Security Analysis Student

TARP Warrants Auction Chart

2011-07-12T11:33:00.002-07:00

Here is the most recent publicly traded TARP warrants. I was looking around for this chart, so I thought I'd share it, cheers.

NYT: The Paradox of Corporate Taxes

2011-02-09T10:28:00.002-08:00

http://www.nytimes.com/2011/02/02/business/economy/02leonhardt.html

Summary of 2007 Berkshire Hathaway (BRK) Chairman Letter

2010-12-15T10:53:00.001-08:00

What were the details of the letter:
• Financial institutions with weak lending practices were suffering as house
prices fell.

• Berkshire acquired Marmon, which Buffett had been paying attention to the
company and its owner, Jay Pritzker, since 1954.

• From 1993 to 2007, percentage increase in pre-tax operating earnings had
grown at a faster pace than per share investments (23.5% vs. 14.3%).

• Enduring “moat.”

An example that a moat exists would be a company with high returns on invested capital in a stable industry.
In addition, the business should not be dependent on managerial brilliance to be successful.

• Three types of “savings accounts.”

Economic returns of a business are dictated by its moats.
Example: See’s Candy, FlightSafety, and US Airways.

• Manufacturing, Service and Retailing Operations had 23% returns on
average tangible net worth.

• All of the “big four” in equity holdings had widened their moats during the
year.

• Derivative contracts had no counterparty risk.

• America shipped about $2 billion of IOUs and assets daily to the rest of the
world.

• America’s rule of law, market-responsive economic system, and belief in
meritocracy are almost certain to produce ever- growing prosperity for its
citizens.

• Unrealistic pension return assumptions and high probability of substantial
pension shortfall in the future.

Practical application:
• Be rational.

• Watch out for the “Helpers.”

• Read the notes in 10-K and 10-Q’s for clues about management behaviour.

Quotes from the letter:
• “A moat that must be continuously rebuilt will eventually be no moat at all.”

• “It’s better to have a part interest in the Hope Diamond than to own all of a
rhinestone.”

• “Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire
we have an abundance of these managers. Their abilities have created
billions of dollars of value that would never have materialized if typical CEOs
had been running their businesses.”

• “Charlie and I are not big fans of resumes. Instead, we focus on brains,
passion and integrity.”

• “Some companies have pension plans in Europe as well as in the U.S. and,
in their accounting, almost all assume that the U.S. plans will earn more than
the non-U.S. plans. This discrepancy is puzzling: Why should these
companies not put their U.S. managers in charge of the non-U.S. pension
assets and let them work their magic on these assets as well? I’ve never
seen this puzzle explained. But the auditors and actuaries who are charged
with vetting the return assumptions seem to have no problem with it.”

3+ questions to the group & group discussion:
• What are the differences between a terrific CEO and a typical CEO?

• How do you know if a business’s moat has widened in any given year?

• What makes See’s to stand out from other candy makers in the industry?

Summary of 2005 Berkshire Hathaway (BRK) Chairman Letter

2010-12-07T23:02:00.002-08:00

What were the details of the letter:

· Completed five acquisitions (two insurers, a RV manufacturer, Business Wire, and an utility) during the year and now have a portfolio of 68 distinctive businesses.

· Capital allocation has shifted to business acquisitions.

· GEICO increased its market share of U.S. private passenger auto business from 5.6% to 6.1%. One percent of market share equates to $1.6 billion in sales.

· Pricing adjustment in reinsurance business to account for factors that have dramatically increase the intensity or frequency of hurricanes.

· Clayton Homes’ loans portfolio has increased significantly since Berkshire’s acquisitions ($9.6 billion).

· Derivatives have continued to mushroom in the industry; while, Berkshire’s positions from Gen Re securities are soon to be closed.

· Widening “moat” (long-term competitiveness) must take precedence of short-term financial results.

· The abuse of option compensation.

· Gotrocks and Helpers: frictional costs of owning securities have increased significantly and greatly reduced investors’ potential returns.

· Excessive debt is a double-edged sword. A string of success can be washed away with one loss.

Practical application:

· Act on your problem as soon as possible.

· Beware of exotic financial instruments.

· Personal gain/loss dictates someone’s action accordingly.

Quotes from the letter:

· “Unlike many business buyers, Berkshire has no “exit strategy.” We buy to keep. We do, though, have an entrance strategy, looking for businesses in this country or abroad that meet our six criteria and are available at a price that will produce a reasonable return. If you have a business that fits, give me a call. Like a hopeful teenage girl, I’ll be waiting by the phone.”

· “Joe, Ajit and I don’t know the answer to these all-important questions [to the factors that caused hurricanes in 2004-2005]. What we do know is that our ignorance means we must follow the course prescribed by Pascal in his famous wager about the existence of God. As you may recall, he concluded that since he didn’t know the answer, his personal gain/loss ratio dictated an affirmative conclusion.”

· “Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.”

· “So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.”

· “When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted.”

· “Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists. (‘Whose bread I eat, his song I sing.’)”

· “Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’”

· “Dow increased from 65.73 to 11,497.12 in the 20th century, and that amounts to a gain of 5.3% compounded annually. (Investors would also have received dividends, of course.) To achieve an equal rate of gain in the 21st century, the Dow will have to rise by December 31, 2099 to – brace yourself – precisely 2,011,011.23.”

· “Any other approach is dangerous. Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero. That is not an equation whose effects I would like to experience personally, and I would like even less to be responsible for imposing its penalties upon others.”

3+ questions to the group & group discussion:

· How active should we be with our portfolio?

· What would be an “exit strategy” for our investment?

· Should we account macro factors into investment decision?

Summary of 2003 Berkshire Hathaway (BRK) Chairman Letter

2010-12-07T23:00:00.001-08:00

What were the details of the letter:

· Equity holdings, as a percentage of net worth, have fallen to an average of 50%, from an average of 114% in the 1980s.

· Valuations and Berkshire’s size have made it difficult to find attractive stocks.

· Given similar valuations, owning businesses is preferable to owning stocks for Berkshire.

· Capital allocation decision will not be guided by past history or short-term profits.

· As long as the standards for acquiring businesses are met [(1) have favorable and enduring economic characteristics; (2) are run by talented and honest managers and (3) are available at a sensible price], Berkshire will continue to buy businesses under any market or economic conditions.

· Acquired Clayton Homes and McLane from sellers with strong reputation (Clayton, Wal-Mart) and did limited due diligence.

· Buffett was critical of President Bush’s tax proposals that favour large corporation and wealthy individuals.

· Buffett also was critical of mutual fund managers and directors who acted against the interest of investors, chief executives who were paid excessively, and corporate boards of directors who were deemed as “independent” but acted otherwise.

· Risk exposures in derivative are difficult to quantify. Gen Re had been trying to exit its derivative positions.

· “Every tub on its own bottom” philosophy—any subsidiary should pay an appropriate rate of interest and should not be subsidized by its parent.

· Buffett mentioned about the mistake of not selling several of larger equity holdings during The Great Bubble.

· Buffett enlarged Berkshire’s currency trading position based on his expressed concerns about U.S. trade deficits.

Practical application:

· Patience.

· Find people you admire.

· Adapt to changing environment but maintain the same framework that is logical and time tested.

Quotes from the letter:

· “A company’s history, for example, may commit it to an industry that now offers limited opportunity. A more common problem is a shareholder constituency that pressures its manager to dance to Wall Street’s tune. Many CEOs resist, but others give in and adopt operating and capital- allocation policies far different from those they would choose if left to themselves.”

· “Under any market or economic conditions, we will be happy to buy businesses that meet our standards. And, for those that do, the bigger the better. Our capital is underutilized now, but that will happen periodically. It’s a painful condition to be in – but not as painful as doing something stupid. (I speak from experience.)”

· “In 1985, Berkshire paid $132 million in federal income taxes, and all corporations paid $61 billion. The comparable amounts in 1995 were $286 million and $157 billion respectively. And, as mentioned, we will pay about $3.3 billion for 2003, a year when all corporations paid $132 billion.”

· “Then, when a management company was sold – invariably act a huge price relative to tangible assets – the directors experienced a “counter-revelation” and immediately signed on with the new manager and accepted its fee schedule. In effect, the directors decided that whoever would pay the most for the old management company was the party that should manage the shareholders’ money in the future.”

· “No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwin’s words, ‘Ignorance more frequently begets confidence than does knowledge.’”

· “You may wonder why we borrow money while sitting on a mountain of cash. It’s because of our “every tub on its own bottom” philosophy. We believe that any subsidiary lending money should pay an appropriate rate for the funds needed to carry its receivables and should not be subsidized by its parent.”

3+ questions to the group & group discussion:

· Temperament: what exactly is needed to be successful in investment operation?

· Corporate/board misbehavior: should we try to identify them?

· Mutual funds: will you ever consider investing in them or suggest to friend/family?

Summary of 1999 Berkshire Hathaway (BRK) Chairman Letter

2010-11-26T20:28:00.006-08:00

What were the details of the letter:

· 1999 was the worst absolute and relative performance in per-share-book value growth of BRK to date.

· Several BRK’s largest investees’ lagged the market in 1999, but the business did better than the stock. Despite the poor showing, Buffett expected BRK to modestly exceed the gain from owning the S&P in the future.

· Buffett expressed his views on why S&P will do far less well in the next decade or two than it had done since 1982, unless the following factors materialize.

o Interest rates must fall further.

o After-tax corporate profitability in relation to GDP must rise.

o The public expectation on equity return must remains lofty.

· Exceptional managerial story by Bill Child, manager of R.C. Willey.

o Bill believed that R.C. Willey could successfully expand in markets outside of Utah and maintain it’s No-Business-on-Sunday policy.

o To back up his business judgment, he personally invested in the land and building of the new store in Boise.

o He would only sell it to BRK at his cost if the store proved to be successful.

o And, he refused to take any interest on the capital he had tied up.

· Insufficient pricing impacted General Re’s results.

· GEICO cost competitive advantages will be sustainable. Overall market share was 4.1% in 1999, up from 2.7% in 1996, with room for significant growth.

· Both FlightSafety International and Executive Jet Aviation had been capital intensive, but they provided services highly valued by customers.

· BRK acquired Jordon’s Furniture and to acquire a major portion of MidAmerican Energy, both from respected referrals.

· Change in goodwill accounting; the end of pooling-of-interests method.

· Look for companies with truly durable competitive advantage.

· Repurchase of BRK shares would only have a minor effect on the future rate of gain in its intrinsic value.

Practical application:

· Identify and associate with first class people.

· Look for people who are willing to tie up their money with their business action.

· Compensation plans have to be simple, directly to relevant operating activities.

Quotes from the letter:

· “We have no contracts at Berkshire. Rather, they [managers] work long and hard because they love their businesses. And I use the word “their” advisedly, since these managers are truly in charge – there are no show-and-tell presentations in Omaha, no budgets to be approved by headquarters, no dictums issued about capital expenditures.”

· “In Ajit, we have an underwriter equipped with the intelligence to properly rate most risks; the realism to forget about those he can’t evaluate; the courage to write huge policies when the premium is appropriate; and the discipline to reject even the smallest risk when the premium is inadequate.”

· “An experienced observer can usually detect large-scale errors in reserving, but the general public can typically do no more than accept what’s presented, and at times I have been amazed by the numbers that big-name auditors have implicitly blessed.”

· “What’s particularly entertaining in these books [sell-side research] is the precision with which earnings are projected for many years ahead. If you ask the author-banker, however, what his own firm will earn next month, he will go into a protective crouch and tell you that business and markets are far too uncertain for him to venture a forecast.”

· “If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries – and seem to have their claims validated by the behavior of the stock market – we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it’s almost certain there will be opportunities from time to time for Berkshire to do well within the circle we’ve staked out.”

3+ questions to the group & group discussion:

· Corporate culture, how important is it? Can we identify strong culture based on the numbers?

· How do we become an experienced observer in a particular field without relying on the financial numbers being presented as is?

· Key metrics and people—how to identify which factors are relevant?

Summary of 1991 Berkshire Hathaway Chairman Letter

2010-10-31T21:16:00.004-07:00

What were the details of the letter

· “Look-through” earnings consist of:

· The operating earnings reported on GAAP basis.

· Retained operating earnings of major investees.

· An allowance for the tax of investees’ retained operating earnings.

· Change in Media economics:

· Competition for eye balls.

· “Bob-around” pattern.

· Future earning prospects impact valuation significantly.

· Does not sell permanent holdings.

· Franchise has a product or service that is:

· Needed or desired;

· No close substitute as determined by its customers;

· Not subject to price regulation.

· Existence of such enterprise can be shown from its pricing power and high rates of return on capital.

· Weak franchise vs. Strong business.

· Ownership of See’s has taught Buffett much about evaluation of franchises.

· Brought H.H. Brown:

· Tough business, but outstanding management.

· Distinguish compensation system.

Practical application

· Create a portfolio that will deliver the highest possible look-through earnings a decade from now. This approach is to force an investor to focus on long-term business prospects.

· Focus on economic franchises.

Quotes from the letter

· “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”

· “If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price.”

3+ questions to the group & group discussion

· What kind of checks and balances do we need to have in place to ensure that we follow established principles?

· Investments in USAir (US Airways), Salomon Brothers, and Fannie Mae—What are the mistakes that we could avoid?

· Franchise vs. Business—how do we distinguish between the two?

Summary of 1987 Berkshire Hathaway Chairman Letter

2010-10-16T02:36:00.000-07:00

1-Minute Summary

· The 1987 letter focused on how to identify business with strong franchise: what factors to consider, how manager should be evaluated, and which numbers are important to the owners.

· In addition, the kind of temperament needed for successful investment operation.

Practical application

· Seeking for the “fortress-like” business franchise

· Really figure out the core competitive advantages of a business

o What value or quality proposition does a particular business brings to its customers.

§ NFM: saving

§ BNews: news hole

§ See’s: superb candy and customer service

o Example: BH insurance unit’s competitive advantages are its strong financial standing and sound underwriting policy

Quotes from the letter

On management

· “The managers of the units should be judged by the returns they achieve on the underlying assets; what we pay for a business does not affect the amount of capital its manager has to work with.”

· “Our managers protect their franchises, they control costs, they search for new products and markets that build on their existing strengths and they don’t get diverted.”

· “Management changes, like marital changes, are painful, time-consuming and chancy.”

On business

· “But a business that constantly encounters major change also encounters many chances for major error.”

· “Making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produced exceptional economics.”

· “We neither understand the adding of unneeded people or activities because profits are booming, nor the cutting of essential people or activities because profitability is shrinking. That kind of yo-yo approach is neither business-like nor humane.”

On investment

· “When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.”

· “Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price. Charlie and I have found that making silk purses out of silk is the best that we can do; with sow’s ears, we fail.”

· “An investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.”

· “Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.”

· “The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.”

· [On items like efficient markets, dynamic hedging and betas] “Their [people’s] interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising ‘Take two aspirins’?”

3+ questions to the group & group discussion

· What weakness/action do you current have that hinder you to stay insulated from market emotions?

· How can you improve on judgment of characters?

· What are the differences between intelligent and unintelligent capital allocation?

Berkshire Hathaway 1971 Chairman Letter

2010-08-29T11:35:00.003-07:00

Berkshire 1971 Chairman Letter

1 Minute Summary:

By the end of 1970, Buffett and Susie's ownership in Berkshire Hathaway (BRK) was approx. 36%.
Buffett had figured out a new type of business (insurance float).
Insurance business was becoming the future of BRK.
Inflation was high at the time (average 4-5%, compared to 1-1.5% in 1955-1965)
U.S. was off the gold standard in 1971 (Nixon Shock).
(Not in the letter) Blue Chip Stamps saw its business model deteriorated. To replace the earnings in the business, president of Blue Chip Stamps suggested that See's Candies was for sale (Munger loved the business, but the price tag was considered expensive at the time—$25m for $5m assets).

What were the details of the letter:

BRK was showing better return on capital (14%, excluding capital gains) as a result of redeployment of capital that started five years ago.
Buffett discussed operations in the three segments (Textile, Insurance, and Banking).
Home & Auto was a major purchase of the year.

New Terminology / concepts / ideas / useful examples:

Management objective should be to improve return on total capitalization, as well as the return on equity capital.
Find managers with talent for operating profitably and enthusiasm for the business.
It would be even more beneficial for the owner if the managers have substantial ownership and pride in the company.

Practical application:

Track record: Compare statements and/or objectives made by managers in previous years with actual financial results in current year.
Insider ownership: Check managers' ownership to see if it is significant. Also check how they've acquired and how long they've had the shares.
Due diligence on management: What if the company has excellent financial results, significant insider ownership, but questionable characters at senior level (ex. American Apparel).

Quotes from the letter:

"We retain a fundamental belief in operating from a very strongly financed position so as to be in a position to unquestionably fulfill our responsibilities."
"We set no volume goals in our insurance business generally—and certainly not in reinsurance—as virtually any volume can be achieved if profitability standards are ignored."

3+ questions to the group & group discussion:

What is the best way to establish and maintain loyalty in relationship with others?
What is the key to perseverance?
How do you identify good character?
Following the crowd—the good and bad?

Chapter 51—Discrepancies between Price and Value (Continued)

2010-06-26T18:54:00.000-07:00

One Minute Summary:

This chapter gave additional reasons for discrepancies between price and value of a security, such as seasoned and unseasoned issues, contractual and non-contractual comparables, and special supply and demand circumstances.

Chapter in Detail:

Seasoned issue—an issue of a company has a high reputation among investors due to its long and successful operating history. The price of a seasoned issue may exhibit price inertia even when its financial statements or future prospects have been weakened.

Unseasoned issue—an issue that usually belongs to the industrial field. Unseasoned issues are very sensitive to adverse developments of any nature. Therefore, during a business storm, a group of unseasoned issues is likely to suffer more than a group of seasoned issues, which speculative opportunities may arise for a security buyer.

Misuse of comparables—an issue is quantitative preferable to others in a similar industry does not imply that issue is a sound purchase. The issue must be considered as attractive on a stand-alone basis.

Contractual related comparables—when a senior issue is more preferable than its junior securities based on quantitative factors, one should consider switching to the senior issue as a sound investment. Any improvement in the business should reflect a better return than one made in the common stock.

Special supply and demand factors—short-term speculative purchases due to temporary excitement in an issue, or its related industry.

Practical Application:

Washington Mutual (WaMu) as a seasoned issue—an analyst may examine WaMu’s financial statements and reveal significant information about its financial position. At the peak of WaMu’s operation, the option ARMs and subprime mortgage represent over 50% of its loan portfolio.
Buy an issue that you can fully understand its business fundamentals, unless a significant, demonstrable discrepancy exists between its current price and value.

Three Quotes:

“We have warned against an overready acceptance of a purely quantitative superiority. The future is often no respecter of statistical data.” Pp. 691
“He buys by reputation rather than by analysis and he holds tenaciously to what he has bought. Hence holders of long-established issues do not sell them readily, and even a small decline in price attracts buyers long familiar with the security.” Pp. 688
“These disparities [of prices between senior and junior securities] arise from the frequent failure of the general market to recognize the effect of contractual provisions and often also from a tendency for speculative markets to concentrate attention on the common stocks and to neglect the senior securities.” Pp. 693

Three questions to the group to test understanding:

Why price inertia exists?
In valuing comparables between companies in the same industry but with different capital structure, how would the analyst account for the differences?
When an industrial issue appears to be undervalued from its comparables, what would be the best course of action?

Clarifications & Group Discussion:

Would you consider expanding your investment horizon to include more senior securities?
What other additional factors may contribute to discrepancy between price and value?
Do we have more “seasoned” industrial issues today?
Technical analysis is a form of special supply and demand?

Chapter 43—Significance of the Current-Asset Value

2010-06-26T18:53:00.001-07:00

Chapter 43—Significance of the Current-Asset Value

One Minute Summary:
This chapter is about using current asset value as an approximation of a company’s liquidation value—book value of current assets should be adjusted to reflect liquidation value. Companies that are selling under liquidation value usually demonstrated unsatisfactory earnings trend, which may continue to operate at a loss and nullify the intrinsic value to below price paid. As a result, the analyst should examine companies that have reasonable basis of earning improvement based on past records and future prospects.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:
• During liquidation, non-current assets are to experience the most shrinkage; thus, as a safety measure, current asset value provides a rough measure of the liquidating value.
• History may serve as an indication of future. In the chart, Manhattan Shirt would likely to yield better results since its net current asset was reduced by 10% during a very difficult period, compared to 60% of Hupp Motor.

Additional comments:
• Liquidating/market value for real estate, buildings, machinery, equipment, nonmarketable investments, intangibles, etc are more easily obtainable today. If the analyst is confidence about his/her source of information, the percentage of liquidating value to book value can be adjusted higher than what is suggested by the chapter.

Practical Application:
• Past history of a bargain issue should be examined to determine whether an investment in such issue will yield satisfactory results in the future.
• To be considered as an attractive investment, these bargains must have potential catalysts in either improvement in future earnings, potential sale or merger, or liquidation distribution.

Three Quotes:
1. “Common stocks that (1) are selling below their liquid-asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains.” Pp. 570
2. “…voluntary withdrawal from an unprofitable business, accompanied by the careful liquidation of the assets, is an infinitely more frequent happening among private than among publicly owned concerns.” Pp. 559
3. “Dividends paid to common-stock holders do not in themselves make the stock any safer. The directors are merely running over to the stockholders part of their own property; if the money were left in the treasury, it would still be the stockholder’s property.” Pp. 573

Three questions to the group to test understanding:
1. What kind of liabilities may be off balance sheet?
2. How would you go about to confirm the book value of current assets on the balance sheet?
3. How would you value the capitalization structure when the debt instruments (preferred or fixed coupon debts that have a convertible feature into common stocks)?

Clarifications & Group Discussion:
1. Case study of Bennett Environmental Inc.

2. What essences should we take away from this chapter since the “net-nets” are less obvious in today’s market?

3. Today, some businesses may have their intangible assets understated. Would you consider “mark-up” the value of these assets? If yes, how would you assess the value, and should the intangibles be considered as a current asset?

4. Would you apply similar discount percentage to the book value for different asset classes suggested by the chapter?

Chapter 37—Significance of the Earnings Record

2010-03-09T22:46:00.000-08:00

Chapter 37—Significance of the Earnings Record

One Minute Summary:

The chapter goes over the significance, as well as pitfalls, of the earnings record.

Chapter in Detail:

Earnings record is used to as a starting point to judge a company’s future earning power. Because a long history of earnings demonstrate some quantitative and qualitative factors of a company, earnings record must cover a number of years to gauge a company’s future earning power For example, a stable rising trend of earnings over a period of 20 years may suggest that the company exhibited favourable prospects during various business cycles.

However, there are a number of key points that should be considered with the company’s earnings record:

1. If there is a quantitative trend, the trend needs to be coupled with supporting qualitative factors:

a. Industry characteristics

b. Inherent stability of the company

c. Future outlook, etc.

2. Valuation should not be based on current earnings.

a. A single year of earnings may only demonstrate the company’s earning power during a particular point of a business/industry cycle

3. Distinctions between average and trend of earnings.

a. Trend may be deceptive

i. Poor prior results

ii. Future competition

iii. Sensible business man approach

4. Deficits should be considered as a qualitative factor

a. A wide variation in the earnings record decrease the representative character of the average

5. Intuition vs. sound analysis

a. Identified qualitative factors should be based on sound reasoning

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

· Intuition vs. Sound reasoning

Additional comments:

· Pension liability and its future impact on the earning power of a corporation should also be considered

· Ignore the share data and look strictly at the total value, e.g. total earnings vs. market cap/enterprise value

Practical Application:

· The analyst should survey the up-to-date and future corporate developments of a company. For example, a company may issue a large quantity of purchase rights as part of an equity financing deal that would be dilutive to future earnings.

· Positive trend of earnings may be deceptive by accounting applications and easily exaggerate the stock price of a company. It’s important to take a private businessman’s perspective and insist on paying a reasonable price based on demonstrated earnings power in the past and confirming that such trend would at least remain in the future.

Three Quotes:

1. “It is the most important because the sole practical value of our laborious study of the past lies in the clue it may offer to the future; it is the least satisfactory because this clue is never thoroughly reliable and it frequently turns out to be quite valueless... [However,] the past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in valuation and selection of securities.”

2. “The analyst cannot follow the stock market in its indiscriminate tendency to value issues on the basis of current earnings. He may on occasion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand pointing to the continuance of these current results.”

3. “The divergence in method [of valuing a company’s share price] between the stock market and the analyst...does not mean that the analyst is convinced that the market valuation is wrong but rather that he is not convinced that its valuation is right.”

Three questions to the group to test understanding:

1. What kind of non-cash items can impact an income statement?

2. What are some hidden expenses that may not be reported on an income statement?

3. With a significant write-off of assets, what impact will this have on a company’s future income statements?

Clarifications & Group Discussion:

1. Case study of Decker’s Outdoor Corp.

2. What kind of qualitative factors should we look for to support the quantitative data?

3. When a company is sold at what seem like a generous valuation in relation to the average of past earnings record and future prospects, should the analyst take action and short the stock, or should he/she ignore such development and spend his/her time to identify other undervalued stocks?

Reading: Chapter 28—Newer Canons of Common-stock Investment

2010-02-21T21:19:00.001-08:00

Reading: Chapter 28—Newer Canons of Common-stock Investment

One Minute Summary:

The chapter gives three general approaches to common-stock investment: secular expansion, individual growth and margin of safety principle.

Secular expansion—investment is relied upon a growth of earnings in the general economy and such growth will be reflected in companies’ profits.
Individual growth—investment is focused on well perceived companies that are thought to be capable of steadily earning growth; therefore, such companies are ideal as long-term investments.
Margin-of-safety principle—investment is based on an analyst’s work to identify stock of a company that is selling below its minimum intrinsic value.

All approaches could be applied successfully but most likely by a few exceptionally talented individuals in the first two approaches due to human nature and market psychology.

Chapter in Detail:

It is argued that a sound common-stock approach includes all of the following:

Investment should be purchased as a group base, since diversification of risk is a key to achieve favourable average result.
Individual issues should pass qualitative and quantitative tests similar to the ones applied to fixed-value investments
Compared to fixed value investment, common-stock investment should place a greater emphasis on the future outlook of the companies.

Secular expansion—index fund investing would be an example of this approach, where it is believed that a broad casual connection exists between a nation’s wealth and its companies’ future earning power. Often, it is believed that a nation’s wealth growth will continue to increase, and this expansion will lead to an increase in companies’ overall profits.

Investors should maintain wide diversification and insistence upon paying reasonable price to guard against the negative consequences from economic boom and bust cycles.

Individual growth—this approach can be followed successfully if it is pursued with skill, intelligence and diligent study. However, the following questions present why such operational is difficult in process.

1. What are growth companies?

The general conception is that companies with above average earning growths from cycle to cycle can be considered as growth companies, but it is difficult for an investor to selection appropriate periods to determine the validity of cycles and sustainability of the growth.

2. Can investor identify them?

Not an easy process because companies goes through stages of growths. A short operation history with exceptional growth cannot be used as a solid base for predicting future growths, and a long history of growth might suggest that the above average growth may be nearing its maturity before the unavoidable decline.

3. Price already factor in the future growth?

If an investor pays a substantial amount for the growth factor, he is inevitable assuming the risk that the growth will be less than he anticipates

Margin of safety principle—this approach is based on the analyst’s work, which is justified by an issue’s price, its qualitative and quantitative factors, as well as general market swing, to identify whether it is selling at a sufficient discount to its intrinsic value. This principle can be applied in two ways:

1. Purchase a group of active issues at times when the general market is low based on the following system:

a. Compose a diversified list of leading common stocks.

b. Evaluate a fair value for the group from their earning yields, compared to the long term interest rate.

c. Establish a buying point at some percentage below this fair value and a selling point above it.

Some difficulties include that the fair value estimation could be wrong, the buying and selling point may be badly chosen, and the human behaviour may hinder the operator’s chance for profit. A strong will is required as this approach is contrariety to the general market sentiment.

2. Purchase undervalued individual common stocks based on the following two types:

a. Purchase of issues with exceptional prospects at a price no higher than a similar private business.

b. Purchase of issues with satisfactory past records and prospects at a much discounted price than what a similar private business would be valued at.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

“Supermaturity”—the company has entered a stage with limited growth and an actually loss in market share and profits.

Discussion on what happened to the large and well-known growth companies from the example in this chapter.

[Feel free to present your input for this section to the group]

Issues Disagree With:

Based on the list of large, well-known growth companies in the chapter, it may be argued that companies with exceptional growth should be considered as investment candidate, even if it means paying a reasonable premium than what a private business man would offer at the time of acquisition.

Practical Application:

A large company with reasonable prospects that survived a severe economy depression could be considered as strong enterprise for investment valuation.

Three Quotes:

“Undoubtedly any of these three viewpoints (long-term growth, next year prospects, stock market trend) may be followed successfully…But we are not so sure that any of these approaches can be developed into a system or technique that can be confidently followed by everyone of sound intelligence...” p.375

“Investment is conceived as a group operation, in which diversification of risk is depended upon to yield a favourable average result.” p.366

(Can growth be used as a basis of investmet selection?) “Our answer is ‘yes,’ provided… [1.] the future are examined with real care and a wholesome of scepticism, rather than accepted quickly via some easy generalization; [2.] the price paid be not substantially different from what a prudent business man would be willing to pay…in private undertaking over which he could exercise control.” p.371-372

Three questions to the group to test understanding:

Based on the concept of “value to a private investor,” what are the two types of investment in common stocks?

Why should a private business be assigned with a discount rate relative to a similar public-traded company?

What are three general approaches to common-stock investment, and what other approaches dominate today’s market?

Clarifications & Group Discussion:

Should we pay more attention to the large and well-known companies that have demonstrated tremendous ability to expand over a long period as investment candidates?

Would it be sensible to stash a list of companies that fits the description of question one and apply Buffett’s suggested philosophy of 20 ticket punch card; in addition, should an investor be willing to pay for a reasonable premium today or waiting for a reasonable price-point?

Companies go through different stages of growth and eventually enter a final phase of “supermaturity.” Is this an advantage or disadvantage for growth companies with a long period of exceptional ability to expand?

Using the concept of “value to a private investor,” which one is a better choice of the two investment types?

Today, a conglomerate could have a number of different businesses under its coporate structure. Would this individual issue be considered as sufficient diversifcation?

Reading: Chapter 21 – Supervision of Investment Holdings

2010-02-10T17:41:00.001-08:00

One Minute Summary:

Supervision of fixed value investment is necessary. However, to achieve an additional 1 to 2.5% yield on top of the U.S. government bonds, an investor is required to buy the right securities and monitor their corporate developments. Yet, with all the effort entailed, he/she is still exposed to a chance of loss. If the spread between corporate bonds and government bonds are within a limited range, say 1% to 2.5%, government savings bonds would a better choice, unless the investor is educated enough to speculate or identify investment opportunities.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

“Gilt-edged securities”—securities that are thought to have the highest level of quality.

Additional thoughts:

Currently, for 10 Year bonds: US Treasury—3.57%; AAA Corporate—4.24%; A Corporate—5.41%; BBB Corporate—6.52%. From the suggested practice, an investor should consider US Treasury bond much the same way it was 70 years ago.

Practical Application:

Large interest coverage—the margin of safety—is an excellent quantitative trait in fix-value investments. However, an operating loss would immediately eliminate that margin of safety. Therefore, earning stability from the issuing corporation is an essential requirement for fixed-value investments.

Three Quotes:

1. “It is doubtful if trading in bonds, to catch the market swings, can be carried on successfully by the investor…we are convinced that any combined effort to advise upon the choice of individual high-grade investments and upon the course of bond prices is fundamentally illogical and confusing”

Type	U.S. bond market (CY2009)	NYSE/AMEX/NASDAQ combined (Jan 2010)
Average daily trading value	$815 billion	$71 billion

2. “The degree of safety enjoyed by the issue, as shown by quantitative measures, must be so far in excess of the minimum standards that a large shrinkage can be suffered before its position need be called into question.”

3. “If only small investors would resolutely reject…an ostensible “sure income return” of 4 to 6%, and thankfully take advantage of the 2.90% available on United States Savings Bonds, we are convinced that they would save an enormous amount of money, trouble and heartbreak.”

A question to the group to test understanding:

1. Why some investors (retail or institutional) must consider types of fixed-value investment?

Clarifications & Group Discussion:

1. Superiority of United States Savings Bonds—has this changed?

2. Why has bond trading become such a dominate force?

3. Systematic supervision—how are you addressing this requirement with your investment?

4. Sources of investment advice—if most sources are terrible by design, why is their popularity in perpetual growth?

5. If a company lacks inherent earning stability, but has a history of large interest coverage. Would you consider purchasing its corporate bonds, and if yes, at what price point?

Security Analysis Chapter 6 Summary

2010-01-16T00:25:00.001-08:00

Reading: Chapter 6 - The Selection of Fixed-Value Investments

One Minute Summary:

The chapter gives an overview of different types of fixed-value investment.

1. “High-grade straight bonds and preferred stocks.”

2. “High-grade privileged issues, where the value of the privilege is too remote to count as a factor in selection.”

3. “Commons stocks which through guaranty or preferred status occupy the position of a high-grade senior issue.”

In addition, the chapter outlines four principles for the selection of fixed-value issues.

1. “Safety is measure not by specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations.”

2. “This ability should be measured under conditions of depression rather than prosperity.”

3. “Deficient safety cannot be compensated for by an abnormally high coupon rate.”

4. “The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those prescribed by statute to govern investments of savings banks.”

Chapter in Detail:

When purchasing a bond, the primary focus should be the enterprise’s earning power and not on the promise and protection of the bond. Bond buyer should take similar approach as equity investors to identify the soundness of the issuing enterprise and exclude bonds that do not meet the standards of safety.

The chapter proposes four principles for selecting individual bonds (see the section above) and focuses on the first principle—“Safety not measured by lien but by ability to pay.” The lien itself is insufficient to make a sound purchase in a bond based on the following reasons:

1. The pledged properties are rarely adaptable to other form of business uses; therefore, should the enterprise failed itself, the pledged assets are likely to suffer a significant drop from its appraised value.

2. The bond holders rarely own the actual pledged assets, unless the realizable value is substantially less what the holders are entitled to. Most of the time, the bond holders took new securities of the reorganized enterprise with a lesser value.

3. Bond holders have to wait for a long period of time during the receivership for the property to foreclose, and an even longer period of time to receive his or her shares among different classes of bond and stock holders. The bond holders are likely to face a significant depressed quoted value for the duration of the receivership and an uncertain outcome to the final disbursement.

Consequently, the chapter offers following position in regard to bond selection:

1. Purchase should focus on an enterprise with plentiful resources to meet its interest payments, even if the bond itself has a lower priority and is less secured than a higher secured bond in a weak enterprise.

2. Identify an enterprise that meets every test of financial strength and soundness, and then select the highest yielding bond offered by that enterprise—this would usually imply selecting the junior rather than the first lien bonds.

3. Among different enterprises, bonds with senior liens should be preferred when the yield among all class of bonds are similar. Junior issues should be considered when they have a substantial yield advantage or asset protection compared to other enterprises based on the following conditions:

a. The protection for the total debt of the issuing enterprise is more than sufficient.

b. The protection for the total debt of the issuing enterprise is considerably higher than senior bonds in other enterprise with similar yields.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

Underlying Bonds—small size bonds that are secured by a lien on an especially important component of the issuer’s business system. Historically, the railroad industry usually issued this kind of bond. Currently, some underlying bonds are issued as a first lien on mortgage claims.

Additional thoughts:

Bonds in receivership should be considered even if the timing is uncertain, given the facts that the enterprise can fulfill its commitments after reorganization.

Practical Application:

1. The Seaboard-All Florida Railway (Seaboard) First Mortgage 6s—this example was used to illustrate that lien is no guarantee against shrinkage in the value of the pledged asset. The bond, which originally sold for $25 million at 98 1/5 in 1925 and due in 1935, had a first lien on approximately 475 miles on newly constructed and finished lines. Seaboard went into receivership in 1931, and the bond was selling as low as 1 cent on the dollar. The bond had raised its market value to 3.875 cents on the dollar at the end of 1939.

Three Quotes:

1. “Soundness of the best investment must rest not upon legal rights or remedies but upon ample financial capacity of the enterprise.”

2. “It is a process of exclusion and rejection, rather than of search and acceptance. In this respect the contrast with common-stock selection is fundamental in character. The prospective buyer of a given common stock is influenced more or less equally by the desire to avoid loss and the desire to make a profit.”

3. “But neither priority nor promise is itself an assurance of payment. This assurance rests in the ability of the enterprise to fulfill its promise, and must be looked for in its financial position, record, and prospects.”

Three questions to the group to test understanding:

1. What are the differences between bond and equity in terms of return and safety?

2. What is a debenture, why should it be considered?

3. What is the difference between straight bonds and preferred stocks?

Clarifications & Group Discussion:

· “The value of the pledged property is vitally dependent on the earning power of the enterprise,” would you agree or disagree?

· Why has corporate bonds been neglected among retail investors as an individual investment candidate?

· When should we consider switching between fixed value investments and equity investments?

Security Analysis Chapter 4 Summary

2010-01-16T00:16:00.005-08:00

Reading: Chapter 4—Distinctions Between Investment and Speculation

One Minute Summary:

The chapter distinguishes the differences between investment and speculation operations. Acquiring an asset will only be considered as an investment when the reasoning to purchase is based on “the study of facts in light of established standards of safety and value.” The standards of safety and value should be based on tangible data with assurance that the purchased asset will have sufficient resources and earning power to promise the safety of the initial investment, with any amount of return that the investor is willing to accept.

Chapter in Detail:

The chapter analytically examines the common distinctions between investment and speculation and offers a sound concept for the definition of investment.

The following chart summarizes the commonly accepted distinctions between the two terms; however, these criteria should not be applied as the difference between the two:

Investment	Speculation
1. In bonds.	In stocks.
2. Outright purchases.	Purchases on margin.
3. For permanent holding.	For a “quick turn.”
4. For income.	For profit.
5. In safe securities.	In risky issues.

Why they should not be used to generalize the two terms:

1. Bonds vs. Stocks. – Poorly secured bond could be categorized as one of the most utterly form of speculation; common stocks can be rated as investment quality.

2. and 3. Outright vs. Marginal Purchases; Permanent vs. Temporary Holding. – The purchase method or intention does not make the transaction an investment. The speculator could be buying a penny mining stock outright and plan to hold it permanently; such operation is still speculative after all.

4. and 5. Income vs. Profit; Safety vs. Risk – A focus solely on income does not make the transaction an investment because profit for strong enterprises could rise steadily over the years and compensate the investors by higher share price. With the fifth distinction, safety should be judged in tangible data, as well as time tested standards, and not based on the current market psychology. An overpriced security is risky no matter how safe it appears relative to its comparables.

The proposed distinction between investment and speculation is as follows:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” This can also be coined as an “Analyst’s investment.”

And

“An investment operation is one that can be justified on both qualitative and quantitative grounds”

Any planned purchase that cannot qualify as an “analyst’s investment” is automatically considerate as a speculative operation.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

Analyst’s Investment – Operations that, upon thorough study, promise safety of principal and an adequate return.
Sheltered Investment – Securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon an adequate taxing power.
Intelligent Speculation – Taking of a risk that appears justified after careful weighing of the pros and cons.
Unintelligent Speculation – Risk taking without adequate study of the situation.
Standards of Safety – Resources and earning power of an institution is sufficient to cover the investor’s contribution.

Issues Disagree With:

If a business has demonstrated outstanding relationship with its customers, labour, and/or suppliers, an analyst should consider this intangible qualitative factor as part of his or her test for standards of safety.

Practical Application:

1. Avoid the Chinese stocks that are trading at multiples of 50 and above.

2. Utilize online resources such as Capital IQ and EDGAR to access industry and company profiles for fact findings.

3. Document the analysis and the reasoning of safeness.

Three Quotes:

“It is important to recognize that such value (“intrinsic value”) is by no means limited to “value for investment”…, but may properly include a substantial component of speculative value, provided that such speculative value is intelligently arrived at. Hence the market price may be said to exceed intrinsic value only when the market price is clearly the reflection of unintelligent speculation.”
“The concept of safety can be really useful only if it is based on something more tangible than the psychology of the purchaser. The safety must be assured, or at least strongly indicated, by the application of definite and well-established standards.”
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

Three questions to the group to test understanding:

1. What are the types of “investment”?

2. What is the relation of the future to investment and speculation?

3. What would be considered as standards of safety?

Clarifications & Group Discussion:

1. Is speculation wrong?

2. How to determine if an operation is an “intelligent speculation”?

3. What should be considered as “Standards of Safety”?

4. What would be considered as an adequate or “thorough” analysis?

Security Analysis Book Study Group

2010-01-03T00:02:00.004-08:00

I am fortunate to know a group of dedicated value investors based in Vancouver, and we are currently in the process of going through Security Analysis by Benjamin Graham, the Dean of Wall Street. I will be publishing my own chapter summary that I am assigned to. I believe this is a valuable exercise, and I hope to share some of the experience to whomever that might stumble on to this little space.

Reading: Introduction to the Sixth Edition—Benjamin Graham and Security Analysis: The Historical Backdrop

One Minute Summary:

The chapter gives a brief historical overview of the U.S. economy and Wall Street since the Great Depression, as well as the Dean of Wall Street himself.

Chapter in Detail:

· Between the publication of the first (1934) and second (1940) edition of Security Analysis, the U.S. economy and the U.S. financial industry were in a terrible shape.

o DJIA had lost 87% of its value from its peak in 1929 to trough in 1932; unemployment rate was approximately 25%.

o DJIA again lost 50% of its value from 1937 to 1938; unemployment was 18.8%.

o NYSE, the exchange itself, was running at a loss every year from 1933 to 1940, with the exception of 1935 with a small nominal profit.

o Total share volume traded was 207.6 million in 1940—about two hours worth of trading in today’s market or 18.5% of 1929.

o One in five NYSE-listed industrial companies was under its net current assets value.

o Merrill Lynch & Co. only required a single floor at 40 Wall Street for the entire company; Morgan Stanley only occupied a single floor as well at 2 Wall Street, and it was the leader for corporate securities underwriting in 1936 —with originations worth of $195 million.

· Major federal regulations of the securities markets were introduced in the 1930’s.

o Public companies need to publish quarterly and annual report to stockholders.

o Institutions regulating the securities markets were established, along with federal insurance of bank deposits.

· Benjamin Graham, the Dean of Wall Street.

o Intrinsic value, defined by Graham, is “that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excess.”

o Graham stated that since the future is unknown, an investor must defend himself or herself again that unknown by paying less than the “intrinsic” value of a stock (“Margin of Safety”).

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

“Nexting” – Animals learn to recognize patterns around their world and use the knowledge to expect what would happen next. Humans are masters of this ability and often mistakenly believe the knowledge is a sound base for future predictions; however, “Nexting” is really just combining the experience of the present and past to arrive at a conclusion for the unknown future. This term is coined by Daniel Gilbert, author of “Stumbling on Happiness” and a Harvard psychology professor. Benjamin Graham understood the foolishness of projecting current experience into the unpredictable future; thus, he urged adhering to the concept of “Margin of Safety”—purchase of a stock significantly below its intrinsic value. In the chapter, an example of “Nexting” is the prediction made in 1939 by Alvin Hansen and Joseph Schumpeter, two Harvard economics professors, that U.S. would experience continued decline in population growth; this idea was echoed by Chelcie Bosland, assistant professor of economics at Brown, in his publication of “The Common Stock Theory of Investment” (1937) that U.S. population growth would stop by 1975.

Use of Leverage – In 1929, Graham-Newman partnership had $2.5 million capital. They had $2.5 million in long/short hedged positions, as well as $4.5 million in long positions. Graham realized later that the stocks they owned, no matter how cheap they appeared to be, were imminent to major financial blows. Even after a careful selection of stocks, the partnership showed a cumulative loss of 70% from the fourth quarter 1929 to the end of 1932.

Issues Disagree With:

N/A

Practical Application:

1. Consider stocks that are under its net current assets value.

2. Special situation, Graham and Klarman’s specialty: assesses the liquidation value of a company with insolvency potential. After a thorough analysis, acquire the stocks if the market value is significantly below the liquidation value.

3. Apply long/short strategy when applicable situation arise. In the chapter, the example involved with a company faced with insolvency. Graham would enter a long position in the liquidating company, again after thorough analysis, that had a much higher liquidation value than its market value, and subsequently, short the stocks of companies in which the liquidating company owns.

Three Quotes:

1. “I blamed myself not so much for my failure to protect myself against the disaster I had been predicting (the 1929-1932 market collapse)…as for having slipped into an extravagant way of life which I hadn’t the temperament or capacity to enjoy. I quickly convinced myself that the true key to material happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic conditions.” –Benjamin Graham

2. “Even when the underlying motive of purchase is mere speculative greed, human nature desires to conceal this unlovely impulse behind a screen of apparent logic and good sense. To adapt the aphorism of Voltaire, it may be said that if there were no such thing as common-stock analysis, it would be necessary to counterfeit it.” –Benjamin Graham

3. “If an investor had purchased 100 shares of the 20 most popular dividend-paying stocks on December 31, 1901, and held them through 1936, adding, in the meantime, all the melons in the form of stock dividends, and all the plums in the form of stock split-ups, and had exercised all the valuable rights to subscribe to additional stock, the aggregate market value of his total holdings on December 31, 1936, would have shown a shrinkage of 39% as compared with the cost of his original investment.” –Robert A. Lovett

Three questions to the group to test understanding:

1. What is “intrinsic” value and how is it determined?

2. What would be an example of the “aphorism of Voltaire” we have seen in the past decade?

3. Why is “Margin of Safety” an important investment concept?

Clarifications & Group Discussion:

1. 10 times earnings, 20 times earnings, or 50 times earnings – Are we creating another New Era theory or time has really changed?

2. Use of Leverage — Should leverage be used? If yes, on what level?

3. The Great Depression – Is this an anomaly?

4. Think about stocks the way a businessperson would think about his or her own family business — Is this the case in today’s market or its relevance has disappeared?

5. Nexting – How can we avoid the folly in making future predictions?

2010 Here We Go!

2010-01-02T23:46:00.004-08:00

http://online.wsj.com/article/SB126126238767798771.html

WSJ has this excellent article for us looking for a fresh new start in the new year and from the so called "Lost Decade". Especially when the last decade was filled with hot tips, hot sectors, hot tech, and pretty much about everything that was expected to shoot up in perpetuity up until 2007.

In particular, "Don't Chase Highflying Stocks", the article rightfully pointed out that the worst type of investments is the one that everybody talks about it. For example, everyone was talking about technology stocks before the dot.com bubble. Also, watch out for herd mentality and following the hot tips; money magazine's top picks for 2000 and beyond are down about a fifth and SmartMoney/WSJ picks are about a half because most of the picks were overweighted in technology stocks--the hotter trend to be in back then.

Happy Investing 2010!

In Deep: Underwater Borrowers (From WSJ)

2009-11-24T12:46:00.010-08:00

Source: http://s.wsj.net/public/resources/documents/info-NEGATIVE_EQUITY_0911.html

Here is an update of the US housing market. It's mind boggling that close to 50% of all homeowners with mortgages in the states of Arizona and Florida had negative home equity (mortgage owned is more than market value of the home) in the 3rd quarter of 2009, with the country's average at 23%.

The US economy is recovering, if we consider the rise in existing home sales as one of the supportive indicators. However, this is only in the beginning of removing excessive housing inventory. We are in an uncharted territory of our financial history. Little was done since the financial crisis of 2008 to address the problem of excessive risk taking, except more debts was piled on. Also, the latest burst in stock market indices only masked away dire needs for a reform in our financial structures.

Excessive money with very low interested flooded the market (see chart below), so it would not be a bad idea to be extra cautious in the short-term as assets are getting bid up.

Money Stock; M1 Yr/Yr% , (total amount of money available in an economy at a particular point in time)

(SA Billions $) (Source: Moody's)

An Alternative to Mutual Funds

2009-10-19T19:48:00.007-07:00

kaChing has officially launched its investment business idea.

This is a radical idea with exceptional benefits if succeeded.

Here is a brief video interview with the kaChing management from "CNBC Squawk on the Street":

http://www.cnbc.com/id/15840232?video=1300149728&play=1

Wrong Way? Wall Street Journal February 26, 2007

2009-09-15T21:13:00.008-07:00

The following article was published on WSJ on February 26, 2007 and is still very much relevant as of today. Recently, a lot of media attentions were on the anniversary of the September 2008 financial collapse. Yet, this recession did nothing to cure our urge to "play" the stock market.

Investors are trading so quickly they may not see the risks in the market for the speed.

In the stock market, the idea of holding on to an investment for the long term doesn't seem to hold much allure any more. According to Sanford C. Bernstein chief investment officer Vadim Zlotnikov, the average holding period for stocks on the New York Stock Exchange and American Stock Exchange last year was less than seven months. In 1999 -- stereotyped as a time of rapid-fire day trading -- the average holding period was more than a year.

In fact, the last time stocks were being held for as short a period as they are now was 1929, when students of history may recall something happened to the market.

Mr. Zlotnikov's analysis doesn't include the increasingly popular, and complex, derivative strategies that investors use to gain exposure to stocks without actually holding shares. On the Chicago Board Options Exchange, for example, the trading volume on individual stock options was 40% higher last year than it was in 2005.

Technology has a lot to do with the increase in turnover. Increased computing power means strategies that 10 years ago existed only in theoreticians' notebooks now can be put into everyday use. Lower trading costs and the 2001 switch to decimalization -- the pricing of stocks in dollars and cents rather than dollars and fractions -- have let investors profit from price anomalies that used to be too expensive to exploit.

Also driving the increase: the rising prominence of hedge funds. Because they tend to be judged by each year's performance, few professional fund managers have the luxury to ignore short-term price swings and invest for the long haul. Losing your job and then having history prove your investing acumen right is nobody's idea of fun. For hedge-fund managers, the short-term performance pressures can be intense -- first, because the high fees they charge make their investors intolerant of losses, second because some of the trading strategies they use mean the losses they face if a position goes wrong can be steep.

The result is a constant trading in and out of positions to capture returns. In today's marketspeak, hedge funds are emphatically working to "generate short-term alpha." What it boils down to is the age-old practice of stop-loss trading -- automatically buying and selling stocks when they rise or fall to specified levels.

Despite all the moving in and out of stocks, stock-price movements have been remarkably quiescent. Stock market volatility -- as measured by actual price movements, rather than the options price-generated "implied" volatility measured by CBOE's market volatility index -- is at its lowest level in 10 years. (Implied volatility is near a decade low.) It may be that the combined effect of all the sophisticated trading strategies in place today have put the stock market into a state of dynamic tension, where all the tugging and pulling effectively cancels each other out, muffling price movements.

At the same time, investors' intolerance of short-term losses could mean that if the stock market seriously stumbles, the droves of fund managers engaging in stop-loss selling could overwhelm the market. When volatility comes back, it could do it in a grand fashion.

I recommend John Bogle's "The Little Book of Common Sense Investing." The book presents a very persuasive argument on index investing but is hardly followed in the real world. Mr. Bogle simply put it this way: "We investors as a group get precisely what we don't pay for. So if we pay nothing, we get everything."

What's happening in the world is exactly the opposite. One example, optionXpress Holding Inc., a highly profitable online brokerage, has a 80% profit margin and after all operating and tax expenses still produce a healthy 20% net profit margin. Its "Daily Average Revenue Trades", a measurement of expected revenue from commissions or fees, increased from $13,600 in 2004 to $36,500 in 2008 as more users opened accounts with optionXpress.

May the best trader wins.

Warren Watch: Bite into this, Mr. Buffett

2009-09-02T15:55:00.001-07:00

http://www.omaha.com/article/20090823/MONEY/708239979

From Warren Buffett Watch - CNBC.com

The Omaha World-Herald relates Buffett's response to a New Jersey nutritional dentist who had written a letter encouraging him to eat more healthy food and take nutritional supplements:

"My diet, though far from standard, is somewhat better than usually portrayed. I have a wonderful doctor who nudges me in your direction every time I see him. All in all, I’ve enjoyed remarkably good health — largely because of genes, of course — but also, I think, because I enjoy life so much every day."

He's also been exercising more in recent years.

Back in 2007, Buffett told CNBC that his doctor had given him a choice two years before: "Either you eat better or you exercise." Buffett said he chose exercise, the "lesser of two evils."

Some Financial Headlines in August 2009

2009-09-01T12:12:00.006-07:00

Climate Change

- Officials, who yesterday estimated agricultural damage from Typhoon Morakot amounted to at least 4.2 billion Taiwan dollars (about $130 million at current exchange rates).

- Auto sales in China rose 63.6% in July from a year earlier to 1.09 million vehicles, the fifth straight month of more than one million vehicles sold.

China

's auto sales rose to 7.2 million vehicles in the first seven months of 2009.

- Car sales in India rose an annual 31 percent in July, an industry body said on Monday, as demand was boosted by new launches and increasing availability of cheaper loans.

-

India

companies sold 115,067 cars during the month, compared with 87,901 cars a year earlier, data from the Society of Indian Automobile Manufacturers showed.

US Mortgage

How to Save an ‘Underwater’ Mortgage WSJ - OPINION By MARTIN FELDSTEIN

- More than three million homes are now in serious default (nonpayment for 90 days or more) or foreclosure, nearly double the number a year ago. Sales of properties in foreclosure or serious default made up one third of all home sales in May and June.

- So far only about 200,000 mortgages have been modified this way, far fewer than the administration’s goal of modifying three million mortgages.

- Nearly half of all modified mortgages go into default within six months. That’s partly because, even when they can afford the reduced mortgage payments, many homeowners default anyway because they owe more on the house than it is worth. Thanks to this “negative equity,” they just walk away.

- Today one-third of all homes with mortgages have mortgage debt that exceeds the value of the home. Among these homeowners, half of the loan-to-value ratios exceed 130%.

- Any homeowner with a loan-to-value ratio over 120% could apply for a reduction in his mortgage balance. The government and the creditor would then share equally in the cost of writing the loan balance down to 120% of the value of the home. But the homeowner who opts for this write-down would be obliged to convert the remaining mortgage to a loan with full recourse that could not be discharged in bankruptcy. Federal legislation would be needed to modify state mortgage and bankruptcy rules to allow homeowners to obtain the new type of mortgage.

- An example shows how this would work. Consider someone with a home worth $200,000 and a mortgage of $280,000, i.e., a loan-to-value ratio of 140%. If the borrower and the creditor both agree, the loan could be reduced by $40,000 to $240,000 (120% of the home value.) The government would give the creditor $20,000 to offset half of the write-down. The homeowner would convert the remaining $240,000 mortgage to a bank loan with full recourse that could not be discharged in bankruptcy.- If this plan succeeds in stabilizing house prices at the present level, the one-time cost to the taxpayers would be capped at $200 billion, even if every homeowner with a loan-to-value ratio over 120% accepted the government-assisted write-down. That $200 billion is less than a 2% fall in house values.

- Existing home sales rose 3.8% to a seasonally adjusted annual rate of 4.76 million units in the second quarter from 4.58 million units in the first quarter, according to the National Association of Realtors (NAR). That is still 2.9% below the second quarter of 2008.

- But foreclosures are rising, and that's pulling down home prices. Foreclosure filings were reported on 360,149 properties in July, according to a RealtyTrac report today. That's an increase of nearly 7% from the previous month and a jump of 32% from July 2008.

- Moody’s latest CMBS Delinquency Tracker (DQT) records the aggregate rate of delinquencies among US CMBS conduit and fusion loans at 2.67%, based on data through the end of June. This represents a 40 basis point increase from the prior month’s 2.27% rate.

- By comparison, the DQT was 0.46% a year ago and is now 245 basis points above the low of 0.22% measured in July 2007.

- Fitch Ratings yesterday said that delinquencies for loans in US commercial mortgage backed securities (CMBS) rose by nearly half a percentage point in July to 3.04 per cent, the highest level since the rating agency began tracking this index of loans in 2001. The loans in the index represent about $480bn in CMBS, or two-thirds of the market.

- To help revive the sector, the Federal Reserve has included CMBS in the term asset backed securities loan facility (TALF), where it lends investors money to buy new deals, though none have been arranged.

- Almost $165 billion in U.S. commercial real estate loans will mature this year and need to be sold or refinanced as rents and occupancies fall, according to First American CoreLogic

US Equities

- Berkshire’s operating earning results for the second quarter and first six months of 2009.

- A Commerce Department report on Thursday showed total retail sales edged down 0.1 percent after increasing 0.8 percent in June, compared with market forecasts for a 0.7 percent gain.

- Initial US Jobless claims 558K and the four week average at 565K. Continuing claims down to 6.202 million from 6.343 million

- AAII Index (American Association of Individual Investors) has risen to the 50% for the first since May 9, 2008 (only 35% are bearish). March 6, 2009 was at 18.9.

- Market Vane Sentiment (a survey of traders) up to 48% now, which is the highest since June 20, 2008.

- The government sold a record $37 billion in three-year notes on Aug. 11 and $23 billion in 10-year notes yesterday. Sales of 3-, 10 and 30-year securities have become monthly, raising $65 billion in July, as the U.S. tries to fund a record budget deficit.

- Today’s sale is the largest-ever offering of the 30-year bond, the prior record being the $14 billion sold in May and February and in February 2006. The U.S. sold $11 billion of the securities in July. At last month’s auction, the notes drew a yield of 4.303 percent.

- Indirect bidders, a class of investors that includes foreign central banks, bought 48.1 percent of the notes at today’s auction. They bought 50.2 percent of the securities in July, the most since February 2006. They purchased 49 percent in the June auction. The average for the past 10 auctions is 32.8 percent.

- The shortfall so far for the fiscal year that ends Sept. 30 totaled $1.27 trillion compared with a $389 billion year-to-date gap in 2008, the Treasury said today in Washington. The excess of spending over revenue for July climbed to $180.7 billion compared with a $102.8 billion gap in July 2008 as the government spent more than in any month in U.S. history.

Breakfast with Dave

2009-08-28T11:21:00.002-07:00

Mr. David Rosenberg is a pretty popular figure in the industry and media nowadays. He has been a bear for sometime.

Here is a nice list of the economic background from last October compared to today.

•The unemployment rate was 6.6% then, today it is 9.4%

•The level of employment (nonfarm payrolls) was 136.35 million; today it is nearly 4.0% smaller at 131.5 million

•The level of nominal GDP was $14.347 trillion; today it is $14.143 trillion

•The level of real GDP was $13.149 trillion; today it is $12.892 trillion

•The 4-quarter trailing operating EPS was $49.50; today it is $39.90.

•The 4-quarter trailing reported EPS was $14.90; today it is $7.90.

•The dividend yield was 2.9%; today it is 2.3%

•The P/E ratio (operating earnings) was 19.6x; today it is 25.2x

•The “real” yield (5-year TIP), which is a bond proxy for “real” growth expectations was 3.0% back in October; today it is 1.7%

•Industrial production was 106.2 (index); today it is 10% smaller, at 96.0

•Industry wide capacity utilization rates were 75.4% then; they are 68.5% today

•Manufacturing inventory-to-shipments ratio was 1.33 back then; now it is at 1.42

•Housing starts were 763k (annualized) units; today even with the recovery they are 581k (24% smaller)

•Commercial construction was $729 billion then, it is $712 billion today

•Oil prices were $71/bbl then, about where they are today

•The “real” yield on the Baa corporate yield was 5.2%; today it is 8.6%

•Bank credit was $9.5 trillion back in October; it is $9.2 trillion today

•The federal deficit was running at a $550 billion 12-month run-rate; today it is $1.3 trillion

•Corporate spreads were 450bps back then; they are 300bps today (this, along with ISM, home sales and consumer confidence polls, are better, and that’s about it).

Bashing Goldman Sachs Is Simply a Game for Fools: Michael Lewis

2009-07-29T00:11:00.002-07:00

I love Mr. Lewis's book "Moneyball", and his latest commentary from bloomberg is quite an entertaining one on some supposedly Goldman Sachs rumors.

Rumor No. 1: “Goldman Sachs controls the U.S. government.”

Rumor No. 2: “When the U.S. government bailed out AIG, and paid off its gambling debts, it saved not AIG but Goldman Sachs.”

Rumor No. 3: “As the U.S. government will eat the losses if Goldman Sachs goes bust, Goldman Sachs shouldn’t be allowed to keep making these massive financial bets. At the very least the $11.4 billion Goldman Sachs already has set aside for employees in 2009 -- $386,429 a head, just for the first six months -- is unfair, as the U.S. taxpayer has borne so much of the risk of the wagers that generated the profits.”

Rumor No. 4: “Goldman employees all look alike.”

Rumor No. 5: Goldman Sachs is “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

I enjoy his explanation to rumor No. 2 the most.

The full article is at http://bloomberg.com/apps/news?pid=20601039&sid=a2X3hNaWcbeg

Philip Fisher's 15 Points - Common Stocks and Uncommon Profits

2009-07-28T23:38:00.007-07:00

I feel foolish for not reading this book earlier in my investing career. "Common Stocks and Uncommon Profits" by Philip Fisher is by far one of the best books on investment. The book was published in the 1950's, but honestly I could not tell a difference because the information in the book is just as relevant today as it was some 50 years ago.

I am borrowing the list from a Morningstar article about Mr. Fisher's 15 points on a worthwhile investment (I will go into more detail and apply the principles in future articles).

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years? A company seeking a sustained period of spectacular growth must have products that address large and expanding markets.

2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited? All markets eventually mature, and to maintain above-average growth over a period of decades, a company must continually develop new products to either expand existing markets or enter new ones.

3. How effective are the company's research-and-development efforts in relation to its size? To develop new products, a company's research-and-development (R&D) effort must be both efficient and effective.

4. Does the company have an above-average sales organization? Fisher wrote that in a competitive environment, few products or services are so compelling that they will sell to their maximum potential without expert merchandising.

5. Does the company have a worthwhile profit margin? Berkshire Hathaway's BRK.B vice-chairman Charlie Munger is fond of saying that if something is not worth doing, it is not worth doing well. Similarly, a company can show tremendous growth, but the growth must bring worthwhile profits to reward investors.

6. What is the company doing to maintain or improve profit margins? Fisher stated, "It is not the profit margin of the past but those of the future that are basically important to the investor." Because inflation increases a company's expenses and competitors will pressure profit margins, you should pay attention to a company's strategy for reducing costs and improving profit margins over the long haul. This is where the moat framework we've spoken about throughout the Investing Classroom series can be a big help.

7. Does the company have outstanding labor and personnel relations? According to Fisher, a company with good labor relations tends to be more profitable than one with mediocre relations because happy employees are likely to be more productive. There is no single yardstick to measure the state of a company's labor relations, but there are a few items investors should investigate. First, companies with good labor relations usually make every effort to settle employee grievances quickly. In addition, a company that makes above-average profits, even while paying above-average wages to its employees is likely to have good labor relations. Finally, investors should pay attention to the attitude of top management toward employees.

8. Does the company have outstanding executive relations? Just as having good employee relations is important, a company must also cultivate the right atmosphere in its executive suite. Fisher noted that in companies where the founding family retains control, family members should not be promoted ahead of more able executives. In addition, executive salaries should be at least in line with industry norms. Salaries should also be reviewed regularly so that merited pay increases are given without having to be demanded.

9. Does the company have depth to its management? As a company continues to grow over a span of decades, it is vital that a deep pool of management talent be properly developed. Fisher warned investors to avoid companies where top management is reluctant to delegate significant authority to lower-level managers.

10. How good are the company's cost analysis and accounting controls? A company cannot deliver outstanding results over the long term if it is unable to closely track costs in each step of its operations. Fisher stated that getting a precise handle on a company's cost analysis is difficult, but an investor can discern which companies are exceptionally deficient--these are the companies to avoid.

11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition? Fisher described this point as a catch-all because the "important clues" will vary widely among industries. The skill with which a retailer, like Wal-Mart WMT or Costco COST, handles its merchandising and inventory is of paramount importance. However, in an industry such as insurance, a completely different set of business factors is important. It is critical for an investor to understand which industry factors determine the success of a company and how that company stacks up in relation to its rivals.

12. Does the company have a short-range or long-range outlook in regard to profits? Fisher argued that investors should take a long-range view, and thus should favor companies that take a long-range view on profits. In addition, companies focused on meeting Wall Street's quarterly earnings estimates may forgo beneficial long-term actions if they cause a short-term hit to earnings. Even worse, management may be tempted to make aggressive accounting assumptions in order to report an acceptable quarterly profit number.

13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth? As an investor, you should seek companies with sufficient cash or borrowing capacity to fund growth without diluting the interests of its current owners with follow-on equity offerings.

14. Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur? Every business, no matter how wonderful, will occasionally face disappointments. Investors should seek out management that reports candidly to shareholders all aspects of the business, good or bad.

15. Does the company have a management of unquestionable integrity? The accounting scandals that led to the bankruptcies of Enron and WorldCom should highlight the importance of investing only with management teams of unquestionable integrity. Investors will be well-served by following Fisher's warning that regardless of how highly a company rates on the other 14 points, "If there is a serious question of the lack of a strong management sense of trusteeship for shareholders, the investor should never seriously consider participating in such an enterprise."

Diversification is the golden rule?

2009-07-20T21:04:00.008-07:00

When it comes to investing, people often question whether they have enough diversification.

"Concentration to create wealth" and "Diversification to preserve wealth" is my usual response. I am not sure where I got those ideas from, but the following from Warren Buffett's letter to shareholders in 1991 is an excellent illustration on this topic.

If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products?

John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F. C. Scott, on August 15, 1934 that says it all: "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. . . . One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence."

The true question then becomes how strong is your willingness to create wealth, and do you understand the implications behind that. In addition, how do you know that your full confidence is not a sense of illusion. The principle of "Margin of Safety" is really the best discipline tool one can use (Simple example: buy asset for 50 cents when it is worth a dollar).

With a margin of safety, the probability of investment success is at a higher percentage but by no mean a guarantee. Just as someone who holds a pair of aces before the flop in a poker game does not guarantee him/her a winner of that round. But by being selective, over the long term, concentrating on good starting hands will eventually pay off more significantly than trying to pick the pots with many marginal hands.

Behavioral Finance 001

2009-07-03T11:07:00.011-07:00

Here is an interesting chart from a study done in 2002 where two groups of professionals are asked to predict some near-term future outcome. One group of analysts are asked to predict the level of S&P 500 in the next month and half. Another group of weather men are asked to predict the average temperature in April for a location (about same one month and half time frame).

Each group are given three mutually exclusive and collectively exhaustive selections of greater than X, between X and Y, and less than Y. A sensible human being, from a mathematical perspective would have a confidence level of 33% (1/3 chance to be correct). Yet, the average level of confidence was about 58% for analysts and 49% for weather men, suggesting overconfidence in our ability may be a nature tendency.

What's more interesting is from the group of respondents that incorrectly predict the outcome. As a side note, about 1/3 of the analysts made the correct choice and about 2/3 of weather men did so as well. Participants who made incorrect forecast are asked for a reason for their inaccuracy. Interestingly enough, none of the analysts mentioned the outcome as lack of experience or insufficient data. Most attributed to the "single prediction" and “ceteris-paribus” defense mechanisms (definition below).

To be a better investor, I think it's more important to understand one's own emotional strengths and stay honest to one's own action than to crunching analysis. The issues mentioned here seems trivial but are very difficult to overcome. The following is a good checklist to remind our brain every once in awhile.

Optimism and Overconfidence:

- Optimism

Well documented trait among young individuals who feel the odds of something bad occurring in their lives are very low or even non-existent. Example: Young adults are far more likely to become disabled than they are of dying, yet the vast majority does not carry disability insurance.

- Overconfidence

People tend to place too much confidence in their ability to predict. They tend to systematically underestimate the risk, which lead to higher probability of surprises.

- Increased Trading

Belief that you can interpret information better than the average investors and often leads to undiversified portfolios.

- Overconfidence in Forecasters

Primary factor leading to overconfidence in professionals is knowledge (education or experience). They feel their forecasts are based upon skill (i.e., an illusion of knowledge)

Forecast defence mechanisms

1. The “if-only” defence.
2. The “ceteris-paribus” defence.
3. The “almost-right” defence.
4. The “it hasn’t happened yet” defence.
5. The “single predictor” defence.

Examples from financial-education.com:

“The “if only” defense says their forecast would have been correct if the advice or analysis they had provided had been followed. This defense is popular because it cannot be proven wrong since historical events will seldom follow a specific analysis. However, the basis of the original forecast was presumably to predict the likely outcome, not the outcome if a certain set of actions occurs. A conditional forecast should also outline the consequences of conditions varying from those set out.

The “ceteris paribus” defense says something interfered with the original forecast. “They would have gone bankrupt but their competitor bought them out.”
The “I was almost right” defense says the forecast almost happened. This applies primarily to averted catastrophes. “Long-term Capital Management’s collapse almost brought down the entire financial system.” If one was predicting the collapse of the financial system, close doesn’t count.

The “it just hasn’t happened yet” defense says the next hedge fund collapse will be the one that brings down the financial system. Either that, or the one following it.
The “single prediction” defense acknowledges that the conditions of the forecast were met but the prediction was still incorrect. However, forecasts are pointless so don’t hold it against the analysis that led to the forecast.”

Loss Aversion:
Individual’s reluctance to accept a loss. A stock may be down considerable from its purchase price, but the investor holds on to it hoping that it will recover. Loss aversion can also lead to risk-seeking behavior.

Reference:
Hersh Shefrin, Portfolios, Pyramids, Emotions, and Biases
James Montier, Behavioural Investing
Schweser CFA Level III Notes
http://financial-education.com/2007/09/09/ego-defense-mechanisms/

Warren Buffett Power Lunch for Glide Foundation

2009-06-24T13:28:00.003-07:00

eBay has released an interesting widget for tracking auctions. Here is the anticipated bidding for a chance to have lunch with Mr. Buffett

Wish everyone the best and have fun doing volunteering too!

TELUS: Excellent Value for a Canadian Telecom Company

2009-06-16T23:54:00.001-07:00

Brief History:
TELUS is a national telecommunication conglomerate in Canada. The company has expanded itself from a local wireline phone company in Alberta, Canada to a national company that offers services in digital broadband/TV, wireline/wireless communication, and healthcare data services.

TELUS was established in 1990, following the reorganization of Alberta Government Phone Commission that established in 1958. In 1998, TELUS become a prominent telecommunication company in Western Canada when it merged with BC TELECOM, a legacy telecommunication company based in British Columbia, Canada.

Why TELUS is a BUY:
• When compared to its 2001-2008 share data, TELUS currently has the highest dividend yield at 6.1% and lowest P/E ratio at 9. TELUS share enjoyed strong dividend growth in the past five years with a current payout ratio of 66%
• If we think TELUS’s equity as a bond, it has a 10% floor return, which 4% is from annualized growth of book value per share in the past five years and 6% from current dividend yield.
• As the number of smartphone users increases, TELUS will be able to collect fees on wireless data usage like a toll bridge. Currently, data plan consist only 7% of total wireless revenue for TELUS
• TELUS, with BELL Canada as its partner, is ready to launch a nationwide GSM network in early 2010 to compete with Rogers communication and capture the advantage of being on a network that has over 80% of the global wireless phone users
• TELUS has a strong presence in Western Canada, a region that is expected to have higher economic activities compare to other parts of Canada.
• TELUS operates in a highly regulated business with high barriers to entry and few industry players. The long-term outlook for this business remains viable with new demand drivers for broadband/wireless communication

Company Analysis:
TELUS (TU), BELL Canada (BCE), and Rogers Communication (RCI) are the main players in Canadian wireless telecommunication industry. Each company controls roughly 30% of total wireless subscribers. Rogers Communication is the only national GSM network provider and has enjoyed substantial growth over the past couple years as most popular smartphones were available only on the GSM network. All companies have other complementary business segments such as cable TV, broadband, and wireline phones. Wireless communication makes up bulk of the revenue (close to or over 50%) for these companies and will be a key revenue growth for these companies going forward.

Couple new entrants, namely Shaw communications and Globalive, made substantial bids and acquired wireless licenses from government of Canada in 2008 and emerged as potential competitors. However, due to global economy turmoil and financing issues, Shaw, a cable based company in Western Canada, has abandoned its plan to build a wireless phone network in the near future. Globalive will likely roll out its wireless network later this year or early 2010, but its ability to be profitable is unclear. Globalive will need to spend $1.8B between the next ten years to establish its wireless business. The competitive landscape is likely to remain the same as the big threes throwing punches at each another.

As of fiscal 2008, Rogers enjoyed the highest average revenue per user (“ARPU”) at $75 dollar per month thanks to its exclusivity of GSM network and a number of smartphones. TELUS and BELL Canada, operators of CDMA network, have “ARPU” at about $63 and $54. When compared to the US counterparts, using AT&T as an example, AT&T has an “ARPU” of $55 (using a rate of $1.10 CAD/USD). If we make the assumption that future competitive pricing will trend towards AT&T’s “ARPU”, the revenue impact as a result of pricing competition will be minimal for TELUS because organic growth of wireless users can potentially offset the lower “ARPU”. As of fiscal 2008, Canadian wireless market only exhibit a 70% market penetration rate, whereas US has a much higher rate of above 80%.

Comparing some basic metrics on the attractiveness of TELUS share against BCE and RCI, TELUS currently has a comparable dividend yield against BCE at 6.1% with a much lower payout ratio of 66% to BCE’s 88%. Rogers has similar payout ratio but only a 3.4% dividend yield. When looking at P/B, P/E and P/S ratios, TELUS has the lowest ratio between the three companies, and TELUS, looking on a standalone basis, is attractively priced at a P/B of 1.3, P/E of 8.18, and P/S of 0.98, with ROE of 15% and EV/EBITDA of 4.2 times.

Another positive is TELUS’s stable senior management team. Darren Entwistle, CEO, and Robert McFarlane, CFO, have both worked in TELUS since 2000 and successfully implement TELUS’s goal to become a national telecommunication company. Book value per share, after share buyback and dividend payout, grew roughly 4% for the past five years. If we expect that 4% is the future book value growth, adding the current dividend yield of 6% will yield a floor return of 10%. This assumption is highly probable given the near-term competitive landscape, the company's stable senior management team, and the users’ demand for wireless services.

Other positives for TELUS include better projected economic prospect in Western Canada, strong brand awareness in Western Canada, overfunded pension plan, and high barriers to enter the wireless market. Also, it could be argued that TELUS may benefit from currency translation gain as Canadian dollar strengthen against US dollar in the long run. Some short-term speculative sparks includes Vancouver’s 2010 Winter Olympic game, GSM network deployment, and foreign investors’ appetite for investing in Canadian businesses.

There are key negative issues to consider. First, TELUS has poor cash position with only $58M cash on hand. TELUS does have a $2B credit facility with about $1B available at prime rate, an attractive 2.25% cost of borrowing. However, prime rate is a variable rate set between the Canadian banks, and an interest rate hike put TELUS at a significant disadvantage. In addition, Capital expenditure going forward should be considered as well. Capex intensity, which is capital expenditure by a percentage of total sales, has been rising from 17% in 2004 to 28% in 2008. The 28% figure includes the cost to obtain wireless licenses from government of Canada in 2008 and is non-recurring. Without the one time cost, the Capex intensity is about 19%, which is still higher when compared to BCE’s 17% and RCI’s 16%. Finally, continuous monitoring on the economic environment where TELUS operates and potential entrants such as Shaw and Globalive is required. It is unlikely for Shaw to give up without a fight, especially when Shaw spent $190M to acquire a significant percentage of wireless licenses in Western Canada from the 2008 auction.

Overall, TELUS has a solid business plan going forward, and its share is priced at a reasonable rate of risks. TELUS is unlikely to achieve admirable share appreciation like what some of the smartphone companies did in the last couple years. But no matter which smartphone company comes out on top in the future, TELUS will be there to collect its fees from customers. Warren Buffett often said “A bird in the hand is worth two in the bush” and the 10% floor return being offered by Mr. Market today is worth some serious consideration.

(All figures and sources are either from company’s SEC filings, Yahoo! Finance, or Financial Post articles)

(Disclosure: Recently long in TELUS)

Harbin Electric (HRBN) Company Update

2009-06-11T17:07:00.001-07:00

Eight months passed by since the last investment rationale was posted. HRBN experienced significant price volatility during the period. HRBN has remained profitable and its business prospects have stayed positive.

It was disappointing to see HRBN made little progress with their Shanghai auto micro-motor facility. Production may finally begin in 2Q09, after two quarters of delay from customers and another quarter or two from construction constraints.

Revenue has dipped in the last two quarters, and the $58M Hengda acquisition has not benefited HRBN’s shareholders. Since acquired in July 2008, Hengda has contributed about $1M of net income, a dismal annualized return of 2.3% from its price tag.

In addition, on a pro forma basis, if we include Hengda’s result in the 1Q08, as if business were acquired on January 1, 2008, the year-over-year quarterly revenue between 1Q09 and 1Q08 declined by 7%.

Some encouraging sights in 1Q09 were the significant reduction in accounts receivable and inventory from the previous two quarters, down from $66M to $43M. HRBN further solidified its balance sheet and has over $64M cash, which is almost enough to service its total debt.

Another encourage news is the recent filings by HRBN to sell additional shares up to $120M. HRBN can sell the shares any time at its own discretion. This has both costs and benefits for the current shareholders. On one hand, there is more share dilution, but on the other hand, more predominated institution investors will join the mix. This will increase the visibility of the company in the long-run.

The SEC filing from HRBN on June 5, 2009 outlined the long-term debt repurchase agreement between HRBN and Citadel Equity Capital. I am speculating that Citadel would want to receive equity shares as part of its early debt redemption. Details are unknown at the moment, so we don't really know if this is a good or bad news for current shareholders. From a top level perspective, this debt repurchase is indeed good news for HRBN because HRBN further establishes itself as a creditable company for willing risk takers.

Overall, HRBN is still a long-term buy given its business prospects, balance sheet strengths, and future expected appreciation of RMB. One thing to keep at the back of mind is managements tend to over-promise and under-deliver, it seems like this is the culture enticed from the CEO himself to make sure HRBN always present itself in the most favorable ways, while downplay any negative developments as much as possible.

(Disclosure: I am long on HRBN)

Value Investing: A Balance Approach by Martin Whitman

2009-06-08T19:55:00.005-07:00

Here are couple bulleted lists that I drew from Mr. Whitman's book. The book did not grab my attention as some of other value investing based book, but I think the following lists are full of wisdom.

Value Investing: A Balance Approach Martin Whitman

Value Investing (VI) uses a balanced approach to analysis so that there is no a priori primacy given to any one factor in an appraisal.
In VI, the essential goal is to value a business or the workout potential for credits issued by trouble companies.
In VI, equity holdings are viewed as permanent or semipermanent commitments, subject only to a risk arbitrage exception.
In VI, macrofactors such as the level of stock averages (e.g., the DJIA), forecasts of interest rates, or the GDP are ignored.
In VI, as part of a balanced approach, businesses are viewed as both going concerns and as resource converters, deploying and redeploying their asset bases and liabilities into new areas including mergers and acquisitions, changes in control, massive refinancing, IPOs, and LBOs.

What has worked in investing

2009-06-08T15:28:00.001-07:00

Tweedy, Browne Company LCC, a well established value based investment firm and worked as the broker for Warren Buffett with the acquisition of Berkshire Hathaway in the early 1960's

The firm has published a very insightful booklet for prospect investors called :

"WHAT HAS WORKED IN INVESTING - Studies of Investment Approaches and Characteristics Associated with Exceptional Returns"

There are 5 specific points:

Low Price in Relation to Asset Value
Low Price in Relation to Earnings
A Significant Pattern of Purchases by One or More Insiders (Officers and Directors)
A Significant Decline in a Stock's Price
Small Market Capitalization

Buffett Is Less Bullish on U.S. Than You Think: Alice Schroeder

2009-06-08T09:21:00.004-07:00

Bloomberg has an interesting article by Alice Schroeder, the author of "The Snowball". Ms. Schroeder presented a different case on the "Buy America" bullish calls from Mr. Buffett.

If you have not had a chance to read "The Snowball", which is about the size of a brick, I would recommend it because it is probably one of the most intimate book about Mr. Buffett's life. The book is more about Mr. Buffett's life and his family and friends. It is not a typical "how to invest like Buffett" book, and I found the book quite entertaining yet very educational at the same time.

Fed Sees Up to $599 Billion in Bank Losses

2009-05-08T08:19:00.004-07:00

For those who are interested with the banking stress test result, WSJ got a nifty interactive chart

The purpose of stress test is to test and forecast that if worse case scenarios do occur, how much capital lifeline will the banks needed in order operate at a regulatory requirement level.

Meanwhile, Taleb and Roubini tagged up again saying we are in the most difficult period of humanity because governments no long have the control they once did

Both are entertaining stories that one must read with a grain of salt.

Happy weekend! comparing all the key metrics between the different financial institutions.

Biggest Event This Weekend for the Market

2009-05-02T19:51:00.006-07:00

Berkshire Hathaway held its annual meeting this weekend in Omaha, NB. Qwest Center arena, the location of the event, was jam packed with 35,000 anxious investors, which I believe is a new record attendance.

CNBC as usual for the last couple years, has a complete coverage about the event you can access here.

Also, Everythingwarrenbuffett, another blogspot site that is dedicated to news on Mr.Buffett, has a nice summary of the event which I will burrow from, and you can access it here.

In addition, I finally get a chance to watch the I.O.U.S.A movie this weekend, and it is an excellent piece of documentary that I recommend everyone to watch it. It is just a little bit over one hour, and you will have a better understanding about the seriousness of all these multi-trillion and billion of leverage could do to our future generations.

We are in a globalized world, and everyone will have to face the problem together. The system is so interconnected that we can no longer categorize serious issues as someone else's problems.

Warren Buffett on Wells Fargo

2009-04-21T11:31:00.010-07:00

I have this anchoring bias with experts that I admire the most, especially Mr. Buffett, so here is an interview by Fortune with Mr.Buffett on why Berkshire owns Wells Fargo. The ideas are presented in very simplistic terms, perhaps too simplified. Nevertheless, Mr. Buffett still offers some great insights and reasoning with their investment in Wells Fargo (WFC).

Mr. Nassim Taleb argued that financial companies in general are prone to the black-swan negative events. If a project went really successful, the bankers wouldn't get additional compensation for their loan. But, if catastrophe happens, the bankers could lose a substantial amount of money. I think this makes a lot of logical sense, but then again not all financial businesses are created equal, perhaps WFC is one of those old, dirty, unpolished traders who have a long and successful trading career as Mr. Taleb witnessed in his life.

Perhaps WFC is the one that understand this risk phenomenon better than its rivals? History is hindsight 20/20, but WFC does seem to have the track record to back it up. Here Mr.Buffett mentioned:

Those guys have gone their own way. That doesn't mean that everything they've done has been right. But they've never felt compelled to do anything because other banks were doing it, and that's how banks get in trouble, when they say, "Everybody else is doing it, why shouldn't I?"

Another issue is the general sentiment that all financial companies are all screwed and not to be trusted. I don't know the probability and when the economy will recover, but WFC seems like one of the top candidates to earn sound return for its shareholders. The reason is its substantial earning power as Mr.Buffett noted:

You don't have to be a rocket scientist when your raw material cost is less than 1-1/2%. So I know that you can have a model that works fine and Wells has come closer to doing that right than any other big bank by some margin. They get their money cheaper than anybody else. We're the low-cost producer at Geico in auto insurance among big companies. And when you're the low-cost producer - whether it's copper, or in banking - it's huge.

Then on top of that, they're smart on the asset size. They stayed out of most of the big trouble areas. Now, even if you're getting 20% down payments on houses, if the other guy did enough dumb things, the house prices can fall to where you get hurt some. But they were not out there doing option ARMs and all these crazy things. They're going to have plenty of credit losses. But they will have, after a couple of quarters of getting Wachovia the way want it, $40 billion of pre-provision income.

And they do not have all kinds of time bombs around. Wells will lose some money. There's no question about that. And they'll lose more than the normal amount of money. Now, if they were getting their money at a percentage point higher, that would be $10 billion of difference there. But they've got the secret to both growth, low-cost deposits and a lot of ancillary income coming in from their customer base.

The recent changes of market to market accounting rules are worrisome. We can only hope the WFC management along with Mr. Buffett will keep acting as ethnically sound as they claim to be.

(Disclaimer: I have personal position in WFC)