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Geoff Gannon February 10, 2006

New Podcast: “Phil Fisher”

I just finished part two of the three part series on spotting a great business. In it, I discuss the writings of Phil Fisher.

Listen to the Gannon On Investing Podcast: “Phil Fisher”

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Geoff Gannon February 10, 2006

Vote in the Widest Moat Contest

Win a copy of Benjamin Graham’s Security Analysis (1940 edition)

In the latest podcast episode, two new Widest Moat Contest picks were unveiled.

They are: Coca – Cola (KO) and SpaceDev (SPDV.OB)

Vote by sending an email to

The author of the contest’s best email will win a copy of Benjamin Graham’s Security Analysis.

Listen to the Gannon On Investing Podcast: “Phil Fisher”

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Geoff Gannon February 10, 2006

Against the Top Down Approach (Again)

Guru Focus recently reprinted my post “Against the Top Down Approach”. In the discussion forum, there was a post by an author who disagreed with me. I wrote a response, and thought it was worth sharing on the blog. By the way, If you haven’t visited Guru Focus yet, you should. It’s a great resource.

Considerations as to the future growth or profitability of an industry are a part of a bottom up approach insofar as they affect the individual security being evaluated.

Obviously, any evaluation of a property in Baghdad would have included an analysis of the risks associated with the ownership of such a property. The fact that those risks also apply to many other properties does not mean a top down approach is necessary. A top down approach begins with those risks. A bottom up approach considers them only insofar as they affect each investment.

An intrinsic value analysis is not the same thing as applying a multiple to current levels of free cash flow. I know this is not what you suggested. However, it is implied in some of your criticism (particularly the Baghdad example).

For instance, if you believe current steel prices are unsustainable, your intrinsic value estimates for steel producers will be lower than they would be if you simply projected current free cash flow levels into the distant future. A belief that steel prices are high is not inconsistent with a bottom up approach. A bottom up approach simply requires you compare your intrinsic value estimates for each investment against your estimates for all other investments regardless of industry.

A retailer, a homebuilder, a steel producer, and a bank should all be judged on the basis of a conservative intrinsic value analysis. There is no need to first determine that any one of these groups is inherently more attractive than any other.

Buffett’s “play” on the dollar is exactly that. I wouldn’t criticize him for it. However, I believe that, if you were to ask him, he would say it was merely the best opportunity to deploy large amounts of capital for a short period of time. He would much rather make long term investments in common stocks at attractive prices. Mr. Buffett would not be doing the same thing if he had less capital to deploy, and therefore a much larger investment universe.

I suspect his attitudes toward the dollar play are similar to those he has expressed about his past arbitrage operations. They are short term commitments with limited upside, and are far less attractive than long term commitments in common stocks made at bargain prices. Berkshire’s investment universe has shrunk considerably as its pool of capital has grown. This is not the kind of investment Buffet made with his own money back in the 1950s, with the partnership’s money, or with Berkshire’s money in earlier years. I doubt he would suggest it is an attractive option for individual investors.

In my article, I wrote:


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Geoff Gannon February 10, 2006

Against the Top Down Approach (Reprint)

This is a reprint of a previous blog post. It was one of my first. My readership has increased greatly since then, and it’s an important topic. So, I thought I should post it again.

If you have heard fund managers talk about the way they invest, you know a great many employ a top down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is not until all these decisions have been made that they actually get down to analyzing any particular securities. If you think logically about this approach for a moment, you will recognize how truly foolish it is.

A stock’s earnings yield is the inverse of its P/E ratio. So, a stock with a P/E ratio of 25 has an earnings yield of 4%, while a stock with a P/E ratio of 8 has an earnings yield of 12.5%. In this way, a low P/E stock is comparable to a high – yield bond.

Now, if these low P/E stocks had very unstable earnings or carried a great deal of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified
. However, many low P/E stocks actually have more stable earnings than their high multiple kin. Some do employ a great deal of debt. Still, within recent memory, one could find a stock with an earnings yield of 8 – 12%, a dividend yield of 3- 5%, and literally no debt, despite some of the lowest bond yields in half a century. This situation could only come about if investors shopped for their bonds without also considering stocks. This makes about as much sense as shopping for a van without also considering a car or truck.

All investments are ultimately cash to cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top down approach to investing is nonsensical.

Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left handed or right handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; it’s false. Even if pitching left handed is inherently more effective, the general manager is not comparing apples and oranges; he’s comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitcher’s handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitcher’s handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the form of security.

It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all

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Geoff Gannon February 9, 2006

Blogosphere Club

As suggested I’ve created an “anything goes” blogosphere club. Please go to Marketocracy and join with whatever you think your best fund is. If you don’t have a fund yet, you can start one just for this club. I’ve joined with DAVD (that’s my fund limited to stocks with a market cap of less than $1b).

I only ask that you keep the funds compliant. Otherwise, diversification is not an issue.

I’m still keeping the 20 Ideas Club and 100 Ideas Club as well. But, they do have specific requirements. If you like the “anything goes” approach, please join the blogosphere club.…

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Geoff Gannon February 9, 2006

On Financial Strength

Although I have previously discussed companies with heavy debt loads (e.g., Energizer), I generally seek to buy shares in companies of unquestionable financial strength. I agree with Marty Whitman, who wrote in his book The Aggressive Conservative Investor that a strong financial position has more to do with the absence of liabilities than with the presence of assets. Businesses with substantial future obligations, whether these obligations are stated on the balance sheet or not, often prove to be disappointing investments.

An absence of liabilities is not merely a safeguard against insolvency. A strong financial position is a first class asset. It allows a company to borrow when money is cheap, rather than when money is needed. Even more importantly, it encourages long – term thinking. There are times when big investments in the future are required. A financially sound firm is in the best position to make such investments.

One of the greatest benefits of a strong financial position is the protection it affords the common stock holder. Countless times, I have mentioned the damage done to shareholders by new equity and debt financing. New equity dilutes; while new debt imperils.

Growth is an important part of the value equation. But, it only counts insofar as the shareholder reaps the rewards. No owner benefits on the basis of total revenues; each benefits to the extent of the profits attributable to his share of the business. Siphoning profits off to creditors or divvying them up among new owners effectively destroys that growth.

Buying stocks when they trade at low earnings multiples does help minimize an investor’s downside risk. But, that isn’t the only way to minimize risk. The future is always uncertain. There are a few companies who possess such wide moats that an investor can largely confine his analysis to the earnings record. He can feel secure in his belief that thirty years from now the business will remain much as it is today. But, these companies are few and far between. Mr. Market rarely offers them at bargain prices.

A strong financial position offers a kind of freedom. It also acts as a safeguard against uncertainty. If an investor buys stock in a company with a strong financial position when it is trading at low price – to – earnings, price – to – sales, and price – to – book ratios, he will greatly limit his risk.

Companies that are both highly profitable and relatively unencumbered can prove to be spectacular investment opportunities, even when the industry in which they operate faces great uncertainty. It is not unreasonable to expect that a financially sound firm generating large amounts of free cash flow will eventually find a way to productively use those cash flows.

A financially sound firm has the luxury of time. It can play the nimble competitor. A highly encumbered business faces greater risks in a period of upheaval.

Insolvency is not the only threat. Often, a highly leveraged company will be able …

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Geoff Gannon February 8, 2006

On My Terrible Disappointment

You’re missing out on a great opportunity to talk stocks with people who love doing exactly that.

I am terribly disappointed in the response to my earlier post regarding the Marketocracy experiment. I expected the readers of this blog to be very interested in such an experiment. The opportunity to pick stocks, see how they perform, and discuss them in forums on Marketocracy and on this blog seemed like a good idea to me.

Well, I’m going ahead with the experiment despite the lack of interest. Bill of Absolutely No DooDahs has joined me. I hope some others will as well, including some of the other value bloggers out there.

To join, sign up at Marketocracy and then click on either of the clubs to join. Once you apply to join, I’ll accept you into the club(s), and we can get started.

I’ll try to put direct links to the clubs below, but I’m not sure it will work. You’re best bet is to go to Marketocracy and register there first. Then, go find the clubs. Anyway, here are the links, in case they do work:

GOI Top 20 Ideas Funds

GOI Top 100 Ideas Funds

Read my original post if you haven’t already.…

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Geoff Gannon February 7, 2006

On the Value Investing Directory

I just created a very modest value investing directory. I hope to add to it in the days ahead. The links are divided into two groups:

Investing Blogs

Investing Resources

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Geoff Gannon February 6, 2006

On Journal Communications

Journal Communications (JRN) consists of seven essentially separate businesses: The Milwaukee Sentinel, Community Newspapers, Television Stations, Radio Stations, Telecommunications, Printing Services, and Direct Marketing. The company’s five reportable segments do not exactly match these seven businesses; however, I believe an investor should analyze JRN on the basis of these seven businesses and their constituent properties, rather than as a single going concern with five reportable business segments.

Additional reasons for this belief will be outlined below. For now, it is sufficient to say that if Journal Communications were to split into seven separate public companies, the combined market value of those companies would be substantially greater than JRN’s current enterprise value. Simply put, the sum of the parts would be valued more highly than the whole.

Journal Communications has an enterprise value of just under $1 billion. Pre-tax owner’s earnings are probably around $125 million. So, JRN trades at eight times pre-tax owner’s earnings. That’s cheap.

Journal’s effective tax rate is 40%. That is an unusually high rate. Journal’s media properties would likely generate more after-tax income under different ownership. The difference would be material; but, for anyone other than a highly leveraged buyer, tax savings would not be a primary consideration. When evaluating Journal as a going concern, it is perfectly appropriate to treat the full 40% tax burden as a reality. These taxes reduce owner’s earnings by $50 million.

With after-tax owner’s earnings of $75 million and an enterprise value of $1 billion, Journal’s owner’s earnings yield is 7.5%. Remember, this is the after-tax yield. The pre-tax yield is 12.5%. When evaluating a company, it’s best to use the pre-tax yield for purposes of comparison. Last I checked, the 30 – year Treasury bond was yielding 4.63%. So, looking at JRN’s current earnings alone, the stock appears to offer a large margin of safety.

This is especially true if you consider the fact that earnings yields offer more protection against inflation than bond yields. They don’t offer perfect protection. But, with stocks, there is at least the possibility that nominal cash flows will increase along with inflation. The cash flows generated by bonds are fixed in nominal terms, and therefore offer no protection against inflation.

When evaluating a long-term investment, such as a stock, I do not use a discount rate of less than 8%. This reduces JRN’s margin of safety considerably. Instead of being the difference between 12.5% and 4.63%, Journal’s margin of safety is the difference between 12.5% and 8%. Is such a margin of safety sufficient? Maybe.

When evaluating a prospective investment, I first look at the risk of a catastrophic loss. What is the magnitude? And what is the probability? For my purposes, a catastrophic loss is defined as any permanent loss of principal. The risk that I’ve overvalued a business is always greater than my risk of catastrophic loss, because I insist upon a margin of safety. A catastrophic loss is one that wipes out the entire margin of safety.…

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Geoff Gannon February 6, 2006

On a Possible Cause for JRN’s Undervaluation

I thought a discussion of the possible causes of Journal Communications’ undervaluation by the market might help us find other similarly undervalued stocks. In the Gannon on Investing Podcast: “Why Small Caps” I stated that undervalued stocks usually suffer from either contempt or neglect. JRN suffers from both.

Journal Communications (JRN) is a relatively small company, despite the diversity of its media assets. The company owns a collection of low profile media assets. The same size company with a well known flagship would not go as unnoticed by investors. Although the Journal Sentinel is a big paper, I don’t believe most investors know the name. Of course, most daily newspapers are only known in and around the city in which they are published. That brings up another possible cause of JRN’s undervaluation. Perhaps the location of the company’s assets has helped it fly under the investing public’s radar.

Maybe. But, I’m not so sure. All of those factors could contribute to the lack of interest in JRN. However, I doubt they are the primary cause.

One of the best possible explanations for JRN’s undervaluation is the company’s lack of debt. Journal Communications is not debt free; however, for a media company, it is very lightly encumbered. Actually, the company also has a low debt load relative to the S&P; 500. But, I want to focus on the company’s debt relative to other media companies, particularly other newspaper publishers, because I believe that is a key cause of the undervaluation.

The stock market doesn’t totally ignore debt. However, it sometimes fails to fully account for the differences in debt levels between companies. In general, unduly leveraged companies are punished by the market. All other things being equal, the stock of such companies trades at a lower P/E ratio. In this way, the stock market does account for debt.

However, punishing companies with a lot of debt is not quite the same thing as rewarding companies with very little debt. That’s where mispricings can occur. Some businesses in exceptional financial condition are not awarded the premiums they deserve. Such businesses are better able to make acquisitions, buy back stock, increase dividend payments, and weather tough times. Just as importantly, they also have the capacity to take on more debt.

On occasion, I have read the argument that excess cash on the balance sheet may be a bad sign, because it suggests management is not running the business in the way that would best maximize returns on equity. It is true that some companies have more cash and less debt than would be best for the maximization of shareholder returns. However, from this, it does not necessarily follow that such companies are less desirable investments.

I have touched on enterprise value a few times before. There is a reason for this. A business’ enterprise value is a better measure of price than its market capitalization. Generally speaking, a company’s cash can be treated as a reduction to the price paid …

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