Looking forward to an uncertain future

Slowly but surely

2012-01-28T08:14:00.000-08:00

Around this time of the year, reflection sets in and many tend to ponder about various things in a philosophical haze. Accordingly as we approach the end on January, I have been beset by doubts about my approach to the capital markets.

What if my thoughts on the virtues of value investing, its “proven” advantage over alternative tactics of speculation and technical charting are in fact just empty theories?. Continued volatility in the market hasn’t helped either. Cheap companies have been getting cheaper, or just going nowhere, throughout 2011 and no clear upward trend to reverse this slide has yet emerged.

It was in this state of mind that I came across an extraordinary documentary/program filmed by the BBC in the summer of 2008 where the cameras followed a group of 8 non-financial types/would-be traders as they did battle with the markets over a 10-week period. The appealingly labelled experiment (funded by a generous UK fund manager) was aptly named “Million Dollar Traders” and can be seen in 10 minute mini-episodes here:

Putting aside the emotional drama of the experiment, (no doubt exacerbated by the constant presence of a filming crew), the results of the exercise were most revealing and contributed to affirm me in my convictions.

To cut a long story short, the 8 random folks, (whose only preparation for the show consisted of a check up on basic math skills and an ability to read financial newspapers) selected to trade equities (both long and short) in a sort of market neutral hedge fund strategy, actually outperformed an index of hedge funds over the 10 week period covered!.

Besides the explicit humiliation bestowed on the hyper-fast trading hedge fund community, a set of additional readings can be made:

1. Firstly, 10-weeks is a laughably short period in which to measure performance, no matter what asset class you are dealing with. (Note some of the trades were put on and subsequently liquidated, often at a loss, in 1 hour!).

2. The sheer randomness of the trade outcomes is a testament to the gambling-like nature of this approach.

3. No comment (let alone implicit reference) was made to the enormous brokerage fees incurred in this process as a consequence of the sheer level of activity. Here again, patient thought out value investing wins by a landslide.

4. Last but not least, the behavioural transformation (read: descent into a nervous wreck of the otherwise previously paused participants) indicates that a speculative approach to financial markets is at odds with basic human traits.

Returning now to life in the present (28th January 2012), as pessimism continues to hold a firm grip on collective thought, I personally find much to cheer about.

And, as a concession to those who may feel my previous statement was typically ambiguous, read on for further insights into the reason for my giddy optimism.

• Zimmer (Ticker: ZMH)
• Xerox (Ticker: XRX)
• Dell (Ticker: DELL)
• LyondellBasell (Ticker:LYB)
• BP (Ticker: BP)

Even after a hefty run up from summer ’11 lows on most of these stocks, the value on offer differential versus the price demanded continues to be most generous.

And please note, no need to read the financial press every morning at 06:00 or to chart every tick on your Bloomberg.
Just sit, watch and enjoy.

Look everywhere

2011-12-05T10:08:00.000-08:00

One of the basic tenets of Warren Buffet’s much copied investing philosophy is the simple “Invest within one’s circle of competence”. Much like the rest of Mr Buffet’s advice, this one reeks of common sense. As such it would be foolish to ignore, and in essence, few wise investors do.

There is, however an aspect of this simple concept of “competence” and “know-how” that is sometimes misunderstood. Investors all over tend to assume that competence equates familiarity and ultimately can only be obtained in conjunction with physical or geographical proximity. Put simply, few players in the capital markets derive any comfort from investing in distant places.

Given the enormous breadth of investment options available to most western investors on a local basis, in the form of thousands of quoted stocks, corporate and government bonds, commodities, options, currencies and other more sophisticated derivatives, it is fair to ask why one would bother to look beyond one’s home country / market.

Undeniably familiarity helps as it brings comfort and security. Notables such as Peter Lynch of the Magellan Fund, claimed that their best ideas came from daily interactions with local companies which would later make it into his portfolio. Moreover, It is often said that every thousand miles travelled from home in investing terms add an additional layer of complexity; thus requiring further due diligence before clarity can be reached.

No doubt there is substance to this approach of keeping close to home. After all, investing requires a thorough business owner-like mentality and some would argue that this level of knowledge can best be achieved via close interaction with the corporation whose security being analysed.

Personally, I agree on the merits of thorough familiarity with the subject of one’s investment, but I hasten to see geographic proximity or even domestic familiarity (also known as patriotism) as the only way to develop the confidence required to pull the investment trigger.

Consciously investing only in one’s home market leads to a world of opportunity, pun very much intended, being ignored. These days, the vast majority of the information required to make sound investment operations is widely available in a format (electronic) which replaces the need to travel and in fact, to interact with management.

Further concerns regarding accounting treatment differences, currency exposure, or even political risks are for the most part, quite simply overstated. The fact remains that, barring a certain number nations whose record of corporate governance remains questionable, most modern states with liquid capital markets operate under the same rules as those of the USA.

Currency concerns can easily be hedged away (if one desires) and political risk is so far off the table in the majority of northern hemisphere nations as to not warrant anything but a passing reference.

In addition, smaller, less “developed” markets such as those of South Korea and certain European states, tend to be less liquid and more prone to provide significant value discrepancies as a result of their limited following. On the other hand finding simple arbitrage opportunities these days in the NYSE strikes me as an unlikely occurrence.

Given the choice between fishing in large, but overcrowded and mostly depleted lakes versus smaller, relatively unpopular but unspoilt locations, I know which ones I’d draw my attention to...

Going it alone

2011-10-31T07:47:00.000-07:00

As the twice-yearly Value Investing Congress (V.I.C) concluded last week, various investing sites provided the observer with a “post-mortem” peak into its conclusions.

Besides the usual, deeply thoughtful, high quality presentations and analyses, I was mostly struck by two things above everything else.

One was the contrarian nature of the recommendations (shorting Green Mountain Coffee Roasters anyone?!) and the other was the level of individualism that is so prevalent among leading investors. By this I mean that no matter how deep the talent bench may be at some of the funds presenting at the V.I.C , the fact remains that both glory and pain are attributable almost exclusively to those at their helm.

Reading letters to investors from high performing funds reveals this feature in clear fashion. Very rarely are references made to the value of consensus decisions or group analysis. Whilst it is true that many great investors cut their teeth at some of the larger funds (think Tiger Management), in their formative years, it is also the case that ultimately a manager worth his salt will set up shop alone.

At a time when some leading investors appear to be faltering such as Bruce Berkowitz at Fairholme (down 27% so far this year) with his ill-timed bet on financials and John Paulson whose Advantage Plus fund is currently down some 32% year-to-date, it is important to ignore the crowd and pay heed to the wise words of Benjamin Graham:

“You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right—and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else."

Personally, I take comfort in these words as I continue to invest new money in the markets whilst the cacophony of macroeconomic prognosticators grows ever louder and the global growth engine fails to take off.

My suggestion is to allow for 3-5 years to pass, and to look back at Mr. Paulson’s and Mr. Berkowitz ‘s annualized performance once again before judging too prematurely.

Investing is indeed a lonely game, but in my opinion it’s all the better for it!.

A good time to invest?

2011-08-29T07:32:00.000-07:00

The last few weeks in the capital markets have been anything but dull. As most of Europe vacationed, volatility in major stock markets jumped, unnerving many and bringing, (not so fond), memories of September 2008.

To illustrate the point just refer to the broad based S&P 500 index performance in the last 4 weeks: It closed just shy of 1.300 on the last trading day of July, dropped 12% to 1.149 in 5 trading days, shot back up 4,5% to 1.200 by mid-August and corrected back to 1.160 by August 26th.

Right now the S&P is down 6% Year-To-Date and some 12,3% lower from its late April high of 1.363. Put bluntly this market has “gone nowhere in 13 years” as its current price (not adjusted for inflation) is the same it was in October 1998.

As this was happening, macro indicators from across the pond delivered ominous news in the form of unexpectedly low GDP growth forecasts from Europe’s last standing hope (read Germany). Not to mention increasing woes from other peripheral nations as they struggle to contain their growing public sector debt. Making matters worse, even the ultimate asset price inflator, a.k.a. Ben Bernanke, failed to prop up expectations at his recent speech in Jackson Hole. No mention, not even a hint was made of a new round of security purchases by the venerable “Fed”, leaving QE3 fans at a loss.

To cap it all, gold, which has served as the last refuge for many, delivered a brutal 100 $ drop on August 24th, bringing into question, temporarily at least, its suitability as a safe haven. In any case, it had appreciated by some 400 $ since mid-July, so in absolute terms such a correction should not come as a surprise.

Investors, both professionals and ordinary folks (the ones I talk to, at least) are rightly shaken by these events and often looking to exit what they consider to be high risk positions. Indeed, the week ending August 19th saw the biggest level of redemptions form Mutual Fund investors since 2008. According to the Investment Company Institute:

“Rattled investors pulled more than $40 billion from mutual funds in a single week this month as fears about the global economy intensified. The total of $40.3 billion was the biggest amount removed from mutual funds in a week in nearly three years”

Some notable hedge funds too have wound down their exposure over recent months, signaling that caution is the new approach. Dan Loeb, whose Third Point fund has annualized 19% since 1995 and is 8% up YTD, has recently continued his 3-month trend of lowering exposure to equities as is now only 23,3% net long versus 30,7% in spring.

So, is it 2008 all over again?. And what if it is?.

From where I am standing it is not 2008 all over again and even if it closely resembles it, one should not shy away for putting new money to work as we speak.

Firstly, leverage levels are way down from 2008 as corporations have been piling cash on their balances and reducing operating expenses to endure an economic downturn. With the exception of certain corporations (Bank of America comes to mind), public entities are in much better shape than in ’08. Just as importantly, equity prices seem to reflect a long drawn-out economic malaise as the current 12.6 S&P 500 P/E ratio implies. Comparing this starting point with the levels reached before the 2008 debacle should provide investors some comfort.

Whilst a new recession cannot be ruled out, the fact remains that money has to flow somewhere and the alternatives to equities are hardly appealing today. Gold, which lest not forget produces no income, is reaching stratospheric heights, US bonds (10-year) yield little over 2,2% even after the S&P downgrade and the real estate market shows no signs of life.

It is unlikely that we have seen the end of downside volatility for the time being and macro-economic uncertainty may continue to dampen spirits. However, from a valuation standpoint, some compelling company-specific opportunities are appearing and we may soon experience yet another investing “2009”.

To quote Mr. Warren Buffet’s memorable words from October 2008 as he made his landmark investments in GE and Goldman Sachs:

“If you wait for the robins, spring will be over”

Amateur Tennis and Investing Glory

2011-07-26T12:35:00.000-07:00

What do Tennis players and investors have in common?.

Not much, surely.

Could you think of a couple of more apparently unrelated activities?. There’s little shared between those at the top the ATP rankings and successful investors. Physical fitness is certainly not one of the common traits. In fact I can think of few activities that are less taxing on the body than indulging in the capital markets.

Shift your focus away however from the Federers and Nadals of this world and towards your average amateur player and you’ll begin to see an emerging picture… Come to think of it, for those of you that partake in the sport, what is the single most important determinant of the outcome in most of your games?.

High ace count? I doubt it.

Blistering fore-hand winners?. Probably not.

Inspired cross-court volleys?. I don’t think so.

How about just consistent reduction in unforced errors?. Yep, that’s it!.

For most of us, and I certainly include myself in this category, tennis is a “loser’s game” with the match going to the player who hits the fewest losers. The same can be said for successful, sustained, long-term investing performance.

I mention this after reading a following wonderful analogy in Howard Marks’ “The Most Important Thing”; itself taken from an article published by Charles Ellis back in 1975 in the Financial Analysts Journal.

Below follows a rather long but eloquent transcript from Mr. Mark’s book which illustrates beautifully the concept:

“His views (Charlie Ellis’) on market efficiency and the high cost of trading led him to conclude that the pursuit of winners in the mainstream stock markets is unlikely to pay off for the investor. Instead you should try to avoid hitting loser. I found this view of investing absolutely compelling.
The choice between offense and defense investing should be based on how much the investor believes is within his or her control. In my view, investing entails a lot that isn’t.

Professional tennis players can be quite sure that if they do A, B, C and D with their feet, body, arms and racquet, the ball will do E just about every time; there are relatively few random variables at work. But investing is full of bad bounces and unanticipated developments, and the dimensions of the court and the height of the net change all the time. The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment. Even if you do everything right, other investors can ignore your favorite stock; management can squander the company’s opportunities; government can change the rules; or nature can serve up a catastrophe…

...the bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match. Thus, defense – significant emphasis on keeping from going wrong – is an important part of every investor’s game”.

So you see, apparently, even us dull “plodders” stand a chance of reaching ultimate investing success.

If only we approached the markets in the same way as we relentlessly return the ball to the open court…

Good things come to those who wait

2011-07-18T06:40:00.000-07:00

Regular readers may have noticed the slow-down in my blogging frequency as of late.

Partially, and not surprisingly, it comes down to lack of time. There is however a more subtle yet equally valid reason also at play. Consciously or not, I have been applying a more patient approach to investing matters. This translates into equal amounts of reading, (this part of the equation will not be reduced), but significantly less actual decision making, whether it concerns specific investment action or writings.

In the spirit of one of my very first posts some 2 years ago (see “It’s often better to just sit still”), the last 3 months been a period of much reflection but little action.

The turning point for me came very suddenly and in crystal clear fashion when I mentioned to my wife a very recent (less than 4 weeks old) stock purchase. For you see, the first question that came to her mind was not an enquiry about the company itself or its economic health or financial performance at all. Oh no. She wanted to know how the stock had performed since I acquired it. Once again, note that I had bought it less than a month before…

Not only did I not have an immediate answer, (I do check spot prices but not on an hourly basis), but more importantly I honestly didn’t really care. The security in question had been bought on the basis of its very favorable (read: cheap) valuation on an absolute and on a relative basis, and returns would be obtained by closing this apparent price-to-value gap. Not a feat I expected the market to accomplish in 4weeks!.

As I went on to explain to her the relevance of balance sheet strength, competitive advantage, brand power and a positive cash-flow trend, an interesting thing happened. She acknowledged the importance of these factors but remained inquisitive about the current stock price. This, as it happens, is the way that most of us operate, guided more by the daily gyrations of a volatile marketplace and than by the underlying factors that truly matter in the long run.

Looking back, I see no reason to change my approach, other than the intrinsic difficulty in its daily application. As anyone with an internet connection and access to TV will attest, it is nigh on impossible to shield oneself from the onslaught of economic “news” and financial “information”. These days, as events unfold regarding the Greek debt crisis and the US debt-ceiling debate, all manner of folks seem to be conversing about such, until recently at least, arcane issues. Passivity right now is awfully hard.

Patience, temperament, and a cool head, do not come naturally. Not for most and certainly not for me. There are however, some methods that serve to minimize our natural “instant-gratification seeking” tendency and provide us with good odds of decent returns:

1. Approach investing as you would saving for your kid’s college fund. Set-up a specific separate account and write up a “contract” for yourself detailing under what exceptional circumstances you would withdraw money for this account. Come back and check the balance 10 years from now

2. Set-up news alarms for your chosen stocks (or companies’ in your funds) related to quarterly earnings reports, and major management changes.

3. Track annual financial performance via public filings (10 Q, 10 K) and make a conscious effort to infer stock price from accounting statements and not vice-versa

4. Review long-term (minimum 10-year) individual securities or index / fund performance. Note that even after the horrific crash of 2008, many good companies and funds have already reached new highs. Underperformance for good stocks does not last forever.

5. Think of your financial investments in the same manner as your education. Even though the return on academic training is initially negative and often slow in coming, the passage of time inexorably delivers considerable value

There’s little to be gained from rapid-fire speculation, except heavy broker’s fees, and higher taxes. And with the long-term odds in your favor, I’d rather be a tortoise than a hare…

Back to the "good" old days

2011-06-11T05:42:00.000-07:00

Recent furore over the IPO of professional networking site LinkedIn, no doubt substantiated by its first trading day price jump of 109% and its $ 8.95 Billion valuation, smells like déjà-vu.

Despite the considerable bout of common sense spouted by its CEO, Jeff Weiner as he was interviewed on CNBC on May 19th on the day his company started trading on the NYSE, alluding to the limited relevance of first-day performance and LinkedIn’s focus “on the fundamentals”, one can’t help but think that we are back to the merry days of 1999. Have we learnt nothing?

Besides the purchasers of LinkedIn’s post-IPO equity, there are ominous references to the kind of speculative behaviour that led to the stock market crash of 2000-2002. Back then as we approached the turn of the century, no brows were raised when sound valuation criteria, either earnings or asset-based were supplanted by more questionable variables such as “clicks” and “eye-balls”. In this instance, following the “success” (for bankers and insiders at least) of LinkedIn, financial journalists and other commentators were fast to question Price/Earnings ratios as next to meaningless.

The truth however is rather different and for the most part, unpleasant.

Valuation wise, the $ 94 per share price can spell nothing but trouble for the future. Diluted Earnings at the company are reported at around $ 3,7 Million, which translates into 7 cents per in earnings per share (EPS). Put it all together and you get a x 1342 P/E ratio. Sure, some 3 weeks have passed now and, as of the last trading day, the company has shed about $ 2,7 Billion in market cap and now sports a lower, but still outrageous, x 1040 P/E.

For the sceptics out there who expect enormous growth to justify these ratios and drag up the denominator (the “E” in P/E), you’d be wise to note that the company itself expects to break-even in FY2012, thus dashing any hope of an earnings driven price justification. Whilst optimists point to examples such as Google to underpin the LinkedIn investment thesis, there are some notorious differences between the two. Firstly, Google was very profitable ($ 500 Million in earnings in its first year as a public entity), not the case with LinkedIn. More importantly, even the mighty Google has seen its once sky-high P/E ratio and stock price decline and remain flat respectively for the since its peak in November 2007. Today it trades at a reasonable x20 P/E

Using other valuation parameters does little to appease concern as the company is, as you’d expect from an internet play, “asset-light” and therefore trades at x 48 the value of its net assets, or book value.

Despite the ample evidence of the mean-returning nature of stocks (i.e. P/E ratios of over X100 always must and will end in tears), talk abounds of further web-darling IPOs. Bankers and would be speculators eagerly await similar IPO-filing announcements from Facebook, Zynga or Groupon. Business magazines are today busy writing glowing articles on these web 2.0 companies much as they did in ’98 and ’99 with the likes of Webvan, JDS Uniphase or CMGI.

Whilst some of these new ventures will survive and indeed prosper, precedent would suggest to not bet on these names. To put it in the words of Joseph Anthony Wittreich:

“History doesn’t repeat itself, but it does rhyme”.

If the complete disregard for valuation risk, exhibited by the outrageous prices of recent IPOs and even private placements of pre-IPO entities, (of note is Goldman Sachs’s investment in Facebook at $ 50 Billion valuation in January 2011) , were insufficient evidence of an impending bubble, there’s more to show. As in previous periods where temporary infatuation with specific sectors of the economy was the norm, there are other components of the business fabric, which, as if to compensate, are blatantly ignored by the investing public.

Being as it is, with funds a finite resource, it should come as no surprise that profitable, asset-rich, brand-protected, business cycle-proof, price insensitive concerns can be found to trade at single digit P/E ratios. How else does one explain the x9 P/E ratio of Xerox?. The almost euphoric atmosphere characteristic of the “new web players” is offset by an excessive pessimism around older concerns. These days, established entities whose growth rates are not projected to exceed 50% are prematurely labelled as “have-beens”.

There is indeed a party going on (as it was in 1999) but we all know how this one will end!.

Who really moves the markets?

2011-05-10T12:45:00.000-07:00

Don’t waste your time in the stock market.

It’s Mr Bernanke, the big boys with their Bloomberg screens in the football-pitch-sized trading floors and the behemoth quant funds that make all the difference. These folks account for over 90% of the daily volume in major exchanges. Further consolidating this picture, the increasing presence of High Frequency Trading funds have pushed the puny individual value investors’ clout further out from the circle of influence.

As we are often reminded, large sophisticated insiders and professionals "move" markets and the rest of us “mere mortals” are left to pick up the metaphorical scraps left on the table. Is there in fact any hope for the individual investor or even the small value-based fund to challenge the battery of all-powerful traders, speculators with deep pockets and lightning-fast trading platforms?.

Maybe, most probably, not in the short run.

Applying a longer term horizon to our investments, however changes the tables rather significantly.

Although the volume data is incontestable, the actual performance in terms of returns on investment tells a very different story. Recent data published by Janet Lowe in her excellent book “The Triumph of Value Investing” points to the liquidity-providing function of high-speed trading funds rather than their market direction-setting impact.

Further analysis of stock market indexes performances since the 1960s confirms that high volumes of trading action in a single identifiable (bear of bull) direction are by nature both self-fulfilling and doomed to reverse violently. The tech-driven boom of the late ‘90s was immediately followed by the brutal ’00- ’02 correction and more recently the credit-fuelled speculation that raised all asset classes up until late ’07 was too replaced with a horrifying drop in securities prices for the subsequent 18months.

Despite having access to the “best” minds in the business, and armed with the most powerful computers and most comprehensive information networks, the afore-mentioned “big boys” failed themselves and their clients miserably twice in a decade.

And what about individuals and small value-based funds?. Information on the former group is by definition hard to come by (though not impossible, see “The Warren Buffetts Next Door: The World's Greatest Investors You've Never Heard Of and What You Can Learn From Them” by Matthew Schifrin for some enlightening showcases).

On the fund front, the performance of prominent value investors such as Daniel Loeb of Third Point Capital, Francisco Garcia Paramés’ Bestinver Asset Management, Mason Hawkins’ Longleaf funds or David Einhorn of Greenlight Capital show the benefits that accrue to contrarian investing. Each of these true investors, in direct opposition to the speculative nature that constitutes the bulk of today’s market action, has delivered bumpy but overall great annualized net returns, topping 10% at a time when indexes were barely in positive territory and large funds actually lost money (nominal and inflation-adjusted).

Just as interestingly, mimicking the actions of these value-investing giants requires none of the tools leveraged by the average large institutional players. In fact, being an individual investor, free from arbitrary investment mandates, conventional limitations or index-hugging temptations will result in a clear advantage from the start.

In the mind of the independent investor shall resonate the following phrase (To borrow from the current incumbent at the White House), yes we can!

When all is said and done, when the dust has settled after the latest CNBC-cheered uptick, prices invariably gravitate towards their true value.

I insist; no matter what happens in the meantime as the ticker tape on the bottom of your screen fluctuates randomly, prices must and will reflect underlying asset worth and earnings power. This is a fact and there is scant indication of it changing anytime soon.

As the French say, Plus ça change ...

Apple products & Dell stock

2011-04-18T08:38:00.000-07:00

Apple, Inc seems to be the rage not just with design-conscious young consumers but also with the hedge-fund crowd. Many famed investors including David Einhorn, (see here) are holding and talking up Apple stock resulting in its remarkable performance over the last few years. Its stock is up 32% in the last 12 months and some 184% since April 2009.

In all fairness Apple scores favourably on two out of three criteria for profitable stock selection, as it represents a high quality franchise with attractive growth prospects. Focusing on the “quality” component, it would be hard to argue against this behemoth, trend-setting company. For the last decade, all of its product launches have been runaway successes shaping the technology and entertainment industry.

Starting with the ubiquitous Ipod family of products, followed by the ground-breaking- Nokia-killing Iphone and ending (for now at least) with the category–creating Ipad computer, Apple has delivered a run of hits unparalleled in recent corporate history. Management too has been both stable and focused, led by the visionary that is Steve Jobs and his trusty and effective lieutenant, Timothy Cook. Add to this a set of world class engineering and design talent, motivated to work in one of the most admired companies in the world and you have the ingredients for a classic virtuous circle of quality.

On the growth front, and despite its stellar run in the 21st century, ample space remains. Apple’s products derive industry-leading margins and continue to be priced at the higher end of the spectrum. Even minor price concessions or an extension to the current distribution partnerships (especially in the area of mobile telephony) in place in the US and Western Europe would likely deliver huge sales unit growth. And bear in mind, that Apple’s footprint in large, growing markets like China and India is currently extremely low.

The third leg of the above mentioned criteria, valuation is however, where Apple stalls. Much as I, and pretty much everyone I know, love this company, its products, stores, branding, design and user experience, I am not inclined to extend my purchasing to its common stock. Apple trades, as of the date of this writing, at a lofty 18x Earnings-Per-Share (EPS) on a trailing basis and its market capitalization represents 5,5x its accounting book value. Even allowing for the fact that book value if of little relevance to companies outside financial services with large amounts of intangible goodwill, as is certainly the case with Apple, 5,5x seems unwarranted.

A further source of concern for the potential investor ought to be the implicit growth expectations built into its current price. Admittedly, as pointed out earlier, opportunities to grow abound but not at the level expected or “priced-in” by the market. To illustrate this point, note that Apple’s Fiscal Year 2010 revenue topped $ 76 Billion growing 54% year-on-year. To merely maintain this momentum would mean finding an additional $ 41,1 Billion in new sales, no mean feat in the current macroeconomic climate!.

Taking the other side of the trade however, is not really an option either. Shorting Apple at this stage and with its stellar balance sheet (low debt , $ 27 Billion cash balance and annual free-cash flow of $ 6 Billion), would not be wise.

Faced with this conundrum I offer some food for thought in the (almost) same space. How about DELL?.

The corporate leader in IT solutions sports:
1. an attractive 10x P/E ratio 2.
$ 10 Billion in net working capital (excluding inventories, of course)
3. A hugely valuable brand
4. a less-fickle target market (corporations with large cash balances)
5. It is, once again, run by its remarkable founder, Michael Dell.

I will certainly be looking at DELL more closely.

Uncertainty is welcome here

2011-04-04T10:50:00.000-07:00

There are no certainties in life, of that you can be sure.

However, if there is one area of endeavor where the perceived value of being sure is highest, that is in the world of investing. Just how many financial press advertisements or investment newsletters with the following taglines have you seen lately?

Unbeatable system guarantees 10% annual returns!

Beat the market with no effort!

Learn to trade like the pros, maximum return with minimum risk!

Whilst undoubtedly appealing to the average (and not so average) folk, messages such as these should trigger a knee-jerk reaction to run a mile in the opposite direction. If I am not mistaken, one of the most recent “examples” of a constant gradient, 10% annual price appreciation curve was provided courtesy of a certain Mr. B. Madoff… This would suggest that steady “certain-like” investing returns are indeed a rare breed.

And yet, it’s not so easy to walk away from marketers touting appealing track records (no matter how brief they might be). So, you may rightly ask, are we simply too gullible to stand a chance of selecting the right investment fund/manager?

Not really.

Humans are drawn to certainty and “black or white” decisions. Since the dawn of time, our species has sought the guidance of leaders as a source of protection and eventual well-being. Typically, over the ages, we have renounced our own criteria and taken comfort in the views of others whose own vision was shrouded in an aura of certainty. That is, we place our trust on those driven by a cause or mission deemed to be “certain”.

Consequently, uncertainty, or its related cousin, ambiguity, continues to be perceived to his day as a flaw to be eradicated. This is most glaringly apparent in the money management business today. Can you picture you typical equity or fixed income fund manager actually admitting their concern over a list of possible outcomes from their investment decisions? To most, this would be akin to committing commercial suicide.

But not to all.

Although clearly counter intuitive, the notion of being unsure is a pre-requisite to long-term investment outperformance. To quote the always eloquent, Seth Klarman:

“There is value in not being sure”

Think about it for a moment… how do you act when you are not sure about the potential outcome of your decisions? Whether you are purchasing a new refrigerator or selecting a school for your kids, you most probably consider multiple factors, probabilities, and consciously or not, assign weights to the likelihood of each possible “outcome” as a result of your decision. Such “common sense” like behavior effectively reduces your risk without completely eliminating it.

Applying the same patient process to investment selection should deliver optimal results despite the lack of certainty. By digging a little further in your elusive, never-ending search for complete information you probably establish a range of values for your valuation parameters, erring on the conservative side.

Accepting the fact that perfect information is a utopian concept , you will probably practice a minimum of diversification in your investments, allowing for the fact that you may, after all, be wrong or just plain unlucky!. And yet, admitting the inherent uncertainty of the investment pursuit is the cornerstone of a rewarding investment experience.

“Happy” 2nd anniversary, Mr Bull Market!

2011-03-20T02:01:00.000-07:00

Be afraid!, be very afraid!... , or so goes a cheesy tagline from a noted ‘80’s horror movie. Silly as it sounds, it may just be the right prescription for approaching financial markets today.

As I write these lines in mid march 2011, what seems like the whole world is engaged in collective celebration as we enter the 3^rd year of a remarkable, 24-month upward surge in the broad benchmark S&P 500, doubling its price level in this timeframe. As usual, financial journalists and all manner of market “savants” are joining the party and further exacerbating the trend.

Over the last few weeks, even as we witness both the turmoil in Libya, Yemen and Bahrain, and the tragic human consequences of a mammoth earthquake and tsunami in Japan, there’s no de-railing this euphoric sentiment. At least not yet…

Deeper, or in fact any analysis of the underlying health of the world’s largest economies depicts however a rather fragile state of affairs. First and perhaps most importantly, the current historically high level of corporate earnings can be, to a large extent, explained away by the abundance of cheap credit. Sound familiar? Yes, the same recipe for getting us to the 2007-2008 bust in the first place. This time also coupled with totally indiscriminate distribution.

Put another way, it’s not too difficult to report growing earnings when money is almost free and also ubiquitous!. Furthermore the distinction between sound businesses and run-of the mill enterprises is dangerously blurred as the tide of capital raises all boats.

Whether intentionally or as an act of suspensions of disbelief, investors seem willing to ignore the waning of an imminent end to the US Federal Reserve’s lax monetary policies, better know as quantitative easing. Is the picture becoming clearer now?

For those not yet convinced about the risks lurking behind the scenes today, here is some food for thought.

Unemployment is at nearing 10% in the US and above 15% in some of the PIIGS. Quite clearly, demand for corporations’ products and services cannot be expected to keep growing with decreased purchasing power from would-be consumers.

Low hiring rates across corporations (the flip-side of unemployment) reveal that much of today’s earnings are driven from inventory level reductions and increased productivity rather than the healthier top-line growth component.

With both sovereign-issued debt and corporate paper yielding negative returns after being adjusted for inflation, and real estate’s protracted secular decline still in progress, much of today’s inflated stock valuations reflect equities status as an investment of last resort (with the notable exception of gold, of course).

All in all, as we prepare to enter spring we should also brace ourselves for a potential number of lean years. Markets are priced for perfection and nothing else will do.

Negative earnings surprises, additional energy shocks or the eventual (but absolutely inevitable) rise in lending rates will turn the collective euphoria into a mad rush for the proverbial market exits. The fact that we have seen it all before, many times over, does not in any way make this prophecy less likely to occur.

However, not all is lost.

At least for disciplined value investors. To them I offer the following message: worry not for the “market” matters little when the search is aimed at individually compelling investment opportunities whilst the herd is busy in a frenzy of liquidity- seeking forced selling.

Such a time may come sooner than we think.

Time is precious, don’t waste it talking to management

2011-03-05T05:26:00.000-08:00

Good business, able management and an attractive valuation. Conventional wisdom suggests that these 3 factors are the basis of sound investment decisions. Consequently compromising on one of the three is a sure route to poor results.

Or so they say.

For a long time now, I’ve pondered about this holy trinity and its impact in real, practical decisions. I struggled with item number two: “Able management” for two reasons:

History suggests that in “strong management versus weak business” situations, the odds favour the perpetuation of the business’ incumbent status. Warren Buffet’s foray into US Air, or more recently, Jean-Marie Messier’s disastrous erosion of market value in the case of Vivendi, bring this concept home in rather clear light.

As Mr. Buffet himself has stated,

"When a 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."

Even under the assumption that management might be able to turn businesses with lousy economics into economic wonders, just how does one go about identifying such management ex-ante?. Sure, we all know now about Steve Jobs turning Apple around in the last decade and unlocking enormous value, but how many would have bet on this outcome in 1997?

Were this not enough to discourage spending one’s precious and finite time on investigating management skill, honesty and motivations, there is a much darker truth out there.

Objective research suggests that actual, direct contact with company management is, for the most part, a waste of time. As renowned behavioural finance expert James Montier writes:

“Managers of companies are just as biased as we are and suffer from over-optimism and over-confidence”.

Quarterly surveys conducted by Duke University on a universe of some 500 CFOs of large American companies over a 4-year period (2002-2005), reveals some very interesting traits:

§ When asked about their own company’s growth expectations versus those of the economy as a whole, management, on average, where some 10% more optimistic regarding their own business than that of the broader economy. Statistically this is simply impossible, but that did not stop their rosy forecasts!.

§ On the subject of stock valuation, a remarkable 63% thought their stock was undervalued, and some 32% though their own fairly valued. This leaves a measly 5% of over-valued stocks by their own admittance. Hardly likely!

In practical terms, these opinions, for indeed this is what they are, are about as valuable as those of the conflict-ridden Wall-Street analysts of internet boom era circa. 1999. This latter group, led then by the infamous trio of Jack Grubman, Henry Blodget and Mary Meeker, encouraged a generation of gullible folks to invest in weak companies at nosebleed valuations on the mere basis of their so-called expert research.

Some 10 years later only Miss Meeker remains in the business, with the other two disgraced and banned from the securities industry.

To be clear, I am not claiming that company management, whose frequent investor relations activity, seems closer to cheer-leading than unbiased information dissemination, should suffer the same fate as the former analysts. But, in the interest of good decision making on the part of investors, I unequivocally advocate limiting contact with management to an absolute minimum.

In so doing, valuable time can be freed-up to afford deep arms-length analysis of business economics and unbiased valuation research. As the say in some rather more fashionable circles than the ones covered here:

Less is more.

Not so free markets

2011-02-08T07:13:00.000-08:00

It hardly seems contrarian or in any way original, these days to engage in a bout of “Fed-bashing”. And yet the appeal is almost irresistible, even some 3 and a half years after the onslaught of the “global recession”. In spite of my natural inclination to question the predominant opinion of market pundits and armchair economists (are here any other types out there?), I will merrily join them just this once as they continue to aim their metaphorical darts at Mr. Bernanke.

So, what prompted this sudden round of Anti-Fed sentiment?. To be perfectly honest, there’s little sudden about it. Ever since the crisis meetings held by our friend Ben in late 2008, in conjunction with the EU’s ECB, the UK’s BOE and Japan’s Central Bank, I have followed the actions of the Federal Reserve with a critical eye.

Sure, at the time as Lehman’s last hours reverberated across financial markets world-wide, I, like most sane people, felt that the coordinated actions of central banks across the world were not only warranted but in fact essential to hold our fragile confidence-based system together to survive and see another day. However, not long after that fateful second week of September 2008, the actions of both the Fed and indeed the US Treasury took a rather random turn. On the one hand, backstopping (ruined) financial giants like AIG whilst at the same time blatantly interfering with free functioning markets via the temporary ban on short-selling activities.

Remarkably enough, this sort of behavior simply has not abated even as we enter 2011. But how could it? After all, the main man behind the wheel, Mr. Bernanke, has willingly admitted that he simply did not see the crisis coming and more importantly “it could not be predicted”!. In short, ordinary citizens, sorry I meant tax-payers, are asked to trust a man who is unwilling and unable to see the obvious bubble-formation on the way up and hence proclaims to be powerless to act. You’d think this weakness would work both ways right?. Wrong.

Consistent, repetitive and clearly excessive use of the tools at Mr. Bernake’s disposal (direct control of the money supply and indirectly of interest rates) has been the hallmark of his actions for the last 36 months. The Governor’s ability to make errors doing all phases of the bubble-to-bust cycle, firstly of omission and ultimately of commission defies the most basic logic. As I write these lines, the second round of money printing is well under way in the US and interest rates remain dangerously close to zero, providing an enormous distortion in the fundamental functioning of a market economy.

Ultimately, as the first signs appear to point that the worst is over and indeed this too “shall pass”, what remains in place is the foundation for a much larger disaster in the future, aided and abetted by a reckless, short-sighted approach. Tax-payers the world over can thank Mr. Bernanke for transferring what was essentially private-market risk onto the wider public ,i.e. us.

On a more micro-level, the damage done to, would-be shrewd asset allocators or to the more mundane community of individual stock pickers out there, has been and continues to be very substantial. The Fed’s actions have made the distinction between weak and strong, well-managed companies very blurry indeed. In the words of Barclay’s strategist Matthew Rothman:

“… After all, a company that is generating lots of free cash flow and has a strong balance sheet …will not be particularly helped by a cheap money regime. Free money doesn’t help them. Instead, it is a company with low cash flow and no cash reserves… that will be disproportionately helped by what is effectively free money. In these situations, true fundamental investors who focus on such banalities as valuations, free cash flow generation, the repeatability of earnings and the return on shareholder equity find themselves struggling to generate returns”.

It is against this backdrop of market tampering that investors must operate in. I just hope that the trend of free money is soon reversed and we all learn to live with the consequences and proven virtues of true free markets.

The waiting game

2011-02-02T23:47:00.000-08:00

Oftentimes I find myself torn between on the one hand, the desire to act in an almost impulsive fashion, taking fast decisions on investing opportunities and, on the flipside, the call for caution and calm thinking.

Lately, and much to my dismay, the “cautious fellow” approach has been winning the battles, if not necessarily the war. My quest for thorough information in security selection and the methodical, open-ended research effort applied to recent opportunities has resulted in some rather metaphorically “low-hanging fruit” not being picked. To be precise, despite recent and obvious write-ups on a number of attractive stocks (see Zimmer here and BP here), no action was taken on my part resulting in considerable price appreciation being foregone. In the more recent case of Zimmer Holdings (ticker: ZMH, a 25% return could have been attained in the span of just x months!. Ouch!

Many a wise investor with years of experience under their belts have referred to the business of asset management as one where, to use baseball parlance, “no strikes are called”. Indeed, theory would suggest that opportunities abound and one should not be constrained to act on every hunch. As the famed risk expert and author Peter Bernstein once put it:

“Once we act, we forfeit the option of waiting until new information comes along. As a result, not acting has value. The more uncertain the outcome, the greater may be the value of procrastination”

I myself would find it hard to argue with the fact that lost opportunity is preferable to lost capital. And yet, lately I’ve been unable to shake an uncomfortable feeling of almost cowardice derived from my lack of investing commitment.

Perhaps the time-tested advice to “sleep on” difficult decisions, is not one that can be universally applied, at least not to investment decisions, which in my book most certainly fit in the “difficult” category. Gathering valuable, impartial, factually correct information about companies is by its own definition a constant process, where perfection cannot be achieved. At least not without the risk of relying on illegal insider information…

Academic research also points to the risk of ascribing excessive importance to new-found information. A recent study, the aptly-titled “On the Pursuit and Misuse of Useless Information”, suggests that additional information provided late into a decision-making process can have a disproportionate impact on the actual decision, often undermining the solid foundation on which the until-then decision was based.

Stated simply, we remember best and rely on the most, on the last piece of information we receive and process. Clearly this flaw could undermine careful consideration of important decisions; or just as gravely, lead one to inaction. Whilst the opportunity cost of inaction in an investment context is perhaps less severe than in other environments, there is certainly a cost attached to this dithering.

Psychologists, and indeed popular wisdom, points to the admittance of having a problem as the first step is the process of correcting that problem (just think of the famous “my name is xx and I am an alcoholic” lines pronounced at AA meetings…).

For my part, I can see not only the cost of my inaction and its obvious consequences in terms of foregone financial gain, but also the impossibility of obtaining full / perfect information prior to committing capital. And yet, it is a very fine line to tread as the search for value continues. I just hope that experience leads to better act / not act decisions.

Investing shortcuts

2011-01-29T05:41:00.000-08:00

A recent re–read of the remarkably successful, (in investment literature circles at least), “The Little Book that STILL Beats the Market” got me thinking once again about just how much effort is required to obtain a worthy return on one’s investment efforts.

Mr Greenblatt’s updated “Little Book” , now encompassing the great recession of 2008 suggests that in fact only a 2-factor model (going by the almost comical name of the “Magic Formula”) is required to extract out long term successful results. Doubters can refer to the following data to dispel any doubts:

Year S&P 500 returns Magic Formula Returns

2007 5,5% 7,1%

2008 -37.0% -38,8%

2009 26,5% 58,9%

1988-2009 (AAGR) 9,5% 19,7%

These results and the whole notion of simple 2-factor models like Mr Greenblatt’s, (based on earnings yield as measured by EBIT/EV and return on assets as measured by EBIT/Net Working Capital+ Net Fixed Assets) fly in the face of the teachings of many so-called “active” value investors, for whom anything short of complete intimacy with the target company is but heresy.

On the other extreme (and as we discussed a couple of weeks ago) is the world of indexing. Successful of course, in the very long term; but hardly a recipe for stellar returns. So what is one to do?

My own inclination, as documented in this blog on numerous occasions, favors the dedicated effort to truly understand specific industries’ competitiveness drivers, financial health AND stability of the security issuer and, where possible, the interests and incentives of incumbent management. Notice, I used the words “where possible” for it often happens that access to management is not only difficult but in fact, on occasions counter-productive…

On this issue, I recall once asking a question at an annual shareholder meeting of a renowned mutual fund management company in Spain, regarding the value of talking to management, were the response was none other than:

“We (the fund managers) are most interested to hear from those companies that do not wish to speak to us”.

In order words, joining the ranks of your average cheerleading / analyst /sycophant feeding on media-friendly companies staffed with extensive Investor Relations departments serves absolutely no purpose at all. So far so good for us non-institutional investors with limited access to mighty “management”.

In this day and age, where abundant literature permeates our book-stores and public libraries enticing readers to benefit from low risk, low effort –high return strategies it is especially important to retain a generous dose of skepticism. In an attempt to strike at the elusive middle ground between achieving a reasonable amount of knowledge and competency and overdoing the research in an effort to find evidence supporting my pre-conceived notions, I will quite happily run of the risk of exceeding on the former.

Notwithstanding the fact that no substitute has yet been found to take the place of thorough, focused preparation as the basis for success, it seems that that patience, and disciplined persistence in the process, as shown with admirable clarity in Mr Greenblatt’s updated book, accounts for the lion’s share of most success stories.

Making the market work for you in 2011

2011-01-08T07:19:00.000-08:00

We are now one week into the 2011 and it’s probably about time for some reflection on the year that just concluded and some planning for the new one just starting. Looking back, the performance of major indices, such as the US based S&P 500 has been more than decent at 12,78% (15,06% including dividends reinvested), with the broader MSCI All-World Ex-US delivering a handsome 13,2%.

Needless to say, these appealing results were readily available with little risk and negligible cost to holders of diversified index-funds such as the Vanguard Total Stock Mkt Idx Adm VTSAX. To quote from Tori Amos´ classic 1994 tune, it has been a “pretty good year”.

And so it seems that despite the turbulence and volatility of recent times, the heated debate in the US around the new Financial Regulation bill, the second round of “quantitative easing” (a.k.a. money printing), and the near complete obliteration of our global financial system as we know it, capital markets performed and provided your average, namely passive participants with a healthy return on their money. Faced with this picture my thoughts turned once again towards the rationale for active investing. Back in June 2010, I argued steadfastly in the face of heavy odds for the benefit of trying to be above average in the investing playground particularly as “average” since the beginning of the century had come to mean, “sub-par” in real terms.

Not so anymore it seems. If the last 12 months´ numbers are not convincing enough and in fact you think, ¨I could do much better than that by picking winning stocks myself or by putting my money with a hot fund…¨ think again. Just ask the legendary and much-respected investor and inventor of the index fund, John Bogle, about the how this approach has performed over time. In his 2007 work, “The Little Book of Common Sense Investing¨ he calculates that only 2% of all equity mutual portfolios will outperform the stock market over 50 years. So, good luck finding the 2%!.

So much for reflection on past performance and the year that was. Turning now to what matters, (i.e. that which we can do something about) finds me taking the opposing view to Mr. Bogle and confirming my thoughts as expressed in June of last year.

The primary reason for my stubborn, (some might say obsessive) defence of an active investing approach for the year 2011 and for that matter for ANY year, is that the facts warrant it. Were it not the case I would be first in line to adhere to the wise words of one JM Keynes who stated:

“When the facts change, I change my mind. What do you do, sir,?”

The facts I am referring too are the lacklustre performance of market averages over more significant periods of time. 3, 5 and 10-year returns for the S&P 500 have been -3,1%, 2,1% and 0,3% respectively. In similar fashion geographic diversification yielded little safety as the MSCI All-World Ex-US delivered a paltry -5,66% for the last 3 years and 1,87% annually since 2006.

Although fund-chasing is statistically a loser’s game, individual stock picking need not be so. For one, individuals have but themselves to answer too and have no incentive to subtly trace an index. Substantiating my optimistic outlook for the private investor in 2011 is the fascinating account of 10 completely unknown (until now anyway) individual investors portrayed in the recent “The Warren Buffetts Next Door: The World's Greatest Investors You've Never Heard Of and What You Can Learn From Them”.

Here, laid bare in the simple yet effective style of journalist Matthew Schifrin, are the ongoing success stories of a set of unrelated individual investors who chose to take an active role in managing their money. A number of them have been beating, or should I say trouncing, market averages by over 10% annually over 5 and 10-year periods. The common trait shared by these folks is not accepting the market’s irrational whims but rather making it work for them.

Mr Benjamin Graham, the father of value investing, would be pleased with these efforts as they represent the spirit of his conceptual role for the “market”, relegated to the role of “servant” as opposed to leader ofintelligent investors.

As 2011 unfolds, this is the side I want to be on.

Seeing the forest for the trees

2010-12-21T06:55:00.000-08:00

Watching my 5 year old son playing on one of those simple and addictive mobile phone-based games reminded me of the behavior of many an investor. The central focus of my offspring is not the game in itself but rather the points tally shown on the top of the small screen. Unremarkable as that may seem, it does however bear a striking resemblance to the real-life actions of investors.

There’s little difference between my son’s dealings and the typical attitude of so-called investors. The latter openly declare themselves as buyers for the long-run and yet seem to measure their success (or more likely their failures), on the basis of the minute-by minute quotations provided by the internet, financial news networks of the daily press. Why grown adults choose to be judged in this manner is something that to this day eludes me.

Surely if some thought has gone into the buying decision (and that is a big “if”), the same thorough process ought to be followed for the reverse course of action. On various occasions in the past I have made a point of the almost total irrelevance of the daily financial banter that is passed off as “news”. As a matter of fact, switching the TV off and not reading certain financial newspapers may actually be an advisable route for those with an impending urge to act.

Acknowledging that in today’s hyper-connected society the afore-mentioned, “cold-turkey” hibernation-style strategy is a tall order and very unlikely to be applied consistently, I offer another approach. How about giving some though to the very few factors which actually move a stock’s price? As few as 2 in fact (if we exclude the ever diminishing impact of dividend policy).

For you see, the fact remains that since the dawn of time only 2 drivers determine stock prices and hence should be of concern to us:
1. Earnings (absolute and growth levels)
2. Market-assigned price multiples (general valuation)

With this remarkably simple framework as a starting point, it becomes a whole lot easier to ignore all the irrelevant, short-term “noise” around us and simply make our decisions on sound policy. After all, who cares if the dollar-yen exchange rate has trended downwards last week or if the rate futures market for pork-bellies is in the words of yet another market analyst “somewhat overbought”?.

To the extent that these concerns have no impact on one’s equity holdings earnings expectations they should be ignored!. In fact the only circumstance in which it may pay to take into account the usual macro-based sound-bites is when they are used to act in the exact opposite manner to that which is suggested by its broadcasters. In other words, when all is positive around you, tread with great caution.

My own experience in this field however, suggests that nothing is as simple as it sounds and the temptation to act and to judge our performance on the basis of the quoted price points is a strong one for us all. By way of example, I purchased some 6 months ago a pharmaceutical stock whose price declined some 30% within weeks of the purchase date, only to rise some 25% in the last 2 months and to level currently at some 10% below my entry point. For sure throughout this volatile ride there were times when I was tempted to “cut my losses” and let the points score (remember my son’s game)?, determine my course of action.

However a revision of the original thesis to validate the assumptions made going into the purchase served to convince me of its long-term value and keep the focus where it should be: its earnings power and financial solidity. At this point my thoughts have turned to adding to the position rather than liquidating it.

Watching the game and focusing on the few things that matter will mean that ultimately the “score” will take care of itself!.

Value can be found (even now)!

2010-11-27T12:43:00.000-08:00

The sheer amount of macro-type (bad) news spewed out by all forms of media over the last few weeks has made it very difficult for those of us used to praising the virtues of a “bottom-up, stock by stock approach, to practice our craft. As a citizen of one of the much maligned “PIIGS”, watching one of the I’s (Ireland) succumb to a sizeable EU-bailout, hot on the trail of the biggest outcast of all (the Greeks), serene is not how I would define my state of mind.

And yet it is at times like these when it pays to be particularly discerning and factual in order to avoid the throwing of the proverbial baby out with the bathwater. With this in mind I made the effort to avoid CNBC television for an entire week (no small feat when one spends time in German-speaking countries without so much as a basic notion of the local lingo…). Time otherwise spent, or as some would rightly say, wasted, watching the usual talking heads from the US-based channel was instead put to better use by digging into publicly available information of some promising companies.

Simply running some basic low P/E, low P/B screens churned out a number of names that attracted my interest right away. Enhancing the output of this purely quantitative step with a mental check for company, sector and product familiarity led me to naturally focus on Zimmer Holdings Inc, (NYSE:ZMH) a US-based “global leader in the design, development, manufacture and marketing of orthopaedic reconstructive implants, dental implants, spinal implants, trauma products and related surgical products”, as described in the CBS Marketwatch company profile.

Put briefly, here we have a research-heavy, technological and brand leader serving a segment of the population which is experiencing secular growth unlikely to be reversed anytime soon, read the elderly. Demand for its products whilst not end-user driven, has been unwavering throughout the harshest economic downturn in the last 70 years, with revenues essentially flat of the last 3 years and EPS at a constant level of around $ 3,50. As such it current $50 equity price-tag is a very reasonable 14,5x.

If that were not enough, Zimmer enjoys large barriers to entry, (this is not a sector where low-cot Chinese knock-off are well received), has enviable cash flow, (some $ 700 M this year alone on revenues of $4 Billion) and considerable pricing power as a by-product of its category-naming brand (think the “Zimmer-frame”).

Balance-sheet strength is not a reason for concern as the company has been adeptly retiring debt and currently sports net current assets in excess of $ 2,1 billion versus $1.1 Billion in 2006.

Admittedly, the extent of the research conducted so far does not warrant an immediate decision, having only covered some 2 of the 7 steps I outlined in my stock search process as written up some months ago in the post “Process vs. Results”. However, full certainty can never be attained in this business and it does at least point us in the right direction. From here on in it’s up the reader to take it a step further and make up his or her own mind on ZMH.

If you ask me, it seems to provide the odds I like to play with…

Long live market strategists!

2010-11-16T06:49:00.000-08:00

I am always amazed at the uncanny ability of market pundits and financial journalists alike, to state the obvious whilst sounding like they just conveyed some groundbreaking news!. Over the last weeks or so a number of said types have littered television networks and investment newsletters with the following mantra:

“It’s a stock picker´s market”

As opposed of what, begs the question?. When pressed a little further, such “luminaries” will venture that given the uncertainty in capital markets, debt and equity alike, it pays to be picky in security selection. Notwithstanding the fact that we are navigating unusual uncertain times, I for one cannot think of a time when a selective approach would not be of use.

Not so for many “market strategy” professionals it seems!. Reading a little further into this collective´s new idea “du jour” would suggest that, absent a volatile scenario such as today´s, “investing” without much concern for individual securities in portfolio composition would be just fine. As a matter of fact numerous professionals have built (and unsurprisingly also buried) entire careers riding on the back of trends both cyclical and secular ones. In all fairness, there is nothing inherently wrong with this, just as long as the investing professional (and his hapless clients) understands the fragile foundation of this approach.

History suggests that luck can account for a significant portion of investment performance as was the case with buyers of the Nifty-Fifty growth stocks of the 1960,s (for a while) BUT given the mean-reverting nature of stock returns, a focus on riding the trend is surely a recipe for an eventual calamity. As always, Warren Buffet put it best with the following observation of investor differences in a bull market:

“Just as a rising tide lifts all boats, it s when the tide goes out that we shall see who´s been swimming naked”.

Sure, individual stock selection requires painstaking research, a thorough understanding of business and sector dynamics and above all an innate level of conviction to stand by one´s opinions. Joining the ranks of the “strategic asset allocators” or the “indexers” on the other hand, is not just clearly less strenuous but psychologically much more comforting. As John Maynard Keynes so brilliantly put it:

"Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally. ...

Investing, like most other productive endeavors tends to reward effort and quality of input in almost linear proportion. Put in terms that an economist would understand, there really is no free lunch in this game. Be that as it may, it astounds me to hear otherwise well-educated, travelled and reasonable individuals commend the virtues of trend following, asset allocation driven tactics, over the proven fruit s of discerning bottom-up security valuation and limited diversification.

And yet, for those of us who refuse to hand over hard-earned dough to trend-seeking, crowd -pleasing asset “gatherers” , there is reason for celebration. Without these folks opportunities to transact at attractive entry and exit prices would indeed be much more scarce.

Long live market strategists!

All bubbles burst

2010-10-10T01:46:00.000-07:00

Some 11 months later, (322 days to be precise) since my rather pessimistic review of Spain’s prospects nothing has changed to merit a change of tone on my part. Moreover, recent data published by the FT on the comparable performance of housing markets since the market peak in late 2006 / early 2007 has raised my concerns a further notch.

In said article, Edward Chancellor of institutional asset manager GMO, points to the perplexity surrounding the gravity defying performance of residential real estate in Spain. For, along with Australia, Spain stands today, some 4 years after the start of the nationwide price drop experienced in US real estate (which would soon be followed by unprecedented sharp falls in Ireland and the United Kingdom), on a league of its own having experienced what amounts to a minuscule 15% drop in real terms.

Some would argue, and indeed many do, that this is reason for joy and optimism, in lieu of my ill-placed concern. A minor price correction would indicate that the forces of supply and demand have played their role and a market that was clearly “frothy” between 2000 and 2007, to use the words of Alan Greenspan, has now worked its way back to equilibrium. Edward Chancellor’s article actually points to some apparently sound reasons for this view.

For one, the prevalence of adjustable-rate mortgages (a feature that is shared with the Australian mortgage industry) has made life considerably easier for actual and would-be Spanish homeowners given the historically low rates in place today. Secondly, the lack of an established rental culture, which implicitly labels renters as little less than social outcasts, certainly contributes to a price-inelastic demand for owned homes.

Be that as it may, I can’t help but think that these rather peculiar and country –specific factors amount to little more than bubble-prolongation drivers. Quite clearly the forces at work in the opposite direction are much larger and permanent in nature.

Firstly, the reasons for the striking stubbornness of the housing market to adjust are by no means based on the steady ground that applies to the only remaining equal, Australia. Down-under things could not be more different, with unemployment rates are less than half those of Spain, the performance of the country’s large commodity driven industries (mining and gold) has been stellar and the migratory flux continues almost unabated. These factors add-up to real economic growth, which to some extent explains recently rising home prices.

Spain on the hand is grappling with 20% unemployment, an enormous glut of undigested housing (over 1.2 million homes at the last count) and a sudden halt of immigration flows. Additionally, housing transactions have collapsed and in rather opaque fashion, banking institutions and the mortgage-heavy savings banks have been known to keep housing assets at well above true market value.

Summing it all up does not result in a pretty picture. Spain is enjoying today hugely lower lending rates than it would otherwise, were it not for the implicit EU-subsidy. And yet in spite of this cheap money, no liquidity exists in the market place, with sellers unwilling to come to terms and convert into real losses their current “paper-gains”. In essence the country, both through the actions of its ill advised home owning mass and the bubble perpetuating measures of its government is not only delaying the inevitable but in fact laying the ground for a very hard landing.

If there’s one thing that should be clear by now to any observer of asset markets, it is that ALL bubbles burst and the bigger they become, the harder they fall. I just hope that for everyone’s sake Spain enters the process sooner rather than later.

2010-10-03T00:32:00.000-07:00

Investing Myths demystified

At least twice before in the 12 months I’ve extolled the virtues of simplicity with regards to investing. Back in November 2009, I made a reference to the proven remarkable results that a simple investing formula threw out. A more recent write up also substantiated this theme by revealing some of the common behavioural pitfalls that plague most investors and the simple, (here’s that word again), ways to overcome them.

For you see, contrary to common belief, obtaining market-beating results year after year is not directly related to the typical traits, qualities or behaviours you’d come to expect . Don’t believe me?. Here are some revealing thoughts that may help you see it my way.

Myth # 1 – It takes a Harvard MBA to make it in this business

It is a know fact that that the asset management industry is for the most part crowded with hyper competitive Alpha-males fresh out of the top US MBA schools. However, it is also equally well known that on average, that same “asset management” industry is a return diminishing machine largely as a result of its herd-like investing mentality.

More compellingly, it’s surprisingly common to find true investment greats amongst those with limited education, non MBA-wielding types such as Walter Schloss whom despite not finishing college has run a successful investment partnership for over 50 years. Or how about Dr. Michael Burry, who was profiled in Michael Lewis’s recent book, “The Big Short” after delivering exceptional returns by calling the sub-prime bubble years before the professionals, despite operating without any formal business qualifications.

Myth # 2 – Professional experience is a must

If that were the case, why is it that most soundly financed, long established funds fail to meet market averages on a multi-year basis?. After all, these institutions are staffed by experienced professionals with years of professional know-how under their belts. Unsurprisingly, many notable investors like Warren Buffett or more recently Monish Pabrai were able to deliver uncommon results right form the start of their professional careers and in both cases without the benefits of time in the industry.

Quite often, relying on external experts is actually detrimental to results. A recent Forbes article, aptly titled “Tap your Inner Buffet” profiles a couple from California, which some 9 years after firing their full-service broker (who had contributed handsomely to their negative returns up until then) managed to turn the tide and deliver a positive 30% annual performance.

Myth # 3 – It takes major resources to succeed

Ask anyone about the images conjured when they think of investing and they probably, and quite rightly, picture a football field sized trading floor crammed with Bloomberg terminals, numerous simultaneous phone conversations and a generally manic atmosphere.To a degree, this is quite true, but in the same vein as with myth # 1, it is not necessarily conducive to investment results.

These days, a mid-sized desk, and a regular PC with an Internet connection is all that suffices to compete head to head with the “professionals”. Quite simply the most important resource is not material in kind. It is TIME. Time spent diligently reading freely available company filings as well as financial press is proportionally related to investment returns.

At the end of the day this is all good news for those of us that are not willing to part with a large part of our savings by way of advisor’s fees. Having said that, there clearly is no substitute for focus, and passion in the craft.

It's (almost) all in the numbers

2010-09-16T01:43:00.000-07:00

I was never that great at accounting, and yet as I made it (eventually) onto year 2 of my 20-month MBA program, I opted for a less than popular course named International Financial Statements Analysis, or INFSA for short. Over the course of 10 weeks, we pored over financial filings of public entities in search of both hidden value and more interestingly, signals of impending trouble.

Whilst this academic interest began to take shape in the fall of 2003, recent reading has brought the relevance of accounting solidity and earnings quality to the forefront of my thoughts. To borrow once again from the wise words of the legendary Warren Buffett:

“accounting is the language of business”

… and as such it pays to understand it.

Numerous authors from Thornton O’Glove in his 1987 classic “Quality of Earnings” to the more recent “Financial Shenanigans” authored by Howard Schilt point to the increasing relevance of performing consistent and thorough analysis of publicly available financial reports. Common practice these days however suggests that all too often investing decisions are made on recommendations of research analysts, CNBC pundits or worse, “well-intentioned” suggestions of friends and relatives.

We’ve talked here before about the less than stellar record of equity analysts in predicting earnings numbers, not to mention their sometimes-obvious conflicts of interest (especially for those working within large full-service investment banks. But at least these people tend to look at financial statements, thoroughly or not.

Financial journalists and other well-meaning members of our social circle however, pose a bigger concern. Frequently we may find ourselves being served an opinion that is just that, the result of a “gut feeling” exercise or equally hazardously, a conclusion drawn from the prevailing consensus at the time…

So, how much does accounting matter? Very much, according to Glen Greenberg of Chieftain Capital, for who even “quality financial information aggregators” (think expensive services such as Capital IQ or Reuters), simply do not cut it. Instead this remarkable investor opts to rely on the raw material filed with the SEC, namely the quarterly 10 Qs and the annual 10 Ks, which all quoted enterprise must present.

So why don’t more people follow suit? After all once you feel the pain of asset declines you’d think there would only be two choices left: steer clear of the markets or do it on the basis of good information. Well, there are actually a number of reasons, though not any “good” ones in my book.

It is boring. It sure can be. Reading and analysing years of financial statements for the vast majority of people is about as much fan as watching paint dry.
It takes time. Performing the kind of research required to truly understand the numbers is a painstaking effort and can be perceived as waste of one’s time.
It is sometimes difficult. Notice I say “sometimes”. At its core financial statement analysis is not a difficult endeavour but rather a fairly mechanical and repetitive exercise. It becomes “difficult” at times as a result of the arcane language used in such documents and the conscious, sometimes blatant effort of corporate accountants to obscure the facts and confuse the readers of reports by burying vital information in remote footnotes.

What to do then in light of this rather ominous scenario?

I believe that there are only two paths available for the serious investor.

DIY – Put the effort (and the hours) in and benefit from identifying potential short-sell opportunities (both Enron and Lehman Bros. where called out by professional investors months before their demise

Seek a professional money manager where the focus is on analysis and not on marketing. Check out the ratio of Investing professionals to Sales & Mktg staff to get a sense of where the focus may lie.

Just note that time not spent talking to self-serving sales types or following the advice of idea-a-minute journalists could be more wisely spent looking at the raw numbers!

Risk first, Return second

2010-09-06T06:44:00.000-07:00

“Invert, always invert” is a famous, often cited quote of Charlie Munger, the 86 year-old billionaire investor better known as the other half of Warren Buffet’s Bekshire Hathaway operation. Simple as it sounds, I hadn’t until very recently come across practical examples of its application.

Sure, many investors these days claim to have a unique approach to their craft; focusing on areas where others dare not tread and supposedly “going the “extra-mile” in their search for an informational advantage. But merely being thorough in due diligence, inquisitive in one’s approach to the stock selection process, does not constitute a novelty anymore. On last count there were more than 7.000 US based hedge funds out there, and you can rest assured that not one of them has been standing around waiting for opportunity to knock on their door.

And yet, in spite of the large research teams sported by these outfits, the millions spent on all manner of screening tools, specialist publications, analyst conferences and proprietary research, little variation is seen in the returns of most participating institutions. There are however some exceptions.

Cue in a gentleman by the name of Mark Sellers, of hedge fund Sellers Capital. Browsing through a transcript of a speech delivered some two years ago, I unearthed the following gems:

“We spend nearly all our time calculating worst-case scenario valuation for a stock before we buy it”.

As a matter of fact, Sellers goes on to specify the quantitative process followed to determine the risk/return ratio threshold required before committing actual capital:

“We look for stocks that have at least 3 times as much upside potential as they have downside risk. So, for example, if the worst-case scenario fair value for a stock is, in our estimation $24, and the current market price is $30, that’s 20% downside risk. If we are wrong, we lose 20%. So we need to feel comfortable that if we’re going to risk losing 20% on a stock, we expect to make in a reasonably likely scenario, 60% or more. As such we would only buy this stock if the fair value in a likely scenario was $48 or higher”.

Obvious as this technique may sound, it is far from commonplace. Can anyone remember the last time they read and analyst valuation report that spent more, or even an equal amount of effort, to value the downside as it did the upside?. 99% of the material I read focused on potential growth patterns and future cash flows as a justification for a soon-to-be-met stock price.
More importantly however are the criteria used by Mr. Sellers as he approaches valuation, be it worst case of best case.

Unlike the chronically over-optimistic equity analysts (especially those with patent conflicts of interest at their investment banks), our man of the day, relies on tangible, fungible assets to determine true current value. Put simply, the $24 worst case valuation mentioned above would represent the liquidation value of the company in question, should it be forced to cease its commercial activity. This to me represents a true margin of safety!.

Returning to the opening remarks of Mr. Munger, it seems that “inverting” of focusing on what could go wrong before shooting for the sky is one clear way to market beating returns.
Just imagine what kind of returns the average mutual fund company, stuffed with supposedly “blue chip” financial stocks like AIG, Lehman and Citigroup, would have obtained in the period 2007-2009 had they focused on the downside as opposed to the beautifully crafted forward 5-year earnings models touted by the Street. Some funds might even have made money!.

A little time spent understanding the true value of those loan books and ignoring the momentum trading mania of late ’07 would have steered them clear of impending trouble. Difficult as it is these days to unearth truly undervalued businesses, they do exist (see BP in July 2010), and, at a time when fixed income markets deliver an almost return-free rate of risk, I would follow the likes of Sellers and Munger and turn the investment process on its head.

“Focus on the downside and the upside will take care of itself”
Mark Sellers, 2008

No free lunch; but maybe a cheaper one is available

2010-08-18T07:46:00.000-07:00

A recent discussion with some relatives of mine in the course of my summer break got me thinking about the “no free lunch” concept that stands at the core of economic theory. Simply put, the famous sentence basically states that no return (in the sense of financial reward), can be obtained without incurring am equal measure of risk.

In general terms, there clearly is no arguing with that. Daily life throws enough examples of this theory in practice every day; think investing, new business creation, or even academic training where the “risk” is not only financial (as in hefty tuition fees) but also one of opportunity cost due to the time consumed. All in all, our parents and educators where right to drill into us, somewhat ungrateful souls, the concept of earning our keep by means of “effort” (read investment/risk) before “pleasure” (read return).

Returning to the afore mentioned discussion however, a casual reference made to the proportionality of risk to reward triggered my debating and sometimes controversial nature. The point made was quite simply (and logically) that no extra return can be earned without incurring a similarly larger, or “extra”, risk. Put simply, my counterparties at the discussion argued adamantly and in full conviction for the benefits of real estate as an investment class over stocks for the simple reason that they carried historically less risk. As a logical offshoot of this line of thought, stocks could possibly deliver better returns than real estate but only because they carried greater risk.

To me this is wrong on a number of levels. Having witnessed the performance of the real estate market in Spain over the last 25 years, of with the first 22 have been marked by a gravity-defying upward surge, and the last 3 by a stalling, slightly negative price trend and transaction-free marketplace, little opportunity remains for any price appreciation, nominal or real.

More seriously though, the simplistic argument that risk and return are linearly proportional does not hold in the cold light of historical asset performance. Not only have small-cap, low-priced “value” stocks delivered higher returns than their “growth” segment counterparts, but they have done so with less price volatility (I hate to used this measure of risk, but I feel compelled to do so, as it is the one referred to by those I am trying to enlighten).

Going back to the stocks versus real estate debate (after all, where else does a mere mortal put his or her money when interest rates are at 1-2%?), the flaws in the theory are even more evident.

For one, we already mentioned that price volatility as a measure of risk is almost meaningless, unless of course your investment horizon is truly short-term (in which case it begs the question of how on earth do you turn a real estate asset liquid without incurring a significant loss, not to mention a hefty tax bill)!.

A broader and more factually correct of looking at risk, (as in the probability of permanent loss of capital), would steer just about anyone in their right mind away from real estate investing in Spain right now. In the most basic of terms, supply is enormous and completely disproportionate whilst demand is minimal and dwindling due to reduced disposable income, critically high unemployment rates, tight credit standards (no lending) and artificially supported high prices (in saving bank’ pro-forma balance sheets) .

Even acknowledging that stock investing is a risky endeavour (and what isn’t?), in comparable terms, it offers plenty that real estate cannot match, such as liquidity, selectivity and much lower residual or holding expenses.

With this in mind, where would you bet today?

Close, but no cigar!

2010-07-25T14:23:00.000-07:00

Exactly a month has passed since I ventured head first into a 500-word expose on the virtues of BP’s common stock as a potentially lucrative investment opportunity (see http://www.juliovildosola.com/2010/06/bp-classic-value-or-major-trap.html.) Furthermore, a $25 limit order at was set for a sizeable purchase (by my standards that is), as the stock hovered around $27 to $28.

By now, it should be clear that said price was never reached as the market’s gross overreaction to the Deepwater Horizon disaster came to a sudden halt right around that precise date. Judging whether the recent 35% rise to its current $36 price tag represents a return to investing common sense or simply a further knee-jerk reaction on the part of jittery speculators, might seem to be nothing more than an interesting academic exercise but for me it has served up a great lesson.

Putting aside a considerable, though manageable, sense of regret at the missed opportunity, I take great comfort to see my investment thesis confirmed in such a short space of time. Clearly, companies no matter how unpopular, do not trade at 4x earnings for long, especially not those with rock solid balance sheets and deep war chests.

Whilst there is obviously no price for being almost right, I don’t walk away form this experience “empty handed”. By the way, for those of you who may remain curious, at $36, BP equity no longer has a margin of safety so compelling as to merit a purchase at this price.

The downside to today’s message however, (there’s always a flip side), is that after seeing this once-in-a-while idea evaporate, there are none to replace it. Current valuations across asset classes, and geographical locations assume a return to peak earnings and minimal debt defaults in the near future. Such over optimistic assumptions do not bode well for returns and leave little margin for error.

Given how poorly the odds are now laid out, it’s unlikely that opportunities of BP’s calibre will be on display for all to see. Be that as it may, I’ll continue to keep in mind one of Benjamin Graham’s timeless maxims in the search for winning bets.

“The market is there to serve you, not to guide you”.