Author: Michael Goode

Book Review: The Theory of Investment Value

John Burr Williams wrote The Theory of Investment Value as his dissertation. First published in 1938, this book is one of the classics of investing. I will not say that the book is a fun read, for it is not. It is dry and difficult. Half the pages are filled with equations. However, this book was a landmark and it remains relevant. This book is far too large and detailed for me to describe in detail, so I will present but a few of the highlights.

John Burr Williams invented the dividend discount model of stock valuation. Previous economists and stock analysts had only guessed at what the proper P/E valuation was for a company or what the proper dividend yield was. Also, most previous analysts ignored the sustainability of the dividend. In his book, Williams made the point that a company could be valued by calculating the present value of the future dividends (discounting those future dividends at the risk-free interest rate).

However, companies sometimes pay dividends that are unsustainable or that are below their true dividend-paying ability. Williams thus showed how to calculate the sustainable dividend payout. This is also known as owner earnings—it is a measure of the earnings after subtracting necessary reinvestment.

Williams also shows that this can be applied even to companies that do not pay a dividend. He made the point that a company increases in value once it has made money, and thus dividends are not necessary (the stock will increase in value proportional to how much would have been paid out in dividends). (As history has since shown, though, companies that do not pay dividends tend to do worse than those that do, simply because they may reinvest the money unwisely.) Williams thus laid the groundwork for what has later become discounted cash flow (DCF) models of valuation. For some types of companies, dividend discount models are still useful today.

Besides this, the last section of the book is a series of examples, ranging from Phoneix Insurance to GM and US Steel. Even if you only read this section, the book is worth the price. The problems facing investors 70 years ago remain today. We would be wise to learn from the past. By all means buy this book and read it.

Disclosure: This article was originally written two years ago and published elsewhere.

How to accidentally commit mortgage fraud

Back in late 2006 I was looking to purchase a small rental property. I initially agreed to purchase a 4-unit building but then backed out after an inspection revealed it to be in poor condition. I signed up with a mortgage broker and would have used her had I gone through with the purchase. We got so far as to look over and sign the good faith mortgage estimate. What I found there surprised me. The broker had pre-filled our answers, which was fine, as I had given her all the correct information. However, I found that our income had magically jumped from $35,000 for the prior year to $83,000. My wife and I were both in graduate school at the time so this was obviously not true. Also, although it was to be a rental building, the broker had checked the box saying that we would live there, contrary to what I had said multiple times.

If I had not read the document carefully I would have inadvertently committed felony mortgage fraud.

See the offending documents (personal info redacted).

The mortgage broker I worked with was Home Loan Experts (now defunct), which was a subsidiary of Golden West Financial, now part of Wachovia.

A short book review of much importance

I could have spent a few pages extolling the virtues of David Dreman and his book, Contrarian Investment Strategies: The Next Generation. Fortunately for you, I did not do that. Instead, I tell you simply to buy the book. It deserves a spot on your library shelf adjacent to Ben Graham’s Intelligent Investor. It is one of the most important investment books you will read. In the book, Dreman discusses at length the problems with estimating future earnings and psychological impediments to effective investing. He also lays out the key reasons why value investing works so well and he gives much data that support his arguments. Much of the data in my forthcoming article on regression to the mean is taken from this book.

Buy this book.

A day in the life of a short seller

What is it like to be a short seller? What is it like to be reviled? What is it like to be feared utterly? It is the most wonderful experience known to man. To give you a glimpse into my wonderful life as a short seller, I give you here a glimpse of what my days look like.

I wake up every morning at 5AM and run 10 miles. I get home and punch a punching bag until my fists are bloody. Each day I pretend it is someone different. Yesterday it was William Telander (of US Windfarming). Today it was Richard Altomare of Universal Express. Tomorrow it will be the despicable Judd Bagley.

My breakfast is the same every morning: oatmeal flavored with ox blood, followed by a banana. I then peruse my favorite blogs before the market opens. There’s Gary Weiss, Herb Greenberg, David Milstead, David Baines, Sam Antar (blah blah blah former CFO of Crazy Eddie’s and convicted felon; okay, we get it Sam, now shut up!), Tracy Coenen, the SEC litigation releases, and the Forbes Informer.

I usually spend my mid-morning tweaking my stock positions. I run a few quantitative screens to search for new stocks to target. I also search all SEC filings for certain phrases that indicate bad companies (such as “Our CEO is a convicted felon who is also a registered sex offender”). I do not stop for lunch. Rather, I grab a few Ks and Qs and a bottle of whiskey and settle down to find weaknesses in the companies I have targeted. Depending upon the companies I am short my midday reading may also include patent applications, scientific articles, and policy papers.

If my energy starts to flag during the day I rip off my shirt, stand in front of the mirror, and shout the following:
“I am a wolf among sheep!”
“I am a master among slaves!”
“I am a god among men!”
“I shall not only destroy my enemies, but I shall annihilate them, wipe them from existence. When I am done they will be gone, forgotten, they will cease to ever have been!”

To really get the blood boiling, I pump my fists and shout, “I am MICHAEL GOODE and I am a SHORT SELLER. I AM ALL POWERFUL! I CANNOT BE STOPPED!” After this motivational interlude I can face the market even if I am down seven digits on the day.

In the afternoon I always call up Patrick Byrne to harass him. I actually get through to him once in awhile. I once pretended I was his father and he believed me for 10 minutes into my diatribe against his conspiracy theories. Late afternoon there are usually more phone calls to many of the big short-selling hedge funds. So far I’ve got a better IRR than Jim Chanos and I like to shove that in his face. He is too much the gentleman to point out that he manages 10,000 times more money than I do. I then call up the Sith Lord, Patrick Byrne’s best friend. I had a bet with him about Overstock.com’s [[ostk]] inventory turns and it looks like he won that.

Sometimes I call up my journalist buddies. I have several journalists on the take, although I do not use their services too often. Anyway, when I focus on truly deplorable companies I have no need of any help. After I am done with phone calls I will usually look up the new financial research (shout out to my buddy Dr. Sloan! Booya!).

By the time I am done with all this it is usually 7pm and I stop for a quick bowl of rice and steamed vegetables. I then settle into my easy chair for another 4 hours of reading financials. And that is a day in the life of a short seller.

Disclosure: If you cannot guess what I should disclose about the above article then I cannot tell you.

Book Review: The Little Book That Beats the Market

Despite an audacious, even pretentious, title, Joel Greenblatt’s Little Book that Beats the Market is a worthwhile book. It seems absurd to pay so much for such a little book, but do not let that get in your way.

There are two keys to any successful investment strategy: having a winning strategy and sticking to that strategy. To stick with a strategy takes guts and determination. Beyond that, you must also be utterly convinced that your strategy will work. That is why I am a value investor and I pay no attention to many things that other investors fancy, such as new technology, paradigm shifts, and exciting products. Because so many investors before me have successfully used the basic strategy I use, I can rest assured that at worst I will do no better than the market as a whole. I fully expect that I will outperform the market by about 5% per year over the next 10 years.

Greenblatt’s book is useful first because it reaffirms much of what we already know and gives us data to increase our resolve. Second, his book can give us a good way to screen stocks.

The magic formula that Greenblatt mentions in his book is this: take the stocks with the combination of the best earnings yields (the inverse of P/E) and the best ROC (return on capital). Invest in each stock for a year and then repeat the procedure.

This is different from a true Graham-style value investor, who cares more about finding companies that are purely undervalued in terms of the P/E ratio or earnings yield. Overall, I agree with Greenblatt more than Graham, especially with pure value stocks seemingly overvalued now.

Now, one of the keys of Greenblatt’s magic formula is that for earnings yield he does not use just the inverse of P/E. He uses EBIT / Enterprise Value. For an explanation of why this is a good thing, see the forthcoming article, “Accruals & EBITDA,” which includes a great example I blatantly took from Greenblatt’s book.

The other key to the secret magic formula for immortality and enlightenment (or something like that), is ROC. No, not the bird. Not even receiver operating characteristics. ROC is Return on Capital. It is not to be confused with ROA (return on assets) or ROE (return on equity). It is harder to calculate than either ROE or ROA, but it is more precise and more useful.

All three terms measure the efficiency of a company’s use of capital. Each is calculated by taking net income and dividing by a different measure of capital. ROE uses the amount of stockholders equity; this is flawed because stockholder equity bears little relation to a company’s assets. ROA uses the total assets of a company; this is flawed because it includes non-earning assets such as goodwill.

ROC includes only earning assets; it uses EBIT as the measure of net income and net working capital plus net fixed assets as the measure of capital. It is thus a more true measure of how much money would need to be expended to achieve a certain increase in earnings. A ROC of 30% would indicate that for each dollar spent on new capital equipment, 30¢ of EBIT would be produced.

Why is ROC important? Any business, no matter how bad its ROC, can be a good deal if bought cheaply enough. However, if the ROC is 3%, it would be foolish to expand the business—it would make more sense to invest that money in bonds and earn 4.5% with no risk. Thus, the higher the ROC, the more profit will accrue in expanding the business. Investing in such great businesses is a way to achieve investing success.

The magic formula simply ranks companies on ROC and EBIT / EV and produces a list of the companies with the best average rank. While this is a very simple concept, it is a good one. I heartily recommend screening for stocks using this method. Greenblatt has even made it easy for us at his website (free registration required).

Buy the book. It is a good introduction to investing and thus makes a great gift.

Disclosure: This review was originally written two years ago and published elsewhere.

Just One Thing

I just finished John Mauldin’s new book, Just One Thing. It took me only two days to read. I cannot enthusiastically recommend this book even thought there are some nuggets of wisdom in it. In the book, twelve investment writers each give their one best investment idea.

Some of the authors rambled and others (Bill Bonner, George Gilder, John Mauldin) did not have anything useful to say that you could not have already picked up from reading Mauldin’s email newsletter or other sources. For those who are not familiar with Dennis Gartman, James Montier, Gary Shilling, and Richard Russell, their chapters make good reading.

The two best chapters were Ed Easterling’s chapter on the capital asset pricing model (CAPM) and its faults and Rob Arnott’s chapter on non-market-weighted index investing. Easterling does a good job of explaining problems with how we look at risk. Arnott makes a good case for avoiding index investing in market-weighted indexes such as the S&P 500. In a market-weighted index, companies that are selling above their true value will be overweighted while companies that are selling below their true value will be under-weighted.

The solution is to invest equal amounts in all different companies. By investing equal amounts in the stocks in the S&P 500, you can average a return of 2% more per year over the market-cap weighted S&P 500. Of course, that is what investors in individual stocks should do. By putting the same amount of money into each stock, regardless of market-cap or price, investors lower their risk while increasing our returns.

Overall, Just One Thing is a decent book and a quick read. Consider buying it.

Disclosure: This review was originally written two years ago and published elsewhere.

Comcast to Shareholders: Screw You!

Comcast [[cmcsa]] has agreed to pay its founder a salary for a full five years after he has ________. The logical (and upsetting) conclusion of that sentence is “retired”. No public company or even private company with minority shareholders should ever pay an executive who is retired or otherwise not contributing. However, Comcast has decided to take callous disregard of shareholders to a whole new level by agreeing to pay its founder for five years after he has died. He will even be paid a bonus in that time. Ouch.

Disclosure: I have no position in CMCSA, nor am I a customer. I have a disclosure policy that shall never die!

Echostar’s $63 million dollar mistake

Oops. Echostar [[dish]] lost $63 million more over the last few years because they included the same income in multiple years. A new SEC reg requires companies to disclose financial errors that are not material but through repetition have become material in aggregate. Sadly, companies do not have to run this through the earnings statement and can take it straight to the balance sheet. Unsophisticated investors may never even notice. See the original article by David Milstead over at the Rocky Mountain News. I recommend subscribing to his column via RSS.

Disclosure: I have no position in DISH; I am a customer. I have a disclosure policy.