Old School Value

This is a continuation of the 41 Contrarian Investment Rules as defined in David Dreman’s Contrarian Investment Strategies.

Contrarian Investment Rules 21-41

Rule 21: Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.

• Prefer to sell when it nears intrinsic value.

Rule 22: Look beyond obvious similarities between a current investment situa­tion and one that appears equivalent in the past. Consider other impor­tant factors that may result in a markedly different outcome.

Rule 23: Don’t be influenced by the short-term (3 or five year) record of a money manager, bro­ker, analyst or advisor, no matter how impressive; don’t accept cursory economic or investment news without significant substantiation.

Rule 24: Don’t rely solely on the “case rate.” Take into account the “base rate“­ - the prior probabilities of profit or loss.

Rule 25: Don’t be seduced by recent rates of return for individual stocks or the market when they deviate sharply from past norms (the “case rate”). Long term returns of stocks (the “base rate”) are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.

Rule 26: Don’t expect the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out.

• Guilty again to some degree.

Rule 27: The push toward an average rate of return is a fundamental principle of competitive markets.

Rule 28: It is far safer to project a continuation of the psychological reactions of investors than it is to project the visibility of the companies themselves.

Rule 29: Political and financial crises lead investors to sell stocks. This is pre­cisely the wrong reaction. Buy during a panic, don’t sell.

• The Obama health care reform scared investors into selling UNH. Rebounded strongly once UNH revealed plans on how it can still profit.

Rule 30: In a crisis, carefully analyze the reasons put forward to support lower: stock prices-more often than not they will disintegrate under scrutiny

Rule 31: (A) Diversify extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren’t getting a clinker. (B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.

Rule 32: Volatility is not risk. Avoid investment advice based on volatility.

Rule 33: Small-cap investing: Buy companies that are strong financially (nor­mally no more than 60% debt in the capital structure for a manufacturing firm).

Rule 34: Small-cap investing: Buy companies with increasing and well-protected dividends that also provide an above-market yield.

Rule 35: Small-cap investing: Pick companies with above-average earnings growth rates.

Rule 36: Small-cap investing: Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one.

• 40-60 small caps in a portfolio? Why not the Russel 2000 instead?

Rule 37: Small-cap investing: Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous.

Rule 38: Small-company trading (e.g., Nasdaq): Don’t trade thin issues with large spreads unless you are almost certain you have a big winner.

Rule 39: When making a trade in small, illiquid stocks, consider not only com­missions, but also the bid /ask spread to see how large your total cost will be.

• Many brokers usually charge more for sub $1 stocks. Commissions get out of control.

Rule 40: Avoid the small, fast-track mutual funds. The track often ends at the bottom of a cliff.

Rule 41: A given in markets is that perceptions change rapidly.

I am currently reading Contrarian Investment Strategies by David Dreman and enjoying the rules that pop out throughout the book. There are 41 in total for the contrarian. There are many obvious rules. My comments are in bullet points and the highlighted rules are the ones I found interesting.

The list of 41 rules is quite long so I’ll break it into 2 parts. Part 2 will be posted tomorrow.

Contrarian Investment Rules 1-20

Rule 1: Do not use market-timing or technical analysis. These techniques can only cost you money.

Rule 2: Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in­-depth profits.

• Having too much information and thinking that one has mastered the details causes the investor to become overconfident.

Rule 3: Do not make an investment decision based on correlations. All correla­tions in the market, whether real or illusory, will shift and soon disappear.

Rule 4: Tread carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.

Rule 5: There are no highly predictable industries in which you can count on an­alysts’ forecasts. Relying on these estimates will lead to trouble.

• Analysts cannot predict the future any better than you and me.

Rule 6: Analysts’ forecasts are usually optimistic. Make the appropriate down­ward adjustment to your earnings estimate.

• Always at the upper range in my experience

Rule 7: Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

Rule 8: It is impossible, in a dynamic economy with constantly changing polit­ical, economic, industrial, and competitive conditions, to use the past accurately to estimate the future. The past gives some frame of reference but cannot be exact.

Rule 9: Be realistic about the downside of an investment, recognizing our hu­man tendency to be both overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.

Rule 10: Take advantage of the high rate of analyst forecast error by simply in­vesting in out-of-favor stocks.

Rule 11: Positive and negative surprises affect “best” and “worst” stocks in a di­ametrically opposite manner.

• Interesting point. He is saying that beaten down stocks don’t go down as much because nobody expects much, but if it does better, everyone is surprised and up it goes. Vice versa for darlings.

Rule 12: (A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.
(B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.
(C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.
(D) The effect of an earnings surprise continues for an extended pe­riod of time.

Rule 13: Favored stocks under-perform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.

Rule 14: Buy solid companies currently cut of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.

• Not a fan of buying companies based on low ratios

Rule 15: Don’t speculate on highly priced concept stocks to make above-average returns. The blue chip stocks that widows and orphans traditionally choose are equally valuable for the more aggressive businessman or woman.

Rule 16: Avoid unnecessary trading. The costs can significantly lower your re­turns over time. Low price-to-value strategies provide well above mar­ket returns for years, and are an excellent means of eliminating excessive transaction costs.

• Very guilty on this one. My expenses are too high.

Rule 17: Buy only contrarian stocks because of their superior performance char­acteristics.

• Disagree

Rule 18: Invest equally in 20 to 30 stocks, diversified among 15 or more indus­tries (if your assets are of sufficient size).

• I’ve written about diversification here. Dreman is more of a mechanical investor so he doesn’t have to keep up with 20-30 companies. The point about industries is relevant.

Rule 19: Buy medium-or large-sized stocks listed on the New York Stock Ex­change, or only larger companies on Nasdaq or the American Stock Ex­change. (Obviously American centric here)

• Disagree. This isn’t contrarian.
  

Rule 20: Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.

Be sure to visit tomorrow for the remaining half.

With the term “cheap” and “value” so often around, especially in a bear market, what are the characteristics of a value trap?

If my wife had to define value, it would be buying a Chanel handbag on sale. From firsthand experience,a 10% sale for Chanel is truly good value. On the other hand, a value trap would be where I bought the Chanel handbag on sale, only to realize it was a fake.

The following  characteristics as described by Investopedia, are some common traps.

Low Multiple Value Trap

Multiples certainly do help in providing a picture of the company, however, if the company has been trading at its low multiples for an extended period of time, there is a reason.

Some reasons for why the company may be so cheap:

1. The company has difficulty generating meaningful and consistent profits and is unlikely to generate institutional or substantial retail interest.
2. Management is reluctant to get out on the road and tell the company’s story to retail and institutional investors.
3. Competition is extremely stiff, and the company is unable to differentiate itself.

No Catalysts

There are some investors that state the deep discount itself is a catalyst. I agree to some degree. A majority of net nets are value traps because they fail in their ongoing operations, yet they have extremely cheap multiples. But if we bought purely for its cheapness and think that management will turn it around sooner or later, we are in for a bad ride. Without a catalyst to unlock its value, the company is a value trap.

In the value investing realm, Sears is a big value stock. By looking at its balance sheet we see that Sears has a huge property value that is being mispriced. However, I believe this fact is well known. Many small investors are aware of it and I’m sure the institutions know it as well. The problem is, the property value has be to unlocked. Unless Lampert unlocks its true value, I wouldn’t be surprised if SHLD doesn’t travel upwards for a while.

High Insider Ownership

Although high insider ownership is a sign of faith by managers, it may also be a deterrent to institutions as it prevents change being enacted if the managers are not performing in the best way. If I am unfamiliar or don’t have enough information on the managers, I am hesitant in purchasing a company where insiders own more than 15%.

This includes companies that have a dual class share structure as it gives the owners an overwhelming authority over the direction of the company.

Investor Rear View Tendencies

One of the problems I faced is placing too much emphasis on the history of the company. If a company has performed admirably for the past 5-10 years, I placed a heavy emphasis that it can continue. This tendency is much like falling for the low multiple trap. Just because the company did well in the past, it doesn’t mean it will continue in the future unless it has a moat and strong market share.

Disclosure

No positions in any stocks mentioned at the time of writing.

AJ is a reader of Old School Value and was kind enough to allow me to post his thoughts regarding the email communication we had over my behaviour with EMAG. I attributed most of the problem to greed but he noted that although greed had something to do with, the underlying issue was that I and most other investors, seek rewards from risk. That is, we are categorised as “reward-risk” investors.

On the other hand, if we look at Seth Klarman, he has an AMAZING record. Throw in the fact that he is a master mind, but also because he always looks at risk and then reward. He discusses this in his book Margin of Safety, which you can find online if you look hard enough. Seth Klarman could be categorised as a “risk-reward” investor.

By focusing on the risk and investing only in situations where it is minimized to the fullest extent, he is getting an additional margin of safety. Also, by focusing on risk, the reward will take care of itself. It certainly is true according to his 20%+ annualized performance since inception.

This brings to mind Monish Pabrai. Another guru with a tremendous record but 2008 proved difficult for him as he bets heavily when the reward is high. One performed excellently in 2008 by focusing on risk to reward, one performed horribly by focusing on reward to risk.

If preservation of capital is not foremost on your mind each and every time you purchase securities, you are a “reward-risk” person. - AJ

This new framework is something that I must adhere to. Out with the old, in with the new.

Preservation of Capital

Presevation of capital is not just limited to the downside. I’ve never felt the need to take profits because I’ve always geared towards buy and hold. AJ puts it nicely.

by keeping risk-reward firmly in mind, especially in arb situations, you will realize you need an exit plan on the upside as well. When you buy you need to have pre-planned exit points on the upside (and downside). You won’t make as much, but you will have preserved your principal. For example, if the stock went up 40% on your original purchase price, sell 70% of it and ensure the safety of your principal - if the stock later crashes, you can cash out and still come out ahead - perhaps not 50%, but 5% for 2-3 months is nothing to sneeze at AND you sleep soundly at night … the 1% chance of killing your principal is not worth the upside - you have many years to invest, but you cannot invest money you have lost - slow and steady wins this race.

Benchmarking

Klarman also states in his book that he focuses on absolute returns. We’ve been trained to focus on IRR and benchmarks against the market, but what good is that it if the market loses $10,000 and I lose $8,000. I still lost $8,000. In a market such as what we have now, there’s no end to the surprises and the amount of money we can lose.

For AJ

Should something ever happen to me, how about taking over Old School Value

But in all seriousness, the email was too good to just keep to myself. Thanks.

In a previous post on Bill Ackman’s rationale for Wendy’s, I included Pershing Square’s 2008 Annual Investor presentation published by Deal Breaker and I wanted to share their investing strategy and see whether I can learn anything from it.

In the presentation they have notes on their holdings which is also a good read.

Pershing Square Investing Strategy

The points of their investing strategy which I found useful are as follows with my comments in ():

• Investment selection process
  • Mid - large cap companies (small investors can include small caps as well)
  • Typically not controlled (if the company is controlled and refuses to unlock shareholder value even with an activist, what hope do we have?)
  • Low financial leverage and modest economic sensitivity (No startup software or tech companies as many are extremely leveraged)
  • Catalyst for value creation (there should be a catalyst. A cheap price is not a catalyst because there is a reason why it got there in the beginning)
• Concentration
  • Invest in best ideas. Approximately 8-12 (I lost far too many opportunities because I was going after too many mediocre opportunities rather than the best one)
  • Willing to replace existing holding for a better idea (willing to sell even at a loss in order to capitalize on better ideas?)
• Generally, no margin leverage (if you don’t have the cash, don’t play the game)
  
• Not worried about sitting on cash (I chased too many mediocre opportunities and was fully vested. Missed out on my truly best ideas)

And the following table sums up why Wall Street should rarely be trusted.

Lessons Learned in 2008

Towards the end there is a section going over their mistakes. Not surprisingly I too am guilty of some.

• Avoid controlled companies
• Own high quality businesses at attractive prices
• Few exceptions unless extraordinarily cheap

The important point is that even special situation companies in distress should have a free cash flow generative business with valuable assets, moats and a high barrier of entry.

A mistake I tend to make regularly is going after too many opportunities with a finite cash base and high broker fee. In 2008 my expense ratio was a disatrous 4.3%! Although everything seems cheap out there, I will maintain a cash position until I get that “best idea”. I’ve sold PSD and hopefully EMAG will close on schedule which will leave me with around 40% of my portfolio in cash.

I have 1 stalwart, 3 fast growers, 3 turnarounds and 1 cyclical.

For those who have read One Up On Wall Street by Peter Lynch, you’ll know that I’m referring to the 6 categories that he assigns to the companies in his portfolio. As I was reading this section, I had never thought about classifying my positions in terms of growth and return potential. I always looked at the different industries that made up my portfolio and it was refreshing to see it another way.

Let me briefly go through the 6 different categories he discusses in his book.

The Slow Growers

These are the large (although not always), saturated or aging companies that are not expected to grow any faster than your fingernails. They generate more cash than they can spend (I’m sure every wife dreams of a husband like this). Examples include the electric utility and waste companies such as AW, NU and CPK. Even Coca Cola (KO) could be considered as a slow grower. One way to determine a slow grower is by their consistent and increasing dividends or even more easily by their historical charts which shows a flat line.

The Stalwarts

These companies aren’t slow growers, but don’t expect it to grow fast enough to give you 100% gains within 2 years or so. Such companies like Adobe, Home Depot and American Express may be able to provide 15-20% per year depending on when and what price you pay for them but anything beyond those rough numbers is an additional bonus.

Stalwarts can provide outstanding opportunities when it is cheap enough because the company has already established itself yet still has growth potential remaining.

Lynch mentions that he keeps a few stalwarts in his portfolio as they are a good protection during recessions and corrections but they are also one of the first to be sold when a new idea comes up.

After reviewing my past sell and purchase patterns, it too seems like my stalwarts have been the first to be replaced when either a better stalwart or faster growth company appears.

The Fast Growers

The companies that grow aggressively and often have growing pains, yet provide the best opportunities for individual investors before Wall Street comes along. There are thousands and thousands of people who knew about Wal-Mart before it became the monster it is now. There are just as many people who knew about the growth potential of Hansen Natural.

Along with growing quickly, comes the added risk these young companies will end up in bankruptcy or the company may grow tired or out of ideas and turn into a slow grower.

The Cyclicals

Up and down, up and down. Fashion, oil, auto industries are a few examples of cyclical industries. There is usually a predictable pattern of high and low sales. Retail sales are highest during the Christmas shopping season and people usually don’t buy a new car every year. They tend to wait a few years or wait until the economy gets better before making purchases. Even airlines are cyclical because people tend to travel more during the summer, hence the peak and off peak rates.

Lynch informs the reader that too many people label cyclicals incorrectly. An example is Ford and GM. Just because these are established “blue chip” companies, many people expect it to act like a JNJ. Looking at the past shows that the graph is more like a moguls course.

The Turnarounds

A majority of what value investors would invest in. Depressed, beaten and oversold companies rebound to its intrinsic value and beyond very quickly once people realize that the company has been successful in turning itself around. The risk is that turnarounds don’t always happen, and companies end up using all of their cash and they are either back to where they started or worse.

Many companies try to turn itself around by diversifying into other unrelated fields of business just for the sake of trying something. Beware of these companies.

On the other hand, Apple has transformed itself from a successful turnaround to a fast grower. They’ve gone from a mediocre computer company to a killer consumer electronics company.

The Asset Plays

An asset play is where the company owns something much more valuable than just its business. The company may own land where oil lies just beneath or it may hold huge amounts of real estate that has been depreciated in the books for so many years that it doesn’t reflect the true value of the company like Sears. It could also be a huge pile of cash sitting around like Berkshire. Spectrum in the telecommunication and media business is an expensive and desired asset as it can give growth potential, monopolies and can also be resold for millions of dollars.

For asset plays to work out, a great deal of patience is required before the market wakes up.

Portfolio Management

I’ve only assigned one category to one company but there are companies that could be a combination. You could even go further and create your own categories.

Looking at my portfolio it seems like I may have one too many turnarounds, but overall, I’m happy with how my portfolio falls into the criterias. It’s a good reflection of my investing style and strategy.

So there is a brief outline of the 6 categories, but for additional topics in an entertaining and good read, you can read it for yourself by purchasing it here.

Disclosure

No positions held in any stocks mentioned.

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