Doing Your Homework

July 2nd, 2009


Investors who buy stocks without reading the company's disclosures leave themselves open to risks of which they are not even aware. Consider Escalade (ESCA), a diversified producer of sporting goods and office equipment.

Escalade is cheap across a variety of metrics. It trades for just $10 million, despite having operating income exceeding $10 million in each of the years 2005, 2006 and 2007. Though the recession turned results negative in 2008, the company has cut costs aggressively and has a good chance of turning a profit in 2009. The company trades with a price to book value of just .12!

But the following tidbit from the company's annual report highlights a very important risk for shareholders:

"The Company is considering the potential for voluntary delisting of its common stock with NASDAQ".

Why might they be considering this?

"In complying with those reporting obligations and the additional requirements imposed upon public companies pursuant to the Sarbanes-Oxley Act of 2002, the Company incurs significant annual out-of-pocket costs. In addition, the time and attention required of management to comply with all such requirements is substantial."

Public companies usually have higher valuations than private companies, because the shares are more liquid, more accessible, and the reporting/compliance requirements instill a level of trust from the point of view of investors. Escalade's management doesn't appear too pleased with the current valuation, however:

"As a small public company, particularly in light of recent economic conditions, the Company has not been able to take full advantage of the potential benefits of being public yet must continue to satisfy all of the requirements to remain a public company."

The company ends this paragraph with a major understatement:

"No final decisions have been made in this regard, but such actions would have a material impact on stockholders if taken."

While the risk of delisting may not prevent some investors from being interested in a cheap-looking stock, for others this falls outside the bounds of what is considered an acceptable investment. As such, it is important that investors read a company's disclosures before deciding to invest, lest they be caught unaware of a potentially detrimental future event.

Disclosure: None

Posted in ESCA, Escalade Inc. | Comments Off

The Fund

July 1st, 2009


I am pleased today to announce the launch of Karsan Value Funds (KVF), a long-term oriented, value investment fund that I will manage. The fund will take equity positions in public companies which trade at discounts to their intrinsic values and where downside risk is low compared to upside potential.

As it can take many years for such companies to return to trading at their intrinsic values, the investment horizon of the fund is of a long-term nature. To that end, investors will be discouraged from short-term dispositions of their securities. Investors will also be unable to sell securities to anyone other than the fund, since new investors may not fully understand the partnership's strategy, and there are certain legal restrictions.

Although the fund will report financial results every quarter, emphasis will be placed on long-term returns, not quarterly results. The fund will likely start out with a capitalization of approximately $400K. As such, using a registered dealer, registering as a dealer, or issuing a prospectus will be prohibitively expensive in the initial year(s). Therefore, the fund's shares are not currently available to the public.

We look forward to providing more information and publishing the first set of results in the near future. Of course, I am always looking for new ideas. If you have any stocks you favour that you believe may fit the investing profile of the fund described above, I'd be happy to hear about them in the comments section. Happy investing!

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Identifying Cheap

June 30th, 2009


Most (though surprisingly not all!) investors like the idea of buying a stock for less than it is worth. But it's the calculation/determination of what a company is worth that trips most investors up. For some securities, however, determining this value can be relatively easy. For example, if a large proportion of a company's assets have a liquid market (e.g. a mutual fund), the calculation can be asserted with much more certainty.

While real estate is not quite as liquid as most stocks and bonds, it is not far-fetched to say that a company whose assets consist mostly of real estate should trade near its book value.

While some adjustments to book value may need to made to better approximate the current market value of the real estate (e.g. if the land was purchased long ago and has since appreciated), one might expect real estate companies to trade near their book values.

Consider Melcor (MRD), a property development company in Western Canada. A large component of Melcor's balance sheet consists of raw land (purchased over the course of a few years) which it prepares and sells as lots to builders. Another large component of its balance sheet consists of commercial property which it has owned and leased for several years or, in some cases, decades.

The following chart depicts Melcor's price to book ratio over the last two decades:

Melcor is trading, relative to its assets, at levels not seen since the mid-1990s. Readers who are pessimistic regarding the outlook for real estate should note that an investment in Melcor does not require a bullish stance on real estate, since this investment constitutes a purchase of real estate at a discount of approximately 50%! The value of the property does not appear in jeopardy either, as while the pace of sales has slowed down, Melcor is still selling its lots at a gain.

When investor sentiment sours, those who take advantage of the situation by purchasing assets at a discount stand the chance to gain the most over the long term.

Interested in another perspective on MRD, or any other stock that's currently on your mind? One of our sponsors, MarketClub, has offered our readers a free analysis of a stock of their choosing.

Disclosure: Author owns a long position in shares of MRD

Posted in MRD, Melcor, P/B | Comments Off

Copying The Best

June 29th, 2009


Many people take comfort in buying stocks that others have as well. After all, if other people think a stock is good, there must be something to it, right? Therefore, it should come as no surprise that people love to know what star investors are buying, so that they can buy the same stocks. For example, shares of CarMax rose 7.5% on the day it was released that Berkshire-Hathaway was buying in.

To fill this investor need for knowing what other investors are buying, a plethora of websites exist that track what large funds are buying. (One of our favourites is marketfolly.com, which we've discussed here.) Can these be useful in guiding your own portfolio decisions? Absolutely, but only to a certain extent. Unfortunately, a number of challenges exist which make it difficult to gain from this knowledge.

Investment companies only have to disclose their transactions at the end of each quarter. As a result, if you base your decisions on what these fund managers do, you could be trading on old news. Under certain circumstances, the SEC will also grant funds the right to delay disclosing their purchases, which makes copying these funds' investments even harder.

There is also the case of mistaken identity. Just because a particular company bought a stock, does not mean the manager you were interested in did. Warren Buffett has griped about this issue in the past:

"The media continue to report that "Buffett buys" this or that stock. Statements like these are almost always based on filings Berkshire makes with the SEC and are therefore wrong. As I’ve said before, the stories should say "Berkshire buys."...Even then, it is typically not I who make the buying decisions. Lou Simpson manages about $2½ billion of equities that are held by GEICO, and it is his transactions that Berkshire is usually reporting."

Stocks the market bought after an erroneous "Buffett buys..." have subsequently fallen back to their previous levels once the market realized its error.

Blindly following the reported investments of fund managers can be detrimental to your portfolio. Nothing beats buying a company for its fundamentals, rather than because others are buying. Knowing the purchases of managers you wish to emulate can be a useful starting point, but investors who also educate themselves put themselves in positions to make better decisions.

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The Psychology Of Human Misjudgement: Pain-Avoiding Denial

June 28th, 2009


Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

The perfectly sane mother of a soldier who had not been heard from since World War II refused to believe her son was not alive and well. In order to avoid the pain she would feel from acknowledging his death, she distorted the facts in her own mind. This is what Munger refers to as simple, pain-avoiding, psychological denial.

It is difficult to criticize an individual who has used this denial to shield themselves from pain, but Munger finds it an admirable trait that others prefer to live by a different creed: "It is not necessary to hope in order to persevere."

While Munger believes we all use this form of denial at various points in our lives, it is particularly visible when used by those who suffer from some form of chemical dependency. Those under the influence of addiction often believe themselves to be in respectable condition with good prospects, when this is clearly not the case.

Posted in Psychology of Human Misjudgement | Comments Off

The Psychology of Human Misjudgement: Influence From Association

June 27th, 2009


Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Humans tend to form judgements based on factors that may be irrelevant. This tendency of humans to be influenced by association is well understood by advertisers. In this way, people can be tricked into believing things that are not true. For example, producers will sometimes charge a higher price for a product only because customers perceive its quality to be higher due to the higher price. The association can even be trivial: if a pretty girl is pictured on the product's packaging, this too can drive buyers to be influenced to purchase.

However, Munger argues that the ramifications of this tendency that are caused by advertising are relatively trivial. The most important miscalculations due to this tendency come from improper associations with past successes, and liking/disliking to the point of ignoring relevant factors.

For example, if a man has success at a casino, he will associate that success with particular behaviours, and believe that his success can be repeated. All too often, he will wager - and lose - far more than his initial gains. Traders who are blessed with early success will often believe they are superior speculators, only to fall victim to their overconfidence. Munger argues two antidotes to combat this improper association: 1) look for accidental, non-causative factors that led to the initial success, and 2) look for dangerous aspects in the new venture that were not present in the old.

When it comes to liking/disliking to the point of ignoring relevant factors, Munger uses the example of man's (un)willingness to listen to bad news. People who "blame the messenger" often find themselves living in realities void of bad news and also void of fact. Munger uses examples from Ancient Persia, two major oil companies, and CBS to illustrate the detriment of ignoring bad news. To counteract this tendency, Munger claims Berkshire has a policy of "Tell us the bad news promptly; the good news can wait."

Posted in Psychology of Human Misjudgement | Comments Off

News From 1930

June 26th, 2009


All too often, investors either ignore or are unaware of historical precedents to today's economic issues. Whether it be the oft-repeated bullish proclamation "They're not making any more land!" (due to a lack of recognition of the repeated boom and bust nature of the housing industry), or beliefs that well-operated, efficient businesses will be quickly erased by emerging technologies, the lessons of history often go unheeded.

One site that offers temporary reprieve from the mentality that we are in uncharted waters is News From 1930. Each day, readers are given a summary of the news on this date in 1930! Following the stock market crash in 1929, investors in 1930 were in a similar position to investors today: is a recovery on the way, or is there more gloom on the horizon?

Of course, we know (or can find out) what happened in the years following 1930, and that doesn't help us determine what will happen tomorrow. However, by educating ourselves on the events that took place in prior recessions, we gain an understanding of where this recession fits (both in magnitude and in velocity) in a historical context, and what needs to take place before a recovery takes place.

Posted in News from 1930 | Comments Off

Site Update: 1 year and 600 subscribers!

June 25th, 2009


Some of our regular readers may have noticed that this site recently celebrated its first birthday! We'd like to thank all our readers for making it a success. This is hopefully only the beginning of the value investing community that is being built here, and to that end there are some exciting new announcements coming up in the next few weeks!

This site also recently eclipsed the 600 subscriber plateau, but we can also tell that there are many visitors who are not subscribers. To subscribe (for free) to the site's content, visitors may click on the orange squares to the right of this post for either e-mail or RSS subscriptions. For an overview of what this entails, see here.

While we already have a link at the top of the page for readers to access the site's most popular articles, the nature of that page is such that the content does not change frequently. As such, we have decided to provide a list of articles in the last 3 months that readers have appeared to take an interest in by traffic and/or links. The articles are in chronological order. Enjoy!


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Don’t Just Buy Any Net-Net

June 24th, 2009


During recessions, with this one being no exception, value investors usually rejoice at the opportunity to purchase stocks at discounts to their net current asset values. That is, stocks that trade for less than their current assets minus their entire liabilities. While purchasing an "index" of net-nets should result in above average profits (if history is any guide), further careful analysis can lead to even higher returns.

Not all net-nets are worth investing in. If the company is burning its assets due to floundering operations, its value (liquidation or otherwise) won't be worth much at all! Consider Shermag (SMG), a furniture manufacturer and distributor. Last year, it had current assets of $48 million and total liabilities of $36 million, yet it was trading at a market cap of just $6 million.

Great value? Hardly. The company has lost about $15 million per year for the last three years. As it burns through its assets in this manner, it quickly erodes any balance sheet value it appears to have. Today, it trades for $300,000, but the drop in value should have caught no one by surprise.

When looking through net-nets, be sure to keep in mind that not all of them offer great value. It takes patience and an understanding of the underlying business to ascertain whether you've found a diamond in the rough.

Posted in Graham net-net, SMG, Shermag | Comments Off

It’s About Returns, Not Profits

June 23rd, 2009


All too often, the media is concerned with a company's absolute profit level in determining how successful a company is. However, what's more important is the company's return on its invested capital, since that has a stronger effect on:

1) The cash flows to the shareholder, and
2) Whether the company has opportunities to grow going forward.

Let's say Company A and Company B both make $1000 / year, and have been growing their profits at 10% per year. Company A and Company B are in the same industry and are similar, except for the fact that Company A has assets worth $5000, while Company B has assets of $20,000. Assuming they were selling for the same price, which company would you rather own?

It may seem like Company B is more desirable. After all, who wouldn't want to own $20,000 worth of assets rather than $500? But actually, if you believe in the growth prospects of this industry, Company A is the better investment! It comes down to "return on assets" (which is sometimes substituted for it's cousin, return on invested capital), which is a measure of what kind of return an investor gets on his money.

For each dollar Company A invests in its assets, it gets $0.20 in earnings, while Company B only manages $0.05. If these companies were to grow their earnings by $100 this year, the owner of Company A would only have to invest $500 for that return, allowing the remaining amount to be paid as a dividend or to repurchase shares. On the other hand, the owner of Company B would have to invest $2000, which means he won't see any of that $1000 profit from last year, and the company would need further financing such as bank loans.

All too often, investors see growth in a company's future, but fail to consider the costs of that growth. All companies require investments in assets in order to support growth, whether it's in the form of fixed assets, working capital, or the acquisition of other firms. The companies with the best return on assets (or return on invested capital) are the ones that reward their investors with cash, not just paper profits.

Posted in ROA, ROIC | Comments Off

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