It was Ben Graham who taught me how to invest. Sure, I had played around with stocks before him, but I didn’t really know what I was doing. His book, The Intelligent Investor, is a one-book course on investing by understanding value.I recommend (and link to) the most recent edition, which has the 1970 edition of Graham’s writing, plus a 2002 commentary by financial writer Jason Zweig. This swells the book to over 600 pages, but it is all useful. I will try to outline below a couple of Graham’s key points.
The most important point that Graham emphasizes is that because we cannot accurately predict the future, we must have an adequate margin of safety. That is, we do not buy a company when it is fairly valued, because there is no room for error. Rather, we buy a stock that is very undervalued; even if the business starts to do a little worse it will still be a great value.
There are two ways we can look at value in companies. We can look at value from the viewpoint of the present value of the future earnings of the company or we can look at the present value of the assets of the company.
Graham liked to buy companies that were trading below 2/3 of their net tangible asset value. You calculate net tangible assets by subtracting all the debts of a company from all ‘hard’ assets, such as cash, receivables, investments, property (while ignoring goodwill, patents, and other hard to value assets).
In buying a company trading at a fraction of its tangible asset value, we are in essence buying it for less than its assets; theoretically, we could close the company and sell off its assets and make a decent profit.
Graham was not usually looking to do this, but in buying a company like that, he knew that its price could not fall much further–if it did, someone would buy up a majority of the company and sell off its assets for a profit. This gave the investor a very small downside risk but a lot of chance for a large profit on the upside.
Companies selling for less than their assets are rare nowadays, although if we wait until the next bear market, we will be able to find some and profit from them. In the meantime, though, we will most often buy companies that are undervalued in terms of their earning potential.
Another important point that Graham made is that, for an intelligent investor, there should be no difference between ‘growth’ and ‘value’ investing. If a company is increasing its earnings at a rapid pace, then its present value will be higher than a company that is not growing.
Thus, a rational value investor will be willing to pay more for a fast-growing company than for a slow-growing company. The problem with most so-called ‘growth’ investors is that they are willing to pay so much for stellar growth that they are left with no margin of safety. During the internet stock bubble, companies such as Yahoo (YHOO: $16.51 -1.67%, market cap: $23.117B) and Amazon.com (AMZN: $132.55 +1.56%, market cap: $58.925B) sold at astronomical P/E ratios. If you had bought Yahoo in late 1999 and held until today, you would have lost over half your money. Buying Amazon would have netted you a small loss–better than Yahoo, but not good considering it has been 8 years since 1999.
Even today, with P/E ratios of 44 and 108, these companies are not cheap. Most likely holding them for the next few years will not be a great investment.
While a company with a high valuation may continue to grow impressively, if its growth starts to slow even a bit, the stock will get hammered. This is why we stay away from overvalued companies, no matter how good they are. There is just too much risk.
Well, in one page I cannot do Ben Graham justice. Buy his book. If you buy only one investment book, this should be it.
Disclosure: I am neither long nor short any of the stocks mentioned above. I own The Intelligent Investor. See my disclosure policy.
Sometimes the stock market is completely irrational. I will illustrate this with two wildcat oil companies (or junior exploration companies as similar companies often prefer to be called). Both companies are highly risky and may never make any profit. They are both highly speculative. Given the risks, however, one seems cheap while the other seems priced for perfection in this world and in the next.
The first company, StormCat Energy (SCU: $27.3555 +0.02%, market cap: $N/A) seems cheap to me. It is trading at an all-time low, just about at its net tangible asset value (about $60 million). It is producing some oil, although still not very much. It remains unprofitable. While I am no oil and gas expert, I know that paying no more than the net value of all the company’s property and equipment (not even considering the value of the oil and gas underground) will lead to success more times than not. As long as the company’s management has some clue what they are doing the company should eventually become profitable. There is a decent chance of management having a clue–the company’s executive roster reveals a decent amount of experience.
Fox Petroleum (FXPE.ob) is a different story. The company has no employees and no assets other than a few mineral leases on property on Alaska’s North Slope and in the North Sea. The company has a market cap of $116 million and its leases are worth at best $50 million (and that is being very generous)–if the company cannot raise enough money to explore or does not find oil, its leases are worth $0. Other than its leases, the company has assets of $2 million. The company’s management does not inspire confidence, either. Only one of the executives has any oil operating experience–while one was involved on the financial side of mining companies and the third has no previous similar experience. Perhaps the only good thing I can say about Fox Petroleum is that management is not being paid absurd salaries.
Fox Petroleum’s contract with its President and CEO does not inspire confidence either: it requires that he work a minimum of three days per week (see the 8k where this is reported). For $140k per year that seems like a very minimal requirement. See the company’s most recent 10Q and 10K for details.
While I am no expert on valuing oil exploration companies, I cannot think of any logic behind the divergent valuations of these two companies.
Disclosure: I have no pecuniary interest in either SCU or FXPE.ob. My disclosure policy never capitalizes its exploration costs.
Whitney Tilson has a nice slidshow discussing how human decision-making causes investment problems.
Martin Sewell has a paper that is essentially a chronological annotated bibliography of behavioral finance research.
I know the literature fairly well and I believe it is imperative for investors to understand how their process of making decisions can lead them to making the wrong investment decisions.
If you are intrigued by hedge funds and want a mutual fund or two that are less correlated with the market, then you are in luck. I am invested in one such fund and just came across another.
The fund I just came across is Weitz Partners III Opportunity (WPOPX). This fund is a partially-hedged mutual fund. Wally Weitz has the discretion to short sell stocks and borrow to increase the long positions as well. Currently the fund is 18% short, 103% long, and 15% in cash. While the fund has not done well in the past two months, very few long/short funds have. The fund’s short positions should give it some downside protection, and if they are good shorts, could juice returns even in an up market. The modest proportion of short selling and leverage in this fund means that even if the short-selling is not very good, the fund will still do okay. This fund has a 1.21% expense ratio, very low for a fund that does short selling.
The other fund I would recommend is the Merger Fund (MERFX). I have been invested in this myself for a couple months. The fund practices merger arbitrage–buying the shares of companies that have agreed to be bought out. This strategy is risky if you or I were to do it, because there is a risk of a large loss with each trade and only a small possible gain. However, a fund such as The Merger Fund is diversified enough so that its returns are not very volatile. This fund should not outperform the S&P 500 in the long run, but it is a consistent performer with low-volatility. It is high-turnover, which means that it belongs in an IRA. Consider it as a replacement for a small portion of your bond portfolio. The fund’s expense ratio is 1.37%.
Nothing is perhaps the hardest thing to do. When faced with a difficult situation, it is far easier to do something, anything, than to sit and watch and wait.
Over-activity is deleterious in many situations: in gardening, in building, in thinking, and in investing. The best thing you can do to improve your investing performance is simply to do less trading. This (and the rest of this article) summarizes the work of Brad Barber and Terry Odean in the article “Trading is hazardous to your wealth: The common stock investment performance of individual investors,” published in 2000 in The Journal of Finance.
Barber and Odean analyzed the actual broker accounts of 66,000 households over a period of five years, from 1991-1996. Some of their results were quite encouraging: on average, the gross returns of those individual investors were about equal with the gross returns of the S&P 500, indicating that individual investors, by and large, do fine.
The problem was that the ‘investors’ traded way too much. Interestingly enough, it wasn’t the trading per se that hurt their performance: the most active traders had gross returns equal to the least active traders. However, their frenetic trading cost them in commissions, and those costs were huge, reducing annual returns from about 18% to about 12%. See the figure below (taken from the article; a larger version is available here). Notice how low the turnover of the quintile with the least trading is–they had maybe 5% annual turnover. Their net return is thus almost equal to their gross return.
There were some other interesting findings in the study: individual investors tend to favor small, high beta (high volatility) stocks. I would call this the ‘Peter Lynch Effect’, since Lynch recommended small companies with prospects for great growth. This is not really important, though, because it is necessitated by the size of institutional investors. Since institutional investors have so much money to invest, they shun small- and micro-caps. Therefore, individual investors have to own a disproportionate share of small-cap stocks.
Since small stocks tend to outperform the market, individuals should have done better the market as a whole. That they did not is telling. While average investors do not beat the market, good investors can do so. I certainly intend to do so.
Click on the thumbnail below for the full-sized graph of investment performance as it relates to frequency of trading.
I have Google Analytics set up on this website, and that makes tracking my visitors (and how they find me) quite easy. A lot of my hits have come from people looking for information on Andrew Left of StockLemon. In fact, 3 of my top 10 articles were about him. A week or two ago I did a multi-part series investigating him. I am quite proud of the job I did profiling him, and it is a service to those who would invest in the companies he disparages that I have helped to dispel some of his critics’ lies about him (while confirming other of the criticisms leveled against him).
Crazy Searches
Evidently, if you search for ‘pretty panties’ or ‘pure panties’ you will find my blog article (syndicated on SeekingAlpha) about Movie Star Inc. (MSI: $0.00 N/A, market cap: $N/A). I would not recommend using those search terms because of the other things you might find! If you search for ‘worst investment blog’, my article on Remote MDX (RMDX.oB) comes up on the first page of Google. I have received numerous visitors searching for prosaic things like ‘value investing’, which is good. I have seen some traffic from people searching for the lyrics to “Catch a Falling Star”, due to my “Short a Falling Stock” parody. I have also received a visit from one poor soul who searched for “phd quant jobs hedge funds pay $1 million”. I have a feeling he is still not making millions at a hedge fund.
Disclosure: I own MSI and I am short RMDX.ob. I have no relationship with Andrew Left of StockLemon. My disclosure policy is a popular place to visit.
Not bad considering that music sales were down big. Rick Munarriz has a decent take on the earnings announcement over at The Motley Fool.
Hastings (HAST: $4.39 0.00%, market cap: $41.8M), currently selling around $7 per share, is a scrappy little retailer that sells books, music, movies, video games, and rents movies and video games. The company is cheap when compared to its book value or earnings. I generally think management is competent, although the company should institute a dividend to better allocate capital.
Disclosure: I own Hastings stock. My disclosure policy always beats analyst estimates.
No, I’m not writing about the old school rap group. I’m writing about Document Security Systems, Inc. (DMC: $4.08 +0.25%, market cap: $61.9M), which is currently trading at $10.90. Any investor in DMC should do one thing: run!
DMC is a company without a decent product, without any significant assets (tangible or intangible), without any hope of ever making any sales significant enough to justify its current market cap. While the company has doubled its revenues over the last year ($1.75 million in Q1 2007, vs. $0.86 million in Q1 2006), about half of that increase has come from acquisitions ($215k from 2006 acquisition of P3) and from growth in the acquired companies (approximately $200k in sales growth in P3, see p.17 of the 10Q for details). Also, for an intellectual property company, Document Security Systems spends very little on R&D: $109k in the most recent quarter (see the August 9, 2007 press release). Net loss was $2.9 million in the most recent quarter (Q2, ended June 30). As for sales, they were up 10% in Q2 2007 versus Q2 2006. Not bad. But again, the company did make some acquisitions in that time. Oh, and share count was up 6% in the same period of time.
DMC’s one supposed asset is a patent on a document security system that prevents documents from being digitally scanned or copied. The one problem is that the patent was ruled invalid in the United States in 2000 and was ruled invalid in Britain and WIPO just this spring (the company has filed appeals). The company is of course appealing the recent rulings in Europe, but the case against them seems to me to be pretty strong. Also, if the company loses its appeals in Europe, it will not only have its patents invalidated but it will be liable for the court costs of the European Central Bank (which is trying to have the patents ruled invalid). The company did win an identical case in Germany, but it is unclear what would happen if the company won cases in some countries but not others. For a brief synopsis, I suggest reading Asensio.com’s report (Asensio.com is an independent short-selling research outfit). I also suggest reading Asensio’s priorreports on DMC. You can see DMC’s European patent online. I have uploaded a pdf copy of the patent to my website here.
I came across an analyst that upgraded DMC to buy recently (see report). It turns out that the company that hired the analyst is being paid $30,000 per year to ‘to assist with strategies related to the increase of share liquidity and general market presence’. That sounds a lot like ‘pump up the stock’ to me. And while the analyst himself is independent, he would be a fool to bite the hand that feeds him, and he is no fool. CCM Opportunities, the research company that hired the analyst, has only 1 company with a rating of sell or avoid, and of the companies that it rates hold, only one is a microcap (others, like WMT and ADM are megacaps). So in other words, if you pay CCM to get coverage for your microcap company, you can be pretty darn sure that you will get at least a ’speculative buy’ rating. Not bad for $30k.
DMC has a market cap of $148 million. It has net tangible assets of about $3 million. Because of its huge SG&A costs and resulting losses, the company’s fair value is $0. I suggest avoiding investing in DMC.
I am currently trying to get a copy of the German patent court decision and I am trying to get an opinion from an expert on European patent law. I will post an update when I know more information.
Disclosure: I am short DMC. Short selling is very risky and I do not recommend it. My disclosure policy has patents pending.
