Post of the Day: Consistent Cash Creators

This topic will cover some math that is well beyond many novice investors ability to apply; however, the discussion about projecting future growth rates is very helpful. George, does a great job explaining the difficulties businesses face when trying to compound their capital for long periods of time. This is the primary reason why Warren Buffett looks for a business with a "Moat." We will discuss moats and competitive advantages in future posts. Check out Fat Pitch Financials:

Exponential growth is seen in nature when reproduction is not limited by food, space, or disease. When bacteria colonies first form, they often grow exponentially. In the business world, when a radically new product catches on with the masses, or goes “viral”, its sales can grow exponentially for a time.

Young innovative companies with low capital reinvestment requirements can sometimes grow their free cash flows exponentially. However, as time passes on, these exponential growers face resource scarcity, market saturation, and labor scarcity. The law of diminishing marginal returns kicks in and it becomes increasingly more expensive to produce additional units of goods or services because each additional input added is less and less productive. Often while this is going on, competitors seeing these excess profits enter the market and start to drive down prices. It is exceptionally difficult to maintain exponential growth for long in competitive markets. This is the reasoning that has always made me hesitant in using exponential growth rates in my valuations..."

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High Hopes for VISA, Another MasterCard? Google?

I was first exposed to the very bright, very concentrated (small number of positions in his portfolio) Mark Sellers at last year's Value Investing Congress West. He is an investor worth listening to. In this article he talks about great companies and their IPOs (Initial Public Offering). His article discusses some relatively recent, successful IPOs and more importantly he is excited about the upcoming VISA IPO. Enjoy!

When Google completed its initial public offering in August 2004, the stock seemed overpriced. Even after reducing its IPO price from $108 to $85, the company’s trailing price/earnings ratio was well over 200. Journalists, analysts and market pundits exclaimed that Google was the most overpriced IPO in years, and warned investors to avoid it.

Shortly after the IPO, analysts were confused about how to model the company’s earnings. The average analyst estimate for Google’s first quarter as a public company was 56 cents a share, but the range of estimates was all over the map. Clearly, there was no “consensus” earnings number. Most analysts were cautious.

When Google then reported earnings in October 2004, its earnings per share were 70 cents a share, and the stock jumped 15 per cent in one day. Analysts then rushed to increase their estimates for the following quarter, but were again too cautious. The next quarter, Google beat the average analyst estimate by 15 cents, earning 92 cents a share compared with estimates of 77. The quarter after that, Google earned $1.29 compared with the average estimate of 92 cents.

As it turned out, Google’s stock was incredibly cheap at its IPO price of $85..."

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Post of the Day: On the History of Gillette

One of Warren Buffett's more famous investments is his purchase of Gillette stock (now owned by Procter & Gamble (PG). This story detail the history of Gillette and his marketing campaign. Investors can learn alot about building a moat from this article.

At the age of 40, King Gillette was a frustrated inventor, a bitter anticapitalist, and a salesman of cork-lined bottle caps. It was 1895, and despite ideas, energy, and wealthy parents, he had little to show for his work. He blamed the evils of market competition. Indeed, the previous year he had published a book, The Human Drift, which argued that all industry should be taken over by a single corporation owned by the public and that millions of Americans should live in a giant city called Metropolis powered by Niagara Falls. His boss at the bottle cap company, meanwhile, had just one piece of advice: Invent something people use and throw away.

One day, while he was shaving with a straight razor that was so worn it could no longer be sharpened, the idea came to him. What if the blade could be made of a thin metal strip? Rather than spending time maintaining the blades, men could simply discard them when they became dull. A few years of metallurgy experimentation later, the disposable-blade safety razor was born. But it didn't take off immediately. In its first year, 1903, Gillette sold a total of 51 razors and 168 blades. Over the next two decades, he tried every marketing gimmick he could think of. He put his own face on the package, making him both legendary and, some people believed, fictional. He sold millions of razors to the Army at a steep discount, hoping the habits soldiers developed at war would carry over to peacetime. He sold razors in bulk to banks so they could give them away with new deposits ("shave and save" campaigns). Razors were bundled with everything from Wrigley's gum to packets of coffee, tea, spices, and marshmallows. The freebies helped to sell those products, but the tactic helped Gillette even more..."

continue the article here.

Post of the Day: Index of Companies Trading Below Net Current Asset Value

Clyde of CHEAP STOCKs has created a great Index worth tracking. His site is dedicated to Benjamin Graham's method of buying a basket of stocks for a price below their Net Current Asset Value. Please visit his site.

We’ve designed what we believe to be the first index of companies trading below their net current asset value. The main purpose of this index will be to track a passive portfolio of net/nets. This index is chock full of small companies many of which have been beaten down, and some of which may not survive. We’ve developed this index primarily as an attempt to gauge net/net performance using a basket approach.

The Cheap Stocks 21 Net/Net Index is a market cap weighted index comprised of companies that met the following criteria at index inception on Tuesday, February 12th, 2008"

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Post of the Day: Notes From Buffett Meeting 2/15/2008

I've got a treat for you today! Here is a link to a Q&A session from students from Emory's Goizueta Business School and McCombs School of Business at UT Austin.

Excerpt:

Emory:

Could you comment on the current rise of sovereign wealth funds from the Middle East and Asia and how they are playing an increasing role in how corporations raise capital. Is competition from these sources for the cash flows of corporations affecting your investment strategies or opportunities?

Buffett:

Any competition is competition. The situation of sovereign wealth funds is interesting. A lot of it is China bashing, OPEC bashing and plays right into politician’s hands. Today, the US will buy $2 billion more from the world than they buy from us. In exchange we give them little pieces of paper and they have to buy assets. As long as we consume more than we produce we have to let the rest of the world invest in us. We created sovereign wealth funds and that $2 billion gains interest. US funds feel they can get the best terms from these foreign investors and lately, enticed them into buying equity. China wanted to buy Unocal, a 3rd rate oil producer with production overseas in places like India. US Congress went ape and 395 representatives signed an anti-Chinese resolution to block the deal. For 100 years the US companies went around buying the world’s assets and bribing officials, but told China they couldn’t buy Unocal..."

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Weekend Reading

From Value Investing News:

Sham Gad : Has Eddie Lampert Lost His Touch?

Consider the following scenario: A great company faces a languishing stock price. A few quarters of managerial efforts fail to revive profits. The stock continues to decline. As a result, the CEO is ostracized for having lost his ability. Sound all too familiar?"

Motley Fool

American Eagle Stock Report(AEO)Interesting Article On American Eagle Outfitters. I should disclose that I have a postion in AEO Jan 2010 Calls. College Analysts

From Value Plays:

MBIA Dismisses Ackman: Got A Better Idea?

The bottom line is they have no plan. What they are waiting for is a State or Federal bailout. They have been "talking" to insurance regulators for months now and nothing has been forthcoming from them. There has been no plan, only stonewalling.

They have dismissed plans from Berkshire Hathaway's (BRK.A) Warren Buffett and now Bill Ackman. Wilbur Ross has stated he was interested in investing in them but talks with management have gone nowhere."

Enjoy!

Post of the Day: Credit Squeeze Still in `Early Days'

One investor worth watching (and listening to) is Prem Watsa of Fairfax Financial (FFH). In this Bloomberg article he states that we are still going to see more pain in the Credit Markets.

If you haven't read about the "Candian Warren Buffett" then you should read this excellent story on Watsa.

Here is an quote from the Bloomberg article:

We're just rolling through mortgages right now, but we haven't gone through all the other areas yet,'' such as credit- card debt, commercial real estate loans and automobile lending, Watsa said."

Enjoy!

Post of the Day: "Katsenelson Predicts"

For my inaugural post of the day I'm linking to the Value Investing Congress's Blog. In this post Vitaliy Katsenelson talks about the difficulties the financial markets are currently experiencing and the ways he predicts that it may play out. Here is an excerpt:

- The US economy will slip into a recession which will last longer than those of the past. The longer this recession lasts – the longer it will last. Economic weakness will feed on itself and cause higher unemployment, which will cause further defaults on loans, and so on.
- The defaults in the financial sector will reach higher levels than we saw in the last recession.
- Lending standards will go from extreme promiscuity to the level of a store manager in the sitcom Married with Children, when a store manager, tired of Al Bundy’s bounced checks, asked him for “cash and three forms of ID”.
- This will also spill over into the corporate sector. In many instances it already has: access to capital markets has of late been considered a birthright, but it is quickly turning into a privilege reserved for an elite few and, in many, cases a source of competitive advantage.
- Oversupply of houses and tighter lending standards will cause the housing market to recover slower than many expect (or are hoping).
- Worst case, we will take the rest of the world into a recession. Slowdown in growth will send the Chinese economy into a deflationary spiral. We’ll learn that the prosperity of the Chinese economy came at the expense of a pile of bad loans which were covered up by high growth. Exposure to BRIC countries that used to be considered an asset may quickly turn into a liability. The global commodity boom will turn into a bust.
- Finally, corporate profit margins will prove unsustainable. They are at all time high (40% above the mean), soon to embark on the journey toward mean reversion, where corporate earnings will either decline or growth will decelerate. Stocks may not appear so cheap anymore."

Click HERE to read the rest of the post.

John Burr Williams says "Discounting Matters"

Intuition

In his 1938 investing text "The Theory of Investment Value" John Burr Williams introduced the ideas of discounting and intrinsic value to investors.

For our purposes "intrinsic value" is synonymous with the value of a business. The value can be expressed as the value of the entire enterprise or (to make easier to compare to the stock price) as a per share value.

"Discounting" is a way of expressing something we understand intuitively, that a dollar today is worth more than a dollar a year from know.

No this isn't another dig on the U.S. dollar. This is true even if our currency wasn't under pressure. No one likes to wait around to reinvest their earnings. If we have to wait then we reasonably expect to be compensated for our time. This compensation for waiting is expressed as a rate, in this case as a discount rate. A discount rate represents our opportunity cost of waiting for a certain cash flow.

A Little Math: What should we pay today to receive $100 in the future?

Let's explore for a moment the math behind discounting the cash paid to us in the future. Here is the formula:
Example: What should we pay today to receive $100 in the future? Let's make a couple of assumptions.

1. We will take the money to purchase the future $100 out of our savings yielding 5% (Our opportunity cost or discount rate).
2. We are willing to wait 1, 5, or 10 years.

Using those assumptions: Future Value (FV) = $100; Discount Rate (i)= 5% or 0.05; Number of Periods (n) =1

What should we be willing to pay for a cash flow with those characteristics? $95.24

What if we wait 5 years (n=5)? $78.35

And 10 years (n=10)? Only $61.39

Clarification

The implications of the Future Value of money might not be entirely clear. Discounting future cash flows helps us avoid overpaying for money received in the future; our required rate of return is built into the equation. Said another way, should you decide to purchase that 2018 cash flow of $100 for $61.39 today you are assured a 5% rate of return. Clear as mud?

More on why discounting cash flows matter in future posts...

Valuation Matters: A Case for Business Valuation

Every Business has a Value

Off Wall Street and outside of lecture halls the idea that every business has a certain value that a prospective owner would pay for the complete enterprise is intuitive. In fact, playing Monopoly with my eight year old and watching her haggle for Illinois Ave. illustrates just how intuitive price vs. value is, but somewhere between elementary school and when we first look at a stock's ticker we get lost. We start assuming that the stock price represents the business's value. This is usually not true.

Ignore Stock Prices

Let's look at a large stable company's stock price over the last year. I'm going to use Johnson & Johnson (JNJ) as my example, but any company would do. Here is a one year chart of the stock price:


Theoretically, an investor could have purchased JNJ for as little as $173 Billion or as high as $196 Billion over just 52 weeks. Do you really think that Johnson & Johnson's business value fluctuated by $23 Billion? That is what the stock price suggests. Let's look at another company's stock price Apple (AAPL) to see if its price gyrations are equally irrational.


52 weeks ago you could buy Apple for about $73 Billion then it shot up $100 Billion to $178 Billion and now you can buy it for less than $110 Billion. Talk about a roller coaster! Unlike amusement parks -watching charts, stock prices, and the market is hazardous to both your health and your wealth.

A business's value changes much more slowly than the quoted stock price. Over the short term the stock price is a proxy for investors expectations and emotions (two things that, for the most part, should be ignored).

Price Equals Value

Price is what you pay for, value is what you get"
-Warren Buffett

As investors we can profit by purchasing business when there is a large discrepancy between the price the market is offering a company for and the value of the underlying business. It is important to note that business's value isn't quoted on the stock market (or anywhere else) so it will take bit more work to find bargains. In future posts we will explore business valuation tools.

Efficient Markets

If you disagree, believe the market is efficient, or find that the idea that there is a disconnect between price and value inherently flawed, then I suggest investing in a low cost index fund. Please read my post on why indexing matters. There is nothing wrong with investing passively AND earning your fair share of the market's return. I'm very happy that many people subscribe to the Efficient Market Theory (I.e. Price = Value Theory) it creates opportunities for the enterprising investor.

Tea Leaves, Soothsayers, and Technical Analysis

Worse yet, if feel that the charts, and therefor the price, is signaling you and believe in soothsayers, tea leaves, and fortune tellers then you should search for "technical analysis" on your favorite search engine.