Canadian Value Investing

Simple & Predictable Businesses

2013-05-25T07:06:00.000-06:00

Much has been written on Warren Buffett's circle of competence statements but I want to look at it from a slightly different point of view. Most often it is said that Buffett prefers to buy stocks that are simple, easy to understand, and whose profitability can be predicted for several decades out.

For example he has said that Coca-Cola and Wrigley's chewing gum are two very each companies whom he can predict will be around for hundreds of years. The trouble is a number of companies have come and gone, so how do you predict which ones will meet the test of time?

Buffett has also said change is the enemy of the rational investor. He much prefers companies that are in industries that never change and never will. So what types of companies meet that description?

I have been reflecting on this for a while and believe part of the answer is found in a simple model we discuss a lot at my workplace and most would have seen in high school. That is Abraham Maslow's Hierarchy of Needs, shown below.

Although Maslow never formulated his hierarchy of needs in such a manner, it does make a decent representation of human needs. As I was reflecting on this hierarchy of needs, I though how every business that ever existed has attempted to meet one of these human needs in one way or another. What is also interesting is that attempting to meet higher level needs of Belonging and Esteem is very difficult but many companies attempt to do so. I believe the success of Facebook is largely due to the attempt of millions of individuals trying to meet their Esteem needs (in an unhealthy way).

What is interesting is that all of our wants are derived from our attempts to meet a basic need. For example you may want to buy a new truck. In this purchase we often use self deception to justify such a purchase by telling our self that it will meet our basic need for transportation. The truth is we are often trying to satisfy our esteem or belonging need. We feel that if we have that new prized possession, others will think better of us. So whether or not we are actually trying to meet a basic or a higher level need (Esteem or Belonging), our underlying needs drive all of our wants. This process may be conscious or unconscious.

So what types of companies does Warren Buffett buy for his company, Berkshire Hathaway? First of all Berkshire is predominately an insurance company. Insurance has been around for hundreds of years and is in the business of risk transfer. For an agreed upon price you can meet your SAFETY needs by paying Geico, Berkshire RE, General RE, or National Indemnity to assume your risk of loss. Furthermore, they focus on property and casualty insurance or protecting basic PHYSIOLOGICAL needs.

What else does Berkshire own?

Acme Brick, Benjamin Moore, Brooks Sport, Clayton Homes, Cleveland Wood Products, CORT, CTB, Dairy Queen, Fechheimer, Fruit of the Loom, HH Brown Shoe Group, HomeServices of America, Johns Manville, Jordan's Furniture, Justin Brands, Kirby, McLane Company, MiTek Inc, Nebraska Furniture Mart, The Pampered Chef, Russell, See's Candies, Shaw Industries (carpet), Star Furniture, Wayne Water Systems, Western Enterprises, and RC Willey Home Furnishings.

What is interesting with this list of many familiar brands is nearly all of these companies meet the basic of all needs including food, shelter and clothing. Those needs will never, ever go away.

Even some of their large equity interests meet these basic needs too, namely Coca-Cola, Walmart, Proctor & Gamble, Kraft and Costco.

Under SAFETY they also own a number of banks including Wells Fargo, American Express, Bank of America, US Bankcorp, Bank of New York, and Visa.

Under BELONGING they own Ben Bridges Jeweler, Borsheims, & Helzberg Diamonds. This is obviously a bet that people will continue the ageless tradition of buying an engagement ring for their significant other. I find the tradition of handing your soon to be bride a glittering gem dug out of the earth to be a total waste of every one's time and money. Nevertheless I doubt the tradition will change because of my point of view. I would recommend the article "Have you every tried to sell a diamond?" for those interested in further reading. De Beers spends millions yearly to ensure we are all brainwashed into holding on to this tradition.

Also under BELONGING, Berkshire also owns a number of media companies and lately has been buying up newspapers that were formerly profitable. Many of these business rest on the fact that we humans are relational and desire information about what is going on around the world. What is interesting is that a number of these businesses have become disrupted because technology is transforming how this information is consumed. I believe Buffett has made his bets in this area because the desire for information will not go away and that those producing the content will still be able to earn a decent return for their efforts.

Under ESTEEM needs Berkshire doesn't own much. I would put NetJets under this category. Perhaps that is why Buffett calls his personal jet the "indefensible". Often once you get to this level, the business and fads are very unpredictable. So have been the profits.

Of course there are other Berkshire businesses that I haven't mentioned like it's large position in IBM. To be honest I'm not exactly sure where to categorize that one. My personal opinion is that Buffett bought it because businesses and government use their services to meet their SAFETY Needs. Now in this case I don't believe that just say it meets a basic need for a business and declare it to be a stable & predictable business. In technology, substitutionary effects are real and paradigms shift can happen quickly. Here Buffett must also believe the switching costs are very, very high.

Anyway, I hope this provides a different angle at how Buffett chooses safe and predictable businesses. If you are every looking to open a business I would recommend ones closest to the base of Maslow's Hierarchy as you are guaranteed to have the largest number of possible customers.

Best Regards,

Kevin

Disclosure: Long BRK.b, WFC, BAC.WS.a,

Xbox 720 - IllumiRoom

2013-04-29T20:44:00.000-06:00

The latest out of Microsoft Research. Many believe this to be part of the new Xbox, rumoured to be called Xbox 720. This might be one of the coolest things I have ever seen. The possibilities are endless.

Best Regards,
Kevin

Disclosure: Long MSFT

Fairfax Shareholder Letter Part 2: Get Defensive

2013-04-21T10:52:00.000-06:00

As mentioned in the previous post, Fairfax has positioned themselves very defensively. Why you might ask? Here are some quotes for you to chew on.

Deleveraging in the private sector has only just begun.

In our 2010 and 2011 Annual Reports, we discussed the Chinese bubble in real estate. This past Sunday (March 3, 2013), the CBS show "60 Minutes" did a segment on the Chinese residential real estate bubble. They showed vast empty cities with "new towers with no residents, desolate condos and vacant subdivisions uninhabited for miles and miles, and miles and miles of empty apartments." They called it the biggest housing bubble in history. We agree! The ultimate collapse of this bubble will have major consequences fro the world economy.

...today the "risk on" trade prevails everywhere, with investors reaching for yield in corporate bonds, high yield bonds and even emerging market debt... For example, Bolivia's recent $500 million 10 year bond, issued at 4-7/8% was 9 times over subscribed even though Bolivia has not issued a bond in 90 years!! Poland did even better, issuing a 10 year bond at 3-3/4%.

We continue to be be early - and bearish!

While commodities prices have yet to collapse (i.e. complete the down cycle)...

As we also said last year, if commodity prices come down after their parabolic increase, Canada will not be spared. Also, Canadian house prices have gone up significantly, driven by lax policies at CMHC (Canada's equivalent to Fannie Mae and Freddie Mac). Canadians have accessed their wealth through lines of credit easily available from the Canadian banks. This has begun to reverse and we are watching from the sidelines.

In 2012, Fairfax shorted the S&P/TSX 60 index to the tune of $206.1 million (notional amount) at an index value of 641.12 (as of Apr 19th, the index stood at 673.33).

We currently have 31% in cash and cash equivalents - earning us very little money.

We did remind you last year but here it is again - cumulative deflation in Japan in the past 10 years and int he U.S. in the 1930s was approximately 14%!! It is amazing to note that including 2012, Japan has suffered deflation in 17 of the last 18 years - beginning about 5 years after the Nikkei Index and real estate values peaked.

In the last three years, we have had significant unrealized losses from our hedging program and from our CPI-linked derivative contracts... ($1.86 billion)

These losses are significant but we consider them unrealized and expect both of them to reverse when the "grand disconnect" disappears - perhaps sooner than you think!

This is what I love most about Fairfax, they are very rational, stubborn and stick to their principles.

Your company is focused on protecting you on the downside of permanent capital loss from the many potential unintended consequences that abound in the world economy.

Bond Portfolio

The company's fixed income portfolio totals $11.4 billion dollars. The vast majority is investment grade bonds and 68.1% is rated AA or better. What is interesting is the comments in the annual report on U.S. state and municipal bonds. The company owns $4 billion worth of bonds insured by Berkshire Hathaway Assurance Corp in the event of a default. This makes the credit risk associated with 35% of the fixed income portfolio bullet proof.

Why Defensive?

So why is Fairfax so defensive? First they don't see the financial crisis of 2008/2009 as something that has totally corrected itself. To answer that you have to look at what caused the financial crisis itself, namely excess debt or leverage. While deleveraging has occurred in the private sector, the public sector has levered up. Total debt in the system, as highlighted again the the Fairfax annual meeting, is still very high.

Why does leverage hurt growth? To understand leverage it is best to be understood in the context of an individual, lets call him Joe. Lets say Joe earns a decent wage but spends all of his income and has no debt. Then lets say Joe wants to make a bigger purchase, which is greater than his income. He has two choices, he can either save or borrow the money. If he saves the money he will have to under consume now in order to make his purchase in the future. This is often the most rational approach.

On the other hand, Joe can borrow the money. In this case he consumes today and under consumes in the future (until the debt is payed off). It is important to note that he has to under consume to a greater degree in this case because he not only has to repay the principle but also the interest. If the money is borrowed on a credit card the under consumption require in the future is huge due to high interest rates.

Now if Joe and his friends all play the same game of consume today and pay tomorrow, growth is great in the short term. However in the long term, the economic output of a country will be artificially high because aggregate consumption today higher than it would normally be without the excessive borrowing. This is also the reason why deflation is likely to occur as demand collapses, along with prices.

This has been going on for years in Canada, the US and almost every western country. However in 2008, the private sector has started to reduce debt levels in almost every country, except Canada. Here we kept on piling on the debt. Canada has had relative strong economic growth driven by the parabolic rise in commodity prices.

In Canada, the average household is levered to to the tune of 165% of annual income (see graph below) and is becoming heavily burdened by the debt load. So long as you can continually add more debt you can continue to consume at a relatively high level, but make no mistake you cannot defy economic gravity. Today many are content to pay interest in perpetuity for past economic gluttony (over consumption). In the US the consumer had reduced debt levels but the public sector has levered up (along with quantitative easing) the consumption level has held up relatively well.

So what difference does this make? If commodities fall, as I expect, Canada will go through a rough process of unwinding these excesses. If the last jobs report is any indication... the loss of 55,000 jobs that took economist by surprise, we may be in for some turbulent times here in Canada. Secondly, the Canadian housing market is starting to turn over. I have read reports of home being purchased in Vancouver with HELOCs so the owners can make interest only payments, can anyone say subprime? To read more about the good, the bad, and the ugly on real estate and the Canadian economy, I suggest reading this article.

Conclusion

For those with significant equity exposure in Canada, particularly banking, you may be at significant risk. The same goes for those holding Canadian equity mutual funds in RRSPs, TFSA's, etc. Every Canadian equity mutual fund has huge exposure to Canadian banking, thus housing and consumer credit. A soft landing for Canada is not likely in the cards. Now there are ways to protect yourself and perhaps profit from this mess, so buyer beware.

Owning Fairfax common stock is a wonderful way to protect yourself from the potential issues in the market today. They are short a number of key markets and have huge deflation protection. If commodity prices collapse due to issues in China, the US and Canada their deflation protection will be worth billions. Given that the stock sells for around book value it isn't even expensive. I can also say that having read their annual report, I can say they are also very conservative in their accounting. Just compare their assumed returns for pension assets to other companies for an example.

Last year Fairfax earned 6.5% on equity, a surprisingly strong result given their equity portfolio was 100% hedged. Look for it to explode if commodity prices or equity markets fall. If neither happen and the economy muddles along, expect similar mid single digit returns on equity. So downside is near zero, and the upside is huge. As I said in Fairfax Shareholder Letter Part 1, it is imperative and prudent to always obsess over the downside.

Good Decisions,

Kevin Graham

Disclosure: Long FFH.

Fairfax Shareholder Letter Part 1: Buy BlackBerry

2013-04-13T12:01:00.000-06:00

After reading the 2012 Annual Letter to shareholders of Fairfax Financial Holding, I thought I should post their interesting and different perspective on the markets. In short, everyone today seems to be accepting an out sized amount of risk today because of quantitative easing. Prem Watsa (CEO of Fairfax) is having none of it and is very defensive.

I want to use this post, and the following one, to highlight my highlights of the Fairfax Annual Letter to shareholders. As I have said before, too many people focus on the upside when investing while value investors fret over the downside. Anyone who has invested long enough knows that you don't have to have very large gains in your portfolio, so long as you don't suffer huge losses.

One bad year, say a loss of 33%, means that you have lost 1/3rd of your capital and have to now earn 50% on the remaining capital just to get back to where you started. Thus it is imperative and prudent to always obsess over the downside. Ben Graham, the father of value investing, in his book the intelligent investor said, "Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY." (Chp. 20, emphasis mine)

With that introduction in mind let's look at Prem Watsa's Annual Letter. I will put each quote in italics and bold and my comments will follow. This will break up this post into two parts just so it's not so too long.

"OdysseyRE is the jewel in the crown, accounting for almost half our business and producing an average accident year combined ratio in the last ten years (since 2003) of 92.8%."

This truly is an outstanding business and I wish they owned more. To be honest and rational, the only other really strong business is Fairfax Asia that has a 10 year average combined ratio of 71.8% and a 26.5% compounded annual rate of growth in book value (2002-2012). However the only problem is Fairfax Asia is writes 1/7th the amount of premiums. That said, if Fairfax Asia keeps growing at a decent clip, it may well be the crown jewel someday. The emerging markets have years of strong growth ahead as Prem went on later to say, "All of these (emerging) markets are growing rapidly because of the low penetration of insurance."

The only other problem is their "crown jewels" often compensate for some of less valuable insurance companies that have been running terrible combined ratios over the part couple years. As I like to say, less is often more. That said, unless the business is consuming capital there is little reason to sell it.

"In 2012, we earned a total investment return of only 4.5%...mainly because of our 100% hedge of our common stock portfolio."

Given the hedges this is not a bad result, especially since the downside protection is so high.

"Markets fluctuate - and often in extreme directions... (Discussing his investment in BlackBerry) At it's low of $6-1/2 per share, it sold at 1/3rd of book value and a little above cash per share (it had no debt). The stock price declined 95% from it's high!"

Mr Watsa then goes on to discuss his rational for the investment in BlackBerry (BB).

"The brand name, a security system second to none, a distribution network across 650 telecom carriers worldwide, a 79 million subscriber base, enterprise customers accounting for 90% of the Fortune 500, almost exclusive usage by governments in Canada, the U.S. and the U.K., a huge original patent portfolio, an outstanding new operating system developed by QNX and $2.9 billion in cash with no debt, are all formidable strengths as BlackBerry makes its comeback!"

While those are all interesting facts, what came next is even more interesting and is the missing link to the Blackberry investment.

"And please note, 1.8 billion cell phones are sold worldwide annually, and of the 6 billion cell phones in the world, only 1 billion are smart phones. Lots of opportunity for Canada's greatest technology company!"

Boy, he just had to throw that in there... What does it mean? Well, here is the logic as I see it.

1) BlackBerry currently has 76 million subscribers worldwide as per their latest earnings, so BlackBerry has a little more than 7-1/2% market share of all smartphones in the world.

2) The growth of the smartphone market is still in it's infancy since only 16% of worldwide cell phones are smartphones.

3) Over time, a large percentage of cell phones will be upgraded to a smartphone. Let's say over the next decade the smartphone market grows from 1 billion to 4 billion (2/3 of total cell phones).

4) If, and I say if, BlackBerry simply retains it's market share in smartphones... How many subscribers will it have? The answer is over 300 million or over 4 times it's current subscriber base.

Of course you can make your own assumptions and of course be conservative (everyone else is), but you easily see they have room for a lot of growth. Even if their market share shrinks, they can still grow their business.

Now for the ironic news of the day... Guess who has higher gross margins, Apple or BlackBerry? That right, Blackberry's gross margin was 40.1% in Q1, while Apple's was 38.6%.

That said Blackberry still has some room to go on the cost side. If we keep working our way through the income statement for Q1 2013, Blackberry spent $383 million on R&D (14.3% of sales) while Apple spent $1010 million on R&D (1.9% of sales). Next if we look at Selling, General and Administrative costs, Blackberry spent $523 million (19.5% of sales) verses Apple's $2,840 million (5.2% of sales).

At the end of the day, the operating margin was 31.6% at Apple in Q1 compared to Blackberry's 6.3%. Clearly Blackberry has a huge amount of opportunity, especially on the SG&A side. They just have to work harder, grow market share and their operating margin will increase.

To be honest about his analysis, I find it amazing how much the market hates Apple stock at this time. Both Apple and Blackberry have solid businesses is a very fast growing segment of the world economy. Both companies seem to be selling at distressed prices today given the above facts. I wonder if Prem and his team shouldn't consider both investments especially given the theme of growth in the smartphone market.

Stay tuned for part two... (Click Here for Part 2: Get Defensive)

Best Regards,
Kevin Graham

Disclosure: Long FFH.

Wells Fargo Annual Report

2013-04-02T22:23:00.000-06:00

"In 2012, we grew revenue 6 percent to $86.1 billion, mostly from noninterest income. (Imagine our earnings power when a more normal rate environment returns.) The revenue growth included double-digit growth in our capital markets, commercial real estate, corporate banking, mortgage, asset-based lending, corporate trust, and international businesses." - John Stumpf - 2012 Wells Fargo Annual Report

John Stumpf is an amazing CEO and runs a tremendously profitable company in Wells Fargo (WFC). I too can only imagine the earnings power when a more normal interest rate environment returns. Wells Fargo will be an earnings dynamo.

It was just over two years ago when I woke up and realize what a ridiculously cheap price Wells Fargo was selling at. Since then I have averaged 16.5% annually plus dividends in a sub optimal economy. Bring on the good times. I fully expect the dividend on my original cost to yield over 8% within two years as the economy normalizes and earnings per share reaches $4 in 2014.

I find it remarkable how nobody is interested in a boring, yet high quality bank like WFC. Meanwhile Warren Buffett is quitely buying 1.2 billion dollars worth of their stock in 2011 and 1.8 billion dollars worth in 2012. I have been beating the drum on them for the past two years too. During that time frame, the earnings per share has risen 23.5% annually. I also believe that an investor today will also realize a benefit from the low relative valuation, not just earnings growth. Growth and value are joined at the hip.

Best Regards,
Kevin Graham

Disclosure: Long WFC

Bank of America Annual Report

2013-04-02T21:37:00.000-06:00

"While we are not yet where we want to be, our results reflect the underlying strength and earnings potential of the company that I believe will become even more apparent this year." - Brian Moynihan - 2012 Bank of America Annual Report

I sure hope so Brian.

Bank of America seems poised to greatly increase profits this year as their litigation issues are really getting behind them. If the $8.5 billion BNY Mellon (as Trustee) settlement gets approved this summer, there will be only small pieces of litigation remaining. Please note the funds for that settlement has already been reserved.

The Legacy Asset Servicing (LAS) division will be mostly wound down at by the end of this year. If I remember correctly, the company started with over 6 million delinquent mortgages in LAS and began this year with only 2.5 million remaining. They have already sold off a large portion of those mortgages and will work though countless more this year. By year end the company estimates they will have only 750 thousand remaining. In other words they will be close to 90% through all of the "bad" legacy assets by year end.

I fully expected the stock to run up after the announcement of the Federal Reserve Stress Tests announced a few weeks ago. The good new is it hasn't and the company has just began buying back up to $5 billion worth of it's common stock. The lower the stock price the better for those holding the stock long term. The warrants I hold are long term and I fully intend on holding them for the long term. The company is also buying back $5 billion of high yielding preferred securities. Interest alone on those preferred shares equal around half a billion dollars a year.

With every passing day the company gets more and more of its legacy issues behind them. The earnings capability will begin to shine through once the costs come down. I fully expect earnings this year and next to surprise many people.

Best Regards,
Kevin Graham

Disclosure: Long BAC class A warrants.

How do I screen for stocks?

2013-03-25T21:37:00.000-06:00

Somebody asked, "Hey Kevin, I wanted to know if you use certain screening tools to screen out stocks? For example, p/e less than 10, debt to equity less than 0.5 and so forth. If you do, which ones to you use and what criteria do you input?"

I guess I should start by saying that I don't generally screen for stocks. When I do I generally start with Price to Book (P/B) value. From there I want to invest in a business that generates a high Return On Equity (ROE). An investor needs to be especially careful with looking at ROE's because it can be easily manipulated by the leveraging the balance sheet (adding more debt).

Book Value

If you read the annual letter to shareholders by either Warren Buffett or Prem Watsa, you will find something in common. Both legendary investors focus on book value and discuss that metric extensively in their letters. The book value of any company acts as an anchor or financial gravity with respect to business value. That is why both Buffet and Watsa use book value as an understated proxy for intrinsic value.

Recently in Canada, a number of so called investors learned this lesson the hard way in Poseidon Concepts (TSE:PSN). How a commodity type business could trade a such a high P/B ratio almost escapes logic. The company had zero competitive advantages and no patents. I wonder how many investors in PSN even knew what the P/B ratio for the company even was? I would bet not that many. Now the stock is a zero. It would makes an interesting case study for those interested.

Return On Equity

Now, in general, I really only want one thing when I make an investment. I want to earn 15% on my money, preferably on day one or as close to day one as possible. If I cannot achieve 15% on my capital then I am not interested in that investment. By this I mean I want to see a clear, rational argument for how I can earn 15% on my purchase price.

What I regularly observe in reading about investments is that many people do this exercise in the precisely the reverse order. They find an investment that they think is cheap then attempt to justify the investment by "rationalizing" some non essential metric. What they are really doing is "irrationalizing" the investment. I am amazed how often some investments are justified, when I know full well the math doesn't add up. PSN would be an example.

The trouble with stocks is that valuations are nothing more than people's expectations. Beyond that, many people look to others to determine what the value is. This means that every time you look at a stock quote to determine what something is worth, you are really asking someone else what the value is. It is best to determine the business value first (unbiased by the opinions of others) and then go search out the market price.

One last thing. If a company doesn't have any earnings it's ROE is zero. Let me say that again. If a company doesn't have any earnings it's ROE is zero. That company is in the business of consuming capital and that is not a good business to be in, unless you're generous. I find it funny how when a company's earnings are non existent (like in the oilpatch or the dotcom bubble), investors run to other metrics such as cashflow. While the words "cash" and "flow" both have a good ring to it, if a company doesn't have any earnings, the cash is flowing in the wrong direction... out the door.

Business Ownership

I look at businesses a little different than most others because of my experience (working in a small business) and my fundamental understanding of capitalism. I don't really know how else to say it. Every business lays out money (capital) in attempt to earn a return on that money (capital). Money is just a easy way of converting one form of capital into another.

So every company lays out capital in an attempt to earn a return on that capital. Beyond that, I want the return on capital to be stable and easily predictable from year to year.

From this I just want to buy at a price point that will give me a 15% return on my investment. This means that almost every business is a potential investment, even if it is a dull boring investment, so long as the price is acceptable.

Now from this I would add that there are a number of other variables that are at play. Every company has different investment merits. Each balance sheet has to be analyzed individually for the assets and what those assets can earn for the business owner. Sometimes there are hidden assets or undervalued assets that may potentially be very valuable.

So my golden rule of thumb is this: How can I earn 15% on my money. I don't care if it's an apartment, a bond, a piece of land, or a stock (part ownership in a business). I just want to earn 15% on my capital.

This may sound simplistic because it really is simplistic. Staying disciplined (rational) and actually finding investments that meet the above criteria is the hard part.

Best Regards,

Kevin Graham

P.S. - I have been extremely busy lately and thus haven't been able to write on this blog. Early this year I was given more responsibilities at work that required more of my attention. Beyond that, I was away on vacation for the first two weeks of February and then was in Ireland for the first 10 days of March (for work). Only recently have I gotten back into my normal routine.

Richard Ivey - Pershing Square Event

2013-01-28T21:16:00.000-07:00

Since I have started blogging I have been pleasantly surprised to meet many people who share my passion of value investing. Recently, I was asked by one follower of this blog to both attend and promote an event being put on by the Investment Club of The Richard Ivey School of Business. I said I would be honored and would gladly post the detail here.

Event Details (Click Here for the Event Brochure):
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The Investment Club of The Richard Ivey School of Business cordially invites you to The CPR Activist Campaign and the Implications for the Canadian Establishment

Featuring iconic author Peter C. Newman and Pershing Square Capital Management, L.P. Partner and Canadian Pacific Director Paul Hilal.

Date & Time:

February 27th, 2013, 6:00 pm - 9:00 pm

Location:

Ivey ING Direct Leadership Centre 130 King St West, Toronto

*Admission is free

Program:

6:00 pm – 7:00 pm

Networking and Cocktails

7:00 pm – 8:00 pm

Keynote Address:

"The Eclipse and Rebirth of Canada's Business Elite: From Aristocracy to Meritocracy" by Peter C. Newman

8:00 pm – 9:00 pm

Q&A with Peter C. Newman and Paul Hilal (30 min)

with Audience (30 min)

(Moderated by Wes Hall of Kingsdale Shareholder Services)

Please RSVP to iveyinvestmentclub@gmail.com by February 8th, 2013.

*This event is open to MBA and Law students, Richard Ivey Alumni and distinguished members of the Ivey business network. The event is not open to the press and will be conducted off the record.

The Richard Ivey School of Business would like to thank the Pershing Square Capital Management, L.P. for their generous sponsorship of this event.

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When I first heard Pershing Square was involved with this event, I immediately said I was not interest in attending. I don't have a huge amount of respect for Bill Ackman, especially in like how how he's handled himself with the whole Herbalife fiasco. I was relieved to hear that Paul Hilal would be attending instead of Mr. Ackman.

While I would have loved to attend this event I unfortunately will not be able to. I am on vacation for the first couple of weeks in February and as soon as I return I am heading down to our USA operations for a week.

Now this event should be quite interesting. As some may be aware the CPR railway played a monumental role in the founding, development and industrialized of the nation and its board of directors has always been composed of the most eminent, and 'untouchable' members of the business/financial/political elite in Canada.

The fact that a foreign hedge fund (Pershing Square) was able to successfully win shareholder support (particularly from other establishment players like Canada Pension Plan, Teachers pension plans, etc) to depose the CPR board members proved to be a watershed event in the history of Canadian business and will have implications for many other organization and investors.

Peter Newman has been advancing the idea that the Canadian Establishment, an old boys club that rules many Canadian corporate boards, is dying. The CPR event may well be he last nail in the coffin, marking the rise of a new class of businessmen and entrepreneurs. His keynote address will be centered on this. The Q&A session will allow the ideas to be explored in greater detail.

It promises to be a great event.

Best Regards,
Kevin

Arkansas Best

2013-01-20T20:43:00.000-07:00

At the beginning of 2012 I recommended Arkansas Best (ABFS), a trucking company. I noticed a fellow blogger has also picked up on the idea. So to save time I thought I would share a link.

You can read his commentary here:

http://reminiscencesofastockblogger.com/2013/01/02/arkansas-best-the-upside-of-union-negotiations/

It's a good analysis and hits on the cost side of their business. ABFS has huge upside if they get costs get under control and the economy picks up. They have been floundering since 2008 but they will get things figured out.

Best Regards,
Kevin

Disclosure - None

2013 Investment Commentary

2013-01-09T21:12:00.000-07:00

Bank of America (NYSE – BAC, $11.61)

BAC was a huge percentage gainer last year but don’t let that fool you. As I pointed out in the post on comparing Canadian & US banks, BAC sells for 1/3 of a comparable Canadian bank on an apples to apples basis. Some of that valuation gap has narrowed, but don’t kid yourself there is still a lot of money on the table.

To begin, BAC has a tangible book value of $13.48/shr at the end of Q3 2012. The company still sells for below that level despite the fact the bank is soundly capitalized. At the end of the Q3 2012 the capital level was 8.97% on a Basel 3 basis. The bank only requires 8.5% so it is now over capitalized and Q4 should add further to this capital buffer.

The bank has been drastically shedding assets during 2012. Now that it has taken care of business they are now in great shape to start growing again and the CEO has stated he has finally instructed bankers to aggressively lend to both mortgages and business segments.

To me the biggest news in Q3 for those who listened to the conference call was that the legacy asset servicing (LAS) group will see expenses fall by $10 billion over the next 5 quarter. That is huge and will greatly add to the bottom line in 2012. Here is part of the Q3 conference call:

Brennan Hawkins - UBS

"Okay. Just to make sure I understood, Brian I think you had said that, as far as the trajectory of the decline in expenses overall when you’re looking at the entire thing at LAS taking a step back, moderate improvements in 2013, but the big lever there is 2014. Is that right or are we reading too much in to it?"

Brian Moynihan - CEO

"No, I think I was saying, that you’ll get the improvement sort of on a quarterly basis all though ’13 and in ’14 you’ll have the run rate of all that accumulated and for you, in year-over-year comparisons, but it’s going to come all during ’13.

We can debate about moderate when we are that [expense base]. The other question was discussing but it will come every single quarters, so it’s not going to be held up and wait, it’ll come as fast as it can.

So the word we’re getting out this quarter has to do with the clients and the 60 plus day in the second quarter into the third quarter came out in the third, and the third quarter comes out in the fourth, it will take just little time, because you actually have to finish the work, reassign accounts and go on.

So it will come, it’s not in quarter-by-quarter, it will come month-by-month, week-by-week all to the ‘13."

Enough said.

The company has a huge low cost deposit base and the huge earnings power of this bank will appear once the LAS expenses come down and interest rates normalize.

The economy is improving and the improvement in the housing market will be a huge tailwind for BAC. Fair value is closer to $20/shr.

***Recent update: The recent legal settlements, particularly with Fannie Mae, settle a large portion of the legacy issues related to Countrywide. While the company still faces some legal issues they have settled $45 billion dollars worth of issues over the past 2 years.

A person I know recently put it this way... BAC is selling for $99 billion below book value. You can argue that they are under reserved but come on now, that is valuation gap is ridiculous.

Investing only requires grade 5 math and rational thinking. The problem is the rational thinking.

Berkshire Hathaway (NYSE - BRK.b, $89.70)

This is perhaps the easiest investment decision a rational person with reasonable expectations can make. Warren Buffett, the CEO, has made it clear the stock was undervalued when he first bought back shares at 110% of book value (BV). He has always treated his shareholders as partners so he doesn’t buy back shares without first letting them know that he feels it's a cheap price.

Since then Buffett, along with the blessing of the board of directors, has bought back 1.2 billion in stock.   He also raised the price he is willing to pay to 120% of BV.

Now anyone with half a brain should realize:

1) Buffett believe the shares are cheap and represent great value at 120% of BV.

2) The shares have a type of “floor” underneath them at that level. That doesn’t mean the stock can’t go lower but it does mean there will be a big buyer below 120% of BV. Buffett has over $40 Billion in cash and is looking for somewhere to invest it.

3) Berkshire has huge exposure to the housing market

4) Buying today at historic low valuation will ensure you benefit from both the growth in earnings and the valuation adjustment as the stock moves higher.

An investor really only has two levers from which to make returns. The first is growth in earnings and the second is an increase in valuations. Some people include dividends but I don't since dividends are merely a percentage of earnings. So with Berkshire you will benefit from increasing earnings power and possibly a higher valuation. Over the past decade the valuation has hovered around 170% of BV.

Lastly Berkshire will also greatly benefit from the improvement in the economy, particularly in housing. Berkshire also does not pay a dividend so all of its earnings are plowed back into the company. They also own a number of outstanding companies that can generate very high returns on capital.

If you put all your money in one stock, Berkshire would provide adequate diversification in one security while generating acceptable returns.

The reason most people won’t buy BRK is because they “think” they can generate a higher return than what Berkshire can generate. For those who hold that belief may I suggest two words, “good luck.”

Sony Corporation (NYSE - SNE (ADR), $11.20)

Sony is an interesting company I initially looked at last summer but I was too stupid to connect the dots at that time. I know, I know at times I am a little slow.

Examining the 2011 annual report for a second time I noticed a couple things? First of all of you took the cash on the balance sheet ($19.2 billion) and subtract the long term debt ($9.3 billion) you were left with just shy of $10 billion in cash. Then if you look at the market capitalization of the company, you could purchase the entire thing for around $12 billion. Now assigning $2 billion for all of Sony is quite ridiculous.

Now to be fair the company lost quite a bit of money in fiscal 2011 year and they are still losing money in 2012. Secondly, the company has never earned very high return on equity which is a reoccurring theme for Japanese companies.

So what do I like. First the new CEO just stated they are going to right size their operations in an attempt to achieve a 10% ROE in 2014. Second, they have a very strong brand name and have strong ties into a number of markets. I realized this after my wife started looking for a stereo with a docking station for her iPod touch. I then realized I had two other Sony stereos in my own house. I also notice Sony speakers in a friend’s new Ford pickup truck. Then I realized that the Sony Playstation and handheld Playstation Vita are popular video game systems.

Then upon investigation, I discovered Sony Pictures Entertainment owns Columbia Tristar and Metro-Goldwyn Mayer. On top of that, Sony Music is the second largest music recording company in the world and owns full rights to Michael Jackson & The Beatles, among others.

It should be clear that Sony owns some very valuable and unique assets. I would bet with some American style management Sony could be worth 5x of the current quote. As Peter Lynch once said, “Go for a company that any idiot can run – because sooner or later any idiot probably is going to run it.” Well, Sony has been run by idiots for a while now and with some decent management they would be worth much, much more.

Wellpoint (NYSE - WLP, $60.92)

Wellpoint is a company I have been watching for a while and finally got around to reading the annual report. For my Canadian readers, Wellpoint is one of the largest US healthcare organizations with 33.5 million members at the end of Q3. They are an independent licensee of Blue Cross and Blue Shield in a number of US states.

Let’s begin by looking at the positives and the negatives.

Negatives

WLP is a very interesting investment candidate because they aren’t the most efficient operator in the sector. They seem to constantly have among the higher medical loss ratios compared to competitors. The medical loss ratio, or sometimes referred to as the benefit expense ratio, is the benefits expense as a percentage of revenue.

They also appear to be floundering as they don’t have a CEO. They have also just purchased Amerigoup which will increase exposure the Medicaid customer base. The downfall here is a lower margin business.  I would have preferred them to buyback more shares.

Next they have been experiencing flat to declining enrollment for several years.

Lastly they are facing increasing regulation which should make the sector much more competitive and limits medical loss ratios and restricts how much they can increase premiums.

Positives

The company is an absolute cash cow. They currently sell for 8 times earnings and just over 7 times free cashflow.

Since 2005 the company has reduced the shares outstanding from 660 million to roughly 310 million at the end of October 2012. You don’t need a calculator to figure out that these share buybacks have been huge. It is interesting to note that revenue and earnings have gone up 200% and 100% since then but the stock price has declined.  P/E ratio has fallen from 17 times to 8 times.

Now if your math is any good you would have also notice that this is not a very good operating performance. Earnings per share (EPS) should naturally double when you buy back half your shares. What this really tells you is that their net profit margin has declined by 50%, not good.

While many would use this to criticize the company I see it as an opportunity. At the current pace of share buybacks, EPS should grow at 10% and if they improve the operating performance of the company they could grow earnings at a much faster clip.

Now this is not some pie in the sky estimate. If their expenses were comparable to say Unitedhealth (NYSE:UNH), earnings would rise by 50%. That is huge opportunity and no revenue growth is required.

Next some of the headwinds facing the company should shortly become tailwinds. First enrollment should begin to rise as the economy improves and companies add to their payrolls. The high unemployment rate over the past several years has hurt the company.

Lastly, the recent regulatory changes (due to Obamacare) has increased costs as company sorts out the changes. Some of these costs are here to stay but some should taper off over time.

If you add it all up you a have a company that is selling well below book value and can earn decent returns on equity. Recent headwinds should shortly turn into tailwinds and they have huge opportunities cut expenses. If the company can find a decent CEO who can get costs under control and the economy picks up a little, watch out, this stock is going to double in very short order.

POSCO (NYSE - PKX (ADR), $82.15)

I’m getting tired so this one is going to be short and sweet. POSCO is the third largest steel producer in the world. So what is so great about POSCO? Well to start with, they are selling for about 60% of book value. Why is that so important? It means you’re paying about the same valuation that Warren Buffett paid for his POSCO shares back in 2005.

Why would you want to own POSCO?  As I've said before, in any commodity business you want to own the low cost producer. POSCO is likely among the lowest cost steel producers in the world and are much more efficient than US competitors. Their operating margins are double that of American steel companies. Lastly, the company has been constantly profitable for the past decade unlike many other steel producers.

POSCO will also benefit as the world’s economy improves.  I would expect ROE and net profits to improve by a couple percentage points.  You’re definitely not buying the company at a time when they are generating peak returns. At 6.5 times normal earnings, your getting over a 15% earnings yield.

Good luck and may 2013 be as profitable as 2012.

Best Regards,

Kevin Graham

Disclosure: I own BAC class A warrants & BRK.b.

Top Investments for 2013

2013-01-01T20:25:00.004-07:00

2012 Year in Review

Well 2012 was a fairly strong year for negative news yet surprisingly the markets were strong. If this year taught me anything it was to avoid the headline news and just buy cheap stocks. There was negative news regarding Europe most of the year and China has been a major drag on commodities. Interestingly enough, despite the negativity, the S&P 500 was up just over 13% and the Dow Jones Industrial Average was up just over 7% for the year. Here in Canada the TSX Composite index was up 2% for the year.

So how did this compare to the stock recommended for 2012? On average, they strongly outperformed the broader markets. Due to my overweight in financials (stated at the beginning of 2012) contributed to very strong returns in my personal portfolio.

Company	Ticker	Return	Return (w/Div)
Bank of America	BAC	109%	110%
Goldman Sachs	GS	41%	43%
First Niagara Financial Group	FNFG	-8%	-4%
Sears Canada	SCC	-4%	6%
Speedway Motorsports	TRK	16%	20%

Average Gain		31%	35%

Here is the graphical performance (click on image to see it better).

Now these five stocks soundly trounced the market as a whole. It doesn't surprise me that the financials led the way with BAC powering ahead. It was so cheap at the beginning of 2012 it was like shooting fish in a barrel. Goldman Sachs performed much as expected but surprisingly it is still very cheap on a Net working capital basis (current assets less all liabilities including long term debt and preferred stock).

I found the First Niagara results quite interesting but not overly surprising. I find it amazing how many stocks sell on a price to earnings (P/E) basis while the underlying earnings capability is much higher. For First Niagara, it's earnings are masked by large integration costs due to acquisition of the HSBC assets earlier in the year. This reduced HSBC's profitability by 135 million in 2012. I still consider FNFG to be cheap.

Sears Canada's result was also interesting. It was up strongly early in the year but ended flat. They did pay a special $1/share dividend from it's cash hoard, so the return was still satisfactory.

Speedway Motorsports benefited from the improvement in the economy. This trend should benefit the company in 2013 as well.

Top Investments for 2013

Bank of America (NYSE – BAC, $11.61)

Berkshire Hathaway (NYSE - BRK.b, $89.70)

Sony Corporation (NYSE - SNE (ADR), $11.20)

Wellpoint (NYSE - WLP, $60.92)

POSCO (NYSE - PKX (ADR), $82.15)

Click Here for Investment Commentary

Safe and Very Cheap (New Category)

Wells Fargo (NYSE –WFC, $34.18) & Microsoft (NYSE - MSFT, $26.71)

Wells Fargo was in the Safe and Cheap last year and it stays there again for this year. I also decided to add MSFT this year because of the recent price decline. To me the recent price decline make the investment even more safer. As a shareholder I am very thankful that the shares are low and I hope they stay there. Why you might ask? So they can repurchase more shares at a cheaper price.

Warren Buffett explained this well in his 2011 letter to shareholders. While discussing his investment in IBM & share buybacks this is what he had to say.

"...Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder (in IBM stock), such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years...

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus. And here a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life."

I couldn't agree more.

Some Honorable Mentions – Research in Motion (TSE - RIM, $11.80), Hewlett Packard (NYSE - HPQ, $14.25), Teva Pharmaceuticals (NYSE - TEVA (ADR), $37.34), Prudential Financial (NYSE - PRU, $53.33), Arkansas Best (NASDAQ - ABFS, $9.55) & a small Canadian energy company which I cannot disclose at this time (but perhaps in the near future)

Again for these stocks you will have to do your own homework. All I will say is that they all have wide appreciation potential but results will depend on the operating results of each company. Many of these companies have their own issues or problems that make the near future cloudy. That is why people avoid them but without uncertainty they wouldn't be cheap. Remember fear is your friend.

Cheers to another great year!

Best Regards,

Kevin

Disclosure – I own BAC Class A warrants, WFC, GS, BRK.b, and MSFT.

US & Canadian Bank Valuations

2012-11-25T16:00:00.002-07:00

Well, I have been pounding the tables on the US Large Cap Banks for a while so I thought I would explain once again why they are cheap but from another angle. The below table, courtesy of TD Securities, gives a very quick and easy picture showing a comparison between the US and Canadian Banks.

The average Price to Book Value Per Share (BVPS) for the six largest banks in Canada is 1.8 times. The US Money Center Banks, which include Bank of America (BAC), Citigroup (C) and JP Morgan Chase (JPM), sell on average for 0.6 times book value. Even the US Super Regional Banks, which includes US Bancorp (USB) and Wells Fargo (WFC), sell at an average of 1.5 times book value.

Now the table above clearly shows significant upside for the large US Money Centered Banks. That said, lets look at little deeper at the individual valuations of the the five large US banks above.

Note: USB is technically the seventh largest bank in the US. JPM, BAC, C, and WFC are the four largest banks in the US ranked by assets respectively.

US Large Cap Banks - Price to Book Value Per Share

So looking deeper, BAC sells for under the average and JPM for above average of 0.6 times BV. Likewise for the Super Regional Banks, WFC sells for less than the average and USB sells for the about the same valuation as the large Canadian Banks.

So this begs the questions. What would the stock price be if the US Banks sold for the same valuation (P/BV) as comparable Canadian banks? Now for this exercise I used the average P/BV of 1.8 times for large Money Centered Banks and 2 times for the Super Regional Banks. I made this adjustment because WFC and USB are much stronger banks and earn higher returns on assets than the Money Centered Banks.

Upside in US Large Cap Banks - Common Shares

So if US Money Centered Banks simply sold at the same average valuation they would be worth anywhere between 1-3 times higher. That is quite a bit of upside. For the US Super Regional Banks the upside for WFC and USB is 61% and 9%, respectively. Perhaps this explains why Warren Buffett is still buying WFC every quarter. He's buying a 60 cent dollar laying out in plain view for all to see.

Can we do even better than the common shares? Lets take a look a the TARP warrants sold off by the US treasury a couple years ago. For this analysis I didn't include the Citigroup warrants because I have no interest in buying Citi common or warrants. USB bought back the warrants directly from the treasury so they are not publically traded.

Upside in US Large Cap Banks - TARP Warrants

***BAC Class A Warrants shown in table above.

Here I assumed the common shares were selling at the same P/BV as the Canadian banks and subtracted the strike price. For example the BAC Class A warrants would be worth $26.01/warrant ($39.31 - $13.30 = $26.01). Now that leaves quite a bit more upside in the warrants.

Now I should also mention that these warrants are also adjusted for dividends beyond a certain price. For the BAC Class A warrants the strike price is adjusted for any dividends above $0.01/share. The JPM and WFC warrants are adjusted for dividends above $0.38/share and $0.34/share, respectively.

Now I should mention that the dividend adjustment isn't as straight forward as first appears. There is a formula in the prospectus that adjusts not only the warrant strike price but ALSO adjusts the number of shares per warrant. This has been referred to the double racketing feature of these warrants. I have modeled these adjustments in a spreadsheet and the reader will have to make their own assumptions to estimate the final strike price and the number of common shares that each warrant will purchase many years from now.

It should be noted by the readers that I have not included any upside in the above table for the aforementioned dividend adjustment. You will have to make your own assumptions.

Conclusion

The US Large Cap Banks are severely undervalued compared to Canadian Large Cap Banks. I know this analysis is crude and high level but makes the point of my discussion here very clear. One would have to look more closely at the price to tangible book value for each bank and determine what types of returns each bank is capable of.

Lastly the riskiness of each bank should be examined based on the type of assets each hold. The Level 3 assets should be considered. I have discussed these factors in the past here on my blog.

Clearly there is significant value among the US Large Cap Banks. Once the smoke clears and the real earnings power of these large banks appear, they will trade much higher. It should also be noted that a number of the US Large Cap Banks are very well capitalized. For example BAC requires a minimum Basel III capital level of 8.5% and after the third quarter of 2012 their capital level stood at 9%. I fully expect BAC and all of the US Banks mentioned above to increase the dividend next March.

Good Decisions.

Best Regards,

Kevin

Disclosure: Long WFC, JPM.WS, & BAC.WS.A

US Energy Independence

2012-10-17T10:21:00.001-06:00

Source: http://www.businessweek.com/articles/2012-10-11/u-dot-s-dot-energy-independence-is-almost-here

Welcome to the shale revolution. The US is definitely moving toward energy independence with the dramatic rise in shale oil and shale gas.

Don't be fooled, this is a paradigm shift.

Regards,
Kevin

The Enterprising Investor

2012-10-07T09:51:00.000-06:00

In my last post we looked at defensive or passive investing. Defensive investing is for those with limited time and knowledge yet still want satisfactory results. On the flip side, if you are willing to put in the time and pick individual stocks you would be considered an enterprising investor.

So, what exactly is an enterprising investor? Here is a definition.

The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades, an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor.

Benjamin Graham - The Intelligent Investor

What are the characteristics of the enterprising investor?

1. Willingness to devote time
2. Careful selection of sound and attractive securities
3. Committed to the effort over a long period of time

So if you want to be a value investor and your just starting out it is going to take a lot of time. If your are passionate about the journey it will be a joy, if your are not it will be a huge burden. Reading financial reports are not for the faint of heart.  As the quote says, the rewarded for your extra skill and effort may be realized by a higher than average return compared to the passive or defensive investor.

That said, you should also have some realistic expectations. A few percentage points over an index is reasonable. If you think you are going to do much better you are self-deceived. Keep in mind that gains for the entire stock market is a zero sum game.  By this I mean that if the entire market increases by 6% this year and you gain 8%,  another investor of similar size will have a return of 4%. If you think you can consistently outperform, it will require a number of characteristics.

Below are three characteristics that I personally believe are helpful in becoming a successful enterprising investor.


1. Time & Patience

The first key to the success of any enterprising investor is the willingness to spend a lot of time. Good investment ideas don't just drop from the sky and nobody is going to tell you where the bargains are. You will have to search them out.

This involves the second and third points below, namely reading and thinking respectively.

If you are starting out I would recommend starting with a printed annual report of a company that you are interested in. Start reading and when you get to some terminology or accounting information you don't understand stop. Then go on the internet or look in a textbook and find out what it means. I purchased a good textbook called The Analysis and Use of Financial Statements by Gerald White for this purpose.

Once you have figured out your missing "gap" go back to the annual report and continue. I know at the start this will seem like a painstaking process, but unless you want to back for further education you it's not a bad option. The difference between going back to school and learning on your own is you willingness to persevere. If you need someone to hold your hand through the process perhaps school is the best option.

Secondly, you will need patience. Just because you have money to invest doesn't mean you should invest it right away. I waited almost two years before I purchased my first stock. Don't get in a rush, in fact, the more patient you can be the higher your returns will be. Markets go up, markets go down. If you ever feel like chasing a stock because you missed the low prices and it's now running up, stop yourself. The ability to say no and stick to your buying price will be the key.

A good way to be patient is by using a checklist. Good thinking requires good questioning ability.  Using a checklist you will bring items to your mind that you otherwise wouldn't have thought of. You will not miss part of the analysis, will keep things more rational and less emotional. Remember, the easiest person to fool is yourself. Our egocentric nature is perhaps the most formidable barrier to clear thinking.  No matter how biased our thinking is it will appear rational to ourselves.

Perhaps you think you are cool and always rational. We'll lets test that idea.  Try thinking of a recent disagreement where you were closed-minded while listening to the views of someone else. Can you think of one? Perhaps you can only think of examples where the other person was closed-minded, but not yourself? If you cannot think of any closed-minded examples in yourself, ask you self why?

(If after some reflection you still cannot think of any closed-mindedness in yourself , you may have moved to a higher level of self-deception.)

2. Reading

Reading is essential if you want to be a successful investor. You will want to read widely but also read selectively. Reading is a time consuming process so you will want to focus your efforts to get the maximum results. Sell your TV if you don't feel you have any time.

What kind of reading do I do?

First off I do not spend hardly any time reading about investing on the internet. You will not find any good information or sound investment advice there. I have said before that if you think you are going to find good stock tips on the internet you are only fooling yourself. Honestly, reading this blog can be a waste of your time.  My online reading consists of a few national newspapers and a few financial reporting websites.

I regularly get my reading material off SEDAR or the U.S. equivalent. SEDAR is an essential source for individual investors in Canada. There you can get all the documents that companies file with the regulators, so it can help filter some of the nonsense found on company websites. I particularly enjoy reading what are called Annual Information Form (AIF) found there. It gives a much better overview of the company, it's history and other important information (ie. Oil & Gas reserve reports).

Often the most useless pieces of information found on company websites are investor presentations. While they may give a quick snapshot of the operations, you should always questions the information given there. All of them have an entire page of legal disclosure at the beginning that tells you that you shouldn't bother reading any further.

I also read at least two books per month. Often related to investing but at other times related to the sciences. I don't read fiction. I am particularly interested in the soft sciences, such as economics and psychology. I read to understand human nature and what makes people behave the way they do.

I just finished an excellent book called The Worldly Philosophers by Robert L. Heilbroner. It begins by discussing human nature and how we are naturally self centered. He then walks you through economic thought starting with Adam Smith, David Ricardo, Karl Marx, Thorstein Veblen, John Maynard Keynes, and Joseph Schumpeter.

I enjoy reading, and learning. It is definitely a passion of mine. I find it amazing how much the world opens up with the more you learn.

3. Independent Thinker

This point has become more clear to me after I read the book called The Snowball by Alice Schroeder. It is a biography of Warren Buffett, the world most successful investor. In that book she describes an inner and outer scorecard and how Warren is 100% inner scorecard when it comes to investing. He doesn't care what others think, if others are buying or selling, or if every wall street analyst has a sell recommendation on a stock he likes.

I have discussed this along with the topic of self-esteem on my blog before. Most people derive there self-esteem and self worth based on what other people think and what they think specifically of them. That would be 100% outer scorecard. That is why I have written on my blog that the success of Facebook is not hard to understand. Facebook users are obsessed with impressing others and influencing their friends opinions. Sadly, too often, they have the opposite result than intended.

Now if you derive your self-esteem from others you will struggle as an investor. Once you buy a stock you will mindless watch to see if everyone else agrees with you or not. Emotions are a huge obstacle to sound reasoning. Those who have studied the human brain understand this works.

Don't ever forget, the stock market is a collection of irrational individuals. This would include myself at times. The key is to understanding and thinking clearly about the irrationality and fears of other market participants. That is where you will gain an edge over time.

This blog post is getting long so I'll end this point with two book recommendations. The first is The Six Pillars of Self-Esteem by Nathaniel Brandon and the other is Critical Thinking by Richard W. Paul & Linda Elder. Both are excellent books on their respective topics.

I should also add that you cannot simply learn about critical thinking from a book. Critical thinking involves objective self examination and comes through increased self awareness. It is a journey where you build your self awareness and as a result you begin to think more rationally.

Conclusion

Becoming a enterprising investor involves a large commitment for those who what to be successful. It involves Time & Patience, Reading, and Independent Thinking. It isn't easy but the results are rewarding. You will gain and develop new skills. You will increase your thinking ability and self-esteem. Looking back at what I have written above, it appears to be quite a tall order. While it does appear to be quite an undertaking, start by taking one step at a time.

One final caveat is in order. If you want to be an enterprising investor and are solely focused on the money or getting rich, the whole process is doomed to failure. You will be too emotional and will end up making risky bets. On the other hand, if you focus on the process of finding a bargain you will be much more successful. So focused on the process, enjoy the process, and the results will come.

Best Regards,

Kevin Graham

Disclosure: Long BRK.b (Warren Buffet's company)

Defensive Investing

2012-09-15T12:05:00.000-06:00

I received an email from an aspiring value investor. He was inquiring about how and where to start on his value investing journey.

Here is my initial response.

---

We'll your background sound a lot like mine but I'm sure you didn't lose as much (percentage wise) as I did when I started.

Taking responsibility for your own investments is a very wise move because there are ways to invest that will save you a lot of money in the long run.

For example, if you invest in mutual funds, you are basically giving away 2-3% of your money every year for expert money management. The problem is these so called professionals don't really care about you. All they care about is their job. You see the biggest risk to them is losing their million dollar a year job. So what they do to minimize that risk is to perform as close to the index as possible. If their performance is to far below the index people will pull their money out and if they are relatively close nobody will pull their money out. So they don't really care about you doing well or outperforming in the long run.

The solution to this problem is quite easy. Fire all advisors and just buy a very low cost index fund, like a vanguard fund or a TD e-series fund. These index funds effectively get you the same thing without the huge fees and expenses.

Now the next question is if you want to be an passive or active investor. Ben Graham used the terms defensive or enterprising investors in his book.

If you want to minimize the time you spend on investing you would be a defensive or passive investor. If you want to do this I would recommend three investment options for you. They are, in no particular order, investing in Fairfax Financial common stock, investing in the Horizons HAV ETF, and lastly investing in Chou mutual funds.

With that said, it appears that I have gone against what I have said above regarding mutual funds. The major differences are in the cost and value you receive. Always remember price is what you pay, value is what you get. When you buy the Horizons HAV ETF you are paying a relatively low fee of 0.7%, I believe. Now that is a very low fee but what you are getting is top notch investment management by Vito Maida, a proven value investor. His long term record speaks for itself and he is ultra conservative. Don't expect huge gains but you will achieve steady long term growth.

As for the last option, Chou mutual funds, you are again getting top notch investment management from a great value investor. Francis Chou has slightly higher fees but again you are getting a good money manager. He doesn't buy stocks just for the sake of buying them. He is disciplined to buy when they represent good value and isn't afraid of going against the crowd. He can and does underperform at times but so do all value investors. Value investors are patient and wait for bargains. That said, Mr. Chou has an outstanding long term track record.

Last and certainly not least is Fairfax Financial (FFH). You can buy the common stock in CAD or USD on the TSE. Put your money in Fairfax and sleep soundly at night. Fairfax is run by Prem Watsa who is sometimes referred to the Warren Buffett of Canada. Fairfax is similar to Berkshire Hathaway (Warren Buffett's company) in that they are predominately insurance companies, Fairfax more so. When you match an insurance company with proven value investing, what you get a cash flow machine. This is proven in Fairfax's long term record. The have grown book value at something like 24% for the past 26 years. Now don't get too excited because the past is the past. Looking forward expect them to grow book value at 10-15% over the long term, not the short term.

If you want an even better strategy, buy or dollar cost average into Fairfax when it trades below book value. Be more aggressive the lower it goes. The rest of the time just keep accumulating cash in your savings account. Fairfax's stock price, like all companies, move up and down based on expectations of fear and greed. When it sells below book value people are fearful, and when it sells for 3 times book value people are greedy. With that said, Fairfax will likely only sell below book value when it appears the sky is falling and all the pundits on TV are screaming sell, sell, sell. It takes courage and a willingness to stand alone when everyone else is heading for the exits.

Now if you want to be an enterprising or active investor that is another story... (to be continued).

Regards,
Kevin

Disclosure: Long FFH

Peak Oil is a Myth

2012-09-12T19:47:00.000-06:00

I just read an interesting article in the Globe and Mail on U.S. oil production. Here is the quote that I found most interesting.

The coming change, according to Bentek, is startling: By 2016, the U.S. will surpass its 1970 oil production peak of 9.6 million barrels a day; by 2022, it will have leapt to 11.6 million barrels a day.

So much for peak oil, it's clearly a myth.

When you don't account for changes in technology and prices, sure peak oil sound reasonable. The problem is you can't treat a dynamic situation as a static analysis. Assumptions make for pretty formulas but don't reflect reality.

For the full article:

http://www.theglobeandmail.com/report-on-business/industry-news/energy-and-resources/us-boom-in-oil-production-spells-peril-for-canadian-crude/article4535525/

In other news, the North Dakota Department of Mineral Resources just reported record oil production of 20 million barrels in July. That is up 59% from the year before. If you step back and look at the big picture, oil production in the state is up 7 times in 7 years. Remarkable.

Regards,
Kevin

Canada - Headed for a Crash

2012-09-08T16:04:00.001-06:00

I thought I would write down a few thoughts on the markets, specifically macroeconomic themes.

For those who have read this blog for any amount of time will understand that I am quite worried about the collapse of the commodity bubble. I know some disagree that we are in a commodity bubble and that is fine. China, a huge consumer of commodities, has started to falter lately and GDP growth estimates keep falling. The housing bubble in China has recently collapsed. That will lower demand for all commodities. Goldman Sachs just issued a warning regarding Chinese growth as well.

For a refresher I would suggest reading the comments from Prem Watsa on China/Commodity bubble that I posted earlier this year. Much of what he has said is starting to come to light today.

http://canadianvalueinvesting.blogspot.ca/2012/03/canada-storm-brewing-in-china.html

What worries me is the spillover into Canada, which will not be spared. Vancouver real estate appears to begun to falter as seen here:

http://www.theeconomicanalyst.com/content/vancouver-housing-full-correction-mode-implications-canadian-banks

I believe Canada, Australia, and most of the mining sector is in for much harder times. This isn't really surprising given the record high profit margins all these commodity companies have enjoyed for the past several years. A number of companies such as BHP Billiton, Rio Tinto, Teck and others have recently issued warning about falling demand.

As for positives here in Canada I don't see much. I own a select few stocks from Canada and could generate a solid list of short candidates, starting with the banks.

How about positives?

So what areas do I see as a positive going forward? In no particular order:

US homebuilders and Mortgage Originators are good bets. The sector is going to have nothing but a tail wind behind it going forward. I own the largest mortgage originators in the US and one of the largest homebuilders.

I like the US banks and I would sell the Canadian Banks. The US banks have strongly recapitalized themselves and could suffer huge losses before running into trouble. I know most people shy away from the sector because the financial crisis is fresh in their mind. That is perhaps the biggest reason for bargains to be found in the sector.

On the other hand, the Canadian banks sell for much higher valuations and are loaded up of over-leveraged Canadian consumer debt, some worse than others. The graph below makes this point rather clearly.

(Source: www.theeconomicanalyst.com)

The problem is that Canadians have been using their houses like ATM machines, much the like the US did in the run up to their correction. In the US, home equity withdrawls peaked at 8-9% of personal disposable income in 2006. Here in Canada we apparently didn't get the memo that this is a problem and is not sustainable. Since 2006, Canadians have been using their home ATM at a rate 8-9% of personal disposable income. That will end... and it will end badly for our economy.

South of the border the US real estate markets appear to be on the mend. Housing prices have bottomed and most regions are up marginally. This bodes well for the healing necessary in the housing market. As Warren Buffett has said, the unemployment rate will fall dramatically once the housing sector begins to rebound.

As noted in my previous post, natural gas is at very low prices and that is showing up strongly in the reduction in drilling. Investing in any commodity that is selling at prices below the marginal cost of production is always a good bet to take. I own the lowest cost explorer and producer of natural gas in Canada.

One theme I particularly like but haven't actively invested in would be companies that buys commodities and sell a brand. These companies are the most likely beneficiary of lower commodity prices as margins are likely to expand in the short to medium term. If you have any suggestions feel free to email ("contact" tab above) or add your comments below.

I think insurance companies are a good bet as interest rates rise. That said, I don't expect interest rates to rise any time soon. The debt deleveraging process has only begun and I believe we are in the midst of a debt deflation period.

As for stocks that I believe are cheap, Fairfax Financial (FFH) just hit a 52 week low this past week, JP Morgan (JPM) is a no brainer with an easy 20% upside from here even in sideways market. Magna International (MG) appears quite cheap and auto sales are on the rebound. General Motors (GM) looks interesting as cash on the balance sheet almost equals its market cap. A number of technology names look cheap such as Dell (DELL) and Intel (INTC) now that the stock has come down again. I have mentioned Speedway Motorsports (TRK) here before and now the the stock has come down again I think the price is reasonable.

I have looked into at least 30 small caps over the past month and haven't found anything to get excited about (mostly in Canada). I believe most small caps to be overvalued at this point in time because of the fragile nature of the economy. With so many cheap, high quality, large caps available today I don't see much reason to look elsewhere. Many of the large caps have strong balance sheets, can and have been issuing debt at record low interest rates recently, and can weather any storm in the economy much better than smaller competitors.

So far, year to date, my portfolio is soundly outperforming the S&P 500 and trouncing the S&P/TSE index. Because of the strong markets, I am in the process of reducing most of my holdings and keeping the proceed in cash. That said, I don't tend to make wide changes in my portfolio and this year I have only made a few select purchases. I will be looking at short ideas for Canada in the near future. Suggestions always welcome.

Regards,
Kevin

Disclosure: I am long FFH, and JPM TARP warrants.

US Oil and Gas Drilling

2012-09-02T22:17:00.002-06:00

Here are a few interesting graphs on the Natural Gas (NG) supply situation. The current oversupply has led to a sharp drop in exploratory and development drilling for NG in the US. Also show is the record levels of US oil drilling.

(Click on image for a larger view)

Exploratory drilling in the US has come to a complete halt. In both May and June not one exploratory gas well was drilled in the US. Since March of this year only 14 exploratory gas wells have been drilled.

Meanwhile exploratory drilling for oil is at the highest level in 27 years.

As seen in the above graph, development drilling for gas has finally fallen to decade lows. We have not seen this low of a level of development drilling since the mid 1990's. Low gas prices are finally starting to have an impact.

By comparison, oil development drilling is at a 26 year high and for good reason, oil prices are in a bubble. This has led to an explosion in oil production in the US.

Due to the strong exploratory and development drilling for oil, crude oil production in the lower 48 is at a 23 year high as seen above. The increase in production over the last couple years is quite remarkable.

So much for peak oil, as many bloggers have aptly named peak idiocy. I have commented before how peak oil theorists misunderstand basic economics, especially how price impacts both technological advancement and substitutionary effects.

The bottom line is that oil production is strong and growing in the US. Couple this with weak global demand, especially from China, crude oil is likely to fall. I can't tell you when but it will fall.

As for NG, low prices have finally taken their toll as exploration and production companies have nearly stopped drilling. One of the main exceptions to this trend is Peyto, who has 8 rigs running as of the end of August. That makes them the second most active driller in Alberta for 3000+ meter rigs.

It will be interesting to see how fast the production response will be to the decreased natural gas drilling. The sooner the better, I hope.

Regards,
Kevin

Disclosure: Long PEY

Inflation or Deflation?

2012-09-01T10:18:00.000-06:00

I have been thinking lately (go figure), and I have been trying to understand the whole inflation/deflation debate. My question is below.

Almost everywhere I look I see comments that all the money printing by the US Federal Reserve will lead to inflation. Despite tripling their balance sheet inflation hasn't shown up at all. The data actually points to slowing inflation.

Are people making a flawed assumption that the money printing at the Fed will lead to inflation?

That brings me to my second point, it appears that we are more likely headed toward deflation instead of inflation. That seems at odds with conventional wisdom, but the Japanese experience of the 1990's comes to mind. Add to this the fact that Fairfax Financial has some derivatives bets on deflation, they must feel deflation is a higher probability.

What I find interesting is that people automatically link money printing to inflation, but is that a flawed assumption? Don't get me wrong, I do believe it will have long term ramifications but in the short term we see some fairly astute investors (at Fairfax) betting the other way. What gives? Is the huge amount of debt in the system going to lead us toward deflation?

Any Thoughts?

I have some ideas on the subject but would like to see others think about this. You can comment, anonymous comments will be allowed, or you can send me an email.

Regards,
Kevin

Disclosure: Long FFH

The Peyto Advantage

2012-08-26T08:56:00.000-06:00

This is perhaps one of the best videos I have ever seen on the Peyto Advantage. As mentioned in my previous post, Peyto is the low cost operator and developer of natural gas in Canada.

Darren Gee, the current CEO of Peyto, gives an excellent overview of the company in this presentation. I know Peyto isn't real popular at these energy conferences, mostly because they often show a lot of industry comparison slides. Darren doesn't do that much in the following presentation but you can find more industry comparison slides on their website (Click Here).

My favorite quote from Darren has to be from a couple years ago when he said something like, "Every oil and gas company comes to these conferences and announce they can drill 100% rate of return wells. What I don't understand is why aren't those same economics coming out of the back end of the company in the reported financial statements?" Good Question!

Enjoy!

Regards,

Kevin

Disclosure: Long PEY.

Peyto Exploration & Development

2012-08-22T21:29:00.000-06:00

Well I guess it's time to reveal the company I said I was about to purchase back in April (Click here for that post).

We'll that company was Peyto Exploration and Development (PEY). I really thought that natural gas (NG) prices were going to stay low for the summer, perhaps even lower than where they are today. I was surprise to see the run up in the share price since my purchase, up just shy of 45% excluding dividend. I was hoping to make more purchases during the summer at even lower prices but that did not materialize.

I did put over 5% of my portfolio in PEY, and wanted to take it to 10%, but I don't think that will be happening now. (I also purchased for a family member's account)

For those who know me, you already know that I have had a significant amount of my portfolio in Peyto for just about ten years. Needless to say its been a very successful investment (see chart below). I started selling over the past couple years, after natural gas prices started falling. Now that gas prices are at the bottom I feel it is a good time to start accumulating again. I also happen to hit the bottom of the falling share price this year, within a day, but that was 100% pure luck.

I wrote a fairly extensive writeup of PEY a few years back on seeking alpha. You can read it here: http://seekingalpha.com/article/235455-peyto-energy-has-competitive-advantage.

Peyto is a unique company in the energy space and their track record clearly backs it up.

When I look to invest in any commodity company I am only interested in one thing. Who is the lowest cost operator? Everything else really isn't not all that important. All the competitors sell the same product at nearly the same price and you have absolutely no differentiation between businesses. So when you find the lowest cost operator you need look no further because they will make the highest profit margins within the category. It's really that simply.

I really don't spend a lot of time looking at other names in the space because being the lowest cost operator is THE ONLY competitive advantage you can have. You will earn the highest profit margins when commodity prices are high and you be the only company to earn a profit when prices are low.

Beyond buying the lowest cost company you must also ask yourself what is the price of the underlying commodity going to do? Since Peyto produces NG, you must be sure that NG prices are going to rise. You can own the most fantastic business in the world but if their prices are falling your investment is likely to fall also. Since Peyto is the lowest cost operator, by a large margin, this means they will be the last company to earn a profit as NG prices fall. We have seen this through this cycle as nearly every NG company is losing money while Peyto is still profitable, even at these current low gas prices.

Because companies cannot control the price of the commodity I tend to stay away from the sector because the risks are too great. It's really speculation on the underlying commodity. All the company can control is production.  Peyto and their operations are with my circle of competence, while commodity prices are not. Let me explain.

Circle of Competence

I define your circle of competence a little differently than others. I consider it to be the separation between what you know and what you don't know. The difference between your facts and your assumptions.

I have told my son the difference between smart people and dumb people is that smart people understand what they don't know. Or at minimum they try to determine where that line is.  I have heard this referred to as second level thinking, or critical thinking. The ironic part is many people have no idea where that line is and more importantly when they cross that line.

So, what about yourself? Let's take a little test to see if you know where that line is.

Q1. Driving due south from Detroit, what is the first country you will come to when you leave the U.S.?

a) Cuba
b) Canada
c) Mexico
d) Guatemala

Are you 100% sure? 95%? 90%? Or less?

Q2. Which country derives more than 75% of its energy from nuclear power?

a) United States
b) France
c) Japan
d) none of the above

Are you 100% sure? 95%? 90%? Or less?

Q3. Approximately how many microbes live in the typical person's gastrointestinal tract?

a) 100 trillion
b) 100 billion
c) 100 million
d) 100,000

Are you 100% sure? 95%? 90%? Or less?

(Answers below)

I am likewise just as capable of crossing that line (and don't even realize it when I do). I am just aware and try to minimize crossing that line but I'm not foolish enough to think that I never cross it. The more consciously I live, the more likely I will stay in and around my circle of competence.

So this is what Warren Buffett means when he talks about your circle of competence. It's separating your facts from assumptions. The more you can rely on facts and not assumptions the more successful your investment results will be. Assumptions require judgement, and often a range of possibilities. Minimizing these assumptions will maximize returns.

In value investing, the more you can define what you know versus what you don't know the more successful you'll be.

This is how Warren Buffett operates. He invests in consistent companies that have a strong competitive advantage and pricing power selling at a cheap price. If a company has very consistent operating history and has a slight hiccup, the market can be unforgiving. If you know the hiccup is non life threatening and non reoccurring it likely is a good opportunity. This is what Buffett refers to jumping over a 1 ft bar rather than trying to clear a 8 ft bar.

Similarly Buffett doesn't need to make assumptions regarding bubble gum, ice cream, carpet or Coke. Every one of these products will have growing demand in the future.

How about commodity prices? How many investors know where prices will end up next year? If you find someone who knows the answer, I'll introduce you to a liar.

So when you invest in commodity companies you start with a huge assumption and that assumption plays a huge part of success of the investment. That is why I typically stay away from commodity companies.

When are Commodity Companies a Good Investment?

The only good time to buy a commodity is when its price is low. That usually happens when the prices are lower than the marginal cost of production. In the NG sector we are experiencing record low gas prices and many producers are losing money. To me, that represents a great time to invest.

Coming out of last winter's heating season it was clear we were headed for a NG supply glut and that is exactly what happened. NG prices have been falling for a few years now and around late 2011 they really started to tank.  They seem to formed a bottom this summer.

Much of the low NG prices can also be attributed to drilling bonanza in the US shale gas plays. That will continue while capital continues to flow into the sector while the land grab is on but won't last forever.

Perhaps low gas prices are the new normal? If that's the case, many companies might be left holding a lot of worthless assets. Buyer beware.

Why Peyto?

For those familiar with Peyto you will know that they are operationally on a roll. Production per share has risen dramatically over the past few years. Last year was an excellent year for drilling results that was masked by low gas prices.

Peyto is currently selling for around 40 times Q2 earnings (annualized) and three times book value. Goes to show you those metrics don't really matter in some investments. It's much more about valuing the assets and buying with a margin of safety. Peyto has the assets and if NG prices rise over the next couple years, Peyto is going much higher.

Looking back Peyto may be a screaming buy at current prices, but again that hinges on your outlook for NG prices.

An important consideration for me was the fact that this spring Peyto was selling as cheap as it was during the darkest days of the credit crunch in 2009 (adjust for the increase in production and decline in NG prices). Technical analysis wouldn't have caught this information. I watched the stock fall and then it started to sell off really hard for a few days, just before I purchased...  I couldn't resist anymore. I didn't think twice about buying while the share price was plunging. Anyway, Peyto was selling as cheap as it was during the recession. It was also yielding over 4.8% at the time of my purchases.

More recently, Peyto just announced they closed their Open Range (ONR) acquisition. It was the first acquisition for Peyto since inception. This was really a great opportunity for Peyto to add to their land base and give them more production capacity in the greater Sundance area. Open Range brought around 5500 boe/d of production to the marriage and Peyto brought 42,000 boe/d. The resultant company will be 3.75% owned by Open Range shareholders and 96.25% owned by Peyto shareholders. Considering ONR is contributing 11.5% on a production basis, I like the deal. While this is a very simplistic way of looking at the deal, the real value is in what Peyto will be able to do with the ONR lands & facilities.

For those unfamiliar with Peyto I would strongly suggest checking out their website, where you will find one of the more shareholder friendly companies in the oil patch. I also think I caught a juicy piece of information in the Q2 conference call. For that information though, you'll have to listen for yourself. Enjoy!

Regards,
Kevin

Disclosure: Long PEY.

Answers: b, b, a. You likely guessed Mexico (100% sure), none of the above (70% sure), and 100 million (50% sure). Don't worry those are typical answers. (Questions were taken from Jason Zweig's book, Your Money and Your Brain)

ATPG - Finally Bankrupt

2012-08-19T16:25:00.001-06:00

Well it's official. ATPG Oil & Gas files for Chapter 11 bankruptcy protection. Here's the link:

http://phx.corporate-ir.net/phoenix.zhtml?c=123846&p=irol-newsArticle&ID=1726749&highlight=

For those with any history on my blog, I wrote some very negative things about ATPG back in 2010. The company was way, way over leveraged and the clock finally ran out. What I did run into was a firestorm of controversy from so called "value investors" who thought ATPG was a bargain. One commenter said it was worth $90/share. I was lectured by many on the "value" in ATPG.

One fellow said I didn't understand the economics of "reinvestment" (since that is somehow different from "investment"). He was full convinced he was going to make "ridiculous excess gains" at the expense of the ignorant (myself included).

The math behind financial statements isn't hard, the problem is we often look at them with glasses that distort reality. Those glasses ignore facts that don't align with what we want to see.

Anyway, here are some links from my previous blog post (in order):

http://canadianvalueinvesting.blogspot.ca/2010/11/atp-oil-and-gas-some-comments.html

I posted the same article on Seeking Alpha, check out the controversy in the comments section.

http://seekingalpha.com/article/235574-why-i-d-avoid-atp-oil-and-gas

http://canadianvalueinvesting.blogspot.ca/2010/11/atpg-caught-longs-with-their-pants-down.html

http://canadianvalueinvesting.blogspot.ca/2010/11/atpg-final-comments.html

http://www.gurufocus.com/news/116641/margin-of-safety--downside-risk

Looking back at those posts, I am still amazed at how strong the cult following for ATPG was. I had a ton of comments on those above posts telling me where I was "wrong". I'm still surprised at those who argued with me that ATPG had earned a profit.

Devon Shire (aka CanadianValue & aka Swizzled)

Clearly this guy has no idea what he's talking about. I see that he has now changed the name of his blog to be the same as mine. It's pretty low of him to try and steal traffic to his blog. I have tried to email him (through several sources) to see if he'll change it, but so far no reply.

We had some lengthy debates since I started my blog and so far he's batting 0 for 2. IF YOU HAVE FOLLOWED HIS ADVICE, YOU WOULD HAVE LOST MONEY.

I find it amazing that he now charges for an investing newsletter, mainly targeting small to mid cap oil and gas. If anyone reading this subscribes to his newsletter, please email me a copy and I'll gladly review his recommendations.

Anyone who knows me understands how much this stuff burns me. The vast majority of investment advice, professional or not, is worthless. The people who listen to them deserve what they get, however, the so called advisor still keeps the fees. The mutual fund industry is the worst.

So what have I learned from this whole experience? First you must often stand alone and stick to your principles in the face of intense opposition. Facts are facts, don't ignore them. The vast majority of "value investors" on the internet are useless. Often these people read one misguided individual who in turn repeats the same nonsense and the cycle is repeated until a whole mass of "investors" on the internet believe their own story (I wonder how many of them actually read the ATPG annual reports and financial startments).

On days like this I am reminded of a quote from Warren Buffett.

The market, like the Lord, helps those who help themselves. The market, unlike the Lord, does not forgive those who know not what they do.

Best Regards,

Kevin

Disclosure: None.

Microsoft - Value or Not (Part 2)?

2012-07-25T18:59:00.001-06:00

Here is the response I got from the fellow investor whom I wrote my original response. I believe other's will find this interesting. Enjoy.

Thanks Kevin: I respect contrary views and learn from them, so please keep them coming.

I agree the financial metrics for MSFT are impressive-- as they were for RIMM, HPQ and NOK. Look how quickly that can change. Many highly respected (by me) value investors own all those companies too. The crowd isn't necessarily correct, even amongst the elites-- thank God for that or we'd never have a chance getting an edge in the market.

My view is that the technology sector is a tough neighborhood these days such that once a company loses its momentum, it is very difficult to restore it-- particularly when you are a giant like MSFT. History has borne this theme out. How many *thriving* companies in the tech sector can you name that have existed longer than 10 years? By thriving, I mean gaining market share and growing both the top line and bottom line. A handful, and some of the few that do qualify have questionable prospects, like MSFT and CSCO. 10 years from now, I wouldn't be shocked if MSFT, CSCO, GOOG and even AAPL (gasp!) no longer existed or were irrelevant. That's my opinion, for what it's worth.

Some of the other woes MSFT faces (I'm sure there are more, but I'm not an expert on MSFT):

1. MSFT has entered a gigantic partnership with NOK (!!!) to launch their phone platform. That's not exactly a blue sky situation and MSFT expects billions of dollars of revenue from the venture. NOK is in the ICU on life support with the crash cart by the bedside. Doesn't look too good....

2. PC sales growth these days is mostly sourced from emerging markets where piracy rates are high and IP protection is a low priority. Morningstar forecasts margin compression due to these very important unfavourable effects.

3. The HTML 5.0 web standard should accelerate cloud computing adoption by the same businesses that could not change over to other OS's in the past. There's no reason to believe that MSFT can transition to a cloud based SAAS enterprise easily, efficiently or effectively.

4. MSFT's size has made it a ongoing target for adverse political interventions worldwide. This has adversely affected the corporate culture as you can see from one employee review taken from Glassdoor.com:

While Microsoft always tried to avoid being become large and bureacratic that's exactly what we've become. Our fear was always that we would become IBM after the DOJ settlement. Ballmer swore up and down that we would never fall into that trap, but the reality is with our size and the constant scrutiny be governments around the world we have become this generations IBM. Everything we do is scrutinzed by lawyers first, we all have to go through training to understand what we can't and can do for customers and partners, while our smaller nimbler competitors can react much more quickly than us.

I noticed that Bill Gates has sold $60MM worth of stock in late 2011 and 2012. I originally thought this was due to the funding requirement for his Foundation as part of an orderly liquidation of his portfolio; however, I see he's been buying Diamond Foods, Ecomotors and Tripadvisor in the same time period, so he may well not be a MSFT bull either.

L

---

Here is my lastest response:

I enjoy the discussion too. I was just getting tired with the comparisons to RIMM, HP and NOK that you continue to make. Let's start there.

First you said.

I agree the financial metrics for MSFT are impressive-- as they were for RIMM, HPQ and NOK.

This is hardly an accurate comparison. MSFT hasn't stumbled at all from a financial standpoint while all the rest have. Unless you can predict the future, I believe you are giving opinion and not fact. I don't have a problem with opinion, they are needed in investing. But to compare MSFT to these companies is a stretch, but is widely believed by many. That is my point. Many investors look at the chart and conclude the underlying business is struggling. MSFT hasn't struggled over the past 5 years, but instead have doubled earnings.

You also said (not in the above message):

Even more interesting is that I couldn't find a single bear case write up for MSFT on any of the investing websites I frequent (and I frequent most of them)-- not a single one. Talk about a rosy consensus.

What about your original email? Does that one count? Isn't the author a CFA? I really don't get the "not a single one" comment, in light of the article you sent.

Back in 2000 MSFT was selling for 50x earnings. That was a rosy consensus. Today they are devoid of a rosy consensus and sell for 7x earnings (net of cash). They have grown EPS 3.3x over that period.

Anyway, I agree that the tech sector is a difficult neighbourhood these day but that is mainly a function of market sentiment. Technology will continue to change our lives. I agree it is difficult to predict the future, but my argument is different. It's that MSFT is so cheap and generates so much cash that your getting a *free* wild card on the future. I'm not paying up for a rosy consensus, I'm getting any future upside for free.

1. Nokia's partnership. If Nokia fails this will have little bearing on MSFT. It will suffer a blow to MSFT in the phone market but they don't exactly have anything to lose, do they? Again this offers upside and I don't have high hopes but who really knows. You believe that it will be negative, I don't know.

2. PC sales. This has been a headline story for some time. The only problem is that it really hasn't impacted the financial results all that much. I understand PC sales are flat and the trends are moving toward cloud computing, but MSFT does have a strategy for cloud computing.

On the topic of PC's, I am in some training this week with some staff from Intel. I have been quizzing them up on the ultrabook, among other things. The have a strong belief that the laptop won't be going away for some time. I would tend to agree.

3. HTML 5 and cloud computing. I don't understand the sector well enough to make a call on how this will play out. Office 365 is being utilized by many large companies such as Lowe's, Quantas, Japan Airlines and Hallmark Cards. The biggest adoption of Office 365 will likely come from small businesses, which is a huge market.

4. Political risk has been around for decades. The business has grown through it anyway. Company culture may very well suck. I hope it does suck. That is something that can always be changed and improved. Just ask IBM or read the book "Who Says Elephant's Can't Dance."

I find it amazing that a business that enjoys 80% gross margins is a business that people think is a poor one. It's not like they have huge competitors in many of their lines of business. Once competition shows up you will see this needle move significantly... just ask RIMM. And RIMM didn't have anywhere near those types of gross margins. Apple's gross margins are less than 50% for pete's sake.

As for Apple, that is a stock where I would have concern. It's purely a consumer show and sales can rise and fall much quicker than expected. The quarter released today is evidence of that. Despite the headline nonsense, revenue and profits were up nicely. The problem is the forecast doesn't look good. The sales of the ipad and iphone can rise and fall as quickly as the ipod has. What are the entrenched advantage of AAPL? Consumer loyalty? That can change overnight as we saw with RIMM. All it takes is the next "cool" device, crackberry's were the rage before the iphone. MSFT has much stronger ties to business and that doesn't tend to change very much. It's too costly to change and re-train everyone. In some cases it's nearly impossible to change.

As for RIMM I don't have high hopes for the future but QNX (the wholly owned software company) does have a strangle hold on vehicle software market. Something like 65% of new vehicles use their software. If RIMM can leverage that they may have a hope. That said, they also better have good devices going forward.

Anyway I should probably quit with the comments on tech. I'm no expert.

Maybe I should just stay away from MSFT but the math is just too good for me. I also believe I have a margin of safety.

Later,

Kevin

Thriving 10 year tech companies: MSFT, IBM, ORCL, CSCO, INTC, ADBE, ANSS, SAP... to name a few.

Disclosure: Long MSFT

Microsoft - Value or Not?

2012-07-23T17:56:00.005-06:00

I was recently sent a link to an article on Why Windows 8 Made me Sell Microsoft (MSFT). The article says that Windows 8 sucks and is going to be bad for Microsoft. Maybe it will suck... I don't know that for sure. This was my response.

---

I am long MSFT. Let me tell you why.

Over the past 10 years they have grown revenue by 13%, earnings by 10%. Over the past 5 years they have grown revenue by 14% and earnings by 13.5%. Yes it is value stock, as we will see, but by those numbers you would think MSFT is a growth stock... but anyway.

Last year they generated $31.6 billion in cash from operations and the capex forecast is $3 billion in the coming fiscal year. That means the owner earnings are running around $3.40/shr. They are generating $2.4 billion in free cash per month and have 63 billion of cash at end of the last quarter. I understand the markets believe they will squander some of their cash on dumb acquisitions (they have before), but let's get serious MSFT is a licence to print money.

Many people look at the share price for the past ten years and have no idea about the underlying business performance of the different divisions. I don't know the future, but today you can buy MSFT at 6.4 times owner earnings or a 15.5% owner earnings yield (net of cash). That is cheap, dirt cheap. If I quoted these figures without giving the name of the business, most every investor would be chomping at the bit to know what company I am talking about. Tell them it's MSFT and they aren't interested.

I can't predict the future but I do know the company's operating performance over the past 10 years has been phenomenal. The past 5 years have been even better. Windows 8 may be great or it might be a flop, Vista was a flop too. I do know that Windows is so entrenched in businesses and consumer PC's that they are not going anywhere. Growth in Servers and Tools has been good and Entertainment has been fantastic. The Windows division was down slightly last year.

I just listened to the conference call and came away with the complete opposite impression regarding the outlook of the company.

So let me highlight my reasons why I believe differently:

1) My opinion was based on financial performance that have yet to show any hint of let up, while this guy "thinks" that Windows 8 will be a flop.

2) Secondly even if he proves correct that Windows 8 is a flop and earnings fall flat or down in the Windows division, I still have an large margin of safety. (My cost is also 25% lower than current market prices)

3) I have different opinion of MSFT's entrenched moat, particularly in businesses. Change just isn't an option.

4) While this goes counter to my recent blog posts on social metaphysics, it still is a fact... MSFT is the most widely held stock by value investors and the second most widely held business by % of assets (the first is Berkshire). You can see the list at the link below.

http://www.dataroma.com/m/home.php

Best Regards,
Kevin

Disclosure: Long MSFT & BRK.b

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