Fund manager Matthew Richey wrote for The Motley Fool for a number of years before leaving to start a hedge fund with fellow writer Zeke Ashton. About one year ago Zeke and Matthew started managing the Tilson Dividend Fund, focused on picking growing, undervalued, companies which pay out a good dividend as well.
A few days ago Matt and I talked about using covered calls to generate a 'synthetic' yield.
Right Price Investing: How do you use covered calls in your general strategy?
Matthew Richey: Our ideal is to sell calls at strike prices that we otherwise would be happy to sell the stock at anyway. For instance, if I think Netflix is worth $40, then I might be happy to sell the $37.50 call and collect a premium of $2.50. That gives me an effective sell price of $40, assuming the stock gets called away, and otherwise I get the $2.50 as a "synthetic dividend" of sorts. Occasionally we're willing to sell calls at a strike price below our estimate of fair value, but only if the call premium is exceptionally high, allowing us to lock in a very high synthetic dividend yield.
RPI: When you find it appropriate, how much of your position do you usually sell calls on?
MR: There are many factors, but ultimately the decision boils down to how much upside in the stock we're willing to give up in exchange for the call premium. On mature businesses where we typically know fair value with reasonable precision -- take Costco, for instance -- we're frequently willing to sell calls on our entire position, so long as the strike price gives us our fair value estimate. But on growing businesses where fair value is less precise -- take Netflix, for instance -- we're less willing to cap our upside with calls, and so might only write calls on one-third or one-half of the position.
RPI: How often do you have to sell stock when you don't want to because you sold the calls?
MR: Rarely. It's happened to us only two times over the past three years, and each time involved a stock that paid a very high dividend, which incentivized the call owner to exercise his call and receive the dividend. For non-dividend paying stocks, I think the chance of being called prematurely is remote. Either way, it's actually to our advantage to have the stock called away early because that means we earn our entire premium without having to wait until the option's expiration, which results in a higher IRR on our invested capital.
RPI: What yield on the total portfolio do you expect each year to come from covered calls?
Honestly, we don't have any specific expectations from one year to the next. It all depends on what types of opportunities Mr. Market pitches our way. To the degree we're finding very deeply undervalued stocks, we'll tend to use less covered calls and rely more on capital appreciation; and vice versa. In the current market, where we're finding many moderately undervalued securities but few deeply undervalued ones, we're using covered calls on a regular basis. So in a year like this one, we expect covered call income may account for perhaps one-quarter of the portfolio's return.
RPI: Would you recommend individual investors use this strategy?
MR: Yes and no. Yes, in that it's a low-risk strategy and an intelligent value investor should be able to make informed judgments about choosing appropriate strike prices that offer adequate premium. But no, in that many individuals will have trouble distinguishing when a covered call offers the best risk/reward versus straight common. The greatest danger with covered calls is that you have to be willing to cap your upside (to the strike price + call premium), so you have to be very careful to only write calls where you're getting a good premium at an acceptable strike price. It takes discernment to recognize which situations are well-suited to covered calls, and which aren't. A 7% covered call yield may look tempting, but it'd be a foolish choice on a stock that has 30% upside in capital appreciation.
The above interview corresponds to a strategy employed by the Tilson Dividend Fund. At the time fo printing the fund owned shares in Netflix and Costco, but this could change at any time. Mike Price does not own shares of either company, but family members of his own shares of the Tilson Dividend Fund.
Other Special Situations Articles
Parts 1&2
Part 3
Wednesday, May 24, 2006
Tuesday, May 23, 2006
Focusing Your Portfolio
A few days ago I saw this post on the Motley Fool discussion boards. Readers of this site will know the article was almost 100% the opposite of my portfolio strategy, soI felt complelled to reply, that reply is here:
"The strategy (of portfolio concentration ) we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."
-Warren Buffett 2003 Letter to shareholders
"We think diversification, as practiced generally, makes very little sense for anyone who knows what they're doing. Diversification serves as protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There's nothing wrong with that. It's a perfectly sound approach for somebody who doesn't know how to analyze businesses."
Also Warren Buffett
"If you assume, based on past history, that the average annual return from investing in the stock market is approximately 10 percent, statistics say the chance of any year's return falling between -8 percent and +28 percent are about two out of three.… What do statistics say you can expect, though, if your portfolio is limited to only five securities? The range of expected returns in any one-year really must be immense. Who knows how the crazy movements of one or two stocks can skew results? The answer is that there is an approximately two-out-of-three chance that your return will fall in a range of -11 percent to +31 percent. The expected return of the portfolio still remains 10 percent. If there are eight stocks in your portfolio, the range narrows a little further, to -10 percent to +30 percent. Not a significant difference from owning 500 stocks."
Joel Greenblatt this time
OK now it's my turn.
You say diversification is necessary for good returns - this simply makes no sense what so ever.
For a bunch of different reason first I'll go over each of your different ways of diluting returns, or diversifying.
You say the reason people lost money during the tech bubble was because they were not diversified, this is not true, no matter what you were invested in you lost money during the tech bubble. Even those people who believed there was a tech bubble and avoided tech lost money; money some haven't yet made back. People who thought there was a tech bubble but sought tech companies which were trading under their fair value with good management and a quality business probably didn't lose as much as could have been because they already had a margin of safety.
Also you say people lost money because they were not diversified, is there proof of this or are these just your thoughts? How do you know whether or not they were diversified?
Next you say,"There are still plenty of opportunities in the stock market....you never know what the market, world, or economy is going to throw at you."
This is not true either. Because of the scrutiny a company must go under before an intelligent investor picks it great investors usually can only come up with 6-8 good ideas a year for investments, that is why they spend a lot of time trying to find 'special situations' to use in their portfolio.
I'm not sure what your method is to pick stocks, to me it seems a lot of companies with high growth rates and P/E s under 25 would pass your test. I, and multiple superinvestors (who I will name later), have successfully invested in companies only when the following, plus a lot more things, occur:
-The company is trading at least 50% under its conservatively estimated intrinsic value.
-Financials and footnotes have been analyzed repeatedly for at least ten years of info. People thought Eddie Lampert was crazy when he bought K-Mart, but he was buying $50 in assets for $1 - later his investment went up 300% in one year, that year he reportedly made over $1 billion dollars in fees just from the K-mart purchase.
-Management has also been scrutinized using the numbers mostly - but also using scuttlebutt. Two great investors with opposing views on the subject made great calls on the same company - AutoZone. Eddie Lampert sent an intern around the country for three months to visit thousands of AutoZone's to see how management was at a local level. Joel Greenblatt simply analyzed the financials over and over and didn't buy the company until over two months worth of analysis was done on the numbers to evaluate management.
-Catalyst, this may seem trivial or an element only a growth investor would use, but sometimes it takes years for a company's value to be shown, many value investors now only buy value when there is an attached catalyst to force management to release value.
-Great business, probably the easiest, only buy companies that have great businesses, and competitive advantages that will keep peers at bay.
-Latticework of mental models, this one is extremely hard to understand when beginning, but learn it and investment returns will vastly improve. Started by Charlie Munger in a speech at USC a while ago – this speech is available at Whitney Tilson's web site somewhere. To simplify it a lot you cannot only have investment knowledge in anything, you must also acquire knowledge from multiple subjects, and use this to your advantage when investing. Mohnish Pabrai has done a great job securing 30% annual returns over the last seven years using this method when analyzing companies.
Next, I can't find where you mentioned it but diversifying among sectors within a portfolio. This is hogwash. A value investor must use up down analysis (find the company and analyze don't look for macro-economic factors that will make an industry fly) but when a whole sector is found to be undervalued the great investor will take advantage of this.
In the mid 1990's many people were thinking outrageous thoughts about the future of cable TV, many thought satellite would take over TV. Businessweek spurred it all when a cover story in 1996 claimed cable didn't have a chance. This story sent the price of the whole cable sector down.
But, Superinvestor Glenn Greenberg saw things a different way; satellite TV didn't have local TV yet, installing a satellite was extremely hard and expensive and dense urban settings did not get good reception at all, Greenberg thought the two would co-exist.
Also, cable companies were starting to introduce phone services , broadband Internet connections and other profitable areas that could isolate them from satellite TV should it actually take over the world. Greenberg noticed all of this and took advantage, he avoided cable companies that were part of bigger schemes or had loads of debt, in stead he picked well managed, quality cable companies and by the end of 1998 he had 40% of his fund in cable. Since then their annual returns have eclipsed 25% annually – including the bubble.
Soon I may make the decision to put over 25% of my assets in coal I do not see this as a bad element or risky. I look at the coal industry's cycles and see that whenever they enter and up cycle it goes up for at least 8 years, sometimes 15, after it starts, this has been proven with historical returns. The coal industry's up cycle has just began and I expect it to go up for at least five more years, but this is not the only reason I may be invested in two key coal companies I believe will produce great returns.
-International Coal (ICO) – Wilbur Ross heads ICO, a billionaire 'vulture' investor who turns crappy companies into good ones. He made over $4 billion for shareholders in his last venture – a steel company. Also the company is undervalued because of selling pressure from the officers of one of the companies, which was merged to create ICO, and because of the Sago mining incident. I can get into how the legal fees for the incident will be well lest than profits, but put simply ICO trades at half the multiple of competitors with worse management.
- James Rive Coal (JRCC) – James River is a coal company that has refused to return value to shareholders, and this is a good thing … because recently an activist got involved, and the company will now most likely return a great amount in a short period of time. For more info on this investment, read this post.
I'm sorry but your notion of diversifying among size also seems delusional to me. Micro caps and small caps aren't as risky as bigger names, in fact they are less risky. Thought they are volatile over short periods the only people who would be affected by this shouldn't be invested in stocks unless they have years of experience. Back to why it's less risky bigger companies are followed by many different analyst, I won't go over the whole advantage with buying small caps I'm sure you've read the 3 a week promotional Hidden Gems articles on the home page of the site. But basically when as many analysts follow these big companies they may be coaxed into 'adjusting' earnings a little bit because of the daily pressure they face. Smaller companies may do they same thing but it is less likely and great investors can easily find small overlooked companies, which are undervalued, and have trustworthy management, these smaller companies will rise faster.
Though small caps are advantageous at whole, any time you find an undervalued opportunity with a high probability of it delivering high returns it needs to be purchased. Only six of these are found a year and all of them being small, or big, should not matter.
Few, we're on the last one now. I won't go through the 'it's dumb thing' I'll go right to why it is dumb. Though there are complicated ways to use closed-end fund arbitrage to take advantage of over or under valued companies, diversifying among countries is a waste of time. You said there are always opportunities, if so why is it needed to go offshore to find companies that do not report the same way, may be adjusting earnings, may have disagreeable government impossible to predict, etc. Basically don't invest in foreign securities unless they are no longer foreign and you have visited the country, and know how the company works.
Risk is reduced not by diluting returns by diversifying and looking at beta; it is reduced by only buying quality companies with a margin of safety.
I wrote this not just to argue, or put you down, but because I feared long-term returns may be in jeopardy. With all the different ways of diversifying you have mentioned here, one would need to own over 100 companies from different countries to be fully 'diversified'. Returns would not be good long-term they would be less than that of an index because one could not keep up with this many companies from this many countries in this many industries all at the same time, especially if he has a job during the day.
A simple way, but rewarding, way to develop a portfolio without having to own a Russian telecommunications company would be to own the following:
- 2 or 3 great quality companies with the intent of owning them forever. These are not easily found and will not be found more than once per year, probably not for a long time.
- 5 to 7 companies trading for less than half of their conservative intrinsic value (be this by way of multiples, earnings power, assets, etc.) with a foreseen catalyst that leaves the potential for a 100% return in two years or less.
- As many special situations as you can find, or you can follow at one time.
Oh yeah, I promised a list of fund managers who concentrate their investments I don't have time to go over all of them now, but go here.
For more on concentrating your investments go to Focus Investor and Right Price Investing the latter is run by yours truly ;-) any opinions of it are welcomed.
-Mike
To read the continuing discussion you need at least a one month free pass to TMF, the thread is here.
Feel free to respond with your comments as well.
"The strategy (of portfolio concentration ) we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."
-Warren Buffett 2003 Letter to shareholders
"We think diversification, as practiced generally, makes very little sense for anyone who knows what they're doing. Diversification serves as protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There's nothing wrong with that. It's a perfectly sound approach for somebody who doesn't know how to analyze businesses."
Also Warren Buffett
"If you assume, based on past history, that the average annual return from investing in the stock market is approximately 10 percent, statistics say the chance of any year's return falling between -8 percent and +28 percent are about two out of three.… What do statistics say you can expect, though, if your portfolio is limited to only five securities? The range of expected returns in any one-year really must be immense. Who knows how the crazy movements of one or two stocks can skew results? The answer is that there is an approximately two-out-of-three chance that your return will fall in a range of -11 percent to +31 percent. The expected return of the portfolio still remains 10 percent. If there are eight stocks in your portfolio, the range narrows a little further, to -10 percent to +30 percent. Not a significant difference from owning 500 stocks."
Joel Greenblatt this time
OK now it's my turn.
You say diversification is necessary for good returns - this simply makes no sense what so ever.
For a bunch of different reason first I'll go over each of your different ways of diluting returns, or diversifying.
You say the reason people lost money during the tech bubble was because they were not diversified, this is not true, no matter what you were invested in you lost money during the tech bubble. Even those people who believed there was a tech bubble and avoided tech lost money; money some haven't yet made back. People who thought there was a tech bubble but sought tech companies which were trading under their fair value with good management and a quality business probably didn't lose as much as could have been because they already had a margin of safety.
Also you say people lost money because they were not diversified, is there proof of this or are these just your thoughts? How do you know whether or not they were diversified?
Next you say,"There are still plenty of opportunities in the stock market....you never know what the market, world, or economy is going to throw at you."
This is not true either. Because of the scrutiny a company must go under before an intelligent investor picks it great investors usually can only come up with 6-8 good ideas a year for investments, that is why they spend a lot of time trying to find 'special situations' to use in their portfolio.
I'm not sure what your method is to pick stocks, to me it seems a lot of companies with high growth rates and P/E s under 25 would pass your test. I, and multiple superinvestors (who I will name later), have successfully invested in companies only when the following, plus a lot more things, occur:
-The company is trading at least 50% under its conservatively estimated intrinsic value.
-Financials and footnotes have been analyzed repeatedly for at least ten years of info. People thought Eddie Lampert was crazy when he bought K-Mart, but he was buying $50 in assets for $1 - later his investment went up 300% in one year, that year he reportedly made over $1 billion dollars in fees just from the K-mart purchase.
-Management has also been scrutinized using the numbers mostly - but also using scuttlebutt. Two great investors with opposing views on the subject made great calls on the same company - AutoZone. Eddie Lampert sent an intern around the country for three months to visit thousands of AutoZone's to see how management was at a local level. Joel Greenblatt simply analyzed the financials over and over and didn't buy the company until over two months worth of analysis was done on the numbers to evaluate management.
-Catalyst, this may seem trivial or an element only a growth investor would use, but sometimes it takes years for a company's value to be shown, many value investors now only buy value when there is an attached catalyst to force management to release value.
-Great business, probably the easiest, only buy companies that have great businesses, and competitive advantages that will keep peers at bay.
-Latticework of mental models, this one is extremely hard to understand when beginning, but learn it and investment returns will vastly improve. Started by Charlie Munger in a speech at USC a while ago – this speech is available at Whitney Tilson's web site somewhere. To simplify it a lot you cannot only have investment knowledge in anything, you must also acquire knowledge from multiple subjects, and use this to your advantage when investing. Mohnish Pabrai has done a great job securing 30% annual returns over the last seven years using this method when analyzing companies.
Next, I can't find where you mentioned it but diversifying among sectors within a portfolio. This is hogwash. A value investor must use up down analysis (find the company and analyze don't look for macro-economic factors that will make an industry fly) but when a whole sector is found to be undervalued the great investor will take advantage of this.
In the mid 1990's many people were thinking outrageous thoughts about the future of cable TV, many thought satellite would take over TV. Businessweek spurred it all when a cover story in 1996 claimed cable didn't have a chance. This story sent the price of the whole cable sector down.
But, Superinvestor Glenn Greenberg saw things a different way; satellite TV didn't have local TV yet, installing a satellite was extremely hard and expensive and dense urban settings did not get good reception at all, Greenberg thought the two would co-exist.
Also, cable companies were starting to introduce phone services , broadband Internet connections and other profitable areas that could isolate them from satellite TV should it actually take over the world. Greenberg noticed all of this and took advantage, he avoided cable companies that were part of bigger schemes or had loads of debt, in stead he picked well managed, quality cable companies and by the end of 1998 he had 40% of his fund in cable. Since then their annual returns have eclipsed 25% annually – including the bubble.
Soon I may make the decision to put over 25% of my assets in coal I do not see this as a bad element or risky. I look at the coal industry's cycles and see that whenever they enter and up cycle it goes up for at least 8 years, sometimes 15, after it starts, this has been proven with historical returns. The coal industry's up cycle has just began and I expect it to go up for at least five more years, but this is not the only reason I may be invested in two key coal companies I believe will produce great returns.
-International Coal (ICO) – Wilbur Ross heads ICO, a billionaire 'vulture' investor who turns crappy companies into good ones. He made over $4 billion for shareholders in his last venture – a steel company. Also the company is undervalued because of selling pressure from the officers of one of the companies, which was merged to create ICO, and because of the Sago mining incident. I can get into how the legal fees for the incident will be well lest than profits, but put simply ICO trades at half the multiple of competitors with worse management.
- James Rive Coal (JRCC) – James River is a coal company that has refused to return value to shareholders, and this is a good thing … because recently an activist got involved, and the company will now most likely return a great amount in a short period of time. For more info on this investment, read this post.
I'm sorry but your notion of diversifying among size also seems delusional to me. Micro caps and small caps aren't as risky as bigger names, in fact they are less risky. Thought they are volatile over short periods the only people who would be affected by this shouldn't be invested in stocks unless they have years of experience. Back to why it's less risky bigger companies are followed by many different analyst, I won't go over the whole advantage with buying small caps I'm sure you've read the 3 a week promotional Hidden Gems articles on the home page of the site. But basically when as many analysts follow these big companies they may be coaxed into 'adjusting' earnings a little bit because of the daily pressure they face. Smaller companies may do they same thing but it is less likely and great investors can easily find small overlooked companies, which are undervalued, and have trustworthy management, these smaller companies will rise faster.
Though small caps are advantageous at whole, any time you find an undervalued opportunity with a high probability of it delivering high returns it needs to be purchased. Only six of these are found a year and all of them being small, or big, should not matter.
Few, we're on the last one now. I won't go through the 'it's dumb thing' I'll go right to why it is dumb. Though there are complicated ways to use closed-end fund arbitrage to take advantage of over or under valued companies, diversifying among countries is a waste of time. You said there are always opportunities, if so why is it needed to go offshore to find companies that do not report the same way, may be adjusting earnings, may have disagreeable government impossible to predict, etc. Basically don't invest in foreign securities unless they are no longer foreign and you have visited the country, and know how the company works.
Risk is reduced not by diluting returns by diversifying and looking at beta; it is reduced by only buying quality companies with a margin of safety.
I wrote this not just to argue, or put you down, but because I feared long-term returns may be in jeopardy. With all the different ways of diversifying you have mentioned here, one would need to own over 100 companies from different countries to be fully 'diversified'. Returns would not be good long-term they would be less than that of an index because one could not keep up with this many companies from this many countries in this many industries all at the same time, especially if he has a job during the day.
A simple way, but rewarding, way to develop a portfolio without having to own a Russian telecommunications company would be to own the following:
- 2 or 3 great quality companies with the intent of owning them forever. These are not easily found and will not be found more than once per year, probably not for a long time.
- 5 to 7 companies trading for less than half of their conservative intrinsic value (be this by way of multiples, earnings power, assets, etc.) with a foreseen catalyst that leaves the potential for a 100% return in two years or less.
- As many special situations as you can find, or you can follow at one time.
Oh yeah, I promised a list of fund managers who concentrate their investments I don't have time to go over all of them now, but go here.
For more on concentrating your investments go to Focus Investor and Right Price Investing the latter is run by yours truly ;-) any opinions of it are welcomed.
-Mike
To read the continuing discussion you need at least a one month free pass to TMF, the thread is here.
Feel free to respond with your comments as well.
Saturday, May 20, 2006
Special Situations, Part 3
In the first two parts of the special situations I wrote about different special situations, or value with a catalyst as Joel Greenblatt calls it, mainly from the book You Can Be a Stock Market Genius.
The third part of the series is about special situations used by hedge funds today, mainly from the books, Super Cash and How to Trade Like Warren Buffett by James Altucher and Value Investing Made Easy by Janet Lowe. I recommend these three books for any one looking to master special situations investments and to be up in down markets as well as rising markets.
The special situations written about here will be:
The third part of the series is about special situations used by hedge funds today, mainly from the books, Super Cash and How to Trade Like Warren Buffett by James Altucher and Value Investing Made Easy by Janet Lowe. I recommend these three books for any one looking to master special situations investments and to be up in down markets as well as rising markets.
The special situations written about here will be:
- Closed-End Fund Arbitrage
- Activist 'piggy backing'
- Deep, Deep Value
- LEAPS
Closed-End Fund Arbitrage
Closed-end funds are mutual funds that have a limited amount of shares and trade on a public exchange (NYSE, NASDAQ) like stocks. Because of the nature of the funds trading on an open exchange they frequently trade above, at a premium, or below, at a discount, to their NAV - Net Asset Value or the value of the mutual fund at the time. Thus a smart arbitrager can find a closed-end fund trading at a discount and buy it until the gap closes, or do vice versa and short a closed-end fund trading at a premium.
However it is not that simple - if it was these situations would not exist. Some closed-end funds trade at a steep discount to their NAV - EQS is the steepest current at a 23.4% discount to NAV, reversion to the mean would present a 31% return - but the discount is probably deserved, closed-end funds that underperform or have always traded for a discount should not be bought without a foreseeable catalyst - like activists - that will propel the fund back to it's NAV.
Currently my favorite in this category is the Gabelli Dividend & Income Trust (GDV). The fund "invests at least 80% of its assets in dividend paying or other income producing securities. In addition, under normal market conditions, at least 50% of the Fund's assets will consist of dividend paying equity securities." according to its website. Currently it trades for about a 15.5% discount to its NAV. Returns have been satisfactory and the dividend yield is 6.6%, so while you wait for reversion to mean, which is about 18%, you own a fund with satisfactory performance and a good yield.
Activism
A method rising in popularity among hedge fund managers is activism. In this method the manager buys >5% of a company he believes is not returning value to shareholders and becomes active in the business until value is returned to shareholders. When selecting companies to buy the manager usually looks for undervalued companies based low cash flow multiples, or companies with a lot of fcf and cash, he then buys 5 or more percent of the company which requires him to file with the SEC, when he files he not only discloses his holdings in the company but he also writes a letter to the board of directors about why he has bought the shares, what he thinks is wrong with the company and how he believes value can be released. This filing is available for everyone to see on the SEC website. Sometimes the company will immediately comply with the manager, but other times the fight can get pretty scary between a manager and a company.
Obviously regular investors cannot become activists, but 'piggybacking' activists is easily possible. When trying to find good activist investments one can use the sec website to follow each filing daily from activists, follow all 13Ds filed, when one is found it must be scrutinized to be reassured that the company will comply with the activist and value will be returned to shareholders, but when an opportunity is found great returns will most likely follow.
My friend Kevin Kelly, of Market Money, has, by far, the best information on potential activist situations. Read the following articles on different situations Kevin has analyzed:
Deep, Deep Value
Deep value has been discussed on this site before, I interviewed deep value focused investor Henry Lu and I purchased Lazare Kaplan which is trading below its Net Net Current Assets. Deep value is basically buying companies trading deeply below assets, at a very low price to earnings multiple or a very high cash flow yield. Companies trading at a fraction of their book or for 1x earnings is what Benjamin Graham originally championed buying.
This type of investing is usually called "cigar-butt" investing, you buy the stock, or pick up the cigar butt, for one last puff then quickly sell it. When investing in deep value the quality of the company is ignored and the investor is focused just on finding companiess so ignored by Wall St. they can be bought for as low as $.25 on the dollar. Because business quality is ignored value traps may be purchased, value traps are companies which appeared to be undervalued but are discounted for a reason, and they will stay discounted, or fall and become more discounted.
To avoid value traps one must look for companies not only deeply undervalued but also with quality, or at least profitable and have an expectation of earnings which will not fall. Also you must make sure management wants to return value to shareholders, if a company is trading below its cash, you must determine how management is going to use the cash, if they will just let it sit then a discount must be applied to cash to adjust for ignorant management.
One deep value opportunity I like right now is ExpressJet Holdings (XJT), XJT trades at about 3.5x earnings with $80 million of net cash and a contract with Continental which guarentees a 10% operating margin, XJT also trades at 1/5 of sales.
LEAPS
I won't go over the basics of options here, go here for that. LEAPS are options with a longer period of time attached to them, usually about two years.
As an example lets say I have resarched DirecTV and have decided they are a good business which is discounted when compared to its peers, has good financials and good management, but the only thing holding them back is the fact that GM holds a large portion of the common stock and investor fear this. I also believe in the near future GM will sell all of these shares, whether it be because they are forced into bankruptcy or if DTV buys back these shares, as they have already started doing.
Because I believe in the company, and think investors will realize this once GM sells the shares and DirecTV is no longer connected to them, I can buy LEAPS for JAN 08 with a strike price of $17, the current price is $17.50 and the options are priced at $2.75. If I buy one contract my investment is $275 (one contract is 100 shares), as opposed to $1,750 if I had bought 100 shares of the common stock.
Lets say in the next year and a half the stock appreciates to $26 per share because GM sells their shares and investors realize it's a good company, my investment in the LEAPS has appreciated about 330% (I bought them for $2.75 the price of the options is now $9, $26-$17) and my investment in the common stock is up only 49%.
Also if DirecTV were to fall because GM refused to sell it shares or something else happened to force DTV's shares down you would only lose you initial investment of $275 with the LEAPS, but you could possibly lose a much higher amount.
Conclusion
I believe that even great investors can only find 6-8 really good investment per year, to insure good investment returns when markets are volatile and good investments are hard to find special situations are needed to propel returns to an exceptional level. Afterall special situations are just 'value with a catalyst'.
Thursday, May 18, 2006
Warren Buffett Wealth
On a recent trip to Florida I was in need of a good investment book to read. I was quickly disappointed at the local Books-a-Million (BAMM) because of the limited selection of good investing books.
Don’t get me wrong they had four sections of a bookshelf worth of investing books, but I had either read the book or had no interest in learning technical analysis of FOREX.
Luckily I found a good book in the business section: Warren Buffett Wealth.
I liked the table of contents and immediately bought it when I saw Robert P. Miles, author of Warren Buffett CEO and 101 Reasons to Own Berkshire Hathaway, wrote it.
I finished the book thinking it was repetitive and basically the same as other books on Buffett, but thought it had two good points:
Developing an Investment Philosophy is Vital
Characteristics of the Next Warren Buffett
Investment Philosophy
Miles dedicates 16 pages of the book to developing an investment philosophy saying, “Investment Philosophy is the cornerstone of all successful investing.”
Having an independent, evolving investment philosophy is essential to successful investing. Buffett’s investment philosophy, one which he has stuck to for over 40 years and one which has served him very well is:
My still evolving philosophy is as follows:
Don’t rely on any outside research to buy a stock
Do as much proprietary research as possible before owning
Buy only quality companies with shareholder-oriented management
Only buy when a company is trading at least 40% below intrinsic value
Own 5-7 stocks with the potential of doubling in two years or less
Own 2-3 companies forever
Try to find as many special situations as possible and buy any with an expected annual return of 25% or more
The best course now is to examine these two investment philosophies, read as much as possible about great investors, and develop your own philosophy to acheive great long-term returns.
The Next Buffett
The other part of the book that I like is about GEICO’s Lou Simpson, who Miles calls the next Warren Buffett – this probably won’t happen because of the age similarity - like Buffett Simpson has great long-term returns, his investment philosophy is summarized below:
Think independently – The investor who relies on watching Jim Cramer’s Mad Money or reading Fortune for all of his investment decisions is destined to have poor returns. Look at what super-investors are buying for ideas, but then do your own research to decide if the investment is worth buying.
Invest in high return businesses, run for shareholders – Even if you find an insanely undervalued stock, if the business is bad or management is focused on its own interests the stock should be undervalued. Avoid these value traps.
Pay only a reasonable price, even for excellent businesses – Even if you find an excellent business with excellent management, buying an overvalued stock will not produce good long-term results. In the late 90s many great internet companies, like eBay (EBAY) and Cisco (CSCO), traded at extremely high prices relative to their intrinsic value – none of the companies survived without losing a good amount of market value.
Invest for the long term – Very few people have become rich by trading on rumors and expected earnings surprises. Those who have are forced to endure the side effects of this life style. Jim Cramer woke at 3 a.m. and threatened to kill employees; Jesse Livermore shot himself in a hotel room. Better returns will be garnered by sticking to a winning strategy of buying companies and not selling for a long time.
Do not diversify excessively – Simply put: If I own 10 companies I believe will deliver exceptional returns why should I dilute those returns with an eleventh company that may not produce those returns?
Conclusion
Warren Buffett Wealth is a very well written book, that I give 2.5 out of 5 stars only because the book is full of already well-known facts that can be found by simply reading one Berkshire annual report.
Don’t buy this book. But, if you ever find it at a library or book store sit down for a few minutes and read the chapters on Lou Simpson, investment philosophies and myths of investing.
Don’t get me wrong they had four sections of a bookshelf worth of investing books, but I had either read the book or had no interest in learning technical analysis of FOREX.
Luckily I found a good book in the business section: Warren Buffett Wealth.
I liked the table of contents and immediately bought it when I saw Robert P. Miles, author of Warren Buffett CEO and 101 Reasons to Own Berkshire Hathaway, wrote it.
I finished the book thinking it was repetitive and basically the same as other books on Buffett, but thought it had two good points:
Developing an Investment Philosophy is Vital
Characteristics of the Next Warren Buffett
Investment Philosophy
Miles dedicates 16 pages of the book to developing an investment philosophy saying, “Investment Philosophy is the cornerstone of all successful investing.”
Having an independent, evolving investment philosophy is essential to successful investing. Buffett’s investment philosophy, one which he has stuck to for over 40 years and one which has served him very well is:
Know What You Own
Research Before You Buy
Own a Business, Not a Stock
Only Invest in 20 Companies in Your Lifetime
Make One Decision to Own a Stock and Be a Long Term Owner
My still evolving philosophy is as follows:
Don’t rely on any outside research to buy a stock
Do as much proprietary research as possible before owning
Buy only quality companies with shareholder-oriented management
Only buy when a company is trading at least 40% below intrinsic value
Own 5-7 stocks with the potential of doubling in two years or less
Own 2-3 companies forever
Try to find as many special situations as possible and buy any with an expected annual return of 25% or more
The best course now is to examine these two investment philosophies, read as much as possible about great investors, and develop your own philosophy to acheive great long-term returns.
The Next Buffett
The other part of the book that I like is about GEICO’s Lou Simpson, who Miles calls the next Warren Buffett – this probably won’t happen because of the age similarity - like Buffett Simpson has great long-term returns, his investment philosophy is summarized below:
Think independently – The investor who relies on watching Jim Cramer’s Mad Money or reading Fortune for all of his investment decisions is destined to have poor returns. Look at what super-investors are buying for ideas, but then do your own research to decide if the investment is worth buying.
Invest in high return businesses, run for shareholders – Even if you find an insanely undervalued stock, if the business is bad or management is focused on its own interests the stock should be undervalued. Avoid these value traps.
Pay only a reasonable price, even for excellent businesses – Even if you find an excellent business with excellent management, buying an overvalued stock will not produce good long-term results. In the late 90s many great internet companies, like eBay (EBAY) and Cisco (CSCO), traded at extremely high prices relative to their intrinsic value – none of the companies survived without losing a good amount of market value.
Invest for the long term – Very few people have become rich by trading on rumors and expected earnings surprises. Those who have are forced to endure the side effects of this life style. Jim Cramer woke at 3 a.m. and threatened to kill employees; Jesse Livermore shot himself in a hotel room. Better returns will be garnered by sticking to a winning strategy of buying companies and not selling for a long time.
Do not diversify excessively – Simply put: If I own 10 companies I believe will deliver exceptional returns why should I dilute those returns with an eleventh company that may not produce those returns?
Conclusion
Warren Buffett Wealth is a very well written book, that I give 2.5 out of 5 stars only because the book is full of already well-known facts that can be found by simply reading one Berkshire annual report.
Don’t buy this book. But, if you ever find it at a library or book store sit down for a few minutes and read the chapters on Lou Simpson, investment philosophies and myths of investing.
Wednesday, May 10, 2006
Update
I haven't updated the portfolio on the site for over a month, this is for two reasons: One, it took about a month to transfer the site to godaddy from 1&1, and I've been updating my spreadsheets with the actual price of the S&P as opposed to the price of VFINX - an index fund which masks the S&P.
The portfolio is currently posted in the members section of the site, to get access to this page simply join the yahoo group linked on the sidebar of the blog and the home page of the site, acknowledging this post is enough to join the group.
I will post all real-time updates on the members page and members of the group will be notified. Proprietary research will be posted on this page as well as notes from books or conferences and shareholder meetings that I attend.
Within the next week the portfolio will be posted in the public portfolio page, with archived portfolio commentary.
As for the rest for the site, the articles section has all archived articles of mine and will soon have feeds from great investing blogs and links to worthy investing websites. The books section is not finished but currently hosts my list of required reading for beginning investors, soon it will have required reading for intermediate and advanced investors and books for strengthening your mental models and for those looking to start a hedge fund.
Look forward to Part Three of the special situations series.
-Mike
The portfolio is currently posted in the members section of the site, to get access to this page simply join the yahoo group linked on the sidebar of the blog and the home page of the site, acknowledging this post is enough to join the group.
I will post all real-time updates on the members page and members of the group will be notified. Proprietary research will be posted on this page as well as notes from books or conferences and shareholder meetings that I attend.
Within the next week the portfolio will be posted in the public portfolio page, with archived portfolio commentary.
As for the rest for the site, the articles section has all archived articles of mine and will soon have feeds from great investing blogs and links to worthy investing websites. The books section is not finished but currently hosts my list of required reading for beginning investors, soon it will have required reading for intermediate and advanced investors and books for strengthening your mental models and for those looking to start a hedge fund.
Look forward to Part Three of the special situations series.
-Mike
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