Tag Archives: portfolio management

Review – The Art of Execution (@harriman, #investing)

The Art of Execution: How the world’s best investors get it wrong and still make millions (buy on Amazon.com)

by Lee Freeman-Shor, published 2015

A “valueprax” review always serves two purposes: to inform the reader, and to remind the writer. Find more reviews by visiting the Virtual Library.

Note: I received a promotional copy of this book from the publisher in exchange for sharing my thoughts AFTER reading it.

Professor Failure

What can we learn from failure? Aside from the fact that there’s an entire industry of business literature fetishizing the idea that it has much to teach us (as a kind of doppelgänger to the decades of success literature that took a person or business’s success as given and tried to look backward for an unmistakeable pattern that could’ve predicted it) I’m personally skeptical of what failure might teach. Life is complex and there is often little to separate the failure and the success but timing and luck in certain endeavors.

So, I approached Freeman-Shors book with some trepidation as the subtitle of the book suggests this is a study of failure. Au contraire, what we have here is actually a psychological or behavioral study, somewhat in the vein of Benjamin “you are your own worst enemy in investing” Graham, which studies not failure per se, but rather how investors respond differently to failure and thereby either seal their fate or redeem themselves.

A Behavioral Typology

The book recounts the investment results of several different groups of portfolio managers who were categorized, ex post facto, into various groups based upon how they reacted to adverse market conditions for stocks they invested in. The Rabbits rode most of their failed investments down to near-zero before bailing out and taking the loss. The Assassins had a prescribed set of rules for terminating a losing position (either a % stop-loss, or a maximum time duration spent in the investment such as a year or a quarter). The Hunters kept powder dry and determined ahead of time to buy more shares on a pullback (ie, planned dollar-cost averaging).

While I am suspicious of backward-looking rule fitting, I do think the author’s logic makes sense. What it boils down to is having a plan ahead of time for how you’d react to failure. The Rabbits biggest mistake is they had none whatsoever, while the Assassins managed to protect themselves from total drawdowns but perhaps missed opportunities to profit on volatility rebounds. The author seems most impressed with the Hunters, who habitually started at a less than 100% commitment of funds to a planned position and then added to their investment at lower prices when the market gave them an opportunity to do so.

Freeman-Shor’s point is that when the price falls on your investment you need to decide that something material has changed in the story or facts and you sell, or else you need to be ready to buy more (because if it was a good buy at $10, it’s a great buy at $5, etc.) but you can not just hang tight. That isn’t an investment strategy. This is why I put this book in the Benjamin Graham fold, the message is all about being rational ahead of time about how you’d react to the volatility of the market which is for all intents and purposes a given of the investing landscape.

Learning From Success, Too

The author goes over a couple other behavioral typologies, Raiders and Connoisseurs. I won’t spoil the whole book, it suffices to say that this section is worth studying as well because it can be just as nerve-wracking to try to figure out whether to take some profit or let a winner ride when you have one. Freeman-Shor gives some more thoughts based on his empirical observations of other money managers who have worked for him on when it’s best to do one or the other.

More helpfully, he summarizes the book with a winner’s and loser’s checklist.

The Winner’s Checklist includes:

  1. Best ideas only
  2. Position size matters
  3. Be greedy when winning
  4. Materially adapt when losing
  5. Only invest in liquid stocks

The last bit is probably most vital for a fund manager with redeemable capital.

The Loser’s Checklist includes:

  1. Invest in lots of ideas
  2. Invest a small amount in each idea
  3. Take small profits
  4. Stay in an investment idea and refuse to adapt when wrong
  5. Do not consider liquidity

Free e-Book With Purchase!

It is hard for me to decide in my own mind if this book is a 3.5 or a 4 on a 5-point scale. I think of a 5 as a classic, to be read over and over again, gleaning something new each time. This would be a book like Security Analysis or The Intelligent Investor. A 4 is a good book with a lot of value and a high likelihood of being referenced in the future, but not something I expect to get a new appreciation for each and every time I read it. A 3 is a book that may have been enjoyable overall and provided some new ideas but was overall not as interesting or recommendable.

While I enjoyed this book and did gain some insight from it, and I think the editorial choices in the book were bold, it’s closer to a 3 in my mind than a 4 just in terms of the writing and the ideas. I’ve found a lot of the content in other venues and might’ve rated it higher on my epiphany scale if this was one of the first investment books I ever read.

But something that really blew me away is that the publisher, Harriman House, seems to have figured out that people who buy paper books definitely appreciate having an e-Book copy for various reasons and decided to include a copy for free download (DRM-free!!) in the jacket of the book. This is huge. I read my copy on a recent cross-country flight and was really agonizing about which books from my reading stack wouldn’t make the trip for carry-on space reasons and then realized I could take this one with me on my iPad and preserve the space for something else. That’s a big value so I am going with a 4 as a result.


Notes – Original Issue Discount (OID) Tax Implications, Lessons Learned (#taxes, #investing)

In the process of carrying out the KV Pharmaceuticals capital structure arbitrage trade of 2012, I got caught with my pants down a bit as I didn’t think to sell the convertible notes before they stopped trading. As a result, I missed an opportunity to lock in a capital loss for tax purposes at the time, which would’ve helped shield some of the income I made on the puts and thus made the trade as a whole more tax efficient.

Instead, I got a double-whammy of tax inefficiency for my ignorance, a chicken that finally came home to roost in tax FY2013 as the CPA assisting me with my tax preparation informed me that I ended up owing an additional sum beyond amounts withheld in prior periods due to Original Issue Discount (OID) interest income related to my defunct KV Pharmaceuticals play!

At first I was shocked and dismayed– the company went into bankruptcy and the securities were eventually removed from my account entirely earlier this year. How could I owe taxes when I never earned any cash interest and will never get back even a penny from the securities I stupidly held onto?

I talked about it with my CPA (who double-checked with his partner) and then spoke to a rep at TD Ameritrade and the matter is decisively not going to turn out in my favor. I learned that when a bond goes into default it often switches from cash interest basis to accrual interest basis in the eyes of the IRS, and like any good group of thugs they want their blood now, not later. In other words, I owe federal income tax on “accrued interest” I not only never received but never will receive. Because the securities were removed from my account in 2014 and not 2013, it looks like I accrued interest income due to me even though we clearly know right now that I’ll never get it.

Instead, I get a stepped up cost basis on the securities (in the amount equal to the accrued interest not received) so when I finally report the loss for FY2014 taxes, it’ll be a total loss of X + Y instead of just X. I get to shield additional future income with the X + Y amount but I paid real cash up front for the privilege.

If I had known better, I would’ve executed this trade such that the gains and losses all occurred in the same period in 2012. I also probably wouldn’t have gotten into a trade in the first place whose money-making mechanics I generally understood but about whose technical execution and tax implications I was grossly ignorant.

Another expensive lesson learned!

Notes – Buffett Partnership Letters, 1957-1970 (#valueinvesting)

Recently I sank into my overstuffed armchair (in this situation, “sank” is used derisively to connote frustration and discomfort with regards to ideal reading conditions) with a copy of Buffett’s partnership letters from the 1957-1970 period in my hands. I found them on CSInvesting.org and had never taken the time to read them before, but figured it was about time as I was curious to consult a primary source on this period of Buffett’s investment career, having already read a 3rd-party recounting in The Snowball.

My interest was to read critically. Buffett’s letters have been read and analyzed and mulled over by thousands of investors and business people and have been discussed ad nauseum. But everyone seems to come away with the same lessons and the same pithy quotes that they throw up on their blogs when appropriate. I wanted to see if I could find anything original. From my own set of knowledge and understanding of Buffett and “how he did it”, I achieved my goal, but I can not guarantee creativity to anyone else who may be reading this. Somehow, somewhere in some overlooked nook of this vast interweb, I may have missed the discussion where someone went over these exact points.

Market timing, or the “value climate”

Amongst value investors, the sin of attempting to time the market is considered to be one of the greatest (for example, see the special note at the end of my recent review of The Intelligent Investor). Luminaries like Graham warn us that attempting to jump in and out of the markets according to their perceived price level being high or low is a speculative activity that will be rewarded as such, which is to say, it’ll eventually end in disaster.

However, while value gurus like Graham warned against market timing as a primary tool of analysis in an investment program, it’s also true that both Graham and Buffett were nonetheless intimately aware of market valuations and sentiment and both of them discussed the way their perception of market valuation influenced their portfolio orientation at any given time. For Graham and his intelligent investors, the response was to weight the portfolio toward bonds and away from stocks when the market was high and the opposite when the market was low. Similarly, Buffett advised in his 1957 letter:

If the general market were to return to an undervalued status our capital might be employed exclusively in general issues… if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio

This quote alone, along with many others just like it throughout the partnership letters, makes it clear the Buffett did not ignore broad market valuations. And not only did he not ignore them, he actively manipulated his portfolio in response to them. However, there are a few key things to note in terms of the heavily nuanced differences between what Buffett did and what the average market timer does:

  • Market timers are forecasters, they act on a perceived market level because of their anticipation about future market levels; Buffett refused to speculate about what the future of the market level might be and instead accepted it for what it was, changing what he owned and in what proportions, not whether he was invested or uninvested
  • Market timers are binary, choosing between “risk on” or “risk off”; Buffett responded to higher market levels by seeking to gain greater exposure to market neutral opportunities (special situations revolving around corporate action) while still continuing to make investments in individual undervalued businesses as he found them
  • Market timers always maintain the illusion of “full control” knowing they can always sell out or buy in any time they like in response to market valuations; Buffett acknowledged that many times he might desire to have greater market neutral exposure but that such opportunities might dry up in the late stages of a bull market, dashing his plans

The importance of relative performance

Another concept of Buffett’s money management style that stood out was his obsession with relative performance. I found this interesting again because the orthodox value investment wisdom is that it is not relative, but absolute, performance which matters– if you permanently lose a portion of your capital in a period, but your loss is smaller than your benchmark, you’ve still lost your capital and this is a bad thing.

Again, from the 1957 letter, Buffett turned this idea on its head:

I will be quite satisfied with a performance that is 10% per year better than the [Dow Jones Industrial] Averages

Because Buffett calculated that over the long-term the DJIA would return 5-7% to shareholders including dividends, Buffett was aiming for a 15-17% per annum performance target, or about 3x the performance of the Dow. But, as always, there was an important twist to this quest for relative out performance. In his 1962 letter, Buffett stated in no uncertain terms:

I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets. Preferably these should involve a substantial decline in the Dow. Our performance in the rather mild declines of 1957 and 1960 would confirm my hypothesis that we invest in an extremely conservative manner

He went on to say:

Our job is to pile up yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus. I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%

And he concluded by noting:

Our best years relative to the Dow are likely to be in declining or static markets. Therefore, the advantage we seek will probably come in sharply varying amounts. There are bound to be years when we are surpassed by the Dow, but if over a long period we can average ten percentage points per year better than it, I will feel the results have been satisfactory.

Specifically, if the market should be down 35% or 40% in a year (and I feel this has a high probability of occurring in one year in the next ten– no one knows which one), we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much

In his 1962 letter, he added further detailing, sharing:

Our target is an approximately 1/2% decline for each 1% decline in the Dow and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative

Why did Buffett focus so much on relative out performance in down years? Because, as a value investor, he was obsessed with permanent loss of capital. In a broad sense, making money in the market is somewhat easy as over long periods of time as the market has historically tended to rise higher and higher. Every now and then, however, it corrects sharply to the downside and it is in these moments when the average investor panics and sells out at a loss, thereby permanently impairing his capital.

Buffett believed that by buying at a discount and taking a more conservative approach to the investment problem from the outset, he would limit any losses he might sustain in the inevitable downturns in the market. This by itself would put him ahead of other market participants because he’d have more of his capital intact. The real power behind this strategy is what comes afterward, as then the just-as-inevitable recovery would continue the compounding process again– with more of his original capital than the other guy, Buffett would enjoy greater pure gain over time as he would have a relatively shallower hole to climb out of each time.

True Margin of Safety: two pillars of value

Fellow value investor Nate Tobik over at OddballStocks.com has talked repeatedly about one of Ben Graham’s concepts which he refers to as the “two pillars of value”, namely, that a company which represents a bargain both on the basis of a discount to net assets and a discount earnings is the most solid Margin of Safety one can possess because you’re not only protected two ways but you also have two ways to “win.”

Reading the Buffett partnership letters, it’s clear that the reason Buffett was knocking it out of the park in his early years was because he relied upon the same methodology. Buffett later was critical of his own early practices and many others have derided the investment style as akin to picking up soggy cigar butts and taking the last puff before discarding them, but there is no denying in studying several of the investments Buffett disclosed that Buffett was buying things which were “smack you over the head” cheap.

For example, in the 1958 letter, Buffett disclosed the partnerships’ investment in Commonwealth Trust Company of New Jersey, a small bank. Buffett claimed the company had a computed per share intrinsic value of $125, which was earning $10/share and trading for $50. This meant that Buffett bought the company for 40% of book value, or at a 60% margin of safety to indicated value. And, in two pillar tradition, he was also buying at a 5x multiple of net earnings– by any standards, an incredibly cheap value. If one were to look at the company as a bond and study it’s earnings yield, this company was offering a 20% coupon!

Making good buys, not good sales

In the example of Commonwealth Trust Co. discussed earlier, though Buffett calculated an intrinsic value of $125/share, he ultimately sold for only $80/share. He did not sell out near intrinsic value but rather far below it. Still, because he had originally bought at $50/share, he nonetheless earned a 60% return despite the company trading at a still-substantial discount to intrinsic value.

As Buffett chirped in his 1964 letter:

Our business is making excellent purchases– not making extraordinary sales

Why does Buffett harp on this idea so frequently? There are a few reasons.

One, an excellent purchase price implies a substantial discount to intrinsic value and earnings power, therefore there is a built-in margin of safety and the downside is covered, a principle of central importance to sound investing.

Two, an individual has 100% control over when they buy a security but relatively little control over when and in what conditions they sell, particularly if they use margin. You may not always get the price you want when you are ready to sell but you will always get the price you want when you buy because that decision is made entirely by you and doesn’t require the cooperation of anyone else. Buying at a discount ensures you “lock in” a profit up front.

Three, buying at a discount gives one optionality. If a better deal comes along, it is more likely you can get back out of your original investment at cost or better when you buy it cheap. When your original purchase price represents a substantial discount you have a better chance of finding a buyer for your shares because even at higher prices such a sale would probably still represent a bargain to another buyer meaning both parties can feel good about the exchange.

This last point was critical in Buffett’s Commonwealth situation. He was happy to sell at only $80/share despite a $125/share intrinsic value because he had found another opportunity that was even more compelling and because his original purchase price was so low, he still generated a 60% return. Meanwhile, the other party who took this large block off his hands was happy to provide the liquidity because they still had a 56% upside to look forward to at that $80/share price.

Early activism, the value of control

Another lesson from Buffett’s partnership letters is the importance and value of activism and control. From an activism standpoint, the examples of Sanborn Maps and Dempster Mills are well-known and don’t require further elaboration in this post (follow the links for extensive case study analysis at CSInvesting.org, or even read Buffett’s partnership letters yourself to see his explanation of how these operations worked).

But activism is something that is best accomplished with control, and often is its by-product. On the topic of control, Buffett said in his 1958 letter with regards to Commonwealth:

we became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal

By gaining a large ownership share in an undervalued company, an investor can play a more active role in ensuring that potential catalysts which might emerge serve to adequately reward shareholders. Similarly, time is money and when one has control,

this has substantial advantages many times in determining the length of time required to correct the undervaluation

An investment situation offering, say, a 30% return, offers a 30% annualized return if captured within a year, a 15% annualized return if gained after two years and only a 10% annualized return if it takes 3 years to realize value. Having control can often be the difference between a 30% and a 10% annualized return by allowing an investor to accelerate the pace at which they turn over their capital.

It is a myth, therefore, that Buffett only became a wholesale/control buyer as he employed greater amounts of capital in his later years. While many of his investments were passive, minority positions in the partnership years, Buffett never shied away from control and activism, even saying in his 1961 letter:

Sometimes, of course, we buy into a general with the thought that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen

In this sense, “value is its own catalyst” and something which is cheap and remains cheap for an extended period of time can actually be a unique opportunity to accumulate enough shares to acquire control, at which point the value can be unlocked through asset conversion, a sale or merger of the company or through a commandeering of the company’s earnings power.

Portfolio buckets: generals, work-outs and control

In his 1961 letter, as well as later letters, Buffett outlined the three primary types of investments that could be found in the partners’ portfolios, the approximate proportion of the portfolio to be involved with each and the basis upon which such investments should be chosen.

The “bread and butter” according to Buffett was his “generals”, businesses trading at substantial discounts to their intrinsic value which were purchased with the intent of eventually being resold at a price closer to the intrinsic value:

our largest category of investment… more money has been made here than in either of the other categories… We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen… Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price… individual margin of safety coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential… [we] are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner

While admitting that the particular and eventual catalyst was often not known with the average investment in a general security, Buffett also admitted in his 1963 “Ground Rules” letter section:

Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use

The next category was workouts:

our second largest category… ten or fifteen of these [at various stages of development]… I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior

The beauty of work-outs is that they relied on corporate action, not market action, to realize value. In this sense, they could provide a meaningful buffer to share price declines in generals during bear markets as their performance was largely “market neutral.” For example, in his 1963 (1962 being a bear market) letter Buffett said:

This performance is mainly the result of having a large portion of our money in controlled assets and workout situations rather than general market situations at a time when the Dow declined substantially

The final category was control, which started out as something of an after-thought or an accidental consequence of investing in certain generals which remained cheap, but later turned into an active category Buffett would search for opportunities in.

Buffett also mentioned the idea of the “two-way stretch” in control situations– if bought at a significant discount, there were generally two ways to profit from a control investment. Either the stock price remained low for a long period of time and control was acquired, in which case “the value of our investment is determined by the value of the enterprise,” or else the stock would move up in the process of consolidating a position in which case it could be sold at a higher level in the way one would normally “complete a successful general operation.”

Time horizons for performance

This particular point is more well-known but it bears repeating here. Buffett was obsessed with long-term performance and constantly advised his partners about appropriate timelines for judging investment performance, especially based-upon the particular type of investment being considered. For example, in his 1960 letter he said:

My own thinking is more geared to five year performance, preferably with tests of relative results in both strong and weak markets

In the 1961 letter, Buffett discussed “establishing yardsticks prior to the act” and again emphasized:

It is my feeling that three years is a very minimal test of performance, and the best test consists of a period at least that long where the terminal level of the Dow is reasonably close to the initial level

In other words, what did your performance look like after a three year period where the broad market index made no progress, or even reversed?

With control situations specifically, Buffett advised:

Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it


It’s clear that Buffett had 15-21 “generals” or about 50-60% of his portfolio, with another 10-15 positions in workouts or another 15-30%, with the remainder in control situations. However, control situations could scale up to as much as 40% of the portfolio in an individual investment if the situation called for it in Buffett’s mind.

And while Buffett mentioned in an earlier letter of having approximately 40 positions in the portfolio in total, he later (around the time he started being influenced by Charlie Munger and other “quality over quantity” investment practitioners) became more critical of the idea of diversification. In the 1966 letter, Buffett lamented:

if anything, I should have concentrated slightly more than I have in the past

He also castigated “extreme diversification”:

The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has in the overall portfolio expectation

Buffett was learning the merits of “concentration” in areas outside the portfolio, as well. In discussing slight additions to the office space at Kiewit Plaza and the hiring of additional support personnel, Buffett added:

I think our present setup unquestionably lets me devote a higher percentage of my time to thinking about the investment process than virtually anyone else in the money management business

Of course, the results of this focus were obvious to all in time.

Sizing things up

Buffett dwelled on “the question of size” at length in his letters to partners. He made it clear that portfolio size and investment opportunity looked something like a continuum with small size on the left of the spectrum and large size on the right, with “generals” hanging near the left pole (size is a disadvantage), workouts inhabiting some kind of middle ground where they were neither benefitted nor impaired by size and control situations distinctly on the right where size was an enormous advantage.

Generals and control situations are, in this sense, almost opposites because Buffett warned that some generals were too small to buy meaningful stakes in for a large portfolio, whereas a small portfolio might never be able to acquire enough shares to gain control of certain investments.

Inflation-adjusting Buffett’s portfolio positions and capital at various points in time also gives important clues to the role size played in his operations. For example, Sanborn Maps was apparently around a $4.5M market cap when he mentioned the company in his letters. This would be about $35M or so in today’s dollars (this is not an endorsement of BLS/CPI measurement techniques, just a convenient rule-of-thumb), so clearly Buffett was hunting in a small/micro-cap space at least at this time.

In a similar vein, Buffett started with $105,000 in capital in 1956, which is about $893,000 in 2012. In his 1966 letter, he complained that the amount of capital being managed at the time, $43,645,000, was beginning to be burdensome in terms of size versus opportunities. This would be about $312,000,000 in 2012, to put it into perspective.

Apparently, the value investment framework Buffett created could work quite well even at a scale that we might consider to be decently large.

Serendipity: the reason for Buffett’s rise, and retirement

Few ever think to mention the incredible role serendipity played in Buffett’s early fortunes, but Buffett himself was well-aware. Not only did he begin his career at the outset of an astounding decade-long-plus bull market, but in 1952,

and for some years subsequently, there were substantial numbers of securities selling at well below the “value to a private owner” criterion we utilized for selection of general market investments

As the bull market started to grow gray hairs in the late 1960s and Buffett began contemplating an exit from the business, he similarly remarked in his 1967 letter:

Such statistical bargains have tended to disappear over the years. This may be due to the constant combing and recombing of investments that has occurred during the past twenty years, without an economic convulsion such as that of the ’30s to create a negative bias toward equities and spawn hundreds of new bargain securities

The comment on the aftermath of the 1930s bears repeating. The primary reason for the prevalence of bargain issues in the market around the time Buffett started investing was due to a massive psychological paradigm shift in attitudes about the stock market following the crash of 1929 and subsequent depression of the 1930s. By the late 1960s, a new inflationary thrust had managed to erase this psychology and great gains were actually made in sending it in the reverse direction. Buffett was convinced of

the virtual disappearance of the bargain issues determined quantitatively

the kind whose figures “should hit you over the head with a baseball bat”, which were being replaced by

speculation on an increasing scale

So how did Buffett respond to these new market conditions where his toolkit didn’t seem to work as well? Did he compromise his standards, or try to shape-shift his style into the “New Era” of investors and keep going? Well, anyone who has studied Buffett already knows the answer. Buffett knew his circle of competence and he knew what worked. When what he knew worked stopped working (because the opportunities weren’t available), he quit.

Despite writing in his 1968 letter that the answer to a potential phase out of the partnerships was “Definitely, no.” Buffett nonetheless in his 1969 letter suggested that “the quality and quantity of ideas is presently at an all time low” and that “opportunities for investment that are open to the analyst who stresses quantitative factors have virtually disappeared” and for this reason, he decided to close up shop.

There’s a lesson for all of us here. As Joel Greenblatt has argued, value investing doesn’t work all the time, which is why it works. We should respect this, just as Buffett did– when the deals dry up, we should go fishing (or at the very least, look for bargains in other markets that are in a different stage of psychology/sentiment/valuation). Trying to make great long-term returns when valuations won’t support it is a fools game and more likely to end in failure.

A few miscellaneous notes

In the 1968 letter, Buffett referred to 10-12% as “worthwhile overall returns on capital employed”.

With regards to dividends, although Buffett always described the return of the Dow for each annual period inclusive of dividends earned, and although when describing his investment in Commonwealth he specifically mentioned that the company was not paying dividends, and although we know from an anecdote in The Snowball that Buffett was receiving substantial dividend checks from his partnership portfolios because his wife Susie accidentally through a few away one time, I noticed that Buffett makes no specific mention in any of the letters of the importance of dividends nor that dividends impacted his investment decisions or philosophy.

Notes – How Did I Come Up With My 16 JNets? (#JNets, #NCAV)

A couple days ago someone who follows my Twitter feed asked me what criteria I had used to pick the 16 JNets I talked about in a recent post. He referenced that there were “300+” Japanese companies trading below their net current asset value. A recent post by Nate Tobik over at Oddball Stocks suggests that there are presently 448 such firms, definitely within the boundaries of the “300+” comment.

To be honest, I have no idea how many there are currently, nor when I made my investments. The reason is that I am not a professional investor with access to institution-grade screening tools like Bloomberg or CapitalIQ. Because of this, my investment process in general, but specifically with regards to foreign equities like JNets, relies especially on two principles:

  • Making do with “making do”; doing the best I can with the limited resources I have within the confines of the time and personal expertise I have available
  • “Cheap enough”; making a commitment to buy something when it is deemed to be cheap enough to be worthy of consideration, not holding out until I’ve examined every potential opportunity in the entire universe or local miniverse of investing

That’s kind of the 32,000-ft view of how I arrived at my 16 JNets. But it’s a good question and it deserves a specific answer, as well, for the questioner’s sake and for my own sake in keeping myself honest, come what may. So, here’s a little bit more about how I made the decision to add these 16 companies to my portfolio.

The first pass

The 16 companies I invested in came from a spreadsheet of 49 companies I gathered data on. Those 49 companies came from two places.

The first place, representing a majority of the companies that ultimately made it to my spreadsheet of 49, was a list of 100 JNets that came from a Bloomberg screen that someone else shared with Nate Tobik. To this list Nate added five columns, to which each company was assigned a “1” for yes or a “0” for no, with category headings covering whether the company showed a net profit in each of the last ten years, whether the company showed positive EBIT in each of the last ten years, whether the company had debt, whether the company paid a dividend and whether the company had bought back shares over the last ten years. Those columns were summed and anything which received a “4” or “5” cumulative score made it onto my master spreadsheet for further investigation.

The second place I gathered ideas from were the blogs of other value investors such as Geoff Gannon and Gurpreet Narang (Neat Value). I just grabbed everything I found and threw it on my list. I figured, if it was good enough for these investors it was worth closer examination for me, too.

The second pass

Once I had my companies, I started building my spreadsheet. First, I listed each company along with its stock symbol in Japan (where securities are quoted by 4-digit numerical codes). Then, I added basic data about the shares, such as shares outstanding, share price, average volume (important for position-sizing later on), market capitalization, current dividend yield.

After this, I listed important balance sheet data: cash (calculated as cash + ST investments), receivables  inventory, other current assets, total current assets, LT debt and total liabilities and then the NCAV and net cash position for each company. Following this were three balance sheet price ratios, Market Cap/NCAV, Market Cap/Net Cash and Market Cap/Cash… the lower the ratio, the better. While Market Cap/Net Cash is a more conservative valuation than Market Cap/NCAV, Market Cap/Cash is less conservative but was useful for evaluating companies which were debt free and had profitable operations– some companies with uneven operating outlooks are best valued on a liquidation basis (NCAV, Net Cash) but a company that represents an average operating performance is more properly considered cheap against a metric like the percent of the market cap composing it’s balance sheet cash, assuming it is debt free.

I also constructed some income metric columns, but before I could do this, I created two new tabs, “Net Inc” and “EBIT”, and copied the symbols and names from the previous tab over and then recorded the annual net income and EBIT for each company for the previous ten years. This data all came from MSN Money, like the rest of the data I had collected up to that point.

Then I carried this info back to my original “Summary” tab via formulas to calculate the columns for 10yr average annual EBIT, previous year EBIT, Enterprise Value (EV), EV/EBIT (10yr annual average) and EV/EBIT (previous year), as well as the earnings yield (10yr annual average net income divided by market cap) and the previous 5 years annual average as well to try to capture whether the business had dramatically changed since the global recession.

The final step was to go through my list thusly assembled and color code each company according to the legend of green for a cash bargain, blue for a net cash bargain and orange for an NCAV bargain (strictly defined as a company trading for 66% of NCAV or less; anything 67% or higher would not get color-coded).

I was trying to create a quick, visually obvious pattern for recognizing the cheapest of the cheap, understanding that my time is valuable and I could always go dig into each non-color coded name individually looking for other bargains as necessary.

The result, and psychological bias rears it’s ugly head

Looking over my spreadsheet, about 2/3rds of the list were color-coded in this way with the remaining third left white. The white entries are not necessarily not cheap or not companies trading below their NCAV– they were just not the cheapest of the cheap according to three strict criteria I used.

After reviewing the results, my desire was to purchase all of the net cash stocks (there were only a handful), all of the NCAVs and then as many of the cash bargains as possible. You see, this was where one of the first hurdles came in– how much of my portfolio I wanted to devote to this strategy of buying JNets. I ultimately settled upon 20-25% of my portfolio, however, that wasn’t the end of it.

Currently, I have accounts at several brokerages but I use Fidelity for a majority of my trading. Fidelity has good access to Japanese equity markets and will even let you trade electronically. For electronic trades, the commission is Y3,000, whereas a broker-assisted trade is Y8,000. I wanted to try to control the size of my trading costs relative to my positions by placing a strict limit of no more than 2% of the total position value as the ceiling for commissions. Ideally, I wanted to pay closer to 1%, if possible. The other consideration was lot-sizes. The Japanese equity markets have different rules than the US in terms of lot-sizes– at each price range category there is a minimum lot size and these lots are usually in increments of 100, 1000, etc.

After doing the math I decided I’d want to have 15-20 different positions in my portfolio. Ideally, I would’ve liked to own a lot more, maybe even all of them similar to the thinking behind Nate Tobik’s recent post on Japanese equities over at Oddball Stocks. But I didn’t have the capital for that so I had to come up with some criteria, once I had decided on position-sizing and total number of positions, for choosing the lucky few.

This is where my own psychological bias started playing a role. You see, I wanted to just “buy cheap”– get all the net cash bargains, then all the NCAVs, then some of the cash bargains. But I let my earnings yield numbers (calculated for the benefit of making decisions about some of the cash bargain stocks) influence my thinking on the net cash and NCAV stocks. And then I peeked at the EBIT and net income tables and got frightened by the fact that some of these companies had a loss year or two, or had declining earnings pictures.

I started second-guessing some of the choices of the color-coded bargain system. I began doing a mish-mash of seeking “cheap” plus “perceived quality.” In other words, I may have made a mistake by letting heuristics get in the way of passion-less rules. According to some research spelled out in an outstanding whitepaper by Toby Carlisle, the author of Greenbackd.com, trying to “second guess the model” like this could be a mistake.

Cheap enough?

Ultimately, this “Jekyll and Hyde” selection process led to my current portfolio of 16 JNets. Earlier in this post I suggested that one of my principles for inclusion was that the thing be “cheap enough”. Whether I strictly followed the output of my bargain model, or tried to eyeball quality for any individual pick, every one of these companies I think meets the general test of “cheap enough” to buy for a diversified basket of similar-class companies because all are trading at substantial discounts to their “fair” value or value to a private buyer of the entire company. What’s more, while some of these companies may be facing declining earnings prospects, at least as of right now every one of these companies are currently profitable on an operational and net basis, and almost all are debt free (with the few that have debt finding themselves in a position where the debt is a de minimis value and/or covered by cash on the balance sheet). I believe that significantly limits my risk of suffering a catastrophic loss in any one of these names, but especially in the portfolio as a whole, at least on a Yen-denominated basis.

Of course, my currency risk remains and currently I have not landed on a strategy for hedging it in a cost-effective and easy-to-use way.

I suppose the only concern I have at this point is whether my portfolio is “cheap enough” to earn me outsized returns over time. I wonder about my queasiness when looking at the uneven or declining earnings prospects of some of these companies and the way I let it influence my decision-making process and second-guess what should otherwise be a reliable model for picking a basket of companies that are likely to produce above-average returns over time. I question whether I might have eliminated one useful advantage (buying stuff that is just out and out cheap) by trying to add personal genius to it in thinking I could take in the “whole picture” better than my simple screen and thereby come up with an improved handicapping for some of my companies.

Considering that I don’t know Japanese and don’t know much about these companies outside of the statistical data I collected and an inquiry into the industry they operate in (which may be somewhat meaningless anyway in the mega-conglomerated, mega-diversified world of the Japanese corporate economy), it required great hubris, at a minimum, to think I even had cognizance of a “whole picture” on which to base an attempt at informed judgment.

But then, that’s the art of the leap of faith!

Notes – 16 Japanese Net-Nets I Put In My Portfolio (#JNets, #NCAV)

Listed below are the 16 Japanese companies that currently compose my “basket” (portfolio-within-the-portfolio) of Japanese net-nets, which I refer to as “JNets”. While most of my picks were classic Benjamin Graham-style companies trading for 2/3rds or less of their Net Current Asset Value (current assets minus total liabilities), some were selected on the basis of being a Net Cash Bargain (trading below the value of the company’s cash minus total liabilities) or as a Cash Bargain (profitable company with no debt trading for less than the cash on the balance sheet).

Strictly speaking, a Net Cash Bargain is a more conservative valuation than a Net Current Asset Value Bargain as there are more assets in front of the liabilities, while a Cash Bargain is a less conservative valuation (it may or may not be an NCAV Bargain) but typically you are getting a higher quality company with stronger earnings power as a result. As Graham noted, equities can be analyzed much like bonds and the true safety of a bond comes from the underlying company’s earnings power, not necessarily the asset values which are a worst-case fall back measure to protect against loss.

The figures in the list below are all in Yen, typically in millions of Yen besides the per share price. At the time of purchase, the approximate exchange value of the dollar against the Yen was 1 USD = 78 JPY. All figures and prices are the most recent available at time of purchase.

For comparative purposes, I summarize at the end of the list the metrics for the entire basket (as if it was a conglomeration of 100% of the equity of all companies included) as well as on an average basis as a representative for an individual company within the basket.

Links in the name of each company take you to their website, if available. Links in the symbol of each company take you to their Bloomberg business bio page, if available.

16 Japanese Bargain Shares (Net-Nets, Net Cash and Cash Value)

Name: Sakai Trading
Symbol: 9967
Industry/product: imports, exports, and wholesales chemical products, synthetic resins, and electronic materials
Market Cap (Ym): 2,210
Share price (Y): 235
Debt (Ym): 0
Cash (Ym): 2,851
EV/EBIT (10yr avg): 12.3x
NCAV (Ym): 4,973
Name: Shinko Shoji Co. Ltd
Symbol: 8141
Industry/product: sells electronic parts and equipment such as integrated circuits (IC) and semiconductor devices, liquid crystal (LC) display modules, condensers, ferrite cores, coils, power supplies, thin film transistor (TFT) thermal printers, head magnets, transformers, motors, sensors, and connectors
Market Cap (Ym): 16,905
Share price (Y): 625
Debt (Ym): 3,000
Cash (Ym): 10,610
EV/EBIT (10yr avg): 12x
NCAV (Ym): 41,899
Name: KSK Co Ltd
Symbol: 9687
Industry/product: develops computer software for various systems related to telecommunication and LSI (Large Scale Integration), provides data processing services for government and insurance group, sells OA (Office Automation) equipment and computer peripheral
Market Cap (Ym): 3,300
Share price (Y): 450
Debt (Ym): 0
Cash (Ym): 4,461
EV/EBIT (10yr avg): 1.6x
NCAV (Ym): 4,926
Name: Daichii Kensetsu
Symbol: 1799
Industry/product: constructs railways mainly for East Japan Railway, constructs infrastructure such as sewage facilities, tunnels, and waterways, builds commercial, institutional, and residential buildings
Market Cap (Ym): 15,124
Share price (Y): 685
Debt (Ym): 151
Cash (Ym): 17,230
EV/EBIT (10yr avg): 2.3x
NCAV (Ym): 19,099
Name: Choukeizai Sha
Symbol: 9476
Industry/product: publishes economics, finance, law, accounting, and tax related books and periodical magazines and business related books, operates a planning center which handles advertising on publishes,provides design & production services for sales promotion pamphlets
Market Cap (Ym): 1,434
Share price (Y): 326
Debt (Ym): 0
Cash (Ym): 2,501
EV/EBIT (10yr avg): -0.1x
NCAV (Ym): 2,933
Name: CLIP Corp
Symbol: 4705
Industry/product: operates a network of cram schools in Nagoya, operates soccer school and lunch box delivery services
Market Cap (Ym): 4,022
Share price (Y): 886
Debt (Ym): 0
Cash (Ym): 5,029
EV/EBIT (10yr avg): 0.1x
NCAV (Ym): 4,196
Name: Noda Screen
Symbol: 6790
Industry/product: processes electrical components such as plastic package substrates and printed circuits boards (PCBs), through a subsidiary, manufactures and sells screen stencils and fluoride chemical products
Market Cap (Ym): 2,849
Share price (Y): 27,000
Debt (Ym): 0
Cash (Ym): 3,641
EV/EBIT (10yr avg): -0.2x
NCAV (Ym): 4,146
Name: Kitakei Co Ltd
Symbol: 9872
Industry/product: wholesales housing materials and home furnishings based in the Kansai area, sells housing facility products such as bathroom units, wooden building materials, special wooden products, housing equipment, veneer boards, chemical products, and housing preservative agents
Market Cap (Ym): 2,963
Share price (Y): 296
Debt (Ym): 0
Cash (Ym): 5,045
EV/EBIT (1oyr avg): 16.8x
NCAV (Ym): 5,133
Name: Ryosan Co Ltd
Symbol: 8140
Industry/product: distributes electronic components, such as integrated circuits (ICs), electronic tubes, semiconductor elements, and personal computers, manufactures heat sinks
Market Cap (Ym): 47,582
Share price (Y): 1,387
Debt (Ym): 172
Cash (Ym): 36,452
EV/EBIT (10yr avg): 7x
NCAV (Ym): 92,515
Name: Daiken Co
Symbol: 5900
Industry/product: manufactures and sells metal and other material parts for building construction and exterior products including curtain rails, exterior panels, garages, and bicycle parking units, provides installation of these products and real estate leasing service
Market Cap (Ym): 2,245
Share price (Y): 376
Debt (Ym): 0
Cash (Ym): 1,753
EV/EBIT (1oyr avg): 5.4x
NCAV (Ym): 4,375
Name: Ryoyo Electro Corporation
Symbol: 8068
Industry/product: wholesales electronic components including semiconductors, sells workstations, personal computers, and printers, operates offices in Singapore and Hong Kong, trades semiconductors from Mitsubishi Electric
Market Cap (Ym): 22,205
Share price (Y): 771
Debt (Ym): 0
Cash (Ym): 28,443
EV/EBIT (10yr avg): 1.6x
NCAV (Ym): 54,847
Name: Nihon Dengi
Symbol: 1723
Industry/product: designs, constructs, and maintains integrated building management systems for air-conditioning, security, and electrical facilities, develops integrated production systems for industrial factories
Market Cap (Ym): 4,805
Share price (Y): 586
Debt (Ym): 0
Cash (Ym): 6,313
EV/EBIT (10yr avg): 4.3x
NCAV (Ym): 8,613
Name: Odawara Engineering
Symbol: 6149
Industry/product: manufactures automatic coil winding machines including micro motor, coreless motor, universal motor, and stepping motor type, provides reconstruction, repair, and parts replacement services for its winding machines
Market Cap (Ym): 4,154
Share price (Y): 650
Debt (Ym): 0
Cash (Ym): 5,411
EV/EBIT (10yr avg): 2x
NCAV (Ym): 6,423
Name: Natoco Co Ltd
Symbol: 4627
Industry/product: manufactures and sells various types of paints including paints for metals, building materials, and auto repair, manufactures high polymer compounds which are used as material for liquid crystal displays
Market Cap (Ym): 4,414
Share price (Y): 603
Debt (Ym): 0
Cash (Ym): 5,403
EV/EBIT (10yr avg): 5x
NCAV (Ym): 6,967
Name: Fuji Oozx
Symbol: 7299
Industry/product: manufactures automobile engine parts such as valves, valve adjusters and rotators, has subsidiaries in Korea, Taiwan, and the United States
Market Cap (Ym): 6,189
Share price (Y): 301
Debt (Ym): 0
Cash (Ym): 6,884
EV/EBIT (10yr avg): 1.6x
NCAV (Ym): 11,623
Name: Excel Co Ltd
Symbol: 7591
Industry/product: sells electronic products, such as liquid crystal devices (LCD), semiconductors, and integrated circuits (IC), including thin film transistor (TFT) modules, TFT-LCDs, cellular phones, car navigation systems
Market Cap (Ym): 6,208
Share price (Y): 683
Debt (Ym): 0
Cash (Ym): 6,679
EV/EBIT (10yr avg): 4.7x
NCAV (Ym): 18,574
Total Basket
Market Cap (Ym): 129,974
EV (Ym): -15,499
10yr avg EBIT (Ym): 27,046
Debt (Ym): 3,323
Cash (Ym): 148,796
NCAV (Ym): 291,244
EV/EBIT (10yr avg): -0.57x
P/NCAV: 0.45x
P/Net cash: 0.89x
P/Cash: 0.87x
EBIT yield (EBIT/Mkt Cap): 21%
Representative Company (Avg)
Market Cap (Ym): 8,123
EV (Ym): -969
10yr avg EBIT (Ym): 1,690
Debt (Ym): 208
Cash (Ym): 9,300
NCAV (Ym): 18,203