Passing on Sandstorm

Over at Above Average Odds Investing, Ryan O'Connor has a very good write up of Sandstorm Metals and Energy.

I read the write-up (which also appears on Value Investors Club, as Above Average Odds Investing is a member) and my interest was piqued.  My mouth even watered.  But the more I read about the company the less enthusiastic I got.  Put simply, Ryan sets out the case for an incredibly cheap company with the potential to be an absolute giant.  You pay nothing for its potential, and get the current cashflows very cheap.  I can't do it justice, so you should just read his post.

But here's what I found when I started looking that bothered me:

• I can’t give myself a plausible but overstated or wrong reason why it’s cheap.
• The CEO Nolan Watson’s Wikipedia page is incredibly promotional.  The editor is “Denvyboy”, who seems to only write about sandstorm and Nolan.  Denvyboy is probably Denver Harris, the investor relations manager for Sandstorm.  I’d prefer if they spent more time on the company than on investors.
• In his youtube video about due diligence, Sandstorm Executive Vice President, David Awram uses the phrase “going forward” five times in less than three minutes.
• The only analyst coverage is from two organisations: National Bank Financial and Cormark Securities.  When you look at their management, one Executive VP is a former VP at National Bank Financial, and another Director is currently Vice Chairman of Cormark Securities.  Seems like they’re only giving analyst coverage to the stock because of the firms’ relationship with management. 
• If Nolan Watson is such a boy genius (with all his contacts from being CFO of a billion dollar company) he should easily be able to find investors.  Furthermore, current investors would trust him and wouldn't be selling shares at the current price.  This is effectively just a restatement of the first bullet point: there's no plausible reason why this stock is undervalued.
• Note that Watson's main trumpeted achievement in his time at Silver Wheaton is raising a billion dollars in debt and equity.  That's a skill, but it's a promotional skill (an important but dangerous one).
• In the Donner deal announced July 13, 2011, Sandstorm provided $25m senior finance to Donner, and in return got the right (and obligation) to purchase 17.5% of the copper and precious metals from the Bracemac-McLeod mine, for the price of US$0.80 per pound (if the market price of copper is above US$2.75 per pound).  If the price is below $2.75 per pound, they can purchase for the lesser of US$0.55 or the prevailing spot price.  That seems like a great deal, but I know nothing about loan financing or mining.  I do know a tiny bit about buying stocks (that's not understatement, I truly mean I know a tiny amount as compared with loan finance and mining, where I know nothing).  And Sandstorm also purchased 6,200,000 Donner common shares for CDN$0.35, for a cost of $2,250,000.  Donner shares last traded at 0.25, for a loss of 28% since purchase.  That's a bad trade so far.
• There are absurd amounts of warrants and options.  There are 155 562 490 warrants outstanding, with an exercise price of US$0.70 and expiry date of December 23, 2012.  That puts a bit of a cap on the stock this year, and the whole concept of having 150 million warrants outstanding when you only have 300 million shares seems a bit crazy – what’ll they do next year?  Any massive increase in the stock price has a pretty heavy ceiling, and no doubt they’ll just issue more warrants if the current ones are exercised.
• I feel like I can’t pinpoint a specific risk that exists.  But it just might be that the business is unsustainable.  Perhaps the unique business model/financing structure allows plenty of room to creatively report assets/income.  I think the market may be pricing this in and that’s why the share price languishes.

So I'm not going to be buying any.  To be honest, it could be a huge mistake.  The bull case from Above Average Odds Investing is compelling, but it just doesn't fit right with me.  I'll be following progress.

Notes on Buffett's letter to shareholders

Geoff Gannon has put together some excellent notes on Buffett's letter to shareholders - released yesterday.  I was going to make some notes, but Gannon does it better than I could.

Warren Buffett on stocks, bonds, and gold

This column is adapted from his upcoming letter to shareholders.

Getting free learning

Aswath Damodaran is putting his whole Valuation, and Corporate Finance classes online this semester.  If you are interested in either, you can take them for free.  You get no official credit from NYU, but you do get to learn stuff from a really smart guy for free.

Here is a link to his instructions and why he's doing it.

Check out his wikipedia page here - he's a smart guy.

I'll be taking both courses.

I haven't blogged in almost two weeks.  I've been pretty busy.  I'll try to think of something to blog about soon.  I've almost finished re-reading The Intelligent Investor.  I'm getting much more out of it the second time around - maybe I'll do a post on that.

Measuring Whitney Tilson's alpha

Whitney Tilson is a value investor.  He co-manages T2 Partners with Glenn H. Tongue.  He was one of the authors of Poor Charlie’s Almanack, generally the best book on Berkshire Hathaway Vice Chairman and multi-billionaire Charlie Munger.

Tilson’s funds lost 24.9% of their value in 2011.  Despite that, they have returned an annualised 6.0% since inception in January 1999.  This is better than the S&P 500 which has returned 2.0% p.a since January 1999.  The total return is 114.2% (T2 Partners) vs 29.2% (S&P 500).

Given that substantial outperformance, you might think that it was obvious that Whitney Tilson can generate “alpha”.  Alpha is a financial term for the risk-adjusted return of an active manager.  Basically, if a manager generates alpha, the manager can achieve the same return as the market with lower risk, or higher returns than the market without a corresponding increase in risk.

I personally think it is very likely that Whitney Tilson can outperform the market.  His letters to investors seem well thought out and he usually has very good justifications for his stock positions.  This, coupled with his performance, suggest to me, a prima facie case for outperformance.  So I decided to test whether a regression shows that Whitney Tilson can generate alpha, or whether he is simply exposing his funds to more risk and achieving a corresponding return.

First, I found and inputted his monthly returns from his later letter from January 1999 to December 2011 into a spreadsheet.  I matched that to the market return minus the risk free rate for all those dates.  I then performed a regression to calculate the 3-factor (Fama-French) and 1-factor (capital asset pricing model) alpha.

I find the story of the 3-factor Fama-French story interesting.  Fama notes in a recent paper that one reason that “value” (as measured by low price-to-book ratios) might outperform growth is that people get some non-financial utility from owning growth stocks.  This makes sense to me.  Some people must like being able to say they own an “up-and-coming” stock rather than an old skeleton they’re just trying to squeeze the last bit of value from.  Think of the film (or book) Moneyball.  It must be exciting to pick young up and comers in your ball team rather than David Justice, a 37 year old who is clearly past his prime.  Despite that, there is more value (as measured by price for performance) in picking David Justice over young glamour players (or at least there was until the Oakland Athletics popularised the strategy). 

Anyway, the 3-factor Fama-French measurement came about because people started to notice that there was a persistent outperformance by “value” stocks (low price to book) and small capitalisation stocks.  One theory was that these stocks were inherently more risky.  But by all conventional measures of risk, they’re not more risky.  The next theory is that it’s “unmeasured risk”.  Effectively the argument is that because they outperform, they must be more risky.  This seems like a triumph of theory over evidence.  It presupposes that the market is perfectly efficient, then explains evidence of its inefficiency (the outperformance of value and small cap stocks) by referring back to the theory and insisting it must be true.  In the face of the question – where is the excess risk? The response is that it can’t be measured yet. 

If the risk can’t be measured, I find it implausible (although not impossible) that market participants are factoring in this unmeasured risk to cause the pricing discrepancy and outperformance.  I find Fama’s proposition of non-financial utility in growth and big cap stocks more convincing.

Now, whether there is more alpha in value and small cap stocks or whether there is more risk is largely irrelevant for our purposes of measuring manager performance.  The key is that you can cheaply access this higher return (be it alpha or risk) through an index fund devoted to value stocks (as measured by low price to book ratios) or small cap stocks (or even both).  Given that ability, you shouldn’t pay a manager high fees to just get you that.

So what does the regression show?

The regression shows that using the 1-factor capital asset pricing model, Whitney Tilson generates 0.305% of alpha per month.  That’s significant, but unfortunately we don’t have enough data points to make it statistically significant.  The null hypothesis is that Tilson has no alpha.  It’s been too long since I did any statistics, but from what I gather, the p-value suggests that if we assume the null hypothesis, there is a 33% chance of obtaining his results just by luck.  The t-stat is 0.977.

Using the 3-factor Fama-French data (ie, controlling for the value effect and the small cap effect), Whitney Tilson generates 0.216% of alpha per month.  That’s not bad either, but the p-value is 0.496 – ie, assuming that Tilson has no alpha, there’s a 49.6% chance of obtaining his results just by luck (assuming my interpretation of a p-value is correct).  The t-stat is 0.683.

Alpha-male?

Unfortunately, 154 months just isn’t enough to give us statistically significant results.  My own personal null hypothesis is that Tilson can generate alpha, but we won’t know for many many years.  By that time, we’re very unlikely to be able to invest money in his fund.  He’ll either be shown to have no alpha and have closed down, or be some alpha generating machine with too much money clogging up his alpha machine and anchoring his performance.

UPDATE: I realised I rudely forgot to thank Turnkey Analyst for the lesson in how to run this regression. He runs through the method and includes a video here.

Warren Buffet sent me a secret message

Back in May Warren Buffet did a video interview

Reuters: You’re always looking for value. What about Microsoft? I know you say you don’t do tech. But given that it has a forward P/E right now that’s below 10, it seems like a value play.

Buffett: Yeah. I agree with you. I regard myself as precluded from either personally or having Berkshire buy Microsoft because if something good happened the following week people would think Bill had told me. So I just see no way that we can ever buy Microsoft and be sure that we won’t look like we had some kind of inside information or something. So it’s off limits. It did look pretty cheap.

I was going to write up all the fundamental quantitative stuff that makes me like MSFT.  But then TurnkeyAnalyst did an amazing job so I'll just send you there.

The conclusion is:

So overall what are the quantitative data telling us about an investment in MSFT?  Perhaps its most distinguishing feature is that MSFT is a cash cow, earning high current and normalized returns on capital and assets based on the wide defensive business moat that its Windows operating system provides.  While in the longer run, MSFT may face significant competitive pressures, it is unlikely to be dislodged from its strong defensible position in a dramatic way any time soon.  There are no obvious red flags from any of our short screens, and the company is hugely profitable and stable, so there is a low risk of financial distress.  The stock looks cheap here, and its strong magic score suggests that you are not overpaying for this very high quality business.  If you are looking for a safe bet in a high quality company in the technology space, MSFT would appear to fit the bill.

We bought MSFT for the fund in early November 2011.  It has appreciated 9% since then and paid a dividend of 0.8% of our cost.  We bought after reading Warren Buffet's comment and taking a look at the return on invested capital and earnings yield.

Seth Klarman and contrarianism

I just read through a collection of Seth Klarman’s letters to shareholders in his fund – the Baupost Group. Klarman is a value investor and wrote the out of print “Margin of Safety”, now selling for over $1000 on Amazon. The Baupost Group has achieved an average annual return of 19% since 1983 for its three partnership funds. The particular letters I read were for a smaller fund that he set up in 1990.

One thing that struck me reading through his letters is his contrarian streak. I think it’s incredibly hard to confidently go against the grain when everyone around you seems like they’re printing money. That’s why Klarman’s letters are so refreshing.

In the letters between 1995 to 2000, he calls the internet bubble several times. You can feel the frustration in his letters as his funds lag various indices by substantial amounts. At one stage (April 1999) $50 000 invested in the particular partnership at its inception (December 1990) would have turned into $139 277. That’s not bad, but $50 000 in the S&P 500 passive index would have returned $250 971! That sort of persistent and dramatic underperformance has got to feel pretty bad.

Klarman makes passing mention of the internet fad in his 1995, 1996, and 1997 letters, but rips into it in 1998:

The U.S. stock market has been propelled by investors falling all over themselves to buy large-capitalization growth stocks like Microsoft, Coca Cola, and even General Electric. At least they are, more or less, good companies. Occasionally, periods of unbelievable excess occur, where near-worthless enterprises are propelled into the stratosphere. Such a period is now upon us.

It is bad enough that the shares of small growth companies announcing stock splits surge skyward as if something value enhancing has actually taken place. Now, suddenly, the siren song of the internet has become even more irresistible for hordes of growth investors.

Consider the case of K-Tel International, the company best known for selling music CDs and tapes on late night television. After hovering in a narrow trading range around $7 a share(for its 4.1 million outstanding shares) since January, the announcement that K-Tel plans to sell its music on the internet caused its shares to skyrocket from $7 to $45 in just one week and to $80 a week later with daily volume exceeding 100% of the freely tradeable shares outstanding. "You put 'dotcom' behind it and they'll buy it", said one analyst commenting on the behavior of internet-obsessed investors. In a similar vein, Market Guide, a provider of financial data, rallied from 3 to 29½ in three trading days after announcing a partnership with America Online. At 29½, the company had a market capitalization of almost $150 million yet it boasts current annual revenue of only $5 million. Watch out below!

And in 1999:

The $200 billion market capitalization of America Online recently exceeded that of IBM. Charles Schwab was recently valued 50% more highly than Merrill Lynch. Priceline, the Internet company that sells airline tickets, was valued more highly than the three largest airlines, combined! eToys came public and immediately jumped to a valuation well above that of the well established Toys "R" Us. The prevailing casino atmosphere must certainly put a damper on trips to Las Vegas or Atlantic City, where there are more losers than winners. In Internet-land, there have been no real losers as of yet; the illusion of a positive-sum casino is an attractive lure for the gambler. Recent exuberance notwithstanding, at today's valuations it is clear that Wall Street is certain to continue issuing shares of new Internet companies until the supply of shares overwhelms the resources of the buyers.

It’s obvious now and in hindsight that he was absolutely, 100% right. He ended up making up all his lagged performance (and then some) in 2000 and later. But at the time it must have been maddening.