Tuesday, November 2, 2010

Buffett on Gold

Buffett was recently asked about gold in a conversation with Ben Stein. His answer was typical Buffett: short, direct, and steeped in common sense and logic.

"You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"

No need to for me to ramble any futher on this one. Read the rest by clicking here.

The Opportunity Cost of Investing: A Simple Concept Gone Missing

Back after months of absence, (quality over quantity right?) here's another post that touches on a basic and valuable, yet often neglected investment process.

We often hear of investing as a zero sum game: one investor's gain can ultimately be traced back to another investor's loss. In the timeless words of Gordon Gekko, "money is not gained or lost but merely transferred...." Yet there is another aspect to this "game" that is often not considered: the economic concept of opportunity cost. Simply, money which is invested today is done at the expense of all other investment options, including the benefits of being in cash.

With a stock market up over 12% in two months, investors seem to be betting on Republican victories in Congress and Ben Bernanke's announcement of further monetary stimulus efforts. While both those outcomes seem likely to occur in line with investor anticipation, investment opportunity cost is very high today. The higher the opportunity cost, the more upside potential an investor should require.

Understanding opportunity cost with respect to investment making decisions lends tremendous value to not only the quality of capital allocation, but investment portfolio composition. The key is in understanding that in investing sometimes the decisions you don’t make are just as valuable as the decisions you do make.

The probability that the markets will suffer a pullback remains elevated for a host of reasons - an increasing deficit, unemployment, legislation, and so forth. Because of this real risk, investors must pay careful attention to the opportunity costs that come with every single investment decision. Capital that one invests today is money that can’t be invested next month. Of course, you could sell anytime but you would be at mercy of Mr. Market’s offer on that particular day. In other words, each incremental amount of invested capital has a higher opportunity cost than the capital that preceded it. So when I’m looking to allocate capital, with respect to my final 20% cash position, my upside requirements are going to be a lot higher than the preceding 20% and so forth. So unless I’m presented with arbitrage or special situation type investments, I’m looking for a two to three fold return before making further investment decisions at current market valuations.

Sounds fairly basic and simple, right? Yet considering the trading volume still going on today, there is an incredible amount of investment activity going on, even from value investors.

Yes I can identify stocks such as Vodafone (and other blue chips), who with its strong dividend yield along with its still unaccounted for 45% minority stake in Verizon Wireless (you can argue that the recent run up in share price is in response to this asset) and quality business models will still likely produce a 10% to 12% annual total return. And yes, a return of 10% to 12% a year is very attractive, but you got to have some holdings that will deliver much higher returns to offset the inevitable laggards in your portfolio year in and year out. A stock that delivers 12% annualized returns may do by being down 5% one year and up 30% the next.

The value of understanding opportunity cost is that it will always ensure the adequate availability of cash when the pool of undervalued investments is at its highest. And availability of such opportunities rises as the market declines. So it makes sense from a value investing approach that as the higher the market goes and hence the smaller the pool of undervalued investment candidates, the more cash a portfolio should hold and vice versa. In reality, however, you see the exact opposite. The fear of buying during declining markets increases portfolio cash levels while the euphoria of bull markets reduces cash on hand.

Thinking in terms of opportunity cost creates a stronger capital allocation discipline which in turn can often lead to above average performance results. When the opportunity cost of investing is low - meaning that the available returns from equities are strong enough to warrant action - odds are that the overall market is cheap and the pool of undervalued stocks is plenty.
Today, the opportunity cost of investing is on the high side. The pool of attractively priced investments, in my opinion, is small and virtually extinct if you're dealing with $500 million or more. The best investments are likely already in your portfolio at buy prices significantly lower than today’s price. When faced with such a dilemma, investors should be extremely picky when making investment selections. .
Today’s value investor is finding slim pickings in the market. The opportunity cost is high at today’s valuations although there are pockets of fertile candidates to be found. Yet as a wise investor once said, “if there is nothing to do, then do nothing.”

Thursday, July 29, 2010

The Risk of Market Timing: The Error of Bottom Hunting

First let me say that this blog is not dead...it's very much alive, but I do apologize for going such a long time without a post. Things have been quite interesting here at Gad Capital. I hope to return back here on a more regular basis. With that.....

History offers some incredibly valuable insight to investors. For investors with a true value orientation, history is even more valuable. As we await for the "double-dip" market decline or run away inflation, spend some time examining the early 1970's. There are valuable lessons there.

For example, during the vicious bear market of 1973-74, the many members of the Nifty Fifty -- the blue-chip stocks of the day -- were trading with P/E ratios of 2-3x, some even lower. Investors who missed that opportunity out of fear decided to wait until the next bear gave them similar valuations. In investing, fear is an emotion that many investors let take over because they simply fail have conviction in their data and analytical reasoning.  Those fearful investors back in the early 1970's are still waiting today for those valuations to come back down to where they were in 1974.

While current valuations are far above anything during 1974 -- or March 2009, for that matter -- the point is that investors waiting to bottom fish are often left waiting and waiting. While the market may have dropped 10%, many stocks significantly underperformed it. The mood seems grim today, and market sentiment seems to be looking down rather than up. So, instead of timing the market, I prefer to price stocks.

With no more government stimulus money fueling consumption and housing sales, growth will inevitably slow in the second half of 2010. It's just hard to see how the private sector can pick up the slack that quickly. This could very likely cause greater downward pressure on equity prices. I'm not suggesting that this is the time aggressively shift from cash into equities. I never think about market timing but think about individual businesses and scenarios as to how those businesses will do in various economic conditions. From there, the idea is to compare the current price with future value of the company, the probability of that future value, and from there, determine if a margin of safety exists.

I also know from history that the fiscal and monetary situation for the US is extremely different today than it was back in 1974. But just in the same way that businesses like AutoZone delivered a 14% annualized return during the lost decade of 2000-2009, there are companies today with the business and quality management that will likely do well this decade.

The beginning of 2009 may turn out to be one of the few opportunities in this lifetime to have allocated 100% to equities (I remember Buffett remarking in 2009 that if he could, he would have put his entire net worth into Wells Fargo - WFC was trading at $9 at the time), this is certainly not the time to be 100% in cash because of the likelihood of another market collapse. At some point the market will pull back - it always does. Value the business and its competitive position in the marketplace. If the price is right, then don't hesitate to follow your convictions.

Tuesday, April 13, 2010

The Curse of the Value Investor Returns

Decades of market data, media reports, analyst reports, and more players in the finacial arena has led to a major transformation the investment field. That transformation can be summed up in a single word: activity. To many investors, inactivity is viewed as possessing inferior investment knowledge. To the value investor, inactivity is bliss. To the value investor, activitiy or inactivity is determined by one principle factor: valuation.

The time to be active was October 2008, despite the fact that the market was ultimately headed lower. Further activity was warranted over the subsequent 6 months. Today, the value investor is confronted with the preverbial curse: very little value in the market despite a seemingly unending rise in the S&P 500.

However, sometimes the best investment idea is no investment at all. As the market continues to remain strong, the pool of quality investment opportunities naturally declines. An investor used to action will come to realize that today's investing environment, while appearing friendly to stock prices, may turn out to be his worst enemy. On the other hand, the value-seeking investor understands that short periods of excellent buying opportunities are often followed by longer periods of inactivity. I currently find the market in this longer period.

French mathematician Blaise Pascal observed "all men's miseries derive from not being able to sit in a quiet room alone." Indeed this observation hits the bulls eye when it comes to reasons why many investors make mistakes in investing. Emotion, and the need for immediate active results, often lend themselves to poor investment decisions. Looking back at 2008 and the many investors who failed to make it alive, investors will benefit from the quip, "to finish first, you must first finish."

Indeed while the best gains are off the table for now, sitting still does not necessarily mean being 100% in cash although if thats what it takes, so be it. I'm not inclined to think we are anywhere near that point of 100% cash as certain sectors, like those within the agricultural industry, continue to offer tremendous value on a multi-year basis. However, the time to be 100% invested was a little over a year ago and may not come back for some time.

So, while triple-digit gains may be gone for know, investors can be patient with names like Vodafone a global wireless communications provider. The shares yield nearly 6% and the company owns 45% of Verizon Wireless, the largest wireless provider in the U.S. Currently, Vodafone gets no dividend from VW because its majority owner Verizon Communications is requiring VW to use its cash to pay down debt it owes. Yet, once this debt is repaid later this year, an opportunity exists for Vodafone to begin receiving a nice infusion of dividend cash payments.

While investment opportunities can always be found, the key is to understand when the opportunities are ample, and when the well is dry. This understanding comes from an understanding of fundamental valuation. Further, such understanding has nothing to do with market timing. Every rational investor should expect temporary periods where his portfolio will show a decline, as volatility exists in stock markets. For the value-seeking investor, buying at absolute bottoms and selling at the top is not the key to investment success. Instead its buying assets below intrinsic value, and when no such assets can be bought, then buy nothing

Sunday, March 21, 2010

Finding an Investment Edge: Management

The ultimate question people often desire to know of investors or investment funds is what makes them so special or uniquely qualified to outperform the market. The investing landscape has changed dramatically over the past 60 years. Back in the 1950's, a young man by the name of Warren Buffett found his edge by essentially being one in a handful of people that truly applied statistical analysis in a market dominated by investment activity that focused its attention on the most commonly known stocks. Add to that a dose of market inefficiency that does not exist today due to the sheer number of market participants, and Buffett found himself in a money making playground.

Nevertheless, Buffett was different than his mentor Ben Graham. While no one will question Graham's paramount influence on the success of Warren Buffett (not even the man himself), Buffett took the tools and built his own foundation. Buffett is indeed a value investor, but a unique one. Reading over his partnership letters, one can clearly see how Buffett developed his own style - his edge.

Buffett's first edge was his classification of the three areas his participated in - workouts, generally undervalued, and arbitrage. But over time, his edge developed into other areas - control situations, buyouts, etc. Then he moved on to insurance, with gave him the edge of extremely low cost capital. In other words, Buffett created his own form of leverage. The rest is history. As Berkshire grew, so too did Buffett's approach to investing, dictated not by a deviation from his root principles of value, but via the need to properly allocate capital.

Thus the key to successful investing is to develop an edge, but more importantly an edge than you can truly exploit in all environments. Occasionally investors will get thrown a year like 2009, when you can very easily find excellent business trading at substantial discounts to net current assets, P/E ratios of less than 4, or a ridiculous fraction of undervalued book value. In times like these, all one needs is to be ready to act quickly and decisively, and then sit still.

However, during the 80% of the market time when prices are fairly valued at best, a clearly defined investment edge can set one apart. Indeed, value investing, practiced in its true form, is in itself a tremendous edge. The ability to buy unloved businesses or companies currently experiencing temporary problems is not something that relatively many investors can really do. The ability to do nothing while markets are very active is another tremendous edge.

Nevertheless, 2008 showed how just about any approach to investing can suffer a setback. Indeed, while many who were fortunate enough to stick around after 2008 got a chance at retribution in 2009, I continue to refine my investment approach from the experiences of 2008. Like many value funds, we underperformed in 2008. And like many, we vastly outperformed in 2009. Even so, the thinking at Gad Capital has evolved.

Make no mistake, as I outline in my book The Business of Value Investing, my approach still firmly has its roots in six steps I outline in making successful investments:

1. Have a sound investment philosophy
2. Develop a good search strategy
3. Learn to value a business and assess the quality of management
4. Have the discipline to say no
5. Be Patient
6. Have the courage to make a significant investment at maximum point of pessimism.

The order above is deliberate. You can do #3 without #2, and so on.

However, seeing as my fund is relatively small in the investment field, I spend a significant amount of time looking where others simply can not look due to sheer size. For example, this year, we were still able to invest in a sub $10 million company with over twice its market cap in cash and no debt. As one of my potential investment partners told me last year at a meeting, "If the goal in investing is to make money, which is determined by investment returns, it seems to me that having a smaller sum of initial capital makes more sense in generating those returns." There's tremendous wisdom in that comment. Far few funds truly exploit the asymmetrical edge available when working with smaller sums. I know spend a bit more time exploiting this asymmetry.

The other component, and one I have come to realize that I've underappreciated significantly, is the tremendous edge one gets when investing alongside quality management. By this, it's no longer enough for me that a CEO owns 10% of the company or travels coach instead of first class (although I value such alignment of interest immensely). Instead, I become very excited when I see extremely unusual behavior from management. For example, when a CEO of a company decides to borrow money to pay off his divorce settlement so he doesn't have to sell a single share of stock to raise money (true story), that grabs my attention. When a CEO flies across the country to buy a tiny business for $100,000 that is earning $50,000 in net profit, that grabs my attention.

When a CEO decides to stop bidding on contracts to let his competitors take the bids because margins are exceedingly low or negative, that grabs my attention. In essence, this CEO is essentially doing something that will cause his share price to go down in short run, but does so because he knows that in the long run, his firm will be around to take the lion's share of projects when margins are again attractive.

Management that behaves in such extraordinary ways usually produces extraordinary businesses in the long run. Such businesses can and should be held during any market environment. In essence, finding management of this type is like finding the best value investor in that industry. So yes, focusing on quality management is nothing new, but I'd argue that how to really examine management is not often done by many.

Wednesday, February 17, 2010

Conservative Investing is Successful Investing

Mention conservative investing and what you often get are people who think that conservative investing means putting money away in the biggest, most stable enterprises which in turn guarantees safety of principal. If the invested capital happens to also appreciate in value, then even the better. But if not, at least being conservative helps one sleep better at night. That may indeed be true, but unless you're ready to ignore inflation, many investors have it backwards when it comes to conservative investing.

While it’s indeed true that enterprises like utilities are defined as conservative, simply buying the large, well known companies does not fulfill the goal of a successful conservative investment approach. Instead, such a viewpoint increases the confusion between acting conservatively and behaving conventionally.

Two Definitions

Conservative investing, when understood and applied properly, is not a low risk low return strategy. Investors must understand two definitions to appreciate the appropriate means by which to invest conservatively.

1. A conservative investment is one which carries the greatest likelihood of preserving the purchasing power of one’s capital with the least amount of risk.

2. Conservative investing is first, the understanding of a conservative investment is, and second, following a specific course of action needed to properly determine whether or not particular investments are indeed conservative investments.

Where many investors falter in attempting to invest conservatively is blindly assuming that by purchasing any security that qualifies as a conservative investment, they are in fact, conservative investors. In other words, such investors simply focus on the first definition.

Such a viewpoint is limited and costly. A successful conservative investment approach requires not only an understanding of what a conservative investment is, but more importantly the correct approach to take in order to identify what truly qualifies as a conservative investment.

Characteristics of Conservative Investment

If based on the first definition, investors already know what qualifies as a conservative investment, then one needs to know what characteristics define a conservative investment which is where the second definition comes into play. There are four broad categories with investors can use to identify a conservative investment.

1. The Safety Factor

Clearly any conservative investment should be able weather market storms better than most. In other to do this, certain characteristics stand out. First, a business should have a low cost of production. Being a low cost producer has the principle advantage that when a bad year hits the industry, the low cost producer has best chance of still churning out a profit or reporting a smaller net loss. Second, a business should have a strong research and marketing department. A company that can not compete by staying abreast of market changes and trends is doomed in the long run. Finally, management should possess financial skill as in doing so they will be well versed in things like per unit cost of production, maximizing return on invested in capital, and other essential elements of business success.

2. The People Factor

This is a rather self-explanatory qualification for a conservative investment. But take notice that excellent people can only be beneficial after a business has demonstrated the signs of quality above. Take note of Warren Buffett’s advice:

“When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

A small company can succeed on the heels of one or two exceptionally talented people. But as a business grows, people throughout the organization must be counted if the company is to succeed and remain a conservative investment.

3. Business Characteristics

This third quality requires a little more work for investors but its well worth the effort. Here, the goal for investors is to determine what advantages or disadvantages may prevent the business from growing and earning more profits despite satisfying the first two conditions. Things to consider are the competitive landscape of the business. The existence of many competitors or the relative ease with which new competition can enter can affect the best of companies. The potential for excessive regulation could also be a game changer.

In essence, remember that just because a company satisfies the obvious conditions of being a conservative investment always remember to consider this third condition. The following examples will illustrate this concept further.

Those Who Fail and Those Who Pass

Great examples of those businesses that pass the test include names like Coca-Cola, Wal-Mart and Johnson and Johnson. These companies have demonstrated time and time again the strength of their franchises. Even more importantly, both of these companies will likely continue to have very favorable future prospects. Coke essentially competes with Pepsi and Dr. Pepper and no one else. More so, it’s unlikely that entrepreneurs are sitting in garages thinking about creating the next great soft drink company.

Because Wal-Mart exists and succeeds, that should raise a red flag for most other retailers, save for Target and a few specailty retailers. Remember Circuit City, which used to be number 2 to Best Buy in electronic retailing? It’s now bankrupt in no small part due to Wal-Mart. Toys ‘R’ Us was taken out in a private transaction a few years ago due to various competitive threats which likely included Wal-Mart's expansion of its toy department.

Of course once a passing company has been identified, the stock price matters only inasmuch as to determine the value gained. Today, names that pass and trade at very attractive prices include Kraft Foods, Pfizer, and Vodafone.

A Collective Approach

Investing conservatively is not about simply identifying large well-known businesses, but going through a process that identifies why a particular company qualifies as a conservative investment. And as you can see from the names above, being an conservative investor can lead to some of most dependable and respectable returns in the market.

Friday, January 15, 2010

Understanding Profits Leads to Better Investment Decision Making

After 2009’s eye popping market performance, investors need to take a moment and consider what really matters when pouring over company financial reports and earnings statements. It ain't net earnings, although to the detriment of many investors, it's the metric they hinge on. Instead its the one metric that supercedes all others, save for maybe the quality of management. That metric is cash flow.

Investors would be very well served to instead pay attention to cash flows first and foremost. While it’s widely known that earnings can be massaged, investors should be aware that not all attempts to manicure earnings are illegal. Management can legitimately make corporate decisions that have a direct effect on the level of reported earnings.

The most significant decision is the use of depreciation to influence earnings. When a business purchases property, plant, or equipment, it is entitled to depreciate that asset. A growing business will likely have capital expenditures that are significantly above depreciation levels. Such a difference is acceptable for a period of time. And cyclical businesses will likely have periods where cap ex goes up dramatically as they make upgrades or new investments.

However, whenever prolonged periods where depreciation is significantly below cap ex or the other way around, investors should take note. Such discrepancies paint an inaccurate picture of earnings, which demands that investors always examine the cash flows along with earnings. When cap ex consistently exceeds depreciation, then true earnings are actually lower than those reported on the income statement. Conversely, when depreciation exceeds cap ex, then the earnings are better than they appear.

And it’s for the above reasons that value investors typically shun away from capital intensive businesses that earn low returns on invested capital. That’s why Buffett’s deal for railroad Burlington Northern has many scratching their heads. While I’m not investing in any railroads, remember that Buffett’s advantage is the fact that he will own 100% of the business plus the likelihood that Berkshire will own it for decades, which is the only possible way he will get the value he often demands (which coincidentally happens to be pretty darn attractive for the sum of money he is putting up). People often neglect little things like the fact that Burlington’s $470 million or so in annual dividends will now go to Buffett

A good understaning of earnings in relation to cash flows will present the real performance picture.