Derivatives or Weapons of Mass Financial Destruction as they have been fondly called by Warren Buffet (WB). He talked about this back in 2002-2003 right at the same time Alan Greenspan was talking about less regulation. We are lucky that WB was just half right, because I cannot fathom where we would be if he was fully right (mushroom cloud type stuff). Having said all this, he has used derivatives where he found mispricing. It is not in the use of the derivatives that he has a problem with, its the unchecked use, the wild wild west type of environment (read: CDS).
Lets see what he did and what we can learn/use in this environment. First in March we heard news that WB sold puts on the S&P 500 and 3 foreign indexes. These puts expire in 15-20 years and gave him $4.5 billion in premiums. What this essentially means is that WB is betting that the markets in 15-20 years will be higher than what they were in March, 2008. Again in October 2008 he sold Puts (~5 million shares) on Burlington Northern Santa Fe (BNI), with a strike price of $76-$80 and collected premiums of around $7/put. His index Put selling strategy might be more of a play on collecting premiums, but the BNI purchase seems to be more geared towards him wanting more stock in the company (he already has a large stake). Now if BNI trades at $74 in the future he would have the option of buying the stock at $76, but he has already collected $7 for the put, so he is essentially buying the stock at $69 - selling Puts is another way of buying a stock.
Call and Put option pricing depends on a lot of things, but one of the major determinants is Vega (volatility). This is a time of unprecedented volatility where the VIX is at historical heights, and therefore these options are priced accordingly - high (and this is where an opportunistic value investor comes in). One of the strategies (derived from WB options activity) could be to sell Puts on indexs/stocks that you want to buy, make some money on premiums and if the they fall to your sweet spot, well then good for you!
Let me give you an example: the S&P 500 (SPY) is trading at around the $88.0 area; you sell $75.0 strike put options on SPY expiring Jan 2009 and collect $4.7 in premiums. If the index falls to that level or below you can essentially buy SPY for around the $70.0 level. If it doesen't then you still get to keep the $4.7 in premiums (but don't get to buy the index, which is a downside if that is what your sole aim was). If you think that S&P at 880 is not the bottom, would you be comfortable buying at the 700 levels? The market would be more than 50% off its highs, and the P/S, P/E ratios would be more in line with previous bear markets troughs. Another example could be Goldman Sachs (GS), the stock is trading at around $100, you can sell the $65 strike puts expiring Jan 2009 and collect $5 in premium, how would you like to buy GS for $60? or keep $5? There are myriad things that you can do with options, but selling options is something that can work well when the volatility is high. Also exactly which strike/time to buy depends on the situation and the goals..
Update: GS is trading at $55 today (19th November), so if you had sold the put option on GS you would have been forced to buy the stock. Again, selling options just for the premiums is a risky strategy, however if you want to own the stock after selling puts or are writing covered calls, that's a different story..
Friday, October 24, 2008
Wednesday, October 22, 2008
Stock Idea: Contango Oil and Gas
Contango (AMEX: MCF) runs on two principles:
(1) The only competitive advantage in the natural gas and oil business is to be among the lowest cost producers
(2) Virtually all the exploration and production industry’s value creation occurs through the drilling of successful exploratory wells
Kenneth Peak, the founder and CEO of Contango is the largest shareholder in the company, has never sold a share and is a very good capital allocator (Buffett type). He has 6 full time employees, all focusing on the highest ROI part of the E&P value chain – exploration. Every other service in the chain is contracted out to an expert that can provide better value for that part of the chain than MCF can. They work with some of the brightest and most successful oil and gas finders in the business. Contango collaborates with a network of about 10 geoscientists with four small, privately held alliance partners. In all their deals, the alliance partners have capital at risk and the deals are structured so that the partners do not make money before Contango makes money. This strategy has paid off - Contango made the largest Natural Gas find (Dutch and Mary Rose) in the Gulf of Mexico (GOM) in the last 2 decades, combing through old publically available data. Contango has the best balance sheet in the E&P sector, with approximately $50 million cash, another $50 million line of credit and $18 million in debt. They have 369bcf in proven reserves and 70 undrilled GOM leases. The Dutch and Mary Rose wells, when operating at full capacity, generate approximately $20 million per month in after-tax cash flow at $7 natural gas and $70 oil prices. The firm has also carved out some properties before and sold them for 10-15x their initial investments, all without paying tax (capital allocation).
The current stock price of approximately $43/share buys 22 mcf of Natural Gas and contemplates $4 natural gas prices and $50 dollar oil. I believe it is not possible for the price of natural gas to remain below $6 for a long period of time (I am not saying it will go up, but below $6 econ 101 will kick in) due to the high cost of marginal supply. MCF can purchase after-tax reserves on the open market, in the form of share repurchases, for approximately $1.75/mcf, which is about half of the cost of developing new reserves through drilling. The company has recently done some buybacks (again capital allocation) but any further buybacks will substantially increase the value of the company.
Warren Buffet has talked about the 'finding costs' as the most important factor in valuing Oil and Gas companies. Contango has total costs (including finding) of $2.18/mcf and is one of the lowest cost explorers in the GOM. The company’s PV-10 valuation with $7.00/mcf of natural gas and $70.00/bbl oil, NYMEX prices flat forever after 35% for projected federal income taxes is approximately $1.3 billion or $78.00 per share. The firm recently got an offer between $75-85/share just for the Dutch and Mary Rose fields (there are other fields, leases and a computer system worth around $10-20/share), but it fell through because of financing. Reserves in the GOM area have traditionally gone for $3.50-$5/mcf; with all these valuation metrics Contango is worth somewhere between $80 - $ 110/share. I am not saying this is the best deal in town (there are E&P companies which have 3-5x potential, but there's more risk) but that there is high visibility and therefore low risk. They have a tangible asset value that can be realized easily and the assets can be easily converted into cash without discounting them.
Mark Sellers has talked about this idea in the Value Investing Congress conferences many times. I researched it and always liked it but Contango never had the margin of safety before, now it does.
Friday, October 17, 2008
Where is the consumer?
This is unprecedented. The fact is that we have never seen a consumer lead recession in our lifetimes. The previous recessions in 73/74 – Oil; 80/81 – Interest Rates; 90/91 - S&L crisis; 2001 - Dot-Com collapse and 9/11 were all exogenous shocks to the economy that resulted in a contraction in business, but were not consumer lead. Every facet of the economy has enjoyed the pearls of leverage over the last 20 years. We were all operating at levels that were not warranted, levels that were sustained only by leverage on the household balance sheet. In order to pay this debt and get the household balance sheet in order, people have to work more jobs, spend less, and save more. Also, the unemployment rate after bottoming early last year at 4.4% is now close to 6.1%; this can easily go to 8-11% if history is any guide. Personal income drives consumption and with unemployment rising, personal consumption will go down. Furthermore, in all likelihood Senator Obama will become President of the United States; and he has talked about ‘taking responsibility’ and ‘saving’ etc. This is in stark contrast to the current administration’s message of ‘spend, it’s the American way’.
The US consumer on average has a disposable income of $10 trillion/year and the saving rate over the last few years has been negative. If we look at the 25 years ending in 1985, the saving rate was 10%. I believe the savings rate would go up substantially; maybe not 10%, but something like 5% over the next 5-10 years and factor in the absent leverage – the consumer (75% of GDP) will be a huge drag on the US economy. I believe that were will be smaller engines in the form of Asian economies (slowing down) but the net result will still be negative - via a negative feedback loop. Now the economy either needs: 1) A Large War 2) Major Technology breakthrough. I place a very low probability of any one of them occurring. In essence, this will be a consumer led recession, is unique, will by all accounts severe and last a long (3-4 years) time. We know that the economy and the stock market are rarely in sync, but as an investor this matters because it is crucial to know where the consumer is when valuing a company.
Warren Buffett in a Fortune magazine article once argued that if there is one indicator he looks at, it is the ratio of the market capitalization of the market to the GNP (I am using revenues). The current P/S ratio of the S&P 500 is 1.22. The current ratio sits above the long-term average of 1.14 since 1975 and the median of 1.10; and is substantially higher than the ratio reached in the 1990 bear market of 0.77 and in the early 1980's of 0.50. There has been however, a permanent upward shift in the level of profitability (although the profit margins of 2006-2007 are unsustainable) in the economy, and the S&P 500 should be able to maintain a relatively higher price to sales ratio. S&P 500's median P/E ratio now is at 13.5 and has fallen to just below its long-term average of 14 and below its median of 15. It's near the valuation levels reached in 2002, but remains noticeably above the levels reached in 1991 - 11, in 1982 - 7 and in 1974 - 5. Taking the P/E and the P/S ratios into consideration the market has further to fall - S&P around 750-800; and might trade flat to down over the next few years with a few bear rallies. There are no predictions, only probabilities. I believe in buying stocks and not markets. Balance sheet strength is as important as ever, and investors should buy stakes in stocks they are prepared to average down on. Although I strongly believe in fundamental bottom up analysis (90%), I think it is essential to have a perspective on the relative valuations (10%).
Update: GMO's Jeremy Grantham has completed the first part of this Quarterly Letter, very interesting commentary. He essentially said that they are nibbling right now, they might be early and that there is risk of a 20% overrun to the downside.
The US consumer on average has a disposable income of $10 trillion/year and the saving rate over the last few years has been negative. If we look at the 25 years ending in 1985, the saving rate was 10%. I believe the savings rate would go up substantially; maybe not 10%, but something like 5% over the next 5-10 years and factor in the absent leverage – the consumer (75% of GDP) will be a huge drag on the US economy. I believe that were will be smaller engines in the form of Asian economies (slowing down) but the net result will still be negative - via a negative feedback loop. Now the economy either needs: 1) A Large War 2) Major Technology breakthrough. I place a very low probability of any one of them occurring. In essence, this will be a consumer led recession, is unique, will by all accounts severe and last a long (3-4 years) time. We know that the economy and the stock market are rarely in sync, but as an investor this matters because it is crucial to know where the consumer is when valuing a company.
Warren Buffett in a Fortune magazine article once argued that if there is one indicator he looks at, it is the ratio of the market capitalization of the market to the GNP (I am using revenues). The current P/S ratio of the S&P 500 is 1.22. The current ratio sits above the long-term average of 1.14 since 1975 and the median of 1.10; and is substantially higher than the ratio reached in the 1990 bear market of 0.77 and in the early 1980's of 0.50. There has been however, a permanent upward shift in the level of profitability (although the profit margins of 2006-2007 are unsustainable) in the economy, and the S&P 500 should be able to maintain a relatively higher price to sales ratio. S&P 500's median P/E ratio now is at 13.5 and has fallen to just below its long-term average of 14 and below its median of 15. It's near the valuation levels reached in 2002, but remains noticeably above the levels reached in 1991 - 11, in 1982 - 7 and in 1974 - 5. Taking the P/E and the P/S ratios into consideration the market has further to fall - S&P around 750-800; and might trade flat to down over the next few years with a few bear rallies. There are no predictions, only probabilities. I believe in buying stocks and not markets. Balance sheet strength is as important as ever, and investors should buy stakes in stocks they are prepared to average down on. Although I strongly believe in fundamental bottom up analysis (90%), I think it is essential to have a perspective on the relative valuations (10%).
Update: GMO's Jeremy Grantham has completed the first part of this Quarterly Letter, very interesting commentary. He essentially said that they are nibbling right now, they might be early and that there is risk of a 20% overrun to the downside.
Wednesday, October 15, 2008
Margin of Safety: Three Most Important Words
when it comes to investing! But what is it? What does it exactly mean? What we essentially hear is that it is buying $1.00 for $0.50, fair enough; but thinking about it over the last few days, I think there are two forms of margin of safety..
Form#1: This is the pure Graham version, where he determines that ABC Corp. is trading for $0.50 while the Book Value of the company is $1.00, the book value is solid. Mr. Market then recognizes that the Book Value is solid and sends the stock price up to reflect that fact. Now IF the company grew by 10% in that year the new Book Value would be $1.10, so we can buy this company for $0.50 and sell it for $1.10, remember most of the money has been made because of the value differential.
Form#2: And this is the modern form. When the US economy moved to a service based economy, there were fewer assets required to produce cash flow. Value investors could not really reply on Book Value's and with the times had to move on to Discounted Cash Flow (DCF) models. The intrinsic value of a business is the Present Value of its future cash flows (P/E and other relative valuation ratios are basically derived from a DCF). Now XYZ Corp.'s is growing at 20%, according to a DCF and has a fair value of $1.20 and the company is trading for $1.00. A value investor will only pay $0.60 for this company while a growth investor might pay around $1.00-1.20 (i really don't know what they would pay!). The value investor is banking that the valuation gap between the fair value (his) and the market will decrease and the growth investor is relying on future growth. This is all fine and dandy but will Benjamin Graham do it this way?
I think not! Remember in our DCF we are implicitly factoring in growth in the cash flows. And this comes down to how value investor's today value securities (and there is nothing wrong with this). We mortals like to label the different type of investing methods, some are value some are growth and so on n so forth. Warren Buffett has said that value and growth are joined at the hip, the only different in the price, and by price we mean margin of safety. Anyways, If we were to use Form#1 in modern day valuation what we would do is value this business factoring in a zero growth rate or a GDP plus (5%) growth rate and then demand a price which is 50% lower than what we figured. If the firm does grow 20% good for us, but we are not making money banking on the growth; we are making the money as the valuation gap seizes. Just something to ponder..
Form#1: This is the pure Graham version, where he determines that ABC Corp. is trading for $0.50 while the Book Value of the company is $1.00, the book value is solid. Mr. Market then recognizes that the Book Value is solid and sends the stock price up to reflect that fact. Now IF the company grew by 10% in that year the new Book Value would be $1.10, so we can buy this company for $0.50 and sell it for $1.10, remember most of the money has been made because of the value differential.
Form#2: And this is the modern form. When the US economy moved to a service based economy, there were fewer assets required to produce cash flow. Value investors could not really reply on Book Value's and with the times had to move on to Discounted Cash Flow (DCF) models. The intrinsic value of a business is the Present Value of its future cash flows (P/E and other relative valuation ratios are basically derived from a DCF). Now XYZ Corp.'s is growing at 20%, according to a DCF and has a fair value of $1.20 and the company is trading for $1.00. A value investor will only pay $0.60 for this company while a growth investor might pay around $1.00-1.20 (i really don't know what they would pay!). The value investor is banking that the valuation gap between the fair value (his) and the market will decrease and the growth investor is relying on future growth. This is all fine and dandy but will Benjamin Graham do it this way?
I think not! Remember in our DCF we are implicitly factoring in growth in the cash flows. And this comes down to how value investor's today value securities (and there is nothing wrong with this). We mortals like to label the different type of investing methods, some are value some are growth and so on n so forth. Warren Buffett has said that value and growth are joined at the hip, the only different in the price, and by price we mean margin of safety. Anyways, If we were to use Form#1 in modern day valuation what we would do is value this business factoring in a zero growth rate or a GDP plus (5%) growth rate and then demand a price which is 50% lower than what we figured. If the firm does grow 20% good for us, but we are not making money banking on the growth; we are making the money as the valuation gap seizes. Just something to ponder..
Monday, October 13, 2008
Arbitrage and Market Turmoil
Seth Klarman and Joel Greenblatt have made careers correctly monetizing on the dislocations in the capital markets. They look for forced sellers where the stock price is depressed not because of the fundamentals but because of the stakeholders who are selling in bulk for one reason or the other. In spinoffs it could be the the holder do not want to or cannot hold on spinco, in additions and deletions from indexes there is opportunity for the astute investor. I am finding now there are opportunities where a deal does not go through and most of the float is held by the arbitragers.
Now suppose a stock is to be taken out at $30/share and was trading at $25/share, which seems to be its intrinsic value as determined by the market. The stock will trade close to $30 and most of the investors holding the shares would have sold their shares to the arbs in the $29 range. Now further suppose that this merger falls apart, for whatever reason (other than a material change in the business suppressing the intrinsic value). Ideally, the stock should go down to around $25/share (in a normal market), but the opportunity arises because it usually does not! The arbs are not in the business of buy and hold, they are in the business of 'buy at 58 sell at 60'. So they will sell their holdings, and because they are levered (to juice the returns) they will sell fast. The stock will have undue downward pressure in these situations and will come way below its $25 intrinsic value. The more it comes down the better it is for investor looking to scoop up a company for cheap. To be sure the window of opportunity here is narrow, the investor would need to do his HW before.
Let me give you an example, after Genesco terminated the merger with Finish Line the stock came down to around $2/share (while the merger was around $15). The price had come down to a fraction of book value for a profitable retailer, and this is mainly because of the forced sales by the arbs. An opportunistic investor could have loaded up and 6 months later sold the position at around $10/share for a 5x return!!
Another example could be the Cerberus-United Rentals buyout. The company went to court but the judge ruled in favor of Cerberus, there was no buyout but Cerberus agreed to pay $100 million termination fee. The buyout was at around $35/share and and URI shares fell to as low as $16/share in the following weeks. Again a opportunistic investor could see that this is way undervaluing the company. The company itself realized that its share price was too low and initiated a tender offer between $22-$25/share for around 20% of its float! The shares traded around $22/share in the ensuing weeks a which seemed to be its value prior to the buyout news.
Now suppose a stock is to be taken out at $30/share and was trading at $25/share, which seems to be its intrinsic value as determined by the market. The stock will trade close to $30 and most of the investors holding the shares would have sold their shares to the arbs in the $29 range. Now further suppose that this merger falls apart, for whatever reason (other than a material change in the business suppressing the intrinsic value). Ideally, the stock should go down to around $25/share (in a normal market), but the opportunity arises because it usually does not! The arbs are not in the business of buy and hold, they are in the business of 'buy at 58 sell at 60'. So they will sell their holdings, and because they are levered (to juice the returns) they will sell fast. The stock will have undue downward pressure in these situations and will come way below its $25 intrinsic value. The more it comes down the better it is for investor looking to scoop up a company for cheap. To be sure the window of opportunity here is narrow, the investor would need to do his HW before.
Let me give you an example, after Genesco terminated the merger with Finish Line the stock came down to around $2/share (while the merger was around $15). The price had come down to a fraction of book value for a profitable retailer, and this is mainly because of the forced sales by the arbs. An opportunistic investor could have loaded up and 6 months later sold the position at around $10/share for a 5x return!!
Another example could be the Cerberus-United Rentals buyout. The company went to court but the judge ruled in favor of Cerberus, there was no buyout but Cerberus agreed to pay $100 million termination fee. The buyout was at around $35/share and and URI shares fell to as low as $16/share in the following weeks. Again a opportunistic investor could see that this is way undervaluing the company. The company itself realized that its share price was too low and initiated a tender offer between $22-$25/share for around 20% of its float! The shares traded around $22/share in the ensuing weeks a which seemed to be its value prior to the buyout news.
Sunday, October 12, 2008
Whats wrong with CA$H?
People sometime have a problem sitting on cash. They might feel like they are not working if they are not deploying cash and that cash if not deployed is not really working for them. An investor would usually keep a portion of his portfolio in cash just in case he/she is confronted with a fat pitch. But how much cash should one keep in the portfolio? The answer is..it depends! Here, I will address the time when the investor is usually feeling pessimistic about the markets prospects or when the markets seem high. There are usually two positions people take when confronted with this:
(1) Increase their Cash holdings(2) Speculate with Gold.
Let me get the gold issue out of the way first and let me tell you why I said speculate. Benjamin Graham said, "An investor calculates what a stock is worth based on the value of its business. A speculator gambles that a stock will go up in price because somebody else will pay more for it". Do you know what the intrinsic value of gold is? I sure don't! A lot of value investors including Jean-Marie Eveillard of the First Eagle funds have large positions in gold. Now on the other hand Warren Buffett has talked about gold as having no use, no utility. According to him we dig a hole to take it out, and then dig another hole to store it! Gold in the markets trades as other commodities trade - supply and demand. Gold however, is different from other commodities as gold is seen as money; more specifically the ultimate form of money. The demand for gold is mostly psychological and comes from the perceptions of investors depending on their views on the macroeconomic conditions at that time and in the future. Since the gold standard was ended on August 15, 1971, the U.S. government has been free to print as much money as they choose, and recently they have been printing a lot of it (M3 supply has risen to 9,873 billion in 2005 from 288 billion in 1959). So when the world around you is getting bubbly, the argument goes buy gold, as it is the only sure thing.
Now cash. The problem here is that when there is uncertainty in the markets (as is the case now), government bonds yield too little, they don't even yield enough to dampen the dilutive effects of inflation! Here my answer to that, so what? Warren Buffett sat on his cash reserves for most of 2002-2007 (and many other periods), he did take stakes in some rail stocks and bought a few companies, but he sure did not go on a spending spree. Now, look at his Goldman Sachs and General Electric purchases, he is getting some of the best deals of his life! I think the underperformance of his cash holdings would be more than offset by the performance of his investments going forward. We must not look a year ahead and think that the yield is not high enough, we should think about the opportunities we can have if we have 103% of the money we started with as opposed to 50%! As Jessy Livermore said, "Big money is made in the waiting". Charlie Munger has talked about sitting on 10-20 million at a time in T-Bills just waiting. He further elaborated, "It takes character to sit there with all that cash and do nothing. I didn't get to where I am by going after mediocre opportunities".
Coming back to Benjamin Graham's point, the problem with gold is that it can be too psychological dependent! I don't know what the "real" value is! I don't know if I bought too soon, too late or when I should sell. I rather have my money in T-Bills, just sitting there so that when Mr. Market throws a fat pitch in a security I really understand, I have enough power to swing hard and let that fat pitch take care of the underperforming years.
Friday, October 10, 2008
Down down down down...
Wow, what a sell off. The market is down around 20% in the last week alone. This is the same as the 1987 crash except that it took a week as opposed to a single day (and the fundamentals then were better). So again coming back to the million dollar question..Is it buying time yet? I addressed capitulation before and determined there's still time, plenty of time. Really? But oil and gas sector is down around 60-80%, quality companies are selling for 1/6th the value they were selling at before and the market is factoring in $60 oil. Well there might be some bargains in this market but lets go through a quiz first; this is courtesy of Prof. Sanjay Bakshi of the Fundoo Professor fame, he teaches Behavioral finance (as important as knowing the numbers) and manages a hedge fund.
So here goes. You go to a store too buy a cell phone and its retailing for $500. The store clerk tells you that if you walk 10 blocks you can get the same phone for $400 (the clerks incentive structure is suspect!). Would you walk 10 blocks to save $100? 90% people would say yes (the rest are just plain old lazy)!
Now that you have a phone, you want to go buy a car and the car is retailing for $20,000. The salesman again tells you that if you walk 10 blocks you can get the same car for $19,900! Save yourself a $100. Would walk 10 blocks to save $100? Very few people here would say yes even though its the same $100. You are buying things that cost very different amounts, but the change to your net worth is the same $100. So rationally, it makes sense to walk and get your car cheaper!!
Professor Baskhi explains it as follows, "The brain, operating at the subconscious level, is often influenced by the presence of false “anchors”. Anchors are pieces of information to which a mind tends to latch on to while making a decision. And the human mind will often latch on to false anchors created by various influences like availability or contrast."
A stock many have fallen and fallen hard, but that does not mean we should look at where the stock was trading just a few months ago and 'anchor' our expectations! That would be a wrong way to look at it. The crash has indeed produced bargains, but these bargains are only to be had after a lot of research and due diligence. It should be determined that the stock is 'safe', has a strong balance sheet and can weather the downturn, if extended. Cheapness can take two forms: (1) Is the stock cheap because its market cap is way below its Book Value (the real book value as determined by you, and don't count the banks here) (2) Is the stock cheap as determined by the future cash flows it will produce. I believe, that in these environments, you can find both, cheap (both type) and safe. Some stocks in the oil and gas sector may have come down so that it is easily determinable that their assets (ignore them if their cost/bbl are high) are worth more than their market cap (after debt). These things take a lot of work and effort. So dig away and find these gems, demand a greater margin of safety but anchoring to the highs, well....
So here goes. You go to a store too buy a cell phone and its retailing for $500. The store clerk tells you that if you walk 10 blocks you can get the same phone for $400 (the clerks incentive structure is suspect!). Would you walk 10 blocks to save $100? 90% people would say yes (the rest are just plain old lazy)!
Now that you have a phone, you want to go buy a car and the car is retailing for $20,000. The salesman again tells you that if you walk 10 blocks you can get the same car for $19,900! Save yourself a $100. Would walk 10 blocks to save $100? Very few people here would say yes even though its the same $100. You are buying things that cost very different amounts, but the change to your net worth is the same $100. So rationally, it makes sense to walk and get your car cheaper!!
Professor Baskhi explains it as follows, "The brain, operating at the subconscious level, is often influenced by the presence of false “anchors”. Anchors are pieces of information to which a mind tends to latch on to while making a decision. And the human mind will often latch on to false anchors created by various influences like availability or contrast."
A stock many have fallen and fallen hard, but that does not mean we should look at where the stock was trading just a few months ago and 'anchor' our expectations! That would be a wrong way to look at it. The crash has indeed produced bargains, but these bargains are only to be had after a lot of research and due diligence. It should be determined that the stock is 'safe', has a strong balance sheet and can weather the downturn, if extended. Cheapness can take two forms: (1) Is the stock cheap because its market cap is way below its Book Value (the real book value as determined by you, and don't count the banks here) (2) Is the stock cheap as determined by the future cash flows it will produce. I believe, that in these environments, you can find both, cheap (both type) and safe. Some stocks in the oil and gas sector may have come down so that it is easily determinable that their assets (ignore them if their cost/bbl are high) are worth more than their market cap (after debt). These things take a lot of work and effort. So dig away and find these gems, demand a greater margin of safety but anchoring to the highs, well....
Thursday, October 9, 2008
Book Review: The Little Book of Value Investing
This is a book by Christopher Browne of the Tweedy Browne fame. They originally used to buy and sell illiquid stocks and then started money management. They have been value investors since Benjamin Graham's time (Walter Schloss worked in their offices), infact he was one of their regular clients. While this was a good read, it is for someone who does not know much about value investing and is a begineer to investing in general. They are the very old school type of value investors and focus on P/B, P/E metrics and are not afraid to go around the world to find value. There were some examples that Chris Browne cited which were useful in forming a prospective.
An example could be the Japanese insurers are selling for 1/3 BV, because the securities in their books are marked at cost and the stock market has had a big run up. They buy these insurers, the regulators change the rules and they can mark the securities at market now and they made some good money. Although, this sounds like a good value investment, but there are a lot of 'if's' in this case, because you are levered to the stock market. What if the market fell? A recent example of this could that Bill Ackman bought Wachovia right after the IRS announced a big change in how the firms can carry the tax losses. Wachovia now has $21 billion of these losses and consequently Wells Fargo announced made a big to acquire it for $15 billion (trumping Citi's FDIC brokered bid)! So knowing these things helps, but now you really need to be very very fast than back in the 1980's when Tweedy Browne bought the shares.
I read this book a couple of weeks ago; he in general about what to look for in a Balance Sheet and the Income Statement. He also presents some research on value stocks vs. other strategies over the long term. There are many other examples of European stocks and relative valuations and how in Europe they don't pay as much attention to the stock market as the US does; the various crises including the Russian debt default, Mexican Peso Collapse, the Asian defaults and the opportunities that arose. A good book, an easy read; buy it if you are starting out and want to get a good introduction to value investing.
An example could be the Japanese insurers are selling for 1/3 BV, because the securities in their books are marked at cost and the stock market has had a big run up. They buy these insurers, the regulators change the rules and they can mark the securities at market now and they made some good money. Although, this sounds like a good value investment, but there are a lot of 'if's' in this case, because you are levered to the stock market. What if the market fell? A recent example of this could that Bill Ackman bought Wachovia right after the IRS announced a big change in how the firms can carry the tax losses. Wachovia now has $21 billion of these losses and consequently Wells Fargo announced made a big to acquire it for $15 billion (trumping Citi's FDIC brokered bid)! So knowing these things helps, but now you really need to be very very fast than back in the 1980's when Tweedy Browne bought the shares.
I read this book a couple of weeks ago; he in general about what to look for in a Balance Sheet and the Income Statement. He also presents some research on value stocks vs. other strategies over the long term. There are many other examples of European stocks and relative valuations and how in Europe they don't pay as much attention to the stock market as the US does; the various crises including the Russian debt default, Mexican Peso Collapse, the Asian defaults and the opportunities that arose. A good book, an easy read; buy it if you are starting out and want to get a good introduction to value investing.
Events and Valuations
One of the recurring themes that many value investors use is to buy companies which have been battered by bad 'events'. The market thinks the sky is falling, and the value investor determines that the event is temporary and places a bet on 'reversion to the mean'.
The most famous examples of this has been Warren Buffett (WB) buying American Express after the salad oil scandal (he actually put around 40% of the partnerships assets in AXP!). Another example could be again WB buying Washington Post in the early 1970's after the Watergate scandal. He determined that these were solid businesses with deep moats and the events were temporary. A recent example could be Sanderson Farms (SAFM), they are a poultry processing company and were hammered after the constant bird flu scares in 2005-06. What did the market think? People will stop eating chicken? Usually what happens after an 'event' is that the company focuses on PR and people either forget (we all know we have short memories) or find safety in the fact that this happened, now the company is more careful (because the PR told them they instituted these state of the art QA process). Anyways during the ensuing few months people resumed eating chicken and the stock went up around 50%.
Now, after the pet food recalls hit (anyone remember?) the firms that produced pet food got severely beaten down. The pet food industry has GDP plus type growth (4-5%) and is fairly recession resilient. The future also seems to be bright for this industry as baby boomers buy pets to accompany them during their waning years. I read the 10K for Menu Foods, and determined the following, (1) Customers which accounted for 40% of the sales no longer would order from Menu (2) A lawsuit was filed (which is almost resolved with minimal damage to menu) (3) The restructuring cost Menu around $55 million (4) The existing customers have increased demand, so their sales are down around 20-30% on average.
This did effect Menu's intrinsic value, the question is by how much? Is the market too negative on Menu's prospects? I believe it is, menu produces an essential product and has its sales down and hence the profits are down (although it did turn positive last qtr). The company is taking the right steps in terms of reining in the expenses and assuring customers that it has put processes in place to make sure this does not happen again. Mr. market has hammered the stock around 80%, while I believe the value should be down around 30%. Running numbers on the company my model predicts that the firm should be valued at around $2.50/share while it is trading at $1/share today. Having said that, there are better buys avaliable in this market and Menu's debt level is higher than what I am comfortable with. This is a case study in value investing and not a buying opportunity.
The most famous examples of this has been Warren Buffett (WB) buying American Express after the salad oil scandal (he actually put around 40% of the partnerships assets in AXP!). Another example could be again WB buying Washington Post in the early 1970's after the Watergate scandal. He determined that these were solid businesses with deep moats and the events were temporary. A recent example could be Sanderson Farms (SAFM), they are a poultry processing company and were hammered after the constant bird flu scares in 2005-06. What did the market think? People will stop eating chicken? Usually what happens after an 'event' is that the company focuses on PR and people either forget (we all know we have short memories) or find safety in the fact that this happened, now the company is more careful (because the PR told them they instituted these state of the art QA process). Anyways during the ensuing few months people resumed eating chicken and the stock went up around 50%.
Now, after the pet food recalls hit (anyone remember?) the firms that produced pet food got severely beaten down. The pet food industry has GDP plus type growth (4-5%) and is fairly recession resilient. The future also seems to be bright for this industry as baby boomers buy pets to accompany them during their waning years. I read the 10K for Menu Foods, and determined the following, (1) Customers which accounted for 40% of the sales no longer would order from Menu (2) A lawsuit was filed (which is almost resolved with minimal damage to menu) (3) The restructuring cost Menu around $55 million (4) The existing customers have increased demand, so their sales are down around 20-30% on average.
This did effect Menu's intrinsic value, the question is by how much? Is the market too negative on Menu's prospects? I believe it is, menu produces an essential product and has its sales down and hence the profits are down (although it did turn positive last qtr). The company is taking the right steps in terms of reining in the expenses and assuring customers that it has put processes in place to make sure this does not happen again. Mr. market has hammered the stock around 80%, while I believe the value should be down around 30%. Running numbers on the company my model predicts that the firm should be valued at around $2.50/share while it is trading at $1/share today. Having said that, there are better buys avaliable in this market and Menu's debt level is higher than what I am comfortable with. This is a case study in value investing and not a buying opportunity.
Capitulation? What Capitulation?
The markets have been ruthless over the last few days. Anything and everything is being sold. The major indices are down around 30% from their all time highs, and are dropping further as I write this. The emerging markets are down around 60% on average. Everyone is looking for a buying opportunity. Is this the time where a value investor should feel like a kid in the candy store? Prem Watsa doesen't think so and he's putting his money where his mouth is (70% of his portfolio is in government bonds). He is expecting markets go to down at least 50% from their all time highs (this will put the S&P in the 750 range!) which is akin to the 1974 market declines. According to him there's a significant recession coming, long and deep. It's going to spread all across the world; It's very difficult to not be caught by it and it'll will be difficult for the Fed to do too much now as they are running out of ammo. As George Soros and Warren Buffett have said, this is the unwinding of the great credit bubble of the last two decades, and something that takes decades to build up is not dismantled in a few months; this will be a prolonged recession perhaps lasting many years.
So when will there be capitulation?
Prem Watsa further clarifies the definition: You'll know about it when no one here is optimistic. You'll know when there's no expectation of a turn. In September, there were resumptions, significant redemption; but history shows you've got to have months of resumptions. That's an indication that people are losing their confidence and want to be out of the market. You'll see the average pension fund going down to 30 per cent, 40 per cent equity allocation. ‘Stock' will be a bad word. This is akin to the 1980's when gold was at its highest and Barron's printed an article recommending gold and shunning stocks. Pension funds got the rules changed so that they could hoard more gold, and we all know what happened to gold and equities in the decades that followed.
Now just to be clear, there is a difference between the economic cycle and the stock market cycle. They lag/lead each other and seldom are in tandem. I do not expect the stock market to go down for years. What will likely happen now is that the analyst estimates will come down, and then the companies will show earnings; as long as the earnings are not beating estimates the market will keep going down. When however, the analysts are very very bearish (this is after the company goes bankrupt usually) and have very low expectations, this is when the stocks are really crushed and even the slightest earnings beat will provide substantial upside. This is the game wall street plays and knowing this a value investor can be careful and can adjust his buying and selling accordingly. So stocks are beaten down at the expectation that it will not beat expectation and then traded up or down with the actual expectations accordingly.
So when will there be capitulation?
Prem Watsa further clarifies the definition: You'll know about it when no one here is optimistic. You'll know when there's no expectation of a turn. In September, there were resumptions, significant redemption; but history shows you've got to have months of resumptions. That's an indication that people are losing their confidence and want to be out of the market. You'll see the average pension fund going down to 30 per cent, 40 per cent equity allocation. ‘Stock' will be a bad word. This is akin to the 1980's when gold was at its highest and Barron's printed an article recommending gold and shunning stocks. Pension funds got the rules changed so that they could hoard more gold, and we all know what happened to gold and equities in the decades that followed.
Now just to be clear, there is a difference between the economic cycle and the stock market cycle. They lag/lead each other and seldom are in tandem. I do not expect the stock market to go down for years. What will likely happen now is that the analyst estimates will come down, and then the companies will show earnings; as long as the earnings are not beating estimates the market will keep going down. When however, the analysts are very very bearish (this is after the company goes bankrupt usually) and have very low expectations, this is when the stocks are really crushed and even the slightest earnings beat will provide substantial upside. This is the game wall street plays and knowing this a value investor can be careful and can adjust his buying and selling accordingly. So stocks are beaten down at the expectation that it will not beat expectation and then traded up or down with the actual expectations accordingly.
Update (21st November): Prem is buying. He essentially said that while the recession might be long and deep, the equity markets have discounted much of it.
Wednesday, October 8, 2008
Paulson, CEO of the US and A
Paulson and his performance as the CEO of the $50 trillion behemoth called the USA. Looking at if the privatized profits and socialized gains theory holds!
Bear Stearns:
Bear came way before the current crisis, and at that time was thought of as a bad apple which would impact the whole system. The stockholders lost their shirts, the only people who were saved were the employees (as many) and the bondholders (which I agree is not ideal). The fed did backstop $30 billion worth of looses, which some of this I think the fed would never see again! Again, the reason they saved Bear was so that they could restore confidence and be like there there, its been taken care of, get on with your business..
Stockholder 0; Bondholder 1; Taxpayer 0
GSE's:
FRE/FNM bondholders HAD to be protected, what did the stockholders get? nothing! Now the good thing about this is that he might be able to make the taxpayer money on that too, these GSE's have huge earning power. The problem here were that they were too levered, and the stockholders loved it until the music stopped. Now the GSE's under the government will be operating at moderate leverage, the government has the holding power to ride the storm and this should ultimately end up making money for the taxpayer.
Stockholders 0; Bondholders 1; Taxpayer 1
Lehman Brothers:
I believe, Paulson did exactly the right thing with LEH, making sure the moral hazard side of the equation is being taken care of. The stockholders were wiped out and the bondholders will be getting pennies on the dollar. The stockholders and bondholders going forward will demand more from their companies, expect better disclosure and not just expect a government put. It is a shame that LEH had to go, but now going forward firms will know and investors will know that the downside is zero. This is akin to a professor who only asks 2 big questions on a final exam, so you have to study everything..Its good that people are aware of RISK
Stockholders 0; Bondholders 0; Taxpayer 1
AIG:
Wow what a deal! Paulson is a loan shark!! AIG is a wonderful company and was solvent (given that there is a very fine line between liquidity and solvency in these markets). Paulson wrote a $85 billion check and got 80% of the company with a 8.5%+3 month LIBOR interest rate (8.5% on the unused portion)! The loan is secured by all the assets of the firm. Warren Buffet himself said that he wants to know who made the deal, he wants people like that at Berkshire.
Stockholders 0; Bondholders 0; Taxpayer 1
Bailout:
And now the 'bailout', and the word bailout is in quotes because its not really a bailout; and because this is one mistake (if you can call it that) that Paulson made - He dint sell it properly! Warren Buffet, Bill Gross and Larry Fink have all come out and said it will be a fantastic deal for the government IF the securities are bought at market. Warren Buffet said he'll personally buy 1% of what the government buys (and he does not swing unless he sees a really fat pitch). Again, theres a big IF here, if they start buying these things at inflated prices, then there are bound to be losses. But prudent buying of these securities would again help the taxpayer.
Taxpayer 1, Economy 1
Paulson is an investment banker, a really top notch investment banker and the US taxpayer is his client. I believe, he is doing exactly what he should be doing. The financial system is so convoluted and intertwined (derivatives of derivatives anyone?) that it is the perfect example of a real world domino. In all this there is one risk, the risk of executives who absolutely made the worst decisions and were grossly incompetent still have their jobs. Yes, their stock options are way under water, but they'll find ways to issue themselves cheaper options as soon as the clouds clear. I just hope the shareholders can see through all this. The other con is that everyone from the auto industry to the governments of California are asking for a bailout! Furthermore, although the government is not in the business of owning enterprises and making money (at least not in the US) this might set a bad precedent. But in summary, Paulson is absolutely doing the best he can with the cards hes been dealt!
Bear Stearns:
Bear came way before the current crisis, and at that time was thought of as a bad apple which would impact the whole system. The stockholders lost their shirts, the only people who were saved were the employees (as many) and the bondholders (which I agree is not ideal). The fed did backstop $30 billion worth of looses, which some of this I think the fed would never see again! Again, the reason they saved Bear was so that they could restore confidence and be like there there, its been taken care of, get on with your business..
Stockholder 0; Bondholder 1; Taxpayer 0
GSE's:
FRE/FNM bondholders HAD to be protected, what did the stockholders get? nothing! Now the good thing about this is that he might be able to make the taxpayer money on that too, these GSE's have huge earning power. The problem here were that they were too levered, and the stockholders loved it until the music stopped. Now the GSE's under the government will be operating at moderate leverage, the government has the holding power to ride the storm and this should ultimately end up making money for the taxpayer.
Stockholders 0; Bondholders 1; Taxpayer 1
Lehman Brothers:
I believe, Paulson did exactly the right thing with LEH, making sure the moral hazard side of the equation is being taken care of. The stockholders were wiped out and the bondholders will be getting pennies on the dollar. The stockholders and bondholders going forward will demand more from their companies, expect better disclosure and not just expect a government put. It is a shame that LEH had to go, but now going forward firms will know and investors will know that the downside is zero. This is akin to a professor who only asks 2 big questions on a final exam, so you have to study everything..Its good that people are aware of RISK
Stockholders 0; Bondholders 0; Taxpayer 1
AIG:
Wow what a deal! Paulson is a loan shark!! AIG is a wonderful company and was solvent (given that there is a very fine line between liquidity and solvency in these markets). Paulson wrote a $85 billion check and got 80% of the company with a 8.5%+3 month LIBOR interest rate (8.5% on the unused portion)! The loan is secured by all the assets of the firm. Warren Buffet himself said that he wants to know who made the deal, he wants people like that at Berkshire.
Stockholders 0; Bondholders 0; Taxpayer 1
Bailout:
And now the 'bailout', and the word bailout is in quotes because its not really a bailout; and because this is one mistake (if you can call it that) that Paulson made - He dint sell it properly! Warren Buffet, Bill Gross and Larry Fink have all come out and said it will be a fantastic deal for the government IF the securities are bought at market. Warren Buffet said he'll personally buy 1% of what the government buys (and he does not swing unless he sees a really fat pitch). Again, theres a big IF here, if they start buying these things at inflated prices, then there are bound to be losses. But prudent buying of these securities would again help the taxpayer.
Taxpayer 1, Economy 1
Paulson is an investment banker, a really top notch investment banker and the US taxpayer is his client. I believe, he is doing exactly what he should be doing. The financial system is so convoluted and intertwined (derivatives of derivatives anyone?) that it is the perfect example of a real world domino. In all this there is one risk, the risk of executives who absolutely made the worst decisions and were grossly incompetent still have their jobs. Yes, their stock options are way under water, but they'll find ways to issue themselves cheaper options as soon as the clouds clear. I just hope the shareholders can see through all this. The other con is that everyone from the auto industry to the governments of California are asking for a bailout! Furthermore, although the government is not in the business of owning enterprises and making money (at least not in the US) this might set a bad precedent. But in summary, Paulson is absolutely doing the best he can with the cards hes been dealt!
Tuesday, October 7, 2008
Why?
Hello and Welcome. I am passionate about value investing and over the years have read the works of several value investors including Benjamin Graham, Warren Buffett, Marty Whitman, and Joel Greenblatt to name a few. I am also enrolled in the Chartered Financial Analyst (CFA) program and have passed Level 2 of the curriculum. The ultimate aim is to work under a reputed value investor in the hope that something rubs off. I've also had the opportunity to learn from several blogs, where authors have selflessly shared their ideas and thesis on various subjects. Why Safe and Cheap? Well there are two rules of investing 1) Don't loose money 2) Don't forget rule number 1. Safe because I believe it is absolutely essential to have a strong balance sheet so that the company can survive the downturns and the capital invested is not permanently impaired - the downside is protected. Cheap is just another way of saying margin of safety, where I'll be looking to buy dollar bills for 50 cents - there is minimal upside. On this blog, I will be presenting thesis on various securities that I analyze, study the activities of the 'gurus' and evaluate general market events from the perspective of a value investor.
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