If you have been a value investor for some time I am sure you once had to explain value investing to a novice. Among one of the classic first question is the following:“What happens if the stock never closes its gap to fair valuation and stays cheap forever?”Chances are you would answer “…sure, the stock can stay cheap for a long time, but eventually it will trade at fair value.” In this article, I will reflect on the importance of eventually and try to like this to the Buffett quote “I rather buy a great business at a mediocre price than a mediocre business at a great price”. First, let me define my usage of some termini. A “great business” for me is a business that has the sustainable ability to generate returns on capital that are in excess of its cost of capital. Don’t label a business “great” too easily as some businesses generate great returns for a while but these returns seem to disappear suddenly.   How come? In my experience, a “not-great” business can generate great capital returns when industry capacity is very well utilized or management has been brilliant for a while. This does not mean high returns on capital cause a business to bet great! A “not-great” business – let’s call it a mediocre business – is able to extract returns on capital that approximate their cost of capital, if we consider the company life-cycle and not a momentary view.   I would go as far as to say: all great businesses generate high returns on capital but not all high return businesses are great. In the end, the difference between great and mediocre comes down to whether or not a given business possesses competitive advantages. If it does, they can defend their high capital returns for a long time. If it does not, competition will push capital returns down to the cost of capital. Leaving out “special situations”, you normally confront either one of two situations in value investing:A mediocre business at a great price   or   A great business at a mediocre price   Let me present to you a framework how our initial question - “when does the gap between value and price close” - play into each of the two situations: A mediocre business at a great price A mediocre business is worth its replacement value. In a clear-cut world, the long-term earnings power of a mediocre business equals replacement value times cost of capital. Obviously, we do not live in a clear-cut world but still, the replacement value * cost of capital = earnings power equation seems to work pretty well.   The calculation of replacement value and cost of capital is not the topic of this article (which does not mean they are not important- quite the contrary!), so let’s assume you have a given replacement value of 100 for a mediocre company. The stock trades at 50 so you have the epic situation of value investing right in front of you: “to buy a dollar for fifty cents”.   They pay out 5 as a dividend and reinvest 5 into the business. In the next period, the replacement value is 105, the earnings power is 10,5 and they would pay out 5,25. This really looks great at first sight, but it is of no incremental value for you as an investor! You should be indifferent to whether you or one of your portfolio companies compounds money at the cost of capital.     What you look out for is excess return, i.e. the stock going from 50 to 100. Also, the chance of the stock going from 50 to 100 is a compensation for bearing the company-specific risk.   Ascribing a utility to the price/value differential for a mediocre business fully depends on the time horizon it takes for the gap to close. As we have seen earlier, letting time pass does not really add value to a mediocre business so there is no structural “drift” that pushes down the price/value gap of a mediocre business.   So would I never touch a mediocre business? In fact I would not as long as I have no catalyst that allows me to realize the price/value differential in a timely manner. What would be such a catalyst? This is stuff for another article but let’s name a few: the company is a likely takeover candidate, it pays a huge dividend, it is aggressively repurchasing stock,… all factors that “free-up” value.   If this sounds too esoteric, read next week’s article on catalysts in which I elaborate a little bit on the topic. A great company at a mediocre priceLife is quite different when you own a great business. Unlike the mediocre one, this business yields returns on capital in excess of its cost of capital. Waiting therefore increases the intrinsic value of the business faster than your benchmark requires and letting time pass is actually a good thing.   In these cases, you do not really have to worry about when eventually exactly takes place, as any passage of time just increases your upside. Imagine a slingshot in which the sling is pulled further and further. At some point it’ll snap back and you make money. Actually this image is not 100% correct as most great business never trade at super-low prices.   As their value increases on its own, even a very soft tension in the slingshot might be reason enough to jump on the train and ride along with the great business. Almost ironically, a catalyst can be harmful to the investor of a great business. Imagine being bought out of See’s Candy by Buffett in 1972: nice to get a little takeover premium but wouldn’t it have been nicer to reap the 40-year long harvest of a great business?   This allows us to conclude why Buffett once said “I rather buy a great business at a mediocre price than a mediocre business at a great price”. In case of a great business, time is on your side and you do not have to worry much about when the gap between value and price closes. However, do not leave out a mediocre business if a catalyst shortens the time it takes for the price/value gap to close.  

We published a brand new paper. Quantitative Value Investing in Europe: what works for achieving alpha. In comparison with the USA there have been relatively few studies conducted on what works in investing in the European stock markets.  With this paper we would like to make a contribution and examine what factors led to excess returns in the European markets over the 12-year period from 13 June 1999 to 13 June 2011. The factors we tested were: ·         Earnings yield, ·         Free cash flow yield, ·         Price-to-book ·         Price-to-sales, ·         Piotroski F-score ·         Return on invested capital (ROIC) ·         Return on assets (ROA) ·         Net debt ·         Relative strength / price index We not only tested the historical value of the factors, but where it made sense, we also tested the 5-year average to see if it is a better indicator to use to generate market outperformance.  When we found a factor that showed strong out-performance we tested it together with other factors to see if two factors generate even more market outperformance.  In addition, we also tested two investment strategies, the MF and the ERP5 strategy, for their ability to outperform the market.  What we found mostly confirmed what other research studies found, but a few results were really astounding.   What if we told you we found a simple two factor method you can use to select investments that led to a 23.5% per year compound return (market was 2.25%) over the 12 years we tested?  That is a total return of 1157.5% compared with the 30.54% the market returned!  Available in online bookstores - ISBN:978-1-4710-9219-0. Subscribers to valuescreeners or the newsletter can download this new exciting paper worth 99€ for free! To download the paper, log in and navigate to the backtests page. Profitable Investing, Philip Vanstraceele  

    52 weeks Price Range. This new factor -together with the other momentum factors (price index 12 months and price index 6 months) -in our Value Screener grid indicates a truth about investing that is difficult to understand: the investor should buy into strength and sell into weakness. The factor measures the proximity of a stock to its 52-week high or 52 week low. The 52 weeks price range is calculated as (current price – 52 week low) / (52 week high – 52 week low). The idea behind using momentum factors with valuation is to find the strongest stocks, or the ones that are going up the most in price.  O'Shaughnessy, in his book “What works on Wall Street”, calculated relative strength by looking at the stocks' returns over the past year. Winners seem to continue to win. Price momentum is the market putting its money where its mouth is. O'Shaughnessy states that the longer the period you consider, the more regression to the mean you can see. There is according to him a regression to the mean after about five years. Stocks that have exhibited five years of strong relative strength are usually on the brink of a turnaround (positive or negative). So results must favor shorter-term relative strength. We also added the Price Index 6 months as a separate screener to combine with other valuation factors. In a paper which we will publish soon, we found that the combination of momentum factors with valuation factors results in powerful screens with high investment value.       Profitable Investing.   Philip Vanstraceele  

Short selling (also known as shorting or going short) is the practice of selling shares that have been borrowed from a broker with the intention of buying these shares back at a later date to return to the broker. In less technical terms: a short-seller is betting on a stock price to go down. [More]

Benjamin Franklin first stated that the only two certainties in life are death and taxes. Investors have become so gloomy that their expectation are low. "We are going to hell ! ", "Stockmarket crashes", "Experts are expecting a double dip recession": this is the kind of stuff that we have read and hear , the last few days ,on television and in the newspapers.“   Growth is too slow for easy deleveraging, politcians are at loggerheads, and global imbalances have hardly diminished. If central banks respond with more newly-minted money, they could make markets more volatile, and the next crisis all the more exciting. The Swiss and Japanese central banks both moved to halt the appreciation of their currencies, which have been competing with gold for the role of investor's favoured haven. Prominent investors such as John Paulson and David Einhorn of Greenlight Capital have bought gold as an explicit bet that central banks an governments would fail the value of paper as fiat currencies. But at some point, there will be a time when things will go better. It always does ! None of this means that the much-feared crisis will not arrive, sooner or later.   Of course, it is impossible to time the market and things can go worse. But remember what Benjamin Graham said "Individuals who cannot master their emotions are ill-suited to profit from the investment process.”  The strain on the exhanges amid the high volatility has underlined the extent to which the market is dominated by electronic trading, in particular the use of sophisticated computer algorithms that either react to new data or are programmed to try to anticipate it. That cause sudden, sharp movements in prices. These algorithms are no tranquilizers for Mr Markets moods. Warren Buffet once said:"Be fearful when others are greedy, and be greedy when others are fearful. You can't do well in investing unless you think independently. And the truth is, you are neither right nor wrong because people agree with you. You are right because your facts and reasoning are right."  At MFIE we like to keep things simple: we only do a few trades a month: 2 buys and 2 sells. We invest systematically and Mr Market offers us deals through our valueScreeners tool. Today stockpicking is very important to obtain a decent result. The last 10 years the global stockmarket did not really go up and it will probably will not move up during the next 10 years. The market went up too much during the 1980s and 1990s (due to unrealistic rates of return assumptions) and it will need to adjust itself to reality, but that will take some time. Vitaliy Katsenelson defines this as a sideways market. The market is a a cowardly lion—it displays occasional bursts of bravado but is ultimately overcome by fear. The good news is that there are bright spots. The right stocks will rule in sideways markets. In bull markets, all stocks dominate bonds. During sideways markets, most stocks don't dominate fixed income instruments; only the right stocks do. A disciplined buy-and sell strategy must be used to make money in this low-return envirenment. So you need to hope for the best and prepare for the worst. Interesting these days is to look to the deep value stocks like Graham Net Nets and negative enterprise value companies.  Mr Market is offering these with a huge margin of safety. Philip Vanstraceele

As promised in our last post, here below some comments  from our visit to this seminar. Our general impression we got from the speakers, is that finding "deep value" stocks has become more difficult than a few years ago. The suggested investments show a smaller margin of safety compared to earlier years. However, it is important to avoid value traps, and so as not to have disappointments. This is important for us to know as mechanical value investors. Sahm Adrangi of Kerrisdale Capital Management  One of the interesting presentations, was about chinese scams companies exposes by Sahm Adrangi of Kerrisdale Capital Management, a value-oriented and special situations fund based in New York. In recent months, Kerrisdale has shared in-depth research with the investment community on fraudulent U.S.-listed Chinese companies, including China Education Alliance and Advanced Battery Technologies. Mr. Adrangi is a leading expert on Chinese stock scams and his work has been discussed in Bloomberg, Businessweek and the Wall Street Journal.  His Long short fund was one of the first funds to investigate all the reverse Chinese mergers.In June last year we wrote anonymously, and over past year and half we have identified a lot of shorts, and taking an active role in exposing them. Kerrisdale compiled two reports on Chinese frauds, China Education Alliance and Advanced Battery TechnologiesThis work has been mentioned by numerous media outlets, including The Wall Street Journal, BusinessWeek and the Financial Times  See : http://kerrisdalecap.com/blog.php   Gulf Resources A new  short idea is Gulf Resources; Gure- Kerrisdale  thinks it should be trading under $1. Gure is a manufacturer of bromine and bromine derivative productsThe company went through RTO in 2006. The stock has gone down as a result of all the RTO news, but is still trading at $12.Gulf- claims to own assets which it does not own. It is only owned by the chairman, they are not owned by the publically traded company.Subsidiaries have same numbers, same addresses.Their largest customer, which appears to be owned by Gulf chairman, has the same address, phone number, and fax numbers as the company.The margins are irrational, 90% of bromine is produced in Shandong, the competitors and service providers know each other well. The company is commodity business but revenue growth is 30-50%.There are many consulting firms that provide reports for commodities.Kerrisdale' fund purchased one by a Chinese chemicals report on Bromine and list the top 30 producers, and their production was ½ of what they claim in SEC fillings.They have talked to other competitors, and Gulf is not a major player, and some even said they think GURE is a fraud. Conclusions for us at MFIE. It's not that we want to shorts these particular companies , but the above tips and ideas are useful to know, how to avoid fraud. (*) source : http://www.valuewalk.com/