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Wednesday, December 23, 2009

Likely Sources of "Positive Alpha": (1) Be Contrarian and (2) Focus; Former Proved in 2009, Latter More Important for 2010

Last week, we shared our view on the purpose of investment research. When we were originally addressed that question, we were also asked the following:

What are the likely sources of positive alpha relative to the market?

(note: alpha = excess return over the market return)

We responded with two points:

(1) Establishing and acting on investment theses where business fundamentals/ economics suggest different fair values for an asset than implied by current market expectations.

The ability to generate positive alpha is best illustrated by Benjamin Graham’s Mr. Market anecdote: on any given day, a manic Mr. Market may offer a ridiculously low price for an asset. On another day, Mr. Market may offer an egregiously high price for an asset. The challenge and opportunity for investors is to capitalize on regular, whimsical swings in market expectations by maintaining a level head.

Varying market moods often produce asset values that are disconnected from fair values determined by the net present value of the asset’s expected future free cash flows, private market value, and, in some cases, net tangible book value. Sound investment research will allow a fund manager to intelligently purchase highly discounted assets with an informed view of true worth, creating a margin of safety. Later, when market euphoria returns, the manager can happily sell the asset into strength, likely generating alpha from having moved against the herd on the initial purchase and subsequent sale.


(2) Running a focused portfolio of top ideas versus a broadly diversified portfolio that contains hundreds of low conviction ideas is more likely to outperform the market. The former can generate alpha if the underlying research and position sizing process is disciplined. The latter is essentially the market.

Let's expand a bit. We believe both "sources" of excess return were made abundantly clear by investor lessons again learned over the past year: swimming against the tide is paramount, as emphasized by the late Sir John Templeton and Warren Buffett in their well-known axioms (shared in our Thanksgiving post). Money can be made by buying a good business (e.g. our PetMed/PETS idea discussed in July) at a fair price and patiently waiting as earnings compound over time. However, the "big money" is usually made by moving against the crowd in times of distress and by concentrating on the best risk/reward opportunities.

How many companies watched their share prices double, triple, quadruple since fall 2008 and/or spring 2009? Countless. And, not merely in one sector -- our #2 "focus" recommendation wasn't even necessary in 2009 as companies across virtually all sectors, ranging from finance, banking, real estate to mining and industrial to retail. Poor fundamentals and high debt loads didn't matter.

Of course, near the bottom, the Market thought the world was ending and the common refrain was "go to cash or buy bonds", with some professional investors even asking "why spend time researching equities?" We personally heard the equities versus credits question, but disagreed and took the opposite stance. It was time to do more research!

We now concur with the view that the "easy money" has been made, but still see opportunities for those willing to focus, move against the crowd, and remain patient. One idea in this category includes our interest in Bidz.com (BIDZ, $2.08) - why purchase such a business given weak consumer spending and expectations for continued consumer headwinds, not to mention other key risks?.... Exactly. You got it. Did we mention an 18% trailing twelve month operating income to enterprise value (TTM EBIT/EV) yield? Impressive, especially given depressed TTM operating income (note: includes benefit of fairly strong 4Q08 EBIT performance).

Happy investing,

Jeffrey Walkenhorst

Disclosure: long PETS, BIDZ.

© 2009 Jeffrey Walkenhorst
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