Lately I’ve been seeing a real uptick in the articles on gold. Even a few have invested in it. I don’t own any gold and I don’t have any exposure to it via miners or other companies. But I often think about the metal and how investors are increasingly fixated on it.
(Flickr:)
Recently, Ben Stein had a chance to interview Warren Buffett and got his thoughts on gold:
My first question, as I sit there on the couch in his office, is: “What about gold? Is this a classic bubble or what?”
“Look,” he says, with his usual confident laugh. “You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”
Okay, so gold is not a screaming buy to Buffett. What should a typical upper-middle-class person in the U.S. buy to prepare for retirement?
“Equities,” Buffett answers without a moment’s hesitation.
My problem with gold is that I think an investment in it requires you to accurately gauge the anxieties and fears of the investors who are buying it. I don’t think I have any talent for doing that. I’ve read a bit on George Soros because his theory of reflexivity seems applicable to playing gold — and Soros has indeed said he intends to keep buying gold, but it’s not a concept I’ve mastered. Maybe mere mortals like us can’t master it. He goes into his theory of reflexivity in detail with his book which I’ve read. While I wouldn’t make an investment decision with his theory, I can see why it works for him.
But, I think the dollar is facing real problems. So finding investments that will protect your purchasing power makes sense.
A lot of people complain that gold is not a productive asset and that’s true. Owning gold is not like owning a business, it probably wont make you rich. I think that beyond supply and demand issues, an investment in gold is really an act of speculation. Gold investors tend to have these specific fears about the economy and see gold as this one commodity that keeps on rising. Inevitably, they must expect that when the time comes they’ll sell to another person at a higher price. That’s momentum investing and it’s a pretty tough game.
However, for some people buying might make sense. A friend, upon hearing what Buffett said that even though all the world’s gold would fill a cube 67 feet in each direction, with its high density it can easily be formed in coins. Plus, with its high value-to-weight ratio, gold can be easily moved. Now contrast that with owning an oil company. You can’t move an oil field and even if you own it, countries can come in and nationalize it or take away your permits. The same goes for farmland. I think it’s for these reasons that gold has remained a store value for so long, even if productively, it’s not very useful.
If you are ultra-wealthy and worth $100M, putting $1M-$5M in gold might make sense as some kind of disaster insurance. If things get really bad, you might be able to flee the country and use your gold holdings to start a new life. From an asset allocation stand point it might make sense. At the same time though, I wonder. If things got so bad that you needed to flee the US, maybe you would be better off investing in guns, ammo, survival training, and canned food.
So would I ever buy gold? Probably not. While I do think the US will face some difficulties such as an elevated level of inflation going forward, I have a hard time wrapping my head around the idea that we’ll be in such bad shape that fleeing the country will be the only option. I’ve seen investors such as Seth Klarman use gold as a disaster hedge without actually owning it. Instead, he used out of the money options which inexpensively gave him exposure to sharp movements in its price. I’m a fan of cheap insurance like that.
I respect the macro though and lately have devoted most of my time recently to finding special situations and event driven value investments. These tend to be more market neutral and have defined catalysts in place, making them easy to test. Right now, to me, that’s a much more appealing strategy than simply buying and holding.
Many of you might remember my post Learning from Michael Burry where I looked at how he started out to get some insights on his investing process. Now, Bloomberg has a new article that talks a bit about where he is finding opportunities:
“I believe that agriculture land — productive agricultural land with water on site — will be very valuable in the future,” Burry, 39, said in a Bloomberg Television interview scheduled for broadcast this morning in New York. “I’ve put a good amount of money into that.”
Agricultural land is one area I’ve thought a bit about. With populations set to increase globally, there will be more demand for food. The thing I have not figured out is a way to play these trend as a value investor. In recent years we’ve seen short bubbles take hold of certain ag. commodities like wheat. Farmland, which is a bit less direct might actually make more sense. If you think about it, when commodities like wheat rise in price there is a real demand for increased production. Governments will try to do whatever they can to keep prices down, so that their people don’t riot. The value of farmland should increase in the long term even as commodities fluctuate, as long as we continue to see a rise in our population.
Another area Burry is looking at is small Asian technology companies:
“I’m interested in finding investments that aren’t just simply going to float up and down with the market,” he said. “The incredible correlation that we’re experiencing — we’ve been experiencing for a number of years — is problematic.”
Still, it’s possible to find opportunities among small companies because large investors and government officials focus on bigger ones, he said. He is particularly interested in small technology firms.
“Smaller companies in Asia, I think, are neglected,” he said. “There are some very cheap companies there.”
I am curious about whether he is looking at China. In some ways, the general disinterest in Chinese equities reminds me of the behavior he saw after the dot com bubble burst. At that time, the general investor community shunned technology firms, despite the fact that many had cash rich balance sheets with virtually no debt. Many of these companies eventually became net-nets or negative enterprise value companies. These were great investments for the value investors that were willing to ignore the words technology and internet, instead choosing to focus on their balance sheets.
If we look at Chinese microcaps today, many trade at incredibly low valuations. There is a good reason for that. The general investor community is worried about the potential frauds that are lurking beneath the surface. I don’t really know how to pick out Chinese frauds well enough to invest in Chinese microcaps. To some extent, I think it is almost a numbers game. Where if you diversify enough you can expect a certain percentage of your portfolio will go to 0 because of fraudulent activities but that a greater percentage will maintain or increase their value.
I wont invest in these Chinese microcaps, but I can imagine that whoever manages to pick the legitimate companies from the frauds will do extremely well.
Finally, Burry is looking at gold:
Gold is also a favored investment as central banks issue debt and devalue their currencies, he said. Governments haven’t adequately addressed the causes of the financial crisis and may be sowing the seeds for future problems by borrowing, he said. In the U.S., lawmakers showed they didn’t understand how to prevent another crisis when they gave the Federal Reserve and Chairman Ben S. Bernanke additional authority, he said.
“The Federal Reserve, in my view, hadn’t seen this coming and in some ways, possibly contributed to the crisis,” he said. “Now, Bernanke is the most powerful Fed chairman in history. I’m not sure that’s the right response. The result tends to tell me they’re not getting it right.”
To me, gold is really a trade where you are trying to profit from the fears/anxieties of the rest of the market. Some traders are very skilled at gauging that kind of sentiment and figuring out when it will shift so that they can then get out of gold and into other assets. I don’t know enough to be able to do that so I’ll stick with analyzing global businesses that have pricing power.
Bloomberg has a video up where you can hear from Michael Burry himself:
For those of you that don’t remember – when I started this blog back in 2007 Fairfax Financial (PINK:/ TSE:) was my largest holding. It was in September and I was nervous about the potential for the sub-prime issue to spread to the rest of the economy. Fairfax represented a really unique opportunity because I purchased shares not only at 1/2 book value but also received the benefits of their credit default swap portfolio which was positioned against major Wall Street financial institutions. In a way, I had an undervalued company which also gave me the ability to hedge against the worst financial crisis in recent history.
Today, in the Wall Street Journal:
As more investors worry about the possibility of deflation—or a sustained period of falling prices that could cripple stocks—Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.
Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter.
The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.
The Fairfax bet, which aims to protect $22 billion of Fairfax’s investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn’t experienced an extended bout of deflation since the Great Depression.
With and , investors went looking for cheap insurance against seemingly improbable events. Today though, that insurance isn’t so cheap. The massive waves of CDOs that were originated in the lead up to the financial crisis helped make a market filled with inexpensive CDSs. That isn’t true for today. To me, insurance is worthless if it is overpriced. Fairfax on the other hand is once again demonstrating their shrewdness. Spending only $174M to protect a $22B portfolio sounds like a good bet:
The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation.
Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.
If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades.
In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment.
The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.
Right now there is a debate about whether we will experience deflation or inflation. It is my thinking that we will follow deflation briefly before inflating our way out of it — moving us into a period of inflation. That seems contrary to Watsa’s bet. But the thing to keep in mind is that Prem Watsa, Fairfax’s CEO, needs to protect his investment portfolio.
Most people don’t realize this, but investment income is what keeps most P&C insurance companies afloat. From 1975 to 2009 there have only been 5 years where the P&C insurance industry generated positive underwriting income. Over the same period insurers had an underwriting deficit of $445B. To make matters worse, we’re in a period of abnormally low interest rates. Most insurers have the bulk of their investment portfolios in fixed income securities. That income is likely to face some downward pressure given today’s yield curve. Some insurers try to chase better yields by going into munis, but I’d be cautious. Some municipalities have rather high budget deficits making the chance of default not entirely unlikely. One might find good short candidates by going through the investment portfolios of different insurers and finding the ones with the worst positioned investment portfolios that are coupled with bad underwriting.
So when I see Prem betting $174M to protect a $22B portfolio against deflation, I don’t necessarily take that as Prem betting the house. $174 million is only about 0.8% of the portfolio. I see this as a way to make sure Fairfax’s investment portfolio, which is crucial to the company’s survival, is protected. As long as their counter parties in the trade (Citibank Canada and Deutsche Bank) survive. It’s entirely possible that the team at Hamblin-Watsa will seek out other derivatives to help them hedge against other adverse macro-economic scenarios. I think that as long as the trades are cheap and offer asymmetric returns, Fairfax will probably consider them.
What does this mean for individual investors like you and me? I think that if right now, you see Fairfax as being undervalued without the derivative trade working out – you might want to consider it for your portfolio. Worst case: you have a cheap insurance company run by one of the best capital allocators in the insurance business. Best case: you have a cheap insurance company that should help hedge your portfolio against deflation. Most individual investors are unable to purchase the kinds of hedges that Fairfax employs, so this is one way to work around that. I would not buy solely on the derivatives trade because we don’t know how long it will take for Fairfax to actually realize their gains (if they realize any at all).
This weekend had two articles on deflation put out by the WSJ and NYTimes. It’s interesting to see the increasing frequency of deflation mentioned in the news. I think that it creates interesting problems for an investor because you never really hear about how to invest in a deflationary environment. Warren Buffett has written extensively on inflation but I cannot recall any letters that go into detail on deflation. That’s probably because deflationary environments are so rare. Both articles provide us with some perspective though.
First up is Paul J. Lim’s
Late last month, Jeremy Grantham, the chief investment strategist at GMO, an investment firm based in Boston, issued a warning about deflation after worrying for months that inflationary pressures were brewing. Mr. Grantham told GMO clients recently that as the recovery has slowed, “downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor.”
In doing so, he joined a growing list of prominent analysts — including William H. Gross, the co-chief investment officer of Pimco — who’ve raised concerns that consumption may be postponed and growth thwarted if price declines occur throughout the economy.
Long periods of deflation are quite rare. In fact, before Japan’s on-again, off-again experience with deflation starting in the 1990s, you have to go all the way back to the Great Depression to find another sustained bout of this trend in the developed world.
One of the issues with deflation is it’s difficult to pick the right historical frame of reference. Japan is brought up the most and I think Richard Koo’s book is regarded as one of the best books on the subject. But some investors don’t even think that Japan will be the right playbook:
Strategists who’ve expressed concerns about deflation aren’t necessarily predicting a return to protracted, Depression-era downward price spirals. “We’re certainly not positioning for a Japan-like scenario,” said Ben Inker, a colleague of Mr. Grantham’s who is GMO’s head of asset allocation.
Robert D. Arnott, chairman of the asset management firm Research Affiliates in Newport Beach, Calif., said that while a brief bout of modest deflation was a threat in the short run, inflation — or rising prices that eat away at consumers’ purchasing power — remained the bigger long-term menace.
He said that growing fears over deflation made it more likely that policy makers would overreact in their attempts to stimulate growth in the economy. And that, in turn, means that “inflation is still what you have to worry about down the road,” he said.
The investors profiled offer a variety of ways to protect your portfolio against deflation. These include long-term government bonds, TIPS, cash, high quality dividend paying stocks, and fixed income securities from companies without highly leveraged balance sheets. I really like the idea of increasing your cash allocation when you start to get worried. That dry powder can be immensely useful when it comes to investing in companies at deep discounts. Whenever the market has a major downturn, its the investors that have a lot of cash who can profit. Moreover, I think that being willing to increase your cash allocation helps you think about the overall valuation of the market. Sometimes, people get so fixated on staying fully invested that they will relax their standards and buy stocks that aren’t really cheap. This behavior leaves you without any real margin of safety in case you’ve missed something in your analysis or if some kind of externality shocks the market.
Then there is Jane J. Kim and Eleanor Laise’s article
Deflation is generally bad news for stocks, since a period of falling prices and weak demand tends to weigh down corporate earnings and, therefore, share prices.
But that doesn’t mean investors concerned about deflation should avoid stocks entirely. Companies with plenty of cash, low debt, steady dividends and products that people will buy even in tough economic times should fare relatively well, analysts say.
And if inflation does come roaring back in the longer term, these companies might still do well because they tend to have significant pricing power. That means they can raise prices to compensate for their own rising costs.
The authors caution that investors should steer clear of financials in a deflationary environment because of the potential for higher defaults and weakened loan demand. The warning on banks is especially important when you think about the commercial real estate market. But what about hard assets?
Gold, which many investors consider an inflation hedge, also can be a useful deflation-fighting tool, analysts say. The government tends to respond to deflationary concerns by printing money, which in turn can spark fears of inflation and drive up the price of the metal. Gold is a hedge against financial stress, and “the source of stress doesn’t matter, whether deflationary or inflationary,” says Joe Foster, manager of the Van Eck International Investors Gold Fund.
In a deflationary period, investors should be especially wary of commercial and residential real estate and the real estate investment trusts that invest in such properties, analysts say. Much of the value of real estate is predicated on an ability to raise rents, says Morningstar’s Mr. Peters. A lack of inflation, little rent-raising power and low occupancy rates, he says, “could come back to hammer this group a second time.”
Gold is not really an investment for me, but I could see its usefulness especially if you think we are going to try to inflate our way out of deflation. It seems as if banks with high CRE exposure might be some of the worst stocks to invest in if you are particularly fearful of a deflation. My thinking is that a higher cash allocation and investments in high quality dividend paying stocks, at perhaps a greater discount than normal might work for smaller investors. I’ve only excerpted certain portions of the articles above, so remember to go back and read the rest.
Last week, Fairfax Financial had their latest quarterly conference call. Fairfax is a holding company of different insurance operations helmed by Prem Watsa, a value investor who is sometimes called the Warren Buffett of the north. I first discovered Fairfax about 3 years ago. I learned of the company’s investing talents and saw that they looked undervalued while trading at a heavy discount to book value. Fairfax also held a portfolio of credit default swaps against major financial institutions which acted as a great hedge against the financial crisis.
Since then, I always look to their commentary to see how they think about today’s markets and their perspectives about risk in the future. Here’s what Watsa said about their hedge ratio:
Prem Watsa
Yes, I’m sorry. So, in response to the in equity markets in 2009, and early 2010, the economic uncertainty in the U.S. our equity hedge ratio to approximately 93% of our equity exposure. The effect of this increase by entering into Russell 2000 and total return swap contracts, average index level of 646.5. This was in addition to the S&P 500. Russell’s total return swap contracts we had done in September 2009 at an S&P 500. Now, I’ll give you some information on the line financials, Thank you.
By hedging 93% of their equity exposure, the folks at Fairfax must really be concerned about the possibility of another downturn. In a recent interview with Value Investor Insight, Watsa outlined some of his worries:
What environment are you positioned for today?
Prem Watsa: The two historical periods we believe are relevant are the U.S. in the Great Depression and the Japanese experience over the last twenty years. In Japan, nominal GDP remained flat for 20 years even though total debt as a percentage of GDP went from 50% to 200%. People will say it’s different this time and that that can’t happen in the U.S. Maybe, but I remember being in Tokyo in 1989 and people were saying the same thing. It won’t be that bad because we have high savings rates, or because the Keiretsu cross-shareholdings provide stability. Look how that turned out.
The economic story was similar in the U.S. in the Depression. After falling dramatically, nominal GNP came back up at the end of the 1930s to where it was in 1929, so there was no growth for the entire period. If not for the war, that would have lasted for a longer time.
So we don’t believe the financial crisis is over. After 20 years in which most developed countries saw leverage going to record levels, we think there are many, many years of deleveraging to go. Governments have tried to step in to mitigate the pain of that process, but as you see already in Europe, attention is turning to cutting spending and raising taxes. We expect after the mid-term elections to see much the same thing in the U.S. With a $1.5 trillion deficit and near-0% interest rates, there aren’t many bullets left.
Our conclusion is that the economy either stays relatively flat as it de-levers, or the economy slips and the resulting crisis of confidence contributes to a double-dip recession.
Are you at all concerned about inflation and rising interest rates?
Prem Watsa: Right now we’re more concerned about deflation, which would reduce Treasury rates even further. If we have a repeat of the U.S. in the 1930s or Japan over the past 20 years, long Treasuries could keep going down – or at least stay very low – for some time.
If we look at Fairfax’s equity portfolio, we can see that it is heavily weighted towards large cap high quality companies like Johnson and Johnson, Kraft, and Walmart. A number of investors have come out saying that large caps present a good value proposition right now – you can find some companies with a steady history of dividend increases and buybacks trading at historically high yields. If you’re worried about inflation, these companies are likely to provide better value than most fixed income investments.
Still, Fairfax has a substantial hedge on their equity portfolio. We know that Seth Klarman of the Baupost Group has also expressed concerns about how fast the market recovered after the crisis. So maybe there is a need to hedge portfolios. Now, smaller investors are precluded from buying the derivatives that Fairfax is using. The simplest choice would be to increase your cash allocation. Klarman has sometimes gone as high as 50% cash in recent year. If you want to get more complicated, you can use cheap insurance by way of out of the money options. With those you can profit immensely if the market declines far more than people expect, you are betting on an improbable event. These options are inexpensive because the event is so improbable to most. The flip side is that you need to continuously rollover that protection because options are targeted to a specific point in time. And it’s a negative carry trade, meaning that each time you are wrong and have to rollover, you lose a little money. The method you choose should fit your investing style. The options approach is definitely going to require more time and a means of offsetting the negative carry (or a willingness to accept it).
I had a chance to interview Zeke Ashton of Centaur Capital and manager of the Tilson Dividend Fund. I think you’ll enjoy the interview. Ashton is a generalist, he is willing to short stocks, and looks across all types of companies — from microcaps to large caps. Plus, he’s based out of Texas. I’ve been hoping to showcase more Texas-based fund managers to prove that we’re not all energy traders down here.
Please give me your thoughts on the interview in the comments section or feel free to e-mail me. I’m always looking for new investors to interview.
You can find more about the Tilson Dividend Fund or learn more about the fund’s performance via .
My questions are in bold.
Can you give us a brief bio of yourself and how you came to run Centaur Capital?
I started my career in the financial software business as a consultant deploying complex treasury and risk management systems for large banks and conglomerates, mostly in Europe. At the time, I thought that my natural career progression might be to become a risk manager for a large bank or insurance company.
Somewhere along the way I developed an interest in the stock market and discovered Warren Buffett’s Berkshire Hathaway letters and was immediately hooked. I also was a big fan of the , and when I decided that I wanted to change careers to investing, I was fortunate enough to land a job there. I moved back to the States and started working for TMF as an investment writer in early 2000 – just in time for the bear market. I spent two years writing articles and research on investing for TMF, which enabled me to learn and refine my own investing approach.
In 2002, I decided that I was ready to start investing professionally, and moved to the Dallas area and started Centaur Capital Partners. I set up a private limited partnership and opened for business with less than $1 million under management, and it took several years to get to the point where Centaur Capital was a viable business. In 2005, we launched a mutual fund called the Tilson Dividend Fund () in partnership with our good friends Whitney Tilson and Glenn Tongue at T2 Partners, and that has done well. We’ve now been in business for eight years, and while it’s not been without its challenges, overall I feel very fortunate to be where I am today.
A while back in 2007 at the about how you think about asset allocation at Centaur. Is it largely the same today? Or has the financial crisis influenced your take on capital allocation?
That VIC presentation was primarily a discussion about portfolio construction, and it was really in reaction to what I thought was a growing pressure amongst value investors to run excessively concentrated portfolios. Keep in mind that this was 2007, and the market had produced a long stretch of good returns from 2003 to early 2007. The book “” had become quite popular, and there were many discussions amongst investors about the potential for employing the Kelly Formula as some sort of secret sauce that would allow investors to increase returns by increasing concentration.
My own view is that most investors are better off running portfolios of 15-25 stocks because such a portfolio would ultimately be a truer reflection over time of an investor’s skill. In other words, a 15-25 stock portfolio has enough concentration to allow a skilled investor to really stand apart from the market, but is not so concentrated that bad luck, bad timing, or one or two mistakes can sink an otherwise competent investor. One of the points of emphasis in that presentation was that concentration shouldn’t be a constant, but rather should be idea and environment dependent. It has always seemed to me that each idea in the portfolio should be sized based on a careful assessment of the body of evidence available for that idea, with particular emphasis on risk factors. This would include factors such as how deeply the security appears to be under-valued, how predictable and reliable the business is, how it is capitalized, the quality and track record of the management team, and even how familiar the investor is with the idea. Also, it should be influenced by the presence of clearly correlated ideas in the portfolio.
I believed then and I believe now that using the flexible 20-stock model portfolio position sizing exercise that I described in the presentation is a very solid framework to start with. In looking back over that presentation today, I wouldn’t change a thing regarding the content of that discussion. But I’d sure like to have the stock picks back – I presented four ideas at that conference and three of the four performed very poorly in the bear market that followed.
How long do you study a potential investment before you decide to buy? After initiating the position, do you continue your research process on the name?
We generally produce a research document that covers all the important components of the investment, both qualitatively and quantitatively, prior to investing. For a simple idea, the document may well be five pages long. For a very complex idea, the report will be longer. But regardless of the complexity of the idea, writing a research document using a fairly standard template serves as both a form of checklist for us and ensures that we both understand the idea and can articulate why the idea meets our criteria for both value and safety. It also allows for a “quality check” in that it can be reviewed by a second analyst internally and even potentially by contacts outside of our shop that may be able to review our work and provide some insight back to us.
You have mentioned in the past that you are increasingly looking at macro data when making an investment. What kinds of macro indicators do you look at? Has there ever been a situation where a stock looked cheap but you did not invest because of the macro?
I wouldn’t say necessarily that we look at macro “data” when making an investment. It is more the recognition that an otherwise compelling idea can get overwhelmed if the larger forces surrounding that idea are negative enough. Going forward, we will probably be a little more cognizant of looking for the larger risks that could really hurt us as investors. As for an example, we basically decided in mid-2008 that we weren’t going to invest in any bank or other leveraged financial business given our concerns about the credit environment, and we sold the one stock he held at that time that qualified, which was American Express (NYSE:). Granted, this was an extreme case, but it did help protect us from the worst of the permanent capital losses that many of our value investing peers suffered in banks and other leveraged financial stocks.
I suspect that our approach going forward when assessing ideas where we have identified a major industry or macro risk would be to use smaller position sizes, demand more compelling prices, or actively look for a way to hedge out any obvious macro risk that we identify if it can be done in a cost-effective way.
When you use valuation methods like DCFs, what kinds of factors do you look at when forecasting? Is it mostly things in the current-year, the past, or your own predictions? How far out do you model?
We use DCFs more as a sanity-check and to reverse engineer current market expectations than to try to produce any kind of precise valuation. When basing our views as far as what the future might look like, we try to look at a longer view of the company’s operating history (normally five to ten years) to see how the business has done over time. As an example, one of our larger current positions is Lab Corporation of America (NYSE:). Qualitatively, this is an outstanding business with tremendous barriers to entry. There is something of a Coke / Pepsi dynamic in the laboratory services industry, with competitor Quest Diagnostics (NYSE:) the slightly larger company in the industry and LH being a strong number two in terms of revenues. LH has been a consistent but moderate grower over many years, with revenue growth in the high single digits and free cash flow growth at around 10% for the last five years. In looking at the recent stock price of around $72, when we plug the numbers into a DCF spreadsheet, we find that the market basically assumes that LH will never be able to grow its free cash flow at more than 2% annually going forward forever. Our view of the company’s growth prospects is significantly more optimistic than that.
So that’s our first sign that LH is a potential opportunity for us.
If I drop in even 5% average FCF growth for LH going out for ten years before dropping down to a terminal growth rate of 2% after that, my spreadsheet tells me the stock is worth $96. Because I’ve owned LH in the past and am extremely familiar with the business, I am very comfortable taking the view that the company will be able to grow its FCF much faster than the current market price is discounting. I don’t have to be super precise. When the stock gets to $85-90, it will be a closer call and I will probably respond by reducing our position size somewhat. So we try to use the full body of evidence we have available about a company, but in general we just don’t buy stocks that require heroic growth assumptions to justify the current price.
You operate largely as a generalist. Sometimes that entails investing in unfamiliar industries. Can you give an example of a case where this happened? What were some of the things you specifically did to learn the ins and outs of the business?
Yes, being a generalist means that one needs to have a framework for getting up to speed quickly when looking at a company or industry that is new for us. So we have learned to quickly identify the business model, which gives us a huge head start in terms of how to approach the research. There really probably aren’t more than a dozen or so basic business models in existence and most companies employ a variation of one of them. Then we start our study of the targeted business and some competitors, and we start reading annual reports, industry publications, and whatever we think we need until we feel we have a good handle on the business. One of the good things about this business is that knowledge is cumulative and the longer I’ve been investing, the more businesses and industries I’ve become familiar with and the faster I am able to get up to speed.
What is one company that you think you would be comfortable with buying and holding for 15 years? Why?
That’s an interesting question, and I’m going to have to answer it by changing your question a bit. We’ve come to believe that if your goal as an investor is to compound at high rates (our goal is 15-20%), that a “buy and hold” philosophy for 15 years simply isn’t likely to work except perhaps in very rare cases. To get that kind of return, you have to buy stocks when they are undervalued and sell them when they are fully valued. Therefore, to give you a stock that I’d be comfortable buying and holding for 15 years simply doesn’t reflect our philosophy, since over a 15-year period we’d expect to have the opportunity to buy a stock at discounted prices and sell it back at full prices multiple times. Of course we are prepared to wait a long time if necessary to get fair value for our holdings, and there are other cases where the performance of the company results in ever-increasing estimates of fair value such that we can hold on to the position for a long time. But we are usually hoping that we will be able to get full value for our stocks within 2-3 years of purchasing them.
So let me give you a list of companies that we admire and that we very much like to own when the stocks are cheap: Fairfax Financial (TSE:), because we admire Prem Watsa. Berkshire Hathaway (NYSE: / ) of course. In our current portfolio, I like Lab Corp (NYSE:), Dreamworks (NASDAQ:), and a small Canadian company called Ag Growth International (TSE:). In all of these, I either have a great deal of comfort and admiration for the management team, or else the business is extremely unique and enjoys a strong competitive advantage.
One of the things that value investors often talk about with shorting is how it gives you potentially unlimited losses. How do you manage risk with shorts?
Shorting is a very tough business, and we continue to learn new lessons every year. I have come to the belief from talking to several guys who are more experienced than myself on the short side that the best way to manage risk is to keep position sizes small and have a slightly more diversified short book. We also limit the size of our overall short exposure. Unlike the long side, where we have no individual position loss limits, we have historically used a position loss limit on short positions, though over time it has probably hurt us as much as it has helped us.
Can you give an example of a past investment mistake? What do you think happened? What did you learn?
Sure. Rather than give you a specific mistake, I’ll give you a category mistake that we’ve made more than once and that I therefore think is one that investors are extremely vulnerable to. The mistake is one of commitment bias, where for example we will decide that a given idea is very compelling but due to its potential risk is justifiable only as a small position. For example, every once in a while we find ideas where there is a very wide range of possible outcomes, but where either the potential magnitude of the return in the good case scenario is very high or we think the probabilities are favorably skewed in our favor. On balance, we’ve done OK with this kind of idea. The problems have come when we’ve initiated the position at an appropriate position size (say, 1% of the fund, or 2% or whatever) but then the stock declines either because of some new development or for another reason. We’ve often added to the stock and built them to inappropriately large position sizes simply due to the lower price, rather than sticking to our initial game plan of limiting our bet. Because of this, we’ve occasionally made what would have been a small loser into a bigger loser.
Another and similar mistake is reacting immediately to a sharp decline in an existing holding on negative news without taking adequate time to fully review the new information to ensure that making the additional deployment is justified by the new development. We try now to be rigorous in ensuring that each incremental add to an existing position is truly justified by the existence of a widening discount to our expected range of fair value and not due to some embedded commitment to the name.
What are some of your favorite books? Investing or non-investing related.
I kind of like to follow good writers around. For financial-related books, I always like to read anything by Roger Lowenstein, with particular nods to his as well as his book that described the causes of the tech and large cap bull market of the late 1990’s. I think Michael Lewis does fantastic work – his latest of course is , but I also loved as well as his non-financial books The Blind Side and .
How do you look at the market cap of a company? Are you less willing to invest in large caps? Do you see more opportunities in one than the other?
No, we don’t care what the market cap is. We are looking to get the best combination of value and safety out of our investment dollars as we possibly can. I do think that large cap, high quality stocks are as cheap now relative to the rest of the market as I’ve ever seen them, and that being the case our portfolio is more heavily weighted to large company stocks than it has been for most of our history.
Can you give us a company that you think is undervalued/attractive right now? What is your thesis there?
Sure. Lab Corp is our biggest position, and I’ve already explained our thinking there. Let me give you an esoteric one. This one is a small position for us, because the stock trades on the pink sheets and isn’t very liquid. Therefore, I’m not making a recommendation, only naming a stock that I personally think is undervalued and attractive. The company is Mass Financial Corp (PINK:), and it trades in the U.S. on the pink sheets under the ticker MFCAF. MFC is a merchant bank specializing in a combination of traditional financing services and proprietary investing, primarily involving commodities and natural resources. The business is run by Michael Smith, who is also the chairman of the company formerly known as KHD Humboldt Wedag and is now called Terra Nova Royalty Corporation (NYSE:TTT).
MFC was spun out of KHD in January 2006, and had negligible book value at the time of its spin-off. The stock trades for $9 and change, and has a market cap of approximately $200 million. In the last four years, MFC has averaged over $40 million in net income and over $50 million in free cash flow. Here’s the book value per-share at the year-end each of the last four years, starting basically from zero at January 2006 (note that the book value per share figures are adjusted for a 9% stock dividend issued in late December 2009):
December 31, 2006 $2.43
December 31, 2007 $4.39
December 31, 2008 $5.71
December 31, 2009 $9.72
Going back further, prior to folding MFC into KHD, Michael Smith ran the company (then called MFC Bancorp) from 1984 to 1995, and during that stretch he grew book value from $1.49 per share to $17.09 per share, which is a pretty impressive performance. Overall, we think that MFC is a very intriguing investment at a discount to book value given the impressive track record.
The downside to an investment in MFC is that there is never really any way to know what Michael Smith is up to. Smith’s policy is to report financial results every six months, and only issues press releases when a material development occurs. In addition, the company’s disclosures are not as highly detailed as one might like regarding its merchant banking and direct investment activities. Nevertheless, the performance of the company speaks for itself, and MFC has an extremely strong and liquid balance sheet and uses very little leverage in its activities, making the historical performance that much more impressive. A couple months ago, MFC took over a majority interest in a micro-cap Canadian listed company called Canoro Resources (CVE:), which has some very interesting oil and gas assets in India. As I mentioned, MFC is a small position for us, but I like having it in the portfolio.
Zeke, thank you for taking the time to interview with Street Capitalist
A while back I mentioned that Monsanto might be a company worth looking at because of their competitive advantage in the seed business. Unfortunately, the stock has moved a lot since we first posted about it at the end of June:
Up 21% in a little less than a month! Too bad I didn’t buy it back then.
Monsanto (NYSE:) has been a real innovator in their field, here is how they define their business:
Monsanto Company (Monsanto) along with its subsidiaries, is a worldwide provider of agricultural products for farmers. The Company’s seeds, biotechnology trait products, and herbicides provide farmers with solutions to produce foods for consumers and feed for animals. The Company operates in two segments: Seeds and Genomics, and Agricultural Productivity.
The thesis you often hear from agriculture bulls of the company is that if the developing world truly does continue its pace of development, we’re going to need more food to nourish those people and that food is going to be grown with the help of Monsanto’s products. Then, if there is a bull market in agricultural commodities — Mosanto’s products will be needed in order to help give farmers the ability to increase their yield and sell for higher prices.
So then what has been the bear case?
We just got out of an agricultural commodity boom and one of the things Monsanto did was steadily increase pricing on their products as the prices of commodities continued to rise. This made a lot of sense when prices for commodities were high, they were able to capture the benefits from the increased yield in their crops. But Monsanto did not adjust pricing as commodities started to fall. That caused a drop in sales which led to an increase in inventories.
Now, I haven’t had a chance to do much valuation work on Monsanto. I know the company on a more qualitative basis. But, Glenn Busch from ValueInvestingCenter has taken a stab at valuing the company:
The Seed and Genomics division is by far the largest division at Monsanto CO. (MON) based on revenues; it accounts for 62% of Monsanto’s revenue. In fiscal year 2009 the Seed and Genomics division had $7.29 billion in sales. For fiscal year 2009 the Seed and Genomics division had a Gross Margin of 61% and an Operating Margin of 22%. In 2008 Seeds and Genomics had an operating margin of 18%. The increase in margins has been due to the launch of newer- higher margin products. Margins are expected to continue to increase further based on more launches of higher margin products like Genuity VT Triple Pro Corn.
For the discounted cash flow that I will run on this division I will use an operating margin of 20% even though recent margins have been higher and are expected to increase further. I will use current interest expenses and taxes but I will use normalized Statement of Cash Flows line items. For growth rates, I will use the median analyst estimate of 10% and the lowest analyst estimate of 6%. I will use 10% as the discount rate because Monsanto CO. (MON) is a large multi-national company with minimal debt and a leader in its field. Currently, Monsanto Co. (MON) has 545 million shares outstanding and to keep it simple I will not factor in any share buybacks.
Below is the range of values for the Seed and Genomics division.
6% Growth = $51.00
10% Growth = $59.00
With Monsanto Co. (MON) currently trading around $57.00 we’re pretty much getting fair value for the Seed and Genomics division and everything else free.
According to Busch, one of the problems was in Monsanto’s agricultural products division. Monsanto produces a herbicide called Roundup, which featured lower adoption rates due to a flood of competitors (they lost patents) and some customers over pricing. They’ve had to reduce prices to clear out excess inventory which has carried over into their margins. Here is Glenn’s take on the division:
I will value the worst case scenario like a perpetuity using a discount rate of 10%. I’ve chosen to value the worst-case scenario like a perpetuity because Roundup is still the largest selling glyphosate product on the market. Glyphosate is also the largest herbicide in use and has been this way for a long time. Monsanto lost its U.S. Patent in 2000 and still has maintained a high level of Roundup sales. I would expect Monsanto to continue to sell more Roundup than what I’m basing this valuation on.
Below is my value for the worst case scenario.
$3.90
So in Glenn’s low case, Monsanto is worth $54.90 all together versus a current price of $57.32. Not a bargain, but it could be if we see another AgBoom because Monsanto could simply increase the prices on their products and reap the benefit. , which you should read to get the whole picture. I’ve only excerpted part of it.
My name is Tariq Ali, I run Street Capitalist. I recently graduated from the University of Texas at Austin. There, I stumbled onto value investing via the school library. I read everything I could and now I'm here, writing out my thoughts and investment ideas.
I have a lot of heroes when it comes to investing, it seems like every investor has some kind of niche. Some, whose books and writings have had the biggest impact on me are: , ,, , and .
Have any questions? Want to stay in touch?
Feel free to e-mail me at TariqTX@gmail.com
Recent Comments