Review – Professional Investor Rules

Professional Investor Rules: Top Investors Reveal The Secrets of Their Success

by various, introduction by Jonathan Davis, published 2013

The many faces of money management

A 1948 Academy Award-winning film popularized the slogan “There are eight million stories in the Naked City”, and after reading the eclectic “Professional Investor Rules”, I’m beginning to think there are almost as many stories about how to manage money properly.

Value and growth, momentum and macro-geography, market-timing and voodoo superstition; all these major investment strategies and themes are on display, and many more to boot, and all come bearing their own often-tortured metaphors to convey their point.

What’s more, it seems the pacing and style of the book change along with the advice-giver: while some of the entries follow the books eponymous “rule” format for organizing their thoughts, others involve myths, lengthy prose paragraph-laden essays and headings with sub-headings. Some have charts, and some do not.

One things consistent, at least– all the advisors profiled contradict one another at some point or other, and some even manage to contradict themselves in their own sections.

But it’s got this going for it, which is nice

Those are some of the glaring cons to the book. It’s not entirely without it’s pros, however.

One of the things I liked about the book is, ironically, also one of its flaws– the great variety of personas. They run the gamut from the known to the unknown, the mainstream to the contrarian, the sell-side to the buy-side. This book is published by a UK outfit (Harriman House), which means many of the professional soothsayers will be unfamiliar to US audiences, but it also means you get a selection of icons from the Commonwealth and former British territories (such as Hong Kong and other Asia-based managers) that you’d likely never hear about on CNBC or other American publishing sources.

Following this contrarian inversion theme, I liked that all the phony  fuzzy thinkers were right there next to the sharper pencils because it made their baloney that much more rotten. I think this is a great service for an uninformed investor picking up this book. If they had come across some of the more foppish money dandies on their own, elsewhere, they’d be liable to get taken in and swindled like the thousands of others who sustain such frauds. But at least in this case you’ve got a go-go glamour guy saying no price is too high for a growing company right next to a value guy warning that that way lies the path to certain, eventual doom.

And maybe this isn’t a big deal to others but I like the packaging on this hardcover edition I’ve got– it’s truly a HANDy size, the fonts and color scheme are modern and eye-catching and the anecdotal organization of the book makes it easy to pick up and put down without feeling too upset over whether or not you’ve got the time to commit to a serious read right then.

Fave five

Here are five of my favorite ideas from the book, along with the person(s) who said it:

  1. At any one time, a few parts of your portfolio will be doing terribly… focus on the performance of the portfolio as a whole (William Bernstein, Efficient Frontier Advisors)
  2. Far more companies have failed than succeeded (Marc Faber, The Gloom, Boom and Doom Report)
  3. Fight the consensus, not the fundamentals (Max King, Investec Asset Management)
  4. When someone says ‘it’s not about the money,’ it’s about the money (H.L. Mencken… consequently not actually a money manager and not alive, but it was quoted in one of the in-betweens spacing out the chapters)
  5. Academics never rescind papers and never get fired (Robin Pabrook and Lee King Fuei, Schroeders Fund, Asia)

Conclusion

Who is this book for? Accomplished, well-read pro-am investors will find nothing new here and much they disagree with, so I’d recommend such readers stay away. Someone completely new to investing and the money management industry might find the book valuable as a current snapshot of the gamut of strategic strains present in the money management industry.

Overall, while “Professional Investor Rules” has its moments, overall I came away less enthused than I did with Harriman House’s earlier offering, Free Capital. For anyone looking to learn investing techniques from accomplished, self-made millionaires, that’s the book I’d point them to– the advice therein is worth multiples of that being given by the mass of asset gathering managers of OPM contained in this one.

Are Cash-Flush Corporate Balance Sheets Hiding Stagnating Operating Efficiencies?

In an article entitled “Too Much of a Good Thing” from CFO.com, we learn that American businesses have become less efficient with their use of working capital over the last year:

Days working capital (DWC) — the number of days it takes to convert working capital into revenue — did decrease marginally in 2011, from 37.7 days to 37 days. But REL downplays the improvement, attributing it in part to the companies’ 13% average revenue growth. “To have a 1.9% decrease is a positive, but not by a lot,” says Prathima Iddamsetty, senior manager of operations, research, and marketing at REL, a working capital consultancy.

Cash on hand across the group of surveyed companies, dubbed the REL U.S. 1,000, increased by $60.3 billion in 2011, helped in part by companies taking advantage of low interest rates to issue more debt, up by a record $233 billion year-over-year. Those companies now have a staggering $910 billion in excess working capital, including $425 billion in inventory, according to REL. “Way too much cash is being left on the table and not being put toward growth objectives,” says Iddamsetty.

But why does it matter?

Indeed, cash is still king for the REL U.S. 1,000. This is clearly evidenced by the $60 billion increase in cash on hand and the $233 billion increase in debt in 2011. Over a three-year period, cash on hand was $277 billion and accumulated debt $268 billion.

But using debt instead of efficient working capital management to get more cash into the bank account “comes with a long-term cost: eventually they will have to pay [the debt] down,” points out Ginsberg. “They’ll also have to generate a return on their existing assets that exceeds the interest rate, which is not what we’re seeing.”

It’s better to tap working capital as a funding source for long-term growth strategies, says Ginsberg. REL Consulting cites top performers in a broad range of industries, leveraging working capital to open up new businesses in emerging markets with growing consumer demand, for instance.

“Top performers have very tight manufacturing timetables and inventory management practices, in addition to strict collections and payment systems that are standardized across all locations,” says Michael K. Rellihan, an associate principal at REL. “The cash they generate from this high level of working capital efficiency is then applied to the growth agenda. Long-term, the result is a powerful benefit to the bottom line.”

“Only process improvements will provide sustainable cash flow benefits,” adds REL’s Sparks. “This requires working more closely with customers, getting better information to suppliers, and improving demand forecasting. You need to have an underlying process in place to manage working capital on a day-to-day basis; if not, it will be difficult to sustain.”

In other words, the growth in corporate debt and the resulting excess cash on the balance sheet gives the illusion of financial and business health in the short-term, when in the long-term these companies still must find ways to improve operating efficiencies and thereby generate profit. Ironically, even as the cost of debt in a zero-interest rate policy environment falls, this is getting harder and harder to do because there are fewer and fewer genuine opportunities to drive real growth and expand the top line while maintaining operating efficiency. It makes you wonder how much of this working capital problem is a symptom of our ZIRP-economy.

There was also a helpful chart showing the state of working capital efficiency by industry that can give you a quick high-level look at winners and losers in terms of working capital management.

How Businesses Grow: The Five Guys Story

What does America’s fastest growing restaurant chain look like on the inside and how was the growth accomplished? For the answers to those questions and many others I read a recent Forbes article entitled “Five Guys Burgers: America’s Fastest Growing Restaurant Chain“.

First, “Five Guys” growth in numbers:

  • Doubled number of stores since 2009
  • Started in 1986; since then, has grown to 1,039 stores in the US and Canada with commitments to open another 1,500
  • Grew 792% since 2006, nearest competitor Jimmy John’s grew 241% over the same period and now has 1,329 stores
  • Company-owned franchises 200; franchised 839
  • Projected sales of $1B+ in 2012; corp revenues of $275M with cash flow of $50M
  • Current value of the company estimated at $500M, $375M of which belongs to the founders, on an initial investment of $70,000

Founder Jerry Murrell and his sons came up with the idea in 1986 when Murrell offered his older sons nearing high school graduation a deal– they could go to college, or they could use their tuition money to start a restaurant.

Like many rapid growth successes stories, early growth was slow and hard to come by. Persevering through employee theft, customer service shortcomings and inter-family squabbles behind the scenes, the group opened their second store in 1989 after being turned down for business loans by numerous local banks. Instead, they raised money $10,000 to $30,000 at a time from 100 friends and acquaintances and committed to always paying on time.

Even early on Murrell received suggestions that he stray from the company’s “core competency” of high quality burgers and fries– coffee, chicken sandwiches, milkshakes and more were all brought up and some even tried but every time Murrell found it to be a disaster. Eventually, Murrell and company gave up, and his disciplined reasoning is instructive in demonstrating his understanding of his own brand:

My fear was that we’d add something new and not be good at it, then some reviewer would write about how bad our coffee was and not how good our burgers and fries are… [The demise of other restaurant chains involves one constant.] They all started to offer too many items and got away from their core.

By 2002, they had 5 stores in Northern Virginia and began thinking about franchising. Murrell received a copy of Franchising For Dummies from his son which he read and that, combined with a fortuitous meeting with former Washington Redskins-kicker and burger joint owner Mark Mosley and consultation with Fransmart the Five Guys team moved ahead, selling out all franchise rights to Virginia within three weeks.

The standard franchisee must have a minimum net worth of $1.5M and liquidity of $500,000. He pays an upfront fee of $75,000 per store, the average store costing $350,000-$500,000 to open and generates an average of $1.2M in revenues each year. Five Guys corporate charges 6% of gross revenues and another 1.5% which is collected for “audits” which are used to pay $1,000 weekly bonuses to stores that score will after being visited by independent examiners. According to Five Guys largest franchisee, stores break even within two and a half years and have operating margins in the mid-teens.

There are other entrants in the “better burger” category such as Smash Burger and Shake Shack (note: I’ve had both and I don’t think they offer much competition) and because of the rapid franchising, Five Guys has occasionally run into the problem of overlapping markets where franchise owners cannibalize one another’s sales. Murrell occasionally buys back franchises when he can and the company is currently working on an overseas expansion which will begin in the UK. There’s talk of expanding to the Middle East and private equity and investment bankers have been on the company’s case for years.

Who knows what lies ahead but so far, through all the ups and downs, the company has remained a thoroughly family affair.

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

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

What’s The Yield On Saudi Prince Alwaleed’s “Strategic” Twitter Investment?

Saudi Prince Alwaleed bin Talal has made a $300M “strategic” investment in Twitter, according to Bloomberg.com:

Alwaleed, who leads the 2011 Arab Rich List, and his investment company agreed to buy a “strategic stake” in Twitter, Kingdom Holding said today. A strategic holding means more than 3 percent, Ahmed Halawani, a Kingdom Holding director, said in an interview. That would give the San Francisco-based company a valuation exceeding $10 billion.

Alwaleed is described by Bloomberg as a businessman and an investor. But Alwaleed is a politician, not a businessman– he is a member of the Saudi royal family, and his capital and wealth are continually generated by the Saudi royal family’s political control over Saudi oil fields. Similarly, Alwaleed is an “investor” in businesses like Citi and Twitter in the same sense that the CIA “invested” in Google and Facebook– for information and for control, not for economic or financial profit.

If this is a challenging view to accept, let’s consider just this recent purchase of his Twitter stake from insiders. According to the article, an industry research group recently cut their forecast for Twitter’s 2011 ad revenue from $150M to $139.5M. What kind of value multiplier did Alwaleed “invest” in if he paid $300M for more than 3% of the company which is now valued at over $10B?

Let’s give Alwaleed the benefit of the doubt and say that Twitter’s 2011 ad revenue comes in at $150M. Let’s further assume that Twitter is a highly profitable company and 30% of their revenues drop down to the bottom line and become net profit. That’s $45M of net profit in 2011.

At a $10B market cap, Alwaleed’s investment was made at 66.6x Price-to-Revenues and 222.2x Price-to-Earnings. I should hope I don’t need to do the math for you to show what kind of growth expectations you have to factor into those ratios for them to make sense.

Now, ask yourself, have you ever heard of the “Best Investor In the Universe”, Warren Buffett, investing in companies at these kinds of multiples? Ask yourself, what kind of margin of safety does Alwaleed have here when paying so much for so little. Ask yourself, is it a credible idea that Alwaleed is truly a successful businessman and investor who has managed to grow his personal fortune to $19.6B (according to Wikipedia) since 1979 by investing at such high multiples?

Alwaleed “is a savvy investor and the hot thing in the IT world is social networking,” said Nabil Farhat, a partner at Abu Dhabi-based Al Fajer Securities.

Historically, how do even “savvy investors” fare investing in the latest “hot thing”?

As hinted at earlier, there is a more reasonable explanation for why Alwaleed invested in Twitter, why he has invested in Citi and News Corp., and why he invests in almost anything– Alwaleed is part of a political front and he makes investments as part of a political agenda. Politics is not an economically efficient system, it cares not for scarcity and cost in the economic sense of productive effort and opportunity cost. Political systems get their revenues from coercion, and they use economic resources as but another means to their arbitrary political ends.

Why did Alwaleed invest in Twitter? Because Twitter played an embarrassing role in the recent “Arab Spring” of revolutionary fervor across the Middle East this year and Alwaleed and his sponsors want to be in a position which allows them the knowledge and influence of the insider, of control. This is what is meant by the savvy Mr. Alwaleed’s “strategic” investment in a not-so-profitable social media favorite.

Why did Alwaleed invest in Citi? Because Citi is a centerpiece to the financial chicanery involving the global drug trade controlled by the CIA, the power-politics of world political intrigue and espionage and the dangerous, corrupt game of arms dealing and the financing of imperial military adventurism.

Why did Alwaleed invest in News Corp.? To control the news!

Let us not confuse legitimate businessmen and investors with political operatives and speculators any longer!

Review – Value: The Four Cornerstones of Corporate Finance

by Tim Koller, Richard Dobbs and Bill Huyett; published 2011

Part I is about the four cornerstones of value. In a footnote in Chapter 1, authors Koller, Dobbs and Huyett define value as:

the sum of the present values of future expected cash flows– a point-in-time measure. Value creation is the change in value due to company performance… we use the market price of a company’s shares as a proxy for value and total return to shareholders as a proxy for value creation.

Further, they explain that the book explores the “four cornerstones of corporate finance” which are:

  1. companies create value by investing capital from investors to generate future cash flows at rates of return exceeding the cost of capital
    1. the combination of growth and return on invested capital (ROIC) drives value and value creation
    2. for businesses with high returns on capital, improvements in growth create the most value, but for businesses with low returns, improvements in ROIC provide the most value
  2. value is created for shareholders when companies generate higher cash flows, not by rearranging investors’ claims on those cash flows
  3. the expectations treadmill– a company’s performance in the stock market is driven by changes in the stock market’s expectations, not just the company’s actual performance; the higher the stock market’s expectations for a company’s share price become, the better a company has to perform just to keep up
  4. the value of a business depends on who is managing it and what strategy they pursue

For a real-life application of these principles, the authors highlight the recent housing bubble, namely, that the mortgage-securitization model violated the conservation-of-value principle because it rearranged risk without affecting the aggregate cash flows of home loans, while the belief that levering up these types of investments increased their value was similarly erroneous because “leverage doesn’t increase the cash flows from an investment.”

Chapter 2 explores return on invested capital (ROIC) which the authors define in simple terms  in a footnote as:

return on capital is after-tax operating profit divided by invested capital (working capital plus fixed assets)

ROIC and revenue growth “determine how revenues get converted into cash flows.” Mathematically, growth, ROIC and cash flow (represented by the investment rate) look like this:

Investment Rate = Growth / ROIC

However, Growth and ROIC have an uneven relationship:

for any level of growth, value always increases with improvements in ROIC. When all else is equal, higher ROIC is always good.

When ROIC is high, faster growth increases value, but when ROIC is low, faster growth decreases value. The dividing line between whether growth creates or destroys value is when the return on capital equals the cost of capital. When returns are above the cost of capital, faster growth increases value.

The authors advise that “most often, a low ROIC indicates a flawed business model or an unattractive industry structure.” The growth-at-all-costs mentality is flawed.

high-return companies should focus on growth, while low-return companies should focus on improving returns before growing.

In Chapter 3, the authors focus on the conservation of value, namely,

value is conserved when a company shifts the ownership of claims to its cash flows but doesn’t change the total available.

To see how managerial decisions affect the value of the business look for the cash flow impact.

On share buybacks,

when the likelihood of investing cash at low returns is high, share repurchases make sense as a tactic for avoiding value destruction.

Caution, however, because

studies of share repurchases have shown that companies aren’t very good at timing share repurchases, often buying when their share prices are high, not low.

And why should they be any better at timing their purchases than any other market timer?

As far as acquisitions are concerned, they

create value only when the combined cash flows of the two companies increase due to accelerated revenue growth, cost reductions or better use of fixed and working capital.

In Chapter 4, the authors discuss the expectations treadmill, stating that

smart investors often prefer weaker-performing companies because they have more upside potential, as the expectations are easier to beat.

The key seems to be finding companies with a high ROIC and a low P/E ratio.

Chapter 5 discusses the best owner principle. For example, some owners add value:

  • linkages with other activities in their portfolio
  • by replicating such distinctive skills as operational or marketing excellence
  • by providing better governance and incentives for the management team
  • through distinctive relationships they hold with governments, regulators or customers
Further, there is a “best owner lifecycle”, meaning that most owners are only the “best” at a given stage in a business’s development. Some excel at the start-up stage, others the growth, others still the maintenance of empire and finally a group is best at the terminal stage where a business is dismantled and its assets are sold off to other enterprises, each owner finding unique ways to increase cash flows at each stage. The implication of this is that
executives need to continually look for acquisitions of which they could be the best owner; they also need to continually examine opportunities for divesting businesses of which they might no longer be the best owner.

Empirically, “the stock market consistently reacts positively to divestitures, both sales and spin-offs.”

Part II is about the stock market. Chapter 6 explores who the stock market is. There are a lot of different participants with differing aims, skill sets and knowledge levels but the authors conclude that ultimately

professional investors–whether they manage hedge funds, mutual funds, or pension funds– are the real drivers of share prices, accounting for virtually all large trades.

The authors estimate that “intrinsic” investors hold 20% of US assets and contribute 10% of the trading volume in the U.S. market. “Intrinsic investors ultimately drive share price, because when they buy, they buy in much larger quantities.”

intrinsic investors are resources for executives, providing an objective, circumspect view of their companies, industries, and competitors by virtue of their buying and selling decisions.

Chapter 7 is about the stock market and the real economy. Here are some aggregate observations:

  • much of the stock market’s stellar performance between 1983 and 1996 was driven by the decline in interest rates and inflation, and the resultant increase in P/E ratios engineered by Federal Reserve Chairman Paul Volcker
  • by 1996, if executives understood what was driving shareholder returns, they would have known returns had to revert to normal levels
  • adjusted for inflation, large U.S. equities have earned returns to shareholders of about 6.5 to 7 percent annually, over the last 100 years
  • this number is derived from the long-term performance of companies in the aggregate, and the relationship between valuation and performance as described by the core-of-value principle
  • over the longer term, shareholder returns are unlikely to deviate much from this number unless there are radical changes in investor risk preferences or radical changes in the performance of the economy
  • long-term GDP growth would have to increase or decrease significantly, or the ratio of corporate profits to GDP would need to change (it has been constant for at least 75 years)
If, as the authors state, “high interest rates increase the nominal cost of capital, while high inflation increases the proportion of earnings that must be invested for growth”, then the implications for the coming period in the markets where we might finally face a high interest rate environment with simultaneously accelerated money printing spells falling P/E ratios across the broad market.
This means that the market as a whole has a more narrow band of longer-term performance than many realize, and that exceptional bull markets will usually be followed by a down market, and vice versa

Chapter 9 deals with earnings management. The authors state that “excessive smoothness raises concerns” that earnings are being actively managed by company leaders. Further, “consensus forecasts aren’t very good” and “analysts’ earnings estimates are not accurate; they tend to be too optimistic, and they almost never identify inflection points.” Importantly, “there is no meaningful relationship between earnings variability and TRS or valuation multiples.”

Part III deals with managing value creation. Chapter 10 is about return on capital.
A company that has a competitive advantage earns a higher ROIC because it either charges a price premium or it produces its products more efficiently (having lower costs or capital per unit) — or both. Price premiums offer the greatest opportunity to achieve an attractive ROIC, but are more difficult to achieve than cost efficiencies.

Low ROIC industries are those with undifferentiated products, high capital intensity and fewer opportunities for innovation.

There are 5 major ways to get a price premium:

  • innovative products
  • quality
  • brand
  • customer lock-on
  • rational price discipline

There are 4 major ways to get cost/capital efficiency:

  • innovative business methods
  • unique resources
  • economies of scale
  • scalability/flexibility
Ultimately, the longer a company can sustain a high ROIC the more value it will create.
ROIC excluding goodwill reflects the underlying economics of an industry or company. ROIC including goodwill reflects whether management has been able to extract value from acquisitions.

Therefore, it might be useful to study both metrics to get a better understanding of management’s competence.

Chapter 11 is about growth.

growth from creating whole new product categories tends to create more value than growth from pricing and promotion tactics to gain market share from peers.

This intuitively makes sense because the former requires the bringing into the production system of previously untapped resources, while the former simply represents the freeing up of existing resources.

There are 4 sources of revenue growth:

  • market-share increase
  • price increase
  • growth in underlying market
  • acquisitions

The limits to the pursuit of growth:

  • sustaining high growth is much more difficult than sustaining high ROIC.
  • history suggests that many mature firms will shrink in real terms
  • U.S. companies have been globalizing, which is responsible for faster sustained growth rates of some U.S. companies than the growth of the economy as a whole
  • portfolio treadmill effect: for each product that matures and declines in revenues, the company needs to find a similar-sized replacement product to stay level in revenues, and even more to keep growing
Chapter 12 examines business portfolios. One study found that “it was better to have a competitive advantage (horse) than to have a good management team (jockey).” Another study found that “companies with a passive portfolio approach underperformed companies with an active portfolio approach.” This means “buy and hold” is a flawed strategy in the long-run, because the value of businesses change according to predictable cycles of birth, growth, flat-lining and death.

The ideal multibusiness company [think, investment portfolio] is one in which each business earns an attractive ROIC with good growth prospects, where the company helps each business achieve its potential, and where executives are continually developing or acquiring similarly high-ROIC businesses and disposing of businesses that are in decline.

To avoid depressed exit prices,

a simple rule of thumb can improve a company’s timing considerably: sell sooner

“When companies do divest, they almost always do so too late, reacting to some kind of pressure.” And a process suggestion for active portfolio management:

hold regular, dedicated business exit review meetings, ensuring in the process that the topic remains on the executive agenda and that each unit receives a date stamp, or estimated time of exit

As far as diversification is concerned:

  • diversification is neither good nor bad; it depends on whether the parent company adds more value to the businesses it owns than any other potential owner could, making it the best owner of those businesses under the circumstances
  • no evidence that diversified companies generate smoother cash flows
  • there is no evidence that investors pay higher prices for less volatile companies
  • diversified companies tend to respond to opportunities more slowly than less diversified companies
  • the business units of diversified companies often don’t perform as well as those of more focused peers, partly because of added complexity and bureaucracy

I noted in the margins that “even for investors, diversification raises transaction costs and provides more opportunities to make errors in decision process.”

Chapter 13 is about M&A. A few points about M&A value creation:

  • strong operators are more successful
  • low transaction premiums are better
  • being the sole bidder helps

Chapter 15 explores capital structure.

large amounts of debt reduce a company’s flexibility to make value-creating investments, including capital expenditures, acquisitions, R&D, and sales and marketing.

Before assuming debt, an investor or business owner needs to ask:

  • what are my expected cash flows?
  • what could go wrong?
  • what unexpected opportunities could arise?
Then, “set your debt level so that you can live through bad times in your industry while having the capacity to take advantage of unexpected opportunities.”
With complex structures and financial engineering, always identify the impact on a company’s operating cash flows and the distribution of cash flows among investors.
Finally, Chapter 17 addresses managing for value.
the only way to continually grow earnings faster than revenues is to cut necessary costs for growing the business, or to not invest in new markets that will have low or negative margins for several years