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Geoff Gannon January 30, 2006

On the Free Cash Flow Margin Method

There are several ways to value a business. Investors often disagree on which to use.

I’ve already mentioned using a DFCF analysis based on a free cash flow margin estimate and a sales estimate for a series of years. I used this method explicitly with (OSTK) and implicitly with Lexmark (LXK). Before reading further, you may wish to review those two examples: “On Overstock” and “On Lexmark”.

The free cash flow margin method has several important benefits:

The analyst needs to focus on only two things: revenue growth and the free cash flow margin. The estimate of the free cash flow margin can be based on quantitative data such as the company’s historical FCF margin, the industry’s historical FCF margin, or gross margins within the business. It can also be based on qualitative data like the variability in those margins, the ability of the business to raise prices in a period of inflation, the nature of competition within the industry, and the company’s competitive position. In cases in which the FCF margin has been consistently and extraordinarily wide or narrow, the quantitative and qualitative data will likely agree.

The analyst is forced to make his assumptions explicit. By using exact projections of sales and the free cash flow margin for each year, the analyst is forced to see just how reasonable or unreasonable his assumptions are. Static multiples and simple equations based on a company’s growth factor let the analyst arrive at a valuation without necessarily knowing what his projects for any given year are.

When projecting growth rates into the future, it is very easy to overlook the cruel realities that mitigate the continuance of any trend. Both static multiples and DFCF calculations based on returns on capital and growth rates will often lead to projections of unachievable sales numbers. You may think you are being very conservative in your growth projections for Google (GOOG); however, when you look at the actual revenue needed to support your valuation, you may find you are assuming far more than you thought. That is why I went over the resulting revenue numbers in the Overstock analysis. I wanted to demonstrate that the revenue growth assumptions were not unreasonable, even going out thirty years.

The factors that determine a business’ free cash flow margin are the keys to understanding, and properly valuing, that business. In coming up with an estimated free cash flow margin, the analyst must ask questions about the nature of competition in the industry, the relation of tangible assets to intangible assets, the profitability of the business, the capital spending required to maintain that level of profitability, the stickiness of a business’ customers, the differentiation of its products, and the business’ ability to raise prices. These are important questions. They need to be asked regardless of the method of valuation used. So, why not use a method of valuation that is inherently focused on these crucial questions?

The free cash flow

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Geoff Gannon January 29, 2006

On an Interesting Idea

The New Wall Street’s latest post contains an interesting idea – please check it out.…

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Geoff Gannon January 25, 2006

What Would Buffett Do?

A while back, there was an interesting post on Shai’s blog about Warren Buffett’s assertion that he could achieve 50% returns on $1 million. This, among other things, got me thinking about how Buffett would invest if he were in the position most of you are. What would he do as an individual investor with a small enough amount of capital to invest that it was really no hindrance?

There are several sources we could use to guess what Buffett would do in your shoes. He has invested some of his own money since taking control of Berkshire, and some of these positions are known publicly. Maybe I don’t watch Buffett closely enough, but I doubt these reports give us a good idea of what Buffett would really do if he were in your shoes.

Buffet ran a partnership before taking control of Berkshire. We could glean something from what’s known about his activities then. But, I don’t think that’s necessarily the best guide either. From what I can tell, the partnership’s holdings were more diversified (in the early years at least) than I suspect a modern Buffett portfolio would be.

I think the right answer is small caps. Buffett’s admitted as much at times. If he didn’t have all that capital to deploy, he’d be looking for the most obviously inefficient pricings – that’s small caps. It has to be. The sheer number of really small publicly traded companies guarantees that’s where the best bargains will be. Small caps are the best place to take advantage of a detailed knowledge of each company. A lot of funds are spread so thin; they can’t have even read all the 10-Ks that well. Several of Buffett’s early purchases seem to echo Graham’s Northern Pipe Line purchase. They involve buying shares in a business for assets that are unrelated (or not necessarily related) to the main line of business. Another similar tactic is buying a business for cash flows (including future working capital reductions) that can be diverted into a more lucrative area (like securities). That’s what led Buffett to Berkshire.

These kinds of opportunities are very rare outside of small cap stocks. If, for instance, a major retailer was, year after year, taking all its free cash flow and using it to buy its leased properties, make early repayments of its mortgages, and buy back stock, people would notice. It would be obvious you weren’t really paying for a business that operates a chain of stores – you were paying for real estate holdings. In small caps, this kind of thing can and does happen. Granted, it doesn’t happen a lot. But, it happens more than enough to create a portfolio based on these kinds of situations.

You really can find businesses that have the majority of their assets in something that isn’t strictly necessary to continue the business. For instance, there are small cap retailers who own almost none of their stores and there are small cap retailers who …

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Geoff Gannon January 25, 2006

On Overstock (Again)

There is a good post over at The New Wall Street entitled: “Overpriced Overstock”. The post makes the case that (OSTK) is headed towards bankruptcy. I encourage you to read it.

Of course, I also disagree with it. Actually, I disagree with the conclusion reached. I don’t disagree with some of the reasoning used to reach that conclusion. For instance, I have visited Overstock’s website, and I do view it as poorly designed, intimidating, and just downright overcrowded.

I also agree that Mr. Byrne’s time could be better spent. However, I don’t agree with one statement:

“I would immediately sell any company whose President spends his time making excuses rather than seeing through the execution of his business plan”


There are two problems here. One, most CEOs of public companies make excuses in their public statements. I was just reading the annual report of a consumer products company that gave “electoral uncertainty” as one of the reasons for a “challenging environment” in the U.S. in 2004. Apparently, a close Presidential election keeps people from shopping.

Two, I don’t see evidence that Dr. Byrne has been doing any of this rather than seeing through the execution of his business plan. I think Overstock has been run according to that plan, and I think that plan is working, as I will explain below. All in all, I can think of candidates for the top job who are a lot worse than Dr. Byrne. In fact, I have had the pleasure of investing in businesses run by such men. My experience was rewarding enough, whenever their stock was cheap enough.

I don’t believe Overstock’s business plan is flawed. In fact, over the past two years or so, I believe Overstock has generated sales in excess of necessary associated costs. Most people will dispute this assertion. It is not borne out by GAAP. Even management’s own financial data suggests sales were below necessary associated costs in a few of these quarters. I think that has to do with the timing of certain expenses more than anything else. I believe sales are already ahead of variable costs, and are growing fast. That’s the formula for future profitability.

It will be interesting to see what Overstock reports for the fourth quarter, because, for Overstock, the Christmas shopping season is a little different from the rest of the year (as it is for many retailers).

The post at The New Wall Street also argues that Overstock is competing with eBay. I don’t believe this is true in any economically meaningful sense. I’ve discussed this kind of competition before, and will be discussing it in my upcoming podcast.

Overstock and eBay (EBAY) are listed in the same industry. I’m sure the management of each company thinks of the other company as a competitor. Still, I’m not convinced there’s much competition going on. The real sales potential for Overstock has nothing to do with eBay. The online retailing market is big enough to …

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Geoff Gannon January 23, 2006

On Technical Analysis

This piece was prompted by a recent post on Value Discipline. I suspect it will be of little interest to most readers. It is a long, plodding piece that contains two extended quotes from dead men. However, if you are interested in the discussion of technical analysis and value investing, you may wish to read it. In either case, you will want to read Value Discipline’s shorter and more interesting post.

Let me first say that I do not now engage in technical analysis; nor, have I ever engaged in technical analysis. I do not believe doing so would be a productive use of my time.

Having said that, I do not claim technical analysis has no predictive value. In fact, I suspect it does have some predictive value. The Efficient Market Hypothesis is flawed. It is based upon the (unwritten) premise that data determines market prices. As Graham so clearly put it in “Security Analysis”:

“…the influence of what we call analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.”


I’ve seen a lot of people cite this quote, without bothering to notice what’s really being said. Graham had a very broad mind, much broader than say someone like Buffett. That’s both a blessing and a curse. At several points in Security Analysis (and to a lesser extent in his other works), Graham can not help but explore an interesting topic more deeply than is strictly necessary for his primary purpose. In this case, Graham could have said what many have since interpreted him as saying: in the short run, stock prices often get out of whack; in the long run, they are governed by the intrinsic value of the underlying business. Of course, Graham didn’t say that. Instead he chose to describe the stock market in a way that should have been of great interest to economists as well as investors.

Data affects prices indirectly. The market is a lot like a fun house mirror. The resulting reflection is caused in part by the original data, but that does not mean the reflection is an accurate representation of the original data. To take this metaphor a step further, the Efficient Market Hypothesis is based on the idea that the original image acts on the mirror to create the reflection. It does not recognize the unpleasant truth that one can interpret the same process in a very different way. One could say it is the …

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Geoff Gannon January 21, 2006

On Friday’s Price Drop

Prices on stocks were reduced Friday, making them slightly more attractive. Sadly, many of the biggest price reductions were among the most expensive issues. For instance, Google’s stock price dropped by almost 8.5%. But, we’re still talking about a hundred billion dollar company. Google (GOOG) is trading at something like sixty times next year’s earnings.

Based on yesterday’s news, you might think all stocks had gone on sale. Sadly, that’s not the case. For instance, shares of Village Supermarket (VLGEA) will now cost you about 2.5% more than they would have on Thursday. However, some other companies I mentioned did go on sale: (OSTK) fell 3.16%

Posco (PKX) fell 3.01%

Journal Register (JRC) fell 2.84%

Home Depot (HD) fell 2.69%

Energizer (ENR) fell 2.43%

American Eagle (AEOS) fell 2.29%

Gannett (GCI) fell 2.03%

It’s always tempting to take a new position at a time like this. But, remember, even among the hardest hit issues, Friday’s price decline was small compared to the margin of safety required for an intelligent investment. I’m only mentioning Overstock, Posco, Journal Register, Home Depot, Energizer, American Eagle, and Gannett, because they already looked promising. Gannett makes the list more because it’s a well known name than for any other reason. Despite the higher debt levels, Journal Register looks more attractive than Gannett, because of the type of properties it owns.

Some of these stocks are more attractive than others. Generally speaking, the stocks at the top of the list look like better bargains than the stocks at the bottom of the list. Perhaps, that’s an indication of investor sentiment. Already out of favor stocks get knocked down even more. Personally, I think it’s just a coincidence. For instance, I thought Jakks Pacific (JAKK), Blyth (BTH), and Timberland (TBL) already looked cheap. On Friday, Jakks and Timberland were up a bit; Blyth was basically unchanged. I suppose asking for a further drop in stocks that are already that cheap is asking for too much.

By the way, is now at a fifty – two week low; Journal Register is at a five year low.

On a personal note, I have to admit Friday’s trading has reinvigorated me. Bargains don’t grow in the sun, and judging by yesterday’s media coverage, there’s a renewed chance of clouds. Still, Friday’s trading didn’t make stocks materially cheaper. A drop of two or three percent is little more than a rounding error.

At least we won’t have to hear about Dow 11,000 on Monday.

Happy Hunting…

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Geoff Gannon January 21, 2006

On The Two That Got Away

“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.”

(Read Warren Buffet’s 1992 Annual Letter to Shareholders)

Lately, I’ve been thinking a lot about Fisher and Munger and their influence on Buffett. If I have not said it before, let me say it now: I believe both men’s influence on Buffett’s investment decisions have been overstated. I do not mean that as a slight to either man. They both have impressive records of their own, and they both offer a lot for investors to study. Phil Fisher and Charlie Munger are two of the greatest investment thinkers of all time. Besides, this post is not about the influence these men had on Buffett. This post is about investment mistakes I have made – mistakes I would not have made had I heeded the advice of Fisher, Munger, or Buffett.

This post is, at least in part, the result of the time I spent at Jason Bond’s blog over the weekend. That may not be obvious; nevertheless, it is true. I’m currently working on a three part podcast series on spotting great companies. I’m also in the process of reviewing two books: Phil Fisher’s “Common Stocks and Uncommon Profits and Other Writings” and Charlie Munger’s “Poor Charlie’s Almanack”. Obviously, these projects are closely related. That fact has been reinforced by two activities I engaged in this week: rereading Warren Buffet’s annual letters and visiting Jason Bond’s blog. Having done these things, I knew I had to write this particular post today.

Two weeks ago, I posted “On Blogs as Public Records”. In that post, I wrote:

“We’ll go over my mistake. Think of it as an autopsy. We’ll determine the cause of my error, and look to prevent it from creeping into our thinking in the future.”


Not surprisingly, both of the biggest mistakes of my investing career have been errors of inaction. However, these errors were not passive. When analyzing decision making, inaction must always be considered an action. A choice is made in either case; whether the outside world sees the results of that choice or not is irrelevant to an analysis of one’s own judgment – or misjudgment.

Three years ago, I failed to buy shares of Building Materials Holding Company (BLG). A year ago, I failed to buy shares of PetMed Express (PETS).

In each case, the stock was clearly undervalued. In each case, I did an intrinsic value analysis and compared the margin of safety to all possible alternatives. In neither case, did I find a possible alternative that had a margin of safety even remotely comparable to that of the stock being considered.

I will spare you the details of my analyses. It is …

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Geoff Gannon January 20, 2006

Last Chance to Enter Widest Moat Contest

This is your last chance to enter the Widest Moat Contest.

All entries must be received by midnight tonight.

Final Notice:

You can win a copy of Benjamin Graham’s “Security Analysis” (1940 edition)

All you have to do is:

Pick the public company you think has the widest moat and leave a voice mail with your name, the name of the company you’ve picked, and a brief explanation of why you picked that company at: 1 – 800 – 782 – 1687

(You can pick up to two companies. If you do, leave two separate voice mails, one pick per message)

I will randomly pair off all the voice mail picks and put one pair into each upcoming podcast. Listeners will vote (via email) for the one with the widest moat from each pair. The pick with the fewest votes will be eliminated. This process will continue until only one company is left. Listeners will include a brief explanation for their vote with each email. The listener who sends in the most interesting email will also win a copy of Ben Graham’s “Security Analysis”.…

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Geoff Gannon January 20, 2006

Widest Moat Contest Closed

The Widest Moat Contest is now closed.

No new entries will be accepted.

The entries that have already been received will be paired off into future podcasts. The winner will be chosen from among those picks.

Thank you to everyone who submitted an entry.…

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Geoff Gannon January 19, 2006

On Small Cap Value and Large Cap Growth

Yesterday, there was an interesting post entitled “Finding Value in Growth” over at Value Discipline. About midway through the post Rick writes:

“As someone who generally has espoused small cap value picks, I have to admit how difficult it is to find value in this part of the universe. A few exceptions naturally do apply, but overall, the pickings are slim.”

I couldn’t agree more. The wheel has turned.

Immediately following the bursting of the speculative internet stock bubble, growth stocks were still overvalued. I found occasional exceptions, but these were short – lived. For instance, I briefly owned Cisco Systems (gasp!). However, I purchased the shares at what happened to be just about the lowest point they’ve traded at in eight years. I sold the stock within a matter of months. This is unusual behavior for me, but I bought the stock when it was undervalued and sold it when it approached fair value – the fact that this happened within a matter of months is the market’s fault, not mine.

What’s really remarkable here is that this undervaluing of Cisco (CSCO) only lasted for a matter of months. Ever since, Cisco hasn’t even approached levels I’d consider buying at. What (still extant) stock is more closely linked in investors’ minds with the internet induced insanity of the late 90s than Cisco? I can’t think of any.

So, one would have assumed Cisco would become one of the most reviled stocks of the earlier 00s. But, that didn’t really happen. Cisco was certainly less appreciated. But, it was only very briefly underappreciated. As I watched the bubble burst, my mouth was watering for the bargains that never came. I was sure great companies like Intel (INTC), Microsoft (MSFT), Cisco (CSCO), and Dell (DELL) would finally be offered at bargain basement prices. But, it didn’t happen.

This once again demonstrates my complete inability to predict stock price movements, future market levels, investor psychology, etc. I’m only good at one thing – finding businesses that are selling for less than they’re worth. Fortunately, this is the only skill an investor needs. Still, the whole experience does serve as a good reminder to ignore anything I have to say about the broader markets or short – term price movements. If I am ever foolish enough (and I’m sure I will be) to write about those things on this blog, please ignore me. That’s the best advice I’ll ever give.

Returning to the Value Discipline post, you’re probably wondering what this little story about Cisco has to do with “Finding Value in Growth”. Well, the wheel has turned. After all these years, “growth” is cheap and “value” is expensive. As I’ve said before, as far as you are concerned there are no such things as growth stocks and value stocks; there are just stocks. Don’t decide on growth or value and then pick a stock that fits into one of those boxes. Just go out and find a business that’s selling …

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