8, also felt this was a very safe way to invest the money oftheir investors.
StocksI didn’t want this to be a book “like all the others,” and most other booksabout Warren Buffett focus on his stock-picking techniques. However, thereality is that this topic cannot be ignored in any work about Buffett. WhatI hope to offer to the dialogue is an examination of studies done on thetechniques that Buffett supposedly uses for his stock picking.And finally, we will examine and study the principle of mean reversion. The commonly quoted aphorism is to “buy when there is blood in thestreets.” Buffett and Graham both recount the story of Mr. Market, who isalways buying when things are too expensive, and selling when thingsare too cheap. Mr. Market is often crushed by the idea of mean reversion.Without focusing specifically on value investing, can the average investorquantify an approach to mean reversion that still carries with it the conceptof margin of safety?
CommoditiesBuffett has never been a big fan of investing commodities. However, he hasseveral times made the plunge, most recently with silver. Many people whotrade commodities do so based on the technicals, chart reading, and puresystems trading. It is interesting to see how Buffett applies his principlesof value investing to commodities.
Does Warren Buffett Trade?
13
CurrenciesCurrencies have never been a popular Buffett investment. In fact, Buffettonly began buying currencies in the past year. “Buy what you know” is theslogan of Buffett fans, and Buffett knows the United States better than heknows any other country. We will explore what made him finally invest inforeign currencies later in this book.Finally, the book concludes with a suggested readings section thatcatalogs the primary books that discussed or influenced Buffett.
CHAPTER 2
Graham-Doddand a Doseof Fisher
arren Buffett claims to be “15 percent [Philip] Fisher and 85percent Benjamin Graham.” You could make the argument thatthe inverse is true, although I take Buffett at his word andthink he is correct, particularly when you look at the activities of hishedge fund from 1957 to 1969 and the activities of his personal portfolio.(Not to mention his overriding philosophy of always looking for a marginof safety.)Let’s begin with a few notes about Fisher. Philip Fisher, the author ofCommon Stocks and Uncommon Profits, advocated buying a focused portfolio, a few companies with above-average potential. How is it possible todetermine above-average potential?
W
• Focus on growing sales.• Focus on expanding research and development (R&D) since that willkeep the company ahead of the curve and capable of growing sales inthe future.• Demographics need to be monitored. Is the market for this companygoing to continue to grow?• Management should be strong and communications with shareholdersshould be direct and honest.
15
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TRADE LIKE WARREN BUFFETT
How does one get the low-down on management? This is what Fisherrefers to as “scuttlebutt.” Interview customers, management, employees,other investors, journalists, and so on. Get the information any way you can.Fisher was also a big fan of focus investing. This is the idea that peopleshould only buy a few stocks. The idea makes intuitive sense in that you canonly focus on a few stocks at a time anyway. If you were in 200 stocks itwould be much harder to follow all of the movements of each stock, andit becomes much more likely that, in the best-case scenario, all you do istrack the overall market.There has been interesting research recently on several of Fisher’s criteria. For instance, looking at the R&D expenses of a company is notalways helpful. The way a company expenses research and developmentmight be just an accounting trick. However, there is a way to look at R&Din a way that is correlated with future stock market performance.According to CHI Research, a consulting firm that focuses on studyingthe intellectual property of companies, a company’s patent portfolio is apredictor of future stock performance. The quality of the patent portfoliocan be assessed by, among other things, the statistics related to forwardcitations to the patents. A forward citation is a note on the front of a laterpatent that states which prior patents the patent pending is improvingupon. The more patents the patent is improving, the more well-spent theR&D dollars were in creating that patent.From 1989 to 1998, CHI constructed a test, selecting the 25 companiesmost undervalued based in part on patent quality indicators such as highlycited patents and short technology cycle times, that is, shorter than theaverage for their industries.As we can see in Exhibit 2.1, the patent/R&D–heavy companies steadilyoutperformed the S&P and even outperformed the Nasdaq by a wide margin during 2000, when tech stocks were down by a wide margin.In fact, CHI Research itself has a patent for its method of picking astock portfolio based on the quality of the patent portfolio for each stock(see Exhibit 2.2).The issue about diversification is a tug-of-war between Graham-Doddpurists and Fisher purists. Fisher advocates a “focused portfolio” approach,that is, a portfolio with just a few stocks in it so that it is easier to follow,research, and manage them. Graham-Dodd advocates more extensive diversification. Fisher’s point—a valid one—is that the more stocks in your port-
Graham-Dodd and a Dose of Fisher
EXHIBIT 2.1
17
Portfolio Performance
Source: Reprinted from the CHI Research website, http://www.chiresearch.com, 2004.
folio, the harder it is to follow them. As Buffett has stated, “Wide diversification is only required when investors do not understand what they aredoing.” And Robert Hagstrom, in his books The Warren Buffett Portfolioand The Essential Buffett, has done some excellent research on the valueof a focused portfolio.Academic research in this area received a boost from a paper by twoUniversity of Michigan professors, Clemens Sialm and Lu Zheng, and one oftheir Ph.D. graduate students, Marcin Kacperczyk.1 Their conclusion afterlooking at all mutual fund data from 1984 to 1999 was that actively concentrated portfolios perform better than funds with diversified portfolios. Theyalso tend to outperform the market, despite the evidence that actively managed funds in general (including the ones with high diversification) tend tounderperform the market. The outperformance occurred both in the 1980sand 1990s, and was sector-independent (so it was not just technology).
1
“On the Industry Concentration of Actively Managed Mutual Funds,” by ClemensSialm, Lu Zheng, and Marcin Kacperczyk, Journal of Finance, 2005.
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TRADE LIKE WARREN BUFFETT
EXHIBIT 2.2(12)
United States Patent
(10) Patent No.:US 6,175,824 B1(45) Data of Patent:Jan. 16, 2001
Breitzman et al(54) METHOD AND APPARATUS FOR
CHOOSING A STOCK PORTFOLIO, BASEDON PATENT INDICATORS(75) Inventors: Anthony F. Breitzman, Cedarbrook;Francis Narin, Ventor, both of NJ (US)(73) Assignee: CHI Research, Inc., Haddon Heights,NJ (US)(*)
Notice:
Under 35 U.S.C. 154(b), the term of thispatent shall be extended for 0 days.
(21) Appl. No.: 09/353,613(22) Filed:
Jul. 14, 1999
(51) In. Cl.†
. . . . . . . . . . . . . . . . . . . . . . G06F 17/68
(52) U.S. Cl.
. . . . . . . . . . . . . 705/36; 705/10; 705/35;705/37
(58) Field of Search . . . . . . . . . . . . . . . . . 705/36, 10, 35,705/37(56)
Refences Cited
U.S. PATENT DOCUMENTS5,761,442 *5,819,2385,934,674 *5,978,778 *6,035,286 *
6/1998 Barr et al. . . . . . . . . . 705/3610/1998 Rembolz.8/1999 Bukowsky . . . . . . . . 273/27811/1999 O’Shaughnessy . . . . . 705/363/2000 Fried . . . . . . . . . . . . . 705/36
OTHER PUBLICATIONS“Techo File: Data Mining for the Soft Assets”. InvesterRelations Dec. 1996.*Stobbs Gregory: “Turning the Corporate Patent PortfolioUsing the Latest Software Tools”. MapiT Briefing Report,Manning & Napier, Jun. 1997.*McGuire, Craig: “The Next Level of Proprietary Protecttion”, Wall Street & Technology, Jan99, vol. 17 Issue 1, p52,1p.”J.S. Perko et al.: “The Transfer of Public Science to PatentedTechnology: A Case Study in agriculture Science”. Journalof Technology Transfer, vol. 22(3) 65–72, 1997.*
CHI Research, Inc. Introduces Tech–Line Analysis ToolTechnology, Information Today, V 15, n 9, p 66, Oct. 1998.*Deng, Z., Lev, B., and Narin, F. “Science and Technology asPredictors of Stock Performance” (Financial Analysts Journal, vol. 55, No. 3, May/Jun. 1999, pp. 20–32).Rosenberg, N. and Birdzell, Jr., L.E. “Science, Technologyand the Western Miracle” (Scientific American, vol. 263,No. 5, Nov. 1990, pp. 42–54).(List continued on next page.)Primary Examiner—Tod R. SwannAssistant Examiner—Jagdish N Patel(74) Attorney, Agent, or Firm—Akin, Gump, Strauss,Hauer & Feld, L.L.P.(57)
ABSTRACT
A portfolio selector technique is described for selectingpublicly traded companies to include in a stock marketportfolio. The technique is based on a technology scorederived from the patent indicators of a set of technologycompanies with significant patent portfolios. Typical patentindicators may include citation indicators that measure theimpact of patented technology on later technology. Technology Cycle Time that measures the speed of innovation ofcompanies, and science linkage that measures leading edgetendencies of companies. Patent indicators measure theeffect of quality technology on the company’s future performance. The selector technique creates a scoring equationthat weights each indicator such that the companies can bescored and ranked based on a combination of patent indicators. The score is then used to select the top rankedcompanies for inclusion in a stock portfolio. After a fixedperiod of time, as new patents are issued, the scores arerecomputed such that the companies can be re-ranked andthe portfolio adjusted to include new companies with higherscores and to eliminate companies in the current portfoliowhich have dropped in score. A portfolio of the top 10–25companies using this method and a relatively simple scoringequation box has been shown to greatly exceed the S&P 500 andother Indexes in price gain over a ten year period.63 Claims, 11 Drawing Sheets
Source: Reprinted from the CHI Research website, http://www.chiresearch.com, 2004.
The reason for this is clear: With a portfolio of just a few stocks, it ispossible that the active manager is able to obtain better information abouteach stock than if the manager had 200 stocks in his or her portfolio. Thisinformation advantage results in better performance on the whole, which isprecisely Buffett’s (and Fisher’s) point.
Graham-Dodd and a Dose of Fisher
19
GRAHAM-DODDAlthough the book Security Analysis by Graham and Dodd fills up morethan 700 pages, the basic message can be summarized by the phrase “margin of safety.”In the chapter “Survey and Approach,” the authors state: “An investment operation is one which, upon thorough analysis, promises safety ofprincipal and a satisfactory return. Operations not meeting these requirements are speculative.”And Graham admits a few paragraphs later that “The phrases thorough analysis, promises safety, and satisfactory return are all chargeablewith indefiniteness,” although their basic points are clear. If someonegives you an inside tip that stock XYZ is going up, then clearly you havenot yet done thorough analysis. If you leverage up your portfolio 200 percent and buy just one stock, then you probably have not promised yourself much safety. And if you lose money, then chances are your return wasnot satisfactory.But let’s look at Graham’s approach to safety more closely, since Ithink this is the underpinning of all of Buffett’s trading and investing,whether it is in stocks, bonds, arbitrage situations, or even insurance.Graham and Dodd state, “The safety sought in investment is notabsolute or complete; the word means, rather, protection against loss underall normal or reasonably likely conditions or variations.” And then a few sentences later the authors add, “A safe stock is one which holds every prospectof being worth the price paid except under quite unlikely contingencies.”However, as Graham later notes when discussing the fates of the fixedincome bonds offered by railroads before the Depression, “even a high margin of safety in good times may prove ineffective against a succession ofoperating losses caused by prolonged adversity.”So what are we to do? Graham states later in the chapter on fixed valueinvestments, “The only effective means of meeting this difficulty lies in following counsels of perfection in making the original investment. Thedegree of safety enjoyed by the issue, as shown by quantitative measures,must be so far in excess of the minimum standards that a large shrinkagecan be suffered before its position need be called into question. Such apolicy should reduce to a very small figure the proportion of holdings aboutwhich the investor will subsequently find himself in doubt.”
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He gives as an example the General Baking Company bonds paying 5.5percent interest. The company itself earns 20 times the amount of its annualinterest payments. Graham notes that this is safe and that if the earningsper year decline to only four times the interest payments, then it might beworth finding a safer investment.Graham-Dodd likes stocks that trade below their liquidating value,where the liquidating value is roughly all of the current and long-term assetsminus all of the current and long-term liabilities on the balance sheet. Asthey state in the chapter “The Significance of the Current-Asset Value” inSecurity Analysis:The phenomenon of many stocks selling persistently below their liquidating value is fundamentally illogical. It means that a seriouserror is being committed either: (a) in the judgment of the stockmarket; (b) in the policies of the company’s management; or (c) inthe attitude of the stockholders toward their property.During the Depression, all of these items were applicable. The marketas a whole was going down as speculators pulled their money out en masse.Management, not anticipating how bad things were getting, was dissipatingtheir assets. And even long-term investors, in need of cash just to survive,were pulling money out of stocks regardless of any value in the stocks.However, ultimately, these types of stocks were what Graham called“investment bargains.” Specifically:Common stock which: (a) are selling below liquid asset values; (b)are apparently in no danger of dissipating these assets; and (c) haveformerly shown a large earning power on the market price may besaid to truly constitute a class of investment bargains. They are indubitably worth considerably more than they are selling for, and thereis a reasonably good chance that this greater worth will sooner orlater reflect itself in the market price. At their low price these bargainstocks actually enjoy a high degree of safety, meaning by safety arelatively small risk of loss of principal.One possible criticism is that these types of plays no longer exist.They existed in the Great Depression, but never since. However, we willsee in the case of Buffett’s personal portfolio that he was able to playthese situations even in the late 1990s. We will look at more Buffett examples in a moment.
Graham-Dodd and a Dose of Fisher
21
But first, my own foray into this phenomenon occurred on December11, 2002, when I wrote the following article on thestreet.com’s sister siteStreet Insight.The Cash Index, James Altucher, Street Insight, December 11, 2002Let’s look at a couple of rules from the greats. Benjamin Graham’s favorite rulewas to find companies that were trading for less than cash and then hold ontothem until they were trading for more than cash. Warren Buffett’s two rules are:Rule #1: Don’t lose money. Rule #2: Don’t forget rule #1. Warren Buffett was astudent of Graham’s for many years. As Buffett put it, “the secret to success isfiguring out who to be the batboy for.” Buffett was Graham’s batboy and Buffett’s rules for investing are directly related to the “margin of safety,” as Graham put it, that you get when you buy stocks that are debt-free and trading forless than the cash in the bank.It sounds simple-if someone is holding a check with your name on it, it isprobably worthwhile to figure out how to cash that check. At first glance, itseems mystifying. Why doesn’t someone just buy all the shares of the companyand then put the cash in his pocket? It is never that easy and the way to makemoney in arbitrage situations, even as simple as these, is to conduct thoroughrisk management and due diligence on the stocks involved.When looking at these stocks, it is important to accept the first premise:they are trading for less than cash for a reason. And that reason is that the market thinks they will run out of cash and eventually declare bankruptcy, rendering the shares worthless (hence the negative enterprise value).Some of the risks involved include:
• Inaccurate reflection of “cash on hand” in their books. Future cashcommitments can be tied up in leases, severance packages, unprofitabledeals that have cash penalties to back out of, etc.
• Business model destined to fail. Management might be obsessed withpursuing until the bitter end a business model that has no chance of turningprofitable. Great examples from the past include MTHR (MotherNature.com),TGLO (theglobe.com), VSTY (VarsityBooks.com), which never could shakethe chains of their strategy until the money ran out.
• Management with no incentive to return value to shareholders. Insome cases, management has direct control over the millions of dollars sitting in the bank. Why would they give that up just to end up unemployed?
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Some of the possible exit strategies that can be enjoyed by holders of companies trading for less than cash include:
• Management-led buyouts. Not always the best strategy for the shareholder (MBOs are the only legal form of insider buying), but we will look at acase below where on an annualized basis we think the risk/reward is there.
• Business turnaround. While rare, the cash does give management theopportunity to step on the brakes without worrying about a crash and seeif they can turn the business around. A notable example was TSCM, whichearlier this year traded below its cash levels and has since rebounded.
• Dividend to shareholders. The board does have legal responsibility tocreate shareholder value when possible and there have been cases wherethe board has determined the only way to do that is to dividend out thecash to shareholders.
• Takeover candidates. Assuming the cash in the financials is accurate andthe business model has some potential for survival, many of the stockslisted below are either potential takeover candidates or are already in theprocess of being taken over, in which case a very direct merger arbitrageanalysis can take place. Recent companies trading below cash that havebeen taken over include VCNT, taken over by Microsoft, presumably to helpthem compete with the MapQuest product offered by AOL Time Warner.
• Reverse merger. The company can decide to eliminate its existing business lines and merge with a profitable company. A recent example is SOFN,which went from $120 million in cash to about $60 million when theywound down their broadband businesses and then merged with a profitableinsurance company, causing a 40 percent jump in their stock price.When developing the cash index presented below, we established eightselection criteria and weighted them accordingly. Our goal was to take out, asmuch as possible, some of the risks mentioned above, as well as to look forcompanies that could be considered possible takeover candidates.1. Market cap < cash. Obviously a criterion, but more importantly, thatcash had to be made up of only cash in the bank plus short-term investments. We left out companies with little cash but significant inventory orlong-term investments.2. Debt/Equity < 0.20. If management is to have any chance of turning thesituation around, they cannot be plagued with debt commitments or debt
Graham-Dodd and a Dose of Fisher
23
covenants. Also, the lack of debt gives the stockholder some degree ofconfidence that bankruptcy isn’t in the near future.3. Market Cap + Annual Burn Rate < Cash. I like to know that if the company continues to burn money at its current rate, then the company canstill be liquidated a year later so I can ideally get my money back, at thevery least.4. Some stability in revenues and earnings. Ideally the company willalready have begun a turnaround (profits this year as opposed to losseslast year) but my primary concern is that revenues are still not dropping ata rate of 50 percent a year with losses still doubling. In some cases revenues will drop, but losses will decrease because the companies are winding down their businesses. That is fine for us.5. A reasonable belief that the sell-off in the stock was partly irrational. While not a quantitative measure, it is useful to look at the situation and understand at a glance why the company’s shares sold off andwhy that sell-off might have been “guilt by association.” For instance, hundreds of Internet companies went bankrupt, but not every company whoseshares sold off will go bankrupt. Later, we will look at examples from theInternet, software, and aviation industries. A company that recently wentpast its cash levels, and so is not included on this list, is CAMZ, a softwarecompany which catered to the IPP industry (a double whammy in the eyesof shareholders who initially sold off their shares).6. Favorable arbitrage analysis. In the instances below where the company has already accepted a takeover offer, we want to make sure thatowning the shares right now still has a high likelihood of having a favorable annualized return.7. Insider buying. While not a requirement, it is nice to know that seniorofficers and directors in the company feel as we do: that the companyshould be trading for higher than its cash levels.8. Institutional ownership. We like to see mutual funds with above-averagetrack records that focus on value opportunities swooping down onto theseopportunities. Among the mutual fund families that we look for include: theRoyce Funds, the Clipper Fund, Heartland, and Artisan.
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The Cash Index as of December 11, 2002 included: PCYC, CLRS, AMIE,PRTS, FAVS, VCLK, NTRT, GEMS, STRD, CPCI, and IATV (see Exhibits2.3–2.13 for a discussion of each stock). (Each exhibit reflects the price andattributes that caused me to write about it on December 11, 2002.)
EXHIBIT 2.3
PCYC
Pharmacyclics is a pharmaceutical company focused on the development ofproducts that improve existing therapeutic approaches to cancer andatherosclerosis.Price
Cash/Share
Book/Share
Cash
Market Cap
$3.53
$7.10
$7.26
$114 million
$57 million
• $27–29 million annual burn rate.• Warren Kanders, chairman of Armor Holdings, and a shareholder activistwho successfully won a proxy to be on CLRS’s board has recently starteda similar battle to be on PCYC’s board.• Insider buying from the CFO last May at higher prices than current.• Royce funds own 450,000 shares.
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
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Graham-Dodd and a Dose of Fisher
EXHIBIT 2.4
CLRS
Clarus Corporation develops, markets, and supports Internet-based businessto-business e-commerce solutions that automate the procurement, sourcing,and settlement of goods and services.Price
Cash/Share
Book/Share
Cash
Market Cap
$5.65
$6.88
$6.37
$107 million
$88 million
• Warren Kanders successfully won his fight to be on the board of directorsand sell off all of their revenue-producing (and money-losing) assets.• $10–12 million annualized burn.• Significant insider purchases by several directors, including Kanders.• Recently hired Morgan Joseph & Co. Inc to look into possible reversemerger opportunities.• Significant increase in institutional ownership over the past month(422,000 more shares bought than sold by institutions).
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
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EXHIBIT 2.5
AMIE
Ambassadors International organizes, markets, and operates internationaland domestic travel programsPrice
Cash/Share
Book/Share
Cash
Market Cap
$8.74
$10.71
$11.49
$105 million
$85 million
• Most recent quarter was profitable, suggesting a turnaround in thebusiness• Stock sold off, in part, because of recent spin-off where shareholderschose to keep shares of the spun off company. Many people bought intothe original company because of the student travel business, which hasnow been spun off as EPAX.
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
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Graham-Dodd and a Dose of Fisher
EXHIBIT 2.6
FAVS
First Aviation Services, Inc. is one of the leading suppliers of aircraft partsand components to the aviation industry worldwide, and is a provider ofsupply chain management services, including third party logistics andinventory management services, to the aerospace industry.Price
Cash/Share
Book/Share
Cash
Market Cap
$3.92
$4.52
$6.40
$32 million
$28 million
• $1.65 million EBITDA, $68,000 net income in the most recent quarter.• Sales down 4% Year over Year (YoY) in the most recent quarter, suggestingsome stability despite worldwide slump in the aviation industry.• CEO and several directors recently purchased shares.
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
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EXHIBIT 2.7
VCLK
ValueClick offers marketers and advertisers traditional and interactive mediaand advertising technology solutions.Price
Cash/Share
Book/Share
Cash
Market Cap
$2.82
$3.00
$2.97
$266 million
$245 million
• $75 million share buyback program.• Small pro-forma profit last quarter.• Institutional ownership has risen 50% in the past 3 months.• Royce & Associates, Al Frank Fund among the top mutual fund holders.• If the company retires the shares that are part of the buyback and priceremains the same, the market cap could go as low as $180 million,making this trade at a significant discount to cash for a profitablecompany.
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
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Graham-Dodd and a Dose of Fisher
EXHIBIT 2.8
NTRT
Netratings provides Internet measurement services.Price
Cash/Share
Book/Share
Cash
Market Cap
$6.62
$7.80
$9.28
$250 million
$232 million
• $30 million annualized burn.• Revenues rose 10% YoY.• Clients increased Quarter over Quarter (QoQ) from 740 to 827.• Renewals include Yahoo! and AOL.• Acquisition spree makes predicting future cash levels hard (five done formostly cash in the past 8 months), but NTRT is emerging as leader.• Although clearly the dot-com bubble has deflated, it is interesting to notethat e-commerce sales are up last month 34% YoY.
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
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EXHIBIT 2.9
GEMS
Glenayre provides unified messaging services.Price
Cash/Share
Book/Share
Cash
Market Cap
$1.33
$1.63
$1.67
$106 million
$87 million
• $77 million in annual sales, $5 million annual burn which is down 87%YoY.• Heavy insider purchasing since June—the president, two directors, twosenior officers of the company.• The Royce Fund family is a large mutual fund shareholder.• Integration of Glenayre’s unified messaging services with Rim’s wirelessplatform recently announced. Just as RIM devices have become thestandard among corporate users of wireless data devices, we feel thatGEMS software will become the standard for wireless unified messaging.
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
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Graham-Dodd and a Dose of Fisher
EXHIBIT 2.10
CPCI
Ciprico provides storage for digital media.Price
Cash/Share
Book/Share
Cash
Market Cap
$3.