Quick announcement. Please update your RSS feeds by coming to http://www.spvalue.com and resubscribing to the RSS feed. Having returned from traveling as well as having finally dealt with a few pressing issues, I found time to rebuild the site including transferring to a more professional and scalable setup with WordPress 3.
I have to say that I am pretty impressed with the software. It wasn’t super easy to install, but it also wasn’t super difficult, and the tools that it gives are very strong.
I will have to write more about this general theme later, but basically I am coming to the conclusion across various levels – professional and personal- that knowing and expressing what to do should be separated from the tedious execution. For instance in this case, one does not need to know how to program to write a Blog. And actually they aren’t necessarily complementary. The best programmers may not write interesting Blogs, and the best Bloggers are probably to busy reading and writing to keep their programming skills up to speed.
Looking forward to starting up again. Lots to discuss.
One trait that seems fairly consistent among value investors (like Baupost, Greenlight, Oaktree, Buffett, and Burry) is a strong propensity to understand exactly where, how much, and, even more importantly, how quickly money is being made and lost.
This is pretty interesting. Every investment is evaluated like a private equity investment – through IRR, even though these are public equity investments. I am fairly certain every value investor has some method of performing the same analysis. It is this analysis that causes the value investor to switch between cash and an investment. Essentially cash sits outside of the investment universe and is “called down” (just like a private equity commitment) when needed. Thus the clock for investment returns starts when the capital is invested/“called”.
Why is this interesting? First is that technically it’s complicated. It requires a more sophisticated MIS (Management Information System) than you can traditionally find off the shelf, and for this reason very few hedge funds engage in this level of analysis.
Secondly in addition to being purely more technically complicated, it’s a much more mentally sophisticated form of analysis – it means that they use a second dimensional statistic other than profit (ie time profit is realized in the form of IRR) to evaluate the success of an investment and to critique the process of making that investment so that it can be replicated where successful or avoided where not.
Lastly, and most subtly, on a strategy and portfolio level this provides and indication of general market conditions by allowing the monitoring of running internal rates of returns on existing positions (that is IRR of the whole portfolio at once or IRR’s of sector or other strategy breakdowns) that can give feedback to where opportunities can be found and when it might be time to harvest a trade or when entire sectors may be over or under valued.
On this last point one can imagine a fund that through its investment style generally generates an IRR of 25% over many years such that there is a reasonable level of confidence in the process. During the October 2008 – March 2009 crisis one could see which strategies were showing the most negative running IRR and identify those as having potentially the best investment opportunities to apply new capital. Similarly if a strategy is showing an IRR well past the average fund IRR, one can at least investigate to see if it may be time to harvest.
This sounds very technical – but isn’t actually – a very similar type of reasoning is used in analyzing businesses. Essentially it’s a bet that the world mean reverts. Margins mean revert, return on equity mean reverts, asset turns mean revert, and leverage mean reverts. Along these lines, performance can have mean reverting properties. There is always room for outperformance in individual investments, but as the pool grows larger to to the point that it then reflects the market, then returns tend to become bounded on either side.
Why does this exist? Because capital can only flow from one sector or one asset class to another so quickly. For this reason we also find momentum in the market. News does not travel instantaneously and investments do not reach fair value over night, and thank goodness for that.
In any case the point is that some level of performance analysis is critical to refining one’s strategy. Essentially as Peter Drucker would say: “What gets measured gets managed.” So it might be wise to follow Greenlight’s example and measure carefully and then manage appropriately.
I am often reminded of the importance of simplicity.
Some of the best investments can be explained rather simply. Also I find its easier to understand a business if I reduce its financials to a simple model.
For a non-finance company I use the following income statement flow:
Revs
-COGS pre depreciation
=Gross Rev (implies gross Margin)
-SGA (implies sales costs)
=EBITDA (implies EBITDA margin)
-DA (implies asset life)
-Interest Expense (implies interest rate)
=Profit Before Tax (PBT)
-Taxes (implies tax rate)
=PAT
/Shares (implies dilution rate)
=EPS
I always model a balance sheet – for cash flow is an implied result of the interaction of the income statement and the balance sheet. This is actually the more complicated part of the analysis (though there are many things that can be done to simplify analysis and projection) and where I suspect real money is made (at least in my experience) as balance sheets are not very well understood and are hardly seriously modeled, especially by sell side analysts. This is a topic I will go into later.
Regarding the income statement, at first sight one might think that the model above only applies to retailers or companies with products to sell… but this is not the case. Business is ultimately about selling products or services, and invariably this involves variable (COGS) and fixed (SGA) costs. So for instance, the fuel line item of a railroad’s income statement could be classified as a COGS.
Another consideration in regards to the income statement is that the COGS reported by some companies needs to be adjusted to remove depreciation and amortization if it is reported inclusive. The reasoning is that depreciation and amortization are not always variable with sales – or at least that the link is a bit strenuous. If sales grow the company may be able to boost asset turns, and including D/A in COGS can lead to seeing a margin improvement when none actually exists (as, if the company just improves asset turns, then presumably D/A won’t change much giving a fixed component to COGS while the variable component grows with sales, in effect showing an improvement). Similarly, if sales decline, a company may not immediately go out and sell assets, and as a result an unadjusted COGS line may indicate declining margins masking the real situation.
There are many other nuances, but these give a sense of the interaction of the income and balance sheets. In general I look at 10 years of balance and income statements to understand the various ranges of different parameters – margins, turns, returns on equity, leverage, receivables and payables relative to sales and COGS, etc. Ultimately the goal is to understand how sales growth leads to potential asset growth and consequently to left over cash flow from sales that can be delivered to the shareholder.
To really make it clear, consider this: there are in fact companies where sales growth leads to very little cash flow left over for the shareholders, and, given the level of interest rates and other investment opportunities, it may not make sense to invest in these companies (as they will only produce cash at distant date) even though the rest of the world thinks they are great investments (leading to a very low implied cash flow discount rate). Conversely, there can be other companies that, due to a complete lack of sales growth or the desire to grow sales, have a tremendous amount of excess cash that can be returned to the stockholder quickly while the market punishes the stock leading to a very high implied discount rate of cash flow.
One trait that seems fairly consistent among value investors (like Baupost, Greenlight, Oaktree, Buffett, and Burry) is a strong propensity to understand exactly where, how much, and, even more importantly, how quickly money is being made and lost.