Wednesday, December 28, 2011

signs of a good CEO

It is widely known that in the long term, management quality has a leg up on profitability because profitability cannot be sustained with a poor management. Based on Buffett´s thoughts, here are some signs of a good CEO.

First and foremost, track record matters a lot. In the case of Buffett, all Berkshire subsidiary CEOs have a proven track record in their respective companies or in the same industry.

Second, CEO compensation should be examined for abuse. Nothing is wrong with paying CEOs well, but to pay them exorbitantly may indicate an extremely flexible corporate governance culture.

Third, a CEO should have a conceptual framework that he or she can articulate well. Analysts should listen carefully to a CEO’s answers at public meetings or conference calls. Buffett also pays attention when CEOs forecast earnings. As he himself points out, “We are suspicious of those CEOs who regularly claim they do know the future — and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers.”

Fourth, it is important to read the company chairman’s annual letters to the shareholders from several years. Investors should be suspicious of letters generally offering excuses for weak results. This may involve poor quality of management. In many of these letters, success is often attributed to management efforts, but failures are attributed to exogenous reasons.

Fifth, attending annual shareholder meetings is paramount. It gives a unique opportunity to evaluate the company’s managers by examining their responses to shareholder questions and to learn more about management attitude towards shareholders. It helps you build trust on management or not. Buffett and Munger have often emphasized the importance of trust and have mentioned that they would not invest in a company if they did not trust its management.

Last and probably overarching, a very high level of integrity among company employees and the CEO is important. Buffett wrote to the employees, “Lose money for the firm and I will understand it; lose a shred of reputation for the firm and I will be ruthless.”

Monday, December 19, 2011

the troubled utility cycle

Any investors should realize that there are four main stages in so called “troubled utility cycle” in order to do right timing entrance and exit for those types of investments. The first stage is disaster strikes. It is faced with a sudden loss in earnings, either because of some huge cost which it could not pass through to its customers, or because a huge asset (such as a new plant) is “mothballed and removed from the rate base.” Its stock would lose around 40%-80% of its value in one or two year period. As investors experienced the drop in the share price, they would no longer felt the utilities as a safe and stable investment. The price keeps falling, and it might trade as low as 20-30% of the book value. The time to stay at that low market depends on each disaster. Lynch cited that in the Long Island Lighting case, the bankruptcy threat made the stock at 30% of its book value for four years.

The second stage is “crisis management.” A utility business would respond to its disaster by cutting capital expenditure and adopting austerity budget. Normally in this period, the dividend would be eliminated in order to bring strength back to its financial structure. At this stage, there would be no reflection on its stock price yet.

After that, the business would come to “financial stabilization.” When it had succeeded in cutting cost, the utility begin to generate enough cash for its own operation. Although it might not earn anything for the shareholders at this stage yet, survival was almost the certainty. The stock price of this period might move up to 60-70% of the book value.

Last but not least, the stage four is that the recovery is recognized. The utility business is capable of earning something for its shareholders, and Wall Street begins to expect improved earnings and the continuation of its dividend. The price of its stock moves up to its book value. So what would happen afterwards? He noted: “How things progress from here depends on two factors: (1) the reception from the capital markets, because without capital the utility cannot expand its rate base, and (2), the support, or nonsupport, of the regulators, i.e, how many costs they allow the utility to pass along to customers in the form of higher rates.”

When recognizing the utilities pattern, employing the good strategy to reap the benefits from investing in utilities is not an issue anymore. Lynch advised people to buy on the omission of the dividend and wait for the good news or investors could wait for the good news to come in the second stage, and then buy the stock. Even when the stock has doubled, a lot of people might think they have missed the bottom, but troubled utilities have a long way to go. “A simple way to make a nice living from troubled utilities: buy them when a dividend is omitted and hold on to them until the dividend is restored. This is the strategy with terrific success ratio.”

Friday, December 02, 2011

Charles Allmon winding down

Charles Allmon will be 91 in a couple of months. He closed his retail investment letter, Growth Stock Outlook, in 2008. (See April 30, 2009, column.)

Now his money management business is being wound up. Accounts are being transferred to Virginia-based Hendershot Investments Inc. (see website), headed by former employees Ingrid Hendershot [iluvbabyb] and Susan Christ, “both CFAs,” as Allmon notes typically, and both graduates of his highly quantitative fundamentalist school of security analysis. He says he may periodically write for their clients.

Allmon’s system supposedly buys stocks solely on the basis of value and eschews market timing. But in fact he has made one of the boldest timing moves in recent market history: He’s been substantially in cash since 1987. Incredibly, despite that, his record has been good — above all in this last disappointing decade.

Over the wild year to date through October, Growth Stock Outlook is up 3.7% by Hulbert Financial Digest count vs. 0.39% for the dividend-reinvested Wilshire 5000 Total Stock Market Index.

Since the Hulbert Financial Digest began following GSO in 1980, its annualized appreciation has been 8.6% vs. 10.8% for the Wilshire.

But on a risk-adjusted basis, GSO is in first place since 1980 among 11 for which HFD has continuous data. (And, Mark Hulbert notes, “one could argue that the proper comparison is with all newsletters I started following in 1980 and which dropped by the wayside along the way — a number that is around three dozen …”)

Moreover, GSO achieved this while being substantially in cash since 1987 — a triumph of stock selection. GSO’s stock selections alone would have significantly outperformed the market over the entire period.

Allmon says he has no party affiliation. But his intense aversion to candidate Obama did lead him to bearishness, even by his standards, presciently in mid-2008. (See June 5, 2008 column.) And he’s doubling down — if Obama is re-elected.

But Allmon also says:

•“In the mid-century you will see a booming economy for your children and grandchildren.”

Allmon predicts that the Dow Jones Industrial Average DJIA +0.48% will reach 25,000 in 2030-2040.

•Gold will then be $4,000-5,000 an ounce, he says reluctantly when pinned down — and will trade in a $1,200-$2,500 range through the next five years. Allmon holds a gold mine stock (see below) but seems to value it primarily as insurance.

How are these macro predictions derived from the micro entrails of balance sheets? What is the balance between analysis and intuition?

Allmon laughs and says I’ll find his final letter to clients, due in mid-December, interesting.

Currently, his model portfolio is about 75% in cash except for:

Altria Group Inc. MO -0.66% (6%)

Bristol-Myers Squibb Co. BMY +0.49% (3%)

Newmont Mining Corp. NEM -2.27% (10%)

Philip Morris International Inc. PM +0.58% (6%)