Tuesday, June 22, 2010

Knowing Vs Understanding

Joel Greenblatt is a very successful value investor and has written a popular book called 'The Little Book That Beats the Market'. In the book, Mr. Greenblatt shows the merits of picking a portfolio of 30 stocks using a "magic formula" - buying businesses cheaply that have high earnings yield and high returns on capital. Furthermore, Mr. Greenblatt's firm has done extensive research to show the validity of such an approach.  However, I see grave dangers in relying solely on such a mechanical approach to investing i.e. without understanding the underlying business and the industry dynamics*.

This goes beyond "magic formula" investing. You cannot help but notice that Wall Street's extent of valuation mostly starts and ends with such simplistic valuation metrics. In this article, I want to point out some of the perils of exclusive dependence on the two "magic formula" metrics - (reciprocal of) PE ratio and ROE.

First, I site four examples from Curtis Jensen's Q1 2006 Letter to Shareholders to illustrate how reported earnings and thus the PE ratio can mislead investors.
"Temporarily depressed earnings: To be sure, high PE ratios can be a sign of any number of developments. In many cases, TAM finds itself investing in companies rich in resources, but experiencing weak current business conditions, or in the throes of a severe industry recession. Superior Industries, for example, a leading maker of forged aluminum automobile wheels with a cash rich, debt free balance sheet, has seen its annual earnings per share (“EPS”) drop to less than $1.00 per share in the current period, from peak levels two to three years ago that ranged from $2.50 to $3.00 per share. Competitive conditions have intensified, as customer demand has waned. Management could rather quickly use the company’s existing cash hoard to repurchase large amounts of stock, and thereby boost the reported EPS. Our expectation, however, is that Superior’s management would use much of the company’s existing cash to protect and grow the business, in order to improve the company’s earning power from the currently depressed levels.
Extraordinary investment: Some of TAM’s portfolio companies continue to invest heavily to build their businesses, temporarily depressing reported earnings. Bandag, Inc. sells supplies and equipment used in the retreading of truck tires, and provides related tire management and vehicle maintenance services. In the past year, through an acquisition, its worldwide franchisee network has added a quick service truck lubrication business. Heavy investments in this business expensed for accounting purposes many of its expansion costs; not surprisingly, reported earnings per share in 2005 fell to $2.52, versus the more than $3.00 earned by the company in 2004. Were Bandag management so inclined, it could defer the spending initiatives to the future, and thereby improve current, reported EPS. Such a move would undoubtedly come at the expense of the company’s future health.
Underemployed resources: Consistent with our “Safe and Cheap” investment philosophy, many TAM holdings are temporarily overcapitalized, meaning the management has not redeployed excess capital into the business. NewAlliance Bancshares, a Connecticut-based bank holding company, might qualify as one such example. The company’s current share price, around $14, is arguably pricey relative to current earnings at $0.50 to $0.60 per share. However, the bank has probably twice the equity capital it needs to not only maintain, but to sensibly grow its business. By growing its book of loans and investments, and prudently repurchasing its own stock during the next three to five years, it is not inconceivable that NewAlliance could earn more than $1.20 per share.
Accounting shortcomings: Other companies, likeBrookfield Asset Management, for example, report earnings numbers that bear little relation to the underlying economic value being created through their growing cash flow and asset redeployments. Brookfield’s current PE ratio, which is around 20x, looks rich, but it is largely irrelevant. For example, accounting rules require that the company expense depreciation related to the company’s real estate, hydroelectric power plants and other infrastructure assets. However, that accounting expense largely overstates the amount of sustaining capital required by the business. The result is a reported earnings number that is, in many ways, fictional, and a PE ratio that is artificially high."
Next, I site an example from Amit Wadhwaney's Q3 2004 Letter to Shareholders to illustrate the dangers of focusing on ROE (even though the example described below is one of a financial company, the underlying philosophy is true for most other businesses)
"The experience of one of the Fund’s current investments—Banco Latino Americano de Exportaciones SA (“Bladex”) provides a cautionary example of such a focus on R.O.E.s gone awry. Since its inception in 1979, Bladex was an unusually well capitalized bank set up to finance intra-Latin American trade. For a number of years, notwithstanding the tremendous economic volatility (hyperinflation, currency collapses, etc.) that characterized the region where it operated, the bank experienced an extremely low level of losses and generated R.O.E.s of 12-15%. This represented an adequate level of profitability, except to some investors who felt that its R.O.E. could be improved upon by reducing the capitalization, by returning what they felt was the company’s excess capital to investors and simultaneously increasing the R.O.E., which would reward them with a higher stock price to boot. After a period of lobbying by investors, Bladex returned roughly $100 million to investors, through a special dividend and stock repurchase. While the company was increasing its operating leverage in this manner, it entered corporate lending, a new line of business, which was growing faster than the bread-andbutter trade finance business—albeit it had a considerably greater risk profile.
The rosy period of higher R.O.E.s and earnings growth that was envisioned for the recapitalized Bladex turned out to be short lived. A year later, the financial repercussions from the Argentinian Peso devaluation almost wiped out Bladex’s capital. It was saved by a share issue (which roughly corresponded to the Fund’s entry point), whose size was $134 million––a little bit more than was originally returned to investors. Equivalently, absent the earlier return of capital, the company would have been better capitalized to withstand the Argentinian crisis and a subsequent funding, if necessary, would have been smaller and obtained on considerably more favorable terms. Currently, Bladex has returned to its lower growth but “safer” business of providing trade finance. It is exceptionally well capitalized with a ratio of Tier 1 to risk-weighted assets of 37.8%—a large number by most measures, but this should be viewed in the context of the riskiness of the region where it operates and where balance sheet strength is an absolute necessity to withstand any unforeseen difficulties that might arise.
As this example illustrates, while there is a trade-off in arithmetic terms between the extent of overcapitalization and return on equity, from the Fund’s perspective this can hardly be said to be an acceptable tradeoff, given the potential increase in the riskiness of an investment that can accompany a capitalization that is unable to withstand significant, unforeseen shocks. The Fund is a long-term, buy and hold investor. "
In conclusion, a low PE ratio and a high ROE are neither necessary nor sufficient conditions of a "value" investment. Knowing these numbers only gives you a starting point - the real work is in understanding these numbers.
"You can know the name of a bird in all the languages of the world, but when you’re finished, you’ll know absolutely nothing whatever about the bird... So let’s look at the bird and see what it’s doing — that’s what counts. I learned very early the difference between knowing the name of something and knowing something" - Richard Feynman.

  1. The Little Book that Beats the Market, Joel Greenblatt
  2. Letter to Shareholders, Curtis Jensen Q1 2006
  3. Letter to Shareholders, Amit Wadhwaney Q3 2004
  4. Richard Feynman, Wikipedia
Disclosure: I have investments that are managed by Third Avenue Management. I do not have investments managed using the Magic Formula Investing. This is not a recommendation to buy or sell any securities. Do your own research before investing or not investing in any security mentioned in this article.

*Appendix: The magic formula investing requires that the portfolio be turned over once a year. This is a critical step to make the approach work - since statistically identified businesses may not actually be cheap and high quality businesses. So, by no means, I am saying that magic formula investing does not work. 

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