Review – Value Investing: From Graham To Buffett And Beyond

Value Investing: From Graham to Buffett and Beyond

by Bruce Greenwald, Judd Kahn, Paul Sonkin and Michael van Biena, published 2001

Three valuation approaches

In the world of value investing, there are three essential ways to value a business: studying the balance sheet (asset values), studying the income statement (earnings power) or studying the value of growth.

Greenwald and company recommend using each approach contingent upon the type of company being analyzed.

The asset value (balance sheet) approach

The virtue of balance sheet analysis is that it requires little extrapolation and anticipation of future values as the balance sheet ostensibly represents values which exist today. (Note: technically, for balance sheet values to be accurate they must have a meaningful connection to future cash flows and earnings which can be generated from them, but that is beside the present point.) Additionally, the balance sheet is arranged in such a way that the items at the top are items whose present value as stated on the balance sheet is more certain because they are closer to being converted into cash (or requiring immediate cash payment), whereas those toward the bottom are less certain. The implication here is that companies trading closer to the value of net assets nearer to the top of the balance sheet are more likely undervalued than those trading closer to the value of net assets nearer to the bottom of the balance sheet.

Putting these principles into practice, when using the balance sheet method, companies which are not economically viable or are experiencing terminal decline should be valued on a liquidation basis, looking at net current asset values and severely discounting long-term fixed assets (and perhaps completely writing off the accounting value of goodwill and certain intangible items). On the other hand, companies whose viability as going concerns is fairly certain should be valued on a reproduction cost basis when using the balance sheet method, meaning calculating a value for replacing the present assets using current technology and efficiencies.

In an industry with free-entry, a company trading for substantially more than $1 per $1 of asset reproduction costs will invite competition until the market value of that company falls. Similarly, a company trading for substantially less than $1 per $1 of asset reproduction costs will find competitors exiting the industry until the market value of the company rises back to the reproduction cost of the assets. Without barriers to entry which protect the profitability of these assets, the assets are essentially worth reproduction cost as they deserve no earnings power premium.

For these firms, the intrinsic value is the asset value.

The earnings power (income statement) approach

Whereas the asset value approach relies more strongly on present market values, the earnings power valuation approach begins to introduce more estimation of the relationship between present and future earnings, as well as the cost of capital. These are decidedly less certain valuations than the asset value method as they rest on more assumption of future phenomena.

The primary assumptions are that,

  1. current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow, and,
  2. that this earnings level will remain approximately constant into the indefinite future.

Based upon those assumptions, the general equation for calculating earnings power value (EPV) is:

EPV = Adjusted Earnings x 1/R

Where “R” is the current cost of capital.

Earnings adjustments, where necessary, should be made on the following basis:

  1. rectifying accounting misrepresentations; the ratio of average recurring “one-time charges” to unadjusted reported earnings should be used to make a proportional adjustment to current earnings
  2. depreciation and amortization adjustments; reported earnings need to be adjusted by the difference between stated D&A charges and what the firm actually requires to restore its assets at the end of the year to the same level they were at at the beginning of the year
  3. business cycle adjustments; companies in the trough of their business cycle should have an addition to earnings in the amount of the difference between present earnings and average earnings, while companies at the peak of their cycle should have earnings adjusted by the difference between average earnings and present earnings (a negative number)

There is a connection between the EPV of a firm and its competitive position. In consideration of economically viable industries:

  1. EPV < asset reproduction cost; management is not fully utilizing the economic potential of its assets and the solution is for management to change what it’s doing, or for management to be replaced if it refuses to do so or proves incapable of doing so
  2. EPV = asset reproduction cost; this is the norm for firms in industries with no competitive advantage, and the proximity of these two values to one another reinforces our confidence that they have been properly calculated
  3. EPV > asset reproduction cost; this is a sign of an industry with high barriers to entry, with firms inside the barriers earning more on their assets than firms outside of them. For EPV to hold up, the barriers to entry must be sustainable into the indefinite future

The difference between the EPV and the asset value of the firm in question in the third scenario is the value of the franchise of the firm with barriers to entry. In other words, the firm’s intrinsic value should equal the value of its assets plus the value of its franchise.

Similarly, in the second scenario, no premium is granted for the value of growth because with no competitive advantages, growth has no value (the cost of growth will inevitably fully consume all additional earnings power created by growth in an industry characterized by free-entry competition).

The value of growth

The value of growth is the hardest to estimate because it relies the most on assumptions and projections about the future, which is highly uncertain.

Additionally, growth has little value outside the context of competitive advantage. Growing sales typically need to be supported by growing assets: more receivables, more inventory, more plant and equipment. Those assets not offset by greater spontaneous liabilities (accounts payable, etc.) must be funded somehow, through retained earnings, larger borrowings or the sale of additional shares, reducing the amount of distributable cash and therefore lowering the value of the firm.

For firms operating at a competitive disadvantage, growth actually destroys value. Otherwise, growth only creates value within the confines of a competitive advantage. This uncertainty of growth and the competitive context of it leads the value investor to be least willing to pay for it in consideration of the other potential sources of value (assets and EPV).

Notes – Competition Demystified: Chapter 5

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Looking for competitive advantages through industry analysis

One way to approach competitive analysis is by critically examining two key measures of performance:

  • operating margins; most useful when comparing firms within an industry
  • return on invested capital; useful for comparing between industries and within

These ratios are both driven by operating profit so they should track one another; when they do not, changes in how the business is financed may be the cause.

As the authors state,

Though the entries on the income statement are the consequences, not the cause, of the differences in operations, they tell us where to look for explanations of superior performance.

Learning by example: the Wal-Mart (WMT) case study

The explanations for Wal-Mart’s success have been numerous and diverse:

  1. WMT was tough on its vendors
  2. WMT monopolized business in small towns
  3. WMT had superior management and business systems
  4. WMT operated in “cheaper” territories in the Southern US
  5. WMT obtained advantages through regional dominance

Let’s examine these claims in order.

The first explanation fails the sniff test because WMT in fact had a higher Cost of Goods Sold (COGS) than it’s competitors. Additionally, its gross profit margins did not increase as it grew larger, implying it was not getting better and better economies of scale with suppliers by buying in bulk.

And while Wal-Mart did manage to generate additional income from higher prices charged in monopoly markets, this advantage was more than offset by its policy of “everyday low prices” in more diverse markets where WMT did higher volumes.

Technologically, WMT was a buyer of logistics and distribution technologies, not a developer of them. Anything it used, its competitors could use as well. Managerially, WMT appeared to have no advantage when it expanded its retailing into hardware, drug and arts and crafts stores. Why would WMT’s superior management be effective at discount general merchandise retailing but not add additional value in these markets?

The fourth explanation fails because Wal-Mart’s opportunities for expansion in the home markets of the South were not very large. Much of Wal-Mart’s growth and success took place in larger markets outside the South.

Wal-Mart’s secret sauce was regional dominance

Competitive advantages occur in numerous, often complementary ways. In the case of WMT, the initial competitive advantage was centered around a concentrated, regional dominance. Though smaller than its competitor Kmart, by focusing on one local region WMT was able to create a number of other competitive advantages for itself, including local economies of scale, that were not available to its competitor:

  • lower inbound logistics due to density of Wal-Mart stores, distribution facilities and vendor warehouses
  • lower advertising costs due to concentration of stores and customer base in target markets
  • concentrated territories which allowed managers to spend more time visiting stores rather than traveling to and from

Looking at Wal-Mart’s activities within the relevant boundaries in which it competed, it was far larger than its competition.

Eventually, economic law won out and growth took its toll on WMT’s great business,

it was unable to replicate the most significant competitive advantage it enjoyed in these early years: local economies of scale combined with enough customer loyalty to make it difficult for competitors to cut into this base.

WMT’s margins and return on capital both began to fall during the 1980s as it began its aggressive growth into the national market. Until then, WMT enjoyed the absence of established competitors.

What could WMT have done if it wanted to grow but maintain its competitive advantages?

If it had wanted to replicate its early experience, Wal-Mart might have targeted a foreign country that was in the process of economic development but that had not yet attracted much attention from established retailers.

Lessons learned from the WMT case study

The WMT case study leaves several general impressions:

  1. Efficiency always matters
  2. Competitive advantages matter more
  3. Competitive advantages can enhance good management
  4. Competitive advantages need to be defended
Learning by example: the Coors case study

From 1945 to 1985, the brewing industry experienced significant consolidation due to the following factors:

  • demographic trends, as home beer consumption rose at the expense of tavern consumption
  • technological disruption, as the size of an efficient plant grew from 100,000 bbl/y to 5M bbl/y, leaving many smaller brewers in a position where they could not afford to keep up
  • advertising trends, as the advent of television meant national brewers could spread fixed advertising costs over a larger revenue base
  • growth in brands, the market segmentation of which did not lead to growth in consumption but did result in larger advertising burdens for smaller brewers
The organization of Coors business

Coors’ business operations were characterized by a few fundamental structures:

  1. vertical integration, Coors produced its own strain of barley, designed its own cans, had its own bottle supplier and even had its own source of water, none of which produced a meaningful cost advantage
  2. operated a single brewery, which required it to transport all its product to national markets at great cost rather than producing within each market and shortening transportation routes
  3. non-pasteurization, which led to shorter shelf life than its rivals, adding to spoilage costs
  4. a celebrity aura, which, like most product differentiation strategies, did not result in a meaningful premium charged for a barrel of Coors compared to its rivals
For Coors, geographic expansion brought with it higher costs and reduced competitive advantage as these business organization decisions interacted with the wider distribution network in unforeseen ways:
  • longer shipping distances from the central plant in Golden, CO, resulted in higher costs that could not be passed on to consumers
  • the smaller share of new local markets it expanded to meant it had to work with weaker wholesalers
  • higher marketing expenses were incurred as Coors tried to establish itself in new markets and then keep up with the efforts of AB and Miller
The net result was that Coors was “spending more to accomplish less.”

Why Coors expansion was so costly

First, although Anheuscher-Busch, the dominant firm in the brewing industry, spent almost three times as much in total on advertising compared to Coors, it spent $4/bbl less due an economy of scale derived from larger total beer output.

Second, Coors experienced higher distribution costs because distribution has a fixed regional component which allows firms with a larger local share of the market to drive shorter truck routes and utilize warehouse space more intensively.

Third, advertising costs are fixed on a regional basis. Again, the larger your share of the market in a given region, the lower your advertising costs per unit. Coors never held substantial market share in any of the national markets it expanded into.

If Coors had “gone local” (or rather, stayed local), all of its competitive disadvantages could’ve been turned into competitive advantages. Advertising expenses would’ve been concentrated on dominant markets instead of being spread across the country. Freight costs would’ve been considerably lower as it would not have been transporting product so many thousands of miles away from its central plant. With a larger share of the market it could’ve used stronger wholesalers who might have been willing to carry Coors exclusively because it was so popular in local markets.

Additionally, Coors sold its beer for less in its home regions, allowing it to win customers from its competitors by lowering prices, offering promotions and advertising more heavily. Expansion, when and if it occurred, should’ve worked from the periphery outward.

The Internet and competitive advantages

Greenwald and Kahn are skeptical of the virtues of combining the Internet with traditional competitive advantages:

The main sources of competitive advantages are customer captivity, production advantages and economies of scale, especially on a local level. None of them is readily compatible with Internet commerce, except in special circumstances. [emphasis added]

With the Internet,

competition is a click away,

and furthermore,

economies of scale entail substantial fixed costs that can then be spread over a large customer base

a state of affairs which often doesn’t exist with virtual, e-businesses.

The Internet is great for customers, but its value to businesses as a promoter of profits is questionable. The Internet doesn’t provide a strong barrier to entry because it is relatively inexpensive to set up an e-commerce subsidiary. Additionally, there are no easily discernible local boundaries to limit the territory  in which a firm competes which is another essential element of the economies of scale advantage.

In other words,

the information superhighway provided myriad on-ramps for anyone who wanted access.

Questions from the reading

  1. Greenwald and Kahn argue that management time is the scarcest resource any company has. Is this true? Why can’t companies solve this simply by hiring more managers and increasing the manager-employee ratio?
  2. In the case study with WMT, why couldn’t Kmart at least match WMT’s efforts in establishing critical infrastructure organization and technology and compete on that basis?
  3. What were the sources of WMT’s customer loyalty?
  4. Which publicly-listed firms have regional dominance as a specific strategy they follow? Do these companies’ financial performance seem to suggest they derive a competitive advantage from this strategy?
  5. In the case study with Coors, what were the industry conditions in beer brewing that made national competition more efficient than local competition?
  6. Standard Oil, another producer and distributor of “valuable liquids” was vertically integrated. Why was vertical integration beneficial in the oil industry but not in the brewing industry for Coors?

Review – The Predator’s Ball: The Inside Story Of Drexel Burnham And The Rise Of The Junk Bond Raiders

The Predator’s Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders

by Connie Bruck, published 1988

This review is going to be brief because, full disclosure, I’ve only read (as of this writing) 180 pages of this book. And honestly, that might be about all I’ll end up reading. Here’s why:

There are great Wall Street/business biography books (The First Tycoon by TJ Stiles, for example, which I will write a review of when I eventually re-read), good Wall Street/business biography books (much of what Michael Lewis has written qualifies, even though I find the author as a person to be a bit nauseating) and bad Wall Street/business biography books, a category of which Connie Bruck’s effort is a member.

Great books in this genre are exciting to read, they’re deeply researched and place major developments and character traits into a meaningful context and they leave the reader feeling like he’s gained some knowledge which is general and timeless in nature. The good books largely accomplish the same but a little less efficiently and with a little less objectivity, the author coming across as being taken by his subject matter.

The bad books offer none of the benefits (historical context, depth of mechanical understanding, deconstruction of character) and come chock full of pointless and irrelevant trivia– lots of dates, tons of deal size data and a mountain of dropped names. The writing is sycophantic and lap-dogish, the tone is that of a hyperkinetic cheerleader and the message is one of ignorant, drooling, envious amazement.

“The Predator’s Ball” is hard to read because it seems like it was hard for Bruck to write. She flings a lot of facts and figures at you but you never get the sense she understands the qualitative significance of any of it. The book is too self-conscious and self-aware– whereas in a Michael Lewis book you can easily lose yourself in the story and feel as though you’re a fly on the wall watching everything happen, Bruck’s book comes across as a series of poorly stitched together self-referential interviews where the illusion and pacing are constantly broken by the author willingly neglecting her editorial duty and allowing herself to be used as a mouthpiece by her interviewee.

And it gets worse.

Bruck spends page after page gushing about the… gushers… of money that were pouring forth on Wall Street during the junk bond-backed buyout boom of the early 80s. But in 180 pages she has yet to stop and ask herself (and then answer) where in the hell all this money is coming from? And the book is purposefully about Michael Milken and his comrades but she makes it seem like they were the only players in the entire world of finance doing any of this stuff when more likely they had competitors not only in the US but around the world. There’s no consideration of monetary policy and little discussion of the regulatory climate. It’s like this drama is unfolding in a vacuum.

It’s not only confusing but so arbitrary as to seem pointless.

By Connie Bruck’s telling, Wall Street drama is a lot like the drama of high school social politics. The book speaks of many parties, hangouts (meetings), liaisons and shenanigans and tries to convince the reader that he should care what all these “popular” kids are doing. It’s all supposed to be extremely interesting, who slept with who, who did a deal with who and for how much and how mad it made someone else. You keep turning the page under the assumption it’s all going to add up to something, that the story is going somewhere and the meaning of all of these interactions will be summarized and revealed.

It never does. That’s when you might feel compelled, as I was, to set the book down in frustration and walk away.

I bought the book because I wanted to understand the LBO world– who were the players, how did it work, why did it happen when it did and what were the major lessons? I highlighted a few things, but mostly I just want my money back.

Notes – Competition Demystified: Chapter 4

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Putting it all together (so far)

All business analyses should begin with a study of competitive advantage by exploring the following, in order:

  1. identify the competitive landscape; which markets? who are the competitors?
  2. test for existence of competitive advantages; stable market shares? exceptional profits for extended periods of time?
  3. identify the likely nature of competitive advantages; supply, demand, economies of scale, regulatory hurdles?

Carrying out the analysis

Start by identifying the market segments that make up the industry as a whole and make a list of the leading competitors in each one, by market share. This is an organizational tool to study the breadth and depth of a competitive market place where the target firm’s role can be placed within.

Then, look for signs of existing competitive advantages by observing the stability of incumbent market shares and the profitability of firms within the market segments.

The more movement in and out, the more turbulent the ranking of the companies that remain, and the longer the list of competitors, the less likely it is that there are barriers and competitive advantages.

Quantitatively,

if you can’t count the top firms in an industry on the fingers of one hand, the chances are good that there are no barriers to entry.

And,

if over a five- to eight-year period, the average absolute [market] share change exceeds 5 percentage points, there are no barriers to entry; if the share change is 2 percentage points or less, the barriers are formidable.

Profitability across an industry is best measured by the use of return on equity (ROE) or return on invested capital (ROIC). As a broad rule of thumb:

After-tax returns on invested capital averaging more than 15 to 25 percent — which would equate to 23 to 38 percent pretax return with tax rates of 35percent — over a decade or more are clear evidence of the presence of competitive advantages. A return on capital in the range of 6-8 percent after tax generally indicates their absence.

Utilize the principle of Occam’s Razor in your industry analysis, keeping things simple until there is a clear need to make them more complex.

Questions from the reading

  1. In the case study in the book, Apple (AAPL) seemed to have spread itself thin by trying to compete in multiple computer industry market segments where it had no clear competitive advantage. Eventually, Apple abandoned manufacturing its own chips and adopted the industry-standard hardware while focusing its efforts on smaller niche markets that had no clear incumbent (including new market segments it created, such as the tablet computer market). Was this the brilliant strategic move responsible for Apple’s current success, or was it something else entirely? Does Apple actually have a clear, sustainable competitive advantage?
  2. A lot of Greenwaldian strategic analysis seems dependent on the observation of historical trends in profitability and market share to arrive at conclusions about the existence of competitive advantage. Is there a way to predict and identify competitive advantage in a new or immature industry without the benefit of historical hindsight?

[amazon asin=1591841801&template=iframe image2]

Notes – Competition Demystified: Chapter 3

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Economies of scale depend on market share

Economies of scale are a competitive advantage that work most effectively in combination with another advantage such as customer captivity.

With some degree of customer captivity, the entrants never catch up and stay permanently on the wrong side of the economies of scale differential.

In general, smaller markets (in terms of geography or product space) present easier realms to obtain a competitive advantage, even with regards to economies of scale. As a market grows in absolute size, it becomes easier and easier for competitors to obtain their own economies of scale and erode the incumbent firms advantages in terms of fixed costs.

By keeping a competitive market small, the incumbent firm can outspend entrants in absolute dollars even if each firm spends the same proportion of revenues on things like R&D, advertising, marketing, distribution, etc.

Erosion in market share are the greatest threat to a firm with competitive advantages derived from economies of scale because as market share falls, the proportion of total costs which are fixed rises and thereby defeats the cost advantage of economies of scale.

Maintaining market share through customer captivity is critical

Customer captivity can be enhanced a number of ways:

  • habit – make purchases more frequent and spread their cost out over time to create a relationship that is easier to continue than replace; encourage repeated, nearly automatic purchases that don’t allow time for critical consideration of alternatives
  • switching costs – extend and deepen the range of services offered, thereby increasing the opportunity cost of switching to a competitor
  • search costs – integration of multiple features into one pricing plan complicates comparison shopping and increases risk of picking a half-effective service or product
The strategy of economies of scale

Economies of scale…

  1. tend to be the longest lived of the three major types of competitive advantage
  2. are vulnerable to gradual erosion and therefore must be defended vigorously
Establishing dominance in a local market and then expanding outward gradually from that hub is the best strategy for firms relying on EoS. Small, local markets only have room for a few competitors, at most, meaning the firm that gains dominance will also gain EoS (if possible) while preventing the competitor from obtaining that same advantage.

Markets grow rapidly because they attract many new customers, who are by definition non-captive. They may provide a base of viable scale for new entrants.

Both incumbents and entrants should focus on niche markets, characterized by:

  • customer captivity
  • small size relative to the level of fixed costs
  • absence of vigilant, dominant competitors
  • readily extendable at the edges
Ultimately, the more variable costs can be shifted to fixed costs, the stronger will be the competitive advantage from EoS.

Remember:

Competitive advantages are invariably market-specific. They do not travel to meet the aspirations of growth-obsessed CEOs.

Questions from the reading

  1. The authors mention an example of Aetna vs. Oxford in the metropolitan insurance market. They argue that because medical service is a local market, Aetna’s national network confers no economies of scale advantage because Oxford has a larger market share of in-network medical providers in specific local markets, such as NYC (60% of market vs. 20%). But part of Aetna’s cost advantages come from general administrative overhead, where EoS at the national level become important. How do you weigh the value of EoS in adminstrative/overhead costs at the corporate level against specific EoS in supply/inventory costs at the local level?
  2. Suggested case study– In 2006, Nintendo (NTDOY) introduced their  Wii home video game console as a part of their effort to achieve the corporate goal of “Gaming Population Expansion“. However, this is a goal with strategic implications as well as tactical ones because it serves to broaden the total market for NTDOY as well as competitors’ (MSFT, SNE) products and thereby changes the way NTDOY competes in that market. Considering the lessons of Chapter 3, how would you judge NTDOY’s strategy? Is this a brilliant way to create a new market niche (casual gamers) that have traditionally been ignored and underserved by the market that NTDOY can profitably keep to itself? Or will this decision result in a growing market that invites new entrants while eroding any advantages NTDOY may have had as a result of EoS? Additionally, NTDOY has been criticized for ignoring the massive, wildly profitable “hardcore gamer” market. Would you criticize NTDOY for this decision? Would you recommend they attempt to make inroads? What broad strategic recommendations might you make to NTDOY with regards to maximizing competitive advantages related to EoS and customer captivity?

Notes – Competition Demystified: Chapter 2

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Differentiation is not a competitive advantage

The tired old story that many companies tell their investors (and many managers tell themselves) is that they can avoid the commoditization of their product through “differentiation”. Convince your customers that your limestone is not generic limestone but “Jeff’s Best limestone”, for instance, and they’re sure to pay a premium price!

The trouble with this strategy is not the gullibility of the consumer, but the mutual ability of the competitor to adopt it for himself.

The reality of the competitive market is that high profits attract competition and without real, sustainable barriers to entry, high profits will be eroded by market fragmentation and declining margins. Product differentiation may allow a firm to charge a “premium” for their product, but it will not protect their market share and as market share falls, the effects of fixed-costs on margins will rise.

Firms producing differentiated goods and services will still face the economics of commodity markets, namely, if they can not produce at a cost at or below the price established in the market, they will fail. This is because differentiated products require additional investments in advertising, marketing, sales and service, product distribution, etc., to make the differentiated claims credible, and these higher costs ultimately lower returns.

Barriers to entry = competitive advantages

As the authors note,

Systems can be replicated, talent hired away, managerial quality upgraded

The only way to obtain real, sustainable competitive advantages is through barriers to entry: obstacles and costs that competitors can not overcome or do not have the resources to cover. These barriers to entry apply only to incumbents, as entrant competitive advantages are essentially available to everyone and therefore are available to no one in the long run, being of limited and transitory value (once you establish yourself in a market, you’re now and incumbent and have lost your competitive advantage).

There are three basic, authentic types of competitive advantage:

  1. supply advantages
  2. demand advantages
  3. a combination of the two

The authors specifically note that,

Measured by potency and durability, production advantages are the weakest barrier to entry; economies of scale, when combined with some customer captivity, are the strongest.

Supply advantages

Supply advantages essentially translate to lower cost structures, which provides the firm with two benefits:

  1. higher profitability through wider margins
  2. ability to strategically lower prices to resist potential entrants or other competitors while maintaining profitability

These lower cost structures normally come from:

  1. lower input costs (special access to a supply that can’t be replicated by the competition at the same cost)
  2. economies of scale
  3. proprietary technology, normally protected by patents/intellectual property laws (any government grant of monopoly would similarly apply as it has the same effect)

Rapid technological change in supply methods can create entrant advantages as pre-existing incumbents find their out-dated technology confers a cost dis-advantage. Conversely, as the pace of technological change in an industry slows, any incumbent advantage due to technological advances can be eroded as rival firms acquire learned efficiencies of their own.

Many strategic analysts cite the role of “innovation” in imbuing certain firms with competitive advantages but these advantages are only sustainable if these innovations can’t be learned, “stolen” or otherwise acquired by competitors over time. In other words,

Innovations that are common to all confer competitive advantages on none.

Meanwhile, privileged access to raw materials is normally only useful in markets which are local in terms of geography or product space.

Demand advantages

Access to customers that rivals can not match translate to demand advantages. Customer captivity is a result of one of three dynamics:

  1. habit – typically applies to one product, not a firm’s portfolio of products, and is a result of frequent and automatic purchases
  2. switching costs – reinforced by network effects, ie, selecting a technology system that becomes common and popular economy-wide
  3. search costs – common when products or services are complex, customized and crucial
Demand side advantages are typically more durable. However, because they rely on the customer for their power they’re susceptible to customers moving, growing old (developing new preferences and needs) and dying. New customers entering the market are uncommitted and can potentially be captured by anyone.

The strongest possible demand advantage, then, would be one which generates an intergenerational transfer of habit.

Questions from the reading

  1. The authors state on pg. 31 that United’s advantageous geographical position at Chicago O’Hare can not be extended to other airports; is this true? Why or why not? Ultimately, what is the source for United’s supply advantage at Chicago O’Hare?
  2. Many of the supply advantages stem from government interference in the market through patent, copyright and other “intellectual property” laws. How might the strategic/competitive landscape change in a “free intellectual market”?

Notes – Competition Demystified: Preface, Chapter 1

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn.

What is strategy?

Strategy is the art of making business decisions with respect to the actions and responses of competitors. Strategy revolves around creating, protecting and exploiting competitive advantages.

Strategy and competitive advantage go hand in hand; where there is no possibility to develop a competitive advantage, there can be no strategic decisions. Markets where competitors have similar access to customers, technology and other cost advantages are not strategic but tactical markets where the only strategy possible is to outrun the competition through operational efficiency– most competitors will be about the same size and none will manage to make or maintain an outsize profit margin as the lack of competitive advantages will drive economic profits toward average cost.

What are the differences between strategy and tactics?

The easiest way to think about the difference between strategy and tactics is to understand that strategic decisions are focused on competitors, while tactical decisions are focused on operations. In other words, strategy is external, tactics are internal in nature.

This helpful table from Competition Demystified may also convey the differences:

  • Strategic Decisions
    • Management level –> top management, board of directors
    • Resources –> corporate
    • Time frame –> long-term
    • Risk –> success or survival
    • Questions: “What business do we want to be in?”, “What critical competencies must we develop?”, “How are we going to deal with competitors?”
  • Tactical Decisions
    • Management level –> midlevel, functional, local
    • Resources –> divisional, departmental
    • Time frame –> yearly, quarterly, monthly
    • Risk –> limited
    • Questions: “How do we improve delivery times?”, “How big a promotional discount do we offer?”, “What is the best career path for our sales representatives?”

Additionally, there are two major strategic issues every business faces:

  1. the arena of competition – which external characters will affect the firm’s economic future?
  2. the management of competition – how do you anticipate and, if possible, control, the actions of these external agents?

Porter’s “Five Forces” and the Greenwald/Kahn “One Ring” that binds them

Michael Porter, author of [amazon text=Competitive Strategy&asin=0684841487] (1980), identified “Five Forces” critical to the competitive environment:

  • Substitutes
  • Suppliers
  • Potential Entrants
  • Buyers
  • Competitors Within the Industry

Greenwald and Kahn focus on one as being the dominant force, potential entrants, specifically from the viewpoint of barriers to entry.

Either the existing firms within the market are protected by barriers to entry (or to expansion), or they are not.

Barriers to entry are critical for maintaining stable businesses and above average profit margins as without them the market will be flooded with competitors whose existence serves to drive down average industry profitability.

As more firms enter, demand is fragmented among them. Costs per unit rise as fixed costs are spread over fewer units sold, prices fall, and the high profits that attracted the new entrants disappear.

The end result is all firms are placed on the operational efficiency treadmill where no firm ever reaches the goal of above average profitability and everyone must run as fast as they can simply to stay in place.

Operational effectiveness might be thought of as a strategy, indeed, as the only strategy appropriate in markets without barriers to entry.

How to conduct a strategic analysis

Ask yourself, in the market in which the firm currently competes or is considering an entrance:

  1. do any competitive advantages exist? And, if so,
  2. what kind of advantages are they?

Exploring competitive advantage

There are only three types of genuine competitive advantage:

  1. supply – a company can produce or deliver its products or services more cheaply than competitors
  2. demand – a company has access to market demand that competitors can not match, usually based upon…
    1. habit
    2. switching costs
    3. search costs
  3. economies of scale – an incumbent firm operating at large scale will enjoy lower costs than its competitors

Companies which manage to grow yet maintain profitability usually achieve this one of three ways:

  • replicate their local advantage in multiple markets
  • continue to focus on their product space as that space becomes larger
  • gradually expand their activities outward from the edges of their dominant market position

Elephants versus ants

Markets which offer competitive advantages are typically characterized by one or two large firms which possess the competitive advantage, elephants, and several smaller, less profitable “competitors”, the ants.

A firm which finds itself in a market where it is the ant should consider getting out of the market as painlessly as possible. A firm which is considering entering a market where an elephant already resides should reconsider the decision as the only real hope for competing in that market is if the elephant creates an opportunity by making a mistake.

With a competitive advantage in place, an elephant can enjoy the outsized profits of his competitive position. Still, developing strategic awareness about its competitive advantages will allow it to:

  • reinforce and protect existing advantages
  • identify areas of growth (geographic and product line-related) that are likely to yield high returns
  • develop policies that extract maximum profitability from the firm’s competitive circumstances
  • identify threats that are likely to develop
Strategic planning

In other words, strategic planning concerns itself with the different areas of business decision-making that competitors can respond to, such as:

  • pricing policies
  • new product lines
  • geographic expansions
  • capacity additions

Questions from the reading

  1. With regards to the elephant vs. ant paradigm, why do ants exist at all, that is, why don’t more firms exit markets where they are ants?
  2. What are common ways in which elephants misstep and allow competition from the ants?

Review – F Wall Street

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
And according to author Joe Ponzio, who started his career working at several of these brokerages and mutual funds, you’d be correct to think that the whole system functions like a racket:
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.

Review – The Conscious Investor

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.

Lesson learned!

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:

  1. How much money came in over the reporting period and where did it come from?
  2. What was it used for?
  3. How much money did the company manage to keep?
If time is limited, reading the Management’s Discussion & Analysis (MD&A) section of company filings is critical, and the aim is “to answer the question whether the management is honest, rational and acting in the best interests of shareholders.”

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:

  1. Cash provided by operations which are positive and trending upward
  2. Cash flows from operations are more than sufficient to cover cash used for investing (CFO > CAPEX)
Share buybacks must be done intelligently if they are to create value.
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:

  1. Know the history of the P/E ratio
  2. Do not buy unless the P/E ratio is toward the lower end of its historical range
  3. Compare the P/E ratio with the P/E ratios of competitors
  4. Compare the P/E ratio with the average P/E ratio for the same sector or overall market
  5. Be wary about buying when the P/E ratio is high
  6. Look at the earnings yield, which suggests a minimum return that can be anticipated if earnings remain steady, with anything more caused by growth in earnings

“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?”

Review – How To Read A Financial Report

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.

Depreciation Expense

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:

  • accumulated vacation and sick leave pay owed
  • partial-month telephone and electricity costs incurred but not billed
  • property taxes charged to the year, but not billed
  • warranty and guarantee work on products sold in the year, so future expenses related to current sales are matched in the present period

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:

  • A/R – an increase hurts CFO; extending customers credit uses cash
  • Inventory – an increase hurts CFO; buying inventory uses cash
  • Prepaid expenses – an increase hurts CFO; paying for expenses uses cash
  • Depreciation – an increase helps CFO; depreciation is a non-cash expense
  • A/P – an increase helps CFO; using credit from suppliers frees up cash
  • Accrued A/P – an increase helps CFO; delaying the payment of accrued expenses conserves cash
  • Income Tax Payable – an increase helps CFO; not paying the full tax burden conserves cash

Summary for the seven cash flow adjustments:

  • Increases in operating assets cause decreases in cash flow from operations; decreases in operating assets cause increases in cash flow from operations.
  • Increases in operating liabilities help cash flow from operations; decreases in operating liabilities result in decreases in cash flow from operations.

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:

  • depreciation and other noncash expenses and losses
  • changes in operating assets
  • changes in operating liabilities
Growth should be good for profit next year, but growth almost always puts a dent in cash flow for the year.

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.