Mr. Market

Benjamin Graham provided the best account of what we are trying to do as investors in a fabulous parable from The Intelligent Investor.   Here is what Graham wrote:

“Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasms or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 investment in the enterprise?  Only in case you agree with him, or in case you want to trade with him.  You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

The true investor is in that very position when he owns a listed common stock.  He can take advantage of the daily market price or leave it alone, as dictated by his inclination.  He must take cognizance of important price movements, for otherwise his judgment has nothing to work on.  Conceivably, they may give him a warning signal that he will do well to heed--- this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come.  In our view such signals are misleading at least as often as they are helpful.  Basically, price fluctuations have only one significant meaning for the true investor.  They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a good deal.  At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

--The Intelligent Investor, Chapter 8

Value Investing Strikes Again!

Some people read about "value investing" or references to the term, without really knowing what the process involves.  Here is one version.

I awoke this morning to the happy news that a stock we own was the subject of a fairly generous tender offer, which turns a small paper loss into a very gratifying paper gain which will soon become a real gain. This would be a good object lesson in the process of value investing.

One of the techniques taught by Ben Graham, to Warren Buffet, and me, among others, is to look for shares which can be purchased for less than Net Net Asset Value. "Net Net Asset Value" is Current Assets less all the debt on the books. IOW, every dime the company owes can be paid from current assets, leaving a net net asset value per share. This values the long term assets, property, plant and equipment at zero. Graham liked to buy stocks meeting these criteria at 2/3rds of NNAV, if possible.

Last year, I came upon the shares of Nu Horizon Electronics (NUHC). According to the FY2009 Annual Report, NUHC had Current Assets of $232,500,000, total debt of $104,846,000, and shares outstanding of 18,043,834. So, (CA-TD)/Shares equals $7.07 per share. In other words, if you paid every dime the company owed from only the current assets, you would have left, in current assets, $7.07 per share, plus all the fixed assets, whatever that would be worth. Two-thirds of that is about $4.67.

From February, 2009 the shares sold for as little as $1.35, and as much as $4.68. I bought shares below $4.00.

The price languished, depressed no doubt by the fact that NUHC had reported a loss of $.51/share in 2009. The low, after the $4.68 high last January, was a bit below $3.00.

For the FY2010, the company reported a loss of only $.13/share, but the NNAV had increased to $7.33 and the finances appeared to be sound. No real worries here.

Today, the news came that Arrow Electronics will buy Nu Horizon for $7 per share in cash. The deal has been approved by both boards and is expected to close in the 4th quarter.

Does it always work out this way? Nope, but this is as close to riskless investing as I can imagine, whereas buying shares at 26 times earnings and 8 times book value, no matter how glittering the prospects, can be fraught with dangers.

In this case, you bought current assets of about $1.60 or so for a dollar, and the fixed assets were free! Nothing is riskless, but this sure gives you a good chance.

I have lost money a couple of times. Zales had decent NNAV and a very low price, but after I bought in, their results kept going downhill, very quickly, and I hit the silk for a bit of a loss. The stock doesn't quit going down just because you bought it! Showing a paper loss is agonizing but the pain is alleviated somewhat by knowing that it was really cheap compared to assets.

A reasonably diversified list of stocks purchased this way ought to give quite acceptable results.

9/20/2010

Forecasting

My boyhood hero, one of them anyway, was Yogi Berra. I wanted to be like him, which turned out to be impossible since a) I'm much better looking, b) I can't hit left handed curve balls, or right handed ones either, for that matter, and c) I am left-handed which pretty much ruled me out as a serious catcher.

Nevertheless, it turns out that Yogi and I are more alike than I had suspected. Berra says his forecasting ability is not very good, particularly when it pertains to the future. Mine is downright lousy. 

Some time back I realized that I couldn't predict the future with any notable prowess, so I quit doing it. I make my investment decisions based on what I know right now, about a company's assets and liabilities, earnings, etc. with no value assigned to what the future may hold. I refuse to pay a dime for a rosy future! I want to buy a dollar for 40 cents, or maybe 60 cents. This seems in most cases to provide an adequate "margin of safety." These are the three most important words in investing.

Here is what my "portfolio" has done, since Jan 2009, stock by stock in alphabetical order: (all are up by the following percentages) 30.31%, 67.33%, 390.4%, 99.39%, 163.47%, 89.47%, 116.38%, 95.85%, 12.29%, 93.60%, 130.86%, 81.21%, 77.17%, 184.58%, and 8.76%. The three that are up the least are recent purchases, all less than one year since purchase. On the entire portfolio, it's about 90%, after a couple of dingers. 

I consider this quite satisfactory, and proof of the methodology of finding and acquiring undervalued stock rather than, say, relying on technical indicators, momentum plays, moon phases, point and figure charting, Elliott Wave, and all the other technical theories out there, almost all of which I have experimented with over the years, or paying the slightest attention to what research analysts of dubious motivation think. My son and I do our own research.

This is the same approach used by Warren Buffett, as taught by Ben Graham. How I wish I had taken this up right out of college where I learned it 45 years ago, and not wasted years and who knows how much money fiddling around with get rich quick schemes!

Employee stock options – what’s the real cost?

by James Allen, Jr.
January 14, 2011

Accounting for the cost of stock options granted to employees is a topic that has been debated exhaustively and will continue to be until a real consensus can be made among standard setters, users of financial statements, managements and independent auditors.  Under the current standards, businesses are required to expense the “fair value” of stock options over the vesting period of the options.  Sounds perfectly reasonable, right?

Well, that depends on whether the fair value is really fair.  Most businesses elect to use the Black-Scholes option pricing model to estimate the fair value of the stock options that they have granted to employees.  It should be noted that the model was not developed for the purpose of financial reporting and with all due respect to Mr. Black, Mr. Scholes and the model’s other developers it is a lousy instrument for the purpose of measuring the cost a business incurs by issuing its employees stock options.  Actually, much controversy exists about the merits of the model for its intended purpose, but the options traders that use it can undertake that debate.

So, what’s a financial statement reader to do?  You can’t simply throw every business that grants stock options into the “too complicated” pile.  Somehow, there must be a way to measure the true cost of this compensation.

The good news – there is.  Just like a lot of the good stuff about a business, its in the footnotes to the financial statements.  There is enough information about stock option awards that you can come to your own conclusions about cost, regardless of your favorite measuring technique.  I prefer measuring these awards based on their intrinsic value at each measurement date.

To illustrate, let’s look at an example.  For the purpose of this example, we’ll review the annual report for Coca Cola (NYSE:KO) for the year ended December 31, 2009.  Footnote 9 contains the disclosures for stock based compensation, including options.  In 2009, total stock based compensation expense was $241 million which was included in selling, general and administrative expenses in the income statement.  At December 31, 2009 there was $335 million of unrecognized cost to be recognized within the next two years related to unvested awards granted.  Take a look at the second table that rolls forward the number of options outstanding.  The column all the way to the right indicates $606 million in intrinsic value related to unvested options ($1,753 million aggregate intrinsic value for 189 million options outstanding less $1,147 million aggregate intrinsic value for 127 million options exercisable).

So at December 31, 2009 there are 62 million options to vest within two years which if exercised at the December 31 closing price would cost the company $606 million to issue, but there is only going to be $335 million expensed?  That’s a big difference, even for a big company like Coca Cola.

So why are we stuck with this inaccurate measure when we could simply have businesses record the actual cost of this compensation when it is known?  Volatility in periodic results is undesirable to management (and most users of financial statements).  Using an intrinsic value approach, as a business’ stock goes up, its financial results would suffer for it.

Accounting for stock based compensation will likely be a controversial topic for the foreseeable future.  Intelligent investors are aware of issues like this one and able to normalize periodic results and book values in order to make their own opinion of the value of a business.

Disclosure - no positions in KO, but I am a customer.

The Tremble Factor

You probably would not choose to dine at a restaurant whose chef always ate elsewhere. You should be no more satisfied with a money manager who does not eat his or her own cooking. It is worth noting that few institutional money managers invest their own money along with their clients' funds. The failure to do so frees these managers to single-mindedly pursue their firms' rather than their clients' best interests.

Economist Paul Rosenstein-Rodan has pointed to the "tremble factor" in understanding human motivation. "In the building practices of ancient Rome, when scaffolding was removed from a completed Roman arch, the Roman engineer stood beneath. If the arch came crashing down, he was the first to know. Thus his concern for the quality of the arch was intensely personal, and it is not surprising that so many Roman arches have survived."

Why should investing be any different? Money managers who invested their own assets in parallel with clients would quickly abandon their relative-performance orientation. Intellectual honesty would be restored to the institutional investment process as the focus of professional investors would shift from trying to outguess others to maximizing returns under reasonable risk constraints.  If more institutional investors strove to achieve good absolute rather than relative returns, the stock market would be less prone to overvaluation and market fads would less likely be carried to excess. Investments would only be made when they presented a compelling opportunity and not simply to keep up with the herd.

At Action Investment Management, we eat our own cooking!