January – March 2008

April 26, 2008

It would be useful to again elucidate our philosophy which has not changed. I reproduce an article I wrote a month ago:

“The stock market with its daily quotations tends to shorten time-horizons because of the ready availability of alternative opportunities and liquidity. It is difficult to think as a part owner when a casino-like mentality pervades. Emphasizing assets and cash flows over earnings is difficult because of the availability bias (focusing on information that is readily available rather than that which is important). The do-something syndrome destroys the patience necessary to wait for the right stock at the right price. Value investing is psychologically difficult when momentum is king. But done correctly and with discipline, value investing gives a decent risk adjusted return.

Here are some ways to look for inexpensive stocks. The list is indicative and is by no mean exhaustive.

1. When stocks start quoting like high grade bonds it is time to buy. To meet any reasonable test of credit capacity, the earnings yield at those low market capitalizations will have to be very high, thus yielding the requisite margin of safety.
   
   
2. When businesses are priced below liquidation value, they are bargains. This usually happens in the absence of current earnings. However if there is adequate asset backing, like net current assets and marketable investments, Mr. Market in all probability would be overdoing the pessimism. Pessimism and perverse pricing usually play together – when one abounds the other cannot be far away. And on occasions, today’s discarded becomes tomorrow’s darlings.
   
   
3. When growth comes for free, it is time to buy. There is no magic formula to determine this, although there are quantitative screens based on Magic Formula (by Joel Greenblatt) to start searching. Such screens determine stocks based on how much the underlying companies earn and how cheap they are.
   
   
4. When bad things happen to good companies, it may be the time to buy. Investors overreact to bad news, however transient and temporary they may be. If the company’s sources of competitive advantage have not changed materially, bad news provides the buying opportunity. As Professor Bruce Greenwald wrote: “In search of disaster has always been a better investment guide than ‘in search of excellence’.”
   
   
5. When a private market value of a company is substantially higher than the stock market capitalization, it is usually time to buy. Benjamin Graham and David Dodd wrote in “Security Analysis”: “On Main Street the idea that a business is worth much less than you could auction it off for would seem preposterous; but in Wall Street, people think of themselves as owning not a part of a business but shares of stock in a business. These shares may be valued, bought, and sold on a basis that bears little relationship to normal appraisal of the business entity on which they have their ownership claim.” Look not to the stock market price tags but to the deals in the M&A markets.The reverse is also true – when the stock market capitalization is higher than the private market value, insiders and promoters usually sell either through public offerings or in the stock markets.
6. When companies with low market capitalizations in relation to earnings, cash flows, book value or sales start announcing buybacks, it may be time to buy. Intrinsic value of the remaining shares will increase after the buyback, and the companies would have either suitably altered the capital structure or else opportunistically deployed low yielding surplus cash.
   
   
7. When heavily leveraged companies start restructuring their operations and finances, it may be time to buy. Again equity must be cheap and there must be adequate cash flow and asset backing available not just to creditors, but also to equity owners.
   
   
8. When the sum-of-the-parts valuations are high and de-mergers are announced, it may be time to buy. This is the stock market’s brand of alchemy – the mysterious creation of value from nothing but a corporate action. Unlike many stories spun on the Street, spin-offs and demergers offer decent upsides, provided the investor is prepared to endure the illiquidity during the period of de-listing and subsequent re-listing.
   
   
9. When a stock quotes below asset value, both tangible and intangible combined, less debt, it is time to look. Seth Klarman of the Baupost Group wrote about the relative ease of measurement of tangible assets: “Tangible assets are more precisely valued and therefore provide investors with greater protection from loss. Tangible assets usually have value in alternate uses, thereby providing a margin of safety.” This follows from Ben Graham.

Warren Buffett however commented: “My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely on economic goodwill. This bias caused me to make many important business mistakes of omission, though relatively few of the commission.” Economic intangibles though harder to value, can be valued and should, where appropriate, be valued.

The hard part is not in buying the bargain; the hard part is in the waiting and in the selling when it is no longer a bargain. But then value investing has always been simple, but never easy.”

I believe that all the stocks in your portfolio are trading at material discounts to what they are worth.