- Negative equity itself is meaningless (could be good or bad)
- Compare net financial obligations to EBITDA
- Think of borrowed money as the price of time; ask yourself if you’d rather they borrow money or spend time
- Stocks in Geoff’s portfolio tend to:
- have positive FCF
- have unusually high ratios of FCF to reported earnings
- buy back shares
- pay dividends
- have excess cash after the above
- “I have found I do not make good decisions when I have to juggle 10 or more opportunities in my head at once”
- “I don’t believe in taking a risk where I think if everything goes perfectly the upside is still going to be in the single digits”
- How much debt is too much debt is a separate issue from whether the debt is being used productively
- When soaring over the market trying to find bargains, these are useful as screening tools:
- tangible book value
- EV/EBITDA
- If an entire country’s market has a low P/TBV or EV/EBITDA, this is important to know; you can buy indexes on this info alone
- However, ultimately the following matter more:
- liquidation value
- market value
- replacement value
- Owner Earnings
- Move beyond being a record keeper — an accountant — and become an appraiser
- The assets that matter most on the balance sheet:
- cash
- investments
- land
- intellectual property
- tax savings
- legal claims
- Cash flow protection is much better than asset protection
- Businesses with special assets that are not separable from the operating business are most likely to not be reflected on the balance sheet and present hidden value
- Being in a strong, safe liquidating position does not necessarily mean you are in a strong, safe operating position
- Working capital needs and capital spending needs are part of the DNA of a business; “you can’t turn a railroad into an ad agency”
- Negative equity itself is not a risk; poor interest coverage is
- Non-aggressive long-run return assumptions:
- stocks – 8%
- bonds – 4%
- When looking at companies with negative equity and stock buybacks, ask yourself the following:
- Earnings yield of stock buybacks > interest rate on borrowed money?
- Need to adjust financial obligations (such as unfunded pension liability) to determine true extent of liabilities?
- Are net financial obligations (debt and pensions minus cash) a low enough multiple of their EBITDA?
- How many years of FCF would it take to pay off all financial liabilities?
- Is the price of the entire company in terms of EV/EBITDA low enough to justify investment?
- How reliable is EBITDA, FCF, etc?
- Common concerns in these situations:
- Moat not wide enough
- High risk of technological obsolescence
- No pricing power/cost cutting potential to support margins
- The right company can have negative equity and be investable if it is a wide moat business with almost no need for tangible investment:
- Negative working capital
- Minimal PP&E
- A wide moat
Is It Ever Okay For A Company To Have No Free Cash Flow?
- Four cash flow measures:
- Owner’s Earnings (most important)
- EBITDA
- CFO
- FCF
- You can get a hint where a company is tripping up in delivering cash to shareholders (FCF) when:
- EBITDA is positive
- CFO is positive
- Net income is positive
- EBITDA measures the capitalization independent cash flow of the business; it doesn’t take into account spending today for benefits that won’t be realized until tomorrow; also misses working capital changes
- Look for companies that are growing quickly in an industry that is not
- Avoid companies that are fast growing in a fast growing industry; it will face more competition every year
- To judge the future ROI of FCF reinvestment with a company that has no FCF, look at:
- Will they be competitive?
- Will competitors over expand?
- Do they have a moat?
- When a company spends so much on growth for so long, you really are betting on what the ROI will be way out in the future
- “There isn’t necessarily a prize for being the last one to succumb to the inevitable. It’s usually more of a moral victory than an economic one”
- Don’t short a great brand; if you want to short something, short a company:
- with a product with inherently poor economics
- a bad balance sheet
- with deteriorating competitiveness
- preferably in an industry with a high morality rate
- When a company reinvests everything, you need to worry about what they’ll earn on their capital many years out
Value Investor Improvement Tip #1: Settle For Cheap Enough
- A lot of people look for:
- lowest P/Es
- lowest P/Bs
- highest div yields
- new lows
- This creates lists of companies that are quantitative outliers, instead of companies you know something about
- You should feel comfortable throwing out 7/10 names found on a screen
- Better to cast a wider net and then focus on companies you can learn a lot about by reading 10-Ks
- Try a screen that combines (Ben Graham-style):
- above average div yield
- below average P/E
- below average P/B
- fewest unprofitable years in their past
- Start with the company that sounds simplest, then move out slowly and carefully to those you understand less well; stop when you find something cheap that you know you can hold as long as it takes
- Another screen:
- EV/EBITDA < 8
- ROI > 10%
- 10 straight years of operating profits
- You need a good reason for picking stocks that don’t meet this criteria
- It’s hard to figure out companies with a lot of losses in their past; so don’t try
- Familiarize yourself with a few stocks; what insiders have is familiarity
- You want to find companies where you can think more like an insider
- For long-term investing health, it’s better to find a slightly less cheap — but still cheap enough — stock you can get familiar with than a super cheap one that is a mystery
- Anything less than NCAV is cheap enough
- “Some of value investing is in the buying; most of value investing is in the holding; almost none of value investing is in the selling”
A House Rises 