Value Investing using Economic Value Added (EVA)

Bruce Greenwald On Value Investing

Nice video of Columbia Business School's Bruce Greenwald talking about the value investing process and the societal benefit of investors and money managers learning that process.

Berk

U.S. double-dip recession out of the question

A double-dip recession? "Simply out the question?" says Lakshman Achuthan of the Economic Cycle Research Institute (ECRI), whose Weekly Leading Index was on pace for its highest annualized growth rate in 38 years. Achuthan said the recovery is moving at the strongest pace the U.S. has seen since the early '80s.

I do not like when Social Scientists, let alone economists, (or any scientist for that matter) express forecasts in such absolutes, but the ECRI gets some benefit of the doubt until proven otherwise. Still, I will weight their work a little more but not with certainty! 

U.S. double-dip recession out of the question: ECRI | Reuters.

BERK

6 New ValueAligned Pay Practices at Valeant

Valeant CEO's Pay Package Draws Praise as a Model - WSJ.com.

In the above article in today's WSJ, G Mason Morfit, chairman of Valeant's board compensation committee and a partner at ValueAct, an activist hedge fund whose 22% stake makes it Valeant's largest shareholder, lays out 6 pay practices that mimic a private equity pay plan in a public company. 

While the article does not say what metric - sales, earnings, ROIC or EVA - annual cash incentives are tied to, we can see from the graph below that after the new CEO Pearson arrived in 2/2008 he was motivated to improve economic margin^{tm  _{right away.}}

^{_{Economic Margin or EM on productive capital (calculation details here) explodes in 2009 to over 30 from 5.2 the year before.  How did he do it?  He sold poor performing businesses, slashed research spending and partnered with another firm to introduce a big drug.}}

^{_{The stock market results so far - +105% since the new CEO started with aligned equity incentives:}}

What's the magic formula?

1. Make top managers buy lots of stock with their own money.

2. Tie equity grants to total shareholder return - share in wealth created don't dilute it.

3. Be generous on the upside, but tough on the downside.

4. Don't grant equity automatically every year.

5. Don't backslide - no bonuses if executives miss targets.  Board will not make up reasons to award bonuses.

6. Scrap entitlement perks like car allowances and club dues - let them buy what they want and need with their own money.

These are indeed aligned motivating incentives, but one size does not fit all type of companies.  For instance, retaining technology executives would be difficult without competitive value option grants each year.

It's nice to see how implementing a ValueAligned bonus plan can still motivate executives to take tough, but value creating decisions.

BERK

8 Investment Mistakes & How to Correct Them

Our ValueAligned Investing process is designed as a counter measure for the investment mistakes we all tend to make simply because we are human.  I think that most people know when they have made an investment "mistake" - like holding on to losers until you break-even while the stock sinks lower and lower - but most people don't really know why they make the mistakes.

This is where behavioral psychology and finance come in.  In today's Personal Section of the Wall Street Journal Meir Statman, a professor of finance at Santa Clara University in Santa Clara, Calif., gives us 8 ways our misguided thoughts and emotions get in the way of successful investing, and what lessons we should learn.  He writes:

Let me give you one example. Investors tend to think about each stock we purchase in a vacuum, distinct from other stocks in our portfolio. We are happy to realize "paper" gains in each stock quickly, but procrastinate when it comes to realizing losses. Why? Because while regret over a paper loss stings, we can console ourselves in the hope that, in time, the stock will roar back into a gain. By contrast, all hope would be extinguished if we sold the stock and realized our loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain—including holding on to the stock long after we should have sold it. Indeed, I've recently encountered an investor who procrastinated in realizing his losses on WorldCom stock until a letter from his broker informed him that the stock was worthless.

Successful professional traders are subject to the same emotions as the rest of us. But they counter it in two ways. First, they know their weakness, placing them on guard against it. Second, they establish "sell disciplines" that force them to realize losses even when they know that the pain of regret is sure to follow.

We know that we are going to lose money on some of our stocks so our process begins with diversification, correct position sizing and target sell prices on the upside and on the downside.  Realized losses are viewed as chances to redeploy capital - and as deductions against future gains.  This last part is so important since we manage money for individuals and families -most of  the money is ion taxable accounts.

The article is here: Investment Mistakes: The View From Behavioral Finance - WSJ.com.

Here are the 8 lessons:

1. The professional traders are faster than you and have much better information so don't try to compete against them, especially in the short-term.  You will lose most of the time especially in the short-term.

2. The future is never just like the recent past, and we tend to lie to ourselves about what we knew after the fact.  Hindsight error leads to think that we could have seen in foresight what we see only in hindsight.  We become way too overconfident in our ability to predict.

3.  Stop focusing on the pain and regret of past decisions and focus at the margin on today and tomorrow.

4. We tend to look for evidence that confirms our belief rather than evidence that might refute it.

5. Buy from the fearful and sell to the greedy - most investors do the opposite.

6. Wealth makes us happy but increases in our wealth make us even happier.  Happiness from wealth comes from gains of wealth more than it comes from levels of wealth.  Losses in wealth make us miserable.  Frame things differently - like compare your level versus somebody else's level of wealth.

7.  Mental accounting - the adding and subtracting we do in our imaginary accounts in our heads - often misleads us.  But we can make it work for us too.

8.  Dollar-cost averaging - investing a set amount at set times regardless of market levels or some false sense of knowing what might happen - minimizes regret.

We designed our investment process knowing that we have these tendencies as humans.  The process guards against these investing biases.

BERK

Rapidan's 2nd Qtr Investor Letter

Embedded below is the actual document - the following is the conclusion of that letter.  BERK

IN THE END

In March we suggested it was not the time to exit your long-term plans. In fact, we suggested that you should add to your stock accounts where possible. Even though the market has run up now it is not the time to exit. We’ll continue to actively manage the portfolios by also revaluing the shares of our great companies and then monitoring their buy and sell points. We will also keep track of market risk and Congressional follies to give us the highest probability that we earn the highest returns going forward.

Since we held on and even bought more shares of great companies when others were panicking, we're willing to hold for the next decade or more – we are confident we will be rewarded from these valuations. We think this time is a fantastic opportunity. And what we do today could make the difference between looking back on this market in regret and reaching our financial goals.

We are experienced advisors who have studied for many years the market cycles, corporate strategy and human behavior. We know that all by yourself without the guidance of an experienced advisor, you may believe that this time is very different from all the others. We understand that it temporarily relieves the psychic pain of losses, and relieves the anxiety of an uncertain future.

That’s why we consider that our best service to our clients isn’t our brilliant economic commentary or our economic/market calls, but simply the saving our clients from their own understandable but sometimes destructive behavior.

 

2nd+QTR+2009+Public

Arrogance and Condescension from a White House Short on Free Speech

White House Battle Against Free Speech Grows » The Foundry.

Yesterday, White House Deputy Press Secretary Bill Burton said on Fox News: “This White House supports free speech.” Now, it is hardly comforting to know we have a White House that feels it has to defend that position. It’s akin to saying, ‘this White House support oxygen,’ but the behavior of senior White House officials over the past few weeks has brought us to this point. A concerted and coordinated effort against cable news channels and their personalities; radio hosts and regular citizens from every walk of life has made Americans across the country fearful of a vengeful Obama administration. 

This is all terrible for the economy and the republic.  How on Earth can these amateurs in the White House get into "fights" with radio talk show hosts.  How are they so tone deaf that they cannot see through their own suspension of disbelief regarding the "implications" of their bills that are right there in black and white?  The lawyers don't understand the nuance - nonsense.

No reasonable person without a vested interest in the radical leap into healthcare (insurance) reform that will lead to radical healthcare changes could rationally support these plans or more specifically the bills in committees and passed out of committee in the House. Either you are blissfully ignorant of the implications of the proposals blinded by your ideology or you are intentionally misleading the public to attempt to hide the true effects and your true intentions.  The people can forgive the former but never the latter.  These bright eyed young altruists are all for anything the Obama higher ups tell them to be for - these are the ideologues with good intentions but ignorant. (here)

Who has the vested interests?  Well, surprise, surprise it is the phamaceutical industry lobbying group, the AMA - the organization - that represents some but not all doctors and the SEIU - the Service Employees International Union. 

Why do unions want the public option and radical reform?  They mostly have great generous benefits.  If it was up to the rank and file they would probably be out protesting with the "Radical Right" democrats and "astroturfers".  But thier leadership has a vested interest in giving the healthcare liabilities of their members over to the government.  Most of the old plans are under-funded anyway.  Get everyone on the public plan and presto more money for the organizers to organize more astroturf.

“The SEIU, unlike other organized labor, did not develop carefully-negotiated pension arrangements for their members,” Johnson said. “They’re dealing with the inability to pay out their pensions, since they’ve got liabilities of $1.5 billion and they only have around $1 billion in the bank. This means they’re $500 million in the hole.”

If they can’t get the public option passed, Johnson argues, they will have nothing to keep their members on the rolls. After all, the SEIU has spent millions to encourage the passage of the Employee Free Choice Act (EFCA), or Card Check, a measure that would require a public vote on the unionization of a work place. The result? Nothing.

The Pharma company lobby has made a deal with the devil.  The administration sold them "protection" for some $80 billion in cost savings.  In return for that they get Obama persuading Waxman to go lightly on drug cost controls - yeh right.  We are now going to see the Pharma companies create more Harry and Louise ads in favor of this convoluted mess!  They sold their soul for a short period where the government is going to pay for more pills for more people. Dumb, dumb deal.

And finally those doctors are all aboard as represented by the AMA - right?  Well no.  I have not talked to or heard one "real doctor" come out in favor of this thing.  The AMA does not represent nearly all doctors and like their union leader elitists and Pharma bosses cowering before the might of the Chicago thugs in the White House, the lobbyists and politicians that run the AMA have been all too happy to sell their members' interest down the river.

The current crowd running over Washington has very little respect for the people they serve.  They are supposed to say it and we believe it.  If we don't trust them then it must be some plot - never their own fault. 

Trust is earned.  They have broken the trust which undermines the very core of consensual government and capitalism.  

Stock market participants are happy that there seems to be a check on the President's and Congress' power - but soon it will be September and the big tent will once again rise above the circus in Washington.  The stock market will get scared and interest rates will soar as the Democrats lie and cheat their way to the Healthcare laws of their dreams.

Faster please. 

BERK

As Industrialized Countries Cut Corporate Taxes, U.S. Rate Still Second-Highest

The Tax Foundation - As Industrialized Countries Cut Corporate Taxes, U.S. Rate Still Second-Highest.

Washington, DC - Canada, the Czech Republic, Korea, and Sweden all cut their corporate tax rates in 2009, distancing the United States even further from the pack with its combined federal and state rate of 39.1 percent—second only to Japan for the highest corporate tax rate among nations in the Organization for Economic Cooperation and Development (OECD). A Tax Foundation analysis of new OECD data finds that 2009 marks the 12th consecutive year in which the U.S. corporate tax rate is higher than the average rate among non-U.S. OECD nations—and roughly 50 percent higher than that of a mid-ranked country such as Sweden.

"America's high corporate tax rate should be a red flag to U.S. lawmakers worried about the country's flagging economic growth, slow wage growth, and our overall global competitiveness," write Tax Foundation President Scott Hodge and Summer Fellow André Dammert, who authored Tax Foundation Fiscal Fact No. 184, " U.S. Lags While Competitors Accelerate Corporate Income Tax Reform." The Fiscal Fact is available online at http://www.taxfoundation.org/publications/show/24973.html.

Korea enacted the largest rate cut this year of 3.3 percentage points, followed by Sweden and Luxemburg, which cut their rates by 1.7 points and 1 point, respectively. Great Britain - from which Google recently moved its European operation to lower its tax bill - and Japan are transitioning toward more "territorial" tax systems that tax firms only on the profits earned within the country's borders. These global trends toward lower corporate tax rates and "territorial" systems that don't tax foreign profits stand in stark opposition to the Obama administration's proposal to raise more than $220 billion in new corporate taxes by making the U.S. world-wide tax system tougher.

"U.S. lawmakers must take note of these global trends and take steps to make the U.S. corporate tax system competitive with its major trading partners," Hodge and Dammert conclude. "If they don't, we risk continuing to fall behind in the global race to attract capital, jobs, and economic growth."

As President Obama meets with the NAFTA leaders his economic people ought to let their allies in the unions know about this main driver for loss of US competitiveness.  We tax em more they produce and sell more somewhere else. Simple.

BERK

Program has clunky reasoning

Government intervention often (more often than not) has unintended consequences because policy-makers have trouble thinking and planning dynamically.  They assume that conditions are fixed and will remain fixed after the implementation of some policy. 

We live in a complex world.  We also have an abundance of information that is easily manipulated by ever more powerful computers.  Sometimes I think this gives decision-makers the illusion of predictive power - but it is nearly impossible to predict what will happen in such a complex system.  I believe that small scale experiments and likely behavioral effects must be considered before large scale policies are implemented.

As Ed Glazer, a professor of economics at Harvard University, explains that the recent "Cash for Clunkers" program has all the earmarks of bad policy that will have effects the run counter to its stated objectives.

Subsidizing high-mileage cars to reduce carbon emissions is a bit like subsidizing low-calorie foods or low-tar cigarettes in order to reduce obesity or lung cancer. If the amount of cookie consumption was constant, then a lower-calorie cookie would lead to thinner waistlines. But if someone makes a less fattening, delicious cookie, I’ll want to eat plenty of them. Anyone who thinks that the proliferation of diet foods should have made Americans thinner was suffering from the “lump of food fallacy.

Less expensive and more enjoyable driving per mile leads to - surprise! - more driving. 

Program has clunky reasoning - The Boston Globe.

BERK

High and Low Finance - Inside G.E., a Little Bit of Enron

Seeking Alpha reports on Floyd Norris' article about General Electric's recent settlement with the SEC over accounting issues.  It introduces it's breaking news article this way:

With Jack Welch at the helm, General Electric (GE) used to be a shining star of business. What's inside the company now, in the wake of its $50M SEC settlement over charges of book-cooking? Floyd Norris says maybe a little bit of Enron.

High and Low Finance - Inside G.E., a Little Bit of Enron - NYTimes.com.

This seems to suggest that GE was a paragon of virtue when Jack Welch ran the joint.  It just ain't so.  Jack Welch invented the idea that "managing for value" was "making your EPS numbers".  Complicit Wall Street analysts lauded the company for its consistency in always making the numbers - keeping your promises I guess Jack Welch would say.

The problem?  The real world does not and did not work out the way GE's EPS numbers smoothly progressed.  There is so much leeway in GAAP accounting that the bigger and more complex a conglomerate is - the easier it is to "make the numbers".  Whether it's hiding away excess performance in good times or tweaking valuation reserves in the finance subsidiaries, there seems to be endless ways to make the numbers - until there isn't.

Norris says his story reminds him of Enron.  And if you are talking about companies that manipulate their EPS by using off-balance sheet financing, advance selling agreements, big bath accounting or just plain uneconomic investment using loads of debt, the list is long.  Lets take a look at Enron's "Risk Manual":

Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics.  Risk management strategies are therefore directed at accounting rather than economic performance.

Performance is measured by "accounting" not by the economics - not by creating economic value!  And so it was with GE and 90% of the companies in the Russell 3000. 

As the two graphs above suggest, companies can make EPS or accounting income look good while EVA is going straight down.  Why don't all investors and analysts use EVA?  Great question.

BERK

Paying for healthcare will reduce tax receipts - taxes will go up even more.

Martin Feldstein - Obama's Health-Care Reform Plan Is Not the Answer - washingtonpost.com.

Although the president claims he can finance the enormous increase in costs by raising taxes only on high-income individuals, tax experts know that this won't work. Experience shows that raising the top income-tax rate from 35 percent today to more than 45 percent -- the effect of adding the proposed health surcharge to the increase resulting from letting the Bush tax cuts expire for high-income taxpayers -- would change the behavior of high-income individuals in ways that would shrink their taxable incomes and therefore produce less revenue. (my emphasis). The result would be larger deficits and higher taxes on the middle class. (again my emphasis) Because of the unprecedented deficits forecast for the next decade, this is definitely not a time to start a major new spending program.

Tax rates are not the same thing as tax dollars collected. Feldstein shows how the incentive effects of top rate tax increases erode the tax base - that is the level of dollars available to apply the higher rates to.  Not only will new entitlement spending explode the deficit directly, but trying to paying for it with higher tax rates will surely reduce the amount of dollars collected by the government. 

Berk