* * *

BreitBurn is an oil and gas production company structured as an MLP (see my July 2009 letter for a similar discussion of Linn Energy, another MLP). BreitBurn’s business model is fairly simple: their only job is to extract and sell oil and gas from wells they own throughout the U.S. These are wells they have acquired—they don’t take the risk of exploring or drilling for new wells. Basically, BreitBurn is like a portfolio of interest-only bonds—assets (petroleum in the ground) that pay interest (production revenue minus extraction and administration costs) until the bond is paid off (reserves are depleted). Here’s a quick summary of BreitBurn’s goal from their 10-K:

“Our objective is to manage our oil and gas producing properties for the purpose of generating cash flow and making distributions to our unitholders.”

Because BreitBurn wants fairly steady cash flow to fund their distributions, much of their oil and gas production is hedged. That level of hedged production is immune from fluctuations in energy prices. By the summer of 2008 when prices were high, they had managed to hedge about 70-80% of production for three years out. So when energy prices (and the stock market) subsequently collapsed that fall, BreitBurn’s cash flow remained mostly unharmed. However, as with many of the MLPs, Lehman Brothers was both counterparty to their hedges and a large owner of the stock. The “perfect storm” of falling energy prices, a crashing stock market, and Lehman’s liquidation caused BreitBurn’s unit price to fall from over $20 in the summer to under $6 in December.

When BreitBurn appeared on my radar in November, it seemed like the perfect example of a simple, profitable company that was being sold off by non-economic sellers. So despite all the market noise, what were units of BreitBurn really worth?

The above valuation of asset value is a simplistic method of obtaining the market value of oil and gas reserves that BreitBurn owns. The hybrid price of oil/gas was $35 a barrel at the time, which translated into an equity value of around $17 per unit. (Though, had BreitBurn actually liquidated and sold its reserves, it would take a haircut due to the time value of extracting the reserves over a period of years.) Distributable cash flow (profits that can be freely distributed to unitholders) totaled $2.70 per unit, $2.08 of which was actually distributed in the form of a dividend. So at a price of $6 per unit, we were purchasing BreitBurn at a yield of over 30%. This was clearly an asset with a large margin of safety.

We continued to purchase BreitBurn through the next quarter. Even with their hedges in place, cash flow did drop going into 2009 as demand for oil and gas continued to languish. Because of falling energy prices and asset values, BreitBurn’s lenders decided to redetermine their borrowing base (the amount of debt the company is allowed to have in relation to oil/gas reserves). Although BreitBurn was still in the “safe” zone, it was a hectic economic period with little liquidity, and management made the choice to temporarily eliminate the $2.08 distribution. This was a prudent decision, as they could instead pay down debt with their cash flow and eliminate the risk of having to raise new equity or refinance at a bad rate. It’s always better to be safe than sorry. This was one of the many excellent decisions that managers Hal Washburn and Randy Breitenbach made over the past few years.

On April 20, 2009, after the announcement of the dividend cut, BreitBurn’s stock price collapsed again under $6, and gave us another opportunity to buy more units. Our total average cost was $5.90. Over the course of the year, the price moved up steadily with the market. On February 8 of this year, they announced the reinstatement of the distribution at $1.50 per unit. “Yield” investors bought back in, pushing the share price to its current level of around $15 (a 10% yield). We sold a quarter of our position at $14, but BreitBurn remains one of our largest investments.

Braewick Holdings LP currently has a long position in BreitBurn Energy (BBEP). We reserve the right to buy or sell shares at any time.

* * *

Most everyone has heard of the “Type A” and “Type B” personality classifications. In Dan Pink’s book Drive, he adapts MIT management professor Douglas McGregor’s ideas to put forth two more classifications: Type X and Type I. Type X behavior is fueled by extrinsic motivation—external rewards like money and recognition. Type I behavior is fueled by intrinsic motivation—the inherent satisfaction of the activity itself. “I don’t mean to say that Type X people always neglect the inherent enjoyment of what they do, or that Type I people resist any outside goodies of any kind,” Pink says. “But for Type X’s, the main motivator is external rewards. Any deeper satisfaction is welcome, but secondary. For Type I’s, the main motivator is the freedom, challenge, and purpose of the undertaking itself. Any other gains are welcome, but mainly as a bonus.”

Pink lists some well-known examples of both types: Warren Buffett, Oprah Winfrey, and Bruce Springsteen are Type I’s. Donald Trump, Jack Welch, and Simon Cowell are Type X’s. So it’s clear that both personalities can be successful. People can also change over time. But Type I’s almost always outperform in the long run. They’re also the people you want working for you.

On April 30, Biglari Holdings announced that its new compensation agreement with CEO Sardar Biglari would provide him with 25% of the gain in Book Value over an annual hurdle rate of 5%. So if the Book Value of the company went up 13%, Biglari would receive 2% of the company’s equity. At its current size, that amounts to around $7 million, including his regular salary.

In and of itself, this compensation agreement isn’t inherently bad. It’s a typical “pay for performance” scheme that many private investment funds use, including our own. (In fact, Biglari’s hurdle is slightly more generous than ours, but thankfully I haven’t had any complaints—yet.) I won’t delve into the more technical reasons I dislike the agreement—other than to say that a public company is not comparable to a private investment fund for a variety of reasons. I think the bigger implications are with the revelation of Type X behavior and how it affects the culture and future strategy of the company.

Type X behavior is fairly common among the CEOs of public companies. So it’s obviously not a disaster. In this particular case however, I think it permanently damages reputation. Aside from Warren Buffett’s history of good deeds, it gives people (shareholders, company managers, etc.) comfort that he isn’t in it for the money and is on equal financial footing with other partners. The strategy of Biglari Holdings is also that of “growth through opportunistic acquisitions.” Acquiring companies when you have a reputation for selfishness and hostility can be a difficult undertaking. Also, regarding the people already working for Biglari Holdings, this behavior may have the effect of changing company culture for the worse.

Braewick Holdings LP still has a long position in Biglari Holdings (BH). We reserve the right buy or sell shares in BH at any time.

The following are some excerpts from a great interview of Bébéar done by Michael Villette (mentioned in Malcolm Gladwell’s essay “The Sure Thing”). In the interview, Villette’s goal was to test the common belief that Bébéar took more risks than others (both in business and insurance), was a business innovator, and took advantage of others using insider “industry” information.

MV: Explain to me how starting in 1981 you managed to carry out an uninterrupted sequence of acquisitions in France and then in other countries. I would like an explanation with no magic, with facts and figures.

CB: There’s no magic in any of it, nothing extraordinary. The first coup was Drouot, which we bought at a bargain price, because of the panic after the left won the elections.

On the Drouot acquisition:

… the result: we acquired for 250 million francs a company that was valued at 5 billion francs four years later. . . .

MV: Why was Drouot worth so little to start with and so much later?

CB: It’s just like Equitable. People study the issues very poorly. They look at things superficially. Drouot was a company with a very good business that had done some stupid things in real estate. It was taken over hastily by Bouygues. Bouygues knew nothing about the profession of insurance, so he stuck with thinking like a financial analyst, that is, in the short term. He said to himself: “Oh, there’s a hole in this business, it’s terrible!” He didn’t see the value of the underlying business. We bought at a very low price because it seemed to be a company practically on the skids, but since we were insurance professionals, we restored the business immediately, we increased premiums, and so on, and the business took off very quickly. When we bought it, it was losing 200 million. The following year, the budget was balanced, and the third year it earned 200 million.

On the Equitable acquisition:

The entire financial press thought the company was done for, and Wall Street was expecting a bankruptcy at any moment.  … I went to New York, I took a look, I talked with the management, and I said to myself: “This one too has a fantastic business.” So I had to see how big the financial hole was, in comparison with the value of the business. We studied the company for five months, something no one else was doing. We made a bet on a sure thing. . . .

What’s marvelous in this story is that when we did the deal, the head of the company said to me: “Claude, now you know more about the company than I do.” And it was true. We had studied it thoroughly. To do deals like that, you have to be in a profession you know, do a very thorough study, and have the ability to make quick decisions. These were the advantages we had over the others. There was no miracle.

On what constitutes a “good deal”:

MV: If I understand you correctly, correct me if I’m wrong, to do a good deal, you take advantage of a moment of vulnerability of the other party (which doesn’t mean you treat him badly, you can be elegant) and you play on the asymmetry of information.

CB: Absolutely.

MV: You’re not against that interpretation?

CB: No, not at all. You know, in a company, there’s the objective and the subjective. In addition, a company can be worth something for me, considering the business I’m in, considering the know-how I have, and for the next businessman it could be a catastrophe, a millstone. We were just talking about Bouygues: he bought an insurance company by chance, he realized it was not his kind of business, and boom. He went away. It was a good decision by a company head.

On taking insurance risks:

We took small risks in the area of reinsurance, but not on a large scale. It’s easy to do reinsurance. You can sign up to whatever you want. We didn’t want to buy shares in a reinsurer but to learn the business ourselves.

On whether is made his money by being an “innovator”:

MV: In writing the history of major businessmen, to explain their careers, it is often said that they were innovators. And you? You never present yourself as an innovator?

CB: In France, the inventor of modern automobile insurance was a man named Jacques Vandier. He was the head of Macif. He really invented new criteria. I have to admit that I never invented anything. What I was able to do was to recognize the weakness of other companies and exploit that weakness. That is, when opportunities came up, I dared to do what other’s didn’t, but without taking considerable risks. This was simply because facing me were timorous people, bureaucrats, notables.

On his interest in business:

Your last question is why I’m not richer than I am? The explanation is simple. First, I’m the son of civil servants, my parents were teachers, I was more tempted by business and power in business than by wealth. Second, I joined a mutual company where, normally, you’re not supposed to get rich. . . . Later, I started to get wealthy when stock options became legal in France. . . .

You know, it’s never entertaining to manage a company. What’s entertaining is to make progress, to try to do better than the others, to do things that the other’s don’t do. That’s the entrepreneurial spirit.

Claude Bébéar is very much a value investor (protecting himself from risk and uncertainty) whether he calls it that or not. Definitely no Warren Buffett, but an interesting story nonetheless.

Apple has been a fantastic investment over the past decade. In fact, since April 2003 when they launched the iTunes store (and iPod sales took off), a dollar invested in Apple would be worth over $40 today – an annualized return of almost 70%. That’s a return that would make most venture capitalists blush. Not bad for a company founded 27 years prior.

One more statistic: even if Apple stock had gone nowhere from its IPO in 1980 up to 2003, its annual return over the three decades since going public would be 13%, which still beats the S&P 500 by over 3%. In other words, almost all of Apple’s current value (~$230 billion) was created over the last seven years.

Where did that value come from? For the seven years ending 2009, sales grew from $5.7bb to $42.9bb. Over 70% of that growth came from new products: the iPod, the iPhone, media sales, and other related peripherals. On a net profit basis, even more than 70% of Apple’s growth came from new products (segment margins aren’t disclosed, but overall margins have hugely increased and most of that likely came from new products). Aside from the storied brand name, Apple is basically a startup that was funded with the cash and income from their struggling Macintosh business.

Apple and the Red Queen Run the Hedonic Treadmill

“…it takes all the running you can do, to keep in the same place.” – The Red Queen, Lewis Carroll’s “Through the Looking-Glass”

So, clearly, the law of large numbers comes into effect when looking at Apple’s future growth prospects. To double revenues, Apple would have to sell an extra $43 billion a year in products – that’s over 68 million iPhones or 32 million Macs every year.

Of course, investors aren’t counting on Apple’s revenue doubling anytime soon, and the law of large numbers just means it’s more difficult for them to grow, not that it’s impossible. But to me, the more relevant model to use for Apple’s future growth is that of the Red Queen Effect.

In Lewis Carroll’s follow up to “Alice in Wonderland,” Alice comes across the Red Queen (not to be confused with the more popular Queen of Hearts) and for no reason at all they both begin to run. Alice notices that, despite their tireless efforts, they have remained in the same spot. The Queen informs her that she must keep running just to stay put (see the above quote).

In biology, the Red Queen’s race is translated into the principle that “for an evolutionary system, continuing development is needed just in order to maintain its fitness relative to the systems it is co-evolving with.” I think the Red Queen effect is an apt analogy for Apple’s current situation. Here’s why:

• Most of Apple’s growth in sales over the past 2 years has been from the iPhone (68% of growth to be exact).  The iPhone was launched in 2007, and most of these sales have been to new iPhone users. Certainly there are much more non-iPhone users to “convert,” but at some point most iPhone purchases will come from current users who are upgrading. This has already happened with the iPod – as seen in the chart above with iPod unit sales tapering off lately.
• Most future growth will have to come from new iPhone users, iPad sales, and any new products that Apple introduces.
• To justify Apple’s current valuation, the company must consistently come out with new (and popular) products to both maintain and grow profits. In other words, they have to keep running just to stay in the same place.

The one part of Apple’s business that isn’t susceptible to the Red Queen effect is their share of media/app sales through the iTunes & App store. Because of their closed system (disregarding the downside to this model), Apple controls and gets a cut of almost every application and piece of media consumed on their devices.

The iPod/iPhone/iPad act as mobile “delivering devices” for entertainment and productivity applications. If Apple can maintain their closed system – and Clayton Christensen’s prediction continues to be wrong – their share of content distribution will continue to rake in profits.

But as an investment, I don’t think there’s much of a margin of safety if Apple stops “running” and a new product launch fails. Investor’s high expectations have put Apple on a Hedonic Treadmill of sorts that only a fall in price can cure.

Large companies (with competitive advantages) can be pyramids or skyscrapers. Both are large and have commanding presences. Both have high returns.

Pyramids are strong — you can’t knock them over. Skyscrapers are tall and strong, but they can be knocked over much easier. For a pyramid to be destroyed, it must start at the top, and slowly erode over time. After a while, only the foundation will be left. With a skyscraper, the foundation can be destroyed first, and the rest of the company will go with it.

Wal-Mart is a pyramid. Google is a skyscraper (for now — it seems that Larry & Sergey are in the process of building the foundation up). Berkshire Hathaway is a pyramid. Newspapers were pyramids — however, over the last two decades, they have been slowly chipped away starting from the top. Now, the foundation is about all that’s left.

Skyscrapers can be turned into pyramids over time.  But that requires great management and somewhat favorable circumstances. The time it took to build a company doesn’t necessarily tell you what type of building it is.

You can combine this analogy with Buffett’s moat analogy. Moats are barriers to entry — the wider the moat, the harder it is for competitors and disruptive technology to affect the company. But if the moat can be crossed, you’d much rather have a pyramid than a skyscraper.

Related:

“The Restaurant Investor” by Max Olson

In March, 2008, Sardar Biglari won the most important victory of his life. In an activist campaign to gain control of the board of directors of The Steak n Shake Company, Biglari and his partner received nearly triple the number of votes of the directors they were replacing.

It hadn’t been easy—their proxy fight with incumbent management had been going on for more than six months. Biglari and the entities he controlled first purchased seven percent of Steak n Shake during the summer of 2007. In August, the initial filing was made with the S.E.C. stating that Biglari had been in discussions with management. At this point, as with many activist investors, Biglari hoped that management would be open to his suggestions and criticisms of the company. He was the third largest owner of Steak n Shake at the time, holding more shares than all executive officers and directors combined. Only days earlier, C.E.O. Peter Dunn had unexpectedly resigned, stating his intent to “pursue other interests.” It seemed like the perfect time to reform the faltering restaurant chain.

Yet, after Biglari’s initial meeting with the Board and interim C.E.O., he was denied representation and otherwise rebuffed from any involvement with the company. To management, he was as a nuisance—one that if ignored, would go away. But Biglari was not the kind of investor to be ignored. While continuing to accumulate shares, he launched the first blow in the proxy fight on October 1. Along with an official solicitation to shareholders, Biglari wrote a brief letter outlining his intentions and frustration with the performance of Steak n Shake.

During the proxy fight, Biglari’s demands were relatively mild. His initial goal was to obtain two Board seats—one for himself, and one for Philip Cooley (Biglari’s mentor and business partner). But as the Board continued to fight, and Steak n Shake’s performance continued to decline, he determined that simple representation wasn’t enough. The current Chairman and interim C.E.O., along with the Lead Director, had to go. Biglari launched a website titled “Enhance Steak n Shake” and went as far as buying billboard space in the company’s hometown of Indianapolis.

After months of back-and-forth between Biglari and incumbent management, the minority share owners of Steak n Shake made the overwhelming choice to replace current leadership with Sardar Biglari and Phil Cooley. During the contest, some claimed that Biglari was nothing but a corporate raider, only interested in Steak n Shake to pursue short-term profits at the expense of the company. Now, he would have the chance to prove them wrong.

Of course, this wasn’t the first time Biglari had successfully launched a hostile Board takeover of a public company. Despite his relatively young age of thirty-years, this wasn’t even the first restaurant he had pursued.

Continue Reading “The Restaurant Investor”

Everyone needs an “edge” in both investing and business. If it were just a matter of finding and purchasing a security below its intrinsic value, anyone could go out and buy “The Intelligent Investor” and become great. In other words, value investing, in and of itself, is not a competitive advantage.

An “edge” is any method that gives an investor a leg up over the market by obtaining higher returns with lower risk. (Risk in this case being the risk of permanent capital loss–or the size of potential loss times the probability of loss.)

From what I’ve seen, there are six basic advantages, each of which can give investors an edge over the market:

1. Psychological - discipline, patience, and the avoidance of common biases and misjudgments. An extremely difficult advantage to have, but is probably the most common among good investors. (Easier said than done.)
2. Analytical - the ability to look at the same data as everyone else and come to a better, or more accurate conclusion. This is probably the advantage that most investors think they have, but I believe it’s the most difficult one to have an edge in.
3. Informational - better, or more privileged access to information. Includes information obtained by scuttlebutt, being a company insider, or the illegal use of insider knowledge (of the Ivan Boesky type).
4. Inefficient Domain – investing in inefficient, less liquid markets. Includes private businesses, micro-cap equities, illiquid bonds, and certain real estate markets.
5. Risk Management (portfolio) – the ability to limit overall portfolio risk through asset allocation or hedging practices.
6. Cost of Capital (portfolio) – a bonus advantage of cheaper capital for professional money managers.
   a. Explicit cost of capital: Low-cost debt financing, low expectations from equity investors, or low-cost insurance float (think Berkshire Hathaway.)
   b. Implicit cost of capital: Having investors, partners, or shareholders who don’t equate risk with volatility. The ability to have a rather permanent, long-term capital base.

Some of the great investors like Ben Graham, Buffett, Marty Whitman, and Seth Klarman have an edge in many of the above categories. Some specialize by sticking to specific advantages. Paul Sonkin, manager of the Hummingbird Value Fund, only invests in micro-cap, illiquid securities. Charlie Munger sticks to both psychological and analytical advantages, which leads him to make large but infrequent bets.

Each person can have a different edge as long as it gives them some sort of competitive advantage. If you can’t determine what your edge is in any specific investment, then you are likely to be the patsy at the poker table. If you’re an investor in Apple, you certainly don’t have a psychological edge, and you’re not taking advantage of any illiquidity. In other words, you must believe your edge lies in either better information or a more accurate assessment of publicly available data.

“It is incumbent on investors,” says Seth Klarman, “to try to find out why the bargain has become available.” He further elaborates in his 2005 letter to investors:

We believe that while investors need to focus great attention on the fundamentals, they must simultaneously answer the question: What’s your edge? To succeed in today’s overcrowded environment, investors need an edge, an advantage over the competition, to help them allocate their scarce time. Since most everyone has access to complete and accurate databases, powerful computers, and well-trained analytical talent, these resources provide less and less of a competitive edge; they are necessary but not sufficient. You cannot have an edge doing what everyone else is doing; to add value you must stand apart from the crowd. And when you do, you benefit from watching the competition at work.

One interesting aspect of Klarman’s investing style is his allocation into many asset classes. By not limiting himself to one asset class, he is able to hugely increase his universe of investments and also mitigate the risk of a single market class collapsing. If public equities are generally overvalued, corporate bonds, treasuries, private equity or real estate may provide better returns. It is also well known that Klarman doesn’t hesitate to hold a lot of cash when he can’t find any good investments.

In this post, I’d like to examine the investment allocations of the Baupost Fund from both a numerical and qualitative perspective. (Keep in mind that the letters from above are from only one of Baupost’s smaller funds, but my guess is that the allocations are very similar to those in the main fund.)

Let’s take a look at the investment categories:

• Cash and Equivalents (net of any payables)
  
• Equities — North American
• Equities — Western European
• Equities — Other International
• Debt: Bonds, Bank Debt & Trade Claims, Collateralized Mortgage Obligations, Municipal Bonds
• Private Equity: Stakes in private partnerships or businesses
• Securities in Liquidation: Both liquidating trusts and equity/debt in liquidation
• Market Hedges & Other: Call and put options, Warrants, Rights

In his letters, Klarman breaks Baupost’s investments into other categories, such as “Arbitrage or Spread Trades.” However, since these (and some of the other categorizations) are based on qualitative judgments, my analysis uses only the categories listed in the official Schedule of Investments.

Click here for a spreadsheet with the above figures.

Some Observations

The Baupost Fund is more diversified than a typical value investor, but it is more concentrated than most mutual/hedge funds. Baupost doesn’t have targeted asset allocations, but moves into different asset classes opportunistically based on where the best bargains can be found.

Klarman keeps a sizable cash position for most of the period. In 2000, cash and debt holdings are decreased in favor of U.S. equities. This was the period during the bubble when small-cap equities were extremely cheap.

In addition to a large cash position, various market hedges are used as insurance against collapse. Puts on the S&P 500, Russell 2000, and Nasdaq indexes as well as a very small amount of out-of-the-money calls on Gold are used. It looks like Baupost also purchases these hedges opportunistically based on market levels and “cost” of insurance. Total hedges never account for more than 1-2% of the portfolio.

Klarman: “When we take a concentrated position, I’d say a dozen times over 26 years, we have had a 10% or so position.” Over the above period, Baupost made only two 10%+ investments, one of which was a short: Security Capital Group, and Veritas Software Corporation (short).

A few other large investments (7-10%) were: El Paso bonds (1995), Chargeurs (1996-1999), TLC Beatrice International (1995-1999), Hudson City Bancorp (2000), and Finova Capital debt (2001).

Looking at the makeup of Klarman’s portfolio, it may seem like he has unusually high turnover for a “value” investor (upwards of 100-200% in some years). However, I believe this is because his investing style is more like Graham’s than Buffett’s. There are three reasons I can think of for the higher turnover rate:

1. Focus on event-driven investments. With investments in equity, debt, and other alternative assets that are catalyst based, securities are held for a much briefer period. These include special situations like arbitrage, mergers, bankruptcies, restructurings and spin-offs. This allows Baupost to have less correlation to market returns.
2. Tangible assets are favored over intangible assets. Like Graham, Klarman focuses more on tangible asset bargains. He may take into account the value of intangibles (brand, franchise value, etc.), but for the most part Klarman believes it is easier to obtain a margin of safety with more certain asset values. Although not always the case, at times this means purchasing asset-heavy businesses with not-stellar returns on capital. Over time, these businesses will be forced to reinvest or payout their cash flow at paltry returns on tangible equity. If that equity is purchased at a significant discount, those returns could be great — but not over the long-term. Hence, this investment type should have higher than normal turnover.
3. Willingness to sell an investment before reaching intrinsic value. Many value investors may purchase a dollar for fifty cents and sell that dollar for ninety cents or more. If it’s a business, some investors may even hold that ninety cents while anticipating intrinsic value to grow over time. That’s not necessarily a bad strategy, but Klarman seems to prefer buying a forty cent dollar and selling it in short order for sixty cents.

Chart: Bond Yield over Equity Yield. 10-year treasury yield minus inverse of Graham P/E Ratio (10-year average equity earnings yield).
Current value: -2.8% (5/4/2009)
Low value: -4.9% (3/9/2009)

Chart: Trailing 10-year return.
Current value: -3.8% (5/4/2009)
Low value: -5.9% (3/9/2009)

Chart: 10-year trailing Graham (“Real”) P/E Ratio. Price of the S&P 500 divided by the 10-year average of earnings, inflation adjusted.

Current value: 16.1x (5/4/2009)
Low value: 11.9x (3/9/2009)

One conclusion from the above charts is that based on the 128-year average, the market (as represented by the S&P 500) is fairly valued. (Data from S&P, Robert Shiller, and the St. Louis Fed.)

See also: Market Valuation Charts: 10/08

Value investors know that the historic volatility of a stock has nothing to do with its long-term value, and therefore should never be used when making a purchase. However, when purchasing equities, value investors have the luxury of waiting however long they need until price eventually reaches fair value.

If a stock is worth $30, that doesn’t mean a call option with a strike of $20 is worth $10. The option value must also depend on the duration of the option: the further out the expiration, the greater the underlying valuation should affect the option price (and the less volatility should matter). A lot of value investors purchase LEAPs, or options a year or more out, for this very reason.

The Graham-Olson Option Valuation Model

In honor of Benjamin Graham, I put forth the following equation as the value of a call option:

Where:
IV = Intrinsic value of underlying stock*
SP = Strike price of option
BS = Black-Scholes valuation of option
x = Time to expiration (in years)

The Black-Scholes value can be calculated using a spreadsheet model or from websites like this.

Here’s a practical example: Let’s say that you think Burlington Northern (BNI) is worth $90-110. The Graham-Olson model values the $80 January 2011 calls at $8.3-$19.5. Time to expiration is 1.75 years and the Black-Scholes model uses volatility of 25%, risk free rate of 3% and current price of $68.

The graph to the right represents both valuation models of the BNI options with an IV of $100. The x-axis is the time to expiration in years.

The formula isn’t very precise, but then again, neither is value investing. The Intrinsic Value input is obviously very subjective (that’s why I’d probably use a “range” of valuations like in the example above).

The numbers 3 and 5 in the exponent adjust the”shape” of the graph so that on average, a stock should reach its intrinsic value in around 4 years. As you can see from the graph above, the equation puts BNI at approximately intrinsic value in 3 years. These numbers can be adjusted based on how long you think the average stock takes to reach fair value.

Conclusion

I think that most value investors who purchase options already intuitively use the above method when making a purchase. But the Graham-Olson model can be used to check your assumptions using a variety of different inputs.

If a stock is overvalued, it shows that the Black-Scholes formula can overprice even very short-term options. There are also many occasions when an option reaches its value even though the underlying stock hasn’t — in this scenario the Graham-Olson model could be a useful guide of when to sell.

If you have any suggestions or criticisms please feel free to comment below.

* In reality, IV should be the present value of your estimate of IV at the time of expiration.