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Forbes has posted a video and transcript of an interview with Joel Greenblatt.  Greenblatt is the founder of Gotham Capital, an adjunct professor at Columbia Business School where he teaches “Value and Special Situation Investing.”  He is the author of three investment books and, through Gotham, the advisor to four mutual funds, which select stocks based on Gotham’s proprietary system of ranking stocks according to value metrics (essentially an institutional version of the “Magic Formula” from Greenblatt’s The Little Book That Beats the Market)Greenblatt is also the co-founder of the Value Investors Club, a private forum for discussing value and special situation equity ideas.

In the interview, Greenblatt criticizes market-cap weighted indexes and the short-term focus of individual investors and money managers.  He also claims that an equal-weighted basket of value stocks can beat market-cap weighted indexes like the S&P 500 by 6-7% per year, which is what his Formula Investing Funds aim to do.  He also had this to say about value investing in general:

Most business schools do not really teach Benjamin Graham.  There are a few around the country that do.  But for the most case, people are still being taught the efficient market model, and all the math that goes along with that. We kind of feel the way Warren Buffett does: that’s good news for us.  That if everyone’s told you can’t beat the market – and this is the way to go about investing and it makes no sense to you and everyone’s being taught that – it gives a little more opportunity to value investors if you have less competition actually doing the work.

You can watch the video and read the full transcript here.

founded Gotham Capital, a private investment firm, in 1985. Since 1996, he has been a professor on the adjunct faculty of Columbia Business School where he teaches “Value and Special Situation Investing.” He is the author of three investment books: You Can Be a Stock Market Genius (Simon & Schuster, 1997); The Little Book that Beats the Market (Wiley, 2005) and The Big Secret for the Small Investor (Random House, 2011)

Welcome Back

Welcome back, ValueHuntr readers!  In the coming weeks, we will resume regular posts relating to the business of value investing.  In the meantime, we’ve kept some older posts that are still useful and relevant now.  For today’s post, we highlight a timely quote from the latest memo by Oaktree’s chairman Howard Marks.  In this memo, titled “How Quickly They Forget,” Marks comments on investor behavior, memory and risk-taking against the backdrop of today’s “low-return world.”

On risk, Marks had this to say:

Especially since the publication of my book, people have been asking me for the secret to risk control. “Okay, I’ll read the 180 pages. But what’s really the most important thing?” If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want.

You can read the full memo here.

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We introduce a value-based investment model as alternative to the Capital Asset Pricing Model (CAPM) used by business schools, investment banks, and portfolio managers today around the world. We believe that the Capital Asset Valuation Model (CAVM) is a common sense approach to modeling risk-return in a way consistent with Graham and Dodd. We call it a model with some hesitation, as we only use simple algebra and common-sense to arrive at a solution. But the final solution may not come to much surprise many value investors.

Our Starting Point

In CAPM, expected return is dependent on beta, or price volatility relative to the general market as well as the average risk-free rate. It is inconceivable to us how expected returns can be measured as a function of past historical performance and the risk-free rate, as both are outside of the investor’s control.

Our starting point for the new model is recognizing that volatility is not equivalent to risk. To the contrary, as Graham points out in the Intelligent Investor, volatility is simply an opportunity to buy wisely when prices fall.

graham_quote

Our model defines risk as the probability of capital loss associated with a particular investment decision. Defining risk as the probability of loss allows us to define key points in what will become the equation for CAVM. The two key points are:

1) The expected return will be greatest when the probability of loss is zero.

2) The expected return will be zero when the probability of loss is 100%.

 

Derivation of CAVM Equation

Mathematically, the two points above can be plotted in a x-y axis, where y is the expected return and x is the probability of loss (risk).

 plot1

The max and min points on the plot can be incorporated into a linear relationship between expected return and risk, where as expected, investment returns will be a function of risk. This yields the following linear relationship:

Re = Rmax – (Rmax)*[risk]

Since risk has been defined as the probability of loss, then: risk = 1-p, where p is the probability of gain, or a gain confidence interval. The equation becomes:

Re = Rmax – (Rmax)*[1-p]               

 or

Re = Rmax*p

 

This simple equation makes sense. It tells us that the expected return on an investment will be the maximum possible return one can achieve on a particular idea multiplied by a confidence interval. We believe that confidence interval p is dependent on only two things:

1) The certainty to which the gap between value and price will close within the desired or expected time frame.

2) The certainty to which the value of the investment can be measured from the information available to us.

To add a time variable into our equation, we add variable T as one with inverse effect on the expected returns. Our equation becomes:

Re = Rmax*[p/T]

 

Value investors may also recognize that the maximum expected return Rmax occurs when the gap between intrinsic value and price is zero, such that:

Rmax = (IV-Price)/Price

Where IV is the estimated intrinsic value and price is the current price. This equation is zero when IV=Price, or when margin of safety (MOS) is zero.

We, as value investors, define margin of safety as:

MOS = 1-[Price/IV]

So that if price for an investment is for example $20, with an estimated IV of $30, the margin of safety would be 33%. This means that we as investors are paying 67 cents for every dollar of intrinsic value.

Combining the equations for Rmax and MOS provides us with an equation for Rmax solely dependent on MOS:

Rmax = MOS/(1-MOS)

So our equation for expected return becomes:

Re = [MOS/(1-MOS)] *[p/T]

 We believe, as value investors, that this is the equation every investor should be using as an alternative to CAPM. In fact, we believe value investors unknowingly make such calculation when evaluating potential upside vs. downside for each of their investments. The equation is simple, and implies that the only things that matter when making investment decisions are: the margin of safety (MOS), one’s confidence that our calculations are correct (p), and the time it takes for the price-value gap to close (T).

 

Thoughts on the Risk-Return Equation

There are several interesting thoughts that arise from the equation we have derived. Some are outlined below.

– Contrary to CAPM, risk decreases the probability of returns. Maximum expected return is only achieved by completely eliminating risk.

– The maximum risk on an investment is obtained on 3 different ways: margin of safety is zero, confidence interval p is zero, and time is infinity. Therefore, minimum risk comes from having large margin of safety, high confidence interval, and realizing value in the shortest time possible.

– Equation supports Buffett’s idea to investment in businesses whose “cash flows are highly predictable”. A highly predictable business would imply the investor has a high confidence interval p, since the probability of properly establishing an appropriate intrinsic value is high.

– Equation is valid in any type of investment scenario, e.g. stocks, bonds, real estate, etc.

– Equation is undefined as MOS = 1, so a margin of safety of 100% is impossible in the investment world (cannot invest at 0 cents on the dollar).

– Risk is independent of sector and/or diversification strategy. E.g. 1000 holdings will have equal expected returns as 10 holdings as long as the average margin of safety and average confidence interval is identical (though transaction costs would increase in proportion with the number of holdings).

– Investors concentrating in situations with high confidence intervals p (e.g. Buffett) have the ability to make high returns at lower margin of safety than average investor Investors with low p need to invest with higher MOS to make up for the difference.

– Portfolio of investors with identical stocks purchased at identical prices may pose widely different risks. First, MOS estimates will vary between investors. Second, investors may have different confidence intervals p because some the uncertainties of intrinsic value estimation will vary among them.

– Lower MOS will shift return line downward, diminishing returns for investors at identical risks.

 plot31

 

Challenges

– What confidence interval p corresponds to the average stock market investor? We believe that the average investor decision-making process on risk amounts to a coin flip, so we believe p = 50% is appropriate.

 plot2

 
– Confidence interval p is a “fuzzy” parameter which requires skill to evaluate:

1) The certainty to which the gap between value and price will close within the desired or expected time frame.

2) The certainty to which the value of the investment can be measured from the information available.

The skill to deal with these certainties (or uncertainties) can widely vary among investors.

 

 – Average S&P500 return of ~ 6% suggests average investor has historically purchased stocks with an average MOS of 10%.

 

CAVM in Practice: The ValueHuntr Portfolio

We calculate the average MOS for our portfolio both at cost and at the current market price. Our analysis indicates that MOS at purchase was 38%, and a current MOS of 29%.

 mos11

From MOS, we can then obtain the maximum return possible for our portfolio.  Assuming an average confidence interval p of 50%, we can then obtain the expected return of our portfolio.

 rmax1

At the time of our purchases, our portfolio had an expected annualized return of 43%. Our gains have since lowered the expected gains to roughly 26%.

 cavm-plot1

Afterthoughts on ValueHuntr Portfolio Analysis

– Importance of MOS is evident on the risk-return graph above. Even at 80% risk, expected return is still 10%.

– Steep value lines possible due to our focus on small caps, where big discrepancies between IV and Price occur more often than in mid- and large caps.

– Our expected return has gone from 43% to 24% due to investment gains. Ideally, we would re-balance our portfolio to shift to curve upwards by selling stocks with low MOS and buying stocks with larger return prospects.

– We assume that our ability to evaluate the certainty of investment returns given the information we obtain for our various companies is at par with the average investor. Hence, p = 50% (ability to evaluate risk amounts to a coin flip).

 

Any questions or comments regarding CAVM are welcomed.

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Today we examine the Capital Asset Pricing Model, which value investors tend to be skeptical of.

The CAPM assumes that the risk-return profile of a portfolio can be optimized. According to the theory, an optimal portfolio is one which displays the lowest possible level of risk for its level of return. Additionally, since each additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset, (assuming no trading costs) with each asset value-weighted to achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios, i.e., one for each level of return, comprise the efficient frontier.

Furthermore, because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as beta. When the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio (see Figure below).

 capm

According to CAPM, beta is the only relevant measure of a stock’s risk. It measures a stock’s relative volatility – that is, it shows how much the price of a particular stock varies relative with how much the stock market as a whole moves. If a share price moves exactly in line with the market, then the stock’s beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10%, and fall by 15% if the market fell by 10%.

A small and reprobate minority, value investors in the Graham-and-Dodd mould understand the shortcomings of the theory, and disregard both the conventional definition of investment risk and the standard practice of investment risk management.

 

Shortcomings of CAPM

There are two problems we see with the conventional risk-return relationship proposed by CAPM.

The first one is that the expected market rate of return is usually estimated by measuring the geometric average of the historical returns on a market portfolio (i.e. S&P 500). CAPM assumes that expected market return always follows past performance, which is a dubious assumption (as shown in the housing bubble burst of 2008).

The second problem is that the risk free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return. In a similar fashion as the expected return, the average risk-free rate is somehow dependent on past performance, which is not a sensible assumption to make.

Several other assumptions are:

a) The model assumes that asset returns are (jointly) normally distributed random variables. It is however frequently observed that returns in equity and other markets are not normally distributed. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect.

b) The model assumes that the variance of returns is an adequate measurement of risk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors’ preferences more adequately.

c) The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption).

d) The model assumes that the probability beliefs of investors match the true distribution of returns. A different possibility is that investors’ expectations are biased, causing market prices to be inefficient.

e) The model assumes just two dates, so that there is no opportunity to consume and rebalance portfolios repeatedly over time.

 ValueHuntr Portfolio According to CAPM

We have used CAPM to measure the expected performance of our ValueHuntr Portfolio. The analysis, as shown in the figure below, indicates that our portfolio is one with high risk. CAPM estimates our expected return at nearly 5% due to a volatility of 10% above the market average beta of 1.

 capm_valuehuntr

Obviously, we believe these results do not accurately reflect the prospects of our portfolio, as the volatility of our holdings tells us nothing about risk. Tomorrow, we will introduce a simple relation developed by ValueHuntr to be used as an alternative to CAPM.

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Buffett Loves WFC and USB

Warren Buffett tells shareholders that “I would love to buy all of US Bancorp or I would love to buy all of Wells Fargo, if we were allowed to do it.” The problem, he says, is that Berkshire Hathaway would have to become a bank holding company.  Berkshire already owns substantial stakes in the two banks. Buffett’s bullish statement came in response to a question on whether shareholders should get wiped out when the government steps in. Buffett again singled out Wells Fargo for particular praise, calling it a “fabulous” bank that “will be a lot better off in a couple of years than if none of this had happened.” Recalling that Wells shares fell below $9 earlier in the year, he said at that price, “If I had put all my net worth in one stock, that would be the stock.”

BRK still “AAA rated” in Buffett’s Mind

Warren Buffett tells shareholders today that Berkshire Hathaway is “still triple-A” in his mind, but admits he’s irritated the company has lost its top credit rating from Fitch and Moody’s.He doesn’t, however, think the downgrades will materially hurt the company. Buffett says no matter how Berkshire is rated, there “can be no stronger credit” for any other company.

Buffett: Intrinsic Value for Most Newspapers Is Zero

Warren Buffett says Berkshire Hathaway would not buy most of the newspapers in the United States “at any price.” He says the changing media environment now means newspapers “have the possibility of unending losses” and he does not “see anything on the horizon that causes that erosion to end.” Buffett says the days when a newspaper could have a monopoly in a large city and make a lot of money are over. But he promises Berkshire will not sell the Buffalo News, even though it had opportunities to do so in the past at higher prices than it would bring now: “On an economic basis you should sell this business.  I agree 100 percent but I am not going to do it.”  Buffett says the union at the Buffalo newspaper has been cooperating on building a model that will generate “a little bit of money” for Berkshire.” Berkshire also has a stake in The Washington Post Company that it bought in the 1970s.

Moats Rare and Eroding

In response to a question, Munger warned that businesses with truly sustainable competitive advantages are increasingly rare and noted, “Unfortunately, a lot of moats are filling up with sand, such as daily newspapers and network television stations.”

Berkshire Purchased Cheap Corporate Bonds

Warren Buffett revealed the company had “got a chance to buy some corporate bonds very, very cheaply a few months back.” He also says he bought some bonds for his own personal account. Buffett’s partner Charlie Munger added that some of the corporate bonds purchased by Berkshire are already up between 20 and 25 percent.

No Buybacks for Now

Warren Buffett says there are no plans for a buyback of Berkshire Hathaway stock right now, although he did not rule out the possibility in the future. He did, however, set a very high bar.  The stock price would have to be “demonstrably below” a conservative estimate of the company’s intrinsic value. That implies Buffett does not think the stock is clearly undervalued at its current level of $92,511 a share.  It’s down about 30 percent over the last twelve months. He also said that shareholders would be informed in advance if the company did decide to go ahead with a buyback. Buffett says he think many companies make a mistake when they buy back shares, by paying too much.  He pledged that Berkshire would never make that particular mistake, although it might err by not buying when the price is low.

Berkshire Will Not Be Spinning Off Any Subsidiaries

Warren Buffett promises that Berkshire Hathaway won’t be “spinning off any companies” in the future.He joked that anytime someone suggests the company could get a short-term gain from a spin-off, he throws them out of the office. “We’ve listened to presentation after presentation” over the years from bankers proposing various deals, and “there’s always a fee” involved. Buffett says it’s important the companies bought by Berkshire can trust they will remain with Berkshire.

Berkshire Succession Plan

The four candidates to potentially succeed Buffett as chief investment officer did not “cover themselves in glory” last year, failing to outperform the benchmark S&P 500 stock index.  But Buffett remains confident in their long-term track records. As Munger said, “they got creamed”. But he adds, “I did not either.  I am very tolerant in that respect… But their average over 10 years has been modestly to significantly better than average, and I would say that would be the case over the next 10 years.” None of the four, some Berkshire insiders and some outsiders, beat the S&P 500 last year. The three CEO candidates previously identified, but not revealed publicly, are all Berkshire insiders.

Buffett says there are still three internal candidates to take over his CEO role, including one who would step in immediately if he died suddenly. “If I drop dead tonight … the board knows who … and they would feel very good about that (person). Not too good I hope.”

Buffett also praised Ajit Jain, chief of insurance operations. We think Ajin is a top contender to replace Buffett.

Buffett told shareholders today that “it would be impossible” to replace Ajit Jain as the chief of Berkshire Hathaway’s insurance operations. Buffett says he wouldn’t give the same latitude on risk to any other executive. “Ajit is needed, and we won’t find a substitute for him”, Buffett emphasized.

Why won’t Buffett or Berkshire disclose the candidates’ names?  Buffett cities General Electric’s experience, when Jeff Immelt was named the next CEO and the other two candidates left the company.  “I don’t see any advantage in having some crown prince around.”

Preview of Q1 Results

 

Warren Buffett started during the meeting’s question-and-answer session with shareholders by giving them a preview of next Friday’s earnings report for the first quarter.

Buffett says operating earnings will be about $1.7 billion, after taxes.  That compares to around $1.9 billion last year, and works out to a decline of almost 11 percent. He partially attributes the drop to losses in Berkshire’s investing portfolio and to losses on credit default swaps.Book value fell about six percent during the period. Berkshire’s float has increased by about $2 billion due to a Swiss Re transaction.

Utility earnings are “reported down” a bit, partially due to a prior benefit from Berkshire’s now discarded deal with Constellation Energy Group.  Buffett says he was disappointed that deal didn’t work out. He expects Berkshire’s utility and insurance businesses will do “quite well” unless there is some “huge natural catastrophe.” Aside from insurance and utilities, all of Berkshire’s other businesses “are basically down.”

Buffett reports that Berkshire ended the first quarter with about $22.7 billion in cash, but it spent $3 billion the very next day on its Dow Chemical transaction. Buffett also notes that Berkshire’s credit default swaps have gotten worse since he wrote his annual letter to shareholders earlier this year.

IQ is Irrelevant

 

Buffett commented that “Picking bottoms isn’t our game. Pricing is our game. It’s not so difficult, whereas picking bottoms is impossible.To be a successful investor, you don’t need to understand higher math or law. It’s simple, but not easy. You do have to have an emotional stability that will take you through almost anything. If you have 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What’s most important is inner peace; you have to be able to think for yourself. It’s not a complicated game.”

 

Munger added: “There is so much that is false and nutty in modern investment practice. If you just reduce the nonsense, you’ll do well. If you think your IQ is 160 but it’s 150, you’re a disaster. It’s much better to have a 130 IQ and think it’s 120.”

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buffett_munger

 

Friday Events

 

3:30 p.m. to 5 p.m.: Free panel discussion on Value Investing.

Location: Creighton University’s Harper Center, 620 N. 20th St.

 

Panelists are:

 

John Maginn, former chief investment officer of Mutual of Omaha

Charles Heider, president, of Charles Heider Co.

Bruce Greenwald, Columbia School of Business

Frank Reilly, Notre Dame University

Thomas Russo, Semper Vic Partners

James Crichton, Scout Capital Management

Ryan Sailer, Union Investment Management Group

Mark Wynegar, First National Bank of Omaha.

 

6 p.m. to 10 p.m.: Shareholder cocktail reception at Borsheims in Regency Court.

 

8:30 p.m. to 10 p.m.: Free ice cream cone to those presenting credentials at Dairy Queen, 404 N. 114th St. Authors of books on Warren Buffett and Charlie Munger will be on hand.

 

Saturday Events

 

7 a.m. – Doors open at the Qwest Center in downtown Omaha.

 

8:30 a.m. – Movie begins.

 

9:30 a.m. to 3 p.m. – Question-and-answer session with Warren Buffett and Charlie Munger. Questions had to be submitted in advance. Lunch break at 12:45 p.m.

3:15 p.m. to 3:30 p.m. – Shareholder meeting.

9 a.m. to 4 p.m.: Borsheims Regency Court brunch at 9 a.m. Entertainment will include two-time U.S. chess champion Patrick Wolff, playing blindfolded against all comers; magician Norman Beck of Dallas; and top bridge players Bob Hamman and Sharon Osberg.

 

3:15 p.m. to 3:30 p.m.: International Meet & Greet.

 

5:30 p.m. to 8:00 p.m.: Warren’s Western Cookout at Nebraska Furniture Mart.

 

7:30 pm to 9:00 p.m.: Peter Buffett concert and conversation at the Rose Theater.

 

Sunday Events

 

 

9:30 a.m. to 4:00 p.m.: Borsheims shopping day.

 

1 p.m. to 10 p.m. – Shareholders evening at Gorat’s Steak House. Reservations required.

 

The Renaissance of Value

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There are several documents written by Ben Graham that are currently stored at the New York Research Library, and amongst them is a microfilm document titled “The Renaissance of Value”, written in 1974 by Ben Graham and which I have just obtained for our readers.

 

The document discusses several questions posed by Graham, one being the following: to what degree should the valuation techniques presented in Graham & Dodd’s Security Analysis be modified to account for recent developments?

 

According to Graham, the midpoint of the value range has typically been found by applying an appropriate multiplier to estimated future earnings, which is not the best technique to use (This technique is still used today). Instead, the earnings figure taken should be what Graham calls “normal current earnings” and all the future prospects – favorable or unfavorable, specific or general – should enter into the multiplier. This procedural change obviates the necessity of establishing a future value, and then discounting the same to its present worth.

 

In this document, Graham also corrects some of the formulas he proposed in Security Analysis. For example, Graham had previously suggested that the intrinsic value could be approximated by a formula that employs a single variable G, representing the expected growth rate over the next seven to ten years. The formula read:

 

Value = “current normal earnings” x (8.5+2G)

 

However, Graham states that this formula had the great defect of failing to allow for changes in the basic rate of interest. To account for this, Graham re-states his intrinsic value formula as:

 

Value = “current normal earnings” x (37.5+8.8G)/AAA rate

 

With the AAA rate at 5.39% today and a historical GNP growth rate of 4%, Graham’s equation indicates that the current multiplier for the market should be 13.5. With operating earnings at $49 for the S&P500, Graham’s formula seems to indicate a fair value of 661 for the S&P500 benchmark relative to its current value of 831. At ValueHuntr, we do not believe in a single formula for valuation estimates, but it is an interesting exercise.

 

Additionally, it is clear that Graham saw no systematic way of reducing multipliers to allow for investments in companies with a below par debt position. His advice to analysts is to rather avoid attempting a formal valuation of such companies. In other words, analysts should limit their appraisals to enterprises of investment quality.

 

In general, “Renaissance of Value”, as Graham noted in 1974, involved the reappearance of sub-working capital opportunities. It seems that 2008 was a year which Graham would hail as the “Re-Renaissance of Value”.

 

A scan of the microfilm document has been posted in our resources section. Click here to read.

 

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