Compounding Life

At CGI Las Vegas I listened to presentation by John Del Vecchio from Ranger Alternatives. John manages the Ranger short book and has a strong background in accounting forensics. Specifically finding companies with low earnings quality before the market does and building “short” positions based on that information.

In his presentation he referenced some stats from a Blackstar Funds paper on the Russell 3000 index between years 1983-2006.

Russell 3000 stats 1983-2006

39% of stocks were unprofitable investments

18.5% of stocks lost at least 75% of their value

64% of stocks underperformed the Russell 3000

25% of stocks were responsible for all of the market’s gains

Well obviously an enterprising investor after reading this would be diligently researching looking for the %25. If you only invest in those companies you are sure to outperform the market. Well not always…

What a difference a day makes

The paper also gives us a sampling of some of the best performing stocks during that time period and their performance after the peak:

Thoughts

It would be interesting to see of the %25 that made up %100 of the gain in 1983-2006, how many companies would still be worth owning today. Looking at that list there are a couple. Of course there are some that would have resulted in a permanent loss of capital and some that are not permanent losses yet but for which the immediate future is not bright. Lets take a quick look at a couple…

GE

If you had bought GE on 01/03/83 at its closing price of 91.75, split adjusted (48:1) each share would be worth around $670 today. I figure thats about %8.3 compounded annual gain. If you had sold that share before the market drop you would have approximately 3x that amount somewhere around %12.5 compounded annually. Not including dividend payments. While GE is a mess today, its fair to say you could of done worse things than buying a share of GE in 1983.

MSFT

If you had bought MSFT when they went public on 03/13/86 at $28, split adjusted (288:1) each share would be worth around $8000 today. Around %29.3 compounded annually. Not including dividend payments.

Conclusion

This data reinforces a couple of points that I sometimes temporarily forget.

1. If you own a sub par company because it was undervalued when you bought it, sell it when it reaches intrinsic value and take your profit. There is no reason to hold it afterwards because it is likely to fall into the %64 that under perform the market. If you sell it and move on to the next value you will be on your way to out performing the market.

2. Paying a little bit of a premium for a a great business with a great moat and great management can pay off big time.

3. I think people should really call “buy and hold” “due diligence, buy and due diligence hold, rinse repeat”.

There is some discussion going on about diversification at Oldschoolvalue a site that I read regularly. Like most things investment related you can find opinions telling you to do almost anything. Buffett is known historically as a non diversified investor, meaning a generous amount of his capital are tied up in small number of investments. Does that mean you should have a concentrated portfolio? Here are Buffet’s thoughts he delivered to an MBA class.

If you are not a professional investor, if your goal is not to manage money in such a way to get signifigantly better return than the rest of the world, then I believe in extreme diversification. I believe that maybe 98, 99 or maybe more than 99 percent of people who invest should extensively diversifiy and not trade. So that leads them to an index fund type of decision with very low cost. Because all they are going to do is own a part of America and they have made a decision that owning part of America is worth while. I don’t quarel with that at all and that is the way they should approach it… Unless they want to bring an intensity to the game and make a decision to start evaluating businesses. Once your in the business of evaluating businesses and you decide that you are going to bring the effort and intensity… and time involved to get that job done, Then I think that diversification is a terrible mistake…

If you really know businesses you probably shouldn’t own more than six of them, if you can identify six wonderfull businesses , that is all the diversification you need. You are going to make alot of money and I guarantee you that going into a 7th one instead of putting more money into your first one has got to be a terrible mistake. Very few people have gotten rich on their 7th best idea, but alot of people have gotten rich on their best idea.

But to quote Buffett again…

A public-opinion poll is no substitute for thought.

Regardless of what experts or friends say. Ultimately you have to decide whats best for you. You are the one that has to sleep at night with your investment decisions.

Arbitrage in the purest sense exists when there are multiple markets for something and one of the markets prices said something lower than the other. For a real simple example lets say that a certain collectible baseball card sells for $30 in California over the counter. You can take the same baseball card to a card shop in Boston and sell it $50. There is a very low risk opportunity to make a $20 profit per card if you can buy them in California and sell them in Boston. So you buy a bunch of these cards in California and ship them to your old friend from High School who lives in Boston. The shipping averages out to $1 per card and you cut your friend in at $5 per card. 

  $50  Market price in Boston

- $30  Market price in California

______

  $20  Spread

  -$1  Shipping 

  -$5  Comission 

  $14  Total profit per card

What you are doing here is a form of arbitrage.

Some people might call this
scalping; it won’t surprise you that practitioners opted for the
French term, arbitrage.

- Buffett in the 1988 Berkshire Letter to Shareholders

There are many different forms of arbitrage. People sometimes engage in arbitrage on sports betting, where they can place bets at different books at different odds in such a way that no matter what the outcome of the game or race they are guaranteed a profit. Casinos practice “statistical” arbitrage. All the games they offer have a statistical advantage in favor of the house that guarantees over time they will profit. 

Warren Buffet was engaged in a unique arbitrage situation involving cocao beans while working for Ben Graham’s Graham-Newman Corp. Buffett writes about in the 1988 Berkshire Letter to Shareholders:

 
Some offbeat opportunities occasionally arise in the arbitrage field.  I participated in one of these when I was 24 and working in New York for Graham-Newman Corporation.  Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 50 cents per pound.  In 1954 a temporary shortage of cocoa caused the price to soar to over 60 cents.  Consequently Rockwood wished to unload its valuable inventory – quickly, before the price dropped.  But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

     The 1954 Tax Code came to the rescue.  It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business.  Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity.  Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.  

     For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.  The profits were good and my only expense was subway tokens.”

 

Risk arbitrage is the most popular type of arbitrage when it comes to securities markets and involves “merger & aquisition” situations. For example Lester Floor Tiling announces it is attempting to buy out Smith Carpet Company (company names are made up) and offering $20 per share of Smith Carpet Company stock. If you purchase Smith Carpet Company stock for under $20 you can profit from this transaction when and if it happens. 

As the name implies there is risk involved in these situations. Smith Carpet shareholders may vote against the buyout, regulatory agencies might step in and say that this would create a flooring product monopoly that would not be in the interest of consumers. In M&A activities there are endless lists of things that can prevent deals from happening.

Take all of these risks and then factor in the current credit freeze and market volatility. Things can get hairy and do.  Mergers that seemed likely months ago can now fall apart quite easily.

Value investing blog Oldschoolvalue has been dilligently following a risk arbitrage opportunity regarding Emageon Inc. (symbol EMAG) and Health Systems Solutions Inc. (symbol HSSO). HSSO made an offer to purchase EMAG at 2.85 share. HSSO had a hard time meeting deadlines for the deal but ultimately ponied up $9 million in an escrow account to be paid to EMAG in the event that they could not follow through on the deal. $9 million may not seem like a lot, but put it in context HSSO’s market cap as of this writing is $8.3 million and the deal value of $69 million, its a fairly substantial deposit. So when news hit the deal was going to close February 11th the stock price started soaring up to $2.60 as people started getting in on the deal. The day before the deal was supposed to close the price started droping and investors were worried. Was there insider information about the deal falling through that was causing people to sell? The market in general was taking it in the pants so a lot of people (myself included) attributed the price drop to a combination of market volatility and people selling early to lock in their profits. 

The deal fell apart.Stanford International Bank in Antigua decided not to fund HSSO’s purchase and EMAG shot down to the $1 dollar level. To make it even more interesting, the decision to not fund the purchase has brought more attention to Stanford International and there is some speculation that the bank which has had abnormally high return rates on its certificates of deposits might be up to no good. In fact they are the subject of a probe.

I am left holding EMAG shares for quite a bit less than what I paid for them as are alot of other people. After doing a mental post mortem I have a couple of lessons learned.

1. Coming off of a successfull arbitrage with Puget Sound Energy I was probably not as critical of the EMAG deal as I should of been. Had the Puget Sound Energy deal fallen through I would have been content holding my position through the current market and collecting the dividends. In assessing the deal I did not put enough weight on the fact that EMAG is not a stock I would be content with holding an extended period of time. I think looking forward, my overall feelings about holding the secuirty in question should have a heavy weight on my decision. Even if the odds look like they are 90% or greater, the quality of the stocks in question should be paramount to my decision because I do not engage in enough arb situations to balance out the losses.

2. More due dilligence on Stanford International Bank may have set off some flags that I should steer clear of the deal. The fact that they offer abnormally high returns on CDs and are based in Antigua a place where I have little knowledge of the local financial regulations might have tipped me off. But of course hindsight is 20/20. 

3. I know very little about the industry that EMAG and HSSO are involved in. One nice thing about the Puget Sound Energy deal was that I live in Puget Sound and hence was close to the pulse. In addition I know a person that had been Puget Sound Energy shareholder for a long time who gave me some valuable insight as well.

Typically those who engage in arbitrage when faced with this type of situation sell their position, take their losses and move on. I was tempted to do this but I have decided not to for the following reasons:

1. Sell off. There are alot of people closing out their positions and driving down the price. I don’t believe the current price reflects the value of the stock and I do not have an existing opportunity waiting for the funds currently invested in EMAG. 

2. EMAG recieved 9 million in cash because the deal fell through. As of this writing EMAG is trading right around their book value and a little bit over their cash per share not including the 9 million in cash they just recieved. While the cash will not bring the book value up to my purchase price, I think they are better positioned or ride it out. 

While I understand the “cut your losses and move on” way of thinking, I believe the exit much like the entrance into the position requires some thought and in this case my thought is to hold on for a little while and not let the actions of the masses sway my judgement.

Some good arbitrage related reading:

1988 Berkshire Hathaway Letter

Buffett on Valuation: Risk Arbitrage Edition

Arbitrage: Emageon (EMAG)

Updates:

1.Turns out that the Stanford International is the focus of probe and key people are facing criminal charges.

2.I ended up selling my EMAG position because I feel I have found a good investment idea that will be a much better allocation of remaining funds instead of waiting for EMAG to recover.

Alot of people look at investing primarily as a vehicle for making money.  I on the other hand enjoy researching companies and finding stocks to buy its an interesting activity that also has the potential for financial reward. Having a passionate interest in stocks and companies is key to investing in my opinion. If you don’t posses that then you are probably better off buying an index fund or sticking your money in a safe interest earning account.  Buying something on a tip from a friend or based on market trends to make some easy money is like walking into a casino. You have no knowledge about where your money is really going, you are just interested in turning a profit.  Furthermore without this passionate interest I feel that you will be less likely to learn anything from investing mistakes and hence you will be condemed to repeat them.

My interest in companies and the market is the key motivator behind my investments. The financial pay off is almost secondary but I won’t lie making money is part of the game.  I don’t invest to lose money  However there are some investments I make purely because I want to own a small piece of certain companies . I like being somewhere and seeing there products or signs and thinking “I own a little chunk of that”.  So the point of this post is to describe how I currently buy little pieces of companies just for the sake of having a position and not nessecarily for financial reward.

Currently I use a Sharebuilder account for that.  I mention them not as a promotion but to describe how I use them because their service is somewhat unique.  Primarily with scheduled investments they only charge a $4 commision, you can invest an even dollar amount once a week and you can get fractional shares. 

Let’s take MVL (Marvel Entertainment) as an example. When I first saw that Marvel was publicly traded I thought that it would be really cool to own a piece of the comic book and movie industry. It spoke to the little kid in me. However I know little about those industries. I know very little about Marvel as a company and even after doing some research I might find it does not meet my criteria for buying stocks. But it is still a good company and the fact remains that I want to own it

That is where sharebuilder comes in.  A basic sharebuilder account is free and with the right promo code they will give you $50 4-6 weeks after your first transaction. So you open a free account make one purchase and you get $50, sweet. On top of that for the first month you can try their premium subscription free of charge which gives you 6 free scheduled investments, even better. To top it off you can schedule the premium trial to end at the end of the month so you don’t have to worry about forgetting to end the trial and then getting charged the re-occuring monthly fee. 

For the cost of eating out one night I can buy a share or two of Marvel paying a very low or in the case of a new account free comission and relish in the thought that I own part of a comic book company.

For my normal larger more researched investments I use a full featured online broker with standard comissions and real time trades. I use Sharebuilder to satisfy my desire to own little pieces of America that don’t always satsify my standard investing criteria. 

This is by no means a recomendation to follow my lead.  I am sure some people might think that buying a stock just for the sake of owning that company even in tiny positions is a bad idea. These are all personal preferences and you should always think for yourself when looking at any investment option regardless of the dollar amount.

A few other things worth noting about Sharebuilder:

1. You can setup dividend re-investment (I believe its turned on by default).

2. Scheduled investments happen every Tuesday morning and must be scheduled by the Monday before at 5pm. So you the price you pay for share is not known when you schedule the purchase.

3. Sharebuilder sells fractional shares. So if a stock you want to own is a little out of your price range, for example a Berkshire Hathaway (BRK.B) B share you can purchase a fraction of this share and add to your position over time eventually getting an entire share.