Sunday, November 8, 2015

Two dozen articles of interest

Auto loans
Harvest Investor writes that automotive debt, adjusted for the size of the labor force, has grown more slowly during the past decade than headline figures suggest. Auto debt per worker has grown dramatically over longer periods, however.

Book reviews
Inner Scorecard has a nice review of Robert Shiller's Irrational Exuberance that describes some of book's important ideas.

Bull, Bear & Value discusses Warren Buffett's investment in Stanrock Uranium, a uranium miner that went bankrupt in 1959 and reorganized during the early 1960s.

Vienna Capitalist argues that commodity traders' "one-time" losses are less one-time than they appear. Commodity traders sometimes invest in mining companies as a way of buying minerals at below-market prices, so the traders' trading and investment profits should be looked at together rather than discretely.

Steven Sinofsky dissects Blackberry's competitive failure, writing that "The case of Blackberry is interesting because the breadth of disruptive forces is so great.  It is not likely that a case like this will be seen again for a while." He notes that "description of disruption tends to lose all of the details leading up to the failure as things get characterized at the broad company level or a simple characteristic (keyboard v. touch) when the situation is far more complex."

Jim Chanos offers a bearish analysis of the energy market and argues that Shell, Cheniere Energy, and SolarCity are overvalued.

Ronald Redfield provides an archive of research reports on Enron that were published from 1996 until the company's bankruptcy in 2001.

Exchange-traded funds
Fritz explains why some ETFs may blow up. Arbitrage between ETFs and underlying investments can fail because the underlying securities are much less liquid. It's also possible for an ETF have a short interest many times larger than its outstanding shares, which can create problems if a lot of shares are redeemed.

Alpha Vulture links to a study that analyzes the relationship between intelligence and investing success. Smarter investors are more likely to buy stocks at their monthly lows and to sell their losers while holding onto winners. They also "exhibit superior market timing, stock-picking skill, and trade execution."

A number of compelling investor interviews are availiable online, including:
• An interview with Paul Tudor Jones from January 2000
• Interviews with members of Institutional Investor's "Hedge Fund Hall of Fame"
Bruce Berkowitz's interview with Outstanding Investor Digest in 1992, in which he recommends Wells Fargo stock
• Two Barron's interviews with Glenn Greenberg and John Shapiro from 1987 and 1988

Horseman Capital writes that "Tokyo will see larger expansion of office supply than any other major developed city in the world" during 2015 and 2016, even though Japan's working age population is set to decline significantly over the next 25 years.

Bear of Burrard Street is looking for an internship at an investing firm. If there are any investment managers read this, I would encourge you to take a look at his excellent blog.

Leveraged buyouts
Forager Funds calls Anchorage Capital's acquisition of Dick Smith the greatest private-equity heist of all time. Although Wesray's purchase of Gibson Greeting actually had higher returns, Anchorage's returns were still phenomenal-- a 5200% profit in a couple of years.

Elon Musk
Andrew Aurenheimer calls Elon Musk an obvious fraud and compares him to Eike Batista. Like Batista, Musk manages several large companies at once while making hyperbolic claims about the future. Another similarity the article doesn't mention is that Batista and Musk both pledged their stock holdings for significant loans.

David Merkel explains what the Panic of 1907 and the Crash of 1929 had in common and how Jesse Livermore was able to predict both.

The New York Times describes how Brazil's government-employee pensions are even more generous/outrageous than Greece's.

Horseman Capital notes that Pemex "had burned through all of the equity capital the company ever generated by 2004" and is now using its employees' pension contributions to finance distributions to the Mexican government.

Premier Foods
Investing Sidekick offers a case study of Premier Foods, a British company that made two large, ill-timed acquisitions in 2006 and has struggled to reduce its debt since then.

Kurt Eichenwald writes that Martin Shkreli became the subject of a criminal investigation by the US Attorney's Office after allegedly siphoning money out of Retrophin through phony consulting payments.

A message-board poster describes how Bill Ackman tried to effect a fraudulent merger to save his first hedge fund from failing:

[Ackman] had bet Gothman assets on golf courses that went down the toilet. When I got involved First union (FUR) was in liquidation and had enough equity to pay out all the common $2-$3/share and preferred whole. Ackman made an offer to buy FUR which had $100m in cash or so. His plan was down right fraud as i heard the story.

A friend of mine that bought a lot of the preferred very cheap sued Ackman because he was planning on merging a bankrupt firm into FUR. His apparent plan was buying out the common for cash and not ever paying the preferred a dime of dividends and [stripping] the rest of the preferred's expected payout cash out of FUR for his defaulted golf courses. So the preferred cash would go to gotham and the preferred paper would be backed [by] a bankrupt operation.

My friend said he spent $200k of his own money to litigate this and it came down to literally the last minute before the Judge saw Ackman's plan. He stopped the planned merger.

Mark Manson argues that "happiness requires struggle" and that success is less a result of how much people desire something than how much they're willing to sacrifice in order to get it.

Small caps
Irrelevant Investor marshals a lot of evidence to demonstrate that the historical data showing that small-cap stocks outperform large caps are less meaningful than they appear. Eric Falkenstein previously came to the same conclusion, writing that small-cap stocks' return premium "is an order of magnitude lower than what was originally discovered around 1980."

"Max Vision" argues that Regional Management faces the same challenges as its larger, more prominent peer World Acceptance.

Value and Opportunity is skeptical of SunEdison, writing that the company has no moat and that its "accounts are pretty much incomprehensible not only on the financing side but also cash flow wise." V&O also points of that, contrary to what David Einhorn has claimed, solar panels are depleting assets. Finally, he argues that SunEdison's business model depends on selling assets to yield vehicles that give their investors bad risk-adjusted returns.

Reuters reports that Sweden has "a household loan-to-disposable income ratio of more than 170 percent" and "70 percent of Swedish home owners have interest-only mortgages." A separate Reuters article describes how the Riksbank and the Swedish government have contributed to the country's housing bubble. (H/t Fritz for both articles.)

In a bearish report on Liquidity Services, Off Wall Street offers an anecdote about Wal-Mart that suggests the retailer is losing its famous emphasis on low costs:

[M]ost of Jacobs’ value comes from a contract with Walmart that accounts for about 70% of revenues. Coincidentally, Irwin Jacobs, the former owner of Jacobs Trading, is said to be close friends with Lee Scott of Walmart. It is unclear whether the contract was executed at arms length, just a few months prior to this acquisition, but given Jacobs’ profitability, one has to wonder. 

Anecdotally, we have been told by one of LQDT’s competitors that certain Walmart personnel involved in the reverse supply chain were furious when LQDT acquired Jacobs, as it became clear just how favorable the contract was for LQDT, presumably at Walmart’s expense. 

Wednesday, September 23, 2015

Jack Schwager's interview with John Bender

Stock Market Wizards is the third installment in Jack Schwager's series of interview books. Many people consider it the series's worst book. That may be true if it's judged by its average interview, but Stock Market Wizards also has the single best interview that Schwager has done: his conversation with an options trader named John Bender.

Bender argues that the Black-Scholes formula for valuing options is flawed because it assumes that price moves are normally distributed. Bender believes that a) price changes usually don't adhere to the normal distribution and b) there is no alternative model for pricing options that applies to all securities. As he says:

[There's no] one-size-fits-all model that is better than the standard Black-Scholes model. The key point is that the correct probability distribution is different for every market and every time period. The probability distribution has to be estimated on a case-by-case basis.

Estimating the probability distribution requires knowing who the market participants are and understanding their psychology, how they finance themselves, etc. Bender describes one instance when, contra Black-Scholes, a large price decline was more likely than a small price decline:

[I]n 1993, after a thirteen-year slide, gold rebounded above the psychologically critical $400 level. A lot of the commodity trading advisors, who are mostly trend followers, jumped in on the long side of gold, assuming that the long-term downtrend had been reversed. Most of these people use models that will stop out or reverse their long positions if prices go down by a certain amount. Because of the large number of CTAs in this trade and their stop-loss style of trading, I felt that a price decline could trigger a domino-effect selling wave. I knew from following these traders in the past that their stops were largely a function of market volatility. My perception was that if the market went back down to about the $390 level, their stops would start to get triggered, beginning a chain reaction.

I didn't want to sell the market at $405, which is where it was at the time, because there was still support at $400. I did, however, feel reasonably sure that there was almost no chance the market would trade down to $385 without setting off a huge calamity. Why? Because if the market traded to $385, you could be sure that the stops would have started to be triggered. And once the process was under way, it wasn't going to stop at $385. Therefore, you could afford to put on an option position that lost money if gold slowly traded down to $385-$390 and just sat there because it wasn't going to happen. Based on these expectations, I implemented a strategy that would lose if gold declined moderately and stayed there, but would make a lot of money if gold went down huge, and a little bit of money if gold prices held steady or went higher. As it turned out, Russia announced they were going to sell gold, and the market traded down gradually to $390 and then went almost immediately to $350 as each stop order kicked off the next stop order.

The Black-Scholes model doesn't make these types of distinctions. If gold is trading at $405, it assumes that the probability that it will be trading at $360 a month from now is tremendously smaller than the probability that it will be trading at $385. What I'm saying is that under the right circumstances, it might actually be more likely that gold will be trading at $360 than at $385.

He argues that the same dynamic occurred before and during Long Term Capital Management's collapse:

Last year [1998], it was my belief that stocks were trading on money inflows rather than their own intrinsic fundamentals. IBM wasn't going up because the analysts were looking at IBM and saying, "Here's the future earning stream and we predict the price should rise to this level." IBM was going up because people were dumping money into the market...

A market that is driven by inflows can have small corrections, but it has to then immediately recover to new highs to keep generating new money inflows. Otherwise, money inflows are likely to dry up, and the market will fall apart. Therefore, this type of market is likely to either trend higher or break sharply. There is a much smaller-than-normal chance that the market will go down 5 or 6 percent and stay there. Based on this assumption, last year I implemented an option strategy that would make a lot of money if the market went down big, make a little bit if the market went up small, and lose a small amount if the market went down small and stayed there. The market kept up its relentless move upward for the first half the year, and I made a small amount of money. Then the market had a correction and didn't recover right away; the next stop was down 20 percent.

Most of the abnormal probability distributions he mentions involve positive feedback loops. A rising market attracts inflows, and the inflows make it rise further, or selling begets selling and prices quickly fall. George Soros was one of Bender's investors, and his emphasis on feedback loops is reminiscent of Soros's ideas in The Alchemy of Finance. The emphasis helped Bender earn a 269% return in 2000 when the Internet bubble burst:

[The Internet bubble involved] the distortion of a positive feedback loop-- higher Internet stock prices influenced more buying of Internet stocks, causing still higher prices and so on. This can only go on for so long before a negative feedback develops. Consider what happened with IPOs during the latter stages of the bull market. Companies with $10 million of computer equipment and an idea that had no barrier to entry were selling at capitalizations of $4 billion. The day when somebody pays billions for a company that takes millions to set up is the day you are going to see twenty smart people start twenty more companies that look exactly the same.

Another notable feature of Bender's trading strategy is its complexity. His basic idea-- that there's no single model for pricing options-- is brilliant but simple. Trading on that idea is far less simple: it requires deep knowledge of many different markets, which in turn requires a mix of talent, knowledge, and hard work. (He mentioned working 20-hour days in his interview.) This makes it difficult for other investors to compete away the strategy's excess returns.

Many investors noticed that spinoffs were traditionally undervalued and responded by buying spinoffs. That eliminated their excess returns. Many investors have also noticed that Black-Scholes is flawed, but few of them have achieved Bender's returns because few of them have the same breadth of knowledge.

Tuesday, September 22, 2015

McDonald's: the next Tesco?

A few years ago, Tesco was a popular value stock. It was written up four times on Value Investors Club. Warren Buffett was a shareholder. While the company's recent earnings were disappointing, its historical results were fantastic and bulls thought a turnaround was likely.

Today McDonald's is a popular value stock. It was written up twice on VIC earlier this year. A large hedge fund, Glenview Capital, is a shareholder and has touted the stock. While the company's recent earnings are disappointing, its historical results are fantastic and bulls think a turnaround is likely.

With the benefit of hindsight, we know that Tesco was a value trap. I think McDonald's is another value trap. The arguments that investors have made for buying McDonald's are similar to the arguments people made for buying Tesco.

Bad same-store sales are blamed on loss of focus

When they were written up on VIC, Tesco and McDonald's both suffered from deteriorating same-store sales.The VIC authors argued that this was a result of the companies losing focus.

After Tesco became the largest grocer in Britain, it made an ambitious effort to expand internationally. In June 2012, kevin155 wrote, "I believe that since Tesco was so focused on their growth initiatives, some of the best management talent and resources has been foucused outside the UK."

In April 2015, cmg90 wrote, "In 2013-2014, MCD’s SSS turned negative as a result of strategic misdirection, operational inefficiencies, and disenfranchised franchisees." He added, "Menu proliferation (100 items added over last decade) has hurt order speed (doubled order time in many stores) and order accuracy."

A good investment for the next few years

In 2011, cowboy wrote, "We believe an investment in Tesco plc offers an excellent risk/reward for those with a 3-5 year time horizon."

This past April, gordon703 wrote, "I believe MCD represents a compelling risk/reward investment opportunity over the next 3-5 years."

A wonderful company with scale advantages, etc.

Both the Tesco and the McDonald's bulls are backward-looking: they portray TSCO/MCD as a legendary company and its ongoing problems as a temporary deviation from phenomenal long-term results.

According to the VIC authors, "Tesco is one of the world's great retailers" and "a good franchise with a strong long-term history of growth and returns" while "MCD is a very high quality business with a irreplaceable brand" and "market leading position in a growing, defensive category, significant scale advantages and a highly stable business model."

Each company has economies of scale. Tesco "enjoys significantly lower COGS than its competitors, as well as operational economies of scale" while McDonald's has "a margin of safety provided by its significant scale advantages."

Each company owns valuable property. "MCD's sacrosanct real estate could be worth ~$140B alone," while "Tesco owns ~70% of its real estate. Based on management’s estimate of its properties’ worth, the stock currently trades at approximately that value." Another Tesco bull argued that "According to management this property is worth GBP38bn, which is more that the current enterprise value of GBP33bn."

Each company promoted a promising manager from its international business to the top spot. Tesco's former CEO, Phillip Clarke, "did a very good job establishing new foreign markets as well as growing them to their current sizes today." McDonald's "new CEO Steve Easterbrook is credited with successfully turning around the McDonald’s UK business in the mid / late 2000s."

Concluding thoughts

This is a superficial comparison, and Tesco and McDonald have many important differences: they're headquartered in different countries, they operate in different industries, etc. I don't know if McDonald's will implode the way Tesco has, but I think theMcDonald's bulls are making many of the same flawed arguments that the Tesco bulls made.

Another important difference between Tesco and McDonald's is valuation: Tesco traded at 10-13x earnings before its share price collapsed, while McDonald's trades at 21x this year's expected earnings. McDonald's has all the makings of an undervalued turnaround except that it isn't undervalued.

Saturday, August 22, 2015

Book review: "The White Sharks of Wall Street" by Diana Henriques

The White Sharks of Wall Street is primarily a biography of Thomas Mellon Evans, a corporate raider who began his career during the Great Depression and rose to prominence after World War II. The book is also a survey of his contemporaries: several other corporate raiders became prominent in the 1950s, although none of them matched Evans's success or longevity as an investor.

Evans was a poor relative of Andrew Mellon's family, and his first job after graduating from Yale in 1931 was working for the Mellon-controlled Gulf Oil. He began investing in stocks around the same time, specializing in buying net-nets, which became plentiful as the Depression worsened.

After several years of working at Gulf and investing successfully, he convinced his rich relatives to bankroll his acquisition of an entire company: H.K. Porter, a manufacturer of steam engines. Porter had gone bankrupt as diesel engines rendered steam obsolete, and Evans took control of the company by buying its bonds at ten cents on the dollar.

The investment wasn't successful at first: Evans tried and failed to expand Porter's product line, and a boardroom revolt nearly forced him out of the company. His fortunes improved during World War II when ammunition factories, which couldn't use diesel engines because of the risk of explosion, began ordering steam engines.

After the war, he used Porter as an acquisition vehicle. His first acquisition was the Mount Vernon Car Manufacturing Company, which he bought for less than the company's cash on hand. The seller was a family trust. Later acquisitions came from the same mold as Vernon: they tended to be small manufacturing companies with unsophisticated owners and few rival bidders, so Evans was able to buy them cheaply. He also repurchased Porter stock when it became a net-net.

All of the companies he bought were traditional manufacturing companies-- his approach of buying an underperforming business, selling assets, and cutting costs probably wouldn't have worked for a consumer-facing company.

This acquire-and-liquidate strategy often generated hostility, and Evans was considered pushy and obnoxious. When he acquired Mt. Vernon, he had difficulty getting a bridge loan even though it posed almost no risk to potential lenders.

Although the cultural barriers to corporate raids and liquidations were high, the legal barriers weren't-- at least at first. The SEC didn't mandate 13D schedules until 1968, so surprise raids were possible, and were practiced with increasing frequency, before then. As corporate raiders began winning proxy fights, corporate managers devised new defenses and lobbied state governments to pass anti-takeover laws.

Despite these challenges, two things made corporate raids remunerative.

Excessive conservatism was one. The Great Depression had ended only with the start of World War II, and people thought that high wartime profits would give way to another lean decade, necessitating that companies hold large cash reserves. They didn't foresee that the destruction of America's economic rivals-- and demand for American goods to rebuilt them-- would lift profit margins for an entire generation.

Principal-agent problems were the other. As the book describes it:

As more of corporate America's stock came into the hands of mutual funds and other passive institutional investors, the power of the shareholder... had become weaker and less effective. By the 1950s, most chief executives had been essentially liberated from the need to cater to shareholders at all... In the robustly profitable 1950s, for example, corporations were paying out substantially less of their profits in the form of dividends than they had paid in the boom years of the 1920s.

Besides Evans, some the prominent raiders of the late 1940s and 1950s were Charlie Green, Leopold Silberstein, Louis Wolfson, and Robert Young. Many of these guys eventually fell by the wayside-- in general, they were better at identifying undervalued businesses than at running them. Also, railroads were popular activist targets, and railroad profits fell significantly in the mid-1950s.

Takeovers continued in the late 1950s and 1960s, but they increasingly became friendly: conglomerate-builders like James Ling replaced corporate raiders as the main acquirers. The book notes that:

Although Ling's approach-- borrowing money to buy a company and paying off the debt by selling some of its assets-- was exactly how Tom Evans had acquired Mount Vernon Car Manufacturing Company in 1944, Evans considered most of the newcomers' acquisition strategies foolish because they often came at the expense of real shareholder value.

As the environment changed, Evans changed his modus operandi to buying a minority stake in a company and launching a tender offer. This would prompt his target would seek white knight, letting him sell his stake at a profit. His intent wasn't to solicit greenmail, although he took greenmail from Morrison Knudsen in 1978.

He conducted only one hostile takeover late in his career, launching a tender offer for Missouri-Portland Cement in 1975. After he'd acquired half of the company's shares, he took it private through a leveraged buyout in 1977, years before the LBO mania began.

During his decades-long career, Evans was an early practitioner of many things that later became popular: net-net investing, corporate raids, financial engineering, conglomeration, greenmail, and finally leveraged buyouts.

Apart from his financial genius, he had few admirable qualities - his second wife shot herself after he cheated on her, and he had a strained relationship with his children. Ironically, two of his sons became CEOs of public companies, and each fended off a hostile takeover in that capacity.

Another irony was that Evans retired in the early 1980s, just as the great bull market began and other investors got rich doing the things he pioneered. It took Evans 35 years to make a hundred million dollars, but the bull market allowed some of his imitators to amass comparable fortunes in less than a decade.

Friday, August 21, 2015

Quick note: a comparison with 1994

American stocks have plunged during the past few days, and that's led some market commentators to draw comparisons between today's market and the volatile markets of 1987 and 2008. I think 1994 is a better comparison.

In 1994 the S&P 500's net change was minimal, but many financial markets experienced significant volatility. Oil, emerging markets, and junk bonds all fell, like they've fallen this year.

The S&P 500

In the six months from October 1993 to March 1994, the S&P 500 traded in a narrow range before falling 7% in six trading sessions. It subsequently rebounded and ended calendar-year 1994 down 1.65%, although the total return was positive thanks to dividends.

In the past six months, the S&P 500 has traded in a narrow range before falling 6% in four trading sessions so far.

Many market pundits have commented on the stock market's weak breadth this year. The same dynamic existed in 1994. In the months before the market broke down, the NYSE advance-decline line was noticeably weak.

Corporate debt

Junk bonds and investment-grade bonds both fell 3% in 1994. They're down by comparable amounts so far in 2015.

Crude oil

From October 1993 to March 1994, crude oil fell 27%, staged a dead-cat bounce, and then fell back to its lows.

During the past twelve months, crude oil has followed the same pattern of a large decline, a dead-cat bounce, and a second decline, but the percentage moves have been twice as large and it's taken twice as long to play out.

Emerging markets

In 1994, emerging-markets stocks and bonds underperformed their first-world counterparts by double digits. So far in 2015, emerging markets have significantly underperformed developed markets.

Sunday, July 26, 2015

Articles of interest

A major Burger King franchisee thinks that 3G overpaid for the company (h/t Glenn Chan):

They received an offer for Burger King that was much more than our group [of buyers] thought the brand was worth. 3G bought it for basically $4.5 billion. The investment groups that originally bought Burger King – Texas Pacific and Goldman Sachs – had only paid like $1.4B...

3G came in and was willing to pay a big premium, $25 a share for Burger King. We were shocked at that.

Auto lending
According to Bloomberg, "the rejection rate for auto loans over the previous 12 months fell to 3.3 percent in June, down from 10.3 percent in October 2013."

Arguing against efficient-markets triumphalism, Robert Shiller writes that "Maybe Buffett’s past investing style can be captured in a trading algorithm today. But that does not necessarily detract from his genius. Indeed, the true source of his success may consist in his understanding of when to abandon one method and devise another."

According to The Globe and Mail, Canada is experiencing a housing boom even though its "working-age population... is growing at the slowest pace on record, a paltry 0.4 per cent or just one third of the long-term average."

Inflation and deflation
Michael Pettis argues that "[U]nder certain conditions lower interest rates and depreciating currencies may actually exacerbate deflationary pressure" and that these conditions exist in China today.

Investing ideas
Back of the Envelope Investing analyzes Ferronordic Machines, a Volvo construction equipment dealer in Russia. The analysis is part of a series called "cheapest stock of the week" that looks at cheap stocks from (primarily) Scandinavia and Finland.

Investing strategies
Bear of Burrard Street describes how he finds investment ideas, with an emphasis on special situations, event-driven ideas, and cloning.

Market Wizards
After turning $2000 into a reported $200 million in the 1980s, Richard Dennis went broke in 1990 and had to borrow money to pay a legal settlement. Likewise, Gary Bielfeldt incurred $172 million in losses in the late 1980s and was stuck with a large tax bill that he couldn't pay.

Describing the dynamics of the shipping industry, Credit Bubble Stocks writes that "Ships have very high skew because the supply is inelastic enough... that the rates an owner can charge will have huge swings. Huge swings attract speculators with borrowed money."

Fox Sports argues that cord-cutting and a la carte cable pricing threaten ESPN's business model. As ESPN's subscriber count declines, so will its ability to buy broadcasting rights, subjecting the network to a vicious cycle.

"Doggydogworld" argues that not only is the market above its historical average valuation, the historical average has been inflated by a long-running bubble. He writes, "The real issue is not how far we sit above the 'long term' trend, but how far our long term trend is above the equilibrium level."

Thursday, May 21, 2015

Are declining businesses good shorts?

As the post title suggests, I was curious to see if declining businesses are good shorts. "Declining business" doesn't have a universal definition, so here's how i define it: it's any company that faces a big risk of obsolescence, either in the products and services it sells or the way it sells them. Sometimes declining businesses go from being the industry standard to filling a market niche, but usually they disappear completely.

I found twenty-eight publicly-traded companies that have been described as declining businesses. I've probably missed a few, but I think this is a representative list:

Abitibi-Bowater (newsprint)
Barnes & Noble (book retailing)
Best Buy (electronics/media retailing)
Blockbuster (video rental)
Borders (book retailing)
Cinram (DVD manufacturing)
Eastman Kodak (photography)
Fairfax Media (newspapers)
GameStop (video-game retailing)
Gatehouse Media (newspapers)
Hollywood Video (video rental)
Idearc (yellow pages)
Knight-Ridder (newspapers)
LaBranche (market making)
Lee Enterprises (newspapers)
McClatchy (newspapers)
Movie Gallery (video rental)
Nidec (disk drives)
Outerwall (video rental)
RadioShack (electronics retailing)
R.H. Donnelley (yellow pages)
Seagate (disk drives)
Solocal (yellow pages)
Spok Holdings (pagers)
Valassis (junk mail)
Van Der Moolen (market making)
Western Digital (disk drives)
Western Union (money transfer)

To avoid hindsight bias, I've included any company that was widely expected to decline, even if it subsequently defied these expectations. The disk-drive manufacturers are examples of this. A VIC writeup from 2010 begins, "We believe that a great migration from HDDs to flash-based / SSD-based devices has begun," and Jim Chanos made a similar argument for shorting Seagate in 2013. Yet the disk-drive industry has prospered over the past five years despite flat computer sales and the growing use of solid-state drives.

I've excluded companies that own both declining and growing businesses. For example, Gannett owns both newspapers (in terminal decline) and television stations (not declining yet), so it's not on the list, although several pure-play newspaper publishers are.

I've also excluded companies that are declining for company-specific reasons. Blackberry has imploded over the past five years, but that's because of strategic mistakes it made, not because its product category (smartphones) is becoming obsolete.

Of the twenty-eight companies listed above, thirteen have gone bankrupt or fallen 90%+ in the stock market. But a surprisingly large number have held their ground, and some have actually seen their stock prices rise. My conclusion is that declining businesses aren't great shorts, but that comes with the caveat that this is an anecdotal survey.

Risks to shorting declining businesses

Many investors believe that identifying a technological revolution's losers is easier than identifying its winners. Warren Buffett expressed this sentiment when he wrote that, "You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money. But there was one obvious decision you could have made back then... and that was to short horses."

The future isn't always so obvious. Horses actually survived technological change better than one might have expected them to. In the 1840s, Britain underwent an enormous railroad-building boom. Observers widely expected this to reduce demand for horses, but the opposite happened:

[R]ailways created an increased demand for horses. The rails provided efficient transport once one got to them, but the “first-mile problem” of getting to the rails... as well as the general stimulus given to the economy by the new technology, called for more horses. In fact, railways themselves used horses extensively, not only for local deliveries of goods they handled as carriers, but also within rail yards, to move wagons around.

More recently, some businesses that were expected to decline have proven resilient, including Gamestop, Outerwall, Valassis, and Western Union. Best Buy has withstood the showroom effect better than I thought it would.

Industry consolidation has allowed the disk-drive makers to earn record profits despite weak end-markets and a technological threat from flash memory. Seagate's market cap was $5 billion at its 2011 lows, and the company earned $5 billion in the following 24 months. The stock is up 400% since 2011 and 40% since Chanos panned it. One or two gainers like Seagate will offset the profits from shorting a lot of companies that actually declined.

I'd assumed that declining businesses would decline independent of economic environment, giving short-sellers both profits and diversification. I'm no longer sure that's the case. A few examples of declining businesses reflecting broader economic conditions:

• McClatchy's newspaper business experienced its earliest and most severe circulation declines in the states that had the biggest housing bubbles. The company's California papers declined 1-2 years before its other papers, and the Miami paper it acquired when it bought Knight-Ridder declined fastest of all.

• Kodak's stock was flat from 2001-07 as its business weakened and didn't collapse until the 2008 recession began.

• R.H. Donnelley may be the most spectacular blowups on my list, falling ~95% from mid-2007 to early 2008. It peaked at the same time the market peaked in 2007, and its collapse coincided with the beginning of the biggest recession since the 1930s. (To be fair, the yellow-pages sector collapsed so quickly and completely that Donnelley probably would have suffered even without a recession.)

Most declining businesses were previously cash cows, and some of them pay large dividends as a legacy of that. Kodak declared large dividends for years as its cashflow deteriorated. Solocal, a French yellow-pages publisher, paid a huge special dividend in 2006 and paid large regular dividends for years thereafter. Both Kodak and Solocal subsequently suspended their dividends, and their stock prices collapsed, but having to pay dividends for years before realizing a profit is an IRR killer.

Some declining businesses manage to sell themselves to dumb competitors once the decline has begun, e.g. Hollywood Video and Knight-Ridder.

Shorting declining businesses involves all the usual hassles of shorting: volatility, negative rebates, the risk of being bought in, etc. Labranche traded at $12 in 2000 and ultimately sold itself for less than $5 in 2011, but it spiked up to $50 at one point in the meantime.

Possible exceptions

Although I think that declining business are generally mediocre shorts, there are a couple situations in which they may have better odds.

The first is a declining business making a big debt-financed acquisition after the decline has already begun. The benefits of this are twofold: the debt amplifies the decline's effects, and it makes paying dividends less feasible. McClatchy took on a lot of debt to acquire Knight-Ridder in 2006, after newspaper circulation had started falling. McClatchy traded at $53 before announcing the acquisition, and by 2009 its stock was under a dollar.

The second is when there's a precedent for the decline. Fairfax Media is an Australian newspaper publisher. By late 2009 most American newspapers had imploded, but Fairfax still had robust margins and traded at 10x EBITDA. The company's stock is down 40% since then, and at one point it was down much more. I don't think there was anything unique in the Australian market that would have prevented it from following America's footsteps.

Similarly, Solocal, the French yellow-pages company, traded at a high EBITDA multiple in 2009-10 even though American yellow-pages companies had already gone bankrupt. Solocal's stock closely tracked France's CAC40 index in 2008 and 2009, so investors weren't pricing in the risk of secular decline that had already happened in another big market.

Tuesday, May 19, 2015

Twenty-five spinoffs that blew up

Consolidated Freightways (1996) - The unionized division of a large trucking company. Its financial condition steadily deteriorated after the spinoff, and it finally went bankrupt in 2002 when couldn't obtain a surety bond it needed to operate.

Reliance Acceptance (1997) - A subprime auto lender that spun out of a regional bank named Cole Taylor Financial, Reliance went bankrupt a little more than a year after its spinoff. David Einhorn was a shareholder and mentions in Fooling Some of the People All of the Time that Reliance had a lot of defaulted loans for which it couldn't locate and repossess the collateral.

Solutia (1997) - A chemical-manufacturing spinoff from Monsanto that went bankrupt in 2003. Environmental liabilities played a starring role in the company's collapse.

Vlasic Foods (1998) - Campbell's Soup spun this off as a way to jettison several of its secondary brands, including Vlasic pickles and Swanson frozen foods. It also used the spinoff to jettison $500mm of debt. The company went bankrupt within three years.

Azurix (1999) - This was Enron's water unit. It had negative cashflow and problems with big projects in India and Argentina. According to Wikipedia, "The company was formed with an IPO of $800 million and an opening stock price of $22.00, which fell to $2.00 within two years."

Avaya (2000) - A spinoff from Lucent, it lost 95% of its value in the following two years. The stock subsequently recovered, but total return from the the spinoff until Avaya's leveraged buyout in 2007 was still negative.

Huttig Building Products (2000) - A spinoff from Crane Corp. Management at the time of the spinoff was incompetent and nearly ran the company into the ground. They were replaced with better operators, but then the company suffered during the housing bust. Huttig has survived two near-death experiences, but the stock is still below where it was on the date of the spinoff.

Synavant (2000) - Synavant began life as a unit of IMS Health that offered marketing software to drug companies. The company lost a few big contracts post-spinoff, and the stock went to zero.

Visteon (2000) - After Ford spun Visteon off, it looked very cheap on projected earnings, but the earnings never materialized. The company limped along until 2009, when it filed for bankruptcy.

MCI (2001) - Worldcom issued an MCI tracking stock in 2001 as a way to separate its declining long-distance business from the rest of the company. While this wasn't a true spinoff, it served the same purpose as many spinoffs. MCI was saddled with a lot of debt and a big inter-company payable. The tracking stock became worthless after the Worldcom accounting fraud was revealed, but it had already lost most of its value by then.

Agere (2002) - Another spinoff from Lucent. Like Avaya, this one plunged right after the spinoff, partially recovered, but still gave investors negative long-term returns.

Constar (2002) - The plastic-packaging division of Crown Cork & Seal. It had less pricing power than Crown's can business and a large debt load. It's filed for bankruptcy three times since the spinoff.

Blockbuster (2004) - Separated from parent Viacom in 2004 and paid a large special dividend in the process. The debt it took on to pay the dividend, along with the innovator's dilemma, prevented it from competing effectively with Netflix.

ACCO Brands (2005) - This office-products company was a spinoff from Fortune Brands and MeadWestvaco. I'm not familiar with the company, but a Value Investors Club writeup argues that sales of office products have fallen since 2007 and are in secular decline. Acco's stock is down 70% since the spinoff.

Tronox (2005) - Like Solutia, Tronox went bankrupt because of environmental liabilities and a recessionary economy. Spun off from Kerr-McGee in what was later ruled to have been fraudulent conveyance.

Idearc (2006) - Verizon shrewdly spun off this yellow-pages publisher before yellow pages became obsolete. Burdened with billions of debt, Idearc quickly went bankrupt. Unlike Kerr-McGee, Verizon managed to beat a fraudulent-conveyance rap.

Seahawk Drilling (2009) - A spinoff from Pride International that served drillers in the Gulf of Mexico, Seahawk was saddled with a big tax liability and aging assets, its largest contact was set to expire, it served a high-cost basin, and business suffered after the Macondo disaster. Bankrupt within two years.

Lone Pine Resources (2011) - Spun out of Forest Oil. I'm not familiar with Lone Pine, but the stock went straight down after the spinoff, and the company filed for bankruptcy in 2013.

NovaCopper (2012) - A copper-themed exploration spinoff from NovaGold. This has lost nearly 90% of its value in an extended bear market for exploration stocks.

Orchard Supply (2012) - A regional chain of hardware stores spun off from Sears. High debt, high prices, and competition proved a fatal combination for the company.

Sears Hometown and Outlet (2012) - Another dud from Sears. The spinoff was supposed to carve out a niche in towns and smaller cities where competition would be less intense. The stock has tanked and many Sears Hometown franchisees feel that the company has given them a raw deal.

Civeo (2014) - Hedge funds pressured Oil States International to spin off Civeo, its roughneck hotel unit. It's probably glad they did, because Civeo is down 80% since the spinoff.

Paragon Offshore (2014) - Noble Corp. spun this off with aging assets and a lot of debt right before oil prices plunged.

Rayonier Advanced Materials (2014) -- I haven't followed this one, but Rayonier spun it off last year. Down 60% since then.

Seventy-Seven Energy (2014) - Formerly the captive services division of Chesapeake Energy, this has fallen 80% in its eleven months as a public company.

Some general opinions

Many companies use spinoffs as "garbage barges" that separate problematic business units from the rest of the company. This all but guarantees that spinoffs' returns will vary a lot-- they may outperform the market on average because they tend to undervalued at the time of the spinoff, but some of them have structural flaws that will sink them even if they're priced cheaply.

I don't think spinoffs, on average, are undervalued any longer. They were historically undervalued because investors overlooked them, but the growth of the hedge-fund industry has changed that. By now everyone has read Joel Greenblatt's book and knows his techniques for finding special situations, and some of Greenblatt's disciples are managing large funds.

Glenn Chan writes that spinoffs "[A]re gimmicky. Most of the time they lower the intrinsic value of the business due to legal and accounting fees." I agree, especially with regard to some of the recent spinoffs that activist shareholders have pushed through. Spinoffs that are intended to garner higher stock-market valuations can actually destroy value through transaction costs, increased public-company costs, and in some cases loss of focus.

Articles of interest


Scott Fearon offers a skeptical opinion of Apple's prospects:

Apple is a consumer product company. That’s an extremely volatile business, especially when–like Apple–you’re a consumer product company with exactly one hot-selling consumer product... As others have pointed out, Apple is now a cellular phone company that happens to make a few other products on the side. Yes, that cellular phone is fabulously popular right now. It’s shattering sales records left and right. But, like all consumer products, the iPhone is still subject to the fickle whims of consumer tastes.


Warren Buffett was in the news recently saying that "If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I’d do it." Stagflationary Mark points out that Buffett has a poor record of predicting interest-rate moves.


GaveKal writes that "2014 marked the 10th consecutive annual increase in aggregate leverage as measured by total liabilities as a percent of equity. Meanwhile profit margins are down by more than half over the same period." Much of last year's leverage increase took the form of rising inventories and accounts receivable rather than rising debt.

Independent power producers

A doctoral candidate at NYU provides an overview of the 2002 merchant energy crisis, focusing on the experiences of AES, Calpine, and NRG. Particularly interesting is his discussion of AES, which extensively used non-recourse project financing and avoided bankruptcy when many of its peers had to file.

Lumber Liquidators

After previously defending Lumber Liquidators from some of Whitney Tilson's more hysterical accusations, "Max Vision" writes that the company's situation is getting worse. By pulling Chinese laminate from its stores after previously insisting it was safe, Lumber Liquidators has opened itself to inventory writeoffs, lawsuits, and bad publicity.


Fortune reports that Christie's and Sotheby's, despite having an effective duopoly, are unable to earn oligopolistic profits.

Discussing Micron, Russ Fischer writes that "Oligopolies do not have a license to steal" and that "What isn't discussed so much is that, while an oligopoly can stabilize prices, it has no effect on costs."

On the other hand, Reihan Salam writes that industry consolidation has allowed hospitals to charge exorbitant prices. Salam also argues that hospitals, since they're often the largest employers in their Congressional districts, have enough political power to thwart efforts to rein them in.


Korea JoongAng Daily discusses Posco's origins as a state-owned company and the Korean government's continued interference in the company's operations since its privatization in 2000.

Profit margins

In "The Profit Parfait," Deloitte researchers analyze the different methods companies can use to earn sustainably high profit margins. Among other interesting anecdotes, the article mentions that Weis Markets earned high margins by pioneering the use of store brands but that its margins fell when competitors caught up. My impression is that Tesco has had the same experience in Britain, pioneering things like store brands and loyalty cards that have since been widely adopted.


A 1998 Fortune article profiles FirstPlus, a subprime lender that offered 125% loan-to-value mortgages in the 1990s. Borrowers typically took loans from the company to pay off other, higher-interest loans (e.g. credit-card debt). According to the article, "FirstPlus usually doesn't bother with appraisals anymore--it mostly takes the borrower's word as to a home's value. And competing lenders are offering 135%, 150%, even 200% second mortgages."

FirstPlus depended on securitizations to finance itself. The securitization market shut down a few months after the article was published, and the company went bankrupt in early 1999.


Dani Rodrik argues that Turkey's economic problems are large and growing and that, contrary to popular belief, they began before the country's political problems. Rodrik also writes that "Turkey (and other similar countries) benefited from an unusually favorable external environment. In particular, financial globalization and the availability of cheap foreign capital seems to have played a critical role."

Tuesday, April 21, 2015

Good to Great is a flawed book

One of my first posts on this blog was a harsh review of The Outsiders in which I claimed that it had the same methodological problems as Jim Collins' Good to Great. After re-reading Good to Great, I realize that comparison was unfair and want to retract it. The Outsiders has a problem with survivorship bias, but the methodological flaws in Good to Great are both deeper and more numerous.

Good to Great has already received a fair amount of criticism. For instance, Phil Rosenzweig has written that Collins, by basing his research on subjective interviews and newspaper articles, falls prey to the halo effect. Others have noted that Collins doesn't seek out disconfirming evidence. I can't add to that except to say that they're right, so rather than repeating other people's general criticisms, this post will flesh them out by describing some of the book's specific flaws.

A suspect methodology

According to Wikipedia, Good to Great "aims to describe how companies transition from being average companies to great companies and how companies can fail to make the transition."

The book measures greatness by stock-market return: a company that made the transition from good to great is one that underperformed the S&P 500 Index or matched it up to a point in time and then significantly outperformed both the index and its industry rivals from then on.

Collins describes eleven companies that made the transition. He pairs each company with a competitor that had much lower stock-market returns and ostensibly failed to make the transition.The good-to-great companies are as follows (less successful competitors in parentheses):

Abbott Labs (Upjohn), Circuit City (Silo), Fannie Mae (Great Western Bank), Gillette (Warner-Lambert), Kimberly Clark (Scott Paper), Kroger (A&P), Nucor (Bethlehem Steel), Philip Morris (R.J. Reynolds), Pitney Bowes (Addressograph), Walgreens (Eckerd), and Wells Fargo (Bank of America).

To determine why some companies made the transition and others didn't, Collins interviewed corporate executives from the relevant companies and read thousands of newspaper and magazine articles. Many people who criticize Good to Great home in on this research methodology: they argue that articles about a company reflect people's perceptions of the company rather than its true state, and that interviews are susceptible to hindsight bias.

I agree on both counts, but I think Good to Great has several other flaws:

• Some of the pairs aren't really comparable. Fannie Mae is a government-chartered mortgage guarantor, while Great Western was a regional bank. Bethlehem's workforce was unionized while Nucor's wasn't, and that prevented Bethlehem from making some of the strategic decisions that Nucor made.

For the pairs that are comparable in business strategy, Collins ignores differences in size and leverage. Good to Great doesn't mention how much debt the good-to-great companies and their comparisons used. As Valueprax writes, "I did wonder how many of the market-beating performances cataloged were due primarily to financial leverage used by the organization in question, above and beyond the positive effects of their organizational structure."

Some of the good companies were smaller than their comparisons when they began the transition from good to great. Simply being smaller and having more room to grow might have contributed to their outperformance. Collins ignores this, e.g. when he compares the performance of Circuit City-- a tiny near-bankrupt retailer when it began its transition from good to great-- with General Electric, one of America's largest companies:

If you had to choose between $1 invested in Circuit City or $1 invested in General Electric on the day that the legendary Jack Welch took over GE in 1981 and held to January 1,2000, you would have been better off with Circuit City-by six times.

• The winning companies' successful decisions weren't necessarily independent of the losing companies' unsuccessful decisions. In some cases, a winning company's decision turned out well because its losing competitor made a bad decision at the same time.

Philip Morris owed much of its growth to international expansion: Marlboro became the best-selling cigarette in the world before it became the best-selling cigarette in the United States. At the same time, R.J. Reynolds made minimal effort to expand overseas. If Reynolds had devoted more resources to foreign markets, Philip Morris would have faced a formidable competitor and might not have grown so successfully.

More generally, some companies are successful not because they're run by brilliant people but because their competitors are riddled with agent-principal problems or other kinds of dysfunction. When Roy Ash became CEO of Addressograph, he had been fired from his previous company and wanted to reestablish his reputation as a "conglomerateur." Personal rather than financial considerations motivated his actions, and Addressograph underwent a disastrous acquisition binge under his leadership.

• By comparing two companies within an industry and ignoring the rest of the industry, Collins may draw misleading conclusions.

Let's say that company A (a good-to-great company) centralizes, while company Z (a much less successful competitor) decentralizes. Prima facie, it looks like centralization contributed to A's success and decentralization contributed to Z's failure. But if companies B and C in the same industry decentralized and still managed to perform almost as well as company A, then the difference between centralization and decentralization is much less meaningful than the A-Z comparison makes it seem.

• Collins measures a company's success or failure by its stock-market return. This is problematic because many things besides business strategy affect stock performance, such as starting and ending valuations, the amount of debt a company employs, its ability to refinance its debt, and legal issues.

A comparison of Ball Corporation and Crown Holdings, which manufacture aluminum cans, illustrates this. Ball's stock was flat from 1985 to 1997, while Crown's stock rose 1000%, handily outperforming the S&P 500. Since then, Ball's stock has risen 1900% while Crown's stock has fallen slightly.

In the 1990s Ball spun off its original glass jar business, much like Good to Great role models Kimberly Clark and Walgreens exited their original businesses, to focus on higher-margin can manufacturing. Superficially, it looks like Ball made the transition from good to great during the '90s while Crown began to flounder.

The real reason for Ball's outperformance is very different: in the 1960s, Crown briefly owned a company that made asbestos. It owned the company for only 90 days, but that was long enough for trial lawyers to target Crown with billions of dollars in asbestos lawsuits by the late '90s.

When this legal burden hit Crown, it already had large debts as a result of past acquisitions. The combination of debt and asbestos nearly drove the company into bankruptcy, and its stock fell 98% from 1997 to its late-2001 nadir.

Over the past ten years, Ball and Crown have had almost the same stock-market performance-- Crown has actually outperformed slightly-- which suggests that Ball's cumulative outperformance since 1997 is entirely a result of Crown's asbestos crisis rather than actions that Ball's management took.

Vague principles and conclusions

The principles in Good to Great are less a blueprint for success than a description of the ideal business. Companies need to develop "a simple, yet deeply insightful, frame of reference for all decisions," and they need "egoless clarity" to figure out what they're good at. They also "need executives, on the one hand, who argue and debate- sometimes violently- in pursuit of the best answers, yet, on the other hand, who unify fully behind a decision, regardless of parochial interests." They should "shun technology fads AND pioneer the application of technology." Collins tells us that companies need to ride the flywheel, not the doom loop, which is his way of saying that it's preferable for companies to benefit from positive feedback loops rather than suffer from negative feedback loops.

He also writes, "We found [that successful companies] first got the right people on the bus, the wrong people off the bus, and the right people in the right seats-and then they figured out where to drive it."

But exhorting companies to "get the right people on the bus" ignores the practical difficulties of doing so. And Collins doesn't explain what "right people" means-- The smartest? The ones who work best in a team even if they aren't individually brilliant? It probably varies by situation, but Good to Great offers little specific advice to support its generalizations.

Elsewhere, Collins succumbs to hindsight bias. He writes that level-five leadership means being driven yet humble and that having a level-five leader is better than having a boastful, publicity-seeking CEO. Okay, but a self-assured CEO who's successful will be seen, in retrospect, as driven and inspiring. An unsuccessful self-assured CEO will be seen as arrogant and egotistical.

Collins claims that successful companies need "big hairy audacious goals," or BHAGs. He acknowledges that not every company with big goals succeeds but offers a rule for telling the winners and the losers apart: "Bad BHAGs, it turns out, are set with bravado; good BHAGs are set with understanding."

The way he applies these principles to his subject companies is no more enlightening. Explaining the concept that made Walgreen successful, he writes:

What was the concept? Simply this: the best, most convenient drugstores, with high profit per customer visit. That's it.

And Circuit City:

Its distinction lay not in the "4-s" [service, selection, savings, satisfaction] model per se but in the consistent, superior execution of that model.

And Wells Fargo:

Wells saw itself as a business that happened to be in banking.

Trying to explain why Gillette underperformed the S&P 500 in the late 1990s, Collins writes that the company "stumbled in 1999. We believe the principal source of this difficulty lies in Gillette's need for greater discipline in sticking to businesses that fit squarely inside the three circles of its Hedgehog Concept."

The real reason is much simpler: Gillette traded at an extremely high P/E ratio in the late '90s, and eventually even strong business performance couldn't support its valuation. This wasn't unique to Gillette: other richly-valued blue chips like Coca-Cola, Pepsi, and Disney saw their share prices peak a year or two before the general market.

Narrative uber alles

Good to Great is essentially narrational, and Collins omits or downplays things that contradicts his narrative. His descriptions of individual people are idealized, which calls their accuracy into question. Every good-to-great CEO is a mild-mannered company man with unexpected reserves of strength-- it's Clark Kent as CEO. Collins' description of Gillette's leader is typical:

[Gillette CEO Colman Mockler's] placid persona hid an inner intensity, a dedication to making anything he touched the best it could possibly be...

It wouldn't have been an option within Colman Mockler's value system to take the easy path and turn the company over to those who would milk it like a cow, destroying its potential to become great, any more than it would have been an option for Lincoln to sue for peace and lose forever the chance of an enduring great nation.

Ron Perelman attempted a hostile takeover of Gillette in the 1980s. Good to Great describes the company heroically fighting Perelman off ("In the proxy fight, senior Gillette executives reached out to thousands of individual investors- person by person, phone call by phone call-and won the battle") but doesn't mention that Gillette paid him greenmail.

The book contrasts Wells Fargo's success after banking deregulation in the 1980s with Bank of America's poor stock-market performance during the same period. Wells and B of A were both international lenders in the 1970s, but Collins doesn't state how many third-world loans each bank made. An FDIC report suggests that B of A would have become insolvent if it had been forced to mark its '70s-vintage international loans to market. Dealing with these loans must have hurt its stock-market performance and its ability to respond to changes in the competitive environment, but Collins doesn't discuss this.

The book also contrasts Bethlehem Steel's complaints about imported steel with Nucor's blase attitude toward imports. Collins makes it seem that Bethlehem scapegoated foreign competitors for its failings, whereas Nucor acknowledged the realities of the steel market and strove to become the best player in the industry. In reality, Nucor's steel had lower value by weight, so it didn't have to worry about imports like Bethlehem did.

Collins suggests that a dysfunctional, hierarchical management structure was the root cause of Bethlehem Steel's problems, downplaying the role of the company's labor unions. He portrays workers and unions as lacking agency and merely reacting to management's actions:

But the union argument begs a crucial question: Why did Nucor have such a better relationship with its workers in the first place? Because Ken Iverson and his team had a simple, crystalline Hedgehog Concept about aligning worker interests with management interests and-most importantly-because they were willing to go to almost extreme lengths to build the entire enterprise consistent with that concept. Call them a bit fanatical if you want, but to create great results requires a nearly fanatical dedication to the idea of consistency within the Hedgehog Concept.

This is wrong on several counts. First, Bethlehem's factories were primarily in the northeastern states that had entrenched unions, whereas Nucor's factories were primarily in Southern states where union activity was low.

Second, when unions tried to expand in the South, they did a lot things that alienated the workers they were trying to organize, like giving leadership roles to Northern transplants and imposing onerous work rules in places that traditionally had never had them. The actions of the unions themselves probably contributed to Nucor's union-free status.

Finally, once a labor union has established itself at a company, it has an incentive to keep company-employee relations bad to justify its existence. Bethlehem could have made the same effort as Nucor to pursue a "crystalline Hedgehog Concept about aligning workers and management" and it still would have had worse labor relations.

Collins writes that "Nucor came to see that it had tremendous skill in two activities: (1) creating a performance culture and (2) making farsighted bets on new manufacturing technologies." Bethlehem couldn't create a performance culture because union-imposed work rules were designed to increase employment by making its foundries less efficient. It couldn't make farsighted bets on mini-mills because its union-imposed cost structure prevented it from doing so profitably.

After tobacco's health risks were thrust into the public consciousness, Philip Morris and R.J. Reynolds each diversified by acquiring non-tobacco businesses. According to Collins, Philip Morris "stayed close to its brand-building strengths in 'sinful' products (beer, tobacco, chocolate, coffee) and food products," while RJR's executives acted like "country boys with too much cash in their pockets," buying businesses they knew nothing about and losing money. Collins singles out RJR's purchases of Sea-Land, a shipping company, and Aminoil, an oil company, as flawed acquisitions.

The truth is quite different. Like Philip Morris, RJR acquired a number of food brands, including Hawaiian Punch, Vermont Maid, My-T-Fine, Chun King, Del Monte, and Kentucky Fried Chicken. It also bought Heublein Spirits and Wine.

Collins claims that RJR, after years of pouring money into Sea-Land, "acknowledged failure and sold" the company. RJR actually spun Sea-Land off in 1984, and according to Wikipedia, "that year, [Sea-Land] achieved the highest revenues and earnings in its 28-year history."

Nor was 1984 an anomaly: "Sea-Land, which operates a fleet of more than 60 containerships serving 180 ports and cities in 58 countries, posted a record $157 million profit on revenue of nearly $1.6 billion in 1982."

Ultimately, CSX acquired Sea-Land at a premium in 1986. Sea-Land might have been a mediocre acquisition for RJR-- it invested a lot of money in Sea-Land after the acquisition, so its record profits are less impressive than they may seem-- but it wasn't the disaster Collins makes it out to be.

Aminoil wasn't a disaster either. Actually it was a phenomenal success, even after Kuwait nationalized one of the company's oil fields. In Internationa Law and Arbitration, Todd Weiler writes:

The tobacco company, RJ Reynolds, bought Aminoil from its founders in 1970 for US$40million and sold it in 1984 for US$1.7billion, collecting about US$180million in compensation from Kuwait for loss of the concession on the way.

RJR made dozens of times its money on the Aminoil purchase, and even the confiscation of its Kuwait property yielded a 350% return off the purchase price!

The following passage, although tangential to the book's message, offers another illustration of how Collins privileges story over fact:

To use an analogy, the "Leadership is the answer to everything" perspective is the modern equivalent of the "God is the answer to everything" perspective that held back our scientific understanding of the physical world in the Dark Ages. In the 1500s, people ascribed all events they didn't understand to God. Why did the crops fail? God did it. Why did we have an earthquake? God did it. What holds the planets in place? God.

Here Collins accuses medieval people of ignorance while demonstrating his own. The 1500s aren't the Dark Ages, not even by the most liberal definition. The 1500s weren't a period of scientific stagnation, either: medieval Europe had a lot of major inventions that Rome lacked. And religion and science were more compatible in pre-modern times than is generally believed. One historian notes that "Until the French Revolution, the Catholic Church was the leading sponsor of scientific research."

If Collins is so careless with matters of historical record, then we should be skeptical of his own research.


I don't want to criticize Good to Great for not being perfectly scientific. Doing controlled experiments in business and investing is difficult if not impossible, so every finance book is bound to have some subjective or unfalsifiable elements. Yet I think this book has enough identifiable flaws that criticism is justified.

The problem with Good to Great isn't that Collins is a storyteller, it's that the stories are myths.

Saturday, April 18, 2015

Michael Burry's posts on Silicon Investor

Michael Burry is famous for predicting the 2006-08 housing bust and managing a hedge fund that profited from it. But Burry wasn't always a star fund manager: from 1996 to 2000, he was an individual investor and a prolific commenter on the Silicon Investor message boards.

Burry's posts on Silicon Investor offer a fascinating window into the past. They also offer a fascinating window into his evolution as an investor, giving the impression that he had a lot of innate talent.

That's easy to say in light of his subsequent success, but I think most people who read his posts contemporaneously would have agreed. Actually, some did: Joel Greenblatt was one of Burry's readers and seeded him when he started his fund in November 2000. And in 2003, Zeke Ashton wrote that "Dr. Burry... may be the finest money manager I know, and I have the privilege of knowing many outstanding professional money managers."

Burry's stock picks and the commentaries he wrote on those picks were good but common-sensical. In my mind, his posts stand out less for his discussion of individual companies that his versatility: he invested in net-nets, beaten-down cyclicals, and GARP stocks and made money in each category.

The posts also suggest that he had an uncommon willingness to change his mind. In 1996, he was bearish on gold and even started a new discussion board called Gold -- the eternal short? but in 1999 he turned bullish and bought gold near its generational low. He was initially bullish on Pre-Paid Legal because he thought it was pioneering a new industry, but he later became skeptical of the company's business model and shorted it. In late 1996 he worried that the stock market would crash and shorted an S&P 500 ETF as a hedge against his stocks, but that didn't stop him from making money over the next several years.

The Long Term Capital Management crisis in 1998 gave Burry his only major setback. He was completely out of the market at its July peak, but he got back in too early, and the stocks he bought-- mainly small caps and foreign stocks-- fell further than the market. After previously complaining about a lack of bargains, he wrote near the market's lows that "it takes less than five minutes to find a bargain, and just another five minutes to see it get cheaper." Around that time, he added money to his brokerage account and converted it from cash to margin, which helped him recover and finish the year flat.

Before joining Silicon Investor, Burry had traded futures using technical analysis:

In futures, I learned a lot about TA. The frustrating thing was it worked. You could actually predict the moves. But slippage ate away everything. I was up big at times, never down big. I left with 98% of my original capital.

As a value investor, he continued to use some technical concepts. In particular, he had a rule that called for getting out of stocks that made new lows. This gave him mixed results: for example, it got him out of Mattel and Alliance Semiconductor before they collapsed, but it also prompted him to sell Philip Morris and Tricon Global Restaurants in early 2000 right before they doubled. He bought Abercrombie and Fitch in 2000 at 11-12 and sold it at 10. The stock went down another 20% from there, but it quadrupled off that low in the following year. (It's possible that he got back into PM, Tricon, or A&F later on, after he'd started his fund and stopped commenting on Silicon Investor.)

Comments on individual stocks

Burry discussed dozens of individual stocks on Silicon Investor. Most of the discussion occurred on two boards called Buffettology and Value Investing, but he also commented on numerous stock-specific message boards. Below are a few of his most notable picks.

• Apple
He bought Apple in April 1999, and the stock tripled by the end of the year. His reasons for buying were:
1. It was statistically cheap and had a large net cash balance.
2. Wall Street was skeptical of the company because of its historical underperformance. ("You have all of Wall Street trained to think that Apple is the antithesis of good business thanks to case studies from the 80s.")
3. It had pricing power on its newest products and a strong consumer franchise. ("This is a consumer franchise, not a corporate one. And I think Buffett's point has always been that in the long run it is the consumer franchises that last.")

• and Borders
During 1999, he shorted and bought Borders, writing that "Online booksellers compete on price only. It's a commodity world. Borders competes on environment, location, timeliness, and has IMO the most comprehensive selection of any bookstore, if not music store."

This proved to be very wrong, but he actually made money shorting Amazon. (Amazon peaked in April 1999, almost a year before the NASDAQ Composite.) And many of his criticisms of internet retailing, while ultimately false for Amazon, were true of the sector in general: in the aggregate, the first wave of dotcom retailers gave investors terrible returns.

• Hyde Athletic
He bought a profitable net-net called Hyde Athletic, sold it for a ~50% gain, and then watched it triple from his sale price. The company later changed its name to Saucony, and its stock eventually fell back to net-net status.

General investing comments

Many of Burry's most insightful comments were about general issues rather than specific stocks. Although he was only in his twenties when he posted on Silicon Investor, he had already developed an impressive philosophy of investing by then.

• Bubble anecdotes
I overheard two conversations today. Both were about investing - one involved the med center librarian, the other a janitor. Moreover, the friend I describe with the half-mill is not the first overnight success story. As I might've mentioned before, my two best friends and my younger brother's two best friends all became multimillionaires this year. But you know, even though I'm here in Silly Valley, I'm on the fringe - that same guy who made half a mill went on a date with an HP IS employee who said it'd take 2 mill to buy her house. When informed of his goal of 3-5 million in a few years, she scoffed and said "That should last 2-3 years." Then she asked what doctors are making in the Valley. He said "$100 to $120k." She actually sniffed. 

• Warren Buffett
Buffett's buy-and-hold philosophy is his third incarnation, which comes of necessity due to the size requirement on his investments. And his absolute best years - the ten years of his partnership- were not of the buy-and-hold type. He was very successful flipping small caps for rather quick gains when he was able. I'm sure he would love to now if it would make any difference to him. Then again, with the REITs, maybe he did.

Could it be that by investing as Buffett does now, despite our tiny size, we are giving up the inherent advantage of being an individual, small investor?

To try to emulate Buffett perfectly without his full complement of skills and advantages (which I do not have, but any of you here might for all I know) seems foolhardy. So I take something else from Buffett - the willingness to improvise new investment parameters as fits my situation.

Every year the [Berkshire Hathaway annual] report becomes more a marketing tool. Never more than this year. 

• Buybacks
I wish to evaluate companies in the midst of proven buybacks. Small marginal companies have taken to using buyback announcements as a publicity stunt to support their stock. More often
than not, the buybacks do not materialize. When they do, they end up not retiring the stock and placing it in the corporate treasury, which is of marginal use to shareholders. Everyone should
be aware of this trick. 

• Buying and holding
Buy and hold becomes mantra at the end of a bull market. Buy and hold becomes anathema at the end of a bear market. Thanks to the raging bull for those 10 years, everyone is preaching buy, hold, patience. However, if you had invested in the market in 1969, you would be at a significant loss in 1983, especially given the high inflation of the times and the down market. In the early 50's, the common logic was that stocks simply don't go up, thanks to the doldrums market from the mid 30's to the mid 50's.

• Insider buying
My own pick based primarily on insider trades was BMC. So now it's 1/2 the price of the "significant" insider buys. I'm sure the information can be helpful, but I'm not sure the conventional ways of analyzing it are necessarily correct. I'm thinking my mistake was putting too much emphasis on the insider trading, even to the point it allowed me to overlook fundamental flaws and warning signs. 

On the subject of insider buying, I spent some time looking at this, and it turns out it is not too hard to find stocks in which insiders made buys at significantly higher prices than current ones. So either they misjudged the market or their fundamentals.

• The Internet
It's been noted here before, but one of the biggest traps that novice value investors can fall into is that of the "growth at a value price" when in fact the market already is just showing that it knows that the barriers to entry simply splinter in the face of fresh capital. 

What really gets me about the internets is not so much the valuations, but that so much of it is indefensible. For instance, Exodus Communications is borrowing $1 billion at 10% to build data centers round the world. Intel could do the same thing, with greater brand name, and would hardly have to borrow to do it. And if it did, it could borrow at much less than 10%, and provide much of its own hardware.

• Net-nets
I believe Graham bought a huge basket (100's) of them. Additionally, the market was depressed so a higher percentage of the NN's were just misunderstood. In this market, a net-net would carry more risk, I would think, because it is less likely to be overlooked and more likely to be really in trouble. Also, I can't find hundreds to diversify and lessen my risk.

When looking at net nets as individual picks in a concentrated portfolio in a frothy market, we're not following Graham's method very well anyway. So I insist on extra corroborating value analysis/evidence to help me when I add my one or two or three net nets to a portfolio. Tweedy Browne has done some proprietary research on this which which is mentioned here and there in various investing texts. Their feeling is that the net nets that actually did well when purchased as part of a broad diversified portfolio of them were the ones that had horribly negative earnings rather than positive earnings, and that had business models that didn't seem viable. This makes sense, because net net is really a proxy for a form of liquidating value, and becomes least relevant in an operating company that is expected to continue to run forever.

If one does subtract out operating lease burden, then retailers become doubly suspect as net nets - their inventories are already as suspect as they come.

• Sentiment
Can the market possibly take a major hit if everyone is planning on it? Why not? The last five years everyone planned for the market to go up. 

• Short selling
For the last week I've been carrying "The Art of Short Selling" around with me just about everywhere...

If there's one thing that keeps hitting me in the head about that book and its cases is that there's a lot of time to short and still come out ahead. The problem with net stocks is that they appear as if they require constant capital infusions, which makes them good shorts. But they're getting these infusions at will. That makes now now a good time. When the capital spicket is turned off, the stocks will react downward, but won't fully account for how bad the news is then. They'll be terminally wounded but the price won't reflect it. That's when IMO you'll be able to grab a lot of the net stocks on their way to zero. But before that, a lot of smaller companies will pitch themselves to larger companies. So the wild card is that they get taken over by a bigger, stupider, more capital-rich, company.

Tuesday, March 24, 2015

The limits of activist short selling

Last week, The New Yorker published an article by James Surowiecki called In Praise of Short Sellers. The title is a bit misleading, since the article focuses on activist short sellers rather than short sellers in general. The tone is laudatory: while short selling is often criticized, activist shorts are actually a good thing because they counter "Wall Street’s inherent bullish bias," play "a vital role in uncovering malfeasance," and "contribute to the diversity of opinion that healthy markets require."

I have a more skeptical opinion of activist shorting. I don't think it's inherently bad, but neither do I think one can generalize about it the way Surowiecki does. Activist short sellers have been financially successful and have uncovered numerous frauds in the past few years, but there's no guarantee they will be successful or beneficial in the future.

Activist shorting, as it's practiced today, has a few potential flaws:

1. There's an inherent conflict of interest. Activist shorts make money when the stocks they target go down, and this gives them an incentive to exaggerate their targets' problems. Having hyperbolic bearish opinions in addition to hyperbolic bullish opinions doesn't make the market more efficient. It just means there's twice as much misinformation.

2. Over the past few years, activist short sellers have had a high batting average and have exposed dozens of Chinese reverse-merger frauds. Their success has trained investors to assume that allegations of fraud are correct until they're disproved. This allows Batesian mimics to free ride off the success of past activists by making specious accusations of fraud.

3. The Chinese reverse-merger companies were unique in how completely, pervasively fraudulent they were. Exposing them brought a lot of activist shorts to prominence and increased the amount of money that activist shorts have to invest, but now that most of the Chinese frauds have been busted, there's a much larger pool of money/talent chasing fewer frauds.

4. Many investors piggyback on activist short sellers, raising the cost to borrow shares of activist targets.

Examples of bad activist shorting

• Amtrust
John Hempton argues that Geoinvesting's report on Amtrust is full of serious errors.

A Gotham City Research report accused Blucora of distributing malware and facilitating Internet searches for child pornography. Neither accusation was true, but Blucora stock fell sharply the day after Gotham released its report.

Kerrisdale Capital called Globalstar "The Most Egregious $4 Billion Stock Promotion Since Sino-Forest." Sino-Forest was an arrant fraud that stole hundreds of millions of dollars from investors. By contrast, Globalstar's controlling investor has poured money into the company. Globalstar may have a flawed business plan, but it has nothing in common with Sino-Forest.

Barry Minkow's Fraud Discovery Institute accused Lennar of cheating its joint-venture partners and running a Ponzi scheme. The accusations were false and were part of an effort to extort money from the company. Minkow later pleaded guilty to conspiracy to commit securities fraud and went to prison.

 Lumber Liquidators
At Whitney Tilson's suggestion, 60 Minutes investigated Lumber Liquidators. The television show later claimed that some of the company's products have harmful, illegal levels of formaldehyde. Since then, this claim has effectively been refuted-- see articles from Citron Research, "Max Vision," and The Motley Fool. I don't think Tilson intended to smear Lumber Liquidators when he approached 60 Minutes, but after the show aired and the company responded, he dug in and repeated misleading statements about its products.

Notably, Geoinvesting, Gotham City, and Kerrisdale have done good research on other companies. Geoinvesting and Kerrisdale have exposed Chinese frauds; Gotham City's research brought down a Spanish fraud called Let's Gowex. Being right on one company doesn't guarantee that an activist short will do quality work on others.

"Only shady companies attack shorts"

Surowiecki ends his article by repeating the popular belief that companies don't criticize short sellers unless they have something to hide:

Of course, short sellers are often wrong, and that may yet prove to be the case with Lumber Liquidators. But the fact that the company’s response to the charges was to attack short sellers should give investors pause. In a 2004 study, Owen Lamont, a business-school professor, looked at more than two hundred and fifty companies that had gone after short sellers—filing lawsuits, calling for S.E.C. investigations, and so on. Their long-term performance was dismal: over three years, their average stock-market return was negative forty-two per cent. That suggests that, if you react to bad news by shooting the messenger, it may be because you know the message is true.

This is less meaningful than it sounds.

Nearly all of the companies in Lamont's study were speculative companies with questionable prospects. Many were outright frauds. It wasn't the act of retaliating against short sellers that made their stocks go down, but the fact that their retaliation was symptomatic of much deeper problems. Lumber Liquidators is a real business with a history of profits. Apart from criticizing short sellers, it has nothing in common with Lamont's losers.

And Lumber Liquidators actually has a good reason to criticize the shorts. As a retailer, it depends on its customers' trust to stay in business. The claims that 60 Minutes made about the company didn't just temporarily hurt its stock price, it arguably caused lasting damage to the business itself.


Activist shorts aren't necessarily wrong, but they aren't necessarily right either. Investors should judge activist short claims individually and avoid generalizations about how short sellers are doing a public service or only guilty companies attack their critics.