for playing the market
    1. Chartist-approach
      1. Not necessarily irrational or illogical
      2. Movements of the market do represent aggregate behavior, however, to date no truly successful chartist model has been created
    2. Random-walk theorists
      1. at any instant, price changes follow no predictable pattern
      2. using only trading information, there is no predictability to prices
    3. filtering rules or formula-timing
      1. best that can be said is their mechanical application can save investors from getting suckered into go-go markets or being rushed out the exits by mass panic
  4. On arbitrage
    1. topic for a professional, requires plenty of calculation and minimization of trading costs (should be a member of an NYSE firm)
    2. Thorpe and Kassouf’s book is recommended
  5. Portfolio balancing
    1. “Beta” is the estimated market sensitivity of a stock, measured in terms of an expected incremental percentage return associated with a one percent change in return of the S&P500
    2. For the avg investor, problems occur far more often with security analysis than portfolio selection
    3. Most important for someone running many millions of dollars; for everyone else, this is over-rated; all the best portfolio-balancing in the world won’t save you from poor analysis
  6. Fundamental security analysis and corporate finance
    1. Good fundamental analysis involves perception, training, understanding and a high degree of abstraction in implicit or explicit model building– picking the right variables and causal relations
    2. There are far fewer skilled practitioners than there are opportunities to practice security analysis
    3. The idea that fundamental analysis is not necessary because markets are efficient is flawed because most analysts are incompetent, which prices ultimately reflect
  7. Calculation or evaluation
    1. The problem facing any serious analyst is what the figures mean, not what they happen to be
    2. For example, imagine a company carrying real estate on its books at $1.5M; the significance changes when we learn that they represent 100,000 acres of California coastal land carried at the 1880 purchase price
    3. Valuations change depending upon the context of valuation; estate planning, income taxes, obtaining a loan, etc. all produce different valuations of the same entity

Chapter 5, Risk and Uncertainty

  1. The outsider faces greater risks than the insider
    1. he cannot acquire complete knowledge of a company, no matter how many documents he studies
    2. he (and the insider) face the possibility that the analysis is wrong
    3. he may fail to properly appraise the quality and honesty of the management
    4. he may simply fall prey to the unpredictability of the future
    5. the market may fail to realize intrinsic value for extended periods of time, even if the analysis of those values is correct
  2. Assessing the investment odds: risk and reward
    1. conventional wisdom states that the key to investment risk is the quality of the issuer
    2. high quality issuers tend to be well-known, and this knowledge is reflected in asset prices
    3. therefore, the cliche, “You have to take chances if you want to make money”
    4. but financial position of the security holder and the price of the issue are also important factors in judging risk and reward
  3. Quality of the issuer
    1. A company can become high quality just because important people within the investment community say it is; they’re often proven wrong
    2. never buy when a high quality company is being touted because it is probably overpriced then
    3. if your investment matters to you, obtain at least a rudimentary knowledge of the company before investing
  4. Price of the issue
    1. Good investors focus on how much they can lose; “risk averse”
    2. higher price translates to higher risk, lower price, lower risk
    3. there can be considerably lower risk investing in a lower quality company at a lower price than at a higher quality company at a higher price
    4. an investor with more time and expertise to spend on his analysis should weigh price considerations more heavily; an investor with less time and less expertise should weigh quality considerations more heavily
  5. Financial position of the holder
    1. an investor who buys the best quality stock at a fraction of its overall value is taking a significant risk if he can’t afford the purchase
    2. investors on margin can turn high quality investments (such as USTs) into speculative gambles
    3. investors often take losses when they do not have enough funds to live on and are forced to liquidate at an inopportune time
    4. without the resources to ignore them, an investor has no guard against stock-price fluctuations
  6. Portfolio diversification versus securities concentration
    1. diversification is a way to reduce risk in situations where the investor lacks knowledge
    2. in situations where the investor enjoys enough knowledge, confidence and financial position to weather temporary setbacks, the risk-reward ratio may be tipped in favor of concentration
  7. Considering the consequences
    1. The astute investor examines consequences as well as odds
    2. The odds can be strongly in favor of appreciation/success, but the consequences of failure so severe (insolvency) that the risk-reward ratio is still not in favor of making an investment
  8. Risk and investment objectives
    1. The cash-return investor will base his investment decision on different factors in evaluating risk than the special-situation investor, even when using the same facts
    2. Risk-reward ratio will provide the investor with a guide to use in defining his investment objectives
    3. Cash-return investors with no opportunity to investigate carefully should focus primarily on quality of the issuer
      1. reference bond rating services
      2. reference the investors own independent conclusions
      3. any doubts, don’t invest; sell if owned
      4. should limit investments to debt securities in most instances
        1. debt securities have a legally enforceable right to be paid principal and interest
        2. higher up in the capital structure in the event of an insolvency
    4. workout- or special-situation investor should focus on price of the issue
      1. he finds safety in a low price
      2. place important emphasis on the four elements of the FIA

Chapter 6, Following the Paper Trail

  1. Principle documents of the paper trail:
    1. Form 10-K; official annual business and financial report
    2. Form 10-Q; quarterly financial report, includes disclosures of certain material and extraordinary events that occurred during the three-month period
    3. Form 8-K; filed within 15 days of a reportable event, unscheduled material events or corporate changes
    4. Annual reports; most important way most public companies communicate with shareholders
    5. Quarterly reports
    6. Annual-meeting proxy statements; used to solicit votes of shareholders
    7. Merger proxy statements; issued to shareholders to vote on an asset conversion-matter such as merger, consolidation, sale of assets or liquidation (S-14)
    8. Prospectuses; registration statements issued when securities are being offered publicly (S1 & S7)
    9. Cash tender offer circulars; sent when a publicly announced offer is made to buy shares for cash
    10. Encumbrances are almost always spelled out in these documents and their footnotes
  2. The documents and how to read them
    1. Simply reading these documents will give you a good idea of whats contained within and what their use is
    2. If you can obtain copies of the preparation documents used to create the SEC officially regulated forms, you can get an idea of what the preparer has to consider in making disclosures
    3. Other important documents
      1. Forms 3 and 4; disclosure by insiders concerning their shareholdings and changes in holdings
      2. Form 144; filed by holders desiring to sell restricted stock under Rule 144
      3. Form 13F; filed by all managers with accounts of marketable equity securities greater than $100,000,000
      4. Schedules 13D; filed within ten days by persons who have acquired 5 percent or more of an outstanding security issue (or, who acquire an additional 2 percent within a 12 month period after already acquiring 5 percent)
      5. Schedules 14D; similar to 13D, filed prior to making a cash tender offer for more than 5% of shares outstanding
    4. What the paper trail doesn’t do
      1. does not provide company forecasts, company budgets and valuation appraisals of assets
      2. no real disclosure as to specifics of running the business, such as appropriate levels of capital expenditure, marketing, research and development, etc.
      3. might miss small acquisitions that do not require a shareholder vote

Chapter 7, Financial Accounting

  1. Types of accounting
    1. cost (or control or managerial)
      1. purpose is to tell a management what its costs are
      2. internal, essential to the operation of the business
    2. income-tax
      1. not supposed to measure economic reality, unlike cost-accounting
      2. designed to create an economic reality (tax bill) based on rigid set of principles (Internal Revenue Code)
      3. emphasis is on minimizing tax exposure
    3. financial
      1. sandwiched between cost accounting and income-tax accounting
      2. “primary purpose is to provide quantitative financial information about a business enterprise useful to owners and creditors”
      3. seeks to “fairly” represent the results of operations and the financial position of the company
  2. How to understand financial accounting, five major misconceptions:
    1. no need to distinguish between financial accounting versus income-tax and cost accounting
    2. financial accounting has much the same role in corporate analysis and in stock market analysis
      1. primary emphasis in corp analysis is on what numbers mean, not what they are
      2. in corp analysis, no rule that one accounting number is more important than any other; in stock market analysis, primary emphasis tends to be put on net income/earnings per share
      3. in corp analysis, profit is thought to come from the business factors themselves; stock market analysis, profit comes from what one thinks someone else will pay for the security later
      4. because stock market analysis doesn’t rely on deep understanding of the underlying business, value is sought elsewhere– in precise attainment of estimated numbers
    3. accounting can be made distortion-free an/or realistic and/or uniform
      1. financial accounting is based on Generally Accepted Accounting Principles
        1. an attempt is made to match revenues with costs on an accrual basis to the exclusion of matching cash inflow with cash outflow
        2. an attempt is made to view businesses on a going-concern basis
        3. financial-accounting is primarily based on exchange prices
        4. financial-accounting is primarily based on historical costs
        5. financial statements are designed to be general-purpose, “serve the common needs of a variety of groups”
      2. as a result, financial-accounting can not be distortion-free, realistic or uniform
      3. financial-accounting is more useful at measuring the economics results and values rather than the solvency of a business
        1. more useful for judging a strict going-concern
        2. less useful for a natural resource company, real estate or life insurance companies or companies engaged in mergers, acquisitions and imaginative financing and refinancing
        3. as an example, most high quality real estate that is well-maintained doesn’t depreciate over time, but it has to for tax and accounting purposes
    4. about the meanings of GAAP
      1. inter-industry distortions arise based upon calling similar circumstances “permanent differences” or “timing differences”
    5. about the shortcomings of the corporate audit function and the ethical standards of independent auditors in the US

Chapter 8, Generally Accepted Accounting Principles

  1. Myths and realities about the meaning of GAAP
    1. Myth #1; GAAP tends to, or ought to, be rigidly codified with a series of well-articulated do’s and don’ts
    2. Myth #2; GAAP is all-encompassing and is, or should be, designed to measure all sorts of corporate events and phenomena
    3. Myth #3; GAAP should tell the Truth, that somehow it can be made more realistic for average investors while still becoming more informative and more useful for all of its users
  2. Eleven underlying assumptions of GAAP which provide insights into its uses and limitations:
    1. ownership of, that is, title to, tangible assets is the basis of value and the means of creating income
      1. ignores the value of intangible assets, such as lack of debt or ability to create new debt, advantageous debt terms, price at which new equity can be raised, etc.
      2. some other intangibles:
        1. long-term, favorable (or unfavorable) contracts with key employees, customers and vendors
        2. trade names and patents
        3. distribution channels, such as dealer organizations
        4. manufacturing know-how
        5. licenses to do business
        6. tax-loss carry-backs (worth cash) and tax-loss carry-forwards
      3. GAAP becomes increasingly less descriptive when intangibles play a larger role in creating value and income
        1. GAAP provides good benchmarks to value the output of a steel mill, for example
        2. GAAP does not provide good bench marks for valuing the worth of a medical degree
    2. corporate asset items have independent values unmodified by their inclusion as but one small part of a going concern
      1. as a practical matter, few assets of a going concern have value that is independent of the going concern
      2. independent values exist only in asset-conversion
      3. passivity and liquidity are highly interrelated; more liquidity means less responsibility in administering the asset
    3. changes in accounting rules should not be disruptive of important existing practices unless there is conflict among establishment members
      1. GAAP is an establishment tool and its basic purpose is to aid, not to fight or alter, an existing economic system
      2. changes should be expected to be evolutionary, not revolutionary or radical
    4. a puritan work ethic is desirable; hence achievement through going-concern operations are far more desirable than achievements through asset conversions– mergers and acquisitions, reorganizations or refinancings
      1. profit should be created from going-concern operations, not capital appreciation through asset arbitrage
    5. the medium is the message
      1. immediate stock market impact is what financial statements are directed to
    6. precise definitions are a desirable goal
      1. as much as possible, items should be defined as expense or income, liability or proprietorship
      2. except for insurance-company accounting, no recognition that many items (deferred income taxes, unexpired subscriptions, low-interest rate mortgage loans, etc.) have elements of both expense and income, or liability and proprietorship
    7. GAAP is designed primarily to protect the cash buyer of securities
      1. great bulk of cash buyers of corporate securities are lending institutions– banks, insurance companies, pension trusts and finance companies
      2. GAAP tends to explain “how bad things are if you give up your cash for this security”
      3. GAAP is less suited to explain how a holder of equity securities will fare when asked to give them up for cash or other securities, such as in an acquisition or merger
    8. security holders tend to be monolithic: all have the same interests
      1. GAAP assumes all stockholders are interested in the price of the stock they own
    9. per-share market prices are per se important and are the single most significant indicator of the value of entire businesses
    10. in classifying assets or liabilities, physical substance and legal substance are deemed to be more important than economic substance
      1. often non-current, fixed assets are highly liquid due to their being subject to asset-conversation activities
      2. similarly, many current assets are locked up as part of the operation of the going-concern and are not liquid or marketable
    11. there is a basic identity of interests between a company and its various stockholder groups
      1. much more realistic to consider the relationships between company and stockholders and stockholders vs. stockholders as combinations of communities of interest and conflicts of interest
  3. Myths about the shortcomings of the corporate audit function and the ethical standards of the US independent auditing profession
    1. most speculative bubbles have been in industries or issues where GAAP is either nonexistent or of little significance in appraising a business or stock

Chapter 9, Tax Shelter (TS), Other People’s Money (OPM), Accounting Fudge Factor (AFF) and Something Off the Top (SOTT)

  1. Tax shelters
    1. people try to avoid maximum rates
    2. people try to avoid being unable to control the timing of a tax liability
    3. people try to avoid transactions that produce a taxable event but not the cash to pay for it
  2. Other People’s Money
    1. OPM is different in different situations
      1. banks, it is depositors’ money
      2. AmEx, it is paid but not cashed traveler’s checks
      3. insurance company, it is premiums paid
    2. OPM can be used to enrich an opportunistic promoter at little to no cash cost to himself
    3. OPM is dangerous for common-stock investors
      1. hard to predict the short- to intermediate-term price activity
      2. danger of loss where there is a lack of positive cash-carry (cash income on investment exceeds cash interest costs of loan)
  3. Something Off The Top
    1. insiders view outsiders SOTT as having a free ride; enjoying the profits of a company without doing the work
    2. insiders themselves enjoy SOTT through special information access, nice offices, special opportunities through business relationships and contacts, opportunities to buy cheap stock and PPM (power, prestige, money)
    3. control can often be a negative in the event of a company being “sick”; in this case, being an outsider is SOTT
    4. a general rule for public investors is to avoid companies whose mgmts have general disdain for outsiders and try to claim SOTT at their expense
  4. Some preliminaries on the Accounting Fudge Factor (AFF)
    1. there is no “right” way to account for things
    2. are you a senior lender, a common stockholder or the president of the company, etc?
    3. are you interested in cash returns, the build-up of intrinsic value, the price of the stock or some combination of the three?

Chapter 10, Securities Analysis and Securities Markets

  1. Companies and securities can only be analyzed in context; what is good or bad in one context becomes bad or good in another
  2. Variables that can not be quantified as good or bad:
    1. profit margins
    2. size
    3. liberal accounting policies
    4. low net asset value
    5. Wall Street sponsorship
    6. the trading assumption versus the investment assumption
    7. convertible securities
    8. limitations of comparative analysis
  3. Reasons for acquiring and holding securities
    1. aggressive mgmts might fully utilize liquidity, thus creating a weak financial position
    2. high book value relative to market price when price-earnings ratios are high results in low return on investment
    3. companies with high profit margins, high stock prices and low book values attract competition
    4. companies that survive and prosper in highly cyclical, unprotected industries tend to be run by able mgmts
  4. Profit margins
    1. low profit margins can be a strong reason for purchasing a security if it is believed the margins will improve; small improvements in low margin situations can result in big, leveraged returns
    2. companies with consistently high profit margins tend to be popular and thus over-priced
    3. it often happens that companies with consistently high profit margins suddenly lose them overnight
  5. Size
    1. small companies should be chosen because of the appreciation potential inherent in their prospects for growing into giant businesses
    2. many small and medium sized companies are well financed and effective competitors, meaning they are high quality issuers even if not recognized as such
    3. large firms are best selected by investors with no ability or time to get to know their investments better
    4. in general, the smaller the business, the riskier, however, there are times when high prices can make large businesses riskier on a relative basis
  6. Liberal accounting policies
    1. a firm can use liberal accounting policies to gain market sponsorship through excitement about its strong earnings profile; this market sponsorship can be used to attract financing at extremely generous rates, improving the firm’s financial position
    2. if a stock goes up far enough and its management is astute, it can use the “Chinese dollar”, or puffed value, to buy economic value elsewhere at a discount
    3. The standard of investment behavior for passivists as well as activists should be, “Worry about the investments you made, that you shouldn’t have,” not, “Worry about the investments you should’ve made, but didn’t”
  7. Advantages of a low net asset value
    1. a company with a lower NAV might have a higher ROI
    2. all assets come with encumbrances; sometimes having a lower NAV relative to a competitor with higher NAV can result in greater ROI because the higher NAV requires more maintenance and other costs to keep it current, even when not actively productive
  8. Wall Street sponsorship
    1. “sponsored security” is an issue that is recommended and/or purchased by people in the financial community who are able to lure or influence others to acquire that security
    2. important for those interested in immediate performance or timing or in owning a highly marketable, actively traded security
    3. buying poorly sponsored or unsponsored equity securities has its advantages for long term investors because this is typically where bargains are found
  9. The trading assumptions versus the investment assumptions
    1. Much advice about how to invest is given from the perspective that the market knows more than the individual investor, and thus should be heeded accordingly
  10. Convertible securities
    1. issuers of convertibles are frequently second-rank companies who include convertibility to “sweeten the deal”
  11. Limitations on comparative analysis
    1. the goal is not completeness, but “good enough”; time and knowledge are at a premium
    2. “good enough” is the standard for measuring market and business performance; no one can be best all the time or own all the resources in the world

Chapter 11, Finance and Business

  1. Heavy Debt Load
    1. high debt can be viewed as a reason to purchase a stock, especially in a bull market, because many equate it to aggressive mgmt
    2. another reason high debt can be an asset is if the debt was acquired at attractive terms and competitor firms are not able to replicate such financing
  2. Large cash positions
    1. can be a sign of unattractiveness when:
      1. entrenched, non-raidable mgmts refuse to make productive use of funds
      2. where mgmt refuses to use funds to undertake necessary expenditures
    2. watch out for companies that appear strong financially but operationally are weak because they have not invested properly in their businesses
  3. Diversification versus concentration
    1. some enterprises excel with a singular focus
    2. others benefit from diversification
    3. the jury is out
  4. Management incentives
    1. management expenses and salaries are paid before all other securities
    2. management looting is generally not a problem in larger firms, but it is widespread enough that no security holder should assume there is a community of interest between mgmt and security holders
  5. Advantages of highly cyclical companies in competitive industries
    1. the adversity and challenge of these industries tend to attract highly talented mgmt
    2. they also tend to be well financed and relatively liquid because they can’t afford not to be
  6. Going public and going private
    1. What a business is worth as a private enterprise is different from what it is worth as a public enterprise
    2. A private company can go public by selling its own equities, or it can sell out for cash to a company that is already public
    3. Many times a public company is worth far more private than public so it will go private by purchasing up shares for cash
      1. a company repurchasing stock is, in effect, going private when it does so
  7. Who runs most companies?
    1. Myth is that they’re run by their directors; day-to-day reality is they are run by their mgmt
  8. Consolidated versus consolidating financial statements
    1. Sometimes, due to cross-ownership of securities held within a senior organization, the common equity of a child company can take a “de facto” status as a senior security within the parent organization
  9. Negative values in owning assets
    1. “everything’s got a price”
    2. “I wouldn’t own that asset if you gave it to me”
    3. Because ownership of most assets entails obligations and expense, the second statement is typically truer than the first

Chapter 12, Net Asset Values

  1. The usefulness of book value in security analysis
    1. book value is an accounting number and it is limited in usefulness as any accounting number is
    2. by itself it means little; gains significance relative to other figures and information
    3. quantitative measure of assets; tells us “how much”
  2. Book value as one measure of resources
    1. the amount of resources a company has to create future earnings is a good indicator of future earnings power; book value measures available resources
    2. corporate buyers tend to focus on book value as an indicator of how they can redeploy newly acquired resources
    3. important in calculating ROI and ROE
  3. Book value as one measure of potential liquidity
    1. opportunities to create tax carry-backs can occur when a common stock is selling at a steep discount from brick-and-mortar book value and the business has been paying high tax rates
    2. useful when a profitable business is available for acquisition at a price well below net asset value as shown on the tax records
    3. IRS can end up providing a substantial amount of the cash needed to finance the acquisition
  4. Book value analysis as a competitive edge
    1. most stock traders focus on short-term earnings, which is reflected in market prices
    2. focusing on large high-quality asset values as an indicator of good future earnings could give an investor an edge as these will not be reflected in high market prices
    3. changes in earnings and P/E ratios can be sudden and violent; changes in book value, however, tend to be gradual
  5. Limitations of book value in security analyses
    1. does not, in and of itself, measure the quality of a company’s assets
      1. high-quality means approaching being down free and clear of encumbrances
      2. high-quality means the business has a mix of assets and liabilities that appear likely to produce high levels of operating earnings and cash flows
      3. high-quality means assets tend to be salable at a price that can be estimated accurately

Chapter 13, Earnings

  1. Wealth or earnings?
    1. Generation of reported income is one way to create wealth
      1. another is creating unrealized appreciation
      2. another is realizing the appreciation that has been created
    2. Reported income generation is the least tax sheltered way to grow wealth; creates incentive for asset-conversion
    3. Private company mgmt tends to minimize reported income to minimize tax burden; public company mgmt tends to maximize to enjoy higher stock price
      1. allows investor to realize gains through selling and borrowing
      2. allows the company to issue stock for cash or to acquire other companies
  2. The long-term earnings record
    1. In fundamental analysis, special attention should be given to the importance of a favorable long-term earnings record
    2. The major component of NAV for most publicly owned businesses is retained earnings
    3. Earnings record is extremely important for a strict going-concern analysis
    4. Judging the quality of an issuer is another situation where a strong long-term earnings record is important to the analysis
  3. “Parsing” the income account
    1. The static-equilibrium approach
      1. looks at current earnings and the earnings record as principal factors in market price determination
      2. market prices within an industry tend toward equilibrium– a stock out of equilibrium could be a reason for buying or selling
      3. important in i-banking world, where new issues are commonly priced at lower than typical multiples as a marketing tool
    2. The dynamic-equilibrium model
      1. uses past and current record of current earnings as a base for estimating future earnings
      2. projected increase is then used for predicting a future stock price
    3. Various definitions of earnings
      1. what accountants using GAAP report them as
      2. what accountants using GAAP report them as, as measured by overall performance, including extraordinary items and discontinued operations
      3. the increase in value of a business (incl stockholder distributions) from one period to the next; ie, changes in NAV
      4. the increase in the ability to make stockholder distributions over and above actual stockholder distributions without reducing actual invested capital
      5. the increase in the ability to make payments to all security holders, not just equity holders, during a period
      6. the increase in ability to improve future sales, accounting profits and/or cash flow during a period
    4. use caution when an expanding business’ earnings are not “real” because they can not finance their own growth without being acquired, ex, Parliament brand cigarettes from small private company Benson and Hedges
    5. may make sense to stress “earning power” (wealth creation) versus “earnings” (reported accounting earnings)

Chapter 14, Roles of Cash Dividends in Securities Analysis and Portfolio Management

  1. The three conventional theories
    1. John Burr Williams
      1. common stock is worth the sum of all the dividends expected to be paid out on it in the future, each discounted to its present worth
      2. criticism: only apply in a tax-free world where the reason for owning stocks is to receive dividends and the reason for all corp activities was to pay dividends
      3. instead, more realistic to say that common stock held by non-control stockholders is worth the sum of all the net after-tax cash expected to be realizable in the future from ownership of the common stock, with such net cash coming in the form of cash disbursements from within the company (dividends, liquidations) or from without (stock purchasers, lenders accepting stock on margin)
    2. Modigliani and Miller
      1. as long as mgmt is thought to be working in the best interests of the shareholder, retained earnings should be regarded as equivalent to a fully subscribed, preemptive issue of common stock, and therefore that dividend pay-out is not material in the valuations of a common stock
      2. criticism: no evidence that mgmts share a “community of interest” with stockholders
      3. mgmt, if they are responsive to stockholders, tend to focus on the interests of holders that will bring the best benefits to mgmt
    3. Graham and Dodd
      1. in the vast majority of companies, higher common-stock prices will prevail when earnings are paid out in dividends rather than retained in a business
      2. criticism: emphasis should be on which stock — low dividend payer or high dividend payer — is more attractive to which type of investor
  2. Cash dividends as a factor in market performance
    1. ceteris paribus, a low dividend payer is better for an investor seeking market appreciation rather than cash-carry
    2. lower dividend companies tend to sell at lower prices, thus they tend to be more attractive buys
    3. a company whose common stock is available at a lower price will have more room to increase its dividend; dividend increase record is important for some in valuing stocks
    4. lower dividends translates to higher retained earnings and thus improved financial position over time
    5. countervailing argument: high-dividend payers tend to be better buys because a high payout ratio means mgmt is more attuned to the desires of most outside stockholders
    6. stockholders can be hurt by companies paying out high dividends long after it is wise for them to do so
    7. Graham and Dodd view is valid in the short-run but seems to make less sense in the long-run
  3. The placebo effect of cash dividends
    1. dividends increase in importance for securities holders insofar as they lack confidence in their outlook or mgmt or in the reliability of disclosures
    2. dividends are a hedge against being wrong
  4. Cash dividends and portfolio management
    1. Dividends increase in importance with the shareholder’s need for immediate cash income from his portfolio
    2. dividends become a negative factor when the shareholder wants a tax shelter or has no need for income and has confidence mgmt will successfully reinvest retained earnings
    3. securities with a high cash return can be attractive due to positive cash-carry
  5. Cash dividends and legal lists
    1. cash dividend income is a legal or quasi-legal necessity for many securities holders
  6. Cash dividends and bailouts
    1. the ability to convert assets to cash is a key consideration for many buyers for control purposes; always key for outside investors
    2. assuming an investor has no control over a company whose common stock he has invested in, eventually he will want the opportunity to convert into cash
  7. The goals of security holders
    1. most owners of senior securities are interested solely in cash income
    2. in contrast, some equity holders can be interested in cash return (dividends or cash sale of shares) but many are interested in earnings return

Chapter 15, Shareholder Distributions, Primarily from the Company Point of View

  1. Cash dividends or retained earnings
    1. “proper” dividend payout policy should be made from the point of view of the corporation, not the stockholder
    2. dividend payouts are a residual use of corporate cash and company requirements for cash in other areas have primacy
    3. dividend policy should be dictated by company needs for funds for expansion as well as for margin of safety
    4. companies should retain earnings whenever they have profitable ways to deploy it– this is not determined by the price of their stock as proclaimed by the stock market
    5. high dividends can be used by mgmt to create a higher stock price and thus protect the mgmt from raids
  2. Distributions of assets other than cash
    1. can create a taxable event with no cash to pay it
  3. Liquidation
    1. any payment by a corporation to its shareholders is a form of liquidation
    2. in truth, there is no such thing as liquidation in any meaningful sense, but rather asset-conversion
  4. Stock repurchases
    1. receipts of cash are taxed on a capital-gains rate only
    2. benefits:
      1. corporation benefits because cash requirements on future dividends are reduced
      2. EPS, BVS and corp reality value per share may be enhanced
      3. can promote strong stock market price, thus increasing the companies future financial position and financing opportunities
    3. disadvantages:
      1. if buy-ins are of massive size, investors may be forced out of the company at a price much lower than corp reality, even if at a substantial premium to market prices
      2. possible conflicts with insiders who might want to purchase shares, appearance of payoffs to insiders who want to sell

Chapter 16, Losses and Loss Companies

  1. Quality considerations and tax-loss companies
    1. an organization suffering economic losses can be attractive from the POV of asset-conversion acquisitions if:
      1. the resources employed by the company can be put to another use so losses are stemmed
      2. the business lacks overwhelming amounts of indebtedness
      3. it has available to it tax benefits growing out of the former losses
  2. On accounting and income
    1. tax benefits, for accounting purposes, are treated as extraordinary items
    2. however, these benefits have very real cash consequences and can generate substantial future earnings when reinvested, regardless of how they are accounted for
  3. Be wary of acquiring equity securities of the encumbered firm
    1. the danger in investing in loss corporations is that they have become so encumbered that there is no practical way to invest safely and profitably
    2. “big-bath” write-downs should be viewed as nonrecurring from the standpoint of judging the stewardship of the mgmt
  4. Commercial banks’ portfolio losses
    1. principal earnings assets of banks are investments in loans to customers and investments in securities, notably UST and munis
    2. when interest rates rise, the banks’ loan book falls in value, so they purposefully take losses to reinvest in higher yielding securities
  5. The “turned the corner” theory
    1. many times people will invest in small, losing companies with no record of profitability with the belief that when they “turn the corner” the market will substantially appreciate their new growth records
    2. risky
      1. hard to predict the future of uncertain businesses
      2. new issues normally not priced on bargain bases relative to corporate reality
    3. these securities rarely prove attractive from the FIA

Chapter 17, A Short Primer on Asset-Conversion Investing: Prearbitrage and Postarbitrage

  1. prices paid for common stocks for investment purposes are different from prices paid for control of businesses
  2. Four types of “do-able” asset-conversion activities that might be spotted with the FIA
    1. more aggressive employment of existing assets
    2. merger and acquisition activities
    3. corporate contests for control
      1. incorporated and domiciled in states where there are no strong anti-takeover statutes
      2. share ownership is widespread or blocks are locked up in private transactions
      3. possible low will of mgmt to resist a takeover
      4. absence of impediments to takeover, such as being in a regulated industry
      5. no antitrust problems
      6. there do not appear to be important people or institutions, such as customers, employees or suppliers, who could harm the takeover target by terminating relationships
    4. going private
  3. Postarbitrage
    1. occur after an asset-conversion event when securities owned by public shareholders remain outstanding
    2. sometimes when an offer to acquire securities is announced and less than all the shares tendered are accepted, arbitragers tend to dispose of masses of stock they have accumulated shortly afterward, depressing market prices
    3. important to avoid mgmts that have a predatory predilection
    4. post-arbitrage securities tend to be relatively unmarketable or not marketable at all
    5. one important rule of thumb: acquire shares at prices two thirds or less than control shareholders paid in the recent past to obtain control

 

Notes – Sanborn Maps, Dempster Mills, Nintendo’s Rise

Warren Buffett & Sanborn Map: An Early Balance Sheet Play

  • Buffett first got involved with Sanborn Map in 1958 because it represented a relative undervaluation compared to his then current holding in “Commonwealth”, even though he still thought “Commonwealth” was undervalued
  • Beginning in 1958, it represented 25% of the partnerships assets and BLP was the largest shareholder which “has substantial advantages many times in determining the length of time required to correct the undervaluation”
  • By 1959, represented 35% of partnership assets
  • Buffett recognized that the business operated in a “more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort”
  • Sanborn faced a changing business environment which beginning in the 1950s which “amounted to an almost complete elimination of what had been sizable, stable earning power” (after-tax profits: 1930s, $500,000; late 1950s, <$100,000)
  • Buffett estimated the reproduction value of Sanborn’s map assets at tens of millions of dollars
  • In addition, Sanborn Map carried a valuable portfolio of marketable securities which it began accumulating in the 1930s
  • Buffett: “Our bread and butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action”
  • The margin of safety was based on the fact that the investment portfolio was worth far more than the company was selling for in the market
  • Additionally, Buffett took a control position which gave him an added margin of safety
  • Buffett made roughly a 50% profit, according to Roger Lowenstein

Warren Buffett & Dempster Mills: Control Investing And Asset Conversion In A Net-Net

  • In 1962, BLP owned 70% of Dempster Mills’ shares (with another 10% controlled by associates), representing approximately 21% of partnership assets
  • Buffett: “Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from [general market overvaluation during a strong bull market]”
  • Buffett: “When control is obtained, obviously what then becomes all-important is the value of assets”
  • Buffett chose to value the partnerships shares based on a discounted estimate of what the assets would gather in a prompt sale (discounted liquidation value)
  • Buffett originally hoped he could turn around the company with existing management; when this failed, he brought in Harry Bottle on the advice of Charlie Munger
  • Bottle, at Buffett’s behest, proceeded to liquidate the balance sheet, converting assets from the manufacturing business (a poor business) into marketable securities, which BLP saw as a good business
  • Buffett: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake”
  • Buffett’s first purchases of DMM began in 1956 when it was a net-net trading at $18 with $72 in book value and $50 in NCAV per share; the company had had profitable operations in the past but was a break even at the time of purchase
  • Buffett: “Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years… [due to] an improved industry situation, a takeover offer, a change in investor psychology, etc.”
  • Harry Bottle’s effect:
    • Reduced inventory by 75%, reducing carrying costs and risk of obsolescence
    • Correspondingly freed up capital for investments in marketable securities
    • Cut SG&A by 50%
    • Cut factory overhead expenses by 25%
    • Closed 5 unprofitable branches leaving the company with 3 profitable branches
    • Eliminated production lines tying up capital but producing no profits
    • Adjusted prices of repair parts to yield additional annual profits
  • Buffett: “It is to our advantage to have securities do nothing price wise for months, or perhaps years, while we are buying them. This points up the need to measure our results over an adequate period of time. We suggest three years as a minimum.”
  • Other notes:
    • In 1961, Buffett committed $1M to DMM (his biggest investment yet), buying the controlling interest and staking 20% of BLP’s assets in the process
    • Sold the company as a going concern in 1963 for a $2.3M profit, nearly tripling his investment
    • Bottle’s employment agreement was based on a percentage of profits

Harvard Business School: Nintendo’s Competitive Advantage In The Early Home Video Game World

  • Prior to Nintendo’s dominance, the home video game market was led by Atari and suffered a number of boom-bust cycles where as much money was lost on the way down as was made on the way up
  • The cost of video game consoles has been falling in real terms since the 1980s:
    • 1977, Atari VCS $200, game cartridges $25-30 retail, $5-10 cost to mfger
    • 1983, Commodore, Casio and Sharp game systems sold for around $200-350
    • 1983, Nintendo launches Famicom system at $100 retail price (believed to be at or below cost), and had extracted a rock-bottom chip price of $8/chip by placing an order for 3M units
  • Home video game systems were a growing market:
    • 1982, 17% of US households had a video game system
    • 1990, Nintendo Famicom/NES console was in 1 out of every 3 households in the US and Japan and home video games represented a $5B worldwide industry
  • Nintendo’s development costs were up to $500,000 per title (Y100M) and marketing expenses were several hundred million yen
  • Nintendo’s approach was to focus R&D on developing one or two hit titles per year rather than several minor successes
  • Manufacturing of cartridges was subcontracted at a unit cost of $6-8, which then retailed for $40
  • Part of Nintendo’s value was in hit franchises such as Super Mario Brothers (1985), the Legend of Zelda (1987) and Metroid (1987), the first two of which were developed by hit designer Shigeru Miyamoto
  • Demand for games soon outstripped supply, so Nintendo allowed six firms to be licensed software makers, paying royalties of 20% of the $30 wholesale price per game:
    • Namco
    • Hudson (later acquired by Nintendo and brought in-house)
    • Taito
    • Konami
    • Capcom
    • Bandai
  • By 1988, 50 licensees, who were also charged the 20% royalty rate and had to absorb Nintendo’s manufacturing costs
  • Cumulative sales of Famicoms from 1983-1990 = 17M, Nintendo had gained 95% market share of 8-bit home video game market
  • On average, Japanese consumers bought 12 games for every Famicom system purchased
  • Nintendo, via Nintendo of America subsidiary, rolled out NES (Famicom) in the US in 1985 at $100/system
  • NOA limited licensees to producing 5 NES titles per year; had to place orders for manufacture through NOA at a cost of $14/game cartridge which wholesaled for $30 and were then marked up an additional $15 at retail
  • By 1991, 100 licensees with only 10% of software development in-house at Nintendo
  • Nintendo began licensing Mario and other characters to TV shows, cereal packets, T-shirts, records and tapes, books, board games, toys and other media
  • NOA’s highly targeted ad budget was about 2% of sales and promotional partners were utilized extensively
  • WMT did not stock competing video game systems
  • In 1989, NOA proposed creating a proprietary online network for its game consoles, allowing users to play games, trade stocks, do e-banking and other activities that would later become common place throughout the late 90s but which Nintendo itself failed to capitalize on with its own later systems repeatedly!
  • 1989, Nintendo releases Game Boy handheld game console in Japan, retail price $100, games $20-25, designed to broaden the appeal of their systems (another strategy Nintendo would later utilize with the Wii)
  • By 1992, 32M Game Boys shipped worldwide and consumers bought on average 3 games per year
  • In 1991, Nintendo signed a consent decree with the FTC ending many of their dominant licensing, manufacturing and wholesaling/retailing practices, completely changing the economics of Nintendo’s business