Notes – A Compilation Of Ideas On Investing

How to Screen for Hidden Champions

  • If I could recommend only one book for value investors to read it would be Hidden Champions of the Twenty-First Century
  • Reading about Exxon Mobil (XOM) and Apple (AAPL) and Starbucks (SBUX) and thinking you are becoming a business expert is like reading about blue whales and elephants and thinking you are becoming an animal expert. Tiny insects are a lot more common than giant mammals
  • Screening for Hidden Champions:
    • 10 years consistent >= 15% op margin and market cap < $1B
    • 10 years consistent >= 15% ROE and market cap < $1B
    • 10 years consistent >= 8% ROA and market cap <$1B
    • 10 years consistent EPS increase and market cap < $1B
  • If an ultra-conservatively managed family company earns 10% on equity it would probably earn closer to 20% on equity if it was sold to a professionally managed multinational
  • Some companies have negative equity, to correct for this, screen for >= 8% ROA regardless of ROE
  • The best place to screen for hidden champions in the UK is SharelockHolmes

Backtesting Net-Nets: Does It Matter?

  • Net-nets are a symptom of the overall stock market’s health
  • You should ignore a net-net for two years after you buy it, at minimum
  • The key to a successful NCAV portfolio is to not sell your winners too fast
  • If a stock has low institutional ownership, low short interest, no analyst coverage, and a small number of shares outstanding – nobody is looking at the company; buy net-nets where institutions own the fewest shares
  • Inactivity is necessary to really judge your net-net selection skills
  • If you are just taking a profit (or loss) in a net-net within 1 to 2 years of buying it – I think you’ve basically just traded a stock on a different basis than you analyzed it
  • A good net-net is really just a decent business. Why would insiders still control 10% to 50% of a company that has been public for 10 to 30 years?
  • Try to buy the “best” net-net available each month with an emphasis on “safe” rather than “cheap”
  • Attractive net-net criteria:
    • Long history of consistent profitability
    • Long tenured CEO
    • High insider ownership
    • Low leverage
    • High cash relative to share price
    • Good capital allocation decisions
    • Simple business
    • Good business
    • Lasting business
  • Ideally, you don’t want to pay more than the company’s own cash for the stock
  • High insider ownership in a newly public company doesn’t have the same meaning as it does at an old company
  • Dividends are nice, not because they’re important but because of what dividends are a symptom of
  • Retailers are tough net-nets; a retailer that loses some of its competitiveness is a retailer that could be out of business in a matter of years
  • How to sabotage a NCAV portfolio: sell too soon; if you sell your winners when they go up, you destroy the performance of a net-net; the big winners are needed to outweigh the big losers and the mediocre performers
  • The holding of net-nets is critical
  • Slowly assemble a net-net portfolio over a period of a couple years, and don’t sell anything for those first two years

Should You Wait for a Crash – Or Buy Today’s Best Bargain?

  • To get consistently good investment results, follow one of two programs:
    • Buy companies that are clearly selling for less than their conservatively calculated value to a private owner
    • Buy companies that will earn high returns on capital while growing quickly for many, many, many years to come
  • During periods of panic, look for obvious mispricings; for example, high quality companies trading at less than 10x FCF; 10x free cash flow is less than stocks are generally worth
  • To fill a portfolio in the midst of a market crash, have a shopping list of companies you like but are overpriced ahead of time
  • You are very unlikely to cause any sort of catastrophic problem for yourself just by overpaying for the right kind of company. Buying the wrong company is your biggest risk
  • Just wait for an obviously wonderful business selling for the kind of price a normal stock sells for in normal times

Warren Buffett Checklist to Invest in a Great Business: KO

  • Buffett had 9 criteria he examined when determining whether he was investing in a great business:
    • Does the business have an identifiable consumer monopoly?
    • Are the earnings of the company strong and showing an upward trend?
    • Is the company conservatively financed?
    • Does the business consistently earn a high rate of return on shareholders’ equity?
    • Does the business get to retain its earnings?
    • How much does the business have to spend on maintaining current operations?
    • Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?
    • Is the company free to adjust prices to inflation?
    • Will the value added by retained earnings increase the market value of the company?

Free Cash Flow: Adjusting for Acquisitions, Capital Allocation and Corporate Character

  • Make your Ben Graham investments on an EV/EBIT basis
  • Make your Warren Buffett investments on a price-to-free-cash-flow (P/FCF or P/OE) basis

How to Read a 10-K: What is the Most Important Part?

  • The only 10-K I read from cover to cover is the most recent 10-K
  • Print out and mark up a hard copy of the latest 10-K, 10-Q, and 14A
  • Check all of the 8-Ks and 13Gs from the last year or so
  • If there was a scandal, a proxy battle, legal case, unconsummated merger, etc. – read the 8-Ks and other documents surrounding that time period even if it was many years ago
  • Read the oldest 10-K as well as the newest
  • Read any shareholder letters ever written that are still available
  • Enter Balance Sheet, Cash Flow and Income Statement data into an Excel spreadsheet for every year the company reported to EDGAR
  • Always have at least 10 years of data
  • Look at the notes to the financial statements most critically
  • Ask yourself the following questions:
    • What is customer behavior in the industry?
    • Why do customers choose what they choose?
    • What does management really think? What are they really like?
  • Gannon prefers investing in companies where he understands customer behavior the best

How Long Should You Hold a Net-Net?

  • All we need to do is make sure that the stocks we buy are clearly worth more than we pay for them
  • Forget about trading a net-net a full year after buying it and instead focus on the two things that matter most:
    • Picking the right stock (company)
    • Holding that stock regardless of what the market does
  • Never sell a net-net in less than one year unless:
    • You made a mistake
    • You need to buy something else (that’s better)
  • A one to five year holding period is the right length for net-nets
  • Never sell a net-net just because it reached NCAV; NCAV is still really, really cheap

How to Get a Job in Value Investing

  • Look for someone trying to build a research team from scratch
  • The best combination is often when the position is brand new and the right person was impressed ahead of time
  • Do lots of research for free and then let it get into the hands of someone who can hire an analyst
  • Talk to everybody whose work you respect by sending them an email; share your best ideas with them
  • Set aside time to writing and reading about value investing every single day
  • Don’t send your casual thoughts to those you’re trying to impress; you want them to think of you as a thorough, insightful researcher

What is the Buffett/Munger Bargains Newsletter?

  • Investing in net-nets is the best way for a dedicated, “do-it-yourself” individual investor to beat the market
  • The newsletter’s strategy is to find companies with the following attributes:
    • Simple business
    • Favorable long-term prospects
    • Able and honest management
    • Consistent earnings
    • Good ROE
    • Little debt
    • Very attractive price
  • It is modeled on the Buffett/Munger of the 1970s
  • “Really good businesses usually don’t need to borrow… they make the most of an already strong business franchise or concentrate on a single winning business theme” -Buffett
  • Use the higher of today’s interest rates and long-term average interest rates when considering valuations

How I Pick Stocks for the Ben Graham Net-Net Newsletter

  • Traditionally, big net-nets have been poor performers
  • The ratio of insider ownership to institutional ownership is actually one of the best predictors of the future stock market performance of a net-net
  • What makes for a good net-net?
    • High insider ownership / Low institutional ownership
    • High F-Score
    • Consistent earnings
    • Simple business
    • Decent ROE
    • Decent long-term prospects
  • The idea is to get the best business for the lowest price

How Should You Divide Your Research Time?

  • I put my energy towards whatever is most clearly undervalued
  • I keep cash close to 0% when I have good ideas
  • The important thing is picking the exact right company and then picking the approximately right price
  • I spent probably half a year thinking about buying DWA before I put in my buy order
  • A typical net-net for me is a 10% position held for just over a year
  • I spend almost half my time looking at net-nets and almost half my time looking at high quality companies
  • I look longer at each high quality company I research
  • Required reading:
    • Warren Buffett’s Letter to Shareholders (1977-Present)
    • Warren Buffett’s Letter to Partners (1959-1969)
    • The Snowball: Warren Buffett and the Business of Life
    • Buffett: The Making of An American Capitalist
    • Poor Charlie’s Almanack
    • Common Stocks and Uncommon Profits (by Phil Fisher)
    • The Interpretation of Financial Statements (by Ben Graham)
    • The Intelligent Investor (1949 Edition)
    • Security Analysis (1940 Edition)
    • Benjamin Graham on Investing
    • Benjamin Graham: The Memoirs of the Dean of Wall Street
    • One Up on Wall Street (by Peter Lynch)
    • Beating the Street (by Peter Lynch)
    • You Can Be a Stock Market Genius (by Joel Greenblatt)
    • The Little Book That Beats the Market (by Joel Greenblatt)
    • There’s Always Something to Do (about Peter Cundill)
    • The Money Masters
    • Money Masters of Our Time
    • Hidden Champions of the Twenty-First Century
    • Jim Collins Books: Built to Last, Good to Great, How the Mighty Fall, and Great by Choice
    • Distant Force (about Henry Singleton)
    • Kuhn’s The Structure of Scientific Revolutions and The Essential Tension
  • Specific reading on extreme market conditions:
    • The Big Short
    • Too Big to Fail
    • This Time is Different
    • When Genius Failed
    • The Panic of 1907
  • Knowing about historical episodes is understanding what the paper looked like every morning to folks who were as blind to the future as you are now
  • Case studies of investments made by investors whose books, letters, etc., the student has read
  • Side-by-side comparisons of stocks with the names of the companies omitted, for example:
    • Buffett’s investment in GEICO, Wells Fargo, Coca-Cola, Gilette, etc.
    • Graham’s investment in Northern Pipeline, DuPont/GM (long/short), etc.
    • Phil Fisher’s examples in his book
    • Joel Greenblatt’s examples from his books
    • Peter Cundill’s investments in his biography
    • Peter Lynch’s investments in his books
    • MSFT at different points in its history, WMT versus Costco, present day modern US railroads, present day comparison of high-quality large versus high-quality small company, comparison of present-day hated companies and historical Warren Buffett equivalent
  • Value investing is mostly about doing original research alone
  • New value investors love reading books on theory and technique; they spend too lite time studying specific stocks
  1. Open Google Translate
  2. Find the stock on its home stock exchange
  3. Read the company’s annual reports
  4. Study comparable companies in your home country
  5. Enter the stock’s past financials in a Microsoft Excel spreadsheet
  6. Use the past financials and comparison companies to appraise the stock’s value to a private buyer
  7. Compare the stock’s appraised value to its market price
  8. If the market price is more than 75% of the appraised value, forget about the stock
  9. If the market price is less than 50% of the appraised value, focus on the stock
  10. Otherwise: use your best judgment

The Infinite Regression Investment Philosophy

Courtesy of the 2012 FRMO Letter to Shareholders [PDF]:

If one were to look at the 100 US public companies with the largest defined benefit pension plans, one would find the likes of Exxon Mobil, General Electric, Pepsi, Verizon and UPS. As of the end of 2011, using these largest 100 as a proxy, American companies recorded perhaps the largest underfunded status ever, certainly within the past dozen years, both in dollar and percentage terms. And this follows a helpful three years of double-digit annualized returns on their plan assets.

Moreover, there is much reason to expect this position to worsen. The discount rates they use to determine the present value of all their future estimated pension obligations is about 3 times higher, at an average 4.8%, than it should be, since we know the average investment grade bond yield today to be about 1.3%. This means that the obligations are actually far larger than currently presented in these companies’ financial statements. Moreover, these pension plans, on average, still presume to earn almost 8% on their plan assets. Yet, over 40% of the plan assets are invested in bonds. Assuming, as one must, that 40% of these pension plan assets will earn 1.3% at best, then those bond portfolios, all else equal, can contribute only 0.5% to the return of the entire plan assets. This leaves the remaining 60%, most of which is invested in equities, to produce the balance of the 8% expected return, which means the balance must produce about a 13% return every year.

First, one is hard pressed to suggest that this reality will come to pass, so that one should expect much larger funding deficits in the coming years and, it follows, much larger contributions to those pension plans, which in turn must detract from shareholder earnings and earnings growth. That pending reality, though, is less interesting than this one: that these companies, by dint of their investment philosophy and practice, place the major portion of their equity assets in the S&P 500 (and other indices representing essentially the same, largest companies in the US), in order to attempt to earn the highest risk-adjusted expected returns. Yet the S&P 500 to a significant degree is composed of the set of companies with the largest pension plans, which are problematic as described above– these companies are investing in themselves for future returns to restore their pension plans, even as they themselves are problematic because of these pension plans. But this is their formulaic process, and the tools by which this process is measured and implemented are these self-same indices.

This is Free Lunch-thinking.

By the way, value investor Geoff Gannon (much beloved on this site) has written a lot about Dun & Bradstreet, a company with an underfunded pension liability sword hanging over its neck. He makes the case for why this is not something to worry about with DNB but I have to say it’s the one thing making me hesitate about jumping in to an otherwise compelling franchise opportunity.

In general, I try to avoid companies with employee pension plans, at least the defined benefit variety. They may be “private” and “voluntary” but to me they smack of socialism-lite. They’re uneconomic and based upon absurd assumptions and unrealistic expectations. They are, like Social Security, promises that can’t be kept and must eventually be broken.

The trouble is, shareholders will almost always be sacrificed first because we exist in a culture today that penalizes capital and sees the equity holder as a villain and cheat.

Geoff Gannon Digest #5 – A Compilation Of Ideas On Investing

Why I Concentrate On Clear Favorites And Soggy Cigar Butts

  • Graham and Schloss had >50 stocks in their portfolio for much of their career
  • They turned over their portfolios infrequently; probably added one position a month
  • To avoid running a portfolio that requires constant good ideas:
    • increase concentration
    • increase hold time
    • buy entire groups of stocks at once
  • With his JNets, Gannon purchased a “basket” because he could not easily discriminate between Japanese firms which were both:
    • profitable
    • selling for less than their net cash
  • Portfolio concentration when investing abroad is based upon:
    • which countries do I invest in?
    • how many cheap companies can I find in industries I understand?
    • how many family controlled companies can I find?
  • Interesting businesses are often unique

How Today’s Profits Fuel Tomorrow’s Growth

  • To elements to consider with any business’s returns:
    • How much can you make per dollar of sales?
    • How much can you sell per dollar of capital you tie up?
  • Quantitative check: Gross Profit/ ((Receivables + Inventory + PP&E) – (Payables + Accrued Expenses))
  • Once an industry matures, self-funding through retained earnings becomes a critical part of future growth; it’s the fuel that drives growth
  • A company with high ROIC isn’t just more profitable, it can more reliably grow its own business
  • Maintaining market share usually means increasing capital at the same rate at which the overall market is growing
  • Higher ROIC allows for the charting of a more reliable growth path
  • Industries where ROIC increases with market share present dangers to companies with low market share or low ROIC
  • The easiest place to get capital is from your own successful operations; tomorrow’s capital comes from today’s profits

Why Capital Turns Matter — And What Warren Buffett Means When He Talks About Them

  • Capital turns = Sales/Net Tangible Assets
  • Buffett nets tangible assets against A/P and accrued expenses; gives companies credit for these zero-interest liabilities, rather than assuming shareholders pay for all of a company’s assets
  • Buffett’s businesses tend to have higher sales per dollar of assets
  • Companies with higher sales per dollar of assets have higher ROIC than competitors even if they have the same margins
  • There’s more safety in a business in an industry with:
    • adequate gross margins
    • adequate capital turns
  • Industries dependent upon margins or turns open themselves to devastating attacks from the player who can maximize key variables you control:
    • price
    • cost
    • working capital management
    • etc.
  • Companies often compete on a specific trait; it has to be a trait that is variable and can be targeted for change

How to Lose Money in Stocks: Look Where Everyone Else Looks — Ignore Stocks Like These 15

  • It’s risky to act like everyone else, looking at the same stocks everyone else looks at, or by entering and exiting with the crowd
  • Don’t worry about which diet is best, worry about which diet you can stick to; find an adequate approach you can see through forever
  • Having Buffett-like success requires every day commitment
  • You should aim to earn 7% to 15% a year for the rest of your investing life if you aren’t going to fully commit like Buffett did
  • A good investment:
    • reliable history of past profitability
    • cheap in terms of EV/EBITDA
    • less analyst coverage
  • A list of such stocks:
    • The Eastern Company (EML)
    • Arden (ARDNA)
    • Weis Markets (WMK)
    • Oil-Dri (ODC)
    • Sauer-Danfoss (SHS)
    • Village Supermarket (VLGEA)
    • U.S. Lime (USLM)    
    • Daily Journal (DJCO)
    • Seaboard (SEB)
    • American Greetings (AM)
    • Ampco-Pittsburgh (AP)
    • International Wire (ITWG)
    • Terra Nitrogen (TNH)
    • Performed Line Products (PLPC)
    • GT Advanced Technologies (GTAT)

Notes – A Compilation Of Ideas On Investing

How To Think About Retained Earnings

  • Grab 15 years of data from EDGAR and compare receivables, inventory, PP&E, accounts payable and accrued expenses to sales, EBITDA, etc.; E.g., if receivables rise faster than sales, this is where “reinvestment” is going
  • For a quick comparison, look at:
    • Net income
    • FCF
    • Buybacks + dividends
  • Compare debt (total liabilities) between the start of the period and the end and subtract the difference to get growth in debt
  • Then, sum all dividends and buybacks over the period, and all net income over the period
  • Then, subtract the change in debt from dividends/buybacks; what is left is dividends/buybacks generated by the business, rather than growth in debt
  • Then, compare this to net income to see the ratio of earnings paid out to shareholders
  • You can compare the growth in net income to retained earnings to get your average return on retained earnings
  • Look at the change in net income and sales over 10 years and then the ratio of cumulative buybacks and dividends to cumulative reported earnings
  • You’re looking for the central tendency of return on retained earnings, whether it is approx:
    • 5%, bad business
    • 15%, good business
    • 30%, great business
  • Companies with single products easily generate high returns on retained earnings, but struggle to expand indefinitely

One Ratio to Rule Them All: EV/EBITDA

  • EV/EBITDA is the best ratio for understanding a business versus a corporate structure
  • Net income is not useful; FCF is complicated, telling you everything about a mature business but nothing about a growing one
  • General rule of thumb: a run of the mill business should trade around 8x EBITDA; a great business never should
  • Low P/E and low P/B can be misleading as it often results in companies with high leverage
  • P/E ratio punishes companies that don’t use leverage; they’re often worth more to a strategic buyer who could lever them up
  • The “DA” part of a financial statement is most likely to disguise interesting, odd situations; if you’re using P/E screens you miss out on companies with interesting notes on amortization
  • Control buyers read notes; why use screens that force you to ignore them?
  • FCF is safer than GAAP earnings or EBITDA because it’s more conservative and favors mature businesses
  • EBITDA misses the real expense in the “DA”, but FCF treats the portion of cap-ex that is an investment as expense, so they’re both flawed; investment is not expense
  • No single ratio works for all businesses in all industries; but to get started, EV/EBITDA is the best for screening
  • Example: cruise companies have huge “DA”, but no “T” as they pay no taxes
  • “Only you can calculate the one ratio that matters: price-to-value; there is no substitute for reading the 10-K”
  • Empirical evidence on ratios:

Blind Stock Valuation #2: Wal-Mart (WMT) – 1981

  • There is something wrong with believing a stock is never worth more than 15 times earnings
  • “Growth is best viewed as a qualitative rather than a quantitative factor.”
  • Buffett’s margin of safety in Coca-Cola was customer habit– repeatability
  • Buffett looks for:
    • Repeatable formula for success
    • Focus
    • Buybacks
  • “The first thing to do when you’re given a growth rate is not geometry. It’s biology. How is this happening? How can a company grow 43% a year over 10 years?”
  • Stable growth over a long period of time tells you a business has a reliable formula; look for businesses that behave like bacteria
  • Recognizing the value of changes after they happen is important, not predicting them ahead of time
  • You can’t post the kind of returns Wal-Mart did through the 1970s without a competitive advantage
  • Buffett gleans most of his info from SEC reports, things like 10-year records of gross margins, key industry performance metric comparisons, etc.

GTSI: Why Net-Net Investing Is So Hard

  • The challenge of net-nets is you often have no catalyst in sight and no wonderful future to visualize as you hold a bad business indefinitely
  • Graham’s MoS is integral– you can be off in your calculation of value by quite a bit but Mr. Market will often be off by even more
  • Focusing too much on time could be a problem in net-net investing
  • Two pieces of advice for net-net investing:
    • Put 100% of focus on buying and 0% on selling
    • Put 100% of focus on downside and 0% on upside
  • Money is made in net-nets not by the valuing but by the buying and holding
  • “You want to be there for the buyout.”
  • The hardest part of net-net investing: waiting
  • Graham and Schloss were successful likely because they built a basket, so they were always getting to buy something new that was cheap instead of worrying about selling
  • Focus on a process that keeps you finding new net-nets and minimizes your temptation to sell what you own

Can You Screen For Shareholder Composition? 30 Strange Stocks

  • Shareholder composition can help explain why a stock is cheap
  • A company’s shareholder base changes as the business itself changes; for example, a bankruptcy turns creditors into shareholders
  • Shareholders often become “lost” over the years, forgetting they own a company and therefore forgetting to trade it
  • Some companies go public as a PR ploy, so investors may be sleepy and inactive
  • Buffett understood this and understood that a stock could be a bargain even at 300% of its last trade price– National American Fire Insurance (NAFI) example
  • Buying a spin-off makes sense because many of the shareholders are stuck with a stock they never wanted
  • An interesting screen: oldest public companies with the lowest floats (in terms of shares outstanding); a lack of stock splits combined with high insider ownership is a recipe for disinterest in pleasing Wall St

How My Investing Philosophy Has Changed Over Time

  • Info about Geoff Gannon
    • high school dropout
    • bought first stock at 14
    • read [amazon text=Security Analysis (1940 Edition)&asin=007141228X] and [amazon text=The Intelligent Investor (1949 Edition)&asin=0060555661] at 14
    • over time, became more Buffett and less Graham
    • made most money buying and holding companies with strong competitive positions trading temporarily at 6, 10 or 12 times earnings
  • I like a reliable business with almost no history of losses and a market leading position in its niche
  • Geoff’s favorite book is Hidden Champions of the Twenty-First Century, which is part of a set of 3 he recommends to all investors:
    • You Can Be a Stock Market Genius (by Joel Greenblatt)
    • The Intelligent Investor (1949 Edition)
    • Hidden Champions of the Twenty-First Century
  • Everything you need to know to make money snowball in the stock market:
    • The Berkshire/Teledyne stories
    • Ben Graham’s Mr. Market metaphor
    • Ben Graham’s margin of safety principle
    • “Hidden Champions of the 21st Century”
  • Once you know this, if you just try to buy one stock a year, the best you can find, and then forget you own it for the next 3 years, you’ll do fine; over-activity is a major problem for most investors
  • Bubble thinking requires higher math, emotional intelligence, etc.; that’s why a young child with basic arithmetic would make a great value investor because they’d only understand a stock as a piece of a business and only be able to do the math from the SEC filings
  • There are always so many things that everyone is trying to figure out; in reality, there are so few things that matter to any one specific company
  • One key to successful investing: minimizing buy and sell decisions; it’s hard to screw up by holding something too long
  • Look for the most obvious opportunities: it’s hard to pass on a profitable business selling for less than its cash
  • Extreme concentration works, you can make a lot of money:
    • waiting for the buyout
    • having more than 25% of your portfolio in a stock when the buyout comes
  • I own 4-5 Buffett-type stocks (competitive position) bought at Graham-type P/E ratios
  • “There is a higher extinction rate in public companies than we are willing to admit.”
  • Most of my experience came through learning from actual investing; I wish I had been a little better at learning from other people’s mistakes

Notes – A Compilation Of Ideas On Investing

Is Negative Book Value Bad?

  • Negative equity itself is meaningless (could be good or bad)
  • Compare net financial obligations to EBITDA
  • Think of borrowed money as the price of time; ask yourself if you’d rather they borrow money or spend time
  • Stocks in Geoff’s portfolio tend to:
    • have positive FCF
    • have unusually high ratios of FCF to reported earnings
    • buy back shares
    • pay dividends
    • have excess cash after the above
  • “I have found I do not make good decisions when I have to juggle 10 or more opportunities in my head at once”
  • “I don’t believe in taking a risk where I think if everything goes perfectly the upside is still going to be in the single digits”
  • How much debt is too much debt is a separate issue from whether the debt is being used productively
  • When soaring over the market trying to find bargains, these are useful as screening tools:
    • tangible book value
    • EV/EBITDA
  • If an entire country’s market has a low P/TBV or EV/EBITDA, this is important to know; you can buy indexes on this info alone
  • However, ultimately the following matter more:
    • liquidation value
    • market value
    • replacement value
    • Owner Earnings
  • Move beyond being a record keeper — an accountant — and become an appraiser
  • The assets that matter most on the balance sheet:
    • cash
    • investments
    • land
    • intellectual property
    • tax savings
    • legal claims
  • Cash flow protection is much better than asset protection
  • Businesses with special assets that are not separable from the operating business are most likely to not be reflected on the balance sheet and present hidden value
  • Being in a strong, safe liquidating position does not necessarily mean you are in a strong, safe operating position
  • Working capital needs and capital spending needs are part of the DNA of a business; “you can’t turn a railroad into an ad agency”
  • Negative equity itself is not a risk; poor interest coverage is
  • Non-aggressive long-run return assumptions:
    • stocks – 8%
    • bonds – 4%
  • When looking at companies with negative equity and stock buybacks, ask yourself the following:
    • Earnings yield of stock buybacks > interest rate on borrowed money?
    • Need to adjust financial obligations (such as unfunded pension liability) to determine true extent of liabilities?
    • Are net financial obligations (debt and pensions minus cash) a low enough multiple of their EBITDA?
    • How many years of FCF would it take to pay off all financial liabilities?
    • Is the price of the entire company in terms of EV/EBITDA low enough to justify investment?
    • How reliable is EBITDA, FCF, etc?
  • Common concerns in these situations:
    • Moat not wide enough
    • High risk of technological obsolescence
    • No pricing power/cost cutting potential to support margins
  • The right company can have negative equity and be investable if it is a wide moat business with almost no need for tangible investment:
    • Negative working capital
    • Minimal PP&E
    • A wide moat

Is It Ever Okay For A Company To Have No Free Cash Flow?

  • Four cash flow measures:
    • Owner’s Earnings (most important)
    • EBITDA
    • CFO
    • FCF
  • You can get a hint where a company is tripping up in delivering cash to shareholders (FCF) when:
    • EBITDA is positive
    • CFO is positive
    • Net income is positive
  • EBITDA measures the capitalization independent cash flow of the business; it doesn’t take into account spending today for benefits that won’t be realized until tomorrow; also misses working capital changes
  • Look for companies that are growing quickly in an industry that is not
  • Avoid companies that are fast growing in a fast growing industry; it will face more competition every year
  • To judge the future ROI of FCF reinvestment with a company that has no FCF, look at:
    • Will they be competitive?
    • Will competitors over expand?
    • Do they have a moat?
  • When a company spends so much on growth for so long, you really are betting on what the ROI will be way out in the future
  • “There isn’t necessarily a prize for being the last one to succumb to the inevitable. It’s usually more of a moral victory than an economic one”
  • Don’t short a great brand; if you want to short something, short a company:
    • with a product with inherently poor economics
    • a bad balance sheet
    • with deteriorating competitiveness
    • preferably in an industry with a high morality rate
  • When a company reinvests everything, you need to worry about what they’ll earn on their capital many years out

Value Investor Improvement Tip #1: Settle For Cheap Enough

  • A lot of people look for:
    • lowest P/Es
    • lowest P/Bs
    • highest div yields
    • new lows
  • This creates lists of companies that are quantitative outliers, instead of companies you know something about
  • You should feel comfortable throwing out 7/10 names found on a screen
  • Better to cast a wider net and then focus on companies you can learn a lot about by reading 10-Ks
  • Try a screen that combines (Ben Graham-style):
    • above average div yield
    • below average P/E
    • below average P/B
    • fewest unprofitable years in their past
  • Start with the company that sounds simplest, then move out slowly and carefully to those you understand less well; stop when you find something cheap that you know you can hold as long as it takes
  • Another screen:
    • EV/EBITDA < 8
    • ROI > 10%
    • 10 straight years of operating profits
  • You need a good reason for picking stocks that don’t meet this criteria
  • It’s hard to figure out companies with a lot of losses in their past; so don’t try
  • Familiarize yourself with a few stocks; what insiders have is familiarity
  • You want to find companies where you can think more like an insider
  • For long-term investing health, it’s better to find a slightly less cheap — but still cheap enough — stock you can get familiar with than a super cheap one that is a mystery
  • Anything less than NCAV is cheap enough
  • “Some of value investing is in the buying; most of value investing is in the holding; almost none of value investing is in the selling”

Notes – How To Pick Net-Nets: Two Philosophies From Geoff Gannon And Gurpreet Narang

Buying Net-Nets: What Is The Right Margin Of Safety? by Gurpreet Narang

  • Margin of safety demanded depends on the quality of assets and quality of earnings
  • The subtext of Graham’s 2/3 Rule is that asset values on the balance sheet are inexact
  • In liquidation, liabilities are real but asset values are questionable
  • Liquid assets are easily squandered by bad management or bad operating businesses
  • In addition to discounting assets, look for other positive factors to enhance margin of safety:
    • excess cash relative to assets
    • high return on invested capital
    • ten straight years of operating income
    • ample free cash flows
  • The more liquid the assets, the better the margin of safety
  • One way to improve upon NCAV is P/NQAV, or Price-to-Net Quick Asset value (cash, securities and receivables)
  • Discount demanded moves in inverse proportion to:
    • quality of assets
    • quality of management
    • quality of return on assets
  • Earnings should be backed up by cash flows, preferably with free cash flows
  • Net-nets should be chosen for inherent cheapness, not a hope for liquidation
  • Walter Schloss: “A stock well-bought is half-sold.”
  • Michael Burry: buy at prices “so low that a potential acquirer proposing them would be laughed out of the boardroom”

How To Pick Net-Nets by Geoff Gannon

  • Best Net-Nets:
    • Are around $25M market cap or less
    • High insider ownership
    • High F-score
  • Biggest risks for Net-Nets:
    • Fraud
    • Bankruptcy
    • Share dilution
  • Look for Net-Nets:
    • In the US
    • With positive retained earnings
    • Z-score >3
    • Highest F-scores amongst current crop of NCAVs
    • Highest insider ownership %
  • Similarly, avoid:
    • Foreign
    • Negative retained earnings
    • Z-score ❤
    • Lower/lowest F-score
    • Lower/lowest insider ownership
  • Magic Formula for NCAVs:
    • Rank by F-score
    • Rank by insider ownership
  • Add up the two ranks and choose the highest combined scores
  • You don’t need upside potential, you need downside protection
  • Hold them for longer than a year
  • Take the 10-Q and read it like a credit analyst, asking yourself, “Would you be willing to lend money to this company?”
  • More by Geoff Gannon at How To Pick Solid Net-Nets

Notes – A Compilation Of Ideas On Investing

Why I’d Never Pay More Than Book Value For Nokia

  • You hate to see a group of the top five companies of an industry where they entered the industry at different times; this implies companies are coming and going as they please
  • You want the company you’re looking at to have a relatively high market share, ie, the company’s market share divided by the next closest competitor is high (1.5+)
  • The first line of defense in competitive environments is having the most customers relative to the alternatives; being the preferred product
  • As long as you believe a company’s competitive positions are lasting, you can buy the stock on a P/E basis

Ben Graham Net-Nets That Don’t File With The SEC

  • The simplest way to separate safe net-nets from unsafe net-nets is the number of consecutive years of profits
  • Profitable net-nets seem to be especially common candidates for abandoning the responsibilities of a public company without actually getting taken private
  • If you can’t trust the controlling family, you can’t trust the auditors

Free Cash Flow Isn’t Everything

  • Buffett-style approximation of unleveraged return on tangible equity: EBIT/(Receivables + Inventory + PPE) – (Accounts Payable + Accrued Expenses)
  • This represents the net investment; in the example of WMT, it represents their ability to finance $50B in productive assets at 0% interest
  • Reinvestment in businesses with sustainable double-digit ROIs is superior to receiving dividends (thanks to higher FCF)
  • It is harder to find companies who can earn high returns on unlevered equity and increase the size of that tangible equity over time than it is to find companies who can earn high returns on unleveraged tangible equity
  • For looking at return on invested tangible assets: EBITDA/(Receivables + Inventory + PPE) – (Accounts Payable + Accrued Expenses)
    • then, go back 15-20 years and find range, median, etc.
    • examine how much tends to be converted to net income or FCF to get an idea of profitability
  • FCF != Owner’s Earnings; only counting the cash available after a company grows will result in you passing up many good, growing businesses simply because they’re growing
  • If a company is earning good returns on their investments, it’s okay for them to not produce a lot of FCF
  • Businesses you’re investing in for profitable future growth should be 150% of the growth you think you could provide with another use of the money; the 50% represents margin of safety in your future compounding
  • Over time, more reliable returns compound better than less reliable returns
  • The most reliable ROIs tend to be in businesses built around a habit
  • Habits are the first line of defense in a business
  • The best business defenses involve:
    • defending specific customers
    • defending specific locations
    • defending specific times
  • Buffett’s favorites are business which:
    • have pricing power
    • have the lowest costs (can operate profitably at margins competitors can not)
  • Your return in a good business, held forever, depends on:
    • Growth; what quantity of earnings are you purchasing today?
    • ROI; how much room is there for reinvesting those earnings in the future?
    • Earnings yield; what will you earn on those reinvested earnings?

Earnings Yield or Free Cash Flow Yield: Which Should You Use?

  • Look to the story of Hetty Green; don’t put more into an asset unless the return you can get from that addition is better than what you could get elsewhere
  • A company that grows value doesn’t have to pay anything out; with real Owner’s Earnings, no FCF is necessary
  • FCF is useful for determining how much money is available for:
    • Dividends
    • Stock buybacks
    • Debt repayment
    • Acquisitions
  • In this case, use FCF/Market Cap to determine your “equity coupon”
  • Owner’s Earnings is useful for determining: How much bigger will my snowball get this year?
  • OE are just as valuable as FCF if and only if the future return on retained earnings is comparable to the average of the past; the wider the moat, the more reliable the historical average is
  • If you think you can earn 10% in your brokerage account:
    • a company earning 12% unlevered returns on tangible net assets is probably a wash and it’d be better if they gave them to you
    • but a company earning 20% is a different beast altogether– you’re probably better off letting them compound your money for you
  • If you know ROI will stay above what you could achieve yourself, use a P/E type measure (or EV/EBIT or EV/EBITDA, depending on accounting) to price the stock, don’t use FCF
  • Valuing businesses by ROI:
    • By earnings; reliably above average returns on investment
    • By FCF; consistent companies with a mixed or impossible to evaluate ROI situation
    • By tangible book; inconsistent companies with an unreliable or poor ROI situation
  • Stated another way:
    • Good, reliable companies are snowballs; worth what it can grow as it travels downhill; dynamic
    • Mixed, reliable companies are waterfalls; worth the rate of its flow; constant
    • Unreliable, bad companies are rocks; worth its weight; static
  • Remember– assets produce earnings; earnings become assets; the process repeats
  • Ask yourself:
    • What is the sustainable rate of cash removable from the business?
    • What is the value added or subtracted from the business by the resource use decisions of management?
  • Assume that retained earnings at subpar businesses to be worth less than their stated amount; similarly, retained earnings at above average businesses are worth every penny
  • With great businesses with favorable long-term prospects, treat earnings as FCF; it’s fine to use the earnings yield
  • Never make the mistake of thinking depreciation is a provision for the future; it’s a spreading out of the past
  • At bad businesses, cash is worth much more than inventory, receivables, property, etc.; in these cases, don’t use earnings yield, use FCF yield and asset value

How To Analyze Net-Nets Undergoing Change

  • As part of a group, you can easily invest in businesses undergoing change
  • “Managers rarely rush to evacuate excess capital from a sinking ship. Usually, they’re still there trying to save the wreck.”
  • It’s generally better to invest in a corporation undergoing change than a business undergoing change
  • With changing customer habits, it can be nearly impossible to predict future earnings
  • I require at least ten years of history before investing in a company for any reason other than its cash; prefer 15-20 years of history whenever possible
  • Overcapitalized companies undergoing change are good stocks to follow
  • Worldwide, there are fewer investors looking at Swedish stocks than US stocks; that’s an advantage if you’re looking at Swedish stocks, so use it

What Broker To Use When Buying International Stocks (Gannon On Investing)

  • Geoff uses a full service broker, but recommends Interactive Brokers or Noble Trading for most others looking to buy foreign stocks
  • If going with a full service shop:
    • personally know a broker ahead of time
    • give him your account with a clear understanding of what it is you want to do; try to negotiate a flat, guaranteed commission structure so you know how much it’ll cost you and he knows you’re worth the trouble
    • a good rule of thumb is 1% per roundtrip trade; it’d be greedy for the broker to ask for more than 2%
  • If a broker promised me it could buy any stock anywhere in the world for 2% of my assets per year, I’d take that deal
  • I look at my cost in a stock on an after-commission basis
  • “My broker won’t let me buy that stock” is never a valid excuse; if the broker won’t buy the stock, get a new broker
  • “Ben Graham said investing is most intelligent when it’s most businesslike. Business often means work”
  • Never let anything get in the way of buying the best bargains, especially not your broker

How To Find Cheap Foreign Stocks

  • Online research process for finding foreign stocks:
    • Screen for stocks in specific countries using the FT Screener
    • Check the business description, EV/EBITDA, etc., at Bloomberg
    • Look at the 10-year financial history at MSN Money
    • Go to the company’s website and read their annual reports
  • Bloomberg has the best worldwide coverage of stocks in their database
  • A good screen to start with at FT.com is a single digit P/E screen– just scoop up the simplest, most obvious bargains
  • Many European companies that aren’t too tiny trade in Germany
  • Use Google Translate if you’re having language issues
  • Beware of accounting differences:
    • US uses GAAP; insists on historical cost and does not permit revaluation of non-financial assets; in general, old US companies with lots of land and inventory (using LIFO) are more likely to contain “hidden assets”
    • RoW uses IFRS; PPE and investment property less likely to be carried on balance sheet at extremely low stated value; different way of valuing biological assets; never uses LIFO accounting for inventory; less likely to mask an asset’s liquidation value than GAAP
  • Good screen in the US due to GAAP accounting for depreciation: (Accumulated Depreciation /Tangible Book Value) * (Tangible Book Value/Market Cap) > 1; shows you the cheapest stocks relative to what a competitor would pay to own their assets; produces a real Ben Graham-type list
    • should also add: Tangible Book Value > Total Liabilities
    • and: Net Income > 0
  • Due to accounting differences, if you’re new to international investing, focus on earnings bargains, not asset bargains
    • It’s okay to buy companies that are cheap P/B if they have 10 yrs of consistent earnings
    • Otherwise, stick to low P/10yr avg earnings
  • Low EV/EBITDA is good to use around the world as it erases some differences in accounting
  • Good UK-specific screener– SharelockHolmes

How To Find Foreign Stocks: 13 Promising Companies From The U.K. (Gannon On Investing)

  • I went to the London Stock Exchange website; then I browsed stocks alphabetically
  • I was looking for potentially promising companies, regardless of price
  • In other countries, I start by looking for good businesses I can understand; the bar is higher overseas
  • Use the following process for finding promising companies:
    • At the LSE website:
      • clicked “fundamentals” tab
      • scrolled down to ROIC
      • looked for positive number in the double-digits
      • 20%+ ROIC over the last few years
    • Look the company up in Bloomberg
      • If you can’t understand the business description, throw it out
      • If it sounds like it has the potential to earn very high returns on capital, proceed
    • Looked up the annual report’s cash flow statement
      • CFO > CAPEX in each of the last several years
      • ie, should be generating FCF
    • For all the companies that qualify, download the past annual reports into a folder on desktop
    • Start reading annual reports from oldest to most recent
    • Then, appraise the value of the company, ideally without looking at the price first
      • 10x normal EBIT
      • 15x normal FCF
      • if the company is trading at least 25% below the value you appraised it at and you love the business, consider buying
  • Searching alphabetically is an old school, Buffett way of stock research
  • “Having to form your own opinions from scratch does wonders for investment analysis”; searching from scratch puts you in the best mindset to value a stock objectively
  • Three dependable ways to turn up great stock ideas:
    • Go through a list from A to Z
    • Read value investing blogs
    • Direct, personal experience with the company
  • Good UK value investing blogs:
  • “My best investments come from stocks I study and pass on due to price, only to buy the same stock some 4 or 5 years later when it has its Salad Oil Scandal moment”

5 Japanese Net-Nets: And How To Analyze Them

  • Net-net investing worked in actual practice in the 1930s and 1940s in the US; Japan is similar, but worse
  • Price and value determine your returns based on four factors:
    • Earnings yield (price)
    • ROI (profitability)
    • Sales growth (growth)
    • Dividend yield (dividends)
  • The lower the yield on the stock, the higher its earnings yield, growth and ROI need to be to justify investment
  • Japan is experiencing deflation of -0.7% while the US is experiencing inflation of 2.9% so you need to add 3.6% to all Japanese yields to get the equivalent in real terms in the US
  • A company’s real dividend yield is effectively a reduction in your hurdle rate
  • Japan is a low/no growth economy, so it makes sense to pay out earnings as dividends or retain them as cash rather than tie them up in low-return, long-term investments such as PPE
  • The margin of safety in Japanese net-nets is that the dividend yield is a payback unrelated to ROI
  • With Japanese net-nets, you exchange low growth and low ROI for high dividend yields, deflation (rising cash value) and excess cash
  • Japanese net-nets offer P/E around 10, dividend yield around 3% and net cash close to market cap, meaning you get three bets:
    • the value of the stock’s future retained earnings stream
    • the value of the stock’s future dividend stream
    • the value of the stock’s future cash pile deployment
  • The biggest threat to Japanese net-nets is a decline in the value of the  yen; this is the best reason for passing on net-nets in Japan
  • “If half my money is in dollars and half is in something else and all 100% of my portfolio is in some of the cheapest stuff on earth– my results will be fine… over time”
  • The US in the 1930s is the best illustration of what net-net investing in Japan is like
  • “I prefer a lot of uncertain opportunities to make money over time to one seemingly certain exit strategy”
  • The quality of net-nets in the US is not as good as in Japan; most US net-nets are extremely unsafe; this is a consequence of a few good years in the stock market