Mr. Market

I’ve heard Warren Buffett say that chapter 8 of “The Intelligent Investor” is among most important things he has ever read about investing. Chapter 8 introduces Mr. Market. For those of you unfamiliar with him, Mr. Market is supposed to be thought of as a manic-depressive business partner that is willing to sell you his shares of the business with prices being affected by his crazy moods. We are supposed to think of the market this way and buy when Mr. Market is sad.

I disagree. I think it is dangerous to think of the market as some mentally ill business partner that you can take advantage of. Certain areas of the market function like that, and at very rare times the entire market functions like that, but on average the market is very, very smart.

The market is composed of millions of people, many of them with IQs that God should have more evenly distributed, and they are all competing to make money. Buffett has also said that “like the lord, the market helps those who help themselves, but unlike the lord, the market does not forgive those who know not what they do.” To try and compete with the 200 plus analysts and thousands of money managers who are looking at Apple is just stupid. It’s like trying to beat the average scores of the PGA tour. Even the pros don’t beat the pros.

But you may be thinking, “well I had a friend who bought microsoft or walmart in 1992 and they did it because they could see that those were winning companies.” Your friend got lucky. That’s it. The future is unknowable for the most part. 99% of the time the market gets prices correct and future price fluctuations are determined by what happens in the future.

Michael Mauboussin writes about group experiments where everybody is asked to guess how many marbles are in a jar, or how much a cow weighs. For the most part the individuals are way off but the average of the guesses tends to be very close to the real answer. I hate to say it but the market is just like this. Trying to compete with the average of wallstreet’s best is a dumb way to try and make money. Just go to vegas instead.

That doesn’t mean that I think the market is unbeatable but you have to look at things realistically. When you buy a stock, there is someone else selling it. What makes you think that you are on the right side of that trade? Really think about the person on the other side of that trade. If there is any chance that it is Seth Klarman or Ted Weschler, you had better look elsewhere.



Late Q3 Commentary

This was a letter written at the end of Q3. Just getting back into posting something. I will resume with real posts soon.

I have edited out reference to clients and performance as it is irrelevant but I did a crappy job, so if the flow is bad, deal with it.

Q3 Letter

The key to making money in stocks is not to get scared out of them. -Peter Lynch

The General Market in Q3 2012
During Q3 we have seen increased hopes that the economic situation in Europe might not be as bad as previously thought. This, combined with the widespread belief that the Fed will continue attempts to stimulate the sluggish U.S. economy at all costs, caused a rally in the market. My personal view is that the latest round of quantitative easing is a signal that the Fed feels like the economy is in trouble. The expansion of the money supply that has occurred within the last four years is unprecedented. We will not know the exact effects of this for many years but it seems dangerous to carry on such an experiment.
Interest rates as low as we now see with an almost guaranteed inflationary environment occurring within the next decade creates a terrible environment for lenders. Who wants to lend money at 1% with inflation running higher than that currently and potentially much higher than that in the future? Having said that, government and corporate bonds are being purchased in large numbers (a form of loan to the government or corporation), so obviously somebody wants to. While the payoffs from owning equities may not come for years (like a bond with no definite coupon or maturity date) owning pieces of businesses at the right prices seems to be the safest, and most lucrative, investment over the next 10 years. As always with long-term investing, a prediction like that could make me look pretty stupid for some time; luckily I have some time.

…you don’t win by predicting the future; you win by getting the odds right. You can be right about the future and still not make any money. At the racetrack, for example, the favorite horse may be the one most likely to win, but since everyone wants to bet on the favorite, how likely is it that betting on the favorite will make you money? The horse to bet on is the one more likely to win than most people expect. That’s the one that gives you the best odds. That’s the bet that pays off over time. –Will Bonner
Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. –Charlie Munger
I always enjoy looking where others are not. With investing not only must you be correct about your thesis but it must be one that others aren’t able to see or act on or your view will already be priced into the issue. That is why I prefer companies with little or no analyst coverage. It is very difficult to gain insights that others don’t have about a company that is followed by a team of the world’s greatest analysts. To this extent, I believe in the weak form of the Efficient Market Hypothesis. Well-followed companies are almost always correctly priced and studies show that the best and brightest suffer from the paradox of skill when they wander into this area. Everyone analyzing those companies is so good that they can’t beat each other. While that may not be entirely true, it is almost entirely true.
On that note, I would like to introduce you to the largest position in our portfolio. Despite its recent run up I still think it is worth holding.
Conrad Industries, Inc (CNRD) builds and repairs a variety of marine vessels at four facilities located in Louisiana and Texas near the Gulf Coast. It has been in operation for 64 years. The founder, now 96, still sits on the board. 2/3rds of revenues come from new construction while the rest comes from repairs. The repair business is higher margin and growing.
CNRD has a small competitive advantage that all Jones Act builders participate in. The Merchant Marine Act of 1920 states that any vessel that transports goods between American ports must be U.S. built therefore CNRD gets a lot of steady business.
CNRD currently has an enterprise value of $76m and had operating income of $29m on average capital expenditures of about $4m for free cash flow of $25m. At the current price the owner gets an earnings yield of 33% and an EV/EBITDA multiple of 2.3. 10 year average operating income is $12.6m for an earnings yield of 17%. Their business has changed for the positive since 2005 with the construction of a deepwater facility that can better service their oil customers and focus on higher margin business. Conservative and cyclically adjusted estimated run-rate earnings would be right around $15m. A recent comparable sold for an EV/EBITDA of about four although the comparable company (Todd Shipyards) had lower margins and lower growth numbers than CNRD. I believe that CNRD should at least trade in line with this comparable.
The company has $55m in unadjusted net current assets which is about $9 per share and a total net asset value of $103m which is $16.91 per share. The company last traded hands at $17.99 and our average price paid was right around $16. Seeing net assets at 6% above our purchase price is a comforting thing.
The interesting part of the asset valuation comes when adjusting property, plant, and equipment to their real value. The land that CNRD operates on was purchased in 1948, 1974, 1996, 2000, and 2011 but is carried at cost. CNRD’s return on average equity (which is a good metric given that they are nearly debt free) is roughly 22%. Of course, this is overstated because book value is understated due to the unadjusted carrying value of the land. I can’t know exactly what the land is worth, but it is safe to say that it is worth more than it was in 1948. Also the goodwill of the operations that were purchased with some of the land has since been amortized to zero, this accurately reflects accounting goodwill but not economic goodwill.
We can know that returns on invested capital have been good given that CNRD has compounded book value at nearly 14% for the last ten years and more than 20% for the last five.
Insider ownership is just about 50% but executive compensation is reasonable. Management is not abusing shareholders in the slightest and has been aggressively buying back shares – annually retiring about 3% of shares.
The risks here are the cyclicality of the business and some customer concentration. Neither of these is especially concerning given the price we are paying. CNRD’s capital structure can handle a downturn just fine and while government and oil make up large parts of revenues, it is worth noting that these are both uniquely steady and reliable customers.
With a 33% earnings yield we pay for the investment in three years. Even if we are near peak earnings for this cycle, that is awfully cheap.
I have been following the company since 2010 when I first purchased it for my personal portfolio at around $8 per share after searching through the business casualties of the Deepwater Horizon incident. At the time it was the best risk/reward investment I had ever seen. At nearly $18 I still believe it is a good investment.
So what’s the catch? Why is it so cheap?
It’s illiquid and it’s cyclical.
CNRD is illiquid which means that large, intelligent buyers can’t participate (there aren’t very many advantages to having small amounts of capital but this is one of them.) Even smaller funds would have a hard time taking a position in a company like this. Aside from the fund’s prohibitive size they must always be afraid of investor redemptions which would force them to sell shares into lurking limit orders, placed by bottom feeders (like me), in order to gain the liquidity that the fund needs to exit the position. I am fortunate to have patient investors so taking advantage of a situation like this becomes possible. I have never thought liquidity should be much of a prohibitive issue just as ease of divorce should not be a reason in favor of commitment.
The cyclicality makes the business somewhat unpredictable. Lucky for us, foolish Mr. Market seems to fear uncertainty more than risk and the negative cyclicality is more than priced in. Benjamin Graham once said something to the effect of “most investor losses come from poor companies purchased in good times” which then results in the investor losing money as earnings regress to the mean. Of course any business is a great investment at one price and a terrible investment at another. CNRD may not be a great business but it is better than average. I don’t believe that the business risk in CNRD is substantial at $16 per share given that the company has a good history of operations and could likely be liquidated for not much less than $16.
The situation reminds me a little of KSW because KSW was similarly illiquid and cyclical with substantial insider ownership and a solid balance sheet. I first purchased KSW for about $2.90 in 2010 thinking it was worth about $6. It then rallied to over $4 and I sold it not because it had reached full value but because I found something more attractive. In the summer of 2011 KSW was once again pushed down to about $3 at which point I bought it again. The price eventually climbed to about $4 before it was bought out at $5 by another company. This up and down over more than two years is typical of value investments and just because the person who bought my shares from me at over $4 had to sit on 30% losses for a time, it doesn’t mean that anything had changed with the business or that their investment was a poor one. It just takes time for value to be realized. I never judge how the investment is doing based on the share price, it’s how the business is performing and the value of the underlying assets that matter. Eventually the market will realize that value.

Going Forward
I am increasingly convinced that basic quantitative evaluation outperforms qualitative evaluation. I think most of the outperformance comes from the elimination of investor bias – in other words, eliminating investor emotion. In a game of probabilities, which investing so often is, a purely logical formula is likely to beat those who make decisions that mood could possibly influence. I continue to move further in this quantitative direction as I see more and more evidence that it works.
The bulk of my strategy consists of running a variety of screens that have a long history of outperformance, then further narrowing down the list by qualitative evaluation. In the last year the basic quantitative screen has beaten my performance. Of course, any time frame less than three years is mostly meaningless but I will continue to heavily rely on a purely quantitative formula to generate lists and will focus on the highly ranked companies when I make my decisions. Most of my losses over the years have come when I strayed from the surety of the numbers into biased projections of what a company’s potential was. Benjamin Graham would not have been impressed.
I will remain true to a strategy that has worked ever since equities have existed and has also worked in every market around the world. The strategy is buying cheap companies based on the numbers in obscure and inefficient areas of the market, being patient, and holding enough companies that the odds can work in your favor. As Warren Buffett has said so many times, “investing is simple, but not easy.” Kind of like dieting.
Stocks are not as cheap as they were a year ago, however, they are still the best of the investing alternatives as far as I can see. I think we will be glad that we owned them, and not something else, in 3-5 years.

(The above is not a solicitation or recommendation to buy. Do your own research, do not rely on mine. The author holds a position in CNRD)

The Quantitative Value Screen

I highly encourage individual investors to take advantage of screening technology and I will be writing about this frequently. Here is a sample of what I mean.

If you haven’t heard of Joel Greenblatt’s magic formula, go look it up. It’s a simple quantitative formula that ranks companies based on quality and cheapness. It is just one of many formulas that can be used to eliminate emotion, increase discipline, and choose an average of stocks that are highly likely to outperform the market averages.

I have a few quantitative screens that I like to use. Let me show you the results of one that I have been testing recently. I exclude industries in the same way Greenblatt does because some of my metrics are similar to Greenblatt’s (earnings before interest isn’t a great way to look at financial companies, for example).

The model uses 26 ranking metrics. This first graph shows a backtest covering over 13.5 years. 30 stocks are held for a year and then rebalanced.

The blue line at the bottom is the S&P 500. Notice that $100 dollars becomes $4244 (annualized return of 32%) with the formula and $111 with the S&P. There are no OTC companies included in the backtest.

If the screen’s rankings are broken into deciles, here is how each of the deciles perform.

Each of these deciles holds about 400 companies. It’s facsinating to see that the screen works in order. As in, we can know how a group of stocks will perform relative to others. If you don’t think that is amazing then you are hopeless.

The above is rebalanced every year. For non-taxable accounts a more frequent re-balancing may be an option depending on brokerage costs. Here is the same screen above backtested over the same time period but with three month re-balancing.

That’s 46% per year in a nearly flat market.

Here is the 3 month rebalancing broken into 50 rank buckets.

All of these are run on the Compustat Point in Time Database.

My question is… why doesn’t everybody use a screen like this?

We will discuss some of what goes into making a screen like this, how it might be improved upon, and why the individual investor might do well if they ditched their mutual funds and tried a similar approach to the one above.

15% Return Today and Let it Grow

Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?

Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.

Smith: But there’s 27,000 public companies.

Buffett: Well, start with the A’s.

I was recently reading some forum posts by Warren Buffett’s biographer, Alice Schroeder. Alice wrote that much of what Buffett does is screening. Not with a computer model of course, but just scanning page after page with his eyes. In fact this is the way he began too. When Buffett began his investing partnership he took a copies of the moody’s manuals, which were many thousands of pages long, and flipped through them page by page. He did this with each one more than once too. In the beginning he was able to compound money at rates north of 30% per year with the moody’s manuals as his guide.

That gets one to thinking… what was in those manuals? Not much. They had the company name, a description of the business, its properties and subsidiaries, a list of officers and directors, a basic income statement and balance sheet for the last 2 years, and a description of the capital structure. If you would like to see samples here are two:


He wasn’t projecting earnings, he wasn’t doing a discounted cash flow analysis and complex financial modeling. He still doesn’t do those things today. Don’t believe me? Here is Alice explaining:

If the greatest investor in the history of the world doesn’t do discounted cash flow and projections, why should I? I’m not saying that a DCF is completely useless, just almost useless. I am at odds with Bruce Greenwald on this one. I saw him speak in Omaha two weeks ago where he announced that DCF was a “complete waste of time.” I think it is an almost complete waste of time. I think it is useful if you reverse engineer it. It is much easier to make a binary judgement on market expectations than to try and project earnings. This is all for another post though. Back to the topic.

Alice said that Buffett would look for a 15% return day one and let it grow from there. So Buffett needed to make sure that he was going to get a 15% earnings yield and that the return would likely grow. Of course this isn’t the only way he invests, but it is one of the ways he invests. Buffett often likes to say that he would rather be vaguely right than precisely wrong.

So how do we know if a business will give us a 15% return day one. When you buy a business you are paying for a stream of earnings. If a business earns $10 and you pay $100 then you are getting a 10% earnings yield. In this way a stock is just like a bond except without a call or maturity date. Additionally that earnings yield can grow as the business earns more and more. The trick now is finding businesses that give you a 15% earnings yield and maybe more.

Our advantage over Buffett

When Buffett worked at Benjamin Graham’s hedge fund, he sat in an office next to Walter Schloss and calculated net current asset values (looking for stocks trading below their liquidation value) hour after hour, day after day. Today that would take less than one one-thousandth of a second. At my fingertips I can scan 10,000 publicly traded companies faster than an eye-blink. I just did it and found 64 companies trading for a conservative estimate of net current assets. I just did Buffett’s entire calculation job at the Graham-Newman partnership faster than it takes to say booya! Earnings yields can be found the same way. In fact even complicated formulas can now be applied and even backtested in nano seconds.

This means that we could narrow the universe down to only companies that are likely to give us our desired 15%.

I’m sure that Buffett gained a lot more from flipping through the Moody’s manuals than just which stocks to buy that day. The mental database and work ethic that was built is part of what has made him a legend. However, unless you are Warren Buffett, you have a great deal to gain by using modern screening technology.

Forecasting is Futile

On a similar subject to my last post here are James Montier’s thoughts on forecasting and discounted cash flow. Well stated.

How You Can Beat the Pros

Before I get to typing I have to warn you that the title of this post is a little misleading. You see, I’ve been reading “How to Invest” books for many years now and I would like to let you in on a little secret. Most of these books are deceiving. It’s not that they don’t have value investing theory correct, they do. It’s that they make it sound much easier than it is. Even Joel Greenblatt’s “The Little Book that Beats the Market” (which I highly recommend) makes the strategy sound much easier than it is, and it doesn’t get much easier than buying stocks off of a list once a year.

The average “how to” investment book teaches you the basics (a stock is a piece of a business, Mr. Market is crazy, buy companies on the cheap) but they don’t tell you that you are up against some serious competition. Think of the stock market like a sport, say boxing. With a little training the average person may have a chance against the local tough guy, but get in with the big boys and you may be drinking your food through a straw for a while.

I believe the average investor has a few significant advantages over the institutional investors but one of those advantages is not in the “analysis” department. So why do all these books try and teach the layman valuation analysis, especially of large and well-known companies? Do you really think you will know more than 20 full time analysts? Remember that every time you buy a stock, someone is selling it. What makes you think that you know more than the other guy? How has the universe made this value apparent to only you? (hint: it hasn’t) On average the individual investor’s main strengths over the top analysts are two: small amounts of capital, and the ability to weather periods of underperformance. The former doesn’t sound like much of an advantage but just trust me on this one. The latter can be quite the challenge without a systematic, replicable, and disciplined approach.

Implied in the “small amounts of capital” advantage is the ability to search in areas of the market that the big guys can’t play. Of course if the big guys aren’t playing there then there are more likely to be gamblers in that area, not intelligent analysts. (Warren Buffett tells a story about when he was on his honeymoon in Vegas and at a casino. He says he remembers looking around the room at hundreds of well off fools participating in various mathematically unfavorable activities with their hard earned money and thinking to himself “if this is who I’m up against in life, I’m going to be rich.”)

In order to pay for a good analyst a mutual fund or hedge fund must be managing a relatively large amount of money, since this is where they pull their fees from. A relatively large amount of money is usually more than a few hundred million dollars and often a few billion dollars. So pretend you are a mutual fund and you have $1B. One day you are combing through financial statements and you stumble upon a ship builder in Louisiana that is selling for $40m. It has about $28m in cash, another $28m in receivables, $10m in inventory, another $15m in other current assets, and has normalized earnings of about $20m. Not only that the company has existed for more than 60 years, generates average returns on capital of 20%, has 50% insider ownership and only $5m in debt. You begin to get excited because this company is silly cheap. You could buy it at $7 and it must be worth at least $15, maybe more. There are a few problems though.

$40m is 4% of $1B. If you buy the company and the price doubles you will have made 4%. That’s good. The problem here is that you have no chance of buying that entire company for $40m. As Dr. Michael Burry has written:

“…I buy common stocks for the portfolio as if I were buying pieces of businesses.

In fact, at all times I strive to buy stock at prices per share that no acquirer could ever pay for the whole company – not because the prices are too high, but because the prices are so low that a potential acquirer proposing them would be laughed out of the boardroom. Such is the opportunity afforded by the very human market for common stocks.”

With 50% insider ownership and low liquidity you would have to pay much more than $40 m for that business. Also, you are a mutual fund. Mutual funds are restricted by law from owning more than 10% of a company’s outstanding shares. So at most you could buy $4m dollars of this company. That is .4% of your fund. So a doubling of the stock price gets you .4%. There may be issues with buying 10% of the company also. Because of the infrequent trades in a small company like this where owners hold 50% of shares, your buying is likely to move the share price quite a bit. Depending on your fund, you may also be restricted from buying illiquid companies like this. So even though it is a no-brainer investment, you have to pass.

There aren’t many disadvantages to having a fat wallet but here we have found one. This means that all of the people with fat wallets (read as “talented analysts”) are forced to play in the big companies. If thousands of very talented analysts who manage trillions of dollars are constantly combing for bargains in the big companies the survival chances of a weekend stock picker are slim… if they compete head to head.

To beat the big guys you must be more patient and also try and be in the areas that they can’t (or wait for another 2008 when panicked investors force a manager’s hand). I’m not saying that buying large companies is always out of the question, I’m just saying that you will be competing with some very skilled people and to think that you might be buying shares from Jeremy Grantham or David Einhorn is a terrifying thought.

Berkshire: the Pilgramige

Last night I returned from the Berkshire Hathaway annual meeting. Hearing the most successful investor in the world speak about hundreds of topics was an amazing experience; I recommend it to anyone who has the opportunity.  Buffett is, of course, one of a kind and there will probably never be another investor quite like him, but that doesn’t mean the rest of us should give up and accept the poor returns of many large mutual funds. Buffett himself has said that emotional stability, a favorable temperament, is the most important key to investing success, not a high IQ. This is good news.

Buffett spoke to this topic in particular at the annual meeting and he said one thing I’ve heard him say a few times before:  if he were going to teach people how to invest there would be two courses, how to think about the market and how to value a business. The introductory concepts to each of these imaginary courses are presented in chapter 8 and chapter 20 of Benjamin Graham’s The Intelligent Investor.

In chapter 8 the reader is introduced to the ignominious Mr. Market. Buffett says this chapter is the most important thing he has ever read about in his life. Mr. Market is to be thought of as an occasional drunk or mentally ill business partner. Sometimes he is feeling euphoric and will only sell you his shares of the businesses at a high price, and sometimes he has fallen off the wagon (again) and is willing to unload businesses at a substantial discount. The trick is to take advantage of him, not to mimic his moods. Taking advantage of a mentally ill Mr. Market sounds a little bit exploitative, but be honest with yourself–it sounds fun, too.

While this seems easy, it is very challenging in practice because we are all hardwired to follow the herd. Even as my father-in-law and I were rushing through the Centurylink Convention Center (where the Berkshire meeting is held) on our way to find our seats, we found ourselves saying “let’s go this way, that’s where everyone else is going.” A lot of that behavior came from not knowing what we were doing and the irony at following the crowd was pretty thick given that we were there to glean wisdom from one of the world’s foremost contrarians. I couldn’t help but think that the market often functions exactly like a crowd rushing to find their seats. There is a major difference between seat selection and investing though; if you make a wrong seat selection you can still see the entire event, if you make a bad enough investment decision your retirement is gone (maybe not gone, but I had to add a little drama). In most cases there is safety in numbers and comfort in consensus. In the stock market, however, the consensus is often wrong, therefore, if you’ve followed along, so are you.

Joel Greenblatt, in his book “The Big Secret for the Small Investor” explains that the best performing mutual fund of the last decade compounded at an incredible 18% per year. However, the average investor in that fund lost 11%. How can that be? Remember the saying “buy low, sell high?” It turns out the average investor does just the opposite. (See the Wall Street Journal article here.) This behavior is not unique to this mutual fund either; almost every stock fund sees inflows of money after a period of outperformance and outflows after a period of underperformance. Deduct the fees that the average mutual fund charges and you have the unmistakable disappointment of very low returns.

So don’t do it! Benjamin Graham once said something to the effect of, “an investor’s biggest enemy is likely to be himself.” It follows that if you remain disciplined through Mr. Market’s highs and tantrums you will have eliminated the largest obstacle standing between you and good returns.

How can it be done? There are two ways. You can either be born with a favorable disposition, disinclined to follow the crowd, or develop an understanding of investment principles sufficient that your rationality can overcome your tendency to get your lemming on. I can’t do anything for you on the former; this blog is hopefully a resource to those interested in the latter.