After what happened to equity markets in 2008, many financial "experts" began to question whether or not any investing school of thought really worked. Those who believed that the market was efficient found egg on their face when all was said and done. I didn't need 2008 to prove to me that markets were inefficient. The proof positive reason I have for market inefficiency is simple this: the stock market consists of human participants who by their very nature are irrational and inefficient creatures.
The other school of thought that took a beating was that of value investing. I've never really been fond of using the term value investing, since I subscribe to the Charlie Munger view that "all investing is value investing." Further I believe that the value and growth aspects of investing are merely two sides of the same coin. Nonetheless, its because precisely that so few individuals actually subscribe to the tenants of value investing (those being risk aversion, avoidance of crowd psychology, buying businesses in out in favor places, etc.) that we do use the term value investing. So it is in this context that I dispense of the term value investing and how I adhere to it.
Let me use a moment now to throw in a shameless plug for my recent book that was just published by John Wiley and Sons, "The Business of Value Investing" which focuses on precisely how a businesslike mind frame is what true value investors employ in selecting equities. The book focuses on the six essential elements (use of the word element is deliberate - elements are essential to life) that are incorporated in the value investors mind.
Back to the topic at hand. Value investing was left for dead after 2008. I mean when Bill Miller nearly 50% in a year and Mohnish Pabrai drops by nearly 60%, surely the approach is flawed. Never mind that folks criticizing the tenets of value are dismissing over 80 years of results by Ben Graham, Walter Schloss, Warren Buffett, and Seth Klarman. Even I will admit the Gad Partners Funds' had a terrible 2008, down nearly 45 percent. But the value investor sticks to his knitting, obviously willing to tweak his or her approach, but never doubting the inherent success of the foundations of value investing. (By the way, I believe Miller is up nearly 50% this year and Pabrai is up over 100%. As for the GPF, I can't get into the specifics but we are in between Miller and Pabrai. Obviously simple tells you that even those results have yet to get any of us back above 2008 levels, but we are not done, not by a long shot.)
Where many "value" folk go wrong is in a very fundamental sense. Many investors spend far too much time focusing on the income statement first and the balance sheet second. No question, profits are important, but without a solid foundation, those profits are only as good as the business environment. And no business environment stays rosy forever - there are hiccups. And if business setbacks are hiccups, 2008 was a trip to the ICU.
The balance sheet must always be the most relied upon piece of information. In basic value terminology, the balance sheet is the FIRST MOAT. Of course, the balance sheet alone is not enough. The income statement is the SECOND MOAT. A debt free, cash rich company is great, but not so great if that business can't produce profits. Still a profitless company with a sound balance sheet still has value creating catalysts - buyout, liquidation, etc. - that serve to protect the investor. The same is not true for a profitless company loaded with debt or poor assets. The results here can often be massive shareholder dilution in order to keep the company afloat or worse, bankruptcy.
Tuesday, October 13, 2009
Thursday, September 17, 2009
Thursday, September 10, 2009
Macro Matters
Despite the often perceived notion that adherents of value investing ignore the macro economy, nothing could be further from the truth. Make no mistake: the central tenant of value investing is to buy assets at a significant discount to thier intrinsic value, where such an intrinsic value is typically determined by the cash generation of those assets.
The problem to those outside the value circle looking in is that value investors often make such investments during the most pessimistic market environments, which almost always means that the stock price will fall some more once it is purchases. This leads many to believe that a value oriented approach ignores macro economic considerations.
Such beliefs are myths and if you look at the approaches of the most successful value investors, consideration is always given to certain macro economic factors. Understanding this delicate distinction will prove very fruitful to investors going forward in making investment decisions.
If there is anything that trumps all other considerations to a value investor, it’s the price paid for a security. In many cases, a fire-sale price can be overcome by macro considerations. For example, consider the restaurant industry. For many reasons, many restaurants aside from ultra budget friendly places are relatively unattractive investment candidates to many value investors. Restaurants are often characterized by thin profit margins, extremely low barriers to entry, and the availability of numerous substitutes.
But what is also considered are things like the rate of unemployment, the household savings rate, and consumer spending. You might not see this in the value investor's analysis of the company per se, but they are all seriously considered in any worthwhile analysis.
Nonetheless, where the value investor hinges his ultimate bet on is the price paid for the security.
The Future for Investors
So looking ahead, what doest this mean for investors? It means that just because a stock has a P/E of 8, it might not represent a bargain when you consider the macro environment going forward. As noted investment manager Jeremy Grantham remarked recently after the recent market rally, it appears the market is headed for “seven lean years.”
But it also means that value can be ascertained in various forms. For mental stimulation, consider the following example:
For instance at P/E of 20, many value "wannabes" may be quick to dismiss Hutchison Telecom International a company that provides mobile and fixed line telecommunications services in the Asia-Pacific region, specifically in areas like Indonesia, Vietnam, and Thailand. You’re essentially getting a company with a huge option on increased telecommunications use from the world’s fastest growing region.
Hutchison used to be a huge amalgamation of telecom businesses throughout the emerging world. However, the company recently spun-off the Hong Kong and Macau operations into Hutchison Telecommunications. HTX is now the more “volatile” growth targeting emerging markets provider. Even after the spin-off Hutchison Telecom owned 51% of Partner Communications the number 2 telecom based in Israel. Subsequently the stake was put up for sale for $1.38 billion
Quickly looking at Partner, Hutchison Telecom may seem like an absurd bargain. Hutchison currently has an enterprise value of some $1.5 billion, while the 51% stake in Partner is will fetch HTX $1.4 billion. This might seem that investors are getting to bet on telecommunications growth in Indonesia, Veitnam, and Sri Lanka for free. Unfortunately, the market is already aware of about $900 million in cap ex that Hutchison is planning for expansion into the emerging countries. Still, if any of those emerging countries do as well as India or China in terms of penetration, there’s huge upside.
So Hutchison offers a very interesting play in the fastest growing region in the world. Underlying this thought is a favorable long-term macro view: as a country develops its citizens will need communication capabilities.
If you train yourself to look at a company in such a fashion, you begin to understand what matters most when looking at a business.
Put the Process Before the Outcome
Value investing works if pursued patiently and meticulously. The goal is to always seek out market mis-pricings because when you can, the margin of safety protects you from sudden or temporary shifts in the macro-economic environment. But that doesn’t mean value investors ignore the macro economy, instead it’s always factored into a thorough and quality analytical framework.
The problem to those outside the value circle looking in is that value investors often make such investments during the most pessimistic market environments, which almost always means that the stock price will fall some more once it is purchases. This leads many to believe that a value oriented approach ignores macro economic considerations.
Such beliefs are myths and if you look at the approaches of the most successful value investors, consideration is always given to certain macro economic factors. Understanding this delicate distinction will prove very fruitful to investors going forward in making investment decisions.
If there is anything that trumps all other considerations to a value investor, it’s the price paid for a security. In many cases, a fire-sale price can be overcome by macro considerations. For example, consider the restaurant industry. For many reasons, many restaurants aside from ultra budget friendly places are relatively unattractive investment candidates to many value investors. Restaurants are often characterized by thin profit margins, extremely low barriers to entry, and the availability of numerous substitutes.
But what is also considered are things like the rate of unemployment, the household savings rate, and consumer spending. You might not see this in the value investor's analysis of the company per se, but they are all seriously considered in any worthwhile analysis.
Nonetheless, where the value investor hinges his ultimate bet on is the price paid for the security.
The Future for Investors
So looking ahead, what doest this mean for investors? It means that just because a stock has a P/E of 8, it might not represent a bargain when you consider the macro environment going forward. As noted investment manager Jeremy Grantham remarked recently after the recent market rally, it appears the market is headed for “seven lean years.”
But it also means that value can be ascertained in various forms. For mental stimulation, consider the following example:
For instance at P/E of 20, many value "wannabes" may be quick to dismiss Hutchison Telecom International a company that provides mobile and fixed line telecommunications services in the Asia-Pacific region, specifically in areas like Indonesia, Vietnam, and Thailand. You’re essentially getting a company with a huge option on increased telecommunications use from the world’s fastest growing region.
Hutchison used to be a huge amalgamation of telecom businesses throughout the emerging world. However, the company recently spun-off the Hong Kong and Macau operations into Hutchison Telecommunications. HTX is now the more “volatile” growth targeting emerging markets provider. Even after the spin-off Hutchison Telecom owned 51% of Partner Communications the number 2 telecom based in Israel. Subsequently the stake was put up for sale for $1.38 billion
Quickly looking at Partner, Hutchison Telecom may seem like an absurd bargain. Hutchison currently has an enterprise value of some $1.5 billion, while the 51% stake in Partner is will fetch HTX $1.4 billion. This might seem that investors are getting to bet on telecommunications growth in Indonesia, Veitnam, and Sri Lanka for free. Unfortunately, the market is already aware of about $900 million in cap ex that Hutchison is planning for expansion into the emerging countries. Still, if any of those emerging countries do as well as India or China in terms of penetration, there’s huge upside.
So Hutchison offers a very interesting play in the fastest growing region in the world. Underlying this thought is a favorable long-term macro view: as a country develops its citizens will need communication capabilities.
If you train yourself to look at a company in such a fashion, you begin to understand what matters most when looking at a business.
Put the Process Before the Outcome
Value investing works if pursued patiently and meticulously. The goal is to always seek out market mis-pricings because when you can, the margin of safety protects you from sudden or temporary shifts in the macro-economic environment. But that doesn’t mean value investors ignore the macro economy, instead it’s always factored into a thorough and quality analytical framework.
Tuesday, April 28, 2009
Invest Like It's The End of the World and Be Rewarded
It's been nearly four months since I last posted - it's always about quality not quantity, eh? Needless to say, I've been - and happily so - swamped with reading annual reports and finishing up my first book, due out in October. Nonetheless, with investors of all stripes turning thier heads looking for answers, I'm here to say I don't have any. But I do have some thoughts on what seems to be a prudent approach to our craft.
I have a lot of respect for Ian Cumming and Joe Steinberg, the top brass at Leucadia. Like everyone else, they had a dismal 2008. Many of Leucadia's investments - commodities, real estate, wineries - are simply dependant on the economy turning around. But one year a track record doesn't make. But 30 or so years it does and Leucadia's results over that time have been off the charts: book value per share has increased at a 17.3 compounded annual growth rate from 1979 - 2008.
So naturally, I enjoy reading the company’s annual letter to shareholders for any nuggets of wisdom or investment ideas since Leucadia is nothing more than a conglomerate of investment holdings. Reading Leucadia's annual letter over the weekend, I was intrigued by Cummings and Steinberg's assessment of the future.
"Out of prudence we have a pessimistic view as to when this recession will end. To think otherwise would be to gamble about the beginnings of good times whereas by imagining a bleak future we will most likely survive for the good times to arrive."
So naturally, I enjoy reading the company’s annual letter to shareholders for any nuggets of wisdom or investment ideas since Leucadia is nothing more than a conglomerate of investment holdings. Reading Leucadia's annual letter over the weekend, I was intrigued by Cummings and Steinberg's assessment of the future.
"Out of prudence we have a pessimistic view as to when this recession will end. To think otherwise would be to gamble about the beginnings of good times whereas by imagining a bleak future we will most likely survive for the good times to arrive."
I find the above statement to be one of the greatest pieces of investment wisdom I've come across recently. Investors would be well served to take the above assessment and apply it to their investments going forward. I like to call it an “invest for the worst and hope for the best” kind of approach to investing today.
My approach stems from the fact that investors are crazy if they are analyzing most businesses based on 2007 profits/multiples. Don't get me wrong: we could very well be easily sitting in the midst of the greatest buying opportunities of a lifetime. Indeed, I lean towards this view. However, it's with prudence that investors must assume that the market will remain in a funk in order to profit handsomely when spring does come. Because if you assume the worst, your investment process, by default, will become much more skeptical. All investors should arm themselves with a healthy does of skepticism at all times.
The wonderful thing about 45% market declines is that many stocks fall a lot a harder, thus setting the setting for phenomenal returns. Forget the preverbial 50 cent dollar - they are a dime a dozen today. Thirty cent - even ten cent dollars - can be found today with a little extra effort.
True value investors are not afraid to pounce if a security is widely undervalued. They time stock prices and not stock markets. In a recent interview Buffett said he would relish the opportunity to be in his 20's all over again today.
We're certainly not out of the woods yet, and it seems that it really won't be until 2011 until the economy recovers again. But it's a guessing game as to when the stock market will turn - they are forward looking creatures after all. But then again, value investors aren't timing stock markets.
Monday, January 5, 2009
What Really Matters In Investing
Why Prudent Investors Focus on Holding Period Returns
With 2008 finally over, many investors have equity portfolios that have shriveled by 30% to 70%. Simple arithmetic will tell you that if you're down 50% in 2008, you need a 100% return to get back to even. While possible, it will be a remote possibility for many to earn a triple digit return in 2009 considering that many consider it to be a healing year at best.
Whether we like it or not, investing is most beneficial and pays off when done for a period of many years. As such, investors holding securities are better off focusing on holding period returns, which is what really matters. The stock market swings wildly in the short run, but over time, stock prices have always caught up with the underlying fundamentals of the business. Skeptics will correctly argue that investing a dollar invested in the market over the past decade would be worth slightly less today. But I’m not talking about investing in the broad market, but instead individual securities.
One thousand dollars invested in steel producer Nucor would be worth about $20,000 at the end of 2008. The same $1,000 invested in UnitedHealth Group in 1998 would be worth over $15,000 today once you factor in three 2 for 1 stock splits that occurred in 2000, 2003, and 2005. Even boring old Wal-Mart shares would have been worth about $3,000 today in exchange for putting up $1,000 in 1998, and this is not including the dividend. And even and investment in 1998 in Whole Foods which today trades around $9 share, down from an all-time high of $80, would be up over twofold when accounting for the two stock splits.
The market is tough to beat, but you could have easily made satisfactory returns over the past ten years in which the market went nowhere. And these returns would have outperformed real estate, bonds, and just about any other asset class.
The next decade will be no different even if you started in 2008 and can muster the courage and patience to keep going. No one has a clue what the market performance over the next five and ten years will be. But everyone will agree that there will be many companies that will be bigger, better, and more profitable. And Mr. Market doesn’t care about fundamentals in 2008, businesses that continue to improve profit generation will ultimately be recognized.
History Doesn’t Repeat Itself...But It Does Rhyme
Knowing a little market history after the worst year since the Depression can be very instructive. The following chart shows how the Dow has fared during and after recessions.
Recessionary Period (Change in Dow during recession) (Change one year after)
Aug 1929 - March 1933 (-84.2%) (81.1% )
May 1937 - June 1938 (-23.2%) (-2.4%)
Feb 1945 - Oct 1945 (21.3%) (-9.4%)
Nov 1948 - Oct 1949 (-0.12%) (18.7%)
July 1953 - May 1954 (21.6%) (29.7%)
Aug 1957 - April 1958 (-9.9%) (36.8%)
April 1960 - Feb 1961 (7.5%) (6.9%)
Dec 1969 - Nov 1970 (-1.4%) (4.7%)
Nov 1973 - March 1975 (-19.0%) (30.1%)
Jan 1980 - July 1980 (11.5%) (1.9%)
July 1981 - Nov 1982 (7.4%) (22.8%)
July 1990 - March 1991 (1.2%) (11.0%)
Mar 2001 - Nov 2001 (-5.7%) (-9.7%)
The crucial part, of course, is how long our current recession will affect the market. No one truly knows. What we do know is that the market will have turned by the time we get the “official” word.
But another important chart to look at is below.
Company [2001 Price] [2003 Price] [2007 Price]
Apple [$7-$13] [$6 - $12] [$82 - $200]
Vulcan Materials [$37 - $55] [$29 -$49] [$77 - $129]
Tesoro Corp [$5 - $8] [$2 - $7] [$31 - $66]
Transocean [$23 - $57] [$18 -$26] [$73 - $150]
Fluor [$15 -$31] [$10 - $22] [$37 - $86]
Source: Value Line (note: prices reflected low’s and highs for the year are rounded to nearest dollar for illustrative purposes)
The sample above is instructive in showing us how markets behave. Many securities that were bought in 2001 - a year of double digit market declines - were deeply underwater at the end of the year. Two years later many investors were still down by over 50% on many holdings if they had held on. But by 2007, if you had invested in solid companies with great earnings power, you more than made up for it. Even with a 60% two year decline in share value for Fluor shares in the heavy construction firm more than rewarded long-term investors. Assuming you had bought at $25 in 2001, you were down over 50% by 2003. Assuming you had sold at $65 in 2007, your six year holding period return was $160%. I’ll take numbers like that all day.
This recession is vastly worse than the 2001 variety. But as a long-term investor, you should keep your focus on holding period returns and if you stick with businesses that will be doing well a couple of years from now, you’ll realize that stocks can still produce the best returns.
With 2008 finally over, many investors have equity portfolios that have shriveled by 30% to 70%. Simple arithmetic will tell you that if you're down 50% in 2008, you need a 100% return to get back to even. While possible, it will be a remote possibility for many to earn a triple digit return in 2009 considering that many consider it to be a healing year at best.
Whether we like it or not, investing is most beneficial and pays off when done for a period of many years. As such, investors holding securities are better off focusing on holding period returns, which is what really matters. The stock market swings wildly in the short run, but over time, stock prices have always caught up with the underlying fundamentals of the business. Skeptics will correctly argue that investing a dollar invested in the market over the past decade would be worth slightly less today. But I’m not talking about investing in the broad market, but instead individual securities.
One thousand dollars invested in steel producer Nucor would be worth about $20,000 at the end of 2008. The same $1,000 invested in UnitedHealth Group in 1998 would be worth over $15,000 today once you factor in three 2 for 1 stock splits that occurred in 2000, 2003, and 2005. Even boring old Wal-Mart shares would have been worth about $3,000 today in exchange for putting up $1,000 in 1998, and this is not including the dividend. And even and investment in 1998 in Whole Foods which today trades around $9 share, down from an all-time high of $80, would be up over twofold when accounting for the two stock splits.
The market is tough to beat, but you could have easily made satisfactory returns over the past ten years in which the market went nowhere. And these returns would have outperformed real estate, bonds, and just about any other asset class.
The next decade will be no different even if you started in 2008 and can muster the courage and patience to keep going. No one has a clue what the market performance over the next five and ten years will be. But everyone will agree that there will be many companies that will be bigger, better, and more profitable. And Mr. Market doesn’t care about fundamentals in 2008, businesses that continue to improve profit generation will ultimately be recognized.
History Doesn’t Repeat Itself...But It Does Rhyme
Knowing a little market history after the worst year since the Depression can be very instructive. The following chart shows how the Dow has fared during and after recessions.
Recessionary Period (Change in Dow during recession) (Change one year after)
Aug 1929 - March 1933 (-84.2%) (81.1% )
May 1937 - June 1938 (-23.2%) (-2.4%)
Feb 1945 - Oct 1945 (21.3%) (-9.4%)
Nov 1948 - Oct 1949 (-0.12%) (18.7%)
July 1953 - May 1954 (21.6%) (29.7%)
Aug 1957 - April 1958 (-9.9%) (36.8%)
April 1960 - Feb 1961 (7.5%) (6.9%)
Dec 1969 - Nov 1970 (-1.4%) (4.7%)
Nov 1973 - March 1975 (-19.0%) (30.1%)
Jan 1980 - July 1980 (11.5%) (1.9%)
July 1981 - Nov 1982 (7.4%) (22.8%)
July 1990 - March 1991 (1.2%) (11.0%)
Mar 2001 - Nov 2001 (-5.7%) (-9.7%)
The crucial part, of course, is how long our current recession will affect the market. No one truly knows. What we do know is that the market will have turned by the time we get the “official” word.
But another important chart to look at is below.
Company [2001 Price] [2003 Price] [2007 Price]
Apple [$7-$13] [$6 - $12] [$82 - $200]
Vulcan Materials [$37 - $55] [$29 -$49] [$77 - $129]
Tesoro Corp [$5 - $8] [$2 - $7] [$31 - $66]
Transocean [$23 - $57] [$18 -$26] [$73 - $150]
Fluor [$15 -$31] [$10 - $22] [$37 - $86]
Source: Value Line (note: prices reflected low’s and highs for the year are rounded to nearest dollar for illustrative purposes)
The sample above is instructive in showing us how markets behave. Many securities that were bought in 2001 - a year of double digit market declines - were deeply underwater at the end of the year. Two years later many investors were still down by over 50% on many holdings if they had held on. But by 2007, if you had invested in solid companies with great earnings power, you more than made up for it. Even with a 60% two year decline in share value for Fluor shares in the heavy construction firm more than rewarded long-term investors. Assuming you had bought at $25 in 2001, you were down over 50% by 2003. Assuming you had sold at $65 in 2007, your six year holding period return was $160%. I’ll take numbers like that all day.
This recession is vastly worse than the 2001 variety. But as a long-term investor, you should keep your focus on holding period returns and if you stick with businesses that will be doing well a couple of years from now, you’ll realize that stocks can still produce the best returns.
Wednesday, December 3, 2008
Mueller Water Arbitrage: Taking Candy from a Baby
Mueller Water Products (NYSE: MWA & MWA-B) was spun out of Walter Industries in 2006. Prior to the spin-off Mueller’s Class A shares were already trading in the market via an IPO. Subsequent to the spin-off Mueller issued Class B shares to the existing shareholders of Walter Industries. The share structure was that 25 million A shares were floated and 85 million B shares were spun-off. Both classes of stock have identical economic value. The only difference was that the B shares came with eight votes per share versus only one vote for each A share. The superior voting rights would suggest that the B shares should command a premium to the A shares.
Historically, the A shares tended to trade at a premium to the B shares, typically at a level of 5-10%. The only reason explaining this mismatch was the greater supply of B shares and the fact that there was greater selling pressure on the B shares from Walter Industries shareholders who wanted to monetize their Mueller stake. Additionally, unlike a Berkshire Hathaway, where conversion rights exist between the A and B shares, Mueller has no such conversion rights, so there was nothing to prevent shares from trading one to one.
In September of 2008, I noticed that the B shares were trading at $6 while the A shares were hovering around $9, or a 50% premium to the B shares. This was an absurd spread which can only be explained by the irrational market behavior that has engulfed investors recently. The trade was simple: I shorted an equal dollar amount of A shares against a long dollar amount of B shares. Believe or not, there were plenty of A shares to short. Within days the spread had closed to within 20%. My goal was to exit the position when the spread came close to the historical 5-10%. But as luck would have, the company announced that at the next annual meeting, it would put to a vote a resolution to make the A shares convertible to B shares on a one for one basis. The spread closed to within 1% immediately. We didn’t need to conversion announcement to make money but it was icing on the cake. At a 50% spread, the short/long trade was like taking candy from a baby.
Historically, the A shares tended to trade at a premium to the B shares, typically at a level of 5-10%. The only reason explaining this mismatch was the greater supply of B shares and the fact that there was greater selling pressure on the B shares from Walter Industries shareholders who wanted to monetize their Mueller stake. Additionally, unlike a Berkshire Hathaway, where conversion rights exist between the A and B shares, Mueller has no such conversion rights, so there was nothing to prevent shares from trading one to one.
In September of 2008, I noticed that the B shares were trading at $6 while the A shares were hovering around $9, or a 50% premium to the B shares. This was an absurd spread which can only be explained by the irrational market behavior that has engulfed investors recently. The trade was simple: I shorted an equal dollar amount of A shares against a long dollar amount of B shares. Believe or not, there were plenty of A shares to short. Within days the spread had closed to within 20%. My goal was to exit the position when the spread came close to the historical 5-10%. But as luck would have, the company announced that at the next annual meeting, it would put to a vote a resolution to make the A shares convertible to B shares on a one for one basis. The spread closed to within 1% immediately. We didn’t need to conversion announcement to make money but it was icing on the cake. At a 50% spread, the short/long trade was like taking candy from a baby.
Wednesday, November 19, 2008
Valuations Don't Matter - In the Short Run
The markets are going through a historic transformation. During this process, all rationality goes out the window. Consider what happened to the tripling in price of credit swaps covering Berkshire Hathaway for a bet they made that doesn't come due until 2019.
Valuations today simply mean nothing...in the short run. "Cheap" has taken on a whole new meaning. And if your business has any amount of meaningful debt, the market hates you even more.
Without a doubt the excessive decline in share prices has been exacerbated by the forced selling--from everyone. Mutual fund redemption's are at an all time high. Pension funds are getting hit. And of course, our hedge fund brethren who decided to buy $15 dollars worth of stock for every dollar handed to them by investors.
I echo Buffett's sentiments that years from now, certain businesses will be earning record profits. Nonetheless, while it's a fools game to attempt to call a bottom, certain things must occur before the environment truly gets better going forward. Mr. Market is confused and it's absurd to see nearly 1,000 point swings in a single day. At this point, a stable 1,000 advance in the market over the course of year would represent over a 12% return - something that every investor would take solace in.
While we value investors prefer to concentrate our efforts in our very best ideas, I think one will do exceedingly well in today's market by buying a less concentrated basket of excellent securities that are trading at magnificent discounts to their true value. Many large-cap companies today are trading at absurd valuations even when you normalize earnings over multi-year periods. ConocoPhillips is absurdly cheap and makes money even when oil is at $50. American Express is another.
Joel Greenblatt has done just this by simply buying hundreds of his Magic Formula stocks and going away. The irony in investing is that as markets tank and performance declines, it's easier to invest going forward. Starting point matters. An amateur investor picking a basket of low P/E, strong balance sheet stocks today will likely produce better numbers over the next year or two than many seasoned pros. This merely a function of getting in at a much lower starting point.
While the re-capitalization of the big financial firms was a big step in the right direction (whether you agree with the actual plan or not, no plan at all would have caused unthinkable consequences), we still need to see:
1. Stabilizing Housing Prices - It's amazing that homebuilders still continue to pump out new houses and even more amazing that no homebuilder has gone under. Supply of new homes need to cease.
2. Resumption of corporate M&A Activity - companies need to start taking their cash and putting it to work. When this happens, everyone on the sideline will take notice.
Now is not the time to be losing faith, but I wouldn't expect much in the short run. Investors could be down another 10% to 15% before finally being vindicated.
Valuations today simply mean nothing...in the short run. "Cheap" has taken on a whole new meaning. And if your business has any amount of meaningful debt, the market hates you even more.
Without a doubt the excessive decline in share prices has been exacerbated by the forced selling--from everyone. Mutual fund redemption's are at an all time high. Pension funds are getting hit. And of course, our hedge fund brethren who decided to buy $15 dollars worth of stock for every dollar handed to them by investors.
I echo Buffett's sentiments that years from now, certain businesses will be earning record profits. Nonetheless, while it's a fools game to attempt to call a bottom, certain things must occur before the environment truly gets better going forward. Mr. Market is confused and it's absurd to see nearly 1,000 point swings in a single day. At this point, a stable 1,000 advance in the market over the course of year would represent over a 12% return - something that every investor would take solace in.
While we value investors prefer to concentrate our efforts in our very best ideas, I think one will do exceedingly well in today's market by buying a less concentrated basket of excellent securities that are trading at magnificent discounts to their true value. Many large-cap companies today are trading at absurd valuations even when you normalize earnings over multi-year periods. ConocoPhillips is absurdly cheap and makes money even when oil is at $50. American Express is another.
Joel Greenblatt has done just this by simply buying hundreds of his Magic Formula stocks and going away. The irony in investing is that as markets tank and performance declines, it's easier to invest going forward. Starting point matters. An amateur investor picking a basket of low P/E, strong balance sheet stocks today will likely produce better numbers over the next year or two than many seasoned pros. This merely a function of getting in at a much lower starting point.
While the re-capitalization of the big financial firms was a big step in the right direction (whether you agree with the actual plan or not, no plan at all would have caused unthinkable consequences), we still need to see:
1. Stabilizing Housing Prices - It's amazing that homebuilders still continue to pump out new houses and even more amazing that no homebuilder has gone under. Supply of new homes need to cease.
2. Resumption of corporate M&A Activity - companies need to start taking their cash and putting it to work. When this happens, everyone on the sideline will take notice.
Now is not the time to be losing faith, but I wouldn't expect much in the short run. Investors could be down another 10% to 15% before finally being vindicated.
Friday, October 17, 2008
Buffett Says "Buy American"
On October 17, 2008 Warren Buffett wrote a op-ed piece for the New York Times.
All I can say is please read it....Buffett NY Times
All I can say is please read it....Buffett NY Times
Thursday, October 2, 2008
One-Hour Interview: A Conversation with Warren Buffett
Follow the link below to view the one-hour interview of Buffett with Charlie Rose last night:
A Conversation with Warren Buffett
A Conversation with Warren Buffett
Sunday, September 28, 2008
Book Excerpt: THE SNOWBALL
Below are two excerpt's from Alice Schroeders's The Snowball: Warren Buffett and the Business of Life, the first ever authorized biography of Buffett.
In January 1943, following his father Howard Buffett’s election to Congress as a Republican representing Nebraska, the Buffetts moved to Virginia. The 12-year-old Warren had to change schools. Uprooted and unhappy, his grades suffered and his behaviour took a rapid turn for the worse.
Bad grades were the least of Warren’s troubles in junior high. His parents didn’t know it, but their son had turned to a life of crime.
“Well, I was antisocial, in eighth and ninth grade, after I moved there. I fell in with bad people and did things I shouldn’t have. I was just rebelling. I was unhappy.”
“We’d just steal the place blind. We’d steal stuff for which we had no use. We’d steal golf bags and golf clubs. I walked out of the lower level where the sporting goods were, up the stairway to the street, carrying a golf bag and golf clubs, and the clubs were stolen, and so was the bag. I stole hundreds of golf balls.” They referred to their theft as “hooking”.
“We immediately saw that this would put us out of business – not because of the economic loss, but because the message that would go out to the rest of the world in headlines in the papers on Monday would be ‘Treasury to Salomon: Drop Dead.’ In effect, the response to installation of new management and banishment of the old would be an extraordinary censure delivered at an equally extraordinary time exactly coincident with the first actions of the new management.”
In January 1943, following his father Howard Buffett’s election to Congress as a Republican representing Nebraska, the Buffetts moved to Virginia. The 12-year-old Warren had to change schools. Uprooted and unhappy, his grades suffered and his behaviour took a rapid turn for the worse.
Bad grades were the least of Warren’s troubles in junior high. His parents didn’t know it, but their son had turned to a life of crime.
“Well, I was antisocial, in eighth and ninth grade, after I moved there. I fell in with bad people and did things I shouldn’t have. I was just rebelling. I was unhappy.”
“We’d just steal the place blind. We’d steal stuff for which we had no use. We’d steal golf bags and golf clubs. I walked out of the lower level where the sporting goods were, up the stairway to the street, carrying a golf bag and golf clubs, and the clubs were stolen, and so was the bag. I stole hundreds of golf balls.” They referred to their theft as “hooking”.
Link to: Financial Times Excerpt Part One.
Early on the morning of Sunday August 18, 1991, Warren Buffett met John Gutfreund, Salomon’s outgoing chief executive, and Tom Strauss, shortly to stand down as its president, in one of the many conference rooms on the 45th floor of Salomon’s office downtown, just before the meeting at which the board would ratify Buffett’s apppointment as interim chairman. This was to be announced later that day. The board gathered outside. Suddenly, a lawyer appeared in the conference room where Buffett was meeting Gutfreund and Strauss, waving a message from the US Treasury Department. It was going to announce in a few minutes that Salomon was barred from bidding at Treasury bond auctions, both for customers and for its own account. All of them understood that in minutes Salomon would be shot in the head.
“We immediately saw that this would put us out of business – not because of the economic loss, but because the message that would go out to the rest of the world in headlines in the papers on Monday would be ‘Treasury to Salomon: Drop Dead.’ In effect, the response to installation of new management and banishment of the old would be an extraordinary censure delivered at an equally extraordinary time exactly coincident with the first actions of the new management.”
Thursday, September 4, 2008
Wednesday, August 27, 2008
Longleaf Parnters 2008 Semi-Annual Shareholders Letter
As always, Mason Hawkins and Co. deliver a must read for the serious investor:
"We do not know how long economic uncertainty and shareholder fear will last. Bear markets do not die of old age. The mispricing, however, is providing the opportunity to own high quality companies with terrific five year outlooks that imply high long-term IRRs.We are aggressively adding personal capital to the Funds and encourage our partners to do the same. Given that bullish sentiment is at its lowest level in 14 years and that some are recommending exiting equities altogether, there is plenty of panic in the air. Historically, the best time to invest has been when owning stocks has felt the worst.
Throughout history a small number of successful investors have used periods of fear to build portfolio foundations for substantial long-term gain. John Marks Templeton was among the greatest.We pay tribute to Sir John who not only provided a rolemodel for investing, but also was a trusted advisor and supportive investment partner."
Link: Longleaf Partners Letter
"We do not know how long economic uncertainty and shareholder fear will last. Bear markets do not die of old age. The mispricing, however, is providing the opportunity to own high quality companies with terrific five year outlooks that imply high long-term IRRs.We are aggressively adding personal capital to the Funds and encourage our partners to do the same. Given that bullish sentiment is at its lowest level in 14 years and that some are recommending exiting equities altogether, there is plenty of panic in the air. Historically, the best time to invest has been when owning stocks has felt the worst.
Throughout history a small number of successful investors have used periods of fear to build portfolio foundations for substantial long-term gain. John Marks Templeton was among the greatest.We pay tribute to Sir John who not only provided a rolemodel for investing, but also was a trusted advisor and supportive investment partner."
Link: Longleaf Partners Letter
Monday, August 18, 2008
The Security [Buffett] Liked Best in 1952
This is a gem article written by Buffett over 50 years ago. I remember in Omaha Buffett telling me that he found this business in the back of the famous "10,000 page Moody's manual" that he went through page by page. Like his approach to GEICO, Buffett's analysis is simple and hits on what counts.
A big thanks to Dah Lau for sending this out.
Western Insurance Securities Company, 1952
by Warren Buffett
Again my favorite security is the equity stock of a young, rapidly growing and ably managed insurance company. Although Government Employees Insurance Co., my selection of 15 months ago, has had a price rise of more than 100%, it still appears very attractive as a vehicle for long-term capital growth.Rarely is an investor offered the opportunity to participate in the growth of two excellently managed and expanding insurance companies on the grossly undervalued basis which appears possible in the case of the Western Insurance Securities Company.
The two operating subsidiaries, Western Casualty & Surety and Western Fire, wrote a premium volume of $26,009,929 in 1952 on consolidated admitted assets of S29,590,142. Now licensed in 38 states, their impressive growth record, both absolutely and relative to the industry, is summarized in Table I below.Western Insurance Securities owns 92% of Western Casualty and Surety, which in turn owns 99.95% of Western Fire Insurance. Other assets of Western Insurance Securities are minor, consisting of approximately $180,000 in net quick assets. The capitalization consists of 7,000 shares of $100 par 6% preferred, callable at $125; 35,000 shares of Class A preferred, callable at $60, which is entitled to a $2.50 regular dividend and participates further up to a maximum total of $4 per share; and 50,000 shares of common stock.
The arrears on the Class A presently amount to $36.75.The management headed by Ray DuBoc is of the highest grade. Mr. DuBoc has ably steered the company since its inception in 1924 and has a reputation in the insurance industry of being a man of outstanding integrity and ability. The second tier of executives is also of top caliber. During the formative years of the company, senior charges were out of line with the earning power of the enterprise.
The reader can clearly perceive why the same senior charges that caused such great difficulty when premium volume ranged about the $3,000,000 mark would cause little trouble upon the attainment of premium volume in excess of $26,000,000.Adjusting for only 25% of the increase in the unearned premium reserve, earnings of $1,367,063 in 1952, a very depressed year for auto insurers, were sufficient to cover total senior charges of $129,500 more than 10 times over, leaving earnings of $24.74 on each share of common stock.It is quite evident that the common stock has finally arrived, although investors do not appear to realize it since the stock is quoted at less than twice earnings and at a discount of approximately 55% from the December 31, 1952 book value of $86.26 per share. Table II indicates the postwar record of earnings and dramatically illustrates the benefits being realized by the common stock because of the expanded earnings base.
The book value is calculated with allowance for a 25% equity in the unearned premium reserve and is after allowance for call price plus arrears on the preferreds.Since Western has achieved such an excellent record in increasing its industry share of premium volume, the reader may well wonder whether standards have been compromised. This is definitely not the case. During the past ten years Western's operating ratios have proved quite superior to the average multiple line company. The combined loss and expense ratios for the two Western companies as reported by the Alfred M. Best Co. on a case basis are compared in Table III with similar ratios for all stock fire and casualty companies.
The careful reader will not overlook the possibility that Western's superior performance has been due to a concentration of writings in unusually profitable lines. Actually the reverse is true. Although represented in all major lines, Western is still primarily an automobile insurer with 60% of its volume derived from auto lines. Since automobile underwriting has proven generally unsatisfactory in the postwar period, and particularly so in the last three years, Western's experience was even more favorable relative to the industry than the tabular comparison would indicate.Western has always maintained ample loss reserves on unsettled claims.
Underwriting results in the postwar period have shown Western to be over-reserved at the end of each year. Triennial examinations conducted by the insurance commissioners have confirmed these findings.Turning to their investment picture, we of course find a growth in invested assets and investment income paralleling the growth in premium volume. Consolidated net assets have risen from $5,154,367 in 1940 to their present level of $29,590,142. Western follows an extremely conservative investment policy, relying upon growth in premium volume for expansion in investment income. Of the year-end portfolio of $21,889,243, governments plus a list of well diversified high quality municipals total $20,141,246 or 92% and stocks only $1,747,997 or 8%. Net investment income of $474,472 in 1952 was equal to $6.14 per share of Western Insurance common after minority interest and assuming senior charges were covered entirely from investment income.
The casualty insurance industry during the past several years has suffered staggering losses on automobile insurance lines. This trend was sharply reversed during late 1952. Substantial rate increases in 1951 and 1952 are being brought to bear on underwriting results with increasing force as policies are renewed at much higher premiums. Earnings within the casualty industry are expected to be on a very satisfactory basis in 1953 and 1954.Western, while operating very profitably during the entire trying period, may be expected to report increased earnings as a result of expanding premium volume, increased assets, and the higher rate structure. An earned premium volume of $30,000,000 may be conservatively expected by 1954.
Normal earning power on this volume should average about $30.00 per share, with investment income contributing approximately $8.40 per share after deducting all senior charges from investment income.The patient investor in Western Insurance common can be reasonably assured of a tangible acknowledgement of his enormously strengthened equity position. It is well to bear in mind that the operating companies have expanded premium volume some 550% in the last 12 years. This has required an increase in surplus of 350% and consequently restricted the payment of dividends. Recent dividend increases by Western Casualty should pave the way for more prompt payment on arrearages. Any leveling off of premium volume will permit more liberal dividends while a continuation of the past rate of increase, which in my opinion is very unlikely, would of course make for much greater earnings.
Operating in a stable industry with an excellent record of growth and profitability, I believe Western Insurance common to be an outstanding vehicle for substantial capital appreciation at its present price of about 40. The stock is traded over-the-counter.
A big thanks to Dah Lau for sending this out.
Western Insurance Securities Company, 1952
by Warren Buffett
Again my favorite security is the equity stock of a young, rapidly growing and ably managed insurance company. Although Government Employees Insurance Co., my selection of 15 months ago, has had a price rise of more than 100%, it still appears very attractive as a vehicle for long-term capital growth.Rarely is an investor offered the opportunity to participate in the growth of two excellently managed and expanding insurance companies on the grossly undervalued basis which appears possible in the case of the Western Insurance Securities Company.
The two operating subsidiaries, Western Casualty & Surety and Western Fire, wrote a premium volume of $26,009,929 in 1952 on consolidated admitted assets of S29,590,142. Now licensed in 38 states, their impressive growth record, both absolutely and relative to the industry, is summarized in Table I below.Western Insurance Securities owns 92% of Western Casualty and Surety, which in turn owns 99.95% of Western Fire Insurance. Other assets of Western Insurance Securities are minor, consisting of approximately $180,000 in net quick assets. The capitalization consists of 7,000 shares of $100 par 6% preferred, callable at $125; 35,000 shares of Class A preferred, callable at $60, which is entitled to a $2.50 regular dividend and participates further up to a maximum total of $4 per share; and 50,000 shares of common stock.
The arrears on the Class A presently amount to $36.75.The management headed by Ray DuBoc is of the highest grade. Mr. DuBoc has ably steered the company since its inception in 1924 and has a reputation in the insurance industry of being a man of outstanding integrity and ability. The second tier of executives is also of top caliber. During the formative years of the company, senior charges were out of line with the earning power of the enterprise.
The reader can clearly perceive why the same senior charges that caused such great difficulty when premium volume ranged about the $3,000,000 mark would cause little trouble upon the attainment of premium volume in excess of $26,000,000.Adjusting for only 25% of the increase in the unearned premium reserve, earnings of $1,367,063 in 1952, a very depressed year for auto insurers, were sufficient to cover total senior charges of $129,500 more than 10 times over, leaving earnings of $24.74 on each share of common stock.It is quite evident that the common stock has finally arrived, although investors do not appear to realize it since the stock is quoted at less than twice earnings and at a discount of approximately 55% from the December 31, 1952 book value of $86.26 per share. Table II indicates the postwar record of earnings and dramatically illustrates the benefits being realized by the common stock because of the expanded earnings base.
The book value is calculated with allowance for a 25% equity in the unearned premium reserve and is after allowance for call price plus arrears on the preferreds.Since Western has achieved such an excellent record in increasing its industry share of premium volume, the reader may well wonder whether standards have been compromised. This is definitely not the case. During the past ten years Western's operating ratios have proved quite superior to the average multiple line company. The combined loss and expense ratios for the two Western companies as reported by the Alfred M. Best Co. on a case basis are compared in Table III with similar ratios for all stock fire and casualty companies.
The careful reader will not overlook the possibility that Western's superior performance has been due to a concentration of writings in unusually profitable lines. Actually the reverse is true. Although represented in all major lines, Western is still primarily an automobile insurer with 60% of its volume derived from auto lines. Since automobile underwriting has proven generally unsatisfactory in the postwar period, and particularly so in the last three years, Western's experience was even more favorable relative to the industry than the tabular comparison would indicate.Western has always maintained ample loss reserves on unsettled claims.
Underwriting results in the postwar period have shown Western to be over-reserved at the end of each year. Triennial examinations conducted by the insurance commissioners have confirmed these findings.Turning to their investment picture, we of course find a growth in invested assets and investment income paralleling the growth in premium volume. Consolidated net assets have risen from $5,154,367 in 1940 to their present level of $29,590,142. Western follows an extremely conservative investment policy, relying upon growth in premium volume for expansion in investment income. Of the year-end portfolio of $21,889,243, governments plus a list of well diversified high quality municipals total $20,141,246 or 92% and stocks only $1,747,997 or 8%. Net investment income of $474,472 in 1952 was equal to $6.14 per share of Western Insurance common after minority interest and assuming senior charges were covered entirely from investment income.
The casualty insurance industry during the past several years has suffered staggering losses on automobile insurance lines. This trend was sharply reversed during late 1952. Substantial rate increases in 1951 and 1952 are being brought to bear on underwriting results with increasing force as policies are renewed at much higher premiums. Earnings within the casualty industry are expected to be on a very satisfactory basis in 1953 and 1954.Western, while operating very profitably during the entire trying period, may be expected to report increased earnings as a result of expanding premium volume, increased assets, and the higher rate structure. An earned premium volume of $30,000,000 may be conservatively expected by 1954.
Normal earning power on this volume should average about $30.00 per share, with investment income contributing approximately $8.40 per share after deducting all senior charges from investment income.The patient investor in Western Insurance common can be reasonably assured of a tangible acknowledgement of his enormously strengthened equity position. It is well to bear in mind that the operating companies have expanded premium volume some 550% in the last 12 years. This has required an increase in surplus of 350% and consequently restricted the payment of dividends. Recent dividend increases by Western Casualty should pave the way for more prompt payment on arrearages. Any leveling off of premium volume will permit more liberal dividends while a continuation of the past rate of increase, which in my opinion is very unlikely, would of course make for much greater earnings.
Operating in a stable industry with an excellent record of growth and profitability, I believe Western Insurance common to be an outstanding vehicle for substantial capital appreciation at its present price of about 40. The stock is traded over-the-counter.
Monday, July 28, 2008
PIMCO's Mohamed El-Erain
This is an excellent 25 minute interview with whom I think is one of the most sophisticated and astute investors. Three years ago, I had the amazing pleasure of hearing Mr. El-Erian speak live in New York City. The theme of his discussion then? Why the global economic shifts would have to lead to a general rise in oil prices.
Mr. El-Erian is tops on my list of the most qualified individual to assume the Chief Investment Officer position at Berkshire Hathaway (although as CO-CEO at PIMCO, that may not occur).
To view the interview with Charlie Rose, please click here.
Mr. El-Erian is tops on my list of the most qualified individual to assume the Chief Investment Officer position at Berkshire Hathaway (although as CO-CEO at PIMCO, that may not occur).
To view the interview with Charlie Rose, please click here.
Sunday, June 29, 2008
Excellent Seth Klarman Interview
TRUE VALUE Investor Seth Klarman gives a wonderful interview courteous of Alpha Magazine.
For the full interview visit Alpha Magazine here.
Some excerpts.
"We're not the stereotypical hedge fund in terms of an idea a minute. We come in with a view that a security is trading for less than it’s worth, and we buy it."
How did you decide value investing was for you?
I was fortunate enough when I was a junior in college — and then when I graduated from college — to work for Max Heine and Michael Price at Mutual Shares [a mutual fund founded in 1949]. Their value philosophy is very similar to the value philosophy we follow at Baupost. So I learned the business from two of the best, which was better than anything you could ever get from a textbook or a classroom. Warren Buffett once wrote that the concept of value investing is like an inoculation- — it either takes or it doesn’t — and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it or they don’t. Ultimately, it needs to fit your character. If you have a need for action, if you want to be involved in the new and exciting technological breakthroughs of our time, that’s great, but you’re not a value investor and you shouldn’t be one. If you are predisposed to be patient and disciplined, and you psychologically like the idea of buying bargains, then you’re likely to be good at it.
Biggest mistakes?
There are too many examples that we could say, “Ah, that was right in our sweet spot, and we should have had it.” All investors need to learn how to be at peace with their decisions. We as a firm are always going to buy too soon and sell too soon. And I’m very at peace with that. If we wait for the absolute bottom, we won’t buy very much. And when everybody’s selling, there tends to be tremendous dislocation in the markets.
What’s the secret to success?
Every manager should be able to answer the question, “What’s your edge?” This isn’t the 1950s, when all you had to do was buy a corner lot and build a small drugstore and it gradually became incredibly valuable land or you owned a skyscraper or you built a small shopping center and it became the big regional mall. The market’s very competitive; there are a lot of smart, talented people, a lot of money chasing opportunity. If you don’t have an edge and can’t articulate it, you probably aren’t going to outperform.
For the full interview visit Alpha Magazine here.
Some excerpts.
"We're not the stereotypical hedge fund in terms of an idea a minute. We come in with a view that a security is trading for less than it’s worth, and we buy it."
How did you decide value investing was for you?
I was fortunate enough when I was a junior in college — and then when I graduated from college — to work for Max Heine and Michael Price at Mutual Shares [a mutual fund founded in 1949]. Their value philosophy is very similar to the value philosophy we follow at Baupost. So I learned the business from two of the best, which was better than anything you could ever get from a textbook or a classroom. Warren Buffett once wrote that the concept of value investing is like an inoculation- — it either takes or it doesn’t — and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it or they don’t. Ultimately, it needs to fit your character. If you have a need for action, if you want to be involved in the new and exciting technological breakthroughs of our time, that’s great, but you’re not a value investor and you shouldn’t be one. If you are predisposed to be patient and disciplined, and you psychologically like the idea of buying bargains, then you’re likely to be good at it.
Biggest mistakes?
There are too many examples that we could say, “Ah, that was right in our sweet spot, and we should have had it.” All investors need to learn how to be at peace with their decisions. We as a firm are always going to buy too soon and sell too soon. And I’m very at peace with that. If we wait for the absolute bottom, we won’t buy very much. And when everybody’s selling, there tends to be tremendous dislocation in the markets.
What’s the secret to success?
Every manager should be able to answer the question, “What’s your edge?” This isn’t the 1950s, when all you had to do was buy a corner lot and build a small drugstore and it gradually became incredibly valuable land or you owned a skyscraper or you built a small shopping center and it became the big regional mall. The market’s very competitive; there are a lot of smart, talented people, a lot of money chasing opportunity. If you don’t have an edge and can’t articulate it, you probably aren’t going to outperform.
Monday, June 9, 2008
Buffett's Bet Against the Hedge Funds
Putting his money where his mouth is, Buffett recently disclosed a bet saying that a group of hedge funds, after fees, would fail to outperform the S&P 500 index. Most of you will remember Buffett's references in the 2006 annual report about all the little "helpers" in the hedge fund world that are slowly taking a piece of the pie.
Carol Loomis, long-time Buffett friend and editor of the annual reports, broke the news about this bet in Fortune. The link is below.
Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking.
But in July 2007, Ted Seides, a principal of Protégé but speaking for himself at that point, wrote Buffett to say he'd like to make the bet - or at least some version of it.
Buffett's Big Bet
Carol Loomis, long-time Buffett friend and editor of the annual reports, broke the news about this bet in Fortune. The link is below.
Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking.
But in July 2007, Ted Seides, a principal of Protégé but speaking for himself at that point, wrote Buffett to say he'd like to make the bet - or at least some version of it.
Buffett's Big Bet
Monday, June 2, 2008
Why Value Investing Always Wins - Numbers Don't Lie
This morning an article appeared in the London Free Press titled "Value Investing Rewards Patience." This article provides a wonderful perspective on why "value investing" always outperforms. The article attempts to define the parameters of a value stock. Typically, most academic studies have separated businesses via the following:
Low price to book ratio = Value
High price to book ratio = Growth
While the above categorization does make sense, it's far too rigid today to be taken as the definitive method for distinguishing between the two types of stocks. Newer studies now look at various other metrics such as price to cash flow, price to earnings, etc. in trying to separate the two classes of stock for research purposes. According to these studies, the performance of value investing has vastly outperformed a growth oriented approach.
I have always felt that value and growth are merely two sides of the same coin when it comes to investing. Growth is simply a lever that creates value over time. I think the idea behind this article and the many others that prove that value beats growth is that with value investing, the aim is to pay as little as possible for that future growth. Businesses that are selling for close to the value of tangible assets, high cash flow yields, etc. will experience a dramatic expansion in multiples as they begin to demonstrate sound operating results.
I think the best way to see if someone is a value investor is not by the ratios of the stocks they hold, but instead by a wonderful little quote by Warren Buffett:
"To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework."
Below are excerpts from the article followed by the link to the whole article.
Judging "value" on the basis of a single financial metric such as book-to-market value was criticized for being too parochial. So, the academic community began to incorporate other relative valuation methods, such as price to cash flow, price to earnings, price to tangible book value and others.
Despite the excellent performance of growth stocks in the 1990s, Chan and Lakonishok show that large-cap value stocks actually outperformed large cap growth by 12.2 per cent annually from 1990 until 2001. The same was true from 1969 until 2001, with value outperforming growth by 10.4 per cent per year.
The small-cap numbers were even more impressive. From 1990 until 2001, value outperformed growth by 19.4 per cent annually. The long-term outperformance number from 1969 until 2001 for this group was 16.5 per cent.
This is really important:
Chan and Lakonishok also argue that value stocks are no riskier than growth stocks. They show that even in down markets, value stocks suffered less than growth stocks -- an important litmus test for investors.
At the end of their study, Chan and Lakonishock subtly conclude that the difference in value and growth returns is largely a result of irrational investor behaviour -- a persistent human trait that they argue will continue to reward patient value investors for a long time to come.
Read the full article:
Value Strategies Reward Patience by Neil Murray
Low price to book ratio = Value
High price to book ratio = Growth
While the above categorization does make sense, it's far too rigid today to be taken as the definitive method for distinguishing between the two types of stocks. Newer studies now look at various other metrics such as price to cash flow, price to earnings, etc. in trying to separate the two classes of stock for research purposes. According to these studies, the performance of value investing has vastly outperformed a growth oriented approach.
I have always felt that value and growth are merely two sides of the same coin when it comes to investing. Growth is simply a lever that creates value over time. I think the idea behind this article and the many others that prove that value beats growth is that with value investing, the aim is to pay as little as possible for that future growth. Businesses that are selling for close to the value of tangible assets, high cash flow yields, etc. will experience a dramatic expansion in multiples as they begin to demonstrate sound operating results.
I think the best way to see if someone is a value investor is not by the ratios of the stocks they hold, but instead by a wonderful little quote by Warren Buffett:
"To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework."
Below are excerpts from the article followed by the link to the whole article.
Judging "value" on the basis of a single financial metric such as book-to-market value was criticized for being too parochial. So, the academic community began to incorporate other relative valuation methods, such as price to cash flow, price to earnings, price to tangible book value and others.
Despite the excellent performance of growth stocks in the 1990s, Chan and Lakonishok show that large-cap value stocks actually outperformed large cap growth by 12.2 per cent annually from 1990 until 2001. The same was true from 1969 until 2001, with value outperforming growth by 10.4 per cent per year.
The small-cap numbers were even more impressive. From 1990 until 2001, value outperformed growth by 19.4 per cent annually. The long-term outperformance number from 1969 until 2001 for this group was 16.5 per cent.
This is really important:
Chan and Lakonishok also argue that value stocks are no riskier than growth stocks. They show that even in down markets, value stocks suffered less than growth stocks -- an important litmus test for investors.
At the end of their study, Chan and Lakonishock subtly conclude that the difference in value and growth returns is largely a result of irrational investor behaviour -- a persistent human trait that they argue will continue to reward patient value investors for a long time to come.
Read the full article:
Value Strategies Reward Patience by Neil Murray
Thursday, May 22, 2008
Value Investing Business School
The desire to become a "better" value investor is arguably one of the most popular discussions of the day amongst the value investing click. I have an MBA degree and I am very proud of it and the school I earned it from. But MBA school did not directly contribute to my becoming a better investor. An MBA has aided me in several invaluable ways, but I'm not here to talk about that.
Instead, to become a better investor you need to be able to do one thing and one thing only: THINK RATIONALLY. Unfortunately, this is not an easy task and no MBA class (at least to my knowledge) trains someone how to really think practically.
While I was somewhat disappointed with the quality of questions at this years Berkshire Hathaway meeting, you can always count on Buffett to deliver. One of this year's gems was when Buffett commented on the fact that nearly all business schools do nothing to train students to become better investors.
If you want to truly succeed as an investor, learn to do two things and two things only:
1. Know how to value a business
2. Learn how to think about stock markets and understand volatility.
In an earlier post, "Where Most Investors Stumble" I commented on the backwardness of many investors when thinking about the stock market:
Whether you realize it or not, many investors often commit mistakes that regularly go unnoticed. Or worse, the mistake is made under the false assumption that the activity is actually correct. Such common traps include...
2. Interpreting market volatility as a destroyer of opportunity when it is instead a creator of opportunity. If your approach is sound then volatility allows you to buy that which was cheap yesterday cheaper today.
If you can truly learn about evaluating businesses and understand that the market is here to serve you and not guide you, your investment performance will truly be off the charts.
If you understand the two concepts Buffett noted above, you will be able to clearly apply the following framework, which I believe is the simplest and most effective way at approaching the stock market.
1. Have a sound investment philosophy
2. A Good Search Strategy
3. Ability to value a business and assess quality of management
4. Discipline to say no
5. Patience
and once you can do the above you will have the ability to...
6. Make a significant investment at the maximum point of pessimism.
Find me a successful investor (Buffett, Berkowitz, Hawkins, Pabrai, Einhorn, etc.) and I'll show you an investor who performs all of the above.
Instead, to become a better investor you need to be able to do one thing and one thing only: THINK RATIONALLY. Unfortunately, this is not an easy task and no MBA class (at least to my knowledge) trains someone how to really think practically.
While I was somewhat disappointed with the quality of questions at this years Berkshire Hathaway meeting, you can always count on Buffett to deliver. One of this year's gems was when Buffett commented on the fact that nearly all business schools do nothing to train students to become better investors.
If you want to truly succeed as an investor, learn to do two things and two things only:
1. Know how to value a business
2. Learn how to think about stock markets and understand volatility.
In an earlier post, "Where Most Investors Stumble" I commented on the backwardness of many investors when thinking about the stock market:
Whether you realize it or not, many investors often commit mistakes that regularly go unnoticed. Or worse, the mistake is made under the false assumption that the activity is actually correct. Such common traps include...
2. Interpreting market volatility as a destroyer of opportunity when it is instead a creator of opportunity. If your approach is sound then volatility allows you to buy that which was cheap yesterday cheaper today.
If you can truly learn about evaluating businesses and understand that the market is here to serve you and not guide you, your investment performance will truly be off the charts.
If you understand the two concepts Buffett noted above, you will be able to clearly apply the following framework, which I believe is the simplest and most effective way at approaching the stock market.
1. Have a sound investment philosophy
2. A Good Search Strategy
3. Ability to value a business and assess quality of management
4. Discipline to say no
5. Patience
and once you can do the above you will have the ability to...
6. Make a significant investment at the maximum point of pessimism.
Find me a successful investor (Buffett, Berkowitz, Hawkins, Pabrai, Einhorn, etc.) and I'll show you an investor who performs all of the above.
Tuesday, April 29, 2008
Where Many Investors Trip Up
Whether you realize it or not, many investors often commit mistakes that regularly go unnoticed. Or worse, the mistake is made under the false assumption that the activity is actually correct. Such common traps include:
1. Investing for capital appreciation when instead you should be investing for capital preservation. Investing in this manner is like crossing the street after only looking straight ahead. The destination might be clear, but without looking left and right, the consequences can be perilous.
2. Interpreting market volatility as a destroyer of opportunity when it is instead a creator of opportunity. If your approach is sound then volatility allows you to buy that which was cheap yesterday cheaper today.
And most important of all: spending time thinking about when to sell a security when all your time should be spent learning when to buy a security. This is a mistake that many investors commit without ever realizing it.
Many people believe that knowing when to buy is much simpler and easier to do than when to sell. However, the real reward in investing comes from making smart buying decisions. Selling is simply the activity that rewards your disciplined buying approach. Far too many investors exaggerate the selling process. In doing this, they subconsciously approach the investment process backwards. In my most recent letter to partners, I discussed the fallacy in "learning" when to sell an asset:
"...you only need to do a few things right to be a successful investor. Knowing when to sell a security is not one of them. Money is made when the asset is bought not when it's sold. Learning when to sell is a task that far too many investors spend far too much time attempting to perfect. In his 50+ years as an investor, Warren Buffett has realized losses on an absurdly low percentage of his investments (less than 5%). Buffett spends little time worrying about when he should sell his investments and instead on focuses on buying assets cheaply. This buying process should be at the center of an investor's focus. You can never go broke by taking profits. If you maintain a disciplined approach to the price you pay for an asset, the selling process will take care of itself. Echoing Shelby Davis, 'you just don't know it at the time.'"
Your profits (or losses) are made the minute you buy an asset. You just won't "see" it until you sell. If you concentrate your efforts on buying businesses selling at a discount to intrinsic value, the odds are favorable that when you need your money, you will sell at a higher price. Understand of course that intrinsic value can be impaired if the fundamentals of the business deteriorate. This is possible with any investment, but much less likely with superior businesses with successful long-term operating performance.
The common mistake is made when investors confuse buying a business and buying a stock. When buying something cheap, investors often take that to mean buying the stock at the bottom. This is flawed thinking. You can still make money even if you buy at top--as long as the intrinsic value is substantially higher.
Also, investors assume that if they sell at a profit only to see the share price advance further, then they made a mistake by selling too soon. But that too reflects the wrong perspective. First of all, anytime you sell an investment at a gain, you have succeeded. I learned at an early age that you will not lose money by selling something for more than you paid for it. So, if that's the name of the game, then mastering the buy side is how you win the game. Warren Buffett once remarked that "investing is simple, but not easy." It's simple in that all you need to do is find a handful of great businesses selling at reasonable prices and let time do its thing.
Yet investing is not easy because most investors have a hard time being patient. Mohnish Pabrai once told me that two things occur to him after he makes an investment: When he buys, the stock usually dives, and after he sells, the stock rockets. Yet in the almost nine years that he's been running the Pabrai Investment Funds, he's boasting an annualized return above 20% -- after fees.
All investors make mistakes. But if you do your work, chances are you won't make many big mistakes. A couple of huge mistakes can wipe you out for good. Concentrate your efforts on a few very simple lessons and you tilt the odds of outperforming most.
1. Investing for capital appreciation when instead you should be investing for capital preservation. Investing in this manner is like crossing the street after only looking straight ahead. The destination might be clear, but without looking left and right, the consequences can be perilous.
2. Interpreting market volatility as a destroyer of opportunity when it is instead a creator of opportunity. If your approach is sound then volatility allows you to buy that which was cheap yesterday cheaper today.
And most important of all: spending time thinking about when to sell a security when all your time should be spent learning when to buy a security. This is a mistake that many investors commit without ever realizing it.
Many people believe that knowing when to buy is much simpler and easier to do than when to sell. However, the real reward in investing comes from making smart buying decisions. Selling is simply the activity that rewards your disciplined buying approach. Far too many investors exaggerate the selling process. In doing this, they subconsciously approach the investment process backwards. In my most recent letter to partners, I discussed the fallacy in "learning" when to sell an asset:
"...you only need to do a few things right to be a successful investor. Knowing when to sell a security is not one of them. Money is made when the asset is bought not when it's sold. Learning when to sell is a task that far too many investors spend far too much time attempting to perfect. In his 50+ years as an investor, Warren Buffett has realized losses on an absurdly low percentage of his investments (less than 5%). Buffett spends little time worrying about when he should sell his investments and instead on focuses on buying assets cheaply. This buying process should be at the center of an investor's focus. You can never go broke by taking profits. If you maintain a disciplined approach to the price you pay for an asset, the selling process will take care of itself. Echoing Shelby Davis, 'you just don't know it at the time.'"
Your profits (or losses) are made the minute you buy an asset. You just won't "see" it until you sell. If you concentrate your efforts on buying businesses selling at a discount to intrinsic value, the odds are favorable that when you need your money, you will sell at a higher price. Understand of course that intrinsic value can be impaired if the fundamentals of the business deteriorate. This is possible with any investment, but much less likely with superior businesses with successful long-term operating performance.
The common mistake is made when investors confuse buying a business and buying a stock. When buying something cheap, investors often take that to mean buying the stock at the bottom. This is flawed thinking. You can still make money even if you buy at top--as long as the intrinsic value is substantially higher.
Also, investors assume that if they sell at a profit only to see the share price advance further, then they made a mistake by selling too soon. But that too reflects the wrong perspective. First of all, anytime you sell an investment at a gain, you have succeeded. I learned at an early age that you will not lose money by selling something for more than you paid for it. So, if that's the name of the game, then mastering the buy side is how you win the game. Warren Buffett once remarked that "investing is simple, but not easy." It's simple in that all you need to do is find a handful of great businesses selling at reasonable prices and let time do its thing.
Yet investing is not easy because most investors have a hard time being patient. Mohnish Pabrai once told me that two things occur to him after he makes an investment: When he buys, the stock usually dives, and after he sells, the stock rockets. Yet in the almost nine years that he's been running the Pabrai Investment Funds, he's boasting an annualized return above 20% -- after fees.
All investors make mistakes. But if you do your work, chances are you won't make many big mistakes. A couple of huge mistakes can wipe you out for good. Concentrate your efforts on a few very simple lessons and you tilt the odds of outperforming most.
Wednesday, April 16, 2008
Buffett Talks Business
We all know Buffett is good..but why is he so good?
Simply put, he keeps things simple and logical. While most other investors are busy trying the "crack the code" with some marevlous analytical break through, Buffett simply breaks everything down to its most basic economic fact.
As an illustration, consider Buffett's discourse on brand value, specifically as it realtes to Coca-Cola. The following comments were made by Buffett at the 1993 shareholders meeting and can be found in Andy Kilpatrick's newest edition Of Permanent Value.
Buffett: Will developments in the generic brand area hurt Coca-Cola? That’s a terribly important question.
“Generic brands have been with us a long time. But lately they’ve attracted a great deal of attention—partly because they’re doing better and in particular because of Philip Morris’s actions a few weeks ago—when, in reaction to the threat and the inroads of generics, they cut the price dramatically on Marlboro.
“I wouldn’t say Marlboro is the most valuable brand name in the world. Coca-Cola is more valuable—and I think that’s been proven by subsequent events. But Marlboro earned more money than any brand name in the world.
“And all of a sudden, Philip Morris took some actions which dramatically reduced the earnings of that brand and changed the pricing dynamic that had existed in the cigarette business for many decades. And since then, Philip Morris has had $16 billion lopped off its market value and RJR’s suffered accordingly.
“It’s a terribly interesting case study and it illustrates one of the dangers of generic competition. Philip Morris cigarettes got to where they were selling for $2.00 a pack. The average cigarette consumer uses something close to ten packs a week. Meanwhile, the generic was at about $1 or thereabouts. So you really have a $500 a year differential in cost per year to a ten-pack-a-week smoker. And that is a big annual cost differential. You better have something that people think is dramatically better than the generic for the average consumer to shell out an extra $500 a year. It’s happening in other areas, too—whether it’s corn flakes or diapers or a lot of things...
“In our case, I think the Gillette brand name, for example, is far better protected against generic competition than the main product of Philip Morris—although there always has been generic competition in blades and there always will be.
“The average male purchases something like 30 blades a year. He pays 70 cents each if he buys the best—which is the Sensor. That’s $21 a year. The best he can do if he wants something that leaves him Band-Aids on his face and an uncomfortable experience costs him $10 a year. So you’re talking $11 for a 365-day experience...
“I think there’s a generic threat of some sort in any industry where the leaders are earning high returns on equity. It just stands to reason that that’s going to encourage competition.
“And the threat may be accelerating in many industries. But I think that brand names with the right ingredients are enormously valuable. Sometimes infrastructure is a problem for the generics. The worldwide infrastructure for Coca-Cola, for example, is very impressive and very hard for a generic provider to duplicate.
“But if somebody wants to sell a generic box of chocolates in California against See’s Chocolates, that’s obviously somewhat of a threat. And I just hope that they take them home on Valentine’s Day and say, ‘Here, Honey, I took the low bid.’ ”
“Wal-Mart’s selling Sam’s Cola. And Wal-Mart is a very, very potent force. One thing that’s helpful is that they were selling it as cheap as $4 a case here. And I don’t believe that’s sustainable. That’s 162/3 cents a can.
“It’s been a while since I looked at aluminum—and it’s down. But I think the can is close to a six-cent item by itself. The can is far more expensive than the ingredients... Distribution costs, trucking, stocking and all that sort of thing have to be fairly similar. In a 12-ounce can, there’s 1.3 ounces of sugar—which at the domestic price, would be around 13/4 cents per can. And that’s got to be the same whether it’s Sam’s Cola or Coca-Cola.
“The Coca-Cola Company sells about 700 million 8-ounce servings—largely of Coca-Cola, but also of other soft drinks—worldwide every day. If you take 700 million and multiply it by 365 days, you come up with 250 billion or so 8-ounce servings of Coke or its products in the world each year.
“The Coca-Cola Company made about $21/2 billion pretax last year. That’s one penny per serving. One penny per serving does not leave a huge umbrella. The generic is not going to buy the can any cheaper. And they’re not going to buy the sugar any cheaper and so on. Their trucks aren’t going to be any cheaper.”
So while everyone is busy looking at P/E Ratios and making forecasts into the future, Buffett simply looks at the business from a businessman's point of view. Ands that all you've got to do folks to succeed in this game.
True to form: 'I'm a better investor because I am a businessman and a better businessman because I am an investor.'
Simply put, he keeps things simple and logical. While most other investors are busy trying the "crack the code" with some marevlous analytical break through, Buffett simply breaks everything down to its most basic economic fact.
As an illustration, consider Buffett's discourse on brand value, specifically as it realtes to Coca-Cola. The following comments were made by Buffett at the 1993 shareholders meeting and can be found in Andy Kilpatrick's newest edition Of Permanent Value.
Buffett: Will developments in the generic brand area hurt Coca-Cola? That’s a terribly important question.
“Generic brands have been with us a long time. But lately they’ve attracted a great deal of attention—partly because they’re doing better and in particular because of Philip Morris’s actions a few weeks ago—when, in reaction to the threat and the inroads of generics, they cut the price dramatically on Marlboro.
“I wouldn’t say Marlboro is the most valuable brand name in the world. Coca-Cola is more valuable—and I think that’s been proven by subsequent events. But Marlboro earned more money than any brand name in the world.
“And all of a sudden, Philip Morris took some actions which dramatically reduced the earnings of that brand and changed the pricing dynamic that had existed in the cigarette business for many decades. And since then, Philip Morris has had $16 billion lopped off its market value and RJR’s suffered accordingly.
“It’s a terribly interesting case study and it illustrates one of the dangers of generic competition. Philip Morris cigarettes got to where they were selling for $2.00 a pack. The average cigarette consumer uses something close to ten packs a week. Meanwhile, the generic was at about $1 or thereabouts. So you really have a $500 a year differential in cost per year to a ten-pack-a-week smoker. And that is a big annual cost differential. You better have something that people think is dramatically better than the generic for the average consumer to shell out an extra $500 a year. It’s happening in other areas, too—whether it’s corn flakes or diapers or a lot of things...
“In our case, I think the Gillette brand name, for example, is far better protected against generic competition than the main product of Philip Morris—although there always has been generic competition in blades and there always will be.
“The average male purchases something like 30 blades a year. He pays 70 cents each if he buys the best—which is the Sensor. That’s $21 a year. The best he can do if he wants something that leaves him Band-Aids on his face and an uncomfortable experience costs him $10 a year. So you’re talking $11 for a 365-day experience...
“I think there’s a generic threat of some sort in any industry where the leaders are earning high returns on equity. It just stands to reason that that’s going to encourage competition.
“And the threat may be accelerating in many industries. But I think that brand names with the right ingredients are enormously valuable. Sometimes infrastructure is a problem for the generics. The worldwide infrastructure for Coca-Cola, for example, is very impressive and very hard for a generic provider to duplicate.
“But if somebody wants to sell a generic box of chocolates in California against See’s Chocolates, that’s obviously somewhat of a threat. And I just hope that they take them home on Valentine’s Day and say, ‘Here, Honey, I took the low bid.’ ”
“Wal-Mart’s selling Sam’s Cola. And Wal-Mart is a very, very potent force. One thing that’s helpful is that they were selling it as cheap as $4 a case here. And I don’t believe that’s sustainable. That’s 162/3 cents a can.
“It’s been a while since I looked at aluminum—and it’s down. But I think the can is close to a six-cent item by itself. The can is far more expensive than the ingredients... Distribution costs, trucking, stocking and all that sort of thing have to be fairly similar. In a 12-ounce can, there’s 1.3 ounces of sugar—which at the domestic price, would be around 13/4 cents per can. And that’s got to be the same whether it’s Sam’s Cola or Coca-Cola.
“The Coca-Cola Company sells about 700 million 8-ounce servings—largely of Coca-Cola, but also of other soft drinks—worldwide every day. If you take 700 million and multiply it by 365 days, you come up with 250 billion or so 8-ounce servings of Coke or its products in the world each year.
“The Coca-Cola Company made about $21/2 billion pretax last year. That’s one penny per serving. One penny per serving does not leave a huge umbrella. The generic is not going to buy the can any cheaper. And they’re not going to buy the sugar any cheaper and so on. Their trucks aren’t going to be any cheaper.”
So while everyone is busy looking at P/E Ratios and making forecasts into the future, Buffett simply looks at the business from a businessman's point of view. Ands that all you've got to do folks to succeed in this game.
True to form: 'I'm a better investor because I am a businessman and a better businessman because I am an investor.'
Saturday, March 8, 2008
A Solid Bet: The Case For Ternium Steel
My approach to investing has fit the philosophy, "Give a man a fish and you feed him for a day, but teach a man how to fish and you feed him for life."
Today, I'll make an exception and outline my analysis for Ternium Steel, one of the most profitable steel companies in the world.
FULL DISCLOSURE: I currently own shares in Ternium. At any point, this could change. Please do your own DUE DILIGENCE before making any investment decision.
On that note...
Ternium Steel is a Latin-American steel producer with principle operations in Mexico, Argentina, and Venezuela. When I first began going over the financials of Ternium in late September, it didn’t take long to realize that this was one of the most profitable steel companies in the world. The numbers literally jumped out of the page.
At the time, Ternium had an enterprise value (EV = mkt. cap + net debt) of $7.5 billion. In 2006, free cash flow was some $840 million. In 2005 free cash flow was over one billion dollars. EBITDA (earnings before taxes, depreciation and amortization) for 2006 was $1.84 billion, implying that Ternium was selling for only 4.1x EBITDA. Even for a steel company this was absurdly low. A quick comparison of peers yielded an average EBITDA multiple of just over 7. Operating margins, at 27%, were among the highest in the world. Ternium boasted a low-cost structure that was best in its class. Ternuim’s Mexican operations included access to iron ore, the main component in steel production, providing Ternium with a cheaper supply of this raw material.
So what was the catch that made Ternium so incredibly cheap? Simply, the market couldn’t seem to get over Ternium’s exposure in Venezuela. At the time, there were threats that Hugo Chavez would nationalize SIDOR, a Venezuelan steel mill which was 60% owned by Ternium, and 40% owned evenly by the Venezuelan government and SIDOR employees. Some careful analysis suggested that the odds of nationalization were low.
Ternium is run by the Rocca family, which has a stellar reputation of running steel mills spanning decades. Their impressive management of Tenaris, another Latin American based steel producer was indicative of the family’s ability and competence in operating steel companies in Latin America. Overall, Venezuela benefited enormously from having SIDOR remain under the control of current management.
In any case, Venezuelan operations represented 25% of Ternium’s EBITDA. So if the worst case scenario played out and SIDOR was nationalized and Ternium received nothing from Venezuela, EBITDA would decline from $1.84 billion to $1.4 billion. At this rate, Ternium was still selling for much less than comparable international steel companies. In the end, nationalization of SIDOR would not substantially impair the overall operating profitability of Ternium. Ultimately, an agreement was reached that avoided nationalization. In exchange, Ternium agreed to sell more steel to Venezuela at a slight discount (~5%) and agreed to make some capital investments in SIDOR.
In April of 2007, Ternium had reached an agreement to acquire Grupo IMSA for $1.7 billion. IMSA is a dominant steel producer in Mexico with additional operations in the southern and western United States. IMSA would add another 3 million tons to Ternium’s annual finished production, bringing total capacity output to 15 million tons. The deal was closed a few months later and in December, Ternium struck a deal with Australia’s Bluescope Steel to sell off IMSA’s U.S. assets for $730 million, allowing Ternium to focus on the steel industry in Latin America.
According to the International Iron & Steel Institute, steel demand in Central and South America is expected to grow at a 4% clip for the next several years. In Mexico, the steel market is growing by over 6%. Only Asia is consuming steel at a higher rate than Latin America. The threat of cheap Chinese steel imports is minimal at best. The costs of shipping a ton of steel over to Central and South America would make the steel more expensive. And being that Ternium runs a very tight ship (no pun intended), I don’t see Chinese steel imports representing any meaningful threat.
For the first nine months of 2007, Ternium generated nearly $700 million in free cash flow. This figure included a $300 million one-time income tax payment made as a result of the IMSA acquisition which Ternium will be able to use as tax credits in the future.
As a result of the IMSA acquisition, Ternium assumed some $3.6 billion in debt, implying a $10 billion enterprise value. I expect the proceeds of sale of IMSA’s U.S. assets will be used to pay off some of this debt. Actual free cash flow, adjusting for the one-time tax charge was over $1 billion for the first nine months of 2007. EBITDA over the same time period was $1.7 billion. Normalizing these figures over 2007 would imply a FCF/EV yield of 13% and EV/EBITDA multiple of approximately 4.5x.
To be conservative, assume that 2007 free cash flow comes to $1 billion, implying no free cash flow in the last quarter. If over the next five years, FCF were to grow by an unrealistically low 10%, the present value of this sum of money discounted back at 10% would be $5 billion. Applying a very reasonable terminal value of 10 times 2012 FCF ($1.6 billion) equates to $16 billion, or a present value of roughly $10 billion, for a total value intrinsic value of some $15 billion. With 200 million shares outstanding, this provides an intrinsic value of $75 a share. If cash flow grows at 15%, intrinsic value per share comes to around $92 per share. A 10% increase in shares outstanding would produce an intrinsic value of $68 to $83 a share.
Ternium is currently earning about $220 in EBITDA per ton of steel and is on track to sell some 10 million tons in 2007 (without IMSA) compared to 6,600 tons in 2005, a growth rate of nearly 24% a year. This equates into 2007 EBITDA of $2.2 billion. As I mentioned, IMSA adds 3 million tons of capacity, but with the sale of the U.S assets, capacity will be slightly reduced. In addition Ternium is undergoing its own capital expansion that should increase capacity by 2 million tons in three years. In five years, tons sold should easily approach 14 -15 million, or less than 10% growth a year. At an average EBITDA of $160 per ton, some 30% less than Ternium’s current level, this would produce an EBITDA of $2.24 to $2.4 billion. At 8x - 10x EBITDA, a very reasonable buyout multiple for any strategic buyer, Ternium would be worth between $17 and $24 billion, or $85 to $120 a share.
Today, I'll make an exception and outline my analysis for Ternium Steel, one of the most profitable steel companies in the world.
FULL DISCLOSURE: I currently own shares in Ternium. At any point, this could change. Please do your own DUE DILIGENCE before making any investment decision.
On that note...
Ternium Steel is a Latin-American steel producer with principle operations in Mexico, Argentina, and Venezuela. When I first began going over the financials of Ternium in late September, it didn’t take long to realize that this was one of the most profitable steel companies in the world. The numbers literally jumped out of the page.
At the time, Ternium had an enterprise value (EV = mkt. cap + net debt) of $7.5 billion. In 2006, free cash flow was some $840 million. In 2005 free cash flow was over one billion dollars. EBITDA (earnings before taxes, depreciation and amortization) for 2006 was $1.84 billion, implying that Ternium was selling for only 4.1x EBITDA. Even for a steel company this was absurdly low. A quick comparison of peers yielded an average EBITDA multiple of just over 7. Operating margins, at 27%, were among the highest in the world. Ternium boasted a low-cost structure that was best in its class. Ternuim’s Mexican operations included access to iron ore, the main component in steel production, providing Ternium with a cheaper supply of this raw material.
So what was the catch that made Ternium so incredibly cheap? Simply, the market couldn’t seem to get over Ternium’s exposure in Venezuela. At the time, there were threats that Hugo Chavez would nationalize SIDOR, a Venezuelan steel mill which was 60% owned by Ternium, and 40% owned evenly by the Venezuelan government and SIDOR employees. Some careful analysis suggested that the odds of nationalization were low.
Ternium is run by the Rocca family, which has a stellar reputation of running steel mills spanning decades. Their impressive management of Tenaris, another Latin American based steel producer was indicative of the family’s ability and competence in operating steel companies in Latin America. Overall, Venezuela benefited enormously from having SIDOR remain under the control of current management.
In any case, Venezuelan operations represented 25% of Ternium’s EBITDA. So if the worst case scenario played out and SIDOR was nationalized and Ternium received nothing from Venezuela, EBITDA would decline from $1.84 billion to $1.4 billion. At this rate, Ternium was still selling for much less than comparable international steel companies. In the end, nationalization of SIDOR would not substantially impair the overall operating profitability of Ternium. Ultimately, an agreement was reached that avoided nationalization. In exchange, Ternium agreed to sell more steel to Venezuela at a slight discount (~5%) and agreed to make some capital investments in SIDOR.
In April of 2007, Ternium had reached an agreement to acquire Grupo IMSA for $1.7 billion. IMSA is a dominant steel producer in Mexico with additional operations in the southern and western United States. IMSA would add another 3 million tons to Ternium’s annual finished production, bringing total capacity output to 15 million tons. The deal was closed a few months later and in December, Ternium struck a deal with Australia’s Bluescope Steel to sell off IMSA’s U.S. assets for $730 million, allowing Ternium to focus on the steel industry in Latin America.
According to the International Iron & Steel Institute, steel demand in Central and South America is expected to grow at a 4% clip for the next several years. In Mexico, the steel market is growing by over 6%. Only Asia is consuming steel at a higher rate than Latin America. The threat of cheap Chinese steel imports is minimal at best. The costs of shipping a ton of steel over to Central and South America would make the steel more expensive. And being that Ternium runs a very tight ship (no pun intended), I don’t see Chinese steel imports representing any meaningful threat.
For the first nine months of 2007, Ternium generated nearly $700 million in free cash flow. This figure included a $300 million one-time income tax payment made as a result of the IMSA acquisition which Ternium will be able to use as tax credits in the future.
As a result of the IMSA acquisition, Ternium assumed some $3.6 billion in debt, implying a $10 billion enterprise value. I expect the proceeds of sale of IMSA’s U.S. assets will be used to pay off some of this debt. Actual free cash flow, adjusting for the one-time tax charge was over $1 billion for the first nine months of 2007. EBITDA over the same time period was $1.7 billion. Normalizing these figures over 2007 would imply a FCF/EV yield of 13% and EV/EBITDA multiple of approximately 4.5x.
To be conservative, assume that 2007 free cash flow comes to $1 billion, implying no free cash flow in the last quarter. If over the next five years, FCF were to grow by an unrealistically low 10%, the present value of this sum of money discounted back at 10% would be $5 billion. Applying a very reasonable terminal value of 10 times 2012 FCF ($1.6 billion) equates to $16 billion, or a present value of roughly $10 billion, for a total value intrinsic value of some $15 billion. With 200 million shares outstanding, this provides an intrinsic value of $75 a share. If cash flow grows at 15%, intrinsic value per share comes to around $92 per share. A 10% increase in shares outstanding would produce an intrinsic value of $68 to $83 a share.
Ternium is currently earning about $220 in EBITDA per ton of steel and is on track to sell some 10 million tons in 2007 (without IMSA) compared to 6,600 tons in 2005, a growth rate of nearly 24% a year. This equates into 2007 EBITDA of $2.2 billion. As I mentioned, IMSA adds 3 million tons of capacity, but with the sale of the U.S assets, capacity will be slightly reduced. In addition Ternium is undergoing its own capital expansion that should increase capacity by 2 million tons in three years. In five years, tons sold should easily approach 14 -15 million, or less than 10% growth a year. At an average EBITDA of $160 per ton, some 30% less than Ternium’s current level, this would produce an EBITDA of $2.24 to $2.4 billion. At 8x - 10x EBITDA, a very reasonable buyout multiple for any strategic buyer, Ternium would be worth between $17 and $24 billion, or $85 to $120 a share.
Wednesday, March 5, 2008
Buffett's New Elephant: Why Muni's Have Buffett So Exicted
For years, Berkshire Hathaway's gigantic cash pile has been growing at a faster rate than attractive opporutnities available to Warren Buffett to invest in. Buffett has made it no secret that he would welcome a huge "elephant" type acquisition for Berkshire where he could deploy ten billion dollars or more of Berkshire's cash. Recently, Buffett has found pockets of opportunity to plunk down a few billion here and there – the Marmon deal for $4.5 billion and a few billion for nearly 20% of railroad operator Burlington Northern. Yet as Berkshire's size has mushroomed, the days when Buffett could chunk nearly 20% of Berkshire's book value into Coke are rare.
It turns that an elephant of an opportunity may lie in the same field that catapulted Buffett and Berkshire from the multi-million club to the multi-billion club – insurance. Late last year, Buffett announced that Berkshire Hathaway had agreed to deal terms with the state of New York to set up shop as a municipal bond insurer. Initially this was a small deal for Berkshire, but the hope was to gradually expand the newly set up Berkshire Hathaway Assurance Corp (BHAC) bond insurance operations across other states.
It didn't take long for Buffett to up the stakes, as he is apt to do when great opportunities exist. Earlier this week, Buffett announced that he had offered to assume liability of the municipal bond insurance operations of MBIA, Ambac and FGIC Corp. In a letter to MBIA, Ajit Jain, President of BH Reinsurance, stated that BHAC's capitalization would be increased to five billion dollars and that "we would undertake not to reduce BHAC's assets by dividends, fees, etc., for a minimum period of ten years." Jain ended the letter by saying "We would be prepared to complete this transaction within the next five days." A closer look into the municipal bond industry reveals why Berkshire is so intrigued by this rare opportunity.
A. Huge Opportunity
According to a recent article published in the Wall Street Journal, the current municipal bond market is approximately $2.6 trillion. Roughly half of this amount is insured by MBIA, Ambac, FGIC, and a few other smaller names. The Wall Street Journal recently cited that in some cases, municipal issuers have paid as much as $2.3 billion a year in premiums to just insure their bonds. And Buffett's offer was on approximately $800 billion or so in municipal bonds. Even for Berkshire, this is serious money.
B. Virtually risk free instruments
Municipal bonds are issued to finance government infrastructure and are often collateralized by the tax revenues of the issuing entity. Since taxes are going away anytime soon, municipal bonds don't default much. According to the article, the state of California, one of largest issuers of municipal bonds, the state requires that tax dollars go first to education and second to pay off bond debt. To wrap your head around why default is unlikely, California's estimated $100 billion in annual tax revenues should do a good job of keeping them from default. Since 1970, municipal bonds rated double B have a cumulative average default rate of 1.74%. The equivalent default rate for double B corporate bonds is – 29.93%.
C. Favorable Economics
Before this current credit crisis, a state like California with its stable tax revenues would benefit very little from having bond insurance. Deciding whether or not to insure bonds is a simple exercise in cost benefit analysis. For example, if a state issuing municipal bonds is looking at paying 4% with insurance versus say 4.75% without insurance and the insurance premium is 50 basis points, then it makes sense to insure. The recent bond-insurer crisis has created a situation whereby even rock-solid municipal bonds are finding it increasingly expensive to fund much needed infrastructure projects. And not all states are sitting flush like California. Typically bond insurers were charging about 30% of the interest savings an issuer would get. So, if you could reduce your bond rate by 0.50% via insurance, the typical premium would be about 30% of that, or 0.15%. Those days are gone. Recently insurers are charging 80% to 90% of the savings. And with investors traumatized by the liquidity crunch, municipal issuers have to rely on bond insurance even with the higher rates. Enter Berkshire Hathaway to seize the day.
D. Competitive Advantage
Here, the case is glaringly obvious. Berkshire arguably boasts one of strongest balance sheets of any company in the world. Its triple-A credit rating is virtually assured. Any municipal issuer that decides to insure with BHAC will guarantee itself a triple-A. In today's rocky credit environment, that implicit guarantee is worth a lot – and Buffett knows it. As a result, BHAC will be able to command higher premiums. And if, as I suspect will be the case, Berkshire will be the insurer of choice in each state that it decides to enter. And since just about all other bond insurers are desperately seeking to raise additional capital, Berkshire will have virtually no initial competition.
So when you add A, B, C, and D, you find an investment opportunity that is vintage Buffett. This deal offers an excellent model for all investors, both individual and professional, to emulate. Look for companies that offer durable competitive advantages, long-term growth opportunities with minimal downside, and selling at very favorable prices. And then when you find them, don't hesitate to back up the truck and load up.
It turns that an elephant of an opportunity may lie in the same field that catapulted Buffett and Berkshire from the multi-million club to the multi-billion club – insurance. Late last year, Buffett announced that Berkshire Hathaway had agreed to deal terms with the state of New York to set up shop as a municipal bond insurer. Initially this was a small deal for Berkshire, but the hope was to gradually expand the newly set up Berkshire Hathaway Assurance Corp (BHAC) bond insurance operations across other states.
It didn't take long for Buffett to up the stakes, as he is apt to do when great opportunities exist. Earlier this week, Buffett announced that he had offered to assume liability of the municipal bond insurance operations of MBIA, Ambac and FGIC Corp. In a letter to MBIA, Ajit Jain, President of BH Reinsurance, stated that BHAC's capitalization would be increased to five billion dollars and that "we would undertake not to reduce BHAC's assets by dividends, fees, etc., for a minimum period of ten years." Jain ended the letter by saying "We would be prepared to complete this transaction within the next five days." A closer look into the municipal bond industry reveals why Berkshire is so intrigued by this rare opportunity.
A. Huge Opportunity
According to a recent article published in the Wall Street Journal, the current municipal bond market is approximately $2.6 trillion. Roughly half of this amount is insured by MBIA, Ambac, FGIC, and a few other smaller names. The Wall Street Journal recently cited that in some cases, municipal issuers have paid as much as $2.3 billion a year in premiums to just insure their bonds. And Buffett's offer was on approximately $800 billion or so in municipal bonds. Even for Berkshire, this is serious money.
B. Virtually risk free instruments
Municipal bonds are issued to finance government infrastructure and are often collateralized by the tax revenues of the issuing entity. Since taxes are going away anytime soon, municipal bonds don't default much. According to the article, the state of California, one of largest issuers of municipal bonds, the state requires that tax dollars go first to education and second to pay off bond debt. To wrap your head around why default is unlikely, California's estimated $100 billion in annual tax revenues should do a good job of keeping them from default. Since 1970, municipal bonds rated double B have a cumulative average default rate of 1.74%. The equivalent default rate for double B corporate bonds is – 29.93%.
C. Favorable Economics
Before this current credit crisis, a state like California with its stable tax revenues would benefit very little from having bond insurance. Deciding whether or not to insure bonds is a simple exercise in cost benefit analysis. For example, if a state issuing municipal bonds is looking at paying 4% with insurance versus say 4.75% without insurance and the insurance premium is 50 basis points, then it makes sense to insure. The recent bond-insurer crisis has created a situation whereby even rock-solid municipal bonds are finding it increasingly expensive to fund much needed infrastructure projects. And not all states are sitting flush like California. Typically bond insurers were charging about 30% of the interest savings an issuer would get. So, if you could reduce your bond rate by 0.50% via insurance, the typical premium would be about 30% of that, or 0.15%. Those days are gone. Recently insurers are charging 80% to 90% of the savings. And with investors traumatized by the liquidity crunch, municipal issuers have to rely on bond insurance even with the higher rates. Enter Berkshire Hathaway to seize the day.
D. Competitive Advantage
Here, the case is glaringly obvious. Berkshire arguably boasts one of strongest balance sheets of any company in the world. Its triple-A credit rating is virtually assured. Any municipal issuer that decides to insure with BHAC will guarantee itself a triple-A. In today's rocky credit environment, that implicit guarantee is worth a lot – and Buffett knows it. As a result, BHAC will be able to command higher premiums. And if, as I suspect will be the case, Berkshire will be the insurer of choice in each state that it decides to enter. And since just about all other bond insurers are desperately seeking to raise additional capital, Berkshire will have virtually no initial competition.
So when you add A, B, C, and D, you find an investment opportunity that is vintage Buffett. This deal offers an excellent model for all investors, both individual and professional, to emulate. Look for companies that offer durable competitive advantages, long-term growth opportunities with minimal downside, and selling at very favorable prices. And then when you find them, don't hesitate to back up the truck and load up.
Tuesday, February 12, 2008
Berkshire's Bond Offer Is a REALLY BIG Deal
For years, Buffett has been waiting for something to "move the needle" at Berkshire. The $4 billion stake in Iscar, the Israeli tool cutting business, should prove very meaningful to Berkshire over the years. Even the eventual total acquisition of Marmon, the industrial conglomerate, should cause some vibration....
Insuring municipal bonds on the other hand, could be a really really big deal. While this is a stretch of the imigination, if Berkshire were to insure municipal bonds in all 50 states, this business could have an effect on Berkshire Hathaway much the same way that GIECO did in the 1980's and 1990's.
A couple of months ago, Buffett committed about $150 million to the newly formed Berkshire Hathaway Assurance Corp., the newly formed entity created to insure municipal bonds in New York. This morning Buffett agreed to committ $5 billion to take over the municipal bond business of MBIA, Ambac,. etc. And he could do it in 5 days.
Below is the letter sent by Ajit Jain, President of BH Reinsurance to MBIA's Bankers at Lazard.
February 6, 2008
Mr. Gary Parr
Deputy Chairman, Lazard
Dear Gary:
As you know, many constituencies in the financial markets have been increasingly focused on the emerging issues in the financial guaranty industry for several weeks now. In fact, we ourselves have had several meetings with the New York Insurance Department to explore whether there is something we can do under the current circumstances that would be helpful in addressing the growing concerns in the financial marketplace. Unfortunately, the structured finance "side" of the business, with its many moving pieces and interdependent variables, has proven to be beyond our ability to adequately analyze. Nonetheless, we are ready and willing to lend our reinsurance support to the municipal side of the house, and in fact had set out in a letter to the New York Superintendent of Insurance a concept that we believe would address the needs and concerns of main street America's municipalities. The Superintendent has no objection to our approaching you with this proposal. We would like to meet with you and your client, MBIA, to discuss whether MBIA would have any interest in the proposal .
The key elements of the proposal we described to the Superintendent were: (1) we would raise the capital level in our monoline insurer, Berkshire Hathaway Assurance Corporation (BHAC), to $5 billion; (2) we would assume by reinsurance the muni bond portfolio of several of the monoline companies for a premium of 150% of the existing unearned premium reserves of the companies (with respect to two of the leading companies this would result in a combined unearned premium reserve of $6 billion, plus $3 billion for a total premium of $9 billion which, with the increased capital contribution to BHAC would result in approximately $14 billion of assets available to meet the combined $600 billion or so of total principal value of municipal bonds insured by these two companies); (3) we would undertake not to reduce BHAC's assets by dividends, fees, etc., for a minimum period of ten years; and (4) we had furthermore proposed that, if the companies found a preferable solution during the first 30 days of our cover, they could have a no-questions-asked walk-away option in consideration of a break-up fee that would be paid to us.
The gist of our proposal to you is that we would reinsure MBIA's current municipal bond insurance portfolio in consideration of a premium payment to us of an amount equal to 150% of the existing unearned premium reserves. Like many potential reinsurance buyers, I recognize that your first reaction may be that this is an excessive premium, and I want to offer you upfront the thought processes that led me to conclude that this is in fact a fair proposal that achieves important objectives for both parties.
We priced this proposed reinsurance cover to reflect the significant opportunity cost from our perspective in providing this type of bulk reinsurance cover. In the current market environment, we are able to command premium levels double (or higher) your client's prior rates to insure the risks that in addition have the benefit of your client's AAA insurance cover. Given our conservative use of capital (for example, the capital ratios in our monoline insurer would be higher than other insurers and would not be subject to reduction by dividends, fees, etc. for a minimum of ten years under the concept we presented to the Department), by offering this cover we forgo these direct opportunities to wrap already wrapped bonds. Despite this, there is an obvious appeal to a bulk transaction like this given the low overhead costs which would be involved.
Taking all these factors into account, we came down in favor of making the proposal and are prepared to pursue it with you directly. It is efficient as both a bulk transaction and a transaction that we believe will help stabilize the currently unstable marketplace conditions for the municipal business. In that sense, this approach also has the appeal of serving the greater public good, not an unimportant consideration for us, both as a matter of principle and as a company with a vested interest in national economic conditions.
From your perspective, I would respectfully suggest that this proposal would allow MBIA to release substantial capital from the municipal bond side of the house that can be deployed to support other obligations. I would submit that our proposal at the pricing levels we require is actually a cheap way for MBIA to raise capital as compared to other alternatives and is therefore of great benefit to MBIA's owners and their municipal bond policyholders.
Should this proposal prove to be of interest to you, and I sincerely hope that it is, we would ask for the courtesy of a reply as soon as possible. We would be prepared to complete this transaction within the next five days.
Sincerely
Ajit Jain,
President
cc: The Honorable Eric Dinallo, Superintendent
New York Department of Insurance
Insuring municipal bonds on the other hand, could be a really really big deal. While this is a stretch of the imigination, if Berkshire were to insure municipal bonds in all 50 states, this business could have an effect on Berkshire Hathaway much the same way that GIECO did in the 1980's and 1990's.
A couple of months ago, Buffett committed about $150 million to the newly formed Berkshire Hathaway Assurance Corp., the newly formed entity created to insure municipal bonds in New York. This morning Buffett agreed to committ $5 billion to take over the municipal bond business of MBIA, Ambac,. etc. And he could do it in 5 days.
Below is the letter sent by Ajit Jain, President of BH Reinsurance to MBIA's Bankers at Lazard.
February 6, 2008
Mr. Gary Parr
Deputy Chairman, Lazard
Dear Gary:
As you know, many constituencies in the financial markets have been increasingly focused on the emerging issues in the financial guaranty industry for several weeks now. In fact, we ourselves have had several meetings with the New York Insurance Department to explore whether there is something we can do under the current circumstances that would be helpful in addressing the growing concerns in the financial marketplace. Unfortunately, the structured finance "side" of the business, with its many moving pieces and interdependent variables, has proven to be beyond our ability to adequately analyze. Nonetheless, we are ready and willing to lend our reinsurance support to the municipal side of the house, and in fact had set out in a letter to the New York Superintendent of Insurance a concept that we believe would address the needs and concerns of main street America's municipalities. The Superintendent has no objection to our approaching you with this proposal. We would like to meet with you and your client, MBIA, to discuss whether MBIA would have any interest in the proposal .
The key elements of the proposal we described to the Superintendent were: (1) we would raise the capital level in our monoline insurer, Berkshire Hathaway Assurance Corporation (BHAC), to $5 billion; (2) we would assume by reinsurance the muni bond portfolio of several of the monoline companies for a premium of 150% of the existing unearned premium reserves of the companies (with respect to two of the leading companies this would result in a combined unearned premium reserve of $6 billion, plus $3 billion for a total premium of $9 billion which, with the increased capital contribution to BHAC would result in approximately $14 billion of assets available to meet the combined $600 billion or so of total principal value of municipal bonds insured by these two companies); (3) we would undertake not to reduce BHAC's assets by dividends, fees, etc., for a minimum period of ten years; and (4) we had furthermore proposed that, if the companies found a preferable solution during the first 30 days of our cover, they could have a no-questions-asked walk-away option in consideration of a break-up fee that would be paid to us.
The gist of our proposal to you is that we would reinsure MBIA's current municipal bond insurance portfolio in consideration of a premium payment to us of an amount equal to 150% of the existing unearned premium reserves. Like many potential reinsurance buyers, I recognize that your first reaction may be that this is an excessive premium, and I want to offer you upfront the thought processes that led me to conclude that this is in fact a fair proposal that achieves important objectives for both parties.
We priced this proposed reinsurance cover to reflect the significant opportunity cost from our perspective in providing this type of bulk reinsurance cover. In the current market environment, we are able to command premium levels double (or higher) your client's prior rates to insure the risks that in addition have the benefit of your client's AAA insurance cover. Given our conservative use of capital (for example, the capital ratios in our monoline insurer would be higher than other insurers and would not be subject to reduction by dividends, fees, etc. for a minimum of ten years under the concept we presented to the Department), by offering this cover we forgo these direct opportunities to wrap already wrapped bonds. Despite this, there is an obvious appeal to a bulk transaction like this given the low overhead costs which would be involved.
Taking all these factors into account, we came down in favor of making the proposal and are prepared to pursue it with you directly. It is efficient as both a bulk transaction and a transaction that we believe will help stabilize the currently unstable marketplace conditions for the municipal business. In that sense, this approach also has the appeal of serving the greater public good, not an unimportant consideration for us, both as a matter of principle and as a company with a vested interest in national economic conditions.
From your perspective, I would respectfully suggest that this proposal would allow MBIA to release substantial capital from the municipal bond side of the house that can be deployed to support other obligations. I would submit that our proposal at the pricing levels we require is actually a cheap way for MBIA to raise capital as compared to other alternatives and is therefore of great benefit to MBIA's owners and their municipal bond policyholders.
Should this proposal prove to be of interest to you, and I sincerely hope that it is, we would ask for the courtesy of a reply as soon as possible. We would be prepared to complete this transaction within the next five days.
Sincerely
Ajit Jain,
President
cc: The Honorable Eric Dinallo, Superintendent
New York Department of Insurance
Thursday, February 7, 2008
Buffett Interview in Canada
The Dow Jones [Industrial] Average started the 20th century at 66 and it ended at 11,400. That is not a bad train to be on. How could anybody lose money on something that went from 66 to 11,400? Well, a lot of people lost a lot of money in stocks because they come in at the wrong time, and they get out at the wrong time, and they buy the wrong things, and they get excited, and they get greedy when others get greedy, and fearful when others get fearful. I say you should get greedy when others are fearful and fearful when others are greedy, but that's hard for most people to do
It is much easier to buy and buy and buy little pieces of a wonderful group of American businesses, and you'll do fine over time and you'll keep your costs low. If you try to be a little bit smarter, you'll probably end up being a lot dumber.
Warren Buffet was in Canada attending the BusinessWire debut there. He spent some time with the Financial Post discussing his thoughts on investing, and the general state of affairs.
Both the written interview and video clip are provided below.
Video Interview
Interview Transcript
It is much easier to buy and buy and buy little pieces of a wonderful group of American businesses, and you'll do fine over time and you'll keep your costs low. If you try to be a little bit smarter, you'll probably end up being a lot dumber.
Warren Buffet was in Canada attending the BusinessWire debut there. He spent some time with the Financial Post discussing his thoughts on investing, and the general state of affairs.
Both the written interview and video clip are provided below.
Video Interview
Interview Transcript
Friday, December 21, 2007
Earnings and Equity Returns
Wall Street is fixated on the earnings number of a business. In the short run, stock prices are very sensitive to a company’s earning achievements.
Earnings Are Not Alone
While profits are essential, understanding how they fit into the value creation process is critical. This is where return on equity comes into play.
An initial yet meaningful way of looking at return on equity is similar to a coupon on a bond. A bond that earns a higher coupon yield than the prevailing rate of interest will trade at a premium, or above its par issued price. A bond that is issued paying ten percent a year will be worth more in the future if future rates on interest have declined. The reason is simple economics: no investor will pay the same price for an eight percent bond if he or she can buy a ten percent bond for the same price. So the price of the existing ten percent bonds will increase until its new market price represents an approximate eight percent effective yield. So if the bond had a face value of $1000 and initially paid $100 a year, its new price would be $1250 because at an annual payment of $100, the return is 8 percent.
Similar to a bond in a fundamental sense, businesses with sustained high returns on equity are usually followed by appreciating stock prices, but not for the same specific reasons as a bond. In the real world, of course, investors in stocks don't just buy and hold.
In the long-run, the rate of return of a stock should equal its return on equity. Consider Microsoft. Microsoft continues to deliver unbelievable returns on equity of over 40 percent and has done so for decades. Yet for years, Microsoft shares have not followed suit.
The times are different. In the beginning Microsoft had lots of space in the software market to deploy its capital. So when Microsoft was generating a ROE of say 40 percent, back then it was able to continue investing that excess capital and generate a similar rate of return. What this means is that Microsoft could take a million dollars, invest it in its operations, and earn $400,000. Microsoft could then take the excess capital and still earn that same 40 percent. Microsoft was able to do this with billions of dollars and this was happening years before the Internet boom.
It is no surprise then, that Microsoft stock rocketed for many years after its IPO and why early investors, Gates, and employees got so fantastically rich off the stock. The company was compounding existing and excess capital at a phenomenal clip. Anytime you can do this for a sustained amount of time, the intrinsic value of a business mushrooms and eventually so will the stock price.
Now What?
Microsoft still generates returns on equity of over 40 percent, yet the stock price sits still. Microsoft is so huge and has so much cash, that it is now only able to generate those returns only the capital needed to run he business. It can no longer take the excess capital and redeploy it at such a high rate of return. This is why it paid that huge dividend a few years back. It made more sense payout some of that excess capital to shareholders than to reinvest back in the business.
Concentrate Your Bets
Anytime you locate a company that offers the talent and ability to redeploy its existing and excess capital at above market rates of return for any sustainable period of time, odds are the stock price will follow suit. An ability to earn excess returns on equity signals that the company offers certain competitive advantages not easily reproduced by its competitors.
In the 1980's Warren Buffett bet over 20 percent of Berkshire’s book value on the Coca Cola Company. Buffett noticed, among other things, that Coke was earning excellent returns on its equity and deploy the excess capital into other infant markets. Berkshire Hathaway itself is a huge capital deployment vehicle. It takes the float from its insurance company and any excess cash from its operating subsidiaries and invests the excess capital very successfully. Berkshire has risen an amazing 7,000-fold since Buffett took control of the company in 1965.
Profits and earnings growth are vital. But what businesses are able to d0 to with those profits sets apart great businesses from good ones.
In 1978, Warren Buffett wrote an article for Fortune Magazine titled "How Inflation Swindles the Equity Investor" In it he noted that there are only five ways to improve return on equity:
1. Higher turnover, i.e. sales
2. Cheaper Leverage
3. More leverage
4. Lower taxes
5. Wider margins on sales
Companies have the least control over tax levels, although management can certainly use creative accounting to temporarily alter the tax rate. An investor is better suited to focus on the others, as the ability to spot improved sales, prudent use of leverage, or cost cutting initiatives can lead one to excellent businesses.
All else equal, sales increase should create an increase in profits. Of course the quality of sales should be carefully examined. As sales increase, accounts receivable level should naturally follow suit. However, if receivables are demonstrating a trend of growing much faster than sales future troubles may lie ahead when it’s time to collect. Additionally, inventory management is important. The application of LIFO or FIFO will affect the profit statement differently during inflationary or deflationary periods.
When used prudently and wisely the use of leverage can increase returns on equity. Similarly, if a business can lower its cost of debt, the corresponding effect is a higher return on equity. Today we are seeing exactly how the mismanagement of leverage has affected those businesses participating in the credit markets. The painful lesson is similar to buying stocks on margin. If you are levered five to one, a ten percent return on the levered portfolio equals a return on equity of 50 percent. The same corresponding loss occurs with negative returns. Unfortunately, most businesses (1) fail to use leverage appropriately and opportunistically; and (2) employ leverage at alarming multiples to equity. The results, as we can clearly see, have been disastrous.
Wider margins are created in one of two ways: increasing prices or decreasing costs. Very few companies can raise prices at will without incurring competition or meaningful declines in volume. Again, this is why Buffett bet so big on Coke. For decades Coke has been steadily increasing the price of its famous syrup with no meaningful loss in market share as a result. As Buffett once quipped, "Who's going to risk saving a nickel over a product they put in their mouth?" Wrigley's chewing gum offers a similar example.
Profits count, but it's what you can do with those profits over time that really matters.
Earnings Are Not Alone
While profits are essential, understanding how they fit into the value creation process is critical. This is where return on equity comes into play.
An initial yet meaningful way of looking at return on equity is similar to a coupon on a bond. A bond that earns a higher coupon yield than the prevailing rate of interest will trade at a premium, or above its par issued price. A bond that is issued paying ten percent a year will be worth more in the future if future rates on interest have declined. The reason is simple economics: no investor will pay the same price for an eight percent bond if he or she can buy a ten percent bond for the same price. So the price of the existing ten percent bonds will increase until its new market price represents an approximate eight percent effective yield. So if the bond had a face value of $1000 and initially paid $100 a year, its new price would be $1250 because at an annual payment of $100, the return is 8 percent.
Similar to a bond in a fundamental sense, businesses with sustained high returns on equity are usually followed by appreciating stock prices, but not for the same specific reasons as a bond. In the real world, of course, investors in stocks don't just buy and hold.
In the long-run, the rate of return of a stock should equal its return on equity. Consider Microsoft. Microsoft continues to deliver unbelievable returns on equity of over 40 percent and has done so for decades. Yet for years, Microsoft shares have not followed suit.
The times are different. In the beginning Microsoft had lots of space in the software market to deploy its capital. So when Microsoft was generating a ROE of say 40 percent, back then it was able to continue investing that excess capital and generate a similar rate of return. What this means is that Microsoft could take a million dollars, invest it in its operations, and earn $400,000. Microsoft could then take the excess capital and still earn that same 40 percent. Microsoft was able to do this with billions of dollars and this was happening years before the Internet boom.
It is no surprise then, that Microsoft stock rocketed for many years after its IPO and why early investors, Gates, and employees got so fantastically rich off the stock. The company was compounding existing and excess capital at a phenomenal clip. Anytime you can do this for a sustained amount of time, the intrinsic value of a business mushrooms and eventually so will the stock price.
Now What?
Microsoft still generates returns on equity of over 40 percent, yet the stock price sits still. Microsoft is so huge and has so much cash, that it is now only able to generate those returns only the capital needed to run he business. It can no longer take the excess capital and redeploy it at such a high rate of return. This is why it paid that huge dividend a few years back. It made more sense payout some of that excess capital to shareholders than to reinvest back in the business.
Concentrate Your Bets
Anytime you locate a company that offers the talent and ability to redeploy its existing and excess capital at above market rates of return for any sustainable period of time, odds are the stock price will follow suit. An ability to earn excess returns on equity signals that the company offers certain competitive advantages not easily reproduced by its competitors.
In the 1980's Warren Buffett bet over 20 percent of Berkshire’s book value on the Coca Cola Company. Buffett noticed, among other things, that Coke was earning excellent returns on its equity and deploy the excess capital into other infant markets. Berkshire Hathaway itself is a huge capital deployment vehicle. It takes the float from its insurance company and any excess cash from its operating subsidiaries and invests the excess capital very successfully. Berkshire has risen an amazing 7,000-fold since Buffett took control of the company in 1965.
Profits and earnings growth are vital. But what businesses are able to d0 to with those profits sets apart great businesses from good ones.
In 1978, Warren Buffett wrote an article for Fortune Magazine titled "How Inflation Swindles the Equity Investor" In it he noted that there are only five ways to improve return on equity:
1. Higher turnover, i.e. sales
2. Cheaper Leverage
3. More leverage
4. Lower taxes
5. Wider margins on sales
Companies have the least control over tax levels, although management can certainly use creative accounting to temporarily alter the tax rate. An investor is better suited to focus on the others, as the ability to spot improved sales, prudent use of leverage, or cost cutting initiatives can lead one to excellent businesses.
All else equal, sales increase should create an increase in profits. Of course the quality of sales should be carefully examined. As sales increase, accounts receivable level should naturally follow suit. However, if receivables are demonstrating a trend of growing much faster than sales future troubles may lie ahead when it’s time to collect. Additionally, inventory management is important. The application of LIFO or FIFO will affect the profit statement differently during inflationary or deflationary periods.
When used prudently and wisely the use of leverage can increase returns on equity. Similarly, if a business can lower its cost of debt, the corresponding effect is a higher return on equity. Today we are seeing exactly how the mismanagement of leverage has affected those businesses participating in the credit markets. The painful lesson is similar to buying stocks on margin. If you are levered five to one, a ten percent return on the levered portfolio equals a return on equity of 50 percent. The same corresponding loss occurs with negative returns. Unfortunately, most businesses (1) fail to use leverage appropriately and opportunistically; and (2) employ leverage at alarming multiples to equity. The results, as we can clearly see, have been disastrous.
Wider margins are created in one of two ways: increasing prices or decreasing costs. Very few companies can raise prices at will without incurring competition or meaningful declines in volume. Again, this is why Buffett bet so big on Coke. For decades Coke has been steadily increasing the price of its famous syrup with no meaningful loss in market share as a result. As Buffett once quipped, "Who's going to risk saving a nickel over a product they put in their mouth?" Wrigley's chewing gum offers a similar example.
Profits count, but it's what you can do with those profits over time that really matters.
Monday, December 3, 2007
Buffett Stays Steady and Buys $2B in TXU Bonds
Buffett put $2 billion of Berkshire Hathaway's cash to work at the end of last week when the company purchased high-yielding bonds issued by Dallas-based power producer TXU Corp.
Berkshire bought into two issues by TXU. It purchased $1.1 billion of 10.25% bonds at 95 cents on the dollar to give Buffett an effective yield of 11.2%. And Berkshire bought $1 billion of 10.5% PIK-toggle bonds (bonds whose interest can be paid out in cash or more bonds) for 93 cents on the dollar, producing an effective yield of 11.8%.
See the full article here:
http://money.cnn.com/2007/12/02/news/companies/buffett.fortune/index.htm?postversion=2007120307
Berkshire bought into two issues by TXU. It purchased $1.1 billion of 10.25% bonds at 95 cents on the dollar to give Buffett an effective yield of 11.2%. And Berkshire bought $1 billion of 10.5% PIK-toggle bonds (bonds whose interest can be paid out in cash or more bonds) for 93 cents on the dollar, producing an effective yield of 11.8%.
See the full article here:
http://money.cnn.com/2007/12/02/news/companies/buffett.fortune/index.htm?postversion=2007120307
Friday, November 16, 2007
Working Paper on Berkshire Hathaway's Investment Returns
Here's an interesting read...Imitation is indeed the sincerest form of flattery.
The link to the entire paper is below the abstract.
Abstract:
We analyze the performance of Berkshire Hathaway's equity portfolio and explore potential explanations for its superior performance. Contrary to popular belief we show Berkshire's investment style is best characterized as a large-cap growth. We examine whether Berkshire's investment performance is due to luck and find that beating the market in 28 out of 31 years places it in the 99.99 percentile; however, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely even after taking into account ex-post selection bias. After adjusting for risk we find that Berkshire's performance cannot be explained by assuming high risk. From 1976 to 2006 Berkshire's stock portfolio beats the S&P 500 Index by 14.65%, the value-weighted index of all stocks by 10.91%, and the Fama and French characteristic portfolio by 8.56% per year. The market also appears to under-react to the news of a Berkshire stock investment since a hypothetical portfolio that mimics Berkshire's investments created the month after they are publicly disclosed earns positive abnormal returns of 14.26% per year. Overall, the Berkshire Hathaway triumvirates of Warren Buffett, Charles Munger, and Lou Simpson posses' investment skill consistent with a number of recent papers that argue investment skill is more prevalent than earlier papers suggest.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1030485
The link to the entire paper is below the abstract.
Abstract:
We analyze the performance of Berkshire Hathaway's equity portfolio and explore potential explanations for its superior performance. Contrary to popular belief we show Berkshire's investment style is best characterized as a large-cap growth. We examine whether Berkshire's investment performance is due to luck and find that beating the market in 28 out of 31 years places it in the 99.99 percentile; however, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely even after taking into account ex-post selection bias. After adjusting for risk we find that Berkshire's performance cannot be explained by assuming high risk. From 1976 to 2006 Berkshire's stock portfolio beats the S&P 500 Index by 14.65%, the value-weighted index of all stocks by 10.91%, and the Fama and French characteristic portfolio by 8.56% per year. The market also appears to under-react to the news of a Berkshire stock investment since a hypothetical portfolio that mimics Berkshire's investments created the month after they are publicly disclosed earns positive abnormal returns of 14.26% per year. Overall, the Berkshire Hathaway triumvirates of Warren Buffett, Charles Munger, and Lou Simpson posses' investment skill consistent with a number of recent papers that argue investment skill is more prevalent than earlier papers suggest.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1030485
Sunday, November 4, 2007
ACTIVE VALUE INVESTING by Vitaliy Katsenelson - A Different Perspective
Anyone fortunate enough to have invested during the bull market that began in 1982 will find easy to say "buy and hold forever." Indeed, for almost twenty years, the market had one general direction - up, and anyone who bought and forgot did well for nearly 18 years. Warren Buffett has described the bull market that began in 1982 as a period unlike any other for the markets and that it is highly unlikely or quite some time before the U.S. markets experience that again. And although Buffett is famous for his "our favorite holding period is forever" line, it wasn't until later in his investing career - when Berkshire's capital was enormous - that this approach really made the most sense for him and Berkshire Hathaway.
Consider that from 1983 until 1999, the average annual return on the S&P 500 was 15.7%, assuming the reinvestment of dividends. A similar return like this for the Dow Jones beginning in 2008 would mean that the Dow would be trading over 139,000 in 2024!
It is in this context that I found Active Value Investing: Making Money in Range Bound Markets by author and portfolio manager Vitaliy Katsenelson an interesting and insightful read on understanding the long mood swings of Mr. Market. One should not assume that the word "Active" in the title to suggest market timing - this is the last thing Vitaliy is concerned with. In fact he readily admits that trying to time the market is a fools game. Instead his focus on using fundamental valuation techniques - discounted cash flow analysis, price to earnings models, and margin of safety - to take advantage of range bound markets.
Any serious participant in the stock markets is well aware that markets trade in in ranges some periods longer than others. During the 16 year period beginning 1966 and ending in 1982, an investment in the Dow Jones index in 1966 would have been worth about the same sixteen years later. Hovering around 1000, the Dow remained around 1000 in 1982. Whatever dividends you earned were wiped out by inflation during that time. A simple buy and hold approach during that time would have produced an annual rate of return of zero percent. Yet during that sixteen year period occurred one of the most opportunistic buying opportunities in the U.S. Beginning in 1974, as Buffett so famously quipped, "I was selling at 3 times earnings to buy stocks at two times earnings."
Active Value Investing discusses how the prudent use of fundamental analysis allows to take advantage of such opportunistic times in the market. Focusing on the only three variables that really matter in a business - value, quality, and growth - investors can learn how intelligently exploit Mr. Market's mood swings. Unlike most great investing books that are focused on the buying process, Active Value Investing takes a very close examination of the selling process, something I find to be the most misunderstood area of investing. Make no mistake, if you can't buy at the right time, knowing when to sell won't mean much. Not only does Vitaliy walk you through his framework of knowing when to buy stocks, but he also takes a deep look at selling stocks, a topic not given enough discussion among value investors. Active Value Investing looks to change all of that.
We all realize that the markets are never a smooth ride and that market timing is mere folly. The key to taking advantage of the market's swings - buying on the stalls and selling on the surges - is to focus on valuation of individual securities. Indeed it is the price in which you buy that ultimately determines your return when you sell. Understanding what to look for in businesses and how to value them is an absolute must if you hope on succeeding in the markets for a meaningful period of time. Active Value Investing helps steer you in the right direction.
Consider that from 1983 until 1999, the average annual return on the S&P 500 was 15.7%, assuming the reinvestment of dividends. A similar return like this for the Dow Jones beginning in 2008 would mean that the Dow would be trading over 139,000 in 2024!
It is in this context that I found Active Value Investing: Making Money in Range Bound Markets by author and portfolio manager Vitaliy Katsenelson an interesting and insightful read on understanding the long mood swings of Mr. Market. One should not assume that the word "Active" in the title to suggest market timing - this is the last thing Vitaliy is concerned with. In fact he readily admits that trying to time the market is a fools game. Instead his focus on using fundamental valuation techniques - discounted cash flow analysis, price to earnings models, and margin of safety - to take advantage of range bound markets.
Any serious participant in the stock markets is well aware that markets trade in in ranges some periods longer than others. During the 16 year period beginning 1966 and ending in 1982, an investment in the Dow Jones index in 1966 would have been worth about the same sixteen years later. Hovering around 1000, the Dow remained around 1000 in 1982. Whatever dividends you earned were wiped out by inflation during that time. A simple buy and hold approach during that time would have produced an annual rate of return of zero percent. Yet during that sixteen year period occurred one of the most opportunistic buying opportunities in the U.S. Beginning in 1974, as Buffett so famously quipped, "I was selling at 3 times earnings to buy stocks at two times earnings."
Active Value Investing discusses how the prudent use of fundamental analysis allows to take advantage of such opportunistic times in the market. Focusing on the only three variables that really matter in a business - value, quality, and growth - investors can learn how intelligently exploit Mr. Market's mood swings. Unlike most great investing books that are focused on the buying process, Active Value Investing takes a very close examination of the selling process, something I find to be the most misunderstood area of investing. Make no mistake, if you can't buy at the right time, knowing when to sell won't mean much. Not only does Vitaliy walk you through his framework of knowing when to buy stocks, but he also takes a deep look at selling stocks, a topic not given enough discussion among value investors. Active Value Investing looks to change all of that.
We all realize that the markets are never a smooth ride and that market timing is mere folly. The key to taking advantage of the market's swings - buying on the stalls and selling on the surges - is to focus on valuation of individual securities. Indeed it is the price in which you buy that ultimately determines your return when you sell. Understanding what to look for in businesses and how to value them is an absolute must if you hope on succeeding in the markets for a meaningful period of time. Active Value Investing helps steer you in the right direction.
Friday, October 26, 2007
Public Pessimism Equals Opportunity for Value Investors
"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful." - Warren Buffett
Security Analysis was published over 70 years ago. To this day, the teachings of Ben Graham and David Dodd hold truer than ever. Graham used to love buying his famous “net-net” stocks, companies that were selling for less than the value of their current assets minus all liabilities. As more entrants came into the markets, these types of opportunities all but vanished. Nonetheless, the enterprising investor applying some serious effort can still uncover some gravely mis-priced securities.
Graham and Dodd’s core concept was to apply analytical effort in examining securities and purchase those selling below their intrinsic worth. The behavior of market participants over the long-term is quite predictable and if you follow the above advice from Buffett, you will do better than most investors. Buffett holds one of the best long term investment records ever, compounding money at over 20% for 40 years. Buffett made his money by exploiting market opportunities where there is a high degree of fear or pessimism.
Welcome Bear Markets
Bear present the most common market environment in which to locate temporarily mis-priced securities. In 1974, after a bull market spanning nearly two decades, the markets fell hard. Overcome by fear most people missed out on one of the century’s best buying opportunities. It was around this time that Buffett began scooping up shares in the Washington Post and Buffett's $10 million investment back then is worth over a billion today. Again in 2003, securities again were cheap, but everyone was afraid even though gap between value and price was wider than it had been in a decade. Investors who are overcome by emotion always disregard market fundamentals leading to the purchase of securities when one should be selling and vice versa.
The year 1987 presents a classic example of the folly demonstrated by most market participants. The year began with surge in share prices for about eight months and was followed by the crash in the October. Bill Ruane and Richard Cuniff of the hugely successful Sequoia Fund remarked,
”Disregarding for the moment whether the prevailing level of stock prices on January 1, 1987 was logical, we are certain that the value of American industry in the aggregate had not increased by 44% as of August 25. Similarly, it is highly unlikely that the value of American industry declined by 23% on a single day, October 19.”
October 20, 1987 would later represent one the best buying opportunities for stock investors.
Investing is "simple but not easy." The idea is simple: simply buy when Mr. Market is acting irrational, but not easy in that most people do the opposite of what they are supposed to be doing: buying on the way up and selling on the way down.
Security Analysis was published over 70 years ago. To this day, the teachings of Ben Graham and David Dodd hold truer than ever. Graham used to love buying his famous “net-net” stocks, companies that were selling for less than the value of their current assets minus all liabilities. As more entrants came into the markets, these types of opportunities all but vanished. Nonetheless, the enterprising investor applying some serious effort can still uncover some gravely mis-priced securities.
Graham and Dodd’s core concept was to apply analytical effort in examining securities and purchase those selling below their intrinsic worth. The behavior of market participants over the long-term is quite predictable and if you follow the above advice from Buffett, you will do better than most investors. Buffett holds one of the best long term investment records ever, compounding money at over 20% for 40 years. Buffett made his money by exploiting market opportunities where there is a high degree of fear or pessimism.
Welcome Bear Markets
Bear present the most common market environment in which to locate temporarily mis-priced securities. In 1974, after a bull market spanning nearly two decades, the markets fell hard. Overcome by fear most people missed out on one of the century’s best buying opportunities. It was around this time that Buffett began scooping up shares in the Washington Post and Buffett's $10 million investment back then is worth over a billion today. Again in 2003, securities again were cheap, but everyone was afraid even though gap between value and price was wider than it had been in a decade. Investors who are overcome by emotion always disregard market fundamentals leading to the purchase of securities when one should be selling and vice versa.
The year 1987 presents a classic example of the folly demonstrated by most market participants. The year began with surge in share prices for about eight months and was followed by the crash in the October. Bill Ruane and Richard Cuniff of the hugely successful Sequoia Fund remarked,
”Disregarding for the moment whether the prevailing level of stock prices on January 1, 1987 was logical, we are certain that the value of American industry in the aggregate had not increased by 44% as of August 25. Similarly, it is highly unlikely that the value of American industry declined by 23% on a single day, October 19.”
October 20, 1987 would later represent one the best buying opportunities for stock investors.
Investing is "simple but not easy." The idea is simple: simply buy when Mr. Market is acting irrational, but not easy in that most people do the opposite of what they are supposed to be doing: buying on the way up and selling on the way down.
Tuesday, October 9, 2007
The 2007 Pabrai Funds Annual Meeting: Comments from a Buffett Disciple
Mohnish Pabrai hosted his second leg of his annual meeting on September 27 in Chicago. Each year, Pabrai holds two meetings - one in Chicago and the other in Huntington Beach, CA to accommodate the geographic disbursement of his investor base.
The meeting began with Pabrai going over the past performance:
1. Since the 1999, the annualized return has been over 29% after fees.
According to data from Lipper, this performance ranks the Pabrai Investment Funds number 3 out of some 4,000 mutual funds during this eight year stretch.
The mutual fund comparison is appropriate because although Funds are legally structured as limited partnerships, consider that:
1. The Funds only take long positions in publicly traded securities - no shorting
2. No leverage (although in the past, a little margin was used during times of plenty at cheap prices)
Sitting Still Can Be Profitable
Buffett used to compare his investing to a baseball player at bat. Unlike baseball, in investing, you have no called strikes. You can wait and wait until the fat pitch comes to hit one out of the park.
Most market participants mistakenly assume that they will be penalized if they don't pull trigger and buy something (who wants to be sitting still when the Dow is up 400 points in a day?).
Let me now give you Sham's Theory on Investing (quite basic as I don't do well with complex situations):
There is no way that you will lose any money if you just sit still and do nothing. Wait for Mr. Market to serve you instead of guide you.
The above statement presents two takeaways:
1. The "price is what you pay/value is what get" concept. As Ben Graham alluded, every stock is a good investment at one price. One has to be patient and disciplined not to overpay. A good company (Google) is not necessarily a good investment ($500+ per share, over 40x P/E, etc.).
2. Be willing to watch your investment decline by 50% and sit still....or buy more. Buffett once remarked that you should be able to see your investment decline by half and have the conviction to buy more if your analysis and reasoning are right. (Remember that I am implying that nothing has occurred to change the intrinsic value - and that you would have caught such a deterioration way before such a drop).
Indeed the Pabrai Funds experienced such a situation and Mohnish discussed the issue at length:
Several years ago, Pabrai experienced a multi month time period during which the net asset values of his fund were down by more than 30%. Stocks he had bought were down by 40, 50 or more percent. According to Mohnish, this was not a hypothetical situation. There were some investors who literally entered his Fund right before the decline and they received statements indicating that their investments were down by over 30%.
There was no specific reason for the decline. The businesses were still intact. There was no direct correlation in the fund's holdings. There was no particular sector or industry weighting on the portfolio. Each company operated in a different industry, with a different set of economic considerations. What had happened was that the Dow Jones average had dropped from around 10,000 to 7,000.
Sometime during this situation, many investors would have gotten out at a decline of 10-15% giving no second thought to the fundamental soundness of the individual businesses.
Once the paper loss is realized, the investor is focused on recouping the loss quickly, an process that often ultimately leads to a less prudent investment approach.
Pabrai discussed the individual investments during that time, his cost, where they stood during the market decline, and ultimately where they stood when he exited.
In the end, the stocks recovered, some doubling and tripling the investment return.
As Mohnish responded to one question about his day to day activities:
"I consider myself a gentleman of leisure. I go into the office with no set goal of buying or selling. I just wait for something to grab my attention."
And that's all that needs to be said. The results speak for themselves.
The rest of the meeting Mohnish spent answering questions and as usual, there was no discussion on any current or potential investments.
The meeting began with Pabrai going over the past performance:
1. Since the 1999, the annualized return has been over 29% after fees.
According to data from Lipper, this performance ranks the Pabrai Investment Funds number 3 out of some 4,000 mutual funds during this eight year stretch.
The mutual fund comparison is appropriate because although Funds are legally structured as limited partnerships, consider that:
1. The Funds only take long positions in publicly traded securities - no shorting
2. No leverage (although in the past, a little margin was used during times of plenty at cheap prices)
Sitting Still Can Be Profitable
Buffett used to compare his investing to a baseball player at bat. Unlike baseball, in investing, you have no called strikes. You can wait and wait until the fat pitch comes to hit one out of the park.
Most market participants mistakenly assume that they will be penalized if they don't pull trigger and buy something (who wants to be sitting still when the Dow is up 400 points in a day?).
Let me now give you Sham's Theory on Investing (quite basic as I don't do well with complex situations):
There is no way that you will lose any money if you just sit still and do nothing. Wait for Mr. Market to serve you instead of guide you.
The above statement presents two takeaways:
1. The "price is what you pay/value is what get" concept. As Ben Graham alluded, every stock is a good investment at one price. One has to be patient and disciplined not to overpay. A good company (Google) is not necessarily a good investment ($500+ per share, over 40x P/E, etc.).
2. Be willing to watch your investment decline by 50% and sit still....or buy more. Buffett once remarked that you should be able to see your investment decline by half and have the conviction to buy more if your analysis and reasoning are right. (Remember that I am implying that nothing has occurred to change the intrinsic value - and that you would have caught such a deterioration way before such a drop).
Indeed the Pabrai Funds experienced such a situation and Mohnish discussed the issue at length:
Several years ago, Pabrai experienced a multi month time period during which the net asset values of his fund were down by more than 30%. Stocks he had bought were down by 40, 50 or more percent. According to Mohnish, this was not a hypothetical situation. There were some investors who literally entered his Fund right before the decline and they received statements indicating that their investments were down by over 30%.
There was no specific reason for the decline. The businesses were still intact. There was no direct correlation in the fund's holdings. There was no particular sector or industry weighting on the portfolio. Each company operated in a different industry, with a different set of economic considerations. What had happened was that the Dow Jones average had dropped from around 10,000 to 7,000.
Sometime during this situation, many investors would have gotten out at a decline of 10-15% giving no second thought to the fundamental soundness of the individual businesses.
Once the paper loss is realized, the investor is focused on recouping the loss quickly, an process that often ultimately leads to a less prudent investment approach.
Pabrai discussed the individual investments during that time, his cost, where they stood during the market decline, and ultimately where they stood when he exited.
In the end, the stocks recovered, some doubling and tripling the investment return.
As Mohnish responded to one question about his day to day activities:
"I consider myself a gentleman of leisure. I go into the office with no set goal of buying or selling. I just wait for something to grab my attention."
And that's all that needs to be said. The results speak for themselves.
The rest of the meeting Mohnish spent answering questions and as usual, there was no discussion on any current or potential investments.
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