Ben Graham, oft considered the father of value investing, found that buying companies trading at a 33% discount to their Current Assets minus Total Liabilities offered investors great returns. The idea is that even at liquidation the investor will get more than his investment, but chances are things will turn around before that's required. For many years, stocks trading at such discounts were near impossible to find in North American markets. Today is a different story, however, as fear has driven the market to such levels that once again stocks such as these exist in droves.
But not all such companies are worth investing in. If the company is burning its assets due to floundering operations, well its liquidation value won't be worth much at all! Consider Shermag (SMG), a furniture manufacturer and distributor. Last year, it had current assets of $48 million and total liabilities of $36 million, yet it was trading at a market cap of just $6 million.
Great value? Hardly not. The company has lost about $15 million per year for the last three years. As it burns through its assets in this manner, it quickly erodes any balance sheet value it appears to have.
When looking through net-nets, be sure to keep in mind that not all of them offer great value. It takes patience and an understanding of the underlying business to ascertain whether you've found a diamond in the rough.
Tuesday, December 2, 2008
Monday, December 1, 2008
The Intelligent Investor: Chapter 18
The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
This is a long and detailed chapter. To do it justice, I would have to reproduce great portions of it, and I think that is beyond the scope of this review. Instead, I will outline some of the key points from the comparisons, without getting into detail about the different pairs of companies.
Look for companies with long histories of dividend payments, prudent investing and moderate growth through conservative debt financing.
Stay away from conglomerates comprised of unrelated companies, that have achieved phenomenal growth through interesting financing methods.
Look for companies selling at a bargain compared to their asset backing (book value). Look for companies with comfortable working capital. Low multiplier companies tend to outperform high multiplier companies.
Be careful when looking at previous growth. Small companies are capable of growing at greater rates than large companies, and as these small companies grow, their growth curves will flatten out. The market may overreact to the previous growth and overvalue the company, believing such growth is sustainable, and this will destroy any bargain opportunities.
Graham’s general observations suggest that, while it is logical for companies with better growth records and higher profitability to command higher multiples of earnings, the intelligent investor must be careful in considering whether the specific differentials in earnings multiples are justified. In many cases, the market becomes overly optimistic and may ignore the underlying soundness of the company while pushing the price high on mere speculation alone.
Again, it is better for most investors to just focus on companies with low P/E multiples. This is a message Graham continuously repeats throughout the book. Zweig does a good job of summarizing this: “If you buy a stock purely because its price has been going up - instead of asking whether the underlying company’s value is increasing - then sooner or later you will be extremely sorry. That’s not a likelihood. It is a certainty.”
From The Mailbag: AutoNation Inc.
This economic slowdown will cause many companies in the auto sector to go under. As such, stocks related to this industry have taken a huge hit over the last year or so. This offers us the opportunity to buy companies that will outlast the recession at large discounts to their intrinsic values. Last week, we looked at certain criteria to look for in order to determine whether a company in this industry represents a good long-term purchase. More than one reader offered up AutoNation (AN) as a company possibly meeting these criteria.
AutoNation owns and operates over 200 car dealerships in the Southern United States. AN is not reliant on only selling cars, however. New car sales make up 56% of revenue, vs 24% used cars and 17% parts and service. As one might imagine, exposure to parts and service helps stabilize a company through hard times: revenue from this segment dropped only 1% through the first nine months of this year, versus a 17% drop in new car sales.
The nature of this company's business requires it to have many fixed costs. Dealerships must be operated and kept in good condition containing a variety of product makes and models in order to make sales. As such, when there's a drop in demand, costs can't automatically be scaled back and thus losses occur. The company lost $1.4 billion last quarter as a result of slowing sales and a Goodwill writedown.
Considering profits will likely be negative for the next while as revenues drop and fixed costs remain, the debt level becomes an important factor in determining the company's lasting power. The balance sheet shows a debt to equity ratio of 66%, but this jumps to 90% after including off balance sheet debt (operating leases, purchase commitments etc. as discussed here) which cannot be ignored.
The company has been mitigating this situation by negotiating buy-outs of their operating leases, reducing inventory (which releases cash) and paying down debt, however, many risks remain. If the recession is short, this company will be just fine and its stock price will rebound. However, if you think the recession will be long, or like us have no idea how long it will be and prefer to play it safe, this leveraged company, both in terms of fixed operating costs and high debt requirements, may not be the one for you.
For those interested in more info on auto dealership analysis, here's a look at interest coverage ratios for various dealers. For those interested in a beaten down auto-related stock with little debt and a flexible cost structure, you may be interested in this article.
Disclosure: None
AutoNation owns and operates over 200 car dealerships in the Southern United States. AN is not reliant on only selling cars, however. New car sales make up 56% of revenue, vs 24% used cars and 17% parts and service. As one might imagine, exposure to parts and service helps stabilize a company through hard times: revenue from this segment dropped only 1% through the first nine months of this year, versus a 17% drop in new car sales.
The nature of this company's business requires it to have many fixed costs. Dealerships must be operated and kept in good condition containing a variety of product makes and models in order to make sales. As such, when there's a drop in demand, costs can't automatically be scaled back and thus losses occur. The company lost $1.4 billion last quarter as a result of slowing sales and a Goodwill writedown.
Considering profits will likely be negative for the next while as revenues drop and fixed costs remain, the debt level becomes an important factor in determining the company's lasting power. The balance sheet shows a debt to equity ratio of 66%, but this jumps to 90% after including off balance sheet debt (operating leases, purchase commitments etc. as discussed here) which cannot be ignored.
The company has been mitigating this situation by negotiating buy-outs of their operating leases, reducing inventory (which releases cash) and paying down debt, however, many risks remain. If the recession is short, this company will be just fine and its stock price will rebound. However, if you think the recession will be long, or like us have no idea how long it will be and prefer to play it safe, this leveraged company, both in terms of fixed operating costs and high debt requirements, may not be the one for you.
For those interested in more info on auto dealership analysis, here's a look at interest coverage ratios for various dealers. For those interested in a beaten down auto-related stock with little debt and a flexible cost structure, you may be interested in this article.
Disclosure: None
Sunday, November 30, 2008
The Warren Buffett Way: Chp 7 Part 1: Equity Marketable Securities
In addition to Berkshire's permanent equity holdings, Berkshire also maintains interests in other equity marketable securities. In 1993, these holdings included General Dynamics, Wells Fargo, Gilette, Federal Home Loan Mortgage Corp. and Guinness plc.
The main difference between Berkshire's permanent equity holdings and marketable equity holdings is on the sell condition. With the permanent holdings, Buffett has indicated that Berkshire will not sell those holdings. The reason why Warren wouldn't sell the permanent holdings is believed to be due to the personal relationships he has with those company's managements. However, the buy criteria for both permanent holdings and equity marketable holdings is the same. Buffett looks for a companies with strong underlying business economics available at attractive prices in the marketplace.
Once Buffett buys an equity marketable security, he is content to hold onto it indefinitely, provided the return on capital is sufficient, management is competent honest and shareholder friendly, and the market does not overvalue the business.
The main difference between Berkshire's permanent equity holdings and marketable equity holdings is on the sell condition. With the permanent holdings, Buffett has indicated that Berkshire will not sell those holdings. The reason why Warren wouldn't sell the permanent holdings is believed to be due to the personal relationships he has with those company's managements. However, the buy criteria for both permanent holdings and equity marketable holdings is the same. Buffett looks for a companies with strong underlying business economics available at attractive prices in the marketplace.
Once Buffett buys an equity marketable security, he is content to hold onto it indefinitely, provided the return on capital is sufficient, management is competent honest and shareholder friendly, and the market does not overvalue the business.
Managing Into The Ground: Robert Nardelli
It's been a rough couple of years for Robert Nardelli, though you wouldn't know it from the compensation he has brought home. First as CEO of Home Depot, now as CEO of Chrysler, he can't seem to do anything right except negotiate pay packages.
Nardelli took the reigns at Home Depot (HD) in the year 2000 after losing a power struggle for the top job at GE to Jeffrey Immelt. A great boom in housing would ensue in the next several years, but Home Depot's stock had essentially remained flat for his entire tenure all the way to 2007! When confronted by angry shareholders at the 2006 annual shareholder meeting, Nardelli limited each shareholder to one minute, and refused to answer many of their questions. Meanwhile, competitor Lowe's (LOW) saw its stock triple during Nardelli's seven years at HD. Nardelli, however, received a $210 million parachute when he left.
A few months later, Nardelli accepted the top job at Chrysler. A year and a half later, he's back in the spotlight! Here he is asking Congress for taxpayer funds to help his company out:
Is Nardelli a bad manager that runns companies into the ground, or simply a victim of circumstance? It's impossible for us to tell from the outside. Operationally, Home Depot has looked great (as we've discussed here) but its stock never really responded. However, his stock results in both of these companies certainly haven't made him look good at all.
Nardelli took the reigns at Home Depot (HD) in the year 2000 after losing a power struggle for the top job at GE to Jeffrey Immelt. A great boom in housing would ensue in the next several years, but Home Depot's stock had essentially remained flat for his entire tenure all the way to 2007! When confronted by angry shareholders at the 2006 annual shareholder meeting, Nardelli limited each shareholder to one minute, and refused to answer many of their questions. Meanwhile, competitor Lowe's (LOW) saw its stock triple during Nardelli's seven years at HD. Nardelli, however, received a $210 million parachute when he left.
A few months later, Nardelli accepted the top job at Chrysler. A year and a half later, he's back in the spotlight! Here he is asking Congress for taxpayer funds to help his company out:
Is Nardelli a bad manager that runns companies into the ground, or simply a victim of circumstance? It's impossible for us to tell from the outside. Operationally, Home Depot has looked great (as we've discussed here) but its stock never really responded. However, his stock results in both of these companies certainly haven't made him look good at all.
Saturday, November 29, 2008
The Warren Buffett Way: Chp 6 Part 9: Fixed-Income Marketable Securities
Arbitrage:
Arbitrage is the practice of taking advantage of a price differentials. Buffett has typically practiced risk arbitrage. With risk arbitrage, a stock price trades in the market at a discount to some future value. In particular, he has looked to invest in large merger transactions where the merger has been publicly announced and is considered to be a friendly event.
Buffett counsels that investors should answer four questions in order to evaluate a risk arbitrage situation:
1) How likely is it that the announced event will take place?
2) How long will your money be tied up?
3) What is the chance that something better will transpire (e.g. a competing bid)
4) What will happen if the event does not take place?
Buffett has practiced arbitrage for decades and estimates that Berkshire has earned on average a 25% pre-tax return on arbitrage operations. He sees risk arbitrage as an alternative to investing in short term treasuries.
Around 1989, Buffett started to withdraw from arbitrage transactions. He noticed that with the increasing popularity of leveraged buyouts came an environment of "unbridled enthusiasm" caused by financial excesses. Buffett has always acted fearful when others were greedy and this may be why he has increasingly looked to make deals with convertible preferred deals rather than arbitrage.
Arbitrage is the practice of taking advantage of a price differentials. Buffett has typically practiced risk arbitrage. With risk arbitrage, a stock price trades in the market at a discount to some future value. In particular, he has looked to invest in large merger transactions where the merger has been publicly announced and is considered to be a friendly event.
Buffett counsels that investors should answer four questions in order to evaluate a risk arbitrage situation:
1) How likely is it that the announced event will take place?
2) How long will your money be tied up?
3) What is the chance that something better will transpire (e.g. a competing bid)
4) What will happen if the event does not take place?
Buffett has practiced arbitrage for decades and estimates that Berkshire has earned on average a 25% pre-tax return on arbitrage operations. He sees risk arbitrage as an alternative to investing in short term treasuries.
Around 1989, Buffett started to withdraw from arbitrage transactions. He noticed that with the increasing popularity of leveraged buyouts came an environment of "unbridled enthusiasm" caused by financial excesses. Buffett has always acted fearful when others were greedy and this may be why he has increasingly looked to make deals with convertible preferred deals rather than arbitrage.
Management Shenanigans: Revenues Reported
Sometimes the pressure of achieving earnings projections can prove to be stronger than management's integrity. One common method managements use to make a company's financial statements look better than the company's actual operating reality is by recognizing revenue earlier than it should. i2 Technologies (ITWO) is an example of a company that fell victim to this shenanigan, and had to settle with the SEC and pay out $10 million in a civil suit as a result of its actions.
In order to best reflect a company's operating reality in a company's financial statements, revenue is recognized not when cash changes hands, but rather when the revenue has been earned. In most cases, this means the good has been transferred to the buyer (and the buyer now assumes its risk) or the service has been performed. In some cases, it's not so easy to determine when this has occurred.
As a software company, i2 Technologies was showing revenue from customers that the SEC deemed were not actually earned. An excerpt from the SEC press release reveals why the SEC drew this conclusion:
Historically, i2 favored up-front recognition of software license revenue, purportedly in accordance with generally accepted accounting principals (GAAP). However, as i2 knew or was reckless in not knowing, immediate recognition of revenue was inappropriate for some of i2's software licenses because they required lengthy and intense implementation and customization efforts to meet customer needs. In some cases, i2 shipped certain products and product lines that lacked functionality essential to commercial use by a broad range of users. In other cases, the company licensed certain software that required additional functionality to be usable by particular customers.
In essence, i2 had not yet completed the work, but was recognizing the revenue. i2 was not dishonest in any disclosure, however. Its policy of revenue recognition was clearly identified in the notes to its financial statements. As we've discussed before, by reading the notes to the financial statements, you will have a much better picture of a company's position than by relying on the financial statements alone.
In order to best reflect a company's operating reality in a company's financial statements, revenue is recognized not when cash changes hands, but rather when the revenue has been earned. In most cases, this means the good has been transferred to the buyer (and the buyer now assumes its risk) or the service has been performed. In some cases, it's not so easy to determine when this has occurred.
As a software company, i2 Technologies was showing revenue from customers that the SEC deemed were not actually earned. An excerpt from the SEC press release reveals why the SEC drew this conclusion:
Historically, i2 favored up-front recognition of software license revenue, purportedly in accordance with generally accepted accounting principals (GAAP). However, as i2 knew or was reckless in not knowing, immediate recognition of revenue was inappropriate for some of i2's software licenses because they required lengthy and intense implementation and customization efforts to meet customer needs. In some cases, i2 shipped certain products and product lines that lacked functionality essential to commercial use by a broad range of users. In other cases, the company licensed certain software that required additional functionality to be usable by particular customers.
In essence, i2 had not yet completed the work, but was recognizing the revenue. i2 was not dishonest in any disclosure, however. Its policy of revenue recognition was clearly identified in the notes to its financial statements. As we've discussed before, by reading the notes to the financial statements, you will have a much better picture of a company's position than by relying on the financial statements alone.
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