Thursday, December 27, 2007

Value Vs Price

As per efficient market theory, price of a stock reflects the current value of the stock incorporating all known information in the price. However, value investors disagree with this proposition. Warren Buffet wrote in one of his annual reports that while stock market is usually efficient, that does not mean it is always efficient. The difference between usually and always is 'night and day'.

It is instructive to understand that why would market misprice a stock when investors (many of whom are highly educated ) focus enormous amount of time to analyze a stock. The simple answer is emotion and time horizon. Lets take this one by one.

First the basic of human emotions that affect stock price is fear and greed. Market has a tendency to swing to extremes during both good and bad times. It is not unusual for the market to extrapolate both good and bad times into distant future.

A case in point about too much optimism in good times is tech stocks during late 90's. Tech stocks like Cisco were very good companies making lots of money. But their stock price reflected enormous optimism about future and that was not achievable. This even extended to tech stocks that did not have earnings or just went public. The late 90's provide an extraordinary learning opportunity to learn for value investors.

Similarly pessimism about future too can be taken to new heights. Currently credit agencies like Moody's or Mcgraw hill (MHP- owns S&P credit rating agency) seem to reflect a gloomy future forever. At some point housing will recover to ordinary levels if not to the extraordinary levels of 2005 and 2006. Similarly capital markets will likely return to normal levels at the very least.

Take the case of Moody's. It's price fell from high of $76 to around $36+ dollar within a matter of months. It is difficult to believe that the value of the company was 100% more than today's price just a few months earlier. Either market over estimated earlier high price or is discounting the current value significantly or bit of both. Either case, market misprices during uncertain (read fear or greed) times. Only time will tell if Moody's price is under valued. But it does show that market takes wide swings and value of solid companies usually do not swing that much in short order of time.

Further Warren once said that it is important to note that these emotions are here to stay. As a whole human race does not get any wiser with respect to these emotions. These will occur many times in future. That is good news (not bad) for value investors who seek to find mispriced stocks.

Time horizon introduces some mispricing because of the way Wall street operates. I have found that if a business has a temporary problem and has a very bright future and will return to creating value in two to three years, Wall street usually will leave it for "dead". It is called "dead money" and the stock is beaten down. Wall street will plan to get back on the stock once it gains "traction"! I am always surprised why this occurs but it is an indirect effect of compensation systems. Most compensation system operates on quarterly or yearly rewards. compensation systems drive behavior and usually this results in intelligent people doing things that they would not normally do. This provides unusual opportunity for those willing to wait. This is the critical information that provides regular investors a leg up over Wall street.

The key point for a value investor to take away is price of a stock is not necessarily it's value. Price is set by auction type market by all market participants which by it's very nature is affected by emotion and time horizon of it's participants. Value of a stock instead is derived by discounting it's future cash flows to present. When they coincide or when price is greater than value, value investors need to walk away. When value is significantly higher than price, swing your bat. Also, usually market is good at recognizing value and will match it's price with value.

It is intructive to read Warren Buffet's lecture on this topic and can be had by

I hope this seals the discussion about market mispricing. Happy value investing...

Monday, December 17, 2007

Western Union - Whats the catch! - Is it a value trap?

WU has a number of well known competitive advantages like huge distribution network that dwarfs competitors, very high profit margins and growth that is not capital intensive. In spite of these advantages, Berkshire sold it's entire stake in Western Union. What could we be missing that Berkshire recognized?

I have to confess that Berkshire selling stakes in WU got me thinking more about what could be wrong with WU's business model. Obivously, no one Knows why Berskshire sold it's stake in WU. It could very well be a distaste for small positions (around $300 million originally...yes it is small for Mr. Buffet!). But it is worth thinking about other aspects as well.

I read WU's annual report to find out. One sentence captured my interest. In it, it is stated that due to pricing actions, revenue reduced 3% and further that this trend will continue into future. In the recent quarter, the management said that revenue reduced 3.3% due to pricing action. This kept me thinking as to why WU will have to reduce price if they have such a strong brand and further that why such price reductions will need to be ongoing. This needs additional thought.

WU has the biggest distribution network among all money transfer firms (3 times bigger than their immediate competitor Money Gram). In exclusive money transfer corridors (where there is little or no competition), they have enormous pricing power. But that is not the case in corridors where they compete with other money transfer companies, especially a big one like Money gram.

Money Gram (MGI) is expanding it's network at a fast rate and as a by product of that, WU starts to lose exclusive corridors of money transfer. This in turn results in Western Union losing pricing power. It is well known that Money gram prices just below western union. While WU has first mover advantage, it is far from being a permanent advantage. This loss of exclusive money transfer corridors results in reduction in pricing and hence revenue. I think that over long term, both operators can co-exist but not at profit levels that WU is currently experiencing.

Oracle of Omaha does like pricing power as a result of strong brand. Brand is just a means to pricing power and is not end all by itself. Think GM vs Coke. Both are powerful brands and only one of them carry pricing power. The key question then is whether WU's brand helps it maintain pricing power which can become a more sustained advantage?

WU's brand symbolizes reliability and convenience. But the relevant question to me is whether Western Union's brand is strong enough to convince a customer to pay a premium price (higher than competitor) and use Western union even when a viable cheaper alternative exists (Money Gram). Or in otherwords, will customers pay a higher price to transfer money through WU if Money gram agent is available in the both send and receive locations? This question is key to determine long term pricing power and share holder returns.

If the answer to above question is 'Yes', it's advantages are sustainable and loss of exclusive corridors don't matter much and Western Union will continue to earn excess returns over long periods of time. If the answer is 'No', it's returns are dependent on competitor having rational pricing and other factors affecting the industry (or in other words, starts to resemble commodity type business over long run).

My view is that it does lose pricing power as as Money Gram expands. But longer term, both companies can co-exist (like Coke, Pepsi or UPS and FEDEX). But it will need to be at lower margins than Western Union currently has. So it will be somewhere between excellant business (franchise as Warren Biffet would call it) and commodity type business.

The money transfer business is high fixed cost and low variable cost. So the last dollar earned goes directly to bottom line. So 3 % revenue lost in pricing actions are going to directly affect the bottom line.

Some offsets to revenue reduction in medium term could be faster international growth or Money gram stumbles in execution due to subprime issues etc. It is true that international segment margins are lower. But that does not explain the 3% reduction in revenue due pricing action.

All in all, I think WU is a good business but will likely not be a great business as it was in the past. Disclaimer, I do own WU. I think it has decent prospects due to international segment (especially Asia and middle east) and due to low capital requirements. But likely will not be a great business as it's numbers currently imply. Any thoughts on this is welcome!

Welcome to blog

Welcome to value investing blog. Yes! this blog as some would have figured out by it's name deals with value investing.

So what do we mean by value investing? Value investing at it's core is simple. You attempt to buy dollar bills for less than a dollar. Hence the name. Different value investors use different strategies to achieve that goal. Some use bankruptcies to pick up gems, some use spin off situations and some prefer buying fallen down quality stocks, some buy companies with the hope of enhancing value and so on. But the general idea is same... that is buy stocks or business with value greater than their selling price. Ben Graham's simple but powerful concept is true today as it was many decades ago.

Postings in this blog will be of two types. One will focus on value investing, it's different methods, thoughts and links from other great investors related to this topic. You could call this theory behind investing.

The second type of posts will deal with investments that the author considers under valued. We will also cover some cases where we think the low price is infact a value trap.

Needless to say, author does not have any crystal ball about the future. Investing is essentially forward looking. You know the past but need to make a reasonable estimation of future which inherantly no one has control over. So use this site for learning and to possibly get a few starting ideas (if you are lucky) to do your own due diligence. This is not just a regular legal disclaimer. It is much more than that. It is very important for you to understand completely what investments you are getting into especially when things dont go as you expected (which occurs more than you would think!).

Lastly, welcome to this blog again and I hope you leave this blog a little wiser than you came and that is a high bar!