Monday, December 31, 2012

2012-Grown From an Infant to a Baby

In the world of value investing, there is little doubt that I was the  equivalence of an infant just coming out of the uterus at the beginning of 2012 even though I was 26 years old already. Ignorant and curious, I embarked on the second year of my journey in value investing. I was ridiculously more confident in January 2012 than I am now at the end of 2012. Looking back, I was trying hard to learn how to sprint before I knew how to walk. As Charlie Munger put it, I was the "one legged man in the ass-kicking competition."

Maybe I was lucky enough that there are quite a few one-legged folks in the ass-kicking competition or maybe I've had the beginner's luck all year. My portfolio somehow returned 31% during 2012, compared to S&P 500's 13.4% return, Dow's 7.3% return and Nasdaq's 15.9% return. As it was during 2011, there were plenty of mistakes and a great deal of lessons learned thereof thankfully. I had the fortune to learn from my own mistakes without suffering badly from them. I also had the privilege to learn from the best value investors-Warren Buffett, Charlie Munger, Arnold Van Den Berg and Michael Shearn. It is a year full of wonderful learning opportunities and I am very grateful for these great opportunities. There are some comfort to be gleaned from my successful investment such as Bank of America, JP Morgan (when it dropped to $31 when the trading loss was revealed), AAR Corporation, General Motor and a homebuilder ETF.  But in my opinion, learning from mistakes is a much better way to get better at investing. Below is a list of all the mistakes I've made this year:

1. Buying value traps: This is the mistake that I've suffered from considerably this year. I've bought almost all notorious value traps this year and 2011 including Research In Motion, Nokia, First Solar and Radio Shack. Now that I think about the whole thing about buying value traps, it is like buying a ticket at a deeply discounted price to get on board of the already sinking Titanic. Not until a few months ago did I realize that a cheap price combined with the fear of missing our and the psychological bias of anchoring past high prices is one of the most powerful forces that can suck value investors into value traps. These value traps are often common stocks on troubled companies, some of which are considered legendary like Nokia and Radio Shack. A seemingly simple but sophisticated in actuality solution to avoid value traps is offered by Charlie Munger when he answered a shareholder's question on how to value a troubled business-it's not going to worth much. Ans Warren Buffett added that they've learned to stay away from troubled companies, the reason of which he had mentioned numerous times in his writings- When a management with a reputation for brilliance tackles a business with areputation for bad economics, it is the reputation of the business that remains intact. If a value investor ever decides to make cigar butts investment, he or she should read the following excellent articles published by

2. Following other's ideas without thorough research. I've learned this the hard way. Similar to a healthy person asking a money-driven quack for suggestions, except that I went above and beyond human's stupidity and actually locked in a two year subscription fee for a "professional" investing services in 2011. The editors of this service call them value investors but constantly making statements like "we are riding the momentum of this stock because the short term chart looks good" or "the volatility of this stock makes it not suitable for our value-oriented service." I was greedy and foolish enough to follow the stock recommendations of this service in a few instances during 2011 and early 2012. The result? I lost more than 30% on Greenbrier Companies (bought at the recommended price of $25 and sold at around $17), more than 20% on Verifone Company, to name a few. Luckily as I kept accumulating more knowledge and worldly wisdom, I realized that this service is anything but value investing related and stopped following it during the first few months of 2012. It makes me uneasy thinking about how many services like this (charging a subscription fee and not aligning their own financial interests with the subscriber's own financial interest. i.e, if the stocks they recommended lost money, the editors still got paid and they would find a way to make it not a big deal. It's like heads I lose, tails you win.)

3. A corollary to the second lesson, which was shared by Mr. Michael Shearn, is never copying others' ideas without thorough research. A lot of part-time value investors simply do not have enough time to research every single idea so they go around and look for the filings of guru investors and pick and choose from guru's investment ideas. This seemingly logical approach suffers from a major drawback in my opinion.  Not all ideas, even from the best value investors, are exempt from mistakes. In fact, most guru investors make big money on a few best ideas and they occasionally make very bad decisions. David Einhorn bought Best Buy and Dell, Whitney Tilson covered his short on Netflix when Netflix was trading near its peak, many other famous value investors bought HPQ, JC Penny, Radio Shack and etc. Value traps are dangerous and sometimes even the best investors fall for them. Combined with the human nature of taking a cognitive shortcut (system 1) and the psychological bias of anchoring (especially the high price in the the past), it is not hard to foresee many small investors blindly follow some famous value investors, only to regret later. My mistake this year in this area is the purchase of Meade Instrument. My only thesis in investing in this stock is that Paul Sonkin sits on the board of this company and he owned stocks of Meade Instrument. It was a micro cap company that is extremely illiquid and the company was facing some major issues in profit margin. Again, I was lucky enough to get out before things got out of control which resulted a more than 50% drop of the stock price. The reason I exited my position early in the game was because as I was reading the most recent 10K and 10Qs of Meade Instruments, I noticed that management had admitted that they had run into some serious problems and they could not see things get better any time soon. My logic told me to exit but there is a little man in my head screaming "don't quit on Meade, you've got Paul Sonkin on your back." To date, this mistake still reminds me of Warren Buffett famous saying :"After ending our corporate marriage to Hochschild Kohn, I had memories like those of the husband in the country song, 'My Wife Ran Away with My Best Friend and I Still Miss Him a Lot.'"

4. The mistake of omission. It is one thing to hear Warren Buffett talk about his mistakes of sucking on one's thumbs when one knew enough to act but for one reason or another did not react, it is another thing to actually sucking on one's thumbs and simultaneously shut down system 2 so that you don't have to react. The reason for this frequent mistake by value investors, in my opinion, is a combination of the sloth and weak will power. For instance, back in March Youku and Tudou announced a merger which would give Youku 71% control of the newly formed entity. The deal is for $ 1 billion (announced). Tudou was trading in a range between $38 and $42.85 after open, with outstanding shares of 28.35 million, market cap would be 1.19 billion at $42 and 1.08 billion at $38, both exceeded the announced amount. The fair value of Tudou’s ADR is $35.27 ($1 billion divided by 28.35millon shares O/S). I saw an almost guaranteed return of approximately $4 per share if I shorted TUDO at $39 per share. I did not act on this because I was too lazy to call my broker. Another costly example is when EDU (a leading Chinese educational institution) was falling 34% based on a rumor that SEC's gonna investigate of it's accounting for VIE, I should have bought in heavily because I know it's a good company with super management, I knew their accounting for VIE is not a problem, I knew the market overreacted so much that the price dropped more than 50% within 2 days. I did not act because I did not realize that opportunities like this are rare and the opportunity cost for not acting promptly is very high. To combat the psychologically wired tendency of sloth, a value investor needs to evoke the most powerful force from his subconscious mind and focus on the opportunity. Compound the opportunity cost for 50 years, write it out and think about how much you can do with the money you could've made if you reacted promptly and decisively, no matter how tired you are, you will be more likely to act. 

5. Use of leverage:  I was way too confident about my ability to predict the market and about my ability to discovery multi-baggers. Not only did I borrow money, but also I entered into triple short positions against the Russel Small Cap index. The recommendation of buying the triple short ETF was given by the value investing service I mentioned in mistake 2 and he never admitted it was his mistake that all his subscribers lost money. He made some right calls during the volatile times during 2011 and I naively thought he had the crystal ball. Well, it looks like in the end, he is no more than a lucky coin flippers that survived after 30 days of the coin flipping competition described in Warren Buffett's 1984 article. Too bad I found out about this more than a year later. 

6. Making bad decisions under the influence of euphoria: This is a mistake I made in late 2011 and early 2012. Even though it was a short sale, it could easily be a long position as well.I wish I've heard Warren Buffett earlier on shorting: If a overvalued stock is selling at X multiples, how do you know it wouldn't sell at 2X multiples? I shorted Priceline when it was selling at $480 and my only reason was that I thought it could go down to $300. I didn't even look at the trailing EPS and forward EPS, in fact, I didn't even do any other research on Priceline because I thought how could a share of an online travel agency be more expensive than a share of Apple?   Another psychological factor that had an impact on me is that my portfolio was doing very well mostly due to extremely good luck. I got carried away and entered into the short position without any thorough analysis even though Priceline was merely selling at about 16x 2012 earnings as a fabulous growth stock. 

I know I'll make more mistakes and I welcome them along the way. I also know I'll probably make the same mistakes because some of them are just due to human nature. I am a Chinese and my ancestors have taught us invaluable lessons on how to deal with mistakes. I'd like to share with fellow value investors my favorite ones:

He who covers up his mistakes intends to make some more. 

Success in the end erases all the mistakes along the way.

Be not ashamed of mistakes and thus make them crimes 

 Happy Investing. 


Saturday, December 15, 2012

Assess the Quality of Management-Summary of Chapter 8 Investment Checklist

Note: Most of the summary below are derived from Mr. Michael Shearn's book "The Investment Checklist". You can find the information on this book from I will not personally take any credits for the summary below. 

Assess the competence of management.

John Mackey of WFM has coined the term conscious capitalism to describe business designed to benefit all of their stakeholders, such as customers, employees, investors and suppliers. Robert Wilmers, CEO of M&T Bank, lived a business philosophy that could be a primer for sound banking: "know your markets and employees, watch credit quality relentlessly, don't gamble with interest rates, and focus on serving your community."

I. Does the management team improve its operations day-to-day or does it use a strategic plan to conduct its business?

  • Most successful businesses are built on hundreds of small decisions, instead of on one well-formulated strategic plan. They build their business day by day, focusing on customer needs and letting these customer needs shape the direction of their businesses. 
  • Another common theme among businesses that improve day by day is that they operate on the premise that it is best to repeatedly launch a product or service with a limited number of its customers so that it can use customer reactions and feedback to modify it. 
  • You need to determine if the management team you are investing in works on proving a concept before investing a lot of capital in it or whether it prefers to put a lot of money in all at once hoping for a big pay off. 
  • Strategic plans fail because they often shut out other opportunities. When an opportunity comes up and it does not fit into the strategic plan of a business, then the management team will likely pass it up. The truth is that most management teams often stumble upon their best ideas. 
  • The strategic plans that are most prone to failure are those that have an overly narrow focus, such as those that set a financial target. What happens in most of these cases is that when the CEO focuses on a specific financial target, they neglect other areas or take on more risk. GE's 29% market share goal in 2003 make them burn billions of dollars and launch new models in too many market segments which they can't adapt quickly enough to make money. Continental Bank in 1976 was the 8th largest bank and they laid out goals to become the largest lenders. They started aggressively pursuing borrowers and took more volatile foreign deposits, loosened lending criteria and relaxed documentation standards. It was bailed out in 1984. 
2. Does the business value its employees? Check 

3. Track management's record in share repurchases, disregarding shares repurchased to offset options dilution. 

4. Positive and negative traits of management:
  • Public interviews are among the best sources for real insights, as are in-depth articles written about the managers. 
  • Whether they have remained in the same industry for a long period of time or if they jump from industry to industry. 
  • Managers who are truly passionate about their business have less time for outside social engagements. 
  • Often times, you can infer the motivation of managers by the number of large social or charity events they attend. 
  • Can you identify a moment of integrity for the manager?
  • You gain more insight into management when conditions are adverse than you do when circumstances are ideal. 
  • The best managers are those who, during adverse conditions such as the one in 2007, disclose more information so their shareholders could better understand the operations of the business and what the management team was doing to cope with the difficult economic situation. 
  • The best managers also quickly and openly communicate how they are thinking about the problems and outline how they are going to solve it. Robert Silberman of Strayer Education disclosed that new student enrollment had dropped 20% in the 2010 winter term, the largest drop that Silberman had seen in his tenure. Even though he did not know the exact reasons, he reported this negative news to shareholder the moment he had the information, and then he held a special conference call first thing in the next morning to answer questions and explained how he was reacting to it. Similarly, Jamie Dimon of JP Morgan disclosed very honestly right after the CDS trading loss in 2012 and reacted promptly. 
  • Whether the tone of the annual report is consistent with the business performance, for example, if the business had a mediocre or horrible year and the annual report started with the positive things, it's a red flag. 
  • If managers remove the scripted sessions from the earnings conference call, this is a positive sign because this indicates that managers want to address shareholder questions or concerns, such as Penn National Gaming's CEO Peter Carlino. 
  • Most of the time, there's no proprietary information regarding marketing, historical merger and acquisitions, personnel, or legal issues. If the unanswered questions have to do with specific financial guidance, that is okay. 
  • Does the manager use double speak (i.e inconsistency). 

Assess the Quality of Management-Summary of Chapter 7 Investment Checklist

Note: Most of the summary below are derived from Mr. Michael Shearn's book "The Investment Checklist". You can find the information on this book from I will not personally take any credits for the summary below. 

Great management can create tremendous value for the business as well as shareholders as long as the business itself is not in permanent decline (think of Warren Buffett and Berkshire Hathaway's Textile operation). Bad management can definitely destroy a great business (Enron, Worldcom).

To Appreciate how essential sound management is to the long-term success of a business, consider that top managers typically:

  • Are responsible for designing the business. 
  • Determine the future growth rate of a business. 
  • Are in charge of choosing the right people and providing the right environment for these people to perform at their highest potential. 
  • Determine how to allocate the firm's capital. 

It is best to evaluate a management team over time. Most errors in assessing managers are made when you try to judge their character quickly or when you see only what you want to see and ignore flaws or warning signs. The more familiar you are with how managers act under different types of circumstances, the better you are able to predict their future actions.

Gather information about managers through Factiva or Lexis Nexis, Wall Street Transcript or the Charlie Rose show etc. Pay particular attention to what motivates the manager and why they are where they are professionally. As you read articles, look for evidence in four basis areas: passion, honesty, transparency, and competence. Look for the ability of a manager to recognize and learn from mistakes and also try to see how quickly they are able to recover from mistakes.

I. What types of manager is leading the company?

  • Owner Operator (1)-Ideal, founder or at least long time partner of business. Dave and Sherry Gold of 99Cents Only Stores, Joe Mansueto Founder or Morningstar, John Mackey, Cofounder of Whole Foods market. 
  • Owner Operator (2)- Also passionate about the business but typically more interested in his or her own personal benefits. These managers typically receive higher compensation packages than OO1. Leslie Wexner, founder of the Limited Brands (owner of Victoria Secrets)
  • Owner Operator (3)- Primarily run the business for personal benefit and do not take shareholders's interest into consideration. You can identify these types of managers by viewing the Related-Party-Transaction found in the company's proxy statement, where you might find such items as personal use of company aircraft, estate planning, personal or home security, and real estate that is owned by the CEO and then leased to the business.  Be Careful with these managers and pay attention to their long term track record in terms of creating value for shareholders. 
  • Long-Tenured (1)- Been with the business for at least 3 years and promoted from within. Risk is they are the wrong manager for the position. (e.g a CFO or COO may not be a good CEO, such as Kevin Rollins of Dell in 2004, Kevin was COO of Dell but led Dell to the wrong direction). 
  • Long-Tenured (2)- Been with the business for a long time but joined the business from the same industry. 
  • Hired Hand (1)-Jump from business to business in a related industry. Tend to make short-term decisions and most of them are cost cutters. 
  • Hired Hand (2)-Join from a completely different industry and typically has no experience with the customer base? 

As you move down from OO to HH, the less information you will have and the more risk you are taking on. There are some industries where specialized knowledge of the business is especially critical : for example, pharmaceuticals, chemicals, and insurance. It is difficult for an outsider to successfully manage these types of businesses.

II. Management Characters:

1. Lions or Hyenas (Lions hunt together while hyenas group hunt only hunting is easy). Hyena characters include:

  • The manager value people more highly because of power, influence, or what they can do for them. 
  • The mangers consider themselves to be better than those around them.
  • They are nice to people that they consider to be important, but disrespectful to others whom they consider beneath them. 
  • They think short-term and just want to win the game. 
2. How did the manager rise to lead the business:

  • Build a 10 year chronicle. 
  • Does the manager have any operation background or just financial background? Ideally you want a CEO that has some operational background. Merck's greatest return came from the leadership of Roy Vagelos who was a scientist and worked in Merck's research department before ascending to CEO. GM's best year was with Harlow Curtice who was involved in sales and designing of GM's car. 
  • What is the managers track record in operating a business? 

III.Management Compensation:

1. Look for CEOs who have low salaries and high stock ownership. Robert Kierlin, founder of Fastenal and his successor as CEO, Willard Oberton. Kierlin earned $63,000 in 2001 but owned 5.87% of the business. Dave Gold was paid $62,000 and owned 40% of business. Joe Mansueto of Morningstar. Russel Gerdin of Heartland Express.

2. Be wary of mangers who hold stock options because stock options often reward managers for things that they are not responsible for such as broad economic gains or industry growth.

3. Be wary of companies that offer Mega-Equity grants to CEOs or other managers.

4. Look for managers who don't monopolize stock options but offer options to all employees: You need to determine if the stock option plan of a company is geared for top executives only or widely distributed to employees as well. Go to proxy statement and find the list of total number of options awarded to the top 5 executive officers and add them up and find the total number of options awarded to all employees. Calculate the %. Exemplary management such as Whole Foods Market's all top management only get 8% of all stock grants.

5. Look for compensation plans that reward long-term performance:

  • Exxon Mobile-half of executive officer's restricted stock vest over 5 years and the other half must be held for 10 years until retirement, whichever is greater. 
  • The ideal compensation structures are those that award for long term creation factors, such as operating income or book value per share,  or economic value created, instead of stock price. 
  • Expeditor International bases its bonuses on operating income by paying its top executives from a pool of 10% of pre-bonus operating income, furthermore, the compensation system is also based on cumulative operating income so if any operating losses are incurred then these losses must be recovered before the executive team can earn a % of of operating profits, and these bonuses make up the majority of executive officer compensation. 
  • Reckitt Benckiser Group links performance based compensation for all executive officers to economic value added, measuring net sales growth, profit after taxes, and net working capital. The long-term incentive program requires that EPS has to grow by 30% over 3 years for the options and the shares to fully vest. 
  • Markel Insurance uses growth in book value per share over a five-year measurement period to base its total compensation package. 
6. Look for restricted stock awards because they reward long term value creation and the longer the vesting period for RSAs and RSUs, the better.

7. A big plus if a company requires stock ownership.

8. Beware of companies that use compensation consultants.

9. A red flag is raised when you find employment contracts in the proxy statement that guarantee that a manager will be paid a certain amount in total cash compensation.

10. Has management been buying or selling the stocks which represent a meaningful ownership %?

  • If you see a stock whose price is continually dropping yet insiders are selling, this is a warning sign. 
  • A cluster of senior executives sell a considerable amount of stocks during a short amount of time (a quarter or two quarters)
  • Aubrey McClendon of Chesapeake has to sell 94% of his stocks for $569 million because of margin call. 

Pillars of Fundamental Short Selling

Franchises have extensive potential potential for financial stumbles; A short seller should look for types of business that eat money-financial services and real estate.

I. Financial statements checklist:
1. One should start with the most updated balance sheet, looking for bogus asset or assets for which the market value is less than the balance-sheet value. Examples are:

  • securities not marked to market
  • real estate with inflated values
  • inventories with obsolete products
  • receivables that have been booked too aggressively
  • receivables with loss provisions too low
  • bad loans
  • Fuzzy, unbankable assets.
2. The AR and Inventory should be tested by looking at the change in AR and Inventory against changes in sales and CGS. For AR, note that the surge in AR may be simply related to acquisition.

3. Check for deferred charges (prepaid advertising, deferred commissions, etc.

4. Check for goodwill and intangibles to see if the company has overpaid for an acquisition or is failing to expense drilling costs or software development costs.

5. Check accumulated depreciation to see if AD drops when gross PP&E rises.

6. What are all nonrecurring gains? Is the company including them in operating income?

II Ratio Analysis

Long term debt to equity
Total debt to total capital
Total debt to equity

III Checklist of Proxy Questions

1. Are executives paid exorbitant salaries? Look at compensation relative to company earnings.
2. How is the bonus? Is the bonus tied to extraordinary efforts, or is it just for doing the job?
3. Does the company pay a % of percentage of pretax profits to the primary officers in the form of bonuses?
4. Stock grants vs stock options vs SARs-SARs are the most generous for the executives, followed by grants.
5. Does the company have an unusual severance pay contract, especially in case of merger or buy-out?

Why Short Sellers Fail?

1.Sloth: The first and biggest reason for failure in stock selection on either the short side or the long side is too little work. Particularly treacherous on the short side, the absence of a carefully reasoned case can have painful consequences. Usually, sloth is prompted by shorting someone else's idea. If, in moments of greed for new ideas, short sellers short stocks without the normal painstaking file-building, spreadsheet-accumulation, brain crunching work, the stocks will always go up quickly and scare the hell out of chastised sellers.
2. Pride/Hubris. Hubris is manifest in two primary analytic errors: (1) the sudden use of rigid formulas (2) the short sale of good companies. The first error is most common in situations where the short seller apply the same formula or spreadsheet or valuation methodology to a group of stocks without thinking because they have been successful in the past for this group of stocks. "This time is no different. " If they have seen 6 S&Ls go under with the same profile, it is easy to short the seventh without worry. The second hubris error is the good-company mistake. Most professionals have this one branded in fire someplace on their body; most amateurs do not realize that it is why they do not like short stocks anymore. Both Julian Robertson and Jim Chanos identified this phenomenon as the major short error. Shorting a good company is always risky. A good company is a company with smart management who pay attention to business trends and customers and who have financial statements reflecting that unlikely blend. If the stock is sold short simply because of valuation, the market immediately shows how high the earnings multiple can go. If a stock is shorted because of perceived temporary problems and because of excessive valuation, good management can fix the problems fast. Jim Chanos talked about shorting Fed Ex. He said Fed Ex was overvalued relative to earnings expectations. The company had temporary problems with Zapmail and new competitors that were causing operating margin problems.  The company told him the problem was solvable but Jim Chanos did not believe them. When Fed Ex reported the quarter, it was a turn around, and the stock ran up 40%.
3. Timing: Underestimate the insanity of the public, especially during a bull market. Investor ebullience can keep a stock price up for years in spite of no earnings, even no product. The second reason for the timing problem is the ability of investment banks to sell another round of financing despite a seriously flawed corporate business plan. Continued flows of financing can keep a dead company on a respirator for years. In the same vein, some short sales fail because the seller underestimated the ability of a leveraged company to grow its way out of the problem-to grow top line faster than the debt capitalization. .

4. If a stock you are thinking of shorting is affected by commodity prices, track the underlying commodity price. If you are short a chicken stock, make sure you understand the chicken cycle, the impact of a drought or an ice store, and corn prices. It is easier to find fundamental balance sheet flaws than to trade grain prices, unless you work on the CBT. Sometimes, however, the presence of large inventory of a commodity on a balance sheet can be a  clue that the company is either speculating rather than attending to business or has lost control inventories.

5. Be careful shorting technology stocks because normal trail signs do not usually apply.

6. Short a stock with small float.

7. Pigheadedness: If something changes, cover. It is not you against them: it is you against you.

8. Quotes from famous short sellers:
i. "The mistake is always shorting the company that's not that bad".
ii."The biggest mistake we've made are where we've seen a company that is overstating earnings but where the internal engine of the business is still strong.
iii. "You can hide disgusting accounting practices with growth for a very long time.

Friday, December 14, 2012

A Few Thoughts on Industry Obsolescence Short

When a major, industry-wide change occurs that negative impact the industry, money can be made by taking a position in a group of stocks clustered around a theme. The analysis should start with tracking key industry metrics for individual companies in the industry.

Taking the Banks and S&L in Arizona back in the late 1980s as an example, when Arizonna's real estate is collapsing, just like when oil price and real estate price in Texas was collapsing, banks and S&L often get hit the most. Short sellers should compare total value of equity as % of total assets and track the make up of loan portfolios. Short sellers should also track the Real Estate Nonperforming Assets against Loan-Loss Reserves. If the ratio of total reserves to Nonperforming assets is declining, the Banks are very likely to be in trouble.

Short Thesis Summary for Troubled Company

During a period of prosperity and economic expansion, the companies that cannot earn a respectable living are left no recourse but to sell out or restructure if the level of the stock price aggravates shareholders or if a raider notes the underlying assets. 3 Categories of opportunities appear in Bull Market:

1. The restructured and heavily indebted company.
2. The "For Sale" but not sold company.
3. The company with deteriorating earnings that attempts to create the appearance of health with sale of assets.

These troubled companies could give you a lot of headache though because very often, Wall Street and other bulls will come out with rumors that someone will buy the troubled companies for more than the stock worth. Some companies may indeed buy the stocks in those companies so the ride can be very volatile. Like Charlie Munger once said, it's not worth that much irritation in life. This is a category that I think even though can be rewarding in the end, may not be a good exercise considering all the possible pains.

Short Framework Applied to Integrated Resources

Company Description: Integrated Resources was a marginal company ( a company has shaky financials, bad management and a history of aggressive but often poorly executed business strategies) that derives its revenue from 3 areas: Life insurance companies, Direct Participation Investment Programs, and Money Management. 

I. Short Sale Categories and Characteristics (There are some overlap):

1. Integrated Resources could be affected in a significant way by changing external events, in this case, the Tax Reform Act of 1986. 

2.Greedy and shoddy management:
i.  Executives were related-brothers. 
ii. Executives earned over 15 million when the company earned 49.8 million in 1986. 
iii.The company even paid medical cost not covered by insurance policies. 
iv. Creative stock bonus incentive plan: When granted stock option, they paid 5% in cash and the remaining balance in installment over the vesting period. 

3. Ugly balance sheet and Accounting Gimmickry:
i. Equity as a % of assets dropped from 20% to 10% (1986 10K). Eroding equity capital affects bargaining and credit standing in the market. 
ii. Integrated booked revenues from future rental proceeds and proceeds realized on sale of property up front when it closed the partnership. These are booked in deferred fees and contract rights. 
iii. Prepaid and acquisition cost up more than 100% with no explanation. 

4. Shift in business strategy: In 1987, Integrated decided to change the product emphasis to income-producing partnerships, variable annuities and money management. 

II Research the Short Candidates and Track Operating Metrics:
1. Q1 1987 income from operations down and cash flow continued to deteriorate. 
2. Q3 cash burn was ameliorated by long term debt and short term debt financing. Shareholder's equity as a % of asset is down to 8.6%. 
3. 1987 10K had a particular interesting footnote: A change in amortization of prepaid acquisition costs in the 4th quarter added $0.97 to earnings. The change was not booked as an extraordinary item. 
4. Also booked a gain from termination of a pension plan. 
5.Q1 1988: Pretax income was down, interest expense was up. The company will continue to require additional funds from sources other than operations. AP was up 270 million to 426 million in just 3 months. Drexel Burnman Lampert helped Integrated Resources with 100 million senior notes. 
6. Integrated resources owned 2 insurance companies: Integrated Resources Life and Capitol Life. The insurance subs, in turn, owned a fair amount of Integrated and Integrated affiliate paperstocks, bonds and notes. 
7. Integrated Resources Life had a surplus of only 77.3 million with 3.086 billion assets. 
8. Capitol Life had surplus of 61 million against asset of 1.9 billion. 
9.Q3 1988: Earnings down again, equity as % of asset down to 7.1%. 
10. Insider were selling in Dec 1988. 
11. On May 16, 1989, Integrated announced that first-quarter results would be late and that there would be a net loss after a preferred dividends. 
12. Around June 1989, the company admitted that cash was a problem and Drexel balked. The stock dived to 5 and Integrated filed for bankruptcy in early 1990. 
III.Important Points to Keep in Mind:
1. The short maxim: Wait to short until reality can be proved. 
2. Short sellers are often shortsighted about the duration of hope for a new industry and for concomitant stock-price decreases. Stock price parabolas can sometimes appear to bend back on themselves, but the rate of return on the short position might look like net income on a company in the interim. 

Tuesday, December 11, 2012

Applying Short Framework to J. Bildner & Sons and Jiffy Lube

J. Bildner was an upscale yuppie grocery store chain that went public in the fall of 1986. It claims to serve time-conscious consumers with high levels of disposable income. In other words, a big 7-eleven with great service and home delivery for i-bankers and the like. The store featured imported tile, marble, European refrigerated cases, antique fixtures, and mahogany paneling and offered everything from video rentals to Brie to Pampers.

I. Short Sale Categories and Characteristics 
1.IPO stock with a franchise mania.
2.Young and inexperienced managers.
3.Flawed business plan: Atlanta and Birmingham did not suit the business plan. People in the South behave differently from the North. No one is going to drive to a mall after work and fight crowded parking lots for pricey carryout, and return home in rush hour traffic to eat in. 

II Research the Short Candidates:
1. The quality of earnings was poor. Other expense went down from 280,339 to 34,781. It turned out that the company used a one-time gain of one of the company's store to offset operating expenses. 
2. Construction delays hurt the expansion plans and the company required more financing than originally anticipated. 
3. Cash burn was quicker than anticipated. 
4. Prepaids and other assets were rising. Aggressive capitalizing pre-operating expenses.
5. The company is not meeting is strategic plan by a large margin. It only opened 23 stores compared to the originally planned 50.
6. Closing of the New York stores with sales price lower than cost.

Jiffy Lube, a quick oil change franchise company, was a growth stock and a short sale candidate with plenty of Wall Street assistance in blowing up the balloon. It was great franchise training, with a classic set of franchise financial statements for short sellers who fought the restaurant rage in the 1990s.

I. Short Sale Categories and Characteristics 
1.Poorly devised business plan: The company bet that a spectacular growth rate of franchises would swamp all competition and leave it in control of the field. 
2. New concept with no barrier to entry. (oil change, how hard is that). 
3. Jiffy Lube took debt for franchisee start-up expenses and they delivered inventories of oil and parts for credit. It is not normal for franchisor to assume all of the risk of many of the franchisees. 

II Research the Short Candidates and Key Development:

1986: Prospectus
1. The Company requires substantial amount of capital to provide for the acquisition and development of centers. 
2. Competition was mounting. 
3. The stock was selling at 40 times next year's earnings. 
4. Operating income was full of nonrecurring items such as gains on the sale of real estate and Company Operated Centers. 
5. Management has routinely facilitated the Company's funding of various projects by either loaning money directly to the Company or personally guaranteeing loans from others. 
6. Conflicts of interest: Certain members of management are investors in area developments and franchises. 

1. Related party transaction. CEO and chairman of the Company through a partnership which he started with 4 other partners, increased Jiffy Lube's revenue and cash. 
2. Non recurring earnings were greater than GAAP earnings. 
3. High AR, average store sales dropping, too much credit to franchises (no moeny down for owners/operators). 
4. Burning cash, but still announced a stock repurchase plan. 
5. Debt is up. 

6. The company also held 31 centers for resale.
7. SEC disagreed with the recognition of area-development fees.
8. The company purchase a new headquarter for $10,500,000.

1. Acquisition rumor, stock spiked but the rumor failed to materialize.
2. Centers for resale were up to 70.
3. Debt kept going up.
4. Credit loss provision increased.
5 Franchisee backed assets escalated from approximately 45% to 79% of total assets.
6. If a company quits adding new franchisees, earnings and revenue growth halt. If a parent subsidizes all the growth of new stores, slow payments can kill already tenuous cash flow.

Short Framework Applied to The Scoreboard Inc

The Scoreboard Inc was a fad company that wrecked the nerves and the net worth of many short seller in 1991, 92, 93 and 94. The Scoreboard Inc repackaged baseball cards and sports memorabilia and sold its wares primarily on home shopping channels.

I. Short Sale Categories:
A company with a fad product.

II. Signs of Potential Short Candidates:
Key Document: Prospectus
1. One of the key officers had a civil claim against a baseballs star for physical assault.
2. The head guy, Goldin, had been chairman of the board of a company that had filed for bankruptcy in March 1990 with a personal default judgment against Goldin. His son and executive vice president received a suspended sentence and three years probation for unauthorized use of credit card accounts to gain access to a computer without payment when he was a student.
3. 33% of revenues were booked through a company owned by a son-in-law.

III Research the Short Candidates:
1. 1990 10K: AR up 142% vs Sales only up 76%. Finished good inventory up 82% vs CGS up only 60%. Prepaids were up 144%, 1.6 million against pretax income of $9.4 million. The only reason cash flow was positive was because of the increase in current liabilities.
2. 35% sales were to related party.
3. Q2 1992 finished goods inventory up 127% with AR up 130% and prepaids up to $7.2 million while sales and CGS were down.

IV.Important Points to Keep in Mind:
1. The accounting based analysis is not difficult to do but it takes time, patience, and a suspension of belief. The lack of attention by other professional investors to these financial details provides the inefficiency in information dissemination that is so central to the short seller's art. In Scoreboard Inc's case, balance sheet mess was key.
2. Even successful short sellers are consistently too early when they sell stocks, sometimes even years too early. In this case, it took almost 4 years.

Sunday, December 9, 2012

Applying Short Sale Framework to Happiness Epxress

Company Description:
Happiness express sells toys and its product is Mighty Morphin Power Rangers.

I. Short Sale Categories:
 Companies that will be affected in a significant way by changing external events. In Happiness Express's case, the fad of its Mighty Morphin Power Rangers has peaked.

II. Signs of Potential Short Candidates:
1. Depending on 1 product Mighty Morphin Power Rangers.
2. Previous sales before Mighty Morphin Power Rangers also concentrated in few products, the licenses of some of which were nonexclusive.
3. Insiders were selling.
4. Cash was burning.

III Research the Short Candidates:
1. Off-Balance sheet purchase agreement of $2 million and minimum executive compensation of $900,000.
2. Inventory soared.
3. Cash kept burning.

NOTE: Valuation, did not signal a safe and secure short. This is, in fact a value trap back in 1995. Earnings for the March 1995 fiscal year were expected to be $1.10, up almost 50% from the previous year, with at least another 50% rise expected for fiscal 1996. That meant the stock was selling at less than 9 times forwarding earnings. It took a year and a half before the stock plummeted.

Applying Short Sale Framework to Medstone International Inc (1988-1990)

Company Description: Medstone International was a lithotripsy company that makes machines for noninvasive disintegration of kidney stones. In layman's term, this company's product crushes kidney stones.

Key Document: IPO Prospectus.

I. Short Sale Categories:
 Medstone has a tremendously inflated stock price that suggests a speculative bubble in a company's valuation.
Medstone will be affected in a significant way by changing external events.

Supporting Facts from prospectus:

1. The product was not patented.
2. The competition was large and international with a significant installed base.
3. Limited operating history, deficit net worth, working capital deficit.
4. Dependence on two key executives.
5. Only one product.
6. Some of the offering money went to senior officers to pay for prior services.

II. Signs of Potential Short Candidates:
1. The stock was trading at $40 between Q2 and Q3 of 1988 because the doctors are promoting the stock extensively. Doctors are reputed to be the marginal suckers on new drugs or medical-products companies for aggressive retail brokers. The doctors promote the stocks to peers and friends and enthusiastically inflate the market value, especially if the product is remotely associated with their area of expertise.
2. Founder and president Richard Penfill sold 100,000 shares of stock in September 1988 before the deadline elapsed.
3. Chairman of the board resigned in December.

III Research the Short Candidates:

What's driving the hype?

1. Q3 1988 was strong, EPS $0.52 per share vs $0.18 estimates. Sales doubled.
2. One analyst estimated earnings of $4.40 in 1989, up from $0.33 in 1987. $4.40 implies only 6 times P/E for a company that's growing fast with the group trading at 15 to 20 times earnings.
3. Signed an agreement with GE and GE will sell Medstone's machine in Europe and Middle east, providing parts, installation, and maintenance.

Reality Check from 10K 1988 and 10Q 1989.

1. Sales to a single shareholder and his affiliated companies made up 13% of the 1988 and 1987 revenues. The shareholder loaned Medstone $75,000 back in 1984.  In connection with his first machine purchase in 1987, he had the right to buy another machine at 80% of the price and received $86,500 in consulting fees from Medstone in 1985 and an additional $123,000 from the offering.
2. 2Q 10Q showed inventory soared from $385,000 in June 1988 to $5.5 million in June 1989.
3. 2Q 1989 sales were donw.
4. Founder and president resigned in August 1989 and the company reported noncompliance issues.
5. Competitor check: Dornier Company, whose product is patented and have the most installed base of 250 machines. Medstone has only placed 9 machines selling $1 million each.

Bucking The Trend-Some Thoughts on Apple

Claim: This is an article I wrote back in September. I saved it but forgot to publish. Apple's stock has dropped more than 20% since then, which I think is reasonable. I don't think Apple is expensive at $538 and 12 times earnings.

Apple has revealed iPhone 5 today, with no surprises. As expected, the new phone is taller, thinner and lighter than the iPhone 4S. It has a four-inch display, enhanced picture resolution and a longer battery life. Its processor and graphics are twice as fast as the iPhone 4S, uses iOS 6 and can run on LTE networks. 
The question is, will it live up to the hype? How many people will either switch to iPhone 5 or upgrade to iPhone 5?  iPhones accounted for 43% of Apple's total sales last year and, according to Sanford C. Bernstein & Co., 70% of Apple's profits. The performance of iPhone 5 is obviously very important to Apple for the next year or so. 
So far, Wall Street seems to think the iPhone 5 will live up to the hype. Wall street is still bullish on Apple. It's not uncommon to see a $1000 price target for Apple's stock from a Wall Street analyst. Some of the best fund managers, including David Einhorn, are stating that Apple's stock is still undervalued by a considerable amount.  The bulls claim that Apple is the most innovative company in the world and people have to keep upgrading their Apple product every year or every 2 years. The Chinese market still has a lot room for Apple to grow. Apple is widely misunderstood, it's not a hardware company, it's a software company that monetizes value through the repeated sales of high-margin software.  Apple could hit 1 trillion market cap. With 932 million shares outstanding, that implies a per share price of over $1000. Let's say Apple's current P/E is indeed too low at 16 time earnings and let's bump it up to 18 times. A $1000 price target would therefore implies an earnings per share of roughly $56, a more than 30% increase from today's earnings per share. So far, this all sounds very reasonably achievable for Apple.  Better yet,  you'll also get about 25% of the earnings as dividend, which you can either reinvest or keep as cash. 

Let's take a look at the 2 most prominent bull's claims . 

Claim one: Apple is the most innovative company in the world and people have to keep upgrading their Apple product every year. 
Possible counterclaim: Apple was the most innovative company in the world when Steve Jobs was still alive. He has passed away for a little over a year and it's reasonably obvious that Apple's product has not been as innovative as before. Apple's humongous run for the past couple of years are based on some great visionary products that were basically invented by Steve Jobs and the historical success of Apple, to a large extent,   is also based on the visions by Steve Jobs. Tim Cook is not even close to Steve Jobs in terms of innovative and visionary thinking. iPhone 4s is a lot like iPhone 4 and the New iPad is very similar to iPad 2, now the so called iPhone 5 seems to me a slightly upgraded iPhone 4s. It will be very hard, if not impossible for Apple to come up with products as revolutionary as the first generation of iPhone and iPad again  without Jobs. 

Claim Two:The Chinese market still has a lot room for Apple to grow.
Possible counterclaim: People who have been to China know that you don't buy Apple's product from an Apple store, there are retailers all over the place who sells Apple's product. In a electronic market where hundreds of small electronic shops operate, over half of them sell iPhone and iPad. My point is do not extrapolate Apple's growth in China based on the number of Apple stores in China. It is extremely easy to buy an iPhone already and adding Apple stores is more like a marketing tool. Plus, people who can afford iPhone has already bought an iPhone, or even two iPhones when the iPhone is considered unique. Now that iPhone is a "street phone", I've seen a lot of people switching to Samsung and Nokia. 

If history rhymes, as it always has, in my humble opinion, at the current price, Apple is not offering a large enough margin of safety for a conservative value investor. Please do not get me wrong, I am not bearish on Apple. I am just saying it looks to me that Apple is not very undervalued, especially if you are very long-term oriented. 

Value-Oriented Short Sale Framework

This framework is based on the book "The Art of Short Selling" by Kathryn Staley.

I. Short Sale Categories and Characteristics (There are some overlap):
1. Companies in which management lies to investors and obscures events that will affect earnings.
2. Companies that have tremendously inflated stock prices-prices that suggest a speculative bubble in a company's valuation.
3. Companies that will be affected in a significant way by changing external events.
4. New Concept stocks that draw a lot of attention and hypes. Fad or bubble stock pricing: usually marked by a stellar price rise over a short period.
5. Accounting gimmickry: clues that the financial statements do not reflect the true state of corporate health.
6.  Insider sleaze:signs that insiders consider the company a personal bank or think the stock should be sold.
7. A gluttonous corporate appetite for cash.
8. Overvalued assets or an ugly balance sheet.
9. Concepts stocks with no or low barrier to entry. (Groupon for example)
10.IPOs of stocks in hot industry that is overhyped and has a lot of competition. (similar to 4)

II Research the Short Candidates:
1. Work from at least 2 years of 10Qs and 10ks and analyze balance sheet, cash flow and financial ratios.
2. Track insider activity and management's compensation vs company's performance.
3. Look at the products, the competitors, the suppliers of production inputs.
4. Read analyst reports and determine consensus.
5. Read and keep up with the news of the company over time to see what happens, how earnings and price progress, what changes.
6. Clear catalyst that will send the company's stock downtown.
7. Keep track of key metrics that indicate trouble such as AR, Inventory, Prepaids and compare them to sales and CGS and operating income.

III.Important Points to Keep in Mind:
1. The accounting based analysis is not difficult to do but it takes time, patience, and a suspension of belief. The lack of attention by other professional investors to these financial details provides the inefficiency in information dissemination that is so central to the short seller's art.
2. Even successful short sellers are consistently too early when they sell stocks, sometimes even years too early. David Einhorn's Allied Capital, Bill Ackman's MBIA, Witney Tilson's Netflex.
3. Short seller fear most a sustained rally in a stock followed by a forced buy-in of their position, resulting in a loss out of their control, particularly in companies with smaller floats.
4. Valuation bets on price alone make bad short sales, i.e shorting a stock just because you think the stock is overvalued may be dangerous. There must be either a fundamental change in the outlook for the company or a major misconception by the stock-buying public.
5. You have to be able to articulate in clear logic what mechanics will impact the income statement and balance sheet negatively. The best way may be talking to competitors and suppliers. The point of short is when those mechanics become overwhelmingly apparent and the stock is still up.
6. Jim Chanos use return on invested capital calculated by EBIT/(All Interest Bearing Liabilities+Equity+Deferred Taxes+Short Term Debt).
7. High ROE makes for a lousy short sale because the company can finance its growth without caring a fig what the Wall Street Pubahs think about the business plan.
8. When a company switches or expands its business line into something completely different, it generally means management fears that growth will slow in the main line. When they expand into a highly competitive business that costs money for product development (like software game titles) when the base business eat money as well, you sit back and watch with relish for the train wreck to happen sooner.