Revisiting Daily Journal Corporation – Five Years Later

Daily Journal Corporation is a publisher of several small specialty newspapers and information services primarily serving the legal and real estate communities in California and Arizona.  With the company’s traditional business experiencing a steady secular decline in recent years, management leveraged its expertise and connections in the legal community to diversify into software management systems for courts and other justice agencies.  A temporary boom in foreclosure notices driven by the housing crash generated cash flow that was used to build a concentrated portfolio of investments under the direction of Chairman Charles Munger.  This portfolio has appreciated significantly in recent years and has left Daily Journal materially overcapitalized.

We first discussed Daily Journal five years ago when software was a relatively minor part of the company and there was only limited disclosure of the securities in the investment portfolio.  At the time, we speculated that the company could be turning into a “hedge fund” that would allow investors to participate in the investment decisions made by Mr. Munger:

The Daily Journal Corporation represents a fascinating case study of a declining business that is still generating significant free cash flow that has been intelligently deployed by management to create additional value for shareholders.  Such a company is in a distinct minority since most firms facing decline tend to pursue value destroying acquisitions or capital investments rather than “accept defeat” gracefully and return cash to shareholders.  It seems likely that Daily Journal’s publishing operations will continue to decline over time and Sustain [a software business] is an unpleasant wildcard threatening to destroy additional value.  However, with Mr. Munger at the helm, the marketable securities portfolio seems likely to at least preserve value for shareholders.  Once Mr. Munger and Mr. Guerin are no longer involved with the company, it would seem only logical to distribute funds to shareholders since there will not be any in-house capability for managing a large investment operation.

To answer the question posed by the title of this article, Daily Journal is not a “rising hedge fund” given management’s intentions to not develop an investment business.  However, it is at least a quasi investment fund operated by Mr. Munger that does not carry a typical “2 and 20” fee structure.  This may intrigue venturesome investors who are also optimistic (or at least not terribly pessimistic) about the durability of the operating business.

Daily Journal shares traded at approximately $65 in late 2011 and currently trade at $242 which represents a compounded annual return of 30 percent.  Obviously, anyone who decided to buy shares five years ago has been richly rewarded.  The good news is that the investment portfolio has appreciated significantly over the past five years.  The bad news is that the newspaper publishing business has continued to decline and the company’s software business, which was dramatically increased due to acquisitions, has failed to achieve profitability.  The other bad news is that all the principal players are five years older.  President, CEO, CFO, Treasurer and Director Gerald Salzman is now 77, Vice Chairman J.P. Guerin is 86, and Mr. Munger will turn 93 on January 1.  No succession plans have been disclosed.

In this article, we focus on the developments that have taken place over the past five years in the company’s three operating segments: (1) The traditional publishing business;  (2) The Journal Technologies software business; and (3) Corporate, which includes the investment portfolio.  Readers interested in background on the company prior to 2011 should first read our prior article referenced above.

Traditional Publishing Business

The traditional newspaper business has been in steady decline over the past five years with advertising revenue taking the biggest hit.  Public notice advertising for foreclosures resulted in elevated revenue for a number of years but the housing recovery in California and Arizona has dramatically reduced this business over the past few years.  A steady reduction in circulation of the San Francisco and Los Angeles Daily Journals, which represent the company’s most important publications, has resulted in a decline in circulation revenue as well as further advertising declines.  Revenue and net income have declined in each of the past five years, as shown in the exhibit below:

As revenues have declined, the company has apparently suffered from diseconomies of scale which resulted in margin pressure.  The company’s SEC filings indicate that revenue reductions will continue to have a significant impact on earnings “because it will be impractical for the Company to offset the expected revenue loss with expense reductions.”  Margins have declined accordingly.

Over the past several years, the company has discontinued the publication of several smaller titles with very low circulation.  Although the company still offers nine publications, the San Francisco and Los Angeles Daily Journals represent the vast majority of circulation revenue.  The exhibit below shows that management has been able to raise the subscription price which has partially offset the steep decline in paid circulation (click on the exhibit for a larger view):

It is difficult to see what might cause circulation trends to reverse or even stabilize.  There appears to be a core constituency that is not price sensitive (the annual cost of a full price subscription is $804);  however, every year there is a steady erosion in circulation.  Not only will circulation revenue continue to decline, but the publications will be less attractive to advertisers as well.  In order to continue to provide a quality product, management cannot cut expenses proportionally since many costs are fixed in nature.  We continue to view this business to be one in secular decline that could end up being terminal at some point over the next decade.

Journal Technologies

Five years ago, the company’s software operations were limited to the Sustain subsidiary which was acquired in 1999.  As we discussed in our prior article, Sustain had not provided consistent profitability up to that point in time.  However, the software business was a minor part of Daily Journal’s overall operations.  This has changed significantly with the acquisition of New Dawn in December 2012 and ISD in September 2013.  The Journal Technologies business accounted for 56 percent of revenue in fiscal 2016, up from only 9 percent in fiscal 2011.

Management was able to fund the purchase of New Dawn and ISD by borrowing $29.5 million against the securities portfolio using a margin account.  This has proven to be low cost financing with the interest rate fluctuating based on the Federal Funds Rate plus 50 basis points.  This funding has become more expensive after the Fed’s recent rate increase and could become more expensive if forecasts for additional rate increases in 2017 prove to be correct.

At least so far, the software business has not proven to be profitable for the company.  The exhibit below shows the result for the Journal Technologies group over the past five years:

It should be noted that amortization of intangible assets, a non-cash charge, is a major component of operating expenses for the segment.  The intangibles consist primarily of customer relationships acquired as part of the New Dawn and ISD acquisitions and are being amortized over five years.  The amortization charge is expected to be $4.9 million in fiscal 2017 and $3.1 million in fiscal 2018 and there will not be any further charges beyond that time.  Assuming that the acquisitions were well thought out, it is unlikely that the customer relationships acquired will be worth nothing in 2018.  If that is the case, at least part of the amortization charge over the past four years can be regarded as meaningless from an economic standpoint.  However, even if we regard all of the amortization expenses as economically meaningless, this segment would still not be profitable.

Corporate (Including Investment Portfolio)

The corporate segment primarily represents the results of the company’s investment portfolio.  As of September 30, 2016, the company held securities with a market value of $166.6 million with an unrealized gain of $108.3 million.  The portfolio was concentrated in seven companies with two based in foreign countries, with the foreign issues valued at $45.5 million* in aggregate.

Four of the securities are included in the company’s 13-F report which is filed with the SEC on a quarterly basis.  As of September 30, 2016, the 13-F portfolio consisted of Wells Fargo, Bank of America, U.S. Bancorp, and POSCO ADRs.  Mr. Munger has left the portfolio almost completely static over the past several years, at least with respect to the positions that are required to be disclosed to the SEC.  For those who have followed Mr. Munger for many years, this lack of activity and extreme concentration is not the least bit surprising.

The exhibit below shows the results of the Corporate segment since 2013 when the company first began breaking it out as a reporting segment.

What is notable is the steady increase in dividend income attributable to the portfolio and the fact that the corporate segment now accounts for the majority of the company’s overall profitability.  It is apparent that the company is massively overcapitalized.  Although management has noted that there are some benefits to the software business of appearing to be a “large” firm, we can conclude that the vast majority of the investment portfolio, net of the margin loan, could be distributed to shareholders if management chose to do so.

Consolidated Summary

When we look at each of the company’s segments in isolation, we observe a traditional business that is in steady decline but still marginally profitable, a software business that has yet to provide profits, and a corporate segment dominated by an investment portfolio that has performed extremely well since it was opportunistically acquired several years ago.

The consolidated results of the three segments, reconciled to the income statement, are displayed in the following exhibit:

Although the company posted a loss in fiscal 2016, this was due to amortization of intangible assets that are probably not entirely economic costs.  Aside from this amortization charge, the company is still modestly profitable.  Operating cash flow was $1.2 million in fiscal 2016.

Conclusion

It is difficult to evaluate Daily Journal’s future prospects given that both operating businesses appear to be struggling.  We can probably conclude that the traditional publishing business is a wasting asset that will eventually either shut down or, more likely, transform into an information service accessible only on the internet.  The information the publishing segment provides is necessary and will continue to be necessary for members of the legal profession.  The question involves the economics of providing this information in the long run and it is difficult for an outsider to gain much confidence in how events will transpire.

The software business has failed to generate profits so far and revenue was stagnant from fiscal 2014 to fiscal 2016.  Management clearly has established relationships in the legal field and the investment portfolio provides customers with confidence that a strong institution is backing their software investment.  The software business could also eventually be spun off into a separate entity or acquired by a larger company.  Still, it is difficult to estimate the value of the software business with much confidence.

The investment portfolio can clearly be valued given the availability of quotations for the securities.  As of September 30, 2016, the portfolio was worth $166.6 million against a margin loan of $29.5 million and a deferred tax liability of $42.3 million.  It is possible that some or all of the securities could be distributed directly to shareholders in the future since the vast majority are not required to run the business.

Daily Journal’s market capitalization is currently $328 million and shareholders’ equity was $125.3 million as of September 30, 2016.  It seems very difficult to justify the large premium over book value given that the securities are worth only their contribution to book value and the operating businesses have very uncertain prospects.  Still, given Mr. Munger’s involvement, Daily Journal is an interesting situation that should be monitored in the future.

* Correction:  The original article posted on December 23, 2016 listed the value of foreign securities as $21.4 million.  This figure is incorrect.  The correct figure is $45,481,000, comprised of a foreign marketable security held in South Korean Won worth $12,667,000 and a foreign marketable security held in Hong Kong Dollars worth $32,814,000 as of September 30, 2016.  Thanks to @GarethEast for pointing out the error.

Disclosure:  No position in Daily Journal Corporation

The Individual Investor’s Performance Incentive System

As we approach the end of the year, many professional investors are focusing their attention on performance metrics that will determine part of their annual compensation.  Hedge funds have typically aimed to operate on a “two and twenty” fee structure where clients are charged a base fee of 2 percent of assets plus a performance fee of 20 percent of returns over a predetermined benchmark.  This fee structure has been under pressure for some time but nearly all hedge funds still operate with some element of a performance fee.  This is meant to align incentives and, at least in part, reduce the principal-agent problem.

In theory, an individual investor has no principal-agent problem at all and should not really require any kind of incentive structure to maximize performance.  Most individuals are best served by adopting Benjamin Graham’s concept of a defensive investor where outperforming the market is not the main priority.  With fees on passive strategies at rock bottom levels, defensive investors will typically want to index their funds and guarantee a result close to a chosen market average.  Enterprising investors, on the other hand, seek to outperform the market and must regard themselves as professionals.  The idea that running outside money is required to treat investing as a profession is common but misguided.  The individual who attempts to be enterprising but does not treat the endeavor seriously or have a distinct advantage of some sort is very likely to achieve a result inferior to a passive strategy, as Benjamin Graham noted in The Intelligent Investor:

“Our enterprising security buyer, of course, will desire and expect to attain better overall results than his defensive or passive companion.  But first he must make sure that his results will not be worse.  It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits.  These virtues, if channeled in the wrong directions, become indistinguishable from handicaps.  Thus it is most essential that the enterprising investor start with a clear conception as to which courses of action offer reasonable chances of success and which do not.”

The entire concept of a “performance incentive system” for an investor managing only his own account might seem absurd but human psychology would lead us to believe that this is not necessarily the case.  It takes a great deal of work and sustained effort for an individual to manage a portfolio professionally, and having goals and internal recognition can help focus the mind.

We also have the case where an individual investor is managing his own account and relying on portfolio returns to sustain his livelihood.  Such an investor could direct his funds into a passive strategy and simply withdraw a small percentage of funds annually and devote no time whatsoever to investing.  By actively managing the account, the investor is implicitly hoping to increase the funds available for withdrawal over the long run.  In the past, many experts have suggested that a 4 percent annual withdrawal rate is “safe” — meaning that inflation adjusted withdrawals can be sustained at that level indefinitely without depleting the portfolio’s long term inflated adjusted value.  At a time of near zero interest rates, it might be more prudent to view a 2 or 3 percent withdrawal rate to be more “safe”.

Let us assume that the individual investor has a choice between deploying his funds in a passive strategy and taking an annual 3 percent withdrawal or seeking to improve this withdrawal rate by actively managing the funds.  How should this investor set up an “incentive system” that will safely allow for increased withdrawals based on performance? We would suggest a simple system that takes into account the following key metrics:

  • Performance Measure #1:  Annualized Portfolio Return.  The absolute level of return is an obvious performance metric to use but we need to determine what timeframe is appropriate for measurement.  Looking at performance over a one year period is clearly inadequate given the highly variable nature of financial markets over short periods of time.  It is surprising that so many professionals managing outside funds can convince their investors to pay them based on annual measures.  We would suggest that a minimum of three years is required to even begin to assess long term results.
  • Performance Measure #2:  Performance vs. Passive Strategy. For any active strategy to provide real value, it must outperform a passive alternative.  Many investors choose to use the Standard & Poor’s 500 as a benchmark but those who specialize in small stocks, international stocks, or other strategies might pick a different benchmark.  The important thing is to pick a passive strategy to measure oneself against ahead of time.  It is also obviously important to focus on total return, including dividends, rather than just the change in the index level.  The passive strategy’s total return should be measured over the same period as the annualized portfolio return.

How would this work in practice?  If we accept the idea that three years is sufficient to measure long term performance, results would be measured on a three year rolling basis.  For example, at the end of 2016, we would look back at results from 2014 to 2016  for both the portfolio and the relevant passive strategy.  At the end of 2017, we would look at results from 2015 to 2017, and so on.

Keeping in mind that our goal is to determine how much the investor may withdraw from the portfolio above the “safe” 3 percent level, we need to develop performance factors appropriate to each of the measures.  These performance factors will be combined to determine our adjusted withdrawal rate.  The figures used below are simply examples and can be adjusted based on the investor’s judgment.  The important thing is to decide on measures that make sense in advance and then to stick with the system unless there are very compelling reasons to make a change.

Performance Factor #1:  Annualized Portfolio Return

The absolute level of the three year rolling annualized portfolio return should play a major role in our system.  Even if the portfolio outperforms the passive strategy, if returns are below a certain level we probably would not want to increase our withdrawal rate beyond the 3 percent baseline.  In the example below, a three year annualized return under 10 percent would automatically result in no incentive being awarded regardless of whether the portfolio has beaten the passive strategy.  For returns above 10 percent, an increasing potential payout factor is specified:

As we can see, the payout percentage rises as performance increases above the 10 percent minimum and tops out at 1 percent if the three year annualized return exceeds 20 percent.  However, in order to actually pay out the incentive, the portfolio must also have outperformed the passive strategy, as we explain below.

Performance Factor #2

Efforts at active management are pointless if they do not result in outperforming a passive strategy over time.  So we need to look at performance versus the passive strategy as well as absolute portfolio performance to judge whether an active strategy has created value.  The table below specifies payout multiples based on the degree to which the portfolio has outperformed the passive strategy on a three year rolling basis:

The table indicates that any underperformance will result in no payout at all, regardless of absolute performance.  As an example, if the portfolio returned 15 percent annualized on a three year rolling basis, that would indicate an additional incentive payout of 0.5 percent based on Performance Factor #1.  However, if the passive strategy provided a return greater than 15 percent annualized, there would be no additional payout because the payout multiple would be zero.  On the other hand, if the portfolio outperformed the passive strategy by over 4 percent, the payout multiple would be 3 and the incentive payout would be 1.5 percent (0.5% x 3).

The Performance Payout Matrix

The matrix below illustrates how the two performance factors would interact at various levels of absolute and relative performance:

Taking the extreme example of achieving annualized returns of over 20 percent and beating the passive strategy by 4 percent, we would take an additional incentive payout of 3 percent.  This scenario would imply that it is safe to withdraw 6 percent from the portfolio rather than the 3 percent baseline level.  Lesser degrees of absolute and relative performance result in much smaller additional payouts with an obvious bias toward conservatism.

One might argue that if a portfolio is generating annualized returns of 15 percent or more, one may be justified in a safe withdrawal rate far in excess of 3 percent.  While this is most likely correct, part of our system is designed to ensure that we are rewarding ourselves only when actually creating value versus a passive strategy.  This is why outperforming the passive strategy is a firm requirement to receive any additional payout in excess of 3 percent.

Obviously, if the portfolio is chronically underperforming the passive strategy over long periods of time, that is a clear indication that the investor would be well served to switch to a passive approach and direct his or her time and energy elsewhere.  The standard in the example shown above is deliberately stringent and meant to encourage introspection and intellectual honesty.  For the vast majority of individual investors, a passive approach is going to make more sense than active management.  Even for investors who have demonstrable skills as enterprising investors, the additional payout resulting from outperforming the passive strategy is deliberately modest in percentage terms.  For modest portfolios, the effort of active management is unlikely to be worth the investor’s time unless he or she also enjoys the process and gets utility from analyzing investments and implementing strategies.

The Undoing Project: A Friendship That Changed Our Minds

The belief that human beings are fundamentally rational individuals is perhaps the most important foundational element of modern economics.  While no economist would ever claim that all individuals are rational all the time, it has long been thought that rational choice governs human behavior frequently enough to be a dominant force driving the economy.

The concept of the invisible hand, first put forward by Adam Smith more than 250 years ago, describes the means by which individual pursuit of rational self interest naturally leads toward socially desirable ends.  Over time, this concept has been expanded upon and refined, perhaps most notably by the recognition that individual self interest can result in the imposition of externalities on others which implies a regulatory role for government.  However, few economists questioned the basic premise of human rationality in a serious way, most likely because doing so would have required incorporating concepts from other intellectual disciplines.

Daniel Kahneman and Amos Tversky did not start their careers with the intention of one day upending the field of economics.  At the start of their collaboration in the late 1960s, they had been shaped by experiences that were superficially similar but, in fact, quite different.  Although Daniel Kahneman was born in Tel Aviv in 1934, he spent his childhood in France during the second world war.  After experiencing many hardships in Nazi-occupied France including the death of his father, he returned to Israel after the war as a socially awkward young man with a deep interest in what drives seemingly inexplicable human behavior.  Amos Tversky was born in Haifa in 1937 and was shaped by the experience of growing up in Israel during its struggle for independence.  He was an extrovert who seemed to be in constant motion.  One wouldn’t have expected these two individuals to be friends let alone end up collaborating in ways that would shake the foundations of economics, but that is precisely what happened.

It takes a skilled writer to combine elements of a biography with a discourse on psychology and economics but Michael Lewis was up to the challenge. The Undoing Project: A Friendship That Changed Our Minds is the remarkable story of Daniel Kahneman and Amos Tversky and the impact of their professional collaboration, but at its core the book is the story of two friends.  Mr. Lewis gets us to think in terms of “Danny” and “Amos” and this human story adds to the context of their professional accomplishments.

By the time of “the collision” between Daniel Kahneman and Amos Tversky in 1969, they had similar resumes despite their very different personalities.  Both had served in the Israeli military and had earned doctorates in psychology in the United States.  They had both returned to Hebrew University and were thought to be rivals, yet they entered into a long collaboration in which their respective skills and personalities combined to create work that neither man could have generated on his own.  The failure of human intuition – the fact that people are not natural statisticians – was a major element of their early work.  Rather than being intuitive statisticians, people seemed to use “rules of thumb”, or heuristics, to make judgments.

Anchoring and Adjustment

One of the most interesting heuristics is referred to as “anchoring and adjustment”.  This is a heuristic that is directly applicable to investors and, once fully understood, quite alarming if our goal is to make rational decisions.  Consider the following example:

Two groups of high school students are given five seconds to guess the answer to a math problem that would require more time to actually solve.  The first group is asked to estimate this product:

8 x 7 x 6 x 5 x 4 x 3 x 2 x 1

The second group is asked to estimate this product:

1 x 2 x 3 x 4 x 5 x 6 x 7 x 8

The study found that the first group’s median answer was 2,250.  The second group’s median answer was 512.  The correct answer is 40,320.  What could account for the huge difference in the estimates from the two groups?  The first group was anchored by the fact that the first number in the sequence is eight.  The second group anchored on the first number in the sequence being one.

This might seems like a clever parlor trick, but additional research revealed many other examples of systematic bias based on the anchoring effect.  People tend to anchor on information that is not at all relevant to the problem they are being asked to solve.  Another example involved asking people to spin a “wheel of fortune” with slots on it numbered from 0 to 100.  They were then asked to estimate the percentage of African countries in the United Nations.  The individuals who landed on a high number in the wheel of fortune guessed that a higher percentage of countries in the United Nations are African compared to individuals who landed on a low number.  Subliminal anchoring appears to be a systematic flaw in human thinking.

The anchoring effect has important implications for investors.  When evaluating a company as a possible investment, to what extent do we allow the current stock price or market capitalization to influence our estimate of what the company is worth?  If we listen to management presentations, to what extent does earnings guidance influence our own estimate of future earnings?  The evidence would suggest that we are prone to taking the initial number we have seen, whether it is a stock price or an earnings estimate, and adjust from that point rather than coming up with our own evaluation in an unbiased manner.

Prospect Theory and Loss Aversion

In 2002, Daniel Kahneman won the Nobel Prize in Economics for his contributions to Prospect Theory which was developed in collaboration with Amos Tversky who died in 1996 at the age of 59.  Following the publication of the main paper describing prospect theory in 1979, the two men grew apart when Dr. Tversky appeared to gain the most professionally from the collaboration.  The very human story of these later years is described well by Mr. Lewis and reinforces the fact that even those who study the human mind professionally are not at all immune to the negative aspects of human emotion including jealousy, envy, arrogance, and just basic misunderstanding.

While the human part of the story is very interesting, prospect theory itself is fascinating.  In 2011, Daniel Kahneman published Thinking, Fast and Slow, a book that describes prospect theory and many additional topics in a format intended for a non-academic audience.  For investors, the principles Dr. Kahneman describes are just as important as having a solid grasp of business fundamentals and valuation.  One very important concept involves loss aversion.  Consider the exhibit below:

Through a series of experiments and surveys, Dr. Kahneman demonstrates that individuals feel the benefits of gains much less forcefully than the pain of losses.  Investors can ask themselves questions such as “What is the smallest gain that I need to balance an equal chance of losing $100?”  Many people will answer $200, or twice as much as the potential loss.  Obviously, each investor will answer this question differently but studies have shown that the “loss aversion ratio” is usually in a range of 1.5 to 2.5.

We feel the pain of losses much more intensely than the pleasure of gains which has important implications.  For one thing, the more often we monitor our investments or the stock market as a whole, the more often we will be faced with “paper losses”.  An investor who monitors the value of his holdings once per quarter will obviously experience paper losses from time to time, but much less often than an investor who checks quotations every week, every day, or every minute.  We can minimize pain by changing the timeframe that we use to evaluate gains and losses.

We Are Not Fully Rational

Perhaps the most important point we can take away from the work of Daniel Kahneman and Amos Tversky is that we are all subject to systematic biases that lead us to make decisions that are not always strictly rational.  People base their decisions on heuristics rather than a dispassionate evaluation of probability.  Furthermore, knowing that this is the case provides no immunity.  Experts in various fields have shown that gut feelings and rules of thumb often govern their behavior.  The consequences can be severe.

What is the answer to this problem?  Being aware of the fact that it exists is a good start but vigilance is required to reduce the chances of error, especially serious errors.  The use of checklists has been shown to help people make better decisions and reduce risk.  Adopting multiple mental models based on different disciplines is also very important.  The fact that two Israeli psychologists dared to cross disciplines and upend centuries of economic assumptions proves this point.  The story of their lives is fascinating and will likely induce readers to explore the subject in more detail.

Purchase The Undoing Project and Thinking, Fast and Slow from Amazon.com.

The Risk of Backing into a Speculative Position

You can choose a ready guide in some celestial voice
If you choose not to decide, you still have made a choice
You can choose from phantom fears and kindness that can kill
I will choose a path that’s clear
I will choose freewill

Freewill (Rush, 1980)

As Jason Zweig points out in last weekend’s Intelligent Investor column in the Wall Street Journal, the distinction between investing and speculation is not always completely clear.  One key point is that the intention behind a purchase of a security can answer the question of whether the move is an investment or a speculation.  But this presents a problem because everyone can have different intentions.  Are we saying that one person’s speculation could be another person’s investment?

Investors vary widely in terms of their capabilities and aptitude for evaluating securities in different industries.  For example, an investor with specific background in the defense industry might evaluate all of the available companies operating within the industry and rank them based on his assessment of intrinsic value relative to the current market price.  Over time, the relative rankings will change and perhaps a market panic might punish one or more companies to the point where there is a large margin of safety.  The investor purchases shares of the most attractive company for investment purposes.  The investor may be correct or incorrect but the intention behind the purchase is to acquire an asset that promises safety of principal and an adequate return.  This would meet Benjamin Graham’s definition of an investment operation.

In contrast, consider the intention of someone who has no particular background in the defense industry but is attracted to the possibility of making money by purchasing stocks in anticipation of a change in the political atmosphere.  This individual might purchase one or more stocks, perhaps even the one that the investor purchased, in anticipation of a change in the political mood hoping that he can sell at a higher price.  This individual is clearly speculating because there is an absence of fundamental analysis behind the purchase and the intent is to profit from changes in sentiment rather than a gap between intrinsic value and market value or the accrual of earnings over a long period of time.

Let’s assume that the investor and the speculator purchased the exact same security at the same time and then subsequently sold at the same time.  Obviously, the returns that both of them will experience are identical, but it is still useful to differentiate between investment and speculation.  This is because over long periods of time, process is important and will eventually dominate results.  The effect of a good process on any individual investment may not be clear but, over time, a good investment process should generate good long term results.

The Default Option

There are plenty of twists and turns that will occur over an investing career.  An investor can purchase a minority interest in a company with the intention of holding for a long period of time but all sorts of corporate actions can alter the timeframe.  The most obvious example involves mergers and acquisitions.  The company that we purchase can transform into a forced cash payout if it is acquired or we can receive shares of an acquiring company in exchange for our stake.  The world is unpredictable and we cannot assume that we will be permitted to hold a security for as long as we envision.  It follows that the investment thesis that underlies an investment may not be allowed to fully play out.

One special case involves spin-offs.  An investor purchases a security of a company that is involved in more than one business activity.  It could be a classic conglomerate or simply a business that has funded a start-up internally.  The company then decides to spin off part of its operation to shareholders.  In such cases, a shareholder will receive shares in a newly created independent company while retaining his or her interest in the original investment.  Logically, the investor must evaluate the investment merits of both companies to ensure that they remain appropriate choices. The default choice of continuing to hold both companies is not necessarily optimal.

As Joel Greenblatt pointed out in You Can Be a Stock Market Genius, spin-offs are often fertile grounds for investors.  Many investors who receive shares of a spin-off will immediately sell those shares regardless of the underlying merits of the newly created independent company.  There are many reasons behind this but the most important might be the fact that the value of the spin-off is usually very small relative to the original investment.  As a result of this type of selling, spin-offs can become undervalued.

You Still Have Made a Choice

Rather than examine the investment merits of picking up newly independent companies created via spin-offs, let’s consider the case where someone has purchased a company on its investment merits and receives shares in a spin-off.  If the shareholder is an investor rather than a speculator, retaining the shares of the newly independent company requires analysis of the economics of the business.  Basically, the investor has to ensure that the spin-off qualifies as an investment rather than a speculation.  Retaining the shares of the spin-off without going through this process is speculative even though the shareholder has not taken any proactive steps to acquire that investment.  He has simply received the shares.  But it is still speculative to hold.

Contango Ore

One recent example that comes to mind is the spin-off of Contango Ore from Contango Oil & Gas which took place in November 2010.  Contango Oil & Gas shareholders received one share of Contango Ore for each ten shares of Contango Oil & Gas that they owned.  At the time of the spin-off, we wrote about the situation in some detail and concluded that Contango Ore had to be classified as a speculation.  The company was set up to explore for gold and rare earth elements in Alaska and had no proven reserves or any prospect of generating revenue for many years.  We concluded as follows:

As we stated at the outset, CORE is a speculative company and it is obvious that the shares could end up being worthless.  In fact, it is probably more likely than not that the shares will have little value in the long run.  Nevertheless, Ken Peak [Contango’s Chairman and CEO] has a history of success in extraction of resources from the earth’s crust and he could very well surprise us with a major discovery.  In addition, speculators may build “castles in the air” and bid up CORE shares in an irrational way due to the fact that it has gold and rare earths exposure.  We are inclined to retain the spun off shares as a “lottery ticket”, although we are under absolutely no illusions that it represents an “investment operation” as defined by Benjamin Graham.

Contango Oil & Gas itself was not a speculative position for someone who understood the industry and owned shares based on an assessment of the company’s intrinsic value and long term prospects.  At the time, many value investors owned shares of Contango Oil & Gas partially due to the fact that the company’s CEO had an unusually value-oriented approach to oil and gas exploration.  We presented the investment case for Contango Oil & Gas a couple of years later and although the investment ended up not working out as expected, the intent behind it was not speculative in nature.

The same cannot be true for continuing to hold Contango Ore.  It was speculative at the outset and remained entirely speculative for a long period of time.  Over a period of many years, Contango Ore drilled test holes in Alaska and recently reported very promising results for the 2016 exploration program. When the shares were initially distributed to Contango Oil & Gas shareholders in late 2010, the valuation of Contango Ore was $4.60 per share.  In response to recent development, shares are now quoted at $21.20.  This represents a compound annual return of ~29 percent since the spin-off.  Ironically, shares of Contango Oil & Gas have collapsed over the past six years and are down over 80 percent since the spin-off.

Winning the Lottery

Receiving shares of Contango Ore in the spin-off was similar to receiving a lottery ticket representing shares in a speculative company with no proven reserves or prospect of receiving any revenue.  Could these shares have been considered an investment for anyone?  Perhaps for an individual who had some special insight into the location where Contango Ore had drilling rights or deep knowledge of gold exploration in general, but even then there would have been no way to assess the intrinsic value of the company.

Is holding Contango Ore today an investment or a speculation?  It is more possible for someone with a special competence in gold exploration to estimate the intrinsic value of Contango Ore today now that extensive drilling results are available but there is obviously still great uncertainty since the company has yet to produce any gold.  Justifying the $92 million market capitalization could be difficult.

Conclusion

It is important to make a clear distinction between investing and speculating and to classify one’s activities appropriately.  The possibility of major losses exist when someone who believes that he is investing is actually speculating instead.  There is nothing illegal or immoral about speculating but such activities really do need to be segregated from investing in our minds to avoid trouble.

The other key point is that one cannot judge whether something is an investment or a speculation simply based on the outcome.  It is possible to have a solid investment framework and still end up with specific investments that did not work out.  It is also very possible to speculate and end up with situations that worked out very well.  The end result alone obviously matters.  But from a process standpoint, we need to care equally about the rationale that led us into specific situations.  We should not fool ourselves into believing that a speculation was really an investment just because it turned out well.

Finally, it is important to understand that we are really making a choice even when we do not act.  If an investor receives shares in a spin-off that he cannot readily evaluate as an investment, he should have the intellectual honesty to either sell or continue holding but with the understanding that doing so is speculative.  Anything else risks polluting the investor’s understanding of his own process and potentially impacting good decision making in other contexts.

Disclosure:  Individuals associated with The Rational Walk LLC have owned Contango Ore shares since the spin off and owned Contango Oil & Gas shares from 2009 to 2013. 

Interesting Reading – December 12, 2016

In this series, we suggest worthwhile reading material on a variety of topics, not all of which are directly related to investing.  

Why Mohnish Pabrai Likes GM, Fiat, and Southwest Air – Barron’s, December 9, 2016.  Mohnish Pabrai’s Pabrai Funds has returned 14.2 percent annually, after fees, since its inception in July 1999 through the end of 2015 compared to 4.3 percent annually for the Standard & Poor’s 500.  In this interview, Mr. Pabrai discusses his background and investing philosophy along with his investment thesis for General Motors, Fiat, and Southwest Airlines.  Mr. Pabrai is also the author of The Dhandho Investor:  The Low-Risk Value Method to High Returns and recently started a new blog.

Why would you want to buy a self-driving car? – Financial Times, December 7, 2016.  John Gapper believes that road transportation is likely to become a utility purchased by volume with a model similar to electricity and water.  Once automobiles are truly self-driving, there will be little reason to actually own a vehicle since the same freedom of travel will be available on demand.  For many people, the cost of transportation will be far lower than owning a personal vehicle.  Our recent article on Elon Musk’s biography is worth reading for those interested in autonomous vehicles.  This is an interesting counterpoint to Mr. Pabrai’s bullish outlook on automobile sales, although it is likely that any move toward less personal ownership of vehicles is many years away.

Overbought!!? – The Brooklyn Investor, December 8, 2016.  The Brooklyn Investor looks at total returns for the Standard & Poor’s 500 over the past fifteen years along with some other market statistics.  While noting that we can enter a bear market at any time, he does not see any reason to believe in an imminent threat of a  “1929/1999/Nikkei 1989-like top” in the stock market.  He has also set up a website as a companion for the blog which offers 13-F data along with some interesting charts on Berkshire Hathaway.

The Story of How McDonald’s First Got Its Start – Smithsonian Magazine, November 1, 2016.  This is a excerpt from Ray & Joan, a recently published book by Lisa Napoli that covers the early years of McDonald’s and how Ray Kroc transformed the company.  The excerpt covers the early activities of the McDonald brothers and ends right as Ray Kroc first came on the scene.  This looks like a very worthwhile book for readers interested in the restaurant industry.

Does Decision-Making Matter? – The New York Times, November 25, 2016.  David Brooks provides his thoughts on The Undoing Project by Michael Lewis, a new book covering the fascinating story of how Daniel Kahneman and Amos Tversky revolutionized how we think about human decision making.  See also William Easterly’s review in The Wall Street Journal published on December 5.  (Note:  The Rational Walk will publish a review of The Undoing Project in the near future.  The book is excellent and well worth reading.)

Business Blunder: Pancake Flipper Al Lapin Jr. & International Industries (IHOP) – Intelligent Fanatics Project, December 1, 2016.  We recently reviewed Intelligent Fanatics Project, a book that presents case studies covering eight business success stories.  In this article, Sean Iddings looks at the opposite scenario:  a “fanatic” who appeared to be on the path to similar success but overreached and ended up failing to realize the potential of the brand he created.

Why Moats are Essential for Profitability (Restaurant Edition) – 25iq, November 18, 2016.  Tren Griffin looks at the economics of the restaurant industry and the importance of a moat in achieving profitability.  The chance of success in this business is quite low given the huge number of restaurants in the United States (624,301 as of the Spring of 2016) and the low margins resulting from vigorous competition.  The kind of profitability posted by a company like Chipotle Mexican Grill until the E. coli crisis hurt results is the exception rather than the rule in this industry.

Efficiency is the Highest Form of Beauty – Mr. Money Mustache, November 24, 2016.  There is much inefficiency in the way the typical consumer goes about spending money, and beauty in pursuing a more efficient personal consumption model:  “Spending is a skill: a Mustachian can buy the same lifestyle with $25,000 that might cost a Consumer Sucka $100,000 per year. If you can cultivate this skill, the Art of the 75% reduction, at any income level, you can go from a lifetime of being in debt, to being rich enough to retire in less than 10 years.”

What’s Speculating?  What’s Investing?  Some of the Wisest Investors Weigh In – The Wall Street Journal, December 9, 2016.  Jason Zweig examines the elusive nature of making hard and fast distinctions between investing and speculating.  The quote from Fred Schwed Jr, author of Where are the Customers’ Yachts?, seems to resonate:  “Speculation is an effort, probably unsuccessful, to turn a little money into a lot.  Investing is an effort, which should be successful, to prevent a lot of money from becoming a little.” 

Warren Buffett Says Donald Trump Won’t Derail the Economy – Fortune, December 5, 2016.  In this interview, Warren Buffett reflects on the 2016 election. Mr. Buffett supported Hillary Clinton but believes that Donald Trump’s victory will not derail the economy and that the U.S. will be wealthier after Mr. Trump’s presidency.  He also has some interesting points to make regarding free trade.

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