Barel Karsan

More PE10 Shortcomings

noreply@blogger.com (Saj Karsan) — Fri, 27 Jan 2012 11:49:00 +0000

The PE10 is a useful ratio that aids the investor in determining the relative price level of the aggregate stock market. But as discussed on this site a few days ago, the metric is far from perfect, as the arbitrary use of a 10-year period can bump up or push down the measurement for normalized earnings, thereby biasing the ratio. Another major weakness of the PE10 as a tool for making historical comparisons has to do with a change in how corporations have returned money to shareholders.

It used to be that dividends were the main method by which corporations paid shareholders. But for various reasons, buybacks appear to have become the preferred choice for corporations looking to return cash to shareholders.

As it pertains to current year earnings, whether corporations doled out returns in dividends or buybacks in the past makes little difference. But because of the way Standard and Poor's records the earnings of the index (using the sum of bottom-up earnings per share), this can have a major effect on past years' earnings.

For example, if the index earned $1 in EPS in 2001, and since then companies have bought back 50% of their outstanding shares, the real "earnings power" represented by that $1 is actually $2.

This concept is perhaps easier to grasp with respect to individual companies. Consider GameStop's quarterly earnings, which show just over $50 million in after-tax earnings in the third quarter of both this year and last year. While the absolute earnings are roughly similar for both years, GameStop has seen more than 10% growth in year-over-year diluted earnings per share as a result of share buybacks. Which number do you think is more relevant, GameStop's EPS pre-buyback, or the fact that it earned just over $50 million in both years? I would argue that the latter is more relevant, and that the former can bias the earnings estimate lower.

Considering the fervor with which companies bought back shares this past decade, this difference can have a significant impact on the estimate of the index's normalized earnings level. Unfortunately, it's difficult to quickly adjust the formula to correct for this problem. The level of share buybacks is inconsistent from year to year, and shares have been repurchased at various prices, ranging from extremely high to extremely low.

Related to this problem is fact that the size of the capital stock has changed. As companies have re-invested the earnings that they have not paid out in dividends or used to buy back shares, they now have larger capital bases from which to earn profits.

Fortunately, there are other methods that can be used that are in keeping with the spirit of the PE10, without suffering from these drawbacks. For example, one could average the index's ROE over the last ten years, and multiply that number by the index's current book value in order to arrive at an estimate for normalized earnings. My rough calculations with imperfect data suggest a PE10 of around 19, and a PE8 of around 18.

Of course, this method still suffers several drawbacks. The biggest problem with using ROE, for example, is that it doesn't correct for different levels of leverage. Higher debt can result in higher ROE, but that doesn't mean these higher levels are sustainable.

Fortunately for value investors, we don't have to spend a lot of time valuing the market. Knowing that it is approximately fully-valued or somewhat overvalued is good to know in general, but our money is made with individual stocks. Figuring out how to make money on the index is a lot harder than it is with individual stocks, since with individual stocks you only have to swing at the most attractive pitches.

PS More shortcomings of the PE10 are available here.

Intimidation Tactics In The Market

noreply@blogger.com (Saj Karsan) — Thu, 26 Jan 2012 11:39:00 +0000

More frauds are being uncovered in China. This article tells the story of one hedge fund manager who is being sued for what appears to be a factual report. Some snippets:

"Everything Barnes wrote was backed up by veteran investigator accounts, photos, multiple onsite interviews and the company’s Chinese filings."

"If he stood by his report, as was his wont, his less than a year old fund would be engaged in a multi-year legal battle with a company that had nothing to lose and could use its working capital to pay its legal bills."

"On August 1, another person called the Absaroka lawyer and told them to drop the investigation or else the caller “Would come down hard on [the lawyer.]”

There is also the possibility that the fraud goes much higher up the food chain than this one company. Apparently, the company's statements filed in China (which were vastly different than those filed in the US in terms of claims of the company's size) have gone missing!

Understanding The PE10

noreply@blogger.com (Saj Karsan) — Wed, 25 Jan 2012 11:31:00 +0000

The PE10 is increasingly becoming a common method for value investors to determine whether the broader market is cheap or expensive. Not only does this method have a logical appeal to it, but data suggests that the magnitude of the market's subsequent 10-year returns is related to its PE10 level.

But while there is a relationship between a market's PE10 level and its future returns, the following chart (courtesy of My Money Blog) illustrates that the relationship is rather approximate:

For example, in both 1902 and 1965, the PE10 stood around 23. But in the ten years following 1902, the market's real return was 50%, while in the ten years following 1965, the market shrank by almost that much!

Why is there such wide divergence between the market's relative price level and its long-term returns? I would argue that part of the reason has to do with the arbitrary 10-year time period inherent in the PE10 calculation. What you actually want in the denominator of the P/E calculation is a normalized earnings number. Sometimes the E10 (the average earnings of the last ten years) does give you a good approximation for that figure. But other times, such as today, it may not.

For example, in many E10 periods, one recession and one market expansion occurs. These periods may result in an E10 that closely approximates a normalized earnings number. Today, however, two recessionary periods (2001-2 and 2008-9) are contained in the last ten years. I would argue that this arbitrarily biases the PE10 upwards, since the denominator of the PE10 includes only one economic peak period but two economic troughs.

If you throw out the 2001-2 period in the PE10 calculation (so more like a PE8), you get a ratio of about 19, compared to the headline number of 21, a 10% difference. The data used to create the PE10 is made freely available by Robert Shiller, and you can play with it yourself by downloading it here.

Revisiting The Forgotten

noreply@blogger.com (Saj Karsan) — Tue, 24 Jan 2012 11:38:00 +0000

Some time after you've purchased a stock, you probably have a pretty good idea as to whether you made a good decision or not. This is because you likely follow the stocks you have purchased fairly closely. This feedback mechanism allows you to fine-tune your stock purchase criteria so that you don't make the same mistakes again. But often, some of the best lessons to be learned come from the stocks you didn't buy, but considered buying!

Unfortunately, investors often forget about these stocks. These stocks don't make it onto their "follow" lists or spreadsheets, and have zero mind-share. As a result, they may never know if their thesis was correct. Not utilizing this potential feedback mechanism for a large number of stocks can prevent one from becoming a better investor.

Consider cataloging the stocks you were close to buying, but didn't. Check back to see if the reason you didn't buy came true. Note that for a small sample, the result might be misleading. For example, a risk you foresaw may not have come to fruition, but may have been a legitimate reason for not buying. Looking at this "non-portfolio" in the aggregate and over several years, however, should help you improve your decision criteria.

Be A Smart Pro

noreply@blogger.com (Saj Karsan) — Mon, 23 Jan 2012 11:20:00 +0000

SmartPros (SPRO) provides training solutions for various markets. As per Google Finance, "[i]ts customers include professional firms and companies of all sizes who purchase the courses for use by their employees, and individuals who purchase courses, programs or subscriptions on a retail basis." This is a small company that trades for just $10 million, but has $6 million of cash and no debt, and has generated $1-2 million of annual free cash over the last few years (excluding acquisitions).

Since the recession began, earnings have been under pressure, as companies have cut back the kind of capital programs that would lend themselves to using one of SmartPros' training solutions. But a good chunk of SmartPros' revenue is recurring in the form of subscriptions, and this has kept the cash rolling in. The subscription business model gives the company a cash cushion as well, as the company's services are purchased in advance, leading to the aforementioned high cash balance and a deferred revenue account of $5+ million.

While the company is engaged in some modest buybacks, the bulk of the cash is unlikely to be returned to shareholders. Management's intention is to continue using its cash flow to grow through acquisition. This strategy has appeared to work in the past, as the company has grown revenue significantly while generating a decent ROE in the process, at least until the recession hit. But this remains a risk for shareholders; an investor might think he is buying a safe asset in the form of a significant cash position, but that position could be gone tomorrow!

The company's top executives do own about 15% of the company, but they also take home rather generous salaries for a company of this size. The top three executives took home nearly 10% of the company's current market cap (or about 5% of the company's annual sales) in salary in 2010 alone.

Don't be fooled by the recent red ink, however; this is a seasonal business, and the company's fourth quarter (which has not yet been reported) is its strongest. Therefore, in a month or so the company's balance sheet may look even stronger!

Some value investors may find SmartPros too cheap to pass up. The steady decline of its stock price over the last few years certainly makes it an intriguing prospect!

Disclosure: No position

The Upside Of Irrationality: Chapter 4

noreply@blogger.com (Saj Karsan) — Sun, 22 Jan 2012 11:14:00 +0000

Through a series of experiments, Dan Ariely documents the many ways in which humans behave irrationally. By understanding these human tendencies, we can both learn to behave more rationally when it is to our benefit, and better understand why those around us are behaving in the way they are.

We like ideas more when we are the ones who came up with them. This is not an easy tendency to test, but Ariely came up with an experiment that got participants to actually think they came up with an idea that he planted. When participants thought they had come up with an idea themselves, they gave the idea higher ratings.

This tendency may serve a useful purpose. It may give us a high level of commitment to our ideas, giving us the power to follow through and carry our ideas to the max. But the dark side is that we close our minds to better ideas, simply because we did not come up with them ourselves. Companies can fall into this trap as well, as many accept internally generated ideas as more useful than those from other, more successful companies.

The Upside Of Irrationality: Chapter 3

noreply@blogger.com (Saj Karsan) — Sat, 21 Jan 2012 11:57:00 +0000

Through a series of experiments, Dan Ariely documents the many ways in which humans behave irrationally. By understanding these human tendencies, we can both learn to behave more rationally when it is to our benefit, and better understand why those around us are behaving in the way they are.

We overvalue things we make ourselves. In other words, the same object will have a different perceived value based on who made it. Ariely demonstrated this using a series of experiments.

An additional finding is that the more effort we put into something, the more we overvalue it. But this applies only if we actually complete the job. Apparently, we carry no sentimental feelings towards objects we put a lot of effort into but couldn't finish.

Some companies have figured this out. By getting customers to put some effort into a job (e.g. eggs must be added to some cake mixes), customers end up valuing the end product more. But there is a fine line to walk here for companies, because too much effort results in customers giving up and not valuing the end product (as per the last paragraph).

Ariely argues that based on these conclusions, we should revisit how we view relaxation. Today, we often pay to have our gardens tended to, or our "surround sound" systems installed. But we may actually gain much more enjoyment out of them in the long-term if we put the effort in ourselves!

Investment Management Out Of Favour

noreply@blogger.com (Saj Karsan) — Fri, 20 Jan 2012 11:21:00 +0000

In the last couple of months, two investment management firms have been discussed on this site as potential value ideas, Janus and Artio. This is not a coincidence, as money management firms appear to be out of favour. Consider the assets under management (AUM) to market cap ratio of these managers over the last few years:

If this is a temporary phenomenon, investors may want to load up on these companies, taking advantage of the cheap prices while they can. But some might say that this is not temporary. An era of poor returns and competition from lower-cost products like ETFs could pose a permanent threat to the fees these firms traditionally generated from their AUM. If they can't get the revenues from AUM that they used to, maybe they aren't worth as much of AUM as they used to be either.

These arguments are laid out by Alice Shroeder in this Bloomberg piece. Judge for yourself: is this a temporary or permanent decline for this industry?

Artio Outflows = Investor Upside?

noreply@blogger.com (Saj Karsan) — Thu, 19 Jan 2012 11:12:00 +0000

Artio (ART) is an investment manager, earning revenues from assets under management (AUM). Lately, investors have been in no mood to invest, causing outflows at Artio that have reduced AUM from $53 billion at the end of 2010 to just $30 billion today. But while this represents a 40+% decline in AUM, the stock price has declined by over 70% over the same period, which could offer an opportunity to investors.

The market is a big believer in trends. So as Artio's AUM has fallen over the last several months (Artio reports its AUM monthly, in releases such as this one), the market appears to assume the trend will continue. If you're trend agnostic, however, and believe assets could rise or flatten just as easily as they could fall, you may think the stock has been oversold. Here's how AUM has bounced around over the last several years:

As a result of the stock's massive decline, Artio now trades for $250 million, despite having generated operating cash flow of at least $50 million in each of the last few years (and these have been some bad years for the industry, resulting in massive cash outflows). In this kind of business, there are few capital expenditures that need to be made, so theoretically most of that money should flow to shareholders. The balance sheet is clean, with a net cash position of $45 million, plus $65 million of investments Artio has made in some of its own funds (seed capital etc).

Earnings in this type of business fluctuate enormously, as fickle investors jump into and out of portfolios based on their perception of the direction of the economy. But for the investor who can withstand volatile earnings, there may be rewards in the long-term through investing when sentiment is very negative.

Disclosure: No position

UFP Technologies Shows Promise

noreply@blogger.com (Saj Karsan) — Wed, 18 Jan 2012 11:37:00 +0000

UFP Technologies (UFPT) has been coming up on value screens lately. The designer and manufacturer of packaging solutions (e.g. the plastic or foam that surrounds your consumer electronic device when you buy it) has generated free cash flow approaching $10 million in each of the last two years, but trades for just $90 million despite a net cash position of $24 million!

There's a lot to like about this company. Returns on assets and equity have been strong since 2006, perhaps thanks to a strong management team. Management incentives also appear aligned with those of shareholders, as the company's CEO owns more than $10 million worth of stock (compared to pre-tax annual compensation of $1.5 million). As a result, you are probably less likely to see the company's cash load spent on acquisitions with poor returns for the purpose of increasing the company's size.

History bears this out, as the company appears to be a very shrewd acquirer. In 2009, the company bought three companies at what appears to be very favourable prices. The company spent $3.7 million and acquired net assets (including a good amount of cash, receivables and inventory) of $4.5 million.

But this is not a stock without some risk. For one thing, current profitability is abnormally high. Consider the company's margins over the last few full fiscal years:

Will current margins persist into the future? They might. If you believe the company has successfully transitioned away from commodity-like packaging towards higher-margin engineered packaging solutions, you might say these margins are sustainable. But you should make sure you know this to be true; otherwise, you could be buying into a company that is likely to see margins compress if/when business conditions in this industry return to normal.

It's not that clear that management believes the current high profits are sustainable. Midway through 2011, insiders (including the CEO) started selling shares, and they haven't bought any shares recently even though the price has fallen more than 20% since those sales.

Another thing potential shareholders should be wary of are the company's stock compensation practices. The company's free cash flow is overstated by about $1 million per year because that's how much stock compensation expense is added back to operating cash flow. While stock compensation is not a cash loss, it is a loss that is certainly felt by shareholders. The company's share count has been rising about 5% per year, and looks set to continue to rise as there are a great number of options remaining outstanding at much lower exercise prices than the current stock price. So although the company touts in its latest press release that its quarterly sales and income are up, these measures are actually both down on a per share basis!

If current earnings hold up, UFPT looks like a steal at the current price. Management appears intelligent with their acquisitions, and so even though the company doesn't buy back shares, there may not be a lot of risk to the company's cash. However, if current earnings are an aberration, shareholders could be left holding a disappointing stock with margins that decline to more normal levels.

Disclosure: No position

hhgregg: Back in Value Territory

noreply@blogger.com (Saj Karsan) — Tue, 17 Jan 2012 11:43:00 +0000

Shares of hhgregg (HGG) fell off a cliff last week after the company reported preliminary numbers from its all-important holiday quarter that were below expectations. But is the company really only worth two thirds of what it was worth last month? It appears likely that hhgregg's price fluctuates to a far greater extent than its actual value, which could provide an opportunity for value investors.

This is actually not the first time hhgregg has been discussed on this site. hhgregg traded in this price range about 6 months ago, and was thus highlighted here. The stock then saw huge gains as positive sentiment returned, as discussed here. It now trades at a P/E of less than 10 despite strong returns on capital and significant revenue growth.

The biggest risk to this industry is of course competition from online retailers. Bricks and mortar retailers like Best Buy and hhgregg are having to compete with web retailers like Amazon who appear to care a whole lot about market share, and not a whole lot about margins. This dynamic has hurt the profits of everyone this year, as the battle for market share is on. But there are a few reasons to believe the threat is a little bit overblown in the long term.

First, there is a large customer segment that prefers to shop in stores. This is seen by the strong returns on capital companies like Best Buy and hhgregg still generate, even though web retailing is not new. Even with hhgregg's recently reduced earnings guidance, the company will earn an ROE of about 14% this year.

Even when customers shop online, however, the retail presence still plays an important role. Best Buy reports that 40% of those who order online choose to pick up the item in store rather than wait for delivery.

This highlights an important aspect of the competitive relationship between Amazon and bricks and mortar retailers. When Amazon innovates, the bricks and mortar retailers can choose to copy. But Amazon cannot copy the innovations of the bricks and mortar companies that involve physical stores. As such, with competent management, bricks and mortar retailers should not only be able to survive, but also thrive.

On that subject, hhgregg has a proven management team that has successfully guided the company while it has gone up against some tough competition for the last several years. The directors and executive officers of hhgregg own more than $200 million of the company as well, which serves to align their interests with those of shareholders.

Finally, hhgregg has grown and generated its strong returns despite sales tax advantages web retailers have enjoyed in most US jurisdictions. This advantage has finally caught the eye of lawmakers, who are now starting to clamp down on Amazon. This will serve to level the playing field between the bricks and mortars and the web retailers.

Just because a stock is cheap doesn't mean it won't go down more. But for long-term shareholders who don't mind the sometimes violent price swings in this stock, hhgregg could turn out to be a rewarding investment...again.

Disclosure: No position

The Upside Of Irrationality: Chapter 2

noreply@blogger.com (Saj Karsan) — Mon, 16 Jan 2012 11:32:00 +0000

Through a series of experiments, Dan Ariely documents the many ways in which humans behave irrationally. By understanding these human tendencies, we can both learn to behave more rationally when it is to our benefit, and better understand why those around us are behaving in the way they are.

Economists believe labour supply and demand is governed almost completely by wages. But humans are not as rational as they are assumed to be, argues Ariely. Job satisfaction and motivation play big roles in how much labour wage-earners are willing to supply.

Ariely cites experiments with animals that have shown that a number of species prefer to work for their food than receive it with no effort. Ariely designed a few experiments to show that humans have a need for their work to have greater meaning. Work that is acknowledged (as opposed to ignored, or in some cases shredded) results in labourers actually having enjoyed their work more. Such labourers were willing to do more for less, suggesting that productivity is enhanced significantly by non-monetary factors.

The rational worker does his job without worrying about whether his work has "meaning". But the real-life worker gets a great deal of motivation from even a simple acknowledgement. Employers take note!

The Upside Of Irrationality: Chapter 1

noreply@blogger.com (Saj Karsan) — Sun, 15 Jan 2012 11:15:00 +0000

Through a series of experiments, Dan Ariely documents the many ways in which humans behave irrationally. By understanding these human tendencies, we can both learn to behave more rationally when it is to our benefit, and better understand why those around us are behaving in the way they are.

One way our intuition doesn't quite match up with data has to do with how bonuses affect performance. In a number of experiments, Ariely demonstrates that large bonuses (e.g. 5 months of salary) actually hurt performance for cognitive tasks. (This is not the same for mechanical tasks, where high bonuses increase performance.)

Ariely surmises that this may be due to the the fact that the receivers of the bonuses become nervous, start fixating on the bonus and find it harder to concentrate. An analogous situation can be found in public speaking, where an overwhelming desire to do well (because of social pressure) actually causes people to perform tasks worse in front of a group than on their own. The financial pressures caused by large bonuses may have the same effect.

The implications of this are closely related to how executives are paid. If they were being paid to lay bricks (a mechanical task), high bonuses would encourage higher performance. However, seeing as how executives are expected to use cognitive skills, high bonuses may actually be hurting the results of the companies which pay them.

Predictably Irrational: Chapter 13

noreply@blogger.com (Saj Karsan) — Sat, 14 Jan 2012 11:26:00 +0000

Dan Ariely is a behavioural economist who refutes the idea that we are fundamentally rational. Through empirical data, experiments and anecdotes, he illustrates that our irrationality can actually be predicted. He then presents ways in which we can make more rational decisions, both as investors and as people.

Apparently, we like to demonstrate our uniqueness. For example, if someone orders a drink ahead of us at a restaurant/bar, we are less likely to order that same drink. When we change our drink choice based on what the person before us ordered, we are also less likely to enjoy our drink, because it was not our first choice. Ariely determined this through experiment.

In this the final chapter of the book, Ariely concludes that it is clear that we do not behave rationally in a slew of different ways. Furthermore, as he demonstrated in the book, our irrational behaviours are not random. Instead, they are systematic and predictable.

As such, we can take steps to rectify our otherwise impending missteps. Ariely argues that economics should be based on how people actually behave, not how they should behave.

Longing The Shorts

noreply@blogger.com (Saj Karsan) — Fri, 13 Jan 2012 11:03:00 +0000

A few weeks ago, potential sources of stock ideas were discussed on this site. The post made reference to contrarian indicators that signal that a stock is hated; this hatred can result in a low price, which value investors love. One such contrarian indicator is a stock's short interest.

Twice a month, the exchanges release how many shares of an issue are held short (with a two-week lag). This can be a helpful resource in not only identifying which stocks Mr. Market hates, but also which same stocks Mr. Market plans to buy later. This is because when a share is shorted, it must be bought back later; as such, a high number of short shares suggests a higher than normal demand for shares in the future.

Highshortinterest.com offers a list of the most highly shorted stocks (relative to their floats) on the major US exchanges. It currently contains about 100 of the most hated stocks in the US, and plenty of stocks with value potential litter that list. For value investors looking for potential ideas worthy of further study, this is a decent place to start.

For example, a few spots down the list, both GameStop and Sears can be found, both of which are favoured by some value investors. Obviously, one shouldn't assume that just because these and other stocks are on the "high short" list, that they don't deserve to be hated.

But when sentiment on a stock is extremely negative, value investors should pay attention. As such, one of the best places to look for stock ideas is the short interest list. Not only are these stocks unpopular and therefore cheap, these short shares will have to be bought back in the future.

Tracking Insider Ownership In Canada

noreply@blogger.com (Saj Karsan) — Thu, 12 Jan 2012 11:01:00 +0000

This post is aimed at investors in Canadian stocks, so for the 80% of you that ignore this market, you can skip now.

You don't see who the significant shareholders are (and how their holdings have changed) when you look up the filings of Canadian issuers on Sedar. That's not because insiders are not required to report their holdings or changes to their holdings. It's because there is a separate reporting system just for this purpose.

On SEDI, you can find information relating to insider transactions by issuer or by insider, making it a rather powerful tool. Insiders include (by definition, through National Instrument 55-104) shareholders who own more than 10% of a security.

So if you want to know if a senior manager has been buying up shares, or who the significant shareholders are of a company you own, it's easy to find out.

Value Research

noreply@blogger.com (Saj Karsan) — Wed, 11 Jan 2012 11:26:00 +0000

Analyst research is generally focused on the short-term. Price targets are set only about one year out, and discussion focuses mostly on issues that will affect the company over the next quarter or two. (As an aside, follow @ShitAnalystsSay on Twitter for some analyst parody. Please hold off on the hate mail - I'm not the guy behind that account!)

But Ultimate Value Finder does not provide that kind of research. This monthly newsletter is value-focused, and offers three high-conviction value ideas per issue. The write-ups are in-depth (about 2000 words per idea), and cover items such as management history, competitive position and other longer-term issues in which value investors (as opposed to short-term traders) would be interested.

Though this newsletter isn't free, it may be worth the subscription fee. One of the three stocks discussed in the January edition is up around 25% already! For more information about this product, or to see the various subscription offerings, go here. Good luck!

Disclosure: I do not contribute to the content of Ultimate Value Finder in any way, however, I have received a review copy of the January edition and may receive further benefits from the author.

The Power Of Inside Knowledge At Canam

noreply@blogger.com (Saj Karsan) — Tue, 10 Jan 2012 11:18:00 +0000

There is a great deal of evidence (one example here) that company insiders (e.g. senior managers) who trade in the stock of their firms do beat the market. Theoretically, this shouldn't happen, as insiders may only trade as long as they are not in possession of material, non-public information. But this is a difficult line to define, as recent events at Canam Group illustrate.

In late December of 2010, company Chairman and CEO Marcel Dutil sold 1.5 million shares (through a company he controls) of Canam at $7/share. Just four months later, the company announced an after-tax charge of $25 million related to additional costs to complete a major contract. The stock began a major descent from that point, as earnings numbers turned negative for consecutive quarters (thanks to this same project).

What Dutil did may be perfectly legal. Four months before the announced write-down, the problems may not have been "material" (at that time; obviously, they subsequently did become so) or "non-public", a complicated definition the courts are charged with interpreting.

But it's hard to believe that just four months before a precise after-tax write-down figure was released to the public, that he did not have any knowledge that things weren't going so well. Such knowledge doesn't mean he did anything illegal (that's for someone better versed in this regulation to decide), but it does demonstrate how insiders do have advantages.

As Canam's stock fell below $3, Dutil became active once again, buying up 900+ thousand shares (through the same company) at just $2.87/share in November. Today, the stock sits above $4/share!

Blindly riding the coat tails of insiders has been found to be profitable, and the reasons appear to be clear. Insiders have better knowledge of the companies they run than does the public, and they may be trading on that knowledge.

Disclosure: Author has a long position in shares of TSE:CAM

Bank Of...Internet?

noreply@blogger.com (Saj Karsan) — Mon, 09 Jan 2012 11:26:00 +0000

I generally stay away from banks, but for value investors who do dabble in the highly-leveraged financial companies, Bank Of Internet (BOFI) may be worth keeping an eye on.

BOFI has only one branch, as it transacts with most of its customers over the internet. This allows it to save a bundle in costs versus its bricks-and-mortar competitors, giving it the opportunity to grow its business by offering superior rates to customers.

BOFI is also very conservative compared to other banks, reducing the risk to value investors. It navigated the disastrous 2008-2009 period unscathed, and current management has no plans to make the bank more aggressive. The current weighted-average loan-to-value ratio is just 57%!

One problem with this stock is that it has recently had a good run already. As such, it now trades above book value and pretty close to the exercise price of convertible preferred shares it just sold. But the good news is that this is a volatile stock, so if a market panic or bank stock panic ensues, one may be able to get in at a very favourable price.

Investing at the current price can still make sense - but to do that one would have to believe in the growth story. But while Bank of Internet has grown profitably over the last few years, it has not yet faced stiff competition. Should well-capitalized, competent competitors enter the field, Bank of Internet could be reduced to the commodity-type business its bricks-and-mortar cousins already face, bringing down growth and returns.

Bank of Internet is a conservatively run, profitably-growing institution. But will it's future be as bright as its past? That part is difficult to predict. As such, unless you really know what you're doing, you don't want to assume future returns will be anything better than average. But an opportunity to pick this up for a discount to book value may occur at some point, so interested investors should be prepared.

Disclosure: No position

Predictably Irrational: Chapter 12

noreply@blogger.com (Saj Karsan) — Sun, 08 Jan 2012 11:40:00 +0000

Dan Ariely is a behavioural economist who refutes the idea that we are fundamentally rational. Through empirical data, experiments and anecdotes, he illustrates that our irrationality can actually be predicted. He then presents ways in which we can make more rational decisions, both as investors and as people.

Employees tend to steal supplies from work, but they will not steal equivalent amounts of money from petty cash. Customers will wear clothes with the label and return them, but they will not steal cash from the cash register. Users of communal fridges will steal food/drinks but will not steal cash placed in the fridge. (Ariely actually did run such an experiment.)

Ariely reasons that this is because we rationalize our thefts. When we steal, we trick our minds into believing there is justification, and this is a lot harder to do with cash. As a result, we find it much easier to steal non-cash objects.

Unfortunately, as we move to a cashless society, this is something that we need to understand. Credit card rates, stock options and frequent flier points are all non-cash but valuable areas by which businesses can steal from the public, and the optics don't appear to be as bad as if they stole cash. But the effect is the same!

Predictably Irrational: Chapter 11

noreply@blogger.com (Saj Karsan) — Sat, 07 Jan 2012 11:31:00 +0000

Dan Ariely is a behavioural economist who refutes the idea that we are fundamentally rational. Through empirical data, experiments and anecdotes, he illustrates that our irrationality can actually be predicted. He then presents ways in which we can make more rational decisions, both as investors and as people.

We are quite dishonest. Not only do robberies result in losses of hundreds of millions of dollars per year, but employees steal hundreds of billions from their employers, the insured over-claim by billions, retail customers wrongfully return billions worth of merchandise, and taxpayers stiff the IRS by hundreds of billions as well.

Stealing is considered wrong in pretty much every culture, and yet dishonesty is prevalent everywhere. Many believe a part of our brain (the superego, as Freud would have called it) enjoys it when we comply with internalized societal values, such as being honest. But sometimes our mind is able to bend reality to justify theft. Ariely suggests, therefore, taking steps to avoid putting people in such situations where they are prone to becoming dishonest. For example, doctors should not receive funds for prescribing certain procedures, and accountants should not be able to consult for their clients on the side.

An honour code also seems to discourage dishonesty. In experiments Ariely conducted, groups who were not policed cheated more on tests than (control) groups that were; however, those who were asked to sign an honour code or who were asked to recall the Ten Commandments did not cheat!

Karsan Value Funds: 2011 Q4 Results

noreply@blogger.com (Saj Karsan) — Fri, 06 Jan 2012 11:35:00 +0000

Karsan Value Funds (KVF) is a value-oriented fund, as described here. Due to securities regulations, the fund is not open to the public at this time. Should that change in the future, there will be an announcement on this site.

For the fourth quarter ended December 31st, 2011, KVF earned $0.26 per share, increasing the value of each share to $12.40. Negative currency movements between the Canadian and US dollars held the fund back from further gains. Had the CAD/USD exchange rate finished the quarter at the same level at which it started the quarter, earnings per share would have been another 26 cents higher. Currency movements are likely to continue to significantly impact short-term results, but their long-term impact is expected to be low.

Contributing to the gains this quarter were positive price movements in the shares of Parlux, hhgregg, and Envirostar (as discussed here, here and here, respectively). As a result, the fund no longer holds positions in these companies.

For the year, KVF was down 5% compared to S&P 500, S&P/TSX and Russell 2000 (total, including dividend) returns of 2.1%, -9% and -3%, respectively. This was a disappointing year for KVF, for a couple of reasons. First, absolute returns (-5%) were negative, thanks in large part to poor price performance in the middle two quarters of the year. Second, as a deep value fund, I would expect KVF to outperform the broader market during bear markets, but it did not do so in 2011 to a satisfactory extent.

It would be easy to blame market inefficiencies and other external factors for the mediocre results this year. So to the extent that I can, I will. As this chart shows, it was a terrible year for value strategies. Fundamental value portfolios were down almost 24% for the year through the middle of December.

But I am hardly off the hook. Some of my poorest decisions of the year are discussed on the Value Fail page, and while the book has yet to be closed on the RIM saga, at this point I think it is safe to say that I overestimated the company's competitive advantages. I expect to learn from these and be better in 2012 and beyond. Thank you for your continued support.

KVF's income statement and balance sheet are included below (click to enlarge). Note that securities are marked to market value, and amounts are in $CAD:

Regulations vs Money-Printing

noreply@blogger.com (Saj Karsan) — Thu, 05 Jan 2012 11:01:00 +0000

As recently as three or four decades ago, companies in the US were wary of buying back their own shares because this could be considered illegal price manipulation. In 1982, the SEC enacted a rule that gives companies repurchasing shares safe harbour from prosecution for price manipulation, and this has been a major contributor to the growth of buybacks. But regulations restricting the flow of capital continue to hamper the productive flow of capital, as the following are among the conditions for safe harbour protection, as set forth by the SEC in Rule 10b-18:

- No repurchase is made at a price exceeding the highest current independent bid
price or the last independent sale price, whichever is higher.
- Non-block repurchase volume does not exceed 25% of the average daily trading volume for the preceding four calendar weeks

Clearly, these could be major deterrents for small companies looking to repurchase shares. Fortunately, these are not requirements; they only protect the company from charges of price manipulation. Still, these conditions likely deter many small companies from using this option for returning cash to shareholders.

Furthermore, many of the large companies listed on US exchanges are also listed on exchanges in other countries. The regulations enforcing buybacks in most other countries are much more restrictive, and therefore the US issue can suffer as a result.

For example, consider the formerly dual-listed (in both Canada and the US) Quest Capital, which was prevented from buying back shares when it traded at a large discount to its book value, which was made up of mostly current assets. While Quest's price did eventually trade up to the company's book value, the per-share book value (and therefore, the subsequent price appreciation) would have been higher had management been allowed to buy back more shares than the regulations stipulated.

For a table outlining the buyback restrictions imposed by various countries on their exchange-listed stocks, see Table 1 at the bottom of the following paper, Survey On Open Market Purchase Regulations.

Governments around the world currently lament the large cash accounts carried on corporate balance sheets, forcing governments to spend and/or print money to keep capital flowing. At the same time, however, government regulations are keeping corporations from buying back shares, which would send cash to more productive uses and reduce the onus on governments to stabilize capital markets.

Strong ROIC = Lucky or Good?

noreply@blogger.com (Saj Karsan) — Wed, 04 Jan 2012 11:48:00 +0000

Companies with strong ROIC and strong ROE numbers may have competitive advantages. On the other hand, there could be many reasons for high returns which could trick the investor into believing a competitive advantage is present. Therefore, it's important for the shareholder to identify the competitive advantage before accepting it as true.

Rising (or falling) commodity prices could make companies which sell (or buy) commodities look like they have an advantage. Temporarily strong markets, or temporary weakness in competitors can also have the same effect. These occurrences will result in elevated returns for extended periods, occasionally for several years. Managements for these companies will of course take credit for such uncontrollable but favourable circumstances, and will claim that the abnormally high returns are due to their effectiveness in securing a competitive advantage for the company. Therefore, the shareholder must investigate the situation and apply his own business sense to determine if the advantage is for real.

Unfortunately, there is no formula one can apply to determine if a competitive advantage exists. Investors must use good judgement, conduct diligent research, and educate themselves by reading the examples of successful investments of the past. Competitive advantages come in all shapes and sizes. For example, Cisco Systems may have an advantage due to its high market share, allowing it to spread its R&D spend over more units, resulting in a quality per cost advantage. Apple (AAPL) may have an advantage in its processes that allow it to consistently innovate and design new products for the consumer.

Philip Fisher's book Common Stocks with Uncommon Profits helps guide the investor in thinking about whether a company in question has a competitive advantage. This is a book that Buffett learned from as well, as he transitioned from Ben Graham stocks to companies with competitive advantages. The book is summarized here.

Buyout Offer At Manhattan Bridge

noreply@blogger.com (Saj Karsan) — Tue, 03 Jan 2012 11:07:00 +0000

On Thursday, Manhattan Bridge (LOAN), a stock that has been discussed a few times on this site as a potential value investment, received a buyout offer. The stock closed up some 22% on the news, but it probably shouldn't have.

It's not that the buyout offer wasn't substantially higher than LOAN's stock price. The offer of $1.30/share represented a 44% premium to the stock's previous price.

It's also not true that the offer wasn't credible. The group making the offer already owns more than 5% of the company, and offered a plan to close the deal within 90 days.

The problem is that more than 50% of the company's votes are controlled by its CEO. A CEO who appears to want to run this business for a long time (based on his recent compensation package, which ties him to the company for 15+ years) and who is unlikely to be willing to sell this company for a large discount to its assets, which is what is being offered.

Unfortunately, there isn't a whole lot that minority investors can do. We can hope that the company buys back shares at this price, but we've been hoping for that for a long time. We can hope that the company liquidates itself to realize value at the current price, but again that is likely wishful thinking.

Instead, the most plausible scenario for seeing the stock price discount reduced may be the success of the company's lending operations. If the company can generate its cost of capital, only then are we likely to see this discount abate. This is likely what management is trying to do, and hopefully it can get there without taking too much risk.

Disclosure: Author has a long position in shares of LOAN