Monthly Archives: March 2009

Pabrai, Position Sizes, and Volatility

0223_mohnishpabrai_170x170Equity investors endured some quick sledding in 2008, with the S&P 500 down over 39%. Though the hill was even more icy in 1931 (with the S&P down over 43%), this historic drop has left its mark on both the portfolios and investing habits of even the best investors.

Mohnish Pabrai, managing partner of Pabrai Investment Funds and author of The Dhandho Investor, is one such marked man. In his January letter to investors, Pabrai relayed that he was changing the size of his portfolio positions due to recent market foibles. In the past, Pabrai had sought to put 10% of a Fund’s assets into 10 investments. In practice, this was difficult to achieve, as market prices would move higher before the position was filled, some investments were too illiquid or thinly traded, or the market capitalizations of the target company were too small. Most often the Funds held 80% of their assets in 10 positions, with the remaining 20% invested in a handful of smaller positions. This strategy of concentration has served Pabrai well, and it coheres with the advice of his mentors Buffett and Munger, who counsel professionals to concentrate their investment portfolios.

However, Pabrai has now decided to size his normal positions at 5% of a Fund’s total assets. Strongly correlated positions will only warrant 2% of the portfolio, to prevent sector weakness from inordinately depressing annual results. In the rare case, perhaps every couple of years, Pabrai will size a position at 10%, but only “if seven moons line up.”

This is a significant change for a successful investor to make, and it contradicts the specific advice of two of his esteemed mentors, Buffett and Munger. And the primary reason for the change is “to temper volatility.”

At the risk of sounding disrespectful, I say turkey feathers (or choose your own animal excrement). As Pabrai himself acknowledges, this change will lower future returns for the Funds, though he assures that “we’ve given up a modest amount of the upside to gain a meaningful drop in volatility going forward.” Despite reassurances, the change runs directly contrary to his long-term investors’ interests. As Pabrai knows, volatility is a statistical device, and not a reliable proxy for risk. Volatility is the effect of Mr. Market’s manic-depressive behavior. Volatility is the intelligent investor’s best friend, for without volatility (particularly the depressive side of it), bargains would be less cheap.

The truth of the matter is that Pabrai has opted to allocate some funds from his best ten ideas to his second best ten ideas, in order to moderate the effect of any “mistakes” on his overall returns. This “solution” strikes me as far worse than volatility or mistakes. Even worse it suggests that Pabrai no longer fully appreciates the difference between his best idea and his twentieth best idea.

‘The Dhandho Investor’ Review

dhandhoMohnish Pabrai begins his The Dhandho Investor: The Low-Risk Value Method to High Returns (Wiley, 2007) with a stunning observation: “one in five hundred Americans is a Patel… [but] over half of all the motels in the entire country are owned and operated by Patels” (1). For those less worldly, Patels are from a tiny area in Southern Gujarat, which resides in the Indian state of Gujarat, the birthplace of Mahatma Gandhi. Having only started arriving in the United States as refugees in the early 1970s, Patels today own over $40 billion in motel assets. How was this quick concentration of wealth possible? Dhandho.

“Dhandho” is a Gujarati word that, most literally, means “endeavors that create wealth.” But more specifically, Pabrai observes that Dhandho is the pursuit of wealth in low risk, high return business opportunities. Pabrai’s father was an early practitioner of the Dhandho way, when, in 1973, he staked all his savings and some borrowed money on a 20 room motel. According to Pabrai’s calculations, if his father failed, he would only be out his original stake of $5000; if he succeeded, he would have an investment whose net present value was worth $93,400. And the odds of success Pabrai puts at 90%. This is pure Dhandho–the no-brainer bet that all investors seek, “Heads, I win; tails, I don’t lose much” (12).

Pabrai uses this Dhandho way in managing his Pabrai Investment Funds. That means, more specifically, that he seeks simple businesses, with durable competitive advantages, in industries with an ultra-slow rate of change, often in situations of temporary distress. When Pabrai finds such businesses, he bets heavily, so long as the odds are favorable, and the price falls significantly below the business’ intrinsic value. Such investments offer low risks and high returns—investing the Dhandho way.

Given our interests at Wide Moat Investing, I found Pabrai’s discussion of durable economic moats fairly brief. Noting that few moats are permanently durable, Pabrai highlights Charlie Munger’s observation that “of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business… That’s how powerful the forces of competitive destruction are. Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best” (68). Building from this observation, Pabrai concludes that “even such invincible businesses like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear” (68). Capitalism’s competitive destruction compels Pabrai to never calculate a discounted cash flow stream for longer than 10 years, nor expect the sale of a business ten years hence at more than fifteen times cash flows (69). Though businesses like Chipotle, Coca-Cola, H&R Block, BMW, Harley Davidson, WD-40, and Tesoro have wide economic moats and durable competitive advantages today, the Dhandho investor is unwilling to make investments based on the projection that they will be even wider or more durable in the future.

All told, The Dhandho Investor was a quick, enjoyable read that succinctly describes Pabrai’s nine investing principles, as well as a few successful Dhandho investments (Servicemaster, Level 3 convertible bonds, and Frontline). While Pabrai spends less time analyzing successful businesses than we might like, he does well to habituate his reader into seeing potential investments probabilistically.

KSW in the Bargain Bin

In addition to holding wide moat companies purchased at a discount, a significant portion of our portfolio resides in profitable businesses selling for substantially less than their liquidation value. As we see it, in these situations, we are not only buying the companies’ assets at a discount, but we are getting its future earnings power for free. We primarily concentrate on micro-cap opportunities, where market inefficiencies tend to be greater, as larger market players are not sufficiently compensated (in absolute terms) to address them. This week we added to our holdings of one such opportunity–KSW, Inc., which the market currently values at $13.52 million (as of 3/13/09’s close), even though it currently has cash and marketable securities of over $20 million (by our estimates) and no long-term debt.

To share a little about the business–KSW, Inc., through its wholly-owned subsidiary KSW Mechanical Services, Inc., furnishes and installs heating, ventilating and air conditioning systems and process piping systems for institutional, industrial, commercial, high-rise residential and public works projects in New York City. Also, KSW serves as a mechanical trade manager, performing project management services relating to the mechanical trades.

As of September 30, 2008, KSW’s book value was $19.32 million, with nearly $17.4 million in cash and $1.6 million in marketable securities. Using data points from the recent press release, the fourth quarter 2008 yielded an additional $1 million in net income. And as of Dec. 31, 2008, KSW’s backlog of work was about $62.5 million.

Though management and the Board could do more to return cash to shareholders, KSW currently has a $1 million share buy back, which was announced in December 2008. Additionally, KSW has paid annual dividends in the past, and last spring they returned a cash dividend of 20 cents per share.

So why is KSW so cheap? In our view, it is likely because new construction projects in NYC are being dropped and current projects halted. In December 2008, KSW announced that two of its projects had been put on hold (the 42nd St and 10th Ave Project for $32 million, and the 56 Leonard Street Project for $24 million). Also, this past week, KSW had one of its customers terminate all of its current trade contracts (on which KSW had about $6 million of outstanding work left).

Yet, does a slow NYC construction market justify KSW’s current share price? In our lights, absolutely not. Its current market price not only values its future earnings power at zero, it values its net cash in the bank at less than 70 cents on the dollar. Basically, the current market price assumes that the company will never earn another dime and will burn through six and half million dollars over the next few years. That proposition strikes us as absurd.

Though some may worry that KSW may not have sufficient work to cover its overhead expenses, it is important to keep in mind that all of its field workers are hired for specific work assignments and hence are not salaried. Additionally, a substantial portion of Chairman and CEO Floyd Warkol’s compensation is paid as a “bonus equal to 9.5% of the Company’s adjusted annual operating profits before taxes, which are in excess of [$250,000].” So, a sizeable portion of KSW’s expenses are not fixed, and should adjust accordingly if less work were available.

All told, KSW’s current market price offers the company’s assets at a significant discount and its future earnings power for free. Though we expect that construction work will decline over the next couple of years in NYC, it will not cease entirely. And if it doesn’t, KSW will likely have work to do, and earnings for its owners.

Disclosure: I, or persons whose accounts I manage, own shares of KSW at the time of this writing.

‘Fooling Some of the People All of the Time’ Review

foolingsome2Over the last couple of days, I’ve buzzed through David Einhorn’s Fooling Some of the People All of the Time (Wiley, 2008), which describes Einhorn’s six year saga shorting Allied Capital. As Joel Greenblatt tells it in the foreword, this was a saga in which the good guys were dragged through the mud and the bad guys carted off millions. At least for a while.

The story begins with a bang in May of 2002 when David Einhorn, then a relatively unknown hedge fund manager, gives a speech at the Tomorrows Children’s Fund charity event in which he lays out his case for shorting Allied Capital. Word of the speech races from the event, and the next morning, Allied opens at $21, a 20% drop. As Einhorn recalls, “I did not for even a minute consider covering any of our short.” (55)

Of course, one can quickly look at the ticker to see how the story ends. But in between lay six years’ worth of accusations, name-calling, “pretexting,” and criminal charges, all from the ultimate loser’s side. Along the way, the reader sees into the state of regulatory oversight, contemporary business ethics, and corporate America. It is an interesting and highly detailed narrative that I would recommend to anyone interested in today’s equity markets.

Particularly interesting was Einhorn’s account of starting his Greenlight hedge fund with $900,000, over half of which came from his parents’ pockets. Even with an abundant contact list, he and his partner “soon realized that almost no one would invest with a couple of twenty-seven-year-olds with no track record.” (19) Yet, his early returns made up for his perceived inexperience, netting partners 3.1% in May of 1996, 6.9% in June, and 4.8% in July. After getting their first million dollar partner that August, money rapidly found its way to their door.

Most useful was Einhorn’s brief descriptions of his earliest investments. Successful investors (particularly Buffett) are often asked where they would be investing with a small, million dollar portfolio, and here Einhorn gives a glimpse into the opportunities that these inquiring investors most covet. In 1997, Greenlight pushed money into insurance company demutualizations, spin-offs, Pinnacle Systems, and some short sales, like Boston Chicken and Samsonite. Boston Chicken bombed because its accounting practices “enabled it to recognize up-front revenue and profit when franchisees opened restaurants. Boston Chicken financed the openings and up-front fees and earned interest on loans to the franchisees. The underlying restaurants were not profitable enough to support the payments to the parent.” (25) In 1998, Greenlight’s short target was Computer Learning Centers, a for-profit education company; in 1999, Seitel, which had a multi-client library of seismic data used to find hydrocarbons.

All told, I thoroughly enjoyed it, and I was reminded what good research really looks like.

Morningstar’s Wide Moat Focus Index

As some may know, Morningstar currently has a Wide Moat Focus Index that “consists of the 20 securities in the Morningstar US Market Index with the highest ratios of fair value… to their stock price, and which have a sustainable competitive advantage…”

For those persuaded by the idea that some businesses have wider economic moats, but without the time or desire to go looking for them, the Index provides the investor with twenty places to start. As of 2/27/2009, the Index included Monsanto Company, Waters Corporation, Starbucks Corporation, Maxim Integrated Products, Fastenal Company, Zimmer Holdings, Applied Materials, Paychex, IMS Health, Forward Air Corporation, The Western Union Company, KLA-Tencor Corporation, Avon Products, eBay, International Speedway, St. Joe Corporation, Autodesk, American Express, Legg Mason, and Bank of America.

Even more useful is Morningstar’s description of their methodology for selecting the favored twenty. First, a business must pass the “show me the money” test, which demands that its return on invested capital (ROIC) has consistently exceeded its cost of capital. Having satisfied this initial screen, Morningstar analysts then assess whether the margin can be attributed to a clear competitive advantage. Morningstar classifies four major types of competitive advantage: high switching costs (e.g., Stryker), lower general costs (e.g., Wal-mart), valuable intangible assets (e.g., Harley-Davidson), or a sufficiently large network of users (e.g., eBay, NYSE).

Stryker benefits from high switching costs because surgeons that use their products would have a difficult time retraining their habits and skills to efficiently use a competitor’s. Wal-mart sells a wide array of basic consumer goods that could be purchased in numerous locations; that is, its products are practically indistinguishable—essentially commodities. In a commodity business, the only lasting advantage is being the perennial lowest cost producer, and in retailing that’s Wal-mart; in car insurance, Geico. Harley Davidson offers a product that its customers will pay a premium for (and then profess their undying love through abundant bodily art). eBay’s network of buyers and sellers offers each an optimal market experience; buyers find a rich selection, and sellers can solicit the largest number of buyers and presumably the highest prices.

Looking over Morningstar’s favored twenty, a couple businesses stand out. First, and perhaps with the benefit of hindsight, it is hard to imagine a retail bank like Bank of America with a sustainable economic moat. The little brick retail banks reign in ubiquity in our town, all seemingly offering similar rates and services. Though it may have been inconvenient to set up banking accounts in the past, online platforms have surely simplified the process.

American Express is also an interesting case. While swiping an AMEX used to carry some cache, today it is mere French vanilla. While American Express does have its credit card network, by sheer numbers, Visa’s and Mastercard’s stand superior.

All told, Morningstar’s Index highlights some interesting businesses for the wide moat investor. We’ll take a deeper look at some in the weeks ahead.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

eBay’s 2009 Analyst Day

logoebay_x451Today is eBay’s 2009 Analyst Day, and the meeting will be broadcast on the web starting at 8:00 AM PT. eBay is one of our significant current investments, and we have produced an extended series analyzing eBay’s economic moat and valuation. So we are eager to see what management will have to say for itself; the stock price has certainly been doing its share of speaking for some time now.

In anticipation of the meeting, eBay’s critics and observers have been pounding the web waves over the last week, offering their suggestions and speculating about future asset sales. Among the suggestions include selling the whole company to Microsoft or Google, selling Skype to Cisco, spinning off a portion of Paypal, and transforming the company into eBay 2.0. Trading at near 6x 2008 FCF, it strikes me that the former is most likely.

At any rate, we’ll be watching and eager to evaluate any proposed changes. Foremost in our minds are the strategic options for their cash held overseas, the possibility of creating an “eBay Local” site that concentrates solely on geographic distance (to snipe at Craigslist), and its progress on the current share buyback. Probably the best plan for current investors would be a coordinated debt offering and large stock tender offer. With no long-term debt and strong, cash flow businesses, they are not optimally levered in their current state. With today’s equity price, it seems a no-brainer to replace equity yielding over 15% FCF with debt costing 5-6%.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

‘Only the Paranoid Survive’ Review

groveOnly the Paranoid Survive (Doubleday, 1996), by Andrew Grove, former CEO and Chairman of Intel Corporation, is a book about “inflection points” in businesses and careers. Inflection points require radical change, but our habits of mind and past investments can make change difficult at these points. Yet, without the requisite change, the ultimate cost is even higher. Grove peppers his insights with numerous anecdotes from Intel’s experience with inflection points in personal computing, and the book serves as a extended illustration of what a CEO’s mind must be to survive—paranoid.

For Grove, Intel’s primary inflection point confronted them in the middle of the 1980s, when they, a company known for their memory chips, were in an increasingly weak competitive position relative to Japanese chip manufacturers. As Grove observes, “when a strategic inflection point sweeps through the industry, the more successful a participant was in the old industry structure, the more threatened it is by change and the more reluctant it is to adapt to it” (50). Intel’s case confirms the point. They were consistently losing money on their memory chips while trying to compete; some recommended building a new, more efficient factory; others recommended more research and development in the hope that a better product would emerge.

The inflection point came in 1985, after Intel had been waffling about their chip problems for almost a year. Grove and then-chairman and CEO Gordon Moore were sullenly batting around ideas when Grove asked “if we got kicked out and the board brought in a new CEO, what do you think he would do?” “He would get us out of memories” was Moore’s response. And from that day, Moore and Grove began the long and difficult journey of persuading Intel to cast aside its accumulated identity and shift its attention solely to microprocessors.

Given the interests of this blog, we found Grove’s laundry list of inflection points to be most useful. In retail, Wal-mart’s efficiency in logistics and its corresponding low prices have required competitors to specialize (e.g., Home Depot, Office Depot) or fail. The introduction of sound into film-making compelled actors to transform their skills or dwindle into obscurity. Containerization enabled the rise in prominence of Singapore’s and Seattle’s ports (where there was sufficient room to expand), and the decline of New York’s. General Motors’ aim to offer “a car for every purse and purpose” resonated with customers more than Ford’s formulaic duplications—“it takes you there and brings you back.”

All these examples highlight an exceedingly important point. Today’s competitive advantages may subtly erode much faster than even the most astute and attentive observers recognize. Wide economic moats protect the castle, but very few endure across a lifetime. Inflection points are the norm, and investors and executives must constantly be looking for them; cultivating paranoia may be wise. To have an economic moat is not enough, for the moat must endure to provide the investor with significant safety.

Disclosure: I, or persons whose accounts I manage, own shares of Office Depot at the time of this writing.

David Einhorn and Return on Equity

einhornHere at Wide Moat Investing our primary task is to pinpoint the characteristics that separate good businesses from the great. So far, we’ve highlighted some qualitative characteristics that may not yield well to quantitative assessment (e.g., Coke has no “taste memory” and appeals to a basic, enduring preference). Yet, many investors begin their search for great businesses by using a handful of quantitative metrics. Margins are often important, for as we observed in our analyses of eBay and Microsoft, high gross margins may signal a business with significant competitive advantages.

Another important quantitative metric for many investors is return on equity (ROE).  For example, Francis Chou looks for excellent companies with a 15% ROE sustained over 10 years or more.*

David Einhorn, President of Greenlight Capital and hedge fund manager, addressed the topic of ROE in his November 2006 talk at the Value Investing Congress. There Einhorn argued that ROE is only a meaningful metric for capital-intensive businesses—like traditional manufacturing companies, distribution companies, most financial institutions, and retailers (4). For businesses that are not capital intensive—whose profits derive primarily from intellectual capital or human resources (e.g., pharmaceutical companies, software companies, etc.)—it is “irrelevant to worry about ROE” (4). Why? Because businesses that are not capital intensive do not generate substantial returns from retained earnings or capital expenditures. For example, if you are an insurance agent, you will bring in much more business and profit by getting on the phone and meeting more potential clients, rather than tripling your office space, or adding that new water feature to the atrium, or buying that highly efficient “document station.” In short, it’s not the “equity” which provides the retums, but the people, the brand, or the proprietary product—things which don’t show up on the balance sheet. ROE then is insignificant. For the most part.

You see, Einhorn observes, and experience confirms, that most non capital intensive businesses have an irresistible urge to direct excess returns back into the business that doesn’t need them, or to acquire businesses that do (i.e., capital-intensive businesses). And so the investment bank, which generates fees upon fees, largely due to its personal relationships with clients and its perceived brand, starts to pour excess capital into lending, trading, hedging, and gambling. Seemingly all of a sudden you have that old investment bank now asking its government for tens of billions of dollars, and it intensely needs the capital!

For Einhorn, the best explanation for such capital (mis)allocations is that such businesses are being run for their employees rather than their shareholders, employees running them just well enough to achieve a respectable 15% ROE, and sure enough, the shareholders’ respect keeps coming.

All told, we find Einhorn quite perceptive on these points. And we find his distinction between capital-intensive businesses and the rest to be crucial. For those numerous investors who use ROE to filter the castles from the shacks, they may be missing valuable investing opportunities. The lesson for the castle lover is clear—while the signs of some moats lurk on the balance sheet, not all do. Quantitative metrics will not uncover them all.

*[In the original post, I said “Joel Greenblatt’s Magic Formula screens for companies with the highest ROE and lowest earnings multiples (i.e., P/E).”  This was sloppy writing.  Greenblatt’s Magic Formula screens for high returns on capital (EBIT/net working capital+fixed assets).  ROE can give misleading numbers for companies with high debt or cash levels.]

Best Investor of 2008

premPrem Watsa of Fairfax Financial Holdings?

Yesterday, Fairfax—a financial services holding company whose subsidiaries include one of Canada’s largest property and casualty insurers—issued its annual report and letter to shareholders. In it, they disclosed that their investment returns for the year were 16.4%, achieved in a year in which all major stock indices were down nearly 50% and bond spreads widened to historic distances. Impressive out-performance to say the least.

Even though a handful of short fund managers and inverse ETFs may have outperformed Fairfax, none achieved comparable returns managing funds of a similar size. How did they do it? Nearly 75% of their investment portfolio was in cash and government bonds; their equity portfolio was fully hedged, and they held large positions in credit default swaps. Likely the only way one could have beaten those results would have been to go all-in on Wrigley or Family Dollar.

Since then, Fairfax has moved out of government bonds and into municipal bonds, and removed their equity hedges. Aside from applauding the show, what can one learn from Fairfax’s performance?

Most simply, it looks like asset allocation was the most important determinant of investing success in 2008. Even if one held the best “castles” with the widest moats, government bonds, cash, and gold would have served a better fortress for one’s investing capital.

Of course, one should not take too much tutoring from one year’s results, especially in a year as unprecedented as this one. Yet, one lesson is clear—wide moat businesses, no matter how desirable, need to be acquired at opportune times and at bargain prices for the investor to outperform market averages. Just buying castles is not enough; they have to be cheap.

Disclosure: I, or persons whose accounts I manage, own shares of Fairfax Financial Holdings at the time of this writing.

Analyzing Sears and Bonds

sears_logo3Yesterday we briefly compared the equity of Sears Holdings to its outstanding “junk” bonds and found that an investor with a short time horizon (say 2-3 years) may find comparable or superior value in the bonds when compared to its equity. To be clear, we don’t mean to suggest that Sears bonds are without risk. One only needs to look to Circuit City, or Linens n Things to see that today’s retail environment is increasingly difficult. And we are assured that more retailers will seek bankuptcy as they watch American consumers begin to cultivate the lost art of saving.

Today, we will take some time to evaluate the risk of Sears bonds in greater detail. Though sophisticated bond analysis tools abound (some more useless than others), relative simplicity will rule this day. Benjamin Graham, in his widely acclaimed The Intelligent Investor, highlights a variety of criteria relevant for bond analysis. First, and most important, is “the number of times that total interest charges have been covered by available earnings for some years in the past” (148). Either the analyst should concentrate on the average multiple of interest coverage over the past seven years, or she can use the multiple of interest coverage in the “poorest” year. Graham concludes that, before income taxes, a retailer must have—at minimum—produced average earnings at least five times the interest charges, or at least four times the earnings of the poorest year.

A second test for bonds is the size of the business. Third, the analyst should assess the ratio of the equity’s market price to the business’ total outstanding indebtedness. And lastly, the analyst should discern the values of the assets on the debtor’s balance sheet.

In the case of Sears Holdings, it appears that its debt does not pass Graham’s first test. According to Sears’ most recent press release, interest expense for the fiscal year ending Jan 31, 2009 was around $272 million. Yesterday, we found Sears average annual FCF to be 1.03 billion; the ratio then is 3.8, below Graham’s 5x threshold.

The second criterion is fine, and the third as well, with Sears’ equity priced in the market at 4.3 billion (as of 3/5/09), compared to 2.9 billion in total long term indebtedness. The fourth criterion is quite interesting in Sears’ case. Given its wealth of real estate assets, its valuable brands, and its ownership stake in Kmart, Lands’ End, and Sears Canada, the balance sheet far understates its true value. For example, Bruce Berkowitz, manager of the Fairholme Fund, conservatively values Sears’ real estate at $90 per share, a valuation he has made using tax records and fairly detailed site analysis. By itself, the value of Sears’ real estate, largely hidden from the balance sheet, should provide the debt holder with an additional margin of safety.

All told, the analyst can see where Sears’ perceived weakness lies—its earnings power in its current state appears too meager. Given its assets however, combined with its cash balance of 1.3 billion, and the 3.5 billion available on its line of credit, some of the risk diminishes.  Diminished enough at least for this investor to seek the proffered returns.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.