Men are anxious to improve their circumstances, but are unwilling to improve themselves; they therefore remain bound.
Men are anxious to improve their circumstances, but are unwilling to improve themselves; they therefore remain bound.
A few days ago I linked to a post from Hedge Fund News in which the author expressed some deep skepticism and reservations about common stock investments in the present era. The primary concerns were that the market is “rigged” to a large extent via Fed front-running and black-box trading algorithms. Stock market investing is largely about an informational edge. Without friends in high places, an army of analysts and a mainframe computer, how is the little guy supposed to have an edge anymore?
First, a contrarian take on the contrarian take.
Front-running the Fed works, until it doesn’t. Many try to front-run the Fed without any real, personal insight into what’s going on there (aka, having a whisper network that’s tapped in to the Fed) and those people get steamrolled in periods like the one we just witnessed in August 2011, when many market participants hit the “Eject” button all at once and the Fed isn’t there with a trampoline to catch everyone. Some do have those networks and their front-running is largely successful (though you have to wonder what the hell happened at PIMCO over the last two months with Alan Greenspan on retainer) and to that I have no response besides to observe that “Life isn’t fair, deal with it.” Some people are born with a Golden FRN lodged between their butt cheeks and some aren’t. It’s obviously not the majority of the market because if it were that’d defeat the whole purpose of having that kind of informational advantage.
For the average, little guy investor, all the Fed does is introduce extreme volatility into the picture. And volatility isn’t risk. In fact, volatility provides true opportunities for the value investor that he otherwise might never have gotten as the inevitable panics that ensue tend to drag down the good companies with the bad. Then, you buy good companies cheaply.
I look at the black-box trading the same way. So what if there are black-boxes? They add volatility to markets. Volatility is opportunity, not risk. Use limit orders if you’re worried about getting manipulated by these robots putting out false bids.
The concern about informational asymmetries caused by institutionalism and hedge fund analyst armies is more substantive. But it still doesn’t mean doom for the little investor (or maybe better to call him the “lone ranger investor”, because he might have a few thousand or he might have a few million). I am going to paraphrase a few points from Jason Zweig’s commentary from chapter 8 of The Intelligent Investor:
Now, let’s flip each of these points around to see how the lone ranger investor is advantaged by each:
A video of Ray Dalio over at Credit Bubble Stocks features Dalio riffing on the high degree to which average hedge fund returns are correlated with the broader markets. The implication is that hedge funds aren’t being creative and independent in their strategies and trades. What good is an army of analysts, in other words, if you’ve got them looking at the same exact companies (AAPL, NFLX, BAC, etc.) that everyone else is looking at? What good is it to be a hedge fund when all this really means is you can hold more than 5% of your portfolio in something like AAPL and then lever the hell out of it and cross your fingers hoping Ben Bernanke’s got your back?
Informational advantages come in three flavors:
Number two is damn near impossible (and extremely legally risky) to get in the current era of financial market regulation for most people. But there is nothing to stop the lone ranger investor from focusing on numbers one and three. In fact, this is where he should be focused.
The real risk, and this was suggested in the Hedge Fund News piece, is that number two might be so pervasive in particular situations that it overwhelms number one and number three. But for the most part, those situations are fairly obvious and can be avoided. For example, don’t buy AAPL if that’s what everyone is trading.
So, that’s some of the advantages the lone ranger has, in spite of it all. But the HFN piece wasn’t total fluff and he’s right to still be skeptical. I was particularly struck by his suggestions about corporate governance. This is a big problem as I see it.
Yesterday I spent some time listening to Albert Meyer talk about his experience with uncovering numerous well-publicized frauds and accounting shenanigans of the last decade ($KO, $TYC, Enron and the New Era Philanthropy Ponzi). The way Albert made it sound, corporate governance in this country is in shambles and a true embarrassment to the idea of free and honest markets.
Albert talked about the problem with option issuance overhang. Even though these items are now expensed following a FASB rules change, Meyer insists that the true costs of executive compensation for many (most?) companies listed on US exchanges is severely understated. He called into question the practice of huge stock buybacks by most companies, which he said is really just the way in which companies cover up the inevitable dilution that would otherwise occur from executive stock option exercising– and it all comes at the expense of shareholders and mutual fund investors whose mutual funds buy the new shares of recently exercised options. One example he gave was $EBAY, which he said reported income of $800M in a particular period but should’ve reported an $800M loss (a swing of $1.6B) once you had factored in the option issuance and subsequent buybacks to prevent dilution.
Albert said there were only 7 companies in the US that do not compensate executives with stock options. He cited numerous examples of Congressional and regulatory (SEC) corruption with regards to the protective relationship these cretins have with American corporate boards and C-level management teams and the stock option issuance scam. He said there is a lot less of it going on outside of the US which is yet another reason why he finds himself seeking out investment opportunities there.
I’m getting into a digression here when I don’t mean to be, but I assure you this is all related. The point is this: the predominating corporate structure for business in this country, specifically amongst publicly-listed companies with career professional management teams who are not also owner-operators of the company, creates a uniquely perverse set of incentives that truly pits the interests of shareholders (the actual owners of the company, its assets and cash flows) against management and even their own boards! The reality in many cases is that executives and obedient, captured boards work together the milk the wealth of the company for themselves with outsized compensation packages based primarily on stock option issuance, leaving shareholders with all the risks and none of the rewards.
And as the HFN piece points out, the entrepreneurial spirit is particularly absent in these kinds of arrangements because it must be. There is no real connection between the performance of the business (good or bad) and the compensation of the board and management. In the event that the company does well, the gains are secretly dissipated through executive stock option exercising and subsequent colossal buybacks. In the event that the company does poorly, management and the board issue themselves numerous stock options at rock-bottom prices with long duration expirations, virtually guaranteeing that should the business ever turn around they’ll be there to siphon off all the gains for themselves and leave shareholders with nothing.
In effect, it’s a game, and a dirty one that the lone ranger investor doesn’t have many tools besides selectivity that he can use to win. It’s such a widespread practice that you really have to either get in at the absolute bottom or find a company where the corporate governance is much more shareholder aligned (high percentage of insider ownership, predominance of cash compensation for executives without major options issuance, share buybacks that occur at market lows not at market highs when management is cashing in their chips and exercising options, low percentage of institutional sponsorship and a truly independent board where ideally executive management doesn’t have many or any seats) if you ever hope to win it.
That is why I’ve been thinking a lot about “going private.” By going private, I don’t mean taking companies that are public, private, though that might be a good start as I honestly think that in many ways having access to public financing is simply an excuse for poorly managed companies to engage in Ponzi finance without it looking like such.
Instead, what I am talking about is being an enterprising, entrepreneurial investor primarily within the private investment space. This means not only starting your own businesses, but making contacts and seeking out investment opportunities that are not party to the public capital markets. In many cases, it means investing locally and investing in what you know about. It also potentially means outsize returns via informational asymmetries and reduced competition (amongst yourself and other potential investors).
In that vein, I was struck by this comment from Mark Cuban that I saw quoted on Tim Ferriss’s 4 Hour Blog in a post about rethinking investing:
YM: Do you have any general saving and investing advice for young people?
CUBAN: Put it in the bank. The idiots that tell you to put your money in the market because eventually it will go up need to tell you that because they are trying to sell you something. The stock market is probably the worst investment vehicle out there. If you won’t put your money in the bank, NEVER put your money in something where you don’t have an information advantage. Why invest your money in something because a broker told you to? If the broker had a clue, he/she wouldn’t be a broker, they would be on a beach somewhere.
Cuban’s sentiment echoes my own here and I find myself sharing this perspective with friends and family members who ask me for investment advice or what to do with their 401k.
The first thing I tell people is, don’t put your money in your 401k if you don’t know what you want to do with it once it’s there. People get taken in by the idea of pre-tax investing and employer matching, but ultimately those advantages are wasted if you are just going to make clueless, doomed-to-fail investments with that money. What good is having 6% matching or investing with 35% more money because you don’t pay taxes on the principal when you put it in, if you’re just going to lose 100% of it anyway?
The second thing I ask them is, what kind of options do you have and what kind of informational advantages do you have when you put your money into your 401k or the stock market in general? Most don’t have a clue. That’s a warning sign! If you don’t know what your informational advantage is, you don’t have one and you’re basically investing blind. Meanwhile, your opponents not only aren’t blind, they’ve got Lasik. They will take your money and run the first chance they get.
The final recommendation I make is, instead of investing in the stock market or a 401k (which the person admittedly knows nothing about), I suggest they save up to start their own business or invest in the business of a friend or family member who they know, trust and have tangible proof of their success. It would be much better to make private arrangements to invest equity or loan money privately in a situation like that than it would be to dump their hard-earned wealth into a Wall Street rucksack and then wake up 20 years later wondering where it ran off to.
When I make those suggestions to others I start to wonder if we would all be better off if we did the same.
In case you missed his previous missive on the subject, entitled “Which Flation Will Get Us?“, Gary North came out today firmly against the idea of a hyperinflationary experience in the US or any other industrialized country with a privately owned central bank. Instead, North is predicting “mass inflation”, which he defines as 15-30% money supply growth per annum.
North bases his conclusion on four premises:
North calls hyperinflation a “policy choice”. He believes the only thing that could change this outcome would be if the Congress nationalized the Fed. Then, all bets are off.
It’s an interesting prediction. It makes a lot of sense. I am not sure how mass inflation will avoid some of the problematic items mentioned above though (particularly #2 and #4).
If North is right, this should be good for gold and not so good for people invested in stocks as consumer price increases will likely outpace increases in stock prices. Stock prices may even get hurt short-term because of increased commodity prices for many businesses.
Robert Wenzel of EconomicPolicyJournal.com fires back:
So don’t put me in the more unemployment camp or the mild inflation camp,or in the non-hyperinflation camp. Long term there are too many unknowns to be in any camp, especially when you have a machine known as the Fed that can shoot out billions trillions of dollars whenever it chooses. I just watch what the Fed is doing and adjust accordingly on a roughly six month basis. The constant adjustments are no way to live, but are necessary because of the fact that we do have a central bank, the Federal Reserve, that manipulates up and down the money supply. Right now, because of the new money accelerated growth that is occurring, I anticipate that the climb in price inflation is going to escalate dramatically, where this spike in price inflation will stop, I have no idea. I just take it six months at a time.
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:
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:
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:
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:
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.
The anonymous author of Hedge Fund News has put out a rather pessimistic, hopeless sounding post in which he asks, “Why invest in stocks?”
- The game is largely about front running the Federal Reserve or the ECB or the Bank of Japan. It seems that the way to make money is to buy before central bankers announce quantitative easing or some other scheme to juice asset prices. However, since I don’t have high level contacts at any of these institutions, I will always be the last one to invest based on the liquidity injections. Of course, there are people who do have contacts at the FED and thus they can essentially front run monetary policy. The question I ask myself is “if I can’t compete with the big boys, does it make any sense to play?” In any other sport, the answer would be a resounding no in order to avoid injury. I don’t think my investing in the stock market is any less dangerous then taking the field with the New England Patriots for training camp. I can get hurt…real bad.
- You also can’t compete with big hedge funds. A major hedge fund might have 100 analysts, key contacts at major brokerages. Paying massive trading commissions has it’s benefits and that benefit is information. The stock market is a game of information and most likely the big hedge fund has vastly superior information to you.
- I like founder owned and operated businesses. I generally find “professional management” is too constipated and far too divorced from the risk taking visionary that usually founded the company. Talk to a corporate middle manager and then talk to hungry entrepreneur working on his baby. You will quickly feel who you would rather back with your precious capital. By the time most companies reach the public markets, the ownership of the company lies in the hands of facelesss financial institutions that are totally divorced from the passion that built the business.
- The markets are run by machines. Insanely powerful computers constitute the majority of trading. Again, the hedge funds have a massive technological edge on the rest of us.
- the Warren Buffet stock analysis that favors buy and hold investing has not worked in the last decade that has been driven by Central banks and macroeconomics. Stock picking has been killed by the four reasons above.
I mention this post because I’ve shared the sentiment myself at times, and especially recently.
Stocks are not just forward-looking instruments, they are forward bets. If you buy stocks, you are making the assumption that, at least for the companies’ whose stocks you buy, things will be better in the future and therefore the prices will be higher. In that sense, Warren Buffett’s “bullish on America” rhetoric matches his investment action. He truly believes America as an idea, as a system, as an investment platform, can not fail because it has not failed, so he wants to buy stocks every time most other people are selling him because he believes his long-term prospects for capital appreciation are good.
And so far, that has worked– wonderfully!
But people like Buffett seem to be ignorant of certain economic truths and inevitabilities, especially with regards to the current problems facing investors, and so some of his optimism comes across as willful naivety.
This isn’t an anti-Warren post, however, so back to the point– what if the future is bleak? What if America is Japan? Some have made comparisons (Mish) and some of those comparisons are compelling. What if America isn’t Japan, but something worse and far more complex altogether?
What if we’re looking at an ongoing or a return to severe recession? What if this is followed by more inflationary antics which, by driving up commodity prices, serve to kill margins in many businesses and beat down earnings, even as general price increases rage on? What if stocks don’t even go up in nominal terms for awhile and then, by the time they do, they’ve lost so much in real terms that there’s no point in investing in them?
What if, what if, what if? A lot could go wrong. And knowing this, a value investor seeks a margin of safety in his investments. If he’s concerned about a depression, he tries to calculate what that might look like and price it in, raise his hurdle rate that much higher. Then, if it’s a good business and he can get it at a significant discount to his calculated value even when considering a rather hopeless scenario as a possible outcome, he buys. If it goes down, he buys some more.
If that worst case scenario plays out, and the world looks like it’s ending, if he’s got any more money left he throws it in the pot and then he goes off to war, or he goes fishing, or whatever and he doesn’t think about it anymore.
Why invest in stocks? Because tomorrow is always another day. Stocks are for the future and there’s always a future, so if you can buy them cheaply, you buy them and you stop worrying about everything else.
The only trouble, the thing that keeps me worrying, is what if the future is going to happen someplace else, not America? A lot of places that were once the future are now the past. It could happen. Invest accordingly.
by John Price, published 2011
This book was not what I expected to be and it certainly was not what I had hoped it would be. The reviews I had read of the book left me waiting in eager anticipation of its arrival in the mail because it sounded like it would do two things I had been looking to do: deliver crushing criticisms of various technical and non-value based approaches to investing; and provide a concise “how-to” as far as preparing an intrinsic value-based financial analysis of business or investment idea.
With regards to the former, Price delivers, but not courageously. His breakdown of various analytical approaches, while thorough, ultimately is not very helpful. Each analytical methodology is described and then followed by a list of strengths and weaknesses, but no decisive conclusion is reached. Surely there’s nothing wrong with leaving it to the reader to make up his own mind, but there’s no objective scale provided or suggested for weighing the strengths and weaknesses of each– it’s hard to tell just from reading whether any particular strength outweighs a weakness, or vice versa. I would’ve liked it if Price had added his two cents about each rather than trying to be dry and officiously neutral.
As for a concise how-to on value investing, this was one of those books where you keep turning the page hoping the author is going to get to the point and suddenly you turn the last page and you’re confronted with the back flap of the book and all you can do is shout out in frustration, “That’s it?!”
The title of the book seems contrived in relation to its content. “The Conscious Investor”, as opposed to an unconscious one? I assume Price is suggesting a level of awareness, but there is an important qualitative difference about being aware of many different concepts and actually understanding their meaning and significance. I didn’t find the book to have much strength in that sense.
At one point, Price suggests that part of being a “conscious investor” means thinking about what it is, exactly, that you’re investing in, and what would be the implications of that investment succeeding. For example, say you invest in a company that manufactures ugly clothing. If the company is successful and your investment pays off, you’ll now be living in a world of ugly clothing everywhere you look. Is that the kind of world you want to live in?
It’s an interesting idea but a perhaps more important one is, “If the company is clearly undervalued, and I don’t invest in it for ethical reasons… does that mean no one else will recognize the undervaluation and invest, thereby preventing that world of [ugly clothing] from becoming a reality?” Whatever the answer to this question, this is clearly an aspect of being a “conscientious investor”, not a conscious one, so again I am left a bit perplexed by this book.
My disappointment and griping aside, there was some value in this book and I did highlight and underline a few things I had wanted to record here for future reference. But even at Amazon’s reasonable new book prices, knowing what I know now I see this book as overvalued, meaning I clearly overpaid and thereby suffered a permanent capital loss. But maybe that was what Price was trying to teach me the whole time, as a value investor.
Some notes and takeaways:
When reading financial statements and company filings, remember to “follow the money“, and ask (and try to answer) the following questions:
Further, in the Proxy Statement (Form Def 14A), you should attempt to determine
whether the presentation on compensation in the Proxy Statement is clear and easy to understand. The overall level of compensation to management and directors relative to the size and performance of the business is important.
When studying earnings growth, as a common stock investor it is important to look at growth in EPS, not net income, because the company may be issuing large number of shares and diluting current shareholders even if it is successfully growing net income.
The quality of earnings is in doubt when net income substantially exceeds cash flow from operations. Ideally, positive cash flow conditions would yield:
If you own shares in a company, but don’t think that it represents value to buy more, then welcoming actions of the company to buy back its own shares is not logical.
Mismatches between net and comprehensive income are also a warning sign.
If in most years the comprehensive income is consistently below the net income… the company has been accumulating losses in comprehensive income aside from the regular income, which may indicate that the economic situation is worse than it would appear from an analysis of the income statement.
A higher current ratio is not always better– sometimes a high current ratio means that inventory is piling up, or the company is extending larger amounts of credit to its customers than it ought to be through growing A/R. A low or downward trending current ratio is almost always a cause for concern, however.
With retail companies, it is important to examine growth of same-store sales to determine whether the company is growing simply through the opening of new stores versus expanding its business within existing stores. Also, high asset turnover is critical in a retail business, which normally has low margins, in order to leverage its returns.
Be vigilant with companies whose primary assets are intangibles, which, if developed internally, may not be represented on the balance sheet. “The smaller the role of intangible assets, the closer to book value a company’s market price is likely to be.”
And a Warren Buffett quote:
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.
Further, according to Price,
Over time, whatever returns a company makes on its equity and capital will be approximately an upper limit on the return made by investing in the company’s stock.
Putting some of this together yields a few “rules” with regards to the P/E ratio:
“Find companies with high and consistent return on equity and not too much debt. Try to determine what is special about them– what economic moats do they have?”
by John A. Tracy, published 2009
There isn’t too much to say about John A. Tracy’s “How To Read A Financial Report: Wringing vital signs out of the numbers”. It’s a basic guide to understanding the income statement, balance sheet and statement of cash flows that all businesses, public and private, rely on to internally control their business as well as report the condition of their business to other investors and third parties.
It’s set up in a wide (versus standard tall) format and goes step-by-step through the various financial statements, their sub-sections and sub-accounts and the way specific items on each financial statement interact with other items on other financial statements. There are a number of tables and figures for illustrative purposes.
Below, I have summarized some of the most important takeaways to serve as a quick reference for myself going forward.
Sales Revenue and Accounts Receivable (A/R)
The average sales credit period determines the size of accounts receivable.
Accounts Receivable Turnover Ratio = Sales Revenue / Accounts Receiveable
The accounts receivable turnover ratio is most meaningful when it is used to determine the number of weeks (or days) it takes a company to convert its accounts receivable into cash.
Cash Conversion Cycle in Weeks (Days) = 52 Weeks (365 Days) / ARTR
Excess accounts receivable means that excess debt or excess owner’s equity capital is being used by the business.
Cost of Goods Sold (COGS) and Inventory
The average inventory holding period determines the size of inventory relative to annual cost of goods sold.
Inventory Turnover Ratio = COGS / Inventory
Dividing this ratio into 52 weeks (365 days) gives the average inventory holding period expressed in weeks (days).
Average Inventory Holding Period in Weeks (Days) = 52 Weeks (365 Days) / ITR
If the holding period is longer than necessary, too much capital is being tied up in inventory. The company may be cash poor because it keeps too much money in inventory and not enough in the bank. If overall inventory is too-low, stock-outs may occur.
Accounting issues: the inventory asset account is written down to record losses from falling sales prices, lower replacement costs, damage and spoilage, and shrinkage (shoplifting and employee theft). Losses may be recorded in the COGS expense account.
Inventory and Accounts Payable
One source of accounts payable is from making inventory purchases on credit. A second source of accounts payable is from expenses that are not paid immediately.
Sellers that extend credit set their prices slightly higher to compensate for the delay in receiving cash from their customers. A small but hidden interest charge is built into the cost paid by the purchasers.
Operating Expenses and Accounts Payable
The recording of unpaid expenses does not decrease cash.
Operating Expenses and Prepaid Expenses
The prepayment of expenses decreases cash.
Accounting issues: a business may be on the verge of collapse and its prepaid expenses may therefore have no future benefit and may not be recoverable (so, a large prepaid expense account should maybe be discounted to 0 in an NCAV analysis). A business may not record prepaid costs; instead it could simply record the prepayments immediately to expense. A business could intentionally delay charging off certain prepaid expenses even though the expenses should be recorded in this period.
The allocation of the cost of a long-term operating asset to expense is called depreciation. In financial statement accounting depreciation means cost allocation.
Accelerated depreciation results in depreciation over a period of time which is considerably shorter than the actual useful life of the asset. Accelerated means front-loaded; more of the cost of a fixed asset is depreciated in the first half of its useful life than in its second half. If useful life estimates are too short (the assets are actually used many more years), than depreciation expense is recorded too quickly.
Book value represents future depreciation expense, although a business may dispose of some of its fixed assets before they are fully depreciated. Chances are that the current market replacement costs would be higher than the book value of the fixed assets– due to general inflation and the use of accelerated depreciation methods.
An expense is recorded when there is a diminishment in value of a company’s intangible assets.
Accounting issues: if the business adopts a sales pricing policy for recapturing the cost of a fixed asset over X years, then an X-year depreciation life would be most appropriate.
Accrued Liabilities and Unpaid Expenses
Typical accrued expenses:
Accounting issues: if a business is seriously behind in paying interest on its debts, the liability for unpaid interest should be prominently reported on its balance sheet to call attention to this situation.
Net Income and Retained Earnings; Earnings Per Share (EPS)
Retained earnings is not an asset and certainly is not cash.
Retained Earnings = Net Income – Dividends Paid to Shareholders
Cash Flow From Operating (Profit-Making) Activities
Cash Flow From Operating Activities (CFO) is best thought of as cash flow from profit.
Drivers of cash flow:
Summary for the seven cash flow adjustments:
Profit generates cash flow; cash flow does not generate profit.
Cash Flow From Investing and Financing Activities
The second section of the statement of cash flows summarizes investments made by the business during the year in long-term operating assets. It also includes proceeds from disposals of investments (net of tax). These are assumedly one-time cash flows, not recurring like cash flows from operations.
The third section of the statement of cash flows reports the cash flows of what are called financing activities. These are cash flows generated outside the business (new equity sales, new borrowings) or cash flows paid to parties outside the company (stock buybacks, debt repayments, dividends to shareholders).
Profit can be viewed as the internal source of cash flow and is the only renewable, recurring one if the business is in good health as a going concern.
The important question to ask is, “What did the business do with its cash flow from profit?”
The other important question is, “Can the business support its other cash flows (investing, financing) with cash from operations?” If not, the business will not remain solvent and liquid in the long-run.
Impact of Growth and Decline on Cash Flow
Cash flow can be higher or lower than net income for the period. There are three main reasons:
A business could speed up cash flow from profit if it were able to improve its operating ratios, such as holding a smaller stock of products in inventory. If anything, however, it may allow these ratios to slip a little by offering customers more liberal credit terms to stimulate sales, which would extend the A/R credit period. Or, the business may increase the size and mix of its inventory to improve delivery times to customers and to provide better selection.
Businesses with lower fixed costs have more flexibility to swiftly respond to business declines by reducing costs, thereby improving margins.
A huge net loss for the year may be due to huge write-downs of assets (or by recording a large liability).
The total cash outlays for expenses could be more than total cash inflow from sales revenue, even after the depreciation add back is considered. This is called negative cash flow. In this situation, a business is using up its available cash at the burn rate, which can be used to determine how long a business can live without a major cash infusion.
Financial Statement Ratios
Cash Flow as % of Net Income = CFO / NI
Cash Flow per Share = CFO / Shares Out
Current Ratio = Current Assets / Current Liabilities
The Current Ratio measures short-term liquidity of the business and should be 2 or higher.
Acid Test Ratio = Cash + ST Investments + A/R / Current Liabilities
Also called the quick ratio, should be 1 or higher.
Debt to Equity Ratio = Total Liabilities / Total Stockholders Equity
Debt-to-Equity is an indicator of whether debt is being used prudently.
Times Interest Earned Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
TIE tests the ability of the business to pay interest from earnings.
Return on Sales Ratio = Net Income / Sales Revenue
Also known as net margin, return on sales measures the ability of the company to earn profit per $1 of sales. It is a sales efficiency ratio.
Return on Investment = Profit / Capital Invested
This is a standard formula with several variants, measuring the profit generated from a particular amount of capital invested. Also,
Return on Equity = NI / Stockholders Equity
Return on Assets = EBIT / Total Assets
The ROA is compared with the annual interest rate on the company’s borrowed money. You want the difference between these two values (spread) to be higher rather than lower. An ROA – Interest Rate > 1 represents gain on financial leverage.
Asset Turnover Ratio = Sales Revenues / Total Assets
Represents the rate at which assets are being converted into sales revenue.
Massaging the Numbers
Businesses can play many games to manipulate their reported financial numbers.
Discretionary expenses, such as repair and maintenance costs, employee training and development, advertising expenditures. Managers have a lot of control over when and how these expenses are recorded by pushing up or delaying such actions.
Stuffing the channels occurs when the manager accelerates sales by shipping more sales to the company’s captive dealers even though they haven’t ordered the products.
Window dressing, whose purpose is to make the short-term solvency and liquidity of the business look better than it really was at the end of the year.
For reporting profits soon, the CEO instructs accountants to choose accounting methods that accelerate sales revenues and delay expenses. To be conservative, the accountants can be instructed to use accounting methods that delay the recording of sales revenue and accelerate the recording of expenses.
If reported earnings are backed up with steady cash flow from operations, the quality of the earnings may be deemed as high.
A quick litmus test for judging a company’s financial performance:
If sales increased by X%, did profit increase X% as well? Did A/R, inventory and long-term operating assets increase by X%?
For example, suppose inventory jumped by 50%, even though sales revenues increased only 10%. This may result in an overstocking of inventory and lead to write-downs later.