Financial Reference

I have never been good about timing the market. My recent posts, buy financial companies and sell UEC (Uranium Energy Corp) have not performed as expected so far. (It has only been a couple weeks so far.)

Financial companies have continued to feel pressure from the mortgage crisis prompting further selling. This has only made these companies cheaper. Before they were on sale; now, it’s closer to a liquidation sale. I will continue to invest in this area.

My recent recommendation to short UEC based on the fact that they have no revenues, are losing money hand over fist, and will likely continue this pattern for the next year or so, has also not performed as expected yet. The stock is slightly higher than where I sold it short.

Again, I am not changing my opinion. UEC’s board recently approved an increase in pay for the CEO, despite posting record losses over the last year. I still believe the company will continue to bleed red and will continue to reward executives — at the expense of shareholders — despite the lack of performance.

In the long run, we will see whether my current valuations are correct. In the meantime, I’ll continue to reflect on my uncanny ability to mistime the markets. Of course, in the end, I’d much rather mistime than misvalue.

This should be my last post regarding the book “Value Investing Today” by Charles Brandes. I think I’ve already given the book too much coverage, but I couldn’t pass up writing about this last screening variable.

According to Brandes, value investors should not invest in a company if the “earnings yield is less than twice current long-term (20 year) AAA bond yields.” (The earnings yield is simply earnings/price — the inverted P/E ratio.)

Presumably, if an investor pays more than two times current bond yields, he would be better off buying bonds. The rule, like many others, sets an arbitrary limit without justification.

Let’s take a look at what this rule means in the current market environment. As of today, 20-year AAA bonds are yielding 5.71%. Using Brandes’ math, we should only look for companies with an earnings yield of 11.42% or higher. Putting this into more familiar terms, we should only be investing in companies with a P/E ratio under 8.76!

This is, needless to say, hard to do.

This rule is ridiculously out of date. It reminds me of companies Graham and Dodd wrote about in “Security Analysis.” Companies that were reasonably profitable and could be bought for less than their liquid assets. These companies are harder to come by today.

A P/E ratio lower than 8.76 is almost always associated with operational difficulties or the end of an economic cycle. If you screen on such a low P/E ratio today, you will likely find many mortgage finance firms, some oil companies, and a few firms that recently reported unusually large non-operating gains.

If you want to find good long-term investments, you would be better of raising the P/E ratio of the screen and adding a return on equity/investment variable to weed out weak operators. While you will still have to sift through many dogs, you will raise your chances of investing in a good company.

This is one of the best times to be an investor if you can just get over the psychological inconvenience of recent losses.

The third quarter earnings season has been a disappointment to say the least. Banks are taking huge charges related to the real estate mess. Even financial companies that are not normally associated with banking, such as E*Trade Financial, have been hit hard by mortgage write-downs.

The cause of the mortgage write-downs is of course the collapse of the real estate bubble. The probability of default has increased across the board, but especially for more exotic, hard to value securities. Even large companies are struggling to value some of these securities — see, for example, Merrill Lynch’s recent restatement.

The fact that the liabilities are hard to value is creating uncertainty and apprehension in the financial arena as no one knows who is going to be hit next. Consequently, everyone with any exposure is on sale. If you are able to ignore headlines, and hold a security for the long term, start allocating more capital to financial companies. You almost can’t go wrong buying any large bank or investment bank in the current environment.

Given a choice, investing in a non-financial company that uses little debt is much better than investing in one that uses debt extensively. But it’s hard to create a simple rule for the amount of debt a company should use.

In Brandes’ book, “Value Investing Today” he uses a general rule of not investing if the level of debt is greater than 100% of tangible equity. Like any other rule with regard to the correct level of debt, this rule is a huge oversimplification.

First, financial companies use a tremendous amount of debt in their operations and should be evaluated against a much different target. The industry in which the company operates matters a great deal when evaluating the debt level of a company.

Second, tangible equity is an accounting idea only. It does not reflect the actual value of the company. The value of debt should be compared to the value of equity which is better reflected by market values than accounting values.

Third, debt should be adjusted for other debt items not reported as debt on the balance sheet. Capital leases and net pension liabilities, for example, should be added to the debt on the balance sheet to get a more realistic estimate of a companies debt level.

While the level of the debt used by a company in it’s operations should be closely evaluated because debt adds risk and can disguise low returns from operations, the evaluation of a companies debt level should involve more than a quick glance at their balance sheet.

This post continues a discussion of the screening criteria in Brandes’ book “Value Investing Today.” His third screeening criteria (I’ll get to the second in a later post) is that tangible book value is above share price.

This criteria is old-school Graham and Dodd. Not even hard-core value investors like Warren Buffett follow this criteria anymore.

There are a couple reasons for this transition. First, companies selling for less than book are harder to find today — not impossible — but harder. Second, most of the companies selling for less than book today either have some losses coming or have an overstated book value. Third, and most importantly, companies selling below book value are likely to have lower returns on capital.

In other words, screening based on book value can find companies selling at a great price, but it also likely to find mediocre companies. Companies selling below book value are likely to be companies with low returns on capital.

One of the major reasons for this is that great companies often have large intangible assets in their brand names. For example, you will likely never see the classic Buffett investment Coke selling anywhere near book since most of the value of the company is intangible.

Paraphrasing Buffett, I would rather own a great company at a good price, than a good company at a great price.

Finally, I found a short: Uranium Energy Corp (UEC). UEC owns some land is currently doing surveys to find uranium deposits. While uranium has a great future, this fact is already reflected in the high valuations of nuclear power-related companies.

UEC has a market cap of $140 million. But they have no revenues and lose about $5 million per quarter.

They support their operation by diluting current shareholders. And will continue to dilute current shareholders as there are no revenues imminent.

If they have a large uranium find, they might survive for the long-term. More likely, they will be lucky to survive they way they dilute the value of the company to support management.

But don’t take my word for it. In their own words, as filed with the S.E.C.:

“WE HAVE A HISTORY OF OPERATING LOSSES AND THERE CAN BE NO ASSURANCES WE WILL BE PROFITABLE IN THE FUTURE.

We have a history of operating losses, expect to continue to incur losses, and may never be profitable, and we must be considered to be in the exploration stage. Further, we have been dependent on sales of our equity securities and debt financing to meet our cash requirements. We have incurred losses totaling approximately $16,969,779 from May 16, 2003 (inception) to December 31, 2006. As of December 31, 2006, we had an accumulated deficit of $16,969,779 and had incurred losses of approximately $14,818,318 during the fiscal year ended December 31, 2006. Further, we do not expect positive cash flow from operations in the near term. There is no assurance that actual cash requirements will not exceed our estimates. In particular, additional capital may be required in the event that: (i) the costs to acquire additional uranium exploration claims are more than we currently anticipate; (ii) exploration and or future potential mining costs for additional claims increase beyond our expectations; or (iii) we encounter greater costs associated with general and administrative expenses or offering costs.”

But don’t worry about the management. They have sweet contracts. In the same SEC filing, you can see that the CEO is paying himself a generous salary ($510,000 including bonus and options) for a company with revenues of $0.

Unless they stumble across a huge uranium find, the company is worth far less than the $140 million. This is especially true when you consider how well the management will compensate themselves if they happen to get lucky.

Disclosure: As you may have guessed, I am short the stock. As always, perform your own research before making investment decisions as even good investors can be wrong much of the time.

I was just reading “Value Investing Today,” a book by the Forbes 400 member, Charles Brandes and I had a couple thoughts. I realize it’s way too early (5:15) to be up, let alone reading and having thoughts, but here they are.

In the book, he details a list of characteristics by which an aspiring value investor should screen. Although he does say that one or more of the criteria can be waived in certain circumstances, I take issue with some of the criteria he uses. Of course, I’m not the billionaire, so you’ll have to make your own judgment.

One of the criterion he uses is that the company should not have any losses for the last past 5 years. The problem with that is that there are many circumstances in which you would want to buy something with recent one-time losses. In fact many of my best performers have fit this criterion.

For example, I invested in both BLX and AES back in 2003. BLX is a Latin American bank that had just written off a large portion of its loans due to the Argentinian financial crisis. AES is an international power company that wrote off a large portion of its assets during some volatile times when some of its hedges broke.

The reason both of these companies survived was (1) losses due to write-downs are usually short-lived, (2) both companies were producing positive cash flow from operations before, during, and after their respective crises.

If you are looking at companies with recent losses make sure that the losses are probably short term and the company is still producing positive cash flow from operations. Or, of course, you could listen to someone who invested his way on to the Forbes 400.

Free markets are great, in theory. In practice, they are much closer to good.

The idea is that free markets allow people to advance their own self-interest, which in turn advances society at large. While this theory is oft-quoted and works better than other systems we have come up with, the truth is more complicated.

Free markets do not form in isolation. A series of laws creates the market. These laws can act as constraints or can encourage inefficient outcomes.

For example, making one form of compensation tax deductible (or off-balance sheet) in the case of base compensation under $1 million (or stock options) can create sub-optimal compensation schemes. These two pieces of the tax code encourage the use of options and discourage high base salaries. In other words, the equilibrium reached in such a market may not be optimal.

Recently, I experienced firsthand a law that created some perverse incentives. I was in Minneapolis this weekend for a wedding. The rehearsal was supposed to last until 3:45 but ended up lasting until 4:10. The problem was that my parking spot was only legal until 4:00.

As my pregnant wife walked out to our car with our son, a tow truck driver looked at them as they tried to stop him and drove away. My son’s car seat, diapers, and medicine were in the car. Needless to say, this was a costly inconvenience for us and could have been much worse. All because we were parked in a spot ten minutes over the limit!

After talking to the towing company, other stranded motorists at the impound lot, and the workers at the impound lot I pieced together the problem. Tow companies are paid based on the volume of cars they bring to the impound lot and they can only tow a car once a ticket has been issued. At least three of us stranded at the impound lot, including me, received a ticket and got towed within ten minutes.

It’s obvious what is going on here: Tow companies are following around ticketing officers and loading as many cars as they can as fast as they can. But do we really want people to be towed if they are parked ten minutes over the legal limit? It seems to me that the punishment does not fit the crime.

The problem is that the incentives created are encouraging an inefficient process. First, extra resources are wasted by creating excessively large towing and impound industries. Second, the people without cars have to find a way to reach the impound lot. Third, had my wife not seen the tow truck I probably would have wasted police resources assuming my car was stolen.

In short, it more efficient for people to be ticketed for minor violations of the law. Confiscation of property should be reserved for gross misconduct. In English, if you outstay your legal rights by a couple minutes you should receive a slap on the wrist; if you blatantly disregard the law, then other more dramatic remedies may be useful.

It is easy to see how this market, created by a legal structure, is far from optimal.

It’s surprising to think that people think that the markets are efficient. After all the bubbles and crashes, all the fortunes won and lost, people still think one security is as good as the next.

If markets are efficient, then there should be no excess returns. That is, after adjusting for risk, every stock should have the same expected return. The problem is, they don’t.

Usually, people try to disprove this theory by finding people who beat the market. While those people can be found, it is more instructive to look at the ones that fail. If markets were efficient people should get the same risk-adjusted return before transaction costs and taxes. However, that’s not what we see.

People have a tendency to buy high and sell low. The returns people earn on their investments often trail the return they would earn by not trying to time the market by even more than transaction costs would suggest.