RANDOM THOUGHTS (THE BROOKLYN INVESTOR | PZENA | APPLE)

I enjoy reading The Brooklyn Investor so much now that I endorse him by adding him to the blogger list on the right.

Pzena’s Deep Value Cycle thing is interesting. All the theory sounds neat until you try imagining yourself in Pzena’s shoes. Some HNWI may be puzzled what kind of woodoo thing one is trying to sell. That’s the difference between what can you come up with being a manager of a few billion and a fistful of dollars.

Such macro and cycle things are useful and it is not about timing the market but knowing in what type of environment you are gyrating. However, this type of discussion reminds me the following misjudgment:

Rationalizing. Tendency to rationalize leads to explain by an apparently rational story: a) whatever action, even irrelevant; b) whatever event, even of unclear origin; c) whatever possible sources of responsibility (external – negatives, self attribution – positives). Everyday media finds good explanations of why market went down or up. Truth is that nobody knows the truth – we can just guess.

Investment management is a tough job if you have to come up with such things. What is more interesting if the whole Apple vs. rest of the world story has taken too far. The Apple part of it is probably right (market cap - $625b) but the ROW is probably too much discounted.

I put it on a napkin (I know I probably left out something important and rounded a bit):

HPQ $33b + DELL $17b + MSFT $250b + NOK $10b + Samsung $55b + GOOG $250b + RIM $5b = $620b < $625b AAPL.

Intel is an important piece of the puzzle and has ~$110b market cap. In the former world 2 monopolies Intel and Microsoft made everyone happy, the entire ecosystem of leaders had an important piece of action/profit. Now this former ecosystem cannot come up with the right business model and Apple with its switching, network, whatever effects took it all almost as a single winner.

I cannot fathom that ROW would not come up with cheaper and very good tablets and phones in the nearest future (Nexus 7 is the first canary) while Apple’s winning gap may start narrowing (note a pace of a difference between iPhone 4 and 5). Sheer size and all the forces preserving status quo at all ROW is slowing the thing down but this will not happen forever. Almost all ROW is swimming in cash. For heavens sake, fire all R&D departments, start anew, reverse engineer, adopt one open, robust and cheap OS and boom, off you go.

By the way, all this rant was somewhat provoked by my research for a hardware upgrade. I want to stay in Windows for spreadsheets / word (xIRR is the most complicated function I use in Excel, track changes in Word, and sometimes I get meticulous on formatting, copy/paste between the programs, things like that), improve my reading experience (iPhone 3 > iPhone 5 and add Nexus 7 with LTE). I am scratching my head if I need 3 devices but really it’s just 2 – I will have an ultra-book on my desk and will be taking Nexus when I go out and iPhone will be serving anywhere/anytime time niche.

I just read what I have written and see how bizarre I sound: Windows, Android, and OS. It’s a complicated world and the battle has not finished, yet.

Disclosure: long DELL, RSH.

OTE BONDS (UPDATE)

3 months of summer have passed quickly. Nothing new really happened in the world except for continuous general worry and unshaken trust in central banks. We are muddling through and may continue this for many years.

Since the last time, OTE bonds were not a bad investment. As a % to par, it grew by ~25% in 3 months but stock almost doubled (in USD terms, note that numbers below are in EUR). Interestingly, the longest maturity bonds increased only 17%.

Maturity	Size, EUR	Coupon	YTM (05/30)	YTM (08/30)	Price of par (05/30)	Price of par (08/30)	Delta
2016/05	900m	4.625%	23.2%	18.9%	55.0%	64.2%	16.7%
2015/02	600m	6.000%	36.3%	23.8%	56.5%	71.5%	26.5%
2014/08	500m	7.250%	41.9%	27.6%	60.5%	76.0%	25.6%
2013/03	1,243m	5.000%	44.0%	22.5%	69.0%	86.6%	25.5%

Back in May my bond money allocation was in a much lower risk 9% return product (EUR deposit at a major Swedish bank) which is maturing soon, consequently, I will have my eyes open in September when supposedly Greek (or even EUR) “solution” will or will not be found. I do not think that odds justify betting a farm on this but a 5-15% position may have its merit.

Just for information purposes…

For convenience: Link to OTE / devaluation and Link to the original note.

Disclosure: no position.

SUSTAINABILITY OF HIGH MARGINS (CHECKLIST)

A significant part of the current bear thesis rests on the shoulders of supposedly "unsustainable profit margins". You have to seek truth in the opposite opinion (my view is that SPY should be around 1,000 rather than where it is at the moment) and I find that arguments in favor of high margins are quite hard to challenge. I decided to make a checklist and revisit it periodically to see if "argument" still sounds realistic. So, is it different this time?

==> US exported lower returning businesses (e.g. manufacturing) to other countries and kept the best pieces locally (pharmaceuticals, tech) (Mason Hawkins of Southeastern Asset Management - Link) = inflation of labor abroad is sending manufacturing jobs back (probably in yet irrelevant quantities);

==> accounting (minority stakes report just profits and no sales) (same source as above) = sounds logical;

==> effective tax rates are lower (probably partially explained by the above points) (David Bianco of Deutsche Bank - Link) = budgets are unbalanced, tax rates may go up, including foreign tax rates;

==> foreign sales and profits are higher (same source as above) = I do not know how he constructed the chart but as I understand, he is saying that the world is different outside of US; it could be simply a function of dollar depreciation;

==> interest rates are lower (same source as above) = this is clearly mean reverting.

This Link dated April 2012 gives a good illustration of how people tend to extrapolate.

I presented my views in the beginning but I want to stress that I am not pretend to anyhow time the market. I am just more cautious these days but an example of PCS shows that the crowd sometimes moves pretty fast in any environment.

I would be grateful for additional points to the checklist.

FOR BEGINNERS (PART IX)

II. c) Psychological Misjudgments (Continued)

You can find List I – Here, List II – Here, and List III - Here. This post concludes psychological misjudgment series.

List IV

It is definitely worth a further digging in Influence by Robert Cialdini (next 6 items are also covered in great detail with practical examples in his book – highly recommended).

1. Reciprocation. According to social rules we should try to repay, in kind, what another person has provided to us. This is one of the greatest mechanisms of mental shortcut triggering. It is greatly exploited in marketing, especially, in combination with some concession or gift and together with perceptual contrast known as a rejection-then-retreat technique

2. Commitment & Consistency. Once we have made a choice or taken a stand, we will encounter personal and interpersonal pressures to behave consistently with that commitment. From the Influence book: “…all of the foot-in-the-door experts seem to be excited about the same thing: You can use small commitments to manipulate a person’s self-image; you can use them to turn citizens into “public servants,” prospects into “customers,” prisoners into “collaborators.” And once you’ve got a man’s self-image where you want it, he should comply naturally with a whole range of your requests that are consistent with this view of himself.” “Lowball” sales tactic is based on this mechanism. Those carefully reading the list will notice traces of loss aversion and other misjudgments.

3. Social Proof. The more uncertain people are – and the higher the stakes involved – the more vulnerable they are to the sort of cue taking that leads to herd behavior. This explains why teenagers are more likely to succumb to a peer pressure. One of ways how to determine what is correct is to find out what other people think about it. Trends and fads begin when individuals decide to ignore their private information and focus instead on the action of others. Do not allow other people to determine the value of things for you.

4. Liking. Research has shown that we automatically assign to good-looking individuals such favorable traits as talent, kindness, honesty, and intelligence. Liking can come via physical attractiveness, similarity, and compliments.

5 Authority. Beware of uniforms, titles, and trappings (expensive watches, jewelry, and cars) and imagine how strong is in combination with clever reciprocity and compliance (restaurant waiters).

6. Scarcity. Obviously, loss aversion plays here the lead role. As a rule, if something is rare or becoming rare, it is more valuable. From Influence: “Whenever free choice is limited or threatened, the need to retain our freedoms makes us desire them (as well as the goods and services associated with them) significantly more than previously.” That is why we have limited editions, deadlines for purchases, queues in front of restaurants, and … stupid parents. 

FOR BEGINNERS (PART VIII)

II. c) Psychological Misjudgments (Continued)

You can find List I – Here and List II – Here.

List III

1. Hindsight Bias. This one is about forgetting the original estimates, a memory distortion. New information becomes new reference point. Once an event has passed, we tend to believe we had better knowledge of the outcome before the event than we actually did. Who cannot remember this “I knew it (had to buy/sell)” feeling.

2. Overconfidence Bias. It is not always arrogance and often appears in the form of unrealistically high appraisal of one’s own qualities versus those of others (90% of drivers in Sweden describe themselves as above average drivers). In other words – it is overestimation of one’s abilities.

3 Familiarity (Heuristic). It is about judging events as more frequent or important because they are more familiar in memory. We place too much value on what we know from our own experience simply because it is from our own experience. People overconfidently confuse familiarity with knowledge.

4 Halo Effect. We have to recognize that products / companies / people are often not successful because of their attributes; they are endowed with attributes because they are successful. Think about the long term value of Harry Potter plot line or actors’ acting.

5. Feedback Loops. Even professional analysts get more optimistic / pessimistic after price goes up / down. In extreme positive / negative feedback cases, when the change in belief is long overdue, it results in bubbles / crashes.

6. Narrow Framing (Inside-Outside View). You focus on the problem at hand and do not see the class to which it belongs. Think about forecast for certain project success or duration. If you are raising the fund, you always underestimate the length of the process and usually forget that majority of such efforts are unsuccessful. Call it animal spirits.

OTE BONDS

Additional dimension to yesterday’s post.

A friend friendly reminded that bonds might be safer, which is very true. OTE has issued enough of bonds - 4 issues. One may argue that if shares look good, bonds will be whole, though Mr. Market is not voting for that at the moment.

Maturity	Size, EUR	Interest	YTM	Coupon	Price of par
2016/05	900m	Annually	23.2%	4.625%	55%
2015/02	600m	Annually	36.3%	6%	56.5%
2014/08	500m	Annually	41.9%	7.25%	60.5%
2013/03	1,243m	Annually	44%	5%	69%

Just for information purposes…

Disclosure: no position.

OTE AND GREXIT

I do not know much about how devaluations work exactly but recent beating of Portugal Telecom and Hellenic Telecommunications made me curious. 

I simply took a napkin and this is what I got. All numbers are in EUR billions.

	Pre exit EUR	Exit impact	Post exit EUR
Net debt	3.35	100%	3.35
Market cap	0.71	50%	0.36
EV	4.06		3.71
Ebitda exGreece	0.40	75%	0.30
Ebitda Greece	1.20	50%	0.60
EBITDA	1.60		0.90
EV/EBITDA	2.54		4.12
Capex	0.6	75%	0.45
EV/(EBITDA - Capex)	4.06		8.23

Even at 4x EBITDA it does not look like the end of the world. 50% devaluation may sound too much because you can hear people speaking about 30% difference of labor competitiveness between south and north. It is true that significant part of OTE (this was the former ticker of Hellenic Telecommunications while it was listed on NYSE) is fixed telco and outside of Greece it is present in countries like Romania, Albania, Bulgaria (at least they must be more competitive than Greece itself), which may justify lower multiple but as I started, it does not smell anything terminal. Additionally, DTEGY.PK (Yahoo shows that it now trades at 4.7x EBITDA) has 40% of it and the state owns 10% and has 5% put at some insane price (20 EUR) (correct me if I am wrong). Communications are like food these days, so cash flows should not go away. 

Question comes to mind if you can get it cheaper - try to imagine if you would dare buying it on the day of devaluation.

FOR BEGINNERS (PART VII)

II. c) Psychological Misjudgments (Continued)

You can find List I – Here.

List II

1. Direction of Comparison. When people view a decision as one of preference, they tend to focus on positive qualities. In contrast, when asked to sell stocks, people tend to focus more on the negative qualities of each option. It is a good idea to go through your stock portfolio routinely and compare holdings to each other and to potential new ones via buying / selling lenses.

2. Extremeness Aversion. Scientifically, this refers to context of choice (and is complemented with tradeoff contrast). In practice, when you have 2 phones to choose from with price tags of $200 and $300, the distribution is approximately 50/50. However, when you add the third option with a price of $500, $300 phone wins by a wide margin (2 to 1 against the cheapest one).

3. Preferential Bias. Once people develop preferences, even small ones, they tend to view information in such a way that it supports those preferences. Everybody heard of the first impression and brand loyalty. It can become very costly. Saying is, that people hear what they want to hear.

4. Anchoring. There is a tendency we all have of latching onto an idea or fact and using it as a reference point for future decisions. Those facts can be completely irrelevant as experiments linked personal code last 2 numbers to the price one is willing to pay for a chocolate. People with high numbers overbid 60-120% those with smaller numbers. Anchors could be previous stock price, price estimate or price trend.

5. Confirmation Bias. People are almost 2 times more likely to select information confirming rather than disconfirming their prior beliefs and behaviors. Defensiveness overweight desire for accuracy in driving a preference for confirming over disconfirming information. Such cognitive dissonance leads to rejecting new facts that are contrary to original investment thesis.

6. Rationalizing. Tendency to rationalize leads to explain by an apparently rational story: a) whatever action, even irrelevant; b) whatever event, even of unclear origin; c) whatever possible sources of responsibility (external – negatives, self attribution – positives). Everyday media finds good explanations of why market went down or up. Truth is that nobody knows the truth – we can just guess.

A CURIOUS CASE OF WIRELESS & AIRLINE CARRIERS

I started to follow a story of PCS and LEAP in 2008 and watched how they went down one from $35 to $7, another from $80 to $5. They always had a pretty good sponsorship of hedge funds, which saw value in those stocks even at now unimaginable levels. Both, of course, failed on their original projections.

The story in 2008 was based on excellent situation in “existing markets” and “true profits” masked by “new [loss making] territories”. E.g. Q2 2009 LEAP’s OIBDA (their name for EBITDA) was $192m in “existing markets” and -$54m in “new territories”. Wild imagination could have assumed that once a loss making business turns into a profit, sky is the limit and annual run rate of “OIBDA” would be $900-1,000m. Fast forward a few years and as of Q1 2012 TTM adjusted OIBDA is $582m. LEAP’s story is especially sad because it turned down merger proposal with PCS back in 2007 (1 LEAP’s share would have been equal 2.75 PCS shares or LEAP now would be worth $19.25 vs. $5 current price). Although, anecdotes float that PCS stole business plan from LEAP, in reality, based on pure numbers, it would have been much better if, in exchange, LEAP had stolen business practices of PCS (now the latter’s EBITDA is 3x larger).

Somehow, I tend to identify prepaid carriers with low cost airlines (e.g. SAVE, DTG.L, ALGT): they both ride the same long term wave of a newcomer against the incumbent’s high fixed cost and slow bureaucracy. LCCs (low cost carriers) are being pursued now by ULCCs (add “ultra”), which probably will be replaced by UULCCs. This sounds almost like textile 40 years ago when new ‘looms’ were coming every year and the entire progress went straight to consumer. [Deflection: Ch. Munger is also puzzled why there is pricing discipline in one industry (my guess is that it is uncoordinated cartel) and it’s absent in another]. I think that LCTelcoC is not a goner.  They sell commodities and give more and more of everything for the same amount of money (or even less) but there is crucial difference in the industry structure (both are oligopolies, btw) – barriers to entry are much larger for telcos (money, license, spectrum). In any case, low cost carriers in both industries are doing ok.

Can They Remain Cheaper & Make Money?

The story goes that PCS/LEAP have (i) newer more efficient equipment without legacy cost, (ii) unlimited and prepaid model is inherently cheaper to operate, and (iii) prepaid is slowly eating into postpaid in the entire world. Their services are 2x less expensive than postpaid plans of major carriers. Of course, that service is not the same (there are plenty of horror stories about any LCC service on internet) but, for a price junkie like me, such things leave impression. Chart below provides good illustration (it is taken from PWC annual survey - Link). PCS & LEAP are both small carriers with revenue <$5b.

Back in 2010, I was fascinated by a slide from PCS presentation. That was the first time when I purchased it @ $5.61.

Can you imagine having price per minute, which is lower than your competitor’s cost? You must be killing them. I was puzzled all this time.

<$5b carriers clock almost 2x more minutes than the big guys. When denominator (number of unlimited minutes) increases, cost/revenue per minute are going down. I do not think that this leads to any new conclusions (big guys also have postpaid plans and I do not have the minutes for them). It is just an observation that some slides are not what they seem.

Another concerning data is that in 2011 cost per new cell site has leveled for big and small carriers. I do not have expertise to make any conclusions – I would be grateful if anybody could take a look and make sense of that. It could be that all cheapest sites are taken and it’s not technology cost only. On the other hand, depreciation per served population (POP) is still materially smaller at smaller carriers… but depreciation per average subscriber jumped in 2011 considerably (LTE). PCS and LEAP depreciation expense went up by 20% in 2011. I present this info fearing that this is the weakest link in the investment [bear] thesis but I think it is not terminal.

PCS was one of the first carriers to implement LTE, which contradicts the lowest cost provider’s modus operandi (they buy only proven technology and at a cheap price, they follow and not lead).

What Happened?

My understanding is that PCS/LEAP stumbled on a set of factors, all temporary in their nature: technological [transition of new technology to mainstream], airwaves [capacity issue – now most of smartphones are on CDMA and clogging up the system and will be fixed after cheap LTE smartphones arrive], competition [aggressive pricing from peers and incumbents], and delayed tax refunds [very relevant for prepaid segment].

Noteworthy, PCS is further advanced in LTE, which also could explain why it did worse than LEAP in Q1. LTE is faster, cheaper technology and has better spectral efficiency but is still very early in the adoption cycle [= expensive smartphones]. Smartphones use lots of data, which degrades user experience (on 2G and 3G networks). I would say, normal pains of growing and changing business.

Additionally, the incumbents cannot aggressively bid on the prepaid front because they fully depend on majority of postpaid subscribers paying $80-$100 [cannibalization risk].

Future Business

In 12-24 months, PCS and LEAP will merge, will be bought out or will post decent net subscriber addition numbers. In the frugal new normal, prepaid should continue taking from postpaid and low cost carriers taking from incumbents. I do not know if they can sustain providing cheaper service but odds are reasonable for people with a longer time horizon (for those who think that 10% pa is good enough [from 10 positions like this and fully hedged with IWO]). I like PCS more because of a lower multiple and better historical track record.

Miscellaneous Housekeeping Items

== LEAP is apparently losing “take over” or “merger” premium.

== current selloff means “no hope” for a quick deal or fix – shareholder base is changing from momentum to value. Since earning call on April 26, LEAP changed 39% of shareholders, PCS 19%, and since year end correspondingly 195% and 137%.

== nothing spectacular on short volume of PCS (might jump after May 1):

Settlement Date	Short Interest	Avg Daily Share Volume	Days To Cover
4/13/2012	7,113,455	3,598,927	1.976549
3/30/2012	3,958,263	3,596,369	1.100628
3/15/2012	3,304,612	6,087,233	1.000000
2/29/2012	4,412,210	9,979,631	1.000000
2/15/2012	3,978,746	4,656,915	1.000000
1/31/2012	3,184,186	3,745,916	1.000000
1/13/2012	4,334,154	6,876,245	1.000000
12/30/2011	3,097,568	2,994,850	1.034298

LEAP’s short interest is more impressing because of higher leverage:

Settlement Date	Short Interest	Avg Daily Share Volume	Days To Cover
4/13/2012	13,303,205	1,458,904	9.118629
3/30/2012	13,065,663	1,280,425	10.204161
3/15/2012	12,969,396	1,560,998	8.308400
2/29/2012	12,163,006	2,039,200	5.964597
2/15/2012	12,065,177	1,399,445	8.621401
1/31/2012	9,926,338	1,386,823	7.157610
1/13/2012	12,385,466	2,611,363	4.742912
12/30/2011	11,769,102	1,768,184	6.656039

== nothing to note on insider activity and ownership changes: CEO is 74 and owns many times more stock than his annual salary (5.6m shares vs. $2.5m salary)

== LEAP: debt 3.2b - cash 0.6b = 2.6b net debt + @$5 market cap 0.5b = 3.1b EV and EBITDA 0.55b = 5.5x

== PCS: debt 4.4b - cash 2.2b = 2.2b net debt + @$7 market cap 2.5b = 4.7b EV and EBITDA 1.3b = 3.6x

== combined: debt 7.6b – cash 2.8b = 4.8b + 3.0b market cap = 7.8b EV and 1.85b EBITDA = 4.2x

Disclaimer: long PCS and LEAP, 5% position each, ~10% in red at today’s level.