Screening For Value

With so many companies to research out there how does one go about finding potential value stocks? Value investors tend to read a lot; Francis Chou has even been quoted as saying he reads upwards of 200 pages (newspapers, magazines, books, etc) every day. On top of daily reading it's important to have a resource to go to when you are fresh out of ideas and need that next company to take a deep dive into. This is where stock screeners are useful.

The best stock screener I have found to date is ADVFN. It is completely free and can screen US, Canadian and UK equities. Also, it has more fundamental criteria available than I've seen anywhere else. If there are any other screeners you are aware of I'd be grateful if you posted them in the comments for the readers, although I challenge you to find one better than ADVFN.

Following are some of my favourite criteria to screen for as well as the constraints I like to place on each:

• Gross Margin: I like a gross margin of at least 20%, this ensures that the company has the ability to alter pricing in order to push through competition and difficult times.
• Inventory/Sales: Industry specific, but you don't want the inventory turns to be too low, especially if you are placing a significant value on tangible assets - the longer the inventory sits for, the more uncertain its value will be.
• Net Cash from Continuing Operations: While GAAP earnings may be negative, these companies can still possibly be cash flow positive. I would be wary of any business that does not show positive cash from operations as they will just be eating into their cash asset and you can't predict for how long.
• Current Ratio: Must be greater than 1 otherwise the company does not have the ability to meet its current obligations. In a market like this where funding is increasingly difficult to raise this is a situation companies should be trying to avoid.
• Price to Earnings Ratio: I like P/E to be less than the long-term market average of 15. This is a good indication that the company may be undervalued, but the specific industry also needs to be considered.
• Price to Book Ratio: I keep this under 2, depending on what I am searching for, just to screen out those companies that are most likely overvalued. There are companies that warrant a premium price/book but these companies will also have a high return on capital, so you will tailor your screen to look specifically for those.
• Price to Tangible Book Ratio: Interesting companies can be found if this criteria is set to less than 1. These will also most likely be companies in distress however so they should be approached with caution.
• Return on Invested Capital: You can set this to be below your estimate of average cost of capital to find those with turnaround potential. Another option is to set this variable greater than your estimate of average cost of capital and combine it with a screen for companies with low Price to Book in order to find companies that are likely trading below fair value.
• Long Term Debt to Total Capital: I set this to a max of 60% and then I evaluate based on the specific company I find. Some industries, those with steady cash flows, can safely service high levels of debt. Then there are those with more variable cash flows that should keep debt to a minimum. Over 60% however is likely getting close to the upper limit of safety for any company.
• Sector: If you want to incorporate a top down view into your investments then screening by sector can be a rewarding way to significantly narrow the options.
• Institutional/Insider Holdings: I usually don't set restrictions for these variables but I do like having them available so that I can get an idea of share ownership. For example, when looking for stocks with turnaround potential I would be hesitant to invest in a company with low institutional and insider holding as no one has an incentive to get the job done.

The above criteria are not always used concurrently. If they were, many times you won't find any companies appearing on the list. Part of the fun of a stock screener is to experiment, play around and see what you find. Different combinations of the above criteria among others, and their individual constraints, will yield different results.

I hope this is helpful in your search for value. As always, I welcome your thoughts and comments and I encourage you to share your own criteria for screening.

A Value Investor Is What I Choose To Be

We've had a lot of new visitors this week coming from various referrals on the web, and other sites where my articles are syndicated. I just wanted to take this opportunity and say welcome. It is my hope that you find this site to be a useful resource whether you are an experienced investor or just getting started. I recommend subscribing to the RSS feed (the orange button to the right) in order to receive the latest posts as they become available. Some articles, especially investment ideas, may be time sensitive and RSS is the best way to get them right away.

The articles and information on this site tend to be focused on the value style of investing as that is what I practice myself and is what I know best as a result. Very important however, especially if you are new to investing, is to pick a style/methodology, learn it well and stick to it. The worst losses in the stock market come from letting your emotions dictate your buy/sell decisions. That is when you are most likely to buy high and sell low; exactly what you do not want to be doing. As a value investor I have a lot of conviction in the value investment philosophy. I definitely do not preach it to be the only way to invest and there are certainly many very successful investors from other disciplines. Over the past few years however I have followed practitioners, read research and conducted some of my own studies. What I have learned is that there truly is a significant and persistent premium attributed to value investing over time and as a result this is the style I am practicing, preaching and most importantly sticking to.

The best place to get started on this site is by clicking on the "basics" heading under the topics to the left. This series of articles will give you a brief introduction to the investment methodology which I utilize. Just as there are many value investors out there, there are also many ways to practice value investing. The methodology I use, which I studied with Dr. George Athanassakos (Ben Graham Chair in Value Investing at the University of Western Ontario) while pursuing an MBA, is based largely on the teachings of Bruce Greenwald at Columbia Business School. A great resource for additional information on this methodology is Bruce Greenwald's book - Value Investing: From Graham to Buffett and Beyond.

Please let me know either through the comments or via email (jonathan at jonathangoldberg dot com) if you have any suggestions for content that you would like to see here and I will do my best to accommodate. In the past I have posted investment ideas, summaries of lectures by notable value investors, market commentary and research findings (of which I admit may be the driest of the bunch i.e. last post). Speaking of research findings, while very dry my last post is an excerpt from a study I have conducted and the excerpt gives a great overview of some important studies which you can research on your own. For those of you that choose to skip that post I hope to have a more "user friendly" post in the future summarizing the findings as well as their applicability to you and your investments.

Look around, read previous posts and think about what you'd like to see in the future. And most importantly, subscribe to the RSS feed to the right of this page so that you are kept up to date with my posts as they become available. Oh yeah, and tell your friends to visit too!

Value vs. Growth Stocks: A Working Paper

I recently conducted a study with Dr. George Athanassakos. In the coming weeks I'm hoping to reformat it for publication in a journal. In the meantime please see below the abstract as well as an excerpt from the paper. Your thoughts would be very valuable.

ABSTRACT

In this paper we study the performance of value versus growth, and the resultant value premium, from 1951 to present. We look specifically at post-war recessionary periods in the United States. We are especially interested in the performance of value versus growth during a “credit crunch” such as the one in the current recessionary period. We find that (1) the only times during recessionary periods that one of either value or growth had positive returns, while the other had negative, were times when growth was negative and value was positive, (2) during both the current financial crisis, and that of the early 90’s, value suffered but performed no worse than growth and (3) there was a significant negative value premium in each of the 12 months leading up to the four most recent bear markets. This paper could prove useful to other researchers of the value premium as well as to practitioners who may be interested in developing a predictive model for use in the field.

EXCERPT

The value premium is the excess return of value stocks over the return of growth stocks. On the aggregate, and for research purposes, value stocks are usually described as those stocks with a low price-to-earnings ratio (or high earnings-to-price ratio). Value stocks can also be selected based on other metrics such as the price-to-book ratio. In practice, the value premium may have even greater significance when an aggregate basket is not used, but rather when specific equity selections are made. In this paper we set out to find how the value premium has performed during the current recession and what impacts a liquidity crisis may have had on value. In doing so we also determine the value premium for specific recessionary periods in the post-war United States and then draw implications from this for future research on the value premium.

A body of research is available demonstrating the significance of the value premium over long time periods (Lakonishok, Shleifer and Vishny 1994, Capaul, Rowley and Sharpe 1993) and in different parts of the world (Athanassakos 2006, Fama and French 1998). Athanassakos (2006) provides evidence for a consistently strong value premium over a 1985-2002 sample period in the Canadian market; a value premium that persists in both bull and bear markets as well as in recessions and recoveries.

There are two main causes of the value premium proposed in the body of research available today; these are the premium as a compensation for added risk and the premium as a result of errors-in-expectations. The most recent research available suggests that the errors-in-expectations theory is the likely cause of the value premium (Athanassakos 2006, Chan and Lakonishok 2004, Lakonishok, Shleifer and Vishny 1994). It is argued that markets are inefficient, evidence being from observations such as “The January Effect” (Athanassakos 1992), and as such there are times when certain equities are unduly overpriced or underpriced due to unrealistic future expectations based on historical returns.

In addition to research on the value premium over long periods of time, there is research available that has looked specifically at value stocks during periods of recession/expansion and bull/bear markets on the aggregate. Some of this research shows that historically the value premium persists during all aspects of the business cycle (Arshanapalli and Nelson 2007, Kwag and Lee 2006). There is also a body of research, however, which demonstrates that fundamentally value stocks are riskier during bear markets and recessions and that the value premium would be negatively affected during these times (Chen, Petkova and Zhang 2006, Xing and Zhang 2005, Black and Fraser 2003, Asness, Friedman, Krail and Liew 2000).

Kwag and Lee (2006) provide evidence that a value portfolio consistently outperforms a growth portfolio throughout the business cycle and that the benefits of value investing are even greater during periods of contraction than during periods of expansion. Arshanapalli and Nelson (2007) also provide strong evidence in support of this, showing that during the 1962-2005 period value portfolios suffered smaller losses during down markets than did growth portfolios. Their study also shows that investing in a high book-to-market portfolio during this time offered a significant value premium in addition to the downside protection that it offered in bear markets. This value premium was significant for all firm sizes. As a result, Arshanapalli and Nelson believe that the value premium doesn’t appear to result from bearing the additional risk these stocks may inherit during a recession.

While the aforementioned evidence provides a strong case for the performance of value over growth stocks during all aspects of the business cycle, value stocks have also performed poorly for significant periods of time (Asness, Friedman, Krail and Liew 2006). Black and Fraser (2003) provide strong evidence that the future expected value premium is negatively related to recently recorded GDP growth over long periods of time. Their research may contradict that of Kwag and Lee (2006) and Arshanapalli and Nelson (2007) in that it lends support to the view of the value premium as a reward for non-diversifiable risk associated with financial distress. They argue that value stocks are riskier during times of recession when investors least want to hold a distressed stock. The findings of Xing and Zhang (2005) provide support to this research as they find that the fundamentals of value firms decline sharply in recessions. While growth firms also experience a decline in fundamentals, the decline experienced is not as deep as that of value firms. The specific areas of underperformance during these times are in earnings growth, dividend growth, and sales and investment growth. It is proposed that as value firms generally have less flexibility than growth firms, due to a higher proportion of tangible assets, they are more susceptible to cost reversibility. As such, they conclude that value firms have a difficult time in smoothing negative aggregate shocks and are more affected by negative business cycle shocks than are growth firms. Providing further evidence to this research are Chen, Petkova and Zhang (2006) who demonstrate a countercyclical value premium, implying that value is riskier than growth in adverse economic times when the price of risk is high. They, like Xing and Zhang (2005) propose that as cutting capital is more costly than expanding capital, value firms don’t have enough flexibility when scaling down during negative business cycle shocks; value is therefore to be more adversely affected by economic downturns.

The previously mentioned research, regarding the demonstrated and expected value premium during negative business cycle shocks, is not unified in findings or expectations. Also, there has not been any research conducted on the performance of the value premium during specific negative business cycle shocks in history. While a significant body of research is available showing that value has outperformed growth in negative business cycles, much of the research points to evidence that value could be expected to underperform when the price of risk is high. This leads us to believe that during a financial crisis, such as the one present during the most recent recession, a significantly negative value premium could be expected. This paper studies a number of specific post-war recessionary periods in U.S. history, including the current one, in order to establish the periods where value did indeed underperform growth. We also provide a real situational analysis from these findings. Our research looks at value versus growth over a longer period than previously conducted research and delves into specific periods of time. To the best of our knowledge this has not been conducted previously. As practitioners believe that the outperformance of certain investment styles can be traced to economic fundamentals (Kao and Shumaker 1999), this paper also considers the macroeconomic indicators of the time periods that are being studied.

We find that it is difficult to make many connections between the realized value premium and the observed macroeconomic indicators in each period. This is likely due to most instances of the variation in the value premium being due to a standard deviation of the value premium that would be expected. There are a number of interesting and specific findings from our research that should greatly add to the study of the value premium in general. Firstly, all the instances where one of either growth or value had negative returns while the other had positive returns were instances where the returns of the growth portfolio were negative while those of the value portfolio were positive. These instances seem to be around situations involving a bubble in the equity markets. Secondly, it is apparent that value did not underperform growth in the most recent financial crisis. It seems that the returns of a value portfolio, while suffering, merely performed as poorly as those of a growth portfolio. This was likely due to a flight to quality across all financial assets and the same phenomenon can be observed during the 1990-1991 recessionary period, which can also be classified as a “credit crunch”. Lastly, and perhaps most interesting, is a persistent negative value premium observed in each of the 12 months prior to the most recent four bear markets. This trend goes back almost 30 years and, as a potential leading indicator, may prove to be the foundation for a predictive model in the future.

A Quote - Ric Dillon

"We think shorting makes us better analysts. Charlie Munger says you really understand a company when you can articulate the negative scenario better than the person on the other side of the trade. We also think that from a business standpoint, if you’ve done all the work and conclude the negative scenario is most likely to play out, it makes a lot of sense to be able to short."

- Ric Dillon, CIO & CEO, Diamond Hill Capital Management, Inc.

Position Update - TSE:BUI

I am now long shares of Buhler Industries, Inc. (TSE: BUI) and the disclosure on the recent analysis has been amended. I purchased shares during trading hours today; the second trading day after initial publication.

Buhler Industries, Inc. (TSE: BUI)

Buhler Industries (BUI) is a manufacturer of high-quality tractors and other related equipment for use in the agricultural industry. They are the only manufacturer of such tractors in Canada and one of four in the world.

The following screen brought this company to my attention:

• Return on Invested Capital (ROIC) greater than 10%
• Price to Book value less than 2
• 5-year earnings growth greater than 5%
• Debt to Capital less than 50%

What I was expecting to find was a company perhaps having a competitive advantage and that should be trading well above its book value but for some reason was able to be bought relatively cheap. BUI definitely wasn’t what I was screening for but I’m happy to have found it. The only reason it showed up on this screen was due to its turnaround performance in FY2008. After 5 straight years of declining sales and abysmal returns on capital, this company suddenly showed an ROIC of almost 17% in 2008 and reported its largest sales number since revenues started to decline in FY2003. This definitely warranted looking into further.

BUI is currently trading at a price/earnings (P/E) of 6.25, a price/book of 1.13 and a price/book (tangible) of 1.29. The company traded at an approximate average P/E of 18 over the previous 5 fiscal years. This definitely looks cheap but the question remains, is it unusually cheap or is the low price warranted? With a market cap of $136 million and no analysts covering the stock to my knowledge, there is definitely a possibility that this company is flying under the market’s radar only to be noticed at a future date.

Coming to BUI’s rescue in FY2007, the company’s worst reporting year since FY2000, was a Russian company by the name of Novoe Sodruzhestvo. This company’s reputation in Russia is, fittingly enough, that they acquire and transform factories. As is apparent from their track record, Novoe Sodruzhestvo lives up to their reputation. Even more fitting is that one of their previous acquisitions is the largest producer of combines in Russia. If you don’t know what a combine is, all that matters is that they are fixed onto tractors and used in agriculture. The Russians have already begun diligently working on their plans for BUI, which include introducing new products to the North American market as well as taking advantage of the Russian company’s distribution network in Eastern Europe. Over 160 official representatives of the combine manufacturer in Russia, Eastern Europe and Central Asia will support the distribution into new markets.

The results of the new ownership have so far been promising. The new owners restructured sales and production activity to be more efficient and reinvigorated the work force with some changes at the management levels. In addition, the Russian’s network overseas enabled the company to ship double the amount of tractors as in the previous year. There is room for improvement, which we can expect to see, as suppliers couldn’t keep up with the production level. The company has already begun improving their supply chain and efforts have been successful to date. Next year’s plans are to further develop the product to cater to client tastes, develop the dealer network through an aggressive marketing budget and more finance options, and to further improve the supply chain by finding replacements for weak suppliers.

Before even attempting to arrive at a value for a company it is important to understand the company and its assets as well as the strategic positioning and the current environment in which the company is situated. Only then can an estimate of fair value be arrived at with conviction. Prior to arriving at or relying on the following numbers it is helpful to read the company’s annual reports, most recent quarterly report and to visit the company’s website as well as those of its competitors. Obviously the more time and effort spent understanding the company and its industry, the better. The largest risk I see going forward is the strengthening Canadian dollar and the impact this may have on the amount of international sales and/or the conversion of those earnings into Canadian dollars. I believe this to be mitigated however by the company's continuing operational improvements as well as by the margin of safety employed in arriving at an entry price.

Based on the current capital structure of 30.2% debt-to-capital and 69.8% equity-to-capital I found a weighted average cost of capital of 8.41%, using proprietary measures. With a ROIC (replacement value of balance sheet) of 4.02% in the last 12 months, earnings power value (EPV) would be expected to be below net asset value (NAV). EPV was found to be $5.65 per share with the major driver being normalized zero-growth free cash flows of $12 million. NAV was found to be $8.75 per share with the major drivers being hidden balance sheet assets (product portfolio and customer relationships) of $33.71 million.

If you would like to understand these numbers in greater detail please see my explanatory articles.

Remember, as value investors we do not want to project future growth unless a company has a sustainable competitive advantage and as such I do not project growth for BUI in my valuation. Rather I see the new management as knowledgeable, capable and as motivated to bring the company’s EPV in line with the competitive state of NAV. It is for this reason that I give an 80% chance to this being accomplished, which implies an intrinsic value of $8.13 per share for the equity.

Utilizing a 33% margin of safety, an entry price of $5.44 is recommended. At its current price of $5.44 this stock should be a valuable one to purchase and to hold onto for the long-term.

Disclosure: Long BUI

Lecture Summary - Francis Chou

Francis Chou is the President of Chou Associates Management Inc., based out of Toronto. His funds, which were started as part of an investment club in 1981, won him the Canadian Investment Award title “Fund Manager of the Decade” in 2005.

The following is a summary of Francis Chou’s lecture, given to the Richard Ivey School of Business on August 19th, 2008.

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Mr. Chou began his lecture with some pointed questions to the audience. When you go shopping do you look for bargains? And when you find bargains does it make a good purchase and good financial sense? Presumably the majority of the audience raised their hands as Mr. Chou declared them to have the makeup of good investors (I did not attend this lecture in person and the audience was not visible on the video recording). He stated further that if you can take those principles from your everyday shopping experiences and transfer them to the stock market then you are well on your way to being a good investor. You do need to learn accounting however as it is the language of business.

Mr. Chou’s views on the pharmaceutical industry are that it contains good, strong companies with high returns on capital although a negative aspect is that it’s really hard to forecast the pipeline; you never know what new drugs competitors will be coming to market with in the coming years and which will be the blockbusters. To mitigate this risk he bought a basket of companies in the sector. Regarding allocation he says that if you are finding bargains in troubled industries you diversify, but if you are finding bargains in good companies then you concentrate.

The reason he saw the pharmaceutical sector as a good bet was because they were beaten down due to expiring patents. He saw this as a good opportunity to step in and buy a basket as there are sure to be new drugs coming through the pipeline in some of these firms, especially with the amount of R&D spend these companies expense. He foresees holding this basket for upwards of 5 years until there are significant events in the industry to drive the sector higher. He also mentioned that in a scenario like this, when you feel the whole sector has been hit and you want to diversify, an ETF is a good option.

As a side-note, when valuing companies Mr. Chou will never rely just on price-to-earnings as earnings can easily be manipulated. He likes to look at free cash flow multiples as well. And regarding evaluating the quality of management, he says to look at capital allocation over many years, not just one year. Additionally, numbers tell a story so you want to look at the numbers first and then evaluate management qualitatively as well.

The largest take-away for me from this presentation is the value of diversifying in certain industries, even as a value investor. I’ve always learnt that as a value investor you want to select the stock that is undervalued and have conviction in its true value, which mitigates the need for diversification and only risks minimizing your returns if you do. Mr. Chou points out a great example of an industry where you may know there’s value but you also have to realize the limitations inherent in making a selection as you never know which company’s laboratory the next blockbuster drug will come from.

Towards the end of his lecture Mr. Chou said something that I would like to reproduce here verbatim.

“If you believe in the value principles and you buy cheap just like you do in your day-to-day life and you think it makes good business sense, just do that in the stock market and you will be successful. The only difference in the stock market is that sometimes it plays on psychology; it plays on your own psychology, on your fears, your greed and sometimes when you buy a stock and it’s cheap it can get even cheaper. If you know what you’re doing and you know you’re buying it cheap and you have that courage to do what is right regardless of what the crowd is doing, there’s no reason why you should not be successful.”

He then went on to say, “And that’s what I did, I just stuck to my guns.” A great presentation by a great investor that should give us all the extra bit of conviction we need to stick to ours.

Video: The Ben Graham Centre for Value Investing

Liquidating the Balance Sheet

As mentioned in my basics course on value investing, the first step I take in valuing a company is discovering its net asset value. That is, the value per share of the company’s assets after accounting for (subtracting) all liabilities. If the company is healthy, and operates in a viable industry, the assets should be marked to their replacement value. These assets need to be replenished as they are used and any competitor wanting to enter the industry would need to pay fair market value in order to acquire similar assets. This replacement value is the normal case and would then be followed by an analysis of earnings power value, as discussed on this site previously.

What if the company is in trouble? Perhaps the company is in imminent threat of default and is not expected to continue normal operations into the future. Earnings power analysis is then useless as we can expect the company to liquidate its assets in order to pay debtors, with holders of common equity receiving the leftovers. In this case the assets of the company should be valued at liquidation value. We assume all assets are to be sold off to the highest bidder. Liabilities are then subtracted from the value of these assets to find what would remain for the holders of common equity.

As value investors, we don’t only consider companies that have long-term holding potential. Value investing is about buying an asset for less than it is worth. In some instances this may involve purchasing a company facing bankruptcy if the investor has conviction that the assets will be worth more to the common equity holder after liquidation than they can currently be purchased for, always including an appropriate margin of safety.

Valuing assets at liquidation requires a great deal of expertise and may require the services of an expert valuator. Keeping some things in mind, however, should assist you in arriving at a reasonable estimate when needed.

• Asset liquidity. The more liquid the assets are, the more likely they are to be sold at book value. For instance, cash is always valued at book value even in the case of liquidation. Marketable securities are another example of a highly liquid asset.

• Failing business vs failed industry. If the business being liquidated operates within a thriving industry then you can expect that there may be competitors willing to purchase the assets. In the case of a non-viable industry however, assets on the balance sheet are more likely to be sold at scrap prices.

• Asset specialization/customization. The pool of potential buyers shrinks the more specialized or customized the asset being sold. A warehouse that is just a stock space for storing items will have many potential buyers and will likely be sold at close to fair value (given a decent real estate market and enough time to sell). On the other hand, a warehouse that has been custom built and designed to house specific types of goods needing special care will likely be sold at far below replacement or fair value in the case of liquidation. It is important to keep industry conditions in mind though as even in the case of very specialized assets on the balance sheet, these assets could have a fair chance at being purchased closer to their replacement value if the industry is viable. In the case of a thriving industry, competitors will likely be bidding to purchase the asset in order to acquire the extra capacity on the market.

While valuing balance sheet assets at liquidation value can be a difficult task, keeping the above concepts in mind should assist you in arriving at a realistic estimate of their value. Best of luck, and as always I will do my best to respond promptly to questions and/or comments posted below.

A Quote - Warren Buffett

Asked if anything was keeping him awake at night, he said there was not. “If it’s going to keep me awake at night,” Mr. Buffett said, “I am not going to go there.” - The New York Times (Sept 7, 2009)

Boost Returns By Selling Options

Options can be a very useful tool to boost your portfolio's returns. While options can be very risky when used to speculate, this isn't necessarily the case when using options backed by stocks you would like to own or which you already own.

Value investors looking for increased returns to their portfolios can employ two options strategies. One is selling covered calls, and the other is selling naked puts.

Being "covered" means that you already own the asset needed to fulfill the obligation of the call option if exercised. Your downside is limited as a result. A "call" means that the purchaser of the contract has the right to purchase the stocks specified from the seller at the exercise price (upon expiry if the market price is at or above the exercise price).

As a value investor you want to hold onto your investments until they approach your estimate of the intrinsic value. Depending on the situation this can take from a few months to a few years. By selling covered calls at your estimate of intrinsic value you receive the premium from the contracts and only need to sell the actual stocks if they reach their fair value by expiry. If this doesn't happen you can employ the process repeatedly, generating a steady stream of premiums.

A "naked" option means that you are left exposed to unknown downside risk in the event that the option is exercised. A "put" means that the purchaser of the contract has the right to sell the stocks specified to the seller at the exercise price (upon expiry if the market price is at or below the exercise price).

By selling naked puts, the value investor is committing himself to purchase a security only if the market price at expiry is at or below the exercise price of the contract. If a security that you would like to own is currently trading at too high of a price then by selling naked puts you essentially earn a premium today and only need to purchase the stock if it reaches your entry price or below by expiry.

As shown above, the contract sold for a covered call should have an exercise price equal to or slightly below your estimate of intrinsic value and the exercise price of a naked put should be equal to your desired entry price. The last decision is the time until expiry, which is a personal choice. The longer the option has until expiry the more valuable it will be, but it also exposes the seller to the risk that something material may change within the company during this time. If a material event impacts your estimate of intrinsic value then you may be contracted to sell or purchase stocks at prices you no longer want to. As a general rule, puts can be sold for a long time out if you believe the company to be stable with changes to intrinsic value (on the downside) being unlikely. Selling calls far into the future however may cause you to hold onto a security well passed the time it reaches intrinsic value, perhaps causing you to miss a window of opportunity to sell if market fluctuations bring the price back down.

The risk involved in these strategies is that you may be either a) forced to purchase a stock for more than the market price (in the case of a put) or b) forced to sell a stock for less than it is currently trading in the market (in the case of a call). Either way, if you are confident in the intrinsic value you determined for the company then you are no worse off than if you didn't sell options but rather purchased and sold the stocks according to your stringent entry and exit points. In fact you are better off, because with options you've earned the premiums.

Lecture Summary - Seth Klarman

Seth Klarman is President of the Baupost Group, LLC. His firm, founded in 1982, manages $15 billion for institutional and high net worth clients. His now out of print book "Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor" sells for $1,200 on Amazon and $2,000 on eBay and has been stolen from most libraries.

The following is a summary of Seth Klarman's lecture, given to the Richard Ivey School of Business on March 17th, 2009.

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Klarman opened his speech by pointing out that peoples' investing temperament seems to be influenced by the state of the market when they graduated from school. As he said, "If you remember how cheap things can get, you don't easily forget that lesson." I attended this lecture in person while completing my MBA, and this statement had a direct impact on me as I would be graduating in one of the worst market climates in history.

In defining value investing, Klarman describes it as a risk averse approach. He says that it's a series of principles and a way of thinking about investing that forces you to first focus on risk, and only then on returns. As the downside is where the pain is for most people, value investing protects against that first.

Klarman's understanding based on research he has seen is that value investing via a mechanical approach (purely quantitative according to P/E, P/B, etc.) adds about 1% to 2% a year. He wonders, however, why anyone would trust a dumb formula when they can do even better through proprietary analysis and investigation. In doing so he can tell when some situations that look cheap (according to a mechanical method) aren't in fact that cheap. As such, his firm's approach to value investing is to follow the philosophy's principles while relying on their own fundamental and detailed research.

Klarman's approach to investing is based on three underlying pillars:

• Focus on risk before focusing on return. This is not risk in the form of beta or volatility but risk in the sense of how much you can lose if you do in fact lose. He mentions that beta or volatility risk is not really risk unless you must sell on the day the price happens to be low. This approach he describes is very different from wall street where reports tend to be written using single point estimates focusing on the upside, with rarely a mention of the various possibilities of potential downside risk.
• Adopt a view toward absolute returns. The world seems to focus on relative performance instead of absolute performance. This sticks most investment firms to the group of "ensured mediocrity" as many just try to lose less than their peers. In focusing on absolute performance, the thought to Klarman of losing any of his clients' capital is unacceptable.
• Employ a bottom-up investment approach. Most of the world employs a top-down investment approach by analyzing the economy, interest rates, etc and then applying these findings to decisions to invest in certain sectors that should perform well in the relevant environment. Klarman does not know anyone with a long-term success rate in doing this. Macro forecasting is very difficult to do, and another issue is that even if you are right you must also be early or prices would have already moved to reflect your viewpoint. While Klarman will still think about the macro environment, he analyzes all his investments using a bottom-up approach.

Klarman started his firm in a similar fashion to Benjamin Graham's beginnings. He had a small amount of capital and would rummage around for mis-priced situations where there was a reason for mispricing and a catalyst present that would enable him to make money. Over the years his firm developed the following core principles:

• Picking clients to ensure the firm will be able to maintain a flexible investment approach. This flexibility also allows the firm to capitalize on opportunities in different markets and asset classes.
• Large amount of employee capital invested in the firm. He wants his firm to be the best place for employees to invest their capital. This ensures a vested interest in the work the employees are performing and would also be a great selling point.
• Having an edge, a reason to think they can outperform. The biggest edge any investor can have, and his own firm's biggest advantage, is in having a long term investment horizon. Lots of funds feel pressure to hold cash or to buy short-term situations but are unable to seek out 3-5 year holds as the capital may only be available for 6 months.
• Foster strong relationships. The firm works hard to ensure they have the best brokers and that they are these brokers' best clients. If they are somebody's first or second largest client then they know they will be made aware of opportunities when large blocks of shares come on the market, etc.
• Having a niche. The firm's particular focus is in complicated situations, one of their favourite areas being in distressed debt. As many firms have mandates to sell when debt hits this distressed level, Klarman's firm is able to take advantage of the ensuing mispricing and is able to make a profit. This is a much more ideal situation then buying from a seller who knows more than you and who has done the analysis and has decided to sell as a result. Klarman's firm really likes situations where there is a supply/demand imbalance. Other examples are situations where a stock is getting kicked out of an index or where a stock is being spun-off from its parent company. In both these situations there are many institutions and indices that would need to sell indiscriminately. As Klarman says, "Time is scarce so you want to look at these situations where there is a good chance of mispricings."

More information about Seth Klarman as well as insights into the Baupost Group's holdings can be found at GuruFocus.com.

Video: The Ben Graham Centre for Value Investing

Less Room to Fall for Value

Today was not a good day for the markets, to say the least. These daily market fluctuations don't faze value investors though, due to the conviction we have in our investments' true worth.

Recently I recommended an investment in Lockheed Martin Corporation (NYSE: LMT). Since it's a high conviction investment of mine I tend not to follow the daily ups and downs in the share price. Rather I keep an eye out for any new press releases or industry news that may cause a significant change in the model. Today, however, I couldn't help but notice that while the S&P was down by more than 2%, my investment in LMT was actually up 0.83%! Granted, this is a daily fluctuation that I already stated no interest in, but barring significant news one would expect a large-cap security like this to move along with the market.

I would like to believe that LMT didn't suffer along with the rest of the market because it is one of the truly undervalued stocks in today's speculative and possibly overvalued market. While we value investors don't give notice to daily fluctuations in share price, it comforts me to know that we probably do have the upper hand when the market decides to go south.