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.

Personal Dilemmas Of The Immoral Economy

The WSJ.com has just posted an article, “Buy, Sell, Fret: Retail Traders Swing Into Action“, that is ripe for commentary from the twin perspectives of value investing and Austrian economics. With any luck, we may even venture into the philosophic territory by the end of this episode. Let’s get started:

In a throwback to the day-trading era, the market’s stomach-churning gyrations are creating a new class of stock obsessives hanging on every dip and rebound.

Average investors are scrambling to stay ahead of the massive swings—often via mobile devices like iPads and smart-phones, leading to sharp spikes in trading volumes at many brokerages.

“I am distracted and frankly unnerved,” says Andy Lavin, a public-relations executive in Port Washington, N.Y., who manages about $800,000 of his own money.

Mr. Lavin says he has been checking his iPad regularly during meetings and on his way to work. On Monday, he bought $15,000 in futures on the Chicago Board Options Exchange Volatility Index. After President Barack Obama addressed the decision by Standard & Poor’s to downgrade long-term U.S. debt, Mr. Lavin dashed to monitor the market reaction.

“If you look away for a second, you lose,” Mr. Lavin says.

One of the themes I’d like to explore here is perception versus reality. For example, Mr. Lavin’s perception is that it is his inability to keep up with the markets, tick by tick, that expose him to potential ruination. The reality is that it is his decision to split his attention and capabilities between his professional job and daytrading which exposes him to ruination.

As a value investor, daytrading is obviously an intellectually bankrupt strategy detached from an understanding of fundamental reality because the economic value of companies do not change as often, rapidly or dramatically as their security prices might. So, anyone who becomes obsessive about the frequent changing of security prices without any regard to the underlying economic value of the company the securities belong to is engaging in a speculative gamble, not trying to keep up with an investment portfolio. Daytrading while at work is as absurd as playing online poker at work, or visiting a virtual blackjack table on your iPad while sitting in a meeting. The illusion (delusion?) of control is precisely the same, as is the inappropriateness of the simultaneity.

As an Austrian economist, this appears to be an outstanding example of some of the many unintended consequences of Federal Reserve monetary policies as well as federal government interventionist policies.

In terms of monetary policy, Ben Bernanke’s reckless inflationary mandate creates new malinvestment in the economy by distorting entrepreneurs’ and other economic actors’ view of the true supply of savings in the economy. Interest rates are driven down below their free market equilibrium levels providing the illusion of wealth that doesn’t actually exist. Entrepreneurs (and daytraders are entrepreneurs, though they’re a variety more ephemeral than a butterfly) usually end up in grossly speculative activities because with the new supply of money in their hands and the lowered cost of borrowing at their backs it pays to do so, or so they think.

Similarly we can see the broad effects of an interventionist, regulatory political framework. Such a superstructure creates so many obstacles and added costs for “normal” economic activity that the productively-eager are pushed into enterprises with the lowest cost of entry and the least number of hoops to jump through before one can nominally start making money. Does it get any easier than opening up an electronic brokerage account and ACHing a large deposit?

At the nexus of these two philosophies, economics and investing, we see another tragedy unfolding– where is the comparative advantage (economist) or the analytical edge (investor) in a public relations professional-turned-daytrader? Why has this man, who appears to be quite successful at his chosen career given the size of his gambling stake — I mean, accumulated personal savings — which amounts to $800,000, investing this money on his own in the financial markets?

Why isn’t he putting that $800,000 of capital to work in his own business, where he seems to be demonstrating an ability to earn outsize returns on capital? Assuming this individual is reasonable and not merely gambling, what might this say about the condition of the economy as a whole that he has not chosen this seemingly obvious alternative?

Continuing:

The high-stakes drama is also making once-calm investors jittery. Richard Chaifetz, chief executive of Chicago-based ComPsych Corp., which provides mental-health counseling for 13,000 companies, says his firm has seen a 15% increase in calls from stressed out employees who are watching the stock markets from their desks.

This is another unintended consequence of inflationary monetary policies and, as a certain French economist of the 19th century might say, “that which is unseen”.

The Federal Reserve and its army of statisticians can only (attempt to) calculate that which is priced in units of money. But that which is not priced in money (until it ends up as a psychotherapist or pharmaceutical bill, anyway) can not be calculated.

What kind of effect on national productivity must this be having with so many people so distracted and made anxious by volatility in the financial markets?

Even some 401(k) investors are getting more active. Before this week, Ryan Jones rarely monitored his investment accounts. Now the 30-year old advertising strategist checks his phone several times a day for market reports and devotes his lunch time to rejiggering his portfolio.

“I’m just a regular guy who started the month with a 401(K) balance, and am trying to make sure it’s still there next month,” he says.

I look at quotes like the one above as proof positive that the 401(K) is not as good a tax-reduced deal as it is marketed as, and especially not for all the “regular guys” trying to manage them on their own with limited allocation options, to boot.

There’s just no way for these people to manage their money intelligently in a 401(K). And yet again, it transforms every saver into a part-time stock analyst and investor. This is not where the average person’s comparative advantage is located. Seeing how widespread the 401(K)-miracle wealth thesis is, I’d even call it something of a mania. Rather than taking their savings and investing in something local, tangible and familiar, many people have learned to wish upon a stock market star, cast their savings into a 401(K) like a penny into a fountain and then attempt to patiently wait the duration of their professional career until they can all cash out easy millionaires and retire to Florida or wherever.

But for that reality to become a reality, someone has to do a lot of work in the meantime because, contrary to what people might’ve thought [amazon text=George S. Clayson was adovcating in his book&asin=1897384343], the money doesn’t multiply itself unaided. Do people really believe that they can unintelligently, haphazardly and especially as in present times, anxiously invest their money in the stock markets and thereby wind up rich by retirement?

Another confused “investor”:

Andrew Schrage, a 24-year-old website editor, shifted the allocations in his $50,000 portfolio, away from equities and further into bonds, selling some of his technology stocks on Tuesday after announcements by the Federal Reserve that the central bank planed to keep interest rates near zero.

Mr. Schrage, who lives in Chicago, says he is planning to plow the money back into stocks, but is waiting for the right opportunity.

“This volatility has forced me to adopt a day-trading mentality,” Mr. Schrage says.

Wrong. The volatility hasn’t forced you to do anything, Mr. Schrage. It is your adoption of the fallacious belief that volatility is risk that has forced you into an uncomfortable position where you suddenly find yourself daytrading to try to avoid it.

The language of this article is curious. This 24-year-old website editor has $50,000 of capital in a financial market portfolio. Does he have $50,000 of capital in his website business? It almost sounds like he is a 24-year-old financial trader, who does some website editing on the side.

I don’t mean to heap scorn on age but it is fascinating that this young man has managed, in only 24 years on this earth so far, to not only find time to educate himself on how to edit websites but also on how to watch the Fed and trade accordingly. And this is, yet again, demonstration of the principle that this activity is pseudo-economic. It is not connected to real economic activity and any derivatives thereof but rather is driven by the moves and anticipation of moves by the central bank.

This is a centrally-planned economy, with centrally-planned financial markets. The trouble for most people is that the central planning aspect is too subtle for them to notice, being obscured under numerous layers of propagandistic “this is free market capitalism” rhetoric.

Nearly finished:

Dan Nainan, a 30-year-old comedian, spent Tuesday in his New York office fixated by the market fluctuations, refreshing the screen on his online brokerage account every couple of minutes throughout the day. About a half-hour before the close of trading, Mr. Nanian sold $120,000 worth of his Apple stock. “I felt a tremendous sense of relief,” he says, “and I’m not buying again.”

In a choppy market like this one, a single lunch meeting or conference call that results in missed trading opportunities can translate into thousands of dollars in losses. Andrew Clark, a 30-year old, real-estate consultant in Birmingham, Ala., sold about half of his Apple Inc. stock on Monday morning after it opened 3.2% down. During a client meeting, he missed a brief rally when the stock went up 1.7%.

“I would have bought those back at that point,” Mr. Clark says. “If you aren’t glued to these movements, you miss so much.”

What other times and places have seen 30-year-old comedians with $120,000+ stock portfolios? These are interesting and unusual times.

Andrew Clark’s comment is instructive because he believes he knows what he has missed when he really hasn’t got a clue. He’s missed Ben Graham. He’s missed out on observing the impact of frequent trading commissions on his bottom line. He’s missed out on the fact that his whole investment strategy revolves, admittedly, around the sure-fire failure of selling low and buying high.

Millions of people like this are born in every generation. They have no way to learn their lessons except by experience. Even then, if their experiences aren’t severe and near-death enough, they’re prone to forget them. They drift idly around during their blissfully ignorant existences like gnats above the highway. If the macroeconomic conditions are just right and they’re presented with the opportunity, they’ll launch themselves straight into the windshield of a market panic and spend the rest of the cruise down the motorway of life wondering how they got there and bemoaning the loss of their more innocent days.

These are people who would probably do just fine managing their personal affairs in more humble, honest economic settings. That’s part of the true villainy of the Bernanke-ite economy, to tempt all these people with fleeting prosperity at the risk of utter ruin, and to do it all at the point of a gun.

After all, who would play these games and take this farcical economic structure seriously if they were free to leave at any time without threat of going to jail, or worse?

Here we arrive at the moral, and the conclusion.