Collected Wisdom from the Blogosphere

“Johansen explained that – to deal with an uncertain future and still move forward – they advise people to have “strong opinions, which are weakly held.” They’ve been giving this advice for years, and I understand that it was first developed by Instituite Director Paul Saffo. Bob explained that weak opinions are problematic because people aren’t inspired to develop the best arguments possible for them, or to put forth the energy required to test them. It was just as important, however, to not be too attached to what you believe because, otherwise, it undermines your ability to “see” and “hear” evidence that clashes with your opinions. This is what psychologists sometimes call the problem of “confirmation bias.
Barry Ritholz’s Blog, Inner Scorecard.

…there is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock but can sell the stock at a small profit, we have somehow lost any sense of having been foolish. On the other hand, if we sell at a small loss we are quite unhappy about the whole matter.
– Common Stocks and Uncommon Profits (Phil Fisher)

“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” –Charlie Munger

“The confidence we experience as we make a judgment is not a reasoned evaluation of the probability that it is right. Confidence is a feeling, one determined mostly by the coherence of the story and by the ease with which it comes to mind, even when the evidence for the story is sparse and unreliable. The bias toward coherence favors overconfidence. An individual who expresses high confidence probably has a good story, which may or may not be true.” — Daniel Kahneman, The Hazards of Confidence

I decided in April to artificially slow down my transaction frequence to 1 transactions per month I did not know that volatility would make a big comeback in the stock market and resemble the “stop-and-go” traffic on Munich’s Autobahn. However, I pretty soon discovered that my restriction had a very calming effect on my nerves. Knowing that I only have one “shot per month” takes away a lot of hectic and pressure especially in volatile times. I discovered for instance that I can better focus on fundamental research if I know that I can’t trade in the next 2 weeks anyway compared to previous times where I would have “watched the tape” all the time and look at all the stocks which would have gone down the most. Also that “gut feeling” when you sometimes have a bad feeling and an urge to sell down at exactly the wrong moment goes totally away. — ValueAndOpportunity

I noticed a few years ago that two common threads ran through all my investing mistakes. The first was that I was buying inferior businesses due to what I perceived at the time to be a low multiple (but alas not a low
valuation). The second was that I was buying inferior businesses due to the prospect of a fast buck or what analysts term a “catalyst”.  I corrected the first mistake by focussing more on the quality of the management and the business model than on the valuation. The second mistake I avoid by opting my investments for an indefinite investment
horizon.  — Robert Vinal, The European Value Investor Interview

This disconnect between knowing that there is something you cannot do and the feeling that *you* personally can do it, has been with me all my life and I think that there is a lot of it on the wall street. […] I call it an “illusion of skill”. You know that it is wrong but you feel something else.
– Daniel Kahneman

Interview with Steve Forbes, Jan 2013.

Most U.S. investors today have a clear opinion about what everyone else has no choice but to do. Which is to say, with bonds yielding next to nothing, the only way investors have a chance of earning a return is to buy stocks. Everyone knows this, and is counting on it to remain the case. While economist David Rosenberg at Gluskin Sheff believes government actions could be directly or indirectly responsible for as many as 500 points in the S&P 500, or 30% of its current valuation, traders have confidence in Ben Bemanke because betting that his policies will drive equities higher bas been a profitable wager. Bernanke, likewise, is undoubtedly pleased with these speculators for abetting his goal of asset price inflation, though we all know that he will not call them first when he decides to reverse direction on QE. Then, the rush for the exits will be madness, as today’ s “clarity” will have dissolved, leaving only great uncertainty and probably significant losses.

Investing, when it looks the easiest, is at its hardest. When just about everyone heavily invested is doing well, it is hard for others to resist jumping in. But a market relentlessly rising in the face of challenging fundamentals–recession in Europe and Japan, slowdown in China, fiscal stalemate and high unemployment in the U.S.– isthe riskiest environment of all.

Only a small number of investors maintain the fortitude and client confidence to pursue long-term investment success even at the price of short-term underperformance. Most investors feel the hefty weight of short-term performance expectations, forcing them to take up marginal or highly speculative investments that we shun. When markets are rising, such investments may perform well, which means that our unwavering patience and discipline sometimes impairs our results and makes us appear overly cautious. The payoff from a risk-averse, long-term orientation is–just that–long term. It is measurable only over the span of many years, over one or more market cycles.

Our willingness to invest amidst failing markets is the best way we know to build positions at great prices, but this strategy, too, can cause short-term underperformance. Buying as prices are falling can look stupid until sellers are exhausted and buyers who held back cannot effectively deploy capital except at much higher prices. Our resolve in holding cash balances–sometimes very large ones–absent compelling opportunity is another potential performance drag.

But we know that in a world in which being anti-fragile is good, what doesn’t kill you can make you stronger. Short-term underperforrnance doesn’t trouble us; indeed, because it is the price that must sometimes be paid for longer-term outperformance, it doesn’t even enter into our list of concerns. Patience and discipline can make you look foolishly out of touch until they make you look prudent and even prescient. Holding significant, low or even zero-yielding cash can seem ridiculous until you are one of the few with buying power amidst a sudden downdraft. Avoiding leverage may seem overly conservative until it becomes the only sane course. Concentrating your portfolio in the most compelling opportunities and avoiding over diversification for its own sake may sometimes lead to short-term underperformance, but eventually it pays off in outperformance.

Seth Klarman via Zero Hedge and csinvesting.

Be patient and tough; one day this pain will be useful to you.
Don’t believe everything you think.
“I will study and get ready, and perhaps my chance will come.” – Abraham Lincoln
Always make new mistakes. — Ester Dyson
“If I had eight hours to chop down a tree, I’d spend six hours sharpening my axe. ” – Abraham Lincoln

Restaurant Group (LON:RTN)

The Restaurant Group operates over 500 restaurants and pub restaurants. Its principal trading brands are Frankie & Benny’s, Chiquito and Coast to Coast. The Group also operates Pub restaurants and a Concessions business which trades principally at UK airports.

It does approximately £600M of revenue and £128M of EBITDA. At the current prices of £3.45/share, the company is selling for £712M and has very low debt (new £38M). Depreciation is ~ £40M.

Red flags: New CEO. Not a significant insider holding (~3x annual salary). Vanilla shareholder letter.

Investment thesis: 10% dividend. 10% growth. Low debt. No share dilution. Investing in growing the business.

Remuneration: Financial performance measures (profit before tax, earnings per share (EPS) and total shareholder return (TSR)) are used as the key performance indicators (KPIs). The combination of EPS and TSR performance conditions provides a balance between rewarding management for growth in sustainable profitability and stock market outperformance. TSR is a clear indicator of the relative success of the Group in delivering shareholder value and, as a performance measure, firmly aligns the interests of Directors and shareholders. The EPS target range will require growth from the current all-time high level of profitability and the TSR condition will be based on recent share price performance. Performance against EPS and TSR targets are reviewed by the Committee

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Cullen/Frost Bankers (CFR)

I recently started a position 50 share position in CFR @$44. I see this as a very long term investment and will continue to build the position if the price goes south of $42.

Management

The management at CFR is very stable. They believe in promoting people from the inside.

Phil Green, who has been with Frost for 35 years and has served as chief financial officer since 1995, is now president of Cullen/Frost, with greater responsibility for and involvement in all areas of the company. Jerry Salinas, who has served as treasurer for 18 years, is now chief financial officer. Paul Bracher, who has been with Frost since 1981, is our chief banking officer, with responsibility for, and as a steward of, our banking operations. And Bill Perotti who, in his 34 years with Frost, has been responsible for both credit and risk, is focusing more time as chief risk officer. – AR 2014

The average tenure with the Company of the five Named Executive Officers included in this proxy statement is in excess of 35 years. – Proxy 2014

Also, the management has significant skin-in-the-game.

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The CEO gets paid according to the net income of the company (traditionally capped at 0.8% of net income). But, it has been generally around 100% of his base salary. The performance measure for the CEO is very qualitative. Frankly, I don’t know how they actually arrive at anything reasonable.

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The primary criterion for annual incentive payments for the Named Executive Officers (other than the Chief Executive Officer) is the measurement of financial performance vs. budgeted net income for Cullen/Frost.

Valuation

The business has done quite well over the years. Here is the balance sheet data from 2010 to 2014 (right to left).

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The growth in deposits have been 10% for the last 5 years !

Frost Bank received the highest ranking in customer satisfaction in Texas in the J.D. Power and Associates 2014 U.S. Retail Banking Satisfaction StudySM for the fifth consecutive year.

At the current price, the company is paying 5% in dividend. So, at current prices, I am looking at a return of > 12%.

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The earning per share on the other hand, has only grown at 4.4% a year during the same time period (2010-2014). This has been happening because of the fed rate being so low.

The Corporation is primarily funded by core deposits, with non-interest-bearing demand deposits historically being a significant source of funds. This lower-cost funding base is expected to have a positive impact on the Corporation’s net interest income and net interest margin in a rising interest rate environment. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) repealed the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts beginning July 21, 2011. To date, the Corporation has not experienced any significant additional interest costs as a result of the repeal; however, the Corporation may begin to incur interest costs associated with certain demand deposits in the future as market conditions warrant.

So, if the Dodd-Frank Act does not ruin the advantage completely, the earnings of CFR will increase nicely in a higher interest environment.

The Corporation’s balance sheet has historically been asset sensitive, meaning that earning assets generally reprice more quickly than interest-bearing liabilities. Therefore, the Corporation’s net interest margin was likely to increase in sustained periods of rising interest rates and decrease in sustained periods of declining interest rates. In an effort to make the Corporation’s balance sheet less sensitive to changes in interest rates, the Corporation entered into various interest rate swaps which effectively converted certain variable-rate loans into fixed rate instruments for a period of seven years.

Second Level Thinking

Why is the company cheap ? The recent drop in oil prices has scared the investors. This is a Texas bank and CFR itself says that they have exposure to oil companies.

Outstanding loans in the energy sector represent about 16 percent of our loan portfolio. That means that 84 percent of our loans are in other sectors, so our portfolio is very well diversified.

 

Recent Update

I bought quite a few positions in the last few days. I will go over them one by one.

American Express (AXP) : Started a 3% position in American Express. I had previously bought and quickly sold around $71.

The company is paying 2.34% on its debt (2014 figure) and receiving ~ 8.3% in interest on the loans it has given to the customers. So, it is earning around 5% for the service (approximately $3.5B a year with $69B loan). If this stream does not grow *at all* and at 15% discount rate this part of the business is worth approximately 3.5 * 1/(1.15-1) = $23B. Looking at the income statement, the non-interest revenue – all expenses = $5B. Again, at 15% discount rate, this stub is worth = $33B And now, with $22B cash on balance sheet, I should be willing to pay ($23 + $33 + $22) B = $78B.

There are several risks with this investment thought. Costco is not renewing the AXP partner card (20% of the loan portfolio), V/MA have changed the business landscape and the management does not seem like they have a great plan in place.

I bought because I like the quality of the business and the fact that it is very cheap.

IBM : Started a 3% position. I have talked to several IT people in UBS/CS and have come to realize that even thought they don’t like their IBM mainframes, they have no other options. The reason is actually quite interesting. Setting up a new mainframe is going to cost a lot. Because banks see their IT as a necessary evil (banking is their main business), they find no reason to spend so much money on a complete revamp of the system when it is working perfectly fine with minor upgrades … Finally, at $122, I could not keep myself from buying the stock. Very cheap and I like the business.

TGS Nopec : Started a 2.5% position. This is an asset light company that collects seismic maps for oil companies. They have a great track record of being very disciplined with their investments. They have invested money when the markets were weak and have consistently maintained a great balance sheet. Again, the quality of the business/management is superb here.

CACC : Started a 0.8% position. I would like to buy more if the price is < $150. Also, in car lending (like America’s Car Mart). The CEO letter by Brett Roberts are worth a read.

Cullen/Frost bankers (1%), Svenska Handelsbank (2%): Svenska and Cullen/Frost are very well run banks. I had made a promise to not invest in banks but after reading their annual reports I was very impressed by the management. CFR has significant management holding (~ 7%) and Svenska’s management summary and compensation are a thing of beauty.

Baidu (2%), Apple (2%) : Again, cheap and great businesses.

Berkshire (1%), Bam (1.5%), Aggreko (3%).

In all these cases, I have tried to shift towards buying great business at good prices.

 

Swatch Group

This is a family owned business.

Two types of shares. Bearer shares are 5 x Registered shares. Total of ~ 30M bearer and ~ 124M registered shares.

As of 31 December 2014, the Hayek Pool, related parties, institutions and persons control 63 169 930 registered shares and 1650 bearer shares, totalling 40.8% (previous year 40.8%) of the votes.

The company runs on meager debt and the management has a very long term view of the business (83.7% equity ratio in 2014).

The family-ownership allows the company to “suffer in the near term” to build the brand value. Even after significant appreciation of the swiss franc they continue to invest here.

Because it is also here, in Switzerland, that we want to be established and to manufacture in the future. For you, for us, for industry, for the region and through this, for Switzerland. Because to us, the idea of “outsourcing abroad” is utter nonsense. — Nayla Hayak, Chairwoman, Swatch

What remains is the valuation.

The company is selling for 30xFCF at the moment (morningstar). But, their investments have been quite high and the “normal” value of the FCF is closer to 1B CHF currently. Which puts the multiple at 20 and the growth in FCF for the last decade to be 5% (FCF was 568CHF in 2005). The 20 multiple implies that the discount rate for the DCF calculation is 5%. Assuming these assumptions to be correct, at current prices I am looking at a return of 10% (5% from FCF growth and 5% from the discount rate). This is too high for me. I will probably be more interested around CHF16B i.e., a 20% drop from the current price.

Tandy Leather

Market Cap ~ 80M (Price $7.87)

A whole-seller of leather (derived products) with over 100 stores worldwide.

Management has big shareholding (~ 33.63%). They have been able to the grow the business moderately 5% revenue in the last 10 years and 7% income. So, this checks out.

The company probably has some moat in terms of locations/quality/variety of products they sell. Unfortunately, this does not seem very sustainable to me. This goes into the “Too Hard Pile”.

Dolby (DLB)

Founded by Ray Dolby (wife Dagmar Dolby, son David Dolby). The founder is dead and the company is still largely owned by the family.

The company has two classes of shares A (which is traded) and B (which is largely owned by the family). They are each  50M in numbers. Holders of Class A shares have 1 vote while the holders of class B have 10. The family owns ~ 100% of class B and ~ 0% of class A. Hence, they have ~ 90% voting power.

They develop sound/imaging technologies, patent them and then earn money by licensing them to OEMs (like Samsung for their cellphones, Microsoft for Surface, Movies etc). They do face competition in these. For example, they were not included in Windows 8 or in Samsung Galaxy S5.

There are several open source models and it is difficult to judge for me if they will continue to have the moat. No one buys a mobile, laptop because it has Dolby on it.

The second main problem I see is from the management point of view. The founding family has rightly hired Kevin Yeaman (CFO 2005-2009 and then CEO 2009-), to run the business and are paying him very well, mostly in stocks ( ~ 18M in the last 3 years in total, out of which $9M in options and $6M in stocks). Unfortunately, with the founding member gone and the son controlling the voting power, I am unable to handicap the politics either.

Disclosure: No position. No plan to start one.