Value Investing Ideas

The title sounds like a terrible advertisement, doesn’t it?

I wonder if anyone is still reading this, given I haven’t updated in quite a while.

Anyway, the amount of cash and cash equivelents in the S&P 500 has reached $1.19 trillion dollars.(http://www.bloomberg.com/apps/news?pid=20601087&sid=aE6W8c9z9Bms&pos=5). That’s a lot. The linked story goes into the details of why and how this is happening. It’s what you’d expect, corporations are trying to insulate themselves against the credit market, they are cutting costs, freezing hiring, not buying back stock, etc.

I decided to see how well I’ve done in the last several months. I know how well I’m doing in my real accounts, but what about the stocks I have written about here? As I say, this is for fun, as 8 months worth of data is pretty meaningless for this kind of investing. As you might imagine, if the returns were negative it would be a lot less “fun”. Anyway, here are the numbers:

Not too shabby. It doesn’t really represent my personal investments, as I’ve never owned BXLC, only had BTF very briefly (better opportunities out there), and I don’t remember if I ever held MGA. Furthermore, I’ve been buying ATPG steadily as it fell down into the $3-$5 range. I’ve also been doing some troubled companies investing where the story has not played out yet. There are several other oil stocks I have been buying but not writing about here (PETD, RAME, et al), plus some boring mega cap stocks, and some interesting companies with value to hedge funds.In some way these writeups disappoint me, in that I have several other very good ideas, but on the other hand I feel that what I do write about I support very well, and they have been great performers. Furthermore, they have a lot more legs left.

With all that caveat out of the way, this chart probably still represents some of my best ideas to date.

I’m still very hot on ATPG, ACTS, and IPHS. I have no opinion on the others, as I’m not really following them. BXLC was trading up to $29 earlier in the year, but gave it all up. I wonder if they will ever do something with their cash - it’d still be a home run for investors if they did.

Anyway, compared to the S&P 500, which has an annualized return of about 25% since Dec 15th, I’d say I’m doing satisfactory.

This has always struck me as an easy question, so the amount of handwringing over it has always left me nonplused. To be fair, many of the top value investors, people I admire, have said it is a tough question, so perhaps everything I write in this post will be wrong. But, judge for youself.

It’s my impression that people use the wrong mindset when deciding to sell. They seem to drop their value investing roots and start to try to guess what the market is going to do in the short term. If you try to do that, then yes, it’s hard to decide when to sell. It’s my opinion, backed by a lot of evidence, that no one can determine short term market movements. If so, if you try to do it all you are doing is speculating. It’s no more correct to speculate on the sell side than on the buy side.

Okay, so how do you decide to sell? Well, the most important thing to understand is that money has no memory. For example, say you buy a stock, some bad news comes out, and it drops 20%. Let’s say it is really bad news - a fundamental shift in the outlook for the company. In this case it makes no sense to just hang on, hoping to eventually make up the 20%. You sell, take the loss, and put the money into a better company.  Your $800 doesn’t know it used to be $1000, and that company is not going to increase in value just because you invested in it and took a paper loss. Always, always, always put your money in an investment with the best rate of return.

So, we use that simple rule to decide when to sell. The rest of this argument is going to be phrased as if you are buying another stock, however, the argument still works if you are going to take the money and put it in a sock drawer or buy a boat with it. Why? Because money has no memory. It doesn’t know if it was used to buy a new stock, or a new boat, or whatever.

Okay, since money has no memory, don’t bother looking at your account and saying “I have 10,000 shares of XYZ”. You do have them, but that knowledge doesn’t affect the sell decision. You certainly don’t say “I bought 10,000 shares of XYZ at $10.00″. That also doesn’t affect the sell decision.

Pretend you have $100,000 to invest. In the entire universe of stocks, what stock or stocks would you buy? The very best stock you know of.

How you make that decision depends on your version of investing, and I won’t go into that here. But obviously you will be looking at FCF, multiple vs yield, your expectations of the future, and risk/reward.

Let’s say ABC is selling at $5 and you think it is worth $10. XYZ is selling at $10 and you think it is worth $13. Both have equal risks and uncertainty. In this case, forgetting for the moment that you own XYZ, you’d definitely buy ABC. Well, how do you get that 100K to invest in ABC. Well look! You have $100K worth of XYZ in your account. Sell it and buy ABC.

That’s extremely straightforward. Just own whatever you think are the best bargains out there. If that means you have to sell something, so be it. Every time you sit down to review your portfolio, figure out what you want it to look like, forgetting what you own now and the paper profit/loss on those. Then, do whatever you need to do (buy/sell) to make your portfolio look like it should.

A few complications: The US government taxes you differently based on your holding period. 15% vs 30% or whatever your effective tax rate is. There are dividends, currently taxed at 15% unless you have an MLP or somesuch. Etc. Natually, you have to factor those into the equation, but they are pretty simple. In this case you could argue the problem gets a lot harder, because you are deciding between selling today at a known price vs next year at an unknown price. Here I pretty much assume no changes in prices, which is a bit conservative given that over time markets rise. You could look at beta, but I think that’s a bit of voodoo.

Another issue related to taxes. Say you bought XYZ, and it dropped 20%. You love this stock, and the price drop was irrational. Normally you’d back up the truck, right? Well, let’s say ABC is equally depressed, and you love ABC just as much as XYZ. In this case, sell XYZ, take the tax write off, and buy ABC. You have the same dollar amount in stock as before, the future is equally bright in ABC vs XYZ, but now you have a juicy tax write off!

The final thing I might think about is delaying the tax bill. If I am figuring out what to sell and it is Nov 30th, I may just wait until the next fiscal year to sell my stock, merely to push the tax burden out a year. But this only works if you aren’t filing quarterly. If you are managing serious money, you are probably filing quarterly.

This post implies a lot of selling/buying. I hope that isn’t the takeaway point. If you bought Berkshire in the 80s and love it, why sell for a few extra percentage points? You know Buffett, presumably you agree with his investment and business philosophies, why go to somebody untried? But that should be part of the decision of “what do I want my portfolio to look like”? Me, I want some solid, indisputable performers like Berkshire, and then some higher risk, but world changing returns like ATP. That way if my risky buys don’t work out, I still have a comfortable nest egg. If they do work out, I’m not just comfortable, I’m very well off. But, here we are veering into buy decisions, which is a different topic.

So, my advice is pretty simple. Figure out the optimal portfolio for you, and just make it happen, not worrying about what you currently have in your portfolio. But don’t give Uncle Sam too much extra money if you can avoid it.

Disclosure: I own ATP, I don’t own Berkshire. They were just chosen as examples of different risk/reward profiles.

Of all the investing literature I have read (and I’m talking Greenblatt, Graham, et. al), it seems that this topic gets very short shrift. However, to my mind (based largely on tracking down everything Bruce Berkowitz has ever said or written publically), it is perhaps the most important topic for a value investor. I can almost understand why this is so. Free cash flow (FCF) is not easy to calculate, and you will not find it in most financial statements nor on online sources. However, to my mind, it is absolutely critical to understand and compute.

Okay, what is FCF? Forget the formal definition for a moment - I assume most could reel it off. Free cash flow is simply the money that is left after you have paid for everything - labor, expenses, research, periodic replacement of equipment, lawsuits, etc. That may sound like earnings - sometimes it is, sometimes it isn’t. Take your personal finances for a moment - you get paid, say, twice a month, and pay your bills. At the end, you (hopefully) have cash left over. However, unexpected things come up - medical bills, an unplanned vacation, gifts to the grandchildren, replacing the roof, whatever. Only after all of that can you really say I have X leftover. That amount is your free cash flow.

Its extremely important to know FCF for a company because this tells you what money actually flows to you, the owner. The money can be used in many ways. It could be used to grow the company, buy back shares, pay for dividends, or just build up in a bank account, reducing the enterprise value to you. It’s a measure of a healthy company, one that can pay for business with cash, not debt.

So, what price to pay for FCF? You will often see multiples bandied about: XYZ is trading at 8x trailing FCF. These multiples are compared to peers, announced as attractive or not, but why? What’s a good price to pay?

As always, we need to perform a discounted cash flow. And, as always, we shy away because who wants to pull out Excel?

Well, you don’t need Excel. There’s a trivial formula that allows you to do it in your head. It’s merely the first year’s FCF multiplied by 1/d, where d is the discount rate. The typical discount rate is 10%, so 1/d = 10. So, multiply the FCF by 10. Easy peasy. Done. If this year’s FCF is $23.8MM, you would be willing to pay $238MM for the company (Enterprise value, of course).

“But wait!” you say, XYZ is supposed to grow, which means FCF will grow. That formula is worthless.

Not so. Just subtract the growth rate from the discount rate. So, if you are going to grow FCF at 3%, then you would have $23.8MM * 1/(10%-3%) = $340MM. If they are going to shrink, add the shrinkage: $23.8MM * 1/(10%+4%) gives the value if FCF reduces by 4% a year.

This may appear counterintuitive: what if the growth rate is 10%? The formula tries to divide by zero, implying the security is worth infinite money. Well, it is. Assume I give you $1 dollar today, $1.1 next year, $1.21 next year, $1.33 the next, etc, 10% more each year. Well, our discount rate is 10%, so next year’s $1.1 is worth $1 today. The $1.21 I’ll get in 2 years is worth $1 today. We have an infinite series of $1 bills.

“But Grape grows at 40% a year, you say. Why isn’t their stock priced in the billions per share? ” Well, first of all, Grape probably doesn’t grow FCF at 40%, but some other measure. But secondly, this kind of growth is never sustained. In 20 years at that pace the company would be worth more than the entire United States. So calculations for these big growth stocks use another formula, one that assumes say 10 years of high growth, 10 years of modest growth, and then a plateau. Ben Graham gives a formula for this, if you are inclined. I avoid this stuff, because you will soon see how wildly the value changes based on just a 1-2% growth change. My crystal ball is not that finely tuned. As an aside, I see “Grape” stock valued at absurd values, assuming this kind of infinite growth. If you do this kind of calculation, look at the actual end value of the company. If you are calculating that it will be selling $250B of i-matches in 20 years, think again. Ain’t no market can absorb that many of anything.

Okay, so there you are. If you want to buy Coke, and your discount rate is 10%, multiply FCF by 10. If it is 15%, multiply by 6.7. I seem to remember some famous investor in Coke who can value companies in his head in about 15 seconds. What was his name? Buffer? Buffy? Something like that…. everyone wonders what his secret is. It’s just simple math.

Edit: I left out an important point. If your DCF says the FCF is worth $300MM, that means you should be indifferent about getting $300MM today, or the cash flows for the forseeable future. In the real world, that is madness, because who can perfectly predict the future? You need to be compensated for the risk you are taking. So, we look for a discount to the FCF. If the DCF value is $300MM, and the enterprise value is $280MM I’d probably pass. If the enterprise value was more in the $150MM-200MM range, and all other factors looked good (good management, solid balance sheet, etc), then I would snap it up.

First, unless I specify otherwise, I have read the annual and quarterly reports, viewed/listened to whatever presentations they might have made, and looked at some of the competitors. My assumption is that no one, at least not a real investor, will buy a stock without the same due diligence. Hence, I am not going to talk much about the balance sheet, how the business is structured, etc. You can get all that info from the reports. What I try to do is pick out what is being missed by Wall Street. After all, the central thesis of value investing is that we can value a business, and that Wall Street often misprices securities. I don’t feel like sitting here and typing for a week. To an extent, that’s laziness, but it is also reflective of a few deeply held convictions of mine. First, the value should slap you in the face, as Buffett says. If you have to reach for a calculator to run a DCF, the value isn’t that apparent. I’m not going to post ideas that require that sort of thing. (Admittedly, my E&P oil/gas ideas are based on valuations of proved and probable reserves, which depends on DCFs. However, these are run by third parties, and are buttressed by recent sales of assets, by which you can gauge if the industry considers these valuations correct or not). Second, I feel too much information is somewhat confusing. This is well documented in both research and in books written for the general public, such as Blink. After you have a few pieces of relevant information, more pieces of information tend to just cloud the issue. I’ve posted ideas elsewhere showing a $300MM company holding several billions of dollars worth of oil/gas, with sufficient cash flow to not only service, but reduce debt, only to get innudated with questions about issues that just don’t change that valuation equation. Why???? People like to worry, second guess, and try to integrate every piece of information. But some pieces of infomation are far more important than others. I like ideas where I don’t have to predict future earnings, guess that a commodity is going to go up or down, guess that Apple is going to invent the next great product (Apple looks like a great investment to me, but what about 3 years form now - are they going to make the next iPhone? I dunno, and thus won’t invest with them).

So, I strive to give you the information that I consider relevent, to be kept in mind while reading the quarterly and annual reports. Take my previous entry on IPHS. I guess I should have posted the % of their business that is phosphates for detergent, the amount that is food additives, their exposure to ag phosphates, etc. But that is all in a pie chart in the annual report. It’s trivial to see that they are being priced like an ag phosphate producer in the face of a recession, when in fact they make a high moat, high margin product for basic foods. That should hit you in the face after looking at it for a bit. Would it change your decision if the ag business was 10% vs 12% vs 14%? If you are making decisions based on those ratios, honestly, it’s way to close to call.

Anyway, that’s how I write these up. Detailed information on any company is available a short google search away, should you need the info, or want to double check what I wrote. Actually, let me amend that. You’d better double check what I wrote. A simple error like # of shares outstanding could completely skew a calculation. These posts are intended as a starting point, not an ending point.

On disclosure, I haven’t decided what to do about that yet. Suffice to say the ideas I post here are generally stuff I’m putting money in, generally make/break levels. I have a few stocks which are a bit of a ‘flutter’ for me - the prices are insanely low, but the future of the company is cloudy. If it survives, it could be a 20 bagger, if it fails, it’s total loss of capital. I’m not going to be posting about that kind of stuff. Generally, if I write about it, unless I strongly specify otherwise, it’s an idea that either I have 10%+ invested in, or would if I had the cash (I’m pretty much fully invested right now). I don’t see the point in posting second tier ideas, and I don’t see how I could reasonably keep track of 20+ companies in detail. OTOH, I’m certainly not going to post my buy/sells, nor notify if I close a position. I will try to be fair and post if a previous idea has soured for some reasons, but I don’t promise to do so. I’m not responsible for your investment decisions. If you can’t quote The Intelligent Investor chapter and verse, the intellectual foundation of this blog, these posts are more likely to hurt than help you.

I will also assume significant sophistication on your part. I’m not going to opine on buying options/leaps vs equities, how to create a stub through shorting or other means, hedging against commodities, etc. I am trying to present undervalued companies, not instruct you in how to manage money at a professional level. Okay, lecture over.

I’m drowning in ideas and data - more ideas than money to invest. That is not so hard in this market, but I had the same problem when the Dow was at 14K. So, I decided to share my sources. N.B. I am very much a Buffett style investor of the partnership years - arbitrage, special situations, workouts, etc. After that, I’m the Munger/Buffett style investor, great businesses at a good price.
Ride their coattails

There are a few money managers I really respect. Most money managers run mutual funds with 50-100 stocks, and who wants to follow that example? While I don’t usually buy the exact shares that the people I research buy, it’s a great starting point. Find out what they are buying, try to figure out why they are buying those issues. Study the competitors.

So, the first step is figure out who you want to copy, or learn from.

The first person should be Buffett. Studies have shown that riding his coattails - blindly buying whatever he buys at a comparable price, will allow you to handily beat the market. Buffet has almost never lost money in the market - his biggest loss is 2%. OTOH, his investments are limited to very big companies with a lot of stock; he has a lot of restrictions that you don’t. There is no point in him buying shares in a company worth $1B; it’s not enough to even move the needle.

From there you have to decide who you want to study. My current favorite is Bruce Berkowitz. while he runs a mutual fund, he is pretty unique in that he only holds a few stocks, and may be invested up to 10% in one company. He always carries a lot of cash. Most importantly, he is a Buffett style investor, and is a great communicator - better than Buffett, in my opinion. That’s a strong statement, in that Buffett is a great communicator. However, Buffett keeps his own ideas close to his chest. I find Berkowitz’s explanations crystal clear, and they give me the confidence to invest like him.

There are many other people, depending on how you like to invest. Like the cigar butt investing style of Graham. Follow Schloss and his son. Like more Buffett style investing? There’s Marty Whitman. Etc.

How do you find out what they are buying/selling?

First, the site Gurufocus.com tracks many famous value investor purchases. They will only give you the information on a time delay (unless you subscribe, which I haven’t done), but it is very interesting to track what your favorite people are doing quarter to quarter. If 3-4 of your favorite people are all buying the same issue, that should be a strong indication that you just might want to research that stock.

It’s a bit more work, but you can get the data from the horses mouth. Gurufocus finds out these buys from the SEC, which runs a website with all available filings. Since you have to file when you buy a certain percentage of a company, or file if you are a money manager, you can find out what these guys are buying. Go to SEC Filings & Forms (EDGAR), click search, and enter the name of the manager, or their fund name. For Buffett, you can either enter Warren Buffett or Berkshire Hathaway.

Next, I set up google alerts for any person I am interested in. I have alerts set up for buffett, Mark Sellers, Berkowitz, and many others, along with any company I currently own or am thinking of owning. Google Alerts Each day you will get an email for any news item, blog write up, etc., that matches the search term. You get a lot of duplicates, the same link reported on multiple days, but pretty quickly you will learn to recognize the new ones. This service is invaluable to me.

Other sources of information

I don’t use forums much. Almost all of them are pretty weak, IMO, for finding new ideas. With one exception. Joel Greenblatt is a value investor with historical returns in the 40-50% range. He has written two books, and I can’t overemphasize reading his first book, How to be a Stock Market Genius. A silly title, but the most information packed book that I have read. It’s 1 of my 2 bibles in this biz. More on that later. He started a forum for professionals. You have to apply by writing up an idea, and believe me, they don’t read like “the 3 arrows are green, and analysts have projected a 30% growth rate.” They are extremely sophisticated analysis’ based on looking at the balance sheet, etc., projecting out future returns (both the best and worst cases), etc. You can only post if your ideas has been accepted. Each week he awards $5000 to the best idea that week. Every idea is voted on by members, you’ll see ranges from around 3 to 6, where 6 is an extremely high value idea (according to the opinions of the members). Most of the members run money; they ain’t “the little guys”. It’s an inside look at the best minds in finance. I’m not suggesting applying, unless you are the best of the best. However, you can read the forums for free, at a 45 day delay. All you can do is read, not post, but you are reading great ideas by great minds. It’s not a typical forum - they don’t chit chat, all you can do is post a writeup of a specific stock. You have to post between 2-6 ideas a year; no more, no less, so he gets the best ideas from each member. If you get low ratings on your ideas, you can be kicked out. For awhile the posts will probably go right over your head, they did mine, but in time they will start to make sense and you will find yourself thinking about investments in the same way. I don’t know a better information source on the web, period. I read it daily. You should too.
Value Investors Club

For professional services, I use Value Line. I subscribe, but it is pretty spendy. However, most larger public libraries will carry it for free, and even allow you to use the online version. If you don’t recognize the name, it is the service that Buffett uses. Most of the other value guys uses it, and only it, as well. Schloss, etc. It doesn’t review every stock in the US, but around 3500 of them. they also have a small & mid cap edition, which covers another few thousand, though in less detail. A new publication comes out each week, with each stock being updated 4 times a year. It’s a great education to just leaf through each new edition each week. Over 13 weeks you will learn about all the major market segments, learn all the major competitors in each segment, and be able to directly compare them one another. It’s an invaluable education - allocate an hour or two each week to the library for the next 13 weeks.

As for books, I think there are 2 that are must reads. The first I mentioned: Greenblatt’s “How to be a Stock Market Genius”. The second is Browne’s “The little book of Value Investing”. Unlike any other of the popular books, he tells you how to go down a balance sheet line by line, evaluating the company. I wrote this up in the book section of the website. It’s an absolute must-have if you want to be able to read an annual report and really figure out the company.

And that is about it. I get tons of ideas from these simple sources, more than I can act on. I don’t bother with things like blogs, the Wall Street Journal, etc. I don’t want to know what the rest of the world is reading and thinking, because I am trying to beat them. I want to know what the best of the best is thinking and buying, because they are the handful beating out the other 99% of the population.
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These are my ideas and source, and they work together far better than the sum of the parts. What value is reading Investors Business Daily when the investors I strive to learn from don’t read it, and don’t invest in that way? I’m not putting down IBD, just pointing out it makes no sense for my style. Rather than trying to read anYhing/everything that others thinks are good, I’m trying to concentrate and distill information. You can read all day, every day, and only read a fraction of what is available. If you want to invest like Buffett, what makes more sense? Reading  IBD, etc., or reading exactly what he reads - Value Line, the Wall Street Journal, etc. If you are a technical investor, reading the Value Investors Club makes no sense. Sure, you stumble across stocks you can trade, but why not read what the best in your business is reading?

This is a blog that I’ve decided to start mostly for myself, to document my ideas about value investing, mainly thoughts about specific companies. The term value investing encompasses many different investing styles, but for most it all starts with Ben Graham. The most popular method discussed today seems to be that developed by Warren Buffett and Charlie Munger. While that is how I came about value investing, I find I’m not very good at figuring out what multi-billion dollar company will have a decades long competitve advantage. Plus, I don’t have the “problem” of deploying billions, nor am I trying to establish a reputation for holding a company forever (a useful reputation for Berkshire Hathawy, useless for me). On the other hand, when I read Joel Greenblatt’s book “How to be a Stock Market Genius” (terrible name, tremendous book) I found a way that was sympathetic with my way of thinking. Looking at spinoffs, restructures, buyouts, and identifying value is much easier, for me, then guessing that Coke will maintain it’s edge for another 5o years. And, of course, the rewards can be much higher - in the range of 40-50% returns per year. On the other hand, this strategy has a greater risk of loss of capital.

Lately I’ve been thinking about risk a lot, partly prompted by reading Taleb’s publications, and partly just by the volutility of the market. Higher returns, even over a decade, mean little if you blow up. I’ve felt strong urges lately to buy these mega-cap, safe companies, but then I find a microcap trading at half the cash in the bank, with no debt and 20% ROE. How do you walk away from that? Even though I will have to find another investing idea in a year or two to replace this stock when it reaches fair value, I’d rather chase 50% profits than the 15% huddle rate that Buffett has.

Well, that is a not well explained stream of conscious, but I want to get an inital post out, mainly to see what it looks like and figure out how I want to structure this site.

I don’t plan to post often, just when I have a really intriguing idea.