Category Archives: Buy Things You Understand

The Limitations of 13F’s

It has become increasingly easy to track the equity holdings of today’s leading investors. Numerous sites track their holdings based on disclosures made in 13F filings.

These 13F’s are an excellent place to search for new ideas. However, there are limitations to this approach if it is not part of a broader, well-concieved investment process.

In order to make big money in the stock market, you need to make meaningfully sized bets when opportunity presents itself. You also need to have the conviction to hold your positions if they decline in price, which all stocks are apt to do from time to time, sometimes by as much as 50%.

If your purchase was based entirely on the fact that a “guru” purchased it, you are less likely to 1) make a meaningful bet and 2) remain calm and not be rattled if the stock goes down 20%, 30% or even 50%.

There is no substitute for having your own thesis – based on your own reasoning – on why a stock is cheap and a good company. The market frequently overeacts to short-term news or problems and the guru won’t be there whispering in your ear to reassure you.

If you know what you are doing and have done your homework, these can be viewed as opportunities to add to your position.

In order to exploit time arbitrage – the discrepancy between the clearing price for the market’s short-term oriented price setters and the company’s long-term intrinsic value – you need to do your own work. 13F’s are a good place to look for ideas, but only the first step in a sound investing process.

Keep It Simple

Noise, noise, noise everywhere. Keep it simple. Begin with the end in mind. What are you trying to accomplish? Value investing is a big world. It’s really a framework that can be applied to any asset. Accept the fact that you won’t understand many – if not most – of these assets and how to value them. Develop the habit of not worrying about it. Focus on what you can do and be at peace. Filter out the chatter. There are people making a lot of money playing basketball, winning the lottery, writing screen plays, selling software, trading cocoa beans – the list goes on and on. You don’t (or shouldn’t) worry about these people, so why should you worry if another investor is able to make a bundle in potash and you don’t even know what it is? Invest with a margin of safety even if you must accept lower returns, particularly if you have already built up some wealth. Don’t go back to zero or take a major haircut. Don’t overreach. It’s easy to understand why using leverage is risky (although many still do it); investing in something you don’t understand is too.

Gold Hiding in Plain Sight

“Finance properly taught should be taught from cases where the investment decisions are easy,” said Munger. “And the one that I always cite is the early history of National Cash Reigster Company. It was created by a very intelligent man who bought all the patents, had the best sales force, and the best production plants. He was very intelligent man and a fanatic, all of whose passions were dedicated to the cash register business. And of course, the invention of the cash register was a godsend to retailing. You might even say that cash registers were the pharmaceuticals industry of a former age. If you read an annual report when Patterson was the CEO of National Cash Register, an idiot could tell that here was talented fanatic – very favorably located. Therefore, the investment decision was easy.” [emphasis added] – Damn Right, Janet Lowe, p. 234.

If you had read NCR’s early annual reports, it would have been obvious. That is what you should be looking for – situations that are obvious. You may only be able to find one or two a year, but that is enough to make you rich. Of course, you need to also make a meaningful investment when you find one.

The point is that the fact that NCR was a no-brainer jumped off the pages of its annual report. John Patterson was laying it all out for anyone willing to read it. This underscores the importance of spending a lot of time reading annual reports. That’s what Buffett does. The greatest investor of our time is intensely focused and jealous of his time, yet he spends most of his day reading annual reports.

Buffett is intensely critical of annual reports that are written by the PR department and have little to say of real meaning. The bad news is that there are a lot of annual reports written in this fashion. The good news is that when you find one that actually says something – where the CEO is laying out the case for why the business is a great opportunity – you may really be on to something.

There is no way to screen for these types of annual reports. You have to go out and find them one by one.

I remember the first time I read Fairfax Financial’s annual reports. It was clear that Prem Watsa was an unusual CEO and that Fairfax was an unusual company. The data was all there and the way it was presented spoke volumes. Berkshire’s shareholder letters are the same way.

History doesn’t repeat itself, but it rhymes.

Another lesson here is not just to read annual reports, but to go back and study the histories of great companies and also great failures in order to build a set of mental models that you can draw upon in analyzing and evaluating prospective investments.

When I read Munger’s description of John Henry Patterson, I could not help but be struck by how much it reminded me of his description of Wang Chuanfu, the chairman of BYD. “This guy,” Munger told Fortune, “is a combination of Thomas Edison and Jack Welch – something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it.” Did Munger’s study of NCR put him in a position to see and appreciate the merits of investing in BYD when the opportunity came along?

The lessons learned from investing and studying businesses are cumulative. That’s why Munger argues Buffett is better now than he’s ever been and that he continues to get better. You should make it a point to study these past winners and losers and add them to your library of mental models. Henry Singleton of Teledyne is another example, about whom I posted recently.

As always, I welcome your own thoughts and feedback.

Checklist for Evaluating Spinoffs

Spinoffs provide a great place for value investors to look for investment ideas. A 1988 study at Penn State showed that spinoffs outperformed the S&P500 by 10% per year in the three year period following the spinoff. Parents of spinoff companies outperformed their industry peers by 6%.

I am a big believer in using lists when evaluating investments so I don’t forget to check or think about something. This is also a good way to keep emotions in check. The following is a list I use based on Joel Greenblatt’s book You Can Be A Stock Market Genius, Even if you’re not too smart! Don’t let the title fool you. Greenblatt has one of the best track records I’ve ever seen and the book is excellent.

Here’s the list:

1. Will the spin-off allow the separate businesses to be better appreciated?

2. Will the spin-off separate a lousy business from a good business?

3. Is the multiple of a great business being penalized by being combined with a good business which the spinoff will fix (AMEX spinoff of Lehnan Brothers)?

4. Does one business have steady earnings and one volatile?

5. Will the spinoff allow each business to be properly valued, for example one division would be better valued using cash flow and another using earnings? (In the example given by Greenblatt, large depreciation charges from its TV stations were obscuring Home Shopping’s earnings.)

6. Does the spin-off allow the parent to rid itself of a business it can’t sell and/or off-load debt?

7. Are there tax advantages to the spin-off such as avoiding a large capital gain?

8. Does it solve a problem, for example antitrust or regulatory, that paves the way for another transaction?

9. Are there reasons, unrelated to value, why the spinoff will fall in price making it cheap?

A. the investment merits are obscured by complexity or what, upon superficial analysis, looks like a bad business

B. removed from an index

C. too small to be held by institutions

D. very different business from the original investment

10. What are the insider’s motives?

11. Do insiders want the spinoff?

A. Is the compensation of the new management strongly tied to that of the spinoff?

B. What percentage of the company’s stock is made available to compensate management and employees?

C. Are key managers moving to the spinoff?

D. Is the parent retaining stock in the spinoff?

E. Does management have an incentive to do the spinoff at a low price to set option strike prices low?

12. Is the spinoff positioned to benefit from high leverage (see Host Marriot example on page 70)?

13. On a pro-forma basis, how does the value of the spinoff compare to it industry?

A. Is the implied P/E lower than that of the peer group (see Value Line for industry group valuations)?

B. Is there an identifiable future event that is not yet factored into the earnings that will drive a higher price and/or multiple, i.e. a new production unit, ship, contract, etc.?

14. Look also at the parent company.

15. Does a partial spinoff reveal that the parent is undervalued?

A. Use ratios to compare the implied value of the parent with the value of peers. (The Sears partial spinoff of Allstate and Dean Witter revealed that Sears was trading at 6% of sales vs. 56% at J.C. Penny.)

16. Look at rights offerings.

Lessons from Jim Rogers and Warren Buffett on How to Research a Company

In order to value a business, you need to do your home work. In a recent article in Fortune entitled “Best Advice I ever got”, Jim Rogers talks about how you can get an edge on the vast majority of people on Wall Street if you simply read everything you can on a prospective investment.

“The best advice I ever got was on an airplane. It was in my early days on Wall Street. I was flying to Chicago, and I sat next to an older guy. Anyway, I remember him as being an old guy, which means he may have been 40. He told me to read everything. If you get interested in a company and you read the annual report, he said, you will have done more than 98% of the people on Wall Street. And if you read the footnotes in the annual report you will have done more than 100% of the people on Wall Street. I realized right away that if I just literally read a company’s annual report and the notes — or better yet, two or three years of reports — that I would know much more than others. Professional investors used to sort of be dazzled. Everyone seemed to think I was smart. I later realized that I had to do more than just that. I learned that I had to read the annual reports of those I am investing in and their competitors’ annual reports, the trade journals, and everything that I could get my hands on. But I realized that most people don’t bother even doing the basic homework. And if I did even more, I’d be so far ahead that I’d probably be able to find successful investments.”

Rogers likes to lay out the data on a company in spreadsheets that go back ten to fifteen years. He believes it is essential to have a long-term historical view of a company. When he sees a period of difficulty or decline, he wants know why, and likewise for periods of prosperity. Copies of Rogers’ spreadsheets can be found in the appendix of John Train’s “The New Money Masters”. I have adopted them for my own work and found them to be highly useful. It is worth noting that they involve no projections.

Staying with the advice giving theme, Buffett recounts a story in a 1991 speech at Notre Dame about when Bob Woodward asked him how to make some money in the stock market. Buffett advised Woodward to go out and research a company like he would a news story. If the company was an obvious bargain, Buffett told him to buy it, if not, take a pass. It is clear from the speech that Buffett uses private market valuations in his business valuation process.

“Bob Woodward one time said to me “tell me how to make some money” back in the ‘70s, before he’d made some money himself on a movie and a book. I said “Bob, it’s very simple. Assign yourself the right story. The problem is you’re letting Bradley assign you all the stories. You go out and interview Jeb Magruder.” I said “Assign yourself a story. The story is: what is the Washington Post Company worth? If Bradley gave you that story to go out and report on, you’d go out and come back in two weeks, and you’d write a story that would make perfectly good sense. You’d find out what a television station sells for, you’d find out what a newspaper sells for, you’d evaluate temperament.” I said “You are perfectly capable of writing that story. It’s much easier than finding out what Bill Casey is thinking about on his deathbed. All you’ve got to do is assign yourself that story.”

“Now, if you come back, and the value you assign the company is $400 million, and the company is selling for $400 million in the market, you still have a story but it doesn’t do you any good financially. But if you come back and say it’s $400 million and it’s selling for $80 million, that screams at you. Either you are saying that the people that are running it are so incompetent that they’re going to blow the $400 million, or you’re saying that they’re crooked and that they’re operating Bob Vesco style. Or, you’ve got a screaming buy when you can buy dollar bills for 20 cents. And, of course, that $400 million, within eight or 10 years, with essentially the same assets, [is now worth] $3 or $4 billion.”

That is not a complicated story. We bought in 1974, from not more than 10 sellers, what was then 9% of the Washington Post Company, based on that valuation. And they were people like Scudder Stevens, and bank trust departments. And if you asked any of the people selling us the stock what the business was worth, they would have come up with an answer of $400 million. And, incidentally, if it had gone down to $60 or $40 million, the beta would have been higher of course, and it would have therefore been [viewed as] a riskier asset. There is no risk in buying the stock at $80 million. If it sells for $400 [million] steadily, there’s much more risk than if it goes from $400 million to $80 million.

But that’s all there is to business. But now you say “I don’t know how to evaluate the Washington Post.” It isn’t that hard to evaluate the Washington Post. You can look and see what newspapers and television stations sell for. If your fix is $400 and it’s selling for $390, so what? You can’t [invest safely with such a small margin of safety]. If your range is $300 to $500 and it’s selling for $80 you don’t need to be more accurate than that. It’s a business where that happens.

Suggested (minimum) checklist for thoroughly researching a company:

1. Annual reports / 10-K’s – five years (including those of competitors). Read the footnotes.

2. 10-Q’s and Proxy Statements – one year, including transcripts of earnings calls (include those of competitors). Seeking Alpha is a good source of transcripts.

3. Build a 10-year spreadsheet on the company, by operating segment if applicable (see Rogers’ spreadsheet for a model). Don’t rely on third party sources for anything more than preliminary research. Going to primary sources will not only ensure the data’s accuracy, but also force you to think about the numbers and what they mean.

4. All available relevant articles in the business trades and press. In addition to the general Internet (Google, Bing, etc.), many libraries offer excellent free online databases, such as Proquest.

5. Build a database of all relevant private market transactions (minimum 5 years).

6. Compare relevant valuation metrics for company to those of competitors (P/S, P/B, P/E, EV/EBIT, EV/EBITA, P/(Owner Earnings). Include an analysis of any industry specific metric, for example, ROA for banks.

7. Study who owns the stock (and who doesn’t). (You may be able to find information on the company in reports and letters of quality institutional investors that own the stock.) Are insiders buying or selling? Do they have “skin in the game”? What about the directors?

10 Reasons Why a Stock Can Be Undervalued

On Friday, July 17, 2009, I wrote that if you find a stock that you believe is undervalued, it is important to try to determine the reason for the undervaluation. As Buffett wrote about poker in his 1987 letter to shareholders, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

Interestingly, some value investors, such as David Einhorn of Greenlight Capital, invert this process. Rather than first looking for undervalued stocks based on quantitative screens, for example, low multiples of price to earnings or price to book value, they first identify areas of the market where undervaluation is likely to be present and then search for good companies within that undervalued sector.

Here is a partial list of reasons a stock may be undervalued:

1. The General Market is Down – This is generally the most obvious reason that a stock is undervalued and occurs when the macro view of the economy is poor. It is useful for investors to have some basic tools to value (not predict) the general market so they can prepare as the market becomes undervalued. (Look for future posts on this subject.)

2. The Macro View about a Particular Industry is Poor – A classic example of this was in the 90’s when the prospects of “Hillarycare” took down healthcare related stocks.

3. The Macro View about a Particular Geography is Poor – In the 1990-1991 recession, California’s economy was in bad shape after its real estate market suffered a large decline. This set-up a great opportunity in Wells Fargo’s stock which Buffett took advantage of.

4. There is a Severe Short Term Problem which does not Damage the Business Franchise – The classic examples here are Buffett’s purchase of American Express after a financial scandal in 1963 and his purchase of Geico in the late 70’s after it severely underpriced its insurance risk. In both cases, the problems could be fixed and, more importantly, they did not damage the competitive advantage of American Express’s brand and Geico’s low-cost structure.

5. The Company has Diversified away from its Core High-Return Business – In the 1980’s, Coke diversified into non-core low-return businesses such as shrimp farming and movie making which masked the gold mine they had in the core soft drink franchise. In 1988, when Buffett began to accumulate Coke at around fifteen times earnings, the stock was not overly cheap based on traditional valuation metrics, but this unwise diversification masked the degree to which the market recognized that Coke was a long-term wealth generating machine.

6. The Company Does Not Pay or Has Cut its Dividend – Buffett cites this as the reason that Commonwealth Trust Co. was undervalued when he bought it in 1958. It probably also contributed to the sell-off in high yield U.S. regional banks as they cut their dividends in 2008 to build their capital bases.

7. The Company is Not Followed – If a small company has little or no analysts following the company it may be undervalued because it is neglected. Nobody is getting paid to follow the stock and cheer it on.

8. The Company is a Spin-Off – This is another classic opportunity area. The new company may have excellent economics and prospects which were not understood or appreciated when it was part of its parent company. Joel Greenblatt’s book You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits provides a great overview of spin-offs.

9. The Company is Emerging from Bankruptcy – The market fails to recognize the value of a newly organized company free of its heavy debt burden or other legacy problems.

10. The Company is Too Complex – This is a favorite area of famed value investor Seth Klarman. If most investors don’t understand a given situation or they are unwilling to do the amount of work involved, it may make an undervalued situation available to astute value investors.

Why Knowing the Reason a Stock is Undervalued is Critically Important

When Buffett purchased shares of the Commonwealth Trust Co. of Union, New Jersey, he indentified the reason that was largely responsible for the depressed price of the company’s stock. It was because the company was not paying a cash dividend. Identifying this reason reduced the probability that there were other unknown or poorly understood reasons why the stock price was depressed which could have materially reduced the intrinsic value of the company and lead to a permanent loss of capital.

When I attended the Value Investing Executive Education course at Columbia, in June of 2007, our professor, Bruce Greenwald, stressed the importance of asking yourself, when you’ve identified a great bargain, why the market is making it available to you at such a great price. If you can’t answer the question, perhaps there are people on the other side of the trade who know something you don’t or who are smarter than you. This is why it also makes sense to look carefully at who else has taken a position in the stock or who has not taken a position in the stock. For example, it may be meaningful to observe that, even though newspaper stocks are selling at extremely low multiples, Warren Buffett and Rupert Murdoch have not stepped in and made purchases. What does it tell you when two of the savviest and knowledgeable media investors in the world have passed on stocks that you may deem to be a great value? This is not in opposition to the idea that an investor needs to do his own independent thinking. It is just another fact in the investment appraisal and a recognition that others may have access to more or better information than you do.

Give Yourself an Edge

It is critical that you identify your edge when purchasing a stock. Assume that the person on the other side of the trade is smart and well informed. If you can’t identify your edge and the other party’s reason for selling you may be the patsy in the transaction.

Buying when others are fearful is one of the best ways to do this. When there is a lot of fear in the market and people are dumping stocks, it is far more likely that sellers are not acting on an informational advantage. They are probably selling for reasons that have nothing to do with value, i.e. they are afraid, they need to raise capital for redemptions or because a security no longer meets their investment policies.

Caution! Just because there is fear in the market is not a sufficient reason to buy a stock. The company must still be selling at a discount to a conservative estimate of intrinsic value. Without an estimate of intrinsic value you may still be purchasing an overvalued company. Buffett suggests writing down your reason for buying a given stock prior to making a purchase. It you can’t state in simple terms why a stock is a bargain, you should not buy it.

There are other ways to gain an edge, but this is one of the best. It is more a function of temperament than superior insight or analytical ability. Simply putting this discipline into practice should improve your results.