Thursday, August 25, 2011

The fair value assessment implied from the recent Warren Buffett BAC deal

Warren Buffett recently entered a deal to buy $5 Billon BAC 6% cumulative perpetual preferred stock, plus free warrants to buy $5 Billion BAC common stocks at $7.14 within 10 years.

From this deal, we can ROUGHLY estimate Mr. Buffett's assessment of BAC's fair value.

First, the preferred stock is clearly a bad deal. 6% is not a high return, plus it is "perpetual". So it has high interest rate risk since interest rate could go a lot higher later. So the warrants must provide good compensation to make the overall deal good.

There are many ways to compute this. An easy way would be considering the return on the combination of preferred stock and common stock.

1. Assume 10% return is a fair return in this case for both preferred stock and common stock (banks will be much safer after the new BASEL III capital ratio requirment, so 10% return is good enough. My requirement on returns are usually higher than the market. Banks used to have a P/E of 10 in the pre-2008 market, but I think only now a P/E of 10 is justified.).
2. Assume BAC will not buy back the preferred stock forever (at least for the next couple of decades)
3. Buffett will not excise his warrant until the end of 10 years (he has no reason to do so in general, after all, warrant is capital-free investment, like long term call options. This is common sense, we don't need Black-Scholes formula to tell us about this).
4. Assume Buffett will require a margin of safety of 33%. (33% is really just my own preference, but this figure was also mentioned as an example in Ben Graham's book)

First, in the next 10 years, preferred stock will be losing 4% each year. At the end of 10 years, it will be losing 0.04 * 1.1^9 + 0.04 * 1.1^8 + ... + 0.04 * 1.1 + 0.04 = 0.04 * (1 - 1.1^10)/(1-1.1) = 0.636 of $5B.

Now we add this amount to the effective cost of the eventual purchase of common stock at the end of 10 years, which gives an effective price of 7.14 * (1 + 0.636) = 11.68 per common stock. At the end of 10 years, Buffett effectively spent $8.18B to buy the common stock. This amount has to earn enough annual return to compensate the 6% preferred stock's low return. It has to earn an extra 2.444% return on top of normal 10% return (5 * 0.04 / 8.18 = 2.44). So that means the fair value at that time would be 11.68 * 12.444 / 10 = 14.53 per share.

Now discount this price back to present using 10% discount rate, it gives 14.53 / 1.1^10 = 5.61 per share.

Buffett would always require a margin of safety, if this margin of safety is 33%. We get the real fair value of 5.61 / 0.6666 = $8.41 per share.

BTW, there is a wild card here: since preferred stock no longer counts in the capital ratio under BASEL III, and the dividend is not tax deductible, banks have a tendency to buy back preferred stock and issue bond instead. So it still has a possibility to buy back the preferred stock even if it has a low interest rate. When they do it, they have to pay the 5% premium to Buffett. If Buffett did his calculations with this in mind, it would actually push down the fair value (we get a lower fair value than $8.41).

Since there are many moving parts, this has to be just a rough estimate. The actual figure in Buffett's mind could be wildly off from this number since a small change on the assumptions would yield a big difference (for example, if we require 11% return or 9% return instead). That said, this analysis gives some insight to the fair value, or at least a wide range of it.

My own analysis shows that bank stocks are depressed mainly because they need to accumulate capital to meet the 9.5% tangible common capital ratio under the new BASEL III rule. Although they have no urgency to do so until 2019 (thus no need to issue new stocks now), it will eventually reduce returns to shareholders and reduce ROE along with future growth. Regulations are not fully defined yet, people are worried about the impact of regulations, such as price fixing (like the new debt card fee limit) or reduced efficiency (higher operational cost). On the litigation side, there is some risk, but I don't think it will be the major impact.

Among the four biggest banks (JPM, BAC, WFC, C), BAC has the lowest capital ratio and largest risky asset which requires even more capital. It would take many years to reach the required capital ratio, so we have to discount its share price based on that fact. However, the fear on regulation and litigation may be still overblown.

On the positive side, higher capital ratio will make large banks much safer and in turn reduce the required cost of capital. Also, it would increase the barrier of entry and reduce the competition in some degree.

Tuesday, March 29, 2011

Why doesn't Black-Scholes model work in long period option pricing?

Buffett doesn't like derivatives and calls it as the financial weapon of mass destruction. Yet he wrote Billions of European Put Options of various stock indexes. The term is very long (10-20 years) and no collateral needs to be posted.

Apparently he thinks this is a good deal and he mentioned in his letter to share holders this is a way to show his belief that the Black-Scholes model doesn't work in long term option pricing. In this case, the price given by the formula is just too high.

There are a list of limitations and assumptions for deriving BSM. The number one is that the stock price follows Wiener process and it is log-normal distribution. In order to arrive at this conclusion, a big assumption here is that the price has same likelihood of going down and going up, no matter what the current price is. In another word, there is no such thing as "over-bought" or "over-sold". A large decline of the stock or index doesn't mean it will be more likely to rise later.

The primary source behind this assumption is again "efficient market assumption". If market is efficient, the current price is "always" justified, and of course, there is no such thing as "cheap" or "expensive" stock.

This may be true for many short term stock movement. But when we get to the stock index in 20 years term, it becomes more obvious that this assumption is not aligned with common sense. In history, we have observed that the price of stock or index eventually revert to their economic earning power, despite the possibility of long depressing period and bubble period (sometimes that period could last 5-10 years, but usually it doesn't last more than 2-3 years).

In a long time scale, it becomes obvious that the market is far from efficient, as we can find so many unbelievable and ridiculous bubbles in the history.

Put it in another way, we can invent a process called "economic arbitrage" (the term is to differentiate it from "trading arbitrage"). If a company's stock is very cheap comparing to its earning power, business people will find it compelling to buy the company's stock instead of investing on starting a new company in that industry. The other argument could be true, if the company's stock is too expensive, people could borrow money to sell short the stock or dump existing portfolio and use the cash proceed to fund a new company on their own.

Now the question is: if we have economic arbitrage, why could the stock price still go out of the reasonable range sometimes? The answer is simple, the market force that are willing to trade and focus on the short term is much bigger than the pure business force (after all, the ordinary Joes can't buy a company or start a new company). But eventually, business force (the weighing machine) will win, when the market force returns to their senses, or when the power of their mania is gradually worn off by the business force.

Saturday, March 5, 2011

Trader = speculator = gambler?

For long, I thought the traders are playing a zero-sum game and their only contribution is to provide liquidity to the market. Overall, they don't provide much value to our society and not surprisingly the general public view them as speculator and gambler too.

However, if we really study the market from the ancient world. At the very beginning, there is no currency. People exchange goods for goods. Of course, this is not convenient at all, since seller may have the goods, but couldn't find the buyer who want his goods AND also has the goods he wanted. The invention of currency creates an intermediary "common" goods that everyone needs.

Still, even with the currency, it is hard to find a buyer that needs the goods. Then it comes market that sets a fixed location for people to sell/buy stuff. Even with market, it is sometimes hard to find buyer/seller or enough buyer/seller for a certain goods. Then here it comes traders who don't need the goods themselves, but intent to act as intermediary to buy and sell to make a profit (catch the spread).

This trader's role needs to take risk on future prices and the risk of having to store the goods, along with the tied-up of capital. It also works on the price differences between markets at different location to balance the supply and demand between different regions or countries.

Overall, the trader's function is balance the supply and demand over "location" and "time", as well as providing more liquidity to facilitate the trades, and the competitions between traders also reduce the spread.

This function is quite important, but didn't get noticed for very long in China. Ancient China's noble class is not as clearly cut as western world, instead, Chinese Emperor has put people to 4 different classes: scholars, farmers, craftsmen and traders/businessmen. Scholars master the literature and knowledge of histories, it seems quite reasonable to put them to the top of the classes? But letting farmers sitting on the second class could be quite surprising to many other countries(even though it is just verbally so). This is because Emperors want to encourage farming and believes that is where the food and wealth comes from. Craftsmen also produce real goods, but that kind of goods are nice to have, but not have to have (like food). At last, the traders were considered as making profits from nowhere, since they didn't produce any real goods. These people were considered as making huge profits without actually doing the hard work. To discourage this kind of behavior, they were put to the bottom of the 4 classes.

Today, we have fully recognized the benefits of trades and think trades are equally important to our economy. However, the importance of trading in equity/derivative markets still haven't been fully recognized. In part, this is reasonable, the convenience of trading equity often makes people more short term oriented and more tempted on buying/selling for short term profit instead of long term investment. This fact is an unnecessary waste of resources and energies. Also, many people who want to profit from speculation ends up losing, a typical phenomenon of gambling.

Still, traders are not just speculators. Market makers and other liquidity traders make their profit primarily from providing liquidity to the market, not from speculation. And just because it is convenient and low cost to sell doesn't mean people should do so frequently with short term vision.

Tuesday, March 1, 2011

Is market efficient?

Warren Buffett said so many times that market is not efficient and the business school is providing misleading trainings in general.

On the surface, the market seems to be efficient since it is pretty hard to beat market for average people. But on the other hand, for traders and value investors, there are many people who can consistently beat the market for many years in a roll.

In my view, it is not a question of whether it is efficient or not. Instead, it is a question how efficient it is. Or in other words, how hard it is to beat the market consistently.

I believe for any normal person who study on the right track for 2-3 years and has enough patience, it is quite possible for him/her to beat the market consistently. In another word, market is far from the efficient level we were told in the textbooks.

Market is not so efficient for four reasons:
1. Human psychology. Many researches in Behavioral Finance shows that we as human being have behavior bias. We tend to neglect the bad part when we are focusing on profit potential (greedy), and neglect the good part when we are focusing on loss potential (fear). Also there is a tendency to be impatient (hope to get decent return in short term). Those who are patient and can control their emotions certainly have a big advantage.
The fact we have so many bubbles in history is not coincidence. It is a pattern keep repeating itself. The existence of these extreme conditions invalidate the assumptions that investment community always react rationally to public available information. It is very clear that experienced value investors were able to identify these bubbles and actually had a consensus among themselves. For example, many value investors sold all their positions and stand in sideline in year 1999. Despite repeated speeches from Buffett that the future return is not going to be good, nobody actually listen to him any more at that time.

2. Different Goal and time horizon. There are many investors competing on the stock market. But no all of them have the same time horizon. Most mutual fund managers have to explain their short term performance. For this reason, they may have trouble to pursue an opportunity that only gives good returns in long term, but will do poorly in short term, even though they do believe it is a good buy. In this case, the money manager's goal is to keep his job and keep getting the management fees, not for the best long term performance. Also, most people tend to be impatient and not tolerable to short term price fluctuations.

3. Different skills. Investors have different skill sets. Some are better on technical analysis, others are better on fundamental. Some only focus on current financial statements, others focus on people factor and long term growth as well. Those people who are on the right track and practiced their skills for many years certainly have an advantage.

4. If most people believe the market is efficient and don't exploit the weakness of the market, then the market will become more inefficient again.

Tuesday, February 22, 2011

Stock Analysis of DST

DST Systems is largest mutual fund servicing and record keeping firm.

On the surface, DST has $6.8 GAAP per share earning in 2010, and $4.43 non-GAP per share earning, the P/E ratio is fairly good comparing to a $50 price.

However, its core business is declining. The registered accounts for Output Solutions declined 10% in 2010. Even though this core business represents only 48% of overall revenue, it is still could result in a 5% decline of revenue every year.

Looking deeply into its annual report and quarterly earnings conference calls, there are other details to be noted:

1. Like other software companies, its maintenance cash flow is bigger than income. The difference is around 50M in the last 5 years. Or $1 per share.

2. It has 1.4B long term investments. About $900M on stocks of 3 companies, and $500M on real estate. With 5% return on these, there are $70M look through earnings every year.

3. Combine #1 and #2, and add on to the non-GAAP earning $4.43, it gives a rough cash flow of $6.83, or 13.6% return each year.

4. However, since the business is declining, it needs to acquire new companies or buy-back shares to keep the per-share earnings from shrinking. The new growth on healthcare side and TRAC will offset the decline though. Plus, 10% decline in 2010 is a special case since it lost a big client which is 6.6% of their business. Also, it added another new big client in Canada. So conservatively, we can assume the business is declining 3% every year assuming no acquisition or significant re-investment. The actual figure is likely less than that. With 3% negative growth, the return is reduced to 10.6% assuming it can buy a business valued like itself in market, or its share price stay at or below $50.

So in conclusion, the conservative fair value is around $53. When doing evaluation, many people tend to forget about the look-through earnings on its long term investments, which is completely separate from its core business.

One of my favorite part is the CEO: Mr McDonnell. I don't know much about this person, but did some basic research on him. Here is what I usually do to study the top management:
1. Look at his basic profile:
He worked in this company for 37 years starting from 27 years old.
2. Hear what he said:
He mentioned many negative points about the company in the quarterly report and earning conference. He emphasized non-GAAP figures even though it is a lot less than the GAAP figure.
3. Watch what he did:
He provided good returns to share holders through share buyback, conservative acquisitions in the past. The share price 15 years ago was around $12 in 1995, comparing to the current $50, it is a 10% return each year, and its share price also goes steadily up if we exclude the impact from market index's fluctuations.

So he seems to be an honest person, with fairly good financial decisions in history.

The biggest individual holder (20% ownership) is ARGYROS GEORGE who seems to be adding to his position all the time for many years, and he also worked for this company for a couple of years in the past.

On the safety side (here "safety" means the probability of bankruptcy, or maximum downside under an extremely hash business environment), the long term investment is more than enough to cover the debt, not mentioning the relatively stable earnings.

For competitive strength, it is the largest mutual fund servicing firm. However, since the business is declining, this strength is not that important any more.

Overall, it is a good stable stock worth investing. The most significant draw back is the negative growth on core business, but with a good CEO, he should find a way to provide good returns to shareholders.

If Mr. Market allows us to buy this stock at $35-$41, it should provide a good safety margin and more appealing returns.

(Disclaimer: I don't own this stock at the moment, but is planning on initiating a position if the price is attractive)

Thursday, February 3, 2011

5 filters on value investments

1. Good Management.
Without a good management, no matter how compelling the valuation is, it is not investor's money. Bad management has many ways to destroy shareholder value, bad acquisitions, bad stock buy-backs, bad expansion strategy..., just to name a few. That said, a mediocre management is acceptable, if all the other aspects are very compelling. However, bad management is never acceptable not matter what, at least not for an "investment".

Good management means honest/integrity and competent. Among these two, honest/integrity is more important. An incompetent management might make a lot of mistakes and no smart decisions, but still it won't destroy too much value.

2. Safety.
This is considering the worst scenarios, or whether there is a significant chance for bankruptcy. Apparently, companies in cyclic sectors, with low profit margin or operating margin, with high debt ratio, rely on single supplier or customer have low safety and uncertainty. Low safety doesn't mean the risk-reward ratio is always bad, but it may not fall into the "investment" category. In that case, it becomes a speculation.

3. Valuation.
This means the stock is relatively cheap comparing to its growth, earning, asset and cash flow.

4. Durable competitive advantages.
Over long term, it is the durable competitive advantage that could maintain consistent high profit margin and above average growth. This is not a must-have though, if the valuation is more focused on current cash flow or asset, and the current earning is not subject major changes if other competitors enter the field.

5. Within circle of competence.
This is what Buffett emphasized in most of his talks. Without deep understanding of the industry, it is hard to really gain any advantage on information. And most retail investors don't have deep understanding of the industry, unless this is the field he/she worked on for many years. So a work-around could be getting some confirmation from some trustable gurus, plus a fair amount of understanding on the field. The effectiveness of this approach still needs to be tested though. This is probably the hardest part for normal investors.

Other non-mandatory filters include Catalyst and Growth. Having a catalyst will improve the efficiency of capital usage. And having good growth potential will increase the upside potential since the fair value varies a lot when the growth rate shifts a little bit. This part is especially important if the intention is to hold stock for many years without selling (like Buffett).

5 filters in the checklist seem to be a lot to remember, but underneath, there really is just one thing: "certainty". I use these filters to achieve high "certainty". That is what Buffett calls "never lose money", what Graham calls "investment, not speculation", and what James Rogers calls "do absolutely nothing unless there is something really worth doing"

Investment and Speculation

One thing that is mentioned repeatedly through the Security Analysis book (by Graham and Dodd) is the difference between "investment" and "speculation".

However, it is interesting that I didn't hear any other people talking about it right now. It may suggest that the current money managers, even they are following value investing methodology, are not considering this as an important point.

It seems to me that Graham considers "investment" as a stable and high certainty investment, but "speculation" is low certainty and volatile even if the risk-reward ratio is good, especially with diversification. Modern Portfolio theory has spent large effort on compose a portfolio to diversify the risk away, plus delicate method on risk calculation and risk control.

However, for value investing, the basic dilemma is still there. If one spends more time on gather as much information and do as much research/analysis as one can, only a small number of securities can be invested at any time. Thus the diversification is only up to a limited degree. If diversification is over a large number of securities, they will suffer from not gaining enough knowledge on the holdings.

My personal view is that "certainty" is the top priority for value investment. Therefore, the focus should be on those investments that are in a TRUE investment grade. That is not saying "speculation" is something one must avoid all the time, but it seems to be a different approach.

Also, without "certainty", it is hard to hold a stock for long time. This conviction definitely matters. That is also why Buffett says "The first principle is to never lose money". Without very high certainty, losing money will happen quite often, even if it is just 20%-30% of the trades.