Monthly Archives: August 2009

Staley Cates of Longleaf on Cash Flow Analysis

Some time ago, I came across an interesting article that lays out an email exchange between investor Dan Ferris and Staley Cates, the president of Southeastern Asset Management, Inc. which manages the highly successful Longleaf family of funds. In the article, Cates explains how Longleaf does discounted cash flows. There are several important takeaways from the article:

  1. According to Buffett, the single best way to value a business is to determine how much free cash it will generate over its lifetime and discount it back to its present value.
  2. One of the challenges of this approach is that it depends so much on things that won’t happen for many years into the future. To compensate, Cates is conservative and assumes no growth after year 8.
  3. Cates uses a 9% discount rate for all businesses to keep things simple. Like Buffett, he appears sceptical of the notion that you can compensate for risk by using a higher discount rate. For Buffett, it’s binary: you either know what you’re doing, in which case you can make a reasonable projection of future long-term earnings, or you don’t, in which case you should “take a pass”.
  4. Cates takes seriously Graham’s concept of “Margin of Safety”. They will not invest unless they can purchase shares at a 40% discount to their conservative estimate of the business’ value, as derived from their discounted cash flow analysis.

Here is the article:

“…The tools you need to understand Buffett’s definition of intrinsic value go by the soporific moniker of discounted cash flow analysis. But when the richest guy in the world says it’s the most important thing you can know if you want to get rich, I’ll bet it’s worth staying awake for…”

“[The intrinsic value of a business] is the discounted value of the cash that can be taken out of a business during its remaining life.”

Cash Flow Analysis: Listening to Warren Buffet

If that statement merely appeared in a textbook, I might yawn and disregard it. But I didn’t get it from a textbook. I got it from Warren Buffett’s Owner’s Manual, available online at www.berkshirehathaway.com. Since Buffett is the richest investor alive, I believe knowing how to figure out “the discounted value of the cash that can be taken out of business during its remaining life” must be just about the most important skill you could ever possess, if your goal is getting rich by investing in stocks.

The tools you need to understand Buffett’s definition of intrinsic value go by the soporific moniker of discounted cash flow analysis. But when the richest guy in the world says it’s the most important thing you can know if you want to get rich, I’ll bet it’s worth staying awake for.

Lacking an informal, or formal, or any other type of relationship with the Sage of Omaha, I asked Staley Cates, co-manager of Longleaf Partners Fund, to enlighten me on the scintillating subject of cash flow analysis. (You’ll recall that Longleaf has been in the Extreme Value Model Portfolio since February 2004.)

Cash Flow Analysis: The Lesson

During our conversation, Cates told me exactly what I needed to know. [Continue reading]

Ben Graham on the Role of Intrinsic Value in Analyzing Stocks (Part 2)

Yesterday, I looked at Graham’s caclulation of the intrinsic value of Wright Aeronautical Corporation. Today, I want to look at his example of J.I. Case.

J.I. Case

Earnings per share
1932 – ($17.40) loss
1931 – ($2.90) loss
1930 – $11.00
1929 – $20.40
1928 – $26.90
1927 – $26.00
1926 – $23.30
1925 – $15.30
1924 – ($5.90) loss
1923 – ($2.10)

Average: $9.50

Here is a profile of the company in early 1933:

Share price: $30.00
Earnings: ($17.40) for 1932
Asset value: $176
Dividends: none
Graham’s range of intrinsic value: $30 to $130

Observations

  1. Graham thought that J.I. Case was an example of a situation where an analyst cannot reach a reliable estimate of intrinsic value.
  2. He goes on to say that if the price were low enough, an analyst MIGHT be able to conclude that it was undervalued, for example at $10.00 per share.

Takeaways:

  1. An analyst cannot assume that a regression to the mean will occur or that an average of past earnings will persist. There must be “plausible grounds” to support the analyst’s projection, particularly if it involves growth.
  2. Some value investors will simply not pay for future growth, on the assumption that no such projection is reliable. Others, such as Buffett, are highly selective and will only invest in a growth company if, in addition to having good growth prospects grounded in facts, it also has a clearly entrenched competitive advantage.
  3. Some companies should be put in the “too hard” pile. There are plenty of fish in the sea and time is valuable; don’t waste it on trying to figure out the unsolvable.
  4. Be highly suspect of asset values, particularly of distressed companies. Sellers of newspapers in today’s market are receiving a cruel object lesson in the value of assets that can no longer produce profits. In his 1985 letter to shareholders, Buffett described what happened when he liquidated Berkshire Hathaway’s looms.

“Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.

The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper routes in Buffalo – or a single See’s candy store – considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people.”

In conclusion, Graham’s notion of intrinsic value is a highly useful concept, if you use it correctly and understand its limitations. As Aristotle said, “It is the mark of an educated man to aim at accuracy in each class of things only so far as the nature of the subject allows.” Be patient and hold your fire until it’s obvious. There have been plenty of these opportunities in the past and there will be plenty in the future.

Ben Graham on the Role of Intrinsic Value in Analyzing Stocks (Part 1)

A lot of what passes for security analysis looks a lot like the Greater Fool Theory. Investopedia defines the Greater Fool Theory as, “A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.” This approach is as old as Wall Street, and, although a (very) few traders may consistently make money using this approach (without the benefit of an advantage such as high-frequency trading), the average person cannot.

Against this backdrop, Benjamin Graham came along and introduced a powerful new idea into the field of security analysis. The foundational idea was that when you buy a stock certificate you are buying a small piece of a real business. And if that is the case, a person ought to be able to come up with some idea of what the business is worth by studying the facts: the assets, earnings, dividends, future prospects, management, litigation, etc. This is what Graham called intrinsic value. Graham further recognized that because of the enormous volatility in the stock market, it would be possible from time to time to purchase shares of a given stock at a clear discount to what the underlying business was worth. This discount not only provided a rational basis for the expectancy of a decent return (or indecent, depending on the level of undervaluation), but also afforded the investor a cushion of safety against errors in judgement and analysis, and unforeseen future events.

Graham points out that it is not possible to determine the intrinsic value of a business with exact precision. It is usually a range of values. If you can establish this range, you can then determine if the stock is undervalued, overvalued, or fairly valued. This lack of precision need not be a problem, if you can buy the stock cheap enough. By analogy, Graham says it is quite possible to determine that a man is obese even if we do not know his precise weight, or that a woman is old enough to vote even if we do not know her precise age.

In Security Analysis (Sixth Edition) (pages 63-67), Graham gives two example of equities where he determines their intrinsic value.

Wright Aeronautical Corporation

Here is a profile of the company in 1922:
Share price: $8.00
Earnings: over $2.00
Dividends: $1.00
Cash per share: $8.00
Graham’s range of intrinsic value: $20 to $40

Observations:

  1. Graham concluded the stock would be a bargain at $8.00 per share.
  2. The low end of the intrinsic value range is at most 10x earnings and as low as 6x earnings if we assume that the company had no debt. (At $20 per share you would only be paying $12 per share net of cash.)
  3. In no case would Graham estimate the value to be greater than 20x earnings ($40/$2).

Here is a profile of the company in 1928:
Share price: $280.00
Earnings: over $8.00 ($3.77 in 1927)
Dividends: $2.00
Net-asset value: $50.00
Graham’s range of intrinsic value in 1929: $50 to $80

Observations:

  1. Graham thought that Wright Aeronautical might be worth as little as just over 6x its 1928 earnings. Graham may have looked at the earnings in 1927 and been unconvinced that the company could maintain earnings at the $8.00 level.
  2. In no case would Graham pay more than 10x (what appear to be peak) earnings of $8.00 per share.
  3. At $280.00 per share (35x 1928 earnings), Graham thought it was clear that Wright Aeronautical was overvalued.

Tomorrow I’ll take a look at J.J. Case Common and draw some conclusions for our use as contemporary value investors.

Interview with Paul Sonkin

The blog Street Capatalist recently did an interview with microcap value investor Paul Sonkin. I written about Sonkin before and feel he is worth following. The interview has some interesting information on how Sonkin searches for investing ideas.


Tariq Ali: Could you give us your brief career history?

Paul Sonkin: I bought my first stock with my bar mitzvah money. I went to college and when I graduated it was when Drexel had just went belly up and I was looking for sell side research positions, couldn’t really find any because all the assistant positions got taken up by those ex-Drexel people so I worked at the Securities and Exchange Commission which was a lot of fun spending a year and a half there spending a year and half at Goldman Sachs. My career was going in one direction and my interests were going in another so I went back to business school and I graduated in 1995. I worked for Chuck Royce for 3 years and then worked for First Manhattan which is Sandy Gottesman’s firm for a year and then I started Hummingbird about 10 years ago. That’s sort of a nutshell.

Tariq Ali: You often hunt in the nano-cap space, how do you find out about these companies? Is it like Buffett said, that you need to just “Start with the A’s” or do you use things like screens or local news periodicals?

Paul Sonkin: You know I’d say that most of my ideas come off of the new lows list. I take that that’s sort of the best hunting ground. And then the other thing that I do is I have these lists of companies i’ve owned before or am interested in. And then I get the news headlines for them on a daily basis and then I do a lot of keyword searches for like spinoffs, liquidations, merger arbitrage, stuff like that. And then I go to conferences I source my ideas pretty much from everywhere. The only place where I don’t source my ideas from is Wall Street. Not a lot of Wall Street research at all. [Continue reading]

Lessons from Buffett’s Partnership on Measuring Investment Results

The emerging field of behavioral finance offers valuable insights into how our actions – whether innate or acquired – can be powerful impediments to optimizing our investment results. For example, we have all heard anecdotally that people are reluctant to open their brokerage statements during a bear market and prefer to simply let the unopened envelopes stack up – perhaps we’ve done it ourselves. This behavior is potentially suboptimal because it may impede taking action in the account that would obviously – from a rational viewpoint – improve our results.

It appears this tendency is widespread and strong. Nachum Sicherman, a professor of Finance and Economics at Columbia has been studying the behavior of about a million account holders at Vanguard. Without knowing the identity of Vanguard customers, which Vanguard carefully safeguards, Sicherman is able to see when people login, how long they stay online, and what they do. His data confirm that when markets are down, the frequency of checking accounts goes down, and that precisely the opposite happens when markets go up.

To be a successful investor it is important to take steps to try to overcome those behavioral tendencies which are counterproductive. We need to find simple ways to overcome our limitations much like we do in other areas, for example, leaving a Post-It note on the door so we don’t forget something the next morning or making a grocery list so we don’t forget an important item. One simple way to improve our investment results is to measure them, which is all the more important if you are an active investor trying to beat a particular benchmark.

The reason for being an active value investor (in contract to a passive investor who buys an index fund) is to outperform readily available alternatives for your capital. If you cannot do this over time, you should probably “hang it up” and either put your money in an index fund or with a select investment advisor who not only has a good track record, but also, and more importantly, has a solid investment process and discipline in place.

Not measuring your investment results makes you susceptible to a number of misjudgments.

Self-deception and denial. This is wishful thinking and not accepting reality. Buffett tells us that, “Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man’s natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience–a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.”

Status quo bias. This is what author Peter Bevelin calls the “do-nothing syndrome – keeping things the way are. Includes minimizing effort and a preference for default options.”

Overoptimism tendency. This is the tendency to simply think you are doing better than you actually are.

I suggest a simple system of measuring your own results based on how Buffett did it when he ran his partnership.

Select an appropriate objective, such as beating the S&P500. For Buffett, it was to achieve a long-term performance record superior to that of the Dow Jones Industrial Average. Buffett selected the Dow because it was widely known and, in his view, representative of investing alternatives available to his partners. Note that some value investors, such as Seth Klarman, prefer an absolute return as a benchmark, rather than a relative benchmark such as beating a given index.

Look at results every six months to see how you are doing. Track both performance for the six-month period and cumulative performance. The cumulative performance figure is useful because it reinforces how small differences in a given period add up to big differences over time.

Allow at least three years before you judge the results. The short term movements of stocks can be highly volatile and random, being driven by the psychology of market participants. It takes a meaningful period of time to judge if your investment approach is truly adding value. Here’s Buffett from his January 18, 1963 partnership letter: “While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.”

Compare yourself to other value investors. In addition to your benchmark, compare yourself to a handful of respected value-oriented equity funds such as Longleaf Partners, Fairholme and Dodge & Cox.

Value Investing Lessons from Ken Shubin Stein

Dr. Kenneth H. Shubin Stein, MD, CFA runs Spencer Capital, a New York-based hedge fund advisor that specialises in deep value investing. Dr. Shubin Stein, 36, previously co-founded Compo Asset Management, LLC, a US-based value investment partnership that later merged into Promethean Investment Group. Shubin Stein comes from a family of doctors and scientists and got involved in investing as a result of the poor results his family obtained from professional advisers. A large portion of his family’s wealth is managed by Shubin Stein.

In a 2007 article, Jame Altucher described Shubin Stein as, “A very Buffett-esque investor. He told me, “I’ve grown up on Buffett’s words. Since I was 11, I’ve read everything he’s ever written and I’ve listened [to] or read as many of his speeches as I could get a hold of.” . . . Shubin Stein’s group takes a very focused approach. He owns only nine stocks, and he performs an enormous amount of research on every one.”

In the following article, “Don’t Catch Falling Knives”, from Forbes, Shubin Stein stresses the importance of doing your homework and not investing in a company you don’t understand. The subtitle of the article is “Value stocks and stocks in trouble can be hard to distinguish. It’s all about the research”.

At the end of last year, Bill Miller, manager of the Legg Mason Value Trust lamented that he had purchased Citigroup at what he thought was a bargain rice, only to see its shares drop lower as the banking crisis worsened. Miller found the experience troubling to say the least. Was the market signaling a depression in the works? Had he missed liabilities on Citi’s books? Was the market irrational? If so, could Miller stay solvent enough to outlast it?

Barry Ritholtz of FusionIQ said that he’d consider buying Citigroup stock under $5 a share. But when the bank’s stock got there, Ritholtz decided not to pull the trigger. He told Steve Forbes: “Yeah. We didn’t buy it. We said Citi at around 10. And I said assuming there’s no more revelations, under $4, $5, Citi could be an interesting thing. So, we watched it, and we just didn’t have the nerve to pull the trigger. And now, Citi is on the dollar menu.”

Two experienced investors made two opposing decisions. For the moment, Ritholtz looks to have made the right decision and Miller has committed the old Wall Street error of trying to “catch a falling knife.” But how do you tell in advance?

Research and clarity are key. Miller is an expert analyst of financial stocks. This is the manager who, after all, came out of the Savings and Loan Crisis on a tear. He watched and invested with the big financial companies as they became conglomerates. Few investors have such intimate knowledge of how these companies are put together as Miller. But look at Ritholtz’s caveat: “Assuming there’s no more revelations…” It seems the stocks that Miller knows extraordinarily well now hold surprises.

Ken Shubin Stein, of Spencer Capital Management, believes that most individual investors won’t be able to tell if they’re being handed a blade or an opportunity because they have to be able to fully understand a company’s liabilities and, most importantly, what might cause its customers to flee. It’s easy for a simple business like Hershey, he says, but more difficult or technology and financial businesses.

Here’s a rule of thumb from Shubin Stein: If you can’t honestly make it through the company’s annual report without your eyes glazing over and your attention wandering toward less arcane subjects, you’re not qualified to judge the stock and are just speculating or following hunches. [Emphasis added]

P. Brett Hammond, chief investment officer of pension giant TIAA-CREF, warns that: “Our equity analysts have a sector. And they spend 60 hours or more a week looking at that sector and the firms in it. And that’s all they do. And from that, what they’re trying to do is pick the two winners, and the two losers to overweight and underweight. And the ability of any individual to do that, to devote that kind of time to it is far diminished from our equity analysts.”

Marc Lowlicht, an adviser with Further Lane Asset Management says, “I could probably do taxes from my background. I never would, because the guy who does it all day is 10 times better at it than I am. Just like the guy who analyzes financial statements is going to be 10 times better at it than I am.”

For the investor determined to go it alone, there is some hope: just stick to the companies you’re best able to understand and use expendable amounts of money. Remember also that the balance sheet is king. Debt, especially in the current environment, can make hash of the best forecasts. The safest value stocks will have a well diversified lot of customers and little or no debt on the books. [Continue reading]

Cerberus’ Acquisition of Chrylser: A Cautionary Tale

Over the weekend, The New York Times ran an article “For Private Equity, a Very Public Disaster” which gave a sobering account of the acquisition of Chysler by the private equity firm Cerberus. There are many lessons in what happened that are worthy of reflection. As anyone who has built up some assets knows, earning money is difficult. Assets, along with reputations, are built over a lifetime, but can be lost or damaged in a very short period. Everyone who invests will make mistakes, but a lot more progress can be made if you simply avoid severe drawdowns to your portfolio. Successful investors think about risk first and study financial history to learn from it. In investing, the allure of massive gains makes turnarounds very attractive. The problem is that few of them actually turn. Here are some thoughts from this “very public disaster”.

Walk away from deals that are “too hard”. “Maybe what we should have done was not bought it.” – Steve Feinberg, a co-founder of Cerberus. The beauty of investing is that you do not have to invest. “I call investing the greatest business in the world,” Buffett says, “because you never have to swing.” You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”

Avoid the “institutional imperative”. Thomas Brown defines what Buffett calls the institutional imperative as, “Any company’s inherent propensity to do dumb things (or avoid doing smart things) simply for the sake of doing them.” Plumbers plumb; painters paint, private equity firms do deals (sometimes that simply should not be done). The allure of transforming an American icon and bringing it back to prosperity may have clouded Fienberg’s judgment. Individual investors would be wise to avoid investing in any company where there is evidence of the institutional imperative, such as a track record of overpaying for value destroying acquisitions.

Good (or even great) management is not enough. The article reports that Feinberg, “Can play a decent game of chess while blindfolded”, and that he is a graduate of Princeton. He is obviously a smart, accomplished businessman and one can safely assume that the Cerberus is loaded with similarly smart and accomplished people. Cerberus’ management contended that, “They had the smarts and managerial prowess to repair companies of any size.” This is usually not enough, however, to overcome a business that is structurally challenged.

Writing to shareholders in 1985, Buffett said, “My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”

Avoid excessive debt. The article reports that the, “Situation was made worse by hefty interest payments on more than $10 billion in debt that Cerberus arranged for Chrysler as part of the takeover, which left the automaker carrying piles of debt just as auto sales were about to plummet.” The situation is always made worse by excessive debt and leaves an individual or corporation with no margin of safety for the inevitable downturn. Avoid investments in companies that have excessive debt and pay close attention to when debt is coming due. Jim Rogers charts out all future debt, year by year, so he knows exactly when it is due.

Stay within your circle of competence. The article reports that, “Don Johnson, a former Chrysler employee, says he worked on initial production of the Jeep Liberty at a plant in Toledo, Ohio, in summer 2007, when Cerberus won the right to buy Chrysler from Daimler of Germany…. Mr. Johnson says he was always skeptical about the carmaker’s new owners. “Cerberus did not have a clue about the automotive industry,” he says. “I don’t think anything could have been worse.” If you don’t understand a business, you should not invest. You are simply at too great of a disadvantage because it is impossible to thoroughly analyze the business.

Avoid businesses that need to spend their retained earnings (and more) just to maintain current operations. The automobile industry is characterized by an insatiable appetite for cash simply to maintain the business. There is little or no cash leftover for shareholders and the stocks of these companies usually reflect this reality. Consider the following account of General Motors from the book “Buffettology”:

“Between 1985 and 1994 it [GM] earned in total approximately $17.92 a share and paid out in dividends approximately $20.60 a share. During the same time period the company spent approximately $102.34 on capital improvements. If General Motors’ earnings during this period totaled $17.92 and it paid out as dividends $20.60, where did the extra $2.68 that it paid out in dividends and the $102.34 that it spent on capital improvements come from?

From the beginning of 1985 to the end of 1994, General Motors added approximately $33 billion in debt, which equates to a per share increase in debt of approximately $43.70. The company also issued 132 million additional shares of its common stock. General Motors’ per share book value also dropped $34.92 a share, from $45.99 in 1985 to $11.74 in 1994, as new-car-development costs sucked up retained earnings. What did all this do for increasing shareholders’ wealth? Nothing.

In the beginning of 1985 General Motors stock traded at $40 a share. Ten years later, at the end of 1994, the stock traded at, you guessed it, $40 a share.”

Here is an extended quote taken from the 1985 letter to shareholders regarding Buffett’s experience with investing in capital intensive businesses. It is highly instructive.

Though 1979 was moderately profitable, the business [Berkshire Hathaway’s textile mill] thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue…

I should reemphasize that Ken and Garry have been resourceful, energetic and imaginative in attempting to make our textile operation a success. Trying to achieve sustainable profitability, they reworked product lines, machinery configurations and distribution arrangements. We also made a major acquisition, Waumbec Mills, with the expectation of important synergy (a term widely used in business to explain an acquisition that otherwise makes no sense). But in the end nothing worked and I should be faulted for not quitting sooner. A recent Business Week article stated that 250 textile mills have closed since 1980. Their owners were not privy to any information that was unknown to me; they simply processed it more objectively. I ignored Comte’s advice – “the intellect should be the servant of the heart, but not its slave” – and believed what I preferred to believe.

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage…

Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers. I always thought myself in the position described by Woody Allen in one of his movies: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly.”

For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 — on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse – not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.

Graham-and-Doddsville Redux

Twenty-five years ago, Warren Buffett wrote his famous essay “The Superinvestors of Graham and Doddsville” which demonstrated that value investing produces market-beating returns. The debate continues. Earlier this month, Barron’s published an article entitled “Not Your Father’s Value-Growth Rotation”. The subtitle of the article provocatively asked, “Is value investing dead?”.

A couple readers and I defended value investing in the on-line comments. In response to our comments, a reader named Dan Star wrote:

“But do you beat the market in the long term, that being tens of years? Please pass along a link to a value fund that has beat the S&P500 Index over 10 years, 20 years. Probably not many and the ones that did are in the tail of the probability curve. Fooled by Randomness?”

In response, I wrote an article which showed that six prominent value mutual funds had bested the Vangaurd 500 Index (arguably the best proxy for actually investing in the S&P 500 Index given its efficient large size and super low expense ratio) by an average of 5.92% per year. I posted a link to the article in the same “Comments” section in Barron’s. Mr. Star again replied:

“Mr. Speicher, can you extend this analysis to 20 years? The ten years have been rather unique, to say the least. Maybe when the FED is playing funny with the money a good value manager can beat the S&P500 Index…”

And so, I decided to take a look. All of the funds I profiled had been in operation for twenty-years except Third Avenue Value, which began in 1990. (It returned 12.48% since its inception on 11/1/1990.) Here are the results:

Longleaf Partners – Average annual performance as of 3/31/2009 over the prior 20 years:
Longleaf Partners – 8.8%
S&P 500 – 7.4%

Dodge & Cox Stock Fund – Average annual performance as of 6/30/2009 over the prior 20 years:
Dodge & Cox Stock Fund – 9.87%
S&P 500 – 7.77

Weitz Value – Average annual performance as of 6/30/2009 over the prior 20 years:
Weitz Partners – 8.9% (the Partners Value fund returned 9.8% per year)
S&P 500 – 7.8%

FPA Capital – Average annual performance as of 3/31/2009 over the prior 20 years:
FPA Capital – 11.79% (assumes the maximum 5.25% sales charge on initial purchase)
S&P 500 – 7.43%

Seqouia Fund – This is the fund Buffett recommended to his partners when he wound down his partnership in 1969. No twenty-year comparison summary data was available. I am presenting the data from 1970, when the fund began, through 6/30/2009.
Seqouia Fund – 13.98% ($10,000 grows to $1,636,578)
S&P 500 – 9.98% ($10,000 grows to $407,639)

In my judgement, these funds actually have some structural disadvantages which impedes their performance. They are large which tends to limit their universe of investment options and makes it more difficult to build positions on particularly attractive depressed, but short-lived, periods in the market. Also, they tend to be more fully invested at all times and they do not hedge, which tends to fully expose them to severe down years such as 2008. Anecdotal evidence suggests that value-oriented hedge funds such as Greenlight Capital and Baupost enjoy an even wider margin of outperformance compared with the S&P 500. Hardworking individual value investors should be able to best these mutual funds by a meaningful margin.

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?

Poker and the Mentality of a Value Investor

In his book “Poker Wisdom of a Champion”, Doyle Brunson writes about a time he went to a neighborhood party with another professional poker player named Harvey and his wife. All the neighbors decided to strike up a friendly little poker game, all that is except Doyle and Harvey, who were just observing.

At one point, Harvey’s wife had to go to the ladies’ room, so she asked Harvey if he would sit in and play a few hands while she was gone. He agreed, but the moment he sat down he felt apprehensive because of the pressure to perform, seeing that he was a professional. The cards weren’t going his way and he began to press. After all, he had something to prove, or at least he felt he did. By the time Harvey’s wife returned, Harvey had managed to lose the better part of her chips.

Brunson draws an important lesson from this simple story. “Some nights you’ve got to wait hours to get a decent hand. Poker skill is something that works for you in the long run.”

And so it is with investing. You can’t press. It is simply not given that on any given day you are going to find a good company, which you understand, with a clear competitive advantage, selling at a meaningful discount to its intrinsic value. Making money is not that easy. You have to go to work everyday and patiently focus on the process. It can be frustrating, but there is no other way, unless you want to resign yourself to, at best, mediocre returns.

Sure, there are paid services that value thousands of companies and that are always ready to serve up a number of undervalued securities. There are articles everyday on the Internet and in the papers offering up the latest “undervalued” stocks. Be very careful here. I’m not saying that these can’t be sources of ideas, but the idea that it is this easy probably doesn’t stand-up to a serious critique. These paid services must produce recommendations, just like financial journalists that cater to investors must produce articles that recommend stocks. Buffett is happy if he can come up with one, or maybe two, good ideas each year.

I’ve read that there are people who make a good living betting on the horses. They don’t bet though like the “average Joe”. They carefully study the stats and odds, and then wait very patiently – days or even weeks – until a situation arises where the product of the odds and the payoff create the mathematical expectancy of a winning bet – and then they bet in size.

“Some nights you’ve got to wait hours to get a decent hand.” Investing is no different.