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on investment discipline

3 Nov

For investors, it’s imperative to establish a disciplined approach and stick with it.   Developing that approach is one of the most difficult parts, however, as what has worked over time in investing does not work at all times.  Yet regardless of what the market is doing someone has done well recently.  Some hedge fund manager made a billion dollars on natural gas spreads, wheat futures, or in Latvian mud art, rare stamps, or old soda pop bottles.  The media will always find examples of who has done well lately.  If it were easy to flit around from strategy to strategy I’d be all over it, but it’s nearly impossible to execute reliably over long time periods.  The trick is not to lose focus on your own approach and to understand that if the core investment framework is sound and well-reasoned, there’s no cause to abandon it just because it’s not working at the moment.  To do so would be like piloting a rudderless ship, at the mercy of winds on the open seas.  It’d be tough to get anywhere.

There is also an undue focus on ‘the market’.  The goal is to beat the market, yes, because active management is, in theory, a fool’s errand without this outcome.  However, the majority of active managers don’t beat the market, and even index funds fall behind (due to fees and expenses).  The overriding goal should be to limit risk while generating returns that meet long-term goals.

Let’s face reality here, the smorgasbord of available investments today – stocks, bonds, real estate, commodities – have rather low forward return prospects.  The low interest rate environment has caused asset prices to be bid up to the point where forward return prospects are in the 4-7% range on average.  The capital markets are not just a place to blindly place capital today.  As Peter Bernstein observed, “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”  Yes, it’d be nice to see double-digit returns, but given the macro environment it doesn’t look possible on a sustainable basis.  (That is, it could run up 20% annually for five years, but the gains would likely be borrowing from well into the future.)  Investors should view an index fund investment today as a decent place to put money, but not a spectacular one.  Individual investments, on the other hand, may offer opportunities for better-than-average returns.

This leads me back to the main point: finding a consistent, disciplined investment approach.  How?  Identify what’s worked over time, regardless of market environment.  A few of these are listed below.  These provide good perspective for investors today, with a stock market that has declined for the past several weeks (but nonetheless remains up for the year).  It’s useful to remind oneself frequently of what has actually worked, especially when the pickings are slim.  As mentioned, they may work over time, but notall the time.

A list of some basics:

  •           A Low Price in relation to earnings, cash flow and asset value,
  •           Insider purchases of significant size,
  •           Recent large declines in a stock’s price,
  •           Smaller companies, and
  •           The above, especially with companies that generate high returns on invested capital.

Consistent execution of a strategy is tough.  For a portfolio manager, it requires institutional support to follow a discipline, especially because there aren’t loads of qualifying investments at all times.  When stocks are cheap, it’s psychologically tough to buy (“they could go lower”) and when they’re high it’s hard to sell (“they could go higher.”)  Individuals might have an easier go at implementing the strategy – the only thing they have to fight is “the urge to do something,” which is a powerful tendency.  (Professional investors aren’t immune, either.)

A final note: following a consistent investment strategy over time requires being very discipline on price paid in relation to value.  So when one can’t find qualifying investments, what ought they do with it?  Hold cash.  Just because it’s not ‘making anything’ doesn’t mean a whole lot. Think about it this way: an investor has $1,000 and a target stock is priced at $50 (worth $50).  If the investor buys today he’ll have 20 shares.  If the stock subsequently declines to $25 (worth $50), he’ll have only $500 (20 shares at $25) and won’t be able to buy more at the now-lower price. If he waited and holds cash, he’ll have $1,000, still, and be able to buy 40 shares for $1,000 that are now worth $2,000 total.  (Yes, the stock could also go up from $50, but wasn’t under-valued in the first place.)   I call the potential returns earned from having excess cash at the right time the ‘opportunity yield’.  The ability to hold cash is an important tool in an investors’ toolkit, and one an investor shouldn’t hesitate to wield.  Warren Buffett says it eloquently, “Lethargy bordering on sloth remains the cornerstone of our investment style.”

In investing there are no strikes called for not swinging, so there’s often no point in swinging unless they’re coming down the middle of the plate.


an opinion on fairness opinions

2 Nov

Several months ago, I reviewed the NYSE Euronext’s proposed merger with Deutsche Borse.  At nearly 900 pages, it was a huge document with loads of information: the agreement and exchange offer, regulatory issues, standalone financials, pro-formas, management discussion, risk factors, background of the merger (a personal favorite), projections of synergies, opinions about the merger from investment banks, etc..  Each time I’ve reviewed merger documents trying to find holes and glean new insights, I continue to be amazed that banks are still paid so much for so-called ‘fairness opinions’.  [This post is a bit longer than usual, but contains several citations with our emphasis that don’t require word-for-word reading.]

Let’s face it, executives are going to push a deal through whether or not it’s good.  With Excel spreadsheets it’s too easy to ‘click and drag’ indefinite predictions of a rosy future.  Valuation models are ‘garbage in, garbage out’, and many large mergers turn out to be just that, garbage, at least for shareholders (executives tend to fare better, owing to change-in-control provisions).  So, predicted ‘synergies’, mostly cost-savings, can really be about anything executives say they are.  Who am I to question their predictions?  And fairness opinions are there to serve the C.Y.A. function for boards of directors.

A fairness opinion is essentially a stamp of approval from an investment bank about a transaction.  In official terms, “A fairness opinion addresses, from a financial point of view, the fairness of the consideration in a transaction.  Fairness opinions are routinely used by directors of companies in connection with a change in control transaction, such as a merger or sale or purchase of assets, to satisfy their fiduciary duties to act with due care and in an informed manner.”

To us, “to satisfy their fiduciary duties” essentially means to pass the buck when a merger doesn’t work as projected.  According to professor Robert Holthausen (@Wharton), more than half of mergers fail and “one recent study found that 83% of all merger fail to create value and half actually destroy value.”  Yet, 80% of board members involved in acquisitions thought theirs had created value for the company.  So, I know out of the gate that regardless of what the opinion says it has about a coin’s flip chance of being accurate.  Yet, bankers are paid millions to prepare these 3-4 page documents with a clear financial incentive to help engender that outcome.

The below excerpt increases the length of the post, but it need not be read in its entirety.  I’ve bolded the main points.

The full text of Perella Weinberg’s written opinion, dated February 15, 2011, which sets forth, among other things, the assumptions made, procedures followed, matters considered and qualifications and limitations on the review undertaken by Perella Weinberg, is attached as Annex B to this document. Holders of NYSE Euronext shares are urged to read Perella Weinberg’s opinion carefully and in its entirety. The opinion does not address NYSE Euronext’s underlying business decision to enter into the combination or the relative merits of the combination as compared with any other strategic alternative that may have been available to NYSE Euronext. The opinion does not constitute a recommendation to any holder of NYSE Euronext shares or Deutsche Börse shares as to how such holders should vote or otherwise act with respect to the combination or any other matter and does not in any manner address the prices at which NYSE Euronext shares, Holdco shares or Deutsche Börse shares will trade at any time. In addition, Perella Weinberg expressed no opinion as to the fairness of the combination to, or any consideration to, the holders of any other class of securities, creditors or other constituencies of NYSE Euronext. [Isn’t this a fairness opinion?]  Perella Weinberg provided its opinion for the information and assistance of the NYSE Euronext board of directors in connection with, and for the purposes of its evaluation of, the combination. This summary is qualified in its entirety by reference to the full text of the opinion. Perella Weinberg’s business address is 767 Fifth Avenue, New York, NY 10153, United States of America. Perella Weinberg has given its consent to the use of its opinion letter dated February 15, 2011 to the Board of Directors of NYSE Euronext, in the form and content as included in this document, as this document stands, at the time of publication.  In giving such consent, Perella Weinberg does not admit that it comes within the category of persons whose consent is required under Section 7 of the US Securities Act of 1933, as amended, or the rules and regulations of the US Securities and Exchange Commission thereunder, nor does Perella Weinberg thereby admit that it is an expert with respect to any part of the Registration Statement on Form F-4 of Alpha Beta Netherlands Holding N.V. filed with the Securities and Exchange Commission, which includes the proxy statement/prospectus, within the meaning of the term “expert” as used in the Securities Act of 1933, as amended, or the rules and regulations of the Securities and Exchange Commission thereunder.

So, hopefully it’s apparent that the opinion really isn’t anything but an expensive formality.

Here are some more “outs” from Deutsche Bank’s opinion (emphasis ours).

DBSI prepared these analyses for purposes of providing its opinion to the Deutsche Börse management and supervisory boards as to the fairness to holders of Deutsche Börse shares from a financial point of view of the Deutsche Börse exchange ratio. These analyses do not purport to be appraisals nor do they necessarily reflect the prices at which businesses or securities actually may be sold. Analyses based upon forecasts of future results, including the broker projections and estimates of the synergies, are not necessarily indicative of actual future results, which may be significantly more or less favorable than suggested by these analyses. Because these analyses are inherently subject to uncertainty, being based upon numerous factors or events beyond the control of the parties or their respective advisors, none of Deutsche Börse, NYSE Euronext, DBSI or any other person assumes responsibility if future results are materially different from those forecast.

Each opinion issued contains similar language.

Don’t forget the indemnification language.  “Deutsche Borse also agreed…to indemnify Deutsche Bank and its affiliates against certain liabilities, in connection with this engagement.”  This language applies more or less equally to each company issuing its opinions and advice.  Bankers are relying on management’s internal projects and representations, and this becomes another out through which they can’t be held liable for future results.

I could go on and on with examples, but won’t belabor the point beyond those illustrated above.

In the NYSE case, Pirella Weinberg was paid $5 million upon the public announcement of the agreement of the combination and is to be paid $22.5 million upon the completion. Deutsche Bank will be paid €14 million ($20.5 million) contingent upon completion of the combination — or a max of €2.4 million ($3.5 million) if not completed, and JP Morgan will be paid $10 million, “a substantial portion of which will become payable only if the proposed exchange offer and merger are consummated.”  Is it really worth more than $50 million for some financial analysis and a rubber stamp?

In summary:

  • The incentive structure is misaligned:
  • Indemnification from the company makes banks’ liability negligible, absent some demonstrable lack of due diligence or fraud
  • Banks are paid mostly through contingent fees (if the deal is consummated)
  • There are numerous “outs”:
    • Like auditors, the representation letter signed by management gives opinion-writers an “out”, i.e., “We relied on management’s representations and do not independently verify…”
    • Buckets of “we do not do X, Y, Z” and “…the opinion is not…” statements
    •  “The future is inherently unpredictable”

All of that said, there is a lot of work involved and some fairly sophisticated modeling is required to back up the opinion.  Yet they simply should not cost $10-20 million on both sides of the transaction.  My company, Sagacious, Inc., offers fairness opinions and is working on for those who desire a fairness opinion but prefer it delivered on a non-contingent, fixed fee basis.  We offer experienced analysis and will work one-on-one with boards of directors and managements to offer an informed, measured opinion.  We’ll determine whether the deal is fair from a financial point of view for a lower, fixed price sans conflicts of interest.  Meanwhile, the shareholders will continue to pay (way too much) for such opinions.

Disclosure: No positions in any of the companies mentioned.

tech confessions from a value investor

1 Nov

It was about a decade ago now that a friend and I started an investment partnership.  The venture was my first foray into managing money for others (friends, family), and it accomplished its intended goal.  First, it made us concentrate on discussing investments on a regular basis.  It established a disciplined feedback mechanism.  It’s like having a running partner – you don’t want to let the other person down.  We discussed strategy, generated ideas, developed reports and wrote letters indicating our thoughts on a regular basis.  The letters are fun to go back and read.  Some things were missed in those reports, however, including many errors of omission that appear glaringly large now.  This post somewhat of a post-mortem along those lines.  While we made plenty of mistakes on the stocks we actually bought, in retrospect, far worse decisions were made with respect to those we discussed but did not buy.  Case in point: Amazon.

Almost from when I began investing, I have been a devout value investor.  (Exception: about the first year.)  The books I read were almost exclusively ‘value’ based.  If I had a mentor, it would be those books and Warren Buffett.  Almost all of them, save a few, dismiss investing in technology stocks almost out of hand.  Buffett, for example, hasn’t touched Microsoft – except for 100 shares in order to receive the annual reports – even though his friend Bill Gates is one of the most brilliant folks he’s met.  (Also, Buffett has jumped into technology lately with his BYD investment, but that’s another story.)  The point is, when I started my mentally was to do the same: dismiss ‘tech’ investments almost out of hand.  “There are enough investments without technology stocks,” I’d say, plus I put them in the ‘too hard’ category.  It’s too hard to figure out what the future will look like.  So I avoided them.

The first rule of investing is ‘don’t lose money’ and the second rule is ‘don’t forget rule #1,” so looking at it from this perspective not investing in fast-changing tech makes a lot of sense.  It IS hard to figure out what the future economics of a business will be, let alone one that is heavily involved in technology.  Underestimated, however, was just how powerful some of these businesses could become.

Anyway, we went on to pass up investing in, at $7.  It was mostly my fault.  I would later pass on the IPO of Google.  I read about the pricing of the offering and considering it too expensive.  (In my defense, IPOs tend to be horrible times to invest.  Who would want to buy from a super-knowledgeable seller?)  Of course, the $85 IPO price looks like a bargain now.  Netflix was another.  I actually bought puts on the stock, trying to profit when the stock fell.  (It hasn’t.)  I must also note that I used Amazon a lot, performed web searches via Google, and was also a Netflix customer.  I loved each of their services.  I thought all three were great companies.  It came down to what I considered a high price in relation to value that I wasn’t willing to bet partners, client, or my own money, on them.  While I’m being masochistic, throw Apple in there, circa 2001.  I passed this over in spite of having several friends who used Macs and loved them.  Oh, then iPods came out…

Buffett has said that “growth” is a part of the “value” equation, that they are not distinct and separate.  This is something  I agree with wholeheartedly.  I’ve always used growth when valuing companies.  It’s the stinginess that, I think, made me not properly consider how growth could impact valuation if returns on capital could be maintained even at very high rates of growth.  Statistically this is very rare.  I also failed to weigh heavily enough how much the people running these companies mattered.  Bezos, Brin/Page, and Hoffman are phenomenal folks — that’s a key takeaway.

Allocating scarce capital involves many tough decisions, and for me the errors of omission keep me up as much as those of commission.  Of course, it’s easy to look back at the winners and say I missed them.  In the intervening period, there were successes in more ‘boring’ companies.  Still, reviewing one’s mistakes is FAR more useful as a learning tool than reviewing successes.  Failure, like success, can involve more luck than skill, but if you know you passed it over for ‘rational’ reasons it’s worth exploring those reasons and considering their validity no matter how much time has passed.   Too, I didn’t buy a bunch of high-flying technology stocks only to see them collapse 95% and lose it all.  So there is some advantage to investing – or not investing – according to a value discipline.

This post is already long enough to make folks who are reading it start to drift off, so I’ll stop here.  In closing, I am certainly more open to technology investments now, but I still prefer to buy the profitable toaster manufacturer trading at $5 with $10 of net cash on its balance sheet.  If I can have a 90% probability of a base hit versus 5% probability of a home run, I’ll still lean toward the base hit.

Disclosure: I own shares of Google (GOOG). 

Chinese demand profile and incremental commodity demand

28 May

I wanted to point out a few things about China from Michael Pettis’ early May newsletter. Below are some really eye-popping statistics about China’s demand profile. (Many thanks to Jeremy Grantham, to whom Pettis credits as the original source for the below statistics.)

Share of global GDP

China’s GDP


China’s GDP (PPP basis)


“The next table lists China’s share of total global demand for a selected list of non-food commodities:

Non-food commodities

Share of global demand



Iron Ore      


















“Finally, the same table for food commodities:

Food commodities

Share of global demand















“What is most noteworthy about these tables, of course, is the disproportion between China’s share of global GDP and China’s commodity consumption.”

Pettis, whose commentary is always original and borderline brilliant, goes on to comment about Chinese investment growth and how re-balancing of the economy in that country (from investment-led demand to consumption-led demand), could have significant effects on non-food commodities (second chart):

“Take iron, for example. If Chinese demand declines by 10%, this would represent a reduction in global demand of nearly 5%. I am not an expert in the commodity markets, but I guess that supply and demand considerations are fairly finely balanced, and a 5% reduction in demand should have significant price repercussions – especially if a material part of Chinese demand represents stockpiling and this stockpiling is reversed.”

Some food (or non-food) for thought.

investors + love = farmland

19 May

As an Iowa native and investor, it’s almost requisite that we follow farmland. About 60% of our farms are owner-operated and over 80% are individual or family organizations. We supply 7% of nation’s food supply with farms that make up over 90% of our land (second only to Nebraska); roughly one-third of the best US farmland is located here. While manufacturing is the largest sector of the Iowa economy, the majority of that is related to food processing and machinery — estimates put the indirect role of agriculture here around 25% of our total economic output. Needless to say, farming in one way or another comprises a large portion of our economic activity and state wealth, not to mention the knock-on effects as incomes in that space move higher.

In the first quarter of the year, farmland was up 16% in the Midwest. At first glance, it appears these increases were justified, since cash rents also gained 16%. Because of this, the price-earnings ratio for farmland was unchanged – which is a good thing given it’s already in the 25-27 range depending on the state. In Iowa, farmland values gained 20% while cash rents grew slightly less at 16%.

Not surprisingly, these year-over-year increases were driven by higher agricultural prices – corn up 50%, soybeans 29%, while milk, hog, and cattle gained at least 20%. Input prices, meanwhile, were up less than 10%, leading to higher profit margins.

We would worry about rising farmland values if bank balance sheets looked stretched, but the average loan-to-deposit ratio was at its lowest level in nearly 15 years (a period over which farmland values are up substantially). In other words, banks have more money to lend; some three-quarters of regional banks have actually lent less than they would like to. The fact that loan demand has actually come down while prices rise bodes well should farm values reverse in sudden fashion. Leverage can be particularly painful on the downside.

So who’s buying? Bankers report that it’s increasingly farmers, rather than investors. It also seems that the number and acreage of farms sold were larger than a year ago. This jibes with our comment in the last post about farmland that farmers know (1) dirt and (2) CDs, or bank certificates of deposit. Given the profile of the incremental farmland buyer, we’re watching CD rates as a leading indicator for farmland values. Should banks begin to pay substantially higher rates on CDs, watch for land values to decline – absent a major change in commodity prices, of course.

Napier comments from Edinburgh

18 May

Russell Napier is a brilliant guy and we love his book Anatomy of the Bear. While he is not always right – no strategist ever is – he has made some great calls with historical precedent to back it up. His recent comments from the 2011 CFA Annual Conference are worth a few minutes of time.

two years and investment professionals’ mindset

17 May

Just returned from the CFA Annual Conference in Edinburgh, Scotland this past week and wanted to get a few thoughts down to maybe crystallize my takeaways. If you’d like a play-by-play, the conference was live-tweeted under @CFAIowa and also the #CFA2011 hashtag. I have found myself returning to these feeds and am likely to reference them several more times as I pen this.

The last conference we attended was 2009, and the world was just six months past a blow-up that brought down Lehman, Bear, and (almost) lots of others. The world had undergone a major shift, a ‘phase transition’. That year, it was as if the attendees were in a dark room, grasping around for the light switch. The various speakers proffered various suggestions on the location of the switch, and attendees were still forming their opinions of what exactly had happened and what was likely to transpire in the future. All we knew at the time was that the market had gained about 50% off the bottom in just two months but it was far from clear whether it was sustainable.

In retrospect, as usual, some forecasters were more right than others and the events since make reflecting on it much easier — had the world collapsed we’d see things much differently today. Instead, equity markets are ahead by double their March 2009 lows and the gains we’ve seen have proven sustainable thus far. In many ways, the light switch has been located.

From the vantage point of 2011, investors seem to have a good grasp of the major (known, large) risks to the world economy. The risks are that are well known today were more or less on the fringe at this time in 2009 – Eurozone economic risks, sovereign credit risks, debt, deficits, over-leveraged consumers, debt-fueled spending, the threat of rising inflation and interest rates, the rise of emerging markets, commodity supply and demand dynamics. Each was more or less reflected to varying degrees in the speeches and seminars this go round. There were a few ‘fringe’ views at the 2011 conference but nothing that was extremely aberrant. (You might have a guy who only likes gold, for example, but even this is almost mainstream today.) Whereas in 2009 the presenters spanned the “31-flavors” gamut, most came in vanilla circa 2011.

I will soon write another post on key takeaways – what might be gleaned from a contrarian viewpoint when ‘everybody knows’ the risks and issues facing investments. I think there are many broader implications for the investment profession as a whole. It seems clear that the powerful ‘institutional imperative’ will impede future performance even though managers, well aware of the potential headwinds facing market valuations and interest rates, believe they should not be 100% invested right now. Just because the risks are apparent doesn’t mean everyone is acting to protect against them. Career risk, or The Risk of Poor Short-Term Performance – a major issue to investment industry credibility – sometimes leads managers do crazy things when viewed from a long-term perspective. Often, ‘what’s right’ is not ‘what’s right now.’

Until next time!

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