MSCI: A Spinoff Story

Spinoffs can be a fertile place for investment ideas. The idea is simple. A stock's price, usually, is an unbiased representation of all expected future cash flows of a company from now till judgment day. Understandably, information and transparency drive this estimate of value.

Charlie Munger amusingly stated that stocks are "valued partly like bonds, based on roughly rational projections of use value in producing future cash. But they are also valued partly like Rembrandt paintings." Well said. Don't pay the Rembrandt premium.

Spinoffs are situations where there is often new information, factors not related to economics (e.g., forced selling by institutions due to lack of index membership of the spun-off company), periods of uncertainty regarding the new spun-off company, and an opaque picture of the recent past--often a guide for forecasting. This implies the market is less efficient; that is, there's a greater liklihood the market's estimate of the company's value deviates from its intrinsic value.


Faro is always on the hunt for these types of investments. In November, Morgan Stanley spun-off its MSCI subsidiary, a purveyor of investment indices and risk and return porfolio analytics. Since November, the stock is up 74% (usually spinoffs go down following initial independence). Why is this up so much and is it still a buy? Revenues grew 19% year-over-year while costs grew less rapidly. Below is a snapshot of the firm.

This is largely an emerging market play to be highlighted more in detail in next week's post. Stay tuned, this could be the 7th best investment you've ever made.


Quick Overview
Pricing power: average
Oligopoly: yes
Recurring revenue: yes
Brand strength: strong
ROIC > Cost of capital: yes
Balance sheet: average
Valuation (buy/sell): TBD


Disclosure: I don't knit.
Image: http://www.icelandicsheep.com/Made-with-TRF-wool-photos/Spin-off.jpg

Temperament like Pre

Buffett and Steve Prefontaine share a common trait. It's not the runner's physique. It's their even temperament.

Steve Prefontaine (Pre), was a former holder of five American track records (2,000 meters to 10,000 meters), made distance running "cool," and is an example of the even temperament found in many who enjoy running.

Proper temperament is paramount for success in both investing and running. Though Buffett is clearly not a runner, he understands the temperament side. To paraphrase The Oracle of Omaha, intelligent investing requires two traits: Ordinary intelligence and and an even temperament. That sounds like an easy recipe for success; the combination is rare, however, and is often accompanied by man's money-making gene.

Intelligence leads to the creation of a simple investment thesis. Temperament helps you avoid the siren songs of the market. And, the money-making gene, is the obsession (in whatever form) with the investment process.

What is temperament?

According to Wikipedia, "temperament is defined as that part of the personality that is genetically based." Dictionary.com defines it as "the combination of mental, physical, and emotional traits of a person; natural predisposition."

So how would one describe the temperament of a runner and how does this temperament potentially limit errors in the investing process? Distance running, especially under intense pain or stress, requires mental, physical and emotional stamina. It requires independence; it is usually a battle with one's self. Running also forces one to ignore exogenous variables and to focus on the few things that count: breathing, form, and pacing. This focus and avoidance of noise is invaluable when making buy/sell decisions.

There are many habits and hobbies that reflect one's temperament. Running is just a painful one that often manifests even temperament; that's half of Buffett's equation for investment success.



Disclosure: I think Pre was awesome
Image: http://www.thefinalsprint.com

How formulaic should stock picking be?

Ratios, numbers, forecasts, and data points are abundant in the financial world. You can't peruse a financial site or catch a business publication without titles like "5 Stocks to own today." There are obvious problems with that headline: why just five? How do you know what my financial needs are to recommend five nifty stocks?

Some articles are gimmicky, others have merit. On whether to use rough rules such as low P/E, Price-to-Book, or Price-to-Sales screeners, the answers is painfully simple: If you're investing your own money in individual stocks and are comfortable with the gyrations of Mr. Market, and, if you understand (and care) what deferred revenue is, you should consider the question. This understandable excludes most people.

For those who dare to brave the waters of the financial markets, and individual stock selection, two ideas make sense: 1) formulaic & broad screeners that slowing lead to investments in 30+ stocks without care for company specifics (in this case, diversification protects you from stupid picks), 2) in-depth and concentrated (5-8 positions) selection based on a) favorable long-term economics, b) the desire to run the business, if it were possible, for a period of about 5 years, c) a reasonable price tag).

I'd prefer the second option of looking at stocks, though it doesn't create great newspaper headlines.



Disclosure: none
Other: Joel Greenblatt's book "Magic Formula Investing" is a great option if you'd prefer the formulaic approach.

Rethinking Margin of Safety

"Confronted with a like challenge to distill the secret of sound investment into three words, we venture the following motto, Margin of Safety."
-- Benjamin Graham


They've been called the three most important words in investing: margin of safety. For security analysis purposes, it describes the gap between intrinsic value and market value. There's an out-of-print book by renowned value-guru Seth Klarman titled after it that sells for over $1000.00.

Margin of safety serves two purposes: 1) to render "unnecessary an accurate estimate of the future." and 2) to guarantee "....a better chance for profit than for loss--not that loss is impossible."

Of course, this is an absurdity to adherents to the semi- and strong-form efficient market hypotheses, since all information is reflected in the stock price and no advantage can be gained through fundamental analysis. However, it is doctrine to savvy investors who believe the market is occasionally inefficient.

In a rebuttal to the wide acceptance of the efficient market hypothesis, Warren Buffett makes the following distinction: "Observing correctly that the market is frequently efficient, they went on to conclude incorrectly that it is always efficient. The difference between these propositions is night and day."

Does that mean that the margin of safety used by many is frequently illusory since markets are mostly efficient? If that's the case, are we often wishing for a margin of safety with the assumptions we use, and then unwisely believing those assumptions?

This idea can be extremely dangerous as investors make quick judgments about a company's worth and compare it to the value quoted in the stock market and say: "Eureka, I've found a bargain!" Even bright "value" investors, obsessive about correcting psychological errors, developing latticeworks of mental models, and avoiding the "herd" mentality, can fall prey to this. Imagine that. Demosthenes was dead on with these words: "The easiest thing of all is to deceive one's self; for what a man wishes, he generally believes to be true." If what at first glance appears to be a margin of safety, try to disprove yourself first.

Too good to be true?
A non-subprime-related company is trading at close to 20% of book value with all expectations to continue as a going concern. The balance sheet contains minimal goodwill and debt net of cash of $94M with a market cap of $113M and book value of $498M. One could say, we'll as long as they don't loose money year after year, there's a cushion, or margin of safety. But even property carried on the balance sheet for over $300M can't relieve the company of $3.6B in long-term leases. Unless the company improves its profit margin of (1.05%) and/or finds a way to renegotiate its leases, the margin of safety is zero since steady state earnings are impossible to extrapolate into the future. It's a tough business when you're a travel center that derives 80% of sales from fuel. TravelCenters of America (TA) may make changes and focus on its higher margin products and services, or fully integrate its recent acquisition, but until then, the margin of safety appears to be illusory.

Though the above example seems obvious. One must be cautious when estimating a margin of safety so that you're right more often than wrong. The trick is an understandable business model, conservatism in estimating, and transparency in the firm's financial disclosure.



Disclosure: None; Citation(s): Ben Graham, The Intelligent Investor;
Image: http://www.selectrucks.com/images/models-landing/heavy-duty-trucks.jpg

Chairman's Letter

Writing Puts

Though the press spun the release of Berkshire's 2007 chairman's letter one way, generally a focus on the company's 18% drop in accounting income (a practically meaningless figure), hats off to. FT.com for its article "Buffett defends sovereign wealth funds".

The chairman's letter contains the usual Buffettisms: the aggressive expected-return assumptions used by corporate America in accounting for pension expenses; expensing of stock options; the slide of the dollar; unbelievable candor; the overview of what makes a great business.

Then there was the new stuff: the defence of sovereign wealth funds; his near-term profit outlook for insurance companies; and, what piqued my interest, his expansion into put writing on indices.


Buffett is no stranger to investments outside the realm of boring but good businesses. Those familiar with Berkshire's history know that. But put writing is a first, at least at this scale and with this much disclosure. I cite a paragraph from page 16.

"The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period."

$4.5 billion in option premiums is great "float" to have over the next 15-20 years. These are European options--only exercisable at maturity--and have a strike price at current index levels! This makes me wonder, who is the counterparty? These are fantastic terms for Berkshire as markets will almost certainly be higher 15-20 years from now.

The Oracle's decades of experience and connections are proving again to be a boon for shareholders. The option writing alone is worthy of a headline in the financial press; for now, it seems to appear only in the minds of astute readers and in the blogosphere.



Disclosure: none