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

Review – Which Broker Should I Use? Online Discount Brokerage Review

I’ve been through a few brokers already in my short investing career. I found answering the question, “How do I trade X?” to be a mysterious one in numerous cases. It turns out the answer was often much simpler than I originally thought.

In the interests of saving other investors some time, I’m going to share what I’ve learned. This is not an endorsement of any of the brokers mentioned, I am not an affiliate/referrer (though I probably should be if I am writing posts like this) and ultimately I don’t care who you use– YMMV.

First, some info tables

I created a few tables to compare online discount brokerage features. The first is a commission and fee schedule for Scottrade, TD Ameritrade/Think or Swim, Fidelity and Interactive Brokers. Please note, this is not exhaustive nor comprehensive, it’s just the info I care most about for the kind of trades I do:

Brokerage Name Scottrade TD Ameritrade Fidelity Interactive Brokers
Stocks (online) $7 $9.99 $7.95 $1/min, 0.5% of order max
Stocks (broker assist) $27 $44.99 $32.95
Stocks (intl) Limited, $7/$27 Extensive and reasonable Extensive and reasonable
Options (online) $7 + $1.25/contract $9.99 + $0.75/contract $7.95 + $0.75/contract $0.25-0.70/contract
Options (broker assist) $27 + $1.25/contract $44.99 + $0.75/contract $32.95 + $0.75/contract
Addtl Fees N/A N/A Activity fee minimum $10/mo

Next up is a comparison of international markets you can trade in with Fidelity and Interactive Brokers, “O” means you can trade there online, “BA” means you can trade there with a broker assist and a blank means no online trade (and potentially no access with a broker, either):

Country Fidelity Interactive Brokers
N America
US O O
Canada O O
Mexico O O
Europe
Austria BA O
Belgium O O
France O O
Germany O O
Italy O O
Netherlands O O
Spain BA O
Sweden O O
Switzerland O O
Norway O
Portugal O
UK O O
Asia
Australia O O
HK O O
India Indian residents only
Japan O O
Singapore O O
New Zealand O
Notes: Claims it can reach nearly any stock in the world via broker assist

For trading Net-Nets

Which is the best online discount brokerage for trading Net-Nets in the US? I’m going to go with Scottrade here. Unless the shares have some restriction or are trading for under $1, it is only $7 per trade making Scottrade by far the cheapest (unless you’re trading in size on IB).

For trading all common stocks (US and international)

For a wider scope, I go with Fidelity. It’s $7.95 in the US for online trades and although the fee varies by country elsewhere, I’ve generally found it to be reasonable. Fidelity claims you can get access to almost any equity market in the world through their brokers, as well. I like that there is no activity or account maintenance fee, as well, which is something that irks me about IB.

For trading corporate debt and cap-arb

I tried doing a capital structure arbitrage trade through IB and not only could they not locate the debt for me because it was a convert and they don’t do converts, I also found their interface to be so confusing I wasn’t even sure if I had bought the related options properly when I put the trade on. IB has a terrible interface and their trade documentation is similarly obscurantist.

As a result, I prefer Fidelity and TDA/ToS. I have found in a few situations that TDA/ToS actually was able to find me bonds that Fidelity couldn’t, which surprised me. But overall, they both work well.

Overall

Fidelity gets my overall vote and I do and will continue to do most of my trading through their service. I have been told by so many people that IB is the way to go but I just find the GUI to be too difficult to understand. It’s outside my circle of competence, it appears! For US Net-Nets, I’ll use Scottrade just to make my trading costs absolute bare-bones and for a hard to find bond I’ll call up TDA/ToS (although they have been stumped to find me certain securities, as well) but more times than not, I am placing trades through Fidelity.

Though, one thing I do like about IB is they offer an account where you can manage a pool of sub-accounts (up to 15) without having any licenses or anything like that, which could be a good option in the future if I ever want to try managing  OPM. Plus, if you ever set up an account with Covestor you must use IB.

Guilt-Free Research: Why I’m Not Scared To Steal People’s Ideas Anymore

I’ve thought a lot about doing my own research in the sense of sourcing ideas.

When it comes to idea-generation, there are essentially two extremes:

  • “Old school Buffett”
  • Index investing

“Old school Buffett” is the investor equivalent of a music DJ “digging in the crates”– a tireless, thorough examining of every idea possible. Sifting, examining, turning over every rock. Buffett’s claim that he started with the A’s in the Moody’s Manuals.

Index investing is the opposite. Index investing is the admission, “I have no ideas.” It is resignation. It is buying everything, instead of buying something.

Most investors’ idea-generation process lies somewhere on the continuum between the two extremes.

I do believe that, especially because I am learning a lot right now, it is best for me to “do my own research” and to come up with as many ideas as I can on my own. To hang closer to the rock-turning end of the spectrum. I also believe that you should always be able to understand and vet an idea on your own that you receive from someone else (no “Investment From Authority”).

However, I have also come to realize that:

  • The greatest investors borrow liberally from others
  • Time is scarce

The second part is probably more important than the first; the first is about soothing a guilty-conscience, the second is about embracing a meaningful constraint of reality and not hanging oneself by a determination to be completely original.

In consideration of these facts, this the value I see in reading good investment blogs– they are chock full of ideas and they’re almost all being given away for free. A lot of the hedge fund guys profiled in “More Money Than God” (review coming) were notorious for getting ideas from others (mostly brokers) and learned to pay for the best ideas and thereby cultivate a network of hard-working, reliably intelligent investors who were creating actionable ideas for them all of the time. Following investor blogs is kind of similar except you don’t pay for the ideas you get. You look for people with styles you agree with, who demonstrate competent analytical skills, then you just follow them and pick off the ideas you like best.

You could also do the same with newsletters. For example, why should I spend hours and hours picking through net-nets on my own (aside from the exercise and practice) to come up with most likely the exact same ones that Geoff Gannon is giving away in his GuruFocus newsletter? Geoff Gannon is fucking smart (and I use the expletive to connote a certain level of emphasis, enthusiasm and awe, here) and if anyone is going to pick net-nets well, it’s probably him.

For $289/yr, I can have Geoff Gannon pick net-nets for me and spend that time digging up other ideas. I also get two other newsletters (the Buffett-Munger one sounds interesting and Gannon might write that, too, the Magic Formula one I am less interested in but still could have value) and a premium stock screener. That could end up paying for itself pretty easily over time. He picks 1 NCAV a month, so it’s essentially $25 an idea. It’s like paying a few extra commissions at Scottrade on each order.

I think I will continue to do a lot of “original” research early on and overall as my life as an investor goes on. But I think there are creative, low-cost ways to get smart people to do a lot of the heavy lifting for you which can free you up to spend precious time and brainpower on other problems/opportunities. I think smart investors learn to leverage themselves that way.

Until recently, it used to really bother me that I might take an idea I got from a good blog and put money into it. It didn’t seem “right” to make money that way. I was even tempted to purposefully NOT invest in the good ideas I found there, believing them to be “tainted” merely by the fact that they weren’t my ideas and I hadn’t come up with them.

But, I feel I’ve faced that guilt and banished it from my investor conscience, now. A fellow investor at CreditBubbleStocks.com reminds me that there is no credit for originality in investing; only in being right by having the best judgment.

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 – 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

Geoff Gannon As Kierkegaard: Leap Of Faith Net-Net Investing

Net-Net guru Geoff Gannon breaks down the secret ingredient to successful Net-Net investing using the example of one of his recent Japanese Net-Nets which received a buyout offer:

What special skills did earning this 130% return require? You didn’t need smarts. The key information – the cash and securities per share – was publicly available. Anyone could find it on the Internet. And the gap was egregious. If you looked at hundreds or even thousands of stocks – in Japan and around the world – Sanjo would’ve popped as a Ben Graham bargain.

No. You didn’t need smarts. You didn’t need any real insight or appetite for risk or anything like that. You just needed to embrace uncertainty.

Sanjo was certainly worth more than 200 yen a share. A lot more. No reasonable person would deny this. But most reasonable investors probably wouldn’t buy the stock. Why? There was no catalyst. No reason for the stock price to rise. Sanjo is a Japanese company. It’s a micro cap. Stocks like that don’t get bought out.

As it turns out, Sanjo’s largest shareholder had been in “intensive discussions and price negotiations with management over the last year.” So there was a catalyst. It’s just that nobody – except the company’s biggest shareholder and its president – knew about it.

That’s the uncertainty in net-nets. Most of the best net-nets have this certain/uncertain duality. It is certain the stock is selling for less than it’s worth. It is uncertain how the stock will ever sell for what it’s worth.

Net-nets are half about knowing and half about believing. They are part knowledge and part faith. If you can’t accept both of those ideas at once – you’ll never be a good net-net investor.

You can only know the stock is selling for less than it’s worth. You simply have to believe the stock will someday sell for what it’s worth.

This is probably also why Net-Nets are best bought in baskets and groups. You usually don’t have enough of a clue of what the catalyst will be to concentrate your holdings into just one company.

So it isn’t necessary to be super smart in your analysis as long as you are super smart in your actions. The big problem for a lot of would-be net-net investors is not bad analysis. It is bridging the gap between analysis and action.

And this is the key point to make about net-nets that earn low returns on equity. You don’t have to see how mean reversion will occur for it to occur.

The future does not care if you can envisage it ahead of time. It comes whether you see it or not. The good news: You can bet on things you can’t imagine.

Close your eyes and jump!