Tuesday, June 25, 2013

reflections from John Emerson

Part 1

I embark on this investing travelogue with a considerable amount of trepidation: First off, the exercise could be viewed as entirely narcissistic. Secondly, the figures I am about to divulge are not matters of public record, therefore the veracity of the numbers could easily come into question. After all, it would not be the first time that a writer invented figures to suit his purposes.

I decided to push the aforementioned apprehensions aside and proceed with my story since I believe it can serve as an inspiration to younger and disgruntled investors. Further, I believe the essays will establish with a high degree of certainty that value investing actually works and equally important, that value investing is a lifelong learning process.

When I embarked upon my investing career around 20 years ago, I was a buffoon (the first three stocks I purchased were gold junior mining stocks - more on that later). Fortunately for me, I was able to transcend the line that separates a cretin from a competent investor before I had obliterated my life savings. That process required an extensive amount of humility as well as a strong commitment to learn from my mistakes.

1994-2000

Today's edition will profile my early investment years which upon further recollection, started in 1994--maybe I should change the title of the series to "Reflections from 19 Years of Investing". The series will be written informally and serve as sort of an investment diary which chronicles my evolution as a value investor. As the title suggests, today's discussion will cover the period from 1994 to the end of 2000.

I still remember the names of the first three stocks that I purchased nearly 20 years ago. They gold mining companies: Pegasus Gold, Eco Bay Mines and Battle Mountain. I came to purchase the stocks after consulting with one of the telemarketers at the home improvement company where I was employed as a commission salesman. Now "that takes some explaining Lucy." You see, the telemarketer was a former Wall Street investment adviser who developed a nasty cocaine habit and served multiple tours of duties at some of the finest rehab facilities in the U.S., apparently to no avail.

Although at the time I was talking to him, he appeared to be on the straight and narrow, in reality, he was heading straight to his supplier with money that he borrowed from a number of his co-workers which included me. For informational value, never loan money to an "ex-junkie" who consistently wears long-sleeve shirts that cover the entire back of his hands - I never saw more than the guy's fingernails. You see he shot up his medicine through the veins on the back of his hands. Please forgive my temporary digression.

Anyway, the drug addict gave me the 800 number of one of his former cohorts who happened to be a gold bug, and the rest is history - so was two-thirds of my $15,000 "investment" after a matter of months. For younger readers, gold and gold mining stocks were not the place to be in the 1990s, as gold steadily plummeted to less than $250 an ounce.

Undaunted by the loss, I abandoned the gold mining sector and invested my remaining $5,000 in Intel (INTC). Why Intel you might ask? To the best of my recollection, I had heard a number of analysts talking about the stock on CNBC and unlike many of the other technology stocks, it appeared to me to be cheap. I have no idea how I came to that conclusion since I had no ability to price equities at the time. I was still in stock picking kindergarten and the concept of a PE ratio was entirely over my head, let alone the concept of free cash flow or return on equity.

As fate would have it, Intel tripled in about a year and my bank roll was miraculously restored with my only loss being the time value of my money. Bear in mind that saving accounts actually paid interest 20 years ago.

2001-2008 (part 1)

I resume the story in early August of 2001, about one month prior to one of the saddest days in American history, Sept. 11, 2001. For some reason I had suddenly become very apprehensive about the market and for one of the few times in my investing career, I acted completely on impulse. I sold out of about 60 percent of my stock positions. I simply called up my broker one morning (I was not doing my transactions on line at that point) and read off the list companies which I wanted to delete from my investment portfolios.

I recall one thing in particular about going to such a heavy position in cash: It made my life extremely boring for the next few weeks. Still, I held tight to my resolution that I would not make any further investments until the market corrected and I temporarily quit doing stock research altogether. The decision was extremely foolish since it was based upon pure speculation rather than any analysis about the valuations of my holdings. As things would turn out, I did not have to wait before the market corrected.

Like most Americans, I remember exactly what I was doing on Sept. 11, 2001; I was watching CNBC as the horrific drama unfolded. I will never forget watching the backdrop of the Twin Towers when the second plane hit; at that point it was evident to all Americans that their country was under siege from terrorists. Mark Haynes navigated the viewing audience through the terrible ordeal with exquisite poise, never cracking or wavering as Americans sat mesmerized in front of their television sets, watching the shocking developments in stunned silence.

September 11 had a profound effect on the psyche of Americans and without question it had a dramatic influence on their buying and spending patterns. About a month after the attack I attended the Fall Home Show in Omaha and almost none of the vendors did any significant business with one notable exception. The man who sold America flags and retractable flag poles sold out his entire inventory quickly. Many of his customers were forced to endure back order periods of several months before they were able to openly display their love for the United States.

The tragedy had reawakened the patriotic spirit of the American people, drawing its citizens closer together; although it also triggered some temporary changes in their behavior. Americans became much less apt to travel long distances for an extended period, following the tragedy. Airplane traffic dropped dramatically and the following year, businesses which relied upon tourist traffic during the summer months would suffer mightily. It appeared that September 11 had significantly reduced the desire of many Americans to spend their money on things pertaining to leisure and entertainment or much of anything else that did not reflect upon their basic needs. Fortunately, the effects of the attack on the American economy would be temporary in duration.

After the shock and sadness of September 11 began to wane a few days later, I resolved that I was going to spend all my available doing stock research. Free time had become an abundant commodity as my business phone had gone silence following the attack. I began purchasing stocks a few weeks following the tragedy, and within about a month, I was once again fully invested. I would remain fully invested in equities for longer than a decade.

After reinvesting all my funds back into stocks shortly after September 11, I enjoyed a stellar performance until the market engaged in a severe correction in the late summer and early fall of 2002. Following September 11, my portfolios advanced about 25% by year end and by the mid summer of 2002, they had advanced by over 55 percent. Bear in mind that I had never enjoyed any real success in investing prior to that point; therefore I was developing a bit of a “Messiah Complex.” Legendary turf writer Andrew Beyer coined that term to describe the tendency of a horse player to become overconfident following a successful run of luck at the race track.

The late summer of 2002 quickly destroyed any personal delusions I held about shutting down my business and living off my investments. I lost every cent of the 55% in paper gains which I had recorded following September 11 in approximately two months.

Another problem presented itself: My wife was now in full scale panic mode and she was putting me under extreme pressure to sell out of all our equities “while we still had something left.” It seems that she had been talking with one of her friends who had recently gone to cash in her 401-K after knuckling under to the pressure of a rapidly dropping market. My wife thought it would be much more prudent to buy a larger house than to invest our life savings in the market.

Fortunately for us, I refused to knuckle under and resolved not to sell any of our positions. The process was greatly aided by the fact that the market turned almost exactly at the point of my wife’s heaviest insistence to liquidate our positions. In the future, I would use her as a “contrarian indicator” and I made a special point to remind her of her wholesale panic whenever she became nervous in regard to a falling market. The experience became extremely important about six years later when the credit crisis developed and our portfolios would lose well over half of their value in a few short months. To her credit, she weathered that storm extremely well.

After the market reversed in the early fall of 2002, our portfolios began an unprecedented run of good fortune. In 2003, the portfolios were up in excess of 80% and by October of 2007 they had more than quadrupled from their trough, around early October of 2002. It was a great five year run; although I never anticipated that approximately that one year later, the majority of those gains would be sacrificed in merely a few short months. But that is a story to be told later in the series.

By 2003 I was developing quit an affinity for purchasing microcap stocks. Apparently, my early experience with Camtek had not destroyed my interest in investing in tiny companies. I decided that I would start investing significant capital in microcap stocks for the following reasons: They were largely under appreciated and under followed by the investing community, and they were more apt to be mispriced than their larger brethren.

I started following a rather sleazy microcap tout service which was later exposed by Barron’s; the service was Ceocast.com. The newsletter did not charge its reading audience a fee; rather they billed the companies which they promoted in the form of cash and shares of their stock. The “pump sheet” was full of extremely low-grade companies which typically traded on the Bulletin Board; however occasionally they would promote a real “diamond-in-the-rough” which traded on a reputable exchange.

Lake Gaming (LACO)

I originally discovered Lake Gaming in the Ceocast newsletter and I eventually purchased shares in the stock, but not for the reasons which the newsletter discussed. Upon reviewing the company, I noticed that Mario Gabelli held a significant position in the stock and it was trading at less than 50% of its tangible book value.

As it turned out, one the major assets the company held, was land on the far south portion of Las Vegas, in close proximity to the airport; they were in the process of monetizing that interest by selling the property to time-share companies. The scenario was reminiscent of Aztar. Furthermore, their balance sheet held significant cash and large amounts of money which was owed to them by certain Indian tribes.

At the end of 2002 the company had a book value in excess of 15 dollars per share. I bought my original position for around 7 dollars a share and following the announcement of non-cash accounting restatement, which had no effect on the book value; the stock dipped to about 4 dollars a share. I doubled my position at around $4.25 per share.

Fate was on my side in the case of LACO; although their Indian Gaming business would not drive their earnings in the near term, another catalyst was about to emerge in early 2003. Lyle Berman, the CEO of LACO was an avid poker player and he had an idea that provided the impetus for the stock to move forward.

Berman pioneered the idea of the World Poker Tour (WPT) and sold the concept to the Travel Channel. Watching poker on television had always been boring since the viewing audience could not see the down cards which the players held. Berman remedied that problem by allowing a camera to expose the down cards to the TV audience. That idea suddenly transformed Texas Holdem into a fascinating spectator’s sport. By the end of 2003 the stock had reached its book value of 15 dollars a share and I decided to take my profits, perhaps a bit prematurely. The stock quickly climbed to about 30 dollars a share on sheer momentum.

In the longer term, the decision to sell turned out to be prudent since the TV success of the WPT never translated into significant profits. The idea may have revolutionized the TV viewing of poker events but it never turned LACO into a cash cow.

Fairchild (FA)

I will conclude today’s discussion with another balance sheet play that resulted in my largest gain at that point in my investing career. The company was Fairchild and I had started accumulating shares in the company, following my reentry to the stock market in the fall of 2001.

It was another company in which Mario Gabelli held a significant position. I can not recall for certain, but I believe the stock was mentioned by Gabelli on CNBC. As is typical with a Gabelli holding, the stock held real estate which was understated on the balance sheet. Specifically, the company owned a large shopping center in Long Island which was almost fully occupied and provided the heavily debt-burdened company with a steady cash flow.

Fairchild held another asset which was extremely undervalued and held a much high intrinsic net worth than the shopping center. More specifically, Fairchild owned a large airplane fastener company which had recorded well over a half a billion dollars in sales in fiscal year 2002 and was returning the company over 70 million a year in EBITDA.

One of the reasons Gabelli liked Fairchild was due to the fact they were extremely overleveraged. That may sound strange but “The Chairman” believed that the CEO and controlling shareholder, Jeffrey Steiner, would be required to do a deal to prevent the holding company from being forced into bankruptcy proceedings.

Steiner had a reputation for several things: Most importantly, he could be described as a very successful wheeler/dealer that was known for buying businesses and later selling them for a tidy profit. Secondly, he was one of the most notoriously overcompensated CEOs on Wall Street and he controlled the board of directors at Fairchild.

When he made a successful deal he was handsomely rewarded in the form of a bonus as well as drawing an excessive base salary. Steiner’s legendary greed was profiled in newspaper articles, business magazines and was even the subject of an entire chapter from the book: "In Search of Excess: The Overcompensation of American Executives".

I bought a large position in Fairchild at around three dollars and when the company dropped to slightly over $2 a share I bought considerably more stock. At that point in my investing career is seems that I was fearless. I as recall, the company represented nearly 20% of my entire holdings when I was finished purchasing the stock. Never before had I taken such a large position as a percentage of my entire portfolios.

In mid July of 2002, I awoke and turned on my living room television set; scrolling across the bottom of the CNBC ticker was the following headline: Alcoa buys Fairchild’s fastener division for 657 million in cash. I jumped so high that I almost hit the 8-foot ceiling in my living room. It seems I had hit the mother lode on Fairchild in less than a year’s time.

When I performed the calculations, I figured that the sale alone should be worth at least $6.50 a share to the Fairchild shareholders but the stock quickly settled under six dollars per share. I pondered the situation carefully and decided that Steiner would never return a dime to the Fairchild shareholders. I sold my entire position at around $5.50 a share, deciding to pay the short capital gains taxes on the shares in my taxable accounts.

The decision turned out to be prudent since Steiner eventually squandered the entire windfall without returning a dime to the shareholders. Of course he received a tens of millions as a finder’s fee for executing the transaction. Gabelli on the other hand, decided to maintain his entire position. For once I had out thought “The Chairman.”

Thereafter, Fairchild dropped slowly and steadily, never again reaching the five dollar range. Following the death of Jeffrey Steiner, the company was liquidated at a small percentage of its former price. As I recall it brought a little over a dollar a share.

*** 2001-2008 (part 2)

I was brimming with confidence entering 2004; I had just recorded my best year ever in terms of gains versus the S&P. All the market indices had recorded a resounding rally since the early fall of 2002; the rally was fueled by the Federal Reserve’s monetary easing policy and a new found optimism about future of corporate profits. It seemed that the tragedy of September 11 was now a distant memory and its effects on the psyche of the US consumer had all but disappeared.

Following precipitous market rallies, value investors must devote increasing research time to uncover bargains. Such was the case in 2004, many of the obvious values had disappeared and simple asset plays, as well as beaten down cyclical stocks were quickly vanishing from the screens of value investors.

During such times, investors either have to become more imaginative in regard to uncovering value propositions, or reduce the number of companies that they hold in their portfolios. At that point in my investing career, I still lacked the confidence to hold just a few large positions; thus I decided to become more creative in my investments. I starting searching for theme investments which I thought would prosper during the cyclical recovery.

The Investing Climate in 2003-2007

Oil, natural gas and other commodities were entering a bull market, driving up the value of the companies who owned or leased the land which held the resources. Oil service and equipment stocks as well as the mining equipment companies would benefit mightily as the demand for their products and services rose dramatically.

Likewise with the housing market, not only were home builders and banks benefiting from the housing boom, so too were the building material suppliers and virtually any business which was related to the worldwide surge in housing market.

I started to focus upon finding companies that would benefit from the aforementioned investment themes, but only investing in companies which still held reasonable valuation metrics. The idea was to locate companies that remained undiscovered by Wall Street which were likely to increase their forward earnings. Furthermore, such companies would frequently become buyout candidates, as larger companies looked to increase their earnings by acquiring businesses that were not already “sky high” in price.

When I would check the ownership of many of the companies that I found to be worthy of research, I frequently ran across the name of Jeffrey Gendell who titled his hedge fund Tontine Asset Management.

The Rise and Fall of Tontine Asset Management and ENGlobal (ENG)

Gendell rarely conducted interviews, almost never publicizing his stock selections or his theories in regard to investing. The average investor had never heard of him or his hedge fund; however anyone who tracked money managers closely, was well aware the outstanding returns which were flowing into the pockets of the clients at Tontine. In 2003 and 2004, Gendell recorded near miraculous gains, approximately doubling the value of his portfolios, in back to back years.

Gendell first caught the eye of Wall Street when he became extremely bullish on US steel companies in the early 2000s. Similar to today, US steel companies were on the outs with investors and Tontine boldly stepped in, heavily overweighting the sector. Shortly after Gendell entered the sector, steel companies began a protracted bull market; it seems that Wall Street had a brand new emerging superstar that was capable of spotting cyclical bottoms as well as possessing sufficient courageous to act upon his convictions.

The prodigious gains of Gendell caught my eye as well, and I began to track the companies in which he held significant ownership. One of the companies that I ran across was tiny ENGlobal (ENG), a Houston-based provider of engineering services to the energy sector. The stock fit my investing theme perfectly and it did not hurt my confidence to know that Gendell felt the same way. Further, the stock appeared to be reasonably valued in terms of the business the company was writing and I believed that its earnings were about ready to spike upward. As you can see, I was not exactly demanding a large margin of safety in my theme investments at that point in time.

I purchased ENG in the spring of 2005 for $2.20 a share; by the mid to late summer of the same year, the stock had climbed to around 9.00 a share. I now had to make a decision on whether to sell the stock and take my gains or continue to hold the stock. As it turns out my decision was made considerably easier when I turned on Mad Money that night and much to my amazement, Jim Cramer was touting this tiny microcap stock. My decision was now etched in stone; I sold ENG at the open of the market the following day, for exactly 9.00 per share.

It had been my experience that Cramer’s late entry into a momentum stocks generally resulted in a market top for the equity. Such was the case with ENG, after the price ascended slightly higher, the stock quickly dropped below 7 dollars a share. In fairness to Cramer, the stock did go much higher several years later but that was a merely temporary spike, the case of a low quality company hitting a temporary sweet spot. A few years later the stock steadily dropped and never recovered; today it trades under a dollar a share.

Now back to the saga of Jeffrey Gendell and Tontine Asset Management. It seemed that Mr. Gendell was not adhering to Ben Graham’s prime directive which suggested that investors should minimize their risk by demanding a sufficient margin of safety on their investment selections. Not only was the hedge fund highly leveraged but almost his entire portfolio was concentrated in debt-laden cyclical companies which were currently benefiting from rising real estate and commodity prices. Apparently, Gendell simply did not believe that the bull market which was triggered by the real estate bubble and the boom cycle in commodities was going to end any time soon.

To make a long story short, in early 2009 Tontine was forced into liquidating its positions and shutting down the fund. I noticed one of the stocks that Gendell was forced to sell was ENG—I wonder if Cramer was still holding the stock? The experience served as a lesson for all investors (me included) who might decide to coat-tail a respected investor without regard to performing their own due diligence on the guru’s stock purchases. The Gendell saga also exposed the extreme danger of employing excessive margin in the hopes of “juicing” one’s investment returns.

2001-2008 (Part 3)

Reflections from 20 Years of Investing (2008-2009)

Reflections from 20 Years of Investing (2010 and Beyond)

The financial crisis of late 2008 and early 2009 had a profound effect on the future investing strategy which I would employ going forward. It literally changed my entire outlook on value investing; I would became a balance sheet oriented investor who held large concentrations in a limited amount of stocks.

The credit crisis had served to remind me of Buffett’s three most importance words in investing: margin of safety. It seemed that my investing success had caused me to lose sight of the potential downside in a stock purchase. That failing had caused me to temporarily underperform the market during the Great Recession. It also had injected an elevated level of risk into my investment portfolios which I was unable to tolerate. The remedy involved making fewer investments and demanding a higher margin of safety.

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