Ray Dalio – When Investors Are Making Money, Which Is Typically After A Large Price Rise, Doing The Opposite Is A Good Idea

Johnny HopkinsRay Dalio Comments

One of our favorite investors here at The Acquirer’s Multiple is Ray Dalio, and one of the best Dalio interviews is in the book, Hedge Fund Market Wizards: How Winning Traders Win, by Jack Schwager. The book provides successful trading philosophies and strategies from fifteen traders who’ve consistently beaten the markets. In this interview Dalio talks about some of the most important lessons and experiences that he has learned from a life of investing.

Here’s an excerpt from that interview:

As the world’s largest hedge fund, you have come quite far. I wonder what your goals were as a young man?

I played around in the markets when I was a kid. I started when I was just 12. It was like a game, and I loved the game. The fact that I could make money playing the game was good, too, but it wasn’t what motivated me. I never had any specific goals like making or managing some level of money.

It is amazing how many of the successful traders I have interviewed got started in the markets at a very young age their teens and sometimes even younger.

That makes total sense to me because the way people think is very much influenced by what they do early in their lives. Internalized learning is easiest when we are young, which is why learning to play a sport or to speak a language well is easier at an early age. The type of thinking that is necessary to succeed in the markets is entirely different from the type of thinking that is required to succeed in school. I’m sure that my being involved in the markets from an early age profoundly affected my way of thinking.

How so?

Most school education is a matter of following instructions—remember this; give it back; did you get the right answer? It teaches you that mistakes are bad instead of teaching you the importance of learning from mistakes. It doesn’t address how to deal with what you don’t know.

Anyone who has been involved in the markets knows that you can never be absolutely confident. There is never a trade that you know you are right on. If you approach trading that way, then you will always be looking at where you might be wrong. You don’t have a false confidence. You value what you don’t know.

In order for me to form an opinion about anything involves a higher threshold than if I were involved in some profession other than trading. I’m so worried that I may be wrong that I work really hard at putting my ideas out in front of other people for them to shoot down and tell me where I may be wrong. That process helps me be right. You have to be both assertive and open-minded at the same time. The markets teach you that you have to be an independent thinker. And any time you are an independent thinker, there is a reasonable chance you are going to be wrong.

Do you remember your first trade?

Yes, I bought Northeast Airlines, which flew between New York and Florida.

How did you pick that stock?

It was the only stock I had ever heard of that was also selling below $5 a share. So I could buy more shares. That was my whole analysis. It didn’t make any sense, but I got lucky. The company was about to go bankrupt, but then it was acquired, and I tripled my money. So I figured this was easy. I don’t remember anything more about any specific stocks I bought as a child. But what I do remember is that when I was about 18 years old, we had the first bear market in my experience, and I learned to go short. Then in college I got involved in trading commodities.

What attracted you to commodities?

I could trade them with low margin requirements. I figured that with low margin requirements, I could make more money.

Any early experiences in the markets stand out?

In 1971, after graduating college and before going to business school, I had a job as a clerk on the New York Stock Exchange. On August 15, Nixon took the U.S. off the gold standard, and the monetary system broke down. I remember the stock market then went up a lot, which is certainly not what I expected.

What did you learn from that experience?

I learned that currency depreciations and the printing of money are good for stocks. I also learned not to trust what policy makers say. I learned these lessons repeatedly over the years.

Any other early experiences stand out where the market behaved very differently from what you expected?

In 1982, we had worse economic conditions than we do right now. The unemployment rate was over 11 percent. It also seemed clear to me that Latin America was going to default on its debt. Since I knew that the money center banks had large amounts of their capital in Latin American debt, I assumed that a default would be terrible for the stock market. Then boom—in August, Mexico defaulted. The market responded with a big rally. In fact, that was the exact bottom of the stock market and the beginning of an 18-year bull market. That is certainly not what I would have expected to happen.

That rally occurred because the Fed eased massively. I learned not to fight the Fed unless I had very good reasons to believe that their moves wouldn’t work. The Fed and other central banks have tremendous power. In both the abandonment of the gold standard in 1971 and in the Mexico default in 1982, I learned that a crisis development that leads to central banks easing and coming to the rescue can swamp the impact of the crisis itself.

Any other events stand out as learning experiences?

Every day provides tactile learning experiences. You are asking me to describe moments. I don’t see it as moments, but rather as a string of tactile experiences. It is not so much a matter of cerebral memories as it is visceral feelings.

You can read about what happened in the market after Mexico defaulted, but that is not the same as being in the market and actually experiencing it. I particularly remember my surprises, especially the painful ones, because those are the experiences that provide learning lessons. I vividly remember being long pork bellies in my personal account in the early 1970s at a time when pork bellies were limit down every day. I didn’t know when my losses would end, and I was worried that I would be financially ruined.

In those days, we had the big commodity boards, which clicked whenever prices changed. So each morning, on the opening, I would see and hear the market click down 200 points, the daily limit, stay unchanged at that price, and know that I had lost that much more, with the amount of potential additional losses still undefined. It was a very tactile experience.

What did you learn from that experience?

It taught me the importance of risk controls because I never wanted to experience that pain again. It enhanced my fear of being wrong and taught me to make sure that no single bet, or even multiple bets, could cause me to lose more than an acceptable amount. In trading you have to be defensive and aggressive at the same time. If you are not aggressive, you are not going to make money, and if you are not defensive, you are not going to keep money. I believe that anyone who has made money in trading has had to experience horrendous pain at some point.

Trading is like working with electricity; you can get an electric shock. With that pork belly trade and other trades, I felt the electric shock and the fear that comes with it. That led to my attitude: Let me show you what I think, and please knock the hell out of it. I learned about the math of investing. [Dalio walks over to the board and draws a diagram where the horizontal axis represents the number of investments and the vertical axis the standard deviation.]

This is a chart that I teach people in the firm, which I call the Holy Grail of investing. [He then draws a curve that slopes down from left to right—that is, the greater the number of assets, the lower the standard deviation.] This chart shows how the volatility of the portfolio changes as you add assets. If you add assets that have a 0.60 correlation to the other assets, the risk will go down by about 15 percent as you add more assets, but that’s about it, even if you add a thousand assets.

If you run a long-only equity portfolio, you can diversify to a thousand stocks and it will only reduce the risk by about 15 percent, since the average stock has about a 0.60 correlation to another stock. If, however, you’re combining assets that have an average of zero correlation, then by the time you diversify to only 15 assets, you can cut the volatility by 80 percent. Therefore, by holding uncorrelated assets, I can improve my return/risk ratio by a factor of five through diversification.

What about the problem of markets becoming highly correlated? As we sit here today, if you tell me that the S&P is down 2 percent, I can tell you the direction of virtually every other market.

I don’t think that’s correct.

Really, you don’t think that’s true?

I think that’s only true because of the way you are defining markets. For example, I can’t tell you which way the Greek/Irish bond spread would move in response to the S&P being down. There are ways to structure your trades so that you can produce a whole bunch of uncorrelated bets. You have to start with your goal. My goal is that I want to trade more than 15 uncorrelated assets. You are just telling me your problem, and it’s not an insurmountable problem. I strive for approximately 100 different return streams that are roughly uncorrelated to each other. There are cross-correlations that enter into it, so the number works out to be less than 100, but it is well over 15. Correlation doesn’t exist the way most people think it exists.

What do you mean by that?

People think that a thing called correlation exists. That’s wrong. What is really happening is that each market is behaving logically based on its own determinants, and as the nature of those determinants changes, what we call correlation changes. For example, when economic growth expectations are volatile, stocks and bonds will be negatively correlated because if growth slows, it will cause both stock prices and interest rates to decline. However, in an environment where inflation expectations are volatile, stocks and bonds will be positively correlated because interest rates will go up with higher inflation, which is detrimental to both bonds and stocks. So both relationships are totally logical, even though they are exact opposites of each other. If you try to represent the stock/bond relationship with one correlation statistic, it denies the causality of the correlation.

Correlation is just the word people use to take an average of how two prices have behaved together. When I am setting up my trading bets, I am not looking at correlation; I am looking at whether the drivers are different. I am choosing 15 or more assets that behave differently for logical reasons. I may talk about the return streams in the portfolio being uncorrelated, but be aware that I’m not using the term correlation the way most people do. I am talking about the causation, not the measure.

You have had only two drawdowns worse than 12 percent in 20 years with the worst being 20 percent. How have you managed to keep your drawdowns so controlled using a directional strategy?

There are two parts to the answer. First, as we discussed earlier, we balance risk across multiple independent drivers. We avoid having too much of the portfolio concentrated in any single driver. Second, we have stress-tested our strategies through multiple time frames and multiple scenarios.

I think many people experience drawdowns that are much larger than they expected because they never really understood how their strategy would have worked in different environments. There are managers who have been in the business for five years and think, I have a great track record; this approach really works. But they really don’t have the perspective of how their strategy would have performed in different circumstances.

Strategies that are based on a manager’s recent experience will work until they inevitably don’t work. In contrast, we test our criteria to make sure that they are timeless and universal. Timeless means that we look at a strategy during all different times, and universal means that we look at how a strategy worked in all different countries. There is no reason why a strategy’s effectiveness should change in different time periods or when you go from country to country. This broad analysis through time and geography gives us a unique perspective relative to most other managers.

For example, to understand the current U.S. zero interest rate, deleveraging environment, we need to understand what happened a long time ago, such as the 1930s, and in other countries, such as Japan in the postbubble era.
Deleveragings are very different from recessions. Aside from the ongoing deleveraging, there are no other deleveragings in the U.S. post–World War II period.

Are there risk limits in terms of individual positions?

There are limits in terms of position size, but not in terms of price. We don’t use stops. We trade approximately 150 different markets, where I am using the term market to also mean spread positions, as well as individual markets. However, at any given time, we probably have only about 20 or so significant positions, which account for about 80 percent of the risk and are uncorrelated to each other.

When you are in a significant drawdown, do you do anything differently? Do you reduce your exposure?

I don’t believe in reducing exposures when you have a losing position. I want to be clear about that. The only pertinent question is whether my being in a losing position is a statistically meaningful indicator of what the subsequent price movement will be. And it is not. For that reason, I don’t alter positions because they are losing.

Is the implication that whether you are at a new high or you are down 15 percent, you will still size positions exactly the same way?

Yes, the positions taken and their size would be exactly the same.

If a position works poorly, does that cause you to reexamine your strategy?

Always. The best discoveries come from positions that don’t work out. For example, in 1994, we were long a number of bond markets, and the bond markets sold off. We have multiple rules and systems that apply to the bond markets, and at the time, they indicated a net long position for each bond market. Afterward, we realized that if we took those same systems and traded them on a spread basis rather than an absolute basis, we could produce a much better return/risk outcome. That change took advantage of the universal truth that you can enhance the return/risk ratio by reducing correlation. If there is a research insight, we change our process.

That is an example of how a losing position caused you to change your process. But what about an individual position that is losing money? I understand that you do not get out or reduce a position simply because it is losing money, but what if you change your mind because you realize that you overlooked some factor or didn’t give some factor enough weight?

No, it doesn’t work that way. The way we change our minds is a function of how that information passes through our decision rules. Our decision rules determine the position direction and size under the circumstances.

So your trading process is fully systematized rather than dependent on discretionary decisions?

It is 99 percent systematized. These systems evolve, however, as the experience we gain might prompt us to change or add rules. But we don’t make discretionary trading decisions on 99 percent of our individual positions.

What if there is some idiosyncratic event that is not incorporated in the system?

If it is something like the World Trade Center getting knocked down, then yes, we may exercise a discretionary override. In most cases, such discretion would be a matter of reducing risk exposure. I would say probably less than 1 percent of trades might be affected by discretion.

Is your process totally fundamentally driven, or does the system also include technical factors?

There are no technical inputs.

So in contrast to the majority of CTAs who use a systematic approach based only on technical factors, primarily or solely price, you also use a systematic approach, but one based on only fundamental factors.

That’s right.

What do you believe is the biggest mistake people make in investing?

The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment. The tendency of investors to buy after a price increase for no reasons other than the price increase itself causes prices to overshoot. When investors are making money because they’re greedy and fearless, which is typically after a large price rise, doing the opposite is a good idea.

Undervalued Target Corp, FCF/EV Yield 12%, Shareholder Yield 14% – Large Cap 1000 Stock Screener

Johnny HopkinsStocks Comments

One of the cheapest stocks in our Large Cap 1000 Stock Screener is Target Corporation (NYSE:TGT).

Target Corporation (Target) is a general merchandise retailer selling products through its stores and digital channels. Its general merchandise stores offer an edited food assortment, including perishables, dry grocery, dairy and frozen items. Its digital channels include a range of general merchandise, including a range of items found in its stores, along with an assortment, such as additional sizes and colors sold only online.

Its owned brands include Archer Farms, Market Pantry, Sutton & Dodge, Art Class, Merona, Threshold, Ava & Viv, Pillowfort, Room Essentials, Wine Cube, Cat & Jack, Simply Balanced and Wondershop. Its exclusive brands include C9 by Champion, Hand Made Modern, Mossimo, DENIZEN from Levi’s, Nate Berkus for Target, Fieldcrest, Kid Made Modern, Genuine Kids from OshKosh and Liz Lange for Target. As of January 28, 2017, the Company had 1,802 stores across the United States, including 1,535 owned stores, 107 leased stores and 160 owned buildings on leased land.

A quick look at Target’s share price history over the past twelve months shows that the price is down 25%, but here’s why the company is undervalued.

(Source: Google Finance)

The following data is from the company’s latest financial statements, dated April 2017.

The company’s latest balance sheet shows that Target has $2.680 Billion in total cash and cash equivalents. Further down the balance sheet we can see that the company has short-term debt of $1.717 Billion and long-term debt of $11.086 Billion. Therefore, Target has a net debt position of $10.123 Billion (debt minus cash). While some investors may be concerned about Target’s net debt position it’s important to consider the company’s free cash flow position below.

In terms of the company’s overall financial strength, all financial strength indicators show that Target remains financially sound with a Piotroski F-Score of 5, an Altman Z-Score of 3.19, and a Beneish M-Score of -2.99.

If we consider that Target currently has a market cap of $30.954 Billion, when we add the net debt totaling $10.123 Billion that equates to an Enterprise Value of $41.077 Billion.

If we move over to the company’s latest income statements we can see that Target has $4.835 Billion in trailing twelve month operating earnings which means that the company is currently trading on an Acquirer’s Multiple of 8.49, or 8.49 times operating earnings. That places Target squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

It’s also important to note that if we take a look at the company’s latest cash flow statements we can see that Target generated trailing twelve month operating cash flow of $6.492 Billion and had $1.748 Billion in Capex. That equates to $4.744 Billion in trailing twelve month free cash flow, or a FCF/EV Yield of 12%. The company has used this free cash flow wisely by spending $3.125 Billion (ttm) buying back shares, while the price is undervalued, and paying out dividends totaling $1.344 Billion (ttm). Both of which provide shareholders with a shareholder yield of 14% (buyback yield 10% + dividend yield 4%).

Some analysts will point to the company’s current revenue of $69.316 Billion (ttm) and net income of $2.786 Billion (ttm) and make comparisons with FY2016 when revenues were $73.785 Billion and net income was $3.363 Billion but its important to consider that in FY2016 the company had $4.406 Billion in free cash flow compared to the $4.744 Billion (ttm) that we see today. That’s an 8% increase in free cash flow (ttm) and an all time high. What’s also important to consider is that the company’s current EPS of $4.88 (ttm) is the second highest in the past ten years and its current dividend of $2.36 (ttm) is an historical high.

Lastly, its also worth taking a look at Target’s annualized Return on Equity (ROE) for the quarter ending April 2017. A quick calculation shows that the company had $10.953 Billion in equity for the quarter ending December 2016 and $11.021 Billion for the quarter ending April 2017. If we divide that number by two we get $10.987 Billion. If we consider that the company has $2.786 Billion (ttm) in net income, that equates to an annualized Return on Equity (ROE) for the quarter ending April 2017 of 25%.

With all of this in mind it is therefore difficult to understand Target’s current P/E of 11.7 compared to its 5Y average 17.4**, and even more difficult to understand when you consider that the company traded on a P/E of 30+ in March of 2015:

(Source: Morningstar)

In terms of the company’s current valuation. Target is a company that is currently trading on a P/E of 11.7 compared to its 5Y average of 17.4**, a FCF/EV Yield of 12%, and an Acquirer’s Multiple of 8.49, or 8.49 times operating earnings. The company is currently generating historically high free cash flow and has an annualized Return on Equity (ROE) for the quarter ending April 2017 of 25%. This is in addition to its shareholder yield of 14% (buyback yield 10% + dividend yield 4%). All of which indicate that Target is currently undervalued.

** Morningstar

About The Large Cap 1000 Stock Screener (CAGR 18.4%)

Over a full sixteen-and-a-half year period from January 2, 1999 to July 26, 2016., the Large Cap 1000 stock screener generated a total return of 1,940 percent, or a compound growth rate (CAGR) of 18.4 percent per year. This compared favorably with the Russell 1000 Total Return, which returned a cumulative total of 259 percent, or 5.6 percent compound.

Charlie Munger – Great Investors Must Be Able To Adapt To A Changing Business Environment

Johnny HopkinsCharles Munger Comments

Earlier this year Berkshire Hathaway Vice-Chairman Charlie Munger was interviewed at the 2017 Daily Journal Annual Meeting. Munger spent time answering questions on a number of subjects including deferred gratification, polymath, filial duties, and the psychology of human misjudgment. The breadth of his knowledge is quite astounding. While the interview is full of investing gems, Munger was asked a question regarding Buffett and how he’s become a better investor after the age of 65. His response is a great lesson for value investors fixed in a certain mind-set:

Here’s an excerpt from that interview:

Question

Charlie, I’m Paul Smith from Los Altos, California. My question relates to a comment you made some years ago about Warren Buffett. I think you said that he has become a significantly better investor since he turned 65, which I found a remarkable comment. I was wondering if you could share information about that maybe we haven’t heard before. I know you’ve commented he’s a learning machine, and we all know the aversion to retail that came out of the Diversified episode, and so on. It would just be interesting, is there something that’s changed about his risk assessment or his horizons, or any color there would be fantastic to hear? Thank you.

Charlie Munger:

Well, if you’re in a game and you’re passionate about learning more all the time and getting better and honing your own skills a little more, etcetera, etcetera, of course you do better over time and some people are better at that than others. It’s amazing what Warren has done. Berkshire would be a very modest company now if Warren never learned anything. He never would’ve given anything back, I mean, any territory he took he was going to hold it.

But what really happened was, we were out in the new fields and buying whole businesses, and we bought into things like ISCAR that Warren never would have bought when he was younger. Ben Graham would have never bought ISCAR. He paid five times book or something for ISCAR. It wasn’t in the Graham play[book], and Warren who learned under Graham, just, he learned better over time, and I’ve learned better.

The nice thing about the game we’re in is that you can keep learning, and we’re still doing it. Imagine we’re in the press for CNBC for all of a sudden buying airline stocks. What have we said about the airline business? We thought it was a joke it was such a terrible business, and now if you put all of those stocks together we own one minor airline.

We did the same thing in railroads. We said railroads are no damn good, you know, too many of them, truck competition, and we were right. It was a terrible business for about 80 years, but finally they got down to four big railroads and it was a better business, and something similar is happening in the airline business.

On the other hand, this very morning I sat down in my library with my daughter-in-law and she booked a round trip ticket to Europe, including taxes, it was like 4 or 5 hundred dollars. I was like, “we’re buying into the airline business?” It may work out to be a good idea for the same reason that our railroad business turned out to be a good idea, but there’s some chance that it might not.

In the old days, I frequently talked to Warren about the old days, and for years and  years and years, what we did was shoot fish in a barrel, but it was so easy that we didn’t want to shoot at the fish while they were moving, so we waited until they slowed down and then we shot at them with a shotgun. It was just that easy, and it’s gotten harder and harder and harder, and now we get little edges…before, we had total cinches, and it isn’t any less interesting.

We do not make the same returns we made when we could run around and pick this low-hanging fruit off trees that offered a lot of it. So now we go into things. We bought the Exxon position. You want to know why Warren bought Exxon? As a cash substitute. He would never have done that in the old days.

We had a lot of cash and we thought Exxon was better than cash over the short term. That’s a different kind of thinking from the way Warren came up. He’s changed, and I think he’s changed when he buys airlines, and he’s changed when he buys Apple.

Think of the hooting we’ve done over the years about high tech, we just don’t understand it, it’s not in our central competency, the worst business in the world is airlines, and what do we do? We appear in the press with Apple and a bunch of airlines. I don’t think we’ve gone crazy. I think the answer is we’re adapting reasonably to a business that’s gotten very much more difficult, and I don’t think we have a cinch in either of those positions. I think we have the odds a little bit in our favor, and if that’s the best advantage we can get, we’ll just have to live on the advantage we can get.

I used to say you have marry the best person that will have you, and I’m afraid that’s a rule of life, and you have to get by in life with the best advantage you can get, and things have gotten so difficult in the investment world that we have to be satisfied with the type of advantage that we didn’t use to get. On the other hand, the thing that caused it to be so difficult was when we got so enormously rich and that’s not a bad tradeoff.

You can read the full transcript here.

Seth Klarman – Value Investing Is Like The E=mc2 of Money and Investing

Johnny HopkinsSeth Klarman Comments

One of the best resources for investors are the Santangel Investor Forum and The Santangel Roundtable. These invitation-only events offer unique investment ideas from some of the world’s top investors. Events were created by The Santangel Review which also provides some great commentary on leading investors.

My favorite commentary is called, The Collected Wisdom of Seth Klarman, which provides a compilation of quotes from The Baupost Group founder. Included in the piece are Klarman’s 17 quotes related to the attractiveness of being a value investor and why few investors have the discipline or patience to be successful value investors.

Here’s an excerpt from that article:

1. “We define value investing as buying dollars for 50 cents.”

2. “There is nothing esoteric about value investing. It is simply the process of determining the value underlying a security and then buying it at a considerable discount from that value. It is really that simple. The greatest challenge is maintaining the requisite patience and discipline to buy only when prices are attractive and to sell when they are not, avoiding the short-term performance that engulfs most market participants.”

3. “Value investing lies at the intersection of economics and psychology. Economics is important because you need to understand what assets or businesses are worth. Psychology is equally important because price is the critically important component in the investment equation that determines the amount of risk and return available from any investment. Price, of course, is determined in the financial markets, varying with the vicissitudes of supply and demand for a given security.”

4. “I’ve actually never seen people be successful over a long period of time without being value investors. To me, it’s sort of like the E=mc2 of money and investing.”

5. “Few are willing and able to devote sufficient time and effort to become value investors, and only a fraction of those have the proper mind-set to succeed.”

6. “When we look at value, we tend to look at it on a very conservative basis—not making optimistic forecasts many years into the future, not assuming growth, not assuming favorable cost savings, not assuming anything like that. Rather looking at what is there right now, looking backwards and saying, is that the kind of thing the company has been able to do repeatedly? Or is this a uniquely good year, and is it unlikely to be repeated? We tend to look at hard assets as much as possible.”

7. “Unlike speculators, who think of securities as pieces of paper that you trade, value investors evaluate securities as fractional ownership of, or debt claims on, real businesses.”

8. “Value investing requires deep reservoirs of patience and discipline.”

9. “As the father of value investing, Benjamin Graham, advised in 1934, smart investors look to the market not as a guide for what to do, but as a creator of opportunity.”

10. “Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong.”

11. “As value investors, our business is to buy bargains that financial market theory says do not exist.”

12. “Buying such bargains confers on the investor a margin of safety, room for imprecision, error, bad luck, or the vicissitudes of economic and business forces.”

13. “To value investors, the concept of indexing is at best silly and at worst quite hazardous.”

14. “Price is the ultimate thing that matters, [although we] worry about risks before focusing on returns.”

15. “Every security or asset is a ‘buy’ at one price, a ‘hold’ at a higher price and a ‘sell’ at some still higher price.”

16. “Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands.”

17. “You have to be able to stand things going bad before they go good.”

This Week’s Best Investing Reads – Curated Links

Johnny HopkinsValue Investing News Comments

Here’s a list of this week’s best investing reads:

Blogs

1. A Dozen Lessons on Investing from Ed Thorp (25iq)

2. The Biggest Stocks (A Wealth of Common Sense)

3. “Worrying is a serious offense” (Above The Market)

4. Academic Research Insight: When Does International Investing Make Sense? (Alpha Architect)

5. Three Lessons from the Bernie Madoff Scandal (CFA Institute Enterprising Investor)

6. A Fanatic is One Who Can’t Change his Mind and Won’t Change the Subject (Cliff’s Perspective)

7. Betting on Things That Never Change (Collaborative Fund)

8. Attrition Warfare: When Even Winners Lose (Farnam Street)

9. Investors, Stop Worrying About Why ‘Nobody’ Is Worrying (Jason Zweig)

10. Episode #63: Gary Beasley and Gregor Watson, “We’re Trying to Really Change the Way People Invest in Real Estate” (Meb Faber Research)

11. Dealing with Failure in Life and Investing: Lessons from the Chaos Monkey (Safal Niveshak)

12. How the Auto Industry is Catching Up with Tesla (The Big Picture)

13. The Topic is Gold (The Irrelevant Investor)

14. It’s not just Amazon’s fault (Vitaliy Katsenelson Contrarian Edge)

Undervalued Finjan Holdings, FCF/EV Yield 38%, Earnings Yield 14% – Small & Micro Cap Stock Screener

Johnny HopkinsStocks Comments

One of the cheapest stocks in our Small & Micro Cap Stock Screener is Finjan Holdings, Inc (NASDAQ:FNJN).

Finjan Holdings, Inc., (Finjan) through its subsidiaries, operates as a cybersecurity company, provides intellectual property licensing and enforcement services. The company owns a portfolio of patents related to software and hardware technologies that proactively detect malicious code and thereby protects end users from identity and data theft, spyware, malware, phishing, trojans, and other Web and network threats. Its patented technologies are used in specific cybersecurity technology areas, including endpoint/cloud software, Web gateway/Internet infrastructure, networking equipment markets, and mobile security. The company’s technology scans and repels the latest and unknown threats to network, Web, and endpoint devices on a real-time basis. It also provides investments in cybersecurity technologies and intellectual property; offers cyber risk and cyber security advisory services; and develops mobile security applications.

A quick look at Finjan’s share price history over the past twelve months shows that the price is up 78%, but here’s why the company still remains undervalued.

The following data is from the company’s latest financial statements, dated March 2017.

The company’s latest balance sheet shows that Finjan has $26 Million in total cash and cash equivalents. Further down the balance sheet we can see that the company has zero debt. Therefore, Finjan has a net cash position of $26 Million (cash minus debt).

In addition to the company’s strong balance sheet, all financial strength indicators show that Finjan remains financially sound with a Piotroski F-Score of 7, an Altman Z-Score of 7.77, and a Beneish M-Score of -1.07.

If we consider that Finjan currently has a market cap of $78 Million, when we add the preferred shares totaling $6 Million and subtract the cash totaling $26 Million that equates to an Enterprise Value of $58 Million.

If we move over to the company’s latest income statements we can see that Finjan has $18 Million in trailing twelve month operating earnings which means that the company is currently trading on an Acquirer’s Multiple of 3.22, or 3.22 times operating earnings. That places Finjan squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

It’s also important to note that if we take a look at the company’s latest cash flow statements we can see that Finjan generated trailing twelve month operating cash flow of $22 Million and had $0 Million in Capex. That equates to $22 Million in trailing twelve month free cash flow, or a FCF/EV Yield of 38%.

Something else that seems to be overlooked is that Finjan’s currently has historically high revenues of $41 Million (ttm) and net profits of $17 Million (ttm). Other historical highs include EPS of $0.46 (ttm) and book value per share of $0.46 (ttm). The company currently holds 33% of its $78 Million market cap in cash and has a net current asset value of $8 Million when you subtract its total liabilities of $13 Million and preferred stock of $6 Million from its current assets totaling $27 Million.

In terms of its present valuation, Finjan is currently trading on a P/E of 7.4, or an earnings yield of 14%, a FCF/EV Yield of 38% (ttm), and an Acquirer’s Multiple of 3.22, or 3.22 times operating earnings. The company also has $26 Million in cash and zero debt. All of which indicates that Finjan is currently undervalued.

About The Small & Micro Cap Stock Screener (CAGR 22%)

Over a full sixteen-and-a-half year period from January 2, 1999 to July 26, 2016., the Small & Micro Cap stock screener generated a total return of 3,284 percent, or a compound growth rate (CAGR) of 22.0 percent per year. This compared favorably with the Russell 3000 TR, which returned a cumulative total of 265 percent, or 5.7 percent compound.

Templeton – It Is Impossible To Produce Superior Performance Unless You Do Something Different From The Majority

Johnny HopkinsJohn Templeton Comments

One of my favorite investing books is, The Little Book of Behavioral Investing – How Not To Be Your Own Worst Enemy, by James Montier. The book takes you through some of the most important behavioral challenges faced by investors. Montier reveals the most common psychological barriers, clearly showing how emotion, overconfidence, and a multitude of other behavioral traits, can affect investment decision-making.

One of my favorite parts of the book comes from Chapter 14 – Inside The Mind of A Lemming. Montier writes about the psychological difficulty of being a contrarian investor and the pain of going against the crowd. It provides a great illustration of what’s happening inside our brains when we’re making contrarian investment decisions. Fortunately, although painful, a strategy of being contrarian is integral to successful investment. As Sir John Templeton put it:

“It is impossible to produce superior performance unless you do something different from the majority,”

Here’s an excerpt from the book:

AS WARREN BUFFETT OBSERVED, “A pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept in its teeth.” Of course, this is a highly defamatory statement with respect to lemmings.

A willingness to subjugate one’s own thoughts for those of a group is a sadly common behavioral affliction. Take a look at the four lines in Exhibit 14.1. Your task is to pick which of the lines on the right most closely matches the line on the left.

EXHIBIT 14.1 Pick the Line

If you are like most people this won’t be a huge challenge. One of the lines is clearly too short, one is obviously too long, and one fits the Goldilocks outcome of just about right.

But what if you were in a room with seven other people, each of whom declared that the longest line was the closest match? Would you stick to your guns or would you bend in the face of a clear unanimous majority?

Of course, a rugged individual like you, would stick to their guns, right? Well, the evidence casts serious doubt on people’s ability to maintain their independence in the face of pressure. Experiments like the one on page 168 have been relatively commonplace since the 1950s. The basic setup is that you are one person in a group of eight or so. Unknown to you, the other participants all work for the experimenter. The room is set up so that each subject gives his or her answer in turn, with the one true subject always going last.

Under these conditions, psychologists have found that people conformed to the incorrect majority view approximately a third of the time. Three-quarters of the subjects conformed on at least one round, and one-third of the subjects conformed on more than half of the rounds.

Interestingly, experiments have found that varying the group size has virtually no impact on the likelihood of someone conforming. As soon as there were at least three people giving an incorrect answer, then about one third of subjects started to conform to the group judgment.

Recent evidence from neuroscientists further increases our understanding of what is actually happening when people conform. Rather than using the straightline test, the researchers used a 3-D image rotation task, in which two images are shown and the people have to decide if the second image is a rotation of the first.

While harder than the simple straightline test, when people performed this test alone they did remarkably well, getting nearly 90 percent of the answers right. Unfortunately, a very different performance was witnessed when they could see the answers given by other members of the group. The rate of correct answers dropped to 59 percent —statistically no better than if they had flipped a coin to make the decision.

Being neuroscientists, this game was being played while the subjects were undergoing a brain scan (an MRI). The researchers found that when people went with the group answer they seemed to show a decrease in activity of the parts of the brain associated with logical thinking—the C-system. Simply put, they seemed to stop thinking.

Not only did participants stop thinking, but when a subject conflicted with the group a very specific part of the brain lit up—our old friend the amygdala, the brain ’s center of emotional processing and fear. In effect, nonconformity triggered fear in people. Going against the crowd makes people scared.

Not only does going against the herd trigger fear, but it can cause pain as well. In this experiment, participants were told to play a computer game while having their brains scanned. Players thought they were playing in a three way game with two other people, throwing a ball back and forth. In fact, the two other players were computer controlled.

After a period of three-way play, the two other “players” began to exclude the participant by throwing the ball back and forth between themselves. This social exclusion generated brain activity in the anterior cingulated cortex and the insula, both of which are also activated by real physical pain.

Doing something different from the crowd is the investment equivalent of seeking out social pain. As a contrarian investor, you buy the stocks that everyone else is selling, and sell the stocks that everyone else is buying. This is social pain. The psychological results suggest that following such a strategy is really like having your arm broken on a regular basis—not fun!

Fortunately, although painful, a strategy of being contrarian is integral to successful investment. As Sir John Templeton put it, “It is impossible to produce superior performance unless you do something different from the majority,” or as Keynes pointed out “The central principle of investment is to go contrary to the general opinion on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.”

Research shows that Templeton and Keynes were spot on. The stocks institutional fund managers are busy buying are outperformed by the stocks they are busy selling. For instance, if stocks are assigned to different portfolios, based upon the persistence of institutional net trade (that is, the number of consecutive quarters for which institutions are net buyers or net sellers is recorded), and then the performance of the portfolios is tracked over a two -year time horizon, there is a 17 percent return difference—the stock that the institutions sold the most outperformed the market by around 11 percent, and the stocks they purchased the most underperformed by 6 percent.

Undervalued Alliance Resource Partners, FCF/EV Yield 35%, ROE 36% – All Investable Stock Screener

Johnny HopkinsStocks Comments

One of the cheapest stocks in our All Investable Stock Screener is Alliance Resource Partners, L.P (NASDAQ:ARLP).

Alliance Resource Partners, L.P. (Alliance) is a producer and marketer of coal primarily to the United States utilities and industrial users. The company operates through segments, including Illinois Basin, Appalachia, and Other and Corporate. The Illinois Basin segment consists of various operating segments, including Webster County Coal, LLC’s Dotiki mining complex, Gibson County Coal, LLC’s mining complex, which includes the Gibson North mine and Gibson South mine, Hopkins County Coal, LLC’s mining complex, which includes the Elk Creek mine, the Pleasant View surface mineable reserves and the Fies property, White County Coal, LLC’s, Pattiki mining complex, Warrior Coal, LLC’s mining complex, Sebree Mining, LLC’s mining complex, which includes the Onton mine and River View Coal, LLC mining complex. The Appalachia segment consists of multiple operating segments, including the Mettiki mining complex, the Tunnel Ridge mining complex and the MC Mining mining complex.

A quick look at Alliance’s share price history over the past twelve months shows that the price is up 13%, but here’s why the company remains undervalued.

The following data is from the company’s latest financial statements, dated March 2017.

The company’s latest balance sheet shows that Alliance has $87 Million in total cash and cash equivalents. Further down the balance sheet we can see that the company has short-term debt of $178 Million and long-term debt of $447 Million. Therefore, Alliance has a net debt position of $538 Million (debt minus cash). While some investors may be concerned about the company’s net debt position, it’s important to take a look at Alliance’s free cash flow below. All financial strength indicators show that the company remains financially sound with a Piotroski F-Score of 7, an Altman Z-Score of 2.37, and a Beneish M-Score of -3.18.

If we consider that Alliance currently has a market cap of $1.492 Billion, when we add the minority interests of $6 Million and the net debt totaling $538 Million that equates to an Enterprise Value of $2.036 Billion.

If we move over to the company’s latest income statements we can see that Alliance had $419 Million in trailing twelve month operating earnings which means that the company is currently trading on an Acquirer’s Multiple of 4.86, or 4.86 times operating earnings. That places Alliance squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

It’s also important to note that if we take a look at the company’s latest cash flow statements we can see that Alliance generated trailing twelve month operating cash flow of $800 Million and had $90 Million in Capex. That equates to $710 Million in trailing twelve month free cash flow, or a FCF/EV Yield of 35%.

Some analysts will argue that Alliance’s current revenues of $1.980 Billion (ttm) and net profit of $397 Million (ttm) are not as high as those recorded in 2014, when revenues were $2.301 Billion and net profit was $497 Million. But I would argue that the company’s current free cash flow of $710 (ttm) is 40% higher than the $432 Million recorded in 2014. Moreover, the company’s current free cash flow is at an historical high. The reason is the significant reduction in capex from $307 Million in 2014 to just $90 Million (ttm) today. The lowest its been in the past ten years.

It’s also worth taking a look at Alliance’s annualized Return on Equity (ROE) for the quarter ending March 2017. A quick calculation shows that the company had $1.088 Billion in equity for the quarter ending December 2016 and $1.141 Billion for the quarter ending March 2017. If we divide that number by two we get $1.114 Billion. If we consider that the company has $397 Million (ttm) in net income, that equates to an annualized Return on Equity (ROE) for the quarter ending March 2017 of 36%. All of which has been achieved while making debt repayments of $445 Million (ttm).

It is therefore difficult to understand Alliance’s current P/E of 4.8 compared to its 5Y average of 9.4*, The company is currently trading on a P/B of 1.3 compared to its 5Y average of 2.8*, and a P/S of 0.7 compared to its 5Y average of 1.1*. Alliance has a FCF/EV Yield of 35% (ttm), and an Acquirer’s Multiple of 4.86, or 4.86 times operating earnings. The company has an annualized Return on Equity (ROE) for the quarter ending March 2017 of 36%, and provides a dividend yield of 14%. All of which indicate that Alliance remains currently undervalued.

* Morningstar

About The All Investable Stock Screener (CAGR 25.9%)

Over a full sixteen-and-one-half year period from January 2, 1999 to July 26, 2016., the All Investable stock screener generated a total return of 5,705 percent, or a compound growth rate (CAGR) of 25.9 percent per year. This compared favorably with the Russell 3000 TR, which returned a cumulative total of 265 percent, or 5.7 percent compound.

Joel Greenblatt – Value Investing Doesn’t Always Work, Which Is Precisely Why It Works

Johnny HopkinsJoel Greenblatt Comments

One of the best reads for any investor is the book, Hedge Fund Market Wizards: How Winning Traders Win, by Jack Schwager. The book provides successful trading philosophies and strategies from fifteen traders who’ve consistently beaten the markets, one of which is Joel Greenblatt. In the book, Greenblatt discusses how he developed his Magic Formula and why value investing continues to work.

My favorite Greenblatt quote from the interview is:

“If I wrote a book about a strategy that worked every month, or even every year, everyone would start using it, and it would stop working. Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term, which sometimes can be as long as two or three years, there are periods when it doesn’t work. And that is a very good thing.”

Here’s an excerpt from the book:

[How the Magic Formula was Developed]

We looked at the 2,500 largest companies in the U.S. In the first test, we ranked the stocks based on the EBIT/EV ratio. We used Compustat’s Point-in-Time database, which is the actual data that was available as of any given past date, so there is no look-ahead bias. That database starts in 1988, so we started our test from that date.

We took the same 2,500 companies and ranked them on their return on capital. We then combined the two ranking —one based on the earnings yield and the other on return on capital. Effectively, we equally weighted these two measures by adding the two rankings, which gave us the best combination of cheap and good. If a company ranked number one based on earnings yield and 250 based on return on capital, its combined rank value would be 251. We weren’t looking for the cheapest companies, and we weren’t looking for the best companies. We were looking for the best combination of cheap and good companies. In the book, I called this combined ranking the Magic Formula.

During the 23 years of our backtest, using the Magic Formula to choose a portfolio of the top 30 names from the 1,000 largest capitalization stocks would have approximately doubled the return of the S&P 500 (19.7 percent versus 9.5 percent). (Selecting portfolios from the 2,500 largest companies would have had an even larger outperformance, but would have required holding less liquid smaller cap stocks.) The decade of the 2000s was particularly interesting. During 2000 to 2009, the formula still managed to deliver an average annualized return of 13.5 percent, even though the S&P 500 was down nearly 1 percent per year during the same period.

The power of value investing flies in the face of anything taught in academics. Value is the way stocks are eventually priced. It requires the perspective of patience because the market will eventually gravitate toward value. We also divided the formula rankings into deciles with 250 stocks in each decile. Then we held those stocks for a year and looked at how each of the deciles did.

We repeated this process each month, stepping through time. Each month, we had a new set of rankings, and we assumed we held those portfolios (one for each decile) for one year. We did that for every month in the last 23 years, beginning with the first month of the Compustat Point-in-Time database. It turned out that Decile 1 beat Decile 2, 2 beat 3, 3 beat 4, and so on all the way down through Decile 10, which consisted of bad businesses that were nonetheless expensive. There was a huge spread between Decile 1 and Decile 10: Decile 1 averaged more than 15 percent a year, while Decile 10 lost an average of 0.2 percent per year.

Since there is such consistency in the relative performance between deciles, wouldn’t buying Decile 1 stocks and selling Decile 10 stocks provide an even a better return/risk strategy than simply buying Decile 1 stocks?

My students and hundreds of e-mails asked the exact same question you just did. The typical comment was, “I have a great idea, Joel. Why don’t you simply buy Decile 1 and short Decile 10? You’ll make more than 15 percent a year, and you won’t have any market risk.” There’s just one problem with this strategy: Sometime in the year 2000, your shorts would have gone up so much more than your longs that you would have lost 100 percent of your money.

This observation illustrates a very important point. If I wrote a book about a strategy that worked every month, or even every year, everyone would start using it, and it would stop working. Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term, which sometimes can be as long as two or three years, there are periods when it doesn’t work. And that is a very good thing.

The fact that our value approach doesn’t work over periods of time is precisely the reason why it continues to work over the long term. Our formula forces you to buy out-of-favor companies, stocks that no one who reads a newspaper would think of buying, and hold a portfolio consisting of these stocks that, at times, may underperform the market for as long as two or three years.

Most people can’t stick with a strategy like that. After one or two years of underperformance, and usually less, they will abandon the strategy, probably switching to a strategy that has done well in recent years. It is very difficult to follow a value approach unless you have sufficient confidence in it. In my books and in my classes, I spend a lot of time trying to get people to understand that in aggregate we are buying above-average companies at below-average prices. If that approach makes sense to you, then you will have the confidence to stick with the strategy over the long term, even when it’s not working. You will give it a chance to work. But the only way you will stick with something that is not working is by understanding what you are doing.

Undervalued Lear Corporation, FCF/EV Yield 10%, ROE 32% – Large Cap 1000 Stock Screener

Johnny HopkinsStocks Comments

One of the cheapest stocks in our Large Cap 1000 Stock Screener is Lear Corporation (NYSE:LEA).

Lear Corporation (Lear) is a supplier to the global automotive industry. The company is engaged in supplying seating, electrical distribution systems and electronic modules, as well as related sub-systems, components and software, to automotive manufacturers. The company’s segments include Seating and E-Systems. The company serves the automotive and light truck market. The seating segment consists of the design, development, engineering, just-in-time assembly and delivery of complete seat systems, as well as the design, development, engineering and manufacture of all seat components, including seat covers and surface materials, such as leather and fabric, seat structures and mechanisms, seat foam and headrests. The e-systems segment consists of the design, development, engineering, manufacture, assembly and supply of electrical distribution systems, electronic modules and related components and software for light vehicles across the world.

A quick look at Lear’s share price history over the past twelve months shows that the price is up 27%, but here’s why the company remains undervalued.

The following data is from the company’s latest financial statements, dated March 2017.

The company’s latest balance sheet shows that Lear has $1.210 Billion in total cash and cash equivalents. Further down the balance sheet we can see that the company has short-term debt of $49 Million and long-term of $1.889 Billion which equates to total debt of $1.938 Billion. Therefore, Lear has a net debt position of $728 Million (debt minus cash).

If we consider that Lear currently has a market cap of $9.964 Billion, when we add the minority interests of $133 Million and net debt totaling $728 Million that equates to an Enterprise Value of $10.825 Billion.

If we move over to the company’s latest income statements we can see that Lear had $1.470 Billion in trailing twelve month operating earnings which means that the company is currently trading on an Acquirer’s Multiple of 7.36, or 7.36 times operating earnings. That places Lear squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

While come investors may be concerned about the company having more debt than cash on its balance sheet it’s important to note that if we take a look at the company’s latest cash flow statements we can see that Lear generated trailing twelve month operating cash flow of $1.610 Billion and had $561 Million in Capex. That equates to $1.049 Billion in trailing twelve month free cash flow, or a FCF/EV Yield of 10%, compared to a net debt position of $728 Million.

The company’s financial strength indicators also indicate that Lear remains financially sound with a Piotroski F-Score of 7, an Altman Z-Score of 3.77, and a Beneish M-Score of -2.73.

Something else that seems to be overlooked is that Lear’s current revenues of $18.893 Billion (ttm) are an historical high. The company’s current net income of $1.033 Billion is also the highest in the past five years with the exception of one year 2012 when net income was $1.283. However, closer inspection of 2012 financials show that in that same year the company had free cash flow of just $272 Million compared with the $1.048 Billion (ttm) that we see today. The reason is that Lear has become much more operationally efficient with historically high gross and operating margins resulting in significant increases in operating income and operating cash flow. Lear also has historically high EPS of $14.39 (ttm), book value per share of $48.35 (ttm), and dividends per share of $1.40 (ttm).

Additionally, it’s also worth taking a look at Lear’s annualized Return on Equity (ROE) for the quarter ending March 2017. A quick calculation shows that the company had $3.057 Billion in equity for the quarter ending December 2016 and $3.331 Billion for the quarter ending March 2017. If we divide that number by two we get $3.194 Billion. If we consider that the company has $1.033 Billion (ttm) in net income, that equates to an annualized Return on Equity (ROE) for the quarter ending March 2017 of 32%. All of which has been achieved without issuing new debt.

Lastly, there’s one more thing that investors should be aware of and that is Lear’s shareholder yield. In addition to the company’s ability to generate loads of free cash it has also allocated capital wisely. This is demonstrated with the $620 Million (ttm) spent to buy back shares and $100 Million (ttm) spent on dividends while the share price remains undervalued. That equates to a buy back yield of 6% and a dividend yield of 1% which together provide a shareholder yield of 7%.

In summary, Lear is a company with historically high revenues and free cash flow. It also has historically high EPS of $14.39 (ttm), book value per share of $48.35 (ttm), and dividends per share of $1.40 (ttm) yet the company trades on a P/E of 10 compared to its 5Y average of 10.4**. Moreover, Lear has a FCF/EV Yield of 10%, an Acquirer’s Multiple of 7.36, and an annualized Return on Equity (ROE) for the quarter ending March 2017 of 32%, while providing a shareholder yield of 7%. All of which indicates that Lear is currently undervalued.

** Morningstar

About The Large Cap 1000 U.S. Stock Screener (CAGR 18.4%)

Over a full sixteen-and-a-half year period from January 2, 1999 to July 26, 2016., the Large Cap 1000 U.S stock screener generated a total return of 1,940 percent, or a compound growth rate (CAGR) of 18.4 percent per year. This compared favorably with the Russell 1000 Total Return, which returned a cumulative total of 259 percent, or 5.6 percent compound.

Peter Lynch – In Investing The Person That Turns Over The Most Rocks Wins The Game

Johnny HopkinsPeter Lynch Comments

One of my favorite all time investors is Peter Lynch. As the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more than doubling the S&P 500 market index and making it the best performing mutual fund in the world. During his tenure, assets under management increased from $18 million to $14 billion

One of the best Lynch interviews can be found in the book, Investment Gurus: A Road Map to Wealth from the World’s Best Money Managers, written by Peter Tanous. In this interview Lynch discusses his investing strategy saying, investing is not about intelligence, its about keeping an open mind and doing a lot of hard work.

Here’s an excerpt from that interview:

Tanous: Peter, since you are arguably the most successful, as well as the most famous, fund manager of all time, and given the focus of this book, I want to zero in on process and methodology, especially on areas that I think will fascinate readers of this book. My first question relates to style. From my analysis, I’d say you have a growth bias, but you really can’t be pegged to one style, unlike so many of the others in this book. In fact, in Beating the Street, you said: “I never had an overall strategy. My stockpicking was entirely empirical.” That was some stockpicking! Apart from hanging around at malls, could you tell us a little bit about the selection process?

Lynch: I guess I was always upset by the fact that they called Magellan a growth fund. I think that is a mistake. If you pigeonhole somebody and all they can buy are the best available growth companies, what happens if all the growth companies are overpriced? You end up buying the least overpriced ones. If you can find growth companies at very low valuations and with great balance sheets and great futures, that’s where you invest. Only sometimes you find that these companies are terrific, but they are selling at 50 times earnings.

My premise has always been that there are good stocks everywhere. Some people say you can’t buy companies with unions, or you can’t buy companies in dying industries; for instance, who would ever buy a textile company? I mean, I didn’t buy it but a company called Unifi went up, I think, a hundred fold in the textile industry. I missed it.

But look at all the money I made with Chrysler and with Boeing. I also lost money with a few airlines and I made money with airlines. But you hear this concept that you can’t make money if you ever buy a company that has a union, because the union will kill it. These are prejudices and biases that prevent people from looking at a lot of different industries. I never had that. I think there are good and bad stocks everywhere.

Tanous: But in zeroing in on the process, one of the things that mystifies me is this: How much of your personal ability just can’t be defined? I mean, how much of it is simply the keen, even instinctive, judgment that you have, and maybe that a lot of other people don’t? Or is there some methodology that you hang your hat on that you, and maybe our readers, can turn to for process?

Lynch: I think that if you take my great stocks, and you ask a hundred people to visit them and spend a reasonable amount of time at it, 99 of them, assuming they had no prejudices and biases, would have bought those same stocks. I disagree with a part of your question. I don’t think that with great stocks you need a Cray super-computer or an advanced Sun microstation to figure out the math.

Take this example of a company I missed: Wal-Mart. You could have bought Wal-Mart ten years after it went public. Let’s say you’re a very cautious person. You wait. Now ten years after it went public, it was a twenty-year-old company. This was not a startup. So it’s now ten years after the public offering. You could have bought Wal-Mart and made 30 times your money. If you bought it the day it went public you would have made 500 times your money. But you could have made 30 times your money ten years after it went public.

The reason you could have done that is that ten years after it went public, it was only in 15% of the United States. And they hadn’t even saturated that 15%. So you could say to yourself, now what kind of intelligence does this take? You could say, this company has minimal costs, they’re efficient, everybody who competes with them says they’re great, the products are terrific, the service is terrific, the balance sheet is fine, and they’re self-funding. So you say to yourself, why can’t they go to 17% [saturation]? Why can’t they go to 21%? Let’s take a huge leap of faith: why can’t they go to 23%? All they did for the next two decades was roll it out. They didn’t change it. I only wish they had started out in Connecticut instead of in Arkansas. I bought Stop & Shop because I saw it here in New England. I also bought Dunkin’ Donuts because they were a local company.

Tanous: You’re touching on what I call the Great Peter Lynch Investment Theorem, which is to observe early business success as it occurs around you. I suppose it helps when the great companies happen to be in your own backyard and you see them every day. Of course, you’ve done well with other companies, too.

Lynch: Yes, but I wish Home Depot had started here in Boston instead of in Atlanta. You could have bought Toys R Us after they had 20 stores open and made a fortune on it the next fifteen years. You have to ask: why can’t this company go from 20 stores to 400 stores?

Tanous: There was something in one of your books that addresses your legendary stockpicking that rang a bell. Fidelity started inviting various corporations in for lunch or breakfast so that you could hear their stories firsthand. But then you contrasted those you invited with the companies who wanted to invite themselves over. Those companies were telling you the same story that they were telling everyone around the Street. Peter, you talk a lot in your books about communications, meetings, information sharing, and so forth, and that starts to give me a picture.

Lynch: Again, I’ve always said that if you look at ten companies you’ll find one that’s interesting. If you look at 20, you’ll find, two; if you look at 100, you’ll find ten. The person that turns over the most rocks wins the game. That’s the issue. If you look at ten companies that are doing poorly, you’ll probably find nine companies that there is not much hope for. But maybe in one of them, one of their competitors has gone out of business, or the plant that caused them a lot of problems has been closed, or they got rid of the division that was losing money. You’ll find one out of ten where something concrete has happened and the stock hasn’t caught up with it. If you look at 20, you’ll find two.

It’s about keeping an open mind and doing a lot of work. The more industries you look at, the more companies you look at, the more opportunity you have of finding something that’s mispriced. The theory is that the market is perfect and that all companies are fairly priced. And that is true in a majority of cases. If you find a company whose stock is on the new high list, generally they’re doing well and they have a good future. You might also find companies where the stock is depressed and they’re doing poorly, and you’ll also find out that the company is having problems.

But maybe you’ll find a company where the stock’s gone from 40 to 4, it has no debt, it has two dollars per share of cash, and they might be losing money but, remember, they have no debt. It’s a real challenge to go bankrupt if you have no debt. I find it interesting that people will buy a bunch of companies that are losing money. If you do, you might as well buy the company that has the good balance sheet and also has something going on that they can show – maybe a new product that is working out well, or something else. Each story is different.

Undervalued Silvercorp Metals, FCF/EV Yield 10%, ROE 17% – All Investable Stock Screener

Johnny HopkinsStocks Comments

One of the cheapest stocks in our All Investable Stock Screener is Silvercorp Metals Inc (NYSEMKT:SVM).

Silvercorp Metals Inc. (Silvercorp) is a silver-producing Canadian mining company. The company is engaged in the acquisition, exploration, development, and mining of silver-related mineral properties in China. The company’s segments include Mining, including projects, such as Henan Luoning, Hunan, Guangdong and Other, and Administrative, which includes Beijing and Vancouver. The company is the primary silver producer in China through the operation of over four silver-lead-zinc mines in the Ying Mining District in Henan Province, China, including SGX, HZG, TLP, Haopinggou (HPG) and the LM mines. The company also has commercial production at its Gaocheng (GC) silver-lead-zinc project in Guangdong Province. Silvercorp’s principal products and source of sales are silver-bearing lead and zinc concentrates and some direct smelting ores. The company sells all its products to local smelters or companies in the mineral products trading business.

A quick look at Silvercorp’s share price history over the past twelve months shows that the price is up 346%, but here’s why the company still remains undervalued.

The following data is from the company’s latest financial statements, dated March 2017.

The company’s latest balance sheet shows that Silvercorp has $96 Million in total cash and cash equivalents consisting of $73 Million in cash and $23 Million in short-term investments. Further down the balance sheet we can see that the company has zero debt. Therefore, Silvercorp has a net cash position of $96 Million (cash minus debt).

In addition to the company’s strong balance sheet, all financial strength indicators show that Silvercorp remains financially sound with a Piotroski F-Score of 8, an Altman Z-Score of 3.54, and a Beneish M-Score of -2.74.

If we consider that Silvercorp currently has a market cap of $487 Million, when we add the minority interests of $55 Million and subtract the cash totaling $96 Million that equates to an Enterprise Value of $446 Million.

If we move over to the company’s latest income statements we can see that Silvercorp had $67 Million in trailing twelve month operating earnings which means that the company is currently trading on an Acquirer’s Multiple of 6.65, or 6.65 times operating earnings. That places Silvercorp squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

It’s also important to note that if we take a look at the company’s latest cash flow statements we can see that Silvercorp generated trailing twelve month operating cash flow of $80 Million and had $36 Million in Capex. That equates to $45 Million in trailing twelve month free cash flow, or a FCF/EV Yield of 10%.

Something else that seems to be overlooked is that Silvercorp’s current revenues of $163 Million (ttm) are the highest in the past five years with the exception of 2013 when revenues were $182 Million. However, closer inspection of the 2013 financials also indicate that the company had just $27 Million in net income in that year compared to the $44 Million (ttm) that we see today. Additionally, 2013 free cash flow was negative ($4 Million) compared to the $45 Million (ttm) that we see today. This is due to a significant reduction in the company’s capex.

Lastly, its also worth taking a look at Silvercorp’s annualized Return on Equity (ROE) for the quarter ending March 2017. A quick calculation shows that the company had $246 Million in equity for the quarter ending December 2016 and $263 Million for the quarter ending March 2017. If we divide that number by two we get $254 Million. If we consider that the company has $44 Million (ttm) in net income, that equates to an annualized Return on Equity (ROE) for the quarter ending March 2017 of 17%.

It is therefore difficult to understand Silvercorp’s current P/E of 11.2 compared to its 5Y average 24.9* when you consider that the company is currently trading on a P/B of 1.9 compared to its 5Y average of 1.3*, a P/S of 3.1 compared to its 5Y average of 3*, and a Price/Operating Cash Flow of 6.3 compared to its 3Y average of 6.8*. While all other valuation metrics are around average the company’s P/E ratio remains 55% below its 5Y average at a time when the company is generating its highest free cash flow in the past five years.

Silvercorp is a company that remains undervalued despite the 346% increase in its share price over the past twelve months. In terms of the company’s current valuation, Silvercorp is currently trading on a P/E of 11.2 compared to its 5Y average of 24.9*, a FCF/EV Yield of 10%, and an Acquirer’s Multiple of 6.65, or 6.65 times operating earnings. The company has $96 Million in cash and zero debt, and an annualized Return on Equity (ROE) for the quarter ending March 2017 of 17%.

* Morningstar

About The All Investable Stock Screener (CAGR 25.9%)

Over a full sixteen-and-one-half year period from January 2, 1999 to July 26, 2016., the All Investable stock screener generated a total return of 5,705 percent, or a compound growth rate (CAGR) of 25.9 percent per year. This compared favorably with the Russell 3000 TR, which returned a cumulative total of 265 percent, or 5.7 percent compound.

Just Why Do Today’s Worst Performing Stocks Historically Outperform

Johnny HopkinsInvesting Strategy Comments

One of my favorite investing books is A Mathematician Plays The Stockmarket by best selling author – John Allen Paulos. Paulos demonstrates what the tools of mathematics can teach us about the machinations of the stock market. One of my favorite parts of the book focuses on regression to the mean in the stock market, and why today’s worst performing stocks historically outperform while today’s best performing stocks historically underperform.

Regression toward (or to) the mean is the phenomenon that if a variable is extreme on its first measurement, it will tend to be closer to the average on its second measurement—and if it is extreme on its second measurement, it will tend to have been closer to the average on its first.

Here’s an excerpt from the book:

There are other sorts of contrarian anomalies. Richard Thaler and Werner DeBondt examined the thirty-five stocks on the New York Stock Exchange with the highest rates of  returns and the thirty-five with the lowest rates for each year from the 1930s until the 1970s. Three to five years later, the best performers had average returns lower than those of the NYSE, while the worst performers had averages considerably higher than the index.

Andrew Lo and Craig MacKinlay, as mentioned earlier, came to similar contrarian conclusions more recently, but theirs were significantly weaker, reflecting perhaps the increasing popularity and hence decreasing effectiveness of contrarian strategies.

Another result with a contrarian feel derives from management guru Tom Peters’s book In Search of Excellence, in which he deemed a number of companies “excellent” based on various fundamental measures and ratios. Using these same measures a few years after Peters’s book, Michelle Clayman compiled a list of “execrable” companies (my word, not hers) and compared the fates of the two groups of companies.

Once again there was a regression to the mean, with the execrable companies doing considerably better than the excellent ones five years after being so designated. All these contrarian findings underline the psychological importance of a phenomenon I’ve only briefly mentioned: regression to the mean.

Is the decline of Peters’s excellent companies, or of other companies with good P/E and P/B ratios the business analogue of the Sports Illustrated cover jinx?

For those who don’t follow sports (a field of endeavor where the numbers are usually more trustworthy than in business), a black cat stared out from the cover of the January 2002 issue of Sports Illustrated signaling that the lead article was about the magazine’s infamous cover jinx. Many fans swear that getting on the cover of the magazine is a prelude to a fall from grace, and much of the article detailed instances of an athlete’s or a team’s sudden decline after appearing on the cover.

There were reports that St. Louis Rams quarterback Kurt Warner turned down an offer to pose with the black cat on the issue’s cover. He wears No. 13 on his back, so maybe there’s a limit to how much bad luck he can withstand. Besides, a couple of weeks after gracing the cover in October 2000, Warner broke his little finger and was sidelined for five games.

The sheer number of cases of less than stellar performance or worse following a cover appearance is impressive at first. The author of the jinx story, Alexander Wolff, directed a team of researchers who examined almost all of the magazine’s nearly 2,500 covers dating back to the first one, featuring Milwaukee Braves third baseman Eddie Mathews in August 1954. Mathews was injured shortly after that.

In October 1982, Penn State was unbeaten and the cover featured its quarterback, Todd Blackledge. The next week Blackledge threw four interceptions against Alabama and Penn State lost big. The jinx struck Barry Bonds in late May 1993, seeming to knock him into a dry spell that reduced his batting average forty points in just two weeks. I’ll stop. The article cited case after case. More generally, the researchers found that within two weeks of a cover appearance, over a third of the honorees suffered injuries, slumps, or other misfortunes. Theories abound on the cause of the cover jinx, many having to do with players or teams choking under the added performance pressure.

A much better explanation is that no explanation is needed. It’s what you would expect. People often attribute meaning to phenomena governed only by a regression to the mean, the mathematical tendency for an extreme value of an at least partially chance-dependent quantity to be followed by a value closer to the average. Sports and business are certainly chancy enterprises and thus subject to regression. So is genetics to an extent, and so very tall parents can be expected to have offspring who are tall, but probably not as tall as they are. A similar tendency holds for the children of very short parents.

If I were a professional darts player and threw one hundred darts at a target (or a list of companies in a newspaper’s business section) during a tournament and managed to hit the bull’s-eye (or a rising stock) a record-breaking eighty three times, the next time I threw one hundred darts, I probably wouldn’t do nearly as well. If featured on a magazine cover (Sports Illustrated or Barron’s) for the eighty-three hits, I’d probably be adjudged a casualty of the jinx too.

Regression to the mean is widespread. The sequel to a great CD is usually not as good as the original. The same can be said of the novel after the best-seller, the proverbial sophomore slump, Tom Peters’s excellent companies faring relatively badly after a few good years, and, perhaps, the fates of Bernie Ebbers of WorldCom, John Rigas of Adelphia, Ken Lay of Enron, Gary Winnick of Global Crossing, Jean-Marie Messier of Vivendi (to throw in a European), Joseph Nacchio of Qwest, and Dennis Kozlowski of Tyco – all CEOs of large companies who received adulatory coverage before their recent plunges from grace. (Satirewire.com refers to these publicity-fleeing, company-draining executives as the CEOnistas.)

There is a more optimistic side to regression. I suggest that Sports Illustrated consider featuring an established player who has had a particularly bad couple of months on its back cover. Then they could run feature stories on the boost associated with such appearances. Barron’s could do the same thing with its back cover.

An expectation of a regression to the mean is not the whole story, of course, but there are dozens of studies suggesting that value investing, generally over a three-to-five pear period, does result in better rates of return than, say, growth investing. It’s important to remember, however, that the size of the effect varies with the study (not surprisingly, some studies find zero or a negative effect), transaction costs can eat up some or all of it, and competing investors tend to shrink it over time.

As a final word on the topic of regression to the mean, Charlie Munger summed it up like this:

“Mimicking the herd invites regression to the mean.”

This Week’s Best Investing Reads – Curated Links

Johnny HopkinsValue Investing News Comments

Here’s a list of this week’s best investing reads:

Blogs

Few Bets. Big Bets. Infrequent Bets (Chai with Pabrai)

Ten Rules For Catching A Bottom (The Irrelevant Investor)

Billionaire Mario Gabelli: ‘I’m glad that Amazon comes along and knocks off everybody’  (Dataroma)

I bought my first Bitcoin (The Reformed Broker)

Every Great Investment Hurts (Collaborative Fund)

Value investing and risk: What you will not learn at university (The Globe and Mail)

It’s the Little Things That Can Color an Investor’s Outlook (Jason Zweig)

Compare Your Country’s Tax Rate (The Big Picture)

Which hedge funds actually beat the market? (The Mathematical Investor)

Mark Yusko On Gut Instinct (And Why His Says We’re Headed For A Crash) (The Felder Report)

The Dark Side of Globalization: An Update on Country Risk! (Musings On Markets)

Zero — Invented or Discovered? (Farnam Street)

A Dozen Things I’ve Learned About Startups from Hunter Walk (25iq)

How to Save Money When You’re Young (A Wealth of Common Sense)

Trend-Following with Valeriy Zakamulin: Moving Average Basics (Part 1) (Alpha Architect)

US Economy: Swimming with the Tide? (CFA Institute Enterprising Investor)

Undervalued RMR Group, FCF/EV Yield 16%, ROE 31% – All Investable Stock Screener

Johnny HopkinsStocks Comments

One of the cheapest stocks in our All Investable Stock Screener is RMR Group Inc (NASDAQ:RMR).

The RMR Group Inc. (RMR) is a holding company and substantially all of its business is conducted by its majority-owned subsidiary, The RMR Group LLC. The RMR Group LLC is an alternative asset management company that was founded in 1986 to invest in real estate and manage real estate related businesses. RMR’s business primarily consists of providing management services to four publicly owned real estate investment trusts, or REITs, and three real estate related operating companies. As of March 31, 2017, The RMR Group LLC had approximately $27.6 billion of total assets under management, including more than 1,400 properties, and employed over 475 real estate professionals in more than 35 offices throughout the United States.

A quick look at RMR’s share price history over the past twelve months shows that the price is up 45%, but here’s why the company still remains undervalued.

The following data is from the company’s latest financial statements, dated March 2017.

The company’s latest balance sheet shows that RMR has $133 Million in total cash and cash equivalents. Further down the balance sheet we can see that the company has zero debt. Therefore, RMR has a net cash position of $133 Million (cash minus debt).

If we consider that RMR currently has a market cap of $789 Million, when we add the minority interests of $146 Million and subtract the cash totaling $133 Million that equates to an Enterprise Value of $802 Million.

If we move over to the company’s latest income statements we can see that RMR had $145 Million in trailing twelve month operating earnings which means that the company is currently trading on an Acquirer’s Multiple of 5.54, or 5.54 times operating earnings. That places RMR squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

It’s also important to note that if we take a look at the company’s latest cash flow statements we can see that RMR generated trailing twelve month operating cash flow of $128 Million and had $0 Million in Capex. That equates to $128 Million in trailing twelve month free cash flow, or a FCF/EV Yield of 16%.

RMR’s free cash flow of $128 Million (ttm) and net income of $44 Million (ttm) are at historical highs. While the company’s current revenues of $268 Million (ttm) are inline with FY2016, RMR has improved its EPS by 19% to $2.77 (ttm) from $2.33 in FY2016 and its book value per share by 19% to $4.66 (ttm) from $3.79 in FY2016. Additionally, RMR now has a record high $133 Million in cash on its balance sheet while maintaining zero debt.

Something else which seems to get overlooked regarding RMR is its annualized Return on Equity (ROE) for the quarter ending March 2017. A quick calculation shows that the company had $141 Million in equity for the quarter ending December 2016 and $145 Million for the quarter ending March 2017. If we divide that number by two we get $143 Million. If we consider that the company has $44 Million (ttm) in net income, that equates to an annualized Return on Equity (ROE) for the quarter ending March 2017 of 31%.

As for RMR’s current valuation, the company is currently trading on a P/E of 17.7, a FCF/EV Yield of 16%, and an Acquirer’s Multiple of 5.54, or 5.54 times operating earnings. RMR has an annualized Return on Equity (ROE) for the quarter ending March 2017 of 31%, plus a dividend yield of 2%. All of which indicates that the company remains squarely in undervalued territory.

About The All Investable U.S. Stock Screener (CAGR 25.9%)

Over a full sixteen-and-one-half year period from January 2, 1999 to July 26, 2016., the All Investable stock screener generated a total return of 5,705 percent, or a compound growth rate (CAGR) of 25.9 percent per year. This compared favorably with the Russell 3000 TR, which returned a cumulative total of 265 percent, or 5.7 percent compound.

Seth Klarman – 13 Tips On How To Find Bargains

Johnny HopkinsSeth Klarman Comments

One of the best resources for investors are the Santangel Investor Forum and The Santangel Roundtable. These invitation-only events offer unique investment ideas from some of the world’s top investors. Events were created by The Santangel Review which also provides some great commentary on leading investors. My favorite commentary is called, The Collected Wisdom of Seth Klarman, which provides a compilation of quotes from The Baupost Group Founder. Included in the piece is Klarman’s 13 tips on how to find bargains. Here’s an excerpt from that article:

  1. “Great investments don’t just knock on the door and say ‘buy me.’”
  2. “It is easy to find middling opportunities but rare to find exceptional ones.”
  3. “ When buyers are numerous and sellers scarce, opportunity is bound to be limited. But when sellers are plentiful and highly motivated while potential buyers are reticent, great investment opportunities tend to surface.”
  4. “ Rather than buy from smart, informed sellers, we want to buy from urgent, distressed or emotional sellers.”
  5. “ A bargain price is necessary, but not sufficient for making an investment, because sometimes securities that seem superficially inexpensive really aren’t.”
  6. “ Institutional constraints and market inefficiencies are the primary reasons that bargains develop. Investors prefer businesses and securities that are simple over those that are complex. They fancy growth. They enjoy an exciting story. They avoid situations that involve the stigma of financial distress or the taint of litigation. They hate uncertain timing. They prefer liquidity to illiquidity. They prefer the illusion of perfect information that comes with large, successful companies to the limited information from companies embroiled in scandal, fraud, unexpected losses or management turmoil.”
  7. “ We pursue opportunity largely off the beaten path, sifting through the debris of financial wreckage, out-of-favor securities and asset classes in which there is limited competition. We specialize in the highly complex while mostly avoiding plain vanilla, which is typically more fully priced. We happily incur illiquidity but only when we get paid well for it, which is usually when others rapidly seek liquidity and rush to sell.”
  8. “ When you have been doing this for a while, you start to become more proficient about where to look, which rocks to look under. The rocks we look under tend to have a few things in common.”
  9. “ You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.”
  10. “ Market inefficiencies, like tax selling and window dressing, also create mindless selling, as can the deletion of a stock from an index.”
  11. “ These causes of mispricing are deep-rooted in human behavior and market structure, unlikely to be extinguished anytime soon.”
  12. “ Investing is, in many ways, a zero-sum activity in which your returns above market indices are derived from the mistakes, overreactions, or inattention of others as much as from your own clever insights.”
  13. “ Typically, we make money when we buy things. We count the profits later, but we know we have captured them when we buy the bargain.”

Undervalued Michael Kors, FCF/EV Yield 16%, Shareholder Yield 19% – Large Cap 1000 Stock Screener

Johnny HopkinsStocks Comments

One of the cheapest stocks in our Large Cap 1000 Stock Screener is Michael Kors Holdings Ltd (NYSE:KORS).

Michael Kors Holdings Limited (Kors) is a designer, marketer, distributor and retailer of branded women’s apparel and accessories and men’s apparel bearing the Michael Kors tradename and related trademarks MICHAEL KORS, MICHAEL MICHAEL KORS, and various other related trademarks and logos. The company operates through three segments: retail, wholesale and licensing. The retail operations consist of collection stores and lifestyle stores, including concessions and outlet stores, located primarily in the Americas (the United States, Canada and Latin America), Europe and Asia, as well as e-commerce. Wholesale revenues are principally derived from major department and specialty stores located throughout the Americas, Europe and Asia. The company licenses its trademarks on products, such as fragrances, beauty, eyewear, leather goods, jewelry, watches, coats, men’s suits, swimwear, furs and ties, as well as through geographic licenses.

A quick look at Kors share price history over the past twelve months shows that the price is down 33%, but here’s why the company is undervalued.

The following data is from the company’s latest financial statements, dated March 2017.

The company’s latest balance sheet shows that Kors has $228 Million in total cash and cash equivalents. Further down the balance sheet we can see that the company has short-term debt of $133 Million and $0 Million in long-term debt. Therefore, Kors has a net cash position of $95 Million (cash minus debt).

In addition to the company’s strong balance sheet, all financial strength indicators show that Kors remains financially sound with a Piotroski F-Score of 5, an Altman Z-Score of 9.10, and a Beneish M-Score of -2.10.

If we consider that the company currently has a market cap of $5.329 Billion, when we subtract the cash totaling $95 Million that equates to an Enterprise Value of $5.234 Billion.

If we move over to the company’s latest income statements we can see that Kors had $690 Million in trailing twelve month operating earnings which means that the company is currently trading on an Acquirer’s Multiple of 7.58, or 7.58 times operating earnings. That places Kors squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

It’s also important to note that if we take a look at the company’s latest cash flow statements we can see that Kors generated trailing twelve month operating cash flow of $1.028 Billion and had $170 Million in Capex. That equates to $858 Million in trailing twelve month free cash flow, or a FCF/EV Yield of 16%.

So while the company has a very strong balance sheet and ability to generate strong free cash flow the company’s share price is still down 33% in the past twelve months. With this in mind let’s take a look at the company’s current financial position.

Kors has historically high revenues of $4.493 Billion (ttm) but the company’s net profits of $553 Million (ttm) are well off the historical highs of $881 Million in 2015. Something which seems to be overlooked however is that Kors current free cash flow of $858 Million (ttm) is an historical high compared to just $472 Million in 2015. That’s an increase of 45%. The reason is that the company has significantly reduced its capex from $385 Million in 2015 to just $170 Million (ttm). In fact you would have to go back to 2013 to find lower capex of $130 Million, when the company had more that 50% less revenue.

In terms of Kors present valuation. The company currently has historically high revenues and free cash flow yet its currently trading on a Price/Earnings of 10.5 compared to its 5Y Average of 29.5*, a Price/Cash of 5.6 compared to its 3Y Average of 16.6*, a P/S of 1.3 compared to its 5Y average of 4.4*, and a P/B of 3.4 compared to its 5Y average of 9.9*. In addition Kors is trading on a FCF/EV Yield of 16% (ttm) and an Acquirer’s Multiple of 7.58, or 7.58 times operating earnings, plus the company provides a shareholder yield of 19% due to its $1.005 Billion (ttm) share buybacks. All of which indicate that the company remains squarely in undervalued territory.

Source: Morningstar

About The Large Cap 1000 U.S. Stock Screener (CAGR 18.4%)

Over a full sixteen-and-a-half year period from January 2, 1999 to July 26, 2016., the Large Cap 1000 U.S stock screener generated a total return of 1,940 percent, or a compound growth rate (CAGR) of 18.4 percent per year. This compared favorably with the Russell 1000 Total Return, which returned a cumulative total of 259 percent, or 5.6 percent compound.

Dan Loeb – Activism Done Properly Doesn’t Have To Be Bad

Johnny HopkinsDan Loeb Comments

Here’s a great interview with Third Point’s Dan Loeb on activism.

Loeb says that activism done right should impact companies in a positive way. He adds, the benefits that activists provide include:

  • Accountability
  • Taking Companies On A More Positive Trajectory
  • Checks and Balances

But most of all it’s the ideas that activists bring that can help companies maximize performance. New ideas provide recommendations by activists for defense and debate by the incumbent management which should result in increased performance and maximized benefits to shareholders. Here’s that very short interview: