20 Punches for Value Investors

"What we learn from history is that people don’t learn from history."

Sat, 05 Nov 2011 16:00:00 -0400

“What we learn from history is that people don’t learn from history.”

- Warren Buffett

Particularly relevant after a successful IPO of a crap company.

A Horrible Year. 2011 YTD end of Q3.

Mon, 17 Oct 2011 11:09:14 -0400

A Horrible Year. 2011 YTD end of Q3.:

Jae Jun of Old School Value Blog gives us a very honest update on his portfolio performance.

The following is a quote by Buffett on measuring performance:

While I much prefer a five year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.

a. Our investment will be chosen on the basis of value, not popularity.

b. That we will attempt to bring risk of permanent capital loss (not short term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments; and

c. my wife and I will have virtually our entire net worth invested in the partnership

"The health of our economy has been measured based on the wrong statistic: unemployment. It’s a..."

Mon, 19 Sep 2011 22:06:30 -0400

“The health of our economy has been measured based on the wrong statistic: unemployment. It’s a political number that everyone pays very close attention to, but it’s not as important to the health of the economy as it appears to be. Statistically, 9% unemployment is high, but most of the unemployment is in low-paying jobs. Unemployment among people with a bachelor’s degree is 5.4%, while among those who don’t have a high school diploma is almost 15%. Workers with a bachelor’s degree make almost three times more than those who didn’t graduate from high school. Thus, the impact of unemployment on the economy is a lot less pronounced than the headline number may indicate. The trend in unemployment is more important than the number itself.”

- Fed is Measuring U.S. Economic Health by the Wrong Number

A great piece by one of my favorite authors.

"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not..."

Sat, 20 Aug 2011 02:34:12 -0400

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.”

- Jeremy Grantham

via Margin Shrinkage – It Can Happen to You

This is a must-read article. Seriously.

"What the human being is best at doing is interpreting all new information so that their prior..."

Thu, 18 Aug 2011 20:19:31 -0400

“What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”

- Warren Buffett on Confirmation Bias

More data on stock market vs GDP/economic data. (via Stock...

Tue, 16 Aug 2011 19:00:46 -0400

More data on stock market vs GDP/economic data.

(via Stock Market Crashes Do Not Predict Recessions | The Reformed Broker)

Statistical Shocker: S&P 500 Performs Best When Economy is Shrinking

Fri, 24 Jun 2011 00:25:00 -0400

Statistical Shocker: S&P 500 Performs Best When Economy is Shrinking:

For some reason all this negative news about the economy has taken its toll, which isn’t normal for me. To help maintain a level head, I spent some time digging into the data and it appears there is almost no correlation between poor economic data and market returns. I’d like to share what I’ve found.

First, this is particularly interesting:

As you can see, there is very little correlation between the economy and the stock market. Not only that, investors choosing to own stocks only in years with negative GDP growth would have earned nearly 4 times as much than investors choosing to invest only when GDP was growing at 5% or better. So the next time someone tells you the market is going to drop because the economy is bad or unemployment is high, send them a link to this blog post.

I also spent some time looking at tables of GDP growth vs. S&P returns and I see no correlation. Here’s a chart comparing the last 10 years during this range-bound market of ours:

Just for fun, here is S&P vs Unemployment:

So thats the data. It’s comforting in a strange way, isn’t it?

Should You Sell Your $AAPL Stock?

Sat, 11 Jun 2011 00:14:02 -0400

When the markets are moving on emotion it can be difficult to keep a clear head. The S&P just finished its 6th week of consecutive losses and Apple’s closing price was the lowest its been in over 6 months. Times like these call for a good old-fashioned rational analysis of the situation.

If you’re an AAPL investor, you know how frustrating these past few months have been. The stock has gone nowhere, bouncing between $325 and $355 while it continues to grow earnings at a pace unheard of for a company its size. Analysts have upgraded the stock and its price target over and over again with an average target currently sitting in the mid $400s, yet nothing sticks.

First, is Apple “Over-Valued”?

Some value investors say that Apple stock is priced for perfection. I say bullshit.

Today $AAPL closed at $325.90. This is the lowest closing price since December 29th, 2010, which is mind boggling given reported earnings now are about 33% higher than they were 6 months ago (EPS is currently $20.98 / share.)

Apple’s trailing 12-month p/e ratio is 15.54, including their ginormous cash hoard. Because each shareholder technically “owns” that cash, lets pull it out and look at its p/e based on its earning capabilities.

Apple has $70/share of cash (h/t Asymco). The value of Apple’s cashflow, brand, property, plant and equipment is $255/share with a p/e of 12.21. A quick scan of Google Finance shows the market deems companies like Macy’s, Wal-Mart, Citigroup and DeVry University worthy of a similar p/e. Uh Huh. What’s even crazier is, based on Horace Dediu’s estimates for 2011 earnings, Apple is currently trading at a forward p/e of ~7 ex-cash.

What Does Apple’s Price Say About It’s Prospects for Growth?

I recently read Vitaliy N. Katsenelson’s excellent book Active Value Investing where he presents a couple models for valuing companies in range-bound markets. I built a spreadsheet to help me model stocks based on his formula for determining an estimate of fair-value p/e. While the formula is beyond the scope of this post, trust me that it is extremely comprehensive.

If I plug AAPL’s info into my spreadsheet and assume average business risk, below average financial risk and average earnings visibility shows that the current price assumes AAPL will grow at an average annual rate of 2.1% for the next 5 years.

(Note: This is just calculating for ex-cash, so add $70 to $255.42 and you get $325.42. If you want to incude cash, it takes 6% growth to get a $325 fair value.)

Considering year over year earnings nearly doubled in the most recent quarter and Apple a) has either a small share of a very large market (PCs) or a large share of rapidly growing markets (phones and tablets) and b) continues to innovate in ways that widen their competitive advantage, I think we can safely assume growth will average more than 2.1%.

What do the Analysts think AAPL is Worth?

The average price target for Apple is around $450. I still have no idea what a “price target” means to analysts, so lets just borrow their growth estimates and plug it into my spreadsheet instead. While analysts are generally way off in their estimates, at least its better than nothing.

Apple has a long history of blowing away consensus estimates, so maybe we can pretend we’re being conservative by just taking them at face value. Yahoo tells me that analysts expect Apple to grow earnings at a compounded rate of 21.31% over the next 5 years. Plug this magical number into my model and you get a fair value of $595.98, ignoring adjustments for cash per share (Oh, by the way, Cash per share in a few years will likely be about what the stock is selling for right now).

A valuation of $595.98 would mean Apple is selling at a 45% discount to my model’s fair value.

But Analysts Are Usually Wrong?!?!

This is true. They tend to be overly optimistic when the world is bright and cheery and overly pessimistic when the world is dark and scary. So lets take another approach to guessing growth.

What you can assume is that companies with a history of producing high returns on invested capital over long periods of time are likely — but not guaranteed — to continue doing so. High returns on invested capital results in financial stability, high margins, fast growth,etc. It’s the #1 think I look for when identifying great companies for further study and Apple has averaged about 25% return on assets for the last 5 years. A ridiculous feat, especially because most of these assets are cash and earning a pittance.

Let’s go back 5 years to 2006. I couldn’t have accurately estimated Apple’s current income for 2011 because the iPhone and iPad didn’t exist at the time. The only thing I could know is that over the last 5 years, they had explosive growth and are committed to pushing innovation in a way that makes computing easier for everyday people. I also know that people happily pay a premium for Apple products and Apple believes in delivering value, not low prices. These two things would make me quite confident in Apple’s ongoing ability to produce a high return on assets and ongoing growth. However, I’d never know that the majority of profit would come from two product lines that didn’t exist.

The problem with a company that earns high returns on invested capital is that eventually competition wants to make high returns on invested capital too, so they enter the market and prices drop as competition heats up. While this is generally true, there are exceptions. Some companies are unfazed by competition and maintain their margins. Apple has shown time and time again that they are one of these magical companies. First with the iPod clones, then iPhone clones and now we are seeing iPad clones fail miserably.

Warren Buffett calls this ability to compete on something other than price “having a wide moat” and Apple’s just doubled in size with the announcement of iCloud. You can argue the minutae of the individual products and their competitiveness all you want, but the only thing that is really important is whether or not Apple is successfully defending and widening their moat. As long as that moat stays strong, they’ll keep growing while maintaining their unusually high margins.

Value Line tells me that Apple has grown earnings at a compounded rate of 30% per year for the last 10 years. Over the last 5 years they grew earnings at a compounded rate of 70% per year. The law of big numbers will eventually catch up with Apple (tree’s don’t grow to the sky you know), but lets say they’ll grow the next 5 years at 1/2 the rate they’ve been growing for the last 10 years, or 15%. While I can understand how growth could be much higher than 15%, I cannot get myself to understand it could be lower. 15% growth for a large company is generally considered impossible for long periods of time, but I think Apple is in a very unique position.

If we plug in 15% to my model, we get a fair value of $484.11, or about a 33% discount to today’s price.

Maintaining Short-Term Sanity Using The Technicals

These two growth estimates gives us a very conservative fair value range of $481.11 to $595.98 based on my model. That places Apple stock in the “RIDICULOUSLY UNDERVALUED” club. The problem is that the short term is generally ruled by short-term minded traders who don’t care all that much about fundamentals or long-term prospects. Which brings us to the witchcraft known as technical analysis.

I know, value investors aren’t supposed to talk about charts or trends or price/volume action. The thing is that the short term is ruled by technical traders and being able to play their game can help you understand when prices are getting close to a technical bottom. It doesn’t always work out, but I find that taking a look at the technicals usually allows me to make buy decisions closer to the actual bottom of a correction.

Here’s a what some of the technicals look like for AAPL right now:

For those unfamiliar with technical analysis, Apple has been bouncing between the two blue lines up top for the last 6 months. Technicians call this a pennant and it typically represents a temporary pause for a stock that has been going up. The bottom line is support, the top is resistance. As you can see we’re sitting at support as of today’s close.

Then we have a trend line pf support that goes back to May of 2010. Long-term trends tend to act as much stronger support than short-term trends and a year is a pretty long time in the Ritalin-laced world of technical traders. We closed about $0.35 under this line today.

Finally we have the 200-day Moving average. AAPL hasn’t come this close to touching it since September 2010, which was its last major bottom. 200-day moving averages are regarded as a very strong support level to the technical trading world.

Take these three things, then sprinkle in some other advanced indicators and you see the stock is severely oversold. This setup has historically been the best time to buy.

Summary

The big problem with technicals is that they tend to work well until that one time they don’t. However, when you combine technical analysis with Buffett-esque fundamental analysis you have the confidence to hold on as long as the assumptions you used to estimate the value of the business remain in tact. If you know you bought a dollar for $0.55, would you be compelled to sell if you find out dollars are selling for $0.50 a week later? I think not.

Looking at the scary state of the market right now probably makes you feel the need to cut and run. If you can let cooler heads prevail, then it’s clear that selling may be the worst thing you can do.

Disclosure: I’m Long Apple. Duh.

"Somewhere in the middle of the bull market the first common-stock flotations make their appearance...."

Thu, 19 May 2011 16:14:26 -0400

“Somewhere in the middle of the bull market the first common-stock flotations make their appearance. These are priced not unattractively, and some large profits are made by the buyers of the early issues. As the market rise continues, this brand of financing grows more frequent; the quality of the companies becomes steadily poorer; the prices asked and obtained verge on the exorbitant. One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history.”

- Benjamin Graham in The Intelligent Investor

So LinkedIn went public today and it popped up over 100% reaching around $10B market cap. Forget P/E. Thats over 40x last years revenues.

The thing is that I’d have to consider Linked In one of the better companies that could go public. Just think about the flood of shit that will likely be headed our way in the coming months.

LinkedIn prices IPO at $45 a share

Wed, 18 May 2011 20:07:00 -0400

LinkedIn prices IPO at $45 a share:

Few Internet companies have tested the public waters since the dot-com crash. LinkedIn’s lofty valuation — some 20 times its 2010 revenue — already has invited comparisons to the heyday of the last boom.

Um. Ok.

This immediately made me think about something I read in James Montier’s excellent book Value Investing. Montier quotes a BusinessWeek article where Scott McNealy, then CEO of Sun Microsystems, says:

“(In 2000) we were selling at 10 times revenues. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold…That assumes zero expenses, which is really hard for a company with 39,000 employees. That assumes I pay no taxes…and that assumes zero R&D for the next 10 years…Do you realize how ridiculous those basic assumptions are? …What were you thinking?”

Best of luck to the $LNKD-buying lemmings tomorrow!

"Cisco is financially strong and we think statistically cheap. It has a dominant market position and..."

Fri, 22 Apr 2011 12:32:44 -0400

““Cisco is financially strong and we think statistically cheap. It has a dominant market position and has been growing within a category that we believe still has a lot of room for future growth. Perceived competitive threats and concerns about possible slower rates of growth have put pressure on Cisco’s stock price, which has allowed us an entry point in the stock that we believe is at roughly a one third discount from a conservative estimate of the company’s intrinsic value.”

- Tweedy Brown in their 2010 annual letter, [via Why Are Value Gurus Buying Cisco? — GuruFocus.com]

I bought some CSCO a couple months back and its been a painful ride so far. As Tweedy says, it offers a high margin of safety based on conservative valuations (33% is their estimate) and I’ve been holding tight. Not sure how much faith I have in a turnaround at this point, which oddly enough leads me to believe the turnaround is coming soon.

"They are not new lessons. Never owe any money you can’t pay tomorrow morning. Never let the..."

Sun, 27 Mar 2011 12:08:08 -0400

“They are not new lessons. Never owe any money you can’t pay tomorrow morning. Never let the markets dictate your actions. Always be in a position to play your own game. Never take on more risks than you can handle. But all of those were old lessons, unfortunately. Even though I didn’t see it coming, those lessons which are timeless allowed us to in effect profit from it rather than suffer from it. Good businesses, good management, plenty of liquidity, always having a loaded gun; if you play by those principles you will do fine no matter what happens. And you don’t ever know what’s going to happen.”

- - Warren Buffett on key lessons from the financial crisis.

[via Warren Buffett: The U.S. is moving toward plutocracy - Haaretz Daily Newspaper | Israel News]

"Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how..."

Sun, 27 Feb 2011 09:00:07 -0500

“

Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours.

Both realized and unrealized gains and losses are fully reflected in the calculation of our book value. Pay attention to the changes in that metric and to the course of our operating earnings, and you will be on the right track.

”

- Warren Buffett in his 2010 Letter to Shareholders

"When Charlie and I met Todd Combs, we knew he fit our requirements. Todd, as was the case with Lou,..."

Sat, 26 Feb 2011 13:10:49 -0500

“When Charlie and I met Todd Combs, we knew he fit our requirements. Todd, as was the case with Lou, will be paid a salary plus a contingent payment based on his performance relative to the S&P. We have arrangements in place for deferrals and carryforwards that will prevent see-saw performance being met by undeserved payments. The hedge-fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich, with their limited partners losing back their earlier gains. Sometimes these same general partners thereafter quickly started another fund so that they could immediately participate in future profits without having to overcome their past losses. Investors who put money with such managers should be labeled patsies, not partners.”

- Warren Buffett in his 2010 Letter to Shareholders

My ongoing search for fairness in fees for managing money continues.

Marriott International announces plan to split in 2

Tue, 15 Feb 2011 11:00:33 -0500

Marriott International announces plan to split in 2:

An opportunity may be a-brewing here.

"The stock market is a no-called-strike game. You don’t have to swing at everything—you..."

Tue, 15 Feb 2011 01:40:00 -0500

“The stock market is a no-called-strike game. You don’t have to swing at everything—you can wait for your pitch.”

- Warren Buffett

I got nothin’ worth a swing right now. I think about this quote often.

"A public opinion poll is no substitute for thought."

Tue, 08 Feb 2011 12:11:34 -0500

“A public opinion poll is no substitute for thought.”

- Warren Buffett

I was looking for ideas tonight on my favorite site for browsing...

Tue, 08 Feb 2011 00:02:40 -0500

I was looking for ideas tonight on my favorite site for browsing for ideas and saw this. I was buying Sabra a while ago when it was in the $16’s. Value Line says there is $30/share of book value. My analysis put it much lower when I was making my purchases. I must have discounted intangible assets or something. Time to revisit.

Sabra Healthcare REIT ($SBRA) is an REIT spin-off from Sun Healthcare ($SUNH or $SUNHD).

Spin-offs can be quite lucrative. I’m up 20 or 30 some-odd percent since Oct/Nov from this whole Sun Healthcare spin-off deal. (It’s weird to calculate becomes symbols come and go.)

Doing some research on Buffett’s original partnership. He...

Tue, 01 Feb 2011 11:29:35 -0500

Doing some research on Buffett’s original partnership. He raised $105,000 from 7 different investors in 1956. Thats about $850,000 in 2011 dollars.

"In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the..."

Tue, 01 Feb 2011 01:14:00 -0500

“

In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive this bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee.

…. the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.

”

- Warren Buffett, 2006 Letter to Berkshire Hathaway Shareholders