***
- Movado Group (NYSE: MOV) - I initiated a position in Q2 2010 after finding Movado in the proverbial "net/net" basket. A "net/net" security is one that trades below its current assets minus ALL liabilities, and is a classic screen for value pioneered by Benjamin Graham. In this case, the entire equity value of Movado was trading below its current assets net of all liabilities. As common sense would suggest, that's what it means to buy $1 dollar for $0.50 cents. However, net/net's are often value traps; there is a reason why a net/net security finds itself trading at such pathetic prices, and that is because value is being actively destroyed. This is the key to successful net/net investing--determining how value is being destroyed, and most importantly, if that's going to stop anytime soon.
In the case of Movado, I considered 1.) its brand, 2.) its management, and 3.) its past earnings power. It's rare to find a recognizable name like Movado in the net/net bin. Most of the time net/nets are no-name companies in a dying industry and the only salvageable thesis is liquidation. As a net/net, zero value was being attributed to the Movado brand, and I assessed that to be unlikely. Movado is headed by Efraim Grinberg, the son of the founder, Gerry Grinberg, who was chairman until his passing in 2009. Efraim owns over 10% of MOV's shares, and a related investment vehicle, Grinberg Partners LP, owns another 15%. Also, the President and COO Richard Cote owns about 8.9%, so adding all of that together equals officers of the company that have their interests aligned with shareholders.
When I started the position, Movado's sales had declined 17% year over year and was incurring losses in its retail stores. Since then, in conjunction with a recovering economy, internal cost-cutting, and the shuttering of its money losing retail operation, sales have started recovering, surprising big to the upside in Q3 2010, and profits are flowing again. The stock has reacted accordingly, working its way out of the net/net doghouse and netting us a 38% gain for the year.
- J. Crew Group (NYSE: JCG) - I have long been a fan of J. Crew's current chairman and CEO, Mickey Drexler, known to Wall St. as the "merchant prince", the man who transformed The Gap from a little-known retailer into a $14 billion/year industry force. When he was unceremoniously dumped by The Gap, the private equity shop TPG lured him into run J. Crew, and he promptly transformed JCG inside and out, growing revenues from $900 million in 2006 to over $1.6 billion today. That he did it during the worst recession of our lifetime is all the more remarkable.
The position was initiated in late October of 2010 after its shares tumbled from $50 down to $32 for no discernible reason besides a souring investor sentiment towards the retail sector. When a baby of this quality gets chucked out of the window with the bathwater, it was an easy decision to buy. My intention was to own JCG for years and years and enjoy watching Mickey Drexler build his new empire piece by piece. Unfortunately, private equity buyers also had the same intention, and one short month later, JCG agreed to a buyout offer of $43.50. Although a 35.8% gain in roughly one month is better than a kick in the teeth, I am a little bummed that I did not get to enjoy the ride.
- A.C. Moore (NASDAQ: ACMR) - A relatively obscure arts and crafts chain that operates in the east coast. I actually started buying ACMR in late 2008 at an average cost of $0.93 cents per share. At that price, it was literally trading for 1/10th of its book value. It was an extreme net/net, and although it was losing money, it was still moving $500 million worth of products each year, and its cash burn rate was slow enough that it would've taken them years to go out of business. Could it happen? I suppose. But I made the bet that our capital markets is rational enough that some intrinsic value will eventually be unlocked, even if it's in pure liquidation. Luckily, it happened in a dramatic way, and I exited the position at $4.10, a 340% overall return on our investment.
- Magna International (NYSE: MGA) - Another name that I started buying in late 2008, Magna is one of the world's largest auto parts suppliers to major OEMs. Chances are you have been in a car that sports Magna-built seats or mirrors or chassis. 2008-2009 were just awful years for the auto sector, with bankruptcies happening everywhere, up and down the supply chain. And again, like ACMR, Magna sold off to about 1/2 book value despite sporting a net cash position on its balance sheet. Their net cash position assured me they would not be going bankrupt or suffer a liquidity crises, so I made a bet on the eventual recovery of the auto sector via MGA. In hindsight, it's easy to say, of course the auto sector would recover--it's America! Everyone drives! But, boy, was it scary to buy anything auto in late 2008.
I started accumulating MGA around $15 (split-adjusted), then it went down to the $10s and I kept buying and sweating. Average cost basis ended up in the mid-teens, and it has paid off handsomely since. MGA has rebounded in an elongated hockey-stick shape, and I started taking profits in 2010 when it was in the $30s and $40s. In hindsight, I was too conservative and too early in selling. Magna's sales and profits has roared back to historical averages as the auto sector recovered strongly. Today the stock is in the $50s, but unfortunately we own only a few token shares now--not really enough to move the portfolio meaningfully anymore.
- Berkshire Hathaway (NYSE: BRK.B) - I bought Berkshire's Class-B shares in 2009 after reading Whitney Tilson's pitch of the stock. It was the most clearly articulated way to think about Warren Buffett's conglomerate I have ever seen, and I was sold. (The presentation has been updated a few times since then, but the core logic and language remains the same. Check it out here.) Honestly, I don't have much insight to offer as to why we own this position besides that, and the fact that I really wanted to go to Omaha for the annual meeting at least once before Buffett retires for good. I was lucky enough to accomplish that goal in 2010, and what a nerdy thrill it was to sit in the cavernous Qwest Arena while Warren and Charlie took questions for hours on end. I may never sell these BRK.B shares, which was up 21% in 2010 and 40% from our cost basis.
***
I make only minimal attempts at trying to forecast where the broader market as represented by the S&P 500 will go in the near term. This is not where I believe my strengths lie, i.e. an ability to read market psychology, sentiment, what-have-you. Of course, for someone obsessed with the markets on a daily basis, it's almost impossible to fight off one's pattern recognition engine, but I almost never put my money where my mouth (mind?) is.
Note that I did not include macroeconomics in that list. I think one of the biggest mistakes that investors make is trying to extrapolate macro data with how the market will move. In the long run, a country's market performance will correlate pretty well with a country's economic performance, but the lag time can vary wildly, especially in the short-run, to the point of complete randomness. As the famous economist John Maynard Keynes puts it, markets can remain irrational longer than you can remain solvent.
What I do try to figure out is, broadly, if the market as a whole is under or overvalued. This is a useful exercise not because I want to wager on index products or derivatives, but because it informs my aggressiveness in investing in securities that tend to correlate with the broader indices. When I believe the markets are undervalued, I target high quality companies with sustainable competitive advantages, such as American Express (NYSE: AXP). The equity shares of wonderful businesses are so infrequently on sale that the only time to really accumulate positions in them is when, to flip a common wisdom upside down, "a falling tide lowers all boats". When markets are overvalued, I attempt to shift allocation of capital towards less market-correlated securities, those that have high probability of specific catalysts occurring that will realize value. Of course, this is easier said than done. It is magnitudes more difficult to identify the latter kind of investments than the former kind, and to make things worse, looking at things through a value-oriented lens, markets tend to be overvalued far more often than undervalued.
I perceive the market in general as of the start of 2011 to be fairly valued to slightly overvalued. As a crude way to quantify this, consider that the forward P/E ratio of the S&P 500 is around 13.5, which is an earnings yield of 7.4%. In contrast, the 10-year U.S. Treasury bond is yielding nearly 4.0%. So, the snapshot equity risk premium, which is the "reward" that investors are willing to settle for for taking the "risk" investing in common stock versus risk-free bonds is a mere 3.4%. Of course, the amount of moving parts in this formula is immense. For one, what if the earnings estimate for the S&P is incorrect? And this does not take into account dividend payments nor the expectations of growth in earnings over time. There have been times in recent history when equity risk premiums are negative precisely because of growth expectations. However, I think it is not a stretch to say given our high unemployment situation and growing national debt burdens that high growth is probably not on the horizon.
There is enough academic work around equity risk premiums to fill a library, but a common sense interpretation seems to me the best way to think about it.
***
After a slow start to 2011 due to a lot of traveling in January, I feel more optimistic about the rest of year. There have been several attractive ideas recently, and I am starting to put cash to work, thankfully. We have been sitting on around 35% cash for a few months now, and it is getting difficult to find easy opportunities. My number one goal with our money is safety, and I must constantly remind myself it is infinitely more preferable to have excess cash than to suffer a permanent loss of capital. Think about it this way: if you have $100 invested and you lose 50%, you would be left with only $50, and just to get back to even, you would need to make a 100% return. That is an asymmetrical relationship that I think a lot of investors forget. I hope I never do.
That aside, annually compounding our investments at an average of 25% is my target, keeping in mind that that figure is over the course of several years, meaning there could be some years I underperform dramatically and be down overall, punctuated by some years with outsized returns. I subscribe to the belief that it is much better to earn a choppy 25% than a smooth 10%, but I fully understand the nervousness that is prevalent when things are stormy. This is the risk of value investing; betting on companies that most people have left for dead or have a variant view on, and sometimes those variant views may hold for a long, long time. It is incumbent upon a steward of capital to triple-check the facts, constantly revisit the thesis, and toughest of all, firmly believe in oneself in the face of a mad world. That, at the very least, I hope I can always do.
