Journeys of a Bumbling Investor

When I was thinking about the issue of double counting of free cash flow, one query that I had was as such:- I understand that me in the position of the small stockholder is at the mercy of the management in terms of how free cash flow is deployed. Hence it is logical that I should only discount cash flows that are literally received by me (e.g. dividends, potential selling price of the stock that I hold). However, if I put myself in the shoes of the business owner (i.e. the Buffett idea), then wouldn’t I truly receive the free cash flows? in the same way as Buffett receives the free cash flows from its subsidiaries which he then channels to his investments. In that case, shouldn’t I be able to discount the projected free cash flows?

The answer is as such: Thinking as a business owner does not make the cash flows more “free”. This is because if say increased capital spending is used to spur growth, then in both cases (i.e. as a small shareholder or as a business owner), those free cash flows are re-invested, and hence are not truly free, and cannot be discounted at that point in time. Even as a business owner, while you receive the cash flows initially,  you need to plow it back again, so you cannot extract the full free cash flow value. The only distinction then between the small stockholder and the business owner is, as highlighted above, the ability to direct the use of the free cash flow. Note however that if the business owner truly discounts the full free cash flow, truly intends to extract the full free cash flow, then he must model in the corresponding effects on the future earnings due to lower or no re-investment.

From my many previous posts, you can tell that I’ve been thinking for some time about this problem with the double counting of “free” cash flow that most people do with DCF, i.e. free cash flow that are re-invested are not truly free for discounting at the point in time in which they are earned.

For a long time I’ve not seen any article highlighting this issue, and in fact to the contrary, every DCF that I’ve seen simply discounts FCF in this “wrong” manner.

Well, I’m glad to finally see this issue being highlighted in a few places! =)

1. An article by Roger Montgomery, a Buffett-follower, at Clime Asset Management here: Questions of Value – An Examination of the 2-Stage Model; and
2. An article by Michael Mauboussin of Legg Mason here: Common Errors in DCF Models, where he highlighted the critical linkage between amount of re-investment and future growth.
3. The Wizards of Wall Street book by Kazanjian carried an interview with Glen Bickerstaff who managed the Trust Company of the West. In there, Glen highlighted that they do not have a good feel of the future return of incremental invested capital (i.e. above mantenance level capital spending). He also uses what he calls a ‘cap rate’ as his valuation metric, which essentially is the IRR.

Rating: Mama desu

Background: One book that I read probably 1-2 years ago. With all these stuff about efficient market hypothesis and stock prices fully reflecting all publicly available information, the book’s catchy caption “Reading stock prices for better returns” caught my attention, as to what you can glean from the current stock prices.

Key points:

1. The book’s main procedure goes like this:
   1. Use the consensus analysts’ earnings growth rates to project future earnings.
   2. Use WACC as the discount factor.
   3. Use the rate of inflation (e.g. around 3%) as the growth rate for calculating the terminal value.
   4. Use the current stock price as the solution for the DCF.
   5. Solve for the implied “competitive advantage period”, i.e. the number of years of “good growth” before hitting the terminal value.
   6. So now, you have the complete “market model” for the stock, i.e. how the market expects the company to perform.
   7. Now perform a competitive strategy analysis for the company (e.g. using Michael Porter’s 5 forces model). Anticipate how expectations will be revised for the primary drivers (i.e. Sales growth, operating margins, re-investment) due to the competitive dynamics. For example, sales growth expectations may change due to changes in volume, selling prices and product mix; operating margins may change due to selling prices, product mix, economies of scale and cost efficiencies. You can see a diagram of the “expectations infrastructure” here (exhibit 3).
   8. Calculate a new expected value of the stock by factoring in your predicted changes in the expectations of the drivers (and their corresponding impacts on the inputs of the DCF).
   9. Buy/sell stocks that trade at sufficient discounts/premiums from their expected values.
2. Include future option grants when estimating future costs.
3. When an acquiring company uses cash, it signals that their own stock is undervalued. On the other hand, if they use stock, it signals that their own stock is overvalued.

Thoughts: While the idea is interesting, I don’t really subscribe to it. I don’t subscribe to EMH and I don’t believe that the market indeed have a consistent view of how DCF should be done, with the competitive advantage period being the flexible variable in question when doing the reverse DCF.

Let’s consider a hypothetical situation: where the Earnings Growth Rate is fixed, and unaffected by ROIC/ROE/etc. This follows on from the train of thought that ROIC/ROE/etc. are not the determinants, but rather it is fueled by sales growth and the free cash flow margin. You can see this from this spreadsheet here: ROIC vs Earnings Growth Rate Spreadsheet

Case 1: No dividends, earnings growth rate = 10%

When ROX = new earnings / (base + earnings) = 10%,

new ROX
= new new earnings / (base + earnings + new earnings)
= new earnings * 1.1 / (base + earnings + new earnings)
= (new earnings + new earnings * 0.1) / (base + earnings + new earnings)
= (0.1 * (base + earnings) + new earnings * 0.1) / (base + earnings + new earnings)
= 0.1
= earnings growth rate

=> ROX stabilises at the earnings growth rate

Case 2: With dividends, earnings growth rate = 10%

Let the stabilising ROX = XXX

When new earnings / (base + 0.8*earnings) = XXX,

new ROX
= new new earnings / (base + 0.8*earnings + 0.8*new earnings)
= new earnings * 1.1 / (base + 0.8*earnings + 0.8*new earnings)
= (XXX * (base + 0.8*earnings) * 1.1) / (base + 0.8*earnings + 0.8*new earnings)

To be stabilising, we must have,
new ROX = XXX
=> (XXX * (base + 0.8*earnings) * 1.1) / (base + 0.8*earnings + 0.8*new earnings) = XXX
=> (base + 0.8*earnings) * 1.1 / (base + 0.8*earnings + 0.8*new earnings) = 1
=> (base + 0.8*earnings) * 1.1 = base + 0.8*earnings + 0.8*new earnings
=> (base + 0.8*earnings) * 1.1 = base + 0.8*earnings + 0.8*XXX*(base+0.8*earnings)
=> (base + 0.8*earnings) * 1.1 = (1 + 0.8*XXX) * (base+0.8*earnings)
=> 1.1 = 1+0.8*XXX
=> 0.1 = 0.8*XXX
=> XXX = 0.1/0.8 = 12.5%
=> XXX = Earnings Growth Rate / (1-Payout Ratio)

=> If the Earnings Growth Rate is the fixed determinant, then the ROX will defined by the Earnings Growth Rate (i.e. Earnings Growth Rate / (1-Payout Ratio))

——–

Context-switch: In the hypothetical scenario that ROX is the determinant, which base should be used?

• One property of the “base” (for the equations above and in a previous post to work) is that it increases by the retained earnings.
• The base using equity or book value will be continually increased exactly by the retained earnings, but not the case for tangible assets. because tangible assets can decrease when debt is paid down.
• So then perhaps using equity or book value as base for projection is more logical
• But using tangible assets as base is more logical for determining the real returns-generating capability of the firm – coz that is not impacted by debt levels.
• But when you talk about tangible capital employed, there is no concept of debt — the debt levels (interest-bearing) do not change the tangible capital employed
• If you don’t minus excess cash, then the tangible capital employed indeed increases by the retained earnings
• Hence you can do projections using tangible capital employed (without minusing the excess cash)

——–

Concluding thoughts:

Earnings Growth Rate & ROX are not the determinants

• If the Earnings Growth Rate is the determinant, then Returns on “all bases” will be the same (eventually all will become (Earnings Growth Rate / (1-Payout Ratio))) – if the characteristic of the base is additive with retained earnings.
• We don’t see that happening, hence it cannot be the case that Earnings Growth Rate is the determinant.
• The ROX also cannot be the determinant as explained in an earlier post, since the earnings are truly due to sales and margins.
• Why did we want to use ROX to project earnings in the first place?
• Because by doing that, we can model in the effects of different payout ratios (i.e. re-investment), e.g. increasing re-investment thru retained earnings helping to increase future earnings (either by increasing sales or improving margins)
• Can we project without using the ROX and yet be able to model in different payout ratios? <– important question

Modeling the re-investment process to project earnings

• Yes, by modeling the re-investment process. We need to estimate the “return on retained earnings” so as to project the impact of retained earnings on future earnings.
• This projection can start at any point in time. If we assume that the earnings for one year can be repeated thereafter (i.e. the old base continues to produce the same earnings year after year after year), then we can project future earnings by using the old base, and adding on the effects of “return on retained earnings” subsequently.
• If we find that the ROX is consistent across many years, then what it means is that the “return on retained earnings” = ROX, then we can project using ROX, Buffettology-style.
• We can estimate the “return on retained earnings” by calculating (Earnings (T + y) – Earnings (T)) / (Retained earnings from T to (T+y)). E.g. (2003 Earnings – 2000 Earnings) / (2000 Retained earnings + 2001 Retained earnings + 2002 Retained earnings). “y” should be varied using 1-year, 3-year, 5-year, 10-year periods. You need to calculate across multiple years as the “fruits” of re-investment may not happen immediately in the next year.

Modeling re-investment is a “short-cut” to reality

• The projection using “re-investment return” is a short-cut.
• In reality, the 3 primary drivers are : Sales growth rate, FCF margin, Payout ratio (i.e. re-investment)
• Capital-intensive companies that require lots of re-investment into PP&E will have a bad FCF margin. Re-investing for expansion or advertising can greatly improve the sales growth rate. Share buybacks are also another form of re-investment which doesn’t impact earnings but may impact valuation.
• To really estimate the effects of each different type of re-investment on Sales growth rate and FCF margin seems fraught with guesswork and errors. May be better to use the “re-investment return” short-cut.

Afternote: An article from Tweedy, Browne (Great 10-Year Record = Great Future, right?) highlighted a warning for assuming a consistent ROX

• “The easy-to-calculate Implied Growth Rate (i.e., return on equity times the percentage of earnings that is reinvested in the business and not paid out to stockholders as a dividend) did not predict future earnings growth, on average, for companies that had been highly profitable over the last ten
  years. Return on equity for these companies, as a group, tended to decline over the next seven years. Financial pasts were not related to financial futures for the companies as a group.”

Buffett has been frequently quoted to use the long-term U.S. Bonds as his discount rate for doing his DCF calculations.

At the 1997 Berkshire Hathaway meeting, Buffett was quoted to have said:

“We use the risk-free rate merely to equate one item to another. In other words, we’re looking for whatever is the most attractive. In order to estimate the present value of anything, we’re going to use a number. And, obviously, we can always buy government bonds. Therefore, that becomes the yardstick rate.”

Responding to a question at the meeting, he was quoted to have said:

Shareholder: Following up on that other question – if you don’t adjust for risk by using higher discount rates, how do you adjust for risk – or do you?

Buffett: Well, we adjust by simply trying to buy it at a big discount from the present value calculated using the risk-free interest rate. So if interest rates are 7% and we discount it back at 7% (which Charlie says I never do anyway — which is correct), then we’d require a substantial discount from that present value figure in order to warrant buying it.

At the 1998 Berkshire Hathaway meeting, Buffett was quoted to have said:

“We don’t discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”

“In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.”

By this time, you would probably think that Buffett simply uses the long-term Treasury rate, while ensuring that the projected cash flows are pretty certain so that you don’t have to increase the discount rate to compensate for earnings risk. However, at the 1994 Berkshire Hathaway meeting, Buffett was quoted:

“In a world of 7% long-term bond rates, we’d certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we’re willing to play. We have to feel pretty certain about anything before we’re even interested at all. But there are still degrees of certainty. If we thought we were getting a stream of cash over the thirty years that we felt extremely certain about, we’d use a discount rate that would be somewhat less than if it were one where we expected surprises or where we thought there were a greater possibility of surprises.”

This is clearly inconsistent with his remarks in 1997 and 1998 where he said he does not adjust the discount rate depending on the riskiness of the projected cash flows. Also, in the 2000 Chairman’s Letter, he wrote:

“The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.”

Meaning that discounting with the risk-free rate results in a value which is the way way upper bound of what you should paying. In conclusion, I believe, if you want to discount, we should look at this in two ways (among many others), first is discounting using the risk-free rate followed by a substantial discount, second is to discount with a higher required rate of return (which Buffettology said Buffett’s was 15%). I still feel that simply calculating the IRR would be the best method.

Also, I still don’t understand why people discount cash flow with WACC. I guess firstly I don’t believe in CAPM; and secondly, doesn’t discounting unlevered free cash flow and comparing with EV already assumes that all debt is wiped out?

I chanced upon this book The Real Warren Buffett: Managing Capital, Leading People by James O’Loughlin at the library today. Found a couple of good quotes from Buffett to capture in this blog.

From Buffett’s 1992 annual report:

“In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”

From Buffett’s 2000 annual report:

“Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush ¾ and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota – nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.”

[Thought: To rank the attractiveness of different uses of capital, Buffett would have to calculate either NPV or IRR. Since he wrote above that he uses the long-term U.S. bonds rate, it seems to imply that he calculates NPV to compare across the different investment opportunities.]

As an aside, basically every value investor in the world uses DCF:

• FocusInvestor.com quoted this from the Clipper Fund: “Our investment approach is very research intensive and includes meeting with management and preparing detailed valuation models for each company followed. The valuation models calculate the intrinsic value which is based on private market transactions and discounted cash flow valuations.”
• It also quoted this from Longleaf Partners: “…determine the company’s ongoing value based on its ability to generate free cash flow after required capital expenditures and working capital needs. We calculate the present value of the projected free cash flows plus a terminal value, using a conservative discount rate.”
• Legg Mason’s Michael Mauboussin likely uses DCF. He has an excellent article on the common errors people make in DCF modeling, here. He has another excellent article on comparing share buybacks vs dividends at here.
• Richard Lawson from Weitz Funds had an interview in the book Wizards of Wall Street where he said: “I ask whether I would like to own a company at its current market price, assuming that I never had a chance to sell it to anybody else. When you think about value from that perspective, all that really matters is the long-term discounted free cash flow. It’s just a function of how much cash you should expect the company to be able to pay out to its shareholders over its life, discounted back to the present.”
• etc.

[Thought: Lawson's quote above is interesting on two fronts. First is when you consider that you would not have a chance to sell it to anybody else, it just means that for the terminal value calculation, you will discount future payouts from the company, as opposed to using data from private market transactions or from movements of a multiple. Second, he is clear that what you discount is what the "company pays out to its shareholders", as opposed to counting free cash flow that is retained.]

Bruce Wasserstein in his book Big Deal wrote about the relationship between the three financial statements: balance sheet, income statement & cashflow statement. I seem to be quoting time and again from this book, which speaks to how good the book is. Even though the book is very very thick (some 1000  pages), the writing is clear, succinct, and illuminating.

Net income – an income statement item – is dependent on interest expense, which is dependent on yearly average debt and cash balances – balance sheet items – which in turn are dependent on cash flow (positive cashflow can be used to pay down debt, negative cashflow would require additional debt to be added), a figure whose calculation begins with net income (cash expenses such as capex, dividends, and stock repurchases are not yet factored into net income).

This is a post of a piece that was written on June 6, 2006, while performing some research on the executive search industry.

The Economics

The Executive Search market concentrates on searches for positions with annual compensation of $150,000 or more, which generally involve board level, chief executive and other senior executive positions.

The industry is comprised of retained and contingency search firms.

Retained firms typically charge a fee for their services equal to approximately one-third of the annual cash compensation for the position being filled regardless of whether a position has been filled, and are retained by the client company on an exclusive basis. Out-of-pocket expenses incurred during the search are billed to the client.

Contingency firms generally work on a nonexclusive basis and are compensated only upon successfully placing a recommended candidate. All major market players adopt the retainer model.

A typical search process is as follows:

1. Consult with the client to understand its organizational structure, relationships and culture, history, expectations, challenges, future direction and operations.
2. Determine the required set of skills, experience, and other characteristics of an ideal candidate for the position. General parameters of an attractive compensation package may be developed.
3. Select, contact, interview and evaluate candidates on the basis of experience and potential cultural fit with the client organization.
4. Present confidential written reports to the client on the candidates who potentially fit the position specification.
5. Schedule meetings (few rounds) between the client and selected candidates.
6. Conduct thorough due diligence and background checks on qualified candidates.
7. Assist the client in structuring the compensation package.
8. Final offer made and accepted.

The Investibility

The Executive Search industry is a cyclical industry, estimated to be worth US$8 to 9bn at the height of the dotcom boom, to US$5 to 6bn by 2003. The North American market accounts for about half of all executive search business, with 35 per cent of revenues sourced in Europe, while Asia, Latin America and Africa absorb most of the remaining 15 per cent.

The industry is dominated by 4 major players: Korn Ferry International (KFY), Spencer Stuart & Associates, Egon Zehnder International, Russell Reynolds Associates, Inc., and Heidrick and Struggles International, Inc. (HSII).

Ordered by 2004 revenue, we have: Korn Ferry (US$438m), Spencer Stuart (US$378m), Heidrick and Struggles (US$375m), Egon Zehnder (US$336m), and Russell Reynolds (US$273m).

None of these firms has any significant competitive advantage over the other competitors.

During an economic downturn, Executive Search firms will typically face significant revenue declines (e.g. 20%) and lay off hundreds of staff to offset losses in the search business. During boom times, revenues will jump (e.g. 30%) and significant hiring will occur.

Assuming no increase in the market size (e.g. expansion in China, India and Russia markets), the Executive Search industry is not a good industry to invest in.

The Executive Search industry has shown its historically consistent tendency to over-invest and over-correct for economic booms and busts. Granted that economic cycles are hard to predict, nonetheless, a systematic problem prevents a CEO to do proper corrections even with accurate predictions.

Imagine being the CEO of a major Executive Search firm. At the peak of a boom, when the firm is experiencing double-digit revenue growth and flush with profits, will the CEO be able to 1) ‘downsize’ firm operations in anticipation of a economy slowdown?, or 2) return cash to shareholders for the same reason?, or 3) slow down the frenzy rate of hiring of search consultants and staff? The obvious answers are No, No and No. The firm will have to go full-steam ahead in hopes of greater and greater profits.

And after some time, when an economic slowdown comes around, the firm starts to find its revenues tanking while its fixed costs are remaining high (e.g. exec search consultants). Massive layoffs result and surplus cash from the previous boom gets ‘burned off’. At the bottom, whatever cash that is left behind will be used to either 1) buffer against further bad business, or 2) kept in reserve in anticipation for their use when the ‘good times’ return.

So where does all these lead to for the small shareholder? In good times, profits go towards expansion and increased operational expenses. In bad times, retained earnings get ‘burned off’. Does all these money ‘come back’ to the small investor? Does the firm get to accumulate profits and consistently grow? The answers to both questions are a flat NO. In summary, the economics of the Executive Search business makes it inappropriate as a long-term investment.

Despite the above, we recognize three factors that may allow an investor to make profits in the Executive Search business:

1. Growth in the Executive Search market through expansions into other markets (e.g. China, India and Russia). While the cyclical nature still persists, the size of the pie still has potential to grow.
2. Capital appreciation when the economy picks up. This involves making short-term bets to ‘ride the wave’ as the economy recovers and brings the search firms along for the ride, and cashing out before an economy downturn. This carries with it the significant risks of market timing.
3. Enduring competitive advantage in terms of customer loyalty. Though extremely tough to pull off, search firms may be able to ‘lock in’ customers through long-term retainer contracts, comprehensive candidates database, etc.

However, relative to other sectors/industries, we believe that investing in the Executive Search industry still remains as an inefficient use of capital.

I had a trading speculative stock (yeah, still  have a gambling streak in me) that spiked on Monday (9 July) for no apparant fundamental reason. Perhaps it was a short squeeze, or perhaps there is some fundamental news that’s not public-public yet. If its a squeeze, we should take the opportunity to sell out our position, but if its something fundamental then we should hold on.

Since we don’t know which is it, perhaps next time, we should take the middle path and just simply sell off 50% of our position.

So Joel Greenblatt uses ROC as defined in an earlier post, with the base being the tangible capital employed. Warren Buffett seems to use Return on NTA (RONTA), from his See’s Candies example in the Essays of Warren Buffett book. However he is often quoted as using ROE.

[Quick recap: Net Tangible Assets = Total assets - intangible assets - Total liabilities - redemption value of preferred stock]

So, which is the right base to use?

To know the true returns-generating capability of the firm, ROC is the right one to use (see earlier post here). RONTA will be inflated (relative to ROC) by the use of debt. Hence it may be useful to compare the RONTA to the ROC to know the “additional return” obtained due to the use of debt (note: additional return = RONTA – ROC). The “additional return” is comparing the existing leveraged firm, vs its unleveraged version (i.e. if you don’t incur any debt and finance everything with your own money, your return = ROC; if you incur the existing debt hence lowering your own cash outlay, your return = RONTA). You should not use ROE as the base would contain “intangible assets”, which does not require any cash outlay to “finance”/”procure”. Hence the meaning of ROE is kinda warped.