by Joe Ponzio, published 2009
“There’s Got To Be A Better Way!”
If you’ve ever managed your own retirement investment portfolio such as a 401k or spent any amount of time watching the talking boxes on Bubblevision, you’ve probably reached several conclusions almost simultaneously:
- Even though we’re told investing in stocks is a surefire way to get rich over time, it never seems to work for the average person
- Investment options in the average 401k seem best served to satisfy the needs and profitability of the Wall Street companies that peddle the products, not the investor who buys them
- In general, the whole game seems rigged against you, from the annual expenses of mutual funds to the incentives those mutual funds have to trade to the regulatory burdens which virtually guarantee they’ll never be creative or contrarian enough to earn the kinds of out-sized returns necessary to make a killing in the markets over time
The Wall Street firms convince you to buy their “preferred” or “recommended” mutual funds; then the mutual funds go out and buy the great, mediocre and bad investments from the brokerages.In order to have access to the trillions of dollars the brokerages control, mutual funds buy “aggressive” investments, pay some of the brokerages’ expenses, and even offer them kickbacks every three months.
Now you’re thinking, “There’s got to be a better way!”
Luckily, there is.
F Wall Street
Enter Joe Ponzio’s inexpensive but thorough primer on Buffett-style value investing, F Wall Street. This book is truly one of the unsung heroes of the value investment classics library that I think should be one of the first titles an aspiring value investor should familiarize themselves with. The book is divided into several conceptual sections.
First, the basics: the market is not perfectly efficient; bonds are not just for old people and stocks are not just for young people and everyone, young or old, should be looking for good investments, not risky ones; mutual funds are essentially designed to fail the average investor; the true risk in the stock market is overpaying for the value available at the time; cash is king.
A bit more on the last part might be helpful. Ponzio defines the value of a business as its current net worth as well as the sum of its future cash flows. As a stock owner, you are essentially a silent partner in the business and silent partners are paid with cash, not profits. Businesses need cash to grow, to acquire other businesses, to service debt, to increase their net worth and to pay dividends to their investors. The superior business, and consequently the superior stock, is the one that can generate the most cash flows, not the biggest earnings.
Owner Earnings and Intrinsic Value
As Ponzio says, focusing on cash flows allows us to “peak inside” the firm and see what management sees. Furthermore, it implies looking at the business like an owner, rather than an accountant or IRS agent– net income/earnings do not represent cash available to the owners because they include a number of non-cash items and they do not account for necessary CAPEX spending to grow and maintain the business.
Owner Earnings represent actual cash flows attributable to the owners of the company in a given period and can be calculated fairly simply:
Owner Earnings = Net Income + Depreciation/Amortization + Non-Cash Charges – Average CAPEX
Average CAPEX should generally be taken over a period of the most recent 3-5 years, though you could use as many as 10 years if that’s how you prefer to look at a business’s history. Owner earnings tell you whether a business is generating enough cash to pay its bills without new infusions of debt or equity, as well as whether it is generating sufficient cash flows to continue to grow. Further, Ponzio states that “For extremely large, stable businesses, free cash flow usually approximates owner earnings.”
Intrinsic value is a related concept which considers the combined value of the current net worth of the business as well as the present value of all discounted future cash flows the business with generate. As a value investor, your goal is to buy businesses trading in the market at steep discounts to your calculated intrinsic value. The difference between intrinsic value and the market price is your “margin of safety” (note that if you pay more in the market than your calculated intrinsic value, this implies a “margin of dissafety” represented by the negative value you’d get from the equation).
To calculate the present value of future cash flows, Ponzio recommends using your desired investment return as the discount rate and sticking to it consistently (so, for example, if you want your investments to grow at 15%, use a 15% discount rate, but be wary that the higher your discount rate, the less conforming investment opportunities you will find). If you have Excel, calculating the value of discounted cash flows is simple. You can enter the following formula into any cell in your spreadsheet,
=PV(DISCOUNT_RATE, NUMBER_OF_DISCOUNT_PERIODS, AMOUNT_OF_ADDITIONAL_INVESTMENTS, FUTURE_VALUE)
By creating a matrix of future anticipated cash flows and then discounting them with the present value function, you can sum them up to get the total present value of present cash flows. When adding this to the business’s present net worth and comparing that amount to current market cap you can get an idea of whether or not the business is trading at a discount or premium to its intrinsic value.
Cash-yields, Buy-and-Hold, CROIC and “No-Brainers”
Ponzio suggests a few more ways to look at possible investments. One is the cash yield, which treats the stock like a bond for comparative purposes. Cash yield is defined as.
Cash Yield = Owner Earnings (or FCF) / Market Cap
Taking this yield, you can compare it to other investments, such as “risk free” government securities. Assuming the government securities are in fact “risk free”, if the cash yield is lower than the government securities the cash yield is telling you that you would likely be better off taking the “guaranteed” yield of the government security rather than assuming the capital risk of a stock. But if the cash yield is higher it could indicate a good investment opportunity, especially because that yield will typically improve over time as the denominator (your acquisition price) remains constant while the numerator (owner earnings/FCF) grows. But, as Ponzio states,
Cash-yield is not a make-or-break valuation; it is a quick and dirty “what’s this worth” number that applies more to slower-growth businesses than to rapidly growing ones.
Whereas cash-yield seeks to answer, “Is this cheap relative to other returns I could get?”, the Buy-and-Hold method seeks to answer “How much is it worth if I buy the entire business?” BAH is a more standard analysis and involves discounting future cash flows and adding them to the present net worth of the business, mentioned above.
A “no-brainer”, in Ponzio’s parlance, is an investment that leaps out at you as ridiculously undervalued– an excellent, growing business trading at a significant discount to its intrinsic value (net worth and discounted future cash flows). When searching for no-brainers, Ponzio suggests you stay in your sphere of confidence by sticking to what you know and asking yourself the following:
- What does the company do?
- How does it do it?
- What is the market like for the company’s products or services?
- Who is the company’s competition?
- How well guarded is it from the competition?
- Five and ten years from now, will this company be making more money than it is today? Why?
If you can’t answer any of those questions, you’re outside your sphere of confidence and probably won’t be able to identify a no-brainer.
There are many ways to identify growing businesses. Sticking to the theme of “watch the cash flows,” Ponzio’s favorite measurement is Cash Return on Invested Capital, or CROIC. CROIC is defined as,
CROIC = Owners Earnings / Invested Capital
(Ponzio suggests using long-term liabilities and shareholder’s equity to estimate IC– obviously if there was preferred equity or some other capital in the business like that, you might want to include it for a more accurate measurement.)
Ponzio recommends CROIC because it demonstrates management’s ability to generate owners earnings from each dollar of invested capital. The more efficient a management team is at generating owners earnings, the more resources it has to grow the business and pay shareholders. But be careful! An extremely high CROIC (such as 45%) is generally unsustainable. Look for anything above 10% as a good CROIC growth rate.
Portfolio Management Is All About The Percentages
You’ve found some great businesses. You know they’re growing and you know they’re trading at big discounts to intrinsic value, offering you your requisite margin of safety. Now you need to figure out how much of each you buy as you construct a portfolio.
A word of warning up front– there’s no science here, even though Ponzio refers to precise percentages. This aspect of investment management is even more art-vs.-science than judging which companies to buy in the first place. That being said, the principles themselves are sound and the truly important takeaway.
Ponzio divides stocks into three main categories:
- Industry leaders: $10B+ market cap, demand 25% MoS, allocate 10-25% of your portfolio
- Middlers: $1B-$10B market cap, demand 50% MoS, allocate up to 10% of your portfolio
- Small fish: <$1B market cap, demand 50%+ MoS, allocate no more than 5% of your portfolio
The percentages are arbitrary but the idea is not. Industry leaders are companies that have proven track records when it comes to cash generation and cash flow sustainability through diverse business conditions. They won’t grow as much (they’re generally too big to do so) but if you can buy them at significant discounts to their intrinsic value, you will be rewarded. These are companies you can buy, read the annual report each year and otherwise sleep easy.
Middlers are companies that are in business limbo. They could grow quickly and become industry leaders, providing you with juicy returns, or they could be surpassed by smaller and larger competitors alike and shrink back to small fish size. Ponzio recommends keeping up with the quarterly reports on these companies and taking prompt action if you think you see any problems approaching.
Finally, small fish are capable of explosive growth… and spectacular failures. Many smaller businesses fail every year. Also, small businesses are often reliant or one or a few major customers for all of their business. If they lose that relationship, or a critical person dies or leaves the firm, their business can evaporate overnight. At the same time, because they are so small, the SF have the most room to grow and if you pick them right, they can turn into the magical “ten-baggers” of Peter Lynch lore. Ponzio recommends following every SEC filing and every news item on these companies as they can go belly up quickly if you aren’t careful.
The key thing to keep in mind is that, however you make your allocation decisions, you should always invest the most in the things you are most confident about. Diversification should be a consequence of your investing decisions, not an outright goal. You will make allocations as various opportunities arise. You don’t benefit yourself by being fully invested all the time, simply to keep your portfolio “balanced” amongst different business types.
Selling Is The Hardest Part
As the legendary Tom Petty once said, “the waiting is the hardest part” and while that’s certainly true of investing for some, what people consistently struggle with even more is knowing when to sell.
There are two times to sell:
- when your investment has closely neared, met or exceeded your estimate of fair value
- when the business you’ve invested in has developed some serious problems that will affect its present value and its future ability to generate cash flows
In the first situation, you must avoid getting greedy. If you had an estimate of intrinsic value when you bought the company (at a discount) and over time your forecast bore out, and if there is no completely new developments in the business which would cause you to drastically re-appraise upward the future value of the business, you sell. That’s it.
Similarly, if you make a forecast for the business’s prospects and you later realize you’ve made a big error in your conceptual understanding of the business and its value, you sell. Short term price volatility is not a “realization of your error”. Realization of your error would be the company generating significantly lower owner earnings than you had anticipated, or worse.
Finally, if you feel full of confusion and can’t sleep easily at night about your investment, tossing and turning trying to figure out what is going on, you sell. It’s not worth the stress and you won’t make good decisions in that state of mind. Just sell it and look for something you can understand a little easier.
And don’t be afraid to take a loss. You will not get every decision right. Luckily, you don’t need to– if you invest with a margin of safety, the reality of an occasional error is built in to the collective prices you pay for all your businesses. Never hesitate to sell simply because you want to avoid a loss. You will screw up now and then. Accept it, sell, and move on to your next opportunity.
F-ing Wall Street All Over The Place
There’s still more to this outstanding introduction to value investing but I don’t have the time or interest to go into all of it right now. In the rest of the book, Ponzio discusses arbitrage, workouts and other special investment scenarios and provides a great “how-to” on getting involved with these investments and taking your game to the next level. He also provides a short primer on bond investing and an exploration of the “different types of investors” ala Ben Graham’s conservative versus enterprising investor archetypes. Rounded out with an investor glossary and a short Q&A and this book is a true gem trading at a significant discount to intrinsic value.
More Warren Buffet than Ben Graham, Joe Ponzio’s F Wall Street is a classic and a great starting place for anyone who wants to jump into value investing head first.
A House Rises 