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Thoughts from VALUEx Vail 2012 Conference
Here are my thoughts from the VALUEx Vail conference. The idea for this conference came to me when I attended VALUEx Zurich, organized by Guy Spier and John Mihaljevic in February 2011 (you can register for VALUEx Zurich 2012, here). The thought of spending three days learning and sharing ideas with smart, like-minded value investors felt instantly right. Investing on some level is a never-ending pursuit to get better. Most of us are locked up in air-conditioned offices where we learn through reading SEC filings, magazines, blogs, etc. Though reading is important, it should not be a substitute for interaction and debate with other investors. That is why, for the second year in a row, I organized a conference in sunny (and at the time, wildfire-threatened) Vail, Colorado.
Before I dive into what I’ve learned from the conference, let me tell you more about the setting and the conference itself. Vail is Colorado’s gem; think of it of as a modern (better) replica of Switzerland, hidden in the Colorado Mountains, two hours west on I70 from Denver. Vail is a green, neatly manicured town, with mostly two-story old-European-styled buildings sitting in the foothills of a gorgeous mountain. It is acutely trying to be European – even its police force drives Volvos (which is unheard of in the United States, where taxpayer money is only spent on American-made cars).
VALUEx Vail is not your typical conference. It is a not-for-profit (but for-learning), by-invitation-only (you have to apply to be invited) conference. All content is participant-generated, which is why the attendees are carefully selected and the size of the conference is intentionally limited to 40 participants. For three evenings, from Wednesday through Friday, we got together at private venues and listened to half a dozen fifteen-minute, well-researched presentations, followed up by ten-minute question and answer discussion sessions. Then we had dinner, which was followed by dessert, usually outside, accompanied by a dessert speaker or two. The day usually ended at a local bar, where conversation continued well into the night. In the morning, the ones who could get up after late-night drinking had breakfast together – more thoughtful conversation. Since the evening event is only open to participants, but Vail is too beautiful to be enjoyed without your loved ones, during the day we took our families to two different ranches. On Thursday, we went to the Lazy J Ranch, where we played horseshoes and bocce ball, and the kids even took some skeet-shooting lessons. On Friday we went to Nova Guides Ranch, where we played volleyball. The kids fished – they didn’t catch anything, but they loved trying.
Here are pictures from the conference, mostly taken by Cristy Reid, and a few by me.
You can find all presentations here.
There is no signup yet for next year’s VALUEx Vail conference, which will most likely be June 19-21. To be notified about it just subscribe to my articles by following this link ).
This VALUEx conference started with a presentation by Josh Tarasoff (here is a link to a PDF), whose long stock idea was Amazon – at the time trading at a modest 179 times trailing earnings. The irony of this was not lost on Josh. In hindsight it was a perfect presentation to start the conference, as the theme of the conference was to challenge our thinking, that is – to borrow a line from Apple – “think different.” Amazon is one of the best-managed and the most innovative companies in the US, if not globally. It constantly pushes the boundaries of what it is. It went into cloud hosting because it felt it had unique expertise running its own enormous website, and now Amazon is going into supply – it will ship goods to you if you run a retail operation.
Josh’s take on Amazon was that it changes the way we shop. Our normal brick and mortar shopping habits are simple: we go to stores every so often, where the merchants have performed their “black art” of merchandise selection, trying to maximize their limited real estate to have the highest appeal to the average shopper (to be more precise: the shopper with the largest wallet). Amazon doesn’t try to appeal to the average shopper or to the wealthiest one, it appeals to the most important shopper – you. Its merchandising strategy is simple: supply everything! With the internet and thus Amazon being on our smart phones, tablets, PCs, etc., we can shop on Amazon whenever we realize we need something – instantly.
Amazon is habit-forming for younger generations and habit-changing for older ones. This way to shop will gradually become embedded into the DNA of younger generations. A few days ago I needed an iPhone car charger. I didn’t add it to my mental shopping list of things to buy next time I go to Best Buy, I simply fired up the Amazon app on my iPhone and bought it. I almost cannot think of a second website where I’d go if I needed to buy something. I might Google it if it was an expensive item; if not I’d just go directly to Amazon.
Amazon’s brick-and-mortar-free cost structure puts it at a competitive advantage against other retailers. The thing I find very refreshing about Amazon is that it allows its competitors to post their merchandise on the Amazon website – they can even do so at lower prices if they like. If a customer buys the competitor’s product, Amazon still makes a commission on the sale. Though we’ve been conditioned by Amazon to think of this as a normal way of doing business online, think about how this would look in the brick-and-mortar setting. Imagine Kohls allowing Target to put their pair of Nike shoes right next to Kohl’s pair of the same shoes, at a lower price.
Josh’s argument was that online shopping has only a 3% market share of total retail sales, but that sometime down the road it will have 20%. Amazon, he believes, will grow at a faster rate than the overall online shopping market. He pointed out that Amazon’s growth rate actually accelerated over the last few years. Smart phones and tablets were probably the accelerators, as they provide instant online access to the world’s largest store and are great price-comparison tools (especially if you are visiting a Best Buy store). Josh’s Amazon’s investment story is not only dependent on future sales but on its margins expanding – they’ve declined from 4.6% in 2010 to 1.8% in 2011. Josh believes that growth and investments in new projects are depressing margins.
You may agree or disagree with Josh’s case for Amazon, but it demonstrates his ability to think outside the value box. Josh considers himself a value investor and believes there is value in Amazon; you just need to have a very long time horizon. There is value in growth, however, when the bulk of a company’s value lies in the significant growth of future cash flows. Your confidence level in the sustainability of high growth has to be incredibly high, however, as a small change in growth assumptions will tank the stock.
The Amazon story is interesting to me for a different reason. Not unlike the Apple iPhone that went through and rearranged all the players in the cell phone industry, Amazon is like a huge plow that is ripping through the retailer industry and transforming it and other industries (it has already changed the book business). I wrote recently about Best Buy, but Best Buy is the low-hanging fruit, the obvious casualty. I keep thinking, which industry will be next?
The Tao of Charlie
Later in the day Jim Basili made a brilliant presentation, titled “The Tao of Charlie [Munger].” Unfortunately, Jim asked me not to share the PDF of his presentation, so I will try to summarize my impressions and interpretation of it, with which Jim may or may not agree.
Value investors come from a deep heritage of value ancestors – Ben Graham, Warren Buffett and Charlie Munger, et al. Most value investors can quote them by heart. Though there is a lot of good that comes with having a rich heritage, if we blindly follow our value ancestors, then the heritage will not leave us on fertile ground but instead be a ceiling for our growth as investors. This quote from the poet Basho nicely summarizes Jim’s first point: “Do not seek to follow in the footsteps of the wise men of old; seek what they sought.”
Known and popular wisdom boxes us in and limits our thinking. We can learn a lot from the greats, but if we follow blindly in their footsteps we’ll never be more than just followers –poor replicas of the original.
Jim’s other message was think (and do) different. Don’t just look for stocks where everyone else does. Most value investors look at the same stock screens and do things in a very automatic, number-driven manner. In solely focusing on numbers – the quantifiable things such as price –we are limiting ourselves. This quote from Albert Einstein summarizes Jim’s point “Not everything that counts can be counted.” We (present company included) are focusing too much on numbers, because they are searchable, they are objective. There is a lot of subjectivity in investing.
Certain things are not quantifiable. For example, a CEO forgoes his pay and takes the bulk of his compensation in stock. That little fact should maybe have more weight in our analysis than the quantifiable fact that the company has return on capital of 14.2% when its competitor is at 18.3%.
Journalist and Value Investor
One of the dessert talks at the end of the first day was by Luis Ahumada, who decided that to become a better value investor he’d benefit from studying journalism, so he enrolled in the graduate journalism program at Columbia. Luis distilled the following similarities between journalists and value investors: they are naturally curious, want to tell a story, are good at developing sources (as Luis put it, if your mother tells you she loves you, get a second source), love complexity, and are good at gathering and distilling information.
Luis stressed the importance of understanding the motivations of stakeholders, something that is valuable both in journalism and investing. The very next day, Luis and I were having beers during lunch at a ranch; and we were discussing Gamestop, a retailer that sells used video games. This was a continuation of a conversation Luis and I have had over a year or two. This time, I used Luis’ “stakeholders” approach to analyze the video-gaming industry. The most important stakeholders in the industry are the video-game makers – the likes of Electronic Arts and ActiVision. Interestingly, though they’ll never admit it in public, they don’t want Gamestop to exist in the future. It is in their best interest to sell games directly to consumers through digital downloads. That way they can bypass Gamestop completely – much higher margins and no more costly inventory and physical media. In addition, with Gamestop out of the picture, the used-game market, which directly competes with new games and steals their sales, will decline dramatically.
While Luis was talking I was thinking about another similarity between a good investor and a good journalist: doing your own original, in-depth research and acting on it, even if it disagrees with the mainstream views. A few years ago I met Carl Bernstein, the journalist who, together with Bob Woodward, uncovered the Watergate conspiracy and caused President Nixon his presidency. I was so excited that I’d met him that I made my kids watch All The Presidents Men, the movie about Watergate. My kids were only four and nine, but they sat through the whole thing.
Anyway, the line from the movie that stuck with me was when Ben Bradlee, the editor of the Washington Post, asks Woodward and Bernstein (I am paraphrasing), “There are 1,600 newspapers in the country, why are we the only ones writing about this?”
What Nixon and his cadre did was very illegal and nearly unthinkable. Woodward and Bernstein were the ultimate contrarians. It required a lot of self-confidence and courage to keep investigating the President of the United States and writing, while almost two thousand newspapers in the country were silent. Let me clarify this; I am not talking about being contrarian for the sake of being contrarian. Standing in the middle of the highway is contrarian because nobody does it, but it is also plain stupid. But if we do our own research and it leads us to a conclusion at odds with mainstream views, that is when being a contrarian is warranted.
As a value investor you often own a stock that is hated by everyone. A lot of times the market is right, and the cheap stock is cheap for good reason, but not all of the time. Acting on the conclusions of your research while the world disagrees with you is difficult, but it is an integral part of value investing.
Luis also talked about a trick journalists use to get at the truth out they interview people for a story. No, not water-boarding. It is, simply, silence. Yes, silence. When you talk to company management, usually you are talking to a smart and experienced communicator, with skills that allowed that person to climb the corporate ladder. Most such people are decent and honest, but they have a bias to present everything in a positive light. But when you ask them a question, listen attentively to them, and when they are done answering, pause as if you are waiting for a further response. This may take them off their well-oiled track and they may give you a more honest answer.
There Are No Mistakes in SEC Filings
On the second day Michelle Leder of footnoted.com fame talked about SEC filings (here is a link to a PDF). The message I got from her talk: there are no mistakes in 10Ks and 10Qs. Most financial documents are templates that are created by corporate lawyers; and though numbers and explanations change from year to year and quarter to quarter, the risks disclosure, for instance, rarely changes. If there is a new section inserted, there is usually a very good reason for it.
A few months before AMR filed for bankruptcy it inserted a bankruptcy risk section into its quarterly filing – Michelle caught that before anyone else. Michelle uses 250 different searches to look for nonquantitative information in financial filings. I read financial statements all day long, but it is simply impossible to read every sentence in every document – I’d simply fry my brains with the monotonous legal language they are full of. So it makes sense to do searches for words that may spell trouble. Also, MS Word offers a very nice feature that allows you to compare documents to see if there are any template changes.
The Warren Buffett of Short Selling
I call Jim Chanos the Warren Buffett of short selling; he is after all the largest short seller in the world, and he’s also one of the smartest people I’ve met (here is a link to a PDF) Short selling is perceived as a deeply un-American activity. After all, America was built on optimism, growth, prosperity. Short selling, on the other hand, is pessimistic by nature: you bet on decline and thus the loss of wealth. But there is nothing evil, immoral, or even un-American about short selling. In the short run, supply and demand will set the stock price. If investors are bearish on a stock, if they own it they sell it; if they don’t own it, they borrow it and short sell it. If they are bullish, they do the opposite. In the long run none of those things will matter. Stock prices will reflect fundamentals, i.e., companies’ earnings and their proper valuation. If short sellers are right and the company is worth less, they make a killing; if they are wrong – well, they lose. This is capitalism at its best – survival of the rightest and brightest.
Being a short seller is far more difficult than being a long investor, as in the long run population grows, the economy grows (I know this assumption is not as easy to make today than, let’s say, ten years ago), and the stock market goes up. Also, risk/reward is skewed against you – stocks can go up to infinity but can only decline 100%. The inverse is true for short sellers: the upside is capped at 100%, while the downside is infinite. I asked Jim about this a while back. He had, as always, a good one-liner answer: “I’ve seen a lot of stocks go down 100%, but I’ve yet to see a stock that went to infinity”.
Your investment style should fit your personality. I know that my personality is not wired for short selling. A few years back, Jim and I discussed a stock that he was short. After our conversation, for the following year I observed that stock doubling and then almost doubling again. From later conversations I know that Jim did not cover his short, so at some point he was down close to 400%. Of course, a year and a half later that stock (deservedly) collapsed and now is trading 50-60% below the price at which Jim shorted it. I probably would have gone bold and acquired an addiction if something like this happened to me. Jim, however, was very calm and nonchalant while this was happening. His research was telling him the stock market was wrong. I have always thought that value investors are the most contrarian investors. Well, I tip my hat to short sellers.
There is a lot long-only value investors can learn from short sellers. I have a friend who runs long/short. He is a terrific investor. When he looks at a stock, at first he doesn’t know if he’ll go long or short it. This neutral predisposition makes his analysis a lot more objective and removes layers of behavioral blockage.
What I learned from Jim’s presentation this year (as well as from last year’s) is that value investors are prone to stepping into a “value trap” – the value investor’s hell, because we look at a company’s past earnings (and/or cash flows), and that becomes our reference point. But the value of any asset is the present value of its future – not past – cash flows. So we should spend a lot more time focusing on future earnings power and not get anchored in past earnings.
During dinner at VALUEx Jim and I talked about how they do research at Kynikos (Jim’s firm). His analysts always start research with a company’s SEC filings, then listen to the company’s conference calls and presentations, and only at the very, very end do they read outside research. As Jim put it, “It’s like peeling the onion from inside out”. He wants his analysts to form their own objective opinions first, and then once they are armed with facts, they can expose themselves to what everyone else thinks.
The final dessert speaker of day two was Jon Markman (here is a link to a PDF). Jon annotated one of my favorite books, a classic among investment-book classics, Reminiscences of a Stock Operator, a novel that provides a great introspective look inside a trader’s mind and teaches many behavioral and common-sense lessons. It was written in 1923 by Edwin Lefevre, and depicts from a first-person perspective the early years of the great trader Jesse Livermore. Jon’s skillful annotation takes you behind the scenes of Lefevre’s story and provides important insights into characters and the backdrop of that very interesting time period. Jon’s annotations are almost like a book within a book. I asked Jon to give a dessert talk about Jesse Livermore and the 1920s.
What was shocking in Jon’s presentation was the economic and social backdrop that preceded the 1924-1929 bull market. The world was reeling from influenza – the Spanish flu – that took the lives of 3% of the world’s population (3% – between 50 and 130 million people!), and the wounds from the 1920-21 depression were still fresh. However, all that did not stop the Dow appreciating almost fivefold in five years. This bull market followed a 1906-1924 secular sideways market – they usually do. In fact it was a classic sideways market: earnings grew about 2.5%, offset by an equivalent price-to-earnings decline which, after eighteen years of a lot of volatility and no returns, bottomed out at about 10-11 times. If the economy and stock market survived and actually went up after all this – oh, and let’s not forget World War I, which ended in 1918 and claimed the lives of a million people – then maybe today global problems are surmountable too.
There are lot of similarities between the 1920s and today. In fact Livermore’s quote says it all: “There is never anything new on Wall Street, because speculation is as old as the hills.” Jon talked about how the 1924-1929 bull market was rigged by stock manipulators. (Market would have likely gone up – valuations were low and economy and earnings were growing, but likely not nearly as much.) Ninety-some years later the market is still (or at least is perceived to be) rigged by high-frequency traders; and short- and long-term rates in the bond market are manipulated by the Federal Reserve (and other central banks) by QEs, which also inflate stock market valuations. And now, if that wasn’t enough, we have a LIBOR manipulation scandal. In fact, if we look at the global economy, the whole thing looks like it has been rigged by governments that are trying to stimulate themselves out of trouble. And of course, the 1924-1929 bull market was followed by … a precipitous, almost 80% drop in the stock market.
This is not a cry from the wilderness, prophesying that the market is about to decline 80%, like it declined during the Great Depression – unless the global economy contracts substantially for a long period of time. Historically, long-lasting bear markets started when valuations were high (if you normalize profit margins, they are still high today) and economy contracted for a long time (think Japan in the early 1990s). But my thought was that manipulation is almost by definition artificial distortion, and the economy and the stock market tend to expunge the distortion by reverting (usually with overcorrection) to where they were supposed to be before the manipulation.
Over dinner, Jon and I talked about Livermore. I said, “Jon, I don’t know a single truly successful trader but know plenty of great value investors. The only trader I knew personally who claimed to be successful ended up running a Ponzi scheme. The ones that are successful usually have a great, a phenomenal, performance record that usually at some point climaxes with the loss of all capital. In fact that is what happened to Livermore; he died destitute. Why is that?” Jon replied that there are some successful traders. Paul Tudor Jones is a success, and there are others. But in general, to achieve phenomenal returns a lot of them had to bet a very large part of the portfolio every time. So yes, it is a matter of time before a bet goes wrong. Livermore took enormous risks, sometimes betting all his money on one trade.
Jon’s final point ws “the main point of the book is lost on some people because there is so much richness in the aphorisms – “Don’t be a sucker.” …. Educate yourself on the ways that Wall Street tricks you out of your money, and then determine the best way to sidestep those deceptions in ways that suit your personality, risk tolerance and time horizon.”
Here are a few quotes from Reminiscences of a Stock Operator that I think are invaluable:
“A man must believe in himself and his judgment if he expects to make a living at this game. That is why I don’t believe in tips. If I buy stocks on Smith’s tip, I must sell those same stocks on Smith’s tip.”
“The recognition of our own mistakes should not benefit us any more than the study of our successes. But there is a natural tendency in all men to avoid punishment. When you associate certain mistakes with a licking, you do not hanker for a second dose, and, of course, all stock-market mistakes wound you in two tender spots – your pocketbook and your vanity.”
“One of the most helpful things that anybody can learn is to give up trying to catch the last eighth or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.”
P.S. Watercolor “Three Colors of Life” is by my father Naum Katsenelson (it hangs in our offices at IMA).
P.P.S. Today I wanted to share with you the Warsaw Concerto, a piano concerto in one movement written by British composer Richard Addinsell for the 1941 film Dangerous Moonlight. When I heard it the first time, it felt like it had a Russian soul behind it. Today, when I looked it up on the most trustworthy source on earth – also known as Wikipedia – I discovered why: “The film-makers wanted something in the style of Sergei Rachmaninoff‘s Rhapsody on a Theme of Paganini or the Second and Third Piano Concertos, but were unable to persuade Rachmaninoff himself to write a new piece or to afford to obtain the rights for any of these existing pieces.”