There IS Accounting For Price With Apple and RIM

Apple (AAPL) and Research In Motion (RIMM) are clearly two of the best companies around. A quick look at their returns on equity over the last several years shows just how successful the companies' investments in research, production, and marketing have proven to be:

These are exactly the kinds of companies that Philip Fisher would want to own. (Philip Fisher was Warren Buffett's mentor when it came to growth stocks.) So why don't these stocks appeal to value investors? Quite simply, because of the price.

While the stellar returns on equity depicted in the chart above are clearly attractive, one must consider how much one has to pay for that equity. As we saw when we compared investments in Office Depot and Staples, adjusting returns for the price of the equity can have a dramatic effect on the attractiveness of a stock from an investor's perspective.

AAPL has a price to book value of almost 7 (meaning investors have to pay almost $7 for every $1 of equity that is in the company), while RIMM has a price to book above 5. Adjusting the above chart to reflect each companies' returns based on the market value of equity yields the following chart:

Clearly, things have to go very right for these companies in the future to justify an investment at current price levels. While the companies are extraordinary and it is quite possible that they will continue to grow and innovate and thus reward shareholders even at these price levels, downside risks are also present. Unexpected negative occurrences could take a large bite out of stock prices when they are at such high levels. If future products are not as successful as past products, or if competition and new entrants are able to slow the growth of these companies, the stock prices will have to correct dramatically.

On the other hand, there are plenty of companies with strong returns on equity (albeit not as strong as those of AAPL and RIMM), but which trade near their book values. As such, if things go wrong, the stocks don't have as far to fall. In many cases, the stocks even trade at levels such that the companies' assets offer investors protection from downside risks. This is the space in which the individual investor, who is not limited to companies of a certain size, should be playing.

Disclosure: None

Jumps In Current Debt

The importance of considering a company's debt repayment schedule cannot be overstated. As discussed here with a live example, debt due in 25 years does not represent the same danger to solvency as debt due in 1 year, though they both may be painted with the same brush ("long-term debt") on the balance sheet. However, a repayment schedule that does not require large payments for several years does not leave the company off the hook. The investor must be aware of issues that can accelerate repayment requirements, as such untimely accelerations are likely to come at a time when a company is already in a weak financial position.

Consider TLC Vision (TLCV), a company we discussed two weeks ago due to its bankruptcy announcement. Last year at this time, it showed current debt of $8 million against current assets of $42 million. Just one quarter later, however, current debt skyrocketed to $89 million. The increase in current debt was not the result of a new loan, however, and so current assets did not increase, leaving the company in a rather precarious situation.

The reason for the unceremonious and abrupt increase in the current debt level was due to the fact that the company was no longer meeting covenants in its long-term debt contract due to operational losses. As a result, what had previously been considered long-term debt (with a great part of the payments not due for several years) became due within the next year. Investors relying on the fact that certain debt payments were not due for several years were sorely disappointed.

In the notes to the financial statements, companies break down their long-term debt due dates so that investors can estimate for themselves the company's ability to service its long-term obligations. Unfortunately, certain triggering events can result in the acceleration of certain payment requirements, and in some circumstances it can force the company into bankruptcy.

Disclosure: None

A Good Business Making Huge Mistakes

LoJack (LOJN), a provider of hi-tech products that help recover stolen vehicles, is one of those companies with strong earnings potential. Before the recession bludgeoned new car sales, LoJack was earning EPS of about $1 annually (the company's share price is around $4 today). There may also be reason to believe there is some persistence to this level of earnings, as LoJack has integrated its systems with law enforcement agencies, has several regional networks in place to detect/find stolen assets once a unit has been reported stolen, and uses its FCC licensed radio frequency and proprietary technology that can find vehicles that are hidden from view (unlike GPS systems).

Furthermore, the company is leveraging its existing infrastructure as it creates products to find not just vehicles but construction assets, laptops and even people with cognitive disabilities. Investing in complementary products to expand markets may help grow sales for years to come, and is one of the 15 things to look for in a stock according to Philip Fisher, whose book is in the process of being summarized here. The company also has more cash than debt, suggesting it can and will emerge from this downturn unscathed.

What is concerning, however, is the multitude and magnitude of some of management's mistakes in the last few years. When calculating a company's earnings power going forward, investors will often add back (and therefore avoid penalizing a company for) one-time charges and other expenses that are not expected to re-occur. When one-time charges occur frequently though, the investor should strongly consider whether management has a tendency to make reckless mistakes.

In the case of LoJack, some of these mistakes have cost shareholders dearly. The company's handling of a contract with a licensee ended up costing shareholders $18 million in a settlement last quarter, which is no small sum considering LoJack only trades with a market cap of $70 million. In addition, the company has taken another $52 million in special charges over the last two years for various items including restructuring charges and asset write-downs as a result of overly optimistic acquisition prices LoJack has been willing to pay.

Though a good business with strong potential and a cheap share price, the expensive mistakes LoJack management has made do not inspire confidence. Investors are left with the task of trying to determine whether such gaffes are likely or unlikely to occur going forward, and this is no easy assignment.

Disclosure: None

Protection From High Debt

Before delving into a full analysis, investors will often take a quick look at a company's balance sheet to get an idea of its financial position. Armed with information about the nature of the company's business, the investor can get a good idea of whether the company is "safe" from a solvency point of view. Since value investors value the protection of capital above all else, a company with a high debt level will often be immediately discarded from further analysis. Sometimes, however, a high debt load is not a threat to solvency at all!

Consider Asta Funding (ASFI), a firm that purchases consumer receivables from companies that offer credit to their customers (e.g. credit card companies, telephone companies). For the quarter ended September 30th, the company shows consumer receivables of $208 million against senior debt of $123 million, for a difference of $85 million.

Note that this is not the same thing as an asset of $85 million against no debt, because of the uncertainty of the value of the asset and the magnification of this uncertainty that results from leverage. To illustrate with an example, if the value of the asset is overestimated by 20%, the levered book value drops by almost 50% from $85 million to $43 million (208 * 0.8 - 123) whereas the value of the unlevered asset would only drop to $68 million ($85 million * 0.8).

In the case of Asta, the value of the assets is rather uncertain. The company purchases its receivables for pennies on the dollar, as the companies selling the accounts have already tried and failed to collect from these customers. Adding to the uncertainty is the fact that high unemployment levels have made it more difficult for Asta to collect on its receivables: the company has written down $184 million of its receivables in the last four quarters.

As such, an investor scanning only the balance sheet might take a look at these numbers and run. However, Asta is a lot safer than it looks. The reason for this comes down to the fact that most of its debt is secured by one particular asset, and only one particular asset. Should that asset (currently carried at $121 million) not perform, the loan of approximately $100 million does not have to be paid from the company's other assets! This is an interesting situation which increases the safety of Asta significantly.

The company trades at just 2/3 of its book value despite the fact that most of the debt is non-recourse. Aaron Stackhouse discusses the company's situation in further detail here, for those interested in further analyzing this company.

Looking at a company's balance sheet can give an investor a good idea of the company's debt level. However, only with a careful reading of the notes to the financial statements can an investor uncover items that significantly alter an investor's perception of how solvent a company may be.

Disclosure: None

Common Stocks And Uncommon Profits: Chapter 3, Part 5

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of this work by Philip Fisher, known as one of the greatest investors of all time.

The following criteria conclude the list of items Fisher requires for stocks with outstanding returns:

13) Will substantial equity dilution be avoided to finance the business' growth?

A company that meets the tests of the other 14 criteria is one that will be able to borrow money to fund growth. However, debt levels will at some point hit a maximum level, which is determined by the type of business carried out. Therefore, if a company is already at a high debt level, equity financing might be employed. The investor should determine the attractiveness of the company after carefully calculating the results of dilution of the company's stock.

14) Does management continue to speak freely to investors when disappointments occur?

For even the best run companies, failures and disappointments occur. The firms showing the greatest gains are those which are always developing new products. Inevitably, some of these will not turn out as well as expected. How management reacts is what's important for the shareholder. If management "clams up" because it does not have a plan, or if management panics, the investor should exclude the company from investment.

15) Does management have unquestionable integrity?

Managements are always in a position such that they may enrich themselves at the expense of shareholders. They are closer to the assets than shareholders, and as a result are granted leeway that can be legally abused in an almost infinite number of ways. For example, they can put relatives on the payroll and pay them salaries above market value. Furthermore, they can lease assets to the corporation at above-market prices. Investors must confine investments to companies where managements are of the highest integrity. Fisher recommends the "scuttlebutt" technique (discussed in Chapter 2) for confirming that management has the necessary integrity.

Common Stocks And Uncommon Profits: Chapter 3, Part 4

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of this work by Philip Fisher, known as one of the greatest investors of all time.

The list of criteria to look out for in order to find home-run stocks continues:

10) How good is the company's cost analysis?

A company cannot have continued outstanding success unless it can accurately break down its costs by product and also at each step of its production process. If a company has weak product costing, products which the company thinks are wildly successful might actually be losing money. Fisher acknowledges that it is rather difficult for the investor to determine the efficiency of a company's costing, however. The "scuttlebutt" method (described in earlier chapters) will work only in identifying companies which are really deficient. Management will also sincerely believe the existing methodology is fine, and therefore little info can be gleaned on this subject from company personnel. Fisher suggests the best the investor can do is recognize the importance of this subject along with the limitations in making an accurate appraisal of the situation.

11) Are there other clues (perhaps industry related) which show the company to be outstanding relative to its peers?

This is a catch-all question, as items which are important in some industries are of no importance in others (e.g. for a retailer, real-estate management and/or leasing costs can make or break a company, but are of little importance in most industries). One useful barometer Fisher uses to compare companies within the same industry is insurance costs. Not only can lower insurance costs lead to larger profit margins in many industries, but they offer a clue as to how well management handles people, inventory and fixed assets in order to minimize waste, damage and accidents. The "scuttlebutt" method is useful in identifying such differences.

12) Does the company maximize long-term or short-term profits?

Some companies will try to gain the greatest possible profit right now, while others will build up good will and thereby gain more in the future. The "scuttlebutt" method is useful here in gleaning information from vendors and suppliers. Does the company force suppliers to offer the lowest possible price, or will it at times pay above contract in order to secure a strong partnership and a dependable source of future supply? Will it help out a customer in a jam, even when not required to do so? This may hurt current profits, but sets the company up for a strong future.

Common Stocks And Uncommon Profits: Chapter 3, Part 3

Warren Buffett has called himself "85% Graham and 15% Fisher". While the works of Graham are often cited, Fisher's book "Common Stocks and Uncommon Profits" is not. Here follows a summary of this work by Philip Fisher, known as one of the greatest investors of all time.

The list of criteria to look out for in order to find home-run stocks continues:

7) Does the company have outstanding labour relations?

Fisher believes that most investors do not fully appreciate the benefits of strong labour relations. While strikes clearly temporarily disrupt production, the benefit of excellent labour relations is far greater than the direct cost of strikes, for if workers feel fairly treated, the company is in a much better position to increase worker productivity.

Unfortunately, there is no easy way to identify whether a company has strong labour relations. But there are some insights an investor can gain. For example, if labour has not been unionized, this may be a clue that workers have not felt the need for union protection. Worker turnover, and the size of job applications relative to other firms can also be useful hints for the investor. The investor should also consider the behaviour of top management towards rank-and-file employees (e.g. are there mass layoffs whenever a small change in sales is anticipated?).

8) Does the company have outstanding executive relations?

The right atmosphere among executive personnel is vital, as the management team's ingenuity and judgement will make or break any venture. Executives should have confidence in their president and chairman. Promotions should be made on the basis of ability, not factionalism or family. Outsiders are brought in only if there is no possibility of finding someone who can be promoted into that position. The investor can usually learn about executive relations by chatting about the company with a few executives scattered across different levels of responsibility.

9) Does the company have management depth?

A one-man management can do very well for several years, but all humans are finite. A corporation with no plan in the event of a corporate disaster could find itself in trouble. Companies worthy of this type of investment are ones which will continue to grow for many years. To develop management depth, authority must be delegated so that managers down the line are given the real authority to apply themselves and grow as managers. Where top brass continually interfere in day-to-day operating matters, strong managers are unlikely to be developed.