The Quarterly Report

  • The Quarterly Report
  • Third Quarter 2011
  • Chuck Osborne

“The Value of Knowing How to Find a Value”

I owe a great deal to my parents, which I know is not unusual. The lessons of childhood still ring true to me today. Yes, it is a cliché, but I really do sound like my parents when talking to my children – and I’m ok with that. The positive impact they have had on my life is immeasurable. There are the obvious attributes: my bald head, my blue eyes, and my bad habit of not always finishing a sentence when I am talking – all things I got from my father. My mother had a big influence, too. In fact, she contributed greatly to my investment philosophy. My mother can find values like few others.

My mother, like most women of her generation, was a full-time wife and mother, and she was good at it. She married the man who invented copper wire by stretching a penny as far as he could, so she really had no choice but to become a value-hunter herself. In hindsight it is simply amazing how far Mom could stretch a dollar, and she did it without sacrificing quality. If Mom were 40 years younger she would be teaching the Internet coupon gurus a few things about saving money without sacrificing being well-dressed and eating like kings.

My parents are products of the Great Depression; my father was born in 1929 and my mother in 1931. They learned early on not to waste anything, and they learned the importance of quality and how to take care of things. One of my father’s favorite mantras is, “Never buy anything for temporary use.” Growing up I took my lunch to school, and I was excited when Mom finally let me stop using the metal lunchbox and carry it in a brown paper bag like the cool kids. Unfortunately I was told that I had to bring the bag back home so we could use it the next day, and the next, until it actually wore out. I would wait until my friends weren’t looking and quickly, but carefully, fold the bag and put it in my backpack.

With this foundation it is no wonder I grew up to be a value investor. You see, investment success is largely about having an investment philosophy. There is more than one way to gain investment success, but it is important to select a philosophy that fits who you are at the core. In the wise words of John Wesley, founder of the Methodist Church, “An erroneous view of ourselves naturally leads to numberless errors.”

I have spoken a lot about the investment process in the past, and there is no doubt that having a disciplined process is key to success, but philosophy runs deeper than process. A process can and should change, as one always should be trying to improve the process, and there is no such thing as improvement without some element of change. Your philosophy, on the other hand, should be written in stone. It is the core of what you believe about investing.

Our philosophy: We believe in owning companies, not trading stocks. A stock certificate is nothing more or less than a fractional ownership in a company. We believe this for very important reasons. From an investment decision-making perspective we believe companies have intrinsic value and that this value can be calculated, or, at the very least, accurately estimated. This value does not change quickly, as the actual performance of a company does not change quickly. It may change faster today in our interconnected global economy than it would have a generation ago, but we are still talking about weeks and months, not seconds. Stock prices, however, change in a matter of seconds. This dynamic creates disconnects between the actual value of the company and the price of the company’s stock. Taking advantage of those disconnections by buying stocks when they are selling for less than what the company is worth, and selling stocks when they are selling for more than what the company is worth, is the essence of value investing.

This is different than having a value investing process, or being put in the “value” box by organizations like Morningstar. One can use a value process to actively trade stocks. One can also have a value philosophy and be deemed a growth investor. In fact, the most famous value investor in the world, Warren Buffett, most likely would have been in Morningstar’s “growth” box for much of his career. Another famous value investor, Bill Miller of Legg Mason, was criticized for buying Google immediately after it went public. His explanation for why this was not a contradiction was simple: he believed the company was worth a lot more than what it was selling for at the time. His method for valuing the company got complicated, but philosophically it is very simple, Google was worth more than the price of its stock. That is value investing at its core, even if the world decides to call Google a growth company.

Our philosophy goes beyond just seeking undervalued securities. Owning a company is much different than trading a stock. Ownership entails responsibility:We care about the companies we own. We care about compensation to executives; about long-term strategy and competitive advantage; about being run ethically. I would never describe us as “socially responsible” because that is a loaded title that often connotes a political perspective. We have owned many companies that others may not, including tobacco companies, liquor and beer companies, and gaming companies. However, we do care about ethical management. We have never owned – and unless something changes dramatically in their culture, we will never own – Bank of America. We have refused to invest in so-called ‘payday lenders’ who market uncompetitive loans to people who need cash before payday, even though they looked like bargains during the financial crisis. We vote our clients’ proxies and pay attention to what actually is happening at each company. This is one of the largest differences between investors and traders, and in my opinion it is why we have seen an increase in corporate misbehavior parallel to the increase of trading over investing.

We believe in buying quality.
Value is not about price alone, but the combination of price and quality. I think this is best described in investing as the combination of price and dynamics. Dynamics can be defined in several ways: it can mean a company with growing earnings, or a positive product launch, or simply positive market momentum. For example, our asset allocation process is based on the concept of relative valuation, aka price, and market momentum, aka dynamics.

Price alone does not work, it is the combination. Price + dynamics = value. Why is it so important to have an investment philosophy? When everything is going well and anyone can make money it isn’t, but when times get hard and markets do crazy things in the short term it is important to know what one believes, and to stick to it. My colleague just finished reading Michael Lewis’s The Big Short about a handful of investors who made a fortune when the real estate bubble burst, and he said it was fascinating to see what these few individuals went through. I jumped to a conclusion I think most people would – that these individuals who were correct about the collapse of the mortgage market must have been jubilant since they made so much money. He said no, it almost ruined them. When we hear these stories of big investors making all this money we tend to only think about the end and overlook the means.

We often believe these windfall investors had some kind of magical power, or unethical inside knowledge, to have made their investment at the perfect time. That does not happen. Ralph Wanger, the famous investor who specialized in investing in small companies, once said you must accept that a stock price will go down when you buy it, and that it will go up after you sell it. Therefore don’t beat yourself up about timing, but instead concentrate on what happens over the entire period you own it. That is easier said than done. Steve Eisman, one of the money managers who bet against the real estate market, first turned negative on real estate in 1997 when he was an analyst at Oppenheimer. He had to wait ten years for his conviction to pay off. Some of the characters in the book almost lost everything before the crash, when they were seeing losses on all their positions and clients therefore were demanding their money back. In times like that, having a good process is not enough. You need faith, and faith comes from a deeper place; it comes from a belief system, or your philosophy.

Not all philosophies are created equal. Many amateur investors will say their philosophy is “to never lose money,” or “to make 20 percent per year.” These are not philosophies, they are goals, or in these extreme examples, merely wishes. An investment philosophy can lead to great results, but it is not about the results. A successful investment philosophy must be based on who you are as an investor, because all philosophies will be tested in the market and keeping the faith during such times often is the key to success. They also must be based on sound investment reasoning.

Our philosophy at Iron Capital is greatly influenced by who I am. I am my parents’ son, influenced my entire life by people who believed deeply in wasting nothing, and getting the best price on the highest quality. Value investing – price and dynamics – fits into that belief system nicely. Our philosophy is also based on studying the careers and philosophies of great investors, from Benjamin Graham and Philip Fisher to Warren Buffett, Peter Lynch, Ralph Wanger, Bill Miller, Joel Greenblatt, Sir John Templeton, Jon Ness, and more. Each of these investors has a different way of describing his process and philosophy but, as with any discipline, they share a core set of fundamentals which can be summarized as the combination of price and dynamics. Some may emphasize one over the other, but in the end it takes both.

If what I am suggesting is true, that all successful investors have the same basic philosophy, then why wouldn’t everyone simply copy it, which ultimately would lead to it no longer working? Joel Greenblatt explains it well in his book, The Little Blue Book That Beats the Market, when he says that value investing always works in the long-term precisely because it does not always work in the short-term. There always have been and always will be periods of time when value investing does not work because the market is ignoring valuations. This usually happens in bubbles, but also has occurred over the past year as the geo-political crisis has driven the market more than the underlying value of the companies whose stocks constitute the market.

Times like this make it difficult to be a value investor. However, this too shall pass. Buying things for less than they are really worth is the recipe for longterm success. I remember my father coming home from work on days when my mother had been shopping. She would greet him by saying, “Come see all the money I saved you.” Some days I feel the same way. I wish I could invite every client into our conference room to show them all the money we have saved through the bargains out there today. My parents are comfortably retired in part because of all that money Mom saved, and is still saving. Old habits die hard.

Investment success is not complicated, but simple and easy are not the same thing. It takes discipline, patience, and a well-defined process. All of those things are made easier when you have a carefully developed philosophy, one based on sound investment principles and knowledge of who you are. I am my parents’ son, always searching for quality at the right price.

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Charles E. Osborne, CFA, Managing Director

Review of Economy

All eyes are on Europe. Our economy continues the slow growth. It feels like a recession but it technically is not. The one thing that could change this is an escalation in the financial crisis in Europe. If they are unable to find an agreeable fix to their debt situation, then Europe will most probably lead the world into another global recession.

Unemployment remains over 9% at 9.1% and job creation is practically non-existent. High unemployment is going to be with us for a while, and it is likely to only get worse. Unemployment among the young is worse as teenagers face an unemployment rate of 24.6%. European type policies will lead to European type results. This is our new normal.

Review of Market

The S&P 500 was down 13.87% and that was better than most other market measures. The debt ceiling debate followed by the S&P downgrade of U.S. Treasuries started a worldwide panic. Just when it seemed like it was over and markets were going to come back we were reminded that Europeans have yet to deal with their debt situation.

Bonds rallied in the quarter along with renewed global worries about sovereign debt in Europe. Even after being downgraded, U.S. treasuries remain the short-term shelter of choice for the “risk-on, risk-off” traders. The Barclays U.S. Aggregate Bond Index was up 3.82% for the quarter.

International markets were the worst place to be, as the European crisis is back in the forefront. The MSCI EAFE was down 18.95% for the quarter. Europe remains the most uncertain market as they are now ground zero for this financial crisis.

Market Forecast

Our outlook has turned negative. We still believe corporate earnings will continue to grow and provide for some upside surprises. Volatility will remain high and there will be big positive days and weeks. However, the crisis in Europe is growing worse and as long as that is hanging over the global economy the overall market trend will be negative.

U.S. large cap stocks remain the most attractive place to be and will likely lose less than small caps and international stocks.

Bonds look troubling over the long haul but will likely remain a safe haven as this crisis plays out. Commodities were approaching bubble levels in our opinion and with the crisis all but certainly diminishing any inflation worries we see their prices falling.

The biggest risk to our outlook is that Europe does somehow get everyone to fall in line and the market pops on this news. We believe that is a small probability and we would rather risk making less in an up market than losing more in a down market.