Those interested in managerial ownership and firm value may be interested in a study by Morck, Shleifer, Vishny. The abstract is below, but in summary, firm value increases as management ownership, and therefore alignment, increases from 0% to 5%. As ownership increases form 5% to 25% management entrenchment reduces firm value. Finally above 25% the alignment effect reasserts and firm value increases. It would be interesting to see any difference in how ownership was achieved, i.e. founders vs option thieves.

The convergence-of-interest hypothesis suggests that a firm’s market valuation should rise as its management owns an increasingly large portion of the firm. On the other hand, the entrenchment hypothesis suggests that as management increases its ownership, the incentive to maximize value declines as market discipline becomes less effective against a larger shareholding manager. The authors attempt to reconcile these competing theoretical predictions by examining empirical data of firm management ownership and Tobin’s Q. The latter variable, equal to the ratio of the firm’s market value to the replacement cost of its physical assets, is used as a proxy for market valuation of the firm’s assets. A piecewise linear regression reveals a positive correlation between management ownership and Tobin’s Q in the 0% to 5% ownership range. From 5% to 25% management ownership, the relationship is negative, but at levels greater than 25% the relationship again is positive. The authors put forward a theory that the convergence-of-interest effect operates over the whole range of ownership, whereas the entrenchment effect reaches a maximum value at some less than 100% management ownership mark. Thus, at low levels, the convergence effect is predominant. At somewhat higher levels, the entrenchment effect becomes predominant. Finally, having reached a maximum value, the still-increasing convergence effect again becomes the predominant factor. Management Ownership and Market Valuation: An Empirical Analysis Morck, Shleifer, Vishny

Everyone knows Buffett’s rules number one and two, never loss money and don’t forget rule number one. They’re great rules and if we could apply more patience in our investing and weave in as many complementary rules like capital is scarce opportunities are plentiful then maybe we wouldn’t suffer many losses. My reality is that I incur losses and the same is probably true for you.

So how much profit does it take to recover from a loss? The following chart highlights conventional wisdom. The greater the loss the ever greater the gain required to make you whole again. For example a 10% loss only requires an 11%, a 50% loss requires a 100% gain and a 90% loss requires a massive 900% to make you whole again.

Scary stuff isn’t it? 10 baggers don’t come along very often.

As I said that is the conventional wisdom and one that is often used to promulgate stop losses and small position sizing opinions. I say the conventional wisdom is bollocks. It takes exactly the same percentage gain to make up for a loss. If you loss 10% it takes a 10% gain to make you whole. If you loss 90% it takes a 90% gain to make you whole.

Why conventional wisdom is wrong

Conventional wisdom is based on serial betting an entire stake. If you make serial bets (one after the other) of your entire stake then it does indeed take a 100% gain to make up for a 50% loss. Do you make serial bets of your entire stake? I doubt it. If like me you have a portfolio of stocks then you’re making parallel investments. If one investment losses 10% you are made whole by another similar sized investment gaining 10%. You never invest your entire stake in one stock, you spread your investment over many stocks.

Pull the weeds and water the flowers. Peter Lynch’s phrase was so good that Warren Buffett asked if he could use it in his annual report. While you may make a 100% loss on an initial investment, I know I have a few times, hopefully you’ll have headed Lynch’s advice and added to your winners. So your wins are magnified as they have more capital invested in them.

I’m not trying to encourage you forsake patience or forget the all important rule of never loss money, just realise that when viewed from the perspective of a portfolio some conventional wisdom is not so wise after all. Mental stop losses also make a lot sense in some cases and are almost essential for traders.

Long term investors, especially those investing in special situations, growth stocks or any other companies where major losses are a possibility should view their investments within the framework of a portfolio and cut their losers and let their winers run.

I’ll conclude with one of Peter Lynch’s 20 Golden Rules:

If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over the time you’re patient. You need to find few good stocks to make a lifetime of investing worthwhile.

If you want to read more then this post on position sizing is in a similar vein.

The following advice is offered with Matrix Composites & Engineering Limited (MCE) owners in mind, but it applies to all value investors who are holding on to fully valued companies.

I offer this unsolicited advice as I believe there are a number of new “value” investors who are sitting on substantial gains in MCE and my view is they should book those gains and move on.

1. Is there a margin of safety at the current level? I think not, the only way to get see a decent MoS is to use a very low required rate of return and optimistic forecasts. The valuation to the right is from the excellent MyClime service. To get a decent MoS I had to use a ROE of 50% and required return of 11%.
2. True value investors don’t forecast. Basing analysis on what analysts forecast is appropriate for growth investors not value investors. Analysts in general are over-optimistic in the long run.
3. Surely you can find a better MoS else where. If not there is nothing wrong with holding cash, it gives a decent return plus the option of buying when bargains do appear.
4. Who is buying at this level. MoMo (momentum) investors that’s who, there is no-one left to buy after them and they’ll head for the exists quicker than you.
5. You never go broke taking a profit.
6. Don’t fall in love with a position.
7. If you don’t want to sell at least put in place a trailing stop.
8. Mr Market is in a great mood at the moment and that means it is time to sell to him.

Put all the above together and I hope you conclude that taking your profit and looking for an investment with better margin of safety is the prudent path of value investing. I’d love to know if and why you disagree.

Disclosure: No position in MCE.

Look beyond the numbers.

I’d like to thank Mike for commenting on this post on ROE. By focusing on the actual calculations, Mike made me realise that I failed to explain the main idea behind the post. ROE is an excellent ratio, it’s one of the first financial ratios you should put in your tool-belt. The next step is to understand the three business levers that underpin ROE; profitability, asset turnover and leverage. The product of those levers is ROE, they are the three main tools management have to enhance the return to owners.

Watching management control those levers is a glimpse into the quality of management.

It’s best to analyse both through time and across similar companies. Take a look at Westfarmers’ ratios. Data from ApsectHuntley. Click Image to enlarge.

Were Westfarmers managing for ROE when they bought Coles? Comparatively, Woolworths have doubled their profit margin, improved their inventory turnover and reduced their leverage to keep their ROE in a healthy mid twenty and up band, over the same timeframe. Woolworths is currently managed better, and according to MyClime selling at a good margin of safety.

Until now we’ve been looking in the rear view mirror, it’s time to look forward to consider what is coming. Westfarmers have the opportunity to improve, unfortunately the current price seems to assume they’re going to. Can WES improve their net margins, or at least stop the slide. I’ll leave you considering the future.

In this article on the five financial ratios you need, the author picks five decent ratios, yet combined they don’t even allow you to construct the basic accounting equation of assets, liabilities and equity. They chose; gross profit margin, net profit margin, current ratio, inventory turnover, return on owner’s equity. By replacing ROE by financial leverage (Assets/Equity), you can easily calculate ROE and determine liabilities. Drop gross profit as well, you’ve already got COGS and Sales in the other metrics. It’s a good list, yet fails to consider the importance of cash flow.

If you want to learn more about financial analysis then I recommend Analysis for Financial Management by Robert Higgins. Amazon has 92 used copied from $0.01. 

Disclosure: No position in WES or WOW. Amazon link; I wonder what my cut of $0.01 would be?

Mike was kind enough to tell me why he thought I went wrong with Neptune. His points were valid and I look forward to his post on Neptune. Here is my reply.

Thanks for your comment. You’re right, cash flow or more correctly owners earnings (shortcut by operating plus investing cash flows, CFO+CFI) showed the big shortfall that the shareholders funded. Cash flashed warning signs as I said on my watch list page and here on this post. “Neptune is not self funding, but they are creating value. It is not an appropriate investment for a defensive shareholder, but enterprising investors may consider it. Buying Neptune requires investors to buy into a growth by acquisition story” and “While I prefer to invest in companies that are both self funding and creating value from a Hewitt Heiserman’s It’s Earnings That Count perspective, I occasionally forsake my better judgment and dip my toe into unabashed growth stories like Neptune.”

As I come from a business background I look at companies as businesses with opportunities and risks and try to understand why their solvency, liquidity, profitability, valuation and activity ratios are as they are. To do that you need the story.

Owner’s earning is good, but you’ll seldom find it in high growth or acquisitive companies. Growth consumes cash in working capital and fixed assets, unless the company has Dell or Blue Nile like negative working capital. Cash flow, ROE, P/E and the plow back ratio are all handy ratios to have in your toolkit and sustainable growth is a great investing criteria.

If I come across a free copy of Value.Able I’ll read it. Roger is a good writer, but I prefer Damodaran, Heiserman, Greenwald, Klarman, Shiller, Fabozzi, Lynch, Tharp, Fisher, Greenblatt, Schwager, Neff, Pabrai, Montier, Grantham, CFA Level 1 Study Sessions, which Investopedia has good notes for, and more.  Ratios are good as filters and for a quick glance, but it’s good to go beyond them to know the business and current story. If you want a really good book to read then check out Hewitt Heiserman’s It’s Earnings That Count.

Mike or others please correct me if I’m wrong, but isn’t Montgomery’s formula simply another version of the dividend growth model, which Damodaran has a good page on. I know Roger uses a multiplier like most valuation models have since Graham published his earnings growth multiplier model. I do like Roger’s A1 style methodology and wonder if he got the idea from time management, as that’s where I first encountered the effectively of two criteria decision rules.  A1 rules work.

• Forward P/E equals payout ratio /cost of equity and growth rate.
• Payout ratio equals 1 – Dividend Growth Rate(g)/ROE or if you prefer g = Retention rate (rr)* ROE, you only need to know one of these as deriving the other is simple.
• From memory Clime do something similar. I’ll refresh my memory tomorrow when I attend two sessions of their’s at Melbourne seminars.
• Is Roger’s equity * payout ratio * multiplier + equity * plow back ratio * another multiplier?

Yes intrinsic value matters, yes you need to be able to work it out. Though keep in mind Buffett does it in his head, it’s not hard to get a close enough number. Writing off book value limits your stock universe as price/book is a great quick screen for value among insurers. I wrote about the power of book to market and how it has delivered Buffett like returns.

As Neptune was risky I only dipped my toe in with a 4% investment. While I should have sold when it was up 60% in two months or anytime on the way down I didn’t. That’s the hidden cost in exchange for a H1 average in my Masters and sitting the CFA Level 1 exams in the same year.

Mike’s post was timely as now that I’m on summer break I have a lot of catching up to do.

Neptune is currently suspended, Christian has gone, his roll-up strategy over extended the company and transferred wealth from investors to rolled-up company owners. Here’s the Chairman’s recap speech at the AGM. I should have limited risk to a 1.5% loss of the portfolio’s value, then it would have only been .75% annual drag. As it is even if Neptune fails it will only be a 1.5% annual drag for the last two years. That downside compares to the opportunity of 15-20% portfolio upside that a well executed roll-up can enjoy. Take a look at Middleby Corp for the type of returns that investors can get if it works well. MIDD is also a great example of why some acquisitive strategies work better than others. The human capital roll-up of buying out small entrepreneurial companies, like Christian pursued at Neptune, seldom works out and at most deserve a small investment kept on short lease. I got it right, except for the short lease.

It’s not over yet, I still own a call option on the new management team returning Neptune to profitability. With Gorgon coming in 2012 and a new experienced CEO I’d haven’t written off Neptune yet. Look for extreme bargain prices for a really cheap call on the turnaround, or keep it on your watch-list and watch the announcements, metrics and news flow closely.

Wikipedia quotes Buffett’s version of owner’s earnings as representing

reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume….Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes…All of this points up the absurdity of the ‘cash flow’ numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract (c)

Here is what I said just after my Neptune investment.

I still don’t feel comfortable investing in NMS and am breaking a personal rule by investing when I have doubts. One of my favourite quotes is capital is scarce and investment opportunities are plentiful. Warren Buffett expressed the same sentiment when he compared investing to baseball without strikes. He said you can wait for the right pitch all day and there is no penalty other than lost opportunity. So, when the fielders are asleep, step up and hit the pitch.

NMS is not in my hitting zone, it’s a fast curve ball with the potential to strike me out.

Disclosure: Long Neptune Marine. Mistakes were made, lessons reinforced. Amazon affiliate payments on book links.

UPDATE:

Via trading markets Neptune Marine Services plans to raise $A80 million to improve its poor financial position. A share placement will raise $A28.3 million, with $A51.7 million from a renounceable rights issue. The capital raising will be priced at $A0.08 a share, while the stock last traded at $A0.205.

ValueHuntr has generously posted a 96 page pdf compilation of 40 papers originally written by Benjamin Graham into an easy-to-read book format. If you’re interested in long term investing and value investing then ValueHuntr’s compilation is a real treat.
Here are a few excerpts I enjoyed.

[On Efficient Markets:] I deny emphatically that because the market has all the information it needs to establish a correct price the prices it actually registers are in fact correct. … Descartes summed up the matter more than three centuries ago, when he wrote in his “Discours de la Methode”: “Ce n’est pas assez d’avoir l’esprit bon, mais le principal est de l’appiquer bien.” In English: “It is not enough to have a good intelligence”—and I add, “enough information” — “the principal thing is to apply it well.” … any security analyst worth his salt should be able to make up an attractive portfolio out of this “universe.” [NYSE stocks]

[On Beta:] What bothers me is that authorities now equate the Beta idea with the concept of “risk”. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management.

Do those things as an analyst that you know you can do well, and only those things. If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that’s the row you should hoe. If you’re really good at picking the stocks most likely to succeed in the next twelve months, base your work on the endeavor. If you can foretell the next important development in the economy, or in the technology, or in consumers’ preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no-bluffing self-examination, and by continuous testing of performance, that you have what it takes to produce worthwhile results.

I ran a screen today looking for companies with good ROE and forward earnings growth. Here are the results. I searched for 20% average two year earnings growth and ROE above 20%. The next step is to see if any of them are undervalued.

Disclosure: Long MTU