Vale tudo investing

The Best Shareholder Letters

2008-07-09T19:54:00.001-07:00

I am a big fan of reading fund managers' shareholder letters. Going back through ten years of shareholder letters from the best fund managers gives you an incredibly useful insight into how they think, analyze opportunities, view risk and rewards and conduct valuations.

The best shareholder letters in my opinion are those by Third Avenue and the Olstein Funds as they really show the reader the investing philosophy and style that underpins these funds. Close runner ups are those by Orbis and Southeastern, though not nearly as in-depth and detailed as Third Ave or Olstein, reading the shareholder reports of these two outfits over the years yields some really useful nuggets of information.

Enjoy

Cross-Shareholdings

2008-07-08T19:41:00.000-07:00

Japan is notorious for cross-shareholdings. Today cross-shareholdings stand at 12.2% of the Japanese stock market's market cap for last financial year, according to Nomura. What seems to be getting the attention is that this is the first rise in cross-shareholdings by Nomura's measurement in more than a decade and presumably prompted by some management teams embracing these structures to thwart attempts by activist shareholders to force them to sharpen up their acts. But what most people gloss over is that cross-shareholdings have been on a downtrend for some time, having peaked in 1987, again according to Nomura.

Anyway, regardless of this, these set-ups can actually be quite an appealing investment in some cases. Japan has numerous situations where small companies sit atop of substantial equity stakes in much bigger corporate brethren.

(Apparently, this is also the case with Italy, according to a former colleague who used to work in Milan. If anyone knows of a list of interesting cross-shareholding investment opportunities I would love to see a copy).

With these kind of investments headline ROE, PER etc are likely to be misleading metrics as they tend to be asset plays. So how to play these?

One can buy one of the shares in the cross-shareholding arrangement, short out the cross-shareholding to back out the underlying business of the one of the companies, which may be trading at very cheap stand alone valuations.

While I'm not sure whether Orbis did this with Fuji Electric back in 1999 the investment at the time certainly lent itself to this and Orbis shareholder letters show that the fund was interested in how the cross-shareholding discounted the underlying business. Asatsu-DK and its capital tie-up with WPP also looks like a possible candidate for shorting out the WPP holding to gain exposure to a cheap ad business.

One can also use the smaller company as a cheap back-door entry into its larger cousin, particularly, when the larger company is trading at cheap valuations. A good example of this is Third Avenue's investment in Toyota Industries, which has a substantial holding in Toyota Motor and Denso.

In some instances the stock may even be trading marginally above or below the value of its cross-shareholdings giving an even greater margin of safety. Southeastern recognized this in its investment in Nippon Broadcasting and its holding in Fuji TV. Value here was eventually realized with Livedoor's hostile bid for Nippon Broadcasting.

Nippon Broadcasting touches on another factor to consider - corporate restructuring. Many of these cross-shareholdings tend to be legacies of keiretsus (group company structures). A buy-out by the head company of the smaller firm is a quick way to realize value - assuming the head company pays a decent price - and is also EPS accretive to the acquirer as theoretically they can retire the shares held by the target thus boosting returns for existing shareholders.

Anyway, I am going to try and draft up a list over time of interesting cross-shareholding plays. This is no doubt going to take a very long time (and right now is less than embryonic) as I don't have access to a Bloomberg, and my list will definitely not be exhaustive but I will be posting sporadically on these at this Google spreadsheet .

Jean-Marie Eveillard's Musings On Japanese Equities

2008-05-25T05:39:00.000-07:00

Investors who acquire over a 5% stake in a listed Japanese company must file a report with the Japanese financial authorities within a few days of going over the 5% threshold level. So if you are interested, as I am, in global value funds' investments in Japanese equities (think Southeastern, Third Ave, Silchester Investors International etc) it is very easy to be able to track them in near-real time once they breach the 5% level.

The caveat being you need to read Japanese and know how to use the EDINET filing system to unearth what you are looking for. If you are interested, you can click on the 5% filing rule link on the right hand side of this blog although the details are in japanese otherwise you can e-mail me and I can send you a list of some big funds filing codes in Japan.

I have noticed that Jean-Marie Eveillard's First Eagle Funds/Arnhold and S. Bleichroeder Advisers have been very active in acquiring stakes in Japanese companies over the past six months from their filings with Japanese regulators.

Anyway, I was reading the latest (May) First Eagle Funds' Conference Call transcript and Mr. Eveillard had a number of interesting things to say about Japanese equity prices. In particular, his musings on net-nets among the Japanese small cap space were particularly interesting as this is something I have touched on before and am looking at establishing a basket position in too.

Also his remarks on SMC may be worth looking at further, there is a write-up of the company over at Value Investors Club and for non-Japan based investors the company's stock trades on pink sheets in the United States.

Finally, he had interesting things to say on currency risk exposure for exporters and how to think about this, and also Japanese insurers - Controlled Greed has a position in Millea, and other value mutual funds are keen on names like NipponKoa, Millea etc.

Edited highlights below

"Today, the Ben Graham-type companies, in other words, the deep value stocks, are not available, really, in the U.S. or in Europe. They’re only available in Japan.

And then, the great majority of those deep value stocks are small stocks... we have been doing some work and we already own a few, have owned sometimes for years, a few small deep value stocks in Japan and we’re in the process of doing some additional work on more.

I mean there are stocks in Japan where net cash, cash and sometimes portfolio securities, net of all financial liabilities, net cash is in excess of market cap, which means that you pay less than nothing for the business. Now, as Marty Whitman likes to say, “There is always something that can go wrong.” In that case, if the company were to suffer a string of losses for the next five years, then of course five years from now the cash would have disappeared as a result of the losses.

... in the Tokyo stock market, there are a few industrial companies, some of them world-class, where the stocks had declined to levels where valuations, we thought, were very attractive. Now, when I say industrial, it implies, of course, cyclical, speaking very generally.

So, we assumed in those cases that operating profits would go down 30% over the next 12 months, which nobody assumes today, but just in case. And, we found out that even if we assumed that operating profits would go down 30% over the next 12 months for those companies, the valuations on that basis remain quite moderate. So, we own SMC, which is the world leader in pneumatic equipment...

We also own Keyence3, which is world renowned for their automation products. Again, I’m not saying that the Japanese economy is doing well; it’s doing so-so. I’m just saying that Japan is not going to sink into the sea and that we think we found some very specific investment opportunities among some Japanese industrial companies...

As I said before, we are long term investors, we hold securities on average for five years, which means that sometimes we own them for six, seven, eight, nine, ten years or more. So, we don’t pay a great deal of attention to whether the company is export sensitive or not unless we felt that number one, the Euro would be strong forever vis-à-vis the American dollar and number two, that the competitive advantage of the European company would be ruined truly by the strength of the Euro, which often is not the case.

I mean there are many German companies, for instance, that do not complain today about the strength of the Euro because they are selling, say, machinery that’s so complex and so competitively strong that price is a minor, not quite a minor factor, but price is not a considerable factor.

So, unless we thought that the Euro would be strong for the next three to five years, we don’t mind owning the stock of a company that either exports much to the U.S. or does a large amount of business in the U.S...

We own the securities of a few insurance companies outside the U.S., specifically in Japan. Although it’s a very particular case, I mean these companies in Japan are vastly overcapitalized. Most of the excess capital is invested in Japanese equities. So, we look at them and, so does Marty Whitman of Third Avenue, as disguised investment companies. "

Walter Schloss speech

2008-05-04T18:52:00.000-07:00

Combined notes from a speech by Walter Schloss at the Ben Graham center for value investing and a Forbes profile of the man in Feb of this year

SEARCH STRATEGY
If there is an industry having a problem look at it and you will likely find a good buy there.
Do the companies pay dividends if the dividends are under threat then wait till the cut, see how much the price drops as they may become attractive.

Schloss likes to buy stocks hitting new lows.
Look for companies without much debt - this is important when company stumbles (and takes the stock price down with it).
With these companies it pays to focus on assets.
Has the book value been rising over the past few years? (e.g. five)

Stks below book value with long track history and inside ownership are good.
Look at annual reports and proxies how much stock directors own, company's history and who owns stock
Schloss doesn't like talking to management as they can sway your judgement, look at the figures instead.
Pay special attention to footnotes.

SELLING & ASSET ALLOCATION
Having target buy price is good move
As you scale your buys in so you should scale your buys out
If you really confident 20% should be max allocation

Mason Hawkins Speech

2008-04-30T05:43:00.000-07:00

Below are some notes from Mason Hawkins' speech at the Ben Graham Center for Investing he gave in 2005.

GOOD COMPANIES
Moats and hidden assets
Quantitative undervaluation and qualitative appeal - competitiveness of business and quality of management

Read trade journals.
Reprice most attractive companies so you have target prices
Read every word of the k/s and read the last five to six.
Read the no. 1 competitors' ks too.

Be careful of combining operating and financial leverage mixed together as you don't know when a recession will occur.
One or the other is reasonably handleable.

Most oil & gas companies have horrible economics.
Coca cola bottlers are good businesses. (Not too sure why?)

Ad companies good because of high FCF generation and ROIC ability
Look at the concentration of business in clients tho.
Saatchi & Saatchi got smacked coz Delta & BA were main clients and then came Gulf War and stock tanked.
Service companies assets are their people - you need LT contracts and no compete agreements in there to ensure you can keep generating high ROICs.

SEARCH STRATEGY
Some screens:
1. ROC over 12% and sell for less than 8x
2. Low price to FCF. i.e. below 10x (average of last 3 years capex and working capital charges is what you take out)
3. All companies below book after intangibles taken out

Look at:
- all companies on new low list
- 10 best investors 13-Fs, e.g. Peter Cundill, have stocks gone down since they bought them?
That warrants attention.

VALUATION
3-methods:
I. Balance Sheet valuations based on today's economics
Inventory adjusted for LIFO + tax liabilities
Receivables etc.
You need to make good adjustments
Intangibles can be incredibly valuable.
What you pay for intangibles should be DCF based.

Liabilities should be cross-checked with footnotes; litigation exposure, pension fund financing etc
What is debt coverage? Is debt manageable?

Buying even a poor business at 1.2 of adjusted book can be a great investment.

II. DCF
The five steps:
1. Use FCF this is cash flow minus working capital charges and maintenance capex
2. Grow out FCF for next 8 years, say they have been growing at 9%, then you wanna grow it out at 6%.
3. Your terminal multiple will be assigned at GDP figures.
4. Then discount at levels way higher than treasuries.
5. Then buy at 60c on the dollar of your valuation.

You do this five hurdles of conservatism and then chuck in qualitative factors, YOU WILL BE FINE.
You need this conservatism coz there are so many inponderables - what rates will be, what management will do etc etc.
Parsimony is also very profitable
Buying at 50c on $ gives you extra compounding effect as business grows.
(If it takes four years to realize value as Hawkins says some businesses can then the compound growth rate here will be 13.6%, this shows why steeper the MOS not only is it safer but the return potential is better)

Discount Rates
In March 2005 US 10-yr treasury yielded 4.5%
Treasury and a few points of risk premium.
But be cautious in low rate environments.
Historically yields have been nearer 6% if risk premium of a few % is tagged on this gives Southeastern's 9% DCF hurdle rate back in March 2005.
N.B. If a business looks too risky don't either bother running a DCF and valuing it, can it.

Terminal Multiple
Terminal multiple should gen be based on LT GDP growth figure and assumes very little/no growth.
So once you hit year nine you multiply projected FCF for year 8 by LT GDP growth rate and then multiply by inverse of your discount rate to get terminal multiple.
E.g. Say company is conservatively expected to grow FCF by 4%pa up to year 8. Year 8 FCF flow is estimated to be $100 and LT GDP growth rate is 2% pa, and you are using a 9% discount rate your terminal multiple is:
(100 x 1.02) x 1/0.09 = $1,133.33 for all cash flows out past year 8 into infinity.
This is then discounted back to present.
You can see more about how Southeastern do their DCF modeling here
(BTW - The various "discount factors" in the table in the linked article are just the discounts that the present value cash flows have compared to their future values)

Problems with DCF Models & Why Good Management Is Important.
The DCF model is essentially a FCF yield model for companies and is thus similar to YTM calculations for bonds.
YTM assumes all coupons occur under steady interest rate environment, this almost always false
You need to grasp what will happen with your coupons in order to gauge your returns.
Unlike a bond where the holder gets the payout and can invest it themselves it is up to company management to invest the FCF coupons on your behalf (this is why competent management is important).

Management needs to be able invest FCF intelligently.
Is working capital eating business up?
Has management done intelligent things like buying back shares when they were cheap e.g. below book?

The company has five choices in how it will invest these FCF coupons:
1. Put in treasuries or pay off debt - usually the yield on treasuries and the cost of their debt will be below your discount rate.
(I.e. not a fantastic use of cash)
2. Put it in earning asset base - i.e. reinvest in business. This will probably earn more than discount rate if company is good.
(Good)
3. Buy shares - worth doing if shares are undervalued by more than the discount rate. (Good)
4. Go on acquisitions - this uses coupons and principal, this can be bad news. Have they made intelligent acquisitions?
5. Return as dividends - if YOU can reinvest at higher than YTM/discount then this is good.

3. Comparable Sales
You adjust comp sales for interest rates in period in which they occured.
Arms-length transactions etc

C/ Discipline and patience - specific price to value settings and ability to wait it out.
2% returns aren;t attractive but 50% losses are even worst.
Great investments are made when you have liquidity and others don't

MARGINS OF SAFETY
If you understand a business PERFECTLY then there is no need for MOS.
The more uncertain you are the more MOS you require.
The bridge 6" above the ground and bridge 2 miles above.
If you don't know how far you can fall, you want a hell of a lot of MOS - that means the bridge has got to be rock solid.

MOS revolves around spectrums of confidence:
The balance sheet at the top is your most confident so you can absolutely load up at this level.
But say with Coke you have to do a DCF so then you are going to be less confident than a company with a wedge of cash on the BS.
Remember the future requires way more MOS.

If there is doubt you can forgo an opportunity

WHEN TO SELL
You can sell when you are fully invested and you find 40c dollar then you sell your 80c dollar to buy into it.
It's the 100% rule you will only swap out if you think upside is 100% on replacement otherwise you stick with it.
Remember you get a ton of frictional costs when you sell.

Francis Chou Speech notes

2008-04-27T02:47:00.000-07:00

These are notes from two speeches given by Francis Chou of Chou associates at the Ben Graham Center for Value Investing of the Richard Ivey School of Business in 2006 and 2007.

I have merged the notes I took from both speeches together.

SEARCH STRATEGIES
When you are value investing you want to look at new lows.
Rejection rates are likely to be 90% for most companies you are looking at and that will be done in about a few mins.
Get to know an industry well.
It takes about six months to get to know an industry - high-tech is more time consuming as product cycle obsolescence means it requires a lot of and continuous work, retail is one of the easiest.
You don't have to be everywhere to have great returns, you just gotta know what you're good at. I.e. circle of competence.

Retailer Valuation
For retailing management has to be outstanding as it is a very tough business. (Keep your eye on the jockey)
Focus on:
i) Accts rec in days - 60 days is average for U.S.
ii) Inventory turnover vs. COGS
High inventory turnover is good.

VALUATION
Valuation doesn't have to be very precise - you are gonna take a range instead.
Just have a MOS on the value range
If you get close to 60% of your picks right you are doing extraordinarily well
You should also try and minimize the damage from the 40% that go wrong
How you minimize mistakes is what guarantees your performance
Be diversified when you begin investing.

Balance sheet analysis is very important - you want to look at inventory and receivables control, especially, for retailers.

Is this a good company or a bad company? Valuation approaches for the two categories will be different.
With crap companies if you pick them up at 5-6x earnings they have already priced in so much bad news that they can be quite profitable even when they do not grow.
For good companies the emphasis is on FCF generation, you don't wanna buy above 10x FCF.

GOOD COMPANIES
The holding period for will be longer for good companies than for cigar butts.
Good companies can grow intrinsic value at 10-15% pa so you can see your investments double or triple in about four or five years, and as long as they are compounding it is worth holding on to.
Achieving value for heavily discounted and downtrodden companies can take 2-4 years anyway.

When you 1st start off checklists are very useful.
Good company checklist:
Is the business simple and easy to understand?
Does it have consistent business history over the past 5-10 years?
Will it have favorable long term prospects?
Is management chasing revenue for the sake of revenue?
Is earnings all wrapped up in inventory, receivables etc?
Is it highly leveraged?
Good companies don't need leverage they can fund from equity - if it is highly leveraged then you may want to look at buying the debt.
Capital allocation by the management is very important if the management leaves that is a big concern.
Remember to focus on the jockey not just the horse.
What has the company been doing with shares?
Have they been buying back shares and hiking dividends? This is always a good sign.
Having cash on the bal sheet as a cushion for tough times.
10-20% of shareholder's equity as cash is nothing bad.

BAD COMPANIES
Net-net is nice and easy way to start investing -It's a brain-dead approach and it really works.
You must play these as baskets as they tend to be troubled companies
20 basket is ideal. 3/10 will probably explode.

Always start with the balance sheet in v.investing and particularly net-nets.
Make sure you are not buying a lot of inventory and receivables, cash is best
Look at tangible book value to share and EV to sales as well
Check on current and quick ratios and cash ratio
Be careful about accounts receivable and inventory measures too (in days) - these can be marked down, unlike cash
Income statement is impt but not that impt for net-nets
Look at capital structure is there debt coming due?
Perhaps they have really cheap debt worth buying or convertibles? Check out the YTM it may be fantastic.
Don't buy into companies about to liquidate as this entails loads of costs that eat up NWC.

Maintenance & Growth Capex

2008-01-07T22:57:00.000-08:00

In my last post about rejigging Greenblatt ROIC someone asked about maintenance capex and growth capex in calculating free cash flow.

Maintenance capex is the spending a firm makes in its plant and equipment to maintain current output while growth capex is the spending in plant and equipment made to ramp up production. Free Cash Flow attempts to differentiate between the two and but as many companies do not issue a division between expansion & maintenance capex figuring it out is often necessary, and this requires making judgement calls.

Often it is easiest to identify maintenance capex.
HOW TO RECOGNIZE MAINTENANCE CAPEX:
1. Typically for mature businesses most capex will be maintenance capex; depreciation should generally be about equal to capex.

2. Continuously high or stable capex over a number of years that does not lead to increased revenues is also probably all maintenance capex.

3. For rapidly growing firms in fast-changing industries (i.e. tech) most capex will actually be maintenance as is it is unlikely such companies could safely cut capex and maintain market position and cash flows. (Cash flow though may not be a good way to value these businesses though, especially start ups.)

RECOGNIZING EXPANSION CAPEX
1. You can read the management discussion and analysis and see if the firm is embarking on new business lines. If capex has been steady for many years, and suddenly spiked up this difference probably indicates new growth capex.

It is important to read what management is doing though as some companies scrimp on capex for a no. of years and then suddenly end up having to rush to make a load of new capex to keep the business humming along. Calculating the average age of equipment and depreciation policies of the firm and benchmark to industry norms is another way to confirm this.

2. If cap ex is significantly higher than depreciation it could indicate new growth cap ex. (Again caveats about management that has been less than generous on capex in the previous years applies to this).

Still, some people - like Whitney Tilson on this post - ignore the difference between the two types of capex completely and deduct the whole lot. The argument being this is generally a conservative way of arriving at FCF.

However, even if you do this there is still the question of how one treats acquisitions. Acquisitions fuel the growth of some companies and should be considered capex.

In particular, if a company is a serial acquirer acquisitions will be part of its strategic business operations... therefore, for these firms acquisitions are capex. How do you figure this out? Read the company literature and make your call.

Deducting Depreciation and Amortization Rather Than Cap Ex
If companies are investing heavily in growth, then the lower D&A figure should be closer maintenance capex costs than the full blown capex numbers. So you may want to go for the D&A number to get normalized FCF, especially, if you foresee the expansion phase ending soon.

D&A can also be useful to approximate FCF when capex is highly lumpy and erratic as the D&A figures tend to be smoother. Alternatively, you can create a normalized capex figure over a period of time to calculate FCF.

GREENBLATT ROIC

2007-12-25T22:27:00.000-08:00

Greenblatt's ROIC formula in The Little Book That Beats The Market is
ROIC = EBIT/Net Working Capital + Net Fixed Assets

For the 20-30 stock TLBTBTM portfolio this is a good quick and dirty calculation. But if you run more concentrated portfolios and do single stock selection then I think it may need tweaking.

Firstly, Greenblatt notes in TLBTBTM's epilogue his version of Roic is unsuitable for utilities or financials. Beyond this McKinsey's observations (see last post) on low capital base firms apply.

The next issue with Greenblatt Roic is it assumes EBIT is approximate to FCF, i.e., Depreciation and Amortization are equal to capex. This should be so most of the time but there are cases when it is not.

Some companies also may have different depreciation policies, e.g. DDB versus SLD, which may distort EBIT comparisons and may need adjustment.

Companies where capex is higher than D&A are investing increasing amounts in their business (assuming the line item for D&A is mostly depreciation). By itself, this is neither good nor bad -- it depends on how wisely the firm deploys the money.

Actually, Mr. Greenblatt himself thinks EBITDA - Maintenance capex
may be a more useful metric for pre-tax discretionary free cash flow.

Acquisitions used to grow or run the business may also need to be factored in as capex.

Another issue may also arise when companies utilise capital leases as opposed to operating leases, their 'lease expense' will instead appear as an interest expense lower down the P&L, distorting EBIT. Here one needs to go into the cash flow statement and find the real lease expense and adjust accordingly.

These issues should have a minor impact but they are worth being aware of.

Finally, the denominator of the formula may not account for all capital and assets required in the line of business. Some companies will rely on off-balance sheet arrangements, such as, operating leases, take-or-pay agreements, use of subsidiaries, sales of receivables and so on.

For companies with large amounts of operating leases McKinsey's criticisms of Roic may apply or one could correct the net fixed asset figure. This can be done either via conversion of the operating lease payments to a capital lease or seeing what other similar companies' asset bases are and the cost of those assets.

Sale of receivables without recourse (revealed in the footnotes) will distort net working capital, profits from such sales should be added back into current assets.

Take-or-pay/throughputs. Best to look at similar companies here and see how widespread these funding agreements are. You may want to take the present value of these payments and add them into the company's fixed asset or working capital base.

Perhaps an improved Greenblatt Roic calculation for picking single stocks would be;
EBITDA adjusted for capital leases - (capex + relevant acquisitions)/Net Working Capital + Net Fixed Assets

Where in the denominator
Net working capital = (current assets - liquidity on hand + funds from sale of receivables) - (current liabilities - short term borrowings)

and

Net fixed assets = tangible fixed assets adjusted for use of operating leases & throughput agreements- construction in progress.

2007-12-10T21:53:00.001-08:00

Return On Invested Capital (ROIC) measures the levels generated by each dollar of capital invested in a company's operations and how profitably management is able to allocate capital to generate cash flow over its weighted cost of capital (WACC).

ROIC-WACC spreads are KEY to value creation. Firms whose ROIC exceed their WACC generate positive net cash flow, creating value; while a company whose ROIC equals its WACC neither creates nor destroys value.

Generally, companies with higher ROIC-WACC spreads are more valuable and command higher multiples.

If a company is selling for, or below, book you can be fairly sure it has not earned its WACC in the recent past.

Firms can create value by one of three avenues:
1. Reallocating/improving use of existing capital to increase the spread.
2. Deploying more invested capital into current operations or investing in new projects provided returns generated by either generate marginal ROIC in excess of WACC.
3. Lowering their WACC.

CAN YOU SEE THE FIRM YOU ARE INVESTING IN DOING THIS? AS THIS WILL BE KEY TO CREATING SHAREHOLDER VALUE!

Increasing industrywide and extraordinarily high ROICs are hallmarks of young, strong and growing sectors. In contrast, sequential declines, or marginal ROICs below historical ROIC (barring seasonal factors), may indicate a mature industry where long-term investment opportunities are waning.

Consistently high ROIC-WACC spreads generally equate to the 'moats' that many investors seek. One very rough way of gauging a 'moat' would be to look to see whether a company maintains a high ROIC-WACC spread for several years.

Again, as a rough rule of thumb, WACCs for most U.S. companies range between 9-13%, so ROICs consistently in the mid to high teens allude to something Moat-like and worth digging into.

PROBLEMS WITH ROIC IN GENERAL
ROIC solves some of the P/E ratio's pitfalls, particularly, PER fails to illuminate whether firms are producing value, or how much capital firms consume to produce earnings. But like all metrics ROIC has its pitfalls.

First off, you obviously need to monitor the trend. ROIC in the high teens may be great, but less so when its come off a base in the 20% range.

More critically, ROIC can be problematic for companies with very low invested capital bases. E.g., companies that outsource production, like software development firms, and most services firms, like advertising agencies, will have very low invested capital bases.

McKinsey & Co. point out for companies with invested capital below 25% of revenue ROIC may not be a fantastic benchmark as small changes in capital requirements can cause the ROIC to be both very large and volatile from period to period.

Some solutions would be to;
1. Normalize capex over a period to smooth out volatility
2. Or not use ROIC altogether, McKinsey offer an alternative calculation for those interested, in the above link.

It is also not helpful to compare ROIC across industries. In 2004, system software development companies' median invested capital as percentage of revenue was -3% compared to 163% for hotels, resorts and cruise liners, according to McKinsey.

ROIC CALCULATION
There are two equations used for calculating ROIC that I have seen used most frequently:

1. The standard ROIC formula
Net Operating Profit After Tax/ Average Invested Total Capital

2. The Greenblatt Method
EBIT/Net Working Capital + Net Fixed Assets

I'm going to focus on the second method in my next post as it seems to have captured value investors' attentions recently. Handily, the Greenblatt method is, I think, more intuitive than the traditional method and easier to calculate.

Back Again and some stuff to come on ROIC

2007-12-05T21:51:00.000-08:00

Sorry for being away for almost six months. Have been studying for the CFA level one, which was quite time consuming.

Anyway, thankfully it is now all over and done with and its december, which means stuff has quitened down and Xmas rolls around... and I now have some more time on my hands to post. I will be posting some stuff on Return On Invested Capital calculations over the next few days....

Spac Structure

2007-06-28T05:43:00.000-07:00

Below is a rundown of the typical Spac structure, variants do exist though: be sure to check the S-1. In fact, it’s usually Spacs with unusual features that make good investments. That's why Baupost probably went for Star Maritime Acquisition (SEA) (links to Value Investor Club write up, membership required).

Spacs are sold in “units”, which are composed normally of one common stock and one or two in-the-money warrants. Check in what kind area the Spac is looking to make a deal in, what the composition of the units are, and how many are being sold to the public. You also want a solid management team; that’s who you are betting on to go get an acquisition together.

You can find what Spacs are coming to market by going to the SEC website and doing an Advanced Search under S-1 filings in Form Type. In “Search for Text” type “blank check company”.

Sometimes, the underwriter will defer all or part of their IPO fees (usually 6% of market cap) and wait till an acquisition/merger is sealed before collecting. This is likely to also put pressure, or incentivize (depending on your perspective), management to bag a deal - it's hard to imagine iBankers doing a deal if they didn't think there would be some fee payoff.

In addition to funds raised via the IPO of units, management typically buys 20% of equity in a private placement, which may or may not be in the form of common stock or warrants, and normally sold at way below the public offering price of the units. Yes, they benefit a disproportional amount if a deal pulls off, but then they have to go scour for the deal plus warrants cannot be exercised until a deal has been completed. Management's warrants sometime come with a 2-3 year lock-up. Basically, this prevents them from off-loading and doing a runner if they get bored.

In some cases, management must buy warrants at a set price on the open market, supporting warrant prices for investors, and ensuring management has more of their money on the line. Management thus has some “skin in the game” whatever the flotation's intricacies.

Spacs are working against a ticking clock, they must seal a deal in 18 months with a 6-month extension if a deal has been announced but not completed within the initial 18 months.

Also it is normal for at least 85% of proceeds from the IPO to be kept in trust, so management can't cane the money on margaritas and lap dancers in Cancun. So while management are hunting for a target the cash accumulates interest, although not always at full money market rates – you need to check the interest payments in the financials to gauge what the trust acct pays.

Theoretically, the money in trust is safe… but it has been pointed out those funds may not be immune to third party claims and shareholders claims may be secondary to other claimants. That having said, I haven’t heard of a case where a Spac has been successfully sued over funds in trust and if the Spac is purely equity-financed its hard to see who else is likely to be above the shareholders in terms of claimants. (If you know of any incidents where shareholders claims have been made secondary to another party, or the funds in trust have been subject to third party claims PLEASE LET ME KNOW).

Once a deal is announced management needs 80% (exceptions exist though) of shareholders backing. The Spac must also use up 80% of cash in their trust for the deal. If a proposal is rejected the Spac shareholders can also force the vehicle to liquidate.

While it is rare, investors have shot down deals before. In December 2006 investors at TAC Acquisition Corp (TACAU) gave the thumbs down for an acquisition of Aviel Systems. In February shareholders approved a dissolution of the company. Obviously, the warrants went up in smoke as they were contingent on a deal being sealed, but the common stk got reimbursed. Holders of common stock received $5.6941 in cash per share; units had originally gone for $6.

Nonetheless, even if YOU don't like the deal and it still gets an 80% thumbs up from other investors you can still cash out (assuming you hold common stock in the Spac) and receive cash in proportion to your slice of funds in the trust. There may be some charges however if the deal receives shareholders' blessing but you decide to liquidate.

One issue which I'm not entirely sure on and would be interesting to check is if you decide to liquidate in the event a deal goes through and you are still holding the original units, presumably your common stock is dissolved but do you still get to hold onto your warrants? Does anyone know?

Anyway, that's the basic lowdown on Spac structure. If you're interested in a much more detailed breakdown of Spacs then check out this link.

In the next post I'll look at why value investors may be interested in these vehicles.

On Running A Concentrated Two-Book Portfolio

2007-06-27T07:14:00.000-07:00

I was looking at Amazon the other day for new books to read and thought I would do a quick search for Seth Klarman's Margin of Safety and Mohnish Pabrai's Mosaic. Both are regarded as must-read value investing books, and both also happen to be out of print.

Klarman's book was published in 1991, it cost $25 (according to the best information I could find) and now goes for $1,700 on Amazon. Pabrai's tome was first released in 2004 - I think for $15 but correct me if I'm wrong - and sells for $340 (also on Amazon).

Put another way Klarman's book has logged an annual return of 29.1% over the past 16 and half years, while Pabrai has clocked up an annual return of 144% since it has been published. The S&P 500 meanwhile has returned 9.8% annually since 1991 and 9.2% since 2004. In fact, I think the returns on both these books is probably even better than the returns on the funds that Pabrai and Klarman manage themselves.

So, what is the lesson here? Well, basically all you need to do is either:

a) diversify by buying a basket of books from good hedge fund managers and wait a bit for some capital appreciation

OR

b) (what value investors prefer to do) conduct fundamental analysis of a universe of money managers who have publishing deals, read the books you believe to be promising and then buy only those you consider to be both of sufficiently high quality and likely to go out of print. You should then go onto bag returns in excess of 25% per annum with far less volatility than the S&P 500.

OK I admit, the last part on volatility was made up. I haven't tested what the price volatility for either of these two books since their publications has been, what their covariance is or what the standard deviation of a two book portfolio composed of Mosaic and Margin of Safety is - and yes a two book portfolio could only have existed since 2004 when Pabrai published Mosaic. Still whichever way you look at it you would need to run a very concentrated portfolio of value investing books to generate these returns.

But hey, both Pabrai and Klarman run concentrated portfolios so no-one could fault you for not trying to emulate their investing style.

Actually, I've read both these books, and while both are very good reads - and I think both of these guys are very good investors who I admire greatly - these two books are definitely NOT worth their price tag.

I guess that's easier said when you've read them as that's the only possible way you could really know whether they are worth their price.

Actually no. I can think of no book on investing that is worth $1,700. I might shell out a few hundred bucks for a Ken Kesey and Tom Wolfe-autographed copy of The Electric Kool Aid Acid Test, but $1,700?

What are people thinking? Well, I admit, at one point I did consider shelling out substantial sums for Margin Of Safety. Luckily I got my hands on a loaned copy and read it.

Yeah, it's a good read and has an interesting slant; I liked the focus on being aware of risk, also the section on valuing a spin-off was useful. But it's nothing that I couldn't have got from doing a lot of Google searches and reading other decent books not out of print, like Greenblatt's How To Be A Stock Market Genius.

(Brilliant book btw, but talk about a value trap; price appreciation on it has been terrible since its publication in 1997, you would have lost money on it as you can get a second hand copy for $6.55 on Amazon and its regular retail price is $14.00, although not sure what the 1997 original price was. Still if they take it out of print maybe it will rise, I'm still holding onto my copy till then.)

Why would I have bought MOS then? Well given Klarman's record and all the newspaper articles, and hype surrounding the book it seemed pretty tempting in a perverse way. Hey and when I was looking at it the thing was only $700 bucks a year and a half back so I could have bagged a decent return too (are book sales capital gains tax free btw?).

So who is paying so much for this stuff? Well I guess, mainly speculators (sorry rare book collectors) and people convinced that the stuff in both books is worth the price tag on them and a route to becoming a great investor, which it ain't.

Let's face it, if you really are a value investor there is no way in hell you should be paying that much for these books, however great the authors are and however sound the content is. Don't be swayed, cast around and you'll find the same information elsewhere and most likely for free.

These book prices are in a bizarre way a good lesson in value investing, there is a difference between price and value. However good the company is, at some point it becomes overpriced; don't be tempted into overpaying for something because of the hype and rarity factor (unless you're a rare book collector, or something).

Oh and by the way, past performance is no indication of current or future performance/results. Your two book portfolio may tank tomorrow unless you know what fair value for them is.

(Also my comparative return statistics may be slightly off the mark as I was only able to get the year that the two books were published in, not the exact month and day, so I assumed both were published on January 1 and then compared to it to the S&P's return over the same period.)

Net/Nets Any Good? And Where Are They All?

2007-06-27T07:13:00.001-07:00

The net current assets investment selection criterion calls for the purchase of stocks which are priced at 66% or less of a company's underlying current assets (cash, receivables and inventory) net of all liabilities and claims senior to a company's common stock (current liabilities, long-term debt, preferred stock, unfunded pension liabilities etc. etc.).

So if a company's current assets are $100 per share and the sum of current liabilities, long-term debt, preferred stock, and unfunded pension liabilities is $40 per share, then NCAV would be $60 per share.

Notice how long-term assets aren't in the equation. I.e. intangible assets and in particular, real estate and equipment are not included. Nor is any going value ascribed to prospective earning power from a company's sales base. That's a high bar to begin with, Graham then adds another hurdle to clear; he would not pay anymore than 66% of $60, or $40, for the stock.

Since most companies have negative NCAVs you have a thin field to begin with but when you're fishing only for stocks at 66% NCAV you can often end up with no companies on the field at all, especially in bull markets like now, albeit one that is starting to look a little weary.

So why go for the 66% level, why not shoot for 80%? That is an option but Graham's reasoning was if you go for firms trading so cheap that there is little danger of them falling further, it's pure margin of safety investing. Still 80% may be a tempting level but we'll come to that later.

What about the other equally important component of investing - knowing when to sell? Given that a lot of NCAV companies tend to be shot to pieces or heavily out of favor the safest strategy (if you're not going to do much detailed analysis of the companies you are buying) is to sell once the company hits its 100% NCAV.

So how did Graham run this strategy back in the day? Luckily for him he started doing this shortly after the Great Depression so there were tonnes of companies that fitted the bill. In fact, at one point he apparently had up to 100 of these companies in his portfolio.

Now I don't know if this is true and what those 100 stocks were, but assuming this is correct I would imagine that's a diversified bunch of companies he had in there. You can diversify away most company specific risk with about 15-20 stocks upwards if you are picking stocks purely using some kind of filter system - so 100 names seems pretty diversified to allow for duds that would blow up on you. Graham reported the average return, over a 30-year period, on a DIVERSIFIED portfolio of NCAV stocks was about 20% per annum.

As some of you may also have noticed though the key word in Graham's portfolio returns is diversified (in case you hadn't noticed I capitalized the word). Graham himself recommended buying a large number of stocks to diversify the risk. The NCAV strategy in Graham's day was thus essentially a forerunner to Greenblatt's Magic Formula system; there will be some real gems in there but if you're not doing a whole load of homework on them best to buy the basket as the stocks on average should give you a decent bang for your buck, actually Greenblatt mentions NCAV in passing on this video... http://merlin.gsb.columbia.edu:8080/ramgen/video3/admin/alumni/Reunion_2006/Reunion_4-8-06_Greenblatt.rm.

That seems to roughly chime with this post over at Cheap Stocks - http://stocksbelowncav.blogspot.com/2007/01/top-10-netnets-four-years-later-we.html
They report a 33.5% return on a basket of the biggest 10 Net/Nets by market cap back in Feb 2003, but there were a few duds in there - with one halving in value and one essentially flat. Standard deviation for the group was a hefty 78.7%, i.e. if you bought just one of these stocks you probably shouldn't expect a return anywhere near 33.5%!!

The biggest risk is the company folding and a complete wipeout of its stock price. Stocks that get down to NCAV territory probably didn't get there because management were on the top of their game. Indeed, there's a real risk some of them will go up in smoke even with your 66% selection criteria.

How real a prospect is that?
Well, I did a google search on NCAV stocks and found an article on the subject over at http://iamamazing.wordpress.com/2006/12/19/the-problem-with-netnets/ This was published seven months ago on Dec 19 2006. It turns up four NCAV candidates;
1. Dominion Homes (DHOM)
2. CET Services (CETR)
3. TransNet Corp. (TRNT)
4. Taitron Components (TAIT)

I decided to take a look at what these stocks did since then... and of those CET Services seems to have imploded. Auditors gave the company a going concern qualification back in April, and it is being delisted from the American Stock Exchange. I haven't poked around into the balance sheet of this company - it may have some pretty decent stuff to give out in the event of a liquidation but that's the stuff of bankruptcy investing, which is a different ballgame.

So of the four names seven months ago one is up in smoke, that's means in order to get a 20% return, like Graham's portfolio had, the other three names are gonna have to be absolutely on a roll over the next five months. Who knows, they may well be, then again they may well join CET in going belly up.

With a lack of candidates (i.e. less than 10 companies at the very least) the 66% NCAV basket buying strategy can be downright dangerous. So how many 66% NCAV are there are out there today?
One place to look is over at http://www.grahaminvestor.com/screens/grahams_result

That yields as of today June 13, two candidates! Relaxing a bit to 80% gives us five names, still not a whole load, and then once we start going above that... well there don't seem to be much of a margin of safety folks if you're just going on a pure stock screen based portfolio.

As it stands NCAV screens for the U.S. market, or screens for stocks trading around or near to it, looks like a good idea generator rather than anything else. That is you need to have a proper look at the names thrown up and judge if the actual companies themselves are decent bets as I suspect buying the basket of 10-15 trading at or nearest to NCAV probably won't be great. Of course, I have no proof of that unfortunately, it's just a hunch. It would be interesting to see a study of how buying a basket of 10 plus Net/Nets at 80% NCAV perform over a one-year plus period. Does anyone know of such a study or some fund that does this kind of strategy?

Finally, the lack of 66% NCAVs may just suggest the market is expensive. After all, the post at Cheap Stocks infers there was a fairly decent wad of them back in 2003. So if there is a market meltdown, which may not be so unlikely, then we could end up with a whole load of 66% NCAV companies and you could snap up 15 plus stocks and sit it out without a load of effort.

Actually, one place which may be fertile hunting ground would be small cap and retail shares in Japan, which have been having an appalling time over the past 18 months after a high-flying internet conglomerate there called Livedoor imploded in a most likely politically-motivated investigation into the company's business practices. The Mothers Index there is down 68% from its lifetime high on January 16th.

But to invest in small cap Japanese stocks you will probably need to have a Japanese brokerage acct - not the easiest thing for non-residents and if you don't read and speak Japanese finding these stocks may be a bit of a beeatch.

Thoughts and comments welcome!

SPACs....

2007-06-24T19:30:00.000-07:00

Has anyone had any experience in investing with SPACs (Special Purpose Acquisition Companies), aka 'Blank Check Companies'?

The area seems to be quite interesting and offer a number of investment possibilities. I would be very interested to hear some thoughts on the area as I am mulling writing on it soon....
Cheers

Eddie

Festival Of Stocks

2007-06-09T07:28:00.000-07:00

Maybe a bit late but the last festival of stocks (#39) is over at stock rake. Check it out at http://www.stockrake.com/festival-of-stocks-39~2007~06.html.

Stock Screens - Do You Use Them?

2007-06-04T00:12:00.000-07:00

I am interested in using a variety of stock screens as an entry point into choosing stocks for a concentrated portfolio.It seems there are any number of screens one can run in order to dig up potential investments, which can end up overwhelming you in terms of choice. So I guess you first need to concentrate on a handful of screens and then wade through them for decent ideas. A few I am looking at are:

1. Magic Formula Investing at http://www.magicformulainvesting.com/, this is the website for Joel Greenblatt's great book "The Little Book That Beats the Market" (http://www.amazon.com/Little-Book-That-Beats-Market/dp/0471733067).The screen turns up stocks based on high earnings yields and high ROICs, you can choose what market cap you are after.While a portfolio of 20-30 stks chosen from this should in aggregate beat most benchmarks, obviously not all of the stocks will be winners... I'm interested in using the screen as a starting point to discover potential gems. One useful blog to see what stocks have been added to the site is http://magicformulainvestor.blogspot.com/ which posts a list of the latest additions to the site on a weekly basis.

Some of the names crop up on the Motley Fool's Inside Value newsletter as well as at Value Investor's Club website.

2. The American Association For Individual Investors at http://www.aaii.com/ has a whole load of interesting screens on its site (subscription only but at US$290 for lifetime membership it is a bargain). I'm most interested in some of the value screens... Perhaps they could be used in conjunction with the MFI screen above to get good results? I've read elsewhere that some people are combining the Piotrsoki screen (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=249455) with the MFI names to help select stocks...Does anyone have an opinion on this?I've come across this fool post http://www.fool.com/community/pod/2006/060727.htm. Some of the other AAII screens look very solid, such as the John Neff or P/FCF screen, as starting points.

3. In his book "Mosaic" Mohnish Pabrai (http://www.amazon.com/Mosaic-Perspectives-on-Investing/dp/0974797413) talks about a number of screens he uses such as stocks trading below one a price to sales basis....He argues that sales (i.e. revenue) tends to be the least tampered line on an income statement so is fairly trustworthy...You can get a P/S ratio screen on Yahoo... I haven't really looked at this as a starting point yet. Does anyone out there use P/S ratio as their jumping off point for promising investments?

4. There is also the 52-week low list, which many people look at but needs to be used with some care as stocks there tend to be at their lows for a reason, it's picking up the bargains here that is the key. Stockpickr has an edited 52-wk low highlight list it publishes here... http://www.stockpickr.com/today/52-Week-Lows/. The full monty of 52-wk lows is available on morningstar at http://quote.morningstar.com/highlow.html. Again back to Mohnish Pabrai, he recommends focusing on stocks one knows rather than all the small cap names and unknown dross that may be settling at these levels.

5. Finally, The Graham Investor has a number of interesting screens such as large/mid-caps trading at or below Net Current Asset Value. The NCAV one can be found here http://www.grahaminvestor.com/screens/grahamsv_result

Also this blog is a good source for stks below NCAV (as the name somewhat suggests)
http://stocksbelowncav.blogspot.com/

I think NCAV could be a very promising lead too, take a look at this link from the above blog...
http://stocksbelowncav.blogspot.com/2007/01/top-10-netnets-four-years-later-we.html

Does anyone have any experience with these screens as leads or thoughts on the matter. Would love to hear your thoughts.

Welcome

2007-06-01T00:06:00.000-07:00

Thank you for visiting Vale Tudo Investing! This is my first blog and I hope to use it to share my investment and money saving ideas. The name comes from a Portugese phrase meaning "Anything Goes" and is used to refer to a style of competitive fighting with minimal rules.

Using fundamental analysis and a value investing philosophy I hope to analyse a few stocks and find a few good companies in U.S. and global markets.

Right now, I'm holding a lot of cash but that is because this is the beginning and I am just starting out as an investor so I welcome your feedback and comments. And thanks for coming.