The Poor Investor – Investigatory Value Investing

"Faber est suae quisque fortunae" -Appius Claudius Caecus

Monthly Archives: September 2012

Higgs Boson, Markowitz, and Graham

From Roumell Asset Management’s quarterly report— I feel this exemplifies the philosophy I espouse on this website quite well.  

A “unified theory” has long been the Holy Grail in theoretical physics that could account for both subatomic and universal realities. It appears the field has made a giant leap forward with the recent discovery of the Higgs boson particle, commonly referred to as the “God particle.” Higgs boson accounts for the various strains of information, analyses, and data that physicists, working with different approaches, have gained over the years from their efforts to better understand our universe. While some physicists prefer to focus on big-picture questions like how time and space interact, others prefer to ask why some particles have mass, while others, such as light, do not. Different starting points, same goal: knowledge.

Although investing is certainly not a hard science, it too has long pursued its own unified theory. On the one hand, financial planners and advisers use asset allocation to construct portfolios with multiple asset classes in order to spread risk and reduce volatility. Harry M. Markowitz is known for his pioneering work on Modern Portfolio Theory. Markowitz’s Portfolio Selection, which he wrote in 1952 while a graduate student at the University of Chicago, serves as the framework for planners using asset allocation as the primary portfolio construction tool. Markowitz argued that a portfolio should be designed using uncorrelated asset classes to maximize returns with the greatest efficiency (reduced volatility).

The shortcomings of the asset allocation model include today’s high level of correlation among asset classes. In addition, performance is tied to overall market returns and leaves little opportunity to exploit market inefficiencies. Of course, many investors in this camp believe security prices reflect all known information and are thus always efficiently priced.

In contrast to the investment allocators are individual securities investors. For value investors like us, Benjamin Graham wrote the gospel with its emphasis on specific security characteristics, margin of safety, and the temperament to see the process to fruition. Graham elegantly stated in 1934, “The field of analytical work may be said to rest upon a two-fold assumption: first, that the market price is frequently out of line with the true value; and, second, that there is an inherent tendency for those disparities to correct themselves.” The mantra for security-specific investors is that market price diverges from intrinsic value often enough to add investment value, particularly in smaller overlooked and/or out-of-favor securities.

As decided adherents of the security-specific, bottom-up value investment camp, Roumell Asset Management does not begin with a belief that we should own a little of everything. Rather, we begin by searching for value in the marketplace, wherever it may be. We firmly believe that obsessing about price paid has a far greater impact on securing respectable returns than gauging what John Maynard Keynes referred to as “the average opinion of the average opinion.” There are multitudes of analysts, commentators, and investors putting forth their opinions about the upcoming direction of gold bullion, U.S. Treasury bonds, and the stock market. We have nothing of substantive value to add to this conversation. It’s not what we do.

A subtle but highly important distinction in reviewing market efficiency literature is necessary, in our view. To paraphrase Warren Buffett, the difference between markets being mostly efficient and always efficient is the difference between night and day.  Interestingly, Berkshire Hathaway seeded additional capital to its two recently hired portfolio managers and gave them authority to manage the funds “exactly as they see fit.”

The reasonable question to ask then is how much should a portfolio be constructed with an emphasis on hitting all the major asset-class boxes (large cap growth, small cap value, emerging market stocks, corporate bonds, etc.) versus putting together a portfolio of security-specific-focused managers with the latitude to go anywhere in their search for value? In other words, rather than arguing about who’s “right” perhaps it’s more reasonable to simply ask: How much Markowitz and how much Graham does an investor want in his or her portfolio? An allocator only need believe that markets are inefficient enough to warrant some exposure to security-specific, bottom-up investors, be they growth or value oriented.

We do not seek to change any investor’s mind regarding investment philosophy. Rather, we want our investors to understand our investment philosophy. Our clients can trust that 100% of our own investment capital will remain invested in our portfolio options because determined research, a deep appreciation for value, a contrarian bent, and a steady temperament are what make the most sense to us.

Notes from The Poor Investor:

 It never hurts to reiterate your basic investment philosophy or tenet to see if your actions correlate with that philosophy/tenet.  If they are out of sync either: a) change your actions, or, b) change your philosophy.  However, as a word of caution, before you start investing heavily on your own you should have a philosophy that is sound (meaning it stands the common sense test), proven (is backed up by reliable data/facts), and unchanging (is time-tested and perfect enough that it does not have to be modified).  If you are constantly changing you investment philosophy and/or method of investing then you are setting yourself up for failure.

And with that I’ll leave you with a quote from James P. O’Shaughnessy:

“…we can see the simple truth that using simple, straightforward and time-tested investment strategies leads to the best overall results in virtually all market environments.”

What’s Next?

A lot has happened since I last wrote…  Mitt Romney chose Paul Ryan to be his running mate.  The European Union seems to have gotten its act together, financially speaking.  Facebook reached a new low and Amazon reached a new high.  Even the auto market has maintained most of its steam in the wake of the European Crisis.  In conjunction with this mostly good news, the stock market has also risen to new heights—following its usual trajectory during an election year.

So what does this mean for the future of the stock market?  Well, I will not pretend to know what will happen with the stock market overall, but there are still plenty of stocks out there that I think will provide favorable returns for those who buy individual stocks.  Some of these names will be familiar, some not.  Bargains come in all shapes and sizes (see Ken Fisher’s Debunkery for more on that).

In regards to the aforementioned “bargains,” let’s start with the more familiar.  At a price-to-sales ratio of 0.3 and a dividend of 3%, Dell is my favorite pick out of all the bottom-dwellers.  There is fear that Dell might be a “value trap” and this very well could be, although, I believe Black Friday and Christmas will serve as important catalysts.  As I type from my Alienware computer (Dell-owned), I remember bargain-hunting for it around the same time as the holidays were fast-approaching.  Also, there is a high margin of safety in that Dell is largely considered a value trap.  Value traps may trap buyers, but usually don’t go any lower.  In the end, the catalysts may prove false, but the stock should not depreciate much from this price.

The next in the “familiar” category, is Nvidia.  Now, this may not be familiar to all, but, computer geeks should be plenty familiar with this company.  Although Nvidia was snubbed by Amazon, its new chips are used in Google’s Nexus 7 and will be used in Microsoft’s new Surface tablet.  With around $5/share in cash, the company is effectively trading at  near 11x earnings, for a company that usually trades around 14x earnings.

In the “unfamiliar” category, the company I’d like to start with is Heska.  This company operates in the veterinary market, selling diagnostic equipment and other products to veterinary clinics.  This is a growing market and its growth is expected to continue well into the future.  The company trades with no debt, 16% of the share price is accounted for by cash, and it has a dividend of 4.60%.  As a smaller company, it is still speculative, and will require more due diligence than the more familiar companies.  However, there is more room for reward here if the company can successfully navigate the next few years.

Last, and also in the unfamiliar category, is Atrion Corporation.  This company has shown tremendous growth potential in a growing market— healthcare.  The company manufactures cardiovascular, fluid delivery, and ophthalmic devices.  It has also ranked highly over the years in Value Line’s “earnings persistence.”  The company has a small dividend (1%), positive cash per share, no debt, and boasts a profit margin of 20%.  Although the company has faced some headwinds as of late, it seems poised to perform well in the coming years.  This is another long-term growth story that will require proper due diligence.

In the face of what else is to come, be assured that there are still plenty of stocks out there whose performance will have nothing to do with what else is to come.  These are just a few of them that you might be interested in.  Feel free to mention some more that you think offer a better opportunity for potential price appreciation over the next few years.

Until next time…

The Poor Investor

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