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 – Sanborn Maps, Dempster Mills, Nintendo’s Rise

Warren Buffett & Sanborn Map: An Early Balance Sheet Play

  • Buffett first got involved with Sanborn Map in 1958 because it represented a relative undervaluation compared to his then current holding in “Commonwealth”, even though he still thought “Commonwealth” was undervalued
  • Beginning in 1958, it represented 25% of the partnerships assets and BLP was the largest shareholder which “has substantial advantages many times in determining the length of time required to correct the undervaluation”
  • By 1959, represented 35% of partnership assets
  • Buffett recognized that the business operated in a “more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort”
  • Sanborn faced a changing business environment which beginning in the 1950s which “amounted to an almost complete elimination of what had been sizable, stable earning power” (after-tax profits: 1930s, $500,000; late 1950s, <$100,000)
  • Buffett estimated the reproduction value of Sanborn’s map assets at tens of millions of dollars
  • In addition, Sanborn Map carried a valuable portfolio of marketable securities which it began accumulating in the 1930s
  • Buffett: “Our bread and butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action”
  • The margin of safety was based on the fact that the investment portfolio was worth far more than the company was selling for in the market
  • Additionally, Buffett took a control position which gave him an added margin of safety
  • Buffett made roughly a 50% profit, according to Roger Lowenstein

Warren Buffett & Dempster Mills: Control Investing And Asset Conversion In A Net-Net

  • In 1962, BLP owned 70% of Dempster Mills’ shares (with another 10% controlled by associates), representing approximately 21% of partnership assets
  • Buffett: “Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from [general market overvaluation during a strong bull market]”
  • Buffett: “When control is obtained, obviously what then becomes all-important is the value of assets”
  • Buffett chose to value the partnerships shares based on a discounted estimate of what the assets would gather in a prompt sale (discounted liquidation value)
  • Buffett originally hoped he could turn around the company with existing management; when this failed, he brought in Harry Bottle on the advice of Charlie Munger
  • Bottle, at Buffett’s behest, proceeded to liquidate the balance sheet, converting assets from the manufacturing business (a poor business) into marketable securities, which BLP saw as a good business
  • Buffett: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake”
  • Buffett’s first purchases of DMM began in 1956 when it was a net-net trading at $18 with $72 in book value and $50 in NCAV per share; the company had had profitable operations in the past but was a break even at the time of purchase
  • Buffett: “Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years… [due to] an improved industry situation, a takeover offer, a change in investor psychology, etc.”
  • Harry Bottle’s effect:
    • Reduced inventory by 75%, reducing carrying costs and risk of obsolescence
    • Correspondingly freed up capital for investments in marketable securities
    • Cut SG&A by 50%
    • Cut factory overhead expenses by 25%
    • Closed 5 unprofitable branches leaving the company with 3 profitable branches
    • Eliminated production lines tying up capital but producing no profits
    • Adjusted prices of repair parts to yield additional annual profits
  • Buffett: “It is to our advantage to have securities do nothing price wise for months, or perhaps years, while we are buying them. This points up the need to measure our results over an adequate period of time. We suggest three years as a minimum.”
  • Other notes:
    • In 1961, Buffett committed $1M to DMM (his biggest investment yet), buying the controlling interest and staking 20% of BLP’s assets in the process
    • Sold the company as a going concern in 1963 for a $2.3M profit, nearly tripling his investment
    • Bottle’s employment agreement was based on a percentage of profits

Harvard Business School: Nintendo’s Competitive Advantage In The Early Home Video Game World

  • Prior to Nintendo’s dominance, the home video game market was led by Atari and suffered a number of boom-bust cycles where as much money was lost on the way down as was made on the way up
  • The cost of video game consoles has been falling in real terms since the 1980s:
    • 1977, Atari VCS $200, game cartridges $25-30 retail, $5-10 cost to mfger
    • 1983, Commodore, Casio and Sharp game systems sold for around $200-350
    • 1983, Nintendo launches Famicom system at $100 retail price (believed to be at or below cost), and had extracted a rock-bottom chip price of $8/chip by placing an order for 3M units
  • Home video game systems were a growing market:
    • 1982, 17% of US households had a video game system
    • 1990, Nintendo Famicom/NES console was in 1 out of every 3 households in the US and Japan and home video games represented a $5B worldwide industry
  • Nintendo’s development costs were up to $500,000 per title (Y100M) and marketing expenses were several hundred million yen
  • Nintendo’s approach was to focus R&D on developing one or two hit titles per year rather than several minor successes
  • Manufacturing of cartridges was subcontracted at a unit cost of $6-8, which then retailed for $40
  • Part of Nintendo’s value was in hit franchises such as Super Mario Brothers (1985), the Legend of Zelda (1987) and Metroid (1987), the first two of which were developed by hit designer Shigeru Miyamoto
  • Demand for games soon outstripped supply, so Nintendo allowed six firms to be licensed software makers, paying royalties of 20% of the $30 wholesale price per game:
    • Namco
    • Hudson (later acquired by Nintendo and brought in-house)
    • Taito
    • Konami
    • Capcom
    • Bandai
  • By 1988, 50 licensees, who were also charged the 20% royalty rate and had to absorb Nintendo’s manufacturing costs
  • Cumulative sales of Famicoms from 1983-1990 = 17M, Nintendo had gained 95% market share of 8-bit home video game market
  • On average, Japanese consumers bought 12 games for every Famicom system purchased
  • Nintendo, via Nintendo of America subsidiary, rolled out NES (Famicom) in the US in 1985 at $100/system
  • NOA limited licensees to producing 5 NES titles per year; had to place orders for manufacture through NOA at a cost of $14/game cartridge which wholesaled for $30 and were then marked up an additional $15 at retail
  • By 1991, 100 licensees with only 10% of software development in-house at Nintendo
  • Nintendo began licensing Mario and other characters to TV shows, cereal packets, T-shirts, records and tapes, books, board games, toys and other media
  • NOA’s highly targeted ad budget was about 2% of sales and promotional partners were utilized extensively
  • WMT did not stock competing video game systems
  • In 1989, NOA proposed creating a proprietary online network for its game consoles, allowing users to play games, trade stocks, do e-banking and other activities that would later become common place throughout the late 90s but which Nintendo itself failed to capitalize on with its own later systems repeatedly!
  • 1989, Nintendo releases Game Boy handheld game console in Japan, retail price $100, games $20-25, designed to broaden the appeal of their systems (another strategy Nintendo would later utilize with the Wii)
  • By 1992, 32M Game Boys shipped worldwide and consumers bought on average 3 games per year
  • In 1991, Nintendo signed a consent decree with the FTC ending many of their dominant licensing, manufacturing and wholesaling/retailing practices, completely changing the economics of Nintendo’s business

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