Posts By: Geoff Gannon

Blind Stock Valuation #1 – Watlington Waterworks

A couple months ago, I posted a blind stock valuation. Basically, I just gave you 7 important financial figures for each of the last 6 years and asked you to value the stock as best you could. I didn’t give you the name of the stock.

And – although I didn’t tell you this – I multiplied all figures by 10 to eliminate any bias caused by you realizing this was a very small stock.

I promised I would give a copy of Ben Graham’s The Intelligent Investor to the reader who sent in the best email telling me how much the stock was worth.

The stock was actually a foreign microcap called Watlington Waterworks. It’s a water company on the island of Bermuda.

Bermuda is a rich island nation – actually a territory of the United Kingdom – 650 miles off the coast of South Carolina. It has a population under 70,000. Bermuda’s economy is based around insurance and American tourism. Its currency is convertible into U.S. dollars at a fixed 1-to-1 ratio.

There is no fresh water on the island. Bermuda’s water comes from removing salt from seawater and collecting rainwater.

This is an analytical exercise. Not a stock tip. In all likelihood, your broker doesn’t have the ability to buy stocks for you in Bermuda.

Here is the information I provided about the company:

And here is the best email a reader sent in:

1) Growth in sales and earnings is roughly tracking inflation.  This is a mature, roughly no-growth business so I will pay no premium for growth.

2) FCF is consistently less than earnings.  So this is a business with a significant amount of long-term assets which causes CapEx to exceed accounting depreciation due to the effect of inflation.

3) FCF in this case is a more relevant determinant of value than earnings.

4) The FCF yield on equity has averaged roughly 10% over the 6-yr period presented.

5) My hurdle rate for investment is 10%, therefore I am willing to purchase the company at 1X equity.

6) So I would be willing to pay up to 181/10.5 or approximately $17.25 per share.

7) An additional consideration: The company is carrying very little debt and has stable earnings.  As a control buyer or an activist investor, I would give strong consideration to leveraging up my equity.

The stock trades on the Bermuda Stock Exchange. Shares last traded hands at $13.95 a share.

Most readers sent in valuation estimates in the $20 to $30 a share range.

Thanks to everyone who participated.

Talk to Geoff About Blind Stock Valuation…

Buy Japan

I haven’t posted to the blog in a while. But the situation in Japan – and Japanese stocks – is definitely worth coming out of hiding for.

No matter how bad the nuclear situation gets, the earthquake and the events that followed will probably be classified by history as:

• A major human disaster
• A moderate economic disaster
• A minor investment disaster

Public companies in Japan have already lost more value in terms of their market caps than could ever be justified by the disaster – no matter how bad the nuclear situation gets – because there’s no way these companies’s future cash flows could be permanently impaired to the degree necessary to cause a loss in intrinsic value equal to their recent loss in market value.

And Japanese public companies were already some of the world’s cheapest businesses. So some of the world’s cheapest stocks just got cheaper.

Some folks are going to argue that the disaster in Japan – and subsequent stock sell-off – provides an opportunity to buy stocks elsewhere. Ignore them. U.S. stocks aren’t cheap. Japanese stocks are. Don’t get fooled into buying stuff on the other side of the world. Go straight for the center of the crisis. Buy there. That’s where the bargains are.

There are lots of problems in Japan.

And I’m going to be brutally honest about them here. Seeing the human tragedy in Japan is something we can mourn as fellow human beings. But it shouldn’t color our view of Japan as investors.

I don’t like most Japanese businesses. The country’s business culture is toxic. It is very shareholder unfriendly. Returns on capital are – and frankly, have always been, even in the boom years – completely unacceptable. Most Japanese companies pander to their customers and do not price their products at the best levels for their shareholders. Japan is an investment basket case. And Japanese stocks deserve to trade at lower price-to-book ratios than the rest of the world’s stocks now and forever.

Having said that, I’m going through the Tokyo Stock Exchange and finding dozens of bargains.

Examples include grocery stores, logistics companies, and gas utilities. Some of these companies – unlike the vast majority of Japanese businesses – earn unleveraged returns on invested capital equal to their counterparts in the United States and Europe. Of course, they are all irrationally underleveraged. Many Japanese companies are.

There are tons of net-nets in Japan.

Some of these companies deserve to remain net-nets forever. Such justifiably permanent net-nets are very rare in the rest of the world. In the U.S., I can name – at most – about half a dozen net-nets that are consistently profitable but have such consistently pathetic returns on capital to deserve a fate of staying a net-net forever. One American example is Duckwall-ALCO (DUCK).

Economists may argue this has to do with Japan’s economic circumstances. I’m more inclined to believe Japan’s economic circumstances have been exacerbated by its business culture.

The profit motive is very weak …

Barnes & Noble – The Human Element

A reader sent me this email:

The way Barnes & Noble (BKS) is trading is starting to bother me.  I don’t see anything in the recent 10-Q that wasn’t already announced.  Borders CEO is saying they hope to come out of (bankruptcy) by end of summer, ok but that is not the end of B&N.  Other than that there is nothing but the market trading as if B&N is going to end in (bankruptcy) itself.  I don’t get it.

Can you offer your take?  I realize you no longer like B&N or maybe you are not interested to offer comments but this sort of movement seems irrational and I am getting uncertain.

One of the really big issues with Barnes & Noble – and probably the reason I sold out – is that the non-profit motivations of Riggio and others didn’t align with my (as an outside investor) very much for profit motives of buying the stock. My fear was that once Riggio defeated Burkle in the proxy contest, the company would be more geared to relentless pursuit of being a big, relevant force in bookselling regardless of what that meant for profits that could actually repay shareholders.

In other words, I was very scared that Nook spending wasn’t a one-time thing. That the existential threat to Barnes & Noble as a company was what management would respond to instead of minimizing direct investment in the Nook and maximizing the milking of today’s cash flows from the actual stores. Basically, I thought Burkle’s motives were safely capitalistic while Riggio’s motives were dangerously paternalistic.

I still do.

Maybe things will work out for Barnes & Noble the company, for Barnes & Noble the institution – but I didn’t think they’d work out well for shareholders. The actions they are taking are crazy from a return on capital perspective. But they obviously make sense from a long-term survival perspective. Still, they are unnecessarily dangerous from a short-term survival perspective. Barnes & Noble’s financial health would be fine without the Nook. It isn’t fine right now and that’s entirely because of the combination of cashing Riggio out of B&N College and spending on the Nook combined with maintaining the dividend through the proxy fight.

Ironically, this pursuit of long-term relevance has endangered the financial health of the company. Unless they stop spending on the Nook, they’re going to be flying a lot closer to the sun than they ought to be. A company with these cash flows shouldn’t be doing this kind of new product investment. They’d say the level of spending is temporary. I’d say you either commit to an arms race or you don’t. But once you commit, it’s out of your control how many missiles you’re going to need next year. Both sides get a say in how much you have to add to the arsenal each year. If Amazon raises the bet, you have to match them or fold. But you no longer get to choose your level …

Investing in Japan – Questions and Answers

A reader sent me this email:

In your research have you come across any good closed end funds? So far I’ve only found JEQ and JOF.

I don’t plan to buy a closed end fund. I plan to buy stocks I select myself.

If your broker can buy in Japan, I’d suggest doing that. Last I saw, the discount/premiums on Japanese closed end funds and ETFs are tighter than normal not wider. In other words, like in Egypt, foreigners are buying into the country wide funds in the middle of the crisis. People are fleeing the specific stocks. But that doesn’t seem to be matched – and certainly not exaggerated – in the funds. Usually, slow motion market declines show the reverse trend. But people may actually be attracted by bad headlines when they happen fast in a country they normally don’t invest in.

I’m working on a list of 100+ Japanese stocks. These are individual stocks I picked myself based purely on their 10 year earnings records. I’ll probably just make my own basket out of those instead of buying into a fund.

But, depending on your broker, that could be too expensive in your case.

A reader also sent me this email:

How are you sizing your Japanese positions? Are you setting a maximum limit of how much your portfolio will be invested in Japan?

I expect to put 25% of my net worth into Japanese stocks.

If prices fell a lot from here and I found stocks I liked, I’d definitely put 50% into Japan.

I’m unlikely to put more than 50% into Japan under any circumstances. It would be possible. But the Japanese stock market would have to drop further by some crazy amount like 50% or something for me to put more than half my net worth into Japanese stocks.

I’m saying that now, but I could change my mind. If I really liked the prices, there’s ultimately no limit to what I’ll put into one country. They’ve got enough public companies in Japan that interest me. If they offer them at low enough prices, I’d be willing to go to 100%. But I already own some American stocks I like, so putting more than 50% in Japanese stocks would be hard right now.

I’m expecting my portfolio will be 25% to 50% in Japanese stocks very soon.

Beyond that – your guess is as good as mine.

But I won’t buy indiscriminately. I’m not going to buy a fund. I’m going to buy from my own list of the cheapest Japanese stocks.

A reader also sent me this email:

“How are you thinking about currency risk?”

I always think about currency risk in terms of purchasing power parity. I just assume I will exchange my foreign currency back into U.S. dollars at the lower of today’s exchange rate or purchasing power parity.

So, I punish overvalued currencies, but don’t treat undervalued currencies as being more attractive. That keeps me out …

15 Japanese Net-Nets

Since my “Buy Japan” post I’ve been getting lots of emails asking exactly which Japanese stocks are worth buying.

 

Warren Buffett’s Letter to Shareholders – Intrinsic Value

Warren Buffett just released his letter to Berkshire Hathaway (BRK.B) shareholders.

I’m reading it now. I’ll talk about it in depth later. But I thought I’d give you my first impression of what matters.

For Berkshire shareholders, Buffett goes into much more detail than usual concerning how to value Berkshire Hathaway. He even tells us what he thinks normal earnings are for Berkshire right now.

As usual, he’s also presenting my favorite way of valuing Berkshire – the two bucket approach. You take the investments per share and you slap a multiple on the pre-tax earnings per share.

Personally, I suggest 10 times pre-tax earnings is the right multiple.

So, if you look at page 6 of the annual letter, you’ll see per share investments are $94,370 and pre-tax earnings per share are $5,926.04. That suggests Berkshire’s intrinsic value – using the two bucket approach and no earnings normalization – is $153,630.

A “B” share is 1/1,500^th of an “A” share. So, Berkshire’s “B” shares – the ones individual investor are most likely to buy – should be worth about $102.

The last trade on Berkshire’s “B” shares was $84.87 a share.

Of course, those earnings aren’t normalized. Buffett gives an estimate of normalized earnings this year.

But I thought I’d share the usual two buckets of value approach and what is says about Berkshire this year.

It’s a smidge undervalued.

Talk to Geoff About Berkshire Hathaway…

Warren Buffett May Be Buying Brasil Foods; Reporters May Be Mistranslating Something

There are reports today that Warren Buffett’s Berkshire Hathaway (BRK.B) is buying shares in Brasil Foods. These reports are very possibly true. But still weird. I am seeing something in the U.S. reports that I’m not seeing in the Portuguese report I could find. However, I can’t read Portuguese. So I assume reporters at places like Bloomberg understand the Portuguese report better than I do.

U.S. sources all seem to be talking about a report in a Brazilian paper. When I check that paper’s website this is the only report I see.

In the original Portuguese:

O megainvestidor Warren Buffett chegou ao Brasil. Executivos da BRF -Brasil Foods contaram a investidores, durante reunião promovida pelo BTG Pactual, que gestores da Berkshire Hathaway, empresa de investimentos do bilionário americano, visitaram o país e estiveram em unidades da empresa. Depois de conhecerem a companhia, formada pela união de Sadia e Perdigão, iniciaram compras das ações na bolsa.

And now in the Google Translated English:

The investor Warren Buffett arrived in Brazil. Executives of BRF-Brazil Foods told investors during a meeting sponsored by BTG Pactual that managers of Berkshire Hathaway, an investment company of billionaire American, visited the country and have been in business units. After becoming aware of the company, formed by the union of Sadia and Perdigao, began buying shares in the stock market.

But, like I said, I can’t read Portuguese so I’m assuming Google Translate and I are missing something here and there are actually fund managers mentioned in some report in Brazil.

If you can read Portuguese, perhaps you see that mention above.

Even if there is such a mention, I don’t believe it.

I believe Warren Buffett may be buying stock in Brasil Foods. I just don’t believe he sent any “fund managers” to Brazil. Someone from Berkshire may have visited. But unless it was Warren Buffett or Charlie Munger, it’s unlikely to have been anyone Americans would call a fund manager.

Regardless, Berkshire Hathaway may own stock in Brasil Foods.

If it does, I’m sure Warren Buffett hates that someone at Brasil Foods opened their yap at an investor conference.

It’s like Posco all over again.

Talk to Geoff About Warren Buffett and Brasil Foods…

Borders (BGP) Files for Bankruptcy

The second-largest book store chain in the United States, Borders (BGP), filed for bankruptcy today.

You may remember my misadventures in the stock of Borders’ biggerst competitor, Barnes & Noble (BKS).

I bought Barnes & Noble shares at $15.36 a share in August. I sold them at $14.82. In the meantime, I received $0.50 a share in dividends. The stock is now at just under $19 a share. Up 28% since I sold it. Given the announcement that Borders will close 30% of its stores in just a few weeks – well, Barnes & Noble will pick up a couple points of market share almost overnight.

I’d be surprised if Barnes & Noble’s shares didn’t close higher today. The bankruptcy was expected. But the combination of the store closing and the New York Times saying that Bill Ackman is still interested in a Barnes & Noble and Borders merger if and only if Borders can close enough of its worst stores in bankruptcy was not necessarily expected.

So, overall, selling Barnes & Noble was not my proudest hour.

As you probably know, they spent too much on the Color Nook for my tastes. They didn’t suspend the dividend. And they did defeat the proxy battle waged by Ron Burkle. They were also slow walking the process of getting bids for the entire company.

That made me unable to evaluate their future and quite able to know their cash flow situation would not be as good as it should have been. The stores, remember, still throw off a lot of free cash flow. It was the Nook that sucked it up.

Obviously, Barnes & Noble is the big winner today.

Borders’s bankruptcy filing is shown below.

Page 10 of the filing shows the company’s top creditors. They’re publishers. Here’s what Borders owes them:

1. Penguin – $41,118,914
2. Hachette – $36,879,656
3. Simon & Schuster – $33,757,444
4. Random House – $33,461,061
5. Harper Collins – $25,793,450
6. Macmillan – $11,434,306
7. John Wiley – $11,191,435

Those are just the top 7 creditors. After that, it’s distributors, coffee/cafe, etc.

There are a couple more large publishers way down the list. McGraw-Hill is owed $3,093,871. Pearson is owed $2,784,766.

Borders Petition

Talk to Geoff About Borders Filing for Bankruptcy…

If I Want to Be a Professional Investor, Do I Need to Get an MBA?

A reader sent me this email:

I’ve been studying value investing for about 2-3 years now. The more I speak to my friends and family about investing the more they tell me I need to go back to school to get my MBA. Since my background is in computer programming I’ve looked into all the different ways to go about switching my career. I’ve looked into different MBA programs around the country but I have reservations about spending a large sum of money on a degree that probably won’t teach me how to become a better investor. I also have reservations about spending large sums of money period. The curriculums at many of these schools really don’t interest me except for a few classes. And if I’m not interested in a subject, I will fail it. What I really want to do in the end is become a better value investor and manage a small portfolio. So my questions to you are:

1. What is your (educational) background?
2. What are your thoughts on getting an MBA?

Thanks,
Tom

I’m a high school drop out. I never completed any school year beyond 8th grade. (That’s age 14 for our non-U.S. blog readers). I have a GED. And I briefly went to college.

I don’t think an MBA will make you a better investor. However, an MBA can be used to show you are serious. Basically, it’s like having a liberal arts degree from an Ivy League school. It’s useless. But it might convince employers you’re smart or at least hardworking.

The three things that make people take you more seriously for a career in investing are: a CFA, a MBA, and an undergraduate degree in economics from a top U.S. school. A CFA is best.

The most useful designation by far is the CPA. It’s not even close.

Training as an accountant and training as a lawyer are the two most useful educational backgrounds for an investor to have.

Accounting knowledge is directly useful. Legal training is indirectly useful. The way law schools train their students to become lawyers exercises the same mental muscles you use when you invest.

The eight most useful courses for investors to take are:

1. Financial Accounting
2. Managerial Accounting
3. Tax Accounting
4. Business Law
5. Marketing
6. Business Administration
7. Microeconomics
8. Macroeconomics

The cheapest way to learn these subjects is to buy the textbooks and read them yourself.

None of those courses are hard.

Like I said, I dropped out of school after 8th grade and I had no problem passing those 8 courses when I briefly went to college.

If someone who never really went to high school can pass those courses, I’m sure someone who finished college – even if it was as a computer programmer – can teach himself those 8 subjects at home using the standard textbooks.

To answer your question: I would strongly advise against getting an MBA.

But – then again – I’m a high school drop out. So I’m not sure you want to …

Why I Don’t Invest in Chinese Stocks

A reader sent me this email:

Hey Geoff,

Let me start this off by saying I am an almost brand new investor (rather than speculator), or at least I hope to become one. I read Warren Buffett’s biography the Snowball, which led me to the Intelligent Investor, and now I am trying to learn everything I can about value investing….I have only been in stocks for a few weeks.  I have bought some well known companies that looked cheap like MSFT, SKX, and RSH, but I am increasingly fascinated by the possibilities of small and micro caps. There are 2 Chinese companies that I have bought and I keep looking at the numbers and they almost seem too good to be true….They do not appear to be associated with the same fraud as a lot of the Chinese reverse mergers, and their P/E ratios and returns on equity look pretty awesome. Do you think I’m crazy to call these companies “investments”?

I don’t invest in Chinese stocks.

Since I look for net/nets, I often end up with a list of Chinese stocks. And my initial impression of Chinese net/nets has been extremely negative. I have seen things literally within seconds of opening their 20-F that turned me off. Things that made me feel there was a chance you could lose everything in the stock.

I could look at the specific stocks you mentioned if you really want. But, honestly, I work at this investing thing pretty hard. I spend a lot of time thinking about investments. I’ve read thousands and thousands of SEC reports. I started when I was 14. I’ve been writing about investments for the last 5 years. And I don’t trust myself to analyze Chinese stocks. I don’t trust my own judgment enough to let me go through the filings and try to separate the good ones from the bad ones. So I’m not sure why you should trust my judgment on any Chinese stocks.

I’m not just saying don’t consider Chinese stocks because you’re a new investor and I’m being overly protective and blah, blah, blah. I’m saying I personally have banned myself from ever considering Chinese stocks because I have seen things you wouldn’t believe in these filings. I don’t like to talk about it because I don’t short stocks. I don’t want to get into controversies over shorting stocks. And I don’t want to come off as racist or anti-China or something. But there are frauds in U.S. listed Chinese stocks. There are some very, very obvious frauds.

I have read press releases from Chinese net/nets where I honestly believe they are saying an event occurred that did not occur. I think they made the whole thing up. I don’t mean they shaded the truth one way or another. I mean they flat out lied about why their CFO left. I’ve seen this more than once.

I think there are Chinese companies out there that are consciously and actively lying to their investors …