Manual of Ideas

Book by John Mihaljevic

Article and Review by GlobalMacroForex

I highly recommend this value equity investing book by John Mihaljevic, where he lays down a fundamental framework for discerning value and profiting from market inefficiencies.

Some of the topics covered include:

·      Deep value assets on balance sheets

·      Cheap vs. Good.  The firm’s return on invested capital

·      Evaluating the CEO

·      Challenges and rewards of screening micro-caps

·      The differences in international markets

Let’s dive right in…

Deep Value Assets: Ben Graham-Style Bargains

Ben Graham’s book Security Analysis, originally published in 1934, was a pioneer for its time in providing a blueprint for thinking about the value of a business, especially in liquidation.  While it’s unlikely that many large firms will have the same deep discounts that Ben Graham was able to find in the Great Depression, it nonetheless established a framework for what he called “net-nets”, which refer to the value of the assets of the firm after liquidation being compared to keeping the firm alive.

In more recent times, economists Eugene Fama and Kenneth French have found that high book-to-market ratio equities tend to outperform their competitors.  This section of the Manual of Ideas focuses in on what is the value of the assets on the balance sheet and searching them for potential misvaluing by the market.  You’re trying to capture valuable assets at cheap equity prices just because the firm itself has a struggling operating income.

However, there are a few things to be careful when buying firms just for liquidation value.

“Investors tend to overestimate liquidation values, as the reality of a dying business tends to hide nasty surprises for investors.”

Management could be concealing the true value of these assets or any potential problems with them.  In addition, it might be difficult to find buyers for illiquid or old assets.  The value can often erode over time.

Also when you buy an asset rich but low return business, time is working against you.  You’re tying capital up to liquid this business that is not giving continuous income.  The illiquidity and time factor on these asset sales can seriously erode your return on investment.

Mihaljevic explains how many times investors feel an equity is deeply undervalued but just can’t get comfortable with it.  He explains how the very reason that the value exists is that investors don’t feel comfortable with this security.

“The good news is you get paid to uncomfortable things when stocks are at trough earnings and low multiples their implied return is high, in contrast, you don’t get paid for doing things are comfortable” –John Lambert, GAM

As this chart from Steven Romick of First Pacific Advisors shows, the best time to buy BP Oil was right after the spill in the Gulf of Mexico,

The best time to buy an asset rich equity is when insider trading is at the most because the management knows the value of these assets and the core business.  Recent operating performance may be driving down the shares but yet from the outside we’re unsure of the fundamentals of business and the true value of the assets on the balance sheet.  This is where insider buying plays such a key role in helping to determine how management really feels about these assets.

Mihaljevic points out how it’s important to determine companies at cyclical lows from those in secular decline.  The core business may be a great value proposition for customers but just happens to have the share price and recent operating performance impacted by business cycle lows.

Joel Greenblatt’s Magic Formula

The Manual of Ideas covers Joel Greenblatt’s Magic Formula which was originally introduced in Greenblatt’s book “The little book that beats the market”.  The focus of this value equity investing strategy is to screen companies by simply asking “what is good and what is cheap?”  In this case, “good” is defined as

Good: Businesses that have a higher return on capital employed

Good formula: Operating Income / Net working capital plus net fixed assets

Cheap:  Not only is the share price cheap, but relative to the firm’s capital structure/debt

Cheap formula: operating income divided by enterprise value

Enterprise value asks if you bought the business today, paid down all debt, and took the cash on the balance sheet.  How much would it cost to do that?  So it’s Market Capitalization plus Debt minus balance sheet cash.

Mr. Greenblatt provides some guidance to avoid pitfalls or value traps.  He advises avoiding capital intense businesses (like mining) because they tend to have a lower return on invested capital.  In addition, he advises against “faddishness” or businesses that offer products that will stop selling as a fad or trend.  Joel Greenblatt points out how capital reinvestment opportunities must exist for the business or it means the core business will decline (ie newspapers).  If there’s no growth or the benefits of a high return on invested capital are diminished, the business can’t continue to invest at that high rate.

Also, he mentions the necessity to avoid businesses with a questionable value proposition to customers.  You should understand clearly how this firm’s products actually add value to their customers.  Along with that same line of thinking, you should avoid firms that seek endless M&A growth because there are not only integration risks, but it also dilutes the original high return on invested capital.  Finally, just like the Ben Graham-style value investing, Greenblatt advises watching for insider management selling as that’s a key indicator that this firm’s future value proposition may be in jeopardy.

Evaluating the CEO

John Mihaljevic outlines the importance of evaluating the CEO.  He says,

“Chief executives distinguish themselves in two ways: business value creation and smart capital allocation”

The CEO should be focusing on the core business’s value proposition to customers and ensuring that the firm’s capital allocation is being used in the most efficient ways with the highest return.  This ties back into Joel Greenblatt’s magic formula of operating income divided by net working capital plus net fixed assets.

Mihaljevic further states it’s important to distinguish good stock performance from good business performance.  Here in lies the key to value investing and the CEO evaluation.  Is this business in a secular decline or is it a temporary cyclical downtown in share price?  In addition, what does financial leverage say about management?  Are they prudent with the firm’s capital and using appropriate risk management?

Investing in Micro-cap stocks

John Mihaeljevic and the variety of asset managers he quotes throughout the book suggest that investing in microcap stocks are a great way to boost the returns from active management.  Micro-cap stocks tend to have more market inefficiencies and their balance sheet assets are less likely to be truly reflected in the share price.  In addition, major shareholders get more sway, so you have more of an ability to influence this business.

Some of the reasons micro-cap stocks tend to outperform may be that large asset management firms can’t invest in them because the equities are too small for the firm’s capital.  Also, they aren’t in the major indices and no sell-side analysts write reports on these micro-caps. 

However, there are some risks with this style of investing.  First, it helps to know why the stock collapsed.  Second keep in mind, even though small caps as a group outperform the larger ones, the difference between the top and bottom of the small-cap returns is larger.  So there’s more room for fundamental based research and active management to shine. 

Mihaeljevic says the key to finding these value micro-cap firms is to move beyond quantitative screens that many investors can rapidly go through screening software.   The key is qualitative analysis.  He points out how few investors are willing to put in the time to go from A to Z and search these companies’ financial statements.  Small companies tend to lump nonrecurring items into financial reports that don’t work well with quantitative screens.

Special Situations

Special situations are time-sensitive events (like a Merger) that provide an opportunity for active management.  In these situations, the time component matters more.  Mihaeljevic asks the investor to consider if the money will sit there forever or if there’s a clearly defined catalyst?

A catalyst is an event that will trigger a change in the value of this investment. 

“In the absence of identifiable drivers of inefficiency, the probability may be higher than our appraisal of value contains an oversight or flaw.”

International Equities

Mihaeljevic concludes his book by discussing international equities and their differences.  He points out how often expectations exceed reality for emerging markets. 

“When the expectations implied in stock prices fall materially short of the likely fundamentals, a buying opportunity may be at hand.”

-Alfred Rappaport & Michael Mauboussin. Expectations Investing

Each country has different standards or screening pitfalls.  For example, corporate governance isn’t as stressed by the management of Russian companies. It’s important to know the local market and understand potential value traps.  In Japan, the Return on Equity number is radically different than American counterparts.  Japanese firms typically hold a larger portion of cash on the balance sheet dragging down the RoE, however that can change their outlook.