So now you know the secret I have kept close to the vest for nearly two years, the "Greed Screen." But why the hell do I call it that? Well, it comes from my analysis of both the success (HSR) and the failure (TPI) of the two original investments culled from the screen. Let's look at what they have in common. They both were heavily owned by insiders and they both paid a dividend. In effect insiders were getting additional income at a reduced tax rate by owning the shares of the company that they ran. In the case of HSR, they hiked the dividend adding to an already juicy yield.
The differences between the two range from obvious to subtle. I won't discuss the obvious differences such as sector membership and geographical areas of operation. The subtle part is the behavior of management. In the case of TPI, management scaled back on their stake while the business deteriorated. They never bothered to pre-announce and warn shareholders of a major revenue fall off. They violated fiduciary duties in my opinion. They were selling out when they got wind of a rocky road ahead at a higher price than what they could have gotten post revenue short fall. The management at HSR, on the other hand, sold the company at a significant premium to what was the current share price.
But are the differences really that different? While management for the companies acted in stark contrast to one another, in my opinion the underlying reason for their behavior demonstrates a common thread. Management acted in their own self interest in both cases. Think about it. Management at HSR boosted the dividend and sold the company at a huge premium, significantly padding their wallets. TPI management reduced their stake as soon as they, not the regular shareholder, knew the shit was going to hit the fan. They protected, if not padded, their own wallets by selling at what they knew would be a higher price than the price would be after the bad news hit. Ultimately, in both cases, management was motivated by greed. They just expressed it differently. After coming to that conclusion, I theorized that the screen was particularly good at finding greedy executive run companies. Thus I named my screen, the "Greed Screen." Other inferences to the movie "Wall Street" are coincidental and very convenient and snazzy I might add! lol
If the screen had a knack for finding greedy executives then, I hypothesized, I could expect to see several things over time from the candidates culled from it; special dividend payments, dividend hikes, stock splits, buy outs, and an occasional SEC and/or criminal investigation(or at least a breach of shareholder trust similar to the TPI example.) Just to be clear, I expected each candidate to exhibit one or more of the above mentioned behaviors, not all! As I stated in the previous blog entry, I invested in two other candidates from the "Greed Screen." I bought sizable positions in LZR and LPHI. So did these two help confirm my hypothesis? In a word, perfectly. Which, quite honestly, shocked the ever-living hell out of me!
LPHI went four for five on the behavior checklist! It paid a special dividend, hiked the annual dividend, had a 5 for 4 stock split, and is now under investigation by the SEC for fraudulent pricing of it's financial products. I lost a few cents a share when I sold out of the position. But, the dividend payments I received over the 15 months or so I held the shares more than made up for the capital loss. LZR went two for five. They hiked the dividend and just received a buy out offer that's a 30% premium to my cost basis. Had I been buying the dip on LZR it would have been better than a 40% premium! Unfortunately, I listened a little too much to the bears' argument on the company and actually considered dropping the position before the buy out offer was made public.
While I have discussed the benefits of investing in candidates from the screen prominently in these two blogs, I haven't discussed the risks very much. I'll avoid discussion on market risk, capitalization risk, sector risk, etc. I could rattle off a whole list, but this would read more like a propectus from a Vanguard mutual fund than a blog! For the sake of discussion I'll assume that the basic fundamental analysis used is not flawed, that is the person using it has not made a major mistake. I'm sure some would argue that using fundamental analysis at all is flawed. I'm not going to delve into the T/A vs. F/A argument, but I will say that using one without at least some knowledge of the other is like playing a football game and only knowing half the rules. I also would add that there may be times when there are few or no candidates on the screen. Today, for example, there is a total of three companies on the screen. Don't worry though, I've found a way around that. Obviously you could park the amount you normally would lend to the strategy in cash until more attractive candidates began to appear. My suggestion would be to allocate to a different system or expand the market cap parameter in the screen.
Expanding the market cap parameter does change the effectiveness of the screen, in my opinion. The bigger the market cap, the more analyst coverage there is. Therefore you have less of an edge. With a little work, you'll end up in a good company or two. However the likelihood of a buy out will be diminished because the pool of suitors is smaller.
Another option, use the same parameters, but instead of using the trailing twelve months time frame, use the five year average. Google Finance allows you to screen like this but Yahoo does not. My suggestion would be to list the most recent year as well so you could see if one good year skewed the average. I have used this alternative, but only recently so I cannot speak to it's results. On the surface it looks like it has a tendency to screen for small Buffet-type companies. That is after you drop the companies with skewed results. My recent purchase of RMCF is based on this version of the screen. Similarities to See's Candy have not gone unnoticed.
In recent times I have read a considerable amount of information either about or written by Warren Buffet. Please note that I had read little of him prior to the establishment of this screen. Most of the information I knew about him was culled from CNBC sound bites and quotations taken from his annual letter to shareholders of Berkshire Hathaway that lacked the context in which they were written. Now after reading nearly half of his letters to shareholders(and counting) and several well written books about his style of investing, I have come to the conclusion that the screen uses many of the tenants put forth by Buffet. I should also mention that this was completely by accident. (Please insert lucky/good analogy here.) Buffet did not exert his influence on me until the year following my use of the screen.
Really the only difference between the style of the screen and Buffet's style is in application. Because of the size of Berkshire Hathaway, recent and future acquisitions will be large. The Greed Screen, of course, focuses on small companies. Our views of management in this instance contrast drastically. My application of the screen searches for self serving managers who will eventually, perhaps by accident, reward shareholders. Buffet searches for the manager who is a good steward of the shareholders' assets ie. the company.
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