Victoria Contrarian Investing Club Google Groups

Just a reminder-- I'm blogging quite a bit less now since I started the Google Group "VictoriaContrarianInvesting" in February of this year.

If you're interested in joining up with like-minded beginner (mostly) value investors, send me an email at lporayko@gmail.com and I'll send you an invitation back. All of our discussions are kept on the VCIC website for future reference. There is a files section where I upload selected investing gems. When I have time, I throw together an informal newsletter with one or two stocks that I've been studying-- mostly for further discussion.

Most of us are not interested in "hot stocks" or buying the latest trend (gold?) so if that's your bent, you probably will find it frustrating. It's my experience that your brain is either wired to be a value investor or you are destined to follow the crowd as a momentum investor. This is why certain value gurus like Bruce Berkowitz, Warren Buffett and Seth Klarman (my 3 favourites, can you tell?) are so open about their analysis techniques and even concerning the stocks that they've bought recently.

From Klarman's "Margin of Safety":

"You may be wondering, as several of my friends have, why I would write a book that could encourage more people to become value investors. Don't I run the risk of encouraging increased competition, thereby reducing my own investment returns? Perhaps, but I do not believe this will happen. For one thing, value investing is not being discussed here for the first time. While I have tried to build the case for it somewhat differently from my predecessors and while my precise philosophy may vary from that of other value investors, a number of these
views have been expressed before, notably by Benjamin Graham and David Dodd, who more than fifty years ago wrote Security Analysis, regarded by many as the bible of value investing.

That single work has illuminated the way for generations of value investors. More recently Graham wrote The Intelligent Investor, a less academic description of the value-investment process. Warren Buffett, the chairman of Berkshire Hathaway, Inc., and a student of Graham, is regarded as today's most successful
value investor. He has written countless articles and shareholder and partnership letters that together articulate his value-investment philosophy coherently and brilliantly. Investors who have failed to heed such wise counsel are unlikely to listen to me."

People can make money using either approach. I think that you make a mistake when you develop "style drift" away from what suits you best, but that's a different whole discussion. I also think that momentum investing is too difficult for me. I'm just not smart enough to figure out group psychology, particularly on that scale. I'll leave that to George Soros, who obviously can.

I plan to track the performance of all the stocks that we discuss in a spread sheet every 6 months. Clearly, the best way to learn is to get continuous feedback- on our objective performance as well as from level headed colleagues that you respect.

l

Insider Ownership helps... or does it?

One of my hypotheses for buying Seaboard SEB and Columbia Sportswear COLM was that a very high insider ownership (about 70% for each of them) would provide the following attractive investment features:

• a strong incentive for management to align its interests with the minority shareholders
• a limit to the downside of the share price during general market downturns as insiders tend to hold on to their shares when they are considered cheap and sell them when they are expensive (or they really need the money)

These advantages are offset by the potential for a complacent management that doesn't have to worry about activist shareholders stirring things up. When a company outgrows the skills and experience of the founders that are reluctant to give up control of the company, that bodes poorly for the business' prospects. The other downside is a legacy curse: rampant nepotism in family owned companies often leads to bad governance as children or grandchildren of the founders do not possess the gifts to lead a company forward, yet they maintain control. Wrigley was a prime example of this issue you need to watch for.

SEB has mostly tracked the major indices pretty well-- particularly since Dec '08. It's price action doesn't support my hypothesis very well. On the other hand, COLM has definitely outperformed the markets. These are both family businesses that I believe are well run. I do wish SEB's executives were a bit more forthcoming with information, though. This is probably one of the main reasons it has been sidelined by Wall St.

Obviously looking at just 2 companies with a high degree of insider ownership over the short term is not even close to conclusive. I was impressed how well their stock prices held up compared to the rest of my portfolio and that's why I decided to look into it further.

Read this interesting and thought provoking study from Oxford that shows 9% excess returns v.s. the S&P 500 for firms where the CEO owns 10% of the outstanding shares or greater. This may indicate that choosing selected stocks with high insider ownership may also increase the upside potential in addition to limiting the downside.

IMHO, it's one of many important factors to consider when you're doing your research.

l

As I've mentioned before, I'm slowly raising cash in order to exploit upcoming opportunities... I'm anticipating a large correction in the next 6-9 months. The market has become irrationally exuberant once again.

My estimate for AEO's intrinsic value is around $15-20/share, so I plan to sell it into strength.

SPLS, a company with management that I've admired and owned for the longer term, is also approaching my guess for its intrinsic value of around $25/share. I'll sell it too soon. I wouldn't hesitate to buy it back again at <$15/share.

Targets I'm monitoring closely, all trading at least 30% above my entry position:

Y (I already own some)
CVL.UN
BDI.UN
PDLI
FACT (I already own some)
PFE
URI
KMX (own it, want more!)
BBEP
BBSI (I already own some)
COP

There are others as well. Yes, I know that many of the above are ideas shamelessly stolen from the revered (for excellent reasons) Mr. Klarman and Mr. Berkowitz. Imitation is definitely the most sincere form of flattery. I also believe that I deeply understand their investment thesis in these companies and my conviction to own them comes along with that understanding.

When Pigs Fly

Although the swine flu may turn out to just be a wake up call for developed nations' health authorities to dust off their "pandemic plans" and actually see if they are workable, there is little doubt in my mind that this event will stress test the world markets.

With the memory of SARS still fresh in the minds of Torontonians and in particular, the citizens of Hong Kong, fear will probably dictatet o the markets until the coast is clear. I think this will be particularly pronounced in highly populated Asian centres if the flu breaks out there.

Of course, there is no need to panic. You and your family should be prepared for this just like any other natural disaster such as an earthquake. Make sure you have a source of fresh water and lots of canned food. It might be nice to have a supply of N95 masks at home for when you need to enter public places with a high traffic rate of potentially infected people like a grocery store or an airport. Soap and water is plentiful in every home-- use it. A small container of hand disinfectant can be carried around and used each time doors are opened and hands are shook. All simple stuff.

When it comes to a financial strategy, I don't think changing tack makes sense to me. I've used the rally to sell my weaker positions into relative strength and consolidated my portfolio a bit. The majority of my holdings are debt free companies with prodigious free cash flows OR are net-net stocks with unlocked value (i.e. a pile of cash the management needs to be forced to distribute to shareholders...). I think that the game plan should not change one iota. If fear knocks down quality companies' market prices well below intrinsic value, then you should buy them, just like always.

It just so happens that Pharma stocks have been out of favour for a few years now and have some of the best balance sheets and cash flows of any sector. I've been accumulating shares in various companies (NVS, SNY, BMY) over the past 3 years and only sold one (SGP).

One could speculate that some of the Pharma companies will get a boost from world wide stockpiling of anti-viral agents and vaccines; however, I think that this is probably overblown. Roche and Glaxo-Smith-Kline have seen little boosts in their share price because they have Tamiflu and Relenza in their portfolio. Novartis' share price actually dropped a bit this morning despite being assigned the task (and being best positioned to do so) of developing a H1N1 vaccine by WHO and the CDC. This process takes 6 months using the "egg" technique, so they've been told to get cracking. I doubt very much that NVS (which I own, BTW) will profit much from this activity in the short term. I think that it is a great company with excellent prospects, but not because of the swine flu.

Morningstar's article on this topic.

Globe and Mail article.

Pork producers could be hurt temporarily and irrationally by the pandemic. Russia has banned all pork products from North and Latin America and other countries are likely to follow suit. The virus is not spread by ingesting the meat or by dead animals; however, governments are likely to react in this fashion to garner political brownie points from their paranoid electorate. I'm watching SEB carefully for an opportunity to add to my position.

Watching the insiders

Read this Ockham research article.

And this Kenyon one too...

for this amongst many other reasons, I've been selling into strength-- mostly positions that I've either lost confidence in because of changing business dynamics or realizing that I made a mistake in my original analysis. Fortunately, with the 6 week bear market rally (is that what this is?) and the favourable forex, I've either broken even or made a modest profit on most of the positions.

I'm raising cash to exploit a few special situations that may present catalysts in the nearer term but I'm waiting for a market pullback before committing too deeply to them. I'm prepared to wait up to and including the fall if I have to.

Age before beauty

Three more grumpy old men give their view on investment opportunities today.

Chou gets crushed

My only mutual fund holdings are Chou Bond and Chou Associates. I've discussed in the past why I'm a fan of this modest but highly skilled capital allocator.

Like many (including the humbled author of this blog), he has suffered from premature accumulation syndrome. Jumping in too early is tough to avoid and one wonders if you're not just lucky if you don't. It's easy to confuse skill with luck until you look at long term track records-- Mr. Chou has one of the best.

Another lesson I learned the hard way is to only entrust your hard earned capital to a person of the highest integrity. Any red flags at all should make you run in the other direction. See below for why I have no plans to redeem my units despite short term underperformance:

News from globeandmail.com

The manager who gave back his fees

Thursday, April 2, 2009
ROB CARRICK

The mutual fund industry is going to hate this.

Investors will be angry that they don't see more of it.

Unhappy at the returns he has generated for clients, money manager Francis Chou is refunding almost all the management fees collected by his Chou Europe fund since it opened for business in September, 2003.

"We have not made money since inception," explained Mr. Chou, a widely respected investing figure whose financial career began in an investment club he formed in 1981 with six Bell Canada co-workers. "I don't like negative numbers long term. Short term - one year, two years or three years, if you do badly that's fine. But long term, you want to make sure you're making money for your unitholders."

What a difference there is between Mr. Chou's tiny, eponymous fund company and his big-boy competition. He looks out for unitholders. They look out for shareholders.

Investors are lax about understanding the cost of owning mutual funds, which means they may not realize that the fees charged by funds don't typically vary with results they produce for investors. Among the 15 largest equity and balanced funds by assets, losses for the 12 months to Feb. 28 range from 16 to 38 per cent. Don't waste your time waiting for fee rebates from any of them.

Mr. Chou's company, Chou Associates Management, has five funds in its lineup and their losses in 2008 ranged from a better-than-average 17.6 per cent for Chou Asia to a lower-than-average 44 per cent for Chou Europe.

As of the end of February, Chou Europe had lost a compound average annual 6.2 per cent since inception. This is the result that prompted him to ask the Ontario Securities Commission for guidance on how to do what may never have been attempted before by a fund company: Rebate all fees taken in by a fund throughout its history.

"It was the right thing to do," Mr. Chou said from his office in the Toronto suburb of North York, which is way off Bay Street.

In fact, Mr. Chou has rebated fees on a limited basis several times in the past. Most recently, he decided to waive roughly 77 per cent of the management fees collected last year from Chou Bond, a fund that holds high-yield corporate bonds. In the mid-1990s, he waived 19 months' worth of fees taken in by Chou RRSP. In 1990, he waived fees for Chou RRSP and his flagship fund, Chou Associates.

These moves are costly, even for a small firm like Mr. Chou's. About $700,000 extra will be available in Chou Bond so it can be invested for the benefit of unitholders, and a total of $547,000 will be put back into Chou Europe.

It's not only unique for a fund company to give back fees it has collected, it's also difficult because of the need for regulatory, legal and accounting advice. "When you go and give back money, you sometimes have to jump through hoops to get it done," Mr. Chou said.

What eased the way was an unusual clause in the prospectus for the Chou family of funds. It states that the matter of waiving management fees entirely or in part is reviewed annually at the discretion of the manager without notice to unitholders.

Management fees are what fund companies pay themselves from their mutual fund returns to cover the costs of running a fund. Some companies have fixed their management fees so they can't rise, others leave themselves the flexibility to charge more.

Mr. Chou's take: "I look at it more that you have to earn that fee rather than have it given to you. If I feel I earned it, I take it."

Here's something else Mr. Chou takes - responsibility for his investment returns, both good and bad. In 2008, the results were largely bad as a result of his value investing approach of seeking beaten-down stocks with the potential to rebound. In the financial crisis that blew up last year, these stocks have been pounded still lower.

In his annual report to clients, Mr. Chou wrote about how he was worried about irresponsible lending and the U.S. housing market, but did not foresee how severely the financial system would be hurt when the bubble burst.

"And so, based on the information we had in 2007, we purchased some stocks at prices that, in hindsight, were too high," Mr. Chou wrote. Go contrast that with the explanations you're going to be seeing from other fund companies as they explain the fiasco of 2008.

***

The Wisdom

of Francis Chou

THE MARKETS

"I think the economy may go south somewhat, but the stock market may not go along. The stock market tends to be a leading indicator by nine months to a year. So it could go up if the economy goes south."

PICKING SECTORS

"All sectors are cheap. Right now, we're just trying to wade into some financials."

FURTHER OPPORTUNITIES

"Everything is depressed, but corporate bonds are more mispriced than equities."

HOW LONG A COMMITMENT INVESTORS SHOULD MAKE TO HIS FUNDS

"I would prefer 10 years."