Sam Zell Epitomizes Contrarian Investing

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There is a reason you won't see any day traders, market timers, or technical analysts on the Forbes 400 list of richest Americans. Those strategies simply have not proven to be consistently successful ways to make money over the long term. You will, however, find Sam Zell's name in the 52nd slot on the 2006 list. If you are wondering what type of investment philosophy Zell abides by, you only have to look at the moves he has made so far in 2007.

After building his commercial real estate company, Equity Office Properties, into an industry Goliath, Zell sold it to the Blackstone Group for $23 billion earlier this year. Given that it was the largest real estate investment trust (REIT) deal ever, coupled with Zell's brilliance, many have suggested the deal signaled the top in the red hot commercial real estate market. Regardless of whether or not that proves true, it is certainly apparent that Zell felt it was a prudent time to cash out of Equity Office when times were good. By definition, very much a contrarian move on his part.

Perhaps even more interesting was the news on Monday morning that Zell had been victorious in launching an $8.2 billion takeover bid for Tribune (TRB), owner of the Chicago newspaper that bears its name and the Chicago Cubs, among many other businesses. The deal is striking because of how many people have called the newspaper business dead, or on the brink of death anyway. Again, Zell is showing an extreme bias toward contrarian investing; selling Equity Office when everybody loved it and buying Tribune when everybody hates it.

Following what Zell is doing is important because the guy is one of the smartest investors around. His place on the Forbes 400 is notable, not just because he is rich, but because the tactics he has used to accumulate wealth are exactly the ones that have proven to be the most successful over time. It's a very important lesson for everyone, especially if you are a proponent of contrarian investing.

Full Disclosure: No position in Tribune at the time of writing

Blackstone IPO Signals Private Equity Market is "As Good as it Gets"

Throughout history, what has been one of the worst types of investments to buy? If you answered IPOs, you're correct. Before commenting on the $4 billion IPO of private equity behemoth Blackstone Group, let's review why exactly IPOs are such bad investments.

Companies sell stock when demand for shares is high, and they buy stock when interest is lacking. If things are going great, demand will be high and an IPO is the preferred way to cash in. The "smart money" as it's called, sells to the dumb money.

Well, guess what? Steve Schwarzman and the rest of the Blackstone Group gang is very "smart" money. If they want to sell a piece of their management company to you, it's probably for a good reason. If they thought the bull market in private equity had a few more years left in the tank, they certainly wouldn't choose to sell now.

This event, unlike the Fortress Investment Group (FIG) IPO (which I don't think marks a top in hedge funds), signals that the bull market in private equity, and perhaps in the stock market in general, is running thin. Think back to the Goldman Sachs (GS) IPO. Like Blackstone, Goldman refused to go public for years, but when things got so good, they couldn't resist anymore. In case you don't remember, Goldman's IPO was in 1999 and the market peaked less than a year later.

Much like the bull still ran a bit after GS went public, I don't think the market will necessarily peak coincidentally with the Blackstone IPO. However, it's important to understand that IPOs are traditionally bad investments for a reason, and it's that reason and that reason alone that explains why Blackstone has chosen to go public. Also, be aware that Blackstone is selling a piece of its management company, so investors in the IPO are buying ownership of their 2-and-20 fee income. The IPO proceeds is not going to be used to fund more private equity deals.

Of course, the irony is that private equity's whole game is convincing companies that the public market isn't worth the trouble and they would be better suited going private. You know if Blackstone wants to go public there is a pretty good reason why. In this case, that reason is dollar bills. Four billion of them, in fact.

Full Disclosure: No positions in the companies mentioned at time of writing

Use Sites Like Yahoo! Finance With Caution

Investors need to be careful when they do stock research on portal sites like Yahoo! Finance. If you enter a symbol in these sites you will quickly get a summary of where the stock trades. Not only do current prices show up, but also other metrics like market cap, earnings per share, P/E ratio, dividend yield, etc.

Keep in mind that oftentimes these numbers are wrong. They can include one-time items like EPS charges and gains, as well as special dividends. Also, the numbers aren't always adjusted in a timely fashion to account for stock splits. The reason I wanted to point this out is because of an email I received summarizing the contents of this week's Barron's Magazine. It said the following:

ST Microelectronics, one of the top five global semiconductor companies, has been beset by troubles including flat sales, a struggle to cut costs, removing itself from the low-margin memory chip business, and competition from strong rivals like Texas Instruments and Qualcomm. Yet its 23x P/E multiple is double that of TI -- and Technology Trader Bill Alpert "doesn't get it."

If you follow semiconductor stocks you might know that Texas Instruments does not trade at 11.5 times earnings. If it did it would be a screaming buy. I'm surprised that a writer for Barron's would make a mistake like this, but as soon as I saw it, I knew exactly where Mr. Alpert got that number; Yahoo! Finance.

Sure enough, when you enter STM and TXN into the site, it shows trailing P/E's for the two stocks as 23 and 11, respectively. However, if you dig deeper you will learn that the TXN number is way too low, likely due to one-time items that Yahoo! (or more accurately the supplier of its data) did not remove. The actual trailing P/E ratio for TXN is 18.5. No wonder Barron's "doesn't get" why TXN trades at half the multiple of STM, it really doesn't.

Don't make the same mistake Barron's did. Always double check numbers on finance portal sites if they look a bit strange. Chances are they were miscalculated.

Full Disclosure: No positions in the companies mentioned

Great Companies Don't Always Make Great Stocks

Many times one will look at a value investor's portfolio and wonder why on earth they own some of the stocks they do. Usually the answer lies in the fact that the manager understands that just because a firm isn't considered to be a great company, it could very well be a great stock going forward. Stock market investing is about buying a share for less than it will ultimately be worth in the future. It is not about buying stocks of great companies and waiting for the cash to roll in. If the stock isn't cheap, it won't outperform consistently over the long term.

I think this is one of the reasons why sell-side analysts tend to be very poor stock pickers. More often than not, they don't want to have a "sell" rating on Best Buy (BBY) and a "buy" on RadioShack (RSH), for instance. The average person will look at that dichotomy and laugh. They might even ask, based on their shopping preferences, "How can RadioShack be a better stock than Best Buy?"

The reason I bring this up is because of an article I read in the March 5th issue of Fortune. It talked about the performance of America's most admired companies versus the least admired. When I see the term "most admired" I equate that to what many investors consider a "great company," a so-called blue chip.

Well, looking at a 1-year chart of the two, we can see who would have been right:

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Accordingly, the results of the study cited in the article weren't surprising to a value investor like myself. The mean annualized return from 1983 through 2006 was +17.8% per year for the least admired, versus just +15.4% for the most admired.

Why was this the case? Because stocks trade based on valuation over long periods of time, not according to the underlying company's popularity or brand name. In fact, the article also cited the average price-to-book ratios of the two groups of stocks being examined. Most admired: 2.07 times book value. Least admired: 1.27 times book value. Hence, the outperformance over a 23 year period of time.

Full Disclosure: Long shares of RSH at time of writing

Comments on Tuesday's 416 Point Drop

I know, I know... I write a stock market blog and have gone more than 24 hours without mentioning the fact that we got a 400 point drop in the Dow in a single day. Since I'm a long term investor and not a trader, the events of this week really aren't all that important to me. I really didn't do much of anything on Tuesday other than just sit back and watch the television screen after it became apparent that something was happening that we don't see every day.

So, why haven't I been very active in the market this week, and what do I think about the whole thing? First, while four hundred points sounds like a lot, in the whole grand scheme of things, it isn't. From peak to trough, intraday, we saw a 5% drop in the S&P 500 over three trading days, which is pretty substantial, I admit. However, if you use closing prices it was less than that, and if you include Wednesday's snap back rally, it was even less than that. Currently, the S&P 500 sits 3.7% below the highs it made in February. To me, this is much to do about nothing. If we had gotten a 3.7& drop over the course of a month or two, few people would think anything of it.

Let's take a step back and put the drop in perspective. I began to get a little cautious when the S&P 500 crossed 1,400 because I thought the market was overbought. However, it kept going up, rising another 4% within weeks. Even with this 3.7% "correction" (I'm hesitant to say that it is over) the S&P 500 is still above 1,400. So, I don't really think this pullback has been big enough to warrant putting every cent of cash to work. We just haven't retraced enough of the gains for me to be optimistic that the smoke has cleared, hence I am not all too enthused about the market's short to intermediate term prospects.

If the sell-off continues, which I suspect it might, then I will likely do some buying. I'd say we would need another 3% to 5% downside from here for me to get to that point. If we instead rally right back up to the highs, then my same overbought worries will persist and I will likely take some money off of the table to save up for a rainy day, or the next 400 point fiasco.

To sum up, I really don't think too much has changed despite this week's events. The market is still up a lot and even with the pullback, I still don't think we are going to see double digit returns this year. It would still take a more typical market correction for me to get aggressive on the long side, so right now I'm really just focusing on individual companies in this environment.

The Power of Multiple Expansion

Stock prices go up for one of two reasons; earnings growth or multiple expansion. If you really want to hit the jackpot with your investments, try and find stocks that can give you both. The combination of the two, as I will illustrate in a moment, is really powerful in terms of shareholder returns.

This is one of the many reasons why value investing has proven to be so successful over time. By buying stocks that have meager valuations, there is always the potential for multiple expansion. Getting earnings growth is even easier because most economies grow over time, so as long as management teams do a good job, earnings growth is inevitable over the long term.

Last year a friend of mine emailed me about a stock he was looking at, beverage giant Diageo (DEO). Diageo is one of the biggest wine, spirits, and beer suppliers in the world, known for brands such as Smirnoff, Guinness, Baileys, Captain Morgan, and Tanqueray. At the time (perhaps about a year ago or so) DEO shares were trading in the low sixties and the company was expected to earn about $4 per share in the coming year. At about fifteen times forward earnings the stock looked pretty fairly valued to me. Given DEO's size and an organic revenue growth rate of about 6 percent, earnings growth would likely average mid to high single digits, so a fifteen multiple seemed reasonable.

I can't remember exactly what my response to him was, but I suspect my feelings on the stock were something like "yeah, it's a solid defensive play with a nice dividend yield, but it looks fairly priced, so I would expect the stock to pretty much track earnings growth." Well, that assessment turned out to be quite wrong. The stock has risen by more than 30 percent since then, to the low 80's.

So what the heck happened? Simply put, most of the gain came from multiple expansion. Beverage stocks have had a great run lately as they offer fairly predictable profits and nice dividend yields (just look at the charts for BUD, KO, and TAP). Defensive investors have placed a higher value on these stocks lately, and their stocks, which used to fetch market multiple of 14-16 times earnings are now getting 17-19 times earnings. Sales growth is still mid single digits, with earnings ranging from the high single digits to low double digits, but the stocks are seen as safe, and as markets rise, some investors look to put money in less aggressive places.

How much of DEO's gain was due to multiple expansion? Well, they earned $4 per share in 2006 and the stock went from a 15 P/E to an 18 P/E, so that is $12 per share in appreciation due to a higher multiple. That amounts to about a 20 percent share price jump (given that the stock was around $60 per share). Add in another 10 percent or so for earnings growth and you get a stock that is up 30 percent in the last year.

I might have been wrong about Diageo, but this should help to explain why valuation is so important when investing in the stock market. Diageo's business hasn't really changed much at all in the last year, but investors' willingness to pay up for the stock has, quite meaningfully in fact. And that, you see, is the power of multiple expansion.

Full Disclosure: No position in DEO at the time of writing

Market Winning Streak Reaches 8 Months

Readers of this blog know I have cautious on the market since the S&P 500 broke through the 1,400 level, but stock prices have continued to rise (about 3 percent more, in fact). January marked the eighth straight month of gains, the longest monthly winning streak in a decade.

Traders will likely try and play the momentum until it fades, but keep in mind that rallies like this are rare, and will end. The first quarter is typically a seasonally strong one, leading up to tax day in April when 2006 IRA contributions are due. The old saying "sell in May and go away" usually spells trouble for the market in the summer, before the historically strong fourth quarter begins.

I can't tell you how many more months we will see gains for the U.S. market, but the streak will end, so just make sure you are not blind-sided when it does. It is very easy to get lulled into a false sense of security when things are going well, but they often will turn on a dime. We will see a pullback this year, and it will feel painful. Just be prepared for it, so you make rational decisions when the time for action is upon us.

Bill Miller Writes About the End of "The Streak"

If you have read about my investment philosophy on peridotcapital.com you will see that I refer to Bill Miller (manager of Legg Mason Value Trust) in comparing my value strategy to others that are more well known than myself. Miller looks at the market differently than most, and I use many of the same techniques when I manage money, so he is an excellent person to read about if you want to get a better idea of what Peridot Capital is all about.

A logical question would be "If Bill Miller is so good, why should I invest with you instead of him?" If you look at Miller's performance in recent years, it pales in comparison with his longer term track record. The reason is quite simple; as Miller as gotten more and more publicity, money has poured into his fund.

He now manages billions of dollars, and as a result, is very limited in the stocks he can buy for his fund. Since Miller prefers very concentrated portfolios, he is now limited to investing in very big companies. With a smaller universe from which to choose his investments, Miller's margin of outperformance is narrowing with each passing year (see chart).

As you may have heard, 2006 was the first year since Miller took over the fund in 1990 that Legg Mason Value Trust failed to beat the S&P 500 index. Although "The Streak" is now over (it is the longest streak by a mutual fund on record), Miller's overall investment philosophies remain very relevant. For managers who don't have the task of investing tens of billions of dollars, continuing to invest according to a contrarian investment strategy will prove very profitable.

Fortunately, for those who aren't familiar with Bill Miller, he writes quarterly letters that are made available to the public, regardless of whether you own shares of his fund or not. In his latest, Miller discusses the end of "The Streak" and other important value investing concepts.

While I would no longer recommend investors buy shares in his fund for the reasons mentioned, I definitely suggest that those interested in contrarian value investing in general, or Peridot Capital more specifically, should read his quarterly letters.