On Birds and Bushes

The intrinsic value of a stock, i.e. its “true” value, is the summation of all future cash flows discounted back to the present from their respective periods. It is not a Price-to-Earnings ratio nor is it a Price-to-Book Value ratio nor is it an EV-to-EBITDA ratio nor is it even a Discounted Cash Flow analysis. Indeed, it is nothing that can be funneled into a formula.

It is an unknowable figure because it is always changing, being impacted every day by a myriad of decisions ranging from a salesman calling in sick to the Central Bank governors sitting around a mahogany table pondering interest rate policy. What the aforementioned ratios give are only rough approximations of that mystical unicorn known as intrinsic value.

Buffett once used Aesop's classic aphorism to illustrate the idea. Is a bird in the hand indeed worth two in the bush? Because, consider also: How sure are you that there are two birds in the bush, and how long will it take to get them out? That's intrinsic value in a nutshell.

Mispriced securities either underestimate the value of the bird in the hand or the potential of the birds in the bush. Let me draw a couple of examples of this kind of thinking in action.

We exited our multi-year investment in PMT this past quarter. PennyMac was founded by ex-Countrywide Mortgage executives in 2009 to invest in all the distressed mortgages left from the savage wake of the housing bust. They also harbored aspirations of becoming a major independent mortgage originator as their founders all possessed experience and industry know-how from their prior employer.

We initiated our position around $18 back in 2011. At the time, even though PMT was earning a near 20% ROE on its distressed investments and paying it out to the tune of a 10% dividend yield, few investors had the appetite to invest in anything related to the mortgage industry. PennyMac couldn’t put capital to work fast enough, evaluating a torrent of loans that banks were incentivized to unload due to post-crisis regulation. In this case, we had a situation where there was both a bird in the hand (fat dividends), and more in the bush (a vast multi-billion market of distressed mortgages needing to be worked out).

Fast-forwarding to 2014, much of the stigma has faded. Mortgages are no longer toxic in the eyes of investors. The pool of distressed mortgages have become shallower, and the persistent low interest rate environment has spawned numerous competitors willing to bid more aggressively and accept a lower ROE. Now, we still have the bird in the hand (the fat dividend has increased by 45% over the past three years), but the birds in the bush are more uncertain. Considering the risks and other opportunities, I closed our position, generally satisfied with our overall IRR, inclusive of dividends, in the mid-teens.

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Now, consider the example of one of our current positions: General Motors (GM). At first blush, it may seem like GM and PMT have nothing in common. But consider the backdrop. GM, once upon a time the mightiest company in America, fell into bankruptcy and required a bailout by the government. Then, a few short years after exiting bankruptcy, just when it seemed like they were getting their act together, a scandal involving covering up faulty ignition switches in several models of their older cars which caused multiple injuries and deaths was uncovered.

GM, like PMT, has become a pariah on sentiment alone. It has become “un-investible” for many simply because the story has a past history of unpleasantness. But what are the facts? The facts are that the scandal and recall and the likely billion plus dollar legal in costs have not damaged their brand in any significant way if measured by cars sold. On the back of a multi-year replacement cycle for autos, GM has posted record sales two years in a row, selling over 9.9 million cars in 2014. GM’s newest mid-size truck, the Chevrolet Colorado, won Motor Trend’s prestigious truck of the year award. This timely award has coincided with the plummet in oil and gas prices and are thus driving sales of not just their trucks, but also their SUVs, both which happen to be the highest margin products in their portfolio.

Qualitatively, the scandal and recall may just be what the doctor ordered to drive true cultural change in as big a company as GM. New CEO Mary Barra has told its employees at a townhall meeting that, “I never want to put this behind us. I want to put this painful experience permanently in our collective memories.”¹ Capital allocation, once a secondary consideration behind the amorphous (and oftentimes unprofitable) goal of being The World’s Biggest Carmaker, has become front and center, with management committing to aggressive share buybacks and increasing dividends. Return On Invested Capital (ROIC) has recently become a reported metric, bringing transparency and accountability to the company who now instead strives to become The World’s Most Valued Carmaker.

By my calculations, GM is trading at a valuation that suggests the company ought to be worthless in ten years. To put it more precisely, using conservative assumptions of no growth and no margin improvement, the sum of the cash they generate over a ten year span, discounted at 10%, equals their entire market value. An investor buying shares of GM today are paying nothing for the cash flows GM will generate ten years hence.

With GM, investors believe the bird in the hand is as good as it gets and there are just a smattering of birds in the bush. I, to the contrary, believe there are plenty of birds left in the bush and they’ll happily emerge with a mere song. And if you think Tesla (TSLA) or Apple will come out with some kind of miracle disruptive car that eat up the entire automotive pie, I have a bridge to sell you. Tesla’s goal is to sell 55,000 cars in 2015, or, 0.5% of what GM delivered last year. Investors in TSLA, on the contrary, have no bird in the hand (they have never posted an annual profit) and are betting there is a veritable flock of birds in a bush that will take ten years to hike to².

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¹ “It was clearly the right message, but was jaw-dropping at GM. Retired executive Steve Harris, who started at GM in 1967, observes, ‘Her remarks at that meeting were unlike anything any previous GM CEO has ever said.’” (Source: http://fortune.com/2014/09/18/mary-barra-general-motors/)

² Morgan Stanley’s valuation model appraises 80% of TSLA’s value from cash flows beyond 2025. (Source: http://www.wsj.com/articles/tesla-targets-pull-away-from-profits-1429889005)

Holding Period as a Consideration With Regards To Common Risk Metrics

There is something about the nature of stock markets that attract speculators and traders who do not care about intrinsic value as opposed to investors who do. Correspondingly, much of risk management has focused on short-term volatility that cater to those security slingers. Standard Deviation has become the de facto number to brag about or manage around. Somehow, somewhere along the line, most investors have been brainwashed to believe a low Standard Deviation is as valuable as a high absolute return.

Pzena Investment Management, a respected shop adhering to a classic value-oriented approach, who put the theory through the wringer (http://www.pzena.com/investment-analysis-3q14-2). Unsurprisingly, they found: “Much of the daily or monthly volatility of a portfolio disappears as the vagaries of short term price movements offset each other in the long term and the frequency of loss decreases substantially.”  In other words, Standard Deviation draws an inaccurate picture for long-term investors when focused on daily or monthly timeframes. Zoom out, and what do we find?

On a month-to-month basis, stocks fluctuate, and for the S&P 500, 40% of the time, it will be lower than it was the previous month. But by zooming out, five-year periods exhibit less relative fluctuation and less loss. The trend of lower volatility and shrinking losses is even more pronounced for ten-year periods.

Okay, great, so we know stocks go up in the long term. Not exactly breaking news. But... why don’t most hedge funds seem to know this?

Here, most hedge funds, although they have a lower monthly Standard Deviation than World Equities (stocks), actually have a higher five year Standard Deviation.

And the kicker is they do not have definitively superior performance over the long term! Stocks generally go up in the long-term. Hedge funds? Not as certain.

The explanation is that most active funds cannot help but micro-manage their short-term volatility. Those Masters of the Universe sell themselves by touting an ability to achieve equity-like returns without equity-like risks. In the short-term, they can make a case for being successful. But longer term, it is a miserable strategy that offers subpar returns with higher risks.

Moreover, it is nonsensical. Equities are, almost by definition, a long duration asset class. Managing short-term volatility for an asset intended as long duration is like zig-zagging a ship across the ocean in a vain attempt to avoid waves. It’ll take twice as long to get to your destination and there is simply no way to guarantee there will be no waves along the way.

Basic Principles of Valuation as Exemplified by the Good Old Lemonade Stand

Investing is laying out a dollar today with the expectation of getting back more than a dollar in the future. There are multiple ways to do this, obviously, but the safest is to lend it to the U.S. government. You are guaranteed your dollar back¹ . It has no risk, hence, it is called the risk-free rate.

Everything else we invest in must logically be anchored to the risk-free rate. In business, if you invest in $100 in inventory, you should have the expectation of selling it at a high enough margin that, when everything including taxes are accounted for, earns you more than the riskfree rate. Otherwise, why bother?

Let's trot out the good old lemonade stand as a concrete example. Its business model: buy lemons, sell lemonades. Its costs (a.k.a. investments): raw lemons, a lemonade stand, hourly wage for your workers, etc. The goal is to make more money selling lemonade than it costs to set up and run the enterprise. At the end of the year, you tally everything up, all the cash that was spent and all the cash that was made. If you spent $1,000 and made $1,200, that is a healthy 20% return on your investment.

But what is this business worth? What is your lemonade stand worth if you want to sell it?

The intrinsic value of anything is the sum total of the cash you can extract from it over its lifespan discounted by the risk you're taking. It's a simple definition but it is basically impossible to pin down an exact number due to the subjective and fluctuating variables in the formula² . Even the value of a risk-free U.S. Government Bond is unknown because interest rates fluctuate continually³ . So, the first thing one should admit upfront is that there is no such thing as an accurate intrinsic value. What we should do instead is make conservative assumptions, acknowledging the inherent uncertainty of the future, and arrive at a rough range that approximates an intrinsic value.

So. Back to the lemonade stand. We know the business earned $200 last year in net profits. The next thing we need to know is, is that profit level sustainable? Is it in a competitive neighborhood with entrepreneurial kids, or is it in a retirement community with little risk of competition? Is its proprietor interested in continuing to manage the stand or do you have to find someone else to run it who may not know the business as well? How about the cost of lemons? Wasn't there a shortage recently due to bad weather? How about repairs to the stand, which has suffered some wear and tear? How about the fact that a controversial study blamed lemonade for increasing the risk of heart disease? Will that dampen demand?

Even after just a cursory bit of thinking on the matter, it's probably pretty clear that there's quite a bit of risk. Lemonade is, after all, a commodity – widely available and undifferentiated. Just because the business earned $200 last year is no guarantee it will earn the same or more next year. Thus, a conservative investor would probably not pay very much for the business⁴ .

As simplistic as this sounds, that's basically business valuation in a nutshell. Figure out how it makes money, figure how much it could make in the future, and then add it up and discount it. To contrast the instability (and thus low value) of a commodity business, consider the worth of a business like Disney. Not only do they own one of the most iconic brands associated with happy childhood memories, they also own ESPN and Marvel and a litany of other cultural mainstays deeply ingrained in global culture. Billions of people will always consume their products and feel good and pass on their stories to their kids who will in turn pass it on to their kids. Properly managed, Disney's cash flows will be prodigious and predictable and unassailable. They are worth many multiples of their annual profits because you can be near-certain they will earn it year after year after year.

***

Why does this matter in the stock market? Because a stock is a fractional interest in a business. A shareholder has a claim on the profits. The more shares you own, the bigger the claim. Logically, it follows that if you've analyzed a company and purchased its shares at a valuation you deem attractive, you'd salivate at an opportunity to lay a bigger claim at a cheaper price.

But, you might argue, such claims to profits are merely theoretical. There's no way to take those profits and, say, buy a house. You depend on selling shares to monetize your investment, and thus, by proxy, depend on what others will pay for your share, i.e. the whims and volatility of Mr. Market. So, the market’s daily movements matter, right?

To which I'd respond, yes, but only if your need for said monetization is immediate or shortterm. In which case, you shouldn't be investing in stocks at all. In finance, there is a concept called duration. The longer the duration of a security, the more prone it is to price swings because the far-future is more unpredictable than the near-future. Equity is the longest duration security of them all, one with essentially limitless duration, and thus, your timeframe, your obligations that you need to meet with the cash, should match up with what you're investing in.

Over time, as I've often quoted Benjamin Graham, the market is a reliable weighing machine. Businesses that are chronically undervalued on the market implement policies to return capital to shareholders via dividends or share buybacks or get sold for big premiums to private buyers. Mismanaged businesses attract activist investors who oust the board and implement radical changes in efforts to preserve or extract value. The bottom-line is, while there are many ways to skin the cat, prices that are out of sync with value almost always, inevitably, converge.

“If you know the enemy and know yourself, you need not fear the result of a hundred battles.”

–Sun Tzu

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¹ But unfortunately, you'll earn, in today's environment, a miserly two pennies a year. And that's only if you promise to lend it for 10 years.
² E.g. What is the appropriate discount rate? What are the expected cash flows each year?
³ E.g. Who would buy your bond for the amount you paid if the coupon on that bond is less than the coupon on a newly issued bond?
⁴ Unless the investor owns, say, a national chain of lemonade stands that he/she can integrate it into, shaving off costs via economies of scale

On Finding Investment Ideas

Legendary value investor Michael Price once guest-lectured in one of my classes at NYU Stern back when I was a bright-eyed bushy-tailed MBA student. One of the questions during the Q&A session was: how do you go about finding investment ideas?

A common answer for a typical investor would probably be to run a screen: take a big list of stocks and their financial figures and sort/filter by standard metrics like Price-to-Earnings or ROI. There’s nothing wrong with that approach. Plenty of great investors, including one of my personal heroes, Joel Greenblatt, make heavy usage of creative screens to build portfolios.

But, instead, Mr. Price picked up a copy of the day’s Wall Street Journal lying on the table and said, I’ll show you. He went down the list of stories on the front page, distilling the essence of each article with impressive speed. A piece on rebounding natural gas prices had him musing about the value of drilling rig operators. Another one on new financial regulations triggered a thought about its effects on a specialty lender that he follows. The announcement of a merger prompted him to make a mental note to go over other companies in that sector to gauge the possibility of further consolidations.

Mr. Price, unimpressed by my bright-eyed-bushy-tailed demeanor

Most of the time, the idea-hunting approach that bears the most fruit for me is similar to Michael Price’s demonstration that day: following my nose. The last investment I made originating from a screen was over four years ago when I found Movado Group (MOV) trading below book value at $10 per share. Most of the time, it’s difficult to identify anything truly tantalizing through screens. Absent dramatic stock market dislocations, computer algorithms usually quickly pick-off the obviously cheap names.

Occasionally it is possible to exploit short-term inefficiencies like our aforementioned AAPL trade. But in general, ideas aren’t so much “found” – like pigs hunting for truffles – as they are “formed” – like laying down nutrients in the soil and waiting for rain and photosynthesis. Buffett was once asked how to get smarter, and he held up a stack of paper and said, “Read 500 pages like this every day. That's how knowledge builds up, like compound interest.” He has also bluntly stated, “My job is essentially just corralling more and more facts and information, and occasionally seeing whether that leads to some action.”

And so, I read. On a typical weekday, I skim at least three newspapers: The Wall Street Journal, New York Times, and Financial Times, and try to read them a la Michael Price. A continuous stream of Google Alerts pours in all day, keeping me up to date on breaking news. I subscribe to industry-specific journals, like American Banker or CIO Magazine. And then there is hedge fund gossip, e.g. who’s buying what, who is in trouble, who might be forced sellers, who is playing activist in corporate boardrooms, etc. Twitter’s become an unusually good source although it takes some effort to sort through the hearsay of citizen journalism.

When doing serious due diligence on a security, I spend hours going through SEC filings, reading Management Discussion & Analysis and Financial Statements and press clippings and investor presentations and conference call transcripts. Most of the time, the resulting action item is… nothing. Data and facts get digested and sorted to build a narrative of the company from which I try to analyze and understand and predict its future performance. More often than not, it gets filed away in the “Too Hard” drawer. It is a bulging drawer, but one I dip back into often when new data and facts arrive, hoping for an insight to form an investible thesis around.

Alas, that laundry list only scratches the surface. In this hyper-competitive market, the only way to maintain a consistent edge is to continuously compound our understanding of the world. We have to stay curious. We must build and polish a latticework of mental models¹ against which we test ideas. Every now and then some of them click, and we invest. Otherwise, we simply wait. Value investing is a game won by temperament, not speed or IQ or raw computing power. It requires, above all, a willingness, nay, desire, to basically sit around and read all day. It doesn’t sound glamorous because it isn’t. But I wouldn’t trade it for any other job in the world.

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¹A term popularized by Charlie Munger, who believes in stock picking as a subdivision of the art of worldly wisdom.

A Live Case Study of Short-Term Market Irrationality

We own a medium-sized position in a Florida-domiciled Property & Casualty (P&C) insurance company specializing in catastrophe risk. Think hurricanes. In 1992, Hurricane Andrew devastated Florida and was, at that time, the costliest hurricane in U.S. history. Insurance companies took heavy losses and stopped writing coverage in the state, deeming it too risky. Florida’s government was forced to establish an insurer of last resort, called Citizens Property Insurance, that wrote catastrophe coverage backed by tax payers because, well, people still want to live in Florida.

Since Andrew, forecasting for hurricanes has dramatically improved, primarily via the leaps in computing power that made crunching gigantic weather data sets more efficient and accurate. By 1999, Citizens was under political pressure to reduce their risk. They formed a “take-out” program that encouraged private insurers to take over their policies. To entice the private sector, there had to be juicy economic incentives. And there were. It is under these favorable auspices that many insurance companies were formed during this time to take advantage of the gold rush, including the hero of our story.

Our company has parlayed the above macro tailwinds to become a publicly traded insurer, of which we began investing in a little over a year ago. They have begun aggressively building out an agency network with their newly raised capital and expanding their coverage to coastal states from Texas to Maine. It has been an extremely successful campaign, more than doubling their policies in-force and compounding their book value by 15+% per annum since 2011. In late July, they reported blowout 2nd quarter results that had per-share earnings growing over 60% yearover-year and sported a return on equity of over 25%. To top it off, almost all the growth was “organic”, originating from their agents rather than from cherry-picking Citizens. 60% of the growth was outside Florida. It was resounding evidence that their business strategy was working. All of that could be had for a tantalizing bargain price of under 10x earnings.

How did Mr. Market reward such excellence the next morning? By selling the stock off by -17%. It ended the trading session valued at 7x earnings, a level reserved for shrinking businesses helmed by incompetent management, the diametric opposite of what this company has been accomplishing. I searched high and low for a reason… and came up empty. A contact reached out to the CFO of the company, who was as perplexed as anyone and even sought clarification from the NASDAQ exchange. Nada.

Such is how irrational Mr. Market can be at times, and it is easy, even instinctive, to feel fear in the face of a rapidly tumbling stock price. But for those who have done the homework and possess the confidence gained through careful and thorough due diligence, fear becomes opportunity. We upped our position in this company the next day, which, unfortunately, make our monthly statements look bad, but has a very probable chance of being highly profitable over time as the company continues its upward trajectory.

And don’t just take my word for it. Several insiders, people with detailed facts and figures of dayto-day operations like management and members of the board, all did the same thing and bought over $2 million worth of shares with their own money the same time I did. As the famed investor Peter Lynch once said, there are many reasons why insiders sell, but only one reason insiders buy: they think the price will rise.

Pilgrimage to Omaha

Subsequent to April, I traveled to Omaha Nebraska for a weekend at the Woodstock of Capitalism. I am, of course, referring to Berkshire Hathaway’s annual meeting, hosted by Warren Buffett and his Vice Chairman Charlie Munger. Buffett and Munger’s influence on me has been thorough and absolute. More than their obvious investment acumen, it is their method of thinking, their worldly wisdom, their steadfast common sense principles that continue to guide both my professional and personal way of life.

Over 18,000 people packed the CenturyLink Center in downtown Omaha. Total attendance is far above that figure, as all the overflow rooms in the Hilton Hotel across the street were fully packed as well. I woke up at 6:30am to try to secure several good seats in the arena, but alas, this vantage was the best I could do:

Warren Buffett and Charlie Munger then took questions for six hours straight (with an hour lunch break), alternating between the audience and a panel of journalists and analysts. If you’re interested, detailed notes from the meeting can be readily found online . But I’ll highlight a few insights here that were especially thought provoking to yours truly. The rhythm of their Q&A is a detailed, earnest, and sometimes long-winded answer by Warren, followed by Charlie adding a colorful sentence or two as a punctuation.

On increasing transparency on executive pay:

A: Shareholders would be harmed by more information on executive pay. Corporate CEOs’ salaries are benchmarked off of their peers, and no one thinks they are worth less than anybody else. People’s satisfaction with their earnings level is relative, not absolute. This has created a vicious cycle of upward trending C-suite salaries that cost shareholders millions every year. Munger: “We don’t want to add to the culture of envy in America.”

On See’s Candies and its significance to Berkshire:

A: Berkshire has done very well with See’s Candies, but it has not grown significantly since the ‘90s. Its main contribution has actually been opening their eyes to the power of brands. Berkshire was smart enough to buy Coca-Cola because they owned See’s – they saw the possibilities of a powerful brand. If they had not owned See’s, they may not have owned Coke. Munger: “Main contribution to Berkshire was ignorance removal. If it weren’t for the fact that we’re so good at removing ignorance, we’d be nothing today.”

On how to figure out one’s Circle of Competence:

A: Be realistic with yourself in appraising your own talents and shortcomings. Don’t be afraid to try different things to figure out where the perimeter of your circle is. Keep friends who will tell you, well, what the hell do you know about that? Munger: “If you’re 5’2”, say no to professional basketball. If you’re 350 lbs, don’t dance ballet. Competency is a relative concept.”

Miscellaneous Munger-isms:

• “If it is a very competitive business, and requires competitive abilities you lack, you should look elsewhere. I immediately decided I wasn’t going to be thermodynamics professor at Caltech. I looked elsewhere over and over and soon there were only one or two career choices left.”
• “GEICO is like Costco. They feel a holy duty to have wonderful product and a wonderful price. Companies like that get ahead over time.”
• “Frugality has helped Berkshire. I look out at the audience and I see frugal, understated people. We collect you people.”

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The purpose of attending the Berkshire Hathaway annual meetings is not to seek mind-blowing epiphanies in the art of investing. Warren and Charlie’s essential lessons stay the same, and Buffett’s increasing penchant to go on TV to give his spin on what’s happening in the world means that there are very few fresh revelations during the Q&A.

Instead, it is more akin to a pilgrimage where one renews his or her “faith” in value investing. As the market’s increasing volatility continue to shake out players who once thought compounding capital an easy game, the Woodstock of Capitalism is a nourishing reminder of the time-tested method of analyzing business fundamentals rather than their ever-shifting stock prices. Stay steadfast, and trust that the scoreboard over the long run will add up in our favor.

“The best way to get a good spouse is to deserve one. It is the same in business and investing. Behave correctly – it’s amazing how well it works.”

-Charlie Munger

Are Markets Efficient?

Last October, the Nobel Prize in Economics was given jointly to three economists, two of whom are on polar opposite spectrums with regards to their views on the Efficient Market Hypothesis (EMH). One, Eugene Fama, is the godfather of the EMH, coining the term in 1969, while the other, Robert Shiller, once wrote that the assertion of an efficient market was “one of the most remarkable errors in the history of economic thought.”

A quick primer: EMH is the theory that financial markets are “efficient”, and that no one can consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. Informally, it’s the assertion that you will never stumble upon a pile of cash on the sidewalk because if such a pile existed, it would have been picked up long before you saw it.

First of all, let’s quickly disprove the idea that the market can be perfectly efficient. Assume that it is. In which case there is no reason for any active stock picker to be in business. In which case everyone is invested in index funds. In which case… how would the index themselves be priced?? It quickly becomes a paradox. The “efficiency” in markets is created by those who don’t believe it is efficient. In other words, someone’s gotta pick up that pile of cash on the sidewalk first.

However, the market is pretty darn efficient. A lot of smart people are in it, viciously weeding out the inefficiency, picking up those piles of cash almost as soon as they drop. Thus, I find it much more prudent to assume the market is efficient, assume the security I’m analyzing is priced correctly, and not to make a move unless I can credibly explain otherwise. For every buyer, there is a seller, and on balance, those who are selling likely have more experience with what they’re selling than those who are buying. Understanding your counterparty’s motive is crucial during due diligence.

Which is all to say, both Dr. Fama and Dr. Shiller are worthy of the Nobel Prize despite their seeming contradictory stances (Efficient versus Not Efficient). The question of “is the market efficient?” is an academic red herring, because the market is an interplay between both forces. Inefficiency breeds efficiency. Indeed, it is the very cornerstone of capitalism, which incentivizes human beings to be ever more productive, ever more efficient.

The added value of an active manager like Incandescent Capital is to direct capital to businesses that are, in my estimation, mispriced. We are doing our part to close the mispricing by providing liquidity to those wishing to sell the security, who can then go forth and redeploy that capital elsewhere. Meanwhile, if my assessment in the mispricing is correct and it closes, we earn a satisfactory profit on our endeavor. Although admittedly abstract, this is not zero sum over the long run. Capital incentivizes people, and the flow of capital directs how and where our innovations come from (e.g. Industrial Revolution -> steam engine; Dotcom Bubble -> Pets.com). Picking stocks may seem like an infinitesimally irrelevant cog in the global economic machine, but as Barack Obama recently mused in The New Yorker, “At the end of the day we’re part of a long-running story. We just try to get our paragraph right.”