I haven’t been looking at the stock market for probably close to a year, but recently got involved again due to the worsening crisis (well, at least what’s reflected in the stock prices).

Just wanted to capture a couple of learning points from the current crisis:

• Stocks of asset management firms and hedge funds will get hammered more because of two reasons (see FIG and BX for examples):
  1. Customer redemptions due to the panic, forces hedge funds and mutual funds to sell at low prices into the market panic and prevents them from taking advantage of the good buying opportunities available. The exception are funds that clearly holds lots of cash that are not “callable” in preparation of buying in true market crashes (e.g. Berkshire Hathaway’s $40bn cash warchest).
  2. Market conditions affect firms that the hedge funds / mutual funds have invested in, either lowering valuations or requiring additional funds and effort to ensure that those firms survive through the crisis.

• Low liquidity stocks (e.g. Preferred stock) will get hammered more because
  1. There are fewer shares to go around, hence fewer buyers to compete for shares that are being sold, hence the bid is lower. Buyers take advantage of that to offer even lower bids. Buyers also offer lower bids to compensate for the lack of liquidity.
  2. In panic selling, sellers are forced to sell at the low bids, especially when margin calls are hit.

• Because of the reasons above, good low liquidity stocks may be bought at terrific bargains during a crash. However, do not buy into low liquidity stock until minimally the following three conditions are met:
  1. A crash has occured (refer to Cramer’s definition in my previous post, e.g. headlines of markets crashing worldwide, people ruined, blood on the streets, etc.).
     If you buy low liquidity stocks before the crash, you will find that you will be holding them all the way down. This is because the crash happens very quickly (e.g. in 2 days), the drop in the bid is huge and sudden, and buyers only bid at rock-bottom prices.
  2. You are prepared to never be able to sell the stocks until the market has recovered (which may be years later). A recovery in the general market may not cause the low liquidity stocks to recover.
  3. You do not take on ANY debt if a large portion of your portfolio is in low-liquidity stock. The huge gapping drops in the price will cause margin calls extremely easily.
     As an example, I bought NCT-PB at $9, with a buffer of $6 before hitting a margin call, and the stock tanked in 2 days to $3.

• Stock market crashes happens quickly, within 1-2 days to a week. Spread out any buying to over at least a 2-week period. Capital is the MOST important thing to have in a crisis. Use it sparingly. Do not exhaust it within a week and get slaughtered in the next.
• I cannot over-emphasize that Capital is the MOST important thing. Cash is KING.
• Do not be overly tempted by 52-week lows. It can ALWAYS go lower. Wait for the true mega plunge before committing the bulk of your capital.
• So far, this crisis have stocks trading pretty range-bound (at low prices of course), with some occasional small dips and a large plunge so far (plunged on 9-10 Oct). Some trading rules for such a market:
  1. If a company plunges due to a “structural issue inherent to that company” (e.g. AIG, WB, MER), you can put the bulk of your capital in due to the over-reaction. Be prepared to sell intra-day (i.e. on the same day) or the day after.
  2. If the overall market drops and you want to take advantage to buy positions in certain companies, spend at the most 20% of your capital. Similarly, sell off immediately when it has recovered to the average of its trading range. You should be holding all cash most of the time.
  3. If it drops further after you’ve put in the 20%, hold and wait for a few days. If the mega plunge happens, go in with the rest of your capital. If nothing happens, you may buy in a little more (max another 10% of your total capital) and hold.

• Do not do dollar-cost-averaging all the way down. That should only be done in good times. Be prepared to wait a few days (min. 3 or more) to determine if its a mega plunge before committing capital.
• PUT IN THE BULK OF YOUR CAPITAL ONLY IN A MEGA PLUNGE! There is nothing worse than running out of capital at the rock bottom of a plunge.
• Look out for “special opportunities”, e.g. 10-for-1 reverse stock split with unaware speculators selling their stock at low prices thinking that there was a jump.
• With high market volatility, dividends are not important. Do not buy a stock to capture dividends. Capital gains/losses occur much more easily and will invalidate any dividends gained anyway.
• Cramer is right – do not fight the cycle. Secular growth stocks like Walgreen (WAG) survived much better than others. Those may be safe harbours when the possibility of a market crisis is looming, and yet you don’t want to pull all out from the market.

I’ll update this post as I learn more

The points here are summarised from an interview with Howard Ward (Gabelli Funds) conducted by Kirk Kazanjian in his book Wizards of Wall Street.

Without question, 1992 and 1993 both were difficult years for you [Aside: drug stocks hammered due to health-care spending concerns + threat of federal health-care and drug-price regulation when the Clintons took office. Philip Morris in April 1993 cut the price of Marlboro cigarettes by 40% overnight. Investors clobbered not only Philip Morris, but all of the consumer staples stocks].

What did you learn during that time?

• Leading brands are valuable assets.
• All of the private label consumer-brand companies (e.g. American Safety Razor, Cott’s, Perrigo) failed to have a lasting or measurable impact on the blue chip multinationals (e.g. Gillete, P&G, Coke, Philip Morris).

How do you figure out how much you’re willing to pay for a stock?

• Developed an earnings valuatino model that tells me what the logical price for a stock is, using a five-year time horizon (don’t work well for cyclical stocks).
• Take the current year’s earnings estimate, grow the earnings by 5 years using a 5-year growth rate.
• Then look at what kind of P/E multiple the market is willing to pay for the stock in 5 years time. Typically will use a P/E number that’s 10% lower than what the market is currently paying and won’t use any multiple that exceeds 30.
• Multiply the year 5 earnings with the year 5 P/E to get the stock price 5 years later.
• Discount that number back for 5 years using the 10-year Treasury rate + 2%. The +2% part is the equity risk premium.
• The discounted present value is the fair value of the stock.

Do you sell when it reaches your target price?

• No. From experience, a stock that is rising rapidly is frequently a leading indicator of an up-side earnings surprise.
• Don’t typically start reducing a position until the stock is at least 10% overvalued.
• Won’t eliminate a position until its about 20% overvalued.

The points here are summarised from an interview with Bob Torray (Robert E. Torray & Co.) conducted by Kirk Kazanjian in his book Wizards of Wall Street.

What have you learned over the years? How has your investment approach matured?

• It is a tough way to make a living by investing in obscure companies, special situations and turnarounds, and trying to take advantage of market cycles.  My experience over several decades convinced me that I should forget about all of that.
• It wasn’t that we didn’t make money, we actually did very well. But I now believe that we could have done about the same, and certainly better after taxes, with less effort, uncertainty, and risk, by simply buying first-rate businesses run by top-notch management and hanging onto them for the long haul.
• To put it another way, early on I was playing the stock market, trying to buy low, sell high, capitalize on turnarounds, breakup values, and so on. Today, I don’t trade at all.

Some other question…

• The value of a business is related to the stream of earnings it generates. The share price will reflect those earnings but cannot alter them. We want to buy at a fair price.

The points here are summarised from an interview with Fritz Reynolds (Reynolds Funds) conducted by Kirk Kazanjian in his book Wizards of Wall Street.

• Look for companies with above-average growth characteristics, strong unit growth (>= 13%), are well managed, and enjoy good pricing power.
• Often that might be the number one or two company in the industry. It could also be economies of scale or worldwide growth.
• Many times it’s a very profitable company with high return on equity.
• It has balance sheet that’s strong, maybe no more than 30% debt.
• Use the PEG ratio (P/E divided by growth rate) as a valuation yardstick. If PEG is 1.25, and interest rates are very high, stocks are a good value. When interest rates are near a 30-year low, the average PEG is 1.5 to 2 for many of the companies ,and they are good values.

The points here are summarised from an interview with Bill Miller (Legg Mason) conducted by Kirk Kazanjian in his book Wizards of Wall Street.

How do you figure out what a company is worth?

• We use what we call a multifactor valuation methodology, i.e. we look at the value of the business every possible way we can.
• We use P/E, P/B, P/CF, but we adjust those numbers for the underlying economic reality.
• We do all the cross-sectional analyses of trying to figure out what the historic parameters have been (i.e. to correspond with the historic underlying economic reality).
• We do a scenario analysis of the business, by projecting cash flows out anywhere from 5 to 10 years under a variety of scenarios. One scenario would be where the current growth rate continues. Another, where the company does a lot worse. Another is where it does better. We then try to figure out what we call the “central tendency of busines value.” Each scenario analysis gives us a different number and then we see how those numbers cluster. If they all cluster around the same thing, then we have a pretty high confidence in the particular valuation range.

CSE is a stock that is beaten down in this mortgage crisis. Even though management affirmed that dividends will be paid as promised earlier, there are still shorts who believe that the dividend would not be paid (which was what happened in many other mortgage companies even though their managements also proclaimed great news before disasters struck).

So you would expect that when the company announced that a dividend of $0.60 will be paid this quarter, the stock should enjoy a small jump. Instead, the stock actually dropped a little. So I said, Wierd, and I went ahead to buy a bunch. Over the next few days, the stock kept tanking, all the way from $18 to $16.

1st Lesson: Don’t think that a battered stock will always jump on dividend announcement.

Well, I averaged down during the tanking, though I was thinking if there was some impending news that I was not privy to – that’s a very scary thought =). Anyway, what happened was that 1-2 days before ex-dividend, the stock started to jump up. There was very significant short covering by short sellers who do not want to end up paying the dividend (to the guy whom they borrowed the stock from). The stock jumped back up above $18. At that time, I was considering if I should sell into the short squeeze. The idea being that the short squeeze was artificial demand, so I should take advantage of that temporary dislocation, else the stock might drop back down significantly on ex-dividend date after the artificial demand has disappeared. This coupled with the possibility that the short sellers might resume shorting the stock again.

But I ended up not selling the stock. On ex-dividend date, the stock opened at $18 (the previous close would be $17.67 when adjusted for the dividend). The stock pretty much stayed above $17.67 during the session and thereafter. The fear of a price tank due to i) lack of artificial demand, and ii) resumed short-selling, did not materialise.

2nd lesson: It may not always be wise to sell into a short squeeze.

The first two lessons illustrate that in the stock market, anything can happen. That’s why its extremely hard to make money from short-term trading. I think the Value Investing is still the sure of making consistent profits in the stock market.

On a related note, NCT announced dividends a few days after CSE’s ex-dividend date. Well, unlike CSE, NCT soared when the dividend announcement was released. Again highlighting the fact that, you can never predict with certainty what would happen in the short-term.

Well, I made a costly mistake this week: I betted that the Fed would not cut rates on 18 Sep 07.

Apparantly, the futures market had a 100% expectation of a 25 basis point cut, and many news articles were clamoring for a 50 basis point cut. The reason that the market gave was that with the credit/liquidity turmoil currently, a recession could potentially develop, hence the Fed should cut rates. However, I felt that the Fed would not bow down to the market pressures and would instead only cut rates when there are definite signs of a slowdown/recession. In fact, with the oil prices making new highs this week and other indicators showing signs of inflation, I felt that that inflation is still a potential problem, so it would be unthinkable to cut rates.

As it turns out: I was wrong. Bernanke bowed down to market pressures and cut rates by 50 basis points.

As a bet against a rate cut, I had liquidated most of my positions, and ended up missing a 15% rally on my positions over two days. With my stocks now at a short-term high, I’m very cautious of going back in for fear that the price level would drop significantly back to pre-rally levels, even though the stock is still clearly undervalued. It made me realised how much a good thing it was to buy a large position when the stock was trading ridiculously low. The psychological comfort and safety of buying in at an extremely low price was wonderful. I should not have let go of that and should have held my position.

On hindsight too, I realised that I was making a call based on a wild guess. I had no idea of Bernanke’s personality, no idea of what kind of pressures/influences the FOMC was subjected to, and no idea of many other factors that would impact the Fed’s decision. I was literally speculating, in the purest sense of the word. Hence my lesson: Never speculate on Fed decisions ever again.

Interestingly, I saw this article about an interview with Warren Buffett on the Fed rate cut (link here). The important quote from Buffett:

“The important thing in stocks is to buy a stock in a good business at a reasonable price. Anybody that is buying or selling stocks based on what the Fed is doing, or what they think they’re going to do at their next meeting, I think is destined to not having a great financial future. It really doesn’t have anything to do with the value of good companies 3, 5 years from now. People who think they can dance in and out based on Fed signals, I think, they’re going to make their brokers rich, but they’re not going to make themselves rich.“

I was doing a very quick compilation of the effects of the liquidity crunch on the financing of some of the mortgage companies that I’m looking at. To set the background, the average interest rate for traditional 30-year fixed-rate mortgages is 6.25%, and the average interest rate for one-year adjustable rate mortgages is 6.34% (from Mortgage Bankers Association’s weekly applications survey for the week ending Sep 7).

You can see that many of the companies’ financing cost jumped up significantly and is way above the residential mortgage rates. The “better and larger” the company, the lower the financing cost relative to others (though still high in the absolute sense).

CapitalSource (CSE)
CSE announced on 11 Sep 07 that they have secured $1.07bn of term financing with commercial real estate loans. The interest paid is the floating commercial paper rate + 1.5% , which at the time of writing this is 6.15% + 1.5% = 7.65%.

Thornburg Mortgage (TMA)
TMA announced on 30 Aug 07 that they issued 20 million special shares and raised $500m (i.e. $25 per special share). The special shares carry a dividend yield = Max(10%, common stock dividend yield), and are convertible to common stock for $11.50 each. TMA is basically diluting the company at a time when their stock is hammered.

Countrywide Financial (CFC)
CFC announced on 22 Aug 07 that Bank of America (BAC) acquired $2 billion in the form of nonvoting, convertible preferred stock yielding 7.25 percent annually. The shares can be converted into common shares of Countrywide at $18 per share, with certain restrictions. That was at a time when CFC was trading at about $22. Again a very significant dilution with the addition of a more ’senior’ security, given away at a low price.

Delta Financial Corporation (DFC)
DFC announced on 14 Aug 07 that it obtained a $60m repurchase financing facility from Angelo, Gordon & Co, with the following conditions:

1. Angelo, Gordon & Co. will receive warrants to purchase 10 million shares of commons stock with exercise price of $5 per share, with the warrants expiring Feb 2009.
2. The repurchase facility is collaterized by all currently existing securitization cashflow certificates (Class P, Class BIO, owner trust certs).
3. Interest rate charged is 6% over one-month LIBOR (at the time of writing, that would be 6% + 5.8% = 11.8%), payable monthly.
4. If the warrants are exercised for at least 5.0 million shares, and thereafter, the holdings of the Angelo Gordon do not decrease beneath that amount, then Angelo Gordon will be entitled to appoint up to two members of the Registrant’s Board of Directors.
5. For so long as the Angelo Gordon Entities own 5.0 million shares of the Registrant’s common stock (or the warrants to purchase those shares), the Angelo Gordon Entities will have preemptive rights to purchase up to one-half of the Registrant’s equity securities that may be offered in certain types of offerings.
6. Under the terms of the warrants, the exercise price will be reduced if DFC issues shares of its common stock (or certain convertible securities) at a price that is less than the exercise price of the warrants.
7. The exercise price of the warrants may also be paid by reducing an equal portion of the principal amount of the Repurchase Facility.
8. The repurchase facility matures in 12 months, if not sooner repaid.

Enough conditions for you?

DFC also issued $10m convertible notes to Mohnish Pabrai, convertible to 2 million shares of common stock at a $5/share. The convertible notes mature in August 2008, if not converted or redeemed earlier, and bear interest at the rate of 6% per annum for the first 90 days, and thereafter at the rate of 12% per annum, until converted or redeemed.

Came across this web page by Damodaran which highlighted some good points on the stable growth rate (link here):

1. The stable growth rate cannot be greater than the overall growth rate of the economy, since if a firm grows forever at a rate higher than the growth rate of the economy, it will be bigger than the entire economy.
2. Make sure you know whether you are choosing to use nominal growth rates or real growth rates.
3. The stable growth rate can be negative.

Rating: OK

Background: Came across this book by Gary Marks. Picked this up because I saw that the Foreward was written by John Mauldin, and I like the weekly newsletters that John Mauldin puts out.

Key points:

1. The nice thing about this book is that it puts out its main point very early on =) Basically, the book defines the “End Game” as the point where individuals and their families no longer have to be concerned about money (e.g. enough principal invested safely for your after-tax income to match or exceed your annual expenses on an ongoing basis). Once you have accumulated enough wealth for you and your family to stop, you should stop putting your wealth at risk. Stop risk-taking with investments of any kind, walk away from the investing game and spend the rest of your life doing something else.
2. To summarize the main point, you want to succeed at your own personal life. Once you have accumulated enough wealth, switch to choosing only risk-averse investments and spend your time enjoying life.
3. How to hedge your investments
   • You have a full position in a bubble period, you don’t know whether the market will continue to go up or tank. Do you sell all and hope to buy in the crash? or do you continue to hold and hope for more speculative gains? Neither. Sell half position – “win some” either way.
   • Diversify the ideas, asset classes and strategies.
   • Always have sell stops in mind before you make an investment.
4. Don’t be afraid to pay your taxes.
5. Real estate investment is bad: tenant problems, lost monthly income when tents leave, lost monthly rent when tenants don’t pay you, hassle of possible evictions, repairs on the house, property tax, property insurance, liability insurance, being responsible for a second and third mortgage to a bank. Not the way you want to spend your time.
6. A family office is an office dedicated to the investments of a multi-generational family (i.e. continuation of legacy wealth). A chief advisor to a family office once said, only 3-5% of the assets maximum are in the stock market. The rest are in extremely conservative hedge funds, hedged accounts, real estate bought and overseen by a development corporation that the family owns (develop from raw land, hence not dependent on price of real estate rising).
7. How to invest
   1. If you have net worth of less than $1.5 million, you should perform dollar cost averaging (in periods of 6 months to a year) on a few broad indexes, or a basket of ETFs (e.g. S&P500 Index, Wilshire 5000 index, some international index, Russell 2000 index, QQQQ, Wilshire REIT index). Make sure you are well diversified in sectors and capitalization sizes.
   2. For people with net worth more than $1.5 million, find a group of hedged funds of funds with consistent levels of good performance net of their fees, and net of your taxes, including tolerable performances under strained market conditions. You want to do growth-oriented, risk-averse, passive investing. Minimum of 3 funds of funds that correlate as little as possible.
8. At the Appendix of the book, Gary gives a nice Fund of Funds questionnaire that an investor can use to ask the General Partner of a fund of funds.

Just came across this interesting article (link here) about Financial Accounting Standards Board (FASB) Statement No. 157. The FASB approved this statement in Sep 06 which introduced a three-level hierarchy for measuring the fair values of assets and liabilities:

1. Level 1 means the values come from quoted prices in active markets. The balance-sheet changes then pass through the income statement each quarter as gains or losses. Call this mark-to-market.
2. Level 2 values are measured using “observable inputs” such as recent transaction prices for similar items, where market quotes aren’t available. Call this mark-to-model.
3. Level 3 means fair value is measured using “unobservable inputs”. While companies can’t actually see the changes in the fair values of their assets and liabilities, they’re allowed to book them through earnings anyway, based on their own subjective assumptions. Call this mark-to-make-believe.

This is my very first post on a company that I’m looking at: Delta Financial Corporation (DFC). As a disclaimer, my writing about a company is not a recommendation nor endorsement, simply jotting down some of the things that I’ve come across that I thought is interesting.

Mohnish Pabrai has a $35/share fair value for this company (which is trading around $4.5 at time of writing). I came across these points that Pabrai has apparantly said about DFC

• Severely distressed industry – DFC stock is at a throwaway price despite being different
• Half of loans originated at retail centers with ultra-low costs
• 78% average loan-to-value and 92% of loans are fixed rate
• Conservative accounting – revenue recognized over life of loan but expenses are recognized immediately
• Mostly a re-fi lender. Not affected much by housing starts. Low California exposure.
• 1/3 owned by insiders. Solid, conservative, owner-oriented management.
• Securitized fair value is over $8 per share, excess book is another $4, and the mortgage banking earnings engine generates $1.50 per share
• Less competition now so earnings will grow. DFC has been hiring and growing recently.
• Earnings could be much higher than $1.50 in 2 to 3 years. With a 15X multiple the intrinsic value is about $35 – more if earnings grow. Once the cloud passes over the industry the stock price should rise.

I’m still doing my research, but I must say that its a very complicated company =)

I was reading an article by John Price on GuruFocus.com (link here) that wrote about Tobin’s Q. It showed a graph illustrating that Robert Shiller’s P/E ratio (price divided by the average earnings per share over the previous 10 years) is a good proxy to use for the comparison between Tobin’s Q with its long-term average (in a log scale).

I then came across another article here that showed that the S&P500’s P/E ratio hasn’t been this low since 1995.

The interesting thing is that, if you had read the 2nd article only, you would likely have thought that the market is undervalued. After all, 10+ years does seem like a long time, so the market should’ve gone through a few cycles, and if current P/Es are at their lowest point compared to the past 10 years, then hey, the market’s cheap.

But if you had also came across the 1st article, you would have seen that P/Es for the whole period from 1995 to 2006 are above their historical mean (i.e. high), in the context of the whole century (1900 onwards). Surprising but seems true.

On a side note, I’ve been meaning to do some work so that I will be able to generate Tobin’s Q ratio for the market, and Robert Shiller’s P/E ratio, so that I can see how over/undervalued the market is. I’ve tried to look for those on the web but have not been successful. Hope to get to do that soon.

Just came across this article written by Anastasios Dimopoulos on a talk given by Mohnish Pabrai at the 4th Annual Value Investing Seminar in Italy (link here). Thought its quite interesting. I quote:”Pabrai’s strict rule is “Do not sell if the intrinsic value is above the market price no matter what happens.” He gave an example which had to do about one of his investments that is mostly sold by now. The company is Universal Stainless & Alloy Products, Inc and the situation unfolded in the following order.

1. Bought stock at $14- 15 in 2002 seeing a forward p/e of 4-7 with no downside and a huge upside.
2. One year later the stock was trading at $5 but he couldn’t see anything wrong with his assessment of intrinsic value. He just waited.
3. One year later the stock was trading at $10-11 and the intrinsic value was estimated at easily over that price. Wait again.
4. In 2005 the stock was trading again at $15 but he didn’t sell at break-even because the intrinsic value was estimated by him at $30, so he bought more and waited.
5. In 2006 the company starts running at full capacity and is very profitable. The thesis is being confirmed and he starts selling at over 90% of intrinsic value. “

I remember reading somewhere before that Mohnish Pabrai rode a tech stock up during the dot-com bubble and managed to sell it at its peak. His learning point however was that, next time, he should sell off once the stock has reached its intrinsic value.

From what I’ve read so far, its tough to value Berkshire Hathaway. I thought it would be useful, as I come across any such articles, to note down how others have valued Berkshire. Here’s some:

1. Barron’s on 13 Aug 07 carried an interview with Gifford Combs, Managing Director and Portfolio Manager of Dalton Investments (link here). Here’s how he got to his valuation:
   

   How cheaply is it selling, and what do you think the true value is?

   It is selling at $112,000 a share, and it is certainly worth somewhere north of $150,000 a share. That value is continuing to compound each year.

   How do you get to $150,000?

   The operating businesses are a superb collection that earn more than 25% on tangible net worth. They should be valued at 20 times earnings, or about $70 billion. I value the finance and utility businesses at 1½ times book value — together they are worth about $26 billion.

   The majority of the value at Berkshire is in the insurance entities, which hold virtually all of the investments. The insurance business depends upon the value one places on the $58 billion of “float,” which are the non-interest-bearing liabilities of the insurance companies. Adjusting for the float and making allowances for deferred taxes, I value the insurance companies at nearly $200 billion. The total comes to more than $290 billion, or about $190,000 per share. More conservative assumptions about investment returns over time would lower that value; but it’s hard to get to a number much below $150,000 per share

2. A Motley Fool article by Philip Durell published on 9 Nov 06 (link here) highlighted a that a quick and dirty way is to use the P/B ratio.

   “A good place to start when valuing Berkshire is to take Buffett’s advice, which he outlines in the Berkshire Owners’ Manual. A simple way to view the company is in terms of book value per share (BV/S). In May 1996, when Berkshire first issued its B class shares, Buffett indicated that the stock price was somewhere close to fair value or possibly slightly overvalued then. At that time, the first-quarter reported BV/S was around $15,200, and the share price was around $34,000. Applying the same ratio to today’s BV/S of $66,300 results in a share price of more than $148,000 per A share, or $4,930 per B share. My more elaborate valuation produces a range of $123,000 and $144,000 per A share. Translated for B shares, this amounts to $4,100 to $4,800. At today’s price, that puts Berkshire between 13% and 25% undervalued.”

3. I remember that Whitney Tilson had a presentation at the Value Investing Congress on his valuation of Berkshire. I’ll add to this post if I manage to get a copy of that.

I stumbled upon an article by John Price published on GuruFocus.com, which led me to his website www.conscious-investor.com. He has put together a neat software that supposedly implements Buffett’s methods. While the software is not free, the website does come with a few videos that showcase the software. If you take a look at the videos, you can basically see John Price’s stock picking / valuation methodology.

Some quick points:

1. His software comes with a screener that allows you to screen companies by
   • ROE – default 10%
   • Market capitalization – default $50 mil
   • Years of history available – default 4 years
   • Debt/Equity ratio – default 50%
   • Current ratio – default 1.5
   • Quick ratio – default 1.0
   • Interest cover – default 2.0
   • Industry category
   • Stability of earnings (some proprietary measure)
   • Stability of sales (some proprietary measure)
2. Comes with a roll-back feature that allows you to perform your analysis as though you are standing at some point in the past (software loaded with 10 years of data).
3. Allows charting of historical data (e.g. ROE, ROC, EPS growth, sales growth).
4. Performs projections and calculates the IRR given the following main inputs:
   • Current price
   • EPS (ttm)
   • P/E ratio at terminal year – average of past few years
   • EPS growth rate – seems to be the average of “CAGR taking the start/end points” and “average annual EPS growth rate over the past few years”
   • Payout ratio – average of past few years
   • No. of years to project earnings growth – default 5 years
   • Tax rate on dividends
   • Tax rate on capital gains
5. Also calculates a maximum price to pay to obtain your “required return”.
6. Margin of Safety is done by calculating the minimum IRR that you would get in the worst case scenario (playing with the inputs above), and see if that minimum IRR is acceptable.

John Price has also set up an excellent website called Stable Growth Companies, very similar to the Magic Formula Investing website by Joel Greenblatt, that will list a ranking of companies based on the stability of their earnings (using his proprietary measure). Good to check out.

I’m starting to read a series of articles written by Buffett-style fund manager Roger Montgomery of Clime Asset Management (www.clime.com.au)

I’ll probably post some interesting/important takeaways as I read through the articles. Here’s one: Roger Montgomery wrote in one article that his approach is to base valuation estimates on 4 elements:

1. Balance sheet equity
2. Return the company can sustainably generate from that equity
3. The manner in which it retains and distributes its earnings
4. A discount rate

This seems very much like the valuation methodology written in Buffettology (by Mary Buffett) but Roger’s method does not use any P/E ratios.

There’s a pretty nice expose on his method at this forum here.

I just read this piece on BusinessWeek which had an interview with Larry Coats of Oak Value Fund. You can find the article here.

I always love it when fund managers reveal their valuation methodology. Here’s Larry Coats’:

What kind of discount do you look for when buying a stock?

“We’re attempting to buy a stock at 65¢ or 70¢ on the dollar, so a 30% to 35% discount. We use a discounted cash-flow model, using an 8% discount rate. The magic in that sauce is not around the discount rate, it’s around the terminal multiple that you put in the valuation equation. Because at the end of year five, you have to assign something as the present value of the future cash flow.

We end up with a portfolio that has, on average, operating margins in excess of 20%, return on equity above 20%, and debt-to-total enterprise value less than 20%. So I’ve got highly profitable businesses generating returns on equity and doing it without significant leverage on the balance sheet.

From a growth perspective, we believe revenue over the next five years for this collection will rise just short of 10%, on average; and earnings growth will be in the mid-teens, or 13% to 15%. We have stocks with higher quality, better growth, less risk in terms of balance sheet, and trade at a market multiple.”

I was thinking about how to calculate the return on re-invested capital, i.e. return on retained earnings.

In reality, the retained earnings can be used for a multitude of purposes, and the returns could be obtained fully in a single year, or perhaps spread over a couple of years (e.g. if i retain $5 per share and re-invested that, the returns from that might come in at different times and amounts over a period of 10 years). How then do you figure out the return on re-invested capital?

Let’s take a not-too-simple and not-too-difficult case. Say each time you retain a certain amount of earnings, you get back cash inflows in equal amounts across a period of 10 years.

In that situation, when you look at the change in earnings from one period to the next, that “change in earnings” is a result of re-invested earnings from 1 year ago, 2 years ago, 3 years ago ……, 10 years ago (more specifically, a part (about one-tenth) of re-invested earnings from 1 year ago, a part (about one-tenth) of re-invested earnings from 2 years ago, etc.). Naturally the re-invested earnings across the different years would be different, which makes things extremely complicated.

To “un-complify” the situation, a simplification is necessary. One simplification is that the different “parts” across the past 10 years, adds up to the full retained earnings of a single year.  Which single year to choose then?

A lousy simplification would then be to use the most recent year before the “change in earnings” — which is what people typically do when they calculate ratios, they simply take the change divided by the base in the previous year, but i doubt that many people actually know the tons of assumptions/simplifications they are making when they do such a calculation.

To improve the calculation, you can do this across multiple years, i.e. calculate the change in earnings between year 1 and year 10, and then divided by the total retained earnings from year 1 to year 9. This should help a little and by using different lengths of time periods, you can see if the results are stable.

Thought I’d write a short note to document the reasons for the current liquidity/credit crunch.

1. Lack of risk controls in underwriting: Loans were given to weak credit without documenting income, balance sheets, and without appraisals. These weak credit folks typically obtain ARMs with a low teaser rate for a first few years, but adjust back up very significantly thereafter.
2. Insufficient credit spread to account for potential delinquencies. Aggressive hedge funds drove out the traditional buyers by accepting the low spreads. Lots of cheap money also made that possible.
3. Creative financial engineering also created riskier and riskier structures that end up being rated AAA (e.g. BBB and lower tranches that when put into a new structure, produces some AAA-rated bonds).
4. Points 1 to 3 above were possible because of the housing market boom, specifically, home price appreciation. That allows for refinancing and resulted in fewer delinquencies than historical periods which affected the pricing of risk for models that used “recent historical data”.
5. With the oversupply of homes, the housing prices tanking, “normal” delinquencies rates start to appear.
6. Panic sets in, with re-pricing of MBSes at very low prices (with much higher delinquencies modeled in). Mortgage lending companies were unable to sell their mortgage pools due to doubts in the credit worthiness.
7. Companies that financed their mortgage pools with short-term financing such as repos, start to get margin calls (since their mortgage pools tanked in value when marked to the panic market). Companies without sufficient liquidity declared bankruptcy (e.g. American Home Mortgage).
8. The panic and over-conservatism of lending liquidity, spreads to other markets, e.g. commercial paper.

With the current liquidity/credit crisis, I thought it will be interesting to take a look at past crashes. Here’s a quick compilation (not comprehensive):

• 1901 – 1903 (17 Jun 1901 – 9 Nov 1903) – 46.1% drop in DJIA.
• 1906 – 1907 (19 Jan 1906 – 15 Nov 1907) – 48.5% drop in DJIA.
• 1916 – 1917 (21 Nov 1916 – 19 Dec 1917) – 40.1% drop in DJIA.
• 1919 – 1921 (3 Nov 1919 -24 Aug 1921) – 46.6% drop in DJIA.
• 1929  (3 Sep 1929 – 13 Nov 1929) – 47.9% drop in DJIA. Kicked off the great depression.
• 1930 – 1932 (17 Apr 1930 – 8 Jul 1932) – 86% drop in DJIA.
• 1937 – 1938 (10 Mar 1937 – 31 Mar 1938) – 49.1% drop in DJIA.
• 1973 – 1974 (11 Jan 1973- 6 Dec 1974) – 45.1% drop in DJIA.
• 1987 – Black Monday (19 Oct 1987)
• 1989 – Friday the 13th mini crash (13 Oct 1989)
• 1990 – Savings & Loans collapse.
• 1997 – Asian financial crisis (27 Oct 1997)
• 1998 – Long Term Capital Management
• 2000 – 2002 (15 Jan 2000 – 9 Oct 2002) – 37.8% drop in DJIA.
• 2002 Summer – freezing up of corporate credit

References:

• Worst Stock Market Crashes
• List of stock market crashes

So from my thoughts in my earlier two posts on projecting earnings, here and here, I was thinking further about whether it is reasonable to project earnings using historical growth rates.

The answer is yes,  but with 3 caveats:

1. You are making an implicit assumption that the payout ratio and the ROX will continue to remain the same as historical numbers.
2. Also, typically by historical earnings growth here, the historical earnings are the raw earnings where the maintenance and growth portions are not separated (due to the difficulty in separating the two portions unless you are a company insider).
3. Due to the problem with the point 2 above, it is best to only do this for stable companies that has been operating for a long time, as opposed to companies just starting out.

The current liquidity/credit crisis is the first market crisis I’ve experienced since I started investing not too long ago. Prior to this, I was always hoping for a crisis, coz if you look at the historical charts, crisis times are simply the best times to make tons of money =) Those are the times where you have Amazon going from $6 to $60 in 1 year, etc.

Well, after the happenings of the past few weeks, I’m proud to come to the realization that I was not fully prepared to take full advantage of this crisis. You can tell from a couple of my earlier posts of the mistakes I’ve made and some learning points. I’m still making mistakes and still learning, and hopefully by the end of this episode, be fully prepared for the next one (which sadly should be many years away). Its a pity though that I had not come across any materials before on how to play a market crisis.

What I would like to do in this post is to simply list down my learning points on how to play a market crisis. I’ll keep updating this post as I learn more pertaining to this topic.

Well, here goes:

1. You’ll typically hear of an impending crisis way ahead of time from the mass media (e.g. dot-com crash, housing market crash, China market crash, etc.)
2. Foretelling the impending drop of the two types of crashes:
   1. Fundamental event-driven: e.g. housing market.
      • Pay attention to earnings conference calls from affected companies (e.g. mortgage lending companies).
      • Listen for signs of the companies experiencing the problems (e.g. home price depreciation, increased delinquencies, etc.).
      • This should give you a 1-3 months headstart for two reasons, i) typical investors do not listen to earnings conference calls, and ii) analysts typically “upgrade” or “hold” their ratings on bad conference calls to allow their own firms to sell off.
      • You can see the “great” work done by analysts w.r.t. the current crisis in these articles:
        • A Quick Look at Historical CFC Calls From Merrill and FBR
        • A History of Analyst Upgrades/Downgrades – Countrywide Financial (CFC), American Home Mortgage (AHM), Thornburg (TMA)
        • How analysts missed a meltdown
   2. Non-event-driven: e.g. dot-com overvaluation crash
      • This one is harder because the crash could happen at any time, like the Cinderella analogy that Buffett used.
      • Jim Cramer offers some tips (see Spotting Tops here).
      • Charles Biderman’s thinking on looking at margin debt, mutual fund flows, change in net trading float may be useful. See here.
      • Bill Miller said that “The NYSE financial index is probably the best barometer of what’s to come. The financials tend to be a very good indicator of where the market’s going. They tend to lead the market because they’re the lubrication for the economy…… But just as financials lead on the downside, they will lead on the upside.”. The symbol is ^NYK on Yahoo Finance (or here). Jim Cramer uses the KBW Bank Index (symbol ^BKX) as a leading indicator.
3. Identify the good companies that you think will survive and prosper after the crash. These will be the companies that will be thrown out together with the bathwater and where you would make your money. The earnings conference calls that you listen to in the earlier step would be a great chance to identify the good/bad companies.
4. Once you judge that the crash is impending, sell out all your positions (if you’re a small investor). Read more here.
5. If you’re adventurous, you may want to short the lousy companies, esp. those that would likely end up in bankruptcy.
6. Wait until the crash happens. If you’re adventurous, you may want to
   1. Wait for a one-day big drop in all affected companies (e.g. mortgage, dot-com)
   2. For severely whacked companies that are good companies (e.g. babies thrown out with the bathwater), buy in at the end of the big-drop day (or start of the next day) to ride a bounce back
   3. Sell off immediately after the bounce back (or at most 1-2 days later), wait for it to drop further, the pain is not over yet
7. Wait and wait until maximum pain. Cramer gives some excellent advice on spotting bottoms here.
8. Once you judge bottom has been reached, slowly buy in good companies bit by bit at good prices.
9. If the price is still going down, you may want to do this (read Getting in during/after the drop).
10. If the price is still going down, you can buy in more if you have the capital. If not, endure the pain =). Do not start selling off hoping to avoid some short-term loss, unless you are extremely extremely sure there will be another significant drop, which should not be the case since you had earlier made the determination that the bottom has been reached.
11. Wait for the gains

Quick summary of points that Ron Baron spoke about in his interview on CNBC – 26 June 07. You can find the clip here:

1. Doesn’t predict macro stuff (e.g. interest rates, oil prices, etc.), except for inflation. Expects price level to double every 15 years, i.e. a 4.6% rate of inflation.
2. Wants to double his investors’ money every 5 years.
3. Find good themes to invest in, and invest for the long-term. Portfolio turns over every 6-7 years.
4. Never invested very much in technology, hard to be a long-term investor with technology field changing very rapidly.

I was reading an excellent interview with Ronald Canakaris of Montag & Caldwell, in the Wizards of Wall Street book  by Kazanjian. Its pretty consistent with the process we have arrived with thus far. Here’s a quick summary of his investment methodology:

• Screen for companies with 10+% growth.
• Shows strong earning growth over the intermediate term (+- from current point in time) in relationship to the earnings growth of other companies. That’s the timing device.
• Best measure of value is the present worth of a future stream of income, which is the present value of each year’s dividend, if there is a dividend, and the present value of the projected price we hope to receive 10 years out. That projected price would be the tenth year’s earnings times the reciprocal of the discount rate. If the hurdle rate is 10%, we put a 10 multiple on earnings 10 years out and then discount it back to the present; if the hurdle rate was 6%, we’d use a 16.7 multiple. Remember you have two income streams for all dividend-paying stocks — dividends and the projected price.
• The hurdle rate is related to the level of bond yields and the financial characteristics of the company. Because stocks have a higher standard deviation in relationship to bonds, they always require a higher rate of return. A company whose earnings variability is low, whose financial characteristics are very attractive, and whose stock trades well will have a lower hurdle rate than a company whose earnings are more variable or whose financial strength and financial profitability ratios are less favorable. We have an array of discount rates for different companies.
• You need 4 ingredients to determine present value:
  1. Normalized earnings (at the starting point), i.e. earnings that can be earned in good and bad times. Figure that out by analysing historical ROE and historical profit margins and determine what a good mean is. For cyclical companies, you want to pick mid-cycle earnings, or the kind that are sustainable on the company’s equity.
  2. Payout ratio. Look at historical data and what management suggests the payout will be going forward.
  3. Growth rate of dividends and earnings.
  4. Hurdle rate, i.e. your required rate of return.
• Want to buy stocks at about 20% discount to present value
• Minimum market cap of $3 billion
• Typically hold 30 to 40 stocks
• Bottoms-up process with a top-down perspective. Look into the industry trends, demand for the company’s products, the company’s market share position, how much opportunity they have to increase market share. Go through the income statement and balance sheet analysis from top to bottom, looking at sales, the potential for sales growth, global opportunities, how well management controls costs, the nature of the accounting, whether it is conservative or liberal, the strength of the balance sheet, and the potential for financing.
• 30 to 50% turnover
• Sell discipline
  1. When a stock gets to a 20% premium to fair value, either cut back or sell. This is because when a company develops momentum in its core product line, that momentum is usually stronger than expected and lasts longer than investors expect. Having this 20% rule keeps us from selling too early
  2. When a company has an earnings disappointment, we analyze the situation. If we’re not willing to add to our position, we sell the stock. This will keep us from freezing up and hoping and praying things will get better and wind up spending much of your time in meetings discussing one stock that may be 2% of the portfolio. If we’re not willing to add to positions when a company has an earnings disappointment, we go on to something else.

Read the S-1 filing, its the best! =) S-1 is the registration statement filed by a company when it first gets listed – tells you alot about the company. The S-1 typically gets filed before the prospectus (Form 424B) gets available to the public. Note that depending on the type of company, the form might be S-xx. E.g. for a mortgage REIT, they file form S-11.

Some sample categories of stuff in the S-1:

• Prospectus summary
• Risk factors
• Use of proceeds
• Dividend policy
• Capitalization
• Dilution
• Selected Financial Data
• Management’s Discussion and Analysis
• Business
• Management
• Principal shareholders
• Underwriting
• etc.

Consuelo Mack from Wealthtrack had a show where they invited value manager Bruce Berkowitz, founder and co-manager of FairholmeFund. You can find the video here. Here’s a summary of what Berkowitz said, and what he looks out for:

• Love serial winners -good management teams. People with
  • Great paper trials
  • Family networth on the line
  • Give shareholders a level playing field
  • Done well in all price environments including difficult environments before
• At least 10% FCF yield (he defines FCF as what is left in the cash register after the company spends what it needs to maintain its franchise without growing)
• FCF growing at twice the risk-free rate of U.S. Treasuries
• He typically averages around 20% of his portfolio in cash (was at 0% only in 2002 at the bottom of the dot-com cash)
• Cash is a strategic asset. Black swans (stressful points) do occur, they are unknowable when they occur, that is the time to buy very good companies at reasonable prices. When the fear is big, that is the time to get greedy.
• Thinks that the market has not yet bottomed (as of 3 Aug 2007)

I read an interesting piece in the Shareholder Letter of Weitz Funds annual report (31 March 2007) by Wally Weitz couple of days back. You can find it here.

He was writing about the subprime mortgage meltdown. I quote:

As fears deepen and the possibility of a temporary, but severe, hit to Countrywide’s earnings looms, we have chosen to hold our position. Our rationale is that we do not know that it will go much lower, and we strongly believe that it should sell at much higher levels in the future. The alternative is to sell our position now with the hope of avoiding some temporary markdowns but risk missing our chance to repurchase the position before the stock recovers. Stocks have a way of bottoming long before the bad news is over and the good news appears. We sold some Berkshire Hathaway A shares in the 1970’s at $510 per share for some short-term reason, and with the stock now at $109,800 per share we’re beginning to think we are not going to get it back for $510.

So he knows well ahead of time that there would likely be a hit to CFC’s earnings, deepening fears, and possibility of a price drop. However, he had chosen to hold on due to the risk that he cannot get back in in time. Gurufocus reports Wally owning close to 11.2 million shares of Countrywide (average daily trading volume over the past 3 months is around 12 mil).

Well, what happened with my portfolio was, I suppose, a result of reading too much stuff from value fund managers =)  Basically, I held on to my stocks, and when the crunch came, my portfolio that is heavily skewed to housing-related stocks, tanked like crazy That’s mistake #1. Mistake #2 is that I’ve bought so much of those stock earlier on, I had no more spare capital to average down. So that got me thinking (nothing beats losing a lot of money to make you think), should I have done differently?

Getting Out Before The Drop
And the answer is Yes!  As a small investor, if you know the price will crash, just get out, sell EVERYTHING! You don’t have to worry about not being able to get back in in time as you can get in and out quickly. And if you’re a fund manager managing a large position, perhaps you should sell out a portion that you know you can get in / out fairly quickly. For example, instead of not selling anything (like Wally above), may be sell 2 million shares? at least that would help limit the loss somewhat.

Getting In During/After The Drop
Now how should you get back in. My big mistake was that I kept buying more as it went down, very soon I’m out of capital – too much too quickly. What happened was I was buying more with each ~4% drop. With a 25% drop you will be out of capital in no time. I need to stagger the buying. I’m thinking in this way:

• Wait for the price to stabilise before buying.
• If the price is stable for a period of about 10 trading days, then buy a small portion.
• If the price remains stable for another 10 days, buy another small portion, so on and so forth.
• If the price drops further (after prior stabilising), let it be stable for 10 days at the lower level before buying a “bigger” small portion. Repeat the general process.
• If the price goes up, don’t be too eager to go all out thinking that you will miss the boat. Forgoing potential gains is fine for the sake of not increasing your potential loss (i.e. the decline may not be over yet). Depending on your read of the situation at that time, decide whether you want to go in more.

[As a side calculation: if for every drop in the price level to the next stable level, you double your "small portion". For a 3-stock portfolio (max 1/3 each), assuming a 3-month decline, 6 stable price levels, the initial "small portion" should be 0.5% of total capital.]

What about about for large fund managers? I think the rules of buying in during/after the drop is the same for both institutional and individual investors. In both cases, unless you have a steady inflow of capital from some other source (at a significant size compared to total portfolio value), you need to keep a reserve of cash to average down.

Are there any rules for buying in when there are no drops? Actually I think for value investing, most of the time the buying happens in distress situations. Without a distress situation, you might be more confident to initiate with a larger position.

Value Investing and Portfolio Management

I think such money management / portfolio management stuff above is a neglected part in the teachings of value investing.

All the value investing literature out there talks more about selecting companies with good business, management, price. I’ve not seen any value investment piece that talks about actually when to enter into the position, how large a position to enter with, what’s the accumulation process, basically how to buy? Similarly, selling presents various challenges. For example, I saw an interview where Mohnish Pabrai said that he had previously rode a company all the way up to the peak at the dot-com boom, and sold it then. On hindsight, he said he should have sold it when it reached its fair value. I remember reading somewhere that Wally Weitz would sell a stock if its trading at too high a value. Even for selling, do you just sell everything off at one shot at fair value? or stagger your selling? or put a “stop-loss order” once it has reached fair value and keep raising the level of your “stop-loss order” as it goes up? basically again, how to sell?

While this money management / portfolio management part may not be as important as the first part on how to pick stocks, its impact on overall portfolio performance is very significant indeed.  If the first part pertains to capital preservation and some gain, money management / portfolio management pertains to making the big gains.

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.

Ways of Projecting Earnings

1. Estimate future earnings growth rate (e.g. calculate CAGR of historical earnings growth, or calculate CAGR of historical equity growth rate), project ahead. [Note: see previous post here to know why you can use equity growth rate.]
2. Using ROIC / ROC / ROE on the base, adding back retained earnings back to the base, repeat.
3. Project sales growth (using historical long-period CAGR), assume a FCF margin (using historical average), project.
4. Project sales growth (using historical long-period CAGR), project gross margin, project working capital schedule, project depreciation schedule, project capex schedule, project tax rate, etc. etc. You get the idea =)

It seems that methods 3 & 4 are commonly used on Wall Street. Bruce Wasserstein in his book Big Deal highlighted that for projecting unlevered free cash flow for DCF, “Margins and growth rates should be scrutinized”. I have also seen JPMorgan financial models projecting working capital schedules, etc.

But what really governs earnings? that will tell us how earnings should be projected.

1. What happens in reality is indeed the growth of sales (due to both inflation and GDP growth), incurring of expenses, and ending up with some free cash flow.
2. ROIC / ROC / ROE are simply different ways of displaying the results, similar to P/E and bond yields, they are the results at a point in time, not the determinants.
3. Why then, does Buffettology use ROE like a determinant to project earnings moving forward?
4. You can only use ROIC / ROC / ROE as determinants if earnings are added to the base (i.e. what you use for the numerator is added to the denominator), and that the process has been happening for an extended period of time (e.g. the company has been running for 20 years), then the metrics (ROIC/ROC/ROE) would have gradually adjusted to the true earnings growth rate (you can see that by doing up a quick spreadsheet). To know whether you can project earnings using ROE, you should also check that the future projection curve “fits” with the historical earnings to know if the model is appropriate.

In that case, does it still make sense for people to project future earnings growth using historical earnings (or equity) growth rates?

• Yes, but if you do that, you make the implicit assumption that the payout ratio and the ROX will remain the same moving forward.
• For companies just starting out, that cannot be the case, coz the payout ratio and ROX will definitely change (e.g. payout ratio might increase as the company matures, ROX will also go down with slowing “growth”).
• Can only do with stable companies, and also after you have checked the payout ratio and ROX.

When the P/E will mean revert (let it be T_pe) is independent from when the competitive advantage period (CAP) ends (let it be T_cap).

If (T_cap > T_pe), i.e. P/E mean reverts before the CAP ends,

• Then it doesn’t matter, it just means that the projected selling prices (using mean reversion and good earnings growth) is A-OK, can be used.

If (T_cap < T_pe), i.e. CAP ends before P/E mean reverts,

• You can still project good earnings growth for the CAP portion, and lousy earnings growth (at the cost of capital or no growth) for the time after the CAP. You can still pick a point as usual for the time of mean reversion – selling price and the corresponding IRR can still be calculated as usual.
• Though the further out T_pe is, the more your performance will be penalised, as the required IRR of around 15% will be much higher than the lousy earnings growth rate (i.e. the calculated IRR will be pulled down significantly by the lousy earnings growth rate).
• After the CAP, the earnings growth rate would have dropped, the P/E range might drop correspondingly. We can set the P/E (for the eventual selling price) to equal the lousy earnings growth rate for the period after the CAP.

Non-Cyclical Companies

• You know the earnings – they are predictable (hence the need to find companies with predictable earnings)
• The predictability of the earnings allows you to, at a particular time point, know/fix one of the variables (among two: E and P/E).
• You don’t know when the booms and busts will happen
• But you know that there will be booms and busts
• Hence there will be mean reversion in the P/Es
• Hence Buffett’s method can be used to predict selling prices of non-cyclical companies

Cyclical Companies

• Earnings depend on the cycles
• Cycles are not predictable, length of cycles varies each time, you don’t know when the booms and busts will happen
• Hence earnings are not predictable (with reasonable accuracy)
• Timing of P/Es are also not predictable, as they depend on the booms and busts
• Earnings and P/Es have -ve correlation. When markets are booming, earnings are high hence P/Es are low. When markets are bottoming, earnings are low hence P/Es are high.
• You know there will be booms and busts
• You know that the average P/E will materialise for sure, within the next 10 years. But this info is useless without predictable earnings. You need to know/fix one of the variables (among two: E and P/E), at a particular point in time in the future.
• Hence prices of cyclical companies are not predictable. Buffett’s method won’t exactly work here.
• Similarly, Christopher Browne’s method of using metrics (e.g. P/B, P/CF, etc.) of past M&A, LBO transactions won’t exactly work as well, because it will need projections of future B, CF, etc.
• However that doesn’t mean that cyclical companies must be put into the “too hard” bin.
• You will still be able to apply Buffett’s and Browne’s methods if you use very conservative estimates for your projections, e.g.
  • Project earnings 10 years later as equal to this current cycle’s lowest earnings, and use the lowest P/E.
  • Project earnings 10 years later as equal to this current cycle’s average earnings (no growth), and use the average P/E as usual.
• If you use very conservative estimates, and still able to get a good IRR, then it can be a good investment. In fact, this will then be a much better steal as compared to investing in non-cyclical companies, where the estimates are not as conservative.

I used to think that one can “average out” or “smoothen”/”flatten” the earnings of a cyclical company across one full cycle so as to do the valuation. I realise now that that is actually not correct.

The “smoothening” process can only help you get the earnings figure at a particular point in time in the future (i.e., x cycles ahead). The smoothened out earnings stream cannot be used for valuation as that would not reflect reality. You would still need to do some fancy time series stuff to generate the future earnings stream if you want to do some form of DCF.

Can you still Buffett’s methodology (according to Buffettology) using a single earnings point in the future? Can you still use the average P/E? My thoughts on this in the next post….

Was reading a part in Bruce Wasserstein’s Big Deal on DCF, he highlighted 3 situations that are difficult to analyse using DCF:

1.  A company with ‘hockey stick’ projections – a firm with mediocre historical performance that is projected to undergo a dramatic turnaround. The timing, scope, cash impact, and long-term stability of the turnaround plays havoc with the DCF technique.
2. A company in a cyclical industry. The danger of the DCF method is that the impact of a part of the cycle closest to the present is exaggerated by the discounting technique: near-term cash flows are given greater weight than cash flows in outer years. Hence a DCF would value more highly a cyclical company in the upswing part of its cycle than a company in the downswing part. But regardless of where a company is in its business cycle, it should maintain the same intrinsic value.
3. High-growth or start-up companies. These companies often have negative cash flow in the early years. Projecting the nature of the company’s subsequet performance is dicey. In addition, the cost of capital generally must be calculated based on industry comparables, of which there might not be any.

How do you know if the P/E range so far, is reasonable? Perhaps the range so far is in the top part of what will play out in the future?

• To ensure that the P/E range (lowest P/E to highest P/E) is reasonable, you need to find a company that has a long history and experienced booms & busts before, as opposed to a brand new IPO where we have not yet seen the full cycle of P/E fluctuations (see more details in the next bullet point). It is also good to plot the historical P/E range to see how the range has been shifting w.r.t market conditions.

How will the P/E range be affected by other factors in the future? by interest rates? inflation? etc?

• The P/E range is an output of valuation, hence it will only be affected by:
  • Factors affecting Earnings (e.g. inflation)
  • Factors affecting the Discount Factors (e.g. interest rates)
• Interest rates: The interest rates will directly affect the P/E range as they directly impact the valuation of cash flows. If the range of interest rate movements deviate significantly from historicals, then the P/E range needs to be adjusted correspondingly. From 1990 – June 2007, the Fed Funds rate ranged from 1% – 8.25%. From 1955 – 1990, the Fed Funds rate ranged from 0.75% – 19% (see time series from Economagic). I think it is a reasonable assumption that the future Fed Funds rate will range from 1% – 8.25%, and hence to use the P/E range from 1990 – June 2007. [Note: if you only use 10 years of historical data, i.e. 1997 - 2007, the Fed Funds range is only 1% - 6.5%. Hence using from 1990 - 2007 will be more conservative.]
• Inflation: Inflation should not affect the P/E range as any compounded increase in the earnings of the company due to inflation, will be counteracted by the nominal interest rate used in discounting (which includes inflation effects and which will also be compounded).

What other factors affect the comparability of P/Es across different time periods?

• I read somewhere about a paper – “Five Factors Distorting P/E Comparisons Over Time” by Art Laffer and Marc Miles that talks about the need to adjust P/Es for interest rates, changes in GAAP, changes in marginal tax rate, etc. (total of 5 factors). I have not been successful in obtaining a copy of the paper, so if anyone who happens to read this and is able to obtain a copy, please contact me!

1. Most DCF calculations out there are wrong, specifically those that discount “retained earnings” in every single year. When an assumption is made about the earnings/FCF growth rate, that assumption comes with it an implicitly assumed payout ratio (i.e. an assumption on a certain amount of the earnings/FCF to be retained and reinvested). The payout ratio is a driver of future earnings growth rate. Those “retained earnings” cannot be discounted every single year as part of free cash flow because they are not truly free, i.e. they cannot be taken out of the business without impacting the future earnings stream. When you discount the “retained earnings” every single year, you are making the implicit assumption that those money can be taken out without impacting the future earnings stream, which is not the case (See previous post Determining the Intrinsic Value of a Business for more details).
2. Even when you base your earnings growth rate assumption on historical earnings growth rates, those historical earnings growth rates were obtained due to certain earnings being retained before (i.e. an implicit payout ratio).
3. These “retained earnings” need to be “rolled-over” to the following year, and the year after that, and the year after that, and so on, until a “certain point” where ONE discount can be done.
4. The dividends however can be discounted normally every single year as those are truly taken out of the business.
5. Given the dividend cash flows every single year, and a lump value at the “certain point”, an IRR can be calculated using the current price.
6. The problem then becomes, how do you calculate the lump value at the “certain point”? If that lump value is the value of the company at that point in time, then you get into a circular argument, coz you are basing the current value today on its value say 10 years later, which is based on its value 20 yeas later, etc. If you can calculate the value of the company 10 years later, you should be able to calculate the value of the company today. How do you calculate the value of a company at any point in time? Actually the questions should be more like “how do you know how much to pay”, “what price will give me a 15% IRR”? Very different from asking “what is the value of the company”.
7. The lump value is what you can sell the company for.
8. There are three methods to determine what you can sell for:
   1. Non-going concern – Liquidation – You can definitely sell the company at liquidation value (minus expenses and a chunk for the effort incurred), so the liquidation value is a lower bound for the lump value.
   2. Going concern – From Transactions – LBO and M&A prices provide an indication of what you can sell the company for (to knowledgeable buyers). Christopher Browne collects metrics of P/CF, P/E, P/S, P/B, etc. of such transactions and apply them to similar companies to determine their lump value.
   3. Going concern – From Market Prices – The price at which you can sell a company for is by definition P/E * E. If earnings are stable and predictable (for a good business), then the volatility of the price is due to the P/E fluctuations. Assuming mean reversion for the P/E (between booms and busts), you can get the price at which you can eventually sell the company. Warren Buffett (according to Buffettology) uses Average P/E * Projected Earnings 10 years later to determine the lump value. This is conservative for two reasons:
      1. Using the projected earnings 10 years later assumes that the price will only be realised 10 years later (i.e. P/E will revert back to its mean by 10 years time), which is a conservative assumption.
      2. Using the Average P/E, as opposed to historical P/Es that are higher than average, is conservative because we don’t have to bank on irrational exuberance to realise our projected selling price.
9. You don’t know when this lump value will materialise, can be 1 year, 5 years, or 10 years. The earlier it materialises the higher your IRR (picture the jump of P/E to the Average P/E, the quicker the jump, the higher your IRR).
10. Using Buffett’s logic (according to Buffettology) on Christopher Browne’s method, Browne should have collected many different sets of metrics at different periods of the economic cycle (e.g. boom, bust, etc.). That is similar to the high and low P/Es experienced by a stock in the market. Browne can then use an “average” P/CF, P/E, P/S, P/B metric set to calculate the lump value (the “average” set can be different for each different industry).
11. Determining the lump value is essentially the same as determining the terminal value of a DCF calculation. Bruce Wasserstein in Big Deal highlighted two methods
    1. Determine the multiple at which comparable companies trade or have been acquired and apply the multiple to the company’s earnings in the last year of projections (e.g. 10 times EBIT). This is similar to point 8 above, and also highlights that for point 8(3), Buffett’s method can be applied with other ratios apart from P/E.
    2. Capitalise the final projections based on some perpetual growth rate. As with my arguments for DCF, I think only projected dividends should be capitalised.

Common Valuation Methods

1. Discounted Cash Flow (DCF)
2. Comparables (with market prices)
3. Comparables (with transaction prices, e.g. M&A, LBO, etc.)
4. Replacement cost of assets (remark: Tobin’s Q ratio uses this)
5. Tangible Book Value
6. Break-up Value
7. Liquidation Value
8. Real Option Value (future growth potential of the company depending on management decisions)

Some books that I’ve read, have wanted to write reviews on, but haven’t managed to do so:

1. The Five Rules for Successful Stock Investing by Pat Dorsey (Morningstar)
2. Little Book of Value Investing by Christopher Browne
3. Margin of Safety by Seth Klarman
4. Intelligent Investor by Graham
5. Dollar Crisis by Duncan
6. Buffettology by Mary Buffett
7. Essays of Warren Buffett
8. Expectations Investing
9. Common Stocks & Uncommon Profits by Fisher
10. Trade Like Warren Buffett by Altucher

Looks like the backlog is really increasing =)

Some books that I’d like to get a copy of / read:

1. Market Wise by Brian McNiven
2. A Wonderful Company at a Fair Price by Brian McNiven
3. Poor Charlie’s Almanack – The Wit and Wisdom of Charles T. Munger
4. The Dhandho Investor: The Low – Risk Value Method to High Returns by Mohnish Pabrai
5. Mosaic: Perspectives on Investing by Mohnish Pabrai
6. Security Analysis by Graham & Dodd
7. You Can Be a Stock Market Genius by Joel Greenblatt
8. Latticework: The New Investing by Robert Hagstrom
9. Investing: The Last Liberal Art by Robert Hagstrom
10. The Aggressive Conservative Investor by Martin Whitman
11. Value Investing: A Balanced Approach by Martin Whitman
12. The Theory of Investment Value by John Burr Williams
13. Damn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger by Janet Lowe
14. Harvesting Profits on Wall Street: Essays in Investing by Ron Muhlenkamp
15. Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald
16. The 5 Keys to Value Investing by J. Dennis Jean-Jacques
17. Just One Thing: Twelve of the World’s Best Investors Reveal the One Strategy You Can’t Overlook by John F. Mauldin
18. The Focus Investor by Richard M. Rockwood
19. The New Financial Capitalists: Kohlberg Kravis Roberts and the Creation of Corporate Value
20. The Vulture Investors by Hilary Rosenberg (book on investing in distressed securities and Martin Whitman)
21. Big Deal by Bruce Wasserstein
22. Valuing Wall Street: Protecting Wealth in Turbuluent Markets (book on Tobin’s Q)
23. It’s Earnings That Count by Hewitt Heiserman

What discount rate should be used for Discounted Cash Flow (DCF) analysis? Should it be the risk-free rate? The cost of capital of the investor? The cost of capital of the firm in question (e.g. WACC)? Does DCF give you the fair value of a stream of cash flow? If not, how do you calculate the fair value of a stream of cash flow (e.g. cash flows from a firm)? and what does the resultant DCF value actually mean?

Thoughts on DCF and Valuation:

1. The discount rate used should be your required rate of return, i.e. the return you want your inflow of cash to earn.
2. Discounting a cash flow stream with your required rate of return, will give you the price that will allow you to get your required rate of return on your money. Note that as cash will be given out in bits and pieces in the future, your required rate of return is only earned by the “remaining money”, i.e. it does not apply to the cash that will be returned in bits and pieces. The re-investment return is a separate issue.
3. If you discount a stream of cash flow by the risk-free rate, then the resultant value is the maximum amount of money you should be willing to pay for that cash flow stream (assuming you can borrow and lend at the risk-free rate). If the price of that cash flow stream is higher, then you can replicate it at the lower cost using your risk-free rate. If the price of that cash flow stream is lower, and the stream is risk-free, then that will set the new risk-free rate.
4. The price you would be willing to pay for a company is somewhere between its liquidation value, and the DCF of a optimistic scenario using risk-free rate as the discount (upper bound).
5. There are only two applications for discounting a cash flow stream by a cost of capital:
   1. The value you get is a benchmark point. If the price of that cash flow stream < benchmark point, then buying that stream will allow you to earn a rate of return higher than your cost of capital.
   2. Calculating an LBO value using the cost of capital and EBIT or NOPAT, to make sure cash flows from the company is enough to cover the cost of capital.
6. Bruce Wasserstein in Big Deal highlighted that for DCF, cash flows of mature companies are generally discounted at the 12 to 13% level depending on the riskiness of the target’s business.
7. What is the fair value of a stream of cash flow? Is that the same as discounting the cash flow stream by a certain discount rate? No. There is no concept of “fair value” for stream of cash flow. Given a stream of cash flow and its price, the only concept is the IRR. Trying to calculate a fair value for the cash flow and comparing with its price, is a useless, redundant thing to do – serves no point. This will eliminate the problem of choosing a subjective discount rate. To compare across different investment opportunities, just compare the IRRs. To select an investment then becomes a matter of picking what IRR you would minimally like to have. According to Buffettology, Buffett’s IRR target is 15%.
8. A quote from Buffettology: “To Warren the intrinsic value of an investment is the projected annual compounding rate of return the investment will produce.”
9. Note that in Berkshire Hathaway’s Owner’s Manual, Buffett wrote, “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”, and “… intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.”. Makes you wonder whether Buffett performs the typical DCF or my type of DCF.

Some simple calculations relating Earnings Growth Rate to ROE:

Case 1: No dividends
Start with SE1
E1 = SE1*ROE

SE2 = SE1*(1+ROE)
E2 = SE2*ROE = SE1*(1+ROE)*ROE
E2/E1 = (1+ROE)

=> Earnings Growth Rate = ROE

Case 2: With dividends
Start with SE1
E1 = SE1*ROE

SE2 = SE1*(1+ROE) – D1
E2 = SE2*ROE = (SE1*(1+ROE) – D1)*ROE
E2/E1 = (1+ROE) – D1/SE1

SE3 = SE2*(1+ROE) – D2 = (SE1*(1+ROE) – D1)*(1+ROE) – D2
E3 = SE3*ROE = ((SE1*(1+ROE) – D1)*(1+ROE) – D2)*ROE
E3/E2 = (1+ROE) – D2/SE2

Check: If D2 = E2, then E3/E2 = (1+ROE) – E2/SE2 = (1+ROE) – ROE = 1, i.e. E3 = E2

payout ratio = D2/E2 = D2 / (SE2*ROE)
=> payout ratio * ROE = D2 / SE2
=> E3/E2 = (1+ROE) – (payout ratio*ROE)

=> Earnings Growth Rate = ROE – payout ratio*ROE = ROE*(1-payout ratio)

[Note: In Rule #1 by Phil Town, the advice is to use the growth rate of equity to project future earnings.

In Case 1: No dividends, Growth rate of equity = SE2/SE1 - 1 = ROE
In Case 2: With dividends, Growth rate of equity = SE3/SE2 - 1 = (1+ROE) - (D2/SE2) - 1 = ROE - (payout ratio*ROE) = ROE*(1-payout ratio)

In both cases, Growth rate of equity = Earnings Growth Rate as calculated before. Hence Phil Town is fine using the Growth rate of equity.]

[Note: The above calculations is applicable with other bases: e.g. if SE means Net Tangible Assets, then ROE becomes the Return on Net Tangible Assets (i.e. FCF/Net Tangible Assets). Some bases are not applicable though, e.g. tangible capital employed minus excess cash. If excess cash is not included, then the definition of this base does not follow the rule of SE2 = SE1*(1+ROE) - D1, so that wouldn't work out. But wouldn't a redefinition of the base change the Earnings Growth Rate? seems like it does.....]

To perform a DCF and then compare the resultant value to the current enterprise value, the cash flows used in the calculation should be free cash flow to the firm (FCFF), which measures the true returns-generating capability of the firm (see previous post on Enterprise Value for the reason). This FCFF is also known as unlevered free cash flow.

[Quick recap on FCFF: Using Net Income as a starting point, depreciation and amortization are added back as they are non-cash expenses. Increases in working capital and capital expenditures - which consume cash but are not incorporated as expenses in the net income figure - are subtracted. The cash flow is then unlevered by adding back any interest expense on a tax-adjusted basis. To tax-adjust the interest expense, one must subtract the tax shield provided by the tax-deductible interest payments.]

Should NOPAT be used instead of FCF? How does NOPAT compare with FCF?

Below are some sample calculations for the most simple case:

NOPAT = EBIT*(1-tau)

FCF
= net income + depreciation & amortization – capex – increase in net working capital + interest expense – tax shield provided by tax deductible interest payments
= NI + dep&amort – capex – increase in NWC + int – int*tau
= (EBIT – int)*(1-tau) + dep&amort – capex – increase in NWC + int*(1-tau)
= NOPAT – int*(1-tau) + dep&amort – capex – increase in NWC + int*(1-tau)
= NOPAT + dep&amort – capex – increase in NWC

EBITDA – dep&amort = EBIT

Operating Cash Flow (aka Cash Flow from Operating Activities)
= EBIT + depreciation & amortization – interest – taxes
= EBIT + dep&amort – int – tau*(EBITDA – (dep&amort + int))
= EBITDA – int – tau*(EBITDA – (dep&amort + int))
= EBITDA*(1-tau) – int + tau*(dep&amort + int)

NI
= (EBITDA – dep&amort – int)*(1-tau)
= EBITDA*(1-tau) – (1-tau)(dep&amort + int)
= EBITDA*(1-tau) + tau*(dep&amort + int) – (dep&amort + int)

Hence Operating Cash Flow
= NI + dep&amort

In the most simplest of cases, using FCF would be equivalent to using (NOPAT + dep&amort – capex – increase in NWC).

In a more realistic scenario, it may be useful to compare the cashflows from using FCF and from using the NOPAT version and understand where the discrepencies arise. For example, to calculate FCFF in some scenarios, you will need to subtract necessary expenditures such as Preferred Stock Dividend Payments, Required Redemption of Preferred Stock, Required Redemption of Debt, etc.

[Note: You don't have to adjust for "tax shield provided by dep&amort" because it is really given/incurred, it is not a non-cash item that needs to be adjusted.]

Rating: Not bad

Background: I actually listened to the audiobook version (read by the author) instead of the reading the actual book. I had initially thought that Cramer was just some crazy hedge fund speculator-type, until I listened to the audiobook, and found him to be not that bad after all, and is pretty much a fundamentals guy. He has some interesting points to learn from in this book.

Key Points:

1. “Buy and homework”, not “Buy and hold”
2. Build in speculation as part of diversification. Speculation is essential to making it big.
3. 3 points from Andy Beyer’s Picking Winners (a horse-racing book)
   • If you learn from mistakes you will not repeat them.
   • Only invest in stocks where the research and information flow aren’t perfect and lots of minds aren’t already trying to figure it out.
   • Only bet in situations where you have total conviction. Leave the rest to others; you don’t have to play. You don’t have to invest in everything that comes down the pike.
4. How Stocks are Meant to be Traded
   • Don’t let your cost basis affect you, the future is all that mattered.
   • Always use limit orders.
   • Wall street only cares about the growth of the future earnings stream. Analysts calculated the P/E and the growth rate, then match it against the P/E and growth rate of the S&P500 to determine if it is “fairly valued” vs the S&P. However, behind that piece of paper, there is a real business throwing off cash. Wall Streeters care about growth; Main Streeters care about enterprise value and how much it would cost to buy the whole company.
5. Investing Basics
   • Diversification is the only free lunch. Diversify against bear markets, company fraud, sector meltdowns, etc. - minimum of five.
   • Do your homework
     • Read the local paper online, every analyst report, the quarterlies, the annuals, every important article, listen to all the conference calls.
     • Know the metric for your industry that measures how a company is doing vs its peers. E.g. cable industry (enterprise value per subscriber), hotels (average revenue per room), airlines (average revenue per seat), retail (same-store-sales), restaurants (same-store-sales), technology (gross margin per product sold), financials (net interest margin).
     • Make sure the business is financially sound (without a lot of debt).
     • The upside and downside are created by two different cohorts. The value guys create the bottom (at a P/E = growth rate); the growth guys create the top (at a P/E = 2*growth rate).
6. Spotting Stock Moves before They Happen
   •  Two logical catalysts for traditional moves of large caps
     • Rotational catalysts – switching by portfolio managers between secular growth stories and cyclical blastoffs.
     • Estimate revision catalysts – rise in companies’ estimates, change in product cycles, demand cycles.
   • For discovered stocks – sector analysis and specific company analysis each explain about 50% of the moves.
   • There are only 2 ways for the stock price to go up – either earnings increases or the P/E multiple increases.
   • Playing with Multiples
     • If the Fed cuts rates, it will stimulate the economy and cause multiple expansion. People are willing to pay a higher multiple now because they anticipate higher earnings in the future (i.e. in the future, the P/E can be the average P/E but the earnings is substantially higher).
     • If the economy downshifts, the multiple will drop in anticipation of lower earnings in the future.
     • The P/E multiple of all sectors respond to the macro picture, so it is important to stay focused on where you think the economy is headed.
     • Cyclical stocks (e.g. Maytag, Dow Chemical, DuPont) must be purchased when the M is highest (i.e. E is lowest, at the bottom of the economic cycle), and sold when M is lowest (i.e. E is highest, at the top of the economic cycle).
     • Non-cyclicals (e.g. P&G, General Mills, Colgate, Coke, Pepsi) must be bought when their M is lowest (i.e. at top of economic cycle), and sold when M is highest (i.e. at bottom of economic cycle).
   • Playing with Earnings
     • Anticipate spending cycles.
       • Airline cycles – Notoriously cyclical with a “7 fat years and 7 lean years” cycle. When Boeing sees a cyclical upturn in its order book, load up on stocks that make parts for Boeing (e.g. Fairchild – screws, BEA Aerospeace – seats, Honeywell – cockpit instruments). Start to sell when the analysts catch on.
       • Semiconductor equipment cycles – When semicon companies start to do well and buy equipment, load up on stocks of Applied Material, KLA-Tencor, Kulicke & Soffa, and Novellus.
       • Telco equipment cycle – Nortels, Lucents, JDS Uniphases.
   • Focus on interest rates
     • Lower rates lowers the cost of buying stocks, and increases the price (i.e. PV) that you are willing to pay for future earnings. Same thing in reverse for higher rates. (i.e. lower rates -> higher P/E, higher rates -> lower P/E).
     • Recognise when inflation is picking up, move ahead of the Fed.
   • Game breakers
     • Look for undiscovered companies. Identify a sexy concept: e.g. nanotechnology, video-on-demand, homeland security devices, low-carb food, etc.
     • In the initial stages, look for companies with revenues, decent bloodlines for management, scientific prospects that sound legitimate (read trade journals, newspaper and magazine articles, academic studies).
     • Search for companies involved, go in if you are early enough (i.e. NY firms have not yet covered them). Own as much of them as you can.
     • Hold the stocks until the analysts at major firms start their promotion.
     • Get out when underwriting after underwriting occurs as the group goes higher and higher.
     • Ingredients for a mass-psychology-driven move upward
       • 40% management – salability of the story, credibility of management, accessibility of information on the company.
       • 30% fundamentals – cash-flow growth, earnings growth/potential, balance sheet, liquidity.
       • 15% technicals – stock momuntum, support levels, simple charts.
       • 15% “thestreet alpha factor” – stock float, low volume relative to float, how the stock has reacted to strong news in the past, short interest ratio. Like to screen for stocks that have minimum of 100,000 shares, $100 million in market cap, price between $1 – $15.
7. Stock-picking Rules to Live By
   • Ten Commandments of Trading
     1. Never turn a trade into an investment – declare upfront whether its a trade or investment. If its a trade, after the “event”, get out immediately.
     2. Your first loss is your best loss – cut your losses quickly.
     3. Its okay to take a loss when you already have one.
     4. Never turn a trading gain into an investment loss.
     5. Tips are for waiters.
     6. You don’t have a profit until you sell.
     7. Control losses; winners take care of themselves.
     8. Don’t fear missing anything.
     9. Don’t trade headlines.
     10. Don’t trade flow (i.e. when you see multiple uptrades or downtrades).
   • Twenty-Five Investment Rules to Live By
     1. Bulls and bears make money; pigs get slaughtered.
     2. Its okay to pay the taxes.
     3. Don’t buy all at once; arrogance is a sin.
     4. Look for broken stocks, not broken companies.
     5. Diversification is the only free lunch.
     6. Buy and homework, not buy and hold.
     7. No one ever made a dime by panicking – don’t sell in a panic! typically, the panic comes at the end of the sell-off, not the beginning or even the middle.
     8. Own the best of breed; its worth it – the cheaper underdog hardly ever wins in the game.
     9. He who defends everything defends nothing, or why discipline trumps conviction – don’t try to buy all the stocks that you like, only defend (i.e. average down) good stocks and let the others go.  You need to rank your stocks.
     10. The fundamentals must be good in takeovers – if the fundamentals are bad, the potential acquirers won’t like it either.
     11. Don’t own too many stocks – 5 stocks.
     12. Cash and sitting on the sidelines are fine alternatives.
     13. No woulda shoulda coulda – don’t keep the mental baggage of a screw-up.
     14. Expect corrections; don’t be afraid of them – don’t panic and sell.
     15. Don’t forget bonds.
     16. Never subsidize losers with winners.
     17. Hope is not part of the equation.
     18. Be flexible.
     19. When high-level people quit a company, something is wrong.
     20. Patience is a virtue – giving up on value is a sin.
     21. Just because someone says it on TV doesn’t make it so.
     22. Always wait 30 days after an earnings pre-announcement before you buy – don’t go in immediately after a stock gets hammered by an earnings shortfall pre-announcement; its typically a precursor of worse things.
     23. Never underestimate the Wall Street promotion machine.
     24. Be able to explain your stock picks to someone else.
     25. There is always a bull market somewhere.
8. Creating your Discretionary Portfolio
   • A stock of a company from your neighbourhood, something that you know or can relate to.
   • An oil stock – some of the most consistent performers with high-dividend yields, great cash flows, and businessess that do well in times of tension.
   • A brand-name blue chip with a 2.5% yield or greater – the above average yield (vs the S&P) will afford you protection if the stock gets hit.
   • A financial.
   • A speculative stock.
   • A soft-goods secular growth stock when it is out of fashion.
   • A high-quality cyclical stock when the economy is at a bottom.
   • A tech stock with a dividend yield.
   • A young retailer that is on a march to national status.
   • A “hope for the future” non-tech stock, e.g. biotech company or something from S&P 600 mid-cap index.
9. Spotting Bottoms in Stocks
   • Market sentiment (for market)
     1. The pain makes the front page of the New York Times.
     2. The Investors Intelligence survey of money managers (found among the indictors in the Investor’s Business Daily available every Thurs morning) show a bull-bear ratio with less than 40% bulls (i.e. more bears).
     3. Mutual fund withdrawals occuring steadily for at least 2 months. Numbers available on Fridays through an organization call AMG, and almost always in the papers Saturday or Monday.
     4. A reading of +35 or more on the VIX for 3 weeks.
     5. A -7 reading on Helene Meisler’s oscillator on Realmoney.com
   • Capitulation (for market)
     1. A dramatic imbalance in the number of new highs to new lows (should have between 400-700 new lows and only a handful of new highs).
     2. No more forced selling by margin clerks from 1.30-2.30pm. When there is no strong sell-off by 2.30pm, its a sign that margin debt has shrunk to acceptable levels and speculation has been flushed out of the system. You can also wait until the SEC releases the monthly margin debt numbers to see radical decline in margin buying (no more hopefuls).
     3. Dramatic spike in volume on the exchanges to indicate that many sellers are cleaned up.
     4. When you are at Stage 5 of the stock market underwriting cyle (see below):
        1. Overheated underwriting market with crazy openings and tons of offering per week -> developing top so get ready to sell alot of stock.
        2. Soon, you have deals opening up unchanged, with little or no premium -> market is sated so be in a minimum of equities.
        3. Then, deals just fail from the moment they come out -> sign of weakness but don’t buy yet.
        4. Then, deal after deal breaks down and the pipeline of new equity dries up -> supply/demand goes out of whack.
        5. One or two months after the flood of new deals ceases, you begin to see a few terrific IPOs and the stocks don’t go down -> buy now!
     5. When you get the “stop trading, order imbalance” sign across the whole stock market, with lots of stocks opening down huge simultaneously on no news.
   • Catalyst (for market)
     • Consider what event could occur that would trigger an “exquisite moment” where a news event that so dwarfs others is about to occur, and the stock market factored in all of the negatives and none of the positives (e.g. Iraq war).
     • After each sell-off, a different trigger will cause the averages to reverse. You don’t  need to know when or what the catalyst is, but you can set yourself up for the ignition.
   • How do you know if you have missed the bottom?
     • The BKX (Bank Index) has been coincident with or has led the market bottom in every case – use as a confirmatory signal.
   • How do you start bottom fishing?
     • Start buying in the morning of the “bottom” with stocks that have additional support from day traders and institutions (e.g. stocks that have been upgraded that morning) – to ‘test waters’ – in case the market drops further, the institutional buying should cushion the downside.
   • Spotting bottoms for stocks
     1. The stock has multiple “sell” ratings.
     2. When bad news hits, the stock ceases to go down.
     3. Consistent large insider buying (need to see large ($M) buys, not small fako buys).
     4. Negative rumors and nothing happens.
   • Other bottoms
     • Sector bottoms due to the Fed cycle
     • Tax-loss bottom – Mutual funds likes to take losses at the end of their fiscal year (mostly in end-Oct). Begin your buying in the last week of Oct, leave some money for the last week of Nov too.
10. Spotting Tops in Stocks
    1. Competition that appears and hurts the business.
    2. Management starts to be vague with numbers.
    3. Overexpansion and M&A.
    4. Government policy changes with negative impacts.
    5. A retailer that has stores in every state with no new areas in which to expand.
    6. A fad stops. Listen to the conference calls of retailers that sell the fad (e.g. Palm, iPods, etc.)
    7. Company sells stock that is at a huge discount to the last sale of its equity.
    8. Accounting shenanigans.
    9. When the market is red-hot, coupled with an S&P oscillator reading of +5 or more, and there are more than 50% bulls.
11. Advanced Strategies for Speculators
    • When you know that you have something big (i.e. strong obvious catalyst), either way, the best way to play it is in puts or calls. But if it isn’t big – which is about 99% of the situations – it is better to use the common stock. 
    • When you short a stock that so many other folks are short, and the brokerages can’t find the stock in the vault to lend out, the brokerages go into the open market to find stock to deliver to the buyer, creating a short squeeze – better to use puts.
    • Rules for shorting
      1. Never short a company that could be on the cover of Business Week as the world’s greatest company – i.e. a great company with a short-term screw-up.
      2. Never short a company that can be taken over.
      3. Never short because of valuation – i.e. price is too expensive.
      4. Use puts instead of borrowing and selling short stock.
      5. Never be shorting together with a bunch of people – research must be original.
      6. It is not cool to be short.

<END>

Rating: Mama desu.

Background: This is a follow-up from my interest in Technical Analysis after reading about the 3 tools (MACD, Slow stochastics, SMA) recommended by Phil Town to be used in conjunction with fundamental analysis.

Key Points:

1. The logic of the technical approach
   • The market discounts everything (i.e. it is forward-looking) 
   • Prices move in trends
   • History repeats itself
2. Trend line breaks: 1%/3% rule: If the security trades more than 1%/3% above/below the trend line, you buy/sell.
3. Support and Resistance
   • Once broken, support becomes resistance, and vice versa.
   • The more times a level was tested, the more important that level becomes.
   • Finding support and resistance levels
     • % retracements – prices retraces 25%, 33%, 38%, 50%, 66% from the high of a move.
     • Price objectives – from patterns such as triangles, head-and-shoulders, etc.
     • Moving averages – 50-day and 200-day moving averages
     • Extrapolating trend lines
     • Price markups – e.g. double the low
     • Volume at Price – places where the volume was high
4. Patterns
   • Head-and-shoulders – The height from the neckline to the top of the head is projected downward from the neckline to get the projected price. If the target is overrun, double the target (i.e. subtract the height again). 
   • Double tops – same as H&S.
   • Triple tops, saucers, lines, cup-and-handle, V tops – basically a list of patterns that seemed pretty useless, either that or the explanations were lacking.
5. Reversals
   • Outside days (high-low range of current day is outside/eclipses the prior day) and inside days (high-low range of current day is entirely within that of the prior day) are signs of weakness – i.e. nobody (bulls/bears) is in control.
   • The stock has been on a downtrend and it makes a new low. If another new low is not made the next day, and the stock can close above the high set on the recent low day, then we have a short-term buy signal.
   • The stock has been on an uptrend and makes a new high. If another new high is not made the next day, and the stock can close below the low set on the recent high day, then we have a short-term sell signal.
   • Island reversal, and hook reversal – no info on how to use them.
6. Consolidations
   • Flags and pennants – Go long/short on a break above/below the line across the highs/lows of the flag/pennant.
   • Triangles
     • Price target – Measure the length of the missing side that will ‘close’ the triangle. Project that length from the breakout point to get the target price.
     • Timing – Triangles typically break out 2/3 to 3/4 of the way through the pattern. If you mark the point in time where the triangle pattern would have reached its apex, that will often mark the peak or trough of the move out of the triangle.
   • Rectangle/box – Height of rectangle can be used to measure and project a target.
   • Rare diamond – very rare
   • Wedges (triangles where both top/bottom trend lines slope in the same direction)
     • A rising/falling wedge favors a downside/upside breakout.
     • Price target – If the wedge is a continuation pattern, the price range of the move before the wedge can be projected from the breakout point. If the wedge is a reversal pattern, the distance traveled by the wedge can be projected from the breakout.
7. Gaps
   • Types of gaps
     • Breakaway gap – ‘nuff said
     • Runaway (measuring) gap – Gap in a continuing trend. Project the length of the move before the gap, to get the price target.
     • Exhaustion gap – Last ditch attempt before a reversal
   • How to trade gaps – Find the halfway point of the gap and assume it will trade back till there.
8. Channels
   • Profit by buying/selling within the channel.
   • Measure the width of the channel and project that distance from the breakout point to get the target price.
9. Moving averages
   • 1-MA system: Go long/short when the price crosses above/below the MA line.
   • 2-MA system: Go long/short when the faster MA crosses above/below the slower MA.
   • 3-MA system: Go long when the fastest MA crosses the middle MA, and the middle MA crosses the slowest MA. Go short as soon as the fastest MA has declined below the middle MA.
10. Relative strength
    • Stocks that performed well/poorly continued to perform well/poorly, so buy strength and sell weakness.
    • Relative strength can be calculated by dividing the daily/weekly close of a stock or group, by a market average or index.
    • Relative strength usually reverses ahead of the trend in the index.
11. Volume
    • Volume leads price, and is a confirming indicator.
    • On-Balance Volume (OBV) is cumulative volume (if today closed higher/lower, you add/subtract today’s volume to OBV). If prices were going sideways and OBV is rising/falling, that meant smart money was accumulating/liquidating.
12. Oscillators
    • Rate of Change (ROC) oscillators, and other momentum oscillators, will lead price action.
    • Look for confirmation once the oscillator diverges from price action (i.e. price makes a new high/low but oscillator does not make a new high/low).
13. Relative Strength Index (RSI)
    • Fluctuates from 0 to 100. Overbought/oversold levels at 70/30.
    • Upward bias in bull market (i.e. levels should be 80/40), downward bias in bear market (i.e. levels should be 60/20).
14. Stochastics
    • Determines where the current closing price resides, within the price range of the last x days. Overbought/oversold levels at 80/20.
    • Fast stochastic: %K is the stochastic indicator using actual price. %D is the smoothed average.
    • Slow stochastic: %K is the %D of the fast stochastic. %D is the MA applied again on the %K.
    • Either used like a normal momentum oscillator (i.e. trade based on the level) or like a MA (i.e. %K crosses above/below %D).
15. Other indicators
    • Advance/Decline (A/D) line
      • Daily cumulative of (# of advancing issues – # of declining issues).
      • Similar to momentum indicators – move together with price trend is good, divergence is bad.
    • Last-hour indicator
      • Daily cumulative of (price change in last hour of trading) to know the “real” price action.
    • Arms Index (TRIN) – unclear explanations.
    • Sentiment
      • Investors Intelligence survey, Bullish Consensus survey, Barron’s surveys.
      • Look at the credit market report in WSJ to find the average maturity of securities held in portfolios of taxable money market funds, typically 29 – 65 days. When fund managers extend/shorten maturities, they expect short-term interest rates to decline/rise (shouldn’t it be the other way around???).
      • Put/call ratios. High at market bottoms, low at market tops.
    • Barron’s Confidence Index (BCI)
      • Calculated by dividing the average yield of high-grade corporate bonds by the average yield of intermediate-grade speculative bonds.
      • Investors will move to high-grade bonds if they anticipate recession, which lowers the yield, and decreases BCI.
      • BCI leads stock prices at turning points by 2 – 4 months.
16. Guidelines for successful trading
    • Have patience and wait for the right opportunity and the right setup.
    • Look for confirmation of the pattern/signal.
    • Don’t trade without stops.
    • Money management is critical.
    • Always add to positions in the direction of the trend. If you are long, add to positions on strength. If you are short, add on weakness. Never add to your position if the market is going against you. Always let the market tell you that you are right.
    • Exiting a trade: Sell 1/3 of the position when the profit target is reached. If the market is still strong, hold the remaining 2/3 until a trend break or a reversal.

General comments: The explanations in the book are not clear and succinct, and the examples are often not obvious (i.e. the explanations below the charts say something, but you just don’t see it). There are also too many exceptions and too many patterns to make the material useful – it would have been better if a self-contained usable framework is presented rather than covering so much material without a proper structure. In general, the approach to viewing the many technical rules of the game, may be to know what others see, as opposed to following the rules blindly.

<END>

Rating: Mama desu.

Background: Got interested in reading this book because of its title TrimTabs Investing: Using Liquidity Theory to Bat the Stock Market with the concept of using supply/demand to help in investing.

Key Points:

1. Building blocks of liquidity analysis
   • L1 – Change in net trading float of shares
   • L2 – U.S. equity mutual fund flows
   • L3 – Margin Debt
2. L1 (Change in net trading float of shares)
   • L1 is the net change in trading float of shares (the supply side). If L1 is positive, the trading float of shares is increasing and institutions are a net seller of stock. If L1 is negative, the trading float of shares is shrinking and institutions are a net buyer of stock.
   • L1 = New Offerings + Insider Selling – New Stock Buybacks – 2/3 New Cash Takeovers – 1/3 Completed Cash Takeovers
   • Note: when a cash takeover is announced, 2/3 of the dollar amount is included in the L1 formula. The final 1/3 is included when the takeover is completed. This is because arbitrageurs typically buy 2/3 of the stock of the target company within a week of the deal’s announcement.
   • Data source: Dealogic, www.theonlineinvestor.com, Thomson Financial
3. L2 (U.S. equity mutual fund flows)
   • L2 measures U.S. equity mutual fund flows (the demand side).
   • L2 = Amount of cash investors are investing in mutual funds that invest in U.S. stocks – Amount of cash investors are withdrawing from mutual funds that invest in U.S. stocks
   • L2 is typically a contrary indicator. Inflows into U.S. equity funds tend to peak around market tops, and outflows tend to peak around market bottoms.
   • Data source: Investment Company Institute (ICI) monthly release @ www.ici.org/stats/mf/index.html, U.S. Department of Treasury release on foreign purchases and sales of U.S. securities @ www.treas.gov/tic/s1_99996.txt    
4. L3 (Margin debt)
   • L3 is the change in the amount of margin debt used to purchase stocks, as reported by the member firms of the NYSE.
   • L3 rises rapidly when investors are very optimistic about the future prospects of the stock market (usually after prolonged period of strong returns). L3 falls significantly after a prolonged period of poor stock returns.
   • Data source: NYSE Member Firms Customers’ Margin Debt @ www.nyse.com/pdfs/marginMMYY.pdf
5. Anatomy of Bull and Bear markets
   • At the beginning of bull market
     • L1 – strongly negative
     • L2 – negative
     • L3 – negative
   • On the way up
     • L1 – remain negative
     • L2 – increasingly positive
     • L3 – slightly positive
   • At the top
     • L1, L2, L3 - strongly  positive 
   • On the way down
     • L1, L2, L3 - increasingly negative
   • At the bottom
     • L1, L2, L3 - strongly negative
6. Lower-risk strategies using liquidity theory
   • Strategies vary contributions and holdings according to expected liquidity conditions. Five stances are adopted based on estimates of daily L1.
     •  < -$800 mil = Strongly bullish
     • -$800 mil to -$400 mil = Bullish
     • -$400 mil to $400 mil = Neutral
     • $400 mil to $800 mil = Bearish
     • > $800 mil = Strongly bearish
   • Perform dollar-cost-averaging by splitting the monthly investment into a stock index fund (SIF) and a bond index fund (BIF). The split proportions will range from 100% in SIF when strongly bullish, to 100% in BIF when strongly bearish.
   • Higher risk strategies involve shorting the market when strongly bearish, e.g. investing 100% in Rydex Ursa Fund (RYURX) which is 100% short the S&P500.
7. Aggressive strategies using liquidity theory
   • More aggressive strategies involve the use of leverage (i.e. margin), and investing in securities such as ETFs and futures, but with similar principles as the lower-risk portfolio strategies.

<END>

Rating: Very Good

Background: Another “value investing” book, but this one’s pretty good. The content is very similar to Buffettology but it lays everything down in a clear, simple to understand manner, with not much homework, that should appeal to the “Defensive Investor” as defined by Graham. The book highlighted many important points about value investing, which I may omit in my summary below if I have already internalised them.

Key summary:

1. Rule #1: Don’t lose money – Rule #2: Don’t forget Rule #1.
2. Certainty comes from buying a wonderful business at an attractive price.
3. The Four Ms
   1. Meaning – Does the business have Meaning to you?
   2. Moat – Does the business have a wide Moat?
   3. Management – Does the business have great Management?
   4. Margin of Safety – Does the business have a big Margin of Safety?
4. Meaning
   1. Do you want to own the whole business?
   2. Do you understand it well enough to own all of it?
   3. 10-10 rule: I won’t own this business for 10 minutes unless I’m willing to own it for 10 years.
   4. Are you willing to buy it as if your family will have to depend on the earnings of the business for the next 100 years?
5. Moat
   1. Five types of Moat (aka sustainable competitive advantage)
      1. Brand – a product you’re willing to pay more for because you trust it
      2. Secret – a business that has a patent or trade secret that makes direct competition illegal or very difficult
      3. Toll – a business with exclusive control of a market – giving it the ability to collect a “toll” from anyone needing that service or product.
      4. Switching – a business that is so much a part of your life that switching isn’t worth the trouble.
      5. Price – a business that can price products so low no one can compete.
   2. The Big Five
      1. Big Five
         1. Return on Investment Capital (ROIC)
         2. Equity, or Book value per share (BVPS), growth rate
         3. Earnings per share (EPS) growth rate
         4. Sales growth rate
         5. Free Cash Flow (FCF or cash) growth rate
      2. The Big Five numbers are proof of the existence of a Moat. All of the Big Five should be equal to or greater than 10% per year for the last 10 years.
      3. Look at 10-year averages, 5-year averages, 3-year averages and 1-year (i.e. the most recent year). Look for consistency.
   3. Rule on Debt: To determine whether a business’ debt is reasonable, find out if it can pay off its debt within 3 years by dividing long-term debt by current free cash flow.
6. Management
   1. A great CEO should be
      1. Owner-oriented.
      2. Driven.
   2. Read articles written on the CEOs, his annual letters to shareholders, etc.
   3. Look into insider trading to make sure executives are not unloading lots of their stock.
   4. Look at the CEO’s compensation to see if its reasonable.
7. Margin of Safety
   1. Calculating the Sticker Price (aka fair value)
      1. Get the current (i.e. TTM) EPS.
      2. Estimate the future EPS growth rate (i.e. the Rule #1 growth rate). Take the minimum of the past equity (yes, equity, not EPS) growth rate, and the average analysts’ estimate for earnings growth. [I do not quite agree with using the equity growth rate here. The reasons given in the book were that if EPS increases while equity stays the same, the intrinsic value will not grow. My counter would be that the impact of that should be reflected in the P/E ratio, to show how much an investor is willing to pay for earnings-that-don't-add-back-to-equity. Qualitatively, that bad scenario can also be screened-out in the Big Five. Finally, since the point is to estimate EPS 10 years later, the historical EPS growth should be the best proxy.]
      3. Calculate the EPS that will occur ten years later.
      4. Estimate the future P/E ratio. Take the minimum of the average historical P/E ratio, and the default P/E (= 2*Rule #1 growth rate).
      5. Calculate the stock price 10 years later.
      6. Calculate the sticker price by discounting the stock price to today’s value (e.g. divide by (1.15)^10 if required return is 15%).
      7. Find the Margin of Safety (MOS) price by dividing the sticker price by 1/2.
8. When to Sell
   1. There are two times to sell
      1. The business has ceased to be wonderful. E.g. the business economics has changed and the moat has disappeared, or the CEO has ceased to be owner-oriented.
      2. The market price is above the sticker price. Institutional investors tend to take profits at that time. Rule #1 investors should look for better opportunities that have a lot bigger MOS.
   2. Guideline for re-buying a business
      1. Yes you can buy in a wonderful business at a MOS that is less than 50%. BUT ONLY IF you had bought in originally with the full 50% MOS.
      2. The first time you buy into a particular business, you would not know the business as well as if you have owned the business for some time. Hence you would need time to prove that your investment hypothesis is correct.
      3. So the first time you buy, only buy in at 50% MOS. After you have been proven right and the price went up to the sticker price, you can sell the stock, and the next time you can buy in at a lower MOS (e.g. 20%).
9. The Three Tools
   1. MACD (Moving Average Convergence/Divergence) shows the movement of institutional money in and out of stocks. Recommended settings 8-17-9.
   2. Slow stochastics tracks the overbuying and overselling of a stock. Recommended settings 14-5.
   3. Moving average tracks an average of the stock price during a specific time period, and are a kind of psychological barrier to the stock price moving up or down. Recommended 10-day moving average.
10. To make use of the Tools, make sure that your position is less than 1% of the daily trading volume.
11. Buying / Selling Discipline (after performing the fundamental analysis above)
    1. The Three Tools (technical indicators) help to take emotions out of investing by setting fixed rules for buying and selling.
    2. Buy when all three tools are “green” (i.e. MACD and stochastics cross above signal lines and stock price crosses above 10-day MA).
    3. Sell when all three tools are “red”.

<END>

Rating: Good

Background: Dell’s stock has been steadily dropping over the past few years, and a couple of value investors (e.g. Bill Miller) have bought into it. I was doing a bit of research into DELL when I chanced upon this book at a bookstore, so I picked it up and gave it a read.

Key Summary:

1. M. Dell grew up with an entrepreneurial spirit - auctioning stamps, selling newspaper subscriptions, etc. He realised that the computer stores at that time, bought PCs from IBM, charged a premium and gave no service. He took advantage of that by assembling his own computers, selling them at a cheaper price and giving better service.
2. Dell’s Direct Model, v1.0 - From the start, our entire business – from design to manufacturing to sales – was oriented around listening to the customer, responding to the customer, and delivering what the customer wanted. Our direct relationship – first through telephone calls, then hrough face-to-face interactions, and now through the Internet – has enabled us to benefit from real-time input from real customers regarding product and service requirements, producs on the market, and future products they would like to see developed… The direct model is based on direct selling – not using a reseller or the retail channel. Because we built only what our customers wanted when they wanted it, we didn’t have a lot of inventory taking up space and soaking up capital.
3. Highest levels of service + products needed - There would always be someone with something that was lower in price or cheaper to produce. What was really important was sustaining loyalty among customers and employees, and that could only be derived from having the highest level of service and very high-performing products.
4. Disdaining inventory - Inventory is the worst thing to own in an industry in which the value of materials or information declines quickly. This is especially worse when you are a technological leap, where the price of your old inventory plunges. To compensate, the price of the products have to be raised, slowing the growth of the company. Improving the speed of the inventory flow is a necessity – it combats the rapid decline in the value of materials and requires less cash and has less risk.
5. Order of business at Dell – In 1993, we didn’t understand the economics of our businesses. We were consuming huge amounts of cash, while our profitability began to deteriorate, and both our inventory and our accounts receivable were piling up. We had grown too quickly. We realized our priorities had to change. We needed to focus on slow, steady growth, and liquidity. Once we got our cash situation in order, we could then turn on the profit valve and eventually reaccelerate our growth. Instead of “growth, growth, growth” the new order of business at Dell would be “liquidity, profitability, and growth” – in that order.
6. Clear metrics - Once we established clear metrics and measurements, it was easy to see which businesses were performing or not, and to change the strategy accordingly. For example, we changed our infomration systems so that a salesperson could see the level of margin for a product literally as he/she was selling it on the phone. Previously, you might have had a case where two salespeople would each sell $1 million worth of our products, but one might have  28% profit margin and the other only 8%. Our improved sales compensation system emphasized profit margins, and since the margins determined the sales representatives’ compensation, they were heavily motivted to change.
7. Three Golden Rules at Dell – 1) Disdain inventory, 2) Always listen to the customer, and 3) Never sell indirect.
8. Phase reivew process for product development – This process created the common language and an agreement across the organization about how products would be developed and launched.  We start with a business contract, which is an agreement among all parts of the organization concerning the product we intend to deliver: what it is, and how it’s supposed to perform in the market. Each phase has its own criteria for achievement. From the beginning, everyone signs on: from design and manufacturing to finance, sales, and services and support. The phase review process becomes a robust planning architecture for teh development of each product because it fosters team responsibility and accountability.
9. Dual reporting -  You need to maintain functional excellence while injecting business accountability. To achieve this, we instituted a system of dual reporting with our people. Most senior-level managers of specific functions, such as finance or human resources or legal affairs, share responsibility with managers of specific businesses, such as particular regions or product lines. Our lawyers in Europe, for example, report both to the head of our European business, as well as to our general counsel at our headquarters in Round Rock.
10. Segmentation – Segmentation offers a solution to the fundamental issue that has challenged Dell since the very beginning: how to sustain our growth as we got bigger. You can grow small companies quickly, but it becomes increasingly more difficult to sustain a high rate of growth in a large corporation. Segmentation allows us to scale our business very rapidly because every time we determine that there is sufficient momentum to segment a unique customer group, we’ll break it off, give it its own organization team, and let it act as a small company.
11. Dell’s Direct Model, v1.1 – In Version 1.0 of the direct model, we eliminated the resller, thereby eliminating the markup and the cost of maintaining a store. In Version 1.1, we went one step further to reduce inventory inefficiencies. The amount of assets required, in this case excess inventory, is inversely proportional to the quality of your information. With less information about customer needs, you need massive amounts of inventory. So if you have great information – that is, you know exactly what people want and how much – you need that much less inventory. Less inventory corresponds to less inventory depreciation. Let’s say Dell has 6 days of inventory compared to an indirect competitor who has 25 days with another 30 in their distribution channel. In that difference of 49 days, the cost of materials will decline about 6%.
12. Inventory velocity – Inventory velocity means squeezing time out of every step in the process. To achieve maximum velocity, you have to design your products in a way that covers the largest part of the market with the fewest number of parts. FOr example, you don’t need 9 different disk drives when you can serve 98% of the market with only four. We also learned to take into acccount the variability of low- and high-cost components. Systems were reconfigured to allow for a greater variety of low-cost parts and a limited variety of expensive parts. The goal was to decrease the number of components to mange, which increased the velocity, which decreased the risk of inventory depreciation, which increased the overall health of our business system. However, without traditional stockpiles of inventory, it is critical to precisely time the discontinuance of the older product line with the ramp-up in customer demand for the newer one.
13. Reward success by narrowing responsibility – When a business is growing quickly, many jobs grow laterally in responsibility, becoming too big and complex for even the most ambitious, hardest-working person to handle without sacrificing personal career development or becoming burned out. Segmenting a job happens in a couple of ways. We’ll bring in additional talent and/or divide a business unit, product organization, or functional unit in some way that makes the newly segmented structure more manageable and more sharply focused to the business opportunity. This allows us to keep our people happy and thriving and maintaining a high grwoth rate. Even when we create create two or sometimes three new groups out of one, the new group is often twice as big as the original one had been, say, two years ago.  There is no added value in expecting people to be superhuman. In that case, you might as well expect them to fail.
14. Information sharing – We share the best ideas throughout our various buesinesses because we’re all working on the same team, toward the same goal. If one team is having great success with medium-size companies, we cross-pollinate their ideas around the world. If another team has figured out how to sell into law firms, we share their learning through the organization. Our best ideas can come from anywhere in the world and be shared instantly.
15. Innovative thinking – How can we teach people to be more innovative? Ask them to approach a problem in a holistic sense. We start by asking our customers, “What would you really want this thing to do? Is there a different way to accomplish that?” Then we try to come up with a totally different approach that exceeds the original objectives.
16. Don’t try to perfume a pig – We receive constant information on everything from our products to demand trends to quality data both in field performance and in our factories. Metrics are posted in the factories and throughout our company. Salespeople can measure their progress literally minute by minute. Almost every activity within the company has metrics attached to it, even so-called soft activities such as legal, public relations, and human resources. Facing a problem and quickly accepting it enables you to address the issues immediately and move on problems faster.
17. Think like an owner (ROIC) – To motivate an employee to think like an owner, you have to give her metrics she can embrace. At Dell, every employee’s incentives and compensation are tied to the health of the business. And one of the best ways we’ve learned to evaluate its health is Return on Invested Capital (ROIC). ROIC became a focusing device. We determined successful strategies by measuring our ROIC and growth for each business. We explained specifically how everyone could contribute: by reducing cycle times, eliminating scrap, selling more, forcasting accurately, scaling operating expenses, increasing inventory turns, collecting accounts receivables efficiently, and doing things right the first time. We decided to reward employees around a matrix of ROIC and growth; higher performance directly correlated to higher ROIC, which came back in the form of higher compensation.
18. Add value “beyond the box” – The idea of adjusting our manufacturing and product development strategy based on customer input seemed obvious to us. We are not just going to be a customer’s PC vendor, but to be part of the customer’s own information technology group, help think about your customer’s bottom line, how can you help them cut costs and increase profits.
19. Complexity kills – Maintaining many supplier relationships adds tremendous complexity and cost to our business. There were the costs of designing all the different components into our computers, qualifying them, and testing them. There were the costs of initiating lots of different relationships and supporting them in the field. There were the costs from confusion to our sales and service teams and to our customers. Our rule is to keep it simple and have as few partners as possible. Fewer than forty suppliers provide us with about 90% of our material needs. Closer partnerships with fewer suppliers is a great way to cut cost and further speed products to market.
20. Proximity pays –  Once we could measure the true returns to our shareholders from buying one component versus another, it was very clear that those suppliers that located their factories close to ours helped us to deliver a higher ROIC than those who were farther away. Obviously if they were closer to us, we had lower shipping costs. But since component costs decline in value an average of 0.5 to 1% per week, proximity also meant that they could get us products more quickly and we could take full advantage of the component cost reductions.
21. Supplier management  – Suppliers need to have a sprint capacity to work with us, and our demand can’t represent a disproportionate amount of their total capacity. We tell suppliers exactly what our daily production requirements are, e.g. “Tomorrow morning, we need 9,762. Deliver them to door no. 7 by 7am.”. One of our tools we use to gauge a supplier’s performance is our supplier report card. In it, we set our standards very explicitly: We detail the number of defects per million we will tolerate; we outline what we expect to see in field performance, on our manufacturing lines, in delivery performance and in the ease of doing business with them. We also evaluate suppliers on cost, delivery, availability of technology, inventory velocity, support of our global business, and the ways in which they do business with us over the Internet. We set quantitative measures for success so they know what we expect and we provide regular progress reports to they know how they’re doing.
22. Inventory velocity revisited – One of the first things we had to do was try to get suppliers to stop thinking about how much inventory they were going to ship to us. Instead, we had to encourage them to think about how quickly that inventory was going to move from the end of their production line through our manufacturing line and on to the customer. “Ship us inventory every day or every hour as we need it. We’ll buy from you faster. And if you can do that, we’ll buy a whole lot more”. Speed to market is important for two reasons. One is that it creates competitive value that can be shared between buyer and supplie. The other is that when it comes to delivering the latest product – no matter what it is – you’re either quick or you’re dead.
23. Using the Internet – Given that our factories run on a continuous-flow manufacturing model, our goal is to get to a point where when we use a component, another one immediately shows up and the supply just keeps replenishing itself, automatically, as we need it. By using the Internet to maintain a continuous flow of materials from our suppliers into our factories, our people spend less time placing orders or expediting parts and more time adding value. The other thing the Internet gives us is immediate transmission of product quality data. We’d like our suppliers to see the information real-time. If we can accelerate the availability of the data, our chances of encouraging suppliers to improve also will increase exponentially. By providing real-time information on the day-to-day mix and volume, we can help our suppliers level-load their factories and minimize their level of inventory. By helping our suppliers do a better job of reducing their supply chain lead times and moving to a higher degree of flexibility within their supply base, we can reduce the total cycle time from when we place the order to when they fulfill it.

Conclusion: The book is a very good read, and the business principles highlighted above are truly excellent. The very core thing that drives the business is the fact that everything revolves around the customer. Listening to customer feedback, acting on it promptly, adding value to the customer, etc. One thing to note is that the book was written in 1999. However, since then, from 2002, DELL has suffered from poor customer satisfaction – the very thing that supposedly drives DELL. Despite an attempt in late-2002 to improve customer service, DELL’s customer service has gone from bad to worse. With reports of long-time customers being ignored, and finally moving to other competitors out of frustration, coupled with the fact that DELL outsourced its customer service call center to India and its related problems, it is not clear whether DELL will be able to turnaround. With the problem in plain sight for years, and the solution clearly available, what exactly has been preventing DELL from fixing the problems and moving to greater heights? As Michael Dell puts it, “Time will tell”.

Rating: Not as good. Abit long-winded.

Background: This book review is slightly off-the-track from the previous book reviews that focus more on investing and finance. But hey, its economics after all.

Key Summary:

1. Legalizing abortion in 1973, was the most important factor in explaining the massive drop in crime rate in the 1990s. Legalizing abortion significantly impacted poor, unmarried, and teenage mothers for whom illegal abortions had been too expensive or too hard to get. Their children, if born, would have grown up in an adverse family environment, and would have been much more likely to become criminals.
2. A real-estate agent keeps her own home on the market an average of 10 days longer and sells it for an extra 3-plus percent. When she sells her own house, the agent holds out for the best offer; when she sells yours, she pushes you to take the first decent offer that comes along because her incremental commission of a better offer is too little an incentive.
3. School teachers cheat by altering their students’ answers to boost up their test scores. Sumo wrestlers cheat by giving away matches when they don’t “need” them in the tournament, in exchange for wins in future.
4. A drug dealer network works similarly to a legal partnership or a large corporate firm. The top 20 bosses earned $500,000 a year. The next 100 leaders earned $100,000 a year. There are 5,300 men working for those 120 leaders, and 20,000 unpaid rank-and-file members. These 5,300 took home $3.30 – $7.00 an hour, and the 20,000 paid membership fees. All these 25,300 men are willing to “work” for peanuts in the extremely competitive field where they will be paid a fortune if they reached the top.
5. The risks that scare people and the risks that kill people are very different. Risk = hazard + outrage. When hazard is high and outrage is low, people underreact. When hazard is low and outrage is high, they overreact. E.g. likelihood of death by pool for children is 1 in 11,000. Likelihood of death by gun in house is 1 in 1 million-plus. However, parents are much more concerned with gun accidents than swimmining pool accidents.
6. Factors that affect risk perception:
   • How imminent is the risk (e.g. next day? 2 years later?)
   • Is the risk within your control (e.g. driving vs flying)
   • What is the hazard rate? (e.g. 1 in 100 will die, or 1 in 1-million-plus)
   • How gruesome is the outcome (… nuff said..)
7. Factors that significantly, positively, correlate with test scores:
   • The child has highly educated parents
   • The child’s parents have high socioeconomic status
   • The child’s mother was thirty or older at the time of her first child’s birth

- END -

What kind of charges should be expensed and what kinds should be capitalized?

To me, a charge can be capitalized only if it satisfies all of the following conditions:

1. the company has a legal right to collect the service paid for in advance
2. the charge is written off during the specified time of service
3. the service paid for is not company-specific, and has value for other companies at the stated capitalized value

The first two conditions are taken from Benjamin Graham’s 1937 edition of The Interpretation of Financial Statements. The 3rd condition is the crucial differentiator that makes sense to me. Companies should not be in the business of smoothening their asset/equity/earnings figures by capitalizing charges – that is the work of the analyst/investor if they choose to do so. Instead, capitalized charges should reflect the true value of the charge that is “left-over”, and by value, I mean market value.

For example, prepaid charges for advertising, and expenses incurred for moving, should not be capitalized. Such items under the assets section distorts the balance sheet because they do not reflect the true value that they can fetch on the market place (e.g. try selling your moving expenses or advertising package to someone). In general though, expensing would be the preferred and more conservative option.

Recently I was looking at John Wiley & Sons (JWA). One of its stated aims is to grow the company by making acquisitions, which it does several times a year. In that situation, revenues, assets, liabilities, equity, etc. will grow as the financials of the acquired company are added onto JWA’s financials. How then do you analyze such a company when its growth is not fueled by its normal operations? (I suppose some can argue that making acquisitions _is_ part of their normal business operations, but let’s not go into that =)

One specific point about JWA is that it funds its acquisitions via bank debt. This additional debt changes the company’s Cost of Capital. One key way to analyze whether such acquisitions are good for the company, is to compare the ROIC with the Cost of Capital, both before and after the acquisition. ROIC is very much like the “interest rate” the company is earning on its invested assets, while the Cost of Capital is the interest rate the company is paying. Naturally then, we would want the ROIC to be as high above the Cost of Capital as possible.

Rating: Decent

Background: One of the books on psychological pitfalls that I've been meaning to read. Charlie Munger has written some good stuff on psychological traps and also introduced me to some excellent material by Robert Cialdini.

Key pitfalls highlighted in the book:

1. Assigning different value to money due to "mental compartmentalization". For example, viewing money from one-time gifts, casino gains, tax refunds, etc. as "cheap", new-found money, and having more tendency to spend them; while viewing money in retirement accounts, inheritences, etc. as "expensive", untouchable money, resulting in being overly-conservative.
2. Viewing gains and losses differently. When considering gains, people want to gain at least "something", and don't like the possibility of "not gaining anything". Hence assume you start off with $1000, with Option A: Get $500, Option B: Get $1000 or $0 with 50-50 chance. Most people would choose Option A. On the other hand, when considering losses, people "don't want to lose anything", and don't like any "sure losses". So much so that they are willing to take on more risk so as to have the chance of "not losing anything". Hence assume you start off with $2000, with Option A: Lose $500, Option B: Lose $1000 or $0 with 50-50 chance. Most people would choose Option B. Note now that the end state of both scenarios are the same. Hence the angle from which you view the problem is important. This pitfall also explains why people tend to sell winners (and capture the gain), while holding on to losers in hopes of a rebound. For me, I would think that most situations in life should be viewed from the "gain" angle – errors of ommision are less "impactful".
3. Being influenced by sunk costs. People are typically influenced by sunk costs, e.g. a person having spent $350 on a theatre ticket, will almost certainly attend, even though he knows its an extremely lousy show and he made a mistake in purchasing the ticket in the first place. Or, having spent $2.5 million on a project, will spend more money to complete the project even though it has been recognised as a lousy project.
4. Ignoring "small" numbers. Small numbers, e.g. incremental expenditures, daily expenditures, brokerage commisions, mutual fund expenses, inflation, etc. adds up to big costs. Thinking them as "insignificant" results in you paying more of these small costs, snowballing into large costs.
5. "Anchoring" onto irrelevant numbers. People tend to anchor on irrelevant numbers, thereby skewing their judgment/estimates. E.g. after a stock has dropped from $40 to $22, people "anchor" on the $40 and think that $22 is a great bargain. Or buying a house at $300,000 during a housing market boom and wanting to sell it at close to $300,000 during a market downturn.
6. Overconfidence in your own abilities and knowledge. A 1981 survey of drivers in Sweden have 90% of them describing themselves as above average drivers. PhD students always underestimate the time they require to complete their thesis. Project managers always underestimate the budget and time required for the projects. Investors always overestimate their ability to pick stocks (also due to the Commitment and Consistency principle from Cialdini).
7. Unwillingness to admit mistakes. "If the stock goes up, I'm a great stock picker. If the stock goes down, its the market's fault and beyond my control".
8. Following the herd. e.g. buying into a stock/fund because it has run up, dumping a stock/fund because everyone else is selling.
9. Knowing too much. Having too much information increases the chances of anchoring onto irrelevant/unimportant information and taking actions that increases the chances committing mistakes.
10. Not knowing the "base rate". 70% of mutual funds underperform the market. Funds that have outperformed the market tend to underperform in the next period, and vice versa. Would a quiet, studious person more likely be a librarian or a salesman? What if I tell you that there are only 100,000 librarians in the country and 1.5 million salesmen?

Despite all the financial pitfalls above, the authors gave a good warning: "Trying to extract every last dime out of your financial decisions is likely to incur significant social and psychic costs."

Summary: I like many of the examples given in the book, but more often that not, I disagree with the explanations. I think the principles given by Robert Cialdini would be more suitably applied in explaining many of the examples.

On why ROIC instead of ROE/ROA:

ROE and ROA are distorted due to differing debt levels and tax rates. It does not allow you to measure the true underlying “returns generating capability” of the company.

Quoting an example from Greenblatt’s book, you can imagine that you can have Company A that has no debt, and Company B that has $50 in debt. The price of Company A is $60. The price of Company B is $10 per share. These two companies can have the same sales, operating earnings, enterprise value, etc. That is, it costs the same to purchase each company, and you get the same operating earnings, However, Company B will have a higher ROE than Company A because it took on more leverage. Hence even though both companies are “as capable” in generating returns, using ROE distorts the measurement due to leverage. To find good companies, we should target those with good ROIC/ROC instead.

On Not subtracting “excess cash” when calculating Invested Capital:

I guess excess “cash” do not literally mean cash cash. For example in the case of Microsoft, Berkshire Hathaway, or companies that have built up a “cash” hoard, most of those cash are in some short-term investments.

In those cases, the cash-equivalents might be earning a rate of return greater than what general shareholders could’ve earned, and those returns are not earned from the main operations of the company.

As such, I think those excess cash should still be subtracted, so that we can measurely accurate the “returns generating capability” of a company from its normal main operations.

On Moving across Capital Structures:

Those two companies are indeed equivalent. For example, you can buy Company A at $60, and then borrow $50. What you end up with is Company B. Similarly, you can buy Company B for $10, pay down the $50 debt, and end up with Company A. In a simplistic sense, a company can ‘move around’ capital structures. The thing that allows you to see that the two companies are “essentially equivalent” in terms of returns generating capability, is that the enterprise value for both are the same, and the EBIT for both are the same.

I agree that taking on leverage will have a tax benefit, and can improve your results in good times, and worsen your results in bad times. However, when we want to determine the true “returns generating capability” of a company (i.e. what is the returns that the company can generate using its assets (don’t confuse this with equity)), then we need to take leverage out of the equation to prevent distortion as previously explained.

You can think of it as a 2-step process:

1. First, is to determine the fundamental returns-generating capability of companies. That will result in a tie between Company A and Company B (i.e. same gross profit using the same amount of assets).
2. Next, you can look at the amount of leverage the 2 companies are taking on. Whether the company is consistently making more than its cost of capital, if so, then the company might be a better buy. Or whether the company is making less than its cost of capital, then even though the P/E is low due to the leverage, it may not be a good buy, etc.

As a final note, it is good to emphasize that the yardstick to use, to compare against a company’s Cost of Capital, is the ROIC. If ROIC > Cost of Capital, then growth is constructive/additive. If ROIC < Cost of Capital, then growth is destructive.

Quotes from Warren Buffett's speech at the University of Florida School of Business on October 15, 1998: 

"… if you $100 million at the beginning of the year, and you will make 10% if you are unleveraged, and 20% if you are leveraged…. what difference if at the end of the year, you have $110 million or $120 million? It makes no difference!… The downside, especially if you are managing other people's money, is not only losing all your money, but it is the disgrace, humiliation and facing friends whose money you have lost…."

On LTCM: "… to make money that they didn't have and didn't need, they risked what they did have and what they did need. That is just plain foolish…. If you risk something that is important to you for something that is unimportant to you, it just doesn't make sense."

Quote from Dr A. Gary Shilling:

"Markets can remain illogical longer than you or I can remain solvent". 

I think Warren Buffett once said this of Investing:

Rule No.1: Never lose money.
Rule No.2: Never forget Rule No.1

I had thought that I fully understood the rules, but apprantly not well enough to practice it =)

A more pertinent rule to hammer in would be “Margin of Safety“. Though its a means to the end, the clarity and size of this “gate” should be sufficient.

So, one of the companies I'm in is not going to file its 10-K on time, and is potentially going to get delisted. Hence my "sudden" interest in this topic =)

To summarize, for the NYSE, a company gets a grace period of 9 months from the deadline, after which NYSE will determine whether or not to let the ticker to continue to trade (up to a period of 3 months more). For the NASDAQ, there is no such grace period.

See http://www.thecorporatecounsel.net/blog/archive/000621.html and http://www.sec.gov/rules/sro/nyse/34-51777.pdf for more information on the NYSE and NASDAQ stance on delisting for late filing of 10-Ks.

See http://www.secfile.net/SEC_calendar.htm for filing deadlines. Definitions of "accelerated filer, etc." can be found here http://www.law.uc.edu/CCL/34ActRls/rule12b-2.html.

From my readings, my impression is that a company is able to officially request for an extension to the filing deadline, for both NYSE and NASDAQ, despite the fact for example that NASDAQ does not have a grace period.

The process/formula to obtain the Instrinsic Value (IV) of a firm using Discounted Cash Flow (DCF) is very similar to the process for calculating a firm's Enterprise Value (EV). I had wanted to see the logical link between these two values.

To summarize and simplify, let FV = value of the firm due to the discounted future free cash flows. Then we have IV = FV + Cash – Debt. By definition from the formula, IV = money you get from liquidating the company.

In the case of calculating EV, we have EV = Market Value (MV) – Cash + Debt. By definition again, EV = money you need to use to buy the company and clear all debts.

Re-arranging the IV formula, we have FV = IV – Cash + Debt. At this point, the equation of FV and EV looks very similar.

Now, note that if say MV < IV, then theoretically we can buy the company (keeping the debt) using MV, and liquidate the company to receive IV, and make the spread. Hence it is clear that MV should be compared with IV.

On the other hand, EV should be compared with FV, and not IV. Note that when MV = IV, then EV = FV. Why should the Enterprise Value be equal to the discounted future free cash flow value? Because, if you were to move in and buy a company using EV, this will settle the debt and the cash, i.e the "current capital structure and excess cash part" is settled, so what you have effectively paid for (i.e. what is left behind), is purely the future cash flows of the business (unleveraged), i.e. FV.

On top of Joel Greenblatt's definition of ROC in the previous post, Morningstar's Pat Dorsey in his book "The Five Rules for Successful Stock Investing" defined Return on Invested Capital (ROIC) as:

Net Operating Profit After Tax (NOPAT) / Invested Capital

where

Invested Capital = Total assets – Non-interest-bearing current liabilities (e.g. accounts payable and other current liabilities) – Excess cash (cash not needed for day-to-day business needs)

Both definitions subtracts "excess cash" from the invested capital. But how does one determine the excess cash? how much of the cash figure in the balance sheet is excess?

One pretty decent way to determine excess cash is given in CFO magazine – see here and original article here.

To summarize, CFO magazine divided companies (of a particular industry) into quartiles, ranked by their cash/sales %. The required cash-level benchmark is the lowest quartile of cash/sales %. Each company's ratio of cash/sales is then compared with the industry benchmark to determine excess cash.

The formula is as follows: excess cash = [cash/sales % - benchmark cash/sales %] x [sales]. (If a company's cash level was below the benchmark level, it wasn't considered to have excess cash.)

Rating: Good

Key Points:

Joel Greenblatt proposed a “magic formula” to rank stocks based on 2 factors: Return on Capital (ROC), and Earnings Yield. Each stock will be ranked based on each individual factor (hence each stock has 2 ranks), then we add the two ranks up, and perform a final sorting. Hence the best score a stock can achieve, is 2.

Return on Capital tells us how good a company is, and is defined as follows:

EBIT / (Net Working Capital + Net Fixed Assets)

where

1. EBIT is used to allow us to view and compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.
2. It is assumed that depreciation and amortization expense (non-cash charges against earnings) are roughly equal to maintainance capex, hence it assumes that EBITDA – Maintenance capex = EBIT.
3. The “capital” in this case is the tangible capital employed. The tangible capital employed tells us how much capital is actually needed to conduct the company’s business.
4. ROA uses total assets, and ROE uses equity. Both total assets and equity values contain intangible assets and do not accurate reflect the amount of capital needed to do the business.
5. Net Working Capital is used because a company has to fund its receivables and inventory (excess cash not needed to conduct the business is not included in the current assets). But it does not have to fork out the full current assets, because it gets what is effectively an “interest-free loan” in the form of account payables. So current liabilities needs to be subtracted from current assets (except for short-term interest-bearing debt, which is money that the company still needs to fork out since its not free).
6. Net Fixed Assets (e.g. real estate, plant, equipment) is net of accumulated depreciation and additional capex.
7. Intangibles, specifically goodwill, is not included because we want to use “tangible capital employed”. Goodwill does not need to be constantly replaced, hence in most cases, return on tangible capital alone (excluding goodwill) will be a more accurate reflection of a business’ return on capital going forward.

Earnings Yield tell us how cheap a company is, and is defined as follows;

EBIT / Enterprise Value

where

1. Enterprise value = market value of equity (including preferred equity) + net interest-bearing debt
2. Note that non-interest-bearing debt (such as accounts payable) is not included in the enterprise value calculation as those are essentially “free money”.

Joel then recommends to hold 20-30 top ranked stocks, and turn them over once a year. A historical study over 17 years showed very good performance of around 30% annually compounded returns.

Thoughts:

1. I am not sure why in the formula quoted in the book for Enterprise value, cash & cash equivalents are not being subtracted. Not too sure whether or not that is intentional.
2. I would think that NOPAT would be a better measure than EBIT, to take into account the differing tax rates. The tax rate, unlike the debt level, is something that a company has no control over. Hence even though two companies may have the same “fundamental earnings generation capability”, the effective tax rate might pick out the winner.
3. We might need to include intangibles such as patents and such on top of the tangible capital employed, as these intangibles arise from R&D spending and needs to be constantly “replaced”. The way Greenblatt specifically singled out Goodwill as the intangible that needs to be excluded, and also that “in most cases, return on tangible capital excluding goodwill will be a more accurate ……..”, also implies that there are some intangibles that would need to be included.
4. I’m not sure why “non-current, tangible assets” are not included in the calculation of the tangible capital employed. Are there any such assets apart from fixed assets (i.e. PP&E)? Wouldn’t it be easier and a better catch-all to use (total assets – intangibles – excess cash) – current liabilities (excl. interest-bearing debt) instead? or (total assets – goodwill – excess cash) – current liabilities (excl. interest-bearing debt) depending on the scenario.

[Quick Reference: Current assets include cash, accounts receivable, inventory, marketable securities, prepaid expenses. Current liabilities include accounts payable, short-term debt, accrued liabilities.]

Another good article on Gurufocus.
According to Marty Whitman, the “safe and cheap” investor looks for four things in an investment:

• High quality balance sheet;
• Competent and shareholder-oriented management;
• Understandable and honest disclosure documents;
• Priced at 50 to 60 cents on a dollar.

Whitman is similar in many respects to Graham. Whitman concentrates more on the value of the company’s assets rather than the earnings that could be generated. Key quotes from the article:

• “It’s a lot easier to look at the quantity and quality of the assets and resources that a company has than to forecast its earnings. Assets can appreciate in value, can be enhanced, sold, or converted into something more productive.”
• “To Whitman, high quality means low debt, acreage of raw land, assets under management, fully paid rent, and other assets that can be easily valued.”
• “Marty Whitman thinks like a LBO control buyer. He asks: “How can I finance the transaction?” It is a balance sheet question regarding what can be put up as collateral to secure lending from the bankers.”
• “No more than 50 or 60 cents on the dollar for what a business would be worth to a private takeover buyer. It is absolutely crazy to pay more than 60 cents on a dollar for non-controlling interests in businesses. The outsiders always face agency problems.”

Rules of thumb for calculating his buying prices for various types of businesses:

• Financial-services companies and depositories: Stated book value.
• Small banks: 80% of book value.
• Mortgage portfolio: Calculate yield to maturity and perform credit analysis.
• Financial-guaranty insurers: Adjusted book value – a publicly disclosed number that is book value plus the equity in the present value of certain future premiums.
• Insurance companies: Adjusted book value.
• Real estate companies: Private appraisal value or market value.
• Real Estate (REITs): Appraisal value or discounted present value of cash flow from operations.
• Broker/dealer and asset managers: Tangible book value plus 2% of AUM.
• Operating companies: 10 times peak earnings or below “net asset value.”
• Tech companies: 2 times book value, less than 10 times peak earnings, 2 times revenue and cash larger than the book value of all liabilities.

I’ve also recently came across this video on The Ben Graham Centre for Value Investing (link here). There is also a nice interview here. Some more good takeaways follows:

Problems with his “safe and cheap” approach:

• In order to get a cheap enough price, typically the near-term outlook of the business has to suck. End up buying stocks that are 30 – 40 times earnings (i.e. earnings are really low, hence P/Es are high).
• In order to get businesses with huge balance sheets, you typically end up with ultra-conservative management. These companies don’t need access to capital markets due to their big strong balance sheets, hence they are non-promotional to Wall Street.
• Positions tend to suffer on marketability and liquidity.

Sell Discipline

• When we make a mistake, e.g. something happens that results in a threat of permanent impairment, competitive forces make the business not feasible.
• When securities become grossly overpriced.
• To meet redemptions (e.g. in 1998, 1998, value funds faced alot of redemptions)

Difference between Graham’s Net-Net and Third Avenue Funds’ Net-Net (from Third Avenue Funds’ 06Q1 Shareholder Letter):- Graham defines “net current assets”, “net working capital value”, “net net asset value” as (Working Capital – All Liabilities – Preferred Stock), which is equivalent to (Current Assets – Current Liabilities – All Liabilities – Preferred Stock). The value is a conservative measure of liquidation value, which makes the conservative assumption that at least enough can be realized from the plant account and miscellaneous assets to offset any shrinkage sustained in the process of turning current assets into cash. Graham noted that the purchase of a diversified group of companies on this bargain basis (i.e. below net-net value) is almost certain to result profitably within a reasonable period of time.

Martin Whitman uses the Net-Net concept with the following caveats:

• Whitman will only look at the Net-Net value if the company is extremely well financed, i.e. it can definitely meet its obligations to its creditors [Note: going-concern]. This is because the current asset value might be boosted up alot by stuff such as inventory, costs in excess of billings, receivables from less than credit-worthy customers, which would not help the company meet its obligations.
• Appropriate re-classification needs to be made on a case-by-case basis. Some current assets such as department store merchandise inventories, are actually lousy fixed assets. They will fetch much less than book value when sold in a Going Out of Business sale, and even as a going-concern, factors such as markdowns, obsolescence, seasonality, mislocation will significantly impact what you can sell them for. On the other hand, some marketable securities are not considered current assets in GAAP when they should be. If you have a fully-leased, Class A office building with credit-worthy tenants on long-term leases, that should be classified as a current asset (in fact, near cash), since you can sell the building very easily.
• Off-balance-sheet liabilities (e.g. may be disclosed in footnotes) need to be subtracted in the net-net calculation.
• Excessive expenses and losses need to be capitalized and included in the liabilities.
• Certain fixed assets, e.g. PP&E can sometimes create cash. E.g. sales of PP&E at a loss can generate tax benefits / cash refunds.

Just read an article on Gurufocus: http://www.gurufocus.com/news.php?id=877 that talks about Benjamin Graham's "net-net" investment strategy in 1979, and Joel Greenblatt's analysis of it back in 1981.

Salient points:
Graham's rough liquidation value (net-net) estimate:
"Current Assets" (cash, accounts receivable, inventory, etc.)
Less: "Current Liabilities" (short term debt, accounts payable, etc.)
Less: "Long Term Liabilities" (long term debt, capitalized leases, etc.)
Less: "Preferred Stock" (claim on corporate assets before common stock)
Divided by: Total Shares Outstanding
EQUALS "Liquidating Value Per Share"

Greenblatt did a study using 6 years of historical data (1972-1978) with the following 2 conditions:

1. Stocks that have shown a loss over the last 12 months, were not considered
2. Stocks were sold after 100% or 2 years (whichever came first)

The screen that worked best was

1. Price / Liquidating Value <= 0.85
2. Price / Earnings <= 5

which returned an annually compounded rate of 42.2% (before transaction costs).

Conclusion: You don't find such bargains (companies selling for less than net working capital) anymore =)

Just saw some articles from Stingy Investor (http://www.ndir.com/SI/articles/1105.shtml) talking about Graham's stock selection criteria for the defensive investor.

Benjamin Graham's Criteria for the Defensive Investor
——————————————————-
P/E Ratio less than 15.
P/Book Ratio less than 1.5.
Book Value over 0.
Current Ratio over 2.
Earnings growth of 33% over 10 years.
Uninterrupted dividends over 20 years.
Some earnings in each of the past 10 years.
Annual revenue of more than $100 Million (1950).
———————————————————-
Source: The Intelligent Investor, 4th Revised Edition (pages 184-185).

As current stock screeners only provide use of 5 years of data, the approximation used by the author was:

Screening criteria used to approximate Graham's rules
———————————————————
P/E Ratio less than 15.
P/Book Ratio less than 1.5.
Book Value more than 0.01.
Current Ratio more than 2.
Annual EPS Growth (5 Yr Avg) more than 2.9186%.
5 Year Dividend Growth more than 0%.
5 Year P/E Low more than 0.01.
1 Year Revenue more than $400 Million.

The results published showed that Graham stocks gained about 36.2% annually for the past 5 years, while the S&P 500 made a small loss.

This anecdotal 5-year result is interesting, after reading the magic formula from Joel Greenblatt's book. My personal preference is still to use the all these "magic formulas" as stock screeners; significant due diligence on each stock will still be required before any purchase.

I picked up a copy of Joel Greenblatt's "The Little Book that Beats the Market" today. In it, it talks about finding cheap companies (high earnings yield) and good companies (high return on capital).

The first time I saw a discussion on the importance of high earnings yield, is in Mary Buffett's Buffettology book (1st ed). At that time, I had a lingering thought that still persists today. The earnings yield is typically compared with the long-term US treasury "risk-free" rate, e.g. if a stock's earnings yield is 10% and the risk-free rate is 6%, then you're "earning more" with the stock, compared to what you're paying.

The thing that bothers me about this comparison is that for a bond, you are guaranteed your principal, whereas for a stock, if you decide to "redeem" that piece of ownership, the money you get is the market price at that time. With a loony stock market, that "market price" can range from zero to a whole lot. Hence with a non-guaranteed principal, there is not much point comparing the earnings yield of a stock to that of a bond (even if you make the 10%, you might lose all your principal). What this also means, is that the price that you pay initially, must be justified by all the future cashflows that comes in, so that even if the price of the stock ends up to be 0, you still get the future cashflows.

Turning next to Return on Capital (ROC), an example cited in Joel's book is that Jason spent $400,000 to set up a store that ended up earning $200,000, so ROC is 50%. Again, the fact that the principal (i.e. that $400,000) must remain, is important. The ROC is 50% because we have (new value/old value) = 1.5, i.e. new value = $400,000 + $200,000 = $600,000 and old value = $400,000. Imagine, after spending $400,000 for the store, if Jason wants to liquidate the store, he can only get back $300,000. That would mean that (new value/old value) = ($300,000 + $200,000) / $400,000 = 1.25, i.e. ROC = 25%.

That leads to an interesting problem, if the accounting books record NTA at cost, i.e. $400,000, then we should do a bit of discounting at the numerator to get the ROC. If NTA is recorded at market value, then it would typically understate the cost and overstate the ROC. In that case, we need to find out how much was actually spent to generate that amount of earnings.

"How much is this business worth?" is a critical question that one needs to ask, after answering

1. Is this a good business?
2. Is there good management?

Typical techniques used to produce that answer, have been a combination of the following: Discounted Cash Flow (DCF), with varying degress of sophistication, Dividend Discount Model, Gordon Growth Model, etc. all the stuff that you find in a corporate finance textbook.

To answer the question myself, I attempted a simple exercise to value a stream of cashflows, where I know what the eventual answer should be. A company can be modeled in the simplest sense, like a savings account. You start off with some money in the account (i.e. net tangible assets), you make interest off the balance (i.e. return on capital), you can choose to withdraw some (i.e. dividends) or keep all the interest in the account (i.e. increase retained earnings, payout ratio of 0).

Hence I built a simple spreadsheet to model a savings account. The account is started off with $1, with annual interest rate of 10%, and all interest are ploughed back into the account. Hence we have a steady stream of interest cash inflows: 0.1, 0.11, 0.121, etc. Now, if I imagine that this "savings account" is in effect a company (i.e. NTA = $1, ROC = 10%, payout ratio = 0%), and given what I know about its future cash flows, will I be able to determine that the fair value of this company is, in fact, $1? (assuming that a bank does give 10% interest rate on accounts)

The short story is that, you cannot discount each of the future values, sum them up, and expect to get $1. The fact that in order to obtain the cash inflow of $0.121 in year 3, you are _forced_ to re-invest the previous year's $0.11, meant that these cash inflows cannot be freely used. Hence in a sense, the "free cash flow" is 0. How then do you value a company with the characteristics above?

What needs to be done, then, is to project future cashflows, use that to determine the value of the company at some point in future, and perform just ONE discount to determine the present value, i.e the intrinsic value of the company (I am skipping the details to do this properly, but the high-level idea is there).

This example illustrates a difficulty in using traditional DCF – its very difficult to determine what cash flow is _truly_ free. (Operating Cash Flow – Capex) is not good enough. Many companies spend this (Operating Cash Flow – Capex) to repay debt, to invest in short-term securities and to expand into new areas. Can we say that the company does not _need_ to repay debt? does not need to expand into new areas to maintain its competitive advantage? If such spending is necessary, then these money cannot be included in the DCF calculation since they are not truly free money that can be taken out (an implicit assumption when you perform a DCF).

A more accurate definition of FCF is needed: Free Cash Flow = "Truly free" cash flow that can be always taken out of the company and the company will still do well. That is, if all the projected FCFs that you have used in the DCF calculation is taken out of the company (e.g. if you project that Year XX has FCF of $YY, then we will withdraw $YY from the company in Year XX), the company must still be able to do well.

Say you have picked out a couple of companies. Done your detailed research, estimated their potential gains, estimated the time horizons in which the catalysts would occur, and finally decided that they are good buys. So how exactly should your optimal portfolio look like? Do you pick the top 8? the top 10? or maybe just the top 3?

It struck me about 1-2 months ago that modeling this basket of stocks, is very much like modeling a basket of credit default swaps.

Studies have shown that the "jump" or appreciation of a stock's price, typically happens in only a few days in a year; meaning that if you miss out say, the best performing 10 days of your stock, your return will be mediocre. This is very much like a "jump" event, that is currently used to model credit events (default, bankruptcy, downgrade, etc.) for the pricing of credit default swaps.

Hence the techniques used to model CDSes (e.g. poisson processes, copulas, etc.), can be applicable to modeling equity portfolios. The random processes can be simulated, with each jump resulting in an amplitude multiplier representing the potential gain of a stock (i.e. discount to fair value), and the intensity of a process relating to the estimated time horizon in which a catalyst would occur. The simulation would then be able to simulate different portfolio value process, get expected values, stderrs, apply variance reduction techniques and all that good stuff. Different portfolio rules (e.g. after a predicted gain is realised, shift money to highest potential gain stock among those that have not "popped" yet) can be applied in the simulation and their results analysed.

I have not seen such a thing being done before yet. Perhaps it is just rare to find someone with exposures to both fields: value/fundamental investing and mathematical finance.

They are essentially the same. In both cases, each shareholder receives a certain number of new shares free of charge, whereby the stock price is reduced accordingly. The total shareholders' equity remains the same. Cash remains the same.

In the case of a stock split, each old share is split into a number of new shares with a reduced par value, leaving the total share capital unchanged.

In the case of a stock dividend, a number of new shares are received for each share owned. The new shares have the same par value as the old shares, whereby the total share capital increases proportionally with the size of the stock dividend. This is done in the accounts by transferring retained earnings to the share capital, which has implications for the ability of a firm to pay out cash dividends in the future (some debt convenents restrict the amount of cash dividends that can be paid out depending on the level of retained earnings).

By "voluntarily" doing a stock dividend and decreasing their retained earnings, companies "signal" that they are in good financial condition and still able to increase their cash dividends (i.e. impact of retained earnings is minor).

http://academic.luzerne.edu/lmajor/AccIIChapt%2014.htm
http://www.econ.au.dk/fag/2786/e05/Splitspaper.pdf

Rating: Above average

Background: Book that I picked up to learn about the "official" contrarian strategies.

Summary:

The key idea is that, buying a set of low P/E, P/CF, P/BV stocks (the study uses the top 1,500 largest companies from the Compustat database), holding it for a long period of time, will bring the greatest gains. The gains will be increased if

1. You sell off stocks that have not performed in 2-3 years, and
2. You sell off stocks when their P/E ratios have reached the market P/E ratio, and replace with another low P/E stock.

Appendix B of the book lists 41 rules for Contrarian Investing. A nice one is:

Rule 12

(A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.

(B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.

(C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.

(D) The effect of an earnings surprise continues for an extended period of time.

Finally, the book has a very good quote from Graham and Dodd's Security Analysis: "Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. Remarkably few also of the large companies suffer ultimate extinction. For most, this history is one of vicissitudes, of ups and downs, with changes in their relative standing." which results in Dreman's Rule 27

The push toward an average rate of return is a fundamental principle of competitive markets

This aids in a way, while estimating the intrinsic value of the company, by helping with the tough questions of "how long will this company be earning above market returns?", and also, "what long-run rate of return should I be projecting?"

I was searching around for the best way to download financial statements into Excel. Here's a summary.

Free sources:

1. MSN Money – have to use a web query to get it into excel, pretty decent, but due to the standardisation, the breakdown (e.g. of the cash flow statement) might not be as granular as you would like. Only has 5 years of data.
2. Reuters – have to use a web query as well, pretty decent, but the standardised fields are slightly different from MSN Money, so the figures that you calculate might be slightly different. Only has 5 years of data.
3. Edgarscan – comes in the form of an excel spreadsheet, but frequently have missing data for the multi-year 10K/Q spreadsheet, especially for recent years. The spreadsheet for the cashflow statement and income statement are good, very detailed. But the disadvantage of being too detailed is that its near-impossible to automate.
4. Better-Investing.org – gets data from S&P Compustat. Very detailed with many many years of data. But all data comes in a huge table (have to use web query), with a column on the field name, and columns to the right with all the values. Not logically organised into Balance Sheet, Income Statement, Cashflow Statement. Hence its gonna be a huge huge pain to arrange all the fields into their proper rows and make sure everything adds up.

Seems like if an automated process is desired, then Reuters/MSN would be the way to go.

Paid sources:

1. Spredgar – Pretty good, with 7 years of data. Places everything into an Excel spreadsheet neatly. But only has Balance Sheet and Income Statement data, no Cashflow Statement.

I don't know of any more sources that can download financial statements into Excel (I'm sure institutional investors have some costly service to do that, but that's out of my league =).

The simple P/E ratio is still being widely used as a proxy for how cheap/expensive a stock is. So what P/E ratio should you use to value your stock? 10? 20? 50? What is the logical basis behind the P/E ratio? Why 10, 20 or 50?

That's a major concern that needs to be answered. Consider Wal-Mart (WMT). If you take an average of WMT's P/E ratio over the past few years, you can probably get a number around 30. So now that its P/E ratio is 18, is it considered cheap? Should you project future earnings and multiply that by 30 to get WMT's price?

And what if I tell you that WMT's yearly average P/E ratio has been consistently declining over the past few years (see the 10-year summary on MSN Money)? Has something changed?

The answer to all these questions lie in the simple concept — intrinsic value aka fair value.

How much you should pay for a company depends on what the company is worth (sounds like a tautology). And what the company is worth now, is the present value of the future worth of the company. The fair P/E ratio is simply a result you get when you divide the fair value by the earnings, it is NOT something that you use in a fundamental manner to value a company.

This also explains the reason why, you can buy a company at a certain price, and even though year-after-year, sales increases, earnings increases, equity increases, but the share price may keep on dropping (with a decreasing P/E). More often that not, it is a case of overpaying for the company right at the start, without a strong basis in determining its intrinsic value.

I was digging around the Net to understand better the issue of expensing of employee stock options for companies.

Initially I had the mistaken idea that companies previously could choose to "capitalize" or expense the option grants, and was wondering how exactly do you "capitalize" an option grant, later I found out that you can't: the old alternative to expensing them is to disclose them in footnotes =)

Another point that I was trying to clarify was whether there is a tax rebate if the tax benefit from stock options is greater than the net income. Turns out that there isn't a rebate, so the actual tax benefit ($cash) shown in the cash flow statement might be less than the calculated benefit using the tax rate.

Good intro series on stock option accounting on Motley Fool:
http://www.fool.com/research/2000/features000908.htm
http://www.fool.com/research/2000/features001012.htm
http://www.fool.com/research/2000/features001228.htm

More detailed accounting and valuation treatment of employee stock options:
http://www.investopedia.com/features/eso/eso1.asp

Examples of how MSFT and CSCO uses the tax benefits:
http://www.fool.com/portfolios/rulemaker/2000/rulemaker000217.htm
http://www.sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2000/10/09/MN3707.DTL

General info on employee stock options:
http://executivecaliber.ws/sys-tmpl/expensingstockoptions/
http://executivecaliber.ws/sys-tmpl/fasbexpensestockoptions/
http://www.feinberglawgroup.com/stockopt.html
http://www.fairmark.com/execcomp/index.htm

A good link on tax issues for investors:
http://invest-faq.com/articles/index-tax.html

Just read a Motley Fool article titled: 4 Critical Errors You Must Avoid
http://www.fool.com/news/commentary/2005/commentary05122308.htm
which reminded me of another Fool article titled: How to Double Your Money

The lesson is the same. Basically, do not buy a company _just_ purely based on a peceived macroeconomic trend (aka hype). E.g. Nanotech is the next big thing, biotech is the next big thing, baby boomers are going to need lots of healthcare, etc.

What is more important, is the company-specific factors themselves, e.g. how competitive is the company, does it enjoy a monopoly? is its management good? etc.

The macro trend provides the "tailwind" that can push a stock further, provided the company is already speeding in the first place.

I have the faint impression that I read somewhere in one of Buffett’s writings, that a gauge of the rate of growth of a company’s earnings can be estimated by

Expected GDP growth + Expected inflation

Hence say Expected GDP growth = 5%, Expected inflation = 3%. Then a company should be able to grow earnings at around 8%. If its EPS growth is > 8%, then that’s excellent. If its < 8%, then that’s bad.

Since my capital currently is very limited (no spare cash sitting around like a $40bn cash hoard =), everytime I want to enter into a new position, I typically have to sacrifice an existing one.

The usual question that pops up is — at what price should I liquidate my existing position? I realise that I typically have been unable to make that sell decision and precious time and opportunities slip by without any action.

I think there are two main decisions

1. Do you want to switch? That decision should be made based on comparison between the expected rates of return for each alternative, using a long-term price target for each.
2. Should I sell NOW? That decision should be made based on comparison between the immediate-term (intra-day) expected rates of return for each option. For example, say from the start of trading day until now, the stock has been fluctuating up and down between 10.00 – 10.50. The price right now is 10.00, hence the short-term potential gain is say 5%. For the alternative, a judgement call has to be made on the possible immediate gain that can potentially happen. If that is more than 5% (with appropriate probability), then you should sell NOW. If that is less than 5% then you can possibly wait for the existing position to go up from 10.00.

Of course, there is the possibility that the existing position might break lower. In that case, a sale of the existing position should not happen, since the short-term potential gain has increased even more.

Read: http://www.fool.com/news/commentary/2005/commentary05120908.htm

Summary:

1. Large, high-quality stocks can double in 5 years.
2. High-quality stocks can double in 3 years if their industries are in favor.
3. One-year doubles are crazy. Can happen if there is exceptionally strong growth, and a recognition of that growth from the market at large.

Takeaways:

1. Need to look for one-year doubles.
2. Cannot stick with one stock for a year, need to switch between multiple stocks in a year, catching a decent gain in each stock, so that eventually by one year, a doubling is effectively achieved.

Doing intra-day dollar-cost averaging is bad.

When stocks tank, they usually tank for a few days. Hence the same tactic for spotting intra-day lows should be applied to a more "macro" picture of using days. Doing that over "days" allows time for the good/bad news to be widely reported, caught on by other investors, acted upon by everyone. Perhaps a rough estimate of 4 days is necessary for a stock price to fully adjust for a piece of news.

This note follows some thoughts arising from the events that was reported in Trading Note #4.

So far, all my stock buys have some basis of fundamental analysis attached. As I have not yet cultivated the long-term buy-and-hold strategy, I am still interested in benefitting from intra-day price movements.

If I would like to go long on a stock, what I'm thinking is this: Buy in with say 1/2 of your allocated capital first. If the stock price goes up (intraday), sell off the stake that you initially bought. If the stock price goes down, buy in with the rest of your capital (1/2) at the lower price.

Similarly, if I would like to go short on a stock: Sell off 1/2 of your holdings first. If the stock price goes up, sell of the rest of your holdings. If the stock price goes down, you could potentially buy-in depending on the drop.

Does this strategy work?

Not quite. In the case of going long, selling off a stock once it goes up is like selling off your winners instead of letting them run. You should only do that if you are _sure_ that the stock is fluctuating within a fixed trading range. Hence you shouldn't sell when it goes up, meaning that the entry price for the other 1/2 is going to be higher (if the entry takes place at all).

In the case of going short, if the stock price does not drop to a sufficiently low level, then the selling point for the other 1/2 of the holdings will be lower (if the selling takes place at all).

Hm, doesn't seem like you can have your cake and eat it too =)

The past 2 weeks have really been painful, instructive, and thankfully quick.

The short story:
Bought in when it just started plunging, sold it when it bottomed. And later during the day that I sold, the stock shot back up and over my original purchase price =(. Things can't get worse much than that =)

The long story:
The stock has been pretty stable around $10.00 – $10.25 for bout a week. Then one day, a neutral piece of news (what I peceived to be) came out. The next trading day, the stock shot up to bout $10.40 for pretty much the rest of the day.

Mistake #1: Thinking that the stock will be stablising at a higher trading range, I wanted to go long the next day at the low-end of the intraday fluctuations.

So the following that I bought in at $10.28, at the same time making Mistake #2: Not buying in at the intraday low (see Trading Note #3). Mistake #1 was a logical/strategic mistake, and Mistake #2 was an execution mistake.

What happened for 4 consecutive trading days after that was that the stock tanked, with the trading range steadily dropping till $9.93 – $10.00. During that 4 days, I was trying everyday to liquidate my holdings and cut my losses, but the greed of earning a few points and minimising my losses prevented the sale every day.

Mistake #3: Being too freakin greedy! And not having decided on a "minimum acceptable selling point" before the market opens.

Finally, when it got down to $9.93, my over-riding thought was "I NEED to get rid of my holdings NOW, regardless of price!". The loss was becoming too significant with potential for even greater loss. Hence I sold all my stake at $9.97.

Mistake #4: Selling without thinking! (see analysis below)

Following my sale, as though Mr Market knew that it had finally got me =), the price just steadily climbed to $10.46, completing the manoeuvre by twisting the blade that was stuck in me for the past 4 days.

Learning Points:

I think there are 3 stages of "development":

1. The first is when you keeping hanging on to your losers, not wanting to realise the loss, hoping for the stock to recover and tying up that sum of money which could be generating better returns elsewhere.
2. The second is when you cut your losses promptly, perhaps with a threshold (e.g. 2% maximum loss).
3. The third is when you combine that with a fundamental view of the stock. If you assume that you currently _do not_ hold any stock of that company, would you want to buy it at that particular price? If the answer is yes, then you should hang on.

I initially thought that I understood point 3. But it turned out that holding a plunging stock clouded my judgement and resulted in a strong urge to just "end the losses". Hence the importance of making that judgement call with the assumption that you do not have any position.

Key takeaways:

1. When an intra-day bottom has hit, it should be _OBVIOUS_ that that _IS_ the intra-day bottom (i.e. prolonged plunge to the 'low' level)
2. High/lows due to spikes up/down in the first 1 hour of the market opening, should be ignored.

Just missed a short-term rally yesterday.

Points learnt:
When deciding at what price to enter into a position, consider:

1. Is the stock price very volatile?
2. Will the recent good news cause the stock price to jump to a higher and stable level?

If the answer to both questions is yes, then you have to be willing to enter into a position at a higher price — don't be greedy. Warren Buffett has an analogy of swinging his bat _only_ when the odds are clearly profitable. I would say that that happens in the case when you can afford to "not buy". But sometimes, the potential gain (ie. opportunity cost) of having a position is large enough for you to swing slightly off just to catch the ball, else the game might just finish without you.

In summary — don't be greedy. If you really want to be long a position, be prepared to give a little. You don't really have to catch the highest high to sell, and the lowest low to buy.

Been meaning to pen down some of the things I've learnt as I do my stock trading. Have been procrastinating on this for sometime until now, so here's the first note =)

Bought my first 5 stocks on 7 Nov 05 (Mon) =), namely BUD, BRKB, MSFT, DJ, GCI. No serious research went into the buys, rather, basic criteria were employed: Good business economics, depressed stock prices (simply from historical charts), total disregard for quality of management. Also looked at some Morningstar reports which gave them 5-star ratings.

Here's a summary of learning points so far:

1. Don't place a market order unless you're really holding on for the long-term. A market order will place you in the unfavourable range of the bid-ask spread which can be quite a few ticks.
2. Placing a limit-buy order on the current bid should guarantee a trade.
3. If you are looking for a low point in the day to enter into a position, its better to wait until the trough has 'just' passed. Murphy's law seems to work well here: everytime you enter when you think its _the_ bottom, it will go down further.
4. If intra-day fluctuations are large, and you want to hold the stock for a long period of time, its worthwhile to sell and re-buy during the day.
5. Never be in a hurry enter into a position. Think! Do you really need to enter into a position now? immediately? Does it _REALLY_ matter?
6. Never do intra-day dollar-cost-averaging (perhaps unless you have a few million in capital). The transaction cost is substantial and dollar-cost averaging only works in the long-run (no, one day is not long).
7. Its good to look at the trade size and price of each trade. That's a better level of detail than just the bid-ask-last trade.

Other points that are not "trading" related:

1. To make capital gains of say 30% on my total portfolio, I would need on average, all 5 stocks to go up 30%. That seemed harder than if I had concentrated my portfolio on 1-2 stocks. But it will have to mean that a lot more research needs to be done in order to concentrate the portfolio into a few highest-probability winners.
2. Do you sell your winners or your losers so that you can get the capital to enter into another position? ALWAYS compare the expected rate of return (including probabilities). Look at the actual numbers. And put your money in the top few choices.
3. If a position drops, do not "wait until it recovers". You don't have to make your money back the same way you lose it. If a stock drops from $100 to $90, it _is_ at $90. That is the value of your position at that time, no concept of profit/loss here. Again, calculate your expected return from that price point.
4. If a stock goes up without any published news, its likely due to unpublished _public_ news (not online yet). Good to load up and prepare to unload very soon.
5. Try to load stocks at such a low that you _know_ that you will never lose money. Its only how much you earn and when.
6. Sometimes, repeated news is what would propel prices. For example, it was already reported months ago that Buffett had a significant stake in BUD. However, its only when the disclosure came a few months later on exactly how many shares that Buffett own (which gets very very widely carried), that BUD went up significantly.

I'm still thinking whether a risky strategy of trading seriously down-and-out stocks will give better returns than a long-term buy-and-hold strategy that should give 15-30% annually….

Rating: Average

Background:
Some book that I picked up when I got the Dollar Crisis book (see previous review)

Detail:
Explains author's stock selection methodology using Relative Dividend Yield (RDY) and Relative Price-to-Sales-Ratio (RPSR) and 12 other qualitative/quantitative factors.

Points:

1. RDY = Stock dividend yield / Market index dividend yield, where Market index dividend yield = Index annual dividend / Current market value
2. Author assumes that for companies with "dividend-paying cultures", dividend is a good indicator of a company's own expectations of future earnings growth prospects. Boards set dividend policies so that the dividend can remain a relatively constant percentage of earnings in good times and bad (showed example of Chevron (CHV) where dividends tracked the volatile earnings).
3. Sell when RDY is below 1. Can only buy when RDY is above 1.25. RDY does not work for stocks with Relative Price not correlated with RDY. Relative Prices = price of stock / price of S&P 500.
4. Stocks with high RDY have very depressed prices and are totally shunned by the market. Author aims to use that to look at stocks while Wall Street is not looking.
5. PSR = Price of stock / Sales per share. RPSR = Stock PSR / S&P 500 PSR
6. Sell stock at mean + stdev. Buy stock at mean – stdev.
7. Screen dividend-paying stocks using RDY. Screen no-dividend-paying stocks using RPSR. After that, screen using 12 fundamental factors.
8. 12 fundamental factors as follows:
   1. Buggy Whip: Are the company's products viable today and into the foreseeable future?
   2. Franchise or Niche Value: Is the company profitably maintaining/gaining market share? Can the company leverage its franchise to enter new markets profitably over time? Has franchase value increased over time?
   3. Top Management and Board of Directors: What is the strength of a company's management depth and culture? Is the management compensation plan tied to increasing shareholder value? Is the Board of Directors independent and relevant (size of board, insiders vs independents, quality and breadth of board)?
   4. Sales/Revenue Growth: Historical growth rates, industry growth rate, trends, estimated long-term company growth rates and catalysts, declining/stable/improving competitive position.
   5. Operating Margins: Trend analysis of firm's operating margins. Operating margins relative to industry margins.
   6. Relative P/E: Trailing/current/foward P/E relative to industry. Historical P/Es. Projected EPS growth rate relative to the industry growth rate.
   7. Positive Free Cash Flow: Free cash flow trend (operating net + DD&A – capital spending – common dividends). Trend in operating cash flow per share relative to EPS. Working capital turnover trend analysis relative to historical and industry. Historical and projected ability of the company to fund its growth internally.
   8. Dividend Coverage and Growth: Current payout ratio in-line with peers. Current yield relative to historical yield. Dividend growth rate relative to earnings growth rate.
   9. Asset Turnover: Improving/deteriorating asset turnover. Company turnover ratio relative to indsutry.
   10. Investment in Business/ROIC: Trend analysis of firm's ROIC relative to WACC. Capex trends relative to depreciation for the company and industry. R&D as a percentage of sales historically and relative to industry trends.
   11. Equity Leverage: Increasing/decreasing leverage. Earnings growth relative to the growth in leverage. Operating margin trends relative to growth in leverage. History of write-offs and restructuring charges if growth has been acquisition driven.
   12. Financial Risk: Debt/equity ratio adjusted to include off-balance sheet items. Trend analysis of the coverage ratio. Firm's reliance on access to capital markets to fund its growth. Firm's historical and projected credit ratings by S&P and Moody's. Firm's ability to fund any maturing debt and/or puttable bonds over the next 2 years. Specific restrictions/covenants stipulated in available credit lines and debt outstanding.
9. Tech stocks tend to be negatively correalted with Pharmaceutical stocks. IT stocks negatively correlated with Financial stocks.

- END -

Rating: Good

Background:
Book that I picked up to better understand the macroeconomic situation, especially with all the talk about impending dollar collapse.

Detail:
Argues that the US dollar will crash very soon. Very good explanatory graphs and charts, good reference for what to look at for macroeconomic predictions. Good book to own.

Points:

1. The Gold Standard (before 1942) and Bretton Woods (1942 – 1973) worked well to prevent crazy crashes, the current system doesn't.
2. Balance of Payements: Current account balance = Net capital and financial account + reserve asset transactions
3. Cited example of Japan. Major exporting power by late 1960s. Huge trade surpluses deposited into the banking system, resulted in increase in high-powered money + international reserves and set off an explosion of credit creation (money supply), leading to asset price inflation. Asset price inflation creates positive wealth effect that spurs consumption and causes the rate of economic expansion to accelerate. That leads to over-investment and overcapacity. Purchasing power of the public (wages) does not increase quickly enough to absorb the surge in production. Hence downward pressure on prices and profits, debtors find they are no longer able to pay interest on their debts, bankruptcies follow, credit contracts, asset prices plunge, economy enters into recession.
4. US will suffer the same fate as the US dollars from the foreign countries get re-invested back into US. Shows data on US, that foreign investors are buying less and less treasuries but more US corporate bonds + agency (fannie/freddie) debt + equities.
5. Countries with balance of payements surpluses will be forced to convert their dollar surpluses into their own currencies, causing a sharp appreciation in their currencies and a sharp decline in the value of the dollar. This will help restore equilibrium but will throw the major exporting nations into recession as their exports to the US collapse.
6. The international monetary system generates deflation. When excessive credit expansion leads to excess capacity and falling product prices. There is also downward pressure on prices brought about by relocation of the world's manufacturing to very low wage countries.
7. Makes the argument that the only safe place for foreign investors to invest their US dollars is in US treasuries. doesn't have a good use for the extra cash.
8. Makes the argument that the US dollar will crash when the US property market pops. The American shopping spree is financed by the bubble in the US property market, fueled by low mortgage rates and ample financing from Freddie/Fannie. How much longer can property bubble last depends on 1) how much longer low mortgage rates, 2) how much longer can americans finance home prices that are rising at a considerably faster rate than the increase in their wages (shows data that Home Affordability Index is dropping).
9. Makes the argument that when the dollar crashes, Ch