Category: Value

This is the biggest mistake value investors make

Value Investing is seductively easy. Summarized into one sentence, Value Investing is the art of picking stocks that are undervalued, a.k.a. buying a dollar for 50 cents.

Tempting, right?

The big problem – paraphrasing what Johan Cruyff said about football – Value Investing is a simple concept, but it is extremely hard to invest with simplicity.

How Value Investors Buy Books

Consider the following analogy:

Put yourself in the shoes of a Value Investor in a book store. Having a natural inclination to buy stuff that is undervalued, you will automatically be drawn to the table with a big sign saying:

  • Books 50-80% OFF! 

…and therein lies the problem.

Buying a book is a bet with an asymmetric outcome. The downside is that you will buy a book and it might turn out to be a waste of your time, plus the $10 to $30 it cost to purchase it. The upside, however, is close to infinite. A good book can fundamentally alter your life.

Coffee consumption is another good example. If you could only drink one cup of coffee a day, you would probably not drink the first cup of joe available to you. You would be more selective. You might even be willing to pay more for the right one.

Mistakes of Omission

Most of the books on the discount table are crap. They are there for a reason.

The Value Investor, focused on the table of discounted books, might end up finding a book that is good enough to be worth the purchase.

At the same time, his attention is turned away from the books that can truly alter his life.

Do you disagree? Let us know in the comments below!

Longevity as an Investment Criteria

In the world of startups and new ventures, the central theme seems to gravitate towards growth and scaling. 

When it comes to growth and scaling, learning how to manage an organization that is constantly getting bigger becomes the biggest challenge. 

However, when you look at the oldest companies in the world, these are all small operations in industries that have hardly changed much throughout the lifetime of those companies. 

Build to Last

Two of the oldest companies in the world are a:

  • Japanese Ryokan 
  • German Brewery

When founders start new companies, most of the time their vision is to disrupt an industry. 

But what if the objective would be to create something that was built to last? If you want to build an impenetrable fortress, you don’t want it to be ever-expanding, would you?

So, here’s a question: What if you were asked to build a company and there would only be one constraint: The total size of the organization would not be allowed to exceed 8 people.

What would you build?

The Columbo Method of Equity Research

Remember detective Columbo? He was a phenomenal character played by Peter Falk in a 1970s TV series called…you guessed it…Columbo. Detective Columbo was a scruffy and simplistic character, dressed in his signature beige raincoat and crumpy white shirt with a loosely knotted tie.

Colombo is no normal detective series, though. As is you would expect, Columbo’s job is to solve murder mysteries. However, the episodes don’t play out with Columbo delving into each case and eventually discovering who is the murderer, in a sharp twist near the end. Columbo is a detective series without the mystery.

In the case of Columbo, each of the 69 episodes begins with the scene of the murder. So, as a viewer, you know from the beginning who the doer is. The rest of the episode is a mental wrestling match between the murderer and lieutenant Columbo.

The Colombo Technique of Investigation

In each Columbo case, the murder is committed by someone close to the victim. This allows Columbo to approach the suspect as a witness or someone who can help Colombo in piecing together the pieces of the puzzle.

To the assailant, Columbo seems totally incompetent. The scruffiness of his hair and clothing give the impression that he slept in his clothes. He constantly scratches his head and he asks the assailant for help. His questions are simplistic and make him look like he’s totally out of his dept.

But Columbo is playing a part. He’s playing dumb. The perpetrator grows confident and starts to get comfortable, even annoyed. The trap is set. In the final minutes of a Columbo episode, the perpetrator has made a mistake and Columbo wrestles him down for the tap-out.

Stock Research and Colombo 

So, how does this relate to equity analysis? In stock research, there is no crime, there is no murderer. As an analyst, you have a stock and you build your opinion based on fundamental analysis.

But therein lies the caveat. You see, it is you who is the perpetrator because once you start your analysis, you start to for opinions. You will start subjecting your mind to all forms of mental biases. You become overly optimistic. You get anchored. You will start to look for confirmation in the data.

“But that’s me, I’m paranoic. Every time I see a dead body I think it’s murdered. Can’t imagine anyone murdering themselves.”  

– Lieutenant Columbo

As an analyst, you have to put on your mental raincoat and find your inner Columbo. You have to take a step back and start to ask yourself the simple question. The overly naive and borderline stupid questions. You have to confront yourself and find start to look for loopholes in your story.

Just One More Thing…

Lieutenant Columbo bombards his suspects with questions. He’s relentless. He keeps coming back with a question. He’s apologetic, he excuses himself. He just can’t help himself, he says. But he keeps coming back for “just one more thing.” 

Not All Growth is Created Equal

To a Growth Samurai, growth is a meaningless term unless is it preceded by an adjective. A Growth Samurai is looking for:

  • Organic Growth
  • Sustainable Growth
  • Profitable Growth

Organic Growth

Organic growth is the strongest indicator that you are doing something right. If traffic numbers or sales are growing disproportionally faster than your sales efforts it means that your sales efforts are getting more efficient. This can mean that you are getting positive word-of-mouth, that your marketing content is getting social engagement or being ranked on search engines or that you are retaining your customers.

Sustainable Growth

Growing sustainable means that you are growing your business without having to finance it externally. Almost all startups require funding in the early stages of the lifecycle but eventually, they will need to become sustainable and able to grow using internal resources.

Profitable Growth

The ultimate goal of any business is to create wealth. A company won’t create wealth unless it captures value. Many companies manage to create a lot of value for their customers but fail to capture the value and turn profits. 

A Growth Samurai understands that growth is meaningless unless it creates value for customers and owners alike. 

Mt. Gox | The Meteoric Rise and Fall of a Bitcoin Exchange

Although the history of the Mt. Gox Bitcoin Exchange is short, it is nothing short of amazing. Mt. Gox is a historic name in the world of cryptocurrencies, as it was one of the first Bitcoin exchanges to take off.

At the peak of its height, Mt. Gox’s customer base represented about 80% of the global trading volume. The rise of Mt. Gox, came to an abrupt end in 2014 when it was discovered that the exchange had become the victim of a large scale hack. Being unable to locate over 850,000 bitcoins that the exchange had in its possession, Mt. Gox was forced to close trading and to subsequently file for bankruptcy. 

Who founded Mt. Gox?

Jed McCaleb founded the Mt. Gox and in 2007, he registered the Mtgox.com web domain with the aim of turning it into a trading site for the famous Magic: The Gathering game cards. He then turned the domain to a bitcoin exchange site. 

After sometimes McCaleb realized he was getting more than he bargained for and he sold the site to Mark Karpeles who is a programmer, foodie, and bitcoin enthusiast and he usually calls himself Magicaltux in numerous online forums. Karpeles then rewrote the back-end software of the site and eventually turned the site into the most popular bitcoin exchange in the world. 

Karpeles was born in France and he spent some time in Israel before settling down in Japan. He got married in Japan and in 2011, he acquired the Mt. Gox exchange from an American entrepreneur known as Jed McCaleb. 

When did Mt Gox open?

Mt Gox was among the first Bitcoin exchange on the web but it was not related to cryptocurrency when it was developed. The mtgox.com domain was bought by programmer Jed McCaleb in 2007 for an online trading platform for virtual cards that are used in the game Magic: The Gathering.

In 2010, McCaleb then saw the opportunity to build a place where people can exchange their fiat currency to and from Bitcoin. This was how mtgox.com was launched as a Bitcoin exchange on July 18, 2010. McCaleb then sold the platform to French-born developer Mark Karpeles after a year.

How did Mt Gox get hacked

Mt Gox was first hacked in 2011 and during the first of the two hacks, the attackers were able to infiltrate into the computer that belongs to an auditor of Mt. Gox. This gave them the chance to change the Bitcoin pricing to a single cent. Afterwards, they then obtained the private keys of Mt. Gox clients which had their precious crypto assets kept in hot wallets which are internet-connected. 

The hackers then went on and create selling orders on the accounts and then bought the Bitcoins at this artificially reduced price and they were able to buy 2000 BTC with this way. This hack was estimated to be about $30.000 theft in Bitcoin and this was then dwarfed by the hack that occurred in February 2014.

The second Mt Gox hack was infamously known as the first major cryptocurrency exchange hack when it happened. The hacked value was an enormous $460 million worth of Bitcoin at the time. Although this may not be the largest hack in terms of the value in fiat money, it is considered to be the largest amount of Bitcoin that was ever stolen. 

More than 850,000 Bitcoins were stolen which includes 750,000 Bitcoins that were owned by its customers. At its peak price, the value of the bitcoin stolen is $17 billion while at the current price this will be about $3 billion.

Although Mt Gox stopped all Bitcoin withdrawals on February 2014, the exchange has already been emptied of its Bitcoins long ago. It was reported that Bitcoins were stolen bit by bit since the beginning of 2011. The group that did this investigation then indicated that by May 2013, the firm no longer held its Bitcoins. Mt Gox then filed for bankruptcy not long after the hack because they were no longer able to continue with the operations.

Will Mt Gox be rehabilitated?

According to TechCrunch, In February of 2019, there is a movement referred to as GoxRising which is working to have an alternative to bankruptcy for Mt Gox. The main idea behind GoxRising is simple and it is that instead of using the bankruptcy courts to give the assets of Mt Gox to the owners of the company, it is making use of civil rehabilitation law so as to return most of the asset to the creditors of the company.

It appears that GoxRising will be successful in these efforts because Tokyo lawyer, Nobuaki Kobayashi has been appointed by the Japanese courts to work on the civil rehabilitation process. This is going to be a piece of good news to those that have lost their assets in the Mt Gox failure because they will likely gain from this deal due to the civil rehabilitation law.

Another potential way this court may end is that the embattled CEO of Mt Gox, Mark Karpeles will likely end up with lots of Mt Gox assets if the bankruptcy process is allowed to move forward. This is because he owned about 80% of the company and when it went bankrupt, it will place him in a great position to get this huge payout under the Japanese bankruptcy law. If this happens, Karpeles knows that his life is in danger as he would receive lots of civil suits from Mt Gox creditors that has lost everything to him. More insults will be added because Bitcoin prices are much higher today than it was in 2014.

With the civil rehabilitation process, it looks like a winning idea to everyone that is involved in this deal and it looks like a way forward. The civil rehabilitation process is expected to take 3-5 years based on the reports from the media. Although civil rehabilitation may be considered to be a time-consuming process, it is still a lot better than bankruptcy.

Read More on Finance and Crypto

Check out our partner publications:

Discount to Net Asset Value | Protect Your Downside

One way to value a stock, especially those of companies that own various subsidiaries or a portfolio of assets, is by analysing the company’s discount (or surplus) to Net Asset Value.

Conglomerate Discount – The Case of Exor

We recently took a close look at Exor N.V., the holding company that controls such publicly traded companies as Fiat Chrysler Automobiles, Ferrari and CNH Industries. Conglomerates like Exor are interesting to analyse as they tend to trade a steep discount on the mark-to-market Net Asset Values (or market-adjusted book value).

In the case of Exor, the company trades at about a 30% discount on the market value of assets on the balance sheet. 

Point of Maximum Pessimism – The Case of Dundee Corporation

If you are a Contrarian Investor, you are trying to go where other investors feel extremely uncomfortable to be. You are trying to go where others are running to the exits, but at the same time, you don’t want to be too early. 

One of those situations is materializing at a Canadian Asset Management Company called Dundee Corporation. After a series of unfortunate events (and decisions), the market capitalization of Dundee is gone from about a billion dollars to about $74 million. 

The company trades at a steep discount to book value, but for good reason. The company has been haemorrhaging money as failed investments have sucked up cash and destroyed shareholders’ capital. 

But investors may have overreacted. Even though the company is taking drastic steps to turn the business around, Dundee’s stock is trading at about a 70% discount to book value. If the company manages to stop the bleeding, a significant re-rating might be in the cards. 

How do Banks Make Money?

You might think that the role of commercial banks is to accept deposits from the public and channel them into projects, where the bank can lend the money out at higher rates of return. You would be wrong.

When you hear the world deposit, you might think that the bank is storing the money for you, therefore acting as a custodian. It isn’t. When you deposit your money in the bank, in a legal sense, you are lending your money to the bank.

Money Creation

Banks, currently, are the effective creators of the money supply. They produce money. They do this by selling promissory notes, such as mortgages, car loans or business loans. Deposits are more like a by-product of the money creation process.

This is brilliantly explained by Professor Richard Werner (who happens to also be the guy who came up with the terms Quantitative Easing), in the following video:

Richard Werner: Essentially, if we want to produce something we need funding. So there is a role for banking in almost everything that happening in the economy. But what exactly is that role? Banks are being thought of as intermediaries. This is not really what is happening. They are creators of the money supply. 

Interviewer: So, you are firmly of the view that banks create money out of thin air?

Richard Werner: I produced the first empirical study to prove that, in the 5,000-year history of banking. Banks are thought of as deposit-taking institutions that lend money. The legal reality is that banks don’t take deposits and banks do not lend money. So, what is a deposit? A deposit is not actually a deposit. It’s not a bailment. It’s not held in custody. 

At law, the word deposit is meaningless. The law courts in various judgements have made it very clear. If you give your money to the bank, even if it is called a deposit, this money is simply a loan to the bank. So, there is no such thing as a deposit. 

Banks borrow from the public. That much we have established. What about lending? Are they lending money? No, they don’t. Banks don’t lend money. At law, it’s very clear. They are in the business of purchasing securities. That’s it. 

So you say: “Ok. don’t confuse me with all that legalese. I want a loan.” Fine, here is the loan contract. Here is the offer letter. And you sign. At law, it’s very clear. You have issued a security, namely a promissory note. And the bank is going to purchase that. That is what is happening. 

Interviewer: Put it in laymen terms.   

Richard Werner: It means that what the bank is doing is very different from what it presents to the public that it is doing. How does this fit together? You say “fine, the bank purchases my promissory note. But how do I get my money?” 

The bank will say, “you will find it in your account with us.” That will be technically correct. If they say, “we will transfer it to your account,” that’s wrong. Because no money is transferred at all. From anywhere inside the bank or outside of it. Why? Because what we call a deposit is simply the bank’s record of its debt to the public. Now, it also owes you money and its record of the money it owes you is what you think you are getting as money. And that is all it is. 

And that is how the banks create the money supply. The money supply consists of 97% of bank deposits. And these are created out of nothing by banks when they lend. Because they invent fictitious customer deposits. Why? They simply restate, slightly incorrectly in accounting terms, what is an account payable liability arising from the loan contract, having purchased your promissory note, as a customer deposit. 

But nobody has deposited any money.

 

The Fundamentals are in the Footnotes

The whole point of fundamental research or value investing or whatever you want to call it is to get an edge by looking a little deeper than others are looking. This is why you won’t get very far by using stock screeners.

Stock Research on Onverstock.com 

We recently published a stock report on the Fundamental Finance Playbook about Overstock.com. The article is a deep dive into the current status of the company’s online retail business. We try to figure out if the business is, in fact, in a turnaround as management claims, or if the company is at risk of running out of cash.

Previously, the management had stated that they were trying to sell the online retail business but so far nothing has materialized. During our research phase we noticed that during the last quarter, consulting fees on the corporate level had increased significantly. By corporate level, we mean not connected to the operations of the online retail business nor the blockchain ventures.

Overstock engaged Guggenheim in 2018 to explore strategic options for the retail business and find possible buyers. If the consulting expenses are mostly in the “Other” business segment and neither in the retail operations nor the tZero operations, it is plausible that Overstock is already in advance negotiations with potential buyers through Guggenheim.

What that indicated to us, was that there was a possibility that Overstock was already working with Guggenheim Securities, the company that Overstock employed to find buyers, on advanced negotiations with possible buyers. These kinds of transactions usually require heavy due diligence, so it would be quite plausible that costs would ramp up like this.

Two Potential Acquirers 

A week after we published, Patrick Byrne, Chairman and CEO of Overstock said in an interview with CNN that the company was in negotiations with two potential acquirers. It remains to be seen if anything materializes from this, but it goes to show that sometimes the fundamental facts are buried in the footnotes.

The Value of the Road Not Taken

In 1916 Robert Frost published his poem The Road Not Taken. It is a narrative poem, where the narrator describes a moment when he comes to a fork in the road while taking a walk through a forest. After mulling it over, the narrator decides to take the road that seems to be less travelled.

The poem is by many regarded as one of the most misunderstood poems in history. It is often quoted when expressing views of individualism and not conforming to general convention.

 

At the end of the poem, the narrator sighs as he tells the reader that he took the road less taken and that it made all the difference. But the sigh is left open to interpretation by Frost, as the reader does not know if the sigh is from relief or regret.

The Misinterpreted Message

“You have to be careful of that one; it’s a tricky poem — very tricky,” Frost is known to have said about the poem. The story has it that he wrote it to tease a friend of his, Edward Thomas, who often had problems with coming to a decision over choices that were offered to him. Frost describes him as a person who, “whichever road he went, would be sorry he didn’t go the other”.

An economist would tell you that the problem that Edward Thomas – just as the narrator in the poem – was battling with was the Opportunity Cost of the choices that he had.

Opportunity Cost

The Opportunity Cost of a decision basically equals the benefit of the best alternative option that you have to choose from. This means also means that the opportunity cost is dependent on the situation that you find yourself in at any given time. Furthermore, it means that your opportunity cost is not the same as my opportunity cost.

The concept of opportunity cost is well known in economics and finance, where it is relatively easier to measure the potential outcomes. The Opportunity Cost of Capital, for example, is the rate of return that could have been earned by putting the same money into a different investment with equal risk.

Mistakes of Omission

In The Road Less Taken, the narrator has two choices. Therefore, his opportunity cost is whichever road that he will not take. If he picks the wrong road, he will have made a Mistake of Omission. When asked about their biggest mistakes at the Berkshire Hathaway 2011 annual meeting, the legendary investors Warren Buffett and Charles Munger highlighted specifically about their Mistakes of Omission.

The Road Less Taken

Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;

Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,

And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.

I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

How to Value Stuff is a website dedicated to thinking about the value of everything and nothing. What us to value something? Let us know. 

 

The Water and Diamond Paradox

How can we know the true value of a thing? This has been a philosophical question that dates back to the times of Aristoteles. Philosopher throughout the ages have asked themselves why water which is vital for all life is cheap while diamonds are expensive even though we can easily do without them?

Diminishing Marginal Utility

The solution to the Water-Diamond Paradox is the economic law of diminishing utility. This can be defined as the economic law which states that when there is an input in the production of a community while the other factors are fixed, it is going to get to a point whereby any addition of the good to the consumer of the good is going to lead to low satisfaction with the diminishing increases in the output.

Supply and Demand

A case study is that assuming you are hungry and you find one apple then it is going to precious to you and you are going to eat it to satisfy your hunger and to stay alive. Then if you go for a walk and you see two more apples then you can eat one just for the fun of it and keep the second one till when you are hungry.

If you then happen to see an orchard with lots of apple fruit and you decide to stay close to the orchard, it will come to a time when you will grow tired of eating an apple as it will be nauseating to you. You can then trade some apple for some other commodities that other people will find it to be valuable to them while it is invaluable to you.

This case study shows that each additional value of a given good satisfies a less important need. You can see this as the first apple that you take is mainly for the appraisal of your hunger so as to survive while the second apple fills you up and the third apple was kept for later so as not to be hungry in the future.

This also implies that the first apple that you saw was priceless as you need it to avoid starvation while the second one was just a pleasurable snack while the value of other apples that you find keeps decreasing.

There is no such Thing as Fixed Value

The example above shows that no good has a fixed value. A good will always be considered valuable when people value them. For example, imagine that your parents would buy a sculpture which they really love. Later, once they once they are passed on, you inherit the sculpture. However, you have never liked the sculpture and you feel like it is taking up space.

You mean to throw it away but you’re reluctant to do so because of the sentimental value your parents attached to the sculpture. When discussing your predicament at a party, you discover to your amazement that there is an art collector in town that has been looking for this exact sculpture for years. Suddenly your perceived value of the sculpture has gone up and you are not willing to part with it unless the art collector submits a reasonable bid for the artwork.

In the context of the Water-Diamond Paradox:

  • During a drought, people would value water more than rare diamonds as they need it to survive.
  • As soon as there is enough water, they will tend to value diamonds more as they have the essential needs to satisfy their hunger and thirst then people try to satisfy their sophisticated needs.
  • This theory applies to all the needs in human lives.