Under The Rock Stocks

Steven Crist - Pari Mutuel Systems

Classic speech on thinking probabilistically: http://www.leggmason.com/thoughtleaderforum/2007/conference/crist.html

“What you really want to do is determine which most-likely winners are good prices and which most-likely winners are bad prices. It is a very simple equation:

Price X Probability = Value

The entire world of investing is that simple too. Here is what I mean. If a horse has a 33 percent change of winning a race, and if you can get odds of 2-to-1 on him (which means tripling your money), there is no value - the horse is priced correctly. If a horse is 6-to-5 (which means you will only get back 120 percent of your bet) and he is only 33 percent to win, then he is a terrible bet. If you’re going to get 4-to-1 (quintupling your money) on a 33 percent chance winner, then it’s a great bet.”

Pabrai valuation philosophy

From recent annual meeting Q&A:

Q: When you identify a prospective investment, can you walk us through how you evaluate its intrinsic value using a Discounted Cash Flow (DCF), mental Gordon Growth Method, your gut or something else? 

A: For most companies that I look at, I usually stop looking at them within maybe 30 seconds after I start and it’s usually for one of two reasons. Either it is outside the circle of competence or the evaluation doesn’t instantly jump out as compelling. Those are the two basic reasons why we take a pass relatively quickly. In general, I haven’t run spreadsheets and I find that, if there is a need to run a spreadsheet, that is a red flag to take a pass. Let’s say you had a company that had a billion a year in cash flow and the company’s cash flows were almost guaranteed to come in. Say, it’s a coke bottler and the cash flows are not going to grow but they were going to stay at a billion a year for as long as you could see, maybe 10 years or more. A business like that, if it had no excess capital, is worth $10 billion or 10 times cash flow. The $10 billion number really hasn’t changed over the last two decades since I have been doing this. This company would be interesting if it were available for $5 billion or less. If I could find it at 5 times cash flow and the cash flow is stable, that would be interesting. If you take the same business and say it is growing at 5-10% or more per year, then you can bump up the 10 times cash flow number to maybe get up to 15 times. I don’t think I would go much more than 15, or maybe 17. You can look at half of that as the price that we would be willing to pay - 7 or 8 times earnings, growing at 10% a year and pretty stable. That would be of interest. So to that extent, if we do a DCF, that’s the DCF we look at.

Seth Klarman’s 12 learnings from WEB

Source: http://www.cnbc.com/id/102398488#

1. Value investing works. Buy bargains.

2. Quality matters, in businesses and in people. Better quality businesses are more likely to grow and compound cash flow; low quality businesses often erode and even superior managers, who are difficult to identify, attract, and retain, may not be enough to save them. Always partner with highly capable managers whose interests are aligned with yours.

3. There is no need to overly diversify. Invest like you have a single, lifetime “punch card” with only 20 punches, so make each one count. Look broadly for opportunity, which can be found globally and in unexpected industries and structures.

4. Consistency and patience are crucial. Most investors are their own worst enemies. Endurance enables compounding.

Michael Price on Investment Style

Humans and / or computers in investing

Characteristically, Michael Mauboussin and his team have written a thought provoking analysis on what can be learned from “freestyle” chess - a game of chess where the player can use a computer.  Currently humans with computers are superior to humans or computers alone.

The article can be found at this link.

A few takeaways are:

• Chess is not a perfect analogy to investing because (a) it is a linear environment, (b) players have perfect information, © skill dominates luck.  However, both rely on process and outcomes can be influenced by mental biases.
• Fundamental investors can leverage computers to (a) crunch numbers and (b) expose new data.
• Quantitative investors can benefit from human touch by (a) seeking causative rationale in software recommendations and (b) adapting to non-linear changes in environment. 

Culture as a predictor of value

Reed Hasting’s presentation on Netflix culture is a great example of how leadership can leverage an “intangible asset” like people and culture to create tangible performance. 

A simple investment checklist

From Value Investor India:

Putting it quantitavely, I would say that I am looking at a CAGR of 26% per annum for 3-5 years or longer if possible.

So what are some of the characteristics of a company which can deliver these kinds of returns?

• The company operates in an industry with above average growth rate which means that the industry is growing at least at 15%+ rates (higher than the GDP). 
• The company is able to earn a high rate of return on capital (at least 15% or higher) for a long period of time (sustainable competitive advantage)
• Company is led by a competent and ethical management
• The company is selling at reasonable valuations

John Paulson on Special Situations

How Will You Measure Your Life? Clay Christensen at TEDxBoston

Charlie Munger on how to think better

Billionaire Charlie Munger offers a two-step filter for making decisions:

“Personally, I’ve gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things-which by and large are useful, but which often misfunction.

One approach is rationality-the way you’d work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions-many of which are wrong.”

- via Farnam Street

A business I would like to own

A list of characteristics to filter ideas against:

• Honest and shareholder aligned management 
• Decentralized corporate culture geared to keeping employees focused on customer and shareholder value
• Industry with little risk of being disrupted by new technology or changes in consumer tastes in five years
• Product or service that is unique for customers it seeks to serve and from competitors
• Large addressable market size and dominant market share
• Low financial leverage
• Little required capital investment
• Return on invested capital greater than 20%
• Selling for price less than 8x operating income or less than 3% implied growth in operating income
• Reporting in country with regulatory protection for minority shareholders
• Other respected value-oriented shareholders

Behold the power of the spin-off

“In March 2000, media company Ziff Davis (ZD) announced a recapitalization and the spin-off of its events (trade show) business. For each share of ZD, s h a r e h o l d e rs received 0.57 shares of ZD Net (an already publicly held tracking stock of the parent’s Internet business); a $2.50 cash dividend; and 0.5 shares of Key 3 M e d i a , which upon completion of the parent company ’s reorganization would be an independent publicly traded company, with additional shares being brought to market via an initial public offering (IPO).

By buying one share of ZD for $11.50, shorting shares of richly valued ZD Net and covering the short as soon as the reorganization was completed and pocketing the $2.50 per share cash dividend, we were effectively purchasing one share of Key3Media for $2.32. This was the equivalent of paying just 6 times trailing free cash flow for a very good, albeit not terribly sexy, business whose competitors (Penton Media and Primedia) were trading at 14 to 15 times free cash flow in the market. Sure enough, the Key3Media IPO shares came to market at $6 per share and the stock traded at $12 per share within a month, delivering a 417% return on our original investment in the parent company stock. Behold the power of the spin-off.”

From: http://www.gabelli.com/Gab_pdf/articles/mariostubs_041801.pdf