While doing some reading this morning I came across a very sensible quarterly update from Kovitz Investment Group. Kovitz has a very good long term performance record:
3 Year Up 27.93% vs 10.36% for the S&P 500
10 Year Up 60.17% vs 30.78% for the S&P 500
Since 1997 Inception Up 307.92% vs 130.20% for the S&P 500
Here is their most recent update to investors:
We’re still in a period where stock movements are highly correlated, which makes it challenging for individual stock selection (our reason for being) to add much value. When market participants begin to focus less on macro themes, we believe the stage will be set for a revival of stock picking, and our portfolio of high quality, financially strong names will benefit through higher relative valuations. The timing of this shift is uncertain, but in the meantime we will continue to monitor the business progress of our holdings and search for new opportunities with a discipline that demands far more in value received than price paid.
Invest Like You’re Buying a Local Business
By most accounts, the economic recovery which began sometime in mid-2009 remains subdued. Unemployment is still lingering at historically high levels. Oil and other basic commodities have increased in price, putting pressure on already thinly-stretched consumers. The Federal Reserve has announced that it is ending its campaign of quantitative easing, which many have felt was in large part responsible for the rise in asset prices experienced over the past year. Sovereign debt woes continue to linger in the euro zone. U.S. debt levels are unsustainably high. Housing prices still show no signs of recovering. The list of concerns is long and appears insurmountable. But it always feels that way when you’re living through it. They say the eye of the storm is calm, but in the investment world it is anything but.
Our focus on private market values (intrinsic values) allows us to ignore the daily fluctuations in quotational “values,” which are largely driven by the emotional struggles of investors tossed and turned in the storm. Going into the end of the quarter, broad measures of the equity market declined six of the last eight weeks, likely a reaction to some or all of the worries listed above (and surely a few others we failed to list). While we don’t want to minimize their importance - they are real issues that need to be addressed - we don’t necessarily believe they should influence our decision making process when evaluating businesses on a long-term basis. Instead, we believe our focus should always be centered on the fundamentals of the business. At the fringe, macro factors may influence our analysis, and they will certainly impact the timing of the result, but their existence would never stop us from purchasing an otherwise sound, high quality business, though they could slightly impact what we’re willing to pay.
In our opinion, evaluating a potential investment boils downs to three basic questions:
1) What are the economics of the business?
2) Does the business have a sustainable competitive advantage?
3) Conservatively, what is it worth?
These basic questions apply whether you are buying a security in a public market with daily trading activity or a neighborhood business with no history of transactions.
For example, if you were considering the purchase of your local coffee shop, what would you want to know about it? You would first focus on factors that determine the economics of the business (i.e., historical annual cash flow, local property values, the demographic characteristics of the neighborhood) and the level of capital needed to generate those cash flows. Next, you would want to concentrate on the competitive issues the shop faces now and may face in the future (i.e., how many other coffee shops are in the area, are they expanding? how likely is it Starbucks will open a location nearby?). You would then use these inputs to determine what you were willing to pay in order to garner a sufficient return for the risk you are taking. Would you spend much time thinking about debt levels in Greece or how much liquidity the Fed was pumping into the economy? If you planned to run the shop for the foreseeable future would you be worried about what price someone would buy it from you the next time the economy turned down? Probably not. You’re most likely going to keep your head down and work diligently to run the business as efficiently and sensibly as possible. If the economics of the business hold and you paid a reasonable price, it is likely that its value will have compounded at an adequate rate regardless of the vicissitudes of the macro economy in the interim.
Publicly traded securities (like the stocks we own) should be thought about no differently. Regardless of the daily barrage of prices, if the businesses were wisely chosen and your time horizon is long enough, a similar compounding of value should occur. Although prices Mr. Market spits out swing wildly, underlying intrinsic values remain fairly stable. Even in the extreme case of an economic recession, intrinsic values should not be markedly impacted. The mathematics behind intrinsic values makes it so. Consider a business with earnings power of $1.00 per share that will grow at a rate of 8% for the next ten years and 3% into perpetuity after that (see Scenario #1 below). Using a discount rate of 10%, a standard discounted cash flow (DCF) computation would yield a value for the business of approximately $21 per share. Compare this to a scenario for the same business, where earnings fall 15% in the first year (to $0.85) due to a recession, then grow at 5% for the next three years, and by year 4 return to the level detailed in the first scenario (see Scenario #2 below). What would the stream of earnings of the business be worth under the second scenario? Using the same DCF analysis, the value would decline to $20.40, which is only about 3% less than the original value.
Yet when recessions hit, when there is the perception that one may hit, or even when there is just some troubling news invading our headlines, businesses like these are sold off via the public markets at a clip of 15%-20% (or more). Why that would be we can only guess. Maybe certain investors lack the confidence that the businesses they own are good enough to recover the earnings power they had before the recession. If that’s the case, why own them in the first place? Others may be fearful of seeing their portfolios decline, extrapolating what would likely be a temporary drop into something more permanent. Or maybe it’s that they deceive themselves into thinking they can sell out and buy back in at a lower price once the “all-clear” signal sounds. Of course, no such signal exists in practice and the dangerous game of market timing remains generally unwinnable.
We have long practiced our bottom-up, security-specific investment philosophy even in the face of concerns about macro issues. We are familiar with selecting (and holding) securities based on a fundamental appreciation for the price versus value proposition, even when particular economic indicators may be flagging and the overall market is falling. Obsessing about “price paid” will have far greater impact on securing respectable investment returns than worrying about daunting macro issues. (Note: “price paid” includes the prices of the stocks we currently own, not just the new ones purchased. After all, if you continue to hold a stock, you are essentially “purchasing” it with each new day.) Stock prices will continue to experience oscillation. They always have, and always will. However, over time, we believe it highly probable that the collection of businesses we own will climb in value at a satisfactory rate
Uncertainty vs. Risk
Human beings abhor uncertainty. An experiment by Hirsh Shefrin, an economist best known for his pioneering work in behavioral finance, demonstrates this exceptionally well. Subjects are offered either a guaranteed $1,000, or a 50/50 chance at $2,000. Because the expected value of the 50/50 chance at $2,000 is $1,000 (50% of the time you get $2,000, 50% of the time you get $0), you would expect that about half of the participants would choose the gamble and half would choose the sure thing. Not so. Results consistently show that much fewer than 50% opt for the gamble of receiving a possible $2,000.
Shefrin calls this phenomenon “aversion to ambiguity” and it manifests itself in the investment world in downward pressure on the prices of securities with uncertain outlooks. In order to avoid uncertainty or ambiguity, an investor’s typical first reaction is to sell or hold off buying until the situation looks clearer. In many cases, however, investors are confusing uncertainty with risk. An uncertain situation does not necessarily mean it’s risky. For example, a company with an uncertain outlook and an already depressed price may have a very favorable investment profile where downside risk is low and upside potential high. The probability of minimal downside is inherently not risky and could even be considered “safe” as compared to investment alternatives with clearer outlooks and higher current valuations.
A corollary to the “aversion to ambiguity” is the fact that people tend to suffer greater pain from losing a given amount of money than they experience pleasure from gaining the same amount. The typical investor is therefore a “pain avoider” who shuns certain stocks when there is any hint of trouble. This tendency results in consistent overreaction to bad news that we believe creates investment opportunity. Inefficient pricing results from the excessive focus on short-term issues that we believe sets up a unique ‘time arbitrage.” The playing field for true long-term thinking is less crowded and this creates an opportunity to buy wonderful, long duration assets at value prices.
By capitalizing on situations where uncertainty is high, but risk is low, we can put ourselves in a position to earn above-average returns. Current holdings that we put in this category include the following:
CVS Caremark (CVS):
Source of Uncertainty: The Caremark Pharmacy Benefit Management (PBM) business has lost some major accounts and has struggled to consistently win new business.
KIG Assessment: We ultimately believe that the PBM’s marketing message will produce positive results. However, even if the unit’s performance continues to stagnate, we don’t feel that much downside risk exists given its current low valuation, and significant upside could be captured if business trends improve. Heads we win, tails we don’t lose much.
Johnson & Johnson (JNJ):
Source of Uncertainty: The McNeil over-the-counter drug business has had significant product recalls due to inadequate and deficient manufacturing processes.
KIG Assessment: We find it somewhat surprising and regrettable that a company whose name was once synonymous with quality could find itself in this situation. However, many of the recalled products will potentially be making their way back on the market in the near future, and we believe they will ultimately win back a large amount of the market share that has been sacrificed. To the extent that these gains prove elusive, any deficiencies may be more than offset by success on the branded pharmaceutical side. J&J’s pharma business is at the front end of a rebirth, driven by new products acquired and in-licensed over the last several years and an increase in internal R&D productivity.
Source of Uncertainty: Housing, housing and housing. The housing market continues to wane, hampering new construction and home improvement sales. Stubbornly high unemployment has contributed to dampened home-related sales.
KIG Assessment: To us this is not a question of “if,” but “when.” Housing will improve, but at a pace closer to that of the tortoise than the hare. Downside price risk is minimal as current earnings in a bad housing market have been priced in, while the upside is substantial as earnings power in a “normalized” housing market will be significantly higher. The real risk is one of opportunity cost: Will the capital be better utilized elsewhere because the upside we envision may take too long to materialize? Patience is a virtue that has historically rewarded us well and we are therefore comfortable with this risk.
Source of Uncertainty: Wal*Mart’s U.S. retail division has suffered from eight straight quarters of negative same store sales. The company may be losing share to the dollar stores.
KIG Assessment: We can’t really sugar-coat this as the company has had several merchandising missteps and has lost some market share at the fringe. Wal*Mart will learn from its mistakes and continue to leverage its cost leadership to maintain its price leadership. Downside risk is hard to envision as its balance sheet strength and cash generation characteristics are powerful counter-measures to weak sales. If the company can regain some of its lost traffic, which we believe it will, margins are set to expand, fueling further earnings growth.
We also believe the company gets little credit for capital management. Management has bought back approximately $45 billion in stock over the past five years (current market capitalization is $190 billion) and has recently authorized another $15 billion to be completed over the next year. Importantly, it is not levering the balance sheet to do this as it can be funded with cash flow from operations. Deploying capital in this manner can have a large impact on increasing sales and earnings on a per-share basis, which is what we’re focused on.
The commonality running throughout the company snapshots we shared above and many of our other holdings is that uncertainty appears to be clouding the judgment of investors who are confusing uncertainty with risk. Avoiding these types of situations (i.e., selling in hopes of buying at a lower price later, or refusing to buy or add to positions) until the picture becomes clearer runs counter to how we have been successful in the past. We’d rather base our decisions on our comprehensive analysis, with the confidence that our forecasts will prove accurate. Besides, there is risk in waiting in that prices typically move up well before the clouds dissipate. Waiting in this manner is just another form of market timing- an area in which we don’t venture.
That an asset is attractive at a certain price might seem intuitively obvious, but many investors consistently ignore the possibility. People feel better when prices are going up and tend to move to the sidelines when prices are going down. People are, in general, momentum investors which is at odds with an investor who bases decisions on the relationship between value and price and leaves emotion out of the equation. Count us as the latter.
During the quarter we purchased shares of Apple Inc. (AAPL). Given that our typical mode of operation is to purchase shares of companies whose share prices are selling at substantial discounts to our assessment of intrinsic business value, this purchase may seem a little puzzling. After all, hasn’t Apple been a market darling going on several years now? By extension, shouldn’t the shares be at least fully valued, if not over-valued? Rest assured that we haven’t abandoned our discipline: We believe shares of Apple are mispriced because the value of the business has grown much faster than the stock price. Given Apple’s run of product development successes, the value of its brand, and its fortress balance sheet, we are hard pressed (even baffled) to explain why the stock is trading where it is. However, our job is to evaluate the historical financial data, assess company fundamentals and industry dynamics, and utilize our judgment to arrive at an independent valuation as to a company’s worth. Our conclusion is Apple’s shares represent an attractive risk/reward opportunity at current levels.
Apple is very widely followed by the analyst community. Because of that, most analysts are focused on ferreting out information that will differentiate themselves from their competitors. This usually takes the form of trying to pinpoint the exact timing of the next iPhone upgrade or what new features may be included in a subsequent generation of the iPad. Analysts birddog suppliers of components to Apple products to gauge exactly how many of each will be sold in the current quarter and they trip over themselves for insight as to what information may be released at its next developer conference. They focus on everything, it seems, except the current valuation. This is what matters most to us, not whether Apple will meet or beat its next quarterly earnings estimates.
At acquisition, Apple traded at about $335 per share. With 936 million shares outstanding, this equates to a market capitalization of $315 billion. Based on our earnings estimate for the fiscal year ending September 30, 2011 of approximately $24 billion, Apple is trading at a price-earnings ratio of 13x. While we consider 13x to be fairly inexpensive for a company of Apple’s stature, it’s actually even cheaper than that when one takes a closer look at he structure of the balance sheet. Assets include $66 billion of cash and short-term and long-term investments, which is up from just $15 billion less than four years ago as cash generation has massively exceeded spending. Stripping out the cash and investments, which can theoretically be liquidated and used to buy back stock, the enterprise value decreases to under $250 billion and the P/E is closer to 10x. As we said, baffling.
As with any company we analyze, there are potential blemishes that could impact Apple’s future earnings power. Among the concerns we have is the possibility of margin compression as competitors use price to go after market share (price being their only weapon as the Apple brand and customer experience is superior). Other concerns include the need for Apple to develop the next big product to spur future earnings growth and whether the company will squander its cash hoard on value destroying acquisitions. The market also seems particularly concerned about Steve Jobs’ health. Us? Not so much. We are buying the underlying business and would not be interested in it if we did not think it was sustainable without Jobs at the helm.
Regarding the next big product, this was actually something that had kept us out of the stock for the last couple of years. However, with Apple’s current suite of products (particularly iPhone, iPad, and Mac computers), earnings for the next several years are sustainable based solely on product cycle upgrades (i.e. new versions of current products). Importantly, at Apple’s current valuation, new products are not priced in and serves as a “free” option were there to be any. However, our belief is that Apple’s competitive advantage stems from a powerful, yet basic, organizational idea: take the latest technology, package it in a simple, elegant form, and sell it at a premium price. The beauty of this scheme is that it’s consistently repeatable and allows Apple to piggyback off competitors’ R&D efforts.
So, at the price we paid, we believe that these risks are mitigated. Cheapness (i.e. buying at low prices relative to intrinsic value) is, in our opinion, the best way to limit threats like these, minimize losses, and earn dependably high returns.
Another new KIG position initiated during the quarter was Goldman Sachs (GS), the company everyone loves to hate. What could we see in a company that is the financial whipping boy of the media, Congress, competitors, and even the general public? Actually, a number of things. Regular readers of this newsletter know that investing all begins with competitive position and ends with price. Competitive position is unarguable in the case of Goldman Sachs, as no financial company enjoys more respect from American corporate leaders and financial competitors. Investment companies with large block size positions for sale in a public company are sure to call Goldman for a quote. Corporate execs who want to market their company to would be suitors are surely going to see what Goldman can do for them. And a powerful hedge fund trader or investment banker looking for new surroundings is likely going to consider seeking employment at Goldman Sachs. All of this was true before September 2008, widely viewed as the height of the financial crisis, and remains true today.
So what has changed, and why is the stock sitting at what appears to be unjustifiably low prices? We would argue that the change is 20% reality and 80% perception. The reality part derives from two sources, one legal and one related to business operations. The legal issue is about whether or not Goldman Sachs acted criminally before, during, or after the financial crisis, and if so, what the government will likely do about it. Our stance is, given what we have seen so far, criminal prosecution is unlikely, and even if pursued, would probably result in a fine versus corporate termination (putting the firm out of business). The government went down this path once before in the aftermath of the Enron affair with Arthur Andersen, the big 5 (at the time) accounting firm, and was chastised for putting the company out of business. Considering the public outcry in the years after the government action against Andersen for hurting so many employees for the actions of a few, it seems unlikely that such a path will be chosen again.
The second issue, one of business operations, is less binary. Where the legal issue is either going to be very pertinent or relatively irrelevant to business valuation, the business operation issue has degrees of seriousness. For instance, since Goldman Sachs chose to become a bank holding company to weather the financial crisis (and became subject to all the regulations that status brought with it), will its return on equity suffer accordingly? Will the company have to spin off more businesses? Will the restrictions against trading cause an exodus of talent? All of these questions have yet to be answered.
So then why buy the stock? Basically, because we believe that the current valuation is much too low for this business even with some degree of earnings erosion from the factors mentioned above. At current prices, Goldman Sachs’ stock is trading near book value. At this valuation, a buyer today is paying nothing for the value of the franchise and its earnings power. The only time it traded anywhere near this valuation was late 2008, when going out of business seemed to be a real possibility for all financial companies. Absent such a panic, Goldman Sachs stock should certainly trade near intrinsic value, north of 1.5 times book, in our opinion.
Our estimate of the intrinsic value of Goldman Sachs is based largely on a couple of factors. Goldman has a thriving asset management business and investment banking operation that require minimal amounts of capital. Earnings are being generated for the company without the need of significant capital, leaving most of those earnings for use in its trading businesses. Also, if you remove our estimate of the value of its non-capital intensive businesses from Goldman Sachs’ share price, its remaining business are trading at a price below book value. That is truly amazing. The market is saying that Goldman management will not only fail to generate a satisfactory return on book value, but it will destroy book value. That is hard to believe given the cheap interest rates that Goldman Sachs borrows at, the reputation Goldman enjoys in the business community, the structure of the organization, and the pedigree of its employees. A minimal return on equity of say 12-14% (not high for a financial company given the use of leverage) over the next 5 years would make the company worth far more than it is valued at today.
A final litmus test is more qualitative in nature. Look back to 1999, around the time of the Goldman Sachs’ IPO. At that time, the stock went public at 3-4 times book value. That's right, 3-4 times the valuation it is at today!! Had the company not gone public back then, it would be hard to believe that Goldman Sachs partners would have brought it out public in today's environment at anywhere near today's prices. Our guess is that in such a situation the partnership would have stayed just that, a partnership.
To make room for these purchases, we trimmed our stakes in several names as needed for each client account. Included in these sales were Automatic Data Processing (NASDAQ:ADP), Costco (NASDAQ:COST), Private Bank (NASDAQ:PVTB), Red Robin Gourmet Burgers (NASDAQ:RRGB), St. Jude Medical (NYSE:STJ), and Vodafone (NASDAQ:VOD).
“The greatest delusion men suffer is from their own opinions.”
– Leonardo Da Vinci
“Patience combined with opportunity is a great thing to have.”
– Charles T. Munger, vice chairman, Berkshire Hathaway
While doing some reading this morning I came across a very sensible quarterly update from Kovitz Investment Group. Kovitz has a very good long term performance record: