Sunday, August 24, 2014

The Value Proposition by Kim Shannon

One of the perks of having a blog like this is that you get contacted by a wide variety of people.  Most people want to discuss investment ideas, some discuss startups, and some are company executives or directors.  A few months back, I was contacted to do a book review on a home grown Canadian value investor.  Since I love to read I could never turn down a book, particularly one related to value investing.
The book is called The Value Proposition – Sionna’s Common Sense Path to Investment Success written by Kim Shannon (CFA, MBA).  Kim has over 25 years of investment experience as a value investor and since 2002 has served as chief investment officer and president of the firm she founded, Sionna Investment Managers Inc. 
Overall ,I would recommend the book to those who want to understand the fundamentals of the value investing framework.  The book caters to a wide audience and I feel both investors and non-investors will learn something from the book.  One thing I found particularly interesting was the reasons why they talk to the management of the firms they invest in, while most value investors don’t (more below)
The book is divided into three sections.  The first section is an introduction to Kim Shannon and the firm she founded.  The second is about Sionna’s philosophy and the last section is about the how Sionna implements its own take on value investing.
In this article I will describe my key takeaways from the book and a few principles that I found interesting or disagreed with.   

Introduction and History

This section discusses Kim’s unconventional upbringing in a military family.  Which had its positives but also had it's negatives.  The most positive lasting impacts were that she developed independent thinking abilities and wasn’t afraid to stand alone (pg. 11).  These attributes will help any value investor as you must be able to trust your own judgment.  Kim also had a passion for reading and learning.  Those are both cornerstones for personal development and are critical for investment success. 

Sionna’s Philosophy

Sionna is based on a value philosophy and they strive to be client centered.  Although most investment firms say they are client centered, I definitely took away from the book that they have more integrity than most investment firms in this regard.  One of the most important keys to a successful investment management firm is to have clients who both understand and share the investing mindset of the firm.  For value firms, this means underperformance when bull markets are raging and outperformance often comes when markets turn down.  The reason this happens is that value investors have a belief in the rationality of the markets over the long term, but definitely not in the short term. 

When you think about it clearly, companies can’t alter their underlying values to a large degree over the short term, but their share price can fluctuate dramatically.  Companies simply don’t have the capacity to double or triple in a matter of months, but the prices of their shares can.”  (pg. 27)

I couldn’t have agreed more when I read this quote.  People don’t get quotes on land, houses, or other assets they own every hour, but they do get quotes on price of businesses on the stock market every second.  These values can and do rise and fall quite dramatically over short periods of time.  This is what makes value investing successful because if you can successfully value a company and buy at a discount you have much better odds at outperforming those who don’t have a clue as to what they are doing.  And that includes more investment professionals than you realize.   
One key difference from Sionna to other investment firms is that they use a relative value approach.  This means they select stocks from all sectors and also stay invested in bull or bear markets.  They are always looking for the cheapest companies in each sector at all times.  This is particularly important in Canada where resource and financial firms dominate your investment choices. 
The benefits of the relative value approach listed in the book were better diversification and a smoother ride.  The smoother ride is definitely helpful to keep clients from selling out at the wrong times.
While the relative value approach has some benefits I couldn’t help but ask myself, what are the downsides?  This is where I found the book lacked because it didn’t discuss the downside. 
I feel there are a few downsides to this approach.  First of all, a relative value approach may take you into a sector where all companies are overvalued.  Just because a stock is the cheapest in a sector doesn’t mean it is cheap.  It could also be overvalued, so why risk the capital for the sake of diversification?  Secondly, the smoother ride is nice but you can't do this without sacrificing the highest attainable total return.  Personally, I prefer to go where the value is and not be constrained by any sector or requirement to be diversified. 
Some of the other foundations to their approach are reversion to the mean and the sources of total equity returns.  What I found interesting is that in range bound markets (see GDP & Stock Market Returns ) 90% of equity returns comes from dividends.  This makes total sense when you look at a company like Microsoft that has been range bound for more than a decade.  While the company has experienced very strong earnings growth, it has been masked by shrinking multiples (P/E ratio).  In Microsoft’s case the P/E ratio fell from over 40x to under 10x during the last 14 years.  The only return investors in MSFT’s stock have seen (until very recently) was in the form of dividends. 
The book briefly talks about other philosophies such as growth, momentum, speculators and Growth at a Reasonable Price (GARP).  I find GARP to be self-deception at its finest.  I constantly see lots of wannabe value investors turn to “GARP” to justify the purchase of their stocks.  Once you start to talk about “growth” you are now turning from what you know to trying to predict what you don’t know.  Being able to differentiate between what you know and what you don’t know is critical to investing.
On a whole I must say I was greatly drawn to the firm and the principles on which they stand.  I wouldn’t hesitate to send potential clients there way as they appear to have more integrity than most investment managers. 

Implementing Investing at Sionna

This is where the book does a really good job and opened my eyes to help me improve my investing ability.  First of all, the book describes their Intrinsic Value Model (IVM).  You will have to read the book for the details; I can’t give it all to you here.  What I will say is that it involves three major quantitative factors: book value, historical ROE, and relative P/E ratio.  Those are all foundational to my own philosophy, so I almost felt I was reading my own approach to investing. 
I tend to think in terms of slightly different factors, those being: book value, normalized ROE, and relative P/BV.  These are only slightly different ways of thinking about the same quantitative factors they use at Sionna.  
From the three quantitative factors they calculate a rough intrinsic value and expected return.  After it passes this preliminary test they do more fundamental research into the company’s financial position.  I especially liked how they approach financial statements very skeptically.
Another key difference to Sionna’s approach is that they attempt to meet with the management of the firms they invest in.  The reason why they do this isn’t to find out more information, although they usually do, but it is to determine whether management is honest and trustworthy. 
Most value investors don’t bother meeting with management because they don’t find it worthwhile and it may even lead to a bad decision.  The reason is that most CEO's are typically quite charismatic and are able to sell ice to an Eskimo. 


If you are looking for a decent book to explain the value investing approach, I would recommend this book.  It provides enough information on both the quantitative and qualitative approaches to solid investing and doesn't waste pages with useless drivel.  As I like to say, most books could be written as a pamphlet and very few authors actually provide new material, chapter after chapter. 
While I understand why they use a relative value approach, I personally could never take such an approach.  I just can’t invest in something only because it is relatively cheap. 
If you are interested in learning how to determine the intrinsic value of a business, the model discussed in this book gives a solid framework on which to do that.  From there you have to dig deeper and look at other quantitative and qualitative measures that are discussed in the book. 

Best Regards,

P.S. I am currently reading Stress Test by Tim Geithner, and it is a fantastic book about the financial crisis.  I'm about half way through and so far I am fascinated at how the various government officials felt like they had to act during the crisis.   
Disclosure: Long MSFT

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