Second Quarter Summary
In the second quarter, our portfolios gave back some of their gains from earlier in the year. Our composite Equity account was down 2.4%, between the returns of the S&P 500 and the Russell 2000. Year to date, our composite Equity account is up 5.5%. Our composite Balanced account was down 2.2%, underperforming both the Vanguard Balanced Index Fund and Thomson Balanced US Mutual Fund index. Year to date, however, our composite Balanced account is up 4.4%, meaningfully ahead of those benchmarks. As we stated in our first quarter letter, we continue to seek compelling investment stories wherever the markets make them available and will stay safely in cash in the absence of such ideas. With the recent market pull-back, we are diligently reviewing new opportunities and past successes for potential investment.
|Annualized as of 6/30/06|
|2Q 2006||YTD 2005||1 Year||3 Year||5 Year||Since
|Vanguard Bal. Index Fund||-1.27%||1.67%||5.41%||8.45%||4.45%||4.20%|
|Thomson US Balanced Index||-1.21%||1.65%||5.44%||7.64%||3.33%||3.24%|
* Please refer to performance disclosures at end of document.
How to Use Financial Metrics
Recently, we decided to investigate whether the financial metrics of companies we looked at, but did not invest in, over the past four years possessed analytic attributes that held some predictive value. For instance, did the companies with the lowest price to earnings ratios perform well? Did the ones with the highest price to book ratios perform poorly? In this current analysis (performed on approximately 200 companies reviewed), we found that many of the companies we looked at outperformed the market. We wanted to see if there were any metrics that could have predicted the subsequent gains many of these securities experienced (without our participation). Perhaps we would find something to improve our ability to pick “winners.”
Here’s what we found:
Enterprise Value (EV defined as market capitalization plus debt minus cash) to Trailing Twelve Month (TTM) Revenue possessed meaningful predictive power. At the time of analysis, the stocks with the lowest EV/TTM revenue clearly outperformed the ones with the highest multiples.
EV to EBITDA (Earnings before interest, taxes, depreciation and amortization) possessed moderate predictive power. Stocks with the lowest EV/EBITDA outperformed those with the highest multiples.
Inside ownership showed itself to possess moderate predicative power. Companies with the highest inside ownership performed better than ones with low inside ownership.
Price to Book Value, Price to Earnings, Price to Cash Flow and Net Cash as a percentage of market capitalization possessed little to no predictive power. In other words, the lowest price to earnings stocks performed no better than the highest ones.
What can we reasonably conclude from this analysis of roughly 200 stocks? Within the universe of stocks that Roumell Asset Management chose to investigate over the past four years, one metric in particular, and two to a lesser extent, showed themselves to possess some predictive power. The study perhaps shows us where to shine the flashlight a bit more, but in no way relieves us from what we noted in our 4th quarter 2005 report, “The entire entity must be viewed from multiple angles to render an informed total investment judgment (not just a current operational judgment).”
The modest conclusion we derive stands in stark contrast to quantitative strategies wherein select financial metrics are held in mantra-like status. These “black box” investment styles rest on the belief that a favorite financial metric can be isolated and acted upon. A recently published book by a best-selling proponent of this viewpoint was reviewed thus, “This market-beating system may be the Holy Grail.” Don’t bet on it.
Surely, we have our favorite metrics. But we are not wed to any particular one(s) and only view each one in the context of the whole. Here’s why: companies with low price to earnings ratios may indicate earnings are simply peaking within a cycle; absence of current earnings may be trumped by significant non-cash producing assets; current high cash flows may mask business underinvestment; current high utilization is sure to be followed by new capacity; book values often do not reflect economic reality and only serve as a starting point; etc. Companies are puzzles for which various financial metrics must be pieced together to be sufficiently understood (metrics need to be viewed as interdependent) – and an investor always invests while missing several pieces. One goal is to buy cheap enough so as to limit the potential negative effects of those missing pieces. Buying “cheap enough” is what we strive to always do.
Our Three Top Purchases in the 2nd Quarter
Berkshire Hathaway, Inc.–Class B, BRK.B. Berkshire Hathaway is a holding company owning subsidiaries in a variety of businesses. The most significant business is insurance, which includes GEICO, one of the largest auto insurers in the US, and General Re and The Berkshire Hathaway Reinsurance Group, two of the largest reinsurers in the world. Non-insurance businesses include, among others, See’s Candies, International Dairy Queen, Fruit of the Loom and Benjamin Moore. In addition to private companies, Berkshire has a portfolio of minority interests in public companies that includes, among others, American Express, Coca Cola and Proctor & Gamble. Berkshire is run by none other than Warren Buffett. Mr. Buffett has been Chairman and CEO since 1970. He owns approximately 32% of Berkshire Hathaway. As many of you know, Warren Buffett is considered one of the greatest investors of all time. Mr. Buffett is basically hands-off when it comes to operating decisions at the various Berkshire businesses. He allows those decisions to be made by the managers of the business units.
Since Berkshire Class B shares hit an historical high price of $3,184 in April 2004, its shares have languished (Note: Class B share is worth 1/30 of a Class A share). There have been several concerns in the market. First, was there someone to take Mr. Buffett’s place in the event he could no longer act as Chairman? At 75 years old, Mr. Buffett says that he’s in good health and wants to continue acting in his current role. He has also made it known that the Board of Directors has chosen a successor, although that information will remain secret until necessary. Another concern was whether or not Mr. Buffett could successfully invest his increasing cash hoard as he had done in the past. The returns on Berkshire shares lagged the S&P 500 in 2003 and 2004, even though shareholders’ equity grew from $65.4b to $86.7b, or 32%, over the same period.
We view Berkshire as a sum of four parts: cash, equity securities (publicly-traded businesses), fixed income securities, and private businesses (predominantly, wholly-owned). At the time of our investment, Berkshire had (and still has) a rock-solid balance sheet with about $40b in cash (30% of its market capitalization), $44b in publicly-traded equity securities and $25b in fixed income securities. Net earnings from its private businesses were approximately $3.4b. At our purchase price, after deducting net cash, equity securities at a conservative 80% of their publicly-traded market value, and fixed income securities, we paid an implied 10x earnings for Berkshire’s private businesses. Thus, while the unmanaged S&P 500 trades at 16x earnings, we own, at the price we paid, a collection of businesses personally selected by Mr. Buffett himself at 10x earnings. Finally, we get to hire Warren Buffett to make astute investment decisions with Berkshire’s cash hoard during a period of time when the market appears to be placing more businesses “on sale.”
Capital Southwest Corporation, CSWC. Founded in 1961, Capital Southwest is a publicly-owned venture capital investment company that invests in small and medium-sized businesses in varied industries in the US. Its holdings include both private and publicly-traded companies. We view Capital Southwest as an undiscovered, mini-Berkshire Hathaway. CSWC is headed by William Thomas, who joined the company in 1962 and has served as President since 1980 and Chairman since 1982. Mr. Thomas owns about 16% of CSWC. CSWC’s Net Asset Value (NAV) has grown over the past 20 years at a compound annual rate of 14.5%.
We have been buyers of CSWC shares over the past several years. It is the largest position in our portfolio, representing about 9% of the total. Capital Southwest provides lots of detail in its annual report to assist in valuation. We update our analysis as new information becomes available. If we believe a significant discount to intrinsic value exists, we do not hesitate to buy shares. Like Berkshire Hathaway, we analyze Capital Southwest using a sum-of-the-parts methodology to derive an adjusted NAV. The three largest publicly-traded investments (Palm Harbor Homes, Encore Wire and Alamo Group) represent about 36% of CSWC’s holdings. In calculating its NAV, Capital Southwest applies an average discount of roughly 37% to the publicly-traded market prices of these three securities (that is, these investments are valued, on average, at only 63% of their market prices because of management conservatism). We also believe the privately-held businesses are conservatively valued.
Capital Southwest, unlike most investment companies, reports its NAV after deducting deferred taxes on unrealized appreciation of investments. However, one must remember that much of the tax will continue to be deferred and, therefore, be invested for shareholders as a result of the long-term investment horizon of Capital Southwest. Moreover, when long-term gains are realized and retained, the company pays the 35% corporate tax for the benefit of the shareholders, but individuals will only pay the capital gain rate of 15% and tax-exempt entities (such as IRAs) will owe no tax. The result is a tax credit or refund to shareholders (such an instance occurred in 2005).
When adjusting Capital Southwest’s reported NAV for “overstated” deferred taxes and what we deem to be overly conservative assumptions on several of its public and private holdings, we arrive at an adjusted NAV that is approximately 50% higher than stated NAV. Normally, CSWC is a rather illiquid security, but we were fortunate to step into the market when there appeared to be a significant seller. As a result, we were able to purchase our shares in the 2nd quarter at a substantial discount to our adjusted NAV calculation.
Intel Corp., INTC. Intel Corp. develops advanced technologies used in the computing and communications industries and manufactures semiconductor microchips. The company has been a pioneer in the development of microprocessors, chipsets, memory and wireless connectivity for the lifespan of the technology age. Founded in 1968, Intel strived to meet the challenge put forth by its co-founder, Gordon Moore, to double the number of transistors on a computer chip every year. This prediction, known as “Moore’s Law,” became the standard for achievement in the computer chip industry. Intel has been the leader in the semiconductor chip industry for almost 15 years and is extremely well positioned to maintain its edge in the evolving digital wireless world.
Currently, Intel is facing a renewed challenge from long-time distant second place rival Advanced Micro Devices, Inc. (AMD). AMD’s recent success has drawn Wall Street’s favor and, consequently, Intel’s stock price has underperformed. AMD has temporarily succeeded in capturing just over 20% of the computer chip industry’s market share. Although AMD has improved its operations, Intel still dwarfs its only significant competitor by maintaining a 78% share. Intel has successfully defended its dominant chip position against several forays by AMD to increase share. We do not believe that AMD’s challenge will result in the permanent impairment of Intel’s business as Intel will use its superior financial position to fend off AMD. Case in point, Intel’s 2005 research & development expenses were $5.1 billion; this compares to AMD’s $5.8 billion in total sales.
The metrics that led us to purchase Intel are compelling: 1) The company’s stock is trading near 10 year trough EV/Sales and EV/EBITDA valuations, 2) Intel is a large free-cash generator; the three year average free cash flow yield (Free Cash Flow/EV) is just under 9%, and, 3) The company has increased its Net Profit Margin and ROE each of the last three years. In addition to the attractive valuation metrics, Intel possesses a rock-solid balance sheet that provides the company a tremendous degree of financial flexibility to accelerate the company’s $25 billion stock repurchase program or increase the current $0.10 quarterly dividend. Peter Lynch, famed retired Fidelity portfolio manager, once said that great companies that are industry leaders go on sale about once every ten years. We believe that our purchase of Intel falls into this category.
Once again, we want to thank you for the trust and confidence you have placed in us. We will continue to watch what the market appears to make cheap, diligently research those ideas and, in the end, select our investments cautiously. If you are aware of individuals who would benefit from our approach, we would welcome the opportunity to talk with them. You can always direct such individuals to our website, www.roumellasset.com. Additionally, we have lots of terrific restaurants in our Chevy Chase neighborhood and would be happy to take you and a friend(s) to lunch to discuss our investment approach. As always, please feel free to contact us directly about your account.
Investment Strategy: Roumell Asset Management, LLC (“Roumell”) employs a value investment strategy in managing client portfolios. Roumell Equity accounts can have up to 100% of assets invested in stocks; Roumell Balanced accounts typically have 65% of their assets allocated to stocks (though the figure can range from 50% to 80% depending upon the needs of the client).
Calculation of Rates of Return: First and foremost, readers of this letter should recognize past performance is no guarantee of future results. Returns are reported net of all management fees and applicable trading costs; annualized returns are the result of linking quarterly returns (only accounts present for the entire quarter are included in a given quarter’s performance composite); returns are time-weighted; returns reflect reinvestment of dividends and other earnings. Returns include an insignificant number of accounts that utilize margin. These returns are based on a composite of Roumell’s accounts and therefore were not necessarily duplicated in any specific account. These consolidated performance numbers include all of Roumell’s fully discretionary accounts within each category. Discretion is defined as the ability of the firm to implement its intended investment strategy without restriction.
Inclusion of Accounts: Currently, in the performance calculations for Roumell Equity, there are 381 equity portfolios totaling $136.1 million. This represents 63.0% of total portfolios and 57.2% of total dollars under management. The standard deviation for Roumell Equity in this quarter is 1.07%. Currently, in the performance calculations for Roumell Balanced, there are 152 balanced portfolios totaling $75.9 million. This represents 25.1% of total portfolios and 31.9% of total dollars under management. The standard deviation for Roumell Balanced in this quarter is 1.5%. A complete list and description of the firm’s composites is available upon request. Additional information regarding policies for calculating and reporting returns is available upon request.
Comparative Indices: Because Roumell utilizes an all-cap (large, medium and small companies) investment strategy, there is no perfect index for comparison purposes. We have included two equity indices and two balanced benchmarks to allow readers to judge our performance against benchmarks that collectively offer good comparative illustrations.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable.