Monday, February 11, 2013

What's the upside?

If anyone was dying to see a long winded analysis of a really attractive company this post isn't it.  I'm out skiing in Utah for a few days, and while I am not planning on researching any companies while I'm out here over the past two days I've been thinking about the following topic.

The topic of this post stems from a conversation I had with someone recently with regards to the time value of research.  As I was riding a lift today I was thinking about what percentage of undervaluation would be attractive as an entry point.  I was thinking about this in the context of the Ben Graham quote where he said you don't need to know a man's exact weight to know he's fat.  Likewise you don't need to know exactly how undervalued a company is to know they're cheap.

When I look for a company I want to add to my portfolio I look for what I call silly cheap companies.  These are the net-nets, the low book value, the hidden asset, hidden earning companies.  Because I invest mostly in small caps I have the ability to only buy companies that are extremely cheap.  A manager of a fund of any respectible size couldn't possibly buy shares in some of the companies I own.  As one travels up the market cap ladder the size of potential undervaluation decreases.  Whereas it wouldn't be surprising if some $10m company grew 100x it's unlikely a $1b company will do the same.  This leads to what I call the Barron's effect.  Most of the companies recommended in Barrons will have a line in the article saying something like "We believe this company could return 18% in the next year."  When I read something like that I wonder how few estimates have to be slighly wrong for that 18% to disappear and the stock be flat.  The problem is most Barrons readers want to purchase large cap stocks, or are in the industry buying larger stocks.  If Barrons came out and recommended some $30m company and said they could triple, their article alone would probably get the stock 40% of the way there on Monday morning.

The percentage of undervaluation is another way of stating a margin of safety.  The margin of safety is just a place holder for error and unknowns.  If I think something is worth $1000, but there are some unknowns I might not invest unless the price were $667 or below.

I believe most if not all value investors understand the concept of margin of safety.  What I think a lot of smaller value investors miss is the time value of research.  One of the advantages of looking at small companies is it doesn't take much time to read all of the annual and quarterly reports.  For some of the unlisted companies I own it might take 20 minutes a year to read all of their financial reports.

The time value of research takes into account the amount of research required for a given return.  For example, take two companies with the same expected outcome, a 50% return on a $10,000 investment.  If the first company is a simple net-net that takes 10 hours to research the hourly return per research time is $500 per hour.  If the second company is very complex and requires 50 hours of research the return per research time drops to $100 per hour.  Given this example it's obviously better to invest in the net-net with 10 hours of research verses the complex company at 50 hours.  What's odd to me is most value investors are attracted to the complex situations and shun the simple investments.  I believe most of this is due to a pride factor, there is a lot more pride in being able to understand AIG or some complex balance sheet verses Logan Clay Products.  Ultimately for myself I don't care about pride, I want the highest returns for the least amount of time.

The obvious conclusion from this is to look for simple investments with large return potentials.  If someone recommends I look at a company that has a 100+ page annual report I will skim a bit before looking at something else unless the recommender states that this company could go up some incredible amount.  In the time it takes to read 100 pages on a single company I could read the annual report of five different small cap firms.  My belief is that better investments are found with the more ground I cover.  That's not to say I'm opposited to reading 100+ page annual reports, it's just that I would prefer the simple companies.

I strongly believe the biggest efficiency gain possible in investing is understanding banking.  There are 7600 banks in the US, I don't know how many are publicly traded, but a lot are.  Banking is unique in that if you understand how to value one bank you understand how to value them all, banking is a commodity industry.  So for the effort it takes to understand how to value banks initally an enormous range of potential investments is opened up.

My concluding thought on this post is when looking at a given opportunity consider the time value of your research.



























15 comments:

  1. Isn't the time taken to research a sunk cost? (at least after the research is done) Of course you could make a guess on the time required beforehand but can't be 100% sure.

    Even if an annual report is slim, you may still need to spend extra time understanding the industry, competitors, customers, etc.

    I'll take a company that every value blog knows (CNRD) as an example. Even though the business is relatively simple, there were some nuances to figure out that added to time to invest. How does the oil spill effect CNRD, how does the Jones act protect the company (and any chance of it being suspended and/or appealed), and is there growth in the barge fleet or just replacement (I think both but the tax change in the early 80s stopped new builds).

    Since a good chunk of time was spent understanding the industry, you might be able to capitalize on another firm tody or in the future. In this case, I was able to get up to speed faster on TRN then I could have otherwise.

    Another factor in research is being prepared. Many times I have done research on a company, said to myself this stock is a screaming price at x, only to look at the chart and see it was there 6 months ago. Keeping up on research gives the potential for opportunities down the road.

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    1. I disagree that research time is a sunk cost. My point, and maybe it wasn't clear is that if I need to research every competitor, and know industry trends to feel comfortable with an investment it's probably not cheap enough. In a lot of cases it's important to understand the industry dynamics because that might be leading to the undervaluation, but if I can't get comfortable without all that extra information the company isn't silly cheap.

      You have a good point about keeping an eye on companies. I'm not the type of person who will research something first then see if the price is right for an investment. I hunt out cheap companies first then consider if they're worth investing.

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  2. oddball i agree your take on banking i have been doing it for a while, bankprobe.com has really help me go through over 7000 banks

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    1. Thanks for the comment, it seems bankprobe launched a week ago, so maybe you're a beta user?

      I'm glad you posted that, I'm actually working on a site that's very similar, I'm hoping to launch it in the spring.

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  3. From a "franchise value investor" standpoint (i.e. Warren Buffet style), the return on invested research time could be inestimable. If you research a great franchise company for 10 hours but hold that company forever, the returns on those 10 hours over decades would be enormous.

    It sounds to me like in the case of an "asset value investor" such as yourself, you expect there to be one or a couple value-unlocking events, at which point you sell off and profit. In this case, it makes sense that the return on invested research time comes into play.

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    1. Maybe? Even for a company I want to own for a while I have a hurdle 10-15% compounded, and I can calculate an expected return based on that. The question I have for the Buffett GARP investors is do you ever sell? What if the great business becomes overvalued in three years, do you sell it or just hold on?

      To steal an analogy from a friend...I look at investing in a similar manner to owning a small store. Stocks are the inventory, I buy my inventory at reduced prices and then have them sit on the shelf (my portfolio) until a buyer comes along offering a fair price. Some of the inventory might sit for years, and sometimes while it's sitting it becomes more valuable and throws off dividends. But if a buyer comes in and offers a fair price I'm always willing to sell. The inventory is eclectic as well, some asset based purchases, some low earnings, a few fallen angels, but all purchased at a discount waiting for a buyer. I'm always on the hunt for new inventory and always willing to sell what I have.

      A different analogy is how I think of some of the Buffett followers. They're like art collectors who are buying these famous paintings at prices which they think are attractive and then go hang the pictures on the wall and never sell them. Eventually some of those pieces might be worth a ton. The difference is the art collector is attached to their art pieces, the store owner isn't attached to their inventory.

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    2. I've seen that store analogy before... possibly on Corner of Berkshire and Fairfax? I like your art collector analogy though. I haven't quite decided which type of GARP investor I am.

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  4. Interesting piece which I hadn't really considered before.

    I suppose one of the benefits of larger companies is their liquidity and therefore the bid/ask spread is narrower. There are also tax advantages to the Buffett style investor over a Graham style.

    Have to confess to being more of a Buffett investor myself but probably due to me being more naturally drawn to companies with competitive advantage and doing well.

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  5. I would like to comment on Buffet's "forever" holding period...

    I think this is a GRAVE mistake and has led him to MANY errors.

    The most prominent one I can think of is that of KO in the late 90's...

    Coke was trading at something like a 60 P/E or more...

    I will grant that KO is a great, TREMENDOUS company, but trading at a 60+ P/E on normalized earnings? For a multi-billion MEGA cap company? That can only end one way...in tears...

    15 years LATER KO is still lower than what it was in 1998.

    There have been other examples of this in Buffet's portfolio, but this is the easiest example I can recall.

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    1. True, but who knows if you'll be able to buy back into a company at the same cost basis you originally had... it turns into a question of whether you want to take profits now, at the expense of possible future peaks in price and/or future dividends

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  6. If I am blessed with the choice of selling KO at a 60+ P/E, I'll make that decision EVERY SINGLE TIME.

    Holding something that is so clearly overpriced is like buying property in the property bubble. "If you don't buy now, you might be priced out forever!"

    It does not matter what your original cost basis was. Clearly WB will never be able to get into KO for that. The question is, is KO fully valued? Is KO overvalued?

    To say that "I will hold this stock FOREVER" is a foolish thing to do.

    CLEARLY, selling KO was one of Buffet's huge mistakes...

    15+ years later, AND THE STOCK IS AT A LOWER PRICE.

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  7. I have a stock pick for you.

    American shipping company.

    www.americanshippingco.com

    It is a shipping company with 10 Jones act ships rented out to OSG. The rental deal is giving the company steady income and there are a profit sharing component which might kick in sometime in 2013.

    If it does it should skyrocket.

    Current MCAP is about 13M USD...

    It might be worth a look at the bookvalue of the ships and the current rates and the deal with OSG.

    Just a tip!

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  8. I don't think it's necessarily just pride; it's more that you want to be looking at the places that no one else is. Complex balance sheets are one such place where there are going to be a lot of people who just throw up their hands and walk away. Small obscure companies trading on the pinks and only distributing financials to shareholders are another. To me, tracking down financial reports of obscure unlisted companies sounds like a lot more work than reading the footnotes of AIG.

    Often I'll look at a really complex oppportunity even if I know I won't touch it just to stretch my skills a bit. I've found that if you look at the really hard stuff once in a while, the kind-of-hard stuff gets a lot easier. There is also something exciting about diving into a mess of a 10K and coming out with the realization that the company is drastically misunderstood and undervalued. Personally, I read financial reports as a hobby rather than to generate alpha (my account value is not large enough to justify the time I spend). While I'm not against picking up a vanilla net-net from time to time, it does tend to get a little boring after a while.

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  9. "What's odd to me is most value investors are attracted to the complex situations and shun the simple investments. I believe most of this is due to a pride factor, there is a lot more pride in being able to understand AIG or some complex balance sheet verses Logan Clay Products. Ultimately for myself I don't care about pride, I want the highest returns for the least amount of time."

    I have wondered about this attraction of many investors to complex investments as well. Perhaps it develops because some investors are at first mainly interested in a certain subject or industry, like mining, rare earth minerals or biotech. Only later on do they end up investing in a company in that industry.

    Also I think many investors are just convinced that in order to achieve great returns you need to "find the next Microsoft" or find some spectacular turnaround. Surely it can't be done if it is not complicated?

    It might also be that investors copy well known value investors like Buffett and Klarman. Most of the stuff they do I don't understand at all. But like you already mentioned in the post, size dominates their choices. I don't think copying Buffett's current strategy is the best idea for a small investor. To use the analogy of "The Snowball": Buffett is at the bottom of the hill and his snowball is huge, while many investors are at the top of the hill with a tiny snowball. A completely different situation that calls for a different strategy. Buffett talks about hunting elephants and that his elephant gun is reloaded. Someone on the Corner of Berkshire & Fairfax forums once posted after raising cash levels in his portfolio that his pea shooter was now reloaded. I thought that was both funny and a good way to think about this issue.

    Nice post! I never really thought of it in terms of the time value of research.

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  10. With KO, something you're missing is that Buffett obtains benefits that other investors don't: for example, his board membership, his friends on the board, and now his son on the board. Buffett has de facto controlled KO.




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