• Ben Graham knew that stocks typically look most attractive at the top of their business cycle (the worst risk-reward ratio) and least attractive at the bottom (the best risk-reward ratio).

• Carl Icahn

  • Ichan started in convertible arbitrage, moved into closed-end mutual fund arbitrage, and eventually to activist investing.
  • He outlined the transition to an activist investor in a 1976 memo “Icahn Manifesto.”
  • The goal was to motivate management to act in the shareholder’s best interest.

Possible outcomes produce profits: liquidation or sale to another company, making a tender offer, proxy fight, or selling stock back to the company.

• Ben Graham was an early activist who saw firsthand how often management ran a business for themselves and at the expense of shareholders. Most shareholders never questioned it.

• Graham’s NCAV was a conservative estimate of liquidation value (a worst-case scenario) for a stock.

• Margin of Safety: protects from permanent loss and provides an opportunity for gain as price rises closer to value. The wider the spread between price and value the wider the margin of safety (lower the risk) and the higher the possibility for gain.

• Testing Graham’s NCAV strategy: NCAV stocks were divided into stocks that were profitable in the prior year and stocks operating at a loss. The portfolio of stocks operating at a loss outperformed the profitable stocks. And the profitable-dividend paying stocks earned a lower return than non-dividend payers.

• NCAV strategy is very limited — usually, very small companies and the opportunities only appear in a bear market and disappear entirely in long bull markets.

• Seth Klarman looks for catalysts to reduce risk and generate returns because catalysts reduce the impact market fluctuations might have on a stock’s price.

• Charlie Munger believed some companies were worth paying a premium for: “The trick is to get more quality than you pay for in price. It’s just that simple.”

• See’s Candies:

  • Buffett paid $25 million for the company in 1972.
  • In 1971, See’s earned $5 million pre-tax on $8 million in tangible assets; a 60% return.
  • A 10% to 12% discount rate put the value of See’s between $40 and $48 million.
  • Buffett called See’s the “prototype of a dream business.” It requires very little capital to operate the business and generates a huge return on capital.
  • In the 2007 BRK letter, Buffett explained why: from 1972 to 2007 earnings grew 16-fold while invested capital grew 5-fold.

• Joel Greenblatt’s “Magic Formula” ranks stocks based on quality and value using: return on capital and earnings yield where earnings yield = EBIT/EV. From 1974 to 2011, the Magic Formula earned a 13.94% annual return versus the S&P 500’s 10.37%.

• Earnings Yield (EBIT/EV) alone earned 15.95% annually from 1974 to 2011, beating the market and Greenblatt’s Magic Formula. Return on capital alone underperformed the market.

• A low valuation ratio is more likely to identify an undervalued stock than a high valuation ratio.

• From 1964 to 2011: EBITDA/EV, EBIT/EV, P/E, EV/FCF, EV/Gross Profit, P/B outperformed the S&P 500 (total return). The top three metrics were EBIT/EV, EBITDA/EV, and EV/Gross Profit, respectively.

• EV = market cap plus debt and preferred stock minus cash. It’s a closer measure of a company’s true cost to an acquirer because an acquirer assumes all the liabilities but gains cash and equivalents after a takeover. Market cap can be misleading, especially for highly levered or cash-heavy companies.

• Investors should be thinking in similar terms as an acquirer.

• Mean Reversion:

  • A few businesses produce persistently high returns on capital but most don’t. Predicting which businesses do is not easily measurable via quantitative factors.
  • Most businesses that earn high returns on capital eventually see those returns revert.
  • High returns on invested capital attract competition and investment that eventually lowers returns across the industry. In the rare cases where high returns persist, it’s larger due to protection from competition.
  • The risk of ignoring the possibility of mean reversion is overly-optimistic valuations that lead to losses.
  • De Bondt and Thaler tested two portfolios of stocks: the 35 extreme winners against the 35 extreme losers from 1926 to 1982 and found the losers beat the winners. They theorized the performance was due to investors overreacting to news — too pessimistic or optimistic — in the short term. In a second study, they tested mean reversion in earnings — earnings of stocks in the loser portfolio grew faster than in the winner portfolio (the winners saw earnings decrease).
  • Dimson, Marsh, & Staunton found an inverse relationship between investment returns and GDP growth per capita. In a second study, country’s with economies with the lowest growth rate produced the highest stock market returns. Investors see high growth in an economy, become optimistic, and bid stock prices too high. The opposite happens with low growth.
  • Lakonishok found that value stocks beat glamour stocks because “naive” strategies failed to account for mean reversion. The authors replicated Lakonishok’s study in 23 developed countries and found similar results — value outperformers glamour.
  • The characteristics behind mean reversion in markets is behavioral.

• Kahneman & Tversky found that people make decisions based on three heuristics — representativeness, availability, and anchoring/adjusting — that lead to mistakes. It causes people to ignore the probabilities of future events when making decisions.

• The three variables in discounted cash flow models — future cash flows, growth rate, and discount rate — are potential sources of error. Being wrong on one can throw the entire model off. Minor changes in the discount rate have the biggest impact. More importantly, the model creates the impression that accurately predicting future cash flows and growth is possible.

• A contrarian investor should anticipate mean reversion in fundamentals and valuation.

• Contrarian Value Portfolio versus Glamour Portfolio

  • Contrarian Value portfolio held stocks with the lowest sales growth and lowest P/B, P/CF, and earnings multiple.
  • Glamour portfolio held stocks with the highest sales growth and highest P/B, P/CF, and earnings multiple.
  • The study was run from 1963 to 1990.
  • Contrarian Value significantly outperformed Glamour over 5 year periods with a cumulative return ranging from 77% to 104% depending on the valuation multiple used.
  • Prior to selection in the portfolio, glamour showed the highest growth in earnings, cash flow, sales, and operating earnings and contrarian value showed the lowest growth in earnings, cash flow, sales, and operating earnings.
  • Contrarian Value versus High-Growth Value
    • Set up similarly to prior study but with the value decile split between high and low growth (contrarian) earning, cash flow, sales, and operating earnings.
    • Contrarian Value significantly outperformed High Growth Value (high growth value outperformed glamour).
    • Two takeaways: value may be more important than growth and low/no growth leads to outperformance while high growth leads to underperformance.

• The Golden Rule of Predictive Modeling: simple models often make as/more reliable predictions than experts.

• Studies on activist campaigns:

  • Activist campaigns against companies produce both short and long-term outperformance in the stock’s price versus the market.
  • Campaigns specific to seeking the sale of the company or a spinoff of assets produced the highest excess returns, respectively.
  • Activist campaigns also outperform a basket of cheap stocks.
  • The more hostile or aggressive campaigns earned a higher return, on average, than friendlier campaigns.
  • Companies hit by activist campaigns show an improvement in fundamentals — improved margins, ROA, ROE, payout ratio, and lowered executive pay.
  • The typical activist target was undervalued, with high cash flows but low payouts, large cash holdings compared to other assets, and poor growth prospects.
  • Typical activist’s primary objective was to fix one of these categories: undervaluation, operational efficiency, low payout and overcapitalization, excessive diversification, independence, poor governance, and undercapitalization.

• A basket of the cheapest of the cheap value stocks outperformed all. The cheapest EBIT/EV decile, split between Deep Value (lowest value) and Glamour (highest value), and versus the entire decile, Deep Value beat all from 1951 to 2013. And equal-weighted Deep Value outperformed market-cap-weighted Deep Value.

Quotes

“This book is an investigation of the evidence, and the conditions under which losing stocks become asymmetric opportunities, with limited downside and enormous upside.”

“Investors aren’t rewarded for picking winners; they’re rewarded for uncovering mispricings — divergences between the price of a security and its intrinsic value. It is mispricings that create market-beating opportunities.”

“Whenever a fight for control is initiated, it generally leads to windfall profits for shareholders. Often the target company, if seriously threatened, will seek another, more friendly enterprise, generally known as a ‘white knight’ to make a higher bid, thereby starting a bidding war. Another gambit occasionally used by the target company is to attempt to purchase the acquirers’ stock or, if all else fails, the target may offer to liquidate.”

“Interestingly enough, although I consider myself to be primarily in the quantitative school…the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight.” This is what causes the cash register to sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat.” — Warren Buffett

“The data suggest that the better bet is fair companies at wonderful prices. The why of it reveals two truths about value investment: First, Greenblatt’s earnings yield is a very good metric for identifying undervalued stocks, and, second, mean reversion is a powerful phenomenon.”

“Abnormally good or abnormally bad conditions do not last forever. This is true of general business but of particular industries as well. Corrective forces are usually set in motion which tend to restore profits where they have disappeared, or to reduce them where they are excessive in relation to capital.” — Ben Graham

“It is impossible to infer the cause of persistence in performance from the fact that persistence occurs. Persistence may be due to fixed resources, consistent industry structure, financial anomalies, price controls, or many other factors that endure… In sum, reliable inferences about the cause of persistence cannot be generated from an analysis that only documents whether or not persistence occurred.” — Michael Porter

“Here is the simple truth: mean reversion is pervasive, and it works on financial results as it does on stock prices. On average, super-normal returns on capital revert to the mean. Only special cases avoid mean reversion, and the factors that separate the also-rans from the special cases are impossible to identify prospectively.”

“A company with great fundamental performance may earn a market rate of return if the stock price already reflects the fundamentals. You don’t get paid for picking winners; you get paid for unearthing mispricings. Failure to distinguish between fundamentals and expectations is common in the investment business.” — Michael Mauboussin

“Mean reversion in the markets looks a lot more like the gambler’s fallacy made real — movements in security prices, individually and in aggregate, tend to be followed by subsequent price movements in the opposite direction. The more extreme the initial price movement, the greater will be the subsequent adjustment in the opposite direction.”

“Graham’s deeper lesson was that value oscillates, too. We err when we examine a stock’s financial statements to analyze its fundamental performance and assume that the trend will persist.”

“Lakonishok, Shleifer, and Vishny’s findings suggest that a contrarian strategy—one that actively seeks out undervalued companies with poor historical performance—will outperform overvalued companies with excellent historical performance.”

“While the High-Growth Value and Contrarian Value portfolios contained stocks trading on approximately the same price-to-value ratios, the stocks in the High-Growth Value portfolios were in some instances cheaper than the stocks in the Contrarian Value portfolios and yet the Contrarian Value portfolios delivered comprehensively better returns.”

“What is clear is that value investing in general, and deep value investing in particular, is exceedingly behaviorally difficult. It is counterintuitive and against instinct, which is why many investors shy away from it. To succeed as deep value investors, we need to overcome our behavioral biases.”

“Any investment strategy that is based upon buying well-run, good companies and expecting the growth in earnings in these companies to carry prices higher is dangerous, since it ignores the possibility that the current price of the company already reflects the quality of the management and the firm. If the current price is right (and the market is paying a premium for quality), the biggest danger is that the firm loses its luster over time, and that the premium paid will dissipate. If the market is exaggerating the value of the firm, this strategy can lead to poor returns even if the firm delivers its expected growth. It is only when markets under estimate the value of firm quality that this strategy stands a chance of making excess returns.” — Aswath Damodaran

“Over the long haul, the market reflects management’s ability to make the most out of its assets. So the price of a company’s stock is like a report card… A going concern should sell for at least the value of its assets, and something more if it has good management. If a company has poor management, the price of the stock will suffer, usually selling substantially below the appraised value.” — T. Boone Pickens

“Where the company is not appropriately capitalized, where it is not minimizing its cost of capital, intrinsic value can be improved by reducing excess cash. In so doing, the market price discount is also likely to be removed, and the company trade closer to its fully realized intrinsic value. The utility of the enterprise multiple is that it identifies precisely this type of company, undervalued with an unexploited intrinsic value. If no activist emerges to improve the unexploited intrinsic value, other corrective forces act on the market price to generate excellent returns in the meantime.”

“The research shows, first, that valuation is more important than the trend in earnings. Cheap, low, or no-growth portfolios systematically outperform expensive, high-growth portfolios, and by wide margins. The second, more counterintuitive finding of the research is that, even in the value portfolios, high growth leads to underperformance, and low or no growth leads to outperformance.”

References

• https://novelinvestor.com/notes/deep-value-by-tobias-carlisle/