Sunday, 18 November 2012

Philip Fisher on Bonds

Philip Fisher is most famous for his stock picking ability, especially in growth companies; most of his book "Common Stocks and Uncommon Profits" is also on the subject of picking enterprises with long-term growth prospects. However, I find his views on debt/bond investing extremely interesting and they should be on every long term investor's mind.The following blurb is from the end of chapter 1:

"As already explained, our laws, and more importantly our accepted beliefs of what should be done in a depression, make one of two courses seem inevitable. Either business will remain good, in which event outstanding stocks will continue to out-perform bonds, or a significant recession will occur. If this happens, bonds should temporarily out-perform the best stocks, but a train of major deficit-producing actions will then be triggered that will cause another major decline in the true purchasing power of bond-type investments. It is almost certain that a depression will produce further major inflation; the extreme difficulty of determining when in such a disturbing period bonds should be sold makes me believe that securities of this type are, in our complex economy, primarily suited either to banks, insurance companies and other institutions that have dollar obligations to offset against them, or to individuals with short-term objectives. They do not provide for sufficient gain to the long-term investor to offset this probability of further depreciation in purchasing power."

Mind you these views were written in the late 1950's when inflation and interest rates were drastically different so lets note some fundamental changes that have happened since and see if his views still apply.

1. Central bankers, even of developed nations were yet to gain credibility on their ability to control inflation. Inflation has been under control for developed markets for the most part since early 1980's.

Although inflation levels are low despite the easing efforts of central bankers, bond yields are not providing much margin for real returns. Investors currently purchasing 10 year government securities are locking in 2% annual return and 0% real return at the current level of inflation. Obviously investors in such securities are still individuals with short-term objectives hoping for another short-term reduction in yields. The risk of higher inflation is obviously still real.

2. Some could argue that recessions have become longer or more severe, especially considering two decades of persistent deflation in Japan and the Great Recession of 2008.

This point is a bit tougher to address since I'm not an expert on the Japanese bust or an economist. I'm not sure of the role that fiscal and monetary policy decisions have played in the Japanese economy but it is clear that other major economies are not suffering from the same problems or policies. Growth has been positive in most developed and developing nations since 2009 with the exception of a few European economies. The credit expansion leading up to the 2008 burst has certainly made it tougher to re-inflate economies out of the slowdown. However even during these extremely tough conditions with many overhangs on individuals and businesses, growth has managed to crawl back to the positive range.

3. Austerity (fiscal restraint) is being considered in many European nations as an alternative method of dealing with recessions.

I suppose this is the one change that if it does start to receive broad support from central bankers, could nullify most of the factors that make bonds unattractive as long-term investments. Two key results of such policies would include 1) corporate profits will suffer from longer periods of negative profit growth, meaning the bust period of the business cycle will be longer 2) no persistent budget deficit that needs inflation, meaning if bond yields offer high enough yields, they could be realized as decent real returns.

Obviously even with persistent deflation or the adoption of austerity, a successful growth company will always outperform bonds; picking growth businesses in such an environment could be much tougher though.

Wednesday, 14 November 2012

Margin of Safety in a real life example - Marvell Technology

Many of us have heard the stories that Buffet can reach an investment decision after a 5 minute look at a company's business and financials. After trying to replicate this exercise tonight and spending an awful lot more time than 5 minutes I've learned a) why Buffet doesn't invest in technology companies b) I'm no Buffet.

Marvell Technologies has been a hot pick for many investors and fund managers of late and despite it's incredibly cheap valuation, it continues to get cheaper. David Einhorn, Joel Greenbalt, and David Dreman (one of the first investment books I read was by Mr. Dreman) are some of the investment managers disclosing new/additional positions in Q3 and the stock is down more than 20% from the lowest possible price they could have bought it for in Q3 - it's not a shabby place to be in when you can buy a stock for more than 20% (most likely 30%-40%) discount than some of the best investors of our time.

So what is the case for Marvell - luckily many others have done a great job of covering the opportunity on and

Will David Einhorn Buy Marvell Again As Price Drops Further?

Stocks Trading For Less Than David Einhorn Paid For Them

Let me summarize their analysis for you - 
MRVL Price: $7.38
Net Current Assets: $3.50 (using 50% inventory value, which is a small part of NCA anyways)
Price - Cash: $3.88
2011 Earnings - $0.99
Projected 2012 Earnings - $1.15-$1.25
Without getting too far ahead of ourselves with 2013 earnings estimates (which are higher than 2012). You are paying under 4x earnings. This should provide you with plenty of safety margin, right?
Cash is cash!
The management has been extremely aggressive in preserving SH value and returning cash to shareholders - share repurchases of 16% last year and a newly instilled dividend of roughly 25% of earnings. If even after these efforts the market doesn't want to treat cash as cash, well then you shouldn't have any problem sitting there and watching your EPS and dividends grow.

My Concern
Sadly, that is where the margin of safety ends, at least for me (someone that doesn't understand the semiconductor market).

Marvell is in the business of designing semiconductors and is not a manufacturer. Their future earnings are dependent on whether their intellectual property is still relevant in the market place. They have a pretty broad product line and their chips are used in devices for data storage, enterprise-class Ethernet data switching, Ethernet physical-layer transceivers, handheld cellular, Ethernet-based wireless networking, personal area networking, Ethernet-based PC connectivity, control plane communications controllers, video-image processing and power management solutions. HDD memory is one of their biggest end-use products and the industry is cyclical and has undergone significant consolidation in the manufacturer space. Western Digital and Toshiba are their two largest customers representing 23% and 10% of revenue respectively.

At this point, I have no knowledge of the HDD memory market - I don't have the answer to what differentiates Marvell's product from it's competitors, what threat substitute products pose to HDD memory, how the business cycle affects designers and manufacturers, how the supply chain of the industry interacts, what the long-run trend is for HDD memory, and endless other relevant questions.

And unfortunately my perceived margin of safety from a bargain valuation has disappeared. I could go with the layman's reasoning that Mr. Einhorn, Greenbalt, or Dreman must have done their homework, or the company has been consistently increasing revenues over the last decade and will continue to do so, or some rhetoric about the fact that even if the company's earnings fall by 50%, well you still have a stock trading at around 8x earnings. But the point of a margin of safety is so that you can sleep worry-free at night and until you fully understand a business, you will not (or should not) be able to do so!

So until I have the time to revisit and understand this industry, I will have to pass up on attractive valuations such as Marvell at $7.36.

Thursday, 1 November 2012

Buffet on EBITDA

From 2002 Berkshire Hathaway Annual Report
Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?

Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to.  Enron’s descriptions of certain transactions still baffle me.

Finally, be suspicious of companies that trumpet earnings projections and growth expectations.  Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).