Wednesday, February 18, 2015

More articles of interest


John Kemp writes a critical analysis of a 2004 academic paper, Facts and Fantasies about Commodity Futures. The paper found that commodity futures had historically delivered better returns than stocks and bonds with less volatility.

Kemp writes that since Facts and Fantasies was published, investors in commodity futures have lost money. He argues that this was the result of institutional investors crowding into an asset class that had previously been an undiscovered niche, forcing returns down. In other words, investing in commodity futures became what Credit Bubble Stocks calls an anti-strategy.

Frank Veneroso predicted this in 2007:

There is no getting around this: the buying pressure of the "pinstripe investor" has destroyed and will continue to destroy the return assumptions that led him to commodity futures baskets in the first place.

Ben Graham expressed similar sentiments about commodities as investments:

It is impossible for any really large sums of money-say billions of dollars-to be invested in such tangibles [gold or commodities], other than real property, without creating a huge advance in the price level, thus creating a typical speculative cycle ending in the inevitable crash.

Dart Group

Dart Group has sparked a lot of interest among value investors and has been written up twice on Value Investors Club. The bull case for the company is that it's a low-cost airline run by a dedicated owner-operator. Red corner demolishes this narrative, showing that Dart Group actually has much higher costs than competitors like Ryanair and Easyjet.

This is a worthwhile post for a couple of reasons: it show how to think about airline competitiveness, and it's also a warning about stories that are plausible but misleading.

Ben Graham

Ronald Redfield has archived copies of the Graham-Newman partnership's investor letters for 1946-1958. The letters don't include any investment commentary, but they reveal two interesting things:

• Graham's partnership owned dozens of stocks at any given time. Apparently there were more deep value opportunities in his time than there are today.

• Graham's performance was relatively consistent through both the late-1940s bear market and the 1950s bull market.

Interest rates

Michael Hudson writes that interest rates experienced a secular decline in the ancient world. The standard interest rate was 20% in Mesopotamia, 10% in Classical Greece, and 8.33% in Rome. This decline occurred independent of political cycles: Rome had lower rates at its political peak than Greece had at its peak, likewise for Greece versus Mesopotamia.

The decline was also independent of economic risk:

In the neo-Babylonian period we see prosperity rising and misharum or andurarum acts becoming a thing of the past, yet interest rates remained constant century after century. This suggests that there was no tatonnement between asset prices, changing risk premiums and interest rates.

Hudson suggests that interest rates fell as mathematical knowledge improved. That is, rates fell because each successive society developed a more precise way of calculating interest. This raises an interesting possibility: that while some market inefficiency is rooted in human nature and may never go away, financial markets have gradually become more efficient as our theoretical knowledge has improved.

I would argue that this dynamic wasn't limited to the ancient world and has occurred recently: classical arbitrage opportunities were common in Ben Graham's time, but they're rare today outside of periods of extreme stress like late 2008.

Hudson also mentions that there was a stark distinction between agrarian and commercial credit in the ancient world. Commercial lenders operated a continuous, relatively sophisticated system of trade finance. By contrast, most agrarian loans were issued after failed harvests by predatory loan-to-own creditors.


Undervaluedjapan argues that laziness can be a virtue for value investors. He points out that there isn't a direct relationship between effort and reward in investing: in many cases, investors can work harder without achieving better results. Under these circumstances, laziness is an advantage if it motivates investors to find more efficient, time-saving ways of finding good investments.


Oddball Stocks writes that an average company can be a great investment, stating that "the difference between a niche and an economic moat is the ability to scale." He gives a hypothetical example of a niche retailer with a unique location:

Consider an example, a bait and tackle shop on the only access road to a state park with a nice lake.  The shop has no pricing power over suppliers, has a low barrier to entry, and doesn't even require specialized skills.  Yet the location of the shop, being the only one on a specific road allows it to charge a bit more and earn above average returns.


A smart message-board poster, "Doggydogworld," offers his thoughts about oil. He mentions that oil-producing countries have accounted for much of the growth in oil consumption over the past decade, so lower oil prices won't necessarily spur demand the way one might expect them to.

The Opium Wars

Michael Pettis writes about the economic origins of the Opium Wars. In the 19th century, most European countries tied their curriencies to the price of gold-- in other words, they had a gold standard. By contrast, China had a silver standard. This made silver more valuable in China, so it was profitable for European merchants to export silver to China in exchange for consumer goods.

Latin America's wars of independence cut off the flow of Latin American silver to Europe, raising silver's price and making it unprofitable to export. British and European merchants responded by exporting opium instead, which led to a monetary shortage in China.

Predictions are tough

A Businessweek article from January 1998 discusses the merger of Meditrust, a nursing-home REIT, with La Quinta Inns. The article was published right before Medicare reimbursement cuts led to a collapse of the nursing-home industry. As a standalone company, Meditrust would have gone bankrupt-- the opportune merger with La Quinta was the only thing that saved it from insolvency.

At the time of the merger, however, La Quinta was seen as a much riskier company. Nursing homes were considered stable businesses, while motels were economically sensitive. The article quotes one Meditrust analyst as saying "a boring, reliable REIT became much more volatile."

Ed Thorp

An interview with Ed Thorp in which he talks about his career and the evolution of quantitative investing. He claims to have discovered Black-Scholes before Black and Scholes discovered it:

[W]hen I began Princeton/Newport Partners in 1969, I had this options formula, this tool that nobody else had, and I felt an obligation to the investors to basically be quiet about it. The tool was just an internal formula that was known to me and a few other people that I employed. Time passed, and Black and Scholes (1973) published this formula.

This raises an interesting question: if Thorp had gone public with the formula, and it had become associated with practitioners rather than academics, would it still have been considered a Nobel-worthy idea?


"Lincott" at Value Investors Club recommends shorting Turkish stocks. He writes that Turkey has an enormous current-account deficit, that much of its external debt is short-term, and that the Turkish banking system has high loan growth paired with declining loan quality.

I'm sympathetic to his pessimism: Turkey has had chronic hyperinflation in the past, so the country's success over the past decade is probably an anomaly.

Sunday, February 15, 2015

Net-nets aren't necessarily value investments

A net-net is a company whose market capitalization is less than two-thirds of its current assets less all liabilities. Ben Graham recommended net-nets as investments, and he and his illustrious disciple Warren Buffett have enjoyed a lot of success buying them. By now Graham and Buffett have both moved on from net-net investing, but it remains a popular strategy among up-and-coming value investors.

Last year, I wrote a skeptical post about statistically-cheap stocks. I quoted a message board commenter, "somrh," who wrote:

Part of what I'm interested in is whether or not value strategies really are 'value' strategies. Some of them seem to work more like short-term mean reversion strategies that may be really lousy over the long-haul.

I was curious to see if this is true of net-nets, so I informally backtested the idea using Value Investors Club. My backtest is unscientific because 1.) VIC doesn't provide a comprehensive survey of net-nets and 2.) I might have missed some of the net-nets that have been written up there. Nonetheless, I'm confident enough about the results to make a few conclusions:

• Many of the net-nets that give investors strong returns are acquired or liquidated within a year or two of becoming net-nets.

• Most net-nets that aren't quickly acquired or liquidated have bad long-term returns. These long-term losers may have good short-term performance, however.

• The performance of net-nets reflects the performance of the broad market to a greater degree than most investors appreciate.

• It may be possible to identify net-nets that will perform better than the net-net average.

Details of the backtest

I looked through VIC's archives for net-nets that were written up between January 1, 2000 and December 31, 2009 and found 55 of them. I divided the 55 net-nets into two groups based on their internal rates of return: 20 winners that had IRRs above 10%, and 35 losers that had IRRs below 10%.

10% may seem like an arbitrary boundary, but I found that the practical distinction was much greater: only a handful of stocks had IRRs near 10% . All but a few of the losers had negative IRRs, while most of the winners had IRRs above 15%.

For companies that were acquired or liquidated or went bankrupt, I measured the IRR from the date of the writeup until the company ceased to be public. For companies that are still public, I measured the IRR from the date of the writeup until today.

The backtest includes three stocks that technically weren't net-nets: two business development companies and a subprime auto lender. I felt comfortable including them because I thought their assets, while not classified as current for accounting purposes, could be liquidated much like inventory or receivables. For example, the auto lender's main assets were loans maturing within three years.

The backtest excludes one net-net that was a Chinese reverse-merger fraud, two net-nets that were involved in litigation that threatened to wipe out their assets, and three insurance companies that traded at less than 50% of book value.

These inclusions and exclusions don't significantly change the results.

Results of the backtest

The 20 winners were:
acls ascx avgn brnc cacs fc feim insp ksw lqid mckc mhh nick plus prls rhdgf scnya slnt ticc wilcf

The 35 losers were: alvr awx dagm ebsc edci edvmf gigm gnom grvy gtsi hmb.v jlmc laco lens lgvn lxnt maxw mlnk mmco myrx msel mvc netp pmry snkty spor taa trnt txcc wnmla wqni

Five of the winners were acquired or liquidated within a year of being written up: ascx avgn lqid mckc slnt. brnc was acquired within two years of being written up.

By contrast only one loser, gnom, was acquired within a year. gnom was purchased at a significant premium to its market price, but the acquiror paid with stock that subsequently lost most of its value.

While the losers all had bad long-term returns, 19 of them had temporary returns of 100% or more from their writeup price: alvr awx dagm edvmf gigm grvy gtsi laco lgvn maxw mlnk msel pmry txcc wnmla wqni.

Almost all of the net-nets were written up during two periods: from 2000 to 2003 and in the twelve months following Lehman Brothers' September 2008 bankruptcy. Only a few net-nets were written up between 2004 and mid-2008. Only one net-net, rhdgf, was written up in 2007.

My opinions

Most net-nets are cheap for a reason: they have structural problems that prevent them from earning adequate returns on investment. Shareholders may profit if they're quickly acquired or liquidated, but the longer they stay in business, the worse shareholder returns are likely to be.

The flip side of this is that more than half of the VIC net-nets that did poorly long-term had strong short-term performance. As I suggested in last year's post, "Rather than measuring outperformance, [studies claiming that net-nets beat the market] may be measuring cheap stocks' ability to stage a dead cat bounce."

I don't think it's possible to divorce the net-nets' performance, at least their short-term performance, from the market environment. Almost all of the net-nets were written up in 2000-02 (a period when statistically cheap stocks outperformed the market), in 2003 (the beginning of an explosive rally), and in 2008-09 (the beginning of another explosive rally).

The one net-net that was written up in 2007, rhdgf, experienced a 60% drawdown after Lehman's bankruptcy. I take that as evidence-- admittedly, very thin anecdotal evidence-- that net-nets' strong historical returns are more a function of market environment than undervaluation. I'd be curious to learn how the net-nets that appeared in 1930 did over the subsequent two years-- my guess is their performance was awful.

Finally, I think it's possible to say ex ante that some net-nets are better investments than others. Five of the winners were profitable when they were written up and also had been profitable historically. Only three of the losers demonstrated consistent profitability, even though the losers were more numerous.

Most of the net-nets that were acquired or liquidated showed signs that an acquisition or liquidation was likely. ascx, avgn, gnom, and slnt hired advisors in order to pursue "strategic alternatives." ascx, avgn, gnom, and mckc implemented significant measures to curtail losses. Activist investors targeted avgn and lqid. I suspect that investor fatigue is what made it possible to buy these soon-to-liquidate companies significantly below liquidation value.