Monday, January 14, 2013

Value from Short Sellers

A good interview of Jim Chanos here.

He makes a very good point about value investing and I like him largely because he has a good head on steady shoulders :)
Hope the site doesn't have a problem with this...

"What are some of the common mistakes that you see value investors making?
Value investing is just one tool in an investor's arsenal. All things being equal, one would prefer to buy stocks cheaply than dearly. But I'm afraid that too many value investors stop the process by just looking at valuation and, in effect, looking at the rear-view and side mirrors, not through the windshield. You have to be very careful, because we looked at our returns over the past 10 years, and, particularly since the advent of the digital age, some of our very best shorts have been so-called value stocks. One of the differences in the value game now versus, say, 15 or 20 years ago, is that declining businesses, while they often throw off cash early in their decline, find that cash flow actually reaches a tipping point and goes negative much faster than it used to.
So, in the past, value investors looked at declining free cash flows and put some discount rate on that. And then they got a value, and then they would say, "Gee, there is the possibility of a call-option value of the business inherent to all its other opportunities. So, if I can buy it at some discount to that present value, I'm in good shape." But we've seen time and time again where the cash flows do not gradually decline. Nor do managements seem very willing to pay out cash flows when they are in a declining business. They often use them to make acquisitions, trying to save the business on a Hail Mary basis. The advent of digitization in lots of businesses also means that the timing gets compressed, meaning that you need to move quickly or you are roadkill on the digital highway. That's true whether you look at companies like Eastman Kodak [ticker: EKDKQ], or Blockbuster, or the newspapers. Value investors have been drawn to these companies like moths to the flame, only to find out that the business has declined a lot faster than they thought and that the valuation cushion proved to be anything but."

It's a very valid point; there are many businesses which no longer have moats and if they have moats, they are eroding quicker than people understand. When Berkshire bought the World Book business, they didn't see the moat eroding quickly... it took a fair amount of time, but even then, it was worth it because the cash flows kept being tapped out to the parent company for WB to use. 
As a minority investor, it's imperative to understand that one does not have control over management decisions. Don't mistake free cash flows for free cash flows ;)

About disruption in the market - he talks about how the shale gas revolution in the US is putting to dirt other projects which were started with assumptions of higher gas prices.
About some of these companies and the nature of their long term contracts:
"But because they use oxymoronic at full-cost accounting, which let's you capitalize everything on your P&L [profit-and-loss statement], the earnings statements don't look so bad. But the cash-flow statements are a disaster."
And that is why cash flows are so important.

Very smart guy. And quite a good interview.
Brilliant stuff.

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