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Bear-market lessons from a master value investor
Tom Kahn's ability to hone in on the intrinsic value of unloved companies has led him to double-digit gains in the last two years -- when the markets were plunging by double digits.
By Jon D. Markman
Thomas G. Kahn thinks Im stupid, and hes not too sure about you, either.
Nothing personal, he quickly adds, but how else to characterize the cargo cult that has appeared online and on TV in recent years to encourage a pagan form of stock worship? Like the Pacific islanders who are supposedly still waiting for American DC-5s to return with the same payload of goodies dropped during World War II, he sees most non-professional investors and their media enablers going through motions that worked at one time but never will again.
Kahn is entitled to this opinion because his middle name is virtually synonymous with value investing, a technique that has stood the test of decades. That "G." is short for Graham -- as in Benjamin Graham -- the 1930s-era Columbia University finance professor whose research on the importance of buying companies at prices below their intrinsic worth has guided Warren Buffett and countless others. Kahns father, Irving, was Grahams teaching assistant at Columbia. And Thomas himself assisted Graham in the 1973 revise of the seminal value-buyers book, The Intelligent Investor -- and is so credited in the acknowledgements.
I sought out Kahn, now head of a private money-management firm in New York, for reassurance that companies are still a store of value in this era of accounting legerdemain. Is the stock market still the best place for a large portion of a familys savings, I wondered, or has its edge over bonds and cash been frittered away by corporate fraudsters?
Price is key
The answer probably wont surprise you, but its valuable to hear. Kahn, who specializes in taking 10%-20% ownership positions in small companies and riding them for decades, believes that stocks are still a good way to employ your capital and have it grow over the years. But he hastens to add: They key question is the price you pay.
The problem with investors who came into the market in the late 1990s, he says, is that they cant seem to get out of the habit of gambling -- buying stocks irrespective of the relationship between price and underlying value. These people are stupid and doomed to failure, he says, and the market will continue to deal brutally with them. In fact, he thinks the market is generally high and will decline this year as people havent lost enough money listening to the jerks at CNBC.
Kahn declares himself uninterested in the market or opinions about the market, however, because he considers its short-term movements random and discussions about those moves worthless chit-chat.
What is not random: Hard assets on a balance sheet, real earnings and smart managements making good decisions. What is not worthless: Time spent finding companies with low price-to-earnings multiples, low debt levels and assets trading at a discount in out-of-favor industries that the market has shunned. We look over a lot of ideas to figure out which might be meritorious investments and which might have cancer, he says. He punts firms run by managers considered untrustworthy, or that are in businesses subject to lawsuits, or are in decline, or both -- like providers of lead additives for gasoline. But still the beat goes on. We always find bargains of one type or another, he says cheerily.
Lessons from a master
In a moment, Ill get to some stocks that Kahn is studying now. But first lets look at a couple of past successes.
One exercise in valuing assets at a discount -- the cornerstone of Graham-style investing -- was the purchase of a large stake in lowly Thriftimart in the 1970s. This was a shabby supermarket chain based in Southern California famous for its giant T signs. Kahn says the owner of Thriftimart had bought most of his retail properties in the 1920s and 30s. Accounting rules required the firm to depreciate the buildings but carry the land at historical cost. Thus the land was a hidden asset carried at an artificially low price on company books. After investigating, the Kahns determined that one day, that value would be unlocked. They had to wait 20 years, but when a French firm finally bought Thrifimart, the capital appreciation turned out to be much greater than a concurrent investment in a popular growth stock like IBM (IBM, news, msgs)
Another favorite, which he still holds today: Hologic (HOLX, news, msgs). This was a debt-free maker of digital X-ray machines with lots of cash, selling for not much more than the value of that cash. It wasnt making money but was both statistically cheap fundamentally and interesting because of the value of patents it held on successful radiology devices. Kahn has bought about 15% of the firm for clients since 1999. While shares declined for a while, prices have since improved as the market came to value the firms dominant technology and growth prospects.
Kahn takes the notion of owning a share of the business very seriously. He is willing to stick with his investment only as long as corporate managers are making the decisions he would make if he were at their desk. Thats not a set of choices that can be reduced to an algorithm or moving average. He doesnt look for a set checklist of items, either, like a dividend or even any earnings. When he buys into a company like Hologic, he endeavors to become an expert in the industry -- traveling to radiology trade shows, visiting hospitals and listening in on endless conference calls. This bespeaks a gravitas and vision that takes years to develop. But its a methodology that should prevent an investor from taking a position in a troubled firm like Enron (ENRNQ, news, msgs) or like Tyco International (TYC, news, msgs) -- companies that are not just expensive, but more importantly, are too dense to be understood well by an outsider.
One more firm he bought after applying a good bit of shoe leather to study: K-Swiss (KSWS, news, msgs), the Los Angeles-based sneaker maker. Research determined that the company was debt-free with a lot of cash, much like Hologic, in a business where it essentially makes nothing and sells nothing. The company is known for designing one-season shoes aimed at teen-agers that are made in Asia and sold at Foot Locker (Z, news, msgs) and other retailers with no markdowns. Its a humble idea, but the stocks low P/E multiple meant it had the capability of being discovered one day -- and it has more than doubled since Kahn purchased. You dont need much to do very well if you start from a low price relative to value, he said.
6 red flags
Kahn can't sympathize with folks conned by Enron, though he has had trouble a time or two in the past. Right now, a big investment in troubled fertilizer manufacturer Mississippi Chemical (GRO, news, msgs) giving him fits. But he agreed to offer a red-flag list:
- Beware of companies (like Enron) that purport to create new industries.
- Beware of banks that are run by aggressive lenders.
- Beware of aggressive acquirers.
- Beware of companies that purport to grow very fast.
- Beware of industries that are capital- and labor-intensive and have low historic returns, like airlines.
- Beware of companies that are too complicated for the founders heirs to run. If you owned a toll bridge thats the only way to cross a river for miles around, you wouldnt have to leave it to a genius to ensure it would keep operating profitably, he said.
Right now, Kahns value orientation has led him to the insurance business, which was knocked for a loop after the September terror attacks but which he believes is about to reap a fortune from higher premiums. His firm has owned like Old Republic International (ORI, news, msgs) for awhile. He also likes office-products retailer OfficeMax (OMX, news, msgs), which is majority-owned by Mexican billionaire Carlos Slim. Kahn calls it statistically cheap and on track to reduce its costs and restructure its distribution. We feel theyll either generate profits or theyll sell out north of $10, up from $4 recently. And he likes network-equipment maker 3Com (COMS, news, msgs) because it is statistically cheap, largely debt-free, trading at a fraction of book value and management is making impressive efforts to restore profitability.
With this sort of deliberate approach, Kahn believes value investing can produce annual returns of 18% to 22% over long periods of time. Typical long-term, all-equity clients at Kahn Brothers & Co., he says, were up 29% in 2001, 22% in 2000, 8% in 1999 and 6% in 1998. It would seem that for them, the bear market in bad stocks has been more of a boon than a bust. Let that be a lesson to all of us.
The following table lists the top 15 positions at the firm, which manages $500 million for pension funds and high-net worth individuals. Kahn says he is not presently adding money to these names.
Kahn Brothers & Co. - Holdings Through January 02 | | Company | Market Val. | Shares | | New York Community (NYCB) | $ 22,975,585 | 1,004,617 | | North Fork Bancorp (NFB) | $ 20,040,775 | 626,470 | | Advanced Marketing (MKT) | $ 16,306,813 | 893,524 | | Old Republic (ORI) | $ 15,145,871 | 540,731 | | American Home Products (AHP) | $ 12,601,290 | 205,367 | | Hudson River Bancorp (HRBT) | $ 12,260,912 | 559,859 | | Hologic (HOLX) | $ 11,903,742 | 1,281,350 | | Mony Group (MNY) | $ 11,113,425 | 321,476 | | IBM (IBM) | $ 10,928,857 | 90,351 | | Seaboard (SEB) | $ 9,135,630 | 29,855 | | Flushing Financial (FFIC) | $ 8,429,172 | 473,549 | | Maritrans (TUG) | $ 7,770,727 | 650,270 | | Dime Community Bancshares (DCOM) | $ 7,559,083 | 269,390 | | Warwick Comm.Bancorp (WSBI) | $ 7,495,001 | 366,341 |
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Source: SEC Form 13-F filed Jan. 31 01
Fine Print
Kahn says that the Benjamin Graham he knew as a longtime family friend wasnt interested in money. He was interested in culture and other intellectual pursuits. Ben was interested in investing to the extent that you could make a reasonable return with safety and use that income to live nicely and pursue more important interests, he said. He noted that Graham wrote a Broadway play, translated books from Spanish, published books on currencies and commodities, and loved to study art. He came to fame as a finance professor at Columbia, however, using case studies with stocks that students like Warren Buffett could observe in real time Kahn says he thinks the economy will not turn around as quickly as Wall Street currently believes. He notes eight years of expansion will take time to be absorbed and digested. If you have a big lunch you dont want to go out and have a big dinner, he said. To find an SEC report listing the holdings of any private manager of more than $100 million, visit FreeEdgar.com and enter their name in the search field at the top of the first page. Click on the link for the 13F-HR report. Click here for Kahn Brothers latest report. On the other side of the financial world, in the trading and market-timing community, the hedge fund manager I refer to as Mr. P says is growing increasingly bullish. A weekly close in the S&P 500 Index above 1,113 or Nasdaq 1,901 would leave him at least neutral. If those lines are crossed by Friday afternoon, Ill sell the Supermodels portfolios two bear funds for a gain ... I will also add OfficeMax (OMX, news, msgs) and 3Com (COMS, news, msgs) to the Supermodels watch portfolio ... For an amusing riff on cargo cults and science by the late Caltech physicist Richard Feynmann, click here.
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