Our 12th issue of ValueFocus, our monthly newsletter for premium members, has been released. For more information see HERE
The month of May has been particularly difficult for value funds, which widely underperformed major indices. Their underperformance, in my opinion, should be a warning sign to investors of these funds, as it is not entirely clear that value managers have learned from the mistakes made in 2008.
Although I am a big believer in value investing, there are several things about value funds that seem contrary to common sense investment principles. Not only have these well-known value funds underperformed, but in most of the cases they have done so significantly. According to Tickerspy.com, their May performance looks like this:
To the credit of most of these funds, they have performed well historically, and their investors have been rewarded handsomely in most cases, some even achieving triple digit returns since inception. However, as an avid follower of the strategies they employ, I have spotted several weaknesses and somewhat disturbing trends:
1) More Preaching Than Doing
Unfortunately, a lot of value managers spend more time preaching value investing than actually practicing it. From writing books to spending a significant amount of their time on TV, it seems that a lot of managers wave the value investing banner to attract capital rather than to deploy it. Consequently, there are more funds which label themselves as following a “value” strategy than actually doing so.
2) Blind Following of Warren Buffett and Berkshire Hathaway
Make no mistake, Warren Buffett is the best investor of all times, and Berkshire Hathaway is an amazing cash generating machine which competitive advantage is firmly built within the company’s high-quality (and low cost) float. If someone is looking for billions of dollars to deploy effectively, Berkshire is probably the best bet.
However, given the small size of most value funds, it is absurd in my opinion for these funds to own shares of Berkshire Hathaway. It is absurd because small funds have the ability to invest in thousands of other companies with better profitability and growth prospects than Berkshire. If Buffett was running his partnership today, would he invest in Berkshire Hathaway himself? I think the answer would be no. Because of its large size, Berkshire cannot possibly offer small investment partnerships investors the 20%+ annual returns that smaller companies could achieve.
Contrary to the thinking of most value investors, Berkshire is not a substitute for cash. For example, Mohnish Pabrai explained back in 2008 how he considers Berkshire Hathaway as a kind of money market account, something akin to cash. After Berkshire dropped 50%, he was forced to change his strategy. To this day, top value funds hold Berkshire with the expectation of achieving above-market returns.
3) Blaming Capital Losses to “Aberrations” and “Dislocations”
Abnormal market conditions should not be an excuse. In fact, because the value strategy is dependent on always investing with a margin of safety, I would expect value managers to outperform by the greatest margin at times of abnormal market conditions. Why blame the market for your mistakes? For an example of what NOT to do, see latest letter to investors by Scottwood Capital, a $900 million hedge fund in Greenwich, CT which lost big-time during the month of May.
4) More Copying Than Developing
Most value managers copy what previous value managers have said and done to justify their strategy rather than developing their own methods. It is my view that they confuse value investing as a strategy, and not an investment framework. The structure of hundreds of value funds is often an exact copy of previously existing funds, such as the Buffett Partnership. The result has been a bunch of Buffett-like funds in terms of structure, but with an investment performance far below those achieved by the Buffett Partnership. Additionally, a lot of funds keep the same proportion of cash to equity that Berkshire does without realizing that what’s good for Berkshire may not be good for their funds. This lack of self-identity is something that plagues a lot of value funds.
An example is hedge fund manager Sardar Biglari, who runs Indianapolis-based fast-food chain Steak ‘n Shake. Under the “Buffett” banner, Biglari wants to diversify away from burgers and milkshakes and transform the company into an all-purpose investment vehicle similar to Warren Buffett’s Berkshire Hathaway. In what I believe to be a show of arrogance, Mr. Biglari renamed the company “Biglari Holdings”. He is even quoted as saying
“if an artist created a masterpiece, it would be absurd to ask him to not put his name on it”
While Buffett generated a high stock price for Berkshire through sheer growth, Mr. Biglari decided to create a high stock price through an artificial 20-to-1reverse stock split. And that was all before increasing his salary from $300K to 900K. Even Biglari’s company website looks suspiciously similar to Charlie Munger’s Wesco.
Again, this is not an attack on value investors, it is a call for more self-identity and originality. Value investing is not a strategy, it is a framework. Instead of resorting to copying what Buffett and other investors built through their lives, value funds should abide by what Graham once said:
If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that’s the row you should hoe. If you’re really good at picking the stocks most likely to succeed in the next twelve months, base your work on the endeavor. If you can foretell the next important development in the economy, or in the technology, or in consumers’ preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no-bluffing self-examination, and by continuous testing of performance, that you have what it takes to produce worthwhile results.
The ValueHuntr Portfolio was up 18% for the first half of the year, compared to -2.3% for the S&P500. The portfolio is currently comprised of 3 long positions (GE, RIG, RMCF), and 2 short positions (BP, IOC). Although we’d like to add more bargains to the portfolio, we have not been able to find as many as same time last year. You can be sure that we will be on the lookout.
The Dow Jones ended May down 7.92%, its worst May performance since 1940. In contrast, the ValueHuntr Portfolio returned 2% for the month.
Since inception in April 2008, the portfolio has returned 145%, relative to -19% for the S&P500. In total, we have taken 16 positions, of which only two have been losing ones: EDEN (-8%) and BP (currently down -2.6%). Our performance compares favorably with well-known value funds, which struggled in May for the most part.
Hedge fund manager David Einhorn, who had questioned the health of Lehman Brothers four months before its collapse, said yesterday at the Ira Sohn Conference that he is still shorting Moody’s Corp, citing the short-term approach it uses in its assessments.
Shares of the rating agency plunged 6.6 percent to $19.50 in after-hours trade, following Einhorn’s comments.
Einhorn, whose Greenlight Capital manages $6.5 billion, reiterated that Moody’s Investors Service continues to use a short-term outlook — only 12 to 18 months — to analyze data to assess countries’ abilities to finance themselves. He spoke before some 1,200 hedge fund executives at the annual Ira Sohn Investment Research Conference.
Einhorn last fall had criticized Moody’s, saying it “…makes five-year medium-term qualitative assessments for each country, but does not appear to do any long-term quantitative or critical work.”
Standard & Poor’s, the rating agency owned by McGraw-Hill’s, shares the same problem, Einhorn said.
He thinks the euro zone debt crisis could cause more problems for the rating agencies.
What’s more, Einhorn said the credit debacle in Greece and its euro zone neighbors could be a prequel to what might occur in the United States.
The Greek crisis might be the first sign the “sovereign debt bubble” is “popping,” adding that the United States still has many inadequately capitalized banks and it is difficult to get an accurate gauge on their health.
With the instability in the banking financial system along with poor government policies, Einhorn has increased exposure in gold and gold securities.
Einhorn says his fund recently bought shares of African Barrick Gold because it is cheaper than other gold miners.
Einhorn said last week at Greenlight Capital Re’s investment meeting that he still holds physical gold. “We tend to think of gold as a currency,” he said, adding, “I think there’s going to be a lot of inflation.”
Bruce Greenwald, director of Columbia’s Center for Graham and Dodd Investing, discusses shorting in the context of a value investment strategy.
We are adding Transocean Ltd to our ValueHuntr Portfolio as an opportunistic and contrarian buy. At the same time, we are adding BP as a short.
It is our view that the uncertainty surrounding the Deepwater Horizon incident has caused RIG to trade far below a reasonable price. Meanwhile, we believe that most liabilities for cleanup will legally fall under BP. Even if RIG’s reputation is adversely affected by this incident, the company is the top deepwater driller in the industry. Unlike BP and other companies, RIG’s competitive advantage is its capability to operate in some of the harshest ocean conditions in the world.
Transocean Ltd is a leading international provider of offshore contract drilling services for oil and gas wells. As of February 3, 2009, the company owned, had partial ownership interests in or operated 136 mobile offshore drilling units. The fleet consists of 39 High-Specification Floaters (Ultra-Deepwater, Deepwater and Harsh Environment semisubmersibles and drillships), 28 Midwater Floaters, 10 High-Specification Jackups, 55 Standard Jackups and four Other Rigs. In addition, the company has 10 Ultra-Deepwater Floaters under construction or contracted for construction.
The company is now trading at some of the lowest multiples throughout its history. The company trades at P/B of 0.88, relative to industry average of 2.44. Additionally, the company is now trading at EV/EBITDA of 5, the lowest ever for the company. A word a caution is that although these numbers look attractive, their attractiveness is dependent on the effect the Deepwater Horizon incident has on the company’s operating income. As we discuss below, we believe RIG will be able to cover its liabilities without permanently impacting the company’s future operating income.
Deepwater Horizon Incident
On April 28, 2010, in connection with the Deepwater Horizon incident, one of RIG’s subsidiaries was notified by the U.S. Coast Guard that, under the provisions of the Oil Pollution Act of 1990 (“OPA”), Deepwater Horizon had been designated as a source of oil discharges and the subsidiary has been designated as a responsible party under OPA. In the notice, the U.S. Coast Guard noted that its information indicates that oil discharges resulting from the incident include discharges from Deepwater Horizon on or above the surface of the water and ongoing discharges from the well head. Because the ongoing discharges from the well head are occurring nearly a mile below the surface of the water, for which RIG believes it has no responsibility under OPA, the company has responded to the U.S. Coast Guard’s notice and denied our subsidiary’s designation as a responsible party to the extent of any underwater discharges from the well head.
While RIG’s potential liability in the oil cleanup is not understood with 100% certainty, there are several points that indicate that RIG’s liability is limited:
- RIG was fully insured for the Deepwater Horizon and has received $401MM to cover damages (see http://www.chron.com/disp/story.mpl/business/6992073.html )
- The total insured value of the rig is $560 million. But Transocean’s insurance also provides up to $1 billion in liability coverage, subject to deductibles, for personal injury claims and possible claims related to wreck removal.
- Although more than 100 lawsuits have already been filed in many states and courts, Transocean is petitioning that the limit of its liability be $26.76MM, as the entire value of its interest in the rig does not exceed this figure. Limitation of Liability comes from 150 year-old maritime law allowing US ship owners to limit their financial liability. Under the Limitation of Liability Act of 1851, a vessel owner is liable only for the post-accident value of its vessel and cargo, as long as the vessel owner can show it had no knowledge of negligence in the accident. Certain types of drilling rigs, such as MODUs (Mobile Offshore Drilling Units) like the Deepwater Horizon are considered vessels under U.S. maritime law because they are capable of being navigated.
Disclaimer: This is not a recommendation to buy or sell any securities. We do not personally own shares in RIG, BP.
By Jason Zweig (WSJ)
Seth Klarman is worth listening to, especially when markets go mad.
Mr. Klarman is president of the Baupost Group, an investment firm in Boston that manages $22 billion. His three private partnerships have returned an annual average of around 19% since inception in 1983—and nearly 17% annually over the past decade, as stocks went nowhere.
To measure Mr. Klarman’s importance as an investor, you need only see the value his rivals place upon his words. You could have earned at least a 20% average annual return since 1991—better than twice the performance of the market—merely by buying and holding Mr. Klarman’s book, “Margin of Safety”: Published that year at a cover price of $25, hard copies now fetch up to $2,400.
But the professorial Mr. Klarman speaks in public about as often as the Himalayan yeti. He made an exception last Tuesday, when I interviewed him in front of a standing-room-only crowd of 1,600 financial analysts at the CFA Institute annual meeting in Boston. He then made another exception, speaking with me over the phone later to clarify points that he feared had been misconstrued.
Mr. Klarman specializes in buying securities that nauseate other investors. As the credit crisis exploded, he put more than a third of his assets into high-yield bonds and mortgage-related securities. I asked him what he had meant, in a recent letter to his clients, when he compared the financial markets to a Hostess Twinkie. “There is no nutritional value,” he said. “There is nothing natural in the markets. Everything is being manipulated by the government.” He added, “I’m skeptical that the European bailout will work.”
Some members of the audience gasped audibly when Mr. Klarman said, “The government is now in the business of giving bad advice.” Later, he got more specific: “By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”
“We didn’t get the value out of this crisis that we should have,” Mr. Klarman told the audience. “For our parents or grandparents, it was awful to have had a Great Depression. But it was in some ways helpful to carry a Depression mentality throughout their later lives, because it meant they were thrifty with their money and prudent in their investment decisions.” He added: “All we got out of this crisis was a Really Bad Couple of Weeks mentality.”
You could have heard a pin drop as Mr. Klarman proclaimed, “I am more worried about the world, more broadly, than I ever have been in my career.” That’s because you can make good investing decisions and still end up with bad results if you reap your profits in currencies that do not hold their purchasing power, he explained.
“Will money be worth anything,” asked Mr. Klarman, “if governments keep intervening anytime there’s a crisis to prop things up?”
To protect against that “tail risk,” said Mr. Klarman, Baupost is buying “way out-of-the-money puts on bonds”—options that have no value unless Treasury bonds plummet. “It’s cheap disaster insurance for five years out,” he said.
Later, I asked Mr. Klarman what he would suggest for smaller investors who share his worries.
“All the obvious hedges”—commodities and foreign currencies, for example—”are already extremely expensive,” he warned.
Especially gold. “Near its all-time high, it’s a very hard moment to recommend gold,” said Mr. Klarman.
Mr. Klarman pointed out that his own ideas “on bottom-up opportunities in undervalued securities are more likely to be accurate than my top-down views on what’s going to happen in the world at large.” In other words, while you might want to insure against a disaster scenario, you shouldn’t bet the ranch on it.
And, said Mr. Klarman, one of the best ways to protect against a decline in purchasing power is to buy whatever is “out of favor, loathed and despised.” So forget about gold or other trendy hedges. Instead, wait patiently for markets—European stocks, perhaps—to get so cheap that they turn most investors’ stomachs. Then you can pounce.
As Mr. Klarman put it, “Sometimes, when you can’t figure out a good defense, the best thing to do is to go on offense.”
We recently checked the robustness of the ValueHuntr model presented on yesterday’s posting by examining whether there is any commonality between the stocks chosen by the model and those chosen by Joel Greenblatt’s “Magic Formula”.
The Magic Formula was introduced in the book “The Little Book that Beats the Market” as an investment strategy developed by Joel Greenblatt for his firm Gotham Capital. According to investment records of the firm, this strategy has been able to generate roughly 40% annualized returns over a 20 year period.
The commonality between the two methods is striking, as 10 of the stocks in the ValueHuntr portfolio (30%) also show up on the “Magic Formula” screen. This is a surprisingly high number, considering that there are 16,000 stocks to choose from in US exchanges. Below, we chose the top 30 stocks chosen by the ValueHuntr model. Stocks also chosen by Greenblatt’s “Magic Formula” are highlighted.