Value Investing Principle #3 (Part 3): Value Investors Love a Good Bargain

In the previous 2 posts on Value Investing Principles (here and here) I looked at the concepts of Margin of Safety, and Intrinsic Value. I explained that the calculation of the intrinsic value of a business is not an exact science but rather a rough estimate of value, hence the need for a margin of safety.

As promised in my previous post, in this post I am going to attempt to answer the last of the 5 questions that I posed:

Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?

In attempting to answer this question I will introduce a new Value Investing concept - 'The Value Trap' . I'll also explain why some investors tend to be fooled by Value Traps, and in a later post will provide some advice on the best way to recognize them.

Drawing on the metaphor I used in the first post, imagine you are shopping and you see packets of pasta at half price. Instinctively you may want to take advantage of the bargain and buy in bulk. Savvy shoppers will immediately ask 'where's the catch?' - and will attempt to identify something faulty with the good (perhaps the pasta is close to its expiry date or is of poor quality). If you've discovered a valid reason why a product is 'on special' or trading at a significant bargain to market prices, you have discovered a 'Value Trap'.

Simply put, I define a Value Trap as a company that appears to be undervalued and a Value Investing opportunity, but in fact does not possess any recognizable significant investment potential.

So, to answer the question I posed: In my humble opinion I believe that for the most part, when a business is valued cheaply, there is a good reason for it and I seek to identify it. Most of the time, the market is to a large extent correct. This is expected. Never in the history of mankind have investors had so much company and industry information available at no cost, and never have they been as savvy and educated.

There are instances, however, when the market has mispriced or undervalued a business with little justification. These include:

(i) When it focuses on the Short Term and ignores Long Term potential: I think this is a primary reason for pricing inaccuracies as analysts and investors with a short term investment horizon focus solely on quarterly earnings. Long Term Value Investors take advantage of such short-sightedness to pick up quality companies cheaply.

(ii) The Market Confuses Uncertainty with Risk - this is a underlying theme of Mohnish Pabrai's investment philosophy. You can read about it in detail here. Basically, investors tend to react in simialr fashion when there exists business uncertainty as when there exists business risk - they panic. Two recent examples come to mind: in 2005 Mercury Interactive's CEO and CEO were accused of fraud with regards to the backdating of options. The market responded with a significant sell-off and drop in market price. Mercury's business and clients had not changed. The only difference is that 2 of Mercury's former senior management would now be wearing orange overalls. Hewlett Packard was able to take advantage of the negative market sentiment and less than a year later to acquire the company for $4.5 biliion in cash. A similar story occured with M-Systems and an internallly-initiated options backdating enquiry which resulted in the market severaly overeacting. Nothing had changed in the business at all, but the end was the same as Mercury's. SanDisk took advantage of the negative market sentiment and low share price and acquired M-Systems for approximately $1.5 billion

(iii) When Investors Do Not Properly Understand The Business: Sometimes investors do not understand the fundamentals of a specific business, and when certain industries face negative sentiment, these businesses included and collectively punished. A current example is the sub-prime crisis. There may exist certain mortgage businesses or financial insitutions that have little exposure to low-quality loans, and yet they have suffered the same fate as the others in the industry.

Rear-View MIrror Investing: Why Investors Fail To Recognize Value Traps?

The main reason that investors fail to recognize Value Traps is what Buffett calls 'Rear View Mirror Investing' - making investment decisions based on past experience. (See the entire article here). Psychologically we all tend to place significant weight on our past experiences and extrapolate them into the future. This is one of our prime learning mechanisms. If we get food-poisoning from dining at a certain restaurant, we most likely won't return there again. And the converse with positive experiences. Unfortunately, this does not exactly work in the investing game, and is a major cause for failing to recognize a 'Value Trap'. As John Maynard Keynes suggests:

"It is dangerous to apply to the future inductive arguments based on past experience, unless one can distinghuish the broad reasons why past experience was what it was."

There are many examples of businesses that were once dominant players in their industry, and in fact still remain dominant, yet the fundamentals of the industry as a whole have changed.

In my next post, I will provide an example of a great business that looks absurdly cheap, but which, because of massive changes in the industry it is in, make it a 'Value Trap'.

Can you think of the industry that I am referring to? Or a business in such an industry?

Until next time: "May you possess the Wisdom to see what the market does not, and the Courage to act on it".

Value Investing Principle #3 (Part 2): Value Investors Love A Good Bargain

"The entrance strategy is actually more important than the exit strategy". – Eddie Lampert

"Plan before acting. Fight only when you know you can win." - Zhuge Liang

In the previous post on the Principles of Value Investing I introduced the concept of Margin of Safety and Intrinsic Value and answered the first of 5 questions that I posed:

(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?

(2) How Do I Calculate the Value of a Stock?

(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?

(4) How great a Margin of Safety do Value Investors generally demand?

(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?

In today's post I will attempt to answer questions 2 to 4.

Q2: How Do I Calculate the Value of a Stock?

The important point to understand here is that calculating the Intrinsic Value of a business or stock is not an exact science. It is an estimate or a range between prices.

A simple example: Let's assume you are interested in purchasing a felafel stand. How would you calculate what price is a fair price you should pay for the business? Hopefully, you would look at 2 factors:

(i) Cashflow: You would try to assess how much cash the business will generate (cash flow) every year after all your expenses have been paid.

(ii) Growth Expectations: You will try to assess the growth potential of the business.

Now let's assume you do some research and discover that similar falafel stands in the area generate in their first year of operation an annual cashflow of $50,000, after all expenses have been paid. And let's assume that you discover that a similar falafel stand increased it's annual cashflow by 10% every year.

Would you pay $50,000 for the stand? Probably – as this means that you would earn back your initial $50,000 in one year. How about $100,000? Yeah, maybe. $200,000? Um, let me think about it. So you now have an estimate – in your opinion it is worth somewhere between $50,000 to $200,000.

If the seller of the falafel stand wants $1 million for it, you would immediately recognize that only a fool would pay such a price – even if there are hundreds of other fools paying similar prices for similar businesses elsewhere. On the other hand, if someone, for some reason offered to sell it to you at $25,000 – you would take a serious look at this deal.

In calculating the intrinsic value of stock, Value Investors apply a method called "Discounted Cash Flow" or DCF. The 2 main assumptions are free cash flow and growth. As much has been written by individuals far more capable than me, I will not go into the actual calcualtion or methodology of DCF. Instead allow me to point you to:

(i) An excellent article from the Motley Fool.

(ii) Joe Ponzio's FWallStreet - Joe's blog is first class - extremely well written, a shining example of an individual bringing value to the market. Specifically look at the 4-part series on The Value of a Business that begins here. You can also download a very good DCF excel spreadsheet which Joee used on his analysis of JNJ here.

Q3: Why Not Pay the Fair Value? Why Must I seek a Margin of Safety?

"One of the hardest things to imagine is that you are not smarter than average" - Daniel Kahneman, New York Times "Why Both Bulls and Bears Can Act So Bird-Brained", March 30, 1997

You haven't been paying attention, have you? Calculating Intrinsic Value is not an exact science – it is estimation only that requires two assumptions – a forecast for annual cash flow in year 1 and an estimated growth rate. As these are only assumptions – they can be wrong (and often are). You need to leave some contingency in the event that your assumptions are wrong.

Warren Buffett refers to the field of construction and engineering where the Margin of Safety concept is applied daily:

"You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing." - The Superinvestors of Graham-and-Doddsville

In his 1974 Letter to Shareholders Buffett wrote:

"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."

This is why I have always said that Value Investors earn their money when they place a 'buy order' - not on the sell. The skill is in buying well.

And in his 1992 Letter to Shareholders he said it again:

“What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).....The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value...... If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”

Q4: How great a Margin of Safety do Value Investors generally demand?

"If you understand a business and if you can see its future perfectly, then you obviously need very little in the way of margin of safety...Conversely, the more vulnerable the business, the larger the margin of safety you require." - Warren Buffett

As the Buffett quote suggests, the Margin of Safety that you give yourself is a function of to what extent you feel confident about forecasting a businesses cashflows and growth. Value Investors typically demand a margin of safety (or discount) of at least 30% (and sometimes as high as 50%) to calculated intrinsic value.

It is also worth noting that the greater the Margin of Safety that you give yourself, the lower the risk in losing your initial investment. The Partners at Tweedy Browne, a well-known Value Investing fund manager explains:

"One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value. Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e. lower risk."

In Part 3 of Value Investing Principle #3, I will attempt to answer Question 5 and discuss what the industry refers to as 'Value Traps'.

"May you possess the Wisdom to see what the Market does not, and the Courage to act on it".

Warren Buffett Bursting with Pride at Israeli Acquisition

Warren Buffett is currently on a whirlwind tour of Asia. The impetus of the trip was an invitation by Iscar CEO, Eitan Wertheimer to Buffett, to officially open Iscar's first metalworking production plant in Dalian China.

In yesterday's exclusive interview with Ha'aretz's Guy Rolnick, Warren Buffett could not say enough great things about his purchase last year of Israeli metalworking company, Iscar.

Below are some of Buffett's thoughts:

"Iscar is a dream deal. It has surpassed all the expectations I had when buying the company, and my expectations had been very high."

"Since I met Eitan Wertheimer [Iscar's CEO], and acquired Iscar, the people at Berkshire Hathaway think I'm a lot smarter".

When Rolnick asked Buffett how Iscar has performed since he acquired it, Buffett responded:

"Next week I have a board meeting in Columbus, Ohio....Only three Berkshire Hathaway companies will be making presentations there: two insurance companies and Iscar.... And when the people from Iscar make their presentation.... the buttons are going to burst right off his shirt because [I'll] be so puffed with pride about that deal."

For those readers who are not up to speed with the Berkshire acquisition of Iscar, here's a quick summary.

• In early 2006, Buffett received aone and a half page letter from Eitan Wertheimer, Iscar's CEO, describing the Iscar business. Buffett stated that when he read the letter something jumped out at him, and he invited Eitan to Omaha.
• Soon after meeting Wertheimer, the details of Berkshire's acquisition of Iscar were agreed upon.. Buffett did not use an investment bank or corporate advisors on the acquisition. He didn't even visit the Iscar plants.
• Berkshire paid $4 billion for an 80% interest of the business. This was Buffett's first acquisition outside of the US.

Soon after the Iscar acquisition, Buffett paid his first visit to Israel. Below is a 7 minute interview from that trip. Apart from the first 25 seconds, the interview is in English.

In the interview, he explains why he does not perceive Israel as a greater security threat than either the US or the UK.

Some Excerpts:

" I can give you an absolute, unequivicol answer....it's very impressive when a country of 7 million or so people turns out a business like this.... I haven't seen anything like this in the US."

"We weren't measuring Iscar against any other Israeli company. We were measuring it against everything we see in the world".

"If you compared Israel in 2006 with Israel in 1948, it's very very impressive".

"Israel should not be a secret....it's remarkable place... particularly the talent.... talent's worth far more than money."

Value Investing Principle #3 (Part 1): Value Investors Love A Good Bargain (Margin of Safety)

"Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety."

– The Intelligent Investor, Chapter 20, Benjamin Graham

"Good warriors prevail when it is easy to prevail. "
- The Art of War, Sun Tzu

In this post, and in the following two after it, I will discuss the ideas behind what is probably the most central concept in the Value Investing discipline: the 'Margin of Safety'. Benjamin Graham, the 'Father of Value Investing' introduced it to the investing world in his book, The Intelligent Investor.

Simply explained, the Margin of Safety principle demands that investors only invest in businesses or stocks that trade at a significant discount to their calculated 'true value'. This 'true value' is also called the 'intrinsic value'. In other words, if you calculate a stock's intrinsic value to be $100, you should give yourself a 'margin of safety' and only pay, say $70 or less for it. Makes sense, right? This is no different to when you go shopping at the supermarket: Pasta, which normally sells for $2 a pack is now on special, and priced at $1. You wouldn't think twice (unless of course you're allergic to pasta or the expiry date is way passed today's). Savvy shoppers will take advantage when items are on sale, and buy in bulk.

All this sounds like common sense, but I bet you're dying to ask the following questions:

(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?

(2) How Do I Calculate the True (Intrinsic) Value of a Stock?

(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?

(4) How great a Margin of Safety do Value Investors generally demand?

(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?

In this post I'm going to answer only the first question. The others will be dealt with in the coming posts.

Q1. Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?

A1: Yes – all the time. Don't believe me? Open any newspaper, or financial website (Yahoo will do), pick any major public company and look at the 52-week high and 52-week low. Let's look at Teva (TEVA). The 52-week low was $30.70, pricing the entire business at around $23.39 billion. (To calculate the value of the entire business, mutliply the no. of shares that are outstanding by the share price). The 52-week high is $45.44, pricing the entire business at $34.62 billion. That's a huge spread – a little over $11 billion. How can this be? Which is the correct and fair price? Can a business change so significantly that it will have gained or lost $11 billion in value in the space of a year? The answer to all this is simply this: the market does not always behave rationally. Why not?

Two reasons that may explain this are:

(i) The market is sometimes driven by the emotions of greed and fear. For example, when an individual invests in a company without really researching it, because he heard from a neighbor that he made several thousand dollars from a stock that shot up 20%. That's not rational - it's insane. Imagine being told that the price of bread increased by 20% at a certain bakery. You wouldn't feel the sudden need to rush out and buy bread from that bakery. You'd look elsewhere for a better deal. Most people however, behave differently when it comes to the stock market. When hearing a stock or fund has increased by a huge amount, they feel that they are going to miss out on the profits and buy after the stock is has already increased in prive. That's greed talking. My neighbor, however, is smarter than that. If I tell him that I bought SanDisk at $37, and it drops to $36, he understands that he can get a better deal than what I got, and he calls his broker. Just like buying pasta on special at the supermarket. Right, Oren?

In Robert Hagstrom's, The Warren Buffett Way, (see also this post) he explains that the Value Investing methodology developed by Graham was based on the belief that the market is often wrong:

"Graham's conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market."

(ii) The market forgets that stocks are fractional bits of actual companies. Some individuals think of stocks as bits of paper that are traded back and forth. They rarely consider the business behind the stock - the products or services, the clients or employees. As Benjamin Graham wrote in Security Analysis in 1934:

"It is an almost unbelievable fact that Wall Street never asks: 'How much is the business selling for? Yet this should be the first question in considering a stock purchase."

"Why Both Bulls and Bears Can Act So Bird-Brained" - a New York Times article written a decade ago explores this in some depth. You can view it here.

So I think it's just about now where we learn the first Value Investing Mantra.

Repeat after me:

"The Price of a stock is not the same as the Value of a stock"

Most investors do not understand this principle, which explains why the market crowd is very often emotionally-driven, and does not behave rationally.

Value Investors focus on the Value of the business, not on the price of it.

As Warren Buffett famously declared: "Price is what you pay, value is what you get."

In the next posts I will continue our discussion on Margin of Safety and look at how intrinsic value is calculated, why you must seek a Margin of Safety, and how great a Margin of Safety is required. I will also briefly discuss 'Value Traps'.

Until next time - May you possess the Wisdom to See what the market does not, and the Courage to act on it.

VIDEO: Legg Mason's Robert Hagstrom on WealthTrack

Legg Mason fund manager, Robert Hagstrom was one of the interviewees on last Monday's edition of WealthTrack.

In my opinion, Hagstrom's greater contribution to the world is not as an asset allocator, but rather as a best-selling author. His books The Warren Buffett Way, The Warren Buffett Portfolio, and Latticework all raised the level of understanding and awareness with regards to Value Investing. In my opinion, all three are invaluable resources for becoming a more successful long-term investor.

In the last 5 minutes of the WealthTrack interview, the host provides a tight summary of Hagstrom's first book - which is about Warren Buffett's Value Investing Philosophy.

Below I provide some excerpts from Hagstrom's comments in the interview. As you will see from my thoughts (tagged IV in blue), I wasn't as impressed as I was from his books.

"It's true, the economy is weak, and it's true, there's a lot of negativity in the market, but these times are also the seeds of future excess returns. I think it's time to be cautious, a time to stay with quality, but I think if you look back at periods like this - these are the opportunistic periods that allow you to build a portfolio that's going to generate very high returns, much better than the market rate of returns".

IV: Why do some investors see what's happening in the market now as a terrible thing, while others are actually glad? The difference between these 2 camps is their 'investment horizons'. Short term oriented investors are having trouble dealing with the recent market weakness. Those investors that adopt a longer investment horizon view these periods as an opportunity to invest in great companies at bargain prices. Hagstrom's fund has an average holding perid of 3 to 4 years - so it is little wonder that he is concerned.

IV: In the interview Hagstrom indicated that his fund is now 100% fully invested in the market (i.e. it's cash holdings are minimal). I found this strange considering the fact that his previous comment suggested that this is the opportune time to look for great prices. If he thinks this is the case, why doesn't he keep some cash in reserve - like Fairholme's Berkowitz or First Eagle's Eveillard? Perhaps Legg Mason's team believe that the worst is already behind us? I don't know.

"We've taken the Warren Buffett Way, the Warren Buffett Process, and tried to apply it to the new economy".

IV: Hagstrom's top 5 holdings are Nokia, Yahoo, Amazon, Qualcomm and E-Bay. They make up a little over 30% of the fund. So he's definitely 'new economy'. I can see how he applies Buffett's principles of businesses with economic moats (you could argue that each is the dominant brand in its space), but what about predictability of future cashflows? You know there's going to be growth - but isn't that already factored into the high valuation multiple? How does one seek a 'Margin of Safety', the centerpiece to the 'Warren Buffett Process', when it is not easy to forecast future cashflows? This is why I wrote in my last analysis of SanDisk that Warren Buffett would not touch it.

When WealthTrack's host, Consuelo Mack, asked Hagstrom whether those stocks offer protection in a weak economy he replied:

"If we go into a recession, there's not much of anything that you can own that will do exceptionally well."

IV:Now I'm not sure about you, but I find this reply a little strange. How about company's that hold large positions of cash? Like Buffett's Berkshire Hathaway (BRK). That's what Sequoia, Fairholme and Eveillard have done - invested heavily in a business with strong cashflows and a strong cash position. When the market really craps out - you can count on Buffett to be pick out the treasure from the trash. How about Charlie Munger's favorite Costco (COST)? Costco will benefit in a recessionary environment as people seek ways to save money - and Costco is certainly one of the obvious places to do so. Another is GEICO - with a reputation as a cheap Insurance provider. Oh - that's right - it's owned by Berkshire.

If you can think of any other investment ideas whose business might benefit from a recessionary period - I'd love to hear them.

Signing off for today: "May you always possess the Wisdom to see what the market does not, and the Courage to act on it".

Shlomi Cohen: SanDisk's Steep Slide - Globes

Shlomi Cohen, one of Israel's veteran financial journalists wrote an excellent piece on SanDisk yesterday. I have followed Cohen's work since I have been in Israel, and he has proven to be very much in the know when it comes to the NAND flash memory industry.

In his column, he attempts to [and in my opinion, succeeds] pinpoint the reasons behind last Friday's market trashing of the stock.

You can view his piece here.

The Market’s Birthday Gift to Me: SanDisk Hammered 15%

I celebrated my 36th birthday yesterday, and received two wonderful gifts – one from my wife and one from the market.

There is a connection between both.

A GIFT FROM MY WIFE:

For the past 5 years I have used the same cell phone – Nokia’s 3100. A simple phone, sturdy with good battery life, it did the job: making and taking calls. I didn’t need or want anything fancier. 5 years ago it was the most advanced cellular handset. Today – a dinosaur.

My wife however, in her good wisdom, thought that it was time that I upgrade to something a little more advanced – Nokia’s N95. I am ashamed to admit that I have been behaving like a little child ever since receiving it. I am thrilled. This baby does just about everything but make percolated espresso coffee. It’s got two cameras – a primary 5-megapixel camera (higher resolution than my digital camera!) and a secondary camera for video calls. Not only can it take digital stills – but also records high quality video. It has GPS Navigation capabilities with regional and local maps, a very functional daily organizer and planner, an MP3 player, radio and a video center. It is able to read pdf, excel and word documents and of course there’s e-mail and internet capabilities, and connectivity via wireless and Bluetooth. And there’s a calendar and clock too! Seriously though, it’s a nice gadget, with more functionality than I’ll ever really need. It’s probably one of the top-of-the-line handsets on the market today, up there with Apple’s iPhone. Just like my previous phone, within 5 years it too will be obsolete. It is hard to imagine what technology will be available 5 years from now.

It soon dawned on me however, that to really take advantage of the N95 I am going to need memory – a lot of it. The more, the better. (You can’t ever have enough memory!). I’m going to carry everything on it – hundreds of tunes, photos of the girls, you name it. Anyway, a quick look on the web reveals that the highest capacity of microSDHC memory available for handsets is a whopping 8GB. The mind boggles when you think of this. My first PC, a 1984 Apple II+ had 64kb of memory. The computer on Apollo 11's Lunar Landing Module, the spacecraft that landed Neil Armstrong on the moon, had 74kb of memory. But I digress. The gargantuan 8GB microSDHC that I yearn for is manufactured by SanDisk (Ticker: SNDK), which brings me to my second birthday gift. The one that came in at end of market trading last Friday.

A GIFT FROM THE MARKET:

Last Thursday, SanDisk (SNDK) released its Q3 earnings report, and by end of Friday's trading the market had severely hammered the stock, which was down 15%. Since the beginning of October, the stock price has dropped by almost 24%. The questions that demand asking are: If SanDisk's Q3 press release showed significant growth, why has the stock price plummeted? Have there been any material changes in SanDisk's business in the last quarter? Is the market behaving rationally here?

What Does SanDisk Do?

"It is not an exaggeration to say that SanDisk receives a percentage of the revenue of virtually every flash device sold on the planet, and considering the explosion of digital content, represented by products like Apple's iPod and iPhone…[this] is a very attractive position [to be in]." – Alex Morozov, Morningstar

SanDisk is the global leader in NAND flash memory technology. What's NAND flash memory, I hear you ask? Let's just say you probably use NAND flash memory several times a day. It's everywhere - cell phones, video games, PDA's, digital cameras, camcorders, television set-top boxes (like TiVo) and USB drives. It has replaced hard drives in some high-end laptops and is even in some of the newer model cars. It benefits from multiple revenue streams which include:

1. Licensing Revenue: licensing royalties from its patents. This year is expected to earn approximately $450 million from royalties (approx. 10% of total revenue)


2. OEM Revenue: Selling NAND flash memory components to OEMs (such as handset manufacturers (approx. 30% of total revenue)


3. Retail Revenue: Retail products such as USB memory sticks, its line of Sansa media players, and its memory cards for digital cameras and cellular phones. (Approx. 60% of total revenue)

Is SanDisk a Dominant Player in the Markets it operates in?

The answer here is a resounding YES.

NAND Flash Memory Production

According to SEMI ('Fabfutures' and 'Fab Capacity Report') SanDisk is the world's largest producer of data storage memory chips. It manufactures, via a joint venture with Toshiba via its 'megafabs' located in Japan. Fab 4, which commenced operations this September, is said to be the size of five football fields, and the most advanced manufacturing plant of its kind in the world.

Retail - USB and Memory Cards

SanDisk is the dominant player in all markets it has entered. It has approximately 42% market share in North America; In Europe, it doubled its market share in the last 12 months to 28% and indicated that it is experiencing difficulties in meeting European demand; in Asia and Australia market share is 23%.

Retail - Media Players

According to recent data from the NPD Group, SanDisk is ranked a distant 2nd in the US MP3 player market, with approximately 10% of market share, compared to Apple's 73%. The good news however is that whenever Apple sells an iPhone or iPod, SanDisk indirectly earns revenue in the form of royalties from Samsung, who make the chips for Apple's products.

Does it possess an 'Economic Moat' (a durable competitive advantage)?

SanDisk's economic moat is its business model. Based on tight vertical integration, SanDisk's business model has allowed it to remain competitive and protect its margins during the tougher periods.

(1) License Royalties: SanDisk's intellectual property, which it strengthened with the M-Systems acquisition in 2006, is the foundation of the business. With more than 700 U.S. patents and more than 400 Foreign patents, it is the only company in the world that has the rights to manufacture and sell every major flash card format and USB flash drive. Revenues from license royalties account for approximately 10% of total revenue and will amount to around $450 million for 2007. The estimated 2-3% that competing manufacturers pay to SanDisk in licensing provides that much of a buffer to SanDisk's margins and allows it to remain competitive, and continue to be the lowest cost producer.

(2) Manufacturing Capabilities: The captive production from the SanDisk-Toshiba Fabs allow SanDisk to pay significantly lower prices for NAND flash components for its own products than its competitors. Again, this enhances SanDisk's competitive position.

(3) Technological Expertise: In the 2006 acquisition of M-Systems, SanDisk acquired superior Flash technology that has yet to be rolled out. Known as X4, it allows NAND flash manufacturers to produce twice as much memory on the same wafer, at half the cost. It is estimated that this will translate to a 30 percent cost reduction in producing a 1 gigabyte NAND flash wafer. During the recent conference call an answer to one of Craig Ellis' questions revealed that in 2008 the majority of products will still be 2-bit per cell, and not X3. This suggests that SanDisk has chosen to keep their 'big technological guns' - X3 and X4 "in reserve" and to roll them out when the business environment turns for the worst. You could come to the conclusion that the fact that SanDisk's management has not chosen to do so as yet means that they are not really 'feeling the heat' yet – and are confidently competing well.

(4) Retail Operations: With more than 210,000 global retail outlets, Sandisk enjoys a large distribution network, which sells its USB and flash memory cards for cell phones, media players, cameras and video games.

What are the Concerns?

(1) NAND Flash is a Commodity – its pricing is Volatile

SanDisk operates in an extremely price-competitive environment. NAND flash memory is a commodity, and is traded on an exchange, with daily pricing which can be viewed at http://www.dramexchange.com/. While SanDisk is vulnerable to this volatile market, it is less so than its competitors because of its low cost manufacturing capabilities.

(2) 2007 SanDisk's growth was not organic, but mostly a result of the M-Systems acquisition

The SanDisk Q3 press release announced: "Revenue Grows 38% Year-Over-Year", "Product revenue was $919 million in the third quarter, up 36% year-over-year and 28% sequentially" and "License and royalty revenue for the third quarter was $119 million, up 52% year-over-year and 11% sequentially". Impressive numbers, right? Well, not exactly.

As Avishai Ovadia correctly pointed out in his blog (Hebrew), you cannot compare revenue and earnings numbers for this quarter to the same quarter a year ago - it's comparing apples to oranges. This year's Q3 data includes the revenues and earnings from the M-Systems acquisition. Last year's Q3 data does not.

(3) SanDisk's Supply Cannot Meet Demand

I think this came through loud and clear in the last conference call. That demand is strong is clearly a good thing, but when that demand cannot be served, customers seek the product elsewhere – and market share is eroded. Which brings me to my next concern.

(4) Capital Intensive Requirements

In early September, SanDisk and Toshiba jointly opened their latest fabrication facility in Japan - Fab 4 – larger than 5 football fields. According to SanDisk's July 2006 8-K, the cost to SanDisk will be in the vicinity of $1.5 billion (through to the end of 2008). SanDisk have already commenced discussions with Toshiba on constructing a new facility – Fab 5, but as was learned from the conference call, capital expenditure requirements for this plant are not expected to hit the books before the second half of 2009.

(5) Samsung and Other Manufacturers May Aggressively Re-Negotiate Licensing Agreements

Samsung, the second largest producer of NAND flash memory components may grow tired of paying licensing royalties to SanDisk, and may aggressively re-negotiate these contracts in 2009. I am not able to provide a qualified opinion on this issue.

(6) Litigation Risks

Sandisk CEO, Eli Harari received a grand jury subpoena as the US Department of Justice is looking into possible anti-trust violations in the industry .Also, the company, along with 23 other companies, are also being sued in a consumer class action that alleges a conspiracy existed to fix flash memory prices.

(7) NAND flash may become superseded by a newer more superior technology

There is always a possibility that this may occur, but even if a more superior technology was developed, billions of dollars have already been invested in manufacturing plants, cell phone design, etc. and I doubt that the new technology will be embarced. I think the probability of this happening is low, and that NAND flash has become the standard for the mid to long term.

What's the Catalyst? What trends will benefit Sandisk's Business?

The catalyst here is forecast NAND flash growth. According to Gartner Dataquest, current global NAND Consumption is estimated at less than 3 trillion MB. By 2011 however, the entire NAND landscape will be completely unrecognizable with estimated consumption at – wait for it – 33.5 trillion MB. This is mind-blowing growth!

Do these estimates make sense? Consider the following:

• 3 years ago there wasn't a single handset that could use an external memory card.
• Up until this year, only 30% of mobile phones could use an external memory card.
• According to estimates by Sweden's Telefon AB L.M. Ericsson, almost two billion people [predominantly in India and China] are projected to start using mobile phones in the next five years.
• Sandisk's recent conference call revealed that the company shipped more mobile card units in Q3 than all of 2006.
• Apple's iPhone has set the standard with the minimum amount of memory required in the handset. It no longer sells the 4 GB model, only the 8GB one. Handset manufacturers that wish to compete are left with little choice but to do the same. All great news for SanDisk's business.

In short, the major growth driver will be the next generation of multi-functional cell phones. Just as I did with my new Nokia I95, users will realize the potential of these devices (high resolution cameras, mp3 players, GPD capabilities] and will demand significantly larger amounts of memory than we are using today.

Another secondary catalyst to watch for is the trend towards laptops with NAND flash memory drives (called Solid State Drives or SSD). These are more reliable than conventional hard drives with moving parts, and allows for a laptop that is significantly lighter. While some high-end models are already on the market, the costs are still too high to hit the mainstream. If prices come down further, SSD drives for laptops may become a secondary growth driver for Sandisk's business.

So What do the Numbers Say?

SanDisk's Balance Sheet is strong:

• Total Assets are more than 3 times total liabilities
• Benjamin Graham typically demanded that Long Term Debt should not exceed Working Capital (or Net Current Assets defined as Current Assets minus Current Liabilities). Sandisk's Balance Sheet meets this criteria.
• 23% of the current share price is cash or short-term securities ($2.31 billion or $9.73 per share).
• Earning in the past 5 years grew on average by 34%, and analysts' consensus has earnings growth in the next 5 years to be 22.75%
• Quality of Management metrics such as Return on Equity (ROE) and Return on Assets (ROA) are not high. Warren Buffett typically seeks businesses with an ROE that has been consistently greater than 12%. This suggests that the business is able to create value for its shareholders. Sandisk's ROE and ROE are under 5%. This is what you would expect from a business that must continuously plow back its earnings into building new manufacturing plants.

So what's the Business Worth?

According to Thomson / First Call, 12 analysts have coverage on Sandisk, and the target valuation ranges between $45 to $75, with a $65 median. Lazard Capital's Daniel Amir, who in my opinion has a good handle on the company values the business at around $63 a share. Citi's Craig Ellis has a target price of $65

If I performed a discounted cashflow solely on the royalty license revenues (which are in essense free cashflow) with the intial year being $450 million, 10% growth for years 1 to 5, and 3% growth for years 6 to 10, and a discount rate of 10%, I receive a valuation of $42 per share - or the current share price.

A complete valuation of the business, with estimated average 5-year growth of 19%, provides a valuation of around $58 per share. This is a 33% discount to the current share price.

So What do I think?

Why did the price drop 15% on Friday after Thursday's earnings call? I'd love to be able to put my hand on my heart, look you in the eye, and give you a good reason. But I can't. I've never really known how to properly explain the sudden movement of crowds. Expectations not met? Perhaps. Lower Q4 guidance? Who knows? Fortunately, I do not assess a business because of price action. Instead, I try to assess what the free cashflows are going to be in the years to come, and formulate a rough valuation on that basis. This is not an easy thing to do with SanDisk or with this industry.

Usually, I try to look at a 10 year history of a business before making an investment. When you analyze 10-year financials you get a feel how a business has been able to handle tough periods, whether it has been able to protect margins, or whether management has been able to create value for shareholders. Looking at Sandisk's 10-year financials is useless. The environment is changing too quickly. 3 years ago, a mobile market did not exist for mobile memory cards. Today it is Sandisk's leading product. This year there is barely a market for Solid State Drives - but that may quickly change.

This is not a business that Warren Buffett would invest in. He would place it on the 'too hard' pile as it is capital intensive, because of its changing nature, and because of its low Return on Equity.

I however, see value here. The NAND memory market is forecast to experience continued explosive growth and while it is true that the industry is highly competitive, SanDisk is extremely well-positioned to capitalize from this growth. It has demonstrated that it is able to enter new markets quickly, and because of its vertically integrated model is able to quickly establish a dominant position.

If I was to place my bets on one player in this industry, it would be SanDisk, and recent share price weakness presents an opportune entry point.

Please read the Legal Disclaimer.

Disclosure: Avi Ifergan has an interest in SNDK.

Avi Ifergan is the Managing Partner of Israel Value Funds (www.israelvalue.com) an Israel-based investment partnership that follows a disciplined and long term oriented Value Investing approach, with a primary focus on Israeli public companies. Avi is a former equity analyst, corporate advisor and serial entrepreneur. These days he spends his time teaching economics at a major Israeli university and seeking value investing opportunities. He very much appreciates your feedback at avi@israelvalue.com.

VIDEO: Warren Buffett Interview on Fox Business (Oct. 18,2007)

The Fox Business Network which commenced operations last week, hit it off to a great start with this great one-hour interview with Warren Buffett. The interview was conducted by Liz Clayman, formerly of CNBC, who recently joined the network. This was not her first interview with Buffett, and as always, Buffett's humility, candor and wisdom does not disappoint.

Below are some of the video excerpts from the interview, along with the gems that I extracted and some personal thoughts (in blue and tagged with 'IV').

On the Economy (6 Minutes)

"We don't really worry that much about Fed policy, and actually we don't really worry that much about a recession - I hope I live to see a couple recessions."

IV: Value Investors do not pay too much attention to macroeconomic figures such as interest rates, inflation, unemployment figures or the trade balance. They only focus on the fundamentals of the business they are analyzing. As they are long term investors, they know that the businesses they invest in will one day go through a recessionary period. It is inevitable. It is for this reason that when analyzing a company, Value Investors look at the 10-year financial history, and assess how well the business fared during the tougher years.

IV: "I hope I live to see a couple recessions." - This is typical of the Value Investing philosophy - Value Investors love market weakness - as these are the times when the best buying opportunities are available. Incidentally, I recently met with the Managing Director of one of Israel's largest mutual funds businesses, and he was telling me how tough this environment was for him, and how these were dark times for the business. His fund managers are not seeking bargains now, but rather taking the market's lead, and exiting their positions.

"When the tide goes out, you see who's been swimming naked".

IV: This is one of my favorite Buffett quotes - one he has used many times. What he means by this is that it is easy to do well as an investor when the market has been rising and you are buoyed by it. The real test however is when the market suffers significant weakness, and investors flee to 'quality' and defensive companies. One such company is Buffett's Berkshire Hathaway (Ticker:BRK)- which has increased 20% since last July.

On Selling Petrochina (5 Minutes)

"Unfortunately I sold it a little too soon..... we made about $3.5 billion on a $500m investment... I still sold it way too soon.... Charlie would say 'you've done it again!".

IV: This type of comment is vintage Buffett, and which has endeared him to fans and investors around the world. He doesn't speak with bravado declaring 'look I turned $500m into $3.5b but rather - 'I screwed up' - I sold it too soon. It's this type of candid talk which Value Investors look for in the management of businesses they are analyzing.

"It was a 100% decision based on valuation."

"We think about 'how much is it selling for?... 'how much do we think it's worth?"

IV: Value Investors do not try to time the market. They do not seek 'bottoms' or 'tops'. Their investments are based on their estimate of what the entire business is worth.

When asked 'How did [Petrochina] come to your attention? How do you find a stock like that'?

"I sat there in my office, and read an annual report, which fortunately was in English - and it described a very good company..... I sat there and said to myself this company's worth about $100 billion (and at the time it was trading for $35 billion). Now I didn't look at the price first. I looked at the business first, and tried to figure out what its worth - because if I look at the price first I'll get influenced by that. I look at the business first, I try to value it and then I look at the price. If the price is way less than what I just valued it at, I'm going to buy it."

"Other guys read Playboy. I read annual reports....I just read every report I can and figure out whether something is cheap."

IV: Buffett's message is clear. You've got to do the work yourself. No shortcuts. Don't listen to analyst reports or rumors. Do your own independent research. Read the annual reports. Look for what the rest of the market is not seeing.

On Buffett's Best Investment Ever (30 seconds)

IV: Those who know Buffett's history will know already that this investment is GEICO. The story goes that whilst studying at Columbia under his mentor Benjamin Graham, the 21-year old Buffett discovered that Graham was on the Board of GEICO. One Saturday morning, he boarded a train and headed to GEICO's headquarters, which were closed. He found a janitor and pleaded with him to take him to someone who worked for the company. The janitor took him up to the only person in the building at the time - Lorimar Davidson, GEICO's Chief Investment Officer. The young Buffett made enough of an impression on the senior executive that Davidson ended up chatting with him for 5 hours. By the end of that Saturday Buffett recognized GEICO business potential, and why Graham had invested in the business. Soon after Buffett invested 75% of his net worth - $9,000 and sold a couple of years later for a 50% profit. In the late '70's Buffett returned to GEICO, and invested more than $47 million into the company. Today that investment is worth more than $9 billion.

You can read a 1951 analysis of GEICO written by a young Buffett here - "The Security I Like Best" - (thanks to Oded for the link).

Buffett on Bear Stearns (50 seconds)

Buffett on the Yankees (2 mins)

Buffett on Succession (1 min. 41 secs)

"All Three [CEO's] of them are far better than I am".

IV: In my opinion, this is one of the secrets to Buffett's success. Buffett's investment company owns 49 private businesses, that employ more than 217,000 employees. The CEO's that run these businesses are all independently wealthy and do not really need to work. Yet they continue to work under and remain extremely devoted and loyal to Buffett. The reason for this is simple: Buffett refuses to take credit for Berkshire's success. Rather he gives all the credit to his managers, often making statements like "All three are far better than me". This is how you earn long-term loyalty. In contrast, a CEO who takes all the credit for himself will inevitably chase away great executives and managers.

Value Investing Principle #2: Value Investors Are Highly Loss Averse

Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1

- Warren Buffett

Value Investors are not just risk averse – they are loss-averse. Protecting the initial investment always takes priority over the objective of capital growth. I liken this to special operations in the military, where there are always at least 2 primary objectives:

(1) the mission at hand
(2) that all operatives involved in the mission return home safely.

The safety of the soldiers always takes priority over the mission's objectives (at least in the Israel Defense Force, which does not believe in 'suicide missions') and their lives will never be endangered unnecessarily. As such all efforts are made to minimize the risks involved and if it is decided that the risks are too high, then the mission is not approved.

And so it is with Value Investing. Value Investors adopt an attitude of 'better safe than sorry'. They are extremely reluctant to take unnecessary risks. You might as well call them the "Chickens of the Investment World". (However, when the market is driven by fear and panic, or behaves irrationally Value Investors display courage and daring that is extraordinary – more on this later).

This also makes a lot of sense. If you invest in a portfolio of stocks worth $100,000 and a market correction occurs decreasing the value of your investment by 50%, what percentage increase is required to return your portfolio to its initial value? Not 50% as you would intuitively think - but 100%. It now has to move twice as much just to return it to its initial value.

So how do value investors assess risks and minimize the probability of investment loss?

(1) Value Investors demand a Margin of Safety
(2) Value Investors are committed to rigorous investigative research
(3) Value Investors only invest in businesses that they fully understand
(4) Value Investors seek businesses that possess 'Economic Moats'

I will discuss and explain each of these points individually in the next couple of posts.

Shabbat Shalom and Have a Great Weekend,

Avi

VIDEO: Fairholme's Bruce Berkowitz Interviewed on CNBC

Maria Bartiromo interviewed Fairholme's Bruce Berkowitz yesterday on CNBC's Money Masters Series. The $6 billion Fairholme Fund (FAIRX) which has adopted Warren Buffett's Value Investing playbook has outperformed the market in 7 of the last 8 years (including this year) since its inception. If you had invested $10,000 with Berkowitz when he set up the fund in 1999, that investment would be worth today nearly $36,000. That's an average annual return of 17.8%. A similar investment in the S&P 500 would have earned you just under $12,000. In the last year alone, the fund achieved 17% returns.

Street Smarts: Value Plays

A Gem from the Interview

When Bartiromo asked him how he screens the market, and what he looks for in an investment, Berkowitz's reply could have been scripted by Buffett himself:

1. Great Owner / Managers that do well in all economic environments.
2. Businesses that generate significant free cash flow.

The relevance of both these points to Value Investing cannot be emphasized enough. Firstly, Value Investors focus on free cashflow, not net profit. Net profit can be manipulated or distorted by one-time items or non-cash expenses (such as depreciation). Cashflow is the only thing that matters. Secondly, cashflow must be assessed across an entire business cycle - preferably 10 years and at least 7. And you need to be looking at what's happening to cashflow during the recessionary years. That's what Berkowitz meant when he said "in all economic environments".

What is Fairholme's Long-Term Performance?

1 Year: 23.33% (S&P 500 - 15.54%)

3 Year: 19.94% (S&P 500 - 13.90%)

5 Year: 19.79% (S&P 500 - 13.99%)

I think these returns speak for themselves.

How was this Performance Achieved?

Fairholme's Value Investing style is best viewed by looking at some of the Fund's metrics. In particular:

(1) Fairholme does not diversify - it has 24 holdings only. In fact, 2 of it's holdings - Berkshire Hathaway (BRK-A) and Canadian National Resources (CNQ) make up just over 35% of the entire portoflio's value.

(2) Fairholme is a Long-Term Investor - the fund's asset tunover is 20%, which means it holds its investments on average for 5 years. You couldn't ask for clearer proof of patience or analysis conviction.

(3) Fairholme is 'Cash-heavy' - Like most Value Investors, Berkowitz views cash as a strategic asset - to be stored and hoarded, and to only be used when great opportunities arise. The Fund does not feel compelled to be fully invested in the market, but rather waits for doom and gloom periods where better value can be found. It currently has 22.5% of its assets in cash.

Fairholme and Berkowitz's team have clearly demonstrated that stellar returns are achievable by a combination of good old fashioned patience, fundamental and research and rational analysis. Value Investing is not rocket science; It just demands that you think critically and independently.

Jean-Marie Eveillard interviewed on Wealth Track

Jean-Marie Eveillard, one of the most successful Global Value Investors in the last 25 years, was interviewed today on Consuelo Mack's Wealthtrack. The video can be viewed here. While the interview offers a glimpse of Eveillard and his outlook and expectations, a look at his portfolio and his current holdings is far more telling. But first, a bit of background info on Eveillard.

Who is Jean-Marie Eveillard?

The 67-year old Frenchman who resides in New York managed the $13.1 billion First Eagle Global Fund (SGENX) for 26 years before retiring in 2005. Earlier this year he returned to his post after the previous fund manager, Charles de Vaulx suddenly resigned. Eveillard has earned a reputation as a cautious, conservative and patient value investor that refuses to overpay for growth potential. Morningstar named him International Stock Fund Manager of the Year in 2001, and in 2003 he received Morningstar's Lifetime Achievement Award. Read on to discover why.

What is First Eagle Global's Long Term Performance?

The fund's long term performance is extremely impressive. It absolutely trounced the relevant benchmarks, with 10-year annualized returns that are more than double the returns of the benchmarks referred to below.

When compared to its peers over the past 20 years, Eveillard's fund outperformed the average global fund by an average of 5% per year.

The fund trailed the market from 1995 to 1999 as a result of Eveillard's reluctance to follow the crowds into the 'Internet hype'. Those investors in his fund who were willing to persevere through this period were well-rewarded in 2000, 2001 and 2002 when the fund returned 10% each year, while the overall market was losing value.

It is worth mentioning that Professor Bruce Greenwald of Columbia University (Buffett's Alma Mater, and where Benjamin Graham, 'Father of Value Investing', taught) recently joined the fund as Director of Research. He is also the author of 'Value Investing: From Graham to Buffett and Beyond'.

What Can We Learn From the Fund?

The very first thing we can observe is that Value Investing as an investment philosophy works - you've just got to possess the gumption, stamina and patience to ignore the what the market is doing, and focus on the long term. Now let's see how this was implemented in this fund:

Asset Turnover: The fund's asset turnover is 29%. Basically this means that 29% of the fund's portfolio is sold within a year. In other words, the fund holds each stock on average between 3 to 4 years.

Asset Allocation & Current Holdings: An examination of the fund's asset allocation and top holdings reveals much about Eveillard's near-term market outlook and expectations.

(1) The fund holds 20% of its assets in cash. This suggests that he is waiting for a correction and is now 'keeping his gun powder dry', and / or that he is unable to identify relevant value investment ideas. Whatever the reason - this suggests that he believes the market is expensive and is due for a correction.

(2) The funds top 3 holdings are:

• Gold (3.37% of the portfolio) - which is inversely correlated with the market (it moves in the opposite direction to the market). Gold is often viewed as an ideal investment option when seeking to protect one's investment portfolio in the event of a market downturn.

• Berkshire Hathaway (BRK) (2.51% of the portfolio) - Warren Buffett's investment holding company, which also holds $47 billion in cash (24% of Market capitalization). Berkshire is the ideal company to be invested in when the overall market outlook is uncertain and a when a market correction is anticipated.


• Costco Wholesale Corp (COST) (2.21% of the porfolio) - This high-volume, no frills warehousing chain offers the lowest prices and widest variety of products to consumers, and will benefit in the event of a weak global or US economy and when the market weakens. Costco, like Gold and Berkshire also represents an ideal defensive investment. Charlie Munger (Warren Buffett's partner), has difficulty hiding his zealot-like admiration for the company and serves on its board. In the 1999 Berkshire Annual Shareholders' Meeting he gushed:
  
  

  "I'm such an admirer of the Costco culture and the Costco system that I'm not sure I'm totally rational.I love the place."

Seeing the levels of cash and defensive holdings it is obvious that Eveillard is expecting a serious storm and is 'battening down the hatches'.

Eveillard Quote:

"The success we've had over the years has a lot to do with the fact that we don't try to keep up with the Joneses on a quarterly or even past-year basis. It's the willingness to take short-term pain that distinguishes us from other investors. We're looking to reward our long-term investors".

- from "Back in First Eagle's Nest", MarketWatch, Dow Jones, March 26, 2007

Further Reading:

The August 2007 edition of Financial Advisor Magazine features a 7-page article titled "The World According to Eveillard". In it, he outlines the Value Investing philosophy and why Value Investing is so difficult. You can read it here.