Origins of Value Investing

The origins of Value Investing has been pushed even further back than Henry Clews.

I am currently reading “Devil Take The Hindmost,” by Edward Chancellor. The book is an excellent review of the history of speculative activity in the financial markets. One quote that I wanted to share was from Richard Steele, an English writer who wrote a publication called the Spectator in the late 17th and early 18th centuries.

“Nothing could be more useful, than to be well instructed in his Hope and Fears; to be diffident when others exalt, and with a secret Joy buy when others think it is their interest to sell.”

Sounds just a little like Warren Buffett when he says:

"Try to be fearful when others are greedy and greedy when others are fearful."

This Is Insane

Wesco Financial (WSC) is down $58 or 17%. This is the insurance company run by Charlie Munger, who sits next to Warren Buffett at every annual meeting of Berkshire. Does the market really feel that Wesco is going to take a loss because it owns CDO's or some other toxic paper?

Berkshire Meeting Recap - Things You Didn't Read in the Mainstream Media

Here are some good quotes from the Berkshire meeting in Omaha that took place last weekend. Most of these were not reported in the mainstream media as they seemed to focus on his "think small" comment regarding returns. I did not attend the meeting, but culled these quotes from the notes taken by Shai Dardashti, and posted on Seeking Alpha. They are not exact quotes since no recording equipment is allowed during the question and answer period.

1) Question - How to pick great managers?

I can’t be of help if you are looking at group of MBAs. They know at this point in life how to fool you, what answers to give you.

My Commentary - Damn right, when I was in grad school, we spent a lot of time learning how to lie during interviews.

2) Question - A University of Chicago Graduate student asked me once, what are we being taught that is wrong?

In business school the amount of time spent teaching option pricing is total nonsense. You only need 2 courses, how to value a business and how to think about stock market fluctuations.

My Commentary - One could make the same claim about the CFA program as well.

3) Question - Big positions. How do you get confident enough?

Students learn corporate finance at business schools. They are taught that the whole secret is diversification. But the exact rule is the opposite. The ‘know-nothing’ investor should practice diversification. Diversify– but it is crazy if you are an expert. If you only put 20% in the opportunity of a lifetime – you are a not being rational. Very seldom do we get to buy as much of any good idea as we would like to.

4) Question - Are investment banks too complicated? Risks unknown?

I think Fed did right thing with Bear. They would have failed on Sunday night, and walked to a bankruptcy judge. They had 14.5tril of derivative contracts – not as bad as it sounds, but the parties that had those contracts would have been required to undo the contracts to establish the liability from the estate.

My Commentary - Surprising answer given his reputation for being unforgiving to people who take too much risk.

5) Question - Do you believe in Jesus Christ?

Buffett - I am an agnostic.
Munger - I don’t want to talk about my relationships.
Buffett - Being an agnostic I don’t have to have an opinion.

My Commentary - Certainly the most surprising question of the day.

6) Question - How do we better measure leverage and accounting of assets, integrity?

Munger - A lot goes on in bowels of American industry which is not pretty. A lot of people got overdosed on Ayn Rand. They would hold that even if an axe murderer in a free market is a wise development. I think Alan Greenspan did a good job on average, but he overdosed on Ayn Rand that whatever happens in free market is going to be alright. We should prohibit some things. If we had banned the phrase, “this is a financial innovation which will diversify risk”, we would have been far better off.

Buffett - When you get into CDO squared, the documentation is enormous. If you read a standard residential security – it consists of thousands of mortgages, then different tranches. Then take CDO and take junior tranches on a whole bunch of juniors – put them together and diversified in theory – a big error to start with. That was nuttiness squared. You had to read 15,000 pages to get a CDO, then 750k pages to evaluate one security in a CDO squared. To let people use 100cents they paid vs. the 10cents it trades at in market is an abomination.

Buffett Letter - Favorite Quotes

My favorite quotes from the annual Berkshire Hathaway letter:

"To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future – you can bet on that. A line from Bobby Bare’s country song explains what too often happens with acquisitions: “I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.”

"The best anecdote I’ve heard during the current presidential campaign came from Mitt Romney, who asked his wife, Ann, “When we were young, did you ever in your wildest dreams think I might be president?” To which she replied, “Honey, you weren’t in my wildest dreams.”

"Charlie and I are not big fans of resumes. Instead, we focus on brains, passion and integrity. Another of our great managers is Cathy Baron Tamraz, who has significantly increased Business Wire’s earnings since we purchased it early in 2006. She is an owner’s dream. It is positively dangerous to stand between Cathy and a business prospect. Cathy, it should be noted, began her career as a cab driver.)"

"There’s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds?"

"Our country’s weakening currency is not the fault of OPEC, China, etc. Other developed countries rely on imported oil and compete against Chinese imports just as we do. In developing a sensible trade policy, the U.S. should not single out countries to punish or industries to protect. Nor should we take actions likely to evoke retaliatory behavior that will reduce America’s exports, true trade that benefits both our country and the rest of the world. Our legislators should recognize, however, that the current imbalances are unsustainable and should therefore adopt policies that will materially reduce them sooner rather than later. Otherwise our $2 billion daily of force-fed dollars to the rest of the world may produce global indigestion of an unpleasant sort."

Credit Crunch?

So is there really a "credit crunch" out there? What of these two facts:

Warren Buffett, the billionaire investor said "money is still available and reduced interest rates make it quite cheap."

Two additional questions were asked in a special poll of the ISM non-manufacturing panel in January. (From ISM report dated Feb 5, 2008)

Question - Is the turmoil in financial markets having any effect on your firm's ability to obtain regular or additional financing?

Yes — 14.6%
No — 85.4%

Four Dumbest Things You Can Do on Wall Street

A hypothetical list of some of the dumbest things a newbie might do on Wall Street.

1. Go to the Berkshire Hathaway annual meeting next year in Omaha and during the question and answer period ask the following question in front of everyone to both Warren Buffett and Charlie Munger, “Can you please tell me what your EBITDA was last quarter and what is your earnings guidance for the upcoming year?”

2. Get an internship with Yahoo, and on your first day fly to Dallas and visit Mark Cuban and ask for the $ 4.5 billion back that Yahoo paid for Broadcast.com in 1999.

3. Cold call Stephen A. Schwarzman, the billionaire and CEO of Blackstone Group, and offer to consolidate all of his credit card debt into a Capital One credit card with a 0% APR for the first year.

4. Become a sell side analyst covering homebuilders, attend the annual meeting of the National Association of Homebuilders, give the keynote speech and start off by saying you anticipate a brief down cycle because “it’s different this time.”

What is Value Investing? – Part II

I think that it is safe to say that when William Ackman, the renowned Hedge Fund Manager that runs Pershing Square Capital, says that Target is “undervalued,” and when Warren Buffett, the equally renowned value investor says that Burlington Northern is “undervalued,” they mean two very different things. And yet both are very successful at what they do and very rich. So who is right?

Ackman is not your typical stereotyped “value investor,” and Target is not your typical stereotyped value stock. Target’s enterprise value is 9.5 times its trailing 12 month EBITDA. Its forward price to earnings is 15.5 times, while it trades at 3.5 times tangible book value. It is not cash rich, holding $550 million in cash, or about $ 0.55 per share according to Yahoo Finance. The performance has been great as well. Target is up 12.3% year to date and has beaten the S & P 500 by 700 basis points.

So what’s going on here? Why is the stock “undervalued?” according to Ackman. Well, in a sense there is the effect of what is known as “cult investing.” When a well-known and successful investor announces that he is buying a stock, the herd moves onto it en masse pushing up the price. Ackman enjoyed that effect as rumors hit the market a week before his filing was done on 7/16/2007.

Buffet and other traditional value investors look for a “great business selling at a great price” in his words. He doesn’t seek to change anything at the company he buys. In fact he wants nothing to change, that’s the entire point. Management usually stays in place.

Ackman wants the company to change, to restructure in some way. Not because it will help the company long term, but because the market will pay more for your company if it looks the way I tell you it should look. For Target, that means sell or spin off your credit card division and try to unlock the value of your real estate somehow. For other companies that are being targeted it might mean something else - sell the entire company, split in two, issue debt and use the money to buy back stock. He doesn’t really care if 2 or 3 years down the road Target is a weaker or stronger company because he probably won’t be a shareholder by then.

I hesitate to say that Ackman is price indifferent to what he pays, because everyone cares about what they pay for something but in a sense he is price indifferent. He creates value at the companies he owns not by making its business stronger or better, but by shuffling parts of the puzzle around. Call it financial engineering if you like. If earnings grow faster than they did before he got there, its not because he helped them become better at retailing, its probably because its share count will decline due to some huge buyback that the company announces. When Ackman sits down with Target management is he going to say that they should work on their merchandising or that they should cut back on the number of SKU’s at their stores?

The Ackman strategy then is this simply put –

1. Find a large cap stock where the market is valuing the stock exactly at what it should be valued at based on the company’s profile.

2. Quietly accumulate a large stake in the company over a period of several months.

3. Leak word on the street that you are building a stake in the company and receive the cult effect.

4. Make your public filing of ownership and send letter to management.

5. Meet with and pressure management to do what you tell them to do to get the stock price up.

6. Wait for management to cave in and see the stock rise even more.

7. Sell quietly in a few months after the general public piles into the stock.

8. Give part of profit to charity but only in years when Hedge Fund manager wealth is getting really bad press.

Now I am not criticizing Ackman for what he does. Everyone has to create value for their investors and if it can be done this way then so be it. I was only trying to demonstrate how two investors who are very different can utter the same word and do it with a straight face.