Tuesday, October 15, 2013

Patience and Capacity to Suffer - Lessons From a Legendary Value Investor

Here is the return information for a fund manager:

Year Fund Manager S&P With Dividends
1 7.91% 37.60%
2 22.51% 23.00%
3 27.04% 33.40%
4 -16.30% 28.60%
5 8.29% 21.00%
Cumulative 49.45% 143.60%
Annualized 8.77% 28.57%

Question: Given the above returns, would you give your money to this fund manager?

I doubt many people will say yes. After all, this manager has seemingly vastly underperformed the market during this specific 5 year period.

Probably a surprise to many of us, the preceding returns were produced by one of the greatest investors of all time - Seth Klarman. And most likely not a surprise to many of us, this 5-year period represents the technology bubble years from 1995 to 1999. I want to clarify that Baupost Group had a year-end of October 31st during this time period. Therefore, the comparison in the table above does not represent the exact degree of under-performance. However, it is close enough to draw conclusions thereof. 

During the tech bubble, even some renowned value investors eventually capitulated to the runaway bull market in growth and technology stocks. It takes a tremendous amount of patience and capacity to suffer in order to maintain the value investing discipline in a soaring market. How did Seth Klarman stick to the value proposition and margin of safety principle during the bubble years and how did he construct his portfolios in a raging bull market? I found the answers in Klarman's letters to investors.


"The primary reason for our underper-formance, of course, is that the Fund has relatively little exposure to the U.S. stock market."

"The Baupost Fund is managed with the intention of earning good absolute returns regardless of how
any particular financial market performs. This philosophy is implemented with a bottom-up value
investment  strategy  whereby  we  hold  only  those  securities  that  are  significantly  undervalued,  and
hold cash when we cannot find better alternatives. Further, we prefer investments, when we can find
them at attractive prices, that involve a catalyst for the realization of underlying value. This serves to
reduce  the  volatility  of  our  results  and  de-emphasizes  market  movements  as  the  source  of  our  in-
vestment  returns.  Positions  with  catalysts  tend  to  lag  a  rapidly  rising  stock  market  (like  this  past year's) and outperform a lackluster or declining one (like we used to have every few years!)."

"We firmly believe that one of Baupost's biggest risks, and, needless to say, that of other investors, is that we will buy too soon on the way down. Sometimes cheap stocks become a whole lot cheaper; it simply hasn't happened lately. (And when that happens, expensive stocks will fare far worse.) "


"In  making  tradeoffs among competing alternatives, we have distinguished ourselves from other professional investors in  several  ways:  our  willingness  to  hold  cash  balances,  sometimes  substantial,  awaiting  opportunities;  our preference for investments with a catalyst for the realization of underlying value; our willingness  to accept varying degrees of illiquidity in exchange for incremental return; and our flexibility in pursuing opportunities in new areas."

"Baupost has long enjoyed a very flexible investment charter, one that has permitted us to depart con-
siderably from our initial conception as US equity and high quality debt investors. This flexibility
has been, we believe, at the core of our investment success over the years." 

"Investors who find an overly narrow niche to inhabit prosper for a time but then usually stagnate. Those who move on when the world changes at least have the chance to adapt successfully."

"The same flexibility that led us into a heavy concentration in thrift conversions in the mid 1980's and distressed corporate debt in the mid-late 1980's, and a smaller hedging bet on Japanese stock market puts in the late 1980s, has led us into a moderate investment in Russian stocks earlier this year, and an important position in European holding companies in 1995-1996."

"Risk is also mitigated by both our constant emphasis on investment fundamentals and on knowing
why each investment we make is available at a seeming bargain price. We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and
the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a
good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking
whether we have an apparent advantage over other market participants in any potential investment.
If the answer is negative, we do not invest."


"The most favorable position going into a sudden downdraft (if you could correctly anticipate one) is
to hold market hedges and/or cash (or better still, short positions, but short sellers have been aging
in dog years for a long time). We hold both, although never enough in a downturn, because both are
costly. Hedges, like any insurance, involve paying a premium. Premiums have skyrocketed in lock-
step with the market's surge over the past two years, and have risen even more in the current volatile
environment. "

"Cash provides protection in a storm and ammunition to take advantage of newly created opportunities, but holding cash involves the considerable opportunity cost of foregoing presently attractive investments. Given the choice between holding mostly cash awaiting the periodic market tumble or finding compelling investments which earn good returns over time but fluctuate to a certain extent with the market amidst turbulence, we choose the latter. Obviously, we could not have earned the returns we have from investing, without investing."

"If the financial markets remain turbulent and retrace some of their decade-long gains, I believe we
will be in a strong position. Despite delivering good investment performance over the Fund's first
seven years of operations, I must remind you that value investing is not designed to outperform in a
bull market
. In a bull market, anyone, with any investment strategy or none at all, can do well, often
better  than  value investors. It is  only in a bear  market that  the value investing discipline becomes
especially important because value investing, virtually alone among strategies, gives you exposure to the  upside  with  limited  downside  risk.

"In  a  stormy  market,  the  value  investing  discipline  becomes crucial, because it helps you find your bearings when reassuring landmarks are no longer visible. In a market  downturn,  momentum  investors  cannot  find  momentum,  growth  investors  worry  about  a slowdown, and technical analysts don't like their charts.  But the value investing discipline tells you exactly what to analyze, price versus value, and then what to do, buy at a considerable discount and sell near full value.  And, because you cannot tell what the market is going to do, a value investment discipline is important  because it is the only approach that produces consistently good investment results over a complete market cycle. "

"The most important investment decision we have made over the past several years is the one to in-
crease our international efforts. This decision resulted in part from a realization that opportunities in
the U.S. were considerably less attractive than they had been, and that the situation would not necessarily improve."

"Value investors should buy assets at a discount, not because a business trading below its obvious liquidation value will actually be liquidated, but because if you have limited downside risk from your purchase price, you have what is effectively a free option on the recovery of that business and/or the restoration of that stock to investor favor."

"In investing, nothing is certain. The best investments we have ever made, that in retrospect seem like
free money, seemed not at all that way when we made them. When the markets are dropping hard
(as they are right now in Asia) and an investment you believe is attractive, even compelling, keeps
falling in price, you aren't human if you aren't scared that you have made a gigantic mistake.
challenge is to perform the fundamental analysis, understand the downside as well as the upside, remain rational when others become emotional, and don't take advice from Mr. Market, who again and
again is a wonderful creator of opportunities but whose advice should never, ever be followed."


"Like the Everest climbers, the problem with reaching the summit is that from there every way  you  go  is  down.  Not  wanting  to  overuse  the  metaphor,  I  won't  go  on  to  recount  the  sudden  storm which seemed to come out of nowhere that brought peril to a number of the climbers."

"What is clear to us, and relatively few others, is how disappointing those long-term returns will actually be from today's market levels. Future returns have increasingly been accelerated into the present and recent past. We have entered greater fool territory, and decent market returns from here, while still a distinct possibility, will depend on an even greater sucker showing up. No one should be surprised if one does; however, no one should base their investment program on his or her existence."

"Persuading budding analysts to postpone the immediate gratification of a momentum or growth stock career for a long-term value investment philosophy is a formidable challenge indeed. Leaving this extraordinary party early, or contemplating not even going, isn't very appealing if all your friends will be there having a great time while it lasts, which appears to be well into the night. To many, the really bad hangover will have been worth it."

"Many of our most promising new ideas are in Western and Eastern European equities. As we started to see in 1996  and  1997,  corporate  restructuring  has  accelerated  in  many Western  European  countries. We
have identified numerous companies in the midst of asset sales, spin-offs, and share repurchases, and
others  actively  exploring  such  transactions. "

"We intend to persevere in our search for value, and remain confident that our cash balances (17% of Fund assets at April 30) are likely to be most valuable just as fewer and fewer investors choose to hold any."


"Sentiment, existing only in the minds of investors, is subject to change quickly and without notice."

"Real value, of bricks and mortar, finished goods inventories, accounts receivable, operating factories and businesses, and even brand names, is hard, although far from impossible, to destroy. If you don't  overpay  for  it,  your  downside  is  protected.  If  you  purchase  it  at  a  discount,  you  have  a  real margin of safety."

"Our concern is that we cannot know when the current love affair with large capitalization growth stocks will end, and what sort of havoc this will wreak on smaller stocks, however inexpensive. As we have explained before, the only logical way to hedge against this risk is to protect an investment in these undervalued smaller stocks with a put option on or short sale of more expensive stocks. We have ruled out short selling for a number of reasons, including the unlimited downside risk that short selling poses. With puts, at least, your cost is limited to the up-front premium. Such a hedge, however, is historically quite expensive and, as we learned last year, far from perfect."

"Our resolution to this dilemma is to position the Fund's portfolio in three parts. A major compo-
nent is cash (held in U.S. Treasury bills and/or in a U.S. Government securities money market fund), at around 42% of the Fund's portfolio at April 30. This asset is available to take advantage of bargains,
but represents important dry powder until some of today's market extremes resolve themselves. "

"Another segment, about 25% of the Fund's portfolio, involves numerous public and private investments  with  catalysts  for  the  partial  or  complete  realization  of  underlying  value. This  includes corporate bankruptcies, restructurings and workouts, liquidations, breakups, asset sales and the like. These situations are generally purchased at expected annual returns of 15% to 20% or more. The success of these investments depends primarily on the outcome of each situation rather than on the level of the stock market. There can, however, be month by month fluctuations in the market prices of these positions." 

"A number of these positions are former spinoffs, ignored and abandoned in a market not oriented toward smaller companies. Most of these situations involve partial catalysts for value realization such as ongoing share repurchase programs and/or insider buying, but these limited catalysts offer only modest protection
from the short-term volatility of the financial markets."

"We underperformed  in 1999 not because we abandoned our strict investment criteria but because we adhered to them, not because we ignored fundamental analysis but because we practiced it, not because we shunned value but because we sought it, and not because we speculated but because we refused to do so. In sum, and very ironically, we got hurt not speculating in the U.S. stock market. "

"Occasionally we are asked whether it would make sense to modify our investment strategy to
perform better in today's financial climate. Our answer, as you might guess, is: No! It would be easy
for us to capitulate to the runaway bull market in growth and technology stocks. And foolhardy. And
irresponsible. And unconscionable. It  is always easiest to run  with the herd; at  times, it can take a
deep  reservoir  of  courage  and  conviction  to  stand  apart  from  it. Yet  distancing  yourself  from  the
crowd is an essential component of long-term investment success."

"Most companies in our portfolio, in addition to compelling undervaluation, have strong market positions, significant barriers to entry, substantial free cash flow, and catalysts in place to assist in the realization of underlying value. Almost all have managements who own significant amounts of stock personally."

"Given the competitiveness of the investment business, we believe it is important in every investment to have an edge, an advantage over the herd. This edge could be a willingness to take a long-term perspective in a short-term-oriented market, a tolerance of complexity when others crave simplicity, or the absence of constraints which either impede the ability of others to act or force them to act in uneconomic ways."


Reading Klarman's letters to investors has been an illuminating experience. His wisdom seems especially relevant in a market environment that we are presently faced with. Although we are not in a bubble territory yet, certain segments of the market have certainly exhibited bubble characteristics. Market leaders in this year's rally include Facebook, Tesla, Linkedin, Netflix and etc. Facebook's market cap is almost 75% of that of Coke Cola and Tesla's market cap is almost 40% of the market cap of GM with revenue only a fraction of that of GM. Neither Facebook nor Tesla has sufficient tangible asset value to serve as down-side protection yet investors seem to care little.

My expectation is that many famous value investor will under-perform this year, just like they have been during the past bull markets. Patience and capacity to suffer is again extremely vital in today's market condition. However, having the right temperament itself is not likely to be enough. The following lessons from Klarman may be beneficial:

1. Always hold cash, which "provides protection in a storm and ammunition to take advantage of newly created opportunities.

2. Adapt flexibility in your portfolio. Try not to limit yourself in an overly narrow niche (such as high quality U.S large cap stocks). Spend some time analyzing spin-offs, merger-arbitrage (such as the recent BBRY deal) situations, bank recapitalization, mutual conversions, or emerging markets. This flexibility will allow you to move into "areas of temporary and compelling opportunities and away from areas of full or excessive valuation, thereby enhancing return while simultaneously reducing risk.

3.Maintain sufficient but not excessive diversification. To quote Klarman, "owning a diverse portfolio in one market may greatly reduce the risk associated with a single company hitting a bump in the road but will not at all reduce the risk of being in that market. If that market runs into a pothole, its components could all break down at once. This is particularly true if that market is trading at record levels of valuation, supported more by money flows than by fundamentals,  as  happens  sometimes. "

4. Last but certainly not least, never forget "MARGIN OF SAFETY."  Real tangible value, such as real estates, cash, inventories is hard to destroy, while "a promising future" can quickly turn into a "sour land of disappointment." 

Monday, October 7, 2013

A Great Jim Chanos Interview


Friday, October 4, 2013

SAIC Spin-Off Quick Analysis

During August last year, SAIC announced its plan to split into two public companies. One company would focus on technical services and another on information technology products, including surveillance and intelligence programs. The spinoff is an effort to prevent conflict of interest, said John Jumper, chairman and chief executive officer. He also thinks it will "unleash growth and value." The technical services business will focus on “on government technical services and enterprise IT businesses,” and become one of the “largest, pure-play government services companies in the market.” This unit has pro forma FYE Jan 31, 2013 revenues of $4b. The solutions-focused business will focus on “delivering science and technology solutions in three high-growth markets that reflect high priority, long-term global needs – national security, engineering and health.” This unit has pro forma FYE Jan 31, 2013 revenues of $7b.

"In this next step of our strategic plan we configure ourselves for the future. Our two new companies will be designed so that their businesses can be more differentiated and more competitive in their own space. More importantly, that addressable space will expand for each as we eliminate the burden of organizational conflicts of interest (OCI)," said Jumper.

The spin-off has been completed last month. The purpose of this article is to analyze both the parent company (Leidos Holdings) and the spin-off company (SAIC) after the spin-off. In performing my analysis, I used Joel Greenblatt's framework specified in his book "You Can Be a Stock Market Genius."


Reasons for Spin-Off

According to the 10-12B filing from SAIC, there are four major reasons for the spin-off: 

1. Reduce Regulatory Constraints in the Pursuit of Business Opportunities. Under the Federal Acquisition Regulations (FAR), when a company has provided SETA (System Engineering and Technical Assistance) services for a particular U.S. Government program, it may be prohibited from selling products to the U.S. Government under the same program due to an organizational conflict of interest. The spin-off will allow us to expand the addressable market for our offerings that were previously constrained by OCI (organizational conflicts of interest) regulations. For example, a contractor that performs on a contract with a U.S. Government customer to provide system requirements for a military weapons system cannot also compete on a contract with the government customer to deliver the weapons system to meet those requirements. Similarly, the contractor that performs on a contract with a U.S. Government customer to deliver a weapons system may not also perform on a contract with the U.S. Government customer to conduct the test and evaluation on the weapons system to verify its performance and satisfaction of the system requirements. Both of these examples pose an actual or potential OCI not allowable under the FAR.

2.Strategic Focus of Management’s Efforts. Our business represents a discrete portion of Parent’s overall business. It has historically had different financial and operational requirements than Parent’s other businesses. The separation will allow us to better focus management’s attention on New SAIC’s business. 

3.Investment Focus. While operating as a part of Parent, the internal investments of the company were directed according to Parent’s strategic interests as a whole. The separation allows us to focus our investments on projects that generate returns for our business.   

4.Improved Management Incentive Tools. As an independent company, we will be able to better structure and incentivize our current and future employees through direct participation in the performance of the company through new equity compensation plans.  

It seems like SAIC's main motivation is similar to  what L-3 did with its spinoff: separating the slow growth, and headwinds-facing parts of its business and  removing internal conflicts, which could possibly bring in new business.

2. Insider Ownership and Compensation Structure:

Long-Term Incentive Awards
The amounts of these awards granted under Parent’s 2006 Equity Incentive Plan are determined based on market data and vary based upon an executive officer’s position and responsibilities.
Stock Options. Approximately 25% of the targeted total value of equity awards granted to New SAIC named executive officers in fiscal 2013 was comprised of stock options. These options vest 20% of the shares at the end of each of the first three years and 40% of the shares at the end of the fourth year and expire at the end of the seventh year. The objective of these awards is to link rewards to the creation of stockholder value over a longer term and aid in employee retention with a vesting schedule weighted toward the end of the option term. Parent believes that stock options motivate Parent executives to build stockholder value because they may realize value only if Parent’s stock appreciates over the option term.
Restricted Stock Units. Approximately 25% of the targeted total value of equity awards granted to New SAIC named executive officers in fiscal 2013 was in the form of restricted stock units (RSUs). These RSUs vest 20% of the shares at the end of each of the first three years and 40% of the shares at the end of the fourth year. RSUs are intended to provide a strong incentive for employee retention and promote the building of stockholder value.
Performance Share Awards. Approximately 50% of the targeted total value of equity awards granted to New SAIC named executive officers in fiscal 2013 was in the form of performance share awards that may result in shares being issued depending on the company’s achievement of specific financial performance goals for each fiscal year over the three-year performance period covering fiscal 2013 through fiscal 2015. In the first quarter of fiscal 2013, the Parent Committee set the performance goals for fiscal 2013 and approved the threshold, target and maximum performance share award amount for the entire three-year period, one-third of which is allocated to each of the respective three year performance periods and is set forth in the “Grants of Plan-Based Awards” table.
The following table sets forth the target number of shares and corresponding target value for performance shares awarded in fiscal 2013 for the three-year performance period covering fiscal 2013 through fiscal 2015, with the target number of shares based on the closing sales price of Parent’s common stock on the NYSE on the trading day before the grant date. The target grant date values were between 50% and 120% of base salary.

      Target Shares      Target Value  
  Anthony J. Moraco
     45,421       $ 600,000   
  John R. Hartley
     15,141       $ 200,000   
  Thomas G. Baybrook
     26,496       $ 350,000   
  Brian F. Keenan
     22,711       $ 300,000   
  Nazzic S. Keene
     31,546       $ 400,000   

The employee incentive plan sounds standard, with options, RSUs and other performance-based equity compensation making up the majority of compensation. Both options and RSUs have a 3-5 years vesting period so long term value creation is encouraged. Executives also have to give back their compensations if financial statements are restated.

3. Comparable Company Analysis:

Comparable Companies: EGL (L3 spin-off) and NOC.

I. Using Operating Earnings

NOC: 52 weeks trading between $13 billion to $21.4 billion, 2012 operating Income $3.13 billion. Price/Operating income ranges from 4.2-7.

EGL: 52 week trading between $300 million and $600 million, 2012 operating Income (excluding goodwill impairment charge) $97 million. Price/Operating Income ranges from 3-6.

Average of NOC and EGL - Price/Operating Income of 5x. Apply that to SAIC's  $281 million operating income, we will get a market cap of about $1.4 billion, or $28.6 per share.

                                       Leidos Holdings

Comparable Companies:
1. Verint Systems Inc (VRNT).
2.L-3 Communications Holdings, Inc. (LLL)
3. Honeywell Internationl (HON) 
I. Using Forward P/E

VRNT: 12.70


 Average: 13

13*3.64= $47.32 per share



     Year Ended January 31, 2013  
           Pro Forma Adjustments        
(in millions, except per share amounts)
   Historical Leidos
Holdings, Inc.
    New SAIC
    Other     Pro Forma  
   $ 11,165     $ (4,690 )   $ —        $ 6,475   
Costs and expenses:




Cost of revenues
     9,814        (4,237     —          5,577   
Selling, general and administrative expenses
     572       (68     —          504   
Separation transaction and restructuring expenses
     38       (28 )     (10 ) [B]      —     





Operating income
     741        (357     10        394   
Non-operating income (expense):




Interest income
     9       —          —          9   
Interest expense
     (93 )     —          —          (93
Other income, net
     8       —          —          8   





Income from continuing operations before income taxes
     665        (357     10        318   
Provision for income taxes
     (137 )     126       (4 ) [B]      (15





Income from continuing operations
   $ 528     $ (231 )   $ 6     $ 303   






Basic earnings per share from continuing operations



  $ 3.64  [C] 





Diluted earnings per share from continuing operations



  $ 3.64  [C] 





Weighted average number of shares outstanding:







    83  [C] 








    83  [C]



     Year Ended January 31, 2013  
           Pro Forma Adjustments        
(in millions)
Leidos, Inc.
    New SAIC
    Other     Pro Forma  
   $ 11,165      $ (4,690   $ —        $ 6,475   
Costs and expenses:



Cost of revenues
     9,814        (4,237     —          5,577   
Selling, general and administrative expenses
     572        (68     —          504   
Separation transaction and restructuring expenses
     38        (28     (10 ) [B]      —     





Operating income
     741        (357     10        394   
Non-operating income (expense):




Interest income
     10        —          —          10   
Interest expense
     (93     —          —          (93
Other income, net
     8        —          —          8   





Income from continuing operations before income taxes
     666        (357     10        319   
Provision for income taxes
     (137     126        (4 ) [B]      (15





Income from continuing operations
   $ 529      $ (231   $ 6     $ 304  

Thursday, October 3, 2013

Terrific Article From Mungerism


My Investment Checklist

Understanding the Business
1. Can I describe how the business operates in my own words?
2. How does the business make money?
3. How has the business evolved over time?
4. What are the costs that the business have to incur?
5. Is the business affected by commodity prices? If so, what commodities and what factors affect the commodity prices? Where are these commodities in their respective commodities cycle?
6. What factors contributed to historical booms and busts?
7. What is the proportion of revenue and profit from foreign operations?
8. Who is the core customers of the business and are customers purchasing decision affected by economic conditions?
9. Is the customer base concentrated or diversified?
10. Is it easy or difficult to convince customers to buy the products or services? How high is the switching cost?
11. What pain does the business alleviate for the customer?
12. How are the business's products/services differentiated from those offered by competitors?
13. Does the business have sustainable moats and what is the source?
14. Does the business have pricing power, can it pass along inflation impact to customers?
15. What type of relationship does the business have with its suppliers?
16. What risks does the business face?
17. Is the business subject to the competition of foreign cheap labor? (Dexter shoes, Berkshire textile)

Industry Analysis
1. How has the industry evolved over time?
2. How does the industry operate?
3. Who are the big players in the industry? How did they become so successful?
4. How intense is the competition within the industry?
5. Is the industry concentrated or fragmented?
6. What are some key indicators/statistics relevant to this industry?
7. Historically, how does the industry perform in different phases of the business cycle and stock market cycle? Does it perform well during bull market or bear market? Does if fall more than the market in a falling market?
8. Is there a long term trend benefiting the business?
9. Is the industry subject to rapid changes?
10. Is the industry subject to strict regulations?

Financial Analysis
1. What are the operating metrics that need to be monitored?
2. What are the best valuation metrics to use?
3. What types of assets does the business have and how easier can they be converted to cash?
4. What is the return on invested capital for this business?
5. What is the level of operating leverage?
6. Does the business generate revenues that are recurring or from one-off transactions?
7. How does working capital impact the cash flow of the business?
8. Does the business have high or low capital expenditures?
9. Is the business subject to huge pension liabilities?
10. What is their derivative exposure as a % of operating income?
11. Is ROA or ROE a better measurement for returns?
12. What is the proportion of intangible and goodwill as a percentage of total assets?
13. What is the asset/equity, debt/equity and interest coverage ratio?
14. When are the debt due?
15. What are off-balance sheet commitments and obligations?
16. Have operating cash flows moved consistently with net income?
17. During the past 3, 5 and 10 years, did the business have to spend all its earnings in capex and acquisitions?

Management Team
1. What type of manager is leading the company?
2. How did the CEO rise to lead the business?
3. Is the compensation structure aligned with the interest of shareholders?
4. What is the stock ownership percentage of the business?
5. Have the leaders been buying or selling stocks?
6. Are the CEO and CFO disciplined in making capital allocation decisions?
7. Do the CEO and CFO buy back stock opportunistically?
8. Does management buy back shares to satisfy RSU issuance? i.e Did share count shrink as the company buys back shares?
9. Is the letter to shareholders meaningful to read?
10. Are managers clear and consistent in their communications and actions with stakeholders?
11. Do the option grant and RSU grants policies encourage management to manipulate earnings so they can exercise options?

Evaluating Growth
1. Does the business grow from M&A or does it grow organically?
2. What is the management team's motivation to grow the business?
3. How much is future growth subject to the law of diminishing returns? i.e What stage in business cycle is the business in?
4. Is the management team growing the business too quickly or at a steady pace?
5. Has the growth in business attracted more competitors?
6. How does management make M&A decisions?
7. How much did management pay for past acquisitions and have they been successful in achieving synergies and expanding market?

Additional Items from Past Mistakes of Other Investors and Myself:
1. Are recent earnings peak earnings? (Berkshire bought Cort, Pabrai bought Delta Financial).
2. Are recent earnings reflective of any bubbles ( First Solar)?
3. Is overcapacity building up? Pay special attention to industry such as shipping and drilling where it can take years for overcapacity to become obvious.
4. If dramatic changes are made rapidly, did management test new strategies before full implementation? Such as Ron Johnson's change at JC Penney.
5. What psychological biases are managers subject to?
6. Does the change ignore human psychological biases? Ron Johnson's termination of promotion at JC Penney.
7. Are gross margin and net margin contracting?
8. Is the business deteriorating due to new entrants or new products from existing rivals? If so, is management too arrogant to acknowledge the need to change? Think about what iPhone did to Nokia and Blackberry and what Nokia and Blackberry's management said about iPhone. Also think about what iPad is doing to Dell and HPQ.
9. What structural factors and long term mega trends are negatively affecting the business?  Think about what internet did to Radioshack and newspapers.
10. If short, is there a long term trend benefiting the business? Is it a valuation only based short?
11. Reverse engineer: How many products does the company need to sell at a normal industry margin in 5 years, 10 years to justify its current valuation.
12. Is the upside at least 2X current prices in 2-3 years, or 5x in 5 years?

Psychological Biases Checklist:
  • Look for disconfirming evidence – killing your own ideas.
  • Emphasize factors that don’t produce lots of easily available numbers.
  • Under-weigh extra vivid experience and overweigh less vivid experience. Same with recent events, i.e. cool off.
  • Remember the lesson: One idea or fact is not worth more merely because it is easily available to you.
  • There’s no logical answer in some cases except to wring the money out and go elsewhere.
  • Don't make any investment decision under euphoria or extreme depression. 

Below is from an article from gurufocus:
1) What are the odds that this company will not be around ten years from today? – As I noted in my previous article “Kill the Company,” this is the first question Buffett will always ask: Is there any chance that a significant amount of my capital could be subject to catastrophe risk? As Alice Schroeder noted, if the answer is yes, he just stops thinking; this is a good example to follow.

2) What is the company’s sustainable competitive advantage? – In my mind, this is essentially the same thing as No. 1: What does this company do that all but guarantees its existence 10, 20 and 50 years from now? For Coca-Cola (KO), it delivers a product with unmatched brand equity (partly due to significant economies of scale) via an unrivaled distribution network; in addition, it has levered this success to enter new categories (juices, teas, sports drinks, etc.) in order to all but guarantee its continued growth even if the shift away from CSDs experienced in the U.S. continues in the future. 

3) Does the company have the financial strength to ride out a rough patch? This is overwhelmingly important, and has been captured as of late in two high profile examples: 

The first is Diamond Foods (DMND), which has been plagued with an accounting scandal: The company was itching to grow a bit too quickly, and now holds $530 million in debt (compared to a market cap of $470 million) compared to marginal profitability. As a result, the company has had to explore strategic alternatives, and will likely need to dilute the current shares outstanding or sell the company as a whole (they are in talks with KKR according to a recent Barron’s article). 

Even when adjusting the prior year’s financial statements to account for the misstated numbers, DMND starts to look attractive at the current valuation based on their growth potential and their current earnings power; the minute my eye catches that overwhelming debt load, I’m forced to walk away in fear of what might lay ahead for this company.

On the other end of the spectrum is Nokia (NOK); while the company has gotten clobbered by Apple’s (AAPL) iPhone and Google’s (GOOG) Android operating system, they are fine from a financial perspective. Even after losing more than 1 billion euros last year, the company has net cash of 5 billion euros, leaving them plenty of time to right the ship (now that we abandoned that burning oil rig, right Mr. Elop?) before the balance sheet becomes an issue.

4) Would you LOVE to see the stock fall 50%? – For me, this is the ultimate test for an investment. If you can look at a company’s competitive position within an industry and know that you would love to buy more at half of today’s price regardless of the short-term noise, that’s a good sign in my book (I've been begging for many to do some since I missed out in 2009, but so far, no gravy). If this isn’t true, there are two likely culprits: Either you question the long-term sustainability of the business, or you don’t understand enough about the company to feel comfortable with bouts of volatility. Either way, its probably a sign that you should move on to the next opportunity.