If everyone has the same information, it is tough to get the edge. At the same time we need to be continuos learning machines. I am trying to keep an habit of reading Chinese business news once a month. Read this interview from CEO of SOHO china. She thinks there is a real estate bubble in China
http://www.cibmagazine.com.cn/Features/Face_To_Face.asp?id=1190&zhang_xin.html
Sunday, January 31, 2010
Wednesday, January 27, 2010
Tell Me if I am Wrong - Howard Marks from Oaktree
Here is an excellent Letter from Howard Marks. I am not a Macro guy but we all need to understand the risks of investing. It is tough to quantify the probability of these events. Whether we are investing in India, China or Emerging markets, we all need to understand the current risks in the US market.
The only thing I know is , If we are buying at deep discounts to intrinsic value, we will do fine in the long run
Memo to: Oaktree Clients
From: Howard Marks
Re: Tell Me I’m Wrong
My readers treat me well. They indulge my penchant for dissecting the past, and they send kind
messages of encouragement. To repay their generosity, I’m going to venture into something I
usually avoid: the future of the U.S. economy.
This memo won’t be about the future in general, just the elements I find worrisome. As I see it,
every investor is either predominantly a worrier or predominantly a dreamer. I’ve come clean
many times: I’m a worrier. By saying that, I absolve myself of having to describe the whole
future. I’m going to cover the negatives, starting with the immediate and ending with the
systemic (some of the latter repeats themes from “What Worries Me,” August 28, 2008). For
the other side of the story, I’d suggest you consult the optimists who seem to be in charge of the
markets these days.
The only thing I know is , If we are buying at deep discounts to intrinsic value, we will do fine in the long run
Memo to: Oaktree Clients
From: Howard Marks
Re: Tell Me I’m Wrong
My readers treat me well. They indulge my penchant for dissecting the past, and they send kind
messages of encouragement. To repay their generosity, I’m going to venture into something I
usually avoid: the future of the U.S. economy.
This memo won’t be about the future in general, just the elements I find worrisome. As I see it,
every investor is either predominantly a worrier or predominantly a dreamer. I’ve come clean
many times: I’m a worrier. By saying that, I absolve myself of having to describe the whole
future. I’m going to cover the negatives, starting with the immediate and ending with the
systemic (some of the latter repeats themes from “What Worries Me,” August 28, 2008). For
the other side of the story, I’d suggest you consult the optimists who seem to be in charge of the
markets these days.
Tuesday, January 12, 2010
Read Bruce Greenwald's interview
I agree to some of his comments. I cannot believe that I have the same hedges for my portfolio as he is talking. Recently I bought S&P puts and gold as hedges for blackswan events. I also agree that some of the best values are on franchises.
Interview - Part1
Read Bruce Greenwald's interview - part2
Interview - Part1
Read Bruce Greenwald's interview - part2
Saturday, January 9, 2010
A one in Billion - True inspirational story - Must read
Some times you can really underestimate, the power of hardwork, determination. culture can be a true advantage a company has. Think about replacing L&T in India, it is almost impossible.
Thanks to Rajeev Desai
Anil Naik......CMD of L&T....
Read On:
A. M. Naik is the Chairman and Managing Director of Larsen & Toubro, one of the most popular Indian companies. He was awarded the Padma Bhushan,India's 3rd highest civilian award,on January 26, 2009. Mr. Naik was also the recipient of the prestigious 'Economic Times Awards-Business Leader of the Year' award, for the year 2008[1]. Anil M. Naik joined L&T in 1965 as a junior engineer and shortly became the youngest manager in Larsen & Toubro's history.
After joining L&T as Junior Engineer in 1965, he rose rapidly through its ranks; he became General Manager in 1985, and Vice President (Operations) and Member of the Board in 1989 (in charge of the erstwhile Group II, now bifurcated into E&C and Heavy Engineering). In 1995, he was appointed President (Operations) and in April 1999, he took over as Chief Executive Officer and Managing Director. On December 30, 2003, he was appointed as the Chairman & Managing Director[2]. Naik is also extensively involved in social work and is currently developing the educational institution set up by his father in a region called Kharel, Gujarat.proud to be anaval Mr.Naik has been announced as an awardee of the Padma Bhushan in India on 26 Jan 2009[3]. AM Naik - A rare interview to MoneyLIFE
September 15, 2008 By 2010, we will hopefully come to the take-off point to becoming a true Indian multinational in our sector He came from a family of teachers, but was essentially a kid from a village in south Gujarat who, by his own admission, was poor in English because he used to think in Gujarati and then translate his thoughts. But language was no barrier to Anil Manibhai Naik, 65, in rising to the top slot in Larsen & Toubro, an engineering and construction giant, or putting it on the path to being a multinational entity and creating enormous value for shareholders. He achieved this through sheer hard work and through what he calls “devotion beyond dedication”. He is the first professional to head the blue-chip company set up by two Danish engineers, Henning Holck-Larsen and Soren Kristian Toubro with financial help from the father of NM Desai (another former L&T chairman). As the executive chairman of Larsen & Toubro, Naik has steered the company through some of its most turbulent times. Under him, L&T has recorded probably the most robust performance and the scrip has had the fastest rise in its history. His prime concern now is attracting and retaining talent for L&T, his biggest pride is in being “partners in nation building” and his big regret is that he has been such a workaholic that he did not spend enough time with his family
ML: Would you start by telling us something about your background?
Ricoh India - Still some value left
I liked the way this author thought about this. Even though it is not as compelling at 26 compared to 32 now. Read this article and make your own judgement. Couple of things I liked about this is it is recurring revenue and dependent on Indian Economy. What I don't like it is importing most of the stuff from Japan. China can kill in the long term.
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have raised for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
The above paragraph is from the “letters to the shareholder” in 2005 by Mr Warren Buffet to the shareholders of his holding company Berkshire Hathway.
As an investor, our sole intention is to find a well-run and sensibly-priced business with fine economics …… and stay invested ignoring the gyrations of the market. But if a stock appreciates rapidly to the point where it no longer represents excellent in absolute terms or reasonable value relative to prospective purchases, or if new information comes to light that causes us to revaluate , it may be sold quite quickly. In this respect, I can’t resist the temptation of quoting Mr. Buffet from his “letter to the shareholders – 2003 ”. “…. We own pieces of excellent businesses – all of which had good gains in intrinsic value last year – but their current price, reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our large holdings during the great babble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I ”
Ricoh India Limited (RIL) is one of India’s leading sellers of office automation equipment like copiers, printers and multifunctional devices. It is the subsidiary of Ricoh, Japan, one of the world’s leading players in the office automation industry. The parent company owns 73.9% of the equity of Rs 39.7 crore.
The Indian office automation market is one of the fastest growing in the world and being driven mostly by BFSI sector (banking/financial service/insurance etc). The Industry in all likelihood will continue to grow in foreseeable future.
Ricoh (Japan) used to operate two units in India , Ricoh India and Gestetner India ( manufacturer of duplicating machines). Few years back, Gestetner India was merged into Ricoh India. The duplicating division was closed and all the employees were given VRS. The cost of closure was charged in the accounts of Ricoh India already. The goodwill arised out of merger was written off in the accounts and as on 31.3.09, entire Goodwill amount was already written off in the accounts.
http://www.capitalideasonline.com/articles/index.php?id=3217
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have raised for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
The above paragraph is from the “letters to the shareholder” in 2005 by Mr Warren Buffet to the shareholders of his holding company Berkshire Hathway.
As an investor, our sole intention is to find a well-run and sensibly-priced business with fine economics …… and stay invested ignoring the gyrations of the market. But if a stock appreciates rapidly to the point where it no longer represents excellent in absolute terms or reasonable value relative to prospective purchases, or if new information comes to light that causes us to revaluate , it may be sold quite quickly. In this respect, I can’t resist the temptation of quoting Mr. Buffet from his “letter to the shareholders – 2003 ”. “…. We own pieces of excellent businesses – all of which had good gains in intrinsic value last year – but their current price, reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our large holdings during the great babble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I ”
Ricoh India Limited (RIL) is one of India’s leading sellers of office automation equipment like copiers, printers and multifunctional devices. It is the subsidiary of Ricoh, Japan, one of the world’s leading players in the office automation industry. The parent company owns 73.9% of the equity of Rs 39.7 crore.
The Indian office automation market is one of the fastest growing in the world and being driven mostly by BFSI sector (banking/financial service/insurance etc). The Industry in all likelihood will continue to grow in foreseeable future.
Ricoh (Japan) used to operate two units in India , Ricoh India and Gestetner India ( manufacturer of duplicating machines). Few years back, Gestetner India was merged into Ricoh India. The duplicating division was closed and all the employees were given VRS. The cost of closure was charged in the accounts of Ricoh India already. The goodwill arised out of merger was written off in the accounts and as on 31.3.09, entire Goodwill amount was already written off in the accounts.
http://www.capitalideasonline.com/articles/index.php?id=3217
Bata - In Indian Psyche - some value still left
Whether we believe it or not, Bata is ingrained in indian Psyche. Now the question is whether the latest generation is going to adapt or not. How the competition is going to respond to it. The best thing is they have 235 acres and developing 25 acres with out any initial investment.
I also like these kind of companies because even though there is a global crisis, people still need to buy shoes and chappals. For Indian roads, we walk more and they worn out quickly. Can you belive we sell 1B shoes/chappals per year. It makes sense with 1B people. With 35% of the branded market share and 9% overall, this is a good thing for BATA. There are couple of huge tailwinds with, the percapita income is increasing and the economies of scale and power of branding will improve as they open up more stores. By they way, you should always use the broker report for information gathering but not necesarrrily decide based on their recommendation. I have also seen their turns have improved in the last three years. They are better utilizing their assets, inventory.
I have seen a lot Emerging Funds in US buy technology stocks in India. They forget if some headwinds are there in US, these businesses are getting affected. If they truly want to diversify they should invest in business which depends on the Indian population, percapita and GDP income/growth. Some times these concepts are simple but you only learn these lessons after a few scars
Read the detail report here
http://www.joindre.cmlinks.com/ResearchReport.aspx?Stype=1&Rtype=3&Ntype=5&id=1#
I also like these kind of companies because even though there is a global crisis, people still need to buy shoes and chappals. For Indian roads, we walk more and they worn out quickly. Can you belive we sell 1B shoes/chappals per year. It makes sense with 1B people. With 35% of the branded market share and 9% overall, this is a good thing for BATA. There are couple of huge tailwinds with, the percapita income is increasing and the economies of scale and power of branding will improve as they open up more stores. By they way, you should always use the broker report for information gathering but not necesarrrily decide based on their recommendation. I have also seen their turns have improved in the last three years. They are better utilizing their assets, inventory.
I have seen a lot Emerging Funds in US buy technology stocks in India. They forget if some headwinds are there in US, these businesses are getting affected. If they truly want to diversify they should invest in business which depends on the Indian population, percapita and GDP income/growth. Some times these concepts are simple but you only learn these lessons after a few scars
Read the detail report here
http://www.joindre.cmlinks.com/ResearchReport.aspx?Stype=1&Rtype=3&Ntype=5&id=1#
Poker and Investing
As I am a poker fan and also into investing..Read this fantastic article from David Einhorn. He also talks about ROE which is very important asset heavy companies and not necessarily on asset light companies.
Thanks Value investing Congress and Manual of Ideas
http://manualofideas.com/files/blog/einhornspeech200611.pdf
Transcript of David Einhorn’s Speech
at the Value Investing Congress
Friday, November 10, 2006
When people ask me what I do for a living, I generally tell them “I run a hedge fund.” The majority give me a strange look, so I quickly add, “I am a money manager.” When the strange look persists, as it often does, I correct it to simply, “I’m an investor.” Everyone knows what that is.
When people ask me what I did on my summer vacation, I generally tell them “I played in the World Series of Poker.” Nobody gives me a strange look.
So I am at the World Series of Poker in Las Vegas and it is time for a break between rounds. A fellow comes up to me as says, “I am from CNBC and we’d like to interview you.” I ask, “About poker or investing?” The fellow looks at me like this is the strangest thing anyone has asked him in a long time; I realize he obviously picked me out due to my large chip stack or, according to my wife, due to my great looks. “About poker” he says as nicely as he can.
Today, I will discuss both. But for this group, who I bet all know what a hedge fund is, I will mostly discuss investing. Investing and poker require similar skills.
Different people approach poker different ways. Loose aggressive types play lots of hands – virtually any two cards – and try to win lots of small pots. They are the day traders of the poker tables. Others play any Ace or any King or any two high cards. They play too many hands, but don’t play them well. These folks can do fine for a while, but get outplayed after the flop by the loose aggressive types who eventually wear them down so that they wind up in a
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desperate spot playing a decent hand against a strong hand for the remainder of their chips. I would compare them to long-only closet indexers who trade too much. Then there are the rocks. These folks sit around waiting for premium hands – high pocket pairs or an Ace, King. They fold and they fold and they fold. They are going to wait until they know they have a huge advantage. Then they bet as much as they can. It is very hard to beat a player like this. They can last a long time. Once people figure them out, nobody will play them when they do play. So they don’t get the chance to get enough chips in when they have a large advantage. Could this be what is becoming of Berkshire Hathaway?
I will tell you my poker style. It is close to the patient players waiting for a big advantage. I don’t play a lot of hands. But I don’t just wait for the perfect hand. They don’t come up often enough. I try to pick out one or two people at the table I want to play against or who I sense don’t want to play against me. When the situation feels right, I put in a big, aggressive raise with a marginal holding. It is very hard to describe how I know the “feel” and sometimes I get it completely wrong. But to do well in a poker tournament, you have to recognize a few non-traditional opportunities and you need to get people to sometimes fold the better hand. I think we invest similarly. By this I mean that most of our investing lines up nicely in the disciplined, traditional value camp – very low multiples of book value, revenues, earnings, etc., but occasionally we are opportunistic and invest in situations that are difficult to justify under traditional criteria but for one reason or another we believe to be better situations than they first appear.
People ask me “Is poker luck?” and “Is investing luck?”
The answer is, not at all. But sample sizes matter. On any given day a good investor or a good poker player can lose money. Any stock investment can turn out to be a loser no matter how large the
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edge appears. Same for a poker hand. One poker tournament isn’t very different from a coin-flipping contest and neither is six months of investment results.
On that basis luck plays a role. But over time – over thousands of hands against a variety of players and over hundreds of investments in a variety of market environments – skill wins out.
My experience at the World Series of Poker was more like what can happen to a very lucky player in any given tournament. It sure was a blast. If I played a lot of poker, I know that over time the real pros would eat me alive. Personally, I think CNBC would be better served to ask me about investing. I think I have more to contribute in that area.
So let’s get to that. How many of you heard me last year? Now how many of you heard someone use the PEG ratio and kind of laughed to yourself when you heard it?
This year, I’d like to talk a bit about ROEs. One of the best investors around, Joel Greenblatt, has written a popular, charming and funny book about investing in great companies at low P/E multiples. To simplify an already simple book, great companies are generally measured as companies that can generate lots of profit without requiring a lot of capital. This means that they have high ROEs.
I recently met a smart hedge fund manager who has built a $10 billion fund around screening for companies with high ROEs and low P/E multiples for longs and low ROEs and high P/E multiples for shorts. The manager adds human analytical effort to confirm that the screened results are not anomalous accounting figures but instead generally confirm the performance of the business. This has been a successful approach.
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My two cents on ROEs is that there are two types of businesses: there are capital intensive businesses and non-capital intensive business. Capital in this definition is both fixed assets and working capital. I define a capital intensive business as a business where the size of the business is limited by the amount of capital invested in it. In these businesses, growth requires another plant, a distribution center, a retail outlet or simply capital to fund growing accounts receivable or inventory. Examples include almost all traditional manufacturing companies, distribution companies, most financial institutions and retailers.
I define non-capital intensive businesses as businesses where growth is limited by things other than capital. Generally, this means intellectual capital or human resources. Examples of intellectual capital are in the pharmaceutical, computer software industries and even some consumer goods like Coke, which rely on brand equity rather than shareholders equity. For example, drug companies are generally limited by the composition of their patent portfolios rather than by their raw manufacturing capacity. Human resource companies are the ones known for the “business going up and down the elevator” every day. Most service companies qualify, including almost any company that sells labor whether it be nurses, construction workers or consultants.
I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees…in fact, they probably wouldn’t increase at all.
When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses
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the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position.
For these companies the “reinvestment” question becomes what do they do with the cash. Do they return it to shareholders? Or do they do something worse with the cash? Think of all the beautiful non-capital intensive businesses that have either bought or entered capital intensive areas…mostly because their core business generated more profits than they knew what to do with.
A current example is the investment banks. Think about investment banking. It should be a wonderful non-capital intensive business. People go up the elevator and generate fees. Fees for corporate finance advice. Fees for raising capital. The top firms also benefit from their brand equity as companies actually measure their status by the perceived brand value of their financial advisors. They get still more fees for assisting buy-side customers to execute transactions in the capital markets and serving as custodians for their assets. None of this requires a lot of capital. From there, they can generate more revenue by facilitating customer orders, by committing some capital and by lending them money. So the investment banks become a bit more capital intensive. This has evolved.
Next the banks enter proprietary trading and investing – generally in everything from short-term trades in liquid securities to merchant banking or private equity efforts. All that cash flow from the great non-capital intensive businesses gets sucked into ever growing balance sheets. Before you know it, the investment banks are holding on-balance-sheet assets of 30x their equity in addition to tons of off-balance-sheet swaps and derivatives.
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What does all this capital-intensive activity do? It drives down the ROEs. Sure the ROEs still seem good at around 15-20%. But when you consider that underneath all the capital intensive stuff is a wonderful non-capital intensive fee-generating business that should have an astronomical ROE, you see that all the proprietary investing and leverage isn’t adding much to shareholder returns here. The irony of this is that these are the companies that everyone else comes to in order to get advice on corporate finance and capital allocation.
Why did this happen? They say that the reason is to diversify the business to stabilize the results, as the fee streams are too volatile for the tastes of public investors. In my view that is a lot of value to destroy in order to stabilize results that are still pretty volatile.
I suspect a better explanation is the investment banks are run for their employees rather than their shareholders. They are run so that there is just enough shareholder return left so that shareholders don’t complain too loudly and a 15-20% ROE seems to be that level. Of course, the returns could be higher, but around 50% of the revenues go to employee compensation.
Given the risk taking nature of the incremental revenues and the fact that 50% of the revenues go to employee compensation, the investment banks are evolving into hedge funds with…how shall I put this?…above-market incentive compensation fee structures.
We have a company in our portfolio, New Century Financial (NEW), that turned a wonderful non-capital intensive business, the origination and sale of mortgages, and reinvested the cash flows into a mediocre capital intensive business of holding mortgage loans. Worse, they went into the capital markets to raise additional capital to focus on the capital intensive opportunity. I thought this was such a bad idea that I joined the Board with the goal of
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unwinding this decision and to free the valuable service business from the investment business. It is too soon to discuss my progress.
One non-capital intensive business we like is Washington Group, which provides design, engineering, construction management, facilities and operations management, environmental remediation, and mining services. Most of Washington Group’s contracts are paid on a negotiated cost-plus basis. The plus is either a percentage of the costs or specific performance incentives or milestone payments.
For 2006, Washington Group is guiding to about $2.50 per share. For 2007, the guidance is $2.60-$2.92 per share. The “Street” has taken that guidance at face value and has declared the stock fully valued at $55.
To us, the shares seem less expensive. There is about $8 per share in cash and a tax NOL worth another $7 per share. Backing these out, the business value is about $40 a share.
We think that guidance is overly conservative. Washington Group’s end markets should experience large growth over the next few years. In 2006, Washington Group will grow backlog more than 16%. The estimates imply earnings growth of about the same percentage.
Until recently, Washington Group also participated in “Rip and Read” bidding for government infrastructure projects. Those projects are contracted based on sealed bids from contractors, all ripped open at the same time. The lowest bid wins the contract. This has not worked out very well for them.
When the customers on those contracts request changes or expansions, Washington Group incurs increased costs. 7 of 11
Washington Group will file a claim for the increased expense with the customer, and it is either paid out or litigated in a process that can take several years. Washington Group has historically recovered money on a good percentage of its claims.
Washington Group accounts for these loss-generating contracts with cost overruns by taking a charge for the expenses expected to be in excess of revenue going forward. Future revenue on the contract is recognized at a 0% EBIT margin. Claims are not recognized in earnings until the cash is received, no matter how far along in negotiations Washington Group and its customer are, or how reasonably claim recoveries can be estimated. In effect, Washington Group will have charges in early quarters, followed by quarters with revenue at 0% EBIT margin, and then later quarters with claims revenue at 100% margin. Washington Group does not include claims recoveries in its guidance.
Lately Washington Group has had three particularly difficult contracts with cost over-runs. This has resulted in repeated charges over the past few years. The 2006 guidance includes $32 million in pre-tax charges that have reduced earnings by about 60 cents per share.
There are other accepted ways to account for cost overruns on government contracts. The largest of these contracts, for which Washington Group has recognized $122 million of the losses, is done through a joint venture for which Washington Group has a 50% share. Washington Group’s publicly traded JV partner estimates $57 million of claims recoveries that it has recorded on its books as an offset to the losses. As I mentioned, Washington Group doesn’t book the recovery until it collects the cash.
I believe that a more reasonable estimate for 2007 starts with 2006, adds back the 60 cents of charges and grows the core business by 16%. That puts me at around $3.60 per share or about 11x
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conservatively stated earnings that give no credit for claims recoveries. I do not believe this is a peak result. This seems pretty cheap for a non-capital intensive business with above average growth prospects and a history of using excess cash flow to buy back stock. For what it is worth, the peer group trades at 20x more aggressive earnings.
Coming back to my main theme. I believe it is very important to analyze ROE and marginal returns on capital…but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.
The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.
This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE. ROE can improve three ways: better asset turns, better margins and by adding financial leverage. I like to look for companies that can expand the ROEs in as many of these levers as possible.
This brings me to my second investment idea, which is, I hope, a good example of what I am talking about.
Arkema is a diversified generic and brand name chemicals company that was created in 2004 by the French oil & gas giant TOTAL following the reorganization of its chemicals portfolio. Arkema consists of three divisions: Chlorochemicals, which is a
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mature and cyclical segment; Industrial Chemicals, which is growing and moderately cyclical, and Performance Products, that occupies high-value-added non-cyclical niches. Arkema’s products are used in automotive, electronics, hygiene & beauty, construction and chemical industries. Almost half of Arkema’s revenue comes from outside of Europe and about two-thirds of its employees and capital employed are located in Europe, primarily in France.
Arkema was spun off and started to trade in May 2006 on the Paris Stock Exchange under the ticker AKE FP. TOTAL management, more focused on its highly profitable oil and gas businesses, had under-managed the “non-core” Arkema segments that have generated margins considerably lower than its pure-play peers.
Arkema currently trades at €38 per share, which translates into a market cap of €2.3 billion and reflects a valuation of 1.2x book value, which was almost halved by a slew of write-downs and provisions in the three years preceding the spin-off. Arkema currently trades at 38% of revenue and 4.9x our estimate of 2006 EBITDA, representing an industry low multiple of a depressed EBITDA result, caused by an industry low 7.7% margin.
We like Arkema because it has a great opportunity to improve its ROE through improving asset turns, margins and, if it is inclined, by adding leverage.
Arkema was spun off with working capital of 23.6% of sales. Industry peers operate in the mid-teens. If Arkema can shrink this number to 17% over time it will free up cash in excess of €6 per share or alternatively, it could grow revenues by 39% without requiring working capital. Arkema should also be able to expand asset turns as it holds €220 million or almost €4 per share of construction projects that are not yet producing. As these come on line, Arkema will get the revenue and income benefits from these investments that have already been made.
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Additionally, Arkema has a good opportunity to expand its margins, as Arkema’s recent “recurring” operating results had significant embedded undisclosed one-off costs depressing these results. The Industrial and Performance Chemicals divisions, Arkema’s two largest, which account for 75% of revenue and all of EBITDA, have had average margins over the last eight years that were significantly higher than recent levels. Arkema’s most comparable company, Degussa, has operating margins almost three times Arkema’s recent results.
We believe that just with the return of Arkema’s two largest divisions to their historical long-range profitability and a modest fixing of its troubled Chlorochemicals division, Arkema should be easily able to expand its EBITDA margin to 10% which would imply only 3.6x “reasonably achievable” EBITDA. After executing an authorized buy-back for 10% of its shares, such results would demonstrate €5 in EPS, implying a 7.6x P/E, and a 12% ROE. This is a dramatic improvement from what we think this year will be €2.50 in EPS and a 7.6% ROE. As I dream into the distant future of possibilities, if Arkema achieves Degussa’s margins, they would earn €8.60 per share, implying a 4.4x P/E, and a 20% ROE.
So I went back to the CNBC reporter and asked him to read my speech and summarize it with a title. He read it, thought long and hard, and came up with Winning Poker Strategies from an Investor. I looked at him in the same confused way he had looked at me back in Vegas. So I’ve come up with an alternative title for today’s talk: Financial Learnings for Make Benefit Glorious Wiseguys.
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Thanks Value investing Congress and Manual of Ideas
http://manualofideas.com/files/blog/einhornspeech200611.pdf
Transcript of David Einhorn’s Speech
at the Value Investing Congress
Friday, November 10, 2006
When people ask me what I do for a living, I generally tell them “I run a hedge fund.” The majority give me a strange look, so I quickly add, “I am a money manager.” When the strange look persists, as it often does, I correct it to simply, “I’m an investor.” Everyone knows what that is.
When people ask me what I did on my summer vacation, I generally tell them “I played in the World Series of Poker.” Nobody gives me a strange look.
So I am at the World Series of Poker in Las Vegas and it is time for a break between rounds. A fellow comes up to me as says, “I am from CNBC and we’d like to interview you.” I ask, “About poker or investing?” The fellow looks at me like this is the strangest thing anyone has asked him in a long time; I realize he obviously picked me out due to my large chip stack or, according to my wife, due to my great looks. “About poker” he says as nicely as he can.
Today, I will discuss both. But for this group, who I bet all know what a hedge fund is, I will mostly discuss investing. Investing and poker require similar skills.
Different people approach poker different ways. Loose aggressive types play lots of hands – virtually any two cards – and try to win lots of small pots. They are the day traders of the poker tables. Others play any Ace or any King or any two high cards. They play too many hands, but don’t play them well. These folks can do fine for a while, but get outplayed after the flop by the loose aggressive types who eventually wear them down so that they wind up in a
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desperate spot playing a decent hand against a strong hand for the remainder of their chips. I would compare them to long-only closet indexers who trade too much. Then there are the rocks. These folks sit around waiting for premium hands – high pocket pairs or an Ace, King. They fold and they fold and they fold. They are going to wait until they know they have a huge advantage. Then they bet as much as they can. It is very hard to beat a player like this. They can last a long time. Once people figure them out, nobody will play them when they do play. So they don’t get the chance to get enough chips in when they have a large advantage. Could this be what is becoming of Berkshire Hathaway?
I will tell you my poker style. It is close to the patient players waiting for a big advantage. I don’t play a lot of hands. But I don’t just wait for the perfect hand. They don’t come up often enough. I try to pick out one or two people at the table I want to play against or who I sense don’t want to play against me. When the situation feels right, I put in a big, aggressive raise with a marginal holding. It is very hard to describe how I know the “feel” and sometimes I get it completely wrong. But to do well in a poker tournament, you have to recognize a few non-traditional opportunities and you need to get people to sometimes fold the better hand. I think we invest similarly. By this I mean that most of our investing lines up nicely in the disciplined, traditional value camp – very low multiples of book value, revenues, earnings, etc., but occasionally we are opportunistic and invest in situations that are difficult to justify under traditional criteria but for one reason or another we believe to be better situations than they first appear.
People ask me “Is poker luck?” and “Is investing luck?”
The answer is, not at all. But sample sizes matter. On any given day a good investor or a good poker player can lose money. Any stock investment can turn out to be a loser no matter how large the
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edge appears. Same for a poker hand. One poker tournament isn’t very different from a coin-flipping contest and neither is six months of investment results.
On that basis luck plays a role. But over time – over thousands of hands against a variety of players and over hundreds of investments in a variety of market environments – skill wins out.
My experience at the World Series of Poker was more like what can happen to a very lucky player in any given tournament. It sure was a blast. If I played a lot of poker, I know that over time the real pros would eat me alive. Personally, I think CNBC would be better served to ask me about investing. I think I have more to contribute in that area.
So let’s get to that. How many of you heard me last year? Now how many of you heard someone use the PEG ratio and kind of laughed to yourself when you heard it?
This year, I’d like to talk a bit about ROEs. One of the best investors around, Joel Greenblatt, has written a popular, charming and funny book about investing in great companies at low P/E multiples. To simplify an already simple book, great companies are generally measured as companies that can generate lots of profit without requiring a lot of capital. This means that they have high ROEs.
I recently met a smart hedge fund manager who has built a $10 billion fund around screening for companies with high ROEs and low P/E multiples for longs and low ROEs and high P/E multiples for shorts. The manager adds human analytical effort to confirm that the screened results are not anomalous accounting figures but instead generally confirm the performance of the business. This has been a successful approach.
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My two cents on ROEs is that there are two types of businesses: there are capital intensive businesses and non-capital intensive business. Capital in this definition is both fixed assets and working capital. I define a capital intensive business as a business where the size of the business is limited by the amount of capital invested in it. In these businesses, growth requires another plant, a distribution center, a retail outlet or simply capital to fund growing accounts receivable or inventory. Examples include almost all traditional manufacturing companies, distribution companies, most financial institutions and retailers.
I define non-capital intensive businesses as businesses where growth is limited by things other than capital. Generally, this means intellectual capital or human resources. Examples of intellectual capital are in the pharmaceutical, computer software industries and even some consumer goods like Coke, which rely on brand equity rather than shareholders equity. For example, drug companies are generally limited by the composition of their patent portfolios rather than by their raw manufacturing capacity. Human resource companies are the ones known for the “business going up and down the elevator” every day. Most service companies qualify, including almost any company that sells labor whether it be nurses, construction workers or consultants.
I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees…in fact, they probably wouldn’t increase at all.
When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses
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the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position.
For these companies the “reinvestment” question becomes what do they do with the cash. Do they return it to shareholders? Or do they do something worse with the cash? Think of all the beautiful non-capital intensive businesses that have either bought or entered capital intensive areas…mostly because their core business generated more profits than they knew what to do with.
A current example is the investment banks. Think about investment banking. It should be a wonderful non-capital intensive business. People go up the elevator and generate fees. Fees for corporate finance advice. Fees for raising capital. The top firms also benefit from their brand equity as companies actually measure their status by the perceived brand value of their financial advisors. They get still more fees for assisting buy-side customers to execute transactions in the capital markets and serving as custodians for their assets. None of this requires a lot of capital. From there, they can generate more revenue by facilitating customer orders, by committing some capital and by lending them money. So the investment banks become a bit more capital intensive. This has evolved.
Next the banks enter proprietary trading and investing – generally in everything from short-term trades in liquid securities to merchant banking or private equity efforts. All that cash flow from the great non-capital intensive businesses gets sucked into ever growing balance sheets. Before you know it, the investment banks are holding on-balance-sheet assets of 30x their equity in addition to tons of off-balance-sheet swaps and derivatives.
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What does all this capital-intensive activity do? It drives down the ROEs. Sure the ROEs still seem good at around 15-20%. But when you consider that underneath all the capital intensive stuff is a wonderful non-capital intensive fee-generating business that should have an astronomical ROE, you see that all the proprietary investing and leverage isn’t adding much to shareholder returns here. The irony of this is that these are the companies that everyone else comes to in order to get advice on corporate finance and capital allocation.
Why did this happen? They say that the reason is to diversify the business to stabilize the results, as the fee streams are too volatile for the tastes of public investors. In my view that is a lot of value to destroy in order to stabilize results that are still pretty volatile.
I suspect a better explanation is the investment banks are run for their employees rather than their shareholders. They are run so that there is just enough shareholder return left so that shareholders don’t complain too loudly and a 15-20% ROE seems to be that level. Of course, the returns could be higher, but around 50% of the revenues go to employee compensation.
Given the risk taking nature of the incremental revenues and the fact that 50% of the revenues go to employee compensation, the investment banks are evolving into hedge funds with…how shall I put this?…above-market incentive compensation fee structures.
We have a company in our portfolio, New Century Financial (NEW), that turned a wonderful non-capital intensive business, the origination and sale of mortgages, and reinvested the cash flows into a mediocre capital intensive business of holding mortgage loans. Worse, they went into the capital markets to raise additional capital to focus on the capital intensive opportunity. I thought this was such a bad idea that I joined the Board with the goal of
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unwinding this decision and to free the valuable service business from the investment business. It is too soon to discuss my progress.
One non-capital intensive business we like is Washington Group, which provides design, engineering, construction management, facilities and operations management, environmental remediation, and mining services. Most of Washington Group’s contracts are paid on a negotiated cost-plus basis. The plus is either a percentage of the costs or specific performance incentives or milestone payments.
For 2006, Washington Group is guiding to about $2.50 per share. For 2007, the guidance is $2.60-$2.92 per share. The “Street” has taken that guidance at face value and has declared the stock fully valued at $55.
To us, the shares seem less expensive. There is about $8 per share in cash and a tax NOL worth another $7 per share. Backing these out, the business value is about $40 a share.
We think that guidance is overly conservative. Washington Group’s end markets should experience large growth over the next few years. In 2006, Washington Group will grow backlog more than 16%. The estimates imply earnings growth of about the same percentage.
Until recently, Washington Group also participated in “Rip and Read” bidding for government infrastructure projects. Those projects are contracted based on sealed bids from contractors, all ripped open at the same time. The lowest bid wins the contract. This has not worked out very well for them.
When the customers on those contracts request changes or expansions, Washington Group incurs increased costs. 7 of 11
Washington Group will file a claim for the increased expense with the customer, and it is either paid out or litigated in a process that can take several years. Washington Group has historically recovered money on a good percentage of its claims.
Washington Group accounts for these loss-generating contracts with cost overruns by taking a charge for the expenses expected to be in excess of revenue going forward. Future revenue on the contract is recognized at a 0% EBIT margin. Claims are not recognized in earnings until the cash is received, no matter how far along in negotiations Washington Group and its customer are, or how reasonably claim recoveries can be estimated. In effect, Washington Group will have charges in early quarters, followed by quarters with revenue at 0% EBIT margin, and then later quarters with claims revenue at 100% margin. Washington Group does not include claims recoveries in its guidance.
Lately Washington Group has had three particularly difficult contracts with cost over-runs. This has resulted in repeated charges over the past few years. The 2006 guidance includes $32 million in pre-tax charges that have reduced earnings by about 60 cents per share.
There are other accepted ways to account for cost overruns on government contracts. The largest of these contracts, for which Washington Group has recognized $122 million of the losses, is done through a joint venture for which Washington Group has a 50% share. Washington Group’s publicly traded JV partner estimates $57 million of claims recoveries that it has recorded on its books as an offset to the losses. As I mentioned, Washington Group doesn’t book the recovery until it collects the cash.
I believe that a more reasonable estimate for 2007 starts with 2006, adds back the 60 cents of charges and grows the core business by 16%. That puts me at around $3.60 per share or about 11x
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conservatively stated earnings that give no credit for claims recoveries. I do not believe this is a peak result. This seems pretty cheap for a non-capital intensive business with above average growth prospects and a history of using excess cash flow to buy back stock. For what it is worth, the peer group trades at 20x more aggressive earnings.
Coming back to my main theme. I believe it is very important to analyze ROE and marginal returns on capital…but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.
The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.
This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE. ROE can improve three ways: better asset turns, better margins and by adding financial leverage. I like to look for companies that can expand the ROEs in as many of these levers as possible.
This brings me to my second investment idea, which is, I hope, a good example of what I am talking about.
Arkema is a diversified generic and brand name chemicals company that was created in 2004 by the French oil & gas giant TOTAL following the reorganization of its chemicals portfolio. Arkema consists of three divisions: Chlorochemicals, which is a
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mature and cyclical segment; Industrial Chemicals, which is growing and moderately cyclical, and Performance Products, that occupies high-value-added non-cyclical niches. Arkema’s products are used in automotive, electronics, hygiene & beauty, construction and chemical industries. Almost half of Arkema’s revenue comes from outside of Europe and about two-thirds of its employees and capital employed are located in Europe, primarily in France.
Arkema was spun off and started to trade in May 2006 on the Paris Stock Exchange under the ticker AKE FP. TOTAL management, more focused on its highly profitable oil and gas businesses, had under-managed the “non-core” Arkema segments that have generated margins considerably lower than its pure-play peers.
Arkema currently trades at €38 per share, which translates into a market cap of €2.3 billion and reflects a valuation of 1.2x book value, which was almost halved by a slew of write-downs and provisions in the three years preceding the spin-off. Arkema currently trades at 38% of revenue and 4.9x our estimate of 2006 EBITDA, representing an industry low multiple of a depressed EBITDA result, caused by an industry low 7.7% margin.
We like Arkema because it has a great opportunity to improve its ROE through improving asset turns, margins and, if it is inclined, by adding leverage.
Arkema was spun off with working capital of 23.6% of sales. Industry peers operate in the mid-teens. If Arkema can shrink this number to 17% over time it will free up cash in excess of €6 per share or alternatively, it could grow revenues by 39% without requiring working capital. Arkema should also be able to expand asset turns as it holds €220 million or almost €4 per share of construction projects that are not yet producing. As these come on line, Arkema will get the revenue and income benefits from these investments that have already been made.
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Additionally, Arkema has a good opportunity to expand its margins, as Arkema’s recent “recurring” operating results had significant embedded undisclosed one-off costs depressing these results. The Industrial and Performance Chemicals divisions, Arkema’s two largest, which account for 75% of revenue and all of EBITDA, have had average margins over the last eight years that were significantly higher than recent levels. Arkema’s most comparable company, Degussa, has operating margins almost three times Arkema’s recent results.
We believe that just with the return of Arkema’s two largest divisions to their historical long-range profitability and a modest fixing of its troubled Chlorochemicals division, Arkema should be easily able to expand its EBITDA margin to 10% which would imply only 3.6x “reasonably achievable” EBITDA. After executing an authorized buy-back for 10% of its shares, such results would demonstrate €5 in EPS, implying a 7.6x P/E, and a 12% ROE. This is a dramatic improvement from what we think this year will be €2.50 in EPS and a 7.6% ROE. As I dream into the distant future of possibilities, if Arkema achieves Degussa’s margins, they would earn €8.60 per share, implying a 4.4x P/E, and a 20% ROE.
So I went back to the CNBC reporter and asked him to read my speech and summarize it with a title. He read it, thought long and hard, and came up with Winning Poker Strategies from an Investor. I looked at him in the same confused way he had looked at me back in Vegas. So I’ve come up with an alternative title for today’s talk: Financial Learnings for Make Benefit Glorious Wiseguys.
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Sunday, January 3, 2010
Interesting post about Nifty P/E
Even though the current P/E is like close to 22. Looks like in the short term Indian markets are reaching fairmarket value. This is not a perfect math. I am sure the earning are slightly depressed especially for the companies that are dependent on exports. The other way to see is I cannot find any bargains in the markets that easily. But if some has a time horizon of more than 3-5 yrs, then there are still some fantastic companies with strong moats.
Reat this good article from Indian Investor Blog
I talk about this often - typically, you want your Earnings Per Share (EPS) growth to, somehow, match the Price-to-Earnings ratio you're paying for the stock. This, at an index level, makes even more sense - a single company may be irrationally high priced or have very high P/E, but the index as a whole should demonstrate EPS Growth levels close to the P/E you pay.
Here's where it's continuing to not make sense. Following my April and August posts, the Nifty P/E continues to scale new levels, while EPS stagnates. continue reading here
Reat this good article from Indian Investor Blog
I talk about this often - typically, you want your Earnings Per Share (EPS) growth to, somehow, match the Price-to-Earnings ratio you're paying for the stock. This, at an index level, makes even more sense - a single company may be irrationally high priced or have very high P/E, but the index as a whole should demonstrate EPS Growth levels close to the P/E you pay.
Here's where it's continuing to not make sense. Following my April and August posts, the Nifty P/E continues to scale new levels, while EPS stagnates. continue reading here
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