Yesterday, Barron’s wrote a bullish story on Laboratory Corp. of America. Chieftain Capital Management, which is run by value investing heavyweight Glenn Greenberg, has held the stock for a number of years and made a great return on the stock. Chieftain holds 3,615,421 shares as of its most recent Form 13F filing.
If you are a reader of my blog, you know that I am a big believer in checklists because they are an effective and simple way to counter human error, which can be very costly. Here is a checklist from South African value investor Tim du Toit who writes at EuruShareLab. I am posting it because it is well thought out and a provides a good point of departure for developing one’s own list.
1. Operating cash flow higher than earnings per share
2. Free Cash Flow/Share higher than dividends paid
3. Debt to equity below 35%
4. Debt less than book value
5. LT debt less than 2 times working capital
6. Pre-tax margins higher than 15%
7. FCF Margin higher than 10%
8. Current asset ratio greater than 1.5
9. Quick ratio greater than 1
10. Growth in EPS
11. Management shareholding (> 10%)
12. Altman Z Score > 3
13. Substantial Dilution?
14. Flow ratio (Good <> 3)
15. Management incentives?
16. Are the salaries too high?
17. Bargaining power of suppliers?
18. Is there heavy insider buying?
19. Is there heavy insider selling?
20. Net share buybacks?
21. Is it a low risk business?
22. Is there high uncertainty?
23. Is it in my circle of competence?
24. Is it a good business?
25. Do I like the management? (Operators, capital allocators, integrity)
26. Is the stock screaming cheap?
27. How capital intensive is the business?
28. High Profitability
29. High Return on Capital
30. Enormous moat
31. Profitable reinvestment
32. Future growth
33. Net share buybacks?
34. Strong cash flow
35. What has management done with the cash?
36. Where is Free Cash Flow invested? Share buybacks, dividends, reinvested, ROE & ROCE, incremental BV growth
Gurufocus has published a very informative interview with Donald Yacktman and his son Brian Yacktman. There are both successful value investors. Like Bruce Berkowitz, they look at stocks as a kind of “equity bond” and they value them by estimating their free-cash yield and growth rate. The interview is in response to questions posed by readers of Gurufocus. I hope you find it as informative as I did.
Traditionally, value investors have tended to ignore macro economic issues and focus on bottom-up investing. The was based not only on the idea that if you purchase a great business at a good price the investment will work, regardless of the macro economic forces at play, but also that the economy cannot be predicted with enough precision to be useful. Recently, value investors have been challenging and questioning this long-held view. I suspect that this has been precipitated by the fact that many value investors saw their portfolios get crushed in the latest bear market.
David Einhorn is now on record as an investor who has begun to pay a lot more attention to macro economic issues. Here’s a quote from his recent talk at the Value Investing Congress.
“The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself a “bottom up” investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the long-short exposure more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time.”
The entire speech is available online courtesy of the excellent blog Market Folly.
The following are my notes from a talk that Tom Gayner and Steve Markel gave on November 20, 2008 at Value Investing Conference at the University of Virginia, Darden School of Business. The talk was entitled “A Casual Talk with Two Guys from Richmond.” Steve Markel is the Vice Chairman of the Markel Corporation, an underwriter of specialty insurance. Tom Gayner is Executive Vice President and Chief Investment Officer of Markel and a highly respected value investor.
Markel is in the business of underwriting specialty insurance at a profit and investing the money the insurance business generates with a long-term orientation.
They believe that their long-term success owes itself to consistent discipline.
Markel insures items that are hard to insure. They typically don’t get involved until those seeking insurance have been turned down by others.
The high level of volatility in the markets in recent times is a sign of a shortened time horizon by many of its participants. There is a growing disconnect between the activities of investment managers and the underlying businesses they own.
Markel’s largest source of investment funds is loss reserves. This is typically invested in fixed income of various durations to provide funds to meet insurance claims.
The second biggest source of funds is shareholders equity which can be invested with an infinite time horizon. Some portion of shareholder equity is invested conservatively in fixed income to provide a margin of safety with regard to insurance claims obligations.
Markel’s first filter for equity investments is that a company be a good business with high returns on invested capital. Although this may seems obvious, Gayner has seen it violated many times. This means a good return on total assets employed, as opposed to a high return on equity through the use of excessive debt.
Making money over time means that you are providing something of value that people are willing to pay for. Gayner won’t invest unless there is a track record of profit.
Markel’s goal is to compound book value per share at a high rate over a long period of time. Since its IPO, Markel has compounded book value at a rate of approximately 20%. This is a result of their business model: underwriting insurance claims profitably and reinvesting the funds with a long-term value orientation.
Their concentration on specialty insurance, where they can get an edge and their unwillingness to write insurance that is not expected to be profitable is key to their success. They use minimal leverage.
Business in general and insurance in particular will be lumpy by its very nature because of the uncertainty of short-term events. Markel measures performance in rolling five-year periods to maintain a long-term perspective.
The second test for equity investments is to insure that the managers of a prospective investment have both talent and integrity. One without the other is useless for investment purposes. These are tough to measure but you can look at a management’s track record as a gauge.
They do not want to provide moral hazards when underwriting insurance. They want their interests and those of the insured party to be closely aligned. For example, they would not insure a $100,000 horse for $1,000,000. They feel that this principle is important in investing and was violated in the recent market debacle. How many executives had nothing to lose when they levered up their companies by a factor of 30 or 40?
The third filter in evaluating an investment is to look at the reinvestment dynamics of the business. Ideally, a business earns a high return on a capital and can reinvest over the long-term at as good or better rate of return. That makes a compounding machine that builds wealth over time. Berkshire Hathaway is the best example of this. The next best thing is a business which generates a high return on capital but does not have a good opportunity to reinvest its funds at a high (or even good) rate of return. The worst thing that a business such as this could do is squander capital in investments that promise a poor rate of return and that destroy value. The worst kind of business is one that generates poor returns on capital and needs more of it all the time. An example of this is the airline business.
The fourth screen for equity investments is price. Markel defines a fair price as one that allows an outside shareholder to earn the same type of return that the business itself earns. If you pay too much, the underlying business may prosper nicely but you will not be rewarded for the investment.
Historically, Markel has traded between 1.5 and 2 times book value. They don’t focus on where the stock trades, which they can’t control, but on building shareholder value over time.
They don’t focus on macro economic factors because they believe that they don’t think they are consistently predictable. They focus on what they can control.
Disclosure: The author owns shares of Markel.
In order to stimulate thinking regarding making an investor checklist, I thought it would be interesting to look at the pilot checklist for a B17 Flying Fortress. Charlie Munger often refers to aviation as a model discipline in the use of checklists. In the 30’s when it was developed, the plane’s complex new technology put its future in jeopardy after the prototype crashed. The development of a checklist was instrumental in making the plane safe to fly. It would go on to be a workhorse in WWII.
This is from the website http://www.galbreath.net/bill/checklist.htm.
“From the Pilot Training Manual for the Flying Fortress – p.55 – 56
APPROVED B-17F and G CHECKLIST
PILOT’S DUTIES IN RED
COPILOT’S DUTIES IN BLACK
2. Form 1 A-CHECKED
3. Controls and Seats-CHECKED
4. Fuel Transfer Valves & Switch-OFF
7. Fuel Shut-off Switches-OPEN
8. Gear Switch-NEUTRAL
9. Cowl Flaps-Open Right- OPEN LEFT-locked
11. Idle cut-off-CHECKED
13. High RPM-CHECKED
15. De-icers and Anti-icers, Wing and Prop-OFF
16. Cabin Heat-OFF
1. Fire Guard and Call Clear-LEFT Right
2. Master Switch-ON
3. Battery switches and inverters-ON & CHECKED
4. Parking Brakes-Hydraulic Check-On & CHECKED
5. Booster Pumps-Pressure-ON & CHECKED
6. Carburetor Filters-Open
7. Fuel Quantity-Gallons per tank
8. Start Engines: both magnetos on after one revolution
9. Flight Indicator & Vacuum Pressures – CHECKED
11. Check Instruments-CHECKED
12. Crew Report
13. Radio Call & Altimeter-SET
2. Trim Tabs-SET
3. Exercise Turbos and Props
4. Check Generators-CHECKED & OFF
5. Run up Engines
1. Wheel-PILOT’S SIGNAL
2. Power Reduction
3. Cowl Flaps
4. Wheel Check-OK right-OK LEFT
1. Radio Call, Altimeter-SET
2. Crew Position-OK
4. Booster Pumps-On
5. Mixture Controls-AUTO-RICH
7. Carburetor Filters-Open
8. Wing De-icers-Off
9. Landing Gear
a. Visual-Down Right-DOWN LEFT
Tailwheel Down, Antenna in, Ball Turret Checked
c. Switch Off-Neutral
10. Hydraulic Pressure-OK Valve closed
11. RPM 2100-Set
13. Flaps 1/3-1/3 Down
14. Flaps-PILOT’S SIGNAL
15. RPM 2200-PILOT’S SIGNAL
Back side of checklist
1. Hydraulic Pressure-OK
2. Cowl Flaps-Open and locked
4. Booster Pumps-Off
5. Wing Flaps-Up
END OF MISSION
2. Radio-On ramp
6. Form 1
1. High RPM & Power-High RPM
2. Wing Flaps-Coming Up
3. Power reduction
4. Wheel Check-OK Right-OK LEFT
1. Wing Flaps-Coming Up
3. Wheel Check-OK Right-OK LEFT
1. Trim Tabs-SET
2. Wing Flaps-UP
3. Cowl Flaps-Open Right-OPEN LEFT
4. High RPM-CHECKED
5. Fuel-Gals per tank
6. Booster Pumps-ON
8. Flight Controls-UNLOCKED
9. Radio Call
1. Landing Gear
a. Visual-Down Right-DOWN LEFT
Tailwheel Down, Ball Turret Checked
2. Hydraulic Pressure-OK
3. RPM 2100-Set
4. Turbo Controls-Set
5. Wing Flaps 1/3 – 1/3 Down
6. Radio Call
7. Flaps-PILOT’S SIGNAL
8. RPM 2200-PILOT’S SIGNAL
1. Throttle Back
3. Mixture and Fuel Booster-Off
4. Turbo Off
5. Prop Low RPM
6. Ignition Off
7. Generator Off
8. Fuel Valve Off
1. Fuel Valve-On
2. Ignition On
3. Prop Low RPM
4. Throttle Cracked
5. Supercharger Off
7. Mixture Auto-Rich
8. Warm up Engine
9. Generator On
SEQUENCE OF POWER CHANGES
1. Mixture Controls
4. Mixture Controls”
In part 2 of the “Wisdom of Seth Klarman” article from Distressed Debt Investing, which I posted on October 9, 2009, there is a great quote about what can go wrong with your investments. If you study Klarman, it is clear that he thinks about risks before rewards, and he takes seriously his commitment to preserve the hard earned capital of his investors.
“For most investments, much can go wrong, including numerous factors beyond an investor’s control: the economy, the markets, interest rates, the dollar, war, politics, tax rates, new technology, labor problems, competition, litigation, natural disasters, fraud, dilution, accounting gimmicks, and corporate mismanagement. Some but not all of these risks can be hedged, often only imprecisely and always at some cost. Other factors are under an investor’s control, but are not always controlled: discipline; consistency; remaining within your circle of competence; matched duration of client capital with underlying investments; prudent diversification; reacting rationally to news or market developments; and of course, not overpaying”
I want to add a few thoughts on how investors can hedge against the risks that Klarman lists.
1. Study economic history and the history of markets. For example, Buffett is a great student of the history of markets and has commented that the Long Term Management blowup was a repeat of Northern Pacific in 1903. He has also commented that he finds many MBAs lacking in their knowledge of financial history. As Twain said, “History doesn’t repeat itself, but it rhymes.”
2. Always invest with a margin of safety. Graham has written that all investing comes down to these three words. Buffett has said repeatedly that Chapter 20 on the Margin of Safety in The Intelligent Investor, along with Chapter 8 on market fluctuations, is the most important thing ever written about investing.
3. Become increasingly cautious and fearful as the general market averages rise. Use basic common sense indicators to measure market valuation, such as the yield of the S&P 500 to that of 10-year U.S. Treasuries and the ratio of the market’s capitalization to U.S. GDP.
4. Look for investments that are not highly correlated with the general market averages. In the 50’s and 60’s, Buffett used control investing and arbitrage for this purpose. He also found a way to hedge multiple compression in his holdings of undervalued large cap stocks, although he does not disclose the specific technique.
5. Don’t be adverse to holding cash if you cannot find opportunities with downside protection and a mathematical expectancy that meets your investment hurdle rate.
6. Having a meaningful percentage of your companies’ earnings come from outside the U.S. is a way to hedge against future devaluation of the dollar.
7. Having companies that have the ability to raise prices and that have modest maintenance capex requirements along with high returns on invested capital can help hedge against inflation.
8. Avoid companies whose earnings are exposed in a material way to countries with political instability or capricious application of the law.
9. Invest in companies that have a clearly identifiable sustainable competitive advantage.
10. Carefully read the 10K’s, 10Q’s and proxy stamements to understand risks to the company, such as litigation and under-funded pension obligations.
11. Pay attention to free cash flow in addition to GAAP earnings and learn to detect financial statement fraud, for example by studying Financial Shenanigans by Howard Schilit.
12. Look for companies whose management has a meaningful ownership of the company’s stock, and, ideally, where management has purchased stock in the open market as opposed to option grants. Judge management by its actions, not its rhetoric.
13. Use extreme caution with companies that are exposed to technical obsolescence or short-term creative disruption.
14. If you don’t have conviction or its too complex, take a pass. There are plenty of other opportunities out there.
15. Think about risks first and rewards second. As 2008 proved, years of gains can be wiped out quickly and successful track records humbled when risk is not managed or given its proper due. Always consider what “black swan(s)” is present in your portfolio or strategy.
Kudos to the blog Distressed Debt Investing for putting together an outstanding four-part series on the wisdom of Seth Klarman. Klarman not only has one of the best records in the business on an absolute basis, but also has done so by deftly managing the risk exposure of his portfolio. He is a clear and consistent thinker who is not swayed in the least by fashion or irrational exuberance.