Barel Karsan

The Little Book That Builds Wealth: Chapter 14

noreply@blogger.com (Saj Karsan) — Mon, 28 May 2012 10:30:00 +0000

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

In this the final chapter, Dorsey tackles the difficult subject of when to sell. Dorsey argues that there are only four right reasons to sell. Before you sell, the answer to one of the following questions must be a yes:

1) Did you make a mistake?
2) Has the company changed for the worse?
3) Is there a better place for your money?
4) Has the stock become too large a portion of your portfolio?

Unfortunately, we anchor ourselves to price and have a hard time selling at a loss even when it may be justifiable (based on the questions above) to sell. The author suggests a way to avoid anchoring: when you buy a stock, write down the reasons you bought it. If the company takes a turn for the worse, pull out your reasons and see if your reasons for buying are still intact.

Finally, avoid selling simply for price. Just because a stock has dropped does not mean you should sell!

The Little Book That Builds Wealth: Chapter 13

noreply@blogger.com (Saj Karsan) — Sun, 27 May 2012 10:48:00 +0000

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

The author discusses more valuation tools to help the investor determine if a company is undervalued. Dorsey first discusses the price to sales ratio, but warns investors to avoid making comparisons between firms in different industries, as margins can vary substantially by industry.

The second tool Dorsey recommends is the price to book ratio. But it's important to understand the nature of the assets that make up book value. Specialized equipment or intangibles may have no redeeming value, whereas brand names that aren't included in book value may. Nevertheless, book value may have a lot of meaning for financial or real estate firms, for example.

Finally, Dorsey concludes this chapter by introducing the price to earnings and price to cash flow ratios. However, readers are warned that earnings and cash flow can be volatile from year to year, and therefore investors should look at a number of years worth of data in order to estimate what the company is likely to be able to earn in the future.

The Little Book That Builds Wealth: Chapter 12

noreply@blogger.com (Saj Karsan) — Sat, 26 May 2012 10:33:00 +0000

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

Though a great deal of emphasis has been placed thus far on identifying companies with moats, investing is not as simple as buying the companies with the largest moats. This is because the price you pay for a stock is critically important to your future investment returns.

Valuing a company is difficult, as a company's value is tied directly to its future economic performance, which is unknowable! Instead of figuring out what a company is worth exactly, therefore, Dorsey argues that all that is required is determining that the company is trading for less than what it's worth.

To do this, Dorsey recommends estimating the company's current free cash flow and reverse-engineering the growth rate the market is implying for the company based on the company's market price. If your growth rate estimate is larger than that of the market, it may make sense to buy.

Governing Appropriately

noreply@blogger.com (Saj Karsan) — Fri, 25 May 2012 10:03:00 +0000

In a previous post, the potential pitfalls of investing in companies with poor corporate governance structures were discussed. But how can an investor protect himself? There are two basic ways. First of all, the investor can become knowledgeable about what makes for good corporate governance, and then study up on each company in which he is interested in order to make sure it follows practices in accordance with sound corporate governance. The second method is to take advantage of the information published by the companies that specialize in rating and reporting on the governance practices of public companies.

A full discussion of what makes for good corporate governance is beyond the scope of what can be provided in this one article, and we have covered some of the basic points in previous articles on corporate governance. Therefore, this article will focus on what's available for those interested in pursuing the second method.

Governance Metrics International (GMI) is a company that has developed a proprietary corporate governance rating model that it has applied to over 4000 companies. The premise behind the company is that firms with superior corporate governance practices generate superior returns. GMI can be contacted for those who wish to receive a sample report.

Standard and Poor's also produces a Corporate Governance Score (CGS), based on the following criteria:

Ownership structure
Shareholder rights
Transparency and disclosure
Board effectiveness

Based on how a company is rated in the above four factors, it is given a CGS rating between 1 and 10.

While it's easy to gloss over corporate governance elements, the wisest investors always keep them top of mind. With the first rule of value investing being "Never Lose Money", ensuring sound corporate governance practices can increase the likelihood of being able to follow that rule successfully.

Running Into A Duckwall

noreply@blogger.com (Saj Karsan) — Thu, 24 May 2012 10:50:00 +0000

About a year ago, Duckwall-ALCO (DUCK) was discussed on this site as a high-risk, turn-around situation. Since then, the company's value has stabilized while it's price has fallen some 30%. As a result, it trades at a 50% discount to its net current assets and is therefore much more compelling from a value standpoint.

DUCK operates 200+ stores in small towns throughout the central US. It appears as though previous management ran this company into the ground, as new management that came in about two years ago had to start from scratch with a deeply indebted, cash-burning situation. But as a reader recently pointed out, things appear to have turned around. The company earned $1.6 million in its most recent fiscal year, compared to a loss of $4.6 million in the year before.

But try selling DUCK's improved situation to Mr. Market. While the company has net current assets above $60 million, DUCK trades for just over $30 million! To be sure, the company's return on capital and return on equity is still weak (the latter coming in at about 1.5%), but there are reasons to believe the new management team has potential to continue to improve the company's financial situation.

First, DUCK management finally believes it has systems in place to be able to reduce inventory meaningfully. Inventory is expected to drop by $15 million this year (half of the company's market cap!), with some of it going towards paying down debt and some going towards share repurchases.

Management also believes there are a few million dollars to be saved annually by re-organizing the company's distribution routes. Furthermore, the company is able to negotiate better lease terms on stores that come up for renewal (operating lease obligations have dropped by $10 million y/y while store counts are essentially flat).

DUCK has also begun to participate in the e-commerce world, offering a number of items to customers online. Management is also in the process of instituting regional pricing and merchandising, which provides an opportunity to increase margins without capital investment.

Finally, shrink also remains an opportunity. Though management has been touting this issue since last year, it has not yet been able to make meaningful progress. Recent software upgrades may help in this regard; if the company can get back to DUCK's shrink average, about a $2 million increase in annual operating income is possible. If DUCK can get to industry shrink levels, about a $4 million increase in operating income is possible.

There are risks to this investment, however. The company carries almost $200 million of debt and operating lease obligations combined. DUCK does have working capital of $150 million, which is what allows it to borrow the $65 million in balance sheet debt that it carries. In addition, the company has land and buildings carried on the books for $12 million.

But management's bonuses are calculated based on the company's ROE, which means you can expect the company to continue to carry heavy debt obligations. This financial leverage magnifies the gains and losses for you as an investor. You can do very well if the trend of managements' improvements continue, but if things turn south again you can also fare very poorly.

Further adding to the risk is that rather than shrink down until it generates decent returns on capital, the company continues to add stores even as it closes unprofitable ones. These require cash investments in equipment and inventory that could otherwise be used to pay down debt or buy back shares.

Shareholders may also want to be aware of some potential financial shenanigans as well. The company has changed its inventory accounting method in each of the last two years, both of which have served to improve the income statement. For example, its most recent change (from the retail inventory method to the weighted average cost method) resulted in a GAAP net income increase of $2.6 million, though there was no cash flow impact.

Overall, however, DUCK does look like a bargain at its current price. This is a profitable company trading at a 50% discount to its net current assets. As mentioned, however, there is a remarkable amount of operating and financial leverage built into DUCK, which may scare some value investors away. Incidentally, if you were to buy shares in this company you would be joining value investor Michael Price.

Disclosure: No position

Mailbag: Transat A.T.

noreply@blogger.com (Saj Karsan) — Wed, 23 May 2012 10:38:00 +0000

The idea that airlines make for lousy investments has been broached a number of times on this site. But what about a tour operator that trades for far less than its cash balance? Transat AT (TRZ) will be of interest to many value investors, thanks to its $190 million market cap versus its cash balance of $640 million. In addition, the company has more than $75 million (after write-downs) in ABCP! Furthermore, the company is generally profitable and free cash flow positive (though last year was an exception).

Transat calls itself a tour operator instead of an airline because it has vertically integrated beyond being a pure airline. It offers packages (hotels, activities etc.) to tourists, handles logistics (e.g. baggage) for many other airlines at a number of airports and operates a number of travel agencies. And yet I'm not sure it can escape the fundamental risks that make airlines such poor investments.

First of all, when a particular vacation route is profitable, nothing stops a competitor from expanding capacity and driving down the returns of the incumbent. And when a route is unprofitable, price wars for marginal revenue can be devastating.

Second, to a large extent the company's costs are out of its control. On revenues of $3.5 billion, Transat paid a lofty $450 million last year just for fuel. Furthermore, the company has almost $800 million worth of operating leases due over the next few years; if these are capitalized and considered debt (which they should be), the company's net cash position cited above all but disappears.

Occasionally, pre-paying customers have been left in the lurch when airlines have gone bankrupt. As a result, regulations require that companies keep a certain amount of deferred revenue in trust accounts. So even though the company has $640 million in cash on the balance sheet, $425 million of that is reserved and held in trust! As an investor, don't expect this cash to ever be released unless the airline is willing to shrink. On a related note, good luck finding an airline operator that isn't obsessed with growth! Transat continues to add cities and routes to its network this year.

Finally, the way Transat's tour operations provide value to customers in the form of cheaper vacation prices is by buying hotel rooms and airline seats (if it needs those of another airline) in bulk and at a discount in advance. As such, they have to anticipate market conditions and make commitments some 6 to 9 months before the vacation season begins. Note only does this require somewhat accurate demand forecasting which can obviously go wrong, but it also exposes the company to the risk that an event (e.g. a recession or terrorist attack or flu scare) will destroy demand. Since costs are fixed to such a large extent, such an event could cause a liquidity crisis, or even bankruptcy. Obviously, these types of events won't happen often, but the investor must recognize that he bears this risk.

Nevertheless, Transat still trades for substantially lower than the replacement value of its net assets. I'd even go so far as to say that an investor would probably do quite well purchasing Transat at its current price. The problem, however, is that downside risk is not adequately protected for black swan or even mildly-gray swan type events, thanks to the long lead times, fixed costs, and exposure to costs that are out of its control. Despite the risks, however, some value investors may be interested. What do you think?

Disclosure: No position

Paulson's Earnings Surprised Somebody

noreply@blogger.com (Saj Karsan) — Tue, 22 May 2012 10:18:00 +0000

Paulson Capital has been brought up a few times on this site because of how cheaply it has traded relative to its current assets. Last week, shareholders were rewarded. Immediately following the company's earnings announcement, shares almost doubled; as a result, this company becomes the latest stock to move from the Stock Ideas to the Value In Action page.

This result re-enforces a number of lessons value investors should already know:

1) Be patient. This stock went down (and quite a bit!) before it went up. Shareholders who gave up lost out, while those who bought more won.

2) Buy companies at discounts to net current assets (that aren't burning through those assets). Even if their prices go down, you know the company's business value is more than its market cap, which should help you with #1.

3) Do your homework. The company's earnings jump should not have been a surprise. Paulson disclosed a large ownership position in a public company that saw a huge price rise over the quarter, which should have been clear to all.

4) Be nimble. Paulson's shares quickly fell back to within its normal trading range such that investors who didn't sell when they were offered the chance have to wait a little longer.

National Presto Continues To Fall

noreply@blogger.com (Saj Karsan) — Mon, 21 May 2012 10:28:00 +0000

National Presto Industries (NPK) now trades with a P/E under 10, having dropped 50% of its share price in just the last year and a bit! Instead of discussing the company further, I'll point you to someone who has already done so at GuruFocus, but come back here when you're done because there are a couple of issues with that article that I want to dissect.

Done reading it? Okay good!

In my opinion, the author does an excellent job describing some of the salient points regarding a potential investment in Presto. Management has shareholder-friendly capital allocation policies (and is of a family tree that Buffett admires!), the company leads in a number of its product categories, and there is unlikely to be any secular decline in the company's products.

But while the author discusses the major risk facing this company, he kind of ignores it when he draws his conclusion that Presto should be purchased at current prices. The risk is one of customer concentration.

If these major customers continue to buy in the future at a similar rate to what they have in the past, I agree with the author that Presto appears undervalued. But when a single customer makes up 47% of sales, there is significant downside risk.

This is not a company trading at a discount to book value that can just shrink if sales decline and still make shareholders whole through monetizing its assets. At 1.5x book value, one has to be sure of the company's earnings power in order to protect the downside, and this is very tough to do when one customer holds so much sway.

Carnage can result from such a situation, as seen in this example; contrast this with Staples, a company with a moat that trades at a similar P/E to Presto but that is not reliant on a single customer. Staples recently walked away from two major contract customers because of price competition, but this did not register a blip on the company's results.

Already, this major customer of Presto's has reduced purchases of late, but the company has blamed the reductions on simply the timing of shipments. Unfortunately, as pointed out by Frank Voisin, the company has blamed the timing of shipments for three quarters in a row, calling into question management's credibility!

Current earnings are good! (They're better than negative earnings!) But even better are sustainable earnings. When customer concentration is high, the sustainability of earnings is harder to predict, reducing the investor's odds of success!

Disclosure: No position

The Little Book That Builds Wealth: Chapter 11

noreply@blogger.com (Saj Karsan) — Sun, 20 May 2012 10:17:00 +0000

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

Dorsey now brings it all together in this chapter, taking the reader through the multi-step process of determining whether a company has a moat. First, he looks for returns on capital; if a company hasn't proven it has a moat with strong returns, you probably don't want to pin your hopes on it.

Second, he tries to identify the moat, and determine whether it will continue or is subject to erosion. Finally, he attempts to ascertain how strong the moat is and whether it is likely to last a long or short time.

After discussions of each company, Dorsey concludes that Deere, Arch Coal, and Fastenal have moats (of varying degree, however) while Martha Stewart Omnimedia, Hot Topic and Pier 1 do not.

The Little Book That Builds Wealth: Chapter 10

noreply@blogger.com (Saj Karsan) — Sat, 19 May 2012 10:21:00 +0000

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

It's important to distinguish between companies that derive strong returns because of their managements and those that do so because of they have economics moats. When it comes to companies with economic moats, managements don't matter as much as you may think. Competitive advantages are rooted in structural characteristics that can't be altered much in the near-term.

The author quotes Buffett: "When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."

Dorsey's advice is clear: bet on the horse, not the jockey. A wide-moat company managed by a mediocre manager will generate better returns on average than a no-moat company managed by a superstar.

Mainstream vs Real Revenue Risk

noreply@blogger.com (Saj Karsan) — Fri, 18 May 2012 10:36:00 +0000

The mainstream finance industry defines a company's riskiness by its stock price's volatility. For value investors, there is no such short cut; a company's riskiness is defined by a slew of factors that can affect the business. Previously, we have considered some items that can affect risk on the cost side. Today's post will discuss some items relevant to risk on the revenue side. The vast majority of analysts and investors are so focused on near-term results that they rarely think about these long-term business risks; investors who consider these are poised to generate better returns in the long-term.

First of all, a company's revenue can have varying degrees of cyclicality. What this means is, during recessions, certain industries are hurt more than others. Conversely, these industries tend to do better when the economy is strong. Nevertheless, there is higher risk involved in a cyclical business, since poor conditions can persist and cause companies to be unable to meet their obligations. For a more detailed discussion of this topic, see this article.

Secondly, risk is lower when a company has a "moat" (as coined by Buffett) that essentially protects it from competition. In these instances, revenues are more stable, thereby reducing downside risk. Of course, companies with strong moats are hard to come by.

Revenue risk is also reduced when a company is not depedent on one product, as having multiple lines serve to diversify a company's risk should a competitor make inroads or should a product become obsolete. Having a diverse array of customers also helps, since that way a company's fortunes are not tied to the health of companies outside of its control. (This was an important factor when we answered a reader's question on auto parts suppliers a few months ago.)

Finally, it's important to understand how persistent current revenues are. Does the company need to keep innovating just to hold revenues steady, or has it already done most of the work? As an example, contrast Walmart with Apple. Apple's earnings are only as good as its latest products, and it must make sure to keep producing products that customers value, which won't be easy over the long-term. On the other hand, Walmart already has a presence where it can sell the products customers value, without having to innovate anew!

While it's impossible to predict the future, investors can better protect themselves from unforeseen events by choosing companies which are less susceptible to revenue declines. By considering the factors discussed above, downside risks can be reduced.

Harbinger, Spectrum Marriage Back In Spotlight

noreply@blogger.com (Saj Karsan) — Thu, 17 May 2012 10:34:00 +0000

In late 2010, Harbinger Group was discussed on this site as a potential value play because its holdings in Spectrum Brands exceeded its market cap! The discount did converge somewhat in late 2011, but it has now widened to even higher levels; since that article in November of 2010, Spectrum's stock is up almost 20% while Harbinger has been practically flat.

What should offer investors confidence in Spectrum's valuation is that it is not some sky-high P/E, overvalued stock with little to no earnings. (In other words, it is not a "cloud play", in every sense of the term.) Spectrum owns a number of consumer brands (including Rayovac and Remington) which have demonstrated steady revenue and operating income growth over the last several years.

In addition to an above-market value holding of Spectrum, investors in Harbinger get to own Harbinger's insurance business (which it had not yet purchased at the time of the 2010 article) for free!

For an excellent look at a sum-of-the-parts valuation of Harbinger that demonstrates how undervalued it may be, check out this article at The Brooklyn Investor.

Disclosure: No position

Volatility Unrelated To Performance?

noreply@blogger.com (Saj Karsan) — Wed, 16 May 2012 10:23:00 +0000

The mainstream finance industry equates price volatility with risk and believes the market to be efficient. That is, prices of stocks are fairly priced, and therefore the only way to generate higher returns is by taking more risk (i.e. buying stocks with higher volatilities).

Value investors, of course, not only reject the fact that the market is efficient (for a terrific essay on the subject by Warren Buffett, see here), but also find flaw with the definition of risk. To value investors, risk represents the potential that the underlying business is or becomes worth less than anticipated, and this is often times completely unrelated to a stock price's volatility. Value investors believe volatility could be caused by the market's general level of fear, supply/demand characteristics of various securities at particular points in time, and other psychological factors unrelated to the underlying business.

A study by Richard Roll has attempted to quantify the various components that comprise a given stock's volatility. His findings are depicted in the chart below:

According to Roll, company specific risks play only a very small role in a stock's volatility. If this information is accepted, it seems ludicrous to believe a stock's volatility - rather than the fundamental business/financial risk of the underlying company itself - is what governs an investment's risk level. Investor confidence, interest rates, and the stage of the business cycle all play far larger roles when it comes to volatility!

Value investors who take advantage of volatility, rather than fear it by equating it with risk, position themselves for market beating returns!

Xerox Has Long-Term Value

noreply@blogger.com (Saj Karsan) — Tue, 15 May 2012 10:13:00 +0000

Xerox (XRX) has a P/E ratio of 7 and a P/OCF ratio under 5. As a result, it trades under book value (!) despite an ROE greater than 10% and operating margins in the high single digits. Before you dismiss this company out of hand as a dinosaur, consider that this is not your father's Xerox. Just as we've recently seen how Dell is no longer the PC company you thought it was (and therefore may be undervalued as well), neither is Xerox the copier/printer maker of yesteryear. Today, Xerox derives the majority of its revenues and profits from the sale of services (business process, IT and document outsourcing).Read more...

Buying IVE For The Long Term

noreply@blogger.com (Saj Karsan) — Mon, 14 May 2012 10:12:00 +0000

So you "get" value investing. You understand the concept of buying stocks when they are unloved and therefore cheap based on metrics such as P/E and P/B, as you realize that such stocks tend to outperform over time. But you don't have the time to constantly screen and then investigate the latest value ideas. So why not invest in an ETF like the S&P 500 Index Fund (IVE)? Read more...

The Little Book That Builds Wealth: Chapter 9

noreply@blogger.com (Saj Karsan) — Sun, 13 May 2012 10:34:00 +0000

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

Convinced that you should be investing in moats in order to generate a strong return with low risk? If so, you will need to know how to find companies with moats, and that's what this chapter is about.

The first thing to realize is that not all industries are created equal; some are more conducive to having companies with moats than others. Dorsey cites the asset management industry as one where moats are easy to find, but the auto parts industry as one that is not conducive to moats.

Similarly, Dorsey argues that software firms tend to have moats where hardware firms don't, as software has to be integrated with other pieces of software, leading to high switching costs. Many moats exist in telecom, where favourable regulatory structures (outside the US) or niche markets protect incumbents.

Dorsey goes on to describe the economics (and moat potential) of a number of industries including restaurants, retail, b2b, industrial, utilities and more. Once you think you have found a company with a moat, check its historical returns using ROIC, ROA and ROE to see if the numbers bear out your thesis.

The Little Book That Builds Wealth: Chapter 8

noreply@blogger.com (Saj Karsan) — Sat, 12 May 2012 10:50:00 +0000

Telus Something We WANT To Hear

noreply@blogger.com (Saj Karsan) — Fri, 11 May 2012 10:07:00 +0000

Dual-class share structures have been discussed on this site as something to be wary of as a shareholder. But in what appears to be a role reversal, one management team recently tried to eliminate its dual-class share structure only to be thwarted by shareholders! The media has portrayed this saga a certain way: Telus Fights For Equality And World Peace (okay, I added the "World Peace" myself).

So you've got the antagonistic, profit-hungry hedge fund from New York ("Why, this stuff's made in NEW YORK CITY???") trying to block a local company's altruistic attempt at improving its corporate governance. But a closer examination of Telus tells us what's really happening.

Usually, dual-class share structures are set up such that management controls the voting shares. This way, management can block attempts at an overthrow. Telus' history is a little bit different, with the dual-class share structure coming into be in order to circumvent government regulations on foreign ownership. As a result, management doesn't own that many voting shares. Instead, it has received a number of options (some 1 million options have been exercised over the last two years with a notional value of $58 million based on today's stock price) and a bunch more in restricted shares (some $22 million worth over the last two years).

But these are mostly in the form of cash or non-voting shares. As a result, management is strongly incentivized to see its non-voting shares receive voting rights! Non-voting shares have typically traded at a 5% discount to the voting shares, so any closing of that gap would reap a windfall for management and other non-voting shareholders.

So Telus proposed that non-voting stock be converted into voting stock on a one-for-one basis. That's it! No compensation for voting shareholders, who presumably paid a voting premium for their shares even though they receive the same dividends and other rights. In other recent cases of dual-class conversion to single-class, we have seen substantial compensation paid to the voting shareholders! In this case, however, voting shareholders were expected to receive nothing in return for sharing their voting rights.

So a hedge fund decided to buy up a block of voting shares (while simultaneously shorting non-voting shares to hedge out risk) and vote against the deal. Instead of offering better terms, however, Telus tried to get the government to help. When the government denied their claim, the company's CEO offered this beauty of a quote:

“I’m not saying, to be clear, that what Mason did was illegal. I find it morally objectionable,” said Mr. Entwistle. “And I find it a great example of what is wrong within the capital markets and I think it is area where securities regulators need to step in."

Of course, when it comes to his telecom business (i.e. not the hedge fund's capital market business), he's wary of regulations. Entwistle is quoted as telling regulators to rely more on market forces, and usher in a new era of minimal regulations.

Incentives play a powerful role in behaviour. When you take the time to figure out what a party's incentives are, you will go a long way towards understanding why they are behaving the way they are.

Also watch out for media portrayals. Writers want an angle, so they will pick out the facts that support a particular viewpoint and ignore those that don't. (I'm as guilty as anyone on this, as this one-sided piece illustrates, but it's important for you as the reader to recognize this when it happens and think for yourself.)

Entwistle remains intent on returning Telus to a single class of shares. Perhaps he should heed his own advice and let market forces determine a price that fairly compensates owners of the voting shares.

Disclosure: No position

Clubbing With Energy

noreply@blogger.com (Saj Karsan) — Thu, 10 May 2012 10:45:00 +0000

I know at least some of you have an interest in joining the Value Investors Club, because readers have periodically asked for my advice on how to join. I'm not a member, nor have I ever applied, but that doesn't mean I can't help!

Frequent commenter "aagold" informed me that he was accepted into the club yesterday, thanks to this write-up. Potential candidates should check it out! Even for those not interested in joining the club, however, the write-up may still offer you a potential buying opportunity for your own portfolio.

Myself, I don't love this particular idea. Frequenters of this blog know that I don't love valuations that rely heavily on commodity price assumptions (which aagold calls an irrational position). Price assumptions aside, I have even less confidence in the liquidation value estimate of the company considering some of the cost of liquidation assumptions.

But, who am I to judge? Only you can judge what makes sense for your portfolio, and obviously the idea is well-liked by the people at VIC (no surprise there, as the grass is always Greenblatt on the other side). So check it out for yourself.

Disclosure: No position

InfoSonics: More Net-Net Asymmetry

noreply@blogger.com (Saj Karsan) — Wed, 09 May 2012 10:00:00 +0000

InfoSonics has already shown up on this site on the Value In Action page, but its recent price action (as pointed out by a commenter on this post) demonstrates what it is we value investors love about stocks trading at discounts to their net current asset values.

InfoSonics had been losing money for a while, and likely for this reason it traded at a large discount to its net current assets. Following the Value In Action post mentioned above, the stock fell 25%, once again offering investors an entry point at a 40%+ discount to net current asset value. I was not fortunate enough to get back in at this point, but what happened next is still interesting as a sideline spectator.

The company turned profitable! InfoSonics reported earnings of $0.01 per share and an outlook that suggested further profits were on the way, which was enough to send the stock price surging some 70%!. This is the beauty of a stock with low expectations: downside risk is low (the stock was already trading at less than cash...how much further could it fall?), and upside potential is high (despite the huge price increase, the company still trades at just over book value!).

To some extent, the improvement in operations was foreseeable. InfoSonics has been operating a growing segment with higher margins and a declining segment with lower margins. As the higher gross margin segment has gained prominence relative to the money-losing segment, the company's earnings picture has continued to improve, and may yet continue to do so if management's comments are any indication.

Still, you never know in advance whether a company will do well. But when you put the odds in your favour by selecting investments where downside risk is low relative to upside returns, you give yourself a chance to generate excellent returns.

Disclosure: No position

GTSI Rockets Upward

noreply@blogger.com (Saj Karsan) — Tue, 08 May 2012 10:00:00 +0000

Investors who frequent the value blogosphere will undoubtedly have seen GTSI Corp (GTSI) come up frequently as an undervalued stock. To my knowledge, it was first brought up at Frankly Speaking in 2010 (and subsequently appeared on that site a number of times), then discussed right here as a Stock Idea in May of 2011, subsequently showed up in a paid newsletter a week later, and finally was featured in August (in the first of many) over at ~~Burger King~~ Whopper Investments*.

Yesterday, the stock rocketed up almost 50% on a buyout offer, giving all of these guys something to cheer about. GTSI is a classic example of a net-net with a seemingly asymmetrical return profile; as it traded at a rather large discount to its net current assets and new management was showing progress at cutting costs in order to reduce losses to manageable levels, downside risk appeared minimal and upside potential high.

That potential came to fruition yesterday as the company announced its intention to be acquired for approximately its net current asset value, resulting in a one-day return of 47%. What lessons can value investors like you draw from this situation?

1) Read value blogs. There are always a lot of good ideas like this one flowing around the value blogosphere, whether the market is expensive or cheap.

2) Buy net-nets that are not destroying value. If the business model is sound, the return profile will thus be asymmetric, putting the odds in your favour.

3) Be patient. Shareholders who bought in 2010 had to wait a couple of years, but eventually saw significant appreciation. Even shareholders who bought in on Friday had to wait until Monday (*slow clap*).

Time to deploy the capital from this investment into the next Stock Idea!

Disclosure: No position

* These are just the ones I recall. If you're a value blogger and I missed your interest in this stock, feel free to let me know and I can add you to the list.

What Leads To Our Overconfidence

noreply@blogger.com (Saj Karsan) — Mon, 07 May 2012 10:26:00 +0000

In a previous post, we saw how humans appear to have an overconfidence bias, and how that can play havoc on financial forecast estimations. What is not immediately clear, however, is the increasing role overconfidence plays the more knowledge one acquires. That is, as expertise rises, so does overconfidence, resulting in the fact that the people with the most knowledge are likely to be the most miscalibrated, which can result in detrimental effects.

But knowledge alone does not doom someone into being overconfident. James Montier argues that it's a lack of feedback that pushes people to be overconfident. To demonstrate this, Montier cites a study performed by Scott Plous that compares the calibration of weathermen against that of doctors. Weathermen were asked to predict the weather, while doctors were asked to diagnose patients (based on case notes). Both were asked to provide confidence intervals, so that their calibrations could be measured.

Interestingly, weatherman were well calibrated, while doctors were very poorly calibrated. Montier argues that this is because weather forecasters benefit from the fact that they receive immediate evidence of their abilities as forecasters, while doctors do not.

While one may be inclined to believe that financial analysts should be like weathermen in that they can see whether their forecasts came true, similar calibration tests appear to show that analysts are calibrated to a similar extent as doctors! As a result, the industry is glowing with overconfidence. Further testing confirmed the opening hypothesis: experts in finance are more overconfident than lay people, as they apply too narrow a band around their estimates as compared to the general public.

The Little Book That Builds Wealth: Chapter 7

noreply@blogger.com (Saj Karsan) — Sun, 06 May 2012 10:02:00 +0000

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

This chapter is about the powerful scale advantage. When considering this advantage, it's important to evaluate a firm's size relative to the competition. Scale advantages occur most when fixed costs (vs variable costs) form a larger part of an industry's cost structure.

To illustrate this advantage, Dorsey describes the trucking industry. The cost of trucks and the salaries of drivers and the fuel required for a particular trip can be seen as fixed costs. The company that has more customers along the route, however, can spread these large fixed costs across higher revenues, thus benefiting from a competitive advantage.

A number of examples are described to illustrate this advantage in action. Darden supplies 650 restaurants with fresh seafood at lower costs because of the number of locations it services; Stericycle collects and disposes of medical waste, and is 15 times larger than its nearest competitor; Sysco, Fastenal, Coke, Pepsi and Diageo all benefit from strong distributor networks that lower costs.

The Little Book That Builds Wealth: Chapter 6

noreply@blogger.com (Saj Karsan) — Sat, 05 May 2012 10:49:00 +0000

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

Cost advantages are explored in this chapter. Cost advantages can come from cheaper processes, better locations, unique assets and greater scale. The next chapter is devoted to the important scale advantage, while this chapter focuses on the first three cost cost advantages.

In theory, process advantages shouldn't exist for long, as competition should figure out ways to copy incumbents. But in practice these advantages can last a long time. Dell (with PCs) and Southwest Airlines are examined to understand why competition was unable to replicate their efficient processes for many years.

Location-based advantages are more durable than process-based ones because locations are much more difficult to duplicate. This can occur frequently in commodity-based businesses, where transportation costs are high relative to product costs.

Finally, unique assets are a catch-all category. An example of a unique asset providing a cost advantage is an easy-to-extract-from (relative to the competition) oil resource.

Why Are You Underperforming?

noreply@blogger.com (Saj Karsan) — Fri, 04 May 2012 10:13:00 +0000

Since we know value investing works (e.g. low P/B and low P/E portfolios outperform), why might you, a value investor, be underperforming? In a fascinating series of posts, Greenbackd breaks down a paper that seeks to examine why different types of value investors underperform. For example, those who adhere to strict screens may underperform because of an unfortunate time period (for certain periods, high P/E and high P/B can outperform) or a lack of diversification.

Or, if you want more details, you can find the whole paper here.