Diary: Value shares are for speculators

When I was doing my Masters course, one of my lecturers, Mr. Hanson, was explaining the coursework we had to do for a module. It accounted for 20% of the final result. He jokingly remarked that we didn't have to do the coursework if we really didn't want to, and that if you merely wanted a pass grade you only had to score 50% .... starting out from minus 20.

This brings me onto value investing. Take a look at Bruce Berkowitz's fund, Fairholme, down 34% YTD, compared to +2.5% for the DJIA. Morningstar rates his overall return as above average, but with high risk. Over 10 years, his fund is up 56% against the DJIA of 18%. He's been outperforming the benchmark by about 2.8% pa - hardly an outstanding achievement, especially considering his fund is rated as having a high risk profile. It would be difficult to say if the outperformance was the result of luck, or skill. Berkowitz is a smart guy, and his all-in on banks may well work out, but as my introductory paragraph alludes to, he's going to have to start out from minus 20 to find out. I'm confident that private investors could have replicated his entire decade performance using simple low/no-analysis value criteria. A brief perusal of my own records seems to indicate that this is the case.

Alternatively, look at Whitney Tilson's Tilson Focus fund, down 22.8% YTD. It is lagging the DJIA since inception in Jan 2007 by a big margin. Morningstar rates its return as low, and risk as above average. Far far far from ideal.

I see that both Berkowitz and Tilson own fair chunks of BRK (Berkshire Hathaway). Berkshire? You guys are getting paid to own Berkshire? For real? What is this, some kind of "fund of funds"? I bet Tilson is even raking in 2 and 20 on his hedge fund for holding Berkshire. The performance from these guys is far from an early Buffett or Greenblatt.

Now let's continue my theme as I talk about RIMM (Research in Motion), NFLX (Netflix), and IMN (Imation).

Let's start with NFLX. In my opinion, it's a value trap, and Whitney called it wrong. Twice. Well, at a PER of 15.9, it's not an outrageous valuation, for sure. It's big problem is that the content providers can squeeze it - which they seem to be doing - and at the merest hint of solid returns you've got operators with deep pockets (Google, Amazon, the dreaded Apple, maybe Microsoft if they feel like doing a cloner) will try to muscle in. I don't like the way Tilson has flip-flopped on NFLX. In his short position, he said that he was short because it was a great company that was too highly valued. Whoah there, cowboy. I distinctly remember him saying that it had structural weaknesses. He seems to have forgotten that. He is now long on NFLX, pointing out its remarkable attributes. Tilson is a very smart guy, and his theses are wonderfully clever, much smarter than I would produce, but in the end they ended up contradicting themselves. Which one is right, the one with the structural weakness, or the one where it's a great company at a good price? For all the cleverness, they can't both be right. The problem is (and I think Tilson's long position is wrong), it's all rather "binary". You're either right or your wrong, and you can't be sure which. If you look at it that way, Tilson's position is effectively a punt. The problem is, if you're wrong, you're going to find it difficult to generate a Greenblatt-esque return. This is why I think value investing is so difficult, and gives only marginal returns. You are essentially betting on things that can go either way. Also, I think if Tilson wanted to invest, he should wait. The current PER is not especially attractive given the risk involved. Maybe single figures would be a more appropriate place to have another look, assuming that it drops that far - which of course you don't know.

IMN the DVD manufacturer, has been subject to a lot of very good discussion lately. It has a good cash position, but it's in a declining market. It's on a PBV of 0.3, but is making losses.  Cash per share is 6.11, and share price is 5.98. So, it's interesting from a value investor perspective and the net-net types. There's a big big but, though. Management is been hell-bent on throwing the cash on non-profitable acqusitions rather than buying back shares. There was an excellent exchange between an analyst and directors (alas, I can't find the link), who brought all the agency problem out into the open. So IMN is not necessarily an attractive investment, unless there is some kind of activism.

Last, but by no means least, is RIMM. It fell 11.2% today, and is now trading at an eye-popping PER of 2.5. Damodaran wrote an interesting article on RIMM yesterday. In brief: their Blackberry is a cash cow whose market share is being corroded by Androids and iPhones. They can either invest the cash in product development and hope for a breakthrough, or attempt a graceful liquidation process where you're trying to maximise shareholder return by milking value. Damodaram actually works jots down how the latter scenario might play out. He comes up with a value of $8.125b, against an EV  of $6b. So, it's not a compelling disparity. If you accept his valuation, then it seems that even at a PER of 2.5, there's nothing compelling about it. There's also a considerable amount of "ifs". As Damodaran points out, if RIMM continues to plough back money into development, that $2b margin can easily be wiped out.

What's interesting is that I notice a speculator, who looks to be pretty successful, take a long position in RIMM. It's obviously a contrarian play, where he expects the stock to at least double - although it could take several years. It should be interesting to see how this one plays out.

Finally, to the title of my post: "value shares are for speculators", which is this: most value shares, are they really investments, or are they just gambles? I suspect that day traders will make lots and lots of profits out of these companies - for those of them that know how to play the game. Patient thoughtful value investors are in a rather trickier position.