Laser Eye Surgery: Too New To Value?

LCA-Vision (LCAV) and TLC Vision (TLCV) compete in an otherwise highly fragmented laser vision correction industry. Because the surgery is elective, expensive, and not generally covered by insurance companies, demand for the surgery is cyclical. As a result, this is a tough time for these companies, and the market has punished the stocks. But this is a relatively new industry...is it too new an industry for us to confidently assess the earnings power of these companies?

After all, value investors prefer to buy businesses that have proven themselves over the course of many businesses cycles. In such cases, one can more accurately predict a company's earnings power. If one can accurately predict the earnings power, one can be confident that after applying a margin of safety, one is getting a good deal.

For example, if Coca-Cola had been invented 10 years ago, perhaps value investors would be hesitant to buy stock...could it be a fad? might it have long-term health effects? But after many successful years, Coke qualifies for consideration, and value investors look for opportunities to buy it at a discount, as we saw when we looked at a graph of its historical P/E over time.

In the same way, we don't know the long-term implications for laser-corrected vision. The market for this surgery is also unknown. The surgeries have been accessible since the 1990s, but only really gained acceptance in the last decade. Here, a look at the total number of annual surgeries may be of assistance:

A few things stand out on this chart. First, we see it's a relatively new industry, with tremendous growth in the late 1990s. Second, we see how cyclical demand is (see the recession of 2002), and how its tied to economic growth. (Note that the 2008 number is an estimate from November 2007; the current 2008 estimate is likely much lower considering the state of the economy.) But we already knew these first two points.

Perhaps the most important thing we can see from this chart is the secular slowdown that appears to be occurring. Despite all the credit excesses, the run-up in housing prices, and higher confidence in this surgical procedure, at no point in the decade was the surgery more demanded than in the year 2000. Furthermore, surgeries actually dropped from 2005 onward, despite a strong economy.

This raises some questions. What is the market going forward? Did all the likely adopters already have the surgery, meaning the sustainable annual rate of surgeries going forward is much lower than the past cycle would indicate? What is the sustainable number of annual surgeries going forward?

These are tough questions to answer, but they do clarify why value investors prefer industries that are tried and tested, as there is far less uncertainty involved.

The Warren Buffett Way: Chp 4 Part 4: Buying a Business

Market Tenets:

There are two critical market tenets that should be adhered to:

1) What is the value of the business?
2) Can the business be purchased at a significant discount to its value?

Warren references John Burr Williams in "The Theory of Investment Value" (1938), when explaining how to value a business. Buffett refers to a discounted net cash flow model as being appropriate to value a business. This approach will allow one to compare all businesses to each other from the perspective of value.

Buffett invests in companies that are simple and understandable and that have operated reliably. By investing within his circle of competence, Buffett can place a high degree of certainty on the future cash flows that a business will generate before he makes an investment. This makes the valuation process more accurate.

Buffett uses a long term U.S. government bond rate to discount the cash flows when valuing a company, however he is cautious in using this discount rate as interest rates decline. He looks for businesses with low business risk and he excludes investing in companies that have high debt, thereby limiting the financial risk. Buffett has said that since he puts a heavy weight on certainty, the whole idea of adding a risk premium to his formula doesn't make sense to him.

Buffett refers to price to earning ratios and price to book ratios as shortcut methods that fall short in determining whether a company is worth buying. Buffett has said that you can find the cheapest investment using the discounted-flows-of-cash calculation.

Tellingly, Buffet has said that if he has made a mistake with an investment it has come from either 1) the price paid, 2) the management joined or 3) the future economics of the business.

The price paid for an investment is critical because it offers protection of capital and can enhance the returns of an investment. If you purchased a company's shares for significantly less than the intrinsic value per share, it provides some margin of error with the original purchase. Likewise, if the company's shares eventually return to reflect the business value of the company, the large discounted purchase price will produce a larger return on the investment.

Buffett looks at owning shares as owning pieces of companies, not owning pieces of paper. Buffett has said that buying a stock without understanding the operating functions of a business is unconscionable. Graham wrote in his book, the Intelligent Investor, that "investing is most intelligent when it is most businesslike". Buffet feels those are the most important words ever written about investing.

Confusion Reigns With Deflation-Inflation Conundrum

The following article was reprinted with permission from the author, George Athanassakos. George Athanassakos is a professor of finance and Ben Graham Chair in Value Investing at the Richard Ivey School of Business. This article first appeared in the Globe and Mail on November 6, 2008, p. B11. The article also appeared in Globe Investor Magazine Online.

The global financial market is a confusing place these days. A battle is raging between concern about deflation in the near term and inflation in the longer term. As a wave of pessimism about capitalism sweeps around the world, investors are searching for reassurance from monetary authorities that this time they won't overreact in their bid to defeat deflation and unwittingly create a more severe problem in the future.

Here is the conundrum in the balance between deflation and inflation.

There is a lot of money to go around and high levels of liquidity. Money supply (M1) has been rising at a rate of close to 9 per cent over the past year in Canada, compared with an annual average of about 6 per cent in the past 15 years. In the United States, M1 has been rising at a 19.5-per-cent annualized rate the past three months and at 11.4 per cent over the past six months to September. And the numbers are getting higher. Central banks around the world, including emerging economies, have also embarked on an unprecedented loosening of monetary policy, with co-ordinated interest rate reductions. Moreover, large amounts of capital and liquidity have been injected in the economies around the world. Strictly speaking from a monetary perspective, this is highly inflationary.

But despite the global co-ordinated easing of monetary policy, and the massive liquidity injections into the system, banks and other investors are increasingly unwilling to lend money. The rates at which banks lend money to each other remain extremely high by historical standards and mortgage rates are rising, despite global interest rate cuts by central banks. Banks are not facing a liquidity problem as they have ample reserves. The problem is that they are unwilling to lend for fear that they will not get their money back.

Banks are hoarding cash, and so are consumers. For example, “currency in circulation” has increased sharply in recent months, according to a report from the U.S. Federal Reserve, to a level not seen since 1999, when Y2K raised consumers' fears about bank computers. In related evidence, Home Depot recently reported a double-digit increase in the sale of safes in the United States as consumers keep cash closer to home.

What happens when there is a lot of money around, but no one wants to lend (invest) it? The answer is: We have a credit crisis.

Credit is the fluid that oils the economic machine. Without credit the economy stalls and the engine of growth sputters. Even healthy companies starve when credit is tightening, as they cannot pay their suppliers and employees. If demand collapses, and goods start to pile up, prices fall. Deflation ensues. We have started to experience falling prices in many sectors of the economy, including housing, furniture, appliances, tools and hardware.

Current conditions are consistent more with an increase in deflationary rather than inflationary pressures. The spectacular de-leveraging we have witnessed over the past few months has led to a buildup of deflationary forces, and this, over a short few months, has led to the collapse of commodities and gold prices and the prices of other investments that are considered good hedges against inflation.

Major producers, like India and China, over-expanded capacity over the past 10 years and overproduced. The fear that all these products will be dumped onto world markets is reinforcing the expectation of lower prices down the road. Excess production in the face of falling demand for an array of products from building materials to laptops, chips, and flat panel TVs increases the expectation of a glut and lower prices even further.

Central banks around the world are trying to deal with deflation by flooding the system with liquidity, while at the same time guaranteeing bank loans and other investments, such as bank deposits, in an attempt to deal with the fear of default.

Currently, in the battle between inflationary forces (too much money floating around) and deflationary forces (the unwillingness to lend/invest), the deflationary forces are winning in the economies around the world as the severe credit squeeze and de-leveraging that has been taking place are working their way through the system. But inflation lurks in the background.

In my opinion, the co-ordinated actions of the central banks and governments around the world will prevent this panic and credit problems from developing into a depression with its requisite deflationary consequences. But central banks and governments tend to overact based on past experience. When the credit problems are resolved, and banks and consumers start to feel more confident, all this accumulated (hoarded cash) liquidity and money supply surge may find their way back to financial and real assets, bid their prices up and in so doing take us back to square one, and a severe inflationary situation two to three years down the road. That is why it is critical for central banks around the globe to monitor the situation carefully and not be complacent as they were in the past. The markets may already demonstrate an implied fear of complacency, as the spread between the yields on the 10 year U.S. Treasuries and three month T-bills has turned up sharply in recent months.

Inflation may be a long-run problem to the short-term credit crunch. And it may bring us back to square one.

The Paper Industry: Wood You Invest?

Many manufacturers of various paper and packaging products are trading at massive discounts to their 52-week highs. Companies such as International Paper (which we discussed here), Catalyst Paper (CTL), Domtar (UFS), MeadWestvaco (MWV) and Sappi Ltd (SPP) are all trading below even their book values. As such, many investors wonder if there is value to be found among this bunch. Unfortunately, there are a few reasons that make this a tough industry in which to invest.

First of all, this is a capital intensive industry, meaning a large component of costs is fixed (as investments in equipment are constantly required). As a result, small drops in revenue hurt the bottom-line in a big way, as companies can't reduce costs in response. As a result, it's very important that these companies have low debt levels, as they have to be able to cope with negative profits every now and then. Unfortunately, many of the companies mentioned above are riddled with debt, which threatens solvency when economic times are what they are today.

Even if one were to choose the best run company (lowest costs, best operating margins) and one which is conservatively capitalized (a low debt to equity ratio), the outlook is unclear. Usually, value investors love such companies, as they are well-positioned to steal market share and bounce back in a big way when demand returns. In this industry, however, there is overcapacity. In such cases, as we've discussed with respect to the airline industry, even the best companies can be hurt due to falling prices, as the products are basically commodities, and therefore when companies with spare capacity slash prices, other firms are forced to respond or lose business.

Finally, its not clear that demand is only in a cyclical downturn. Often, value investors look for opportunities to buy companies on the cheap in cyclical downturns; but here, might we be also in a secular downturn? Newspapers, which represent large customers to the paper manufacturers, are losing advertisers and readers to other media. Should this trend continue, paper manufacturers will continue to see overcapacity, requiring more mill closures and/or more price wars, neither of which bodes well for these companies.

Disclosure: None

The Warren Buffett Way: Chp 4 Part 3: Buying a Business

Financial Tenets:

Warren is guided by the following financial tenets:

1) Focus on return on equity, not earnings per share
2) Use "owner earnings" to understand value
3) Look for high profit margins
4) For every dollar retained, at least one dollar in market value should be created

Buffett warns not to become beguiled by increases in earnings per share. Earnings per share can simply increase because management has retained earnings in the company and now is getting a low rate of return on those retained earnings. According to Buffet, it is the rate of return on the entire equity base that is important to measure.

When looking at return on equity, adjustments need to be made to ensure the returns are sustainable and due to operating activities, not just one-time events. It is also prudent to adjust marketable securities back to a cost value and make a corresponding adjustment to shareholder's equity in order to stabilize the denominator in the return to equity ratio. This will make interpretation of the ratio more precise with regards to how well management has been performing. Lastly, Buffett is not impressed when high returns on equity are the result of deploying significant leverage.

Buffett focuses on "owner earnings" to understand the value of a business. He doesn't just look at operating cash flows because it fails to account for the capital expenditures of a business. High fixed costs businesses often require high capital expenditures, which is exacerbated during inflationary times. Therefore, Buffett looks at owner earnings which is similar to a definition of free cash flow in order to understand the value of a business.

A company's management needs to be able to convert sales into profits. Buffett likes to find management that treats cost controls as an ongoing discipline, not just a part-time endeavor. Buffett muses that the management of low-cost operations often find ways to continue to cut costs while the management of high-cost operations seem to find new ways of spending money. Expenses have a material impact to profit margins, so Buffett understands the value of investing in low cost operations.

Buffett believes that in the short-term, the accuracy of predicting what the financial markets will do is extremely low. However, in the long term, he believes that stock prices will track to the underlying value of a business. Therefore, if the management has deployed additional capital in a company effectively, it should show over a longer-term period in the market price of a company's stock. One quick test to determine how well management has increased shareholder value, is to see if each dollar of retained earnings has at least increased the market share of a company by one dollar or more.

Intelligent Investor: Chapter 14

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.

Defensive investors have two possible strategies for stock selection:

Buy the Market - Acquire a cross-section sample of the leading issues. This will include both high-priced popular and low-priced unpopular companies. This can be done easily today by buying a low-cost index fund, like those offered by Vanguard.

Zweig describes index funds as “the best tool ever created for low-maintenance stock investing - and any effort to improve on it takes more work (and incurs more risk and higher costs) than a truly defensive investor can justify.” I’ll write more about index funds when I review The Little Book of Common Sense Investing by John Bogle.

Select Individual Stocks with a minimum quality of past performance and financial position. In selecting these stocks, the defensive investor must follow the seven criteria set out in an earlier chapter:

1. Adequate Size (Today, this means at least $2 billion in market value)
2. Sufficiently strong financial condition (at least 2:1 current ratio)
3. Earnings stability (10 years of consistent earnings)
4. Dividend Record (uninterrupted payments for 20 years)
5. Earnings Growth (Minimum of at least 1/3 increase in per-share earnings in the past 10 years using three year averages at the beginning and end)
6. Moderate Price/Earnings Ratio (No more than 15x)
7. Moderate Ratio of Price to Assets (Current price not more than 1.5 x book value)

Looking at # 6 and 7, Graham suggests a good rule of thumb: The Price/Earnings ratio times the Price/Assets ratio should not exceed 22.5.

Once you have found stocks that meet all of these criteria, it is time to do your homework and look through their annual and quarterly reports, and proxy statements. Also, check out what % of the company’s shares are owned by institutions. Zweig says that anything over 60% sugests the stock is “overowned” (when the institutions sell, they tend to do so in lockstep, killing the share price).

By following the above rules, the defensive investor creates an adequate factor of safety upon which he can rest.

It is at this point that Graham makes a point that must be understood to grasp this book: You must recognize that, while you invest in the present, you invest for the future, and in so doing, there are only two methods of considering the future: prediction or protection. To claim you can predict anything relevant about the future with any accuracy and be able to consistently make money off this is foolish, so forget about it. Instead, you must invest for the future by protecting yourself in the present.

By protecting yourself in the present, you strive to create a substantial margin between what you pay for the stock and what you think it is worth (after careful analysis) so that this margin can absorb the unfavourable and unpredictable developments in the future.

In short, defensive investors are best to diversify rather than select stocks individually. If they are going to select stocks individually, they must do so carefully with a mind toward building as great a margin of safety as possible so as to protect themselves in the future.

George Weston Stable, But Cheap?

George Weston Limited (WN) has baking, dairy, and food distribution operations in Canada under the Loblaws grocery store brand. Its stock has taken a beating over the last 1.5 years, having lost around 35% of its value. One would not expect spending to drop on essential items such as groceries (as per our discussion earlier on the cyclicality of various industries), so could this represent a value opportunity?

If one looks at the average operating earnings of this company over the last several years (which we advise in order to get an understanding of a mature company's earnings power), they are indeed fairly stable, suggesting recessions don't hurt this company. For this reason, we are willing to put up with higher debt levels than we otherwise would, as WN has a debt/capital ratio above 60%. (This is the exact opposite situation of what we would require for an airline, as we discussed here.)

A simple look at average operating earnings over the last business cycle suggests the company is indeed undervalued. However, your analysis cannot stop there. You must ensure you understand the company's situation before this can be a buy (i.e. this is where circle of competence comes into play). In the last 3 years, operating margins have been lower than they have been in the past. Why? Walmart has entered the grocery business in Canada, representing formidable competition for Loblaws. For those who ignore investing within their circle of competence, this could represent a value trap.

There's another interesting value twist to this company. It has been in operation since 1919 and has bought most of the land for its locations. As such, the stock could offer downside protection to investors even if the operations don't generate decent returns. The problem here for individual investors is that this is a multi-billion dollar company, and so institutions and analysts have made detailed appraisals of the land values, and as such render the stock price more efficient. This is why we much prefer buying smaller companies, and they do perform better; it's too expensive for analysts to get involved when the amount of money that can be invested by institutions is small.

Disclosure: None