Geoff Gannon March 17, 2006

On Value Investing

What is Value Investing?

Different sources define value investing differently. Some say value investing is the investment philosophy that favors the purchase of stocks that are currently selling at low price-to-book ratios and have high dividend yields. Others say value investing is all about buying stocks with low P/E ratios. You will even sometimes hear that value investing has more to do with the balance sheet than the income statement.

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffet wrote:

We think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).

Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.

Buffett’s definition of “investing” is the best definition of value investing there is. Value investing is purchasing a stock for less than its calculated value.

Tenets of Value Investing

1) Each share of stock is an ownership interest in the underlying business. A stock is not simply a piece of paper that can be sold at a higher price on some future date. Stocks represent more than just the right to receive future cash distributions from the business. Economically, each share is an undivided interest in all corporate assets (both tangible and intangible) – and ought to be valued as such.

2) A stock has an intrinsic value. A stock’s intrinsic value is derived from the economic value of the underlying business.

3) The stock market is inefficient. Value investors do not subscribe to the Efficient Market Hypothesis. They believe shares frequently trade hands at prices above or below their intrinsic values. Occasionally, the difference between the market price of a share and the intrinsic value of that share is wide enough to permit profitable investments. Benjamin Graham, the father of value investing, explained the stock market’s inefficiency by employing a metaphor. His Mr. Market metaphor is still referenced by value investors today:

Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you

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Geoff Gannon March 16, 2006

New Podcast: “Buffett’s Letter”

Listen to the Gannon On Investing Podcast: “Buffett’s Letter”

A new podcast episode entitled “Buffett’s Letter” is now available. This is Buffett Week at the Gannon On Investing Podcast. So, feel free to leave a voice mail message about Buffett at 1-800-782-1687. If your comments are worth sharing with others, I will play them on the next podcast.

Enjoy the podcast.

Summary: A discussion of select passages from Warren Buffett’s annual letter to shareholders. The discussion focuses on general investing lessons rather than Berkshire’s performance.

Stocks MentionedEnergizer Holdings (ENR), Procter & Gamble (PG)

Contest Picks: General Electric (GE), Johnson & Johnson (JNJ)

Run Time: 26 minutes

Next Show: “Buffett Businesses”

Listen to the Gannon On Investing Podcast: “Buffett’s Letter”

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Geoff Gannon March 15, 2006

The Great Experiment: Marketocracy Funds Update

About six weeks ago, I set out to conduct an experiment on concentration vs. diversification. I wanted to see how managing a focused portfolio was different from managing a widely diversified portfolio. How would the returns from each type of fund compare?

I created five virtual funds at Marketocracy, placing different restrictions on each. Click below to be taken to the fund page on Marketocracy.

David Fund: May only invest in companies with a market cap less than $1 billion (at time of purchase).

Goliath Fund: May only invest in companies with a market cap greater than $10 billion (at time of purchase).

Jersey Fund: May only invest in companies headquartered in New Jersey.

Shotgun Fund: Attempts to divide assets evenly over top 100 investment ideas.

Sniper Fund: Attempts to divide assets evenly over top 20 investment ideas.

David Fund

This fund has about 12% of its assets in cash. The other 88% of assets are divided among eight stocks as follows:

Overstock.com (OSTK): 16.91%

Jakks Pacific (JAKK): 15.33%

Blyth (BTH): 14.34%

Craftmade (CRFT): 9.14%

Journal Communications (JRN): 8.15%

Rex Stores (RSC): 8.12%

Tuesday Morning (TUES): 8.07%

Weyco Group (WEYS): 7.69%

Since inception (1/28/06) the David Fund has returned 1.39%.

Commentary: OSTK and JAKK have carried this fund. At present, I’m happy with the valuation of these eight stocks relative to the market, and look forward to rounding out the roster by finding one or two additional bargains under $1 billion.

Goliath Fund

This fund has just under 50% of its assets in three stocks: Posco (PKX), Deutsche Telekom (DT), and Home Depot (HD). The other half of the fund’s assets is spread over 22 different stocks.

Since inception (1/28/06) the Goliath Fund has returned 3.97%.

Commentary: Most of the other 22 stocks were selected according to Joel Greenblatt’s “magic formula”. Energy and financials are largely absent from this fund. I hope to keep it that way. I don’t expect to make any changes to this fund in the near future, and believe Goliath’s long-term results relative to a basket of all stocks in the $10b+ universe will likely prove satisfactory.

Jersey Fund

This fund has 100% of its assets divided among 10 stocks:

Village Supermarket (VLGEA): 19.86%

Journal Register Company (JRC): 13.90%

J&J; Snack Foods (JJSF): 8.85%

Avaya (AV): 8.62%

Dendrite (DRTE): 8.25%

Campbell Soup (CPB): 8.20%

Movado (MOV): 8.19%

Emerson Radio (MSN): 8.14%

Church & Dwight (CHD): 8.02%

Engelhard (EC): 7.37%

Since inception (1/28/06) the Jersey Fund has returned 1.78%.

Commentary: I’m very dissatisfied with this group of ten stocks. There are few opportunities in New Jersey at the moment; however, I have decided not to hold cash, because the NJ investment universe is limited. I’d rather sell out one or more positions to move into a bargain when it appears, than to sit on a lot of cash. I believe the lower eight stocks will offer a better return than cash – but, not much …

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Geoff Gannon March 14, 2006

Against Mr. Lynn’s Buffett Bashing Philippic

Read Matthew Lynn’s Buffett Bashing Philippic

Warren Buffett’s annual letter to Berkshire Hathaway (BRK.B) shareholders was released on Saturday, March 4th.

Since the letter’s release there has been some Buffett bashing – much of it coming from the mainstream financial press. The most brazen Buffett bashing to date came from Bloomberg columnist Matthew Lynn, who began his article by writing:

Maybe it is his age, his probable retirement or the mediocre performance of Berkshire Hathaway’s shares the past two years. Whatever the cause, Warren Buffett’s ruminations on the financial markets have taken on a grouchy, quarrelsome tone recently.

For years, investors have pored over the annual statements of the world’s second-richest man. Buffett, 75, has been called the Oracle of Omaha, with every folksy, homespun piece of wisdom elevated to the status of unimpeachable truth.

Stop and look more closely, however, and it turns out you would have more chance of success by checking some tea leaves, or a pack of tarot cards, for financial predictions.

Mr. Lynn’s article is not worth reading – not because it criticizes Buffet, but rather because it is a confused piece of drivel. The article ignores inconvenient facts, and does not bother to scrutinize the author’s own argument or the evidence he puts forward.

Still, I can’t say it’s badly written. If you judge the article by the standards of propaganda writing, it scores pretty well. The tone is bitter yet engaging; the message is clear; and there is the requisite illusion of a logical edifice built upon actual facts.

Like any good propagandist, Mr. Lynn makes liberal use of the straw man technique. The result is effective rhetoric that takes on the appearance of Swiss cheese when viewed by those who value logic above impudence.

Early in the article, Mr. Lynn writes, “And now Buffett tells us that hedge funds and buyout firms are fleecing us all. Once again, the evidence is threadbare.”

Then, he quotes a Mr. Tim Price of Ansbacher & Co. in London as saying: “There is an element of protesting too much…When you look at it, Berkshire Hathaway is not a million miles away from being a giant hedge fund or private-equity fund itself.”

There are two problems here. First, the evidence that hedge funds are fleecing investors is not “threadbare”. Managers are making a lot of money. That fact is not disputed. What is disputed is whether they are worth it.

There is a case to be made that individual managers are worth it. That case is similar to the example I laid out in my first podcast, where I basically said: Lance Berkman and Tony Womack both play baseball and both make a lot of money. One of them is overpaid – he just happens to be the guy making less money.

At the time, I was making a point about executive compensation, not fees paid to money managers. However, the two cases are substantially similar. If, over an investing lifetime, the compound annual …

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Geoff Gannon March 14, 2006

News Item: Sherwin-Williams (SHW)

Today, Sherwin-Williams (SHW) raised its earnings expectations for the first quarter of 2006. Analysts had been expecting earnings per share of $0.59 for the first quarter; on January 26th, the company said it expected to earn between $0.56 and $0.61 per share in the first quarter.

Sherwin-Williams now expects the EPS number to be between $0.75 and $0.79. Net sales are projected to grow by 13-14% over sales for the first quarter of 2005. The previous projection had been for sales growth to come in around 10%.

The earnings update is primarily the result of better than expected sales in the company’s paint stores. Expense control has also been better than expected. As a result, SHW’s gross margin will exceed previous estimates.

Sherwin-Williams will report its first quarter earnings on April 20th.

Related Reading

On Sherwin-Williams’ Profitability

News Item: Sherwin-Williams Lead Paint Lawsuit

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Geoff Gannon March 14, 2006

Suggested Link: Overstock Sell Rationale

Here are three posts from a blogger who recently sold shares of Overstock.com (OSTK). Below, I’ve placed the posts in chronological order so you can follow the author’s thinking over the last few weeks:

Step Back, Jack (OSTK)

Good-bye, Big O (OSTK)

World’s Worst Market Timer (OSTK)

These posts come from a blog called One Guy’s Investments. It is a more personal, less analytical blog than my own. I enjoy reading it from time to time. It is a refreshing change of pace from much of the investment writing found online. If you’re looking for another blog to read, you might want to check this one out – it’s different, but I like it.

Visit One Guy’s Investments

Related Reading

An Analysis of Overstock.com (OSTK)

On the Rationale for the Overstock Post

On Overstock (Again)

On Overstock’s Fourth Quarter

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Geoff Gannon March 14, 2006

Suggested Link: Pilgrim’s Pride – – The Sky is Falling

I’ve previously discussed chicken stocks in general and Pilgrim’s Pride (PPC) and Sanderson Farms (SAFM) in particular. Last Tuesday, the accounting blog 10Q Detective posted on Pilgrim’s Pride:

Pilgrim’s Pride – – The Sky is Falling

Back in January, I suggested that investors interested in chicken stocks look to Sanderson Farms first. My thinking on the matter has not changed. Below, I reprint part of a post from January briefly explaining why you shouldn’t rush off to buy Pilgrim’s Pride, without first taking a good look at Sanderson Farms.

Remember, the following is an excerpt of an old post, the announcement referenced was made in early January:

These stocks may appear cheap, but appearances can be deceiving. It is not a question of if margins will contract; it is a question of when margins will contract. Some value investors will take Pilgrim’s announcement as a buying opportunity. It may be just that.

However, I wouldn’t be buying Pilgrim’s Pride (PPC). When trouble comes, the much smaller, much more conservatively financed Sanderson Farms (SAFM) will be in the stronger position. Sanderson Farms has the better recent record when it comes to earning a good return on capital. On the other side of the scales, Sanderson Farms does trade at a higher price-to-sales ratio than Pilgrim’s Pride. In a business like this, price-to-sales can be an important number, because there is little reason to expect any one company to consistently maintain a wider profit margin than the rest of the industry.

I won’t pretend I understand this industry. I don’t. I won’t pretend I have any clue as to what these firms will earn over the next few years. I don’t. What I do know is that, if I were looking at chicken stocks, I’d start with Sanderson Farms. I suggest you do the same.

Some other bloggers such as Bill of Absolutely No DooDahs have written some very intelligent things about chicken stocks. If any of them are reading this post, I’m sure we would all benefit were they to comment below with the relevant links (hint, hint).

Visit 10Q Detective

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Geoff Gannon March 13, 2006

Stock Analysis Articles

For new visitors, here’s a list of my stock analysis articles to date:

An Analysis of Lexmark (LXK)

An Analysis of Overstock.com (OSTK)

An Analysis of Energizer Holdings (ENR)

An Analysis of the Journal Register Company (JRC)

An Analysis of Journal Communications (JRN)

An Analysis of Pacific Sunwear (PSUN)

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Geoff Gannon March 13, 2006

News Item: Overstock.com (OSTK)

On the day, Overstock shares are up about 10%. Over the last two days, shares of Overstock.com (OSTK) have dramatically increased in price. The increase has been close to 20% for the week. I’m just writing this quick note to assure readers that this price change is small relative to the discount to intrinsic value at which Overstock is selling.

Over the last two months, I have written about the company while its stock was trading at various prices. Nothing has changed. Everything I have written remains as valid today as it was when I wrote it. The market is still valuing the company at a fraction of its true value. If you are interested in purchasing shares of Overstock, you shouldn’t let the relatively small increase in the stock price scare you off.

If you are still undecided, there is no reason to act hastily. First, come to a conclusion as to Overstock’s value. Only after doing that should you check the market price.

Simply put, this post is to assure you that nothing has changed and to encourage patient, confident action based on your assessment of the facts at hand, rather than on emotions such as fear, greed, or anxiety.

Related Reading

An Analysis of Overstock.com (OSTK)

On the Rationale for the Overstock Post

On Overstock (Again)

On Overstock’s Fourth Quarter

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Geoff Gannon March 12, 2006

Suggested Link: Traditions in Value Investing

Traditions in Value Investing

A lengthy overview of traditions in value investing. This articles cover Benjamin Graham, Warren Buffett, and Phil Fisher. It also mentions a few good written works by and about value investors. Highly recommended.

This article originally appeared in Deep Wealth.

The article has been submitted to Fat Pitch News. So, if you like the article, please bid it up over at Fat Pitch News so others will get a chance to read it as well (if enough people vote for the link, it will appear as one of the five headlines displayed on various sites).

Read Traditions in Value Investing

Visit Deep Wealth

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