Monday, September 25, 2017

Articles of interest

Anti-trust law
Lina Khan from Yale Law School describes how Amazon is vulnerable to changes in anti-trust philosophy.

Wired reports that as leading internet companies become more powerful, some anti-trust officials are arguing that "privacy is a competition issue."

Bloomberg interviews Aliko Dangote, Africa's richest entrepreneur.

Intrinsic Investing describes the things that have traditionally made large consumer brands successful and looks at the forces that are now eroding those brands' market power.

Dim Sums descibes the fraud and lack of trust that pervade China's food distribution system.

On a more positive note, The New York Times looks at China's advanced and rapidly growing system of mobile payments.

Trivium China gives an overview of the Chinese Communist Party's upcoming congress.

Andrew King and Baljir Baatartogtokh offer a balanced critique of Clayton Christensen's theory of disruptive innovation.

Master limited partnerships
SL Advisors explains why MLPs have underperformed other kinds of dividend-paying investments in 2017.

Medical devices
UndervaluedJapan has a nice writeup of Fukuda Denshi, a Japanese medical-device maker. He writes that the company trades at an abnormally low valuation despite a history of earning consistent profits and returning capital to shareholders.

Oil and gas
Reuters describes how shale energy players are using financially-creative joint ventures to raise money for drilling.

The Wall Street Journal reports that Enervest, a $2 billion private-equity fund that makes energy investments, has lost nearly all its money.

Petrichor Capital provides an overview of a lecture that Richard Hamming gave to the Naval Postgraduate School. Although the lecture is about Hamming's academic career, many of the concepts seem relevant to investing.

Ockham's Notebook shares some excerpts from Ray Kroc's autobiography Grinding It Out.

The New York Times describes how Best Buy has improved its operations to better compete with Amazon.

Saudi Arabia
Reuters reports on the palace coup that removed Mohammed bin Nayef from the royal line of succession and made Mohammed bin Salman Saudi Arabia's heir apparent.

Jeremy Reimer from ArsTechnica provides a fascinating history of OS2, the IBM operating system that lost out to Windows 95.

Venture capital
TechCrunch describes Softbank's new $100 billion venture-capital fund.

A critical reappraisal of "Margin of Safety"

A few years ago, I wrote a favorable review of Seth Klarman's Margin of Safety. I recently re-read the book, and today my opinion of it is far less charitable. There are three reasons for that:

1. It's derivative of Ben Graham
When I originally read Margin of Safety, I wasn't familiar with Graham's work. Since then I've read Security Analysis, which made me realize that MoS is essentially a carbon copy of SA. Some of the commentary in SA is specific to the stock market of the 1920s and 1930s, and some of the commentary in MoS is specific to the stock market and junk-bond boom of the 1980s, but beyond that Klarman lifted MoS's writing style, its layout, and even its title from SA.

The main difference between the two books is that SA is longer and more detailed. Anyone who's interested in Klarman's ideas can get a more sophisticated treatment of the same topics from Graham.

2. The writing is moralistic
Klarman is an old-school value investor who buys stocks that trade at low price-to-earnings and price-to-book ratios. There's nothing wrong with that--I prefer to buy statistically-cheap stocks too--but he's dismissive of other investing strategies, and the dismissal has a distinct moral element. He presents his style of value investing as the one true way and portrays speculation as nothing more than a "greater-fool game." There's no acknowledgement that riskier stocks can have positive expected value. Klarman calls art and rare coins "rank speculations" and denigrates short-term traders. The moralistic tone is grating.

When I started investing in 2002, I was a regular reader of Bill Fleckenstein's column on MSN Money. Fleckenstein was a permabear and dogmatically argued that the stock market was overvalued. Despite that, he had great trading instincts. On several occasions, he wrote that the market was due for a bounce right before it did, in fact, bounce. But as far as I know, he never acted on these instincts. He seemed to think that buying high-P/E tech stocks was immoral and that the only legitimate way to trade them was to bet on prices falling back to fair value.

I'm sure that attitude kept his returns far lower than they could've been, and for me, his column was a powerful argument against having ideological biases in investing. MoS evinces the same kind of rigid ideological thinking.

3. Many of the case studies were value traps
Klarman illustrates his investing philosophy with short case studies of stocks that he bought during the 1980s and early 1990s. The case studies are too brief to give a sense of why these investments were successful, but they piqued my interest, and I looked online for more information about the stocks in question.

What I found suggests that many of them had major risks that MoS doesn't mention, while others were classic value traps.

Bucyrus was the recipient of a leveraged-buyout offer in July 1987. After the October '87 crash, investors worried that the offer would be withdrawn, and the stock traded at $10 versus the offer's value of $14 in cash and new securities. At the time, Bucyrus had $9 per share of net cash and an "unprofitable but asset-rich mining-machinery business," and Klarman reasoned that the stock was "a real bargain."

The buyout was consummated, and the stock might have been an intelligent gamble on the deal going through, but the net cash provided less of a margin of safety than one might assume. Sales of Bucyrus's mining equipment had surged in the 1970s, but this gave way to an extended downturn in the 1980s and '90s as demand fell and coal miners reused surplus machinery from the '70s rather than buy new equipment. The company finally filed for a prepackaged bankruptcy in 1994 after years of operating losses. Its 10-K for that year states that "meaningful new machine shipments to domestic coal customers cannot be expected until after the mid 1990's."

City Investing Liquidating Trust
City Investing Company decided to liquidate in 1984, and the following year it put a hodgepodge of assets that it couldn't sell into a liquidating trust. The trust's units traded at $3 compared to tangible book value of $5 and distributions of $9 per unit over the following six years. Sounds great, except that much of the trust's return came from distributing its ownership interest in General Development Corp, a Florida land developer whose stock surged while the trust was liquidating but later became worthless.

GDC was a glorified Ponzi scheme. It sold plots of land on installment, promising that it would improve the land once the buyer had finished paying off the installment loan. GDC underpriced the land and lost money on every sale, but as long as the volume of new installment contracts exceeded the volume of maturing contracts, the company was cash-flow positive. When the U.S. entered a recession in 1990, the number of new installment contracts plummeted and GDC experienced a cash crunch. It filed for bankruptcy in 1991.

An investor who recognized the flawed nature of GDC's business could have hedged the trust's interest in GDC by shorting its stock proportionally, but in doing so, the investor would have tied up more money for a much lower profit.

Esco Electronics
Emerson Electric spun off Esco, its military electronics unit, in 1990 when the outlook for defense spending was bleak. After the spinoff, Esco traded at less than 15% of tangible book value even though it was profitable. Over the next five years, the stock doubled, which would normally be a good return, except that every other defense stock performed better. Northrop Grumman and Alliant Techsystems quadrupled, while General Dynamics was up 550%.

I'm sorry if it seems churlish to criticize Klarman for recommending a stock that doubled, but Esco's underperformance despite the astoundingly low valuation suggests the company had problems he doesn't acknowledge.

Intertan operated RadioShack's international stores. In 1986 its stock traded at $11, which was less than its tangible book value and equal to its net working capital. The stock was cheap because losses in Europe were offsetting healthy profits in Australia and Canada. Klarman mentions that the company turned around its European division and that by 1989 the stock was trading above $60.

Unfortunately that was the high point, and Intertan spent most of the 1990s trading below $10. The company never paid a dividend. Circuit City eventually acquired Intertan for $14 per share in 2004, giving shareholders a total return below the inflation rate.

Obviously I don't recommend the book, but if you're still interested in reading it, here's a PDF copy.