The Brain Clearinghouse

On Competition

2006-09-22T19:07:00.000-07:00

Since I started reading about the art of investing I've been thinking about competitive advantage and what it is that allows companies to live and what causes them to die. I've slowly become more and more cautious and demanding in my criteria for stock selection. Since I purchased KSWS I've become more negative regarding its future. It seems to me that history is littered with the corpses of mass-market fashion brands that were intensely popular for a couple of years and then died rapidly. I think that to keep a solid share-of-mind (giving you lasting share-of-market) you need to be selling a product that people buy frequently and is of marginal cost, (Coke, Pepsi, chewing gum, chocolate bars, magazines, newspapers, cigarettes, hair products, toothpaste, razors, batteries, cereal, etc) or a product that is of such a high value that it attracts a nearly reverential group of potential customers. (Ferrari, Rolex, Bentley, Tiffany, Armani, Gucci, Chanel, etc.)There's much more money to be made in the first group, since the pool of potential customers is, essentially, everyone, whereas the driving force behind the share-of-mind of the second group is the fact that the product is unattainable for the vast majority of the population, severely limiting any expansion plans.Then there's the companies that defy this classification but have strong share-of-mind regardless: Nike, Wal-Mart, Bose, (now I'm stretching) Toyota, Honda, The iPod, and that's about all that I can think of right now. Actually, the only one on that list that I'm convinced has a solid share-of-mind is Nike. Nike gets their share-of-mind via their brilliant marketing and ad campaigns. These ad campaigns mostly convey the idea that their shoes improve sport performance, sometimes to a superhuman level. This perception that their shoes are superior in technical features and quality persuades many people who never do any physical activity to buy and wear Nike sneakers. In fact, this is only reason I have seen why any mass-market apparel company has stayed in business for any historically significant amount of time. Fashion-based mass-market apparel brands come and go, but those which convey the perception that their products are technical marvels stick around. I'm thinking of adidas, Reebok, Puma (which along with Lacoste has come through a rough patch and is now shining) and oakley.Unfortunately, KSWS hasn't decided to follow this marketing tack. Understandably, they're afraid of the impact of the intense competition. They've also tried to deviate from focusing on their straight 'classic' show before with dismal results. Unfortunately, there aren't any easy choices here. It looks like Americans are getting tired of K-Swiss as a fashion brand, and shifting to a 'sport' strategy is expensive and risky. But if Puma can pull off a sport/fashion brand renaissance in 10 years, then KSWS can do it too. The longer management sticks to the same-old at KSWS, the more antsy I feel.

Business Valuation pt.3

2006-08-21T07:41:00.000-07:00

An essay to myself about margin of safety:

When I perform a DCF, I use a discount rate which is the long-term government rate, or a couple of points above if I think it is historically low.

If you have something that’s risk-free and you can buy it more cheaply than your DCF indicates, then it’s cheaper than it’s worth.

If you can buy something that is 50% discounted from DCF, it’s only a deal if the risk of no-return (assuming only two options, no-return and total return) is lower than 50% because otherwise, it’s correctly priced, statistically.

The problem is in understanding the real value of risk. There is little-to-no accuracy in finding risk. It is a guess. How can understanding of real risk be increased?

Through complete understanding of the mechanics and economics of a business.
Through an understanding of competitive advantage and its benefits.
Through an understanding of how exposure to debt and fixed liabilities can impose inflexibility on an investment.
Through a deep understanding of accounting procedures and accounting fallacies in common use.

Sometimes even studying these aspects of a prospective investment thoroughly does not lift the fog of inaccuracy around your judgment of risk. In these cases, move on. Don’t be like the children who lie on their back and strain their eyes looking at the clouds, seeing dragons and unicorns and hippopotami where there are really only clouds. Although it’s not so much fun to see clouds for boring old clouds, it’s substantially more financially fattening, I suspect. Remember that the more time and effort you invest in something, the more you start to grow emotional about it.

If you start to investigate the aspects of an investment listed above, and the fog begins to lift quickly, you are deep within your circle of competence (or hopelessly deluded). Only now can you have any confidence in your assessment of risk, and therefore business valuation.

I think what’s key is to have a particularly deep sense of suspicion regarding your ability to evaluate the risk of any investment you consider. That way you avoid tricking yourself into believing that you understand something you don’t. If you have very high standards for the accuracy of your own assessment of risk, you’ll make many mistakes of omission, but not too many or commission.

Then, you can guess. You can say, I’ll guess there’s an 80% chance that the return as outlined in my DCF will come to pass, and there’s a 20% chance that I’ll get nothing. The price of the investment is 50% of your DCF. 100% - (50%/80%) is your real margin of safety in this case. It comes out to 37.5%, but of course this is a misleadingly precise figure. However, you begin to see how margins of safety can get eroded quite dramatically depending on your level of certainty (risk).

I would argue that since the assumptions in both the risk and DCF “educated guesses” are fuzzy by nature, and since an error in one is compounded by any error in the other, investments where there is a substantial amount of certainty are the only ones worth making. This may sound obvious, but let me provide an example:

market value/DCF = 0.1
weighted risk guess = 0.5

100% - (10%/50%) = 80% = margin of safety

market value/DCF = 0.2
weighted risk guess = 1.0

100% - (20%/100%) = 80% = margin of safety

Here, the obvious choice would be the second investment because there is a certainty of substantial returns. The first choice would imply substantial returns but who knows how accurate the weighted risk value of 0.5 is? It’s more difficult to know that you’re half-confident about something rather than completely certain about something.

There is usually a premium to be paid for certainty in the market, but sometimes, you can find investments which are close to a sure thing but where the real certainty is not reflected in the market price.

-FKS

USG

2006-08-16T10:20:00.000-07:00

I’ve added USG to my stokblogs account. I’d like to take a moment to go over my reasoning for this investment. USG is on the hook for personal injury liabilities for a former subsidiary which produced asbestos. Last year, these liabilities were quantified within specific limits and a plan regarding their resolution was formed. In the plan, USG transfers 3.95 billion dollars and all future asbestos personal injury liability claims to a trust. The trust is funded as follows:

- The Reorganized Debtors paid $890 million to the Trust and issued to the Trust an interest-bearing note in the amount of $10 million, payable no later than December 31, 2006; and

- The Reorganized Debtors also issued to the Trust a contingent payment note in the aggregate principal amount of $3.05 billion, which will be payable to the Trust depending upon whether the Fairness in Asbestos Injury Resolution Act of 2005 or substantially similar legislation creating a national trust or similar fund (collectively, the "FAIR Act") is enacted by the 10th day (excluding Sundays) after final adjournment of the current term of Congress (the "Trigger Date"), as described more fully below. (They estimate this date to be no later than sometime in December 2006)

The Debtors propose to fund their obligations under the Plan through (i) cash and marketable securities accumulated since the Petition Date which were used to fund the $890 million payment to the Trust as well as other creditor payments made prior to June 30, 2006, (ii) the Rights Offering, (iii) anticipated tax refunds and (iv) new debt financing.

The rights offering they refer to is an offering they had this year where they gave all their shareholders the right to purchase another share of the company for $40. This raised 1.725 billion. They have 587 million in cash and 69 million in marketable securities. Totalled up: 2.381 billion. I’m going to ignore the tax refunds, although they should be substantial, because I don’t know exactly how much of them will be realized. I’m also ignoring the cash flow of business operations. The difference between the 3.05 billion they need to raise and the 2.381 billion they have available is 669 million. They have a 2.8 billion dollar credit agreement with a syndicate of banks. Most of the credit holds an interest rate of somewhere around less than one percent above LIBOR. Let’s assume an unnecessarily large interest rate of 10 percent and assume they hold the 669 million they need for two years. They paid 37 million in interest last quarter. In the next two years, interest payments liberally calculated would be about 281.8 million. Operating profit this past quarter was 318 million. This company does not have a solvency problem.

So, then the company can be evaluated as a going concern. The company is a business in what I think is a commodity industry. It returns net income after tax which is 19% on net tangible assets minus cash. It has a dominant position in North America in dry wall and panel ceilings, which in a commodity business is one of the only ways you can have any kind of an economic advantage.

176 million net income in most recent quarter = 706 million/year
Assume 20% drop in net income as result of cooling housing market: 564.8 million/year
Subtract the expected interest payments as calculated above: 497.9 million/year
Assume the company will be spending the next two years putting all it’s cash flow towards recovery. Assume the company will only be in business for another 15 years after that with cash flow increasing at a moderate rate of 5%. Also assume discount rate is 6.5% (increased government rate).

DCF calculation gives value of 6.2 billion. Market cap is around 89,849,000 shares outstanding X approx $47/share = 4.2 billion. 32% discount to intrinsic value on extremely conservative basis. There’s a lot of potential gravy to be had here if this near-worst case scenario doesn’t come to pass.

-FKS

Beirut Blog

2006-08-13T10:56:00.000-07:00

Read this blog. Very good stuff.

-FKS

Business Valuation pt.2

2006-08-13T09:22:00.000-07:00

Yesterday I was talking about business valuation in terms of discounted cash flow. However, Seth Klarman and other value investors say that there are other ways to value a business. Klarman says that the other two ways to look at a business are liquidation value and breakup value. Graham for the most part also looked at businesses in this light.

Buffett has asked rhetorically in answer to a question at one of the Berkshire annual meetings, "What do you pay for a business that's losing money?" It seems as though Buffett doesn't put too much stock anymore in the idea that a calculated liquidation or breakup value can provide an estimate of the intrinsic value of a business. Then again, people like Klarman and Irwin Michael have made a lot of money buying stock on this basis. I think, like Buffett says, "There's more than one way to get to heaven."

I'm a lot more comfortable buying great businesses and good prices than with buying business on the basis of net asset value or other book-value-based measurements. If I was in the position of people like Ian Cumming at Leukadia, Icahn, or Kerkorian where I could have a material influence on the behaviour of management, then it'd be a different story. As it stands, I don't like knowing that management in a money losing or below-mediocre business might continue to have more incentive to run things as they have in the past, rather than sell or breakup the business. After all, if they're an employee of the company, they depend on the continuation of the business for their jobs. If they're an owner, they might have to take on huge tax obligations by selling their company. Also, if you sell or breakup a business, you're admitting that you were incapable as a manager of turning things around. This is no small blow to the ego.

People tend not to change their behavior very much. I'd much rather invest in management which I think and hope won't leave or change rather than in management that I hope DOES. I think the latter is much more unlikely to come to pass.

Of course, there will be situations where there is a great, shareholder-oriented management in charge of a terrible business. In THESE situations, I'd love to make a net-net or NAV play. The problem here is that the easiest way for me to evaluate the management is through business performance. When a business' performance is terrible, it's much harder to tell if you like the management.

-FKS

Business Valuation

2006-08-12T19:30:00.000-07:00

Warren Buffett in one of his letters to shareholders writes that he thinks that students learning about investing in business school should only need two courses: "Business Valuation" and "How to think about Market Prices". I know how I think about market prices, so that's one down.

Unfortunately, business valution is the more difficult of the two. Buffett has said that the value of a business is the present value of the future cash flows that can be extracted from the business as an ongoing concern. I agree. Since estimating (really, guessing) the future cash flows out of a business is an inexact art, Buffett says that investors should insist on a huge margin of safety to allow for inadeqacy in their psychic abilities. This is what value investors mean when they talk about buying a dollar for 50 or 40 cents.

However, estimating that what is selling for 50 cents is worth a dollar isn't the end of it. One must also be reasonably certain that what they predict will come to pass. If you estimate that A which is selling for 50 cents is worth a dollar, but only are 50 percent sure of your estimation, then you have a smaller real margin of safety than if you're 80 percent sure of your estimation even if your calculated (numerical) margin of safety is the same in both situations.

THIS is tough. How does an investor KNOW that they are 50 percent or 70 percent or 80 percent sure of the numbers they're calculating? It's not obvious. There's no quantatative measure. If only investing certainty was like making rice: one portion of rice to two portions of water, and you have a success rate of over 90%. But like Charlie Munger says, "Why should something that would make you and your family rich many times over be EASY?"

So certainty of correct decision making was something I've been struggling with for a while. Then I read the Buffett Partnership Letters. There's one thing that Buffett says in it that clarified things for me. When describing his investment philosophy to partners, he says that what he looks for is for the moments when he looks at financial statements (and then the price, presumably) and starts to smile. I know exactly what he means by this. I think one can't really understand this particular feeling until they've experienced it themselves. It's like the feeling you get when you've been stuck on a problem for a long time and you get a sudden insight. So I think the way I'd like to invest is to first develop an extremely high threshold for investment clarity and certainty, read like crazy, and then invest when I start to smile. I suspect this will cause me to be very dour-looking 99% of the time, but probably quite successful.

-FKS

Intro

2006-08-12T18:17:00.000-07:00

This is the Brain Clearinghouse. Where ideas come to coalesce.