Book Review – The Manual of Ideas (by John Mihaljevic)

Book - Manual of Ideas

The Manual of Ideas (2013), by John Mihaljevic, is quite a good and different read. It is different because it covers a wide diversity of value ideas (nine categories of value ideas, as follows), and it focuses on a few key points within each value idea, i.e. the approach, uses and misuses, screening methods, methods beyond screening and the right questions to ask:

  1. Graham-style deep value
  2. Greeblatt-style magic formula
  3. Small-cap value
  4. Sum-of-the-parts or hidden value
  5. Superinvestor favourites
  6. Jockey stocks
  7. Special situations
  8. Equity stubs
  9. International value investments

Personally, reading this cross diversity of value ideas/approaches allows me to examine the core value investing principles (ultimately all of them are value investing to a large extent) and ideas from various different perspectives. Even though I might focus on a few of the categories that suit my style/preference, I believe the ideas and knowledge from the other categories would be helpful at times and improve my cross-disciplinary and lateral thinking. As Charlie Munger always likes to say, ‘To a man with a hammer, everything looks like a nail”, and I will prefer not to be one such man.

This book also introduces me to a lot other investors whom I haven’t heard of and makes me learn more about some of the investors whom I don’t know well enough before this.

The key points that I got from each chapter are listed below.

Chapter 1 – A Highly Personal Endeavour

  • If I directed the allocation of the world’s capital, I would not be able to rely on the market to bail me out of bad decisions. The greater fool theory of someone buying my shares at a higher price breaks down if the buck stops with me. Successful long-term investors believe their return will come from the investee company’s return on equity rather than from sales of stock.
  • Thinking like a capital allocator goes hand in hand with thinking like an owner. Investors who view themselves as owners rather than traders look to the business rather than the market for their return on investment. They do not expect others to bail them out of bad decisions. (Note: Imagine myself as the CEO of Berkshire Hathaway, e.g. Warren Buffett, monitoring my (private) businesses’ operating earnings over time, and allocating more capital to the better ones, and in the end look to earn returns from the growth in those companies, not from the change in valuation/market sentiment.)
  • The old own-a-stock industry could hardly afford to take for granted effective corporate governance in the interest of shareholders; the new rent-a-stock industry has little reason to care.
  • Losses have a perverse impact on long-term capital appreciation, as a greater percentage gain is required to get us back to even. For example, a 20 percent drop in book value requires a 25 percent subsequent increase to offset the decline. (Note: This applies not just to my own investments, but also to the investments/ decisions made by the companies I am looking at or own too.)

Chapter 2 – Deep Value: Ben Graham-Style Bargains

  • “The problem is to distinguish between being contrary to a misguided consensus and merely being stubborn” – Robert Arnott and Robert Lovell Jr.
  • Finally, they came with considerably less opportunity to meet someone cool of the opposite sex while browsing, unless one was looking for a date who wouldn’t mind being taken to a meal at McDonald’s. You see, it took a certain type of person to enjoy bargain bin shopping – and it is no different with Graham-style equity investing.
  • Several years ago, Buffett was reported to have invested some of his personal portfolio into South Korean net nets – companies trading for less than their current assets minus total liabilities. The investment approach of Zeke Ashton, managing partner of Centaur Capital Partners, has evolved similarly. “We very much prefer our ideas to take the form of high quality businesses with excellent management that can grow value over the longer term, but we will buy mediocre assets if the price is right.”
  • Ben Graham, Walter Schloss, John Neff and Marty Whitman are just a few names that came to mind.
  • A holy grail of value investing might be uncovering opportunities that both provide asset protection on the balance sheet and include businesses with high returns on capital.
  • The truism that over the long term an investor in a business will earn a return closely matching the return on capital of the business is only partly true. If the business dividends out all free cash flow, a long-term shareholder will earn a return equal to the free cash flow yield implied in the original purchase price… As the payout ratio declines, the economics of the business becomes increasingly important.
  • States Nick Kirrage, fund manager of Specialist UK Equities at Schroders: “Staffing business… have big fixed overheads and quite volatile top lines, and profits can be quite volatile. Typically, the staffing industry understands this, and they therefore run with balance sheets that are either heavily net cash or very lowly geared. But the market becomes very focused on short-term profits, so once per cycle, the share prices collapse very, very strongly, and people just assume that profits either won’t recover or it will take too long for them to recover – and they can’t really be bothered to wait. For people who are willing to wait for three to five years, that’s wonderful, because you’re not taking balance sheet risk. Therefore, the chance of you permanently losing money is very low. The chance of you making quite a lot of money, because the operating leverage works both ways, is very high“.
  • Scott Barbee, portfolio manager of Aegies Value Fund, says “we generally like to buy companies trading at significant discount to their asset values and at mid to low single-digit multiples of normalised earnings two to three years out”.
  • Comfort can be expensive in investing. Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations. (Note: This applies to all investing – Take advantage of it!)
  • Investors typically do worst when they enter situations in which they lack staying power, whether due to financial or other reasons.
  • Perhaps this is why many investors either adopt an approach and stick with it or evolve from one approach to the other. Few investors apply both approaches (Buffett-style and Graham-style) successfully at the same time in the same investment vehicle.
  • When we attempt to extract value from poor businesses with valuable assets, impatience becomes a virtue. We are not referring to impatience with the stock price – quite to the contrary… Instead, we refer to impatience with regard to the course of the business itself.
  • We find it difficult to argue against Marc’s conclusions, and denial is never a recipe for success, whether in investing or in life. If we accept that creative destruction will continue at least at the pace experienced throughout recent history, then it becomes obvious that businesses trading at deep value prices are likely to be among those that are creatively destroyed… It seems unwise to allocate a large portion of investable capital to any one deep value opportunity, even if the latter promises a large expected return.
  • With smart investors eager to invest in Graham-style bargains, any remaining net nets are likely to possess disqualifying risks (note: this, to me, is second level thinking). As a result, investors may want to keep track of the historical proportion of net nets in various markets around the world. When the proportion exceeds the average, conditions may be ripe for successful deep value investing.
  • According to Whitman, some long-term assets may be more readily marketable than certain short-term assets. For example, a Class A office building in Manhattan may be easier to sell without impairment than the inventory of a failing retailer.
  • Value creation via buybacks – Share repurchases tend to be particularly accretive in the case of companies generating cash from operations while trading below tangible book value. If such companies apply free cash flow toward buying back stock, they accrete tangible book value per share, widening the gap between the market price and accounting net worth… When the stock price of Sears Holdings declined below book value a couple of years ago, Bruce Berkowitz argued that the game would be over for short sellers of Sears stock if Eddie Lampert simply kept buying back stock. Berkowitz appeared to refer to the per-share accretion dynamic described here.
  • We know that the mood of insiders generally swings in close concert with that of other market participants – this is why we see more merger and acquisition activity when prices are high rather than low. When insiders act against the psychological tendency to simply hunker down and not throw good money after bad into a stock that has underperformed, they express a view that the market has overreacted on the downside. Most insiders, by virtue of being businesspeople rather than investors, may weigh operating performance more heavily than the equity valuation in their stock purchase decisions. As a result, it may be rare for insiders to buy stock unless they believe the fundamentals of the business are at least okay.
  • When a business with high working capital requirements hits a speed bump or enters a permanent period of stagnation, working capital needs decline, freeing up cash. In addition, lower capital expenditure (capex) requirements typically mean that the depreciation recorded on existing plant and equipment exceeds maintenance capex. This dynamic causes slow-growth businesses to report free cash flow well in excess of net income. If the market is overly focused on sales declines or the income statement, an opportunity may exist to acquire a business at a high free cash flow yield.
  • Jeroen Bos stresses the importance of a strong top line, as sales restoration might be more difficult to achieve than margin improvement: “I like to see a company that has huge volumes but is not making money… than a company where sales are just completely evaporated, and it has to earn those back.”
  • In his context, it makes sense to start with the quotation the market is putting on a company, although we might normally prefer to appraise an equity security before learning of the market’s appraisal. When we confront an equity that is undeniably cheap (though perhaps not undervalued), we gain insight by extracting the key question embedded in the market price – and answering that question correctly.
  • Such a negative development is not farfetched, as businesses with low capital intensity tends to be most susceptible to competitive threats. When something other than capital employed drives the profits of a business, that something can change quite easily unless the business has a sustainable moat. Businesses with low capital intensity may be more likely to exhibit winner-take-all dynamics, as capital is not a barrier to scale. Consider how quickly Apple crushed well-established companies Nokia, Research in Motion, and even Sony. This was only possible as Apple did not need to scale capital employed alongside market share. Investors who considered investing in beaten-down equity of Nokia too early because the Finnish company seemed to have a capital-light business in addition to large net cash holdings might have been surprised by the degree to which the profitability of the capital-light business would be affected by competition.
  • We like to think about value in these types of situations as follows: If the primary valuation ratio remains constant, will the stock price increase or decrease over time? … Mohnish Pabrai states in a similar context: “I value [consistency of earnings] more than the absolute cheapest business, because then we know there is some sustainability to the cheap business getting even cheaper, and eventually gravity takes over”. Robert Robotti, president of Robotti & Company, also looks for deep value situations in which intrinsic value grows over time. (Note: This applies to both deep value investing and moat investing too (a form of margin of safety)!)
  • According to Toby Carlisle, “The assets of a company are typically worth more as part of a going concern than in liquidation, so liquidation value is generally a worst-case outcome. In my experience, most ‘net net’ companies have been turned around, rather than liquidated”.
  • Economists Eugene Fama and Kenneth French have studied the relationship between stock performance and book-to-market ratios. They have consistently found that equities with high book-to-market ratios outperform those with low ratios.
  • When we invest in an asset-rich but low-return business, time may be working against us. As long as management can hold on to the assets and keep reinvesting at low returns, shareholders may earn unimpressive returns despite a bargain purchase price. As a result, catalysts become a relevant consideration.

Chapter 3 – Sum-of-the-parts Value (Investing in companies with excess or hidden assets)

  • Investors usually analyse a company as a monolithic whole, appraising value based on overall book value, earnings or cash flow. However, many companies can be appraised most accurately by analysing each of their distinct businesses or assets separately and then adding up those components of value to arrive at an estimate of overall enterprise or equity value.
  • Sometimes investors, in their zeal to create a sum-of-the-parts opportunity, slice a company into too many parts, creating an attractive investment thesis in theory but not in reality… However, when the services business is built largely around hardware, the former could evaporate if the hardware business becomes obsolete. In such a scenario, a sum-of-the-parts valuation of interconnected hardware, software, and services units might trigger too optimistic an appraisal of value. (Note: Look out for the inter-dependency and interaction of the different business segments, especially when they have different margins)
  • Stephen Roseman, a portfolio manager of Thesis Fund Management, has made catalysts a key component of his investment approach. “One of the non-negotiable requirements I have with respect to committing capital – on the long side – is a tangible catalyst I can point to within the ensuing six to twelve months. Capital has a cost, and this discipline helps to improve returns in two distinct ways: it helps to avoid value traps, a common foible of value investing; and it helps to improve IRR as capital is deployed closer to events that might help realise value”. (Note: I can apply this catalyst thinking to my own investing style (wonderful companies) too, only if appropriate)
  • In the case of a sum-of-the-parts situation like Berkshire Hathaway, the whole may be greater than the sum of the parts due to Warren Buffett’s ability to create value through capital allocation. In the case of most other conglomerates, a discount to the sum of the parts may be appropriate.
  • Intersegment sales frequently indicate the degree to which the various segments depend on each other. (Note: Check the amount of intersegment sales)
  • The value of sum-of-the-parts valuation exercise grows when the various business segments demand distinct approaches to valuation… Promising ideas include companies with businesses in more than one industry, businesses with vastly different returns on capital, and companies with unexpectedly large businesses in fast-growing geographies.
  • Finally, in the case of an apparently undervalued equity, the perception that some assets are hidden from the view of most investors may explain why the company is undervalued. Seth Klarman has argued that we strengthen an investment case when we understand why the market may have missed, misjudged, or even created an investment opportunity. For example, if we uncover an apparently undervalued company whose stock price has plummeted, the investment thesis will be strengthened by knowledge that a large institutional shareholder was forced to sell shares due to a need to satisfy redemptions of capital by the shareholder’s clients.
  • We have also identified smart investors who appear focused on unusual situations, including equities with overlooked sources of value. We list 10 such investors – Bill Ackman (Pershing Square Capital Management), David Einhorn (Greenlight Capital), Carl Icahn (Icahn Associates), Daniel Loeb (Third Point), Mick McGuire (Marcato Capital Management), Lloyd I. Miller III (private investor), John Paulson (Paulson & Co), Michael Price (MFP Investors), Wilbur Ross (WL Ross & Co), and Marty Whitman and Amit Wadhwaney (Third Avenue Management).
  • Investors may indeed become patsies by failing to realise how many other smart investors have bought into the same story of hidden value. If the perceived discount to fair value does not exist or is later eliminated due to new developments, the outcome might be made more painful because many like-minded investors head for the exits at the same time.
  • By falsely concluding that the market is ignoring the noncore assets, we may overpay for the core business and end up with a value trap… It rarely pays to invest in perceived hidden value unless we like the core business as well.
  • It matters tremendously whether the offer is “buy one, get one free,” or “buy 10, get one free”. As shoppers, we recognise the former as a more compelling offer. As investors, we often overlook this important distinction.

Chapter 4 – Greenblatt’s Magic Search for Good and Cheap Stocks

  • Joel Greenblatt’s track record of 50 percent annualised returns during the 10 years he ran a hedge fund, Gotham Partners, was virtually unmatched in the industry.
  • The longer the holding period, the smaller the role of the exit multiple in determining the investor’s annualised return.
  • To normalise for different tax rates, we use operating income as the numerator of the equation. To normalise for the effects of financial leverage, we use capital employed as the denominator. Greenblatt defines capital employed as current assets excluding cash, minus current liabilities excluding debt, plus net fixed assets, typically consisting of the property, plant and equipment line item on the balance sheet.
  • A few years ago, Joel Greenblatt and Blake Darcy launched Formula Investing…
  • While the market is pretty good at valuing high-return businesses that have reached a steady-state phase of limited reinvestment opportunities, Mr. Market makes two mistakes with some consistency: It overvalues high-return businesses whose returns on capital derive from explosive but ultimately transitory trends or fads… On the flip side, the market may undervalue unhyped quality businesses with sustainable high-return reinvestment opportunities.
  • Similarly, capital-intensive businesses near the top of the cycle have unsustainably high returns on capital employed.
  • As a result, a crucial determination when evaluating magic formula selections is whether they exhibit above-average returns on capital for transitory reasons or for reasons they have some permanence. Warren Buffett calls this moat; others may know it as sustainable competitive advantage. (Note: Be careful not to be just a data analyst – Remember to think about qualitative and think forward-looking (and the business model)!)
  • Adds Josh Tarasoff, general partner of Greenlea Lane Capital Partners: “One of the most powerful ideas I have ever encountered is the one-decision stock: a company you can simply hold for a decade or two and receive an outstanding outcome”.
  • Durability of competitive advantage relates quite closely to a firm’s ability to raise prices in excess of inflation… According to Tarasoff, only real pricing power, that is, the ability to raise prices in excess of inflation, should be regarded as special… When and to what degree a company chooses to exercise its pricing power depends on a number of factors, but the key consideration for investors is whether a firm could raise prices without materially impacting unit sales.
  • High returns on existing capital – the capital already employed in a business – are almost meaningless without an ability to invest new capital at above-average returns. Returns on existing capital, whether high or low, are already reflected in a company’s operating income. In a static scenario, the driver of return to equity investors is the earnings yield – or free cash flow yield, to be more precise.
  • Estimating the extent of the reinvestment opportunity available to a business is no small feat. Josh Tarasoff sheds light on this issue: “For a significant reinvestment opportunity to exist, there must be the potential for long-term unit growth. So, a large addressable market relative to current business is desirable…”

From here on, the points will become much less, as I am becoming lazy… LOL

Chapter 5 – Jockey Stocks (Making money alongside great managers)

  • Chief executives can distinguish themselves in two major ways: business value creation and smart capital allocation.
  • Mr Market has a tendency to deify certain executives, sending their companies’ stock prices into the stratosphere and condemning new purchases of stock to likely underperformance. As investors, our goal should be to identify chief executives who are themselves underappreciated.
  • Times change; human nature apparently doesn’t.
  • A chief executive should own stock (not options) with a market value equal to at least several years of annual cash compensation. Anything less may make the CEO more interested in maximising the pay package than per-share value.
  • Tom Gayner points to an often overlooked check – leverage. “One of the great investors I’ve tired to learn from is Shelby Davis [founder of Davis Selected Advisers]. Shelby said that you almost never come across frauds at companies with little or no debt… If a bad person is going to try and steal some money, they will logically want to steal as much as possible.
  • Daniel Gladis points to incentives as a key reason for investing in family-controlled businesses: “If a family has half or three-quarters of its assets invested in this particular business, they’re probably going to take care of it better than a management for hire that comes and goes in three or four years”.
  • Many business school graduates aspire to be great business leaders. Few aspire to be great capital allocators.
  • Charlie Munger’s advise to invert serves us well when analysing managers – not in identifying the greatest jockeys but rather in eliminating the bad actors, even when those individuals are esteemed by the business establishment. An acid test is compensation.
  • Between the extremes of excellent and poor capital allocators is a world of mediocrity, in which managements often view reinvestment of capital as the default option, giving little consideration to the alternatives.

Chapter 6 – Follow the Leaders (Finding opportunity in superinvestor portfolios)

  • In a review of Youngme Moon’s book Different, Guy Spier writes, “… In saying “no” to the vast majority of people, these businesses ensure that the only people who become customers are those who will value and appreciate the specific configuration the company is set up to provide.” (Note: Ask, is the company in my portfolio saying no to anything? And am I, as a capital allocator, saying no to anything?)
  • Most superinvestors view themselves as employers of management, and they are generally not shy about voicing their views on how existing equity value can be unlocked or new value created.
  • Superinvestors are neither heroes nor infallible. The specific idea we might be copying could turn out to be one investment that becomes a complete write-off.
  • The first step in setting up a superinvestor tracking system is deciding which investors to track. Several factors figure into this decision, including the concentration of an investor’s portfolio, average portfolio turnover, propensity to employ short selling, and the congruence between one’s own investment approach and that of a superinvestor.
  • Turnover is an important consideration because as outside observers we receive only delayed notice of other investors’ buy-and-sell activity.
  • Context is important when assessing the purchase and sale activity of superinvestors.

This chapter also includes a long list of superinvestors in the following categories – Large-cap value, Mid-cap value, Small-cap value, Graham-style deep value, Buffett/Greenblatt-style quality value, Highly concentrated portfolios, Industry specialists, and a few hard-to-follow superinvestors.

Chapter 7 – Small Stocks, Big Returns? (The opportunity in underfollowed small- and micro-caps)

  • Several key developments have created opportunities for small-stock investors, including an increase in the size of institutional portfolios, an escalation of compensation expectations, exclusion of small stocks from major market indices, and scant research coverage by sell-side firms.
  • Even if small caps as a group stop outperforming large caps, the differential between top and bottom performers should continue to be greater in the case of smaller stocks, providing opportunities for research-driven investors.
  • One well-known drawback of small-stock investing is the, at times, severely constrained trading liquidity of smaller companies. Wider bid-ask spreads, greater market impact, and perhaps greater trading commissions conspire to make entering and exiting the equity of small companies a costly affair.

Chapter 8 – Special Situations (Uncovering opportunity in event-driven investments)

  • In markets that exhibit informational inefficiency (Note: Look out for e.g. different segments, with different growth rates, and different profitability (masked), which are not captured by standard financial databases), rewards may accrue to those who make the effort to obtain timely, accurate and relevant information.
  • Investing rules, as distinct from laws, need to be broken occasionally in the pursuit of investment excellence. In this context, rules include the financial formulas (Note: e.g. calculation of EV, when other items like prepaid liabilities may need to be considered and adjusted for) we have memorised along the way.
  • Special situations are one of the few investment areas in which it makes sense to pay at least as much attention to the time component of annualised return as to the absolute return expected in a particular situation.
  • In the absence of identifiable drivers of inefficiency, the probability may be higher that our appraisal of value contains an oversight or flaw. If we can identify a non-fundamental factor that explains the low valuation, we gain confidence in an estimate of value that differs from the market price.

Chapter 9 – Equity Stubs (Investing (or speculating?) in leveraged companies)

  • We need to be careful not to overrreach when our judgment turns out to have been correct. The payoffs in equity stubs may exert an intoxicating effect on the successful investor.
  • The tendency of investors to think about the likely outcome rather than the range of possible outcomes represents a key stumbling block to success in leveraged equities.
  • Our experience suggests that industry-wide sell-offs represent better hunting grounds for potential opportunities than do company-specific crises. A single company may stumble in a way that makes recovery of value impossible, but entire industries disappear rarely.
  • The market sometimes ignores the nonrecourse nature of a company’s debt, perceiving the equity as riskier than it actually is. This creates opportunity for research-driven investors.

Chapter 10 – International Value Investments (Searching for value beyond home country borders)

  • “See the investment world as an ocean and buy where you get the most value for your money” – Sir John Templeton (Note: Fish where the fish are!)
  • In the interviews we conducted with leading investment managers around the globe, most of them expressed a view that the commonalities of international markets outweigh the differences.
  • Numerous studies confirm that adding international equities to a portfolio improves the risk-reward profile, either by boosting expected returns for a given level of volatility or by lowering the volatility for a given level of return.
  • Many investors appear to make the mistake of expecting foreign markets to mirror their domestic market in every material way. This may be particularly true in the area of corporate governance.
  • We avoid much trouble in international investing when we accept that some levers, such as corporate governance, are harder to pull than others, such as the price we are willing to pay.
  • When we go global in the search for investments, we give ourselves a free option to pay a lower price than might be possible in our home market. While no two equities are the same, similar companies frequently trade at materially different valuations across geographies.
  • Buffett’s concept of circle of competence, while typically used in the context of different industries, may also have applicability to different countries. Due to the many unifying features of global equity investing, we may falsely assume that our competence extends to investing in all geographies.
  • One of the biggest drivers of disappointment for investors who venture globally might be an unrealistic view of the promise of emerging markets. In the rush toward growth, many investors readily ignore the return-on-capital prospects of fast-growing but highly competitive and capital-intensive industries.
  • The issue of challenging demographic trends confirms the importance of calibrating fundamentals versus expectations, perhaps best explained in Alfred Rappaport and Michael Mauboussin’s Expectations Investing. When the expectations implied in stock prices fall materially short of the likely fundamentals (Note: e.g. negative demographic headwinds overly price in in the market), a buying opportunity may be at hand.

This chapter also includes a list of 50 international investors who may be considered value investing thought leaders in their respective countries, for example:

  • Kerr Neilson; Platinum; Australia
  • Richard Lawrence; Overlook; Hong Kong
  • V-Nee Yeh, Cheng Hye Cheah; Value Partners; Hong Kong
  • Chris Swasbrook; Elevation; New Zealand
  • Ngiek Lian Teng; Target; Singapore
  • Richard Chandler; Richard Chandler; Singapore
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