A Behavioral Margin of Safety

                In 1991, one of the least-known, best investors of our time wrote a book called Margin of Safety. Seth Klarman, the author and Chairman of the highly-respected hedge fund, Baupost Group, did not take long to figure out that publishing was not going to be where his bread was buttered. He published only 5,000 copies and stopped printing what many value investors  now consider “the bible”. Today the book fetches $2500 a copy on Amazon but might be found used on eBay for $1000. Klarman could now likely turn a tidy profit publishing a few more copies but that clearly was not his objective in the first place. His objective was to get out of his head and on to paper what is the truth about why very few people are highly successful investors and most range from average to outright failures. Most investors, he concludes, focus on return and not risk.

                In the book, Klarman goes out of his way to focus on risk. He notes, “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world."

                Klarman goes on to discuss several methodologies for examining what the true value of a company is versus the perception of its value as portrayed by its stock price. He mentions many methods for evaluating the “real” value of a company -- practices which can be executed by most undergraduate-level finance students. Klarman knew that his formulas and assumptions could be perfect, but unless perception (stock price) and reality merged, he would not make money. The gap needed to be wide enough to account for uncertainties and peoples’ perceptions needed to change.

                While this all seems dull and mathematical so far, great investors like Klarman, Buffet, and Soros are acutely aware that current circumstances  and the corresponding investor behavior they elicit is what leads to any disconnect between the market price and the true value of each of their holdings. They believe that the ideal circumstance for identifying the widest gap (best margin of safety) is when the fewest number of people agree with them. This happens when the behavior of other investors is contrary to their own.  Great investors also know that extreme behavior is not permanent behavior.  Attitudes can change more rapidly than fundamentals and money can be made anticipating these attitudinal shifts.  Money can be made buying companies (or industries, or markets) with the highest “behavioral” margin of safety. Capital can be protected by avoiding (or shorting) those with the lowest behavioral margin of safety (crowded trades).

           What is also quite clear to us is that the longer an investment behavior persists (e.g. buying bonds, selling energy stocks, buying large cap growth stocks, etc.) the greater the likelihood that this behavior will sow the seeds to its own reversal.  At these "behavioral inflection points" the selling will dissipate and turn into buying and the buying into selling.  Said differently, the stocks (or bonds, commodities, real estate) with the lowest behavioral margin of safety are those that have already  gone up the most for the longest period of time.

        When I think of recent history, I think of the stock of Apple.  In September of 2012 the stock eclipsed $700 per share.  Since October of ‘08 Apple ascended to that level in a mesmerizing fashion growing at an annual rate of more than 60%.  Few managers who expected to beat their benchmarks could afford to be left out of this stock.  At $700 per share there was still a cogent argument as to why the stock had a fundamental margin of safety.  Excluding the over $120 of cash per share the company had on its balance sheet,  Apple was still trading at under 12 times its forecasted earnings. This was cheaper than many slower growing, lower quality companies in the S&P 500.  But how high was its behavioral margin of safety?  Did everybody who was going to buy it already own it?

        While this practice is difficult to quantify, I would hazard to guess that the behavioral margin of safety was not high for this investment.  According to Nick Murray Interactive, Apple was one of the top ten holdings in over seven hundred equity mutual funds; four hundred had it as their single largest holding.  400 mutual funds quantitatively demonstrated that this was the single stock that was going to help them the most in beating the market averages over the foreseeable future after it had already gone up more than just about any other stock over the previous four years.  It takes some courage to own any single company.  With Apple it took a great deal more courage not to own it.  I have no idea how this company will perform from current levels ($500 per share a/o 1/2012) but Nick Murray said it best when he commented, “We may no longer be willing to accept even excellence from Apple, because we have in some sense started pricing in magic.”

            The behavioral margin of safety for the stocks in general can vary over time. As we enter 2013 stocks have recovered over 100% from their lows in March of 2009.  One would think that the average investor increasingly participating is one of the reasons for this recovery.  This is not the case. According to Gallup, every year since the recovery began the “participation rate” of American household in stocks has declined.  The participation rate sits at 54%, the lowest level since Gallup started measuring the data in 1999.  Everybody who can own stocks clearly does not own stocks. Every dollar that could come into the stock market has yet to be committed.  We would need to see more investors behaving with impunity before waving the caution flag to our loyal constituency.

The Search For Oracles

"The greatest blessings come by way of madness."  -- Socrates on the Oracle of Delphi

     The focus on recent headlines and worries about the Fiscal Cliff has distracted investors away from the factors critical to long term investment success.  We are content to leave the predictions to others and instead spend our time trying to find value-priced companies that have the potential to grow substantially over time, thereby unlocking the powerful force of compounding.  

     I recently had the privilege of traveling to one of the most important sites of the ancient world:  The Temple of Apollo at Delphi.  Delphi was the longtime home of the priestess of Apollo, an Oracle who was believed to be able to predict the future based on her ability to communicate directly with the Greek Gods.  The Oracle's prominence began to grow immensely sometime around 800 BC and held steady for over 1,000 years ending only with the fall of the Roman Empire.  Citizens from all over the Mediterranean made the long and difficult journey through the mountains simply to seek the Oracle's divine prophecies.  In fact, many of the best known figures of the period (such as Alexander the Great, Cicero, and the Roman Emperor Hadrian) based their decisions for war and politics on her responses to their questions.  The Oracle's prophecies were widely credited as being highly accurate, which is reflected in the incredibly vast store of wealth that was accumulated by the temple (satisfied visitors were expected to make significant donations and gifts).  In many ways, the Oracle can be said to have started the first, and perhaps most enduring, global consultancy.*

     So what does the story of the Delphic Oracle have to do with investing?  When I was touring the site, I couldn't help but think that it speaks to a core element of human behavior.  We all would like to be able to know the future before making decisions regarding inherently uncertain events.  This dynamic is perhaps strongest in today's investment world which is obsessed with predicting the future and constantly in search of modern day Oracles.  CNBC interviews filled with questions about the course of short term events illustrate this quite well with common questions along the lines of, "How will the Greek Parliament vote?", "Where is the price of Gold headed this week?", and our recent favorite, "How are you positioned for the Fiscal Cliff?".  This tendency has helped create a headline-focused trading culture built on the mistaken belief that investing is a predictioneer's game--that those who can most accurately predict the outcome of headline events perform the best.**  The end result is that many investors:

• Spend considerable time trying to predict headlines
• View their portfolio in the context of recent news (shows such as Fast Money and Options Action are indicative of this mindset)
• Trade incessantly, holding securities for increasingly short periods of time (the current average holding period of a stock is now only 3.2 months)
• Engage in herd-like behavior, crowding in and out of the popular stocks and industries of the moment
• Spend little time examining fundamentals and the underlying value of businesses

     The most successful investor of our time has been dubbed the "Oracle of Omaha" by the media.  This title strikes us as particularly ironic given Mr. Buffett's well articulated philosophy of generally avoiding predictions.  That doesn't stop people from asking him to predict the future, though, and the most recent Berkshire shareholders' meeting was filled with questions about recent headlines.  His response: "In 53 years, Charlie and I have never had a discussion about buying or selling in which we talked about macro affairs."  Indeed, Buffet has repeatedly advised investors to "stop trying to predict the direction of the stock market, the economy, interest rates or elections."  This sage advice has not been heeded by the masses.  It is clear to us that Buffet's success has had almost nothing to do with his ability to predict the outcomes of events.  Instead, it has been a direct result of his behavioral investment philosophy combined with a keen analytical ability to value businesses and buy them at prices which offer significant value--something we attempt to do on behalf of our investors each day. 

*As a footnote, an interesting question is how the Delphic Oracle held prominence for over 1,000 years while being engaged in such a difficult activity as predicting the future?  With the benefit of history, we now know that the Oracle had a secret.  Upon reaching the large Temple, guests would be lead to a small chamber, the Adyton, where the Oracle (typically a young woman) would receive guests while sitting on a tripod over a smoky vent.  Upon hearing a question, she is said to have become hysterical and begin to speak in "incomprehensible tongue" which was explained to come straight from Apollo.  Male priests would interpret her rantings and write a short, one or two sentence prophecy.  Research now indicates that her erratic behavior was due to the fact that the vent emitted a natural hallucinogenic gas.  While it is incredible to think that ancient visitors would give credence to the rantings of a drug induced teenaged girl, her behavior would have been something most visitors had never seen before, making the experience more believable.  The real power of the Oracle resided in the Priests who actually wrote down the predictions.  It is believed that the priests were great scholars who turned Delphi into a large information gathering center (a powerful tool in an ancient world where information was scarce).  They were able to research questions beforehand and dispense appropriate wisdom and advice.  For uncertain events (such as, "Will my unborn child be a boy or a girl?"), there was more gamesmanship, and the Oracle is famous for delivering prophecies which could be interpreted as being correct regardless of the outcome (the answer: the double entendre, "A boy not, a girl.").

**Notably, this behavioral tendency has also created incentives for pundits to make bold and extreme predictions.  A correct prediction of a low probability event has the potential to instantly elevate the media profile of the individual making the prediction, while a failed prediction is forgotten or can easily be explained away.  Thus, making a bold prediction has a favorable risk/reward trade-off especially for individuals seeking increased notoriety. 

Small Cap Valuations: Market Cap Bias and the Dangers of Headline P/E Ratios

       Using headline valuation metrics as a barometer can be particularly dangerous and misleading, especially for the Russell 2000 Index.  In addition to distorting the index, a market cap "blind spot" has created persistent inefficiencies (and opportunities) at the smaller end of the small cap universe.  Our small cap strategy, with a current median market cap of roughly $350 million, concentrates on smaller companies because this is precisely where thorough research matters the most.  

  

      During our recent conversations with institutional investors and consultants, we have frequently heard that "small caps look expensive."  Indeed, the Russell 2000 currently sports a headline P/E ratio of nearly 30x trailing earnings compared to around 14x for the S&P 500.  Is this conclusive evidence that small caps are overvalued -- especially relative to large caps?  

      We have been somewhat puzzled by this conclusion, as it contradicts what we have been seeing "on the ground."  As bottom up investors, we spend our time researching one company at a time.  While we are inherently intimidated by high valuations, we continue to come across plenty of small, well-run enterprises which appear to be both undervalued and out of favor.  Likewise, many of the quarterly earnings conference calls we tune in to have continued to garner muted interest at best (with some having no Q&A participants at all)--not exactly a sign of "irrational exuberance" for small caps.  Both of these observations are confirmed by the most recent additions to our small cap portfolio which are valued well below the Russell 2000 Index by most metrics.  So...what gives?

      One part of the explanation lies in the structural market bias we have previously referred to as the "market cap blind spot."  A majority of sell side analysts and professional money managers concentrates on the largest companies in the small cap universe and ignores the smallest ones.  This stubborn reality is reflected in the holdings data for buy-siders:  the average small cap mutual fund in the Bloomberg universe has a median market cap of $1.8 billion - a full three and a half times the $491 million median of its Russell 2000 benchmark.  In addition to creating persistent inefficiencies in the small cap marketplace, this bias has distorted valuations within the index itself.  An average of the valuation metrics presented indicates that the largest quintile of the Russell 2000 is 20% more expensive than the smallest.  This relationship underpins a counterintuitive dynamic in small caps, namely, the size of the company--not necessarily the merits of the business--is often the determining factor of its valuation.  This contrasts sharply with large caps, where size generally plays no discernible role in company valuations.

Evidence of the Blind Spot

 Russell 2000 Median Valuations by Quintile (10/31/2012)*

	Market Cap (Millions)	Trailing P/E	Forward P/E	Trailing EV/EBITDA	# of Analysts
1 (Largest)	1,642	18.6	15.2	13.5	10
2	854	16.7	14.1	12.4	8
3	491	16.3	13.9	13.3	7
4	269	16.4	13.6	11.8	5
5 (Smallest)	150	14.9	13.2	11.3	4

 S&P 500 Median Valuations by Quintile (10/31/2012)*

  

	Market Cap (Millions)	Trailing P/E	Forward P/E	Trailing EV/EBITDA	# of Analysts
1 (Largest)	56,433	15.2	13.2	12.3	28
2	19,999	14.7	13.8	12.4	24
3	7,722	16.4	13.8	12.2	19
4	7,668	16.8	14.5	12.2	19
5 (Smallest)	3,932	15.5	12.8	11.5	16
*We chose to use median data to eliminate the effect of extreme numbers and also believe it is more representative of company valuations found in each quintile. Data assembled from Bloomberg, L.P.

      Because of market cap bias, the Russell 2000's headline P/E (a weighted average) is inflated, as the most expensive companies have the greatest representation in the index.  This dynamic is further compounded by the fact that the Russell 2000 has more than twice the proportion of companies with exceptionally high P/E ratios* (often caused by marginal recent profitability).  In our view, median data produces a far more meaningful comparison because it is less affected be these distortions.  We also believe that median data is more indicative of the valuations of a "typical" company in the index and also more representative of the characteristics which an active manager is most likely to uncover during his or her research.

*10% of Russell 2000 names have a P/E ratio over 40 compared to only 5% of S&P 500 names.     

Median Data Comparison (10/31/2012)
	Market Cap (Millions)	Trailing P/E	Forward P/E	Trailing EV/EBITDA	# of Analysts	Sales Growth	Earnings Growth
Median R2K Company	491	16.9	14.2	8.9	7	5.5%	7.0%
Median S&P 500 Company	12,495	15.9	13.6	9.0	23	2.4%	4.5

      When examined on a median basis, the valuation disparity narrows substantially: small caps are only 4% more expensive than their large cap counterparts despite appearing twice as expensive on a headline P/E basis.  We think that this slight valuation premium for small caps is more than warranted considering their stronger sales and earnings growth characteristics (in red). 

Mis-Impressions

I’m a huge golf fan. I’m a bigger Ryder Cup fan. So Friday morning was the start of a golf fan’s “best 3 days”. The TV was on but I was not tuned in. I had to work.  I looked up every once in a while to see how my American favorites were doing against their European counterparts, and every time I did something bad was  happening to the  Americans. I saw Tiger hit balls into the woods, I saw Furyk “ lip out” putts, so I naturally assumed we were getting our “collective American butts” kicked in the morning session. Much to my surprise this was not the case. Americans and Europeans were tied when the morning session concluded. It occurred to  me that this must be how many  individual investors feel about stocks and the stock market.

Research points out that this is exactly the case. Franklin Templeton surveyed one thousand Americans in 2010, 2011 and 2012, and asked them how they thought the stock market had finished at the end of the previous year. For the year 2009, in which the S&P 500’s total return was 26.5%, 66% of the thousand respondents said that it had been down or flat. For 2010, when total return was 15.1%, 48% of those surveyed said that it had ended down or flat. For 2011, the return was 2.1%, and 53% of respondents said that the market had been down or flat. What’s worse is that, based on these “embedded impressions” and the continuous negative media drumbeat, these same folks are likely deferring investments or vacating well thought out financial plans. Over $300 billion has been withdrawn from actively managed equity mutual funds since the market bottomed in March of 2009(The S&P 500 is up 115% since then). The money is still trickling out because when people glance up at the screen it looks like Phil or Tiger missed another putt.

I guess the  choice is to pay attention or turn the TV off. 

Institutional Bias and the Story of Allied Capital

Over the past weekend, I started and finished the real-life tome Fooling Some of the People All of the Time by famed hedge fund manager David Einhorn of Greenlight Capital.  You could be forgiven for reading the book and thinking it fiction, as the story takes some unexpected twists and turns and at times reads more like a detective novel than a financial narrative.  It's a quick but thrilling read (although that may be over-selling it; I'm the kind of guy whose blood starts pumping when reading a really good 10-K).

The heart of the story is this: really smart hedge fund guy uncovers accounting irregularities at said public company and wages a years-long campaign to raise awareness of the likely-fraud and to ultimately force regulators to intervene.

While the mere existence of practices of aggressive accounting, management opacity, and outright fraud at a public company are distressing, unfortunately they are more common than many investors think.  Mr. Einhorn has done an exception job over the years of rooting out other public companies with such questionable practices.

What is more distressing to me was the burning, unanswered question I was left with at the end: why did it take so long--years, in fact--for the issues at Allied Capital to ultimately be recognized by its shareholders, by the market, and eventually by its regulators?  The stock price of Allied over the ensuing three years from May 2002 (when allegations were first made public) did not visibly discount this information (except in short blips) and actually outperformed the S&P 500 by over 7% per year.

More simply, it paid to be an investor in a company that had decent odds of being fraudulent!

I think the answer to my question, at least in part, lies in the "institutional biases" that motivate many shareholders, private and professional alike, and prevent markets from being perfectly efficient.

To wit:

1.  Few investors do their homework.  While the nitty-gritty details of Allied's accounting practices were laid bare for all to see in the company's regular SEC filings, few investors were willing to roll up their sleeves and do the analysis that ultimately proved incriminating.

2.  Investors love a check in the mail.  Allied's shareholder base had a large contingent of individual shareholders who, as long as they received regular, predictable dividends, did not pay much attention to how those dividends were generated.  They ate the sausage and didnt really care to see how it was made.  These dividend payouts also formed the basis of valuing the company.

3.  Wall Street is a deal machine.  Despite evidence of "irregularities" that should have been as plain as the nose on the face of your average Wall Street analyst, bulge-bracket analysts defended the company "to the death."  Addicted to Allied's regular and lucrative securities offerings, these analysts did not dare to jeopardize investment banking revenues for the sake of honesty.

And so it was, with this biases cemented in the minds investors and professionals alike, that Einhorn's allegations were taken less-than-seriously, and the stock was allowed to work its magic.

*     *     *

In our own search for investment ideas, we constantly remind ourselves to be on the lookout for these biases in other investors.  They are the means by which securities become over-priced and by which they become under-valued.  They are the reason that markets always have been and always will be inefficient.

Many times, these recognizable biases can be a starting point for finding undervalued securities:

Companies with complicated financials whose small but meaningful nuances dont make it into the quarterly press release.

Companies that dont pay dividends in an industry where all of their peers do.

Companies who have no interest in playing the Wall Street game: no continuous equity offerings, unending road shows, or investment bankers on the payroll.

These biases lead other investors to shortcut their decision-making process, usually reaching a conclusion as to whether they should or should not own a stock based on reasons that don't always relate to the fundamental value of the company.  That is our opportunity, and one we seek to exploit every day.