Buying a dollar for 50 cents; Focus on returns, not volatilityVW Staff
Via Pope Brar
For Q4 2013, Brar Investment Fund LP appreciated 6.2% net of fees. Cash represents nearly 19% of our portfolio.
The highlight of the quarter was delivering respectable gains to our investors, while holding a large amount of cash for potential opportunities. Since we purchase investments on very long term view compared to industry standard, we ask investors to measure us on a minimum 3 year and preferably a 5 year view. We cannot promise positive performance on a monthly or quarterly basis. Our aim is to purchase businesses at prices for which we would be laughed out of the boardroom in a complete deal. As absolute focused investors, we do not strategically weigh our holdings against any index and may concentrate our portfolio in an area that best serves our investors.
The main catalyst for outperformance was the appreciation of holdings in the materials and financials sectors. The largest gainer in percentage terms was Horsehead Holding.
Horsehead Holding Corp is the lowest cost producer of EAF dust and zinc products processed from recycling and steelmaking waste. Zinc is traditionally used to galvanize steel, it is the most cost-effective way to prevent corrosion. The company operates EAF dust processing plants around the US. Horsehead’s competitive advantage is the plants are strategically located near major mini-mill production areas, resulting in low transportation costs. It enables Horsehead to pass on savings to customers. The major catalyst is a new plant from which the company emerges as one of the lowest-cost producers of zinc products. The plant uses a low cost patented solvent extraction process called ZINCEX that allows Horsehead to enter the market for higher grades of metal with better applications. Zinc is showing impressive demand growth as an additive to fertilizers, leading to enhanced crop yields. We believe these factors may greatly enhance Horsehead’s earnings going forward.
Our bank holdings continue to rise with increased global stability and improved financial statements. Loan loss provisions are declining and the new loans are starting to outweigh the older non-performing loans. Notwithstanding higher shares prices across the sector, large pockets of opportunity exist in select financials. Despite the fundamental improvement, certain banks continue to trade at book values below 1x, far below our estimated value for well operated franchises that historically commanded at least a 50% higher book value. With declining loan loss provisions, the real earnings power is starting to come forth. This will further enhance the market’s perception of Bank of America, Citigroup, and JPMorgan.
Many investors still view banks as ‘black boxes’ lacking any transparency. Due to mismanagement of risk in the past, investors have reasons to be doubtful. We believe there are specific metrics that one can analyze to gain better understanding of a bank. To shed some light, we developed a Checklist for Analyzing a Bank.
In global macroeconomics, stability is becoming more evident. Recovery in the US continues to gain momentum from the positive developments in shale energy, housing sector, the stock market, innovation in healthcare and technology, and a flow of manufacturing back to the country. China, previously a major concern in Asia, is slowly improving. Major global corporates operating in the country have reported a stabilized business environment after two straight years of decline.
In terms of stock market valuations, our opinion remains unchanged from our previous letter. Many of our peers believe the markets are overpriced. We think the market is far from previous peak levels and is fairly valued. If one observes the historic S&P 500 PE Ratio (seen at www.multpl.com), markets were truly overpriced during the 2000 technology bubble when the average PE ratio reached 40. The current figure is approximately 19. While not inexpensive, we do not view the multiple as abnormally high.
Despite our discussion on the macro level, we believe the intelligent investor will do fine if they solely focus on buying great businesses at not so great prices. Markets are a random voting machine and it is nearly impossible to predict short term movement of markets. However, the investor should be alert for market pricing of the extreme variety, i.e. over/under pricing as seen in the economic crises of 2008-2009 and the 2000-2001 technology led bubble.
Focus on returns, not volatility
The fund maintains a high degree of concentration, typically 10 to 15 stocks, or even less. As a result, our fund may be more volatile than others. We do not view volatility as being a measure of risk. Our aim is to differentiate between real and perceived risk. For example, we believe once a security decreases in value, it offers higher upside and lower risk, provided fundamentals remain unchanged. Bill Miller correctly states, “Real risk and perceived risk are two different things. People perceive risk to be high when prices are low, and they perceive risk to be low when prices are high. That is the psychological problem that people have.”
Majority of the investment community has accepted that most managers are average and the best ones can achieve average returns with below average volatility. With this reasoning, a dollar selling for 50 cents on Monday, 70 cents on Wednesday, and 30 cents on Friday becomes worth less than a dollar selling for 50 cents every day of the week. To us, this does not make sense. The market is full of dollars that consistently sell at 1.2x or greater face value. These overpriced instruments are respected for their consistency, earning the “certification” to have a premium.
In our opinion, fluctuations in price present opportunity, not risk. These types of investments have historically allowed us to outperform against the market. A wildlyfluctuating dollar selling for 30 or 40 cents will always remain more attractive and significantly less risky than one that consistently sells for a higher amount.
Risk is the probability that we permanently lose our capital. We reduce risk by purchasing a handful of great investments that we deeply understand.
How to buy a dollar for 50 cents (or less)
Several people have asked how we are able to invest in a concentrated portfolio with a large margin of safety. Our explanation is simple, we aim is to buy a business that sells for less than half its full value, and dispose when it appreciates to 80% of the value. When fear strikes on a macro or industry level, we utilize our cash and selectively purchase opportunities with the largest margin of safety. During these times, great businesses may sell for less than a third of their intrinsic value on a two to three year view. Note, most investors are short term driven and only invest on a basis of two to three quarters. We come to work in a crises and then go on vacation while the markets price in proper intrinsic value of our portfolio. We are not accurate with determining the exact value of an investment and would be impressed if anyone can do it on a consistent basis. We simply sell when the investment matures to 80% of final value.
In action: common sense, opportunism, and patience
Let’s take an imaginary cyclical company, we’ll call it Widget & Co. The company has a strong competitive advantage, robust balance sheet, and produces niche auto parts. In 2007, Widget generated $2 per share in earnings and sold at a PE of 10x, valuing the company at $20 per share. In 2008, a heavy recession comes, consumers purchase less cars (less auto parts), earnings decrease to $0.50 per share. Seeing no quick end to the recession, Wall Street panics and massively sells the stock. Widget now sells for $5 or 10x this and next year’s estimated earnings. As intelligent investors we know two facts 1. Widget is an excellent company with a strong balance sheet that is able to sustain losses for years 2. The recession will eventually end. With no fundamental change in the business model, Widget is likely to produce $2 per share in normalized earnings. In addition, we stress test the business model using our SAVR Investment Checklist of 90+ items. Confident, we buy Widget for $5, a full dollar for only 25 cents! We sell the stock once it reaches $16 per share or 80% of intrinsic value at $20 per share. I describe a very simple cyclical scenario, similar opportunities can rise in sectors facing temporary stress, or companies with mispriced assets. Holding a concentrated portfolio of these opportunities on a two to three year view may result in nice gains.
To further educate our investors on concentrated investing, we made a small booklet called “Become an Investment Guru”. The basic 15 steps described provide insight on developing an investment process, locating opportunities, and learning from great investors. With patience, common sense, and a dash of opportunism, we believe anyone is capable of harvesting the fruit of intelligent investing.
“What you love you empower. What you fear you empower. What you empower you attract.” – Author Unknown
If you have any questions, please feel free to give us a call.