John Chew of “csinvesting” Responds

John Chew, publisher of “csinvesting“, which it only took me about two weeks to realize stood for “Case Study Investing”, was kind enough to respond to a personal e-mail I sent him by publishing his reply on his blog.

The post itself is a great reference, like everything on John’s blog, and I wanted to link to it here to make sure I always can find the link again for future review. A few of my favorite sentiments are below:

You never “master” investing which is why the journey is fascinating.

Rational humility, the moment you think you know it all, you learn about a shortcoming you never knew you had.

Investing really is constant applied learning which is cumulative.

“Compounding” returns to one’s investment of time and energy in learning the trade!

Foxes are eclectic, viewing the world through a variety of perspectives, with no allegiance to any single approach.

Don’t box yourself in with silly mandates or addiction/devotion to one strategy or style. Markets are dynamic and the best strategy is not the same at all times and in all places. The natural laws of reality dictate that basic truths and financial mechanics will always be active and provide general boundaries within which a rational, conservative investor must operate (such as margin of safety and the principle of buying value at a discount), but even Ben Graham in The Intelligent Investor clearly demonstrated that different markets provide different opportunities: sometimes it is the opportunity to buy outstanding businesses at a discount, sometimes it is the opportunity to buy certain businesses for less than their liquidation values, sometimes it is the opportunity to take advantage of special situation arbitrage, etc.

Few great investors are overnight successes. Many have to overcome failure.

It’s unreasonable to expect perfection because we are not omniscient. We will misstep and occasionally even fall. The art is in finding ways to take tumbles that do not break your leg, back or skull, and learning to pick yourself up again.

Money is about freedom, not consumption.

Money is the ultimate form of potential opportunity. It helps us with, “What can I do?” and not, “How much can I have?” Life is dynamic and it is lived best through abundant action, not abundant accumulation (static).

[Great investors] enjoy the process, not the proceeds.

We have a relative great deal of control over the process we employ, but relatively less control over the proceeds that result from that process. We are not omnipotent– life is volatile. There will be disappointments. Self-esteem and self-satisfaction are built on acting the best way we know how, not achieving the best we know of at any given moment. In life, a journey is guaranteed, a destination is not. Best to learn to savor the ride as it’s all you’ve ever got until it’s over.

Ever wonder why a steel company fluctuates more in earnings and price than a beverage company? The distance from the consumers in terms of time and production structure. Look at your watch. How long did it take to make? Two hours? Well, who mined the sand to make the glass? Who mined the metal to make the case? Who killed the cow to make the leather wrist-band? And who planned all the production? Perhaps your watch took two years from the moment of assembly to the first production of the materials.

A great application of Austrian economics to investment analysis!

Good reminders, all.

Whitney Tilson’s Terrible, Horrible, No Good, Very Bad Investment

Whitney Tilson, famed value investor and manager of T2 Partners, has had a tumultuous and sordid affair with NFLX, a company he first failed to romance as a spectacular ever-rising short and which he now may very well fail to romance as a spectacular ever-cheapening long (Bloomberg):

Tilson had bet against Netflix from at least December, when he first wrote about shorting the stock, until February, when he disclosed to investors in a letter that he covered the short and was no longer confident that his investment thesis was correct. Tilson said he decided to buy shares today because he deemed them “cheap.”

“It’s been frustrating to see our original investment thesis validated, yet not profit from it,” Tilson, 44, said in a statement e-mailed from his New York hedge fund. “The core of our short thesis was always Netflix’s high valuation. In light of the stock’s collapse, we now think it’s cheap and today established a small long position. We hope it gets cheaper so we can add to it.”

Netflix plunged 35 percent to close at $77.37 in New York trading, its biggest drop since Oct. 15, 2004. The shares have declined 56 percent this year.

This is every investor’s worst nightmare and I am not calling attention to this to slander or heap ridicule on Tilson. Far from it– I don’t know if I’d have the cajones to go long a stock (at nearly 18x earnings) that I was previously trying earnestly to short.

That being said, let’s review this performance. If he started shorting in December he probably did it around $165-170/share. If he covered in February it was probably anywhere from $205-220/share. Let’s say $165/share short and $210/share cover. That’s a 27% loss.

The good news is the stock went as high as approximately $298/share, so he dodged that bullet. But then it plunged dramatically since then and is now trading at about $77/share. Assuming Tilson had just held his short (and kept making margins calls, or better yet, kept adding to it), he would’ve ultimately made a 53% gain!

What’s interesting about this? One, it would’ve taken Tilson nearly a year to be vindicated in his thesis. Value investors typically think of themselves as “long-haul” capital allocators. But in the world of shorting, time scales are compressed and a period like a year is more like a decade. A lot more seems to change. The moral of the story, perhaps, is to focus on shorts where you have identified an immediate, short-term catalyst that will cause the market to abandon its effort to push the stock higher. Simply recognizing a stock is overvalued doesn’t appear to be robust enough.

Two, investor psychology appears to be completely different between shorts and longs and with good reason. With a long, many value investors (like Tilson) invite the position to go against them, at least temporarily, rationalizing that this just makes it cheaper and easier for them to make money when their investment plays out. But with a short, where your potential loss is infinite, no investor ever has nor I assume ever will invite the position to go against them. Nobody ever says, “I hope the stock rises substantially from here because it just means another opportunity to short it more and make more money when it finally crashes.” Instead, many end up throwing in the towel, often at the worst possible moment.

Three, this episode demonstrates the need for humility. It’s possible Tilson will eventually make a good bet with his decision to go long NFLX. But if he doesn’t, he’s going to look doubly foolish, rather than singly. And, because he’s had a poor experience with this company once before, he risks making rash, emotional decisions about it in the future out of a subconscious effort to conquer his fear or slay the wild beast that marred him in battle once before.

If I was a big T2 investor, I’d be wanting to know what kind of safeguards Tilson and his team have put into place to prevent emotional bias from getting in the way of their analysis of NFLX going forward. And frankly, I’d have a hard time fighting my urge to tell Tilson to just leave the damn thing alone and reminding myself that I invest with him because I trust his judgment and if I were the expert I wouldn’t be paying him to manage part of my wealth.

The good news is Tilson is an experienced, grizzled value investor with an outstanding track record so even if he ends up totally boffing this one again it’ll likely be far from his undoing. For every potentially poor decision like this Tilson has demonstrated he can make many more superior ones and he doesn’t make the kind of levered, concentrated bets that could lead to a one-position wipeout that some of the less savvy figures like John Paulson have suffered in recent months.

Say what you will about value investors but one thing is for sure, they’re generally more prudent than the average bear, and I mean that metaphorically, not descriptively. Then again, this whole episode makes me wonder how Tilson defined his risk, then and now.

Value Idea: Japanese Net-Nets

Japan seems awfully cheap these days:

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

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

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

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

The challenges to investing in Japan are:

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

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

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

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

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

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

  1. Fraud
  2. Solvency
  3. Ownership dilution

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

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.

Will A Future You Be Glad You Bought Some Stocks?

The anonymous author of Hedge Fund News has put out a rather pessimistic, hopeless sounding post in which he asks, “Why invest in stocks?

  1. The game is largely about front running the Federal Reserve or the ECB or the Bank of Japan. It seems that the way to make money is to buy before central bankers announce quantitative easing or some other scheme to juice asset prices.  However, since I don’t have high level contacts at any of these institutions, I will always be the last one to invest based on the liquidity injections.  Of course, there are people who do have contacts at the FED and thus they can essentially front run monetary policy. The question I ask myself is “if I can’t compete with the big boys, does it make any sense to play?” In any other sport, the answer would be a resounding no in order to avoid injury. I don’t think my investing in the stock market is any less dangerous then taking the field with the New England Patriots for training camp. I can get hurt…real bad.
  2. You also can’t compete with big hedge funds. A major hedge fund might have 100 analysts, key contacts at major brokerages. Paying massive trading commissions has it’s benefits and that benefit is information. The stock market is a game of information and most likely the big hedge fund has vastly superior information to you.
  3. I like founder owned and operated businesses.  I generally find “professional management” is too constipated and far too divorced from the risk taking visionary that usually founded the company.  Talk to a corporate middle manager and then talk to hungry entrepreneur working on his baby. You will quickly feel who you would rather back with your precious capital. By the time most companies reach the public markets, the ownership of the company lies in the hands of facelesss financial institutions that are totally divorced from the passion that built the business.
  4. The markets are run by machines. Insanely powerful computers constitute the majority of trading. Again, the hedge funds have a massive technological edge on the rest of us.
  5. the Warren Buffet stock analysis that favors buy and hold investing has not worked in the last decade that has been driven by Central banks and macroeconomics. Stock picking has been killed by the four reasons above.

I mention this post because I’ve shared the sentiment myself at times, and especially recently.

Stocks are not just forward-looking instruments, they are forward bets. If you buy stocks, you are making the assumption that, at least for the companies’ whose stocks you buy, things will be better in the future and therefore the prices will be higher. In that sense, Warren Buffett’s “bullish on America” rhetoric matches his investment action. He truly believes America as an idea, as a system, as an investment platform, can not fail because it has not failed, so he wants to buy stocks every time most other people are selling him because he believes his long-term prospects for capital appreciation are good.

And so far, that has worked– wonderfully!

But people like Buffett seem to be ignorant of certain economic truths and inevitabilities, especially with regards to the current problems facing investors, and so some of his optimism comes across as willful naivety.

This isn’t an anti-Warren post, however, so back to the point– what if the future is bleak? What if America is Japan? Some have made comparisons (Mish) and some of those comparisons are compelling. What if America isn’t Japan, but something worse and far more complex altogether?

What if we’re looking at an ongoing or a return to severe recession? What if this is followed by more inflationary antics which, by driving up commodity prices, serve to kill margins in many businesses and beat down earnings, even as general price increases rage on? What if stocks don’t even go up in nominal terms for awhile and then, by the time they do, they’ve lost so much in real terms that there’s no point in investing in them?

What if, what if, what if? A lot could go wrong. And knowing this, a value investor seeks a margin of safety in his investments. If he’s concerned about a depression, he tries to calculate what that might look like and price it in, raise his hurdle rate that much higher. Then, if it’s a good business and he can get it at a significant discount to his calculated value even when considering a rather hopeless scenario as a possible outcome, he buys. If it goes down, he buys some more.

If that worst case scenario plays out, and the world looks like it’s ending, if he’s got any more money left he throws it in the pot and then he goes off to war, or he goes fishing, or whatever and he doesn’t think about it anymore.

Right?

Why invest in stocks? Because tomorrow is always another day. Stocks are for the future and there’s always a future, so if you can buy them cheaply, you buy them and you stop worrying about everything else.

The only trouble, the thing that keeps me worrying, is what if the future is going to happen someplace else, not America? A lot of places that were once the future are now the past. It could happen. Invest accordingly.

Review – The Conscious Investor

by John Price, published 2011

This book was not what I expected to be and it certainly was not what I had hoped it would be. The reviews I had read of the book left me waiting in eager anticipation of its arrival in the mail because it sounded like it would do two things I had been looking to do: deliver crushing criticisms of various technical and non-value based approaches to investing; and provide a concise “how-to” as far as preparing an intrinsic value-based financial analysis of business or investment idea.

With regards to the former, Price delivers, but not courageously. His breakdown of various analytical approaches, while thorough, ultimately is not very helpful. Each analytical methodology is described and then followed by a list of strengths and weaknesses, but no decisive conclusion is reached. Surely there’s nothing wrong with leaving it to the reader to make up his own mind, but there’s no objective scale provided or suggested for weighing the strengths and weaknesses of each– it’s hard to tell just from reading whether any particular strength outweighs a weakness, or vice versa. I would’ve liked it if Price had added his two cents about each rather than trying to be dry and officiously neutral.

As for a concise how-to on value investing, this was one of those books where you keep turning the page hoping the author is going to get to the point and suddenly you turn the last page and you’re confronted with the back flap of the book and all you can do is shout out in frustration, “That’s it?!”

The title of the book seems contrived in relation to its content. “The Conscious Investor”, as opposed to an unconscious one? I assume Price is suggesting a level of awareness, but there is an important qualitative difference about being aware of many different concepts and actually understanding their meaning and significance. I didn’t find the book to have much strength in that sense.

At one point, Price suggests that part of being a “conscious investor” means thinking about what it is, exactly, that you’re investing in, and what would be the implications of that investment succeeding. For example, say you invest in a company that manufactures ugly clothing. If the company is successful and your investment pays off, you’ll now be living in a world of ugly clothing everywhere you look. Is that the kind of world you want to live in?

It’s an interesting idea but a perhaps more important one is, “If the company is clearly undervalued, and I don’t invest in it for ethical reasons… does that mean no one else will recognize the undervaluation and invest, thereby preventing that world of [ugly clothing] from becoming a reality?” Whatever the answer to this question, this is clearly an aspect of being a “conscientious investor”, not a conscious one, so again I am left a bit perplexed by this book.

My disappointment and griping aside, there was some value in this book and I did highlight and underline a few things I had wanted to record here for future reference. But even at Amazon’s reasonable new book prices, knowing what I know now I see this book as overvalued, meaning I clearly overpaid and thereby suffered a permanent capital loss. But maybe that was what Price was trying to teach me the whole time, as a value investor.

Lesson learned!

Some notes and takeaways:

When reading financial statements and company filings, remember to “follow the money“, and ask (and try to answer) the following questions:

  1. How much money came in over the reporting period and where did it come from?
  2. What was it used for?
  3. How much money did the company manage to keep?
If time is limited, reading the Management’s Discussion & Analysis (MD&A) section of company filings is critical, and the aim is “to answer the question whether the management is honest, rational and acting in the best interests of shareholders.”

Further, in the Proxy Statement (Form Def 14A), you should attempt to determine

whether the presentation on compensation in the Proxy Statement is clear and easy to understand. The overall level of compensation to management and directors relative to the size and performance of the business is important.

When studying earnings growth, as a common stock investor it is important to look at growth in EPS, not net income, because the company may be issuing large number of shares and diluting current shareholders even if it is successfully growing net income.

The quality of earnings is in doubt when net income substantially exceeds cash flow from operations. Ideally, positive cash flow conditions would yield:

  1. Cash provided by operations which are positive and trending upward
  2. Cash flows from operations are more than sufficient to cover cash used for investing (CFO > CAPEX)
Share buybacks must be done intelligently if they are to create value.
If you own shares in a company, but don’t think that it represents value to buy more, then welcoming actions of the company to buy back its own shares is not logical.

Mismatches between net and comprehensive income are also a warning sign.

If in most years the comprehensive income is consistently below the net income… the company has been accumulating losses in comprehensive income aside from the regular income, which may indicate that the economic situation is worse than it would appear from an analysis of the income statement.

A higher current ratio is not always better– sometimes a high current ratio means that inventory is piling up, or the company is extending larger amounts of credit to its customers than it ought to be through growing A/R. A low or downward trending current ratio is almost always a cause for concern, however.

With retail companies, it is important to examine growth of same-store sales to determine whether the company is growing simply through the opening of new stores versus expanding its business within existing stores. Also, high asset turnover is critical in a retail business, which normally has low margins, in order to leverage its returns.

Be vigilant with companies whose primary assets are intangibles, which, if developed internally, may not be represented on the balance sheet. “The smaller the role of intangible assets, the closer to book value a company’s market price is likely to be.”

And a Warren Buffett quote:

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.

Further, according to Price,

Over time, whatever returns a company makes on its equity and capital will be approximately an upper limit on the return made by investing in the company’s stock.

Putting some of this together yields a few “rules” with regards to the P/E ratio:

  1. Know the history of the P/E ratio
  2. Do not buy unless the P/E ratio is toward the lower end of its historical range
  3. Compare the P/E ratio with the P/E ratios of competitors
  4. Compare the P/E ratio with the average P/E ratio for the same sector or overall market
  5. Be wary about buying when the P/E ratio is high
  6. Look at the earnings yield, which suggests a minimum return that can be anticipated if earnings remain steady, with anything more caused by growth in earnings

“Find companies with high and consistent return on equity and not too much debt. Try to determine what is special about them– what economic moats do they have?”

Investing: How To Do It (That’s What She Said)

I’m reading two posts on how to put theory into practice from two different value investors. Here are Geoff Gannon’s thoughts on how to turn yourself from an armchair value investor into an actual value investor:

  • Have skin in the game; buy individual stocks you pick yourself, rather than mutual or index funds, so you have no one to blame (or cheer) but yourself for your results
  • Keep an investment diary; take ten minutes every day the markets are open and write what you are thinking, feeling, looking at, for future reference
  • Keep an investment bucket list; imagine you had to put your entire net worth into 5 stocks, regardless of price, and couldn’t sell. Try seeing how your thinking is distilled when you look at companies this way, and kick poor ideas off in favor of better ideas over time
  • Practice; work an absurd amount, be an expert. Read a 10-K every day. Find an area you feel especially comfortable in and focus on it
  • Invest with style; your circle of competence, don’t be afraid to find it and stick to it
  • Conclusion: stop reading, start working, grow your own style

As for Andrew Schneck, he recommends the same thing: do the work. You have to get your hands dirty, read some SEC filings and get used to looking at a lot of numbers from a lot of different companies.

He also recommends looking at Value Line as a tool for examining lots of companies, quickly. The more different companies you see, the more you’ll begin to recognize patterns and differences, which will ultimately help you to recognize value from lack of value.

Personal Dilemmas Of The Immoral Economy

The WSJ.com has just posted an article, “Buy, Sell, Fret: Retail Traders Swing Into Action“, that is ripe for commentary from the twin perspectives of value investing and Austrian economics. With any luck, we may even venture into the philosophic territory by the end of this episode. Let’s get started:

In a throwback to the day-trading era, the market’s stomach-churning gyrations are creating a new class of stock obsessives hanging on every dip and rebound.

Average investors are scrambling to stay ahead of the massive swings—often via mobile devices like iPads and smart-phones, leading to sharp spikes in trading volumes at many brokerages.

“I am distracted and frankly unnerved,” says Andy Lavin, a public-relations executive in Port Washington, N.Y., who manages about $800,000 of his own money.

Mr. Lavin says he has been checking his iPad regularly during meetings and on his way to work. On Monday, he bought $15,000 in futures on the Chicago Board Options Exchange Volatility Index. After President Barack Obama addressed the decision by Standard & Poor’s to downgrade long-term U.S. debt, Mr. Lavin dashed to monitor the market reaction.

“If you look away for a second, you lose,” Mr. Lavin says.

One of the themes I’d like to explore here is perception versus reality. For example, Mr. Lavin’s perception is that it is his inability to keep up with the markets, tick by tick, that expose him to potential ruination. The reality is that it is his decision to split his attention and capabilities between his professional job and daytrading which exposes him to ruination.

As a value investor, daytrading is obviously an intellectually bankrupt strategy detached from an understanding of fundamental reality because the economic value of companies do not change as often, rapidly or dramatically as their security prices might. So, anyone who becomes obsessive about the frequent changing of security prices without any regard to the underlying economic value of the company the securities belong to is engaging in a speculative gamble, not trying to keep up with an investment portfolio. Daytrading while at work is as absurd as playing online poker at work, or visiting a virtual blackjack table on your iPad while sitting in a meeting. The illusion (delusion?) of control is precisely the same, as is the inappropriateness of the simultaneity.

As an Austrian economist, this appears to be an outstanding example of some of the many unintended consequences of Federal Reserve monetary policies as well as federal government interventionist policies.

In terms of monetary policy, Ben Bernanke’s reckless inflationary mandate creates new malinvestment in the economy by distorting entrepreneurs’ and other economic actors’ view of the true supply of savings in the economy. Interest rates are driven down below their free market equilibrium levels providing the illusion of wealth that doesn’t actually exist. Entrepreneurs (and daytraders are entrepreneurs, though they’re a variety more ephemeral than a butterfly) usually end up in grossly speculative activities because with the new supply of money in their hands and the lowered cost of borrowing at their backs it pays to do so, or so they think.

Similarly we can see the broad effects of an interventionist, regulatory political framework. Such a superstructure creates so many obstacles and added costs for “normal” economic activity that the productively-eager are pushed into enterprises with the lowest cost of entry and the least number of hoops to jump through before one can nominally start making money. Does it get any easier than opening up an electronic brokerage account and ACHing a large deposit?

At the nexus of these two philosophies, economics and investing, we see another tragedy unfolding– where is the comparative advantage (economist) or the analytical edge (investor) in a public relations professional-turned-daytrader? Why has this man, who appears to be quite successful at his chosen career given the size of his gambling stake — I mean, accumulated personal savings — which amounts to $800,000, investing this money on his own in the financial markets?

Why isn’t he putting that $800,000 of capital to work in his own business, where he seems to be demonstrating an ability to earn outsize returns on capital? Assuming this individual is reasonable and not merely gambling, what might this say about the condition of the economy as a whole that he has not chosen this seemingly obvious alternative?

Continuing:

The high-stakes drama is also making once-calm investors jittery. Richard Chaifetz, chief executive of Chicago-based ComPsych Corp., which provides mental-health counseling for 13,000 companies, says his firm has seen a 15% increase in calls from stressed out employees who are watching the stock markets from their desks.

This is another unintended consequence of inflationary monetary policies and, as a certain French economist of the 19th century might say, “that which is unseen”.

The Federal Reserve and its army of statisticians can only (attempt to) calculate that which is priced in units of money. But that which is not priced in money (until it ends up as a psychotherapist or pharmaceutical bill, anyway) can not be calculated.

What kind of effect on national productivity must this be having with so many people so distracted and made anxious by volatility in the financial markets?

Even some 401(k) investors are getting more active. Before this week, Ryan Jones rarely monitored his investment accounts. Now the 30-year old advertising strategist checks his phone several times a day for market reports and devotes his lunch time to rejiggering his portfolio.

“I’m just a regular guy who started the month with a 401(K) balance, and am trying to make sure it’s still there next month,” he says.

I look at quotes like the one above as proof positive that the 401(K) is not as good a tax-reduced deal as it is marketed as, and especially not for all the “regular guys” trying to manage them on their own with limited allocation options, to boot.

There’s just no way for these people to manage their money intelligently in a 401(K). And yet again, it transforms every saver into a part-time stock analyst and investor. This is not where the average person’s comparative advantage is located. Seeing how widespread the 401(K)-miracle wealth thesis is, I’d even call it something of a mania. Rather than taking their savings and investing in something local, tangible and familiar, many people have learned to wish upon a stock market star, cast their savings into a 401(K) like a penny into a fountain and then attempt to patiently wait the duration of their professional career until they can all cash out easy millionaires and retire to Florida or wherever.

But for that reality to become a reality, someone has to do a lot of work in the meantime because, contrary to what people might’ve thought [amazon text=George S. Clayson was adovcating in his book&asin=1897384343], the money doesn’t multiply itself unaided. Do people really believe that they can unintelligently, haphazardly and especially as in present times, anxiously invest their money in the stock markets and thereby wind up rich by retirement?

Another confused “investor”:

Andrew Schrage, a 24-year-old website editor, shifted the allocations in his $50,000 portfolio, away from equities and further into bonds, selling some of his technology stocks on Tuesday after announcements by the Federal Reserve that the central bank planed to keep interest rates near zero.

Mr. Schrage, who lives in Chicago, says he is planning to plow the money back into stocks, but is waiting for the right opportunity.

“This volatility has forced me to adopt a day-trading mentality,” Mr. Schrage says.

Wrong. The volatility hasn’t forced you to do anything, Mr. Schrage. It is your adoption of the fallacious belief that volatility is risk that has forced you into an uncomfortable position where you suddenly find yourself daytrading to try to avoid it.

The language of this article is curious. This 24-year-old website editor has $50,000 of capital in a financial market portfolio. Does he have $50,000 of capital in his website business? It almost sounds like he is a 24-year-old financial trader, who does some website editing on the side.

I don’t mean to heap scorn on age but it is fascinating that this young man has managed, in only 24 years on this earth so far, to not only find time to educate himself on how to edit websites but also on how to watch the Fed and trade accordingly. And this is, yet again, demonstration of the principle that this activity is pseudo-economic. It is not connected to real economic activity and any derivatives thereof but rather is driven by the moves and anticipation of moves by the central bank.

This is a centrally-planned economy, with centrally-planned financial markets. The trouble for most people is that the central planning aspect is too subtle for them to notice, being obscured under numerous layers of propagandistic “this is free market capitalism” rhetoric.

Nearly finished:

Dan Nainan, a 30-year-old comedian, spent Tuesday in his New York office fixated by the market fluctuations, refreshing the screen on his online brokerage account every couple of minutes throughout the day. About a half-hour before the close of trading, Mr. Nanian sold $120,000 worth of his Apple stock. “I felt a tremendous sense of relief,” he says, “and I’m not buying again.”

In a choppy market like this one, a single lunch meeting or conference call that results in missed trading opportunities can translate into thousands of dollars in losses. Andrew Clark, a 30-year old, real-estate consultant in Birmingham, Ala., sold about half of his Apple Inc. stock on Monday morning after it opened 3.2% down. During a client meeting, he missed a brief rally when the stock went up 1.7%.

“I would have bought those back at that point,” Mr. Clark says. “If you aren’t glued to these movements, you miss so much.”

What other times and places have seen 30-year-old comedians with $120,000+ stock portfolios? These are interesting and unusual times.

Andrew Clark’s comment is instructive because he believes he knows what he has missed when he really hasn’t got a clue. He’s missed Ben Graham. He’s missed out on observing the impact of frequent trading commissions on his bottom line. He’s missed out on the fact that his whole investment strategy revolves, admittedly, around the sure-fire failure of selling low and buying high.

Millions of people like this are born in every generation. They have no way to learn their lessons except by experience. Even then, if their experiences aren’t severe and near-death enough, they’re prone to forget them. They drift idly around during their blissfully ignorant existences like gnats above the highway. If the macroeconomic conditions are just right and they’re presented with the opportunity, they’ll launch themselves straight into the windshield of a market panic and spend the rest of the cruise down the motorway of life wondering how they got there and bemoaning the loss of their more innocent days.

These are people who would probably do just fine managing their personal affairs in more humble, honest economic settings. That’s part of the true villainy of the Bernanke-ite economy, to tempt all these people with fleeting prosperity at the risk of utter ruin, and to do it all at the point of a gun.

After all, who would play these games and take this farcical economic structure seriously if they were free to leave at any time without threat of going to jail, or worse?

Here we arrive at the moral, and the conclusion.

Great Expectations For Investing

I enjoyed the following two commentaries from value investor blogs I follow.

First, from Rohit Chauhan’s “Intelligent investing”, an absurdist scene in near-future India:

If the market and a lot of investors are correct, I can visualize a scene where I will be sitting in my house without power, gas and connecting roads but with the best plasma TV and all kinds of soaps, detergents and packaged goods.

Rohit comments on the fact that infrastructure companies in India are trading cheaply as if their regulatory burdens will not be removed and not allow them to grow, while consumer goods companies are trading at high valuations as if they are about to strongly grow their sales and expand their margins. But for the latter to happen, the former must be resolved.

Conclusion?

Company specific growth depends on a lot of factors beyond the basic macro opportunity and it is rarely a simple, linear process. If you make simplistic assumptions and pay top valuations for it, then the experience can be bad if those expectations do not materialize.

Speaking of expectations, here is one from the “Margin of Safety” blog, written by an anonymous PM managing a private investment partnership, on the differing assumptions between the “I Know” and the “I Don’t Know” schools of forecasting:

In pointing out our inability to see the future in my letter, my intent was to calm potential investors’ nerves. Many saw markets plummeting and they were converting everything to cash just at the moment when the best investment opportunities were arising. I had hoped that I could get them to stop listening to the many pundits in the media who pretended that they knew the future and who all repeated the mantra that we were doomed. I wanted them to focus on what was knowable like the Net Nets that existed at the time. We went “all in” in March 2009, two days before the market bottomed out, not because we could predict the future better than everyone else, but precisely because we tried not to predict it and instead focused on what was knowable.

There has been a seeming race amongst self-declared value investors over the past couple of weeks of ongoing bloodletting in the financial markets to make a contrarian “buy the panic dip” call. It’s like the moment the S&P 500 went 3% into the negative, everyone ran to their dressers and pulled out that dusty old copy of Warren Buffett’s “Be greedy when others are fearful” and began running around town, trumpeting it out to anyone who would take the time to listen.

In their haste to do so, many seemingly ignored whether things were already cheap, or merely getting cheaper. More importantly, few had any specific suggestions as to which companies were now cheap. Instead, these people seemed in a panic of their own to be the first one to declare that everything was now on sale.

But sometimes garbage is garbage and just because it has sold off a little doesn’t mean it didn’t deserve to, or that it won’t ultimately sell off some more. What kind of macro thesis is betrayed by such urgent calls to get one’s money in while the getting is still good any day there happens to be a broad market selloff?

The anonymous PM’s conclusion:

The pendulum reached its apex and has made a significant move back to the other side. Soon it will again be time to buy all of the babies that will get thrown out with the bath water. Are you prepared to pick off bargains, or are you one of the people in the “I know” school who was fully invested on July 7 and selling indiscriminately today? Can you trust your contrarian instincts when those instincts are supported by hard, knowable data, or will you follow the herd and the prognosticators? Which way you answer often accounts for the difference between investment success and failure.

Better yet, I want to know who was fully invested August 5th, prematurely assuming we’d seen the worst of it and so busy making assumptions they didn’t have time to go out and “know” some true discounts firsthand.