At the start of the year, I wrote about valuation levels as compared to historical data in here. As equity markets continued its rise, alarms were sounded over extravagant tech IPO valuation and hyped M&A activity in the private equity and biotechnology area. In particular, well regarded value investors were among those that made these calls:

In his 2013 annual letter, Seth Klarman said “… on almost any metric, the U.S. equity market is historically quite expensive. A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla. The overall picture is one of growing risk and inadequate potential return almost everywhere one looks.”

Separately at the SkyBridge Capital’s SALT 2014 conference in Las Vegas, David Tepper said, “I’m not saying go short, I’m just saying don’t be too fricking long right now. I’m nervous, and i think its nervous time.”

A word of caution should ensue. The theory that financial markets are ahead of themselves may rest well in logic and reasoning. However, it is one thing to realise where valuations are and another to guide investment decisions. In fact, markets periodically trade a little over/under their worth during periods of stock market history. When that happens, investment decisions guided under macro prediction should rightly be in the realm of the macro investor. Unless under extreme valuation scenarios, the value investor’s job should simply be looking at undervalued stocks or control situations, and in short, be macro agnostic. I remember Warren Buffett’s thoughts on these matters and therefore did a patched work of them.

In his 1958 partnership letter, Buffett quoted a friend and stated during that time,

‘exuberant’ would be the proper word for the stock market.”

Yet given such an obvious observation, there was no talk of him going cash or shorting the market. There was essentially no macro-data-backed decisions per se. What followed at the end of the letter was simply,

“The higher the level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments. I would prefer to increase the percentage of assets in workouts…”

That is to say he remains invested no matter what the market was doing, only that he had viewed workouts as partial hedges against the general market. But more importantly, general market valuation did not alter his approach significantly, it only limited his investment opportunities and changed his positions.

Additionally, not only should macroeconomic conditions be largely ignored, the merits of macro forecasting should also be in doubt. Investors and economists have tried in vain to forecast unemployment rates and GDP figures with hopes that these will guide their investment decisions. None, however, succeeded in proving that their endeavours did guide them fruitfully to their results.

During the Q&A session with students at Columbia in the CNBC Special (Warren Buffett & Bill Gates – Keeping America Great, a transcript is available here), Buffett answered a student to his general market question:

QUESTION: I’m Peter Lawrence, first-year student from Columbia. And, first of all, thank you both so much for coming here. Mr. Buffett, the recent runup in the market has been historic. And it seems that many people question the sustainability of the current price level. Do you think the rally is for real?

BUFFETT: What’s going to happen tomorrow, huh? [APPLAUSE] Let me give you an illustration. I bought my first stock in 1942. I was 11. I had been dillydallying up until then. I got serious. [LAUGHTER] What do you think the best year for the market has been since 1942? Best calendar year from 1942 to the present time. Well, there’s no reason for you to know the answer. The answer is 1954. In 1954, the Dow … dividends was up 50%. Now if you look at 1954, we were in a recession a good bit of that time. The recession started in July of ’53. Unemployment peaked in September of ’54. So until November of ’54 you hadn’t seen an uptick in the employment figure. And the unemployment figure more than doubled during that period. It was the best year there was for the market. So it’s a terrible mistake to look at what’s going on in the economy today and then decide whether to buy or sell stocks based on it. You should decide whether to buy or sell stocks based on how much you’re getting for your money, long-term value you’re getting for your money at any given time. And next week doesn’t make any difference because next week, next week is going to be a week further away. And the important thing is to have the right long-term outlook, evaluate the businesses you are buying. And then a terrible market or a terrible economy is your friend. I don’t care, in making a purchase of the Burlington Northern, I don’t care whether next week, or next month or even next year there is a big revival in car loadings or any of that sort of thing. A period like this gives me a chance to do things. It’s silly to wait. I wrote an article. If you wait until you see the robin, spring will be over.

These words jumped out at me in an instance. I dug for the data and confirmed that it was true that 1954 was the best year and that unemployment had more than doubled. It was indeed a messy time yet the equity market roared.

1953 1954
Jan 2.9 4.9
Feb 2.6 5.2
Mar 2.6 5.7
Apr 2.7 5.9
May 2.5 5.9
Jun 2.5 5.6
Jul 2.6 5.8
Aug 2.7 6.0
Sep 2.9 6.1
Oct 3.1 5.7
Nov 3.5 5.3
Dec 4.5 5.0
DJIA (%) -3.8 44
S&P (%) -1.0 52.6

This was especially telling since looking at the state of economy further out did not seem to matter. Evidently, the data speaks for itself. A prediction in macro scenarios even if turned out to be true or right may not translate into equity returns. Also, it means that even if the economy is to slow, equity returns need not have relation to the economy for awhile. Bottom up stock picking should still rule the day.

In particular, this is not to say that looking at macroeconomics is not useful. It is only that a reasoned approach should guide us forward. And in a rather contradictory note, Buffett previously spoke about his macro measure during the dot-com bubble.

He said,

The market value of all publicly traded securities as a percentage of the country’s business–that is, as a percentage of GNP… has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.”

Further, he said that,

“If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire.”

I replicated this measure similar to Gurufocus but with the addition of the OTC markets. My conservative estimation of the total market capitalization as a percentage of GNP stood around 139% to 146% for the most recent figures. The numbers speak for themselves in its scale and that the implications are plenty. Furthermore, valuations today are at where they are because of another major force: The Fed.

It is not without basis that monetary policy has indeed made an impact. At Sun Valley in 1999, Buffett presented a set of numbers in which Carol Loomis wrote in a fortune article (It can be found here). Again, I replicated and updated the numbers with the following.

Dec. 31, 1981: 875
Dec. 31, 1998: 9181.43
Aug. 3, 2014: 16493.37
1964-1981: 373%
1981-1998: 177%
1998-2014: 92%
Dec. 31, 1964: 4.20%
Dec. 31, 1981: 13.65%
Dec. 31, 1998: 5.09%
Aug. 3, 2014: 3.03%

And in the article, he was quoted as saying,

For the market to go dramatically up from where it was then would have required long-term interest rates to drop much further (which is always possible) or for there to be a major improvement in corporate profitability (which seemed, at the time, considerably less possible). If you take a look at a 50-year chart of after-tax profits as a percent of gross domestic product, you find that the rate normally falls between 4%—that was its neighborhood in the bad year of 1981, for example—and 6.5. For the rate to go above 6.5% is rare. In the very good profit years of 1999 and 2000, the rate was under 6% and this year it may well fall below 5%.

What the figures entail are important. For one, in today’s context, interest rates have been and rightfully should be a figure most watched after. At 3.03%, the interest rate is well below historical levels. Although lower interest rates for the long haul is possible, the odds are good that interest rates are going up when monetary policies change. Second, corporate profits after tax as a percent of GDP currently stands at 6.34%, nearly where Buffett calls “rare moments”. If this is true, there are two things that can happen. First, GDP goes higher thereby reducing the percentage worth. Or second, the more detrimental one, a slow down in corporate profitability.

Going forward, it is anyone’s game to predict where the numbers are heading. The numbers and simple angles that I offered above suggest a rather grim prospect for the concerned investor. In any case, it is still more of a macroeconomic prediction and would likely call for an unsound judgement should any decisions be based on these alone.

Certainly, at these valuation levels, it is wise to be well aware of it and proceed with caution and make investment adjustments to it, if any. Again, there is nothing wrong with being fully invested even in a very high market should a reasoned process of security analysis been followed. It all depends on one’s aptitude.




The importance of investment decision making should not be understated. Yet for investors both seasoned and amateurs, some have neglected in recognizing so. This is especially true when probabilities are confused with investment results.

Particularly, investment situations are broken into 4 categories:

i. Bought at probability: unfavourable, Outcome: unfavourable

ii. Bought at probability: favourable, Outcome: favourable

iii. Bought at probability: unfavourable, Outcome: favourable

iv. Bought at probability: favourable, Outcome: unfavourable

When an investment is bought, a set of probability weighted events affords the investor. These future events, which affects the value of a company, are ascribed an expected value by the investor for whom forms the basis of an investment decision. Some times, investments are bought at favourable probabilities, and other times, they are not. For instance, when a company is bought at $75m market cap for a $100m net cash position, many scenarios can happen. The company can start eroding cash through poor acquisition, spending in PP&E, expensing on R&D or the company can start growing that cash reserves through continued growth of the underlying business. Ultimately, it is the assessment of these probabilistic events that determines the investment success of the disciplined investor.

For categories (i) & (ii), outcomes simply justifies a fair scenario where investors are rewarded for their initial commitment of justified risks. Should an investor buy at an unfavourable probability, the outcome should be one of undesirability. Of course, the inverse is also true. However, these events do not always play out as expected in the interim.

Importantly under (iii), when investors buy at an unfavourable probability and are rewarded for it, luck may be mistaken for skills. These investment decisions, judged on the sole basis of results, are likely to impress upon investors their superiority in investing and security analysis. Over a period of relative prosperity, such behaviour is likely to be reinforced.

And to this thought, I recur to the old saying,

Even a broken clock is right twice a day

The result is one that perpetuates a risk-reward framework that is likely to be disastrous at the end.

Equally important under (iv), investors should not concern themselves too much when investments are bought at favourable odds but with undesirable outcomes. In fact, in any given situation, investors should recognize the role of luck. It may have been that low probability events that were considered initially played out as an outcome. It may even occur several times in a row, where the odds were slim but still plausible. These events, judged retrospectively as bad decisions, should not dissuade the investor in his risk-reward framework should initial probabilities are reasoned and correct.

Viewed from a third person perspective, the above categories seem fair and logical. However, what is not apparent is that we may very well fall under (iii) when our thoughts gears us towards (ii). Or that it may be (i) but we see our decisions as (iv). Since it is more likely (ii) and (iv) than (iii) and (ii), the investor often mistakenly stuck himself under these false precepts when results are the judges to our reasoning and skills. This is especially so when outcomes are clearly observable and probabilities are not. The framing bias in humans tends to seek these observable evidences as affirmation to our actions and deny us from realizing the true odds of events. Nevertheless, the problem of drawing such causality is that the results of an investor can be the work of careful analysis in a proper framework or one that is grounded on a flimsy speculative thesis or both.

To the honest, perceptible investor, probabilities and outcomes are always based on qualitative and quantitative judgement. For instance, 2 outstanding investments results over the long haul can be achieved through skilled risk management or sheer luck. Afterall you can always find a monkey that flip heads 32 times in a row in a world of 7 billion of them. When judged by results, both seemed equal, but the odds and risks are clearly different. Therefore whilst the quantitative outcome is laid bare, the qualitative probabilities is one that differentiates. We should then recognize the fallibility of assessing skills based on results examination.

To this end, I quote what Buffett said in India regarding insurance decision making,

You can’t judge by the outcome, you should judge by the probabilities going in.

Although he was referring to supercat insurance underwriting, this is especially telling when investment decision making are concerned. Chiefly, only informed and reasoned assessment of probabilities yields the disciplined investor results that are far superior and sustainable. Probabilities assessed this way are based on an understanding of economics, business, accounting, culture, psychology, law, history and many more. In particular, operating under such a framework is likely to work out reasonably well over time. Without such prudence on the part of the investor, an investment undertaking may very well be speculative. At the end, since probabilities are un-observable and subjective, it is important to know what you know and know what you don’t know. That is why investment management is a game of rationality and that is why it is an art not a science.

There are many ways to invest money. In value investing, there are 2 general ways. One is buying outstanding businesses at a fair price, the other is buying fair businesses at an outstanding price. Either ways, the price that you pay for the value that you get should be the key consideration in any stock purchase. And what we should constantly look out for is the very good returns on risks involved.

To get a clue on how it can be achieved, on 3 separate occasions, Warren Buffett was repeatedly quoted on being able to earn 50% per annum if he had a smaller amount of capital to manage. When asked how he’d achieve these returns, he replied:

On the 1999 Annual Meeting,

“I get together with about 60 people every couple years and get their expectations of returns. Of those investors, I think there’s a half dozen who could get those kinds of returns – but they’re only going to find those returns in small places.

I stumble onto those things occasionally but I’m not looking for them. I’m looking for things that Berkshire Hathaway can do.”

On a student visit in 2007,

“Attractive opportunities come from observing human behavior. In 1998, people behaved like frightened cavemen (referring to the Long Term Capital Management meltdown). People make their own opportunities. They will be frozen by fear, excited by greed and it doesn’t matter what their IQ, degrees etc is. Growth of 50% per year is with small capitalization, not large cap. The point is I got rich looking for stock with strong earnings.

The last 50 years weren’t unique. It’s just capitalizing on human behavior. It’s people that make opportunities when others are frozen by fear or excited by greed. Human behavior allows for success if you are able to detach yourself emotionally.

In 1951, I got out of school at 20 years old. At the time there were two publishers of stock information, Moody’s and Standards and Poor’s. I used Moody’s and went through every manual. I recently bought a copy of the 1951 Moody off of Amazon. On page 1433, there’s a stock you could have made some money on. The EPS was $29 and the Price Range was from $3-$21/share. On another page, there is a company that had an EPS of $29.5 and the price range was $27-28, 1x earnings. You can get rich finding things like this, things that aren’t written about.

A couple of years ago I got this investment guide on Korean stocks. I began looking through it. It felt like 1974 all over again. Look here at this company…Dae Han, I don’t know how you pronounce it, it’s a flour company. It earned 12,879 won previously. It currently had a book value of 200,000 won and was earning 18,000 won. It had traded as high as 43,000 and as low as 35,000 won. At the time, the current price was 40,000 or 2 times earnings. In 4 hours I had found 20 companies like this.

The point is nobody is going to tell you about these companies. There are no broker reports on Dae Han Flour Company. When you invest like this, you will make money. Sure 1 or 2 companies may turn out to be poor choices, but the others will more than make up for any losses. Not all of them will be good, but some will and those will make you rich. And this didn’t happen in 1932, this was in 2004! These opportunities will be there in the next 30 years. You’ll have streaks where you’ll find some bad companies and a few times where you’ll make money with everything that you do.

The Wall Street analysts are brilliant people; they are better at math, but we know more about human nature.

In your investing life you will have several opportunities and one or two that can’t go wrong. For example, in 1998 the NY fed offered a 30-year treasury bonds yielding less then the 29-½ year treasury bonds by 30 basis points. What happened was LTCM put a trade on at 10 basis points and it was a crowded trade, they were 100% certain to make money but they could not afford any hiccups. I know more about human nature; these were MIT grads, really smart guys, and they almost toppled the system with their highly leveraged trading.”

And lastly, on another student visit in 2005,

“Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50’s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.”

Here, there are several things worthy to note. First, such returns are achievable in today’s technology, age and competition in security analysis. Second, we as smaller guys are not comparatively less able to achieve superior returns as compared to the Wall Street Analysts. Thirdly, it is more of understanding human behaviour than on high IQ that counts one’s successes in investing and lastly, knowing more does not means earning more, it is the structural advantage of mis-priced assets that counts.

In a bid to having his question answered, Shai Dardashti even wrote a personal letter to Buffett. And in his reply to Shai Dardashti, he wrote that

a) Situations reminiscent of 1957 – akin to Daehan Flour Mills, (Buffett’s answer: Better for smaller sums)
b) Situations reminiscent of 1987 – akin to Moody’s Corporation? (Buffett’s answer: Better for bigger sums)

Therefore, in the following, I am going to present several methods of analysis in a) The Graham Approach.

Many have raised concerns about the validity of such an aged approach in security analysis. But precisely because it is aged, un-sexy and unpopular, this approach can and should continue to work well. To the uninitiated, the approach comes from buying businesses (often lousy ones) that are selling at far less than their intrinsic value

And as drawn from the replies of Warren Buffett, misunderstood investment comes from several areas. For one, they were present when many did not understand the securities involved. This was reminisce of the high yield bond and distressed debt era that marked the rise of value investors like the famed Howard Marks. In another, they can be uncovered from significant business insights that brought the rise of Berkshire Hathaway with Buffett’s deep understanding in competitive advantages of businesses like Moody’s and the yesteryear newspapers.

More relevant today, opportunities are abound in overlooked areas of smalls caps, OTC markets, insufficient understanding of accounting and human behavior. With that, I will leave one such example that I am currently having a position in.

Resolute Forest Products (RFP)

I bought the stock an average approximate price of $13.1 USD or about $1.2b and it is has dual listing on the Toronto Stock Exchange and the New York Stock Exchange.

Summary: Resolute Forest Products is a global leader in the forest products industry, operating pulp and paper mills and wood products facilities in the United States, Canada and South Korea, and power generation assets in Canada. It offers a diverse range of products, including newsprint, coated papers, specialty papers, market pulp and wood products.

Some negatives:

The newsprint and papers industry has been on a cyclical downturn ever since the financial crisis. Furthermore, it is on a secular decline with the advent of technology that replaces the use of papers.

It emerged out of bankruptcy in 2010 having suffered under a huge debt load that crumbled the company.

The case:

Precisely because of the cyclical and secular downturn, Resolute’s business has been selling at below its reported net book value of $2.5b (3Q 2013) for a while. Any smart investors would have figured such a company should be selling at below its book value since it may never turn a profit. Moreover, since income statement analysis is no good for such a poor business, the balance sheet should confer much insight into its intrinsic value.

In this way, line items are important to reviewing the value of the business.

As per 30th September 2013, the balance sheet is listed at:

Current assets: 2013
Cash and cash equivalents $271
Accounts receivable, net:
Trade $577
Other $127
Inventories, net $528
Assets held for sale
Deferred income tax assets $44
Other current assets $81
Total current assets $1,628
Fixed assets, net $2,330
Amortizable intangible assets, net $66
Deferred income tax assets $1,340
Other assets $191
Total assets $5,555
Liabilities and equity
Current liabilities:
Accounts payable and accrued liabilities $560
Current portion of long-term debt $7
Total current liabilities $567
Long-term debt, net of current portion $597
Pension and other postretirement benefit obligations $1,742
Deferred income tax liabilities $38
Other long-term liabilities $65
Total liabilities $3,009
Commitments and contingencies
Resolute Forest Products Inc. shareholders’ equity:
Common stock, $0.001 par value. 117.0 shares issued and 94.8 shares outstanding as of
December 31, 2012; 114.1 shares issued and 97.1 shares outstanding as of December 31,
Additional paid-in capital $3,749
Retained earnings -$589
Accumulated other comprehensive loss -$565
Treasury stock at cost -$61
Total Resolute Forest Products Inc. shareholders’ equity $2,534
Noncontrolling interests $12
Total equity $2,546
Total liabilities and equity $5,555

Of the items stated above, several large items are of excruciating importance in determining value.

First, deferred tax assets recorded a significant writedown of $615m from $1.9b as of 30th June, 2013 to $1.3b at end of 3Q due to the establishing of a full valuation allowance against the Resolute’s U.S. deferred income taxes.  These costs are associated with Resolute’s Mersey operations which had been indefinitely idled.

Going forward, if the business were maintain profits and be able to operate its existing mills, the deferred tax assets can be realized. Moreover, the fact that management had voluntarily written down $615m signalled integrity. Of the many listed companies out there, very few would have written down deferred tax assets. The odds are good that these assets will be realized through upturns in the business. It seems to be turning around the corner as of late.

Second, fixed assets are listed at $2.3b as of 3Q 2013. Because there was no breakdown, the most recent was from the 10-K filing for 2012. In it, several items were listed:

Land and land improvements $88m
Buildings $289m
Machinery and equipment $2,090m
Hydroelectric power plants $283m
Timber and timberlands $70m
Construction in progress $91m

Going for the big items, starting with land and buildings, valuation gets difficult here since local data about real estate prices are hard to find. Basically, Resolute has a total of 30 paper and saw mills that are located in Quebec (Canada), over US and Korea. Of these, 19 of those were located in Canada where real estate prices have rose steadily for the past few years. The link here is rather weak but the fact that prices have rose suggests the land are worth at least as much as book value. Taking note that several of these plants were left idle and that US real estate prices are recovering, a conservative approach of 80% book value should be applied.

A different story applies to the hydroelectric power plants because its value is contingent on the province of Quebec in renewing its water rights. The province had decided not go but had granted several extensions since 2011. Currently, the problem has been postponed to 1st March 2014. This amount was written down to a more recent figure of $90m.

Lastly, the largest component are machinery and equipment stated at around $2b. This is important because in a case of liquidation, the machinery and equipment may not be worth their book value. In fact, as I recall Buffett’s liquidation of Berkshire Hathaway, what was worth $866,000 of loom machinery was sold for $163,000, a 81% write down. That suggests one thing: machinery book value may deviate enormously from book values. However, as part of its fresh starting accounting after emerging from bankruptcy, Resolute had accounted fixed assets to be worth at $2.6b in 2010. In such a scenario where fair value were assigned on assets after the emergence, it would be a fairly accurate picture of these items. To be safe, I suggest writing down these assets by 20%, to account for the deterioration in value through 2014. Adjusting for the figures yielded:

Fixed Assets   Book Adjust Value
Land and land improvements $88m 80% $70.4m
Buildings $289m 80% $231.2m
Machinery and equipment $2,090m 80% $1,672m
Hydroelectric power plants $283m $90m
Timber and timberlands $70m 80% $56m
Construction in progress $91m 100% $91m
Total         $2,210.6m

Lastly, on the liabilities side, the single most important thing in the analysis is the pension obligation.

Listed on the balance sheet was:

Pension and other postretirement benefit obligations $1,742

For starters, the funded status presents net obligations/assets of a company. These numbers sometimes get fudged by management’s unreasonable estimates of return on assets and discount rates. While actual return on assets get smoothed out over time, discount rates can prove to be an illusion for awhile. However, there are opportunities that can be found here.

On the usual scenario, balance sheet pension and other post-employment benefit obligations that are calculated using U.S. GAAP are reevaluated only annually in the fourth quarter. In determining the size of such obligation, the principal determining factor is the interest rates. As you might know, interest rates have been have been at historical lows due to the continued quantitative easing by the Federal Reserve. In this case, low interest rates meant there is a likely scenario where the obligations are not discounted fairly to its prevent value.

Under the accounting rules, discount rates are required to be either the entity’s long-term investment yield on assets, if the benefit plan is being funded, or other long-term assumptions such as Treasury borrowing rates for securities of similar maturity to
the period over which the payments are to be made. Some entities interpreted the standard with respect to other post-employment benefits (OPEB) to require the use of single-day Treasury rates for the discount rates. Single-day rates render liability projections susceptible to more volatility than rates based on long-term expectations or historical experience and it is this latter idea that is relevant in Resolute’s case.

Based on Resolute’s 2012 10-K filing, assumption for interest rates was a decrease from 4.9% as of Dec 31, 2011 to 4.3% as of Dec 31, 2012, reflecting the lower interest rate through out 2012. The company uses a hypothetical high quality bond portfolio to gauge this measure. The important thing here is that over time, such an assumption lies on a very conservative side, especially against the unusual low interest rate environment. In a very likely scenario, the artificially low interest rates are not sustainable and will likely result in higher interest rates given the reversal in summer over tapering of monetary policy. Accordingly, when these rates rise, the discount rate of Resolute’s should rise as well.  Resolute offered 2 clues on this end:

1) In the 2012 10-K filing, the company stated that: A 25 bps increase will result in a reduction of $188m net pension and OPEB benefit obligation.

2) Because the discount rates are changed only at year end (therefore not reflective of current environment), CFO Lo-Ann Longworth illustrated in Q3 earnings call that if Resolute applies a discount rate that reflects the prevailing interest as of September 30, “we would expect balance sheet, net pension and OPEB obligation to fall by another $ 400 million compared to the amount reported as of September 30, 2013.”

Therefore, because of the way in which Resolute account for its discount rate, net pension and OPEB obligation is overstated, resulting in a seemingly indebted funded status. Moreover as interest rates have fallen somewhat from September through December, net pension and OPEB obligations should be reduced by the stated $400m to $1,342m on a current basis. However, as per the accounting rules, discount rate should objectively reflect the long term basis for time value of money. This measure of discount rate should rightly be in the region of 6%. To get a rough idea of the reduction, when I apply against Point 1), net pension and OPEB obligation should be adjusted by a rough [(6%-4.3%)/0.25%*$188m] = $1,278m, leaving net pension obligation to be around $1,742m – $1,278m = $463m. This is the main part of the value thesis.

And lastly, it is necessary to account for off balance sheet liabilities. In this case, contractual out of balance sheet purchase obligation and operating leases totaling $300m as of Dec, 2012 should be reflected in the balance sheet.

To sum up, in a updated value scenario, the balance sheet should be:

Assets Sept 2013
Current assets: Liquidate Adj. Value
Cash and cash equivalents $271 100% $271
Accounts receivable, net: $0
Trade $577 80% $462
Other $127 100% $127
Inventories, net $528 50% $264
Assets held for sale $0
Deferred income tax assets $44 100% $44
Other current assets $81 100% $81
Total current assets  $1,628 $1,249
Fixed assets, net $2,330 Adj. $2,211
Amortizable intangible assets, net $66 0% $0
Deferred income tax assets $1,340 80% $1,072
Other assets $191 100% $191
Total assets $5,555 $4,723
Liabilities and equity        
Current liabilities:
Accounts payable and accrued liabilities $560 100% $560
Current portion of long-term debt $7 100% $7
Total current liabilities $567 100% $567
Long-term debt, net of current portion $597 100% $597
Pension and other postretirement benefit obligations $1,742 Adj. $463
Deferred income tax liabilities $38 100% $38
Other long-term liabilities $65 100% $65
Total liabilities    $3,009   $2,297
Additional purchase obligation and operating leases   $300

And at my initial purchase price of about $13, the total value brings:

Share Price $13.00 Per Share
Shares Outstanding 94.48 Million
Market Cap $1,228.24 Million
Reported Net Value $2,546
Adj Net Value $2,126
Adj. Upside 73.06%

Essentially, the position is a long on asset/price disparity and a long call option on interest rate with no expiry date. Buying this business at $1.2b affords the investor a comfortable margin of safety with possibly hidden real estate assets, a long call on interest rates thrown in and a recovering business. There are many value hunts like these and no one is going to tell us. It requires much digging in obscure places which demands a lot of time from the intelligent investor. Therefore, it is the tenacity and hardwork that counts.

This example is one of many ways to invest with a value framework (The Gramham Approach). Additionally, I have included here a collection of MSN articles written by Michael Burry that are of a different nature in terms of using a value framework. For your enjoyment, see Michael Burry’s case studies.

Dear Readers,

The equities market has performed superbly for the several years now and when things are looking rosy, we should hold our wallets tight. As Warren Buffett says, “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” Hence, we should be prudent in our analysis to guide us in the near term ahead.

A Short Market History

S&P 500




















Total Return



For the past 5 years, the stock market has not registered a single down year. A further look into 100 years of history saw that the last time the stock market achieved gains on a more than 5 years rolling basis was during the years 1981 – 1988, an 8-year period . The only second period was during the post-war period of 1947 – 1952, a 6-year period. With ours going into the 6th inning, I wonder if the several years ahead can be just as good.

Of course, I am not predicting a down year ahead. Reasons being, the US economy had fallen of the cliff during the financial crisis of 2007-2008 and the S&P 500 had fallen 38.49% during 2008, so we are actually still coming off from a very low base. Secondly, value investing is more a bottom up approach and that being macro agnostic has generally be proven to be sufficient for successful investing. Yes, the performance and valuation of the general economy should provide some hints but they are never imperative in picking value stocks. Thirdly, macroeconomic forecasting is fraught with problems and that no one expert has ever predicted anything many times in a row.

For the year ahead, many market experts have pronounced a very bright future ahead. One equity strategist from J.P. Morgan even goes so far as to claim that the S&P 500 has a one-in-three chance to be up 30% again in 2014. The problem here is that no one has ever measure these expert’s views and that certainly no one has counted how many “views” these experts have made (If you give me 10,000 tries, I would bound to have been right at least once.)

However, it is not to say I am generally pessimistic of the world and the US economy. The US economy has came back steadily and I am generally optimistic about human efforts to succeed and build a better world. It is just that I am agnostic to the forward looking views of the world, optimistic or not. In fact, I normally take a contrarian thought to prevailing perspective especially against the backdrop of bullishness in the markets. Complacency builds bubbles. And with this, I would like to sound out a little caution.

Market Valuation

What I would address here is on equities and their current valuation. In doing so, it would be most appropriate to compare yields that equities currently afford to risk free assets (US Government Treasuries). As dividend yields for stocks only account for the cash paid out to shareowners, taking earnings yields would be more representative of the stock market’s earnings potential for prevailing prices. Earnings yield therefore is the ratio of earnings to price, the opposite of Price / Earnings ratio. Therefore, it is not unreasonable to compare it against the yield on US treasuries keeping in mind that the market has factored in a certain growth rate for its earnings yield. What every investor should ask correspondingly is, “What premium, if any, should I ask for from the stock market, if I can earn a certain risk free rate from a US government treasury bond, assuming earnings will increase by X?” Obviously, it doesn’t get answered all the time. An examination into history will aid us.

During the post WW-II, earnings yield for the stock market was 6.25%, a Price / Earnings ratio of 16x. Think of this as the amount of dollars accrued to you, as a shareholder, payable now or in the future (depending on management). The then risk free asset was in the region of 2.3%. Meaning that you could have invested in 10-Year US Government Bonds and get a virtually risk free interest rate of 2.3% interest payment. The Singapore equivalent is a SGS bond, guaranteed by our government and AAA rated too. The only difference is that the US Bonds are the real risk free bonds, although it has been called into question lately, and is still by far the safest financial instrument in the world (We will reserve the debate of sovereign debt for some other day). Here, the equity risk premium is 6.25% – 2.3% = 3.95% and a ratio of 6.25% / 2.3% = 2.71x shows the additional yield the stock market compensate investors as a whole to take on additional risk in the S&P 500 companies.

Whereas at the height of the dot-com bubble in 2000, the Price / Earnings ratio of S&P 500 was 32, a mere 3.1% earnings yield. The risk free interest rate was then a head scratching 6.2%. These gives us an equity risk premium of 3.1% – 6.2% = -3.1% or a ratio of 3.1% / 6.2% = 0.5, which should have raised eye brows now and then. What this implies is that the stock market had factored in so much of growth then, that it was willing to forgo a 6.2% guaranteed yield on a US treasury bond to buy into the dream of a 3.1% earnings yield that is believed to rise substantially. And we all know how the party ended.

Today, at a Price / Earnings ratio of a nice 20, the earnings yield is at 5% and the 10-year treasury is at 3.04%. That gives us an equity risk premium of 1.96% ( 5% – 3.04%) and a ratio of 1.64. A summary is shown in the following:

Post WW-II 2000 Today
Yield Differential 395 bps -310 bps 196 bps
Yield Ratio 2.71 0.5 1.64

Evidently, the yield comparison suggests the current valuation to be in the zone of reasonableness. It does not seem to suggest anywhere near the lofty heights of the dot com bubble nor at the beginning of a bull run. Is this the whole story? Nope, definitely not that simple, especially in the world of investing. Any good investor would point out that such comparison is fraught with risks and that there are dangers of taking mathematics to single-handedly guide investment principles. As Einstein says it right, “What can be counted don’t always count, what counts can’t always be counted.”

To conclude: baring in mind these risks however, we can only take such calculation as a guide. A relevant overhang in the current valuation is the unusual low interest rates that are (1) unsustainable due to major central banks’ efforts in their monetary policy, (2) at some point in the future, will need to increase considerably and (3) correspondingly, rendering lower valuation of stocks since the higher the interest rates go, the less value future cash flows are afforded to us in the present. That said, earnings are steadily growing in the economy and could warrant higher valuations.

The Most Important Thing is the phrase Howard Marks loves and has even published a book with the exact title. To the intelligent investor, what then should the single most important thing about investing and business be?

Warren Buffett shed some light into this thinking during the Financial Crisis Inquiry Commission interview in which he was subpoenaed for. This transcript, courtesy of the Santangel’s Review, fascinated me. On the first page, when asked about the due diligence he made on his stock purchase of Dun & Bradstreet, the legacy parent company of Moody’s corporation, he answered:

“And basically the single most important decision in evaluating a business is pricing power. You’ve got the power to raise prices without losing business to a competitor, and you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent (laughs), then you got a terrible business. And I’ve been in both and I know the difference”

A further analysis should follow. Consider this:

Example 1
Company Change
Sales $1,000 $1,050 5.00%
Total Cost $900 $945 5.00%
Net Margin 10.00% 10.00%
Net Income $100 $105 5.00%

Example 1 shows a company that has achieved incremental sales of 5%, mainly driven by an increase in volume growth. Assuming operating costs were to increase at a proportionate amount (which is not unreasonable to assume without economies of scale), the company would have had a 5% increase in annual profits.

Contrast this scenario with Example 2.

Example 2
Company Change
Sales 1000 1050 5.00%
Total Cost 900 936 4.00%
Net Margin 10.00% 10.86%
Net Income 100 114 14.00%

Let’s just say that a similar company is able to both sell a lower incremental volume of only 4% coupled with a 1% increase in prices, the result would have been a stark contrast to that of Example 1. Example 2, although only managing 4% more volume, would have been able to hit a 14% increase in earnings solely due to this small display of pricing power.

Therefore, this is needless to say, one of the many important lessons in business. As a business owner, an increment in volume sales is important. However, some day, markets get saturated and volume sales may or may not stagnant for the years ahead. This is especially true in developed countries where matured demographics and low growth environment do not bode well with large volume growth in businesses.

Adding on to the fact that assuming a business has no economies of scale, an increase in volume sales would require additional investment in infrastructure, marketing, distribution and personnel, resulting with a somewhat similar increase in operating costs and expenses. Therefore, the upside to owner’s earnings would likely be limited.

In a scenario where a business has pricing potential, the results are different. An incremental increase in prices would have a perfect flow through right down to an owner’s earnings, as showcased in the examples above. This increased price would not require much expenses incurred beyond the usual menu prices.

Obviously, to the skeptical reader, it should rightfully arose the question: Are there even such businesses around? There are some and the following are the operating numbers for one of them.

Ended About
52-53 Week Year Operating Sales Operating Profits After Taxes Number of Pounds of Candy Sold Price per Pound
31st Dec
1983 (53 weeks) … $133,531,000 $13,699,000 24,651,000 $5.42
1982 ………….. $123,662,000 $11,875,000 24,216,000 $5.11
1981 ………….. $112,578,000 $10,779,000 24,052,000 $4.68
1980 ………….. $97,715,000 $7,547,000 24,065,000 $4.06
1979 ………….. $87,314,000 $6,330,000 23,985,000 $3.64
1978 ………….. $73,653,000 $6,178,000 22,407,000 $3.29
1977 ………….. $62,886,000 $6,154,000 20,921,000 $3.01
1976 (53 weeks) … $56,333,000 $5,569,000 20,553,000 $2.74
1975 ………….. $50,492,000 $5,132,000 19,134,000 $2.64
1974 ………….. $41,248,000 $3,021,000 17,883,000 $2.31
1973 ………….. $35,050,000 $1,940,000 17,813,000 $1.97
1972 ………….. $31,337,000 $2,083,000 16,954,000 $1.85

During a roughly 11 years period, inclusive of 2 recessions, the business managed to triple its prices. To the skilled eye, the nature of the product would have given it away. The business is no fancy product and does not incorporate ground break technology. In fact, this candy business is named See’s Candies, one of the wholly owned subsidiary of Berkshire Hathaway. Warren Buffett has widely used this subsidiary as an example of a great business. More on See’s Candies some other day.

Granted, there are very few businesses out there that have similar characteristics and that if there were to be, they are seldom sold cheap.

Also, I need to stress that an investment in one such company does not guarantee the exponential growth in pricing especially when management does not realize the product’s pricing potential. This is more so of a problem if an investor can not exercise its discretion into the day to day management of the business.

That said, this is the most important thing to an investor in evaluating businesses. Where the strong you feel about a business being able to price higher amidst competition, regulation and consumer demand, the better the business you have at hand.

Investing is about deploying capital for its best use. At any one point in time, the sophisticated investor should ask whether a dollar invested in a certain prospect is better allocated else where. This is applies similarly to the management of a company, for what he does with the dollars matters a great deal, especially to the long term investor.

Assuming you have invested all your cash in stocks. What are you to do when stock prices tumble? The salvation: Stock Buyback. A stock buyback is one the many ways a company can deploy capital to provide value to the shareholder. We examine here a simple scenario.

Suppose you bought stocks of Company A for $1,000 at the following:

Stock Price: $100
Shares Bought: 10
Company A has:
Net Tangible Assets: $2,000
Earnings (2013): $300
Shares Outstanding: 20
Earnings / Share: $15
You own:
Ownership of Company: 50%
Share of earnings: $150

Then in 2014, the average Stock Price rose to $300 and the company decides to buy back shares with last year’s earnings:

Company A has:
Net Tangible Assets: $2,000 (Since the previous $300 was spent buying back shares)
Earnings (2013): $300
Shares Outstanding: 19 (Spent $300 to buy back 1 share)
Earnings / Share: $15.79 ($300 / 19 Shares)
You own:
Ownership of Company: 52.6% (10 / 19 shares)
Share of earnings: $157.9

However, imagine that the Stock Price tumbled to $50 and the company buys back shares with the same amount:

Company A has:
Net Tangible Assets: $2,000 (Since the previous $300 was spent buying back shares)
Earnings (2013): $300
Shares Outstanding: 14 (Spent $300 to buy back 6 shares)
Earnings / Share: $21.43 ($300 / 14 Shares)
You own:
Ownership of Company: 71.49% (10 / 14 shares)
Share of earnings: $214.3

Firstly, make no mistake, you would have suffered when the stock price tripled to $300 instead of when it tumbled to $50. Even though you have spent $0, earnings that are rightfully yours have only grown to $157.9 instead of $214.3, a marked difference. Also, note that this was when normalized earnings remained flat. Clearly, the frequently quoted common sense is not so common. Most investors take comfort when price surges, I, however, take greater comfort when they swoon.

Second and more importantly, it gets back to my point on capital allocation. The management of a company can decide on the value owed to you simply by way of spending the dollars even as the business fundamentals remain the same. Apart from the normal operating of the business, a management can decide how and when to spend the excess cash, from investment in infrastructure, M&A activities, share buybacks, dividends to letting it pile up in the coffers. How this money is spent means worlds to the investor and therefore,  evaluating management is crucial in the investment analysis.

This motivation for stock buybacks was strongly expounded by Warren Buffett in his 1980 Annual Report:

” One usage of retained earnings we often greet with special enthusiasm when practiced by
companies in which we have an investment interest is repurchase of their own shares. The
reasoning is simple: if a fine business is selling in the marketplace for far less than intrinsic
value, what more certain or more profitable utilization of capital can there be than significant
enlargement of the interests of all owners at that bargain price? “

And the crème de la crème of such practices was accomplished by none other than Henry Singleton, who Buffett says “has the best operating and capital deployment record in American business.” For your necessary reading: The following are the major publicly available readings on Henry Singleton.






Cooperman_on_Singleton_Teledyne_against BW

Also, an out of print book: Distant Force: A Memoir of the Teledyne Corporation and the Man Who Created It

These readings necessitate several things: The deployment of capital as a subset of investment and business management, the type & quality of business to buy and manage in this process, the horizon and metrics over which an interested investor is to judge a management’s performance and last of all, how management plays a crucial and imperative part in the investment process.

A new read on capital deployment also can be found here: The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success

A word of caution must ensue. Stock buy backs were virtually unheard of 30-40 years back. In those years, they were even heavily criticized as a surrendering posture of management not being able to grow their business. In recent years, the opposite was observed. Virtually every major listed company in the US has gone on large stock buy backs to “maximize shareholder value”. While such activity should have been a positive proposition, the careful investor should be more of a skeptic. Many of these management trumpeted the idea in a bid to foster investor awareness, but many of them were in actual fact, value destroying.

Alas, the prudent investor should not only look for records of buybacks but to ask for the management’s motivation behind it. Only shares repurchased at below its intrinsic value is value enhancing. A more contrasting scenario is prevalent these days where  management tries to buy back dilutive share options awarded to management and employees. This false premise should raise concerns and affords thinking harder about the management accordingly.

“Price is what you pay, value is what you get”       Warren E. Buffett


Investing is simply laying out money today in hopes of getting more in the future. Therefore, there is an essential difference in the definition of investing and speculating. Simply put, when money is deployed in a certain prospect after a disciplined analytical research, the process shall be deemed as investing. Whereas for the latter, money is deployed without this due process.

That said, it is not always clear which is which, especially to the ones that know not what they know not.

However, it is instructive if we just learn from the best and the basic tenets of investing have been popularized by him for many years. He is the greatest investor of our time, Mr Warren Buffett. I will first reiterate this guiding philosophy that will be central to the ideas and thoughts discussed further in the future posts.

Rule No. 1: Never lose money

Rule No. 2: Never forget rule No. 1

However, some clarification is needed. What it means by never losing money should not be construed as short term quotational loss but as the permanent loss of capital. There is a difference, and that stems from how one should view the market.

The Stock Market

For those of you who are unfamiliar, stocks or shares are financial instruments issued by companies when they need capital for their many activities. When you own a stock of a company, you own a piece of the business. The quoted stock prices on the stock exchange are the bid/ask prices to which we can buy/sell a piece of a company at. Sometimes, these prices reflect the true worth of a company, while in others, they reflect significant deviation from its intrinsic value. This is what is defined as short term quotational loss. In the long term however, prices should reflect the intrinsic value of businesses.

Benjamin Graham, the father of value investing, first laid out the principle 6 decades ago on how to think about the market. The view takes the stock market as the metaphor of a schizophrenic Mr Market. On one day, when he’s happy, he offers an asset at prices excruciatingly cheap and on another, he offers prices so high it can churn your stomach. Indeed, I hold this analogy dearly to my heart to make the market serve and not to instruct me. Also, it is to this irrationality in the financial markets that I seek to profit from it. I have attached a 1955 Stock Market Study during the hearings of the 84th US Congress with Benjamin Graham on factors affecting the buying and selling of equity securities for your further reading.

Taking Risks

In academia and major institutions around the world, risk is defined as standard deviation from the mean or semi-variance, which measures the downside deviation. These definition of risks in equity investment therefore only takes on a mathematical bent in terms of its volatility. However, many of these institutions understood it poorly to define risks in a figure that inherently makes little sense. Since financial markets can get volatile with computer trading, reaction by gross human emotions and fraught analytical process, the changes in prices provides little to no value in ascribing risks inherent in an investment.

As in the Mr Market analogy mentioned earlier, consider an apple with the same quality selling for $1 today and $0.50 tomorrow. If this was a company with a listed stock price, academics and many in the financial world would have defined this company as riskier. This makes little sense because when something gets cheaper, you buy more, because its lesser of a risk. However, this parable does not seem to resonate in the financial world as much.

As a matter of fact, risks should be viewed as the possible degradation in the value of a business. These are governed by the myriad issues that plague businesses, including but not limited to, regulation, litigation, incompetent managers, corporate blunders and chief among them, competition. Therefore, in investing, the price that you pay should guard against these risks.

Margin of Safety

The best way to guard is also laid out by Benjamin Graham in his seminal book, The Intelligent Investor. In Chapter 20, Benjamin Graham stressed the need for a margin of safety in the investments we make. The need of buying an asset at a discount to its intrinsic value, the deeper the discount, the better. It is instructive here that one should require such a margin in his investment endeavors to guard against the risks that I stated above and the misinformation that may exist.

Consider this: When you buy a company that is worth 2X but selling at X, you are buying at a margin of safety. It is also to this concept that we see gains accrued in investments. Should the company remain at the value of 2X for 4 years, prices should some day reflect a value of around 2X. However, you have also guarded yourself against risks if the company were to incur losses of a cumulative X. Prices then should reflect at X, which was the price you paid, rendering no losses on your side by virtue of the margin of safety required.

In conclusion, the tenets to investing is very simple. However, it is by no means easy. Investing requires among other things, temperament, rationality, investigative mind, skepticism, keen interest in business, hard work and all the necessary business skills that you can master. My future posts will show these in detail.

I have attached Benjamin Graham’s lectures presented at the New York Institute of Finance from September 1946 to February 1947 for your interest: The Rediscovered Benjamin Graham Selected Writings of the Wall Street Legend by Janet Lowe.

Also, if you may wonder if these aged concepts still apply today, here is a study by Tweedy, Browne company, formed by the previous students of Benjamin Graham: What Has Worked In Investing by Tweed Browne.

Please feel free to drop some feedback.