On The Two That Got Away

“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.”

(Read Warren Buffet’s 1992 Annual Letter to Shareholders)

Lately, I’ve been thinking a lot about Fisher and Munger and their influence on Buffett. If I have not said it before, let me say it now: I believe both men’s influence on Buffett’s investment decisions have been overstated. I do not mean that as a slight to either man. They both have impressive records of their own, and they both offer a lot for investors to study. Phil Fisher and Charlie Munger are two of the greatest investment thinkers of all time. Besides, this post is not about the influence these men had on Buffett. This post is about investment mistakes I have made – mistakes I would not have made had I heeded the advice of Fisher, Munger, or Buffett.

This post is, at least in part, the result of the time I spent at Jason Bond’s blog over the weekend. That may not be obvious; nevertheless, it is true. I’m currently working on a three part podcast series on spotting great companies. I’m also in the process of reviewing two books: Phil Fisher’s “Common Stocks and Uncommon Profits and Other Writings” and Charlie Munger’s “Poor Charlie’s Almanack”. Obviously, these projects are closely related. That fact has been reinforced by two activities I engaged in this week: rereading Warren Buffet’s annual letters and visiting Jason Bond’s blog. Having done these things, I knew I had to write this particular post today.

Two weeks ago, I posted “On Blogs as Public Records”. In that post, I wrote:

“We’ll go over my mistake. Think of it as an autopsy. We’ll determine the cause of my error, and look to prevent it from creeping into our thinking in the future.”

Not surprisingly, both of the biggest mistakes of my investing career have been errors of inaction. However, these errors were not passive. When analyzing decision making, inaction must always be considered an action. A choice is made in either case; whether the outside world sees the results of that choice or not is irrelevant to an analysis of one’s own judgment – or misjudgment.

Three years ago, I failed to buy shares of Building Materials Holding Company (BLG). A year ago, I failed to buy shares of PetMed Express (PETS).

In each case, the stock was clearly undervalued. In each case, I did an intrinsic value analysis and compared the margin of safety to all possible alternatives. In neither case, did I find a possible alternative that had a margin of safety even remotely comparable to that of the stock being considered.

I will spare you the details of my analyses. It is …

Last Chance to Enter Widest Moat Contest

This is your last chance to enter the Widest Moat Contest.

All entries must be received by midnight tonight.

Final Notice:

You can win a copy of Benjamin Graham’s “Security Analysis” (1940 edition)

All you have to do is:

Pick the public company you think has the widest moat and leave a voice mail with your name, the name of the company you’ve picked, and a brief explanation of why you picked that company at: 1 – 800 – 782 – 1687

(You can pick up to two companies. If you do, leave two separate voice mails, one pick per message)

I will randomly pair off all the voice mail picks and put one pair into each upcoming podcast. Listeners will vote (via email) for the one with the widest moat from each pair. The pick with the fewest votes will be eliminated. This process will continue until only one company is left. Listeners will include a brief explanation for their vote with each email. The listener who sends in the most interesting email will also win a copy of Ben Graham’s “Security Analysis”.…

Widest Moat Contest Closed

The Widest Moat Contest is now closed.

No new entries will be accepted.

The entries that have already been received will be paired off into future podcasts. The winner will be chosen from among those picks.

Thank you to everyone who submitted an entry.…

On Small Cap Value and Large Cap Growth

Yesterday, there was an interesting post entitled “Finding Value in Growth” over at Value Discipline. About midway through the post Rick writes:

“As someone who generally has espoused small cap value picks, I have to admit how difficult it is to find value in this part of the universe. A few exceptions naturally do apply, but overall, the pickings are slim.”

I couldn’t agree more. The wheel has turned.

Immediately following the bursting of the speculative internet stock bubble, growth stocks were still overvalued. I found occasional exceptions, but these were short – lived. For instance, I briefly owned Cisco Systems (gasp!). However, I purchased the shares at what happened to be just about the lowest point they’ve traded at in eight years. I sold the stock within a matter of months. This is unusual behavior for me, but I bought the stock when it was undervalued and sold it when it approached fair value – the fact that this happened within a matter of months is the market’s fault, not mine.

What’s really remarkable here is that this undervaluing of Cisco (CSCO) only lasted for a matter of months. Ever since, Cisco hasn’t even approached levels I’d consider buying at. What (still extant) stock is more closely linked in investors’ minds with the internet induced insanity of the late 90s than Cisco? I can’t think of any.

So, one would have assumed Cisco would become one of the most reviled stocks of the earlier 00s. But, that didn’t really happen. Cisco was certainly less appreciated. But, it was only very briefly underappreciated. As I watched the bubble burst, my mouth was watering for the bargains that never came. I was sure great companies like Intel (INTC), Microsoft (MSFT), Cisco (CSCO), and Dell (DELL) would finally be offered at bargain basement prices. But, it didn’t happen.

This once again demonstrates my complete inability to predict stock price movements, future market levels, investor psychology, etc. I’m only good at one thing – finding businesses that are selling for less than they’re worth. Fortunately, this is the only skill an investor needs. Still, the whole experience does serve as a good reminder to ignore anything I have to say about the broader markets or short – term price movements. If I am ever foolish enough (and I’m sure I will be) to write about those things on this blog, please ignore me. That’s the best advice I’ll ever give.

Returning to the Value Discipline post, you’re probably wondering what this little story about Cisco has to do with “Finding Value in Growth”. Well, the wheel has turned. After all these years, “growth” is cheap and “value” is expensive. As I’ve said before, as far as you are concerned there are no such things as growth stocks and value stocks; there are just stocks. Don’t decide on growth or value and then pick a stock that fits into one of those boxes. Just go out and find a business that’s selling …

On Overstock

Why am I writing about an unprofitable internet company on a value investing blog? Because this blog is about finding dollars that trade for fifty cents; with a market cap of less than 75% of sales, Overstock.com (OSTK) looks like it may be exactly that.

But isn’t it too risky?

The greatest risk in any investment is the risk of overpaying. So, the real question is: what is Overstock worth? I think it’s worth at least $1.5 billion. With Overstock’s market cap currently sitting around $500 million, my valuation certainly looks far fetched. But, there’s only one way to know for sure. Let’s take apart my argument piece by piece, and see if any of my assumptions are unreasonable.

First Assumption: Over the next five years, Overstock will neither generate truly free cash flow nor consume cash. In other words, its free cash flow margin will average 0%. Cash generation in some years will exactly offset cash consumption in other years. Obviously, this assumption is unreasonable, because there is almost no chance the cash flows will exactly offset.

That’s not a problem if it turns out Overstock does generate some free cash flow over the next five years. In that case, my assumption simply errs on the side of caution. If, however, it turns out Overstock actually consumes cash over the next five years, there is a problem – possibly a very big problem. So, which scenario is more likely?

Overstock’s revenues are growing quickly. Gross margins look solid at 13.3% in 2004 and 14.9% over the last twelve months. Overstock’s unprofitability is the result of its selling, general, and administrative expenses (SG&A;) which have been growing exponentially. Will these expenses continue to grow? Yes, but not as fast as revenues. Over the last twelve months, Overstock’s spending on cap ex has been 5.6% of sales. That number is an aberration. In the long run, spending on cap ex should not exceed 3% of sales. Considering the business Overstock is in and the expected sales growth, the company will, more likely than not, generate some free cash flow over the next five years. Therefore, the assumption that Overstock will be cash flow neutral over the next five years is not overly optimistic.

Second Assumption: Over the next five years, Overstock’s sales will grow by 15% annually. Is this an unreasonable assumption? Again, I don’t think it is. Very few industries are expected to grow as fast as eCommerce. Overstock’s revenue growth in 2003 and 2004 was over 100%. In the past year, that growth has slowed. However, it is still closer to 50% than it is to 15%. Overstock isn’t in a cyclical business. So, there is no reason to believe current sales are abnormally high.

Also, all that spending on advertising is increasing consumers’ awareness of Overstock. A review of Overstock’s traffic data shows it has not only been gaining more visitors; it has also been climbing the ranks of the most popular web sites. …

Microsoft vs. eBay

Which company has the wider moat? Vote for Microsoft (MSFT) or eBay (EBAY) by sending an email to [email protected]. Include a brief explanation of your thinking on the issue.

If your vote is the most interesting email of the entire contest, you’ll win a copy of Benjamin Graham’s “Security Analysis”.

The voting for Microsoft and eBay closes at midnight on Monday (12:01 a.m. Tuesday).

Vote now by sending an email to: [email protected]…

Contest: Microsoft defeats eBay

With 67% of the vote, Microsoft (MSFT) defeats eBay (EBAY). Microsoft will advance to the next round to face a yet to be determined opponent.

I am in complete agreement with the description given by one of the voters (Soo Chin):

This fight is like Joe Frazier vs. Mohammad Ali… Two great heavyweights, but there can only be one winner.. in this case.. the Mohammad Ali of business — Microsoft.

Thank you to everyone who voted. I hope you’re enjoying the contest. The next podcast with two more picks should be available within the next 48 hours.

Congratulations to Microsoft (and George of Fat Pitch Financials).…

On Lexmark

At the end of my very first podcast, I mentioned my positive experience with the investor relations people over at Lexmark (LXK). They sent me the company’s annual reports for 1995 – 2004 as well as the accompanying 10-Ks. This happened over two weeks ago; so, I’ve had plenty of time to review the material. But, until now, I haven’t written a word about Lexmark. Why?

In 2005, Berkshire Hathaway bought about a million shares of Lexmark. I haven’t followed this story closely, but I assume the stock was purchased by Lou Simpson rather than Warren Buffett. I have only two reasons for believing this: the total purchase was small relative to Berkshire’s investable assets and the Lexmark purchase is typical of Simpson’s investment philosophy (or at least, what little I can glean about his investment philosophy from his past purchases). Regardless of who actually makes the purchases, a new Berkshire holding always draws a lot of commentary.

The commentary on Lexmark has been almost uniformly negative. Even many value investors have a very dim view of Lexmark at these prices. Now, I am not a contrarian investor. Psychology and sentiment do not enter into my considerations at all. I’ve bought stocks trading near five year lows, and I’ve bought stocks trading near five year highs. I just try to be rational. I’m not afraid to agree with the consensus, if it’s an accurate representation of reality. Here, it isn’t. The model of Lexmark that has emerged in my mind over the past few weeks bears little resemblance to the Lexmark I’ve seen described elsewhere.

Most of the negative comments about Lexmark have focused on the consumer segment. Yet, more than 75% of Lexmark’s profits come from the business segment. The business segment is Lexmark’s franchise. There, the company has managed to build a moat, not a very wide moat, but a moat nonetheless. Lexmark is the only focused, integrated printing company of any consequence. It understands its business customers’ needs, and provides specially tailored solutions that none of its competitors can offer.

Worldwide, some very large companies use Lexmark’s products for some very specialized tasks. Among these are retailers, banks, and pharmacies. Lexmark has complete control of their product including the printing technology itself and the software used to manage its printers (i.e., to interface with the user’s computer). Businesses that care about getting these specialized tasks done right (and getting them done cheap) use Lexmark.

Even Lexmark’s competitors have to concede the fact that Lexmark knows printing better than anyone else. Lexmark is the only company that develops its own ink – jet, monochrome, and color laser technologies. It is a vertically integrated printer business like no other. The two competitors most often mentioned as threats to Lexmark are HP and Dell. While everyone will suffer from deep price cuts; I think it’s HP and Dell who should be scared.

Lexmark has the much stronger competitive position. For years to come, it will …

On the New Podcast Episode

The new podcast episode “Competitive Advantage” is finally up. It’s the one that was originally scheduled for Tuesday. I’ll try to get another episode out real soon, so I can get back on schedule. Whenever there’s a delay like this, you can still count on getting two podcasts each week – that’s my promise to you. I know most of you aren’t listening to each podcast the moment it comes out anyway, so I hope this hasn’t been too much of a disruption. Anyway, I apologize for the delay, and hope you enjoy the new podcast.

Also, I want to thank everyone who sent in entries for the widest moat contest. The two picks I drew for this week were Microsoft (MSFT) and eBay (EBAY). If your pick isn’t one of these two, don’t worry, it’ll be featured on an upcoming podcast.

Don’t forget to vote for either Microsoft or eBay. The voting for these two picks will close at 12:01 a.m. on Tuesday. On next Tuesday’s podcast, I’ll let you know which one was eliminated and which one will move on to the next round. Remember, you can cast a vote by emailing [email protected].

To make your own pick for the widest moat contest leave a voice mail at 1 – 800 – 782 – 1687. Contest entries will be accepted through Friday, January 20th. Don’t forget each person is allowed two picks.

Enjoy the podcast.…

On Korean Stocks

I wanted to direct you to an interesting post over at Shai’s blog: “Warren Buffet’s Comments on the Korean Stock Basket”. I had been looking at Korean stocks previously, but did not see a way to own a diversified group of the cheap ones (that would be impossible via ADRs). Also, having spoken to several Koreans, (I should note these were people who chose to immigrate to this country or chose to attend school in this country, so they may be biased), I was not reassured about corruption issues over there. However, I think, with such a wide margin of safety present in each stock purchase, diversification would have been enough to manage the risk of corruption. Anyway, it’s an interesting post because it again emphasis the importance of looking where others aren’t, and because it offers a glimpse of Warren Buffet’s thinking.…