The Power of Value Investing: Maximizing Returns and Safety

1. The Intelligent Investor (Ben Graham)Common Stocks and Uncommon Profits (Philip Fisher) November 2007 Alex Roman www.scorpioncapitalinc.com

2. What is (Value) Investing? • “An investment operation is one which, upon thorough analysis promises safety of principle and an adequate return. Operations not meeting these requirements are speculative.” -Benjamin Graham, The Intelligent Investor • “This is the essence of value investing, that is, purchasing shares of a company at a price that is substantially lower than the company’s underlying value.” - Charles Brandes, Value Investing Today

3. Margin of Safety “Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.” – Graham, The Intelligent Investor

4. The Principle of Compounding In the early 1600s, the American Indians sold an island, now called Manhattan in New York, for various beads and trinkets worth about $16. Since Manhattan real estate is now some of the most expensive in the world, it would seem at first glance that the American Indians made a terrible deal. Had the American Indians, however, sold their beads and trinkets, invested their $16 and received 8% compounded annual interest, not only would they have enough money to buy back all of Manhattan, they would still have several hundred million dollars left over. That is the power of compound interest over time.

5. Average is usually above-average! • “Back in 1982, the average net worth of a Forbes 400 member was $230 million. To make it onto the 2002 Forbes 400, the average 1982 member needed to earn only a 4.5% average annual return on his wealth — during a period when even bank accounts yielded far more than that and the stock market gained an average of 13.2%. So how many of the Forbes 400 fortunes from 1982 remained on the list 20 years later? Only 64 of the original members — a measly 16% — were still on the list in 2002.” • Question #1: How certain am I to beat the market return long-term (~11.2% over 35 years)? • Question #2: How likely is it that in pursuing a plan to achieve above average returns, I will end up getting average or below average returns instead? (if you lose 20%, of your capital, you need a 25% return to break-even).

6. The Truth about Diversification • "Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing." – W. Buffet • A 1970 study conducted by Fisher and Lorie found that about 80% of the benefits of diversification are achieved by holding 8 stocks; 95% of diversification benefits are achieved by holding 32 stocks; and 99% of the benefits are achieved by holding 128 stocks

7. …instead use the Kelly Optimization Model & Bi-Modal Investing • The Kelly Optimization Model, often called the optimal growth strategy, is based on the concept that if you know the probability of success, you bet the fraction of your bankroll that maximizes the growth rate. It is expressed as a formula: 2p - 1 = x, where 2 times the probability of winning (p) minus 1 equals the percentage of the total that should be bet (x). Online Calculator here: http://cisiova.com/betsizing.asp • Researchers found that Berkshire Hathaway invested 73% of its funds into 5 major investees over three decades and earned a 27% return. (Owning 50 positions at 2% each implies a 49% chance of loss (roughly equal to a coin toss) and is therefore irrational to own the position at all! • Bi-Modal means you either make a high probability concentrated bet or hold cash – nothing in-between or ‘Noah’s Ark’ – two of everything. • Recommendation: The enterprising investor should own no more than ~5-10 stocks. Each new investment proposition should be compared against what is already in the portfolio in a selection-type process to improve quality and expected return.

8. Mr. Market Analogy The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage…The primary cause of failure is that they [individual investors] pay too much attention to what the stock market is doing currently. • Stocks represent fractional ownership in a real-world business, not just pieces of paper or numbers on the computer screen. • You own a business and have a partner called Mr. Market. Mr. Market comes to you every single day, welcome or unwelcome, and tells you his opinion of your share, reasonable or unreasonable. He offers to buy you out or to sell you an additional interest. However, Mr. Market is manic-depressive, and is often swayed by extreme pessimism (fear) and extreme optimism (greed). If you were a rational businessperson, would you allow a daily communication of the value of your share to sway your opinion, or would you use it to your advantage, ignore it, or come to your own conclusion? In the short term, the Market is a voting machine, in the long run, it is a weighing machine.

9. Common Stocks & Uncommon Profits • Big believer in GARP (‘growth at a reasonable price’) • Cheapness is not a sufficient criteria for investment. • Emphasis on qualitative factors (15 point checklist), including franchise value, competitive position, management. • Seeking to filter out 99% of potential ideas and finding the best of the best. • Emphasis on logic and analysis in selecting investments – ‘putting in the time’. • Looking for 10-baggers that are bought and held indefinitely instead of temporarily cheap “cigar-butt” investments that yield a one-time profit. • ‘Scuttlebutt’ and networking. • The time to sell is almost never if the investment is well selected and continues to meet the original investment criteria. • More profit has been given up by selling a good business (even if a stock appears temporarily ahead of itself) than by any other variable. Consider the alternatives. “It is my opinion that in almost any field nothing is worth doing unless it is worth doing right. When it comes to selecting growth stocks, the rewards for proper action are so huge and the penalty for poor judgment is so great that it is hard to see why anyone would want to select a growth stock on the basis of superficial knowledge….” “Is it either logical or reasonable that anyone could do this with an effort no harder than reading a few simply worded brokers’ free circulars in the comfort of an armchair one evening a week?... “…fortune-producing growth stocks can be found. However, they cannot be found without hard work and they cannot be found every day.”

10. ‘Scuttlebutt’ or Doing Business with People you can Trust • Searching ‘Annual Reports’ & footnotes for extra insight. • Searching ‘Proxy Statements’ for performance-based compensation. • Searching ‘Letter to Shareholders’ for key executive language (Goals, Personalized, Informative, Focused on ‘cash’ accounting, historical perspective) • Investigating competitors. • Using the Internet to read news articles, message boards, etc..in order to form an interdisciplinary mental model.

11. How to get rich in the stock market! Principle #1: Investing requires a significant amount of education, research, and ability – all of which can be developed to some degree. It is unrealistic to expect a good result without making a real effort. However, favor indexing, “bet on the jockey”, or ‘copycat’ strategies if you cannot make this commitment. Principle #2: Diversification guarantees a poor result. Instead, the enterprising investor should concentrate their holdings into 10 or fewer positions by having a high standard of ownership. Principle #3: ‘Our investment philosophy is bimodal, either we invest in high returning opportunities or have the money in the bank or under our mattresses’ – Leucadia National CEO Principle #4: Have the proper mental attitude with respect to the Market. ‘Be greedy when others are fearful and be fearful when others are greedy.’ Principle #5: Instead of excessive focus on cheapness, consider the more qualitative aspects of an investment, such as quality of the business. Principle #6: Don’t overpay – the lower the purchase price, the higher the margin of safety AND the total return.