Journeys of a Bumbling Investor

Just came across this interesting article (link here) about Financial Accounting Standards Board (FASB) Statement No. 157. The FASB approved this statement in Sep 06 which introduced a three-level hierarchy for measuring the fair values of assets and liabilities:

1. Level 1 means the values come from quoted prices in active markets. The balance-sheet changes then pass through the income statement each quarter as gains or losses. Call this mark-to-market.
2. Level 2 values are measured using “observable inputs” such as recent transaction prices for similar items, where market quotes aren’t available. Call this mark-to-model.
3. Level 3 means fair value is measured using “unobservable inputs”. While companies can’t actually see the changes in the fair values of their assets and liabilities, they’re allowed to book them through earnings anyway, based on their own subjective assumptions. Call this mark-to-make-believe.

This is my very first post on a company that I’m looking at: Delta Financial Corporation (DFC). As a disclaimer, my writing about a company is not a recommendation nor endorsement, simply jotting down some of the things that I’ve come across that I thought is interesting.

Mohnish Pabrai has a $35/share fair value for this company (which is trading around $4.5 at time of writing). I came across these points that Pabrai has apparantly said about DFC

• Severely distressed industry – DFC stock is at a throwaway price despite being different
• Half of loans originated at retail centers with ultra-low costs
• 78% average loan-to-value and 92% of loans are fixed rate
• Conservative accounting – revenue recognized over life of loan but expenses are recognized immediately
• Mostly a re-fi lender. Not affected much by housing starts. Low California exposure.
• 1/3 owned by insiders. Solid, conservative, owner-oriented management.
• Securitized fair value is over $8 per share, excess book is another $4, and the mortgage banking earnings engine generates $1.50 per share
• Less competition now so earnings will grow. DFC has been hiring and growing recently.
• Earnings could be much higher than $1.50 in 2 to 3 years. With a 15X multiple the intrinsic value is about $35 – more if earnings grow. Once the cloud passes over the industry the stock price should rise.

I’m still doing my research, but I must say that its a very complicated company =)

I was reading an article by John Price on GuruFocus.com (link here) that wrote about Tobin’s Q. It showed a graph illustrating that Robert Shiller’s P/E ratio (price divided by the average earnings per share over the previous 10 years) is a good proxy to use for the comparison between Tobin’s Q with its long-term average (in a log scale).

I then came across another article here that showed that the S&P500’s P/E ratio hasn’t been this low since 1995.

The interesting thing is that, if you had read the 2nd article only, you would likely have thought that the market is undervalued. After all, 10+ years does seem like a long time, so the market should’ve gone through a few cycles, and if current P/Es are at their lowest point compared to the past 10 years, then hey, the market’s cheap.

But if you had also came across the 1st article, you would have seen that P/Es for the whole period from 1995 to 2006 are above their historical mean (i.e. high), in the context of the whole century (1900 onwards). Surprising but seems true.

On a side note, I’ve been meaning to do some work so that I will be able to generate Tobin’s Q ratio for the market, and Robert Shiller’s P/E ratio, so that I can see how over/undervalued the market is. I’ve tried to look for those on the web but have not been successful. Hope to get to do that soon.

Just came across this article written by Anastasios Dimopoulos on a talk given by Mohnish Pabrai at the 4th Annual Value Investing Seminar in Italy (link here). Thought its quite interesting. I quote:”Pabrai’s strict rule is “Do not sell if the intrinsic value is above the market price no matter what happens.” He gave an example which had to do about one of his investments that is mostly sold by now. The company is Universal Stainless & Alloy Products, Inc and the situation unfolded in the following order.

1. Bought stock at $14- 15 in 2002 seeing a forward p/e of 4-7 with no downside and a huge upside.
2. One year later the stock was trading at $5 but he couldn’t see anything wrong with his assessment of intrinsic value. He just waited.
3. One year later the stock was trading at $10-11 and the intrinsic value was estimated at easily over that price. Wait again.
4. In 2005 the stock was trading again at $15 but he didn’t sell at break-even because the intrinsic value was estimated by him at $30, so he bought more and waited.
5. In 2006 the company starts running at full capacity and is very profitable. The thesis is being confirmed and he starts selling at over 90% of intrinsic value. “

I remember reading somewhere before that Mohnish Pabrai rode a tech stock up during the dot-com bubble and managed to sell it at its peak. His learning point however was that, next time, he should sell off once the stock has reached its intrinsic value.

From what I’ve read so far, its tough to value Berkshire Hathaway. I thought it would be useful, as I come across any such articles, to note down how others have valued Berkshire. Here’s some:

1. Barron’s on 13 Aug 07 carried an interview with Gifford Combs, Managing Director and Portfolio Manager of Dalton Investments (link here). Here’s how he got to his valuation:
   

   How cheaply is it selling, and what do you think the true value is?

   It is selling at $112,000 a share, and it is certainly worth somewhere north of $150,000 a share. That value is continuing to compound each year.

   How do you get to $150,000?

   The operating businesses are a superb collection that earn more than 25% on tangible net worth. They should be valued at 20 times earnings, or about $70 billion. I value the finance and utility businesses at 1½ times book value — together they are worth about $26 billion.

   The majority of the value at Berkshire is in the insurance entities, which hold virtually all of the investments. The insurance business depends upon the value one places on the $58 billion of “float,” which are the non-interest-bearing liabilities of the insurance companies. Adjusting for the float and making allowances for deferred taxes, I value the insurance companies at nearly $200 billion. The total comes to more than $290 billion, or about $190,000 per share. More conservative assumptions about investment returns over time would lower that value; but it’s hard to get to a number much below $150,000 per share

2. A Motley Fool article by Philip Durell published on 9 Nov 06 (link here) highlighted a that a quick and dirty way is to use the P/B ratio.

   “A good place to start when valuing Berkshire is to take Buffett’s advice, which he outlines in the Berkshire Owners’ Manual. A simple way to view the company is in terms of book value per share (BV/S). In May 1996, when Berkshire first issued its B class shares, Buffett indicated that the stock price was somewhere close to fair value or possibly slightly overvalued then. At that time, the first-quarter reported BV/S was around $15,200, and the share price was around $34,000. Applying the same ratio to today’s BV/S of $66,300 results in a share price of more than $148,000 per A share, or $4,930 per B share. My more elaborate valuation produces a range of $123,000 and $144,000 per A share. Translated for B shares, this amounts to $4,100 to $4,800. At today’s price, that puts Berkshire between 13% and 25% undervalued.”

3. I remember that Whitney Tilson had a presentation at the Value Investing Congress on his valuation of Berkshire. I’ll add to this post if I manage to get a copy of that.

I stumbled upon an article by John Price published on GuruFocus.com, which led me to his website www.conscious-investor.com. He has put together a neat software that supposedly implements Buffett’s methods. While the software is not free, the website does come with a few videos that showcase the software. If you take a look at the videos, you can basically see John Price’s stock picking / valuation methodology.

Some quick points:

1. His software comes with a screener that allows you to screen companies by
   • ROE – default 10%
   • Market capitalization – default $50 mil
   • Years of history available – default 4 years
   • Debt/Equity ratio – default 50%
   • Current ratio – default 1.5
   • Quick ratio – default 1.0
   • Interest cover – default 2.0
   • Industry category
   • Stability of earnings (some proprietary measure)
   • Stability of sales (some proprietary measure)
2. Comes with a roll-back feature that allows you to perform your analysis as though you are standing at some point in the past (software loaded with 10 years of data).
3. Allows charting of historical data (e.g. ROE, ROC, EPS growth, sales growth).
4. Performs projections and calculates the IRR given the following main inputs:
   • Current price
   • EPS (ttm)
   • P/E ratio at terminal year – average of past few years
   • EPS growth rate – seems to be the average of “CAGR taking the start/end points” and “average annual EPS growth rate over the past few years”
   • Payout ratio – average of past few years
   • No. of years to project earnings growth – default 5 years
   • Tax rate on dividends
   • Tax rate on capital gains
5. Also calculates a maximum price to pay to obtain your “required return”.
6. Margin of Safety is done by calculating the minimum IRR that you would get in the worst case scenario (playing with the inputs above), and see if that minimum IRR is acceptable.

John Price has also set up an excellent website called Stable Growth Companies, very similar to the Magic Formula Investing website by Joel Greenblatt, that will list a ranking of companies based on the stability of their earnings (using his proprietary measure). Good to check out.

I’m starting to read a series of articles written by Buffett-style fund manager Roger Montgomery of Clime Asset Management (www.clime.com.au)

I’ll probably post some interesting/important takeaways as I read through the articles. Here’s one: Roger Montgomery wrote in one article that his approach is to base valuation estimates on 4 elements:

1. Balance sheet equity
2. Return the company can sustainably generate from that equity
3. The manner in which it retains and distributes its earnings
4. A discount rate

This seems very much like the valuation methodology written in Buffettology (by Mary Buffett) but Roger’s method does not use any P/E ratios.

There’s a pretty nice expose on his method at this forum here.

I just read this piece on BusinessWeek which had an interview with Larry Coats of Oak Value Fund. You can find the article here.

I always love it when fund managers reveal their valuation methodology. Here’s Larry Coats’:

What kind of discount do you look for when buying a stock?

“We’re attempting to buy a stock at 65¢ or 70¢ on the dollar, so a 30% to 35% discount. We use a discounted cash-flow model, using an 8% discount rate. The magic in that sauce is not around the discount rate, it’s around the terminal multiple that you put in the valuation equation. Because at the end of year five, you have to assign something as the present value of the future cash flow.

We end up with a portfolio that has, on average, operating margins in excess of 20%, return on equity above 20%, and debt-to-total enterprise value less than 20%. So I’ve got highly profitable businesses generating returns on equity and doing it without significant leverage on the balance sheet.

From a growth perspective, we believe revenue over the next five years for this collection will rise just short of 10%, on average; and earnings growth will be in the mid-teens, or 13% to 15%. We have stocks with higher quality, better growth, less risk in terms of balance sheet, and trade at a market multiple.”

I was thinking about how to calculate the return on re-invested capital, i.e. return on retained earnings.

In reality, the retained earnings can be used for a multitude of purposes, and the returns could be obtained fully in a single year, or perhaps spread over a couple of years (e.g. if i retain $5 per share and re-invested that, the returns from that might come in at different times and amounts over a period of 10 years). How then do you figure out the return on re-invested capital?

Let’s take a not-too-simple and not-too-difficult case. Say each time you retain a certain amount of earnings, you get back cash inflows in equal amounts across a period of 10 years.

In that situation, when you look at the change in earnings from one period to the next, that “change in earnings” is a result of re-invested earnings from 1 year ago, 2 years ago, 3 years ago ……, 10 years ago (more specifically, a part (about one-tenth) of re-invested earnings from 1 year ago, a part (about one-tenth) of re-invested earnings from 2 years ago, etc.). Naturally the re-invested earnings across the different years would be different, which makes things extremely complicated.

To “un-complify” the situation, a simplification is necessary. One simplification is that the different “parts” across the past 10 years, adds up to the full retained earnings of a single year.  Which single year to choose then?

A lousy simplification would then be to use the most recent year before the “change in earnings” — which is what people typically do when they calculate ratios, they simply take the change divided by the base in the previous year, but i doubt that many people actually know the tons of assumptions/simplifications they are making when they do such a calculation.

To improve the calculation, you can do this across multiple years, i.e. calculate the change in earnings between year 1 and year 10, and then divided by the total retained earnings from year 1 to year 9. This should help a little and by using different lengths of time periods, you can see if the results are stable.

Thought I’d write a short note to document the reasons for the current liquidity/credit crunch.

1. Lack of risk controls in underwriting: Loans were given to weak credit without documenting income, balance sheets, and without appraisals. These weak credit folks typically obtain ARMs with a low teaser rate for a first few years, but adjust back up very significantly thereafter.
2. Insufficient credit spread to account for potential delinquencies. Aggressive hedge funds drove out the traditional buyers by accepting the low spreads. Lots of cheap money also made that possible.
3. Creative financial engineering also created riskier and riskier structures that end up being rated AAA (e.g. BBB and lower tranches that when put into a new structure, produces some AAA-rated bonds).
4. Points 1 to 3 above were possible because of the housing market boom, specifically, home price appreciation. That allows for refinancing and resulted in fewer delinquencies than historical periods which affected the pricing of risk for models that used “recent historical data”.
5. With the oversupply of homes, the housing prices tanking, “normal” delinquencies rates start to appear.
6. Panic sets in, with re-pricing of MBSes at very low prices (with much higher delinquencies modeled in). Mortgage lending companies were unable to sell their mortgage pools due to doubts in the credit worthiness.
7. Companies that financed their mortgage pools with short-term financing such as repos, start to get margin calls (since their mortgage pools tanked in value when marked to the panic market). Companies without sufficient liquidity declared bankruptcy (e.g. American Home Mortgage).
8. The panic and over-conservatism of lending liquidity, spreads to other markets, e.g. commercial paper.