Letter #09 June,2008
1.When investments go from hated and reasonable to despised and cheap something is normally up in the market. In this letter, three sources which define risks have been stated.
1)Market valuing the stock at discount despite of the potential of the stock.
This has been co-related with the illustration of Air Asia which was Asia’s largest low-cost airline and probably the lowest cost airline in the world. Air has cost advantage over its peers as the firm had borrowed heavily from the Southwest Airlines model of operations (a point-to-point network configuration, online ticket sales, no reserved seating, one plane type). It dominated the position in the portfolio of nomad investment partnership. The only issue was that the funding of the planes was not entirely secured, and lenders were twitchy.
“Even so, the firm earns a reasonable spread over the cost of capital on its aircraft, whilst forcing pricing on other airlines which leaves them operating at sub economic returns. This is a powerful combination and implies that the business will win in the marketplace in the end. We have no ego invested our analysis (at least, I don’t think we do: if you want to make rational decisions leave your ego behind), outcomes are leveraged and perfectly reasonable people could come to different conclusions as to the firm’s investment merits. However, we do struggle with the price of the shares in the stock market today, which appears to value the firm at a meaningful discount to the value of the company owned fleet of planes. In short, the market has concluded that Air Asia, despite the potential outlined above, should not exist. This is nonsense; as such a valuation would imply that Southeast Asians, who are some of the most price conscious people on the planet, don’t want cheap airfares!”
2)If the problems are self-inflicted, they are usually within the powers of the firm to fix
Games workshop made tabletop games and soon due to the introduction of online games, its sales fell, and the company suffered a lot. The chairman stated in his speech that they great fat and lazy on the back of easy success. The company strongly believed that it can co-exist with the online games however, the market did not value the same.
3)Dilution risk occurs when company issues equity at less than the firm is worth.
This is co-related with the example of municipal bond insurance association which raised capital twice at the price less than its intrinsic value. The nomad investment partnership fully sold the stake in this company.
“So, however cheap MBIA may appear, the prospect of a future capital raising means that one cannot place a valuation on the business per share without knowing the number of shares outstanding, and we cannot know that until we know the size of the losses and the price of any future capital raising. In this Alice in Wonderland world, the stock’s biggest attraction, its apparent cheapness, becomes the investor’s Achilles heel, and it was for this reason that we sold our MBIA shares. And it is also for this reason that recent purchases by Nomad, which are not enough to recap businesses in their own right, and where there is meaningful dilution risk, have been modest in size.”
1)The average holding period for US stocks held in Nomad (ex Berkshire Hathway) was 51 days that was 1/25 of the time the partnership expected to hold an investment.
2)The costs of short-termism, such as dilution risk, are borne by investors when management mark the share price to market and issue equity. In other words, it is borne early in Nomad’s expected holding cycle. The gains from short-termism,
such as the ability to purchase shares for meaningfully less than they are worth, will take far longer to materialize.
“The point of equity is that it is the only permanent capital in the balance sheet. It is there to weather storms, such as the current economic backdrop, and provide a stable base, and of course to earn the rewards of enterprise. This basic building block of society is broken when those with their hands on the permanent capital change their minds with their underwear. It is no coincidence perhaps that pass-the-parcel and musical chairs are children’s games.”
What leads to price increase during momentum investing?
1)Feeling of being left out ( Scarcity/less availability of the stock going forward)
2)Social Proof (once one person had set a high price it was seen by others to endorse the value of the item and they too could pay a higher price knowing they were not alone.)
“We can all do momentum investing, but it is emotional investing and I just don’t think it is that intelligent, or profitable.”