Tuesday, May 31, 2011

In finance, they call it data mining

Source: the wonderful xkcd.

Tuesday, May 24, 2011

Ira Sohn Investment Idea Contest

On Friday, I completed my entry to the Ira Sohn Investment Idea Contest, a major investment contest with many heavy-hitters among the list of speakers. They include: Bill Ackman, Seth Klarman, Carl Icahn, David Einhorn, Joel Greenblatt, and Steve Eisman. On Monday, I was delighted to find out I was chosen among the semi-finalists, which means I will be able to attend. Included below is a copy of my entry.
Stay tuned, I will be posting my notes from the conference later in the week.
In the interest of full disclusure, I am long HPQ.
Your Investment Idea
Hewlett-Packard Company (HPQ)
$44.00; I believe HP's lowered third quarter guidance has led to a market overreaction and will lead to an earnings surprise. After they beat concensus estimates later in the year, investors will value HP on a comparable basis to the industry. With even a conservative valuation (11x earnings) this would place HP in the mid-$40s.
Companies engaged in the diversified computer systems industry such as IBM, Dell, Cisco, and EMC Corporation.
Catalyst - Please explain what action, event, situation or future realization will cause the market to recognize the value discrepancy that you observe. I expect to wait until the third or fourth quarter results are announced, which I fully expect to top the dampened expectations. In other words, I believe that their continued profitability will prove to investors they have overreacted to a nonfactor like guidance.
Hewlett-Packard issued a second quarter press release before the opening of the market on May 17, 2011. In the release, HP reported beating the consensus second quarter earnings estimates ($1.24 vs $1.21), but went on to lower their guidance for the full year citing a tough PC market and weak consumer demand. Investors punished the stock and it opened 6% lower than the close. It has since shed 10% since before the announcements. HP is now trading near its 52-week low at a P/E of 9.2. The market has vastly overreacted.
I believe that the lowering of expectations is setting up an earnings surprise situation because, fundamentally, the public has a misperception of HP's business model and in turn value the company inappropriately. The investing public believes HP is a commodity company yet 63% of its 2010 operating earnings came from recurring revenue streams such as services, networking, and software. Aside from the PC group, none of the other business lines have seen any decline since CEO Leo Apotheker took the helm after Mark Hurd's exit in November. In fact, servers, storage, and networking revenues were up 15% year-over-year, software revenues were up by 17%, and financial services revenues increased by 17% as well. A decline in consumer demand may lower the top-line revenues, as these are HP's most competitive business lines, but it will tend to increase their margins. It will not have the devastating impact on their business that people expect; rather, it will be a symptom of the continued evolution of their business model into a higher margin company.

Investors are discounting the steadiness of HP's earnings stream, not to mention their continued growth in their more profitable services business line. I think it's paradoxical for second quarter GAAP earnings to grow 15% year-over-year and increase gross margins by 1%, and have the market reaction to be to knock 10% off their market cap.

HP is still massively profitable and throwing off enormous amounts of cash which they are using to reward their shareholders. They generated $4 billion of cash in the second quarter and a 22% return on equity. They only paid out $182 million in dividends, but they returned $2.7 billion to the shareholders by repurchasing approximately 64 million shares of stock. They have authorization to repurchase another $8.6 billion in stock and the cash to do it with ($12 billion, or around $6 a share); at present prices this could pull an addition 237 million shares off the market and have a significant impact on their future earnings results. Not to mention the secondary affect it will have on their market price. All of these factors combine to add to the margin of safety of this trade.

Despite being in the tech industry, which doesn't lend itself to value plays very often, HP passes even Ben Graham's stock screener. Their earnings yield (10.9%) is many multiples over the two times the AAA-bond yield (2.8%) criterion. Their total debt ($23 billion) is well less than the 2/3 tangible book value ($68 billion) needed to pass. They do, however, fall short of having a dividend yield (0.9%) of at least two-thirds of the AAA-bond yield, but this is only a crude measure. If we take into account the large stock buybacks that dwarf the declared dividends, we can be sure they are returning a large amount of earnings to their shareholders.

I believe Ben Graham's requirements for purchase of a "bargain issue" from chapter 7 of The Intelligent Investor exactly fit HP's current situation. For one, HP has reasonable stability in its earnings, not only in consistent profitability but also in topping expectations. Even through the financial crisis, HP did not take the large writedowns that plagued other firms. They had only profitable quarters. In HP's worst quarter, Q2 of 2009, it still earned $0.86 a share. According to Graham, a potential investment should have significant size and financial strength. With a $78 billion market cap and $12 billion in the bank, HP does. The $23 billion in debt may be troubling at first glance, but nearly 40% of this figure are short-term borrowings on which they are paying very little (roughly 2% weighted average interest rate), by historical standards, in interest expense. Beyond the $1.75 billion in debt that becomes due this month, there will be no other due dates until March 2012 so the financial risk in the near term is minimal. As already determined, HP is trading well below both its average price and a reasonable P/E valuation based on either its industry position or its prospects. HP passes every Graham requirement to be considered a suitable investment for a defensive investor.

When Hewlett-Packard beats expectations in the third or fourth quarter, Apotheker will emerge from Mark Hurd's shadow and HP will again be a Wall Street darling. Within the next year, as Apotheker's HP proves itself, investors will value the stock closer to the industry average of 14.8. (For comparison - its closest competitor, IBM, which is three times as large, trades at a multiple of 14.3) I've cited my price expectation at 44, which represents a 22% premium to today's market value and covers my required rate of return (which I borrowed from Warren Buffet) of 15%. I believe this is a conservative estimate which provides the investment with a wide margin of safety. Even if HP were to earn exactly what it did in the third quarter last year (which would actually be a decline in total earnings based on the continuing repurchase of shares) and was only valued at 11 times the trailing twelve months earnings, then it would still rise up to the mid-40s. Were it to trade at the industry multiple previously cited, HP could easily trade into the mid-50s. To the best of my ability, I believe Hewlett-Packard represents an excellent risk-reward tradeoff: downside protection based on their industry position and financial history with significant upside potential based on their investment in higher margin and growth industries. This is a classic Graham-type value trade with an embedded option on cloud computing.

Tuesday, May 17, 2011

Notable and Quotable from Better Lucky Than Good

I just finished Better Lucky Than Good, a book on general investing theory. This book is more for the beginner than it is for the advanced investor. In fact, it is probably the perfect gift for an investment adviser to give to a new client. But it didn't satisfy me. I was tricked by the sub-title: "How savvy investors create fortune with the risk-reward ratio". That sounded to me like a technical exposition on balancing risk and reward, which is what drew me in. I was disappointed to say the least.
But I wanted to share a few of my favorite quotes, because on some level the book was helpful. You may find some of the basic accounting quotations not particularly relevant, but I wanted to denote them for my future reference. It's always good to brush up on things you don't use everyday, particularly when it comes to accounting.
  • The cornerstones of a good investment philosophy: a strong business model, good financials, an attractive valuation, and diversification.
  • Fear of being left behind is a powerful force and has caused many investors to make irrational decisions.
  • Paying attention to trends in analysts' comments or changes in them can help you make better investment decisions.
  • In looking at earnings estimates, analyst the trend over the last 60 days. Look for a clear trend of rising estimates (good) or falling estimates (bad) and pay attention to the actual [relative] size of the changes.
  • If you can learn to control your emotions, make rational decisions, and be willing to part with an investment, you will increase your overall returns.
  • Business and investing conditions change, so should your portfolio.
  • #1 Rule of Investing: Only do what allows you to sleep at night.
  • Use earnings estimate revisions as a signal to do more research.
  • If intangibles account for a significant portion of total assets, then shareholders equity could be overstated.
  • Beware if gross margins are narrow, especially if they are 10% or less. Such small gross margins suggest the company lacks pricing power.
  • A sharp increase or decrease in working capital should be examines. It could be an early sign the company is experiencing problems.
  • If a stock has a yield similar to bonds, shareholders are not being reimbursed for the additional level of risk.

Friday, May 13, 2011

Why Hedge Fund Managers Quit

In 2008 and 2009 there were a number of stories about money managers closing down their funds only to open a new one a short time later. Why would someone do that? Because they have the incentive to do so. Incentives matter. 

Knowing this intuitively, I wanted to help convey that incentive visually so I created the graph below. As you can see, as the losses begin the percentages required to get back to even (in financial pjargon it is referred to as the highwater mark) get higher and higher. Notice the logarithmic scale on the left axis.

Percentages don't speak to everyone so I added a time dimension by creating the right axis. If you assume  that the person could earn 20% (a very good return and well over the major indices' averages) constantly (an even bigger assumption than the return because of the volatile nature of stocks) until they earn back all of the loss then for a given % loss on the x-axis you can see how many months it would take to wait for the recovery on the y-axis. As the chart indicates, if a hedge fund manager loses 15% of his (your)  assets, without considering another gyration in the market it would take a manager a full year to reach the highwater mark. A 36% drop, which is similar to what investors witnessed for the full 2008 calendar year, would take three full years to recover. The highwater mark is particularly important in the hedge fund world, because they often have a rule in their contacts which requires them to get back to the highwater mark in order to earn the management fee (usually 2% of assets which is substantial for large funds).

So, facing no possibility of fees in the near future and with the possibility of things taken another downward turn the manager has the incentive to take a rational (not the most moral) step - close down the current fund that is below the highwater mark and create a new fund where he can start getting paid immediately.

Thursday, May 12, 2011

Best Passages from Peter Lynch's Beating the Street: Part 3

OK, let's wrap this up:
  • I don't think of [shopping] as browsing. I think of it as a fundamental analysis on the intriguing lineup of potential investments, arranged side by side for the convenience of stock shoppers.
  • The very homogeneity of taste in food and fashion that makes for a dull culture also makes fortunes for owners of retail companies and of restaurant companies as well. What sells in one town is almost guaranteed to sell in another.
  • You want to avoid the retailers that expand too fast, especially if they're doing it on borrowed money.
  • As a rule of thumb, a stock should sell at or below its growth rate.
  • Digging where the surroundings are tranquil and pleasurable may prove to be as unrewarding as doing detective work from a stuffed chair. You've got to go into places where other investors and especially fund managers fear to tread, or, more to the point, to invest.
  • Reading a prospectus is like reading the fine print on the back of an airline ticket. Most of it is boring, except for the exciting parts that make you never want to get on an airplane or buy a single share of stock again.
  • Whenever book value comes up, I ask myself the same question we all ask about the movies: is this based on a true story or is it fictional?
  • In a highly leveraged company, bank debt is dangerous, because if the company runs into problems the bank will ask for its money back.
  • I'm always on the lookout for great companies in lousy industries. A great industry that's growing fast, such as computers or medical technology, attracts too much attention and too many competitors. When an industry gets too popular, nobody makes money there anymore.
  • In a lousy industry, one that's growing slowly if at all, the weak drop out and the survivors get a bigger share of the market.
  • Peter's principle #16: In business, competition is never as healthy as total domination.
  • The greatest companies in the lousy industries share certain characteristics. They are low-cost operators, and penny-pinchers in the executive suite. They avoid going into debt. They reject the corporate caste system that creates white-collar Brahmins and blue-collar untouchables. Their workers are well paid and have a stake in the companies' future. They find niches, parts of the market that bigger companies have overlooked. They grow fast--faster than many companies in the fashionable fast-growth industries.
  • Peter's principle #17: All else being equal, invest in the company with the fewest color photographs in the annual report.
  • Peter's principle #18: When even the analysts are bored, it's time to start buying.
  • I never hang up on a source without asking: what other companies do you most admire?
  • This is the way you look at a long-shot S&L: find out what the equity is and compare that to the commercial loans outstanding. Assume the worst.
  • Buying on the bad news can be a very costly strategy, especially since bad news has a habit of getting worse.
  • Buying on the good news is healthier in the long run, and you improve your odds considerably by waiting for the proof.
  • This is a very useful year-end review for any stockpicker: go over your portfolio company by company and try to find a reason that the next year will be better than the last. If you can't find such a reason, the next question is: why do I own the stock?
  • Owners can always give you a reason their horses will win, and they are wrong 90 percent of the time.
  • A high p/e ratio, which with most stocks its regarded as a bad thing, may be good news for a cyclical. Often, it means that a company is passing through the worst of the doldrums, and soon its business will improve, the earnings will exceed the analysts' expectations, and fund managers will start buying the stock in earnest.
  • It's perilous to invest in a cyclical without having a working knowledge of the industry and its rhythms.
  • The most important question to ask about a cyclical is whether the company's balance sheet is strong enough to survive the next downturn.
  • One useful indicator for when to buy auto stocks is used-car prices. When used-car dealers lower their prices, it means they're having trouble selling cars, and a lousy market for them is even lousier for the new-car dealers.
  • In the stock market it rarely pays to take yesterday's news too seriously, or to hold an opinion too long.
  • Peter's principle #20: Corporations, like people, change their names for one of two reasons: they've gotten married, or they've been involved in some fiasco that they hope the public will forget.
  • A simple way to make a nice living from troubled utilities: buy them when the dividend is omitted and hold on to them until the dividend is restored.
  • There are always respected investors who say that you're wrong. You have to know the story better than they do, and have faith in what you know.
  • For a stock to do better than expected, the company has to be widely underestimated. Otherwise, it would sell for a higher price to begin with. When the prevailing opinion is more negative than yours, you have to constantly check and recheck the facts, to reassure yourself that you're not being foolishly optimistic.
  • Here's the key question to ask about a risky yet promising stock: if things go right, how much can I earn?
  • There are different shades of buys. There's the "what else am I going to buy?" buy. There's the "maybe this will work out" buy. There's the "buy now and sell later" buy. There's the "buy for your mother-in-law" buy. There's the "buy for your mother-in-law and all the aunts, uncles, and cousins" buy. There's the "sell the house and put the money into this" buy. There's the "sell the house, the boat, the cars, and the barbecue and put the money into this" buy. There's the "sell the house, boat, cars, and barbecue , and insist your mother-in-law, aunts, uncles, and cousins do the same" buy.
  • During periods when mutual funds are popular, investing in the companies that sell the funds is likely to be more rewarding than investing in their products.
  • A healthy portfolio requires a regular checkup.
  • Rejecting a stock because the price has doubled, tripled, or even quadrupled in the recent past can be a big mistake. Whether a million investors have made or lost money on Chrysler last month has no bearing on what will happen next month. I try to treat each portential investment as if it had no history--the "be here now" approach. Whatever occured earlier is irrelevant. The important thing is whether the stock is cheap or expensive today at $21-$22, based on its earnings potential of $5 to $7 a share.
  • You can beat the market by ignoring the herd.
  • Behind every stock is a company. Find out what it's doing.
  • YOu have to know what you own and why you own it.
  • Long shots almost always miss the mark.
  • Everyone has the brainpower to make money in stocks. Not everyone has the stomach.

Best Passages from Peter Lynch's Beating the Street: Part 2

I haven't had much time to go through Peter Lynch's Beating the Street since I last posted, but today I have some free time and would like to get these notes down for yours and my own reference.
  • This is one of the keys to successful investing: focus on the companies, not on the stocks.
  • My methods were not much different from an investigative reporter - reading the public documents for clues, talking with intermediaries such as analysts and investor relations people for more clues, and then going directly to the primary sources: the companies themselves.
  • Every stockpicker could benefit from keeping a notebook of [stock] stories. Without one, it's easy to forget why you bought something in the first place.
  • If you're prepared to invest in a company then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won't get bored.
  • A computer company can lose half its value overnight when a rival unveils a better product, but a chain of donut franchises in New England is not going to lose business when somebody opens a superior donut franchise in Ohio.
  • When you have to concern yourself with what the person behind you thinks about your work, it seems to me that you cease to be a professional. You are no longer responsible for what you do. This creates a doubt in your mind as to whether you are capable of succeeding at what you do--otherwise, why would they be monitoring your every move?
  • Peter's Principle #8: When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6 percent or more, sell your stocks and buy bonds.
  • Why investors attempt to prepare for total disaster by bailing out of their best investments is beyond me. If total disaster strikes, cash in the bank will be just as useless as a stock certificate. On the other hand, if total disaster does not strike (a more likely outcome, given the record) the "cautious" types become the reckless ones, selling their valuable assets for a pittance.
  • No matter how well you think you understand a business, something can always happen that will surprise you.
  • Bargains are the holy grail of the true stockpicker. The fact that 10-30 percent of our net worth is lost in a market sell-off is of little consequence. We see the latest correction not as a disaster but as an opportunity to acquire more shares at low prices. This is how great fortunes are made over time.
  • [Sarcastically talking about a bad call on IBM] you aren't really a fund manager unless you have Big Blue in the portfolio.
  • How much time you spend on researching stocks is directly proportional to how many stocks you own.
  • In stocks as in romance, ease of divorce is not a sound basis for commitment. If you've chosen wisely to begin with, you won't want a divorce. And if you haven't you're in a mess no matter what. All the liquidity in the world isn't going to save you from pain, suffering, and probably a loss of money.
  • Peter's principle #11: The best stock to buy may be the one you already own.
  • Peter's principle #12: A sure cure for taking a stock for granted is a big drop in the price.
  • When your best-case scenario turns out to look worse than everybody else's worst-case scenario, you have to worry that the stock is floating on a fantasy.
  • Tbere's no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock, or, worse, to buy more of it, when the fundamentals are deteriorating.
  • Peter's principle #13: Never bet on a comeback while they're playing "Taps".
  • Here's a tip from experience: before you invest in a low-priced stock in a shaky company, look at what's been happening to the price of the bonds.
  • Cyclicals are like blackjack: stay in the game too long and it's bound to take back all your profit.
  • Stockpicking is both an art and a science, but too much of either is a dangerour thing. A person infatuated with measurement, who has his head stuck in the sand of the balance sheets, is not likely to succeed. If you could tell the future from a balance sheet, then mathematicians and accountants would be the richest people in the world by now.
  • A pile of software isn't worth a damn if you haven't done your basic homework on the companies.
  • I've learned to think of investments not as disconnected events, but as continuing sagas, which need to be rechecked from time to time for new twists and turns in the plots. Unless a company goes bankrupt, the story is never over. A stock you might have owned 10 years ago, or 2 years ago, may be worth buying again.

Monday, May 9, 2011

Is it possible to be scared of a book?

Ordinarily I would say no. But as I grabbed The Intelligent Investor off the shelf this weekend for the first time since I bought it in 2008, I realized it is. This book has been called the greatest investment book of all time by Warren Buffett! It was written by the father of value investing, Ben Graham. For an analogy,

Sun Tzu : War :: Ben Graham : Investing.

Suffice it to say, I was intimidated. Enough to put off reading the book for over three years. If I read the book and then didn't live up to the legends who internalized this tome and went on to rack up the best records in the business, then I'd be a failure. If I could just delay reading it then I could delay the day I would have to look critically at my own performance. People love scapegoats, and not reading The Intelligent Investor became mine. But yesterday something changed. I realized I am not succeeding according to Coach Wooden's definition of success:

“Success is peace of mind which is a direct result of self-satisfaction in knowing you made the effort to become the best of which you are capable.”

I know that I will never realize my potential as an investor without this knowledge. So I grabbed it off the shelf and began. I'm ready now. I'm no longer afraid.

Thursday, May 5, 2011

April Reading List

by Peter Lynch, John Rothchild
Comment: "This book is pretty good. It has great and practical advice for both the novice and the advanced stockpicker. The only downside is that the stock picks are dated now. For instance, he recommended Allied Capital which has since gone bankrupt and is the subject of David Einhorn's book which I finished last month. But just because the recommendations are not valid anymore doesn't mean you can't learn from Lynch's thought process and reasoning. I found these passages invaluable."
by Paul A. Samuelson, William A. Barnett 
Comment: "I hardly ever do this and I hate to say it, but I quit this book before I finished it. It is a little more technical and less accessible than other books on economists that I've read, e.g. "Lives of the Laureates" and "The Worldly Philosophers". I also found it to be repetitive because a considerable amount of the interviews were with people I've already heard describe their background in depth. "
by Isaac Asimov
Comment: "This book was fantastic. I couldn't put it down.
The Foundation trilogy, of which this is not a part but it is in the line of books, won a special Hugo award for best science fiction series ever. This is the first book in that line, so I started at the beginning. I can't wait to read the rest.
by Frank Brady
Comment: "This book was fantastic. Frank Brady knows more about Bobby Fischer than any other living person.
I loved following Bobby's fanatic/obsessive preparation and rise in the chess world and then hated what the pursuit of the world's #1 position did to him as he descended into a sad character on the fringe of society. This book was not exactly an apology for Fischer, but it did have those qualities. For example, Brady gave a number of reasons why Fischer may have become anti-Semitic, one being to strike back at the US Chess Federation.
Reading this book got me so excited about chess that I am going to start learning the game. I think it will give me skills on thinking strategically.
This book is definitely worth your time.
by Alex Berenson, Mark Cuban
Comment: "What a fantastic read. Alex Berenson is a captivating writer who masterfully wove together many different narratives - accounting, government regulatory, and stock market history as well as the stories of corporate misdoings by Computer Associates, Enron, Tyco, and Worldcom. "

Common Stocks and Uncommon Profits and Other Writings (Wiley Investment Classics)by Philip A. Fisher, Ken Fisher
Comment: "My expectations for this book were high. I was severely disappointed. The best part of this book is that it's over. The worst part of this book is that Phillip's son Kenneth owns the rights to the book. He took that privilege and ran with it. Kenneth, a billionaire investor, droned on for a dozen pages of prologue before writing another 27 for the introduction. If you happen to pick up this copy, and I suggest that you don't, skip all of Kenneth's writing. It's horrible.
Phillip writes like I hope that I don't: overly verbose with too complicated a structure. His writing also has too many references to previous statements so quoting him is impossible. In my view, the best investment writers drop little nuggets of wisdom. Because of the way Fisher writes, you won't get much of that from this book. The other problem with the writing is that there are too many examples so the book doesn't stand up historically. I don't want to read about Dow Chemical in the '50s or Motorola in the '70s. Both of these stocks are also written about because Fisher owned them which I found highly annoying.
I did find bits and pieces that I believe was adopted by other investment managers, e.g. three year rule, buying something when it is priced well and not haggling over 1/8ths.
However, I recommend that you skip this book.