Walter Schloss 1973 Forbes Article & Two Ways to Outperform the Market

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I just read an old Forbes piece on Walter Schloss: Making money out of junk. As many regular readers know, Schloss is one of my all time favorite investors. Read more about Schloss on my resource page and also check the Walter Schloss category. He made 21% per year for 47 years, investing in a simple, methodical, low stress manner working 9-4:30 with no other employees or assistants other than his son Edwin.

Here are some key takeaways from the interesting Forbes piece:

  • Focus on cheap stocks. This means not worrying about earnings at the moment, only asset protection.
  • You have three things in your favor here:
    • Earnings turn around and the stock appreciates significantly
    • Someone buys control of the company (buyout)
    • The company begins buying its own stock

One thing I’ve really learned with Schloss is that it’s difficult to buy stocks that have problems. I think that’s a reason why many value investors underperform. They end up buying good businesses, but at prices that will only yield mediocre future returns because it’s hard to buy stocks with problems, or stocks with seemingly no way out. That’s the very reason why the latter type of stocks get mispriced. It’s hard for everyone (including value investors) to own them. This is an important thing to remember. Think differently. Sir John Templeton said you have to do things differently from the crowd if you want a better than average result.

Make a List of Investors Who Have Actually Achieved Significant Results

I have a relatively short list of investors that I’ve extensively studied that have produced exceptional long term results. I highly recommend doing this as it will provide insight into what actually creates significant outperformance. (It’s not always what you might think). There are lots of well known investors, but when you look at their track records, many of them have produced just average results (maybe 100 or 200 basis points better than the S&P). I’m not interested in modest outperformance. I’m certainly not interested in average performance (although in the investment business, the S&P 500-which I consider “the average”-is actually quite good). Nonetheless, I want to do much better.

So make a list of guys who have made 30% a year, or 50% a year in Greenblatt’s case. Study Schloss who made 21% per year for 47 years. Study Graham and Buffett. Study Pabrai. You might notice the same key things I noticed…

How Did The Best Investors Achieve Their Results?

Two things that I’ve noticed over and over again when studying the investors who have outperformed (Pabrai, Buffett, Schloss, Graham, Greenblatt, etc…):

  • They were very concentrated (they did extensive research and bought big positions), or
  • They were diversified, but they bought stocks that no one else wanted (they were far less concerned about understanding the intricacies of the business, and more concerned with valuation and numbers)

Easier said than done (even for most value investors). Concentration is tough, and buying junk is tough. That’s why it’s easier (and less profitable) to own a diversified basket of good companies. It’s easier on you emotionally, and it’s easier to pitch to clients. Over time, you’ll do just fine, but your results won’t be much different than what the overall S&P 500 does.

Read the entire Forbes article for more info on Schloss’ ideas from 1973. 

Case Study-The Story of GEICO, Graham, and Buffett

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Geico is a company that is owned by Warren Buffett’s Berkshire Hathaway. It’s an incredibly interesting company to study. I recently read an outstanding presentation on the company by David Rolfe of Wedgewood Partners. This post is my take… a short summary of the story of GEICO from the notes of that presentation. I recommend studying the presentation for more details on the company itself-I learned a lot by doing so. It’s a great case study. Now… for the story, and the broader lesson….

Throughout its 80 year history, GEICO has dominated the car insurance industry by directly selling insurance to consumers at a lower cost than its competitors. This business model was laughed at in its early years, as analysts said GEICO could never compete with the larger insurance firms and their armies of sales agents. But GEICO did compete, took market share, and grew and grew and grew.

GEICO-The Growth Stock Loved by Two Value Investors

But the reason the company is a fascinating case study is that it made a fortune for both Ben Graham and Warren Buffett. Not only that, but GEICO, for most of its storied history, was considered a high flying expensive growth stock. Buffett occasionally got interested in growth businesses, more so as his career evolved, but Graham was basically allergic to stocks selling for high price to earnings ratios or high price to book ratios.

So it was ironic that Graham ultimately made far more money in this single GEICO investment than all of the other investments he made during the course of his lengthy career… combined. It was also strange that Graham invested nearly 25% of his partner’s capital into GEICO in 1948, acquiring 50% of the growing enterprise for the small sum of just $712,000. This would eventually grow to over $400 million 25 years later!! That is a 500 bagger. To make an understatement: For a guy who made a living hitting base hits, this was a home run.

Around this same time, a young 21 year old Warren Buffett became interested in GEICO after learning that Graham was chairman of the board. Buffett famously took the train to DC on a cold winter Saturday morning and luckily met Lorimer Davidson, an executive at GEICO who spent 4 hours with this “highly unusual young man”.

Buffett began buying stock the next Monday after being “more excited about GEICO than any other stock in my life”. He put 65% of his small fortune of $20,000 (the initial seedlings that would grow into his massive fortune). He also tried to sell the stock to every one of his clients, and wrote this excellent research report called The Security I Like Best.

So GEICO caused Graham to put 25% of his capital into the business when no other security ever represented more than 5% of his well diversified portfolio. And it caused a young Buffett to put the majority of his capital into the stock, also violating his mentor and role model’s investment policy.

But it paid off for both, although much more for Graham, as Buffett sold the stock after a small gain to invest in even more undervalued securities. Buffett would later regret this decision as his initial $13,000 investment would have grown to $1.3 million in just a few short years. (Buffett of course ended up buying GEICO stock again years later, acquiring a major stake in the 70′s during a panic selling spree, and finally buying the whole thing in the 90′s.)

I Like Cheap Stocks and I Like Base Hits

My own investment strategy much more resembles the methodical, statistical approach that Graham and Walter Schloss (and an early Buffett) used to produce consistent returns than the present day Buffett and many of the Buffett followers. Buffett is an anomaly in that his judge of business and people (management) is unparalleled. This gives him a huge edge. He sees intangibles and is able to quantify those intangibles and deduce them down to actionable pieces of information that in turn helps him determine value. It’s based on his lifetime of learning, reading, and experience, and just raw talent.

This is a tough thing to master-the qualitatives. Many try, but end up hugging the index because they buy these great companies at just mediocre prices and thus get average results… the stocks of the companies end up producing great results-high returns on capital and large profits, but because of the valuation paid by these investors, the shareholders returns are inferior to the splendid business results.

So the first thing I always try to do is be careful not to overpay for great businesses. I’m not Buffett, and I don’t try to be. I love great businesses, but I don’t want to overpay. So that leaves me buying cheap stocks, and methodically grinding out investment profits in the style of Graham and Schloss, which is something I enjoy doing very much.

The Lesson of GEICO: Always Be Prepared for the Fat Pitch

However…. here is the lesson: while it’s a prudent and safe strategy to methodically invest in a diversified basket of undervalued stocks– that is, to invest in value stocks, sell them as they approach fair value, and reinvest profits into further undervalued stocks– it is also prudent to be alert and always prepared for an opportunity to hit the home run ball.

Buffett hit a lot of home runs during the course of his career. Graham hit one. Buffett’s a home run hitter. He’s Barry Bonds (without the steroids). Ben Graham is Tony Gwynn. Tony never hit more than 17 home runs in his hall of fame career, and he hit more than 10 home runs in just 5 out of his 20 years that he played. But after batting .289 in his rookie year, he batted over .300 in 19 consecutive years, including .394 in 1994. Gwynn had an incredible career batting average of .338, and he got on base nearly 4 out of every 10 times he stepped to the plate.

That’s a lot of value. And that’s what Graham did. Methodically hit base hit after base hit. But always be prepared for opportunity when it comes.

I’ll end the post with one of my favorite passages from The Intelligent Investor, (which was also featured in the Rolfe presentation I linked to above)-emphasis mine:

Ironically enough, the aggregate of profits accruing from this single investment-decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions. 

Are there morals to this story of value to the intelligent investor? An obvious one is that there are several different ways to make and keep money on Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision – can we tell them apart? – may count for more than a lifetime of journeyman efforts. But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplines capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgment, and the courage to take advantage of them.

Markel (MKL) is a Compounding Machine

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A couple weeks back I wrote a quick post on Tom Gayner, who is an outstanding investor and head of Markel (MKL), one of my favorite companies in America. Markel is a well run insurance company that has been compounding shareholder equity consistently at about 16% per year over the past 20 years. MKL operates with a similar business model to that of Berkshire Hathaway:

  • Write insurance policies to collect premiums
  • Invest the float

Insurance companies make money in those two main categories: underwriting profits and investment profits. Many insurance companies actually lose money writing insurance, but make money on investments. It’s very difficult for insurance companies to produce consistent underwriting profits. The best insurance companies are profitable over time in both their underwriting and their investments.

MKL has been achieved an underwriting profit in 14 of the last 20 years, and has an average combined ratio well under 100% (under 100% is profit) over the past 2 decades. The beautiful thing about running a profitable insurance business is that the float is free and permanent (float is an insurance term which very generally means the temporary funds that the company controls after accepting premium payments but before paying out claims). As long as the underwriting is profitable, this float will act as an interest free loan that never has to be paid back, thus allowing it to be invested in long term securities such as stocks and bonds.

This is where we become even more interested in MKL. Tom Gayner is an outstanding investor. I recommend reading his shareholder letters, which contain a wealth of knowledge on both the investment front as well as the insurance business.

Gayner is a classic Buffett investor: he loves buying great businesses at fair prices. Here at BHI, we love cheap stocks, and we’re looking for significant absolute returns over time… we are trying to study Buffett from the 50′s and 60′s more than Buffett of the 80′s and 90′s, but every value investor loves great businesses and it’s worth studying the way investors like Gayner think.

And the way he thinks? Very simply. No macro economic forecasting, no complex spreadsheets, just simple logic and sound principles. Here is Gayner describing his own investment philosophy:

MKL Investment ProcessThis simple process has allowed Gayner to beat the S&P 500 over time by taking much less risk of permanent capital loss. This investment method combined with a profitable underwriting discipline has led MKL to compound book value at 16% per year. Currently MKL is priced at a 30% premium to book value, and I think it’s probably worth that. MKL is on my great company watchlist, and if it falls to book value or below, it’s likely to be an outstanding long term investment that will allow shareholder returns to match or exceed book value growth over time.

 

How To Determine a Good Investment

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I just wrote this post on my investment process and the idea of using screens. I found it interesting that Buffett doesn’t even consider screens as a tool. I think most of the reasoning is that he doesn’t use technology much, but other reasons include the sheer size of his investment portfolio and the fact that since the 1980′s he has become much more of a business investor interested in the qualitative aspects of a business. He is much more interested in moats, management, and competitive advantages than he is about P/E or P/B ratios.

This is of course a huge departure from the investment methods he learned from Ben Graham, who didn’t really care much about the underlying business, only what the value of the net tangible assets were currently in comparison the the stock price. Walter Schloss was the best practioner of Graham’s methods, making 20% per year for 47 years.

My methods are a synthesis of those three investors, along with some things I’ve learned from Greenblatt. But Buffett of course is the best of them all, and I always learn something when he shares his ideas. I was reading through the Q & A from the recent Berkshire meeting, and this was a passage I thought was excellent:

“We’re looking at quantitative and qualitative. We’re not looking at aspects of a stock; we’re looking at aspects of a business. It’s important to have that mindset that we’re buying a business whether we’re buying shares or the entire company. When Charlie and I look at Value Line or reports or papers or whatever, for one thing we have cumulative of a good many industries and comps and not all by a long shot.

“Different numbers are of different importance depending on the kind of business. If you were a basketball coach you would if walking down the street and a 5’4” person said you ought to sign me up, you might have a prejudice against him but there might be one who’s good. And I might say good luck son, we’re looking for 7 footers, and then we have to worry about whether we can keep them coordinated and keep them in school. We see certain things that tell us, think further, look further. We’ve come up with the conclusion that we can’t make intelligent analysis of all kinds of businesses and usually some little fact slips into view that causes us to rethink something.”

So Buffett is thinking about the business. He reads a lot, and he has built up a huge database of knowledge on a variety of industries, which is his circle of competence. He takes large concentrated positions, so he has to invest this way. He uses tactics that stray far from Graham, but the underlying philosophy is value. The next passage is in response to Doug Kass’ rather silly question about Buffett maybe being too quick to make investment decisions, unlike his old days when he did tremendous due diligence:

“You mentioned how I had the Bank of America preferred stock idea in the bathtub, which was true, but the bathtub wasn’t the key factor. The truth is I read a book 50 years ago called “Bio of a Bank.” I’ve followed BAC and other banks for 50 years and even bought banks. So there are different things we think about in terms of a bank than we think about than when buying (something else)… certain things we think about when buying insurance. Different things depend on brands. Some brands travel very well – Coke is a great example — and some brands don’t travel. We just keep learning about things like that.”

What a great response… basically: ‘yeah I thought of BAC while I was in the bathtub, but it was an easy decision because I’ve studied banks for 50 years’. I like how he says “we just keep learning”. That’s the key. Buffett, like Schloss (and like us here at BHI) loves simplicity. Buffett can be simple because of his database that he has built up over the course of his life. It’s easy for him to determine value from a qualitative standpoint, just like it was easy for Schloss and Graham to determine quantitative value. Check out how simple his BAC thesis is:

“BAC in 2011 was subject to rumors, there was big short interest, morale was terrible. It struck me that an investment by Berkshire might be helpful to the bank and might be to us. I never met Brian, but gave him a call. Not because I calculated some precise P/E ratio, but because I have some idea of what the company may look like in five years and a reasonable amount of confidence and there was a disparity between price and value.“

What… no spreadsheets, no 100 page thesis, no DCF or other projected earnings model? Nope, just a simple thesis and an easy conclusion that “there was a disparity between price and value”. (By the way, the link is to Bruce Berkowitz case study, which I think is a great learning tool, but I don’t think you need a 100 page case study to justify making an investment).

Determing if a disparity exists between price and value: that’s all we are trying to do, and I think if we approach each investment decision with that simple logic, our results would improve as would our efficiency.

Idea Generation: Reading vs Screens

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I thought I’d write down some quick notes regarding my investment process today… This is a topic I write and think about a lot. Having a defined investment process is essential to staying focused and being able to methodically generate long term investment results.

Buffett Reads, He Doesn’t Screen

I read a lot about the Berkshire meeting last weekend, and I have a few friends that attended (I’m anxiously awaiting their first hand accounts). At the meeting, Buffett discussed how he never uses screens to find ideas. I find that interesting… This exchange sheds a little light on how they think about screens:

Charlie Munger: “We don’t know how to buy stocks just looking at financial figures. We need to know more about how the company actually functions. Anything a computer could be functioned to do in terms of screening – do you use a computer to screen anything?”

Warren Buffett: “No I don’t know how to. Bill’s still trying to explain it to me. We don’t use screens. We don’t look for things that have low P/B or P/E. We’re looking at businesses exactly if someone offered use the whole company and think, how will this look in five years?”

I think about screens differently than Buffett and Munger do. One thing you have to consider is how adept they are as business analysts (in addition to security analysts). This is a skill that is developed over the course of a career. It’s very difficult (impossible) to compete with Buffett and Munger on a qualitative basis. But, the thing I took away from reading through the Q & A at the meeting was how much they valued reading.

This is a key takeaway… reading allows you to compound knowledge over time, and it will improve your qualitative skills… knowledge is like compound interest. But until that interest builds up, it is much safer to place greater weighting on the quantitative side of the equation.

I use screens often to filter my list of investment ideas. However, I have noticed that lately, I’ve found that simply reading fund letters and even certain blogs are great ways to find ideas because you get to piggyback on the research and work of others. It’s like having an in house analyst that has already done a ton of work for you. That’s the beauty of the internet and people that are willing to spend their time sharing ideas and research.

So reading blogs is a great way to find ideas. So is reading fund letters and letters to shareholders. Reading these sources for ideas gives you the idea itself, but also often gives you the thesis and the logic behind the investment idea. From there, you can do your own work and determine if you agree or not, but leveraging the work of others is a great way to find and learn about stock ideas.

Screens Are a Starting, Not Ending Point

As for screens, I use them often and I think it’s a great way to filter for interesting ideas. I think Buffett would have certainly used them if he started his career in today’s world. I’m sure Graham would have. Screens are a great way to start looking. But it’s just a start. Reading Value Line is one step better than a screen because you can learn a lot about the businesses as you flip the pages. Reading ideas from other investors is the best of the three, because it gives you the idea, allows you to learn something about the business, and it gives you (in most cases) the reasoning behind why the investor thinks it’s a good idea. So it’s a case study on a current stock idea.

I’ve discussed my investment process in many different posts. I’m currently trying to simplify, and always looking for ways to streamline my process. My basic investment process is divided into three main categories:

  • Idea Generation
  • Research
  • Portfolio Management (Decision making: buy, not buy, hold, sell, etc…)

Currently, the “idea generation” part of my routine has just three sub-categories:

  • Reading through Value Line each week
  • Checking a few screens once per month
  • Reading other investors (professional and non-professional) that share ideas on blogs and in fund letters

For blogs I follow, check the blogroll. For fund letters I read, check out this post.

Of course, idea generation is the first part of my investment process. Research is the second part, and that involves reading annual reports, proxies, and background articles on the stock. Then, a decision has to be made to either buy the stock, put it on a watchlist, or discard it completely. More on that later….

As for screens, I like them, I use them, and I find them helpful in generating ideas. I think they help make my search process more efficient. I think Schloss and Graham would have used them, but certainly not exclusively. They are simply tools. I do believe that reading is a way that allows you to improve skills much more quickly than going through screens.

Investing is an art, but it’s an art form that can be methodically practiced. That’s a big part of what this blog is about. Practice, practice, practice… and finding ways to improve not only results, but the approach to practicing itself.

Human Behavior and Stocks Selling Under $1

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Preston Athey runs the T. Rowe Price Small Cap Value Fund. He’s produced around 12% annual returns for the past 22 years, making him one of the top mutual fund managers in his category. I would imagine it’s hard to run $8 billion (the size of his fund), and have to invest in small caps only, so although 12% isn’t shooting the lights out, given his mandate and the constraints that come from the size of his fund, I’d say his results are exemplary.

In the recent Graham and Doddsville Spring 2013 newsletter, he gave an interview. The following passage was taken from this interview in a response to a question on the inherent bankruptcy risk that comes from investing in small companies. I found that his answer was interesting, and provided a key lesson to keep in mind regarding the behavior of crowds, especially during a bear market. This passage reminds me of the famous investment Sir John Templeton made when he bought all of the stocks on the NYSE trading under $1.00 on the eve of World War II.

Here is Athey discussing how he looks at risk when evaluating small cap stocks (emphasis mine):

“There’s absolutely some bankruptcy risk in investing in small-cap value companies. By definition,they are considered value stocks because there’s something wrong. Perhaps their record isn’t very good or they’re overburdened with debt or they’ve had some bad news that’s really knocked the stock. In the 22 years that I’ve run the Small-Cap Value Fund, I’ve averaged less than one company per year go bankrupt while I own the stock… I consider it an overblown concern and it’s not something I spend a whole lot of time worrying about.

“In March 2009… I gave an interview to Barron’s on the topic ‘Stocks selling for below$1.00’. After giving the interview, I decided to check how many stocks I actually had below $1.00. Remember, this was at the bottom of the market. At the time, 20 stocks out of 300 in the fund were selling for below $1.00… most were bought at prices significantly above that, often above $5.00, so that shows you how much they had come down. So what was going on? 

“First of all, we were in a horrible bear market, so a lot of stocks were down. Secondly, these were probably the lower quality stocks of the group that I held, so in a scary market where people are worried about balance sheets or businesses that maybe aren’t as solid as others, the stocks are going down a lot more. The bottom line is they’re all below $1.00. The question was asked by the reporter, ‘Doesn’t that mean they’re all going bankrupt?’

“In a normal market, I would say if the stock goes below $1.00, the market is telling you they think it’s going bankrupt. In a market like today,that’s probably a reasonable guess… 20% to 30% of those companies probably will go bankrupt. But, at the bottom of a bear market when people are worried about everything, my experience was that they’re not all going to go bankrupt.” 

“There were 20 of my positions trading at below $1.00. I believed that from that point on, when the market came back, most of these stocks would recover. A small fraction would probably go bankrupt, some would track the market,some would do substantially better, and one or two would be home runs. 

“The question was asked:

‘Well if that’s the case, why don’t you sell the ones that are going to go bankrupt and buy the ones that are going to be home runs?’

“If we knew that, obviously we wouldn’t hold the ones that were going bankrupt. Two of those 20 companies were literally selling for less than the value of the cash on their balance sheet, and another half-dozen met Ben Graham’s favorite net-net standard where they were selling for below their net working capital. I felt pretty comfortable holding those stocks. 

“Fast forward a year, four of those 20 actually did go bankrupt. Let’s say that I sold them at some point either right before or right after they filed and realized something less than $1.00. Of the remaining 16 companies, all of them eventually recovered well above $1.00. Some tracked the market, while some went up two times to four times. One of them, Dollar Thrifty, went from $0.60 to $45.00 in a year and half, at which point I sold it.

“If you took that portfolio of 20 companies and evenly weighted them at 5% each, I guarantee you the two-year returns on that portfolio were better than the number one small-cap value fund in the country. But who has the guts to invest a lot of money at the bottom of the market into what the market perceives as horrible companies? I didn’t sell them, but I held on and when the junk rallied, I realized my fair share of profits.”

It’s always good to be reminded that “if you want to have a better performance than the crowd, you must do things differently from the crowd.” That Templeton quote stands at the foundation of my investment philosophy.

DELL and EBIX, Heads, I Win Now; Tails, I Win Later

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Yesterday I wrote a piece where I listed the three categories that my investments typically fall into: Franchises, Cheap and Good Stocks, and Cheap Asset Stocks. I also described a 4th category called Special Situations that I occasionally participate in when I find an interesting idea. The vast majority of my investments fall into the first three categories, but recently, I’ve looked at two interesting special situations that have a few similarities.

Dell and Ebix are two stocks that I’ve been following for some time. Both have shown up in Joel Greenblatt’s screen for months, and I’ve considered both to be potential investment candidates. Both have CEO’s with large ownership stakes, both have negative sentiment surrounding the stock (for different reasons), both look cheap using basic value metrics, and both have traded above their deal price, signaling the market might expect a higher bid.

I own Dell, but unfortunately let Ebix pass by after not being comfortable with their accounting. (This is a lesson in and of itself: when bad news causes a stock to drop dramatically, the market often over discounts the news. The market has a hard time efficiently pricing these types of scenarios, and in my experience, the initial reaction is often the worst (BP during the oil spill, HLF after the Ackman short announcement, etc…). The market tends to price things toward the worst case scenario end of the spectrum, but the worst case often does not materialize.

EBIX Background

Here is a very brief background on EBIX, which has been a short seller battleground stock for a couple years ever since this article came out.  That article was written by an anonymous short seller 2 years ago, causing the stock to lose around a third of its value in one day. Then, more recently, another anonymous short seller named Gotham City Research wrote this scathing research piece in February, again causing a big one day drop in the share price, this time from 19 to 14.

At that point, the stock was beaten down to single digit earnings multiples including an EV/FCF ratio of about 7. This is despite the fact that the company has grown free cash flow at around 40% per year over the past decade. I noticed this stock showing up in Greenblatt’s scan around that point, but never really spent any amount of time looking at it. Although it looked incredibly cheap on the surface, I felt that the short sellers knew much more than I did, so I simply stayed away.

This turned out to be a missed opportunity, as the market quickly revalued the company from a low of $12 a share all the way back to about $18 per share in just a few weeks. It pays to pay attention to situations where there is controversy or uncertainty. That’s where the market is most inefficient.

Then, this past week Goldman Sachs announced a bid for EBIX at $20 per share. This private takeover includes management participation and the CEO Robin Raina will maintain his ownership stake of about 19% of the company. This was a catalyst that made me take another look at the stock, and I noticed some similarities to the DELL situation, which I am currently participating in.

Summary of EBIX Situation

After the buyout was announced, I re-read the negative pieces written by those two short sellers, and I also read through the comment sections on Seeking Alpha. There are some insightful comments on both sides, including numerous bullish arguments written by accountants who know a lot more about EBIX than most of us, including one accountant who has been a shareholder and a consultant to the company for over 10 years. He commented on this piece which was a rebuttal to the short sellers piece. (By the way, as an interesting side note: I am always skeptical of anonymous short sellers who write these research reports. It’s one thing for Bill Ackman to publicly trash HLF, it’s another for someone who doesn’t disclose their identity to do so. Anonymity doesn’t mean that the thesis is less accurate, just less convincing, at least in my opinion. But it is beneficial to read the short’s arguments in this case.)

I started compiling a short list of general thoughts on this EBIX situation:

  • Goldman Sachs is interested in buying the company alongside the management at $20 per share. 
  • The stock initially jumped about 3% above $20, implying that the market believes that a higher bid might come in.
  • This article came out summarizing the same arguments, causing the stock to drop back to about $19.50, which is where I am now interested.
  • At $19.50, there is a 2.5% arbitrage opportunity, but there is the potential upside of another deal coming in.
  • There is a $45 million breakup fee that Goldman has to pay Ebix if Goldman terminates the deal.
  • Robin Raina, the CEO, has about a 19% ownership interest in EBIX, and he will maintain that ownership after the company goes private.

So we now have an interesting arbitrage opportunity. The stock has a lot of controversy, but you have a major investment bank interested at $20. The CEO has a 19% ownership interest, and he is not selling out at $20, which tells me he thinks it’s worth at least that. The stock still is incredibly cheap relative to the earnings and free cash flow.

Here is a quick look at the 10 year numbers:

EBIX 10 Year Data

Final Thoughts and Comparison to DELL Buyout

I wasn’t interested when EBIX had a negative spread between the buyout and the current price, just as I wasn’t interested in DELL when it traded above $13.65. The market was betting on a higher bid in both situations, and I think both stocks might still get a better bid. But here is the main reason I’m interested in both arbitrage opportunities:

I am interested in the arbitrage play because I would still want to own the stock even if the deal falls through. This to me represents a low risk opportunity. Let’s take DELL for example. The buyout represents only limited upside at these prices. But we have an alternative to cash (we get paid a small premium if the deal goes through), and we get the upside potential of another deal coming in 10, 15, 20% higher. But the main protection is that even without the deal, I’d own DELL shares at this price. If you believe Southeastern’s thesis, DELL is worth $24 per share. I’m not sure if it’s worth that or not, but I think it’s worth a lot more than $13.65. So if the deal goes through, we don’t make much, but we preserve our capital. If the deal doesn’t go through, the stock would likely drop some and I’d be able to buy more.

So the following three scenarios could play out, and any of these would be favorable to me, just in different time frames:

  1. The deal closes and I get paid a small premium to my cost.
  2. A higher bid comes in and I’m able to realize a larger gain in a short period of time.
  3. The deal falls apart, likely causing the stock to drop, but allowing me to maintain a long term position (and even buy more) in a stock I believe is undervalued. (It’s worth noting that many large shareholders like Icahn, Southeastern, Pzena and others would probably prefer this outcome as well).

So when you participate in an arbitrage situation where you believe the stock is undervalued even at the deal price, there is little that can go wrong (assuming your valuation assumptions are correct: that of course is the key).

EBIX is a similar situation. After getting more comfortable with the fact that insider ownership and interest from a major bank, along with the publicly available data, I think EBIX is an undervalued stock at $19.50. I don’t own shares yet, and I’m not as convinced on EBIX as I am with DELL, but I still think it’s an attractive risk reward opportunity.

To Sum it Up

Dell and Ebix have a few key similarities:

  • Both stocks have had negative sentiment (for different reasons)
  • Both stocks have dynamic CEO’s with large ownership stakes in the business
  • Both stocks initially traded above their proposed deal price, signaling that the market believes a higher bid might materialize
  • Most importantly for me, both stocks represent good value at the current prices, which allows me to be comfortable knowing that if the deal doesn’t materialize, I can maintain or increase my position.

The only arbitrage plays that I’m ever interested in are the ones where I think the stock is undervalued at the deal price. In most cases, I don’t like the risk-reward that merger arb offers (limited upside, big downside). But when I’d own the shares at the current price, even without the catalyst of a pending buyout, I am interested. I get to own shares in an undervalued stock, with little long term downside, and with the upside of another deal presenting itself, allowing me to make a quick gain. I like these types of risk-reward scenarios… Heads I win now, tails I win later.

Disclosure: John Huber owns DELL for himself and for clients. He may take a position in EBIX in the next few days. Nothing here represents a recommendation for your specific situation. Please do your own research. 

Cheapness is an Excellent Catalyst

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I group my equity investments into three main categories:

  • Compounders (These are Warren Buffett “forever” stocks, or franchise businesses with durable competitive advantages that I’m willing to hold for a long time as long time as long as the business continues to compound cash flow, dividends, and intrinsic value.)
  • Cheap and Good (These are stocks that are not as high quality as the compounders, but are still above average businesses producing good returns on capital but are for some reason selling at a cheap price, often because of some temporary problem. These stocks are often Joel Greenblatt style Magic Formula stocks.)
  • Cheap Assets (These are stocks that give you the opportunity to buy $1 worth of assets at a discount. Net-nets, stocks below tangible book, or stocks with hidden asset values fall into this group. Often times the businesses in this group have problems, but the market is offering you the assets for less than the value on the books, and you get the upside potential of the business improving without paying anything for it.)

But I will invest in a 4th category on rare occasions that I will refer to as special situations, which also what other value investors commonly call this area of investing.

Value Investing With a Catalyst

Joel Greenblatt wrote one of my favorite books called You Can Be a Stock Market Genius where he expertly describes in detail (case studies included) many of the types of these special situations. A special situation, generally defined, is a stock with some sort of corporate catalyst such as a spinoff, reorganization, or merger. Greenblatt made 40% annual returns for 20 years using the techniques he describes in that book.

However, I am not an expert in this area, and so I don’t often invest in these situations, unless I’m comfortable with the underlying value. I have found that it is possible to outperform the market, potentially by a significant margin, by simply owning a diversified basket of undervalued stocks. You could potentially follow Joel Greenblatt’s magic formula and do nothing else, and do extremely well over time. But there are investors who have done much better than that. Often these investors, like Greenblatt in his early years, have used special situations in their investment strategy.

I invest in spinoffs when I think the parent or the spinoff is undervalued, but I don’t really buy spinoff stocks just because they’ve historically done very well (although an argument could be made for this simple idea as well). I occasionally invest in stocks that are involved with a merger or buyout, but again, the common thread is that I want to be comfortable with the valuation before investing. There are some investors that will invest in arbitrage strategies using the deal itself as the entire reason for investing. If the deal falls through, you’re left with a sizable loss and a stock that you may or may not still want. I’ve never been attracted to those types of scenarios.

Value is its own Catalyst

I do spend a lot of time learning about special situations and over time, I may become more skilled in this corner of the value investing world, but for now, I prefer to maintain my diversified basket of above average companies at below average valuations. Just like how many value investors are fascinated by trying to find franchise businesses because Buffett has done so well there, many value investors are also enthralled with stocks with catalysts, because Greenblatt and others have done extraordinarily well with those techniques. I agree with both of those camps, and both strategies can work if you become proficient at them.

But one thing I’ve learned over the years is that value, or cheapness, is its own catalyst. What I mean by this is that when a stock becomes cheap, that very cheapness may produce its own catalyst in the form of a corporate buyout or private equity group becoming interested. But even putting buyouts and mergers aside, when a stock becomes cheap enough, it at some point will cause other value investors to become interested. This is mean reversion, and mean reversion is the most powerful force in markets. When it is applied without leverage (this is important) within the context of an investment strategy, it can yield outstanding results for the patient, disciplined practitioner.

My favorite investor is Walter Schloss, and although I presume he invested in special situations from time to time, he built his exemplary track record (20% returns for 47 years) on the foundation of buying cheap stocks. I doubt that he thought of his strategy this way, but he was essentially using cheapness as his catalyst. He simply tried to buy stocks cheap that had low amounts of debt, with the idea that eventually, these lowly levered companies as a group will survive, and thus the stock price and the valuation will rise (revert to the mean). In some instances, the businesses improved and that represented enormous upside potential for the stocks in his portfolio.

So I try not to worry too much about catalysts. It’s a buzz word on Wall Street, and many investors are obsessed with identifying a catalyst. There is certainly nothing wrong with spending time identifying, evaluating, and analyzing a catalyst if you have the skills and time to do that. There are some outstanding investors I follow that do this regularly, and I learn a lot by reading their fund letters and blogs. I am always trying to improve. But the one thing to keep in mind is that if you properly identify cheap stocks, valuation often works as your tail wind, providing you with a built in catalyst.

Two Examples of Stocks Where Value Became the Catalyst

Dell and Ebix are two stocks that I’ve followed for some time now as both have shown up in Greenblatt’s screen for months. I list these together because they have numerous similarities: both got cheap because of certain problems, both have similar quality metrics such as above average returns on capital, both are involved in a pending buyout, and both have CEO’s with large stakes in the business.

We own Dell, but unfortunately didn’t take a position in Ebix. I didn’t get comfortable with the accounting, but that stock represents an interesting study on its own about how markets inefficiently price event risk and other uncertainties. I’ll have a post discussing these two stocks, and why I might still take a position in EBIX, which has just agreed to sell itself to Goldman Sachs for $20 per share.

But both of these stocks became extremely cheap and both turned out to be special situations, but before the mergers were announced, these stocks began to appreciate significantly. This happens a lot with stocks that have problems, but become extremely cheap. At some point, value creates its own catalyst. Water finds its level, and mean reversion kicks in. It happens over and over and there will be plenty of other opportunities to capitalize on.

Disclosure: John Huber owns Dell for himself and for clients. Please do your own research. Nothing here represents a recommendation. 

Notes on Thrifts and 4 Stocks to Watch

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Last week I went through the Value Line section on thrifts and wrote down some notes and thoughts I have on the industry. Thrifts and small community banks have had a rough few years, but many have survived and repositioned themselves to prosper going forward. Many of them have cleaned up their balance sheets. Many of the bad loans that were written in 2005-2007 were 5-7 year balloons. Time will help heal these banks.

More importantly, the residential real estate market is doing extremely well, and is the healthiest its been since 2005 with sales increasing and inventory stabilizing.

I thought I’d post a few thoughts I have on the thrift industry, along with four stocks that I added to my watchlist. The four stocks all look cheap, all have certain problems, but may turn out to be interesting investment candidates.

A Few Notes on the Thrift Industry      

  • Ultra low interest rates are a problem because shrinking asset yields are negating any loan growth that comes from new loans and/or refinancing.
  • Thrifts have had it tough, but thrifts will benefit if either:
    • Economy picks up, (i.e. long term bond yields will rise) or
    • Fed raises rates (possibly because economy picks up)
  • Basically, if the spreads widen between short and long term interest rates, that will be a good thing
  • Rate hikes are usually bad for lenders, but it might increase spreads, and indicate a better economy
  • Thrifts are currently using M&A to increase profits
  • Many of the stocks offer good yields but watch the payout ratios
  • Book value is important when analyzing thrifts
  • Margins for thrifts have been squeezed, and the consensus is that that will continue. Note: that probably means it’s already priced in. What if rates rise?

4 Thrifts I Like

Here are the four thrifts I like. I don’t any positions at the moment, but will be doing some further research. I included the charts of the Price to Tangible Book Value over the past 10 years. Mean reversion is a very important concept, but I like to see charts like this where these ratios are at a 10 year low (or close to it).

FNFG-First Niagara

FNFG data by GuruFocus.com

  • New CEO, old one had too many acquisitions that bogged down the company.
  • Near 10 year low of $8.00
  • Book is $14
  • Stock typically has sold near or above book (mean reversion matters)
  • Peter Lynch liked equity/assets of 10% or more, FNFG has 13%, historical is 15-20%
  • Dividend was cut last year by 50%, but current yield still 3.7%
  • Assets grown 10-fold via M&A

AF-Astoria Financial Group

AF data by GuruFocus.com

  • Insiders own 21% of the stock
  • Stock price 9.41
  • Book 13.15
  • Sold for 20-30 from 2002-2007 (mean reversion matters)

CFFN-Capitol Federal

CFFN data by GuruFocus.com

  • Pays special dividends (yield has been close to double digits for a few years after factoring in special dividends)
  • Conservative Kansas Thrift
  • Very lowly leveraged, conservative bank with an above average equity to assets ratio

NYCB-New York Community Bancorp

NYCB data by GuruFocus.com

  • Irving Kahn long time favorite (has 8% of his capital in it)
  • 7.1% dividend; many are expecting a cut, but it still would likely be a solid dividend payer even post-cut
  • 1.1% ROA, 8.9% ROE
  • 1.1 P/B
  • Strong equity to assets ratio of 12%

I like FNFG the best of the group, but any of these could turn out to be good investments. I don’t think these will be barn burners, but I think these prices represent a built in margin of safety, and as I mentioned after watching the Steven Romick interview, “Good things happen to cheap stocks”.

As I mentioned at the beginning of the post, residential real estate is a big factor behind these thrifts. Most of the stocks in the industry live and die by housing. The good news is housing is healthy. It is supported by a low supply of new inventory, low interest rates, and an improving economy. Affordability remains high for first time home buyers and buying a home with a 30 year fixed rate under 4% is almost a no-brainer when comparing it to renting. Home builders are becoming more active, but for the past few years new construction housing starts dropped significantly, leading to a multiyear low in inventory. There is also a dearth of available lots for builders to build on, which will put an added constraint on new inventory until new land gets developed and new lots come online. (As a side note, home builder stocks like HOV, DHI, LEN, and PHM have been on a tear in the past 12 months).

Housing also moves in slow, glacial like cycles. I don’t like to think much in terms of top down analysis, but in this case, I do think that housing will be a tailwind for much of the banking world, but especially small thrifts and community banks.

Disclosure: John Huber has no position in any of the stocks mentioned

Think Differently: Buying Cheap Stocks is Difficult

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“If you want to have a better performance than the crowd, you have to do things differently from the crowd.” -John Templeton

The above quote is one of my all time favorites. It’s a ubiquitous concept: we hear it all the time…. buy what others are selling, buy fear, sell euphoria, etc… The quote represents obvious importance. But the interesting thing is that although it’s an oft used phrase, it is practiced much less often than you might realize. Taking a look at the portfolios of most large investment funds, you’ll find many of the same securities. Some of this has to with the size of some of the funds. If you manage $10 billion, there are only so many stocks you can buy, especially if you have to be diversified.

However, a lot of the similarities come from the fact that it is hard to go against the crowd. It’s hard to buy unknown stocks, and it’s especially hard to buy hated stocks with well-known problems. This is difficult for everyone, amateurs and professionals alike. It’s even difficult for value investors. Many of the value investors today model their portfolios and their investment philosophies after Warren Buffett (for good reason). I also spend an incredible amount of time thinking about Buffett and his methods, and studying his letters. But here is a challenge that we have to overcome: Buffett preaches the benefits of franchise businesses that can compound their net worth over time (for good reason).

Everyone Wants to Own Franchises

The problem is this: everyone understands the fact that it’s a good thing to own a business like that. Thus, the stocks of these businesses are often priced at a premium. Take a look at JNJ, MCD, WMT, KO, or PG just to name a few… these are some of the greatest companies in the world. They almost certainly will have wonderful futures and their stocks will likely be higher years down the road. These stocks are great in permanent portfolios, but I don’t expect them to provide market beating returns over time at the current valuations. They likely will provide market matching returns with less risk, but they won’t give you 20% annual returns over time.

This doesn’t necessarily make them bad long term investments. I simply keep them on a list and observe their valuations during market corrections. I love buying and holding a quality business when the market offers me a price that will lead to above average future returns. But buying and holding a diversified basket of average priced (or in this current market-often overpriced) franchise businesses will not lead to significant long term outperformance. It might lead to moderate outperformance, but it won’t lead to huge returns.

Two Alternative Choices

So if you want abnormal returns, you have to do something differently: you either have to concentrate your holdings like Buffett has done during the course of his career (or like Allan Mecham, when he put 50% of his assets into BRK last year-what a great decision that was at $105K per share)… or, if you want to maintain at least adequate diversification like I prefer, you have to buy stocks that others are selling at cheap valuations. This often means buying cheap stocks with problems. And it’s difficult to do because there are hundreds of reasons why you shouldn’t buy the stocks you’re buying and there are many people who will call you crazy.

Take a look at the comments in any bullish Seeking Alpha article on JC Penney. You’ll find extreme emotion. When people begin hurling insults at an author who merely suggests a contrarian view, it often means that the bad news is already priced into the stock. (I don’t necessarily know about JCP specifically, but this is just a good example of maximum pessimism at the present time).

Difference Between Understanding the Concept and Actually Implementing It

I often comment on how Buffett made 50% per year at the beginning of his career when he was managing a small sum of just his own capital. He also guaranteed he could do that today if he were managing a small sum. I’m sure Buffett could do that as well. He doesn’t say things like that if he doesn’t believe it. But the key to that now famous remark is this: he wouldn’t be buying the same stocks he’s buying now if his goal was 50% per year. Not even close.

His portfolio may have contained a few big positions in some great companies, but it also would have likely had numerous smaller positions in stocks trading at extremely cheap valuations. His portfolio would also be turning over much faster (he wouldn’t be holding stocks forever, and he didn’t hold stocks forever in his early years-he sold them as they reached fair value to raise cash to invest in more bargains).

To look at a great example of a current investor who thinks differently and also is generous enough to share his ideas, check out Reminiscences of a Stock Blogger. His portfolio is filled with smaller companies, many of them in the natural resource space (the author is Canadian). His portfolio looks a lot different than mine, but it also looks a lot different than everyone else’s also. That’s the key. He thinks independently, and he buys cheap stocks. Notice how it’s worked out for him so far since he’s been tracking his results.

Thinking Independently Works

Other famous examples of investors who thought and acted differently were Buffett in his early years, Walter Schloss throughout his career, Joel Greenblatt, and Michael Burry. They all owned stocks that others either hated or didn’t even know about. They found bargains in a variety of areas using a number of different methods. But the one thing they had in common in addition to buying value was that they thought differently than the crowd. They wanted a better performance from the crowd, and they knew to do so, they had to act differently as well.

Templeton would have approved…