To a class of graduate students at Boston College, Mohnish Pabrai facetiously said that he had spoken to the Great Spirit of the Universe. And in that conversation the Great Spirit confessed to him that the Ten Commandments, originally handed off to Moses, were slightly off.
And for the next two hours, Pabrai presented to the class of MBAs the Ten Commandants as given to him.
I thought it was a wonderful talk. It introduces some of the fundamental principles of value investing which I decided to summarize in this meditation.
While management fees have been dropping, over 98% of asset managers still charge a management fee between 0.25% and 2.00% of assets under management. So managers continue to pay their utility bills, whether they win or lose money for you.
Pabrai argued against this practice for two reasons. First, with such a misaligned incentive structure, the asset manager typically spends his or her time growing assets under management while their sole focus should be to earn a higher-than-market rate of return for you.
Second, as Charles Ellis wrote in Investment Management Fees Are (Much) Higher Than You Think, a one percent management fee may seem trivial and harmless at a first glance. But when viewed as a percentage of the actual income generated by the asset manager, management fees in the financial industry are high, ranging between 10% and 20% of the actual investment revenue. As a point of reference, your local property manager would charge 3% to 8% to manage your home while you are away on vacation.
The investment management profession was intended for the individual. "If you like to sit in a room alone, intrigued by how the world works, you will do just fine," Pabrai said.
To him, hiring a team of analysts will distract the asset manager with tiresome managerial duties. And instead of carefully reading about investments, the manager will eventually read the analyst’s cliffs notes.
By explicitly investing in stocks, you implicitly take unforeseen risk. For example, buy Coca Cola stock today and you will immediately be exposed to changes in consumer preferences (just try to pitch to consumers a coconut or Kombucha drink a century ago) and to geopolitical changes (for decades after World War II, consumers did not purchase AEG products because they were associated the Germany).
In short, expect a bumpy road and be humble.
Because of commandment number three, investors must look for stocks that will multiply by at least two-fold within three years. Grab your HP12C and you will see that this is an implied expected return greater than 25% per year.
In his talk, Pabrai described his investment in Fiat Chrysler, a car company, that was at the time he had bought its stock, the valuation was a price to earnings of one. Another example was a company in the funeral business. "Good things happen when you buy companies at a p/e of 1,” he proclaimed.
If you cannot mentally understand why you are buying the stock of a company, you should not invest in the stock in the first place. Surely, Quants that trade in stock market using math algorithms, would be disappointed.
I think Pabrai argued for us to get rid of Excel program because by adjusting input assumptions, we may turn a mediocre investment into an excellent one. This is known in the investment industry as “garbage in, garbage out”.
In this commandment, Pabrai brings a wonderful example of the implicit, unrealistic, growth expectations of a current investor in Apple, as the stock is trading at over 20 times the trailing earnings.
While we see ourselves as rationale machines, constantly weighting the cost and benefits of our decisions, current research says otherwise. And so, this commandment addresses our emotional side.
It is only a matter of time before something drastically bad will happen to us. And it is important to prepare for times when we will recite that these are times that try men's souls.
To some, Vipassana yoga is the answer. To others it may be family or a community to belong to. For yours truly, it is reading about history as a means to appreciate the present and to prepare for the future.
The Pareto principle, also known as the 80/20 rule, states that roughly 80% of the effects comes from 20% of the causes. What had become a business axiom (80% of the sales come from 20% of the clients) applies to stock research.
For example, reading a company’s annual filings, such as 10-k report, which often takes less than an hour, provides the reader with a general understanding of the business, its industry and its risks. It quickly provides answers to questions such as how much deb does the company carry? What is the return on invested capital over the past five years?
Yet if you get distracted and read about possible changes in government policies where the company domiciles, or if you look at the history of the stock price and try to infer where the stock is heading based on the historical movements, you will get overwhelmed.
No need to bring much details or to further expand on this concept. In shorting stocks the math operates against you (your upside is limited while your downside goes to infinity). View Pabrai's talk at Google for an expanded discussion on the topic of shorting.
And not only that you bet on a future outcome, which is by definition unknown in the present, you are betting on its timing. And if the Oracle of Omaha does not short, why should you?
In Buffett’s owns words:
“Charlie and I have agreed on around 100 stocks over the years that we thought were shorts. Had we acted on them, we might have lost all our money, every though we were right just about every time. A bubble plays on human nature. Nobody knows when it’s going to pop, or how high it will go before it pops.”
Charlie Munger said that, “You can’t get ahead in life if you owe someone 20% on the money they gave you.”
Pabrai, who reveres Munger, takes the principal to heart. You will rarely see leveraged institutions - such as banks - in his portfolio of stocks. Without borrowing money, you can't go bankrupt.
Pabrai did not invent the 0/6/25 investment model (zero percent management fees, six percent hurdle rate and a quarter of the profits to the asset manager). But he thought it was crazy that no asset manager had copied this business model.
Pabrai shared with MBAs that most of his investing ideas are the result of reading annual reports by other fund managers and copying ideas that are sensible to him.
With that, I am certain he would be proud of me for copying - and for sharing with you – his ten commandments.
Benjamin Graham would be proud. Using Value Line stock screener for stocks trading at less than 5 times the trailing earnings per share, I came across a company that operates in the unglamorous business of food distribution.
United Natural Foods, I quickly learned, is a fortune 500 company that had earned a profit in each year of the past decade. And yet it was trading at less than 5 times the trailing earnings per share. Was I dreaming?
The historical operating financials were beautiful. In 2008, earnings per share were $1.38 compared to $3.26 earnings per share as of its most recent annual filing. And this not-to-be-taken for-granted 9% compounded rate of growth was achieved with little dilution of outstanding shares. And participants in capital markets, whether speculators or investors, traded the stock of United Natural Foods as low as $13 (in 2009) and as high as $84 (in 2015).
The income statement and balance sheet were attractive, too. After adjusting for an impairment expense, I arrived at a three-year average cash flow per share, net of capital expenditures, of about $2. More importantly, there was plenty of income to service the debt: the operating income to interest expense ratio was greater than 14 times during that period.
And after removing goodwill from the reported assets, I arrived at book value per share of $29 in 2018 and of $26 in 2017. Put differently, priced at $22 per share, UNFI was trading at 25% discount to book value.
Yet the price of the stock had more than halved this year. In January, common shares in UNFI were quoted at around $50. With the passing of six months, the stock declined to $32 from $42 in less than a month, a drop of 24%. And for those investors that held the stock, at the time of this writing, the stock price is $10.
It will not take you long to learn that Mr. Market is angry with UNFI because of its Animal Spirits. "This transaction accelerates UNFI's growth strategy by immediately enhancing our product range,equipping us to bring an attractive, comprehensive product portfolio to an expanded universe of customers," said Steve Spinner, UNFI's boss.
"The combination of UNFI and SUPERVALUE provides a substantial premium and delivers certainty of value to our stockholders, meaningful benefits to our customers and expanded opportunities to our employees."
And as somewhat expected from any merger and acquisition transaction by a Fortune 500 company, Spinner used the s-word. Synergy.
The expected, rosy future of the combined entity is the result of a serious gamble. The gamble being the amount of debt UNFI used to finance the transaction, where the cash used to pay out SUPERVALUE shareholders was not from retained earnings, but using the willingness of lenders.
And in a rising interest rate environment, management decided that adding $1.2 billion in a new revolving line facility, as well as adding $2.05 billion in the form of a term loan. Not a good idea.
The dean of the world distressed debt, Howard Marks, once said that we should not predict future, but instead, focus our attention on the present and what present conditions say about the future.
In the case of UNFI, certainly we cannot predict what the company’s income statement will look like in five years, but we can understand the significant amount of the leverage taken. Due to the acquisition, United Food increased the right side of its balance sheet by three times, from $1.2 billion as of July 2018 to over $4.3 as of today.
So, not only are current buyers of the stock taking leverage risk and risk related to how successful the merger will prevail, but also,invariably, these traders are taking on risks that the company never addressed previously.
To name a few: the company is highly dependent on the success of Whole Foods Markets, as it accounted for about 37% of the fiscal 2018 sales. Or that the firm operates in a low margin business where profit margins are expected to decease as the industry is consolidating.
I had other, idiosyncratic reasons to avoid UNFI stock. First, I do not shop at Whole Foods. I believe they sell overpriced items that can easily be found elsewhere at a cheaper price.
And it is absolutely meaningless to me that in some stores you can now shop without taking your wallet from your pocket (I didn’t thought it to be of such an inconvenience).
Second, I believe UNFI overpaid for SUPERVALUE, which to me is a sign of an overly optimistic, bullish management. In its most recent annual filing, SUPERVALUE disclosed to shareholders that the stock price range was $14 in the fourth quarter of 2018. Yet UNFI paid $32.50 for the same stock.
UNFI's management must not believe in the Efficient Market Hypothsis.
While I did not buy any shares in UNFI, I did buy an equity interest in other businesses this year. In Make Equity Great Again I wrote why I bought shares in the company best associated with the word "Victoria’s Secret models.”
Unrelated to the beautify business, but somewhat implicitly related to the business of being and looking healthy, in Lifeway Foods: Why I am long probioticsI wrote about my purchase of a small company that produces kefir products.
And in August of this year, I described my Tupperware purchase, both of the physical product itself and of the company's stock. You can read more about it in Tupperware Company: A Quality Product but Shareholders Should Beware of The Debt Level.
General Electric's recent annual report left readers scratching their head. The company operates in nine, materially different segments, and comments on each segment as if the reader is expected to understand the risk facing the oil industry and the healthcare industry. To analyze the financial statement of a company with one operating segment is a challenging task; it is exponentially harder in the case of GE.
To explain its operating results, GE came up with its own definition of financial performance metrics. Those metrics include imaginative terms such as "EPS from continuing operations", "GE Industrial plus verticals EPS" and "Adjusted GE Industrial CFOA". With so many adjustments to reported earnings, we must wonder whether they are meaningful at all.
Not only is it difficult to understand the meaning behind the definitions, the annual report contains typos. On page 102 of the annual report, management makes an error as it reports on $9,698 million in adjusted GE industrial CFOA. It should be $9,168 million.
There is no way around it: GE reports on a deteriorating financial health. If we look at the revenue from the sales of goods and services over the past six years, we find a compounded annual growth of 2% per year, from $101 billion in 2012 to $113 billion in 2017. But the operating expenses increased by three times as much. The operating expenses compounded growth was 6% during that time, from $75 billion in 2012 to $107 billion in 2017.
Another troubling fact is that GE's debt service increased from $1.3 billion to $2.7 billion during the 2012 to 2017 time period. So the gross revenue to interest expense ratio has steadily declined over the past six years. It was 19 times in 2012; six times in 2015; and merely two times in 2017. In numbers: GE revenue was $113 billion; its operating expenses were $107 billion; gross revenue was $6 billion and with an interest expense of $2.7 billion, the coverage ratio is 2.2 times.
The dismal trend in operating performance is found in GE's balance sheet too. In 2012, the company had $600 billion in tangible assets and $557 billion in liabilities for a tangible equity balance of $43 billion. In 2015, total tangible assets were $410 billion, and liabilities were $389 billion, for a tangible equity balance of $21 billion, a drop of 51%. Two after, in 2017, the tangible assets were $274 billion and liabilities were $292 billion. A deficit in the reported equity account. In other words , the accountants reported that GE will not be able to pay off its liabilities (let alone the common shareholder) if it is to sell all of its assets as reported on the balance sheet. Yikes.
It is practically impossible to proselyte where GE will be in five years. A month ago, GE announced that it will be selling its 62.5% interest in Baker Hughes. A year ago, Jeffrey Immelt retired as Chief Executive Officer and three and half years ago, on April 10, 2015, GE announced it would sell most of the assets of GE Capital.
There have been so many changes; how can one see the distant horizon? With no idea where GE will be in the future, I thought about valuing GE by simply adding up the market value of its subsidiaries, as if they were separately owned entities. But here too I ran into a difficulty. Separately, GE does not report who is the competition for each of its subsidiaries, and given its behemoth size, GE is simply too big for a competitor to purchase its assets entirely.
In a day-to-day business transaction, a prospective buyer usually asks: What am I getting by investing my cash in this business? The answer is usually how much cash flow will be returned, and what is the value of the asset being acquired after any liabilities are paid off. In the case of GE, it is guessing a game to determine either of the two.
Between 2012 and 2017, the stock traded as low as $17 (in 2017) and as high as $33 (in 2016). I believe there are many investors who estimate that the stock value is now somewhere worth somewhere between $20 to $25 per share. Let us assume that it is the case for the remaining paragraphs.
Even if the stock is worth $25 per share, given the uncertainty, GE is not a bargain. Grab your HP12C and you will find that assuming that GE's stock price will reach $25 five years from today, the expected rate of return is 14%. Including the expected dividend per share of $0.48, the expected rate of return is 17%. A less than adequate return given the amount of uncertainty.
This meditation is an example of when the best investing idea is the one you do not invest at all. What drew my attention to GE in the first place was a precipitous decline in the stock price. Excited about the opportunity of purchasing stock for $14, I quickly learned some hard truths; that management halved the dividend rate in the last quarter of 2017 from $0.25 to $0.12 per quarter; and that management took a significant impairment expense of $6.2 billion last year with little explanation.
In February of this year, I bought 100 shares of GE at a total cost of $1,474. (It represents about 0.59% of the total cost of my portfolio of stocks.) I bought those shares just to force myself to read more about the company. I am glad I learned more about GE and I am also glad I am no longer a common stock holder. The word of GE is simply too confusing for me.
"We recently announced our decision to abandon the new nuclear project. Since making this filing, members of our senior management team and I have been meeting with a variety of stakeholders, Governor McMaster, and members of the South Carolina General Assembly, to discuss their concerns," said Kevin Marsh, boss of Scana Corporation. "We recognize that this process creates some uncertainty regarding the timing and impact of our abandonment decision."
When Wall Street analysts hear the word “uncertainty" a punishment to the stock price soon follows. Since that August 2017 earnings call, the stock price has been declining each month and now trades at a 12-month low of $37. It traded for $65 prior to that call.
The saga continued as the company surprisingly reported a loss of $172 million or $0.83 per share, for year-end 2017. I think it caught many of us by surprise because the 2008 - 2016 average earnings per share was $3.50 (during that 9-year period, earnings per share ranged between $2.95 and $4.16). Capital markets are merciless when management reports on a loss.
The 2017 loss in earnings was due to an impairment loss of $1.12 billion. The non-cash expense was directly related to the abandonment of the nuclear project as mentioned in the first paragraph. Excluding the impairment loss, I estimate that earnings would have been about $805 million, or $5.67 per share.
I was planning to purchase shares in SCG. To me, the non-cash cost (though it is a real cost for current shareholders who are looking to sell their positions) resulted in mispriced stock and, with the abandonment of the nuclear plant, would likely have freed future capital to be distributed as dividends. But the story is much more complicated.
The company had charged its South Carolina based customers much higher than average utility prices for over decade. Effectively, the consumer had paid for the construction of the nuclear plant. And Scana will not be able to charge these utility prices in the future. In short, the abandonment of the plant was a true cost, not just an accounting convention. It was a cost in the time and energy (no pun intended), the present devaluation of the stock, and for future profits.
This is a story where the past is not indicative of the future. While the company has been paying dividends to its shareholders since 2000 it is uncertain whether it will continue to do so in the future.
Second, the operating performance was adequate, but it is questionable whether it will continue; the 2017 revenue was $3.07 billion, compared to $2.84 billion in 2013; the adjusted earnings (which exclude the impairment loss) increased to $805 million from $633 million during that five-year period. But as mentioned, future utility charges will have to be lower.
SCG is now selling in the market place at about par. This is a relatively low valuation compared to past valuation. In 2016, with a book value of $39, SCG traded between $74 and $37, an average premium of 140%. In 2015, with a book value of $36, the stock traded between $76 and $59, a premium of 190%.
Its earnings multiple is lower than other energy companies. Take Southern Company (SO) as an example. The company reported on $24 equity per share and the stock trades for $46, a 190% premium. Another example is Duke Energy Corp (DUK) - the stock changed hands for $79, with a reported book value of $60 per share, a premium of 130%. NextEra Energy (NEE) stock price was $167, with a book value of $60, a 278% premium.
Using the adjusted earnings of $5.6 per share, SCG trades at about 7 times the earning multiple, or 12 times the 2008-2017 earning multiple, which includes the 2017 loss. During that decade, the earning multiple was as low as 9 times and as high as 18 times. The average multiple was 13 times.
It is likely that in 2019, current SCG shareholders will own the stock of Dominion Energy (D). In December of last year, Dominion announced that it would replace all of the outstanding shares of Scana with its own stock, at an exchange price of 0.669. Dominion may be a terrific stock to own, but I know very little about the company.
Capital markets often value stocks using past trends and penalize stocks when surprises occur. A 2016 investor in SCG, who had listened to Wall Street analysts, may have been tempted to purchase the stock as earnings increased for 9 consecutive years (the annual compounded growth was 4%).
With the belief that the earnings trend must continue, the 2016 investor would have purchased the stock at a price range of $59 and $76, representing an earnings multiple of 18 to 14 times the 2016 earnings, or the 170% premium to book value. A dear valuation.
But the nature of business is that as industries become profitable, either (1) more competition will enter the market place, squeezing future margins, or (2) the concept of diminishing return to capital kicks in.
In the energy sector there is additional risk. Energy-related businesses face constant scrutiny from regulators (read: If regulators realize that margins are abnormally high, they will likely opine that the business is a monopoly and break down its parts.)
In sum, as earnings increase, the probability grows that future earnings will suffer. Against common convention, this is the point in time when you, the rationale investor, should be wary of the stock and less excited about where it will be.
**This week I became a lawful permanent resident. And so, I am celebrating with a hot dog, Budweiser, and apple pie.**
It is a misconception to think that each stock purchase involves an elaborate, detailed analysis. If you would have asked me how to analyze a company immediately after my business school days, my answer would be: "First, you HAVE to understand the balance sheet and income statement. Then you NEED to make sure that the cash flow statements reconcile to the balance sheet. After that, you MUST prepare a SWOT analysis, KNOW the competition, LISTEN to analyst calls with management and then READ everything Wall Street has to say."
But my answer, filled with action verbs, would be utterly wrong because all you really need is one, good investment idea. The great investors of our times realized this principle a long time ago. When Mohnish Pabrai purchased the stock of BYD, a Chinese manufacturer of automobiles, I doubt how much he understood the underlying economics of the company. Yet, I am confident that he was following what Charlie Munger said about the company’s founder, Wang Chuyan-Fu.
In Charlie’s words:
“Wang is a combination of Thomas Edison and Jack Welch - something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it.”
So Pabrai’s idea was to follow the footsteps of Munger. And it worked.
Last week I placed a position in Frontier Communications (FTR) that now represents about 7% of my stock portfolio. The investment idea is a mispricing, due to the 2017 goodwill expense and a change in the dividend policy.
Adjusted for a 15-to-1 stock split in 2017, over the past decade, FTR traded as low as $46 and as high as $241, with a 10-year average stock price of $90. Compare that to 2017, when the stock traded for as low as $6 and as high as $57. At the time of this writing, FTR trades at about $7.
I attribute the steep decline in stock price to two reasons. First, management reported a loss of about $2 billion in 2017. This was the steepest reported loss over the past decade. Details on the reported loss can be found on page 70 of the 10-k report, where you will read that management took about $2.75 billion in a goodwill impairment. And if you would like to see how it affected the balance sheet, just flip to page 69 and you will see that the account titled "Goodwill, net" declined to $7 billion from $9.7 billion the year prior.
The second reason for the steep decline in stock price is that management decided to no longer distribute dividends to common shareholders. On page 48 of the 2017 annual report, they wrote:
"The Board of Directors has suspended the quarterly cash dividend on the Company’s common stock beginning with the first quarter of 2018. The declaration and payment of future dividends on our common stock is at the discretion of our Board of Directors, and will depend upon many factors, including our financial condition, results of operations, growth prospects, funding requirements, payment of cumulative dividends on Series A Preferred Stock, applicable law, restrictions in agreements governing our indebtedness and other factors our Board of Directors deem relevant."
Management explained that the goodwill expense was taken because the reported balance sheet value of the company was higher than the price shareholders would receive if the company was sold in real life. To arrive at a fair value for FTR, management reduced their EBITDA multiple from 5.8 times the EBITDA to 5.5 times.
Do you see the disproportion? Management lowered the EBITDA multiple by 5%, and the stock price declined by 90% from its average price over the past three years. What is even more peculiar is that in 2014, management reported an EBITDA of $2.1 billion (the stock traded for as low as $63 and as high as $127 during that year) and the EBITDA for 2016 was $3.3 billion.
Let me remind the reader that a goodwill expense is, by definition, a non-cash expense. It is no different than if the real estate market told you that the home you purchased for $100,000 a year ago is now worth $50,000. Yet, while your bank account would be unaffected by the change in your home’s market value, in the case of GAAP accounting for public companies, you would realize a loss.
To explain how little I care about FTR's elimination of dividends to common shareholders I will use a thought experiment. Let’s imagine that instead of buying shares in FTR, I lent out the money to my friend, John. In the loan agreement, John promised to return 1/5 of the loan at the end of each year. But in year 4, John explained to me that instead of returning the 1/5 of the loan amount owed to me, he wanted to invest the money by opening, say, a food truck, in which he would give me an interest percentage.
Just as it would be unreasonable for me to conclude that John was a deadbeat for not returning the 1/5 of the original loan amount, I don’t see any issues with FTR retaining profits for future endeavors.
What is considered a praiseworthy practice by Wall Street is often not in the best interest of the shareholders. When FTR acquired the wireline operations of Verizon Communications, it used debt in the form of preferred stock to finance the acquisition. This was not a cheap source of financing. To date, the total interest expense paid to the preferred common shareholder is $550 million. And had management refrained from paying dividends on the common stock between 2017 and 2015 (it paid $1.2 billion in dividends during that time), the entire acquisition of Verizon could have been with cash.
The careful reader will note that I did not write about FTR’s true, intrinsic value. This was not an omission of thought, but due to the simple reality: I have no idea at this point. I know little about the wireless industry and even less about Frontier Communication’s market share. Yet, as I alluded to in the second paragraph, sometimes all that we need as investors is just one good idea.