Daily Idea: Murphy USA (MUSA)
Murphy USA will trade on the NYSE under the ticker “MUSA”.
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Special Situation: The WP Stewart Rights…
Read moreBen Graham Defines an Investment
An investment operation is one which can be justified on both qualitative and quantitative grounds.An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.Thorough Analysis: The study of the facts in the light of established standards of safety and value.Safety: Protection against loss under all normal or reasonably likely conditions or variations.Satisfactory Return: Any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.
(Security Analysis, 1940)
To have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.
(The Intelligent Investor, 1949)
Key Terms
- Operation
- Qualitative
- Quantitative
- Thorough Analysis
- Safety of Principal
- Satisfactory Return
- Margin of Safety
- Figures
- Persuasive Reasoning
- Body of Actual Experience
Daily Idea: Berendsen
Berendsen trades in London under the ticker “BRSN”.
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Miko NV: Coffee and Plastics – A Tasty Combination
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Read moreDaily Idea: George Risk (RSKIA)
George Risk trades over the counter under the ticker “RSKIA”.
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Is it Time to Dump George Risk?…
Read moreQuality, Capital Allocation, Value and Growth
In my last article I talked about the first 3 of the 7 things I look for before buying a stock – understanding, durability and moat. Today, I’ll talk about the other four areas I focus on.
First up is quality. We can look at quality a couple ways. One way – which I remember from reading Greenbackd and the book Quantitative Value Investing (which cites an article on the subject) – is using a metric from high up the income statement. Something like gross profits divided by NTA.
This is a good first check. A business should have high gross profitability. Most of the companies I look at have fairly high gross margins. However, all of these subjects are a little tricky because of the accounting definition of sales. Sales are defined in accounting terms for a company in ways that might not make sense from an economic perspective.
For example, Omnicom (OMC, Financial) doesn’t record billings as sales. Nor does DreamWorks (DWA) record box office as sales. However, some companies that buy and quickly resell – at very, very low margins – do count the transaction as a purchase and sale rather than a contracted service. I’m not knocking any of these approaches to accounting – we need one definite way of measuring sales. But it’s important to keep in mind that you can sometimes restate sales without restating anything – like earnings, cash flow, etc. – that actually matters.
What matters is the economic profits a company earns. Sales can be very useful comparisons between companies that use similar accounting. But, I’m not sure gross profitability means the same thing across all industries. For example, I would not be concerned with gross profits at ad agencies, defense contractors, or drug distribution. This is just common sense. For example, AmerisourceBergen (ABC, Financial) hasn’t posted a gross margin above 5% at any point in the last 10 years. Yet, return on equity has rarely been below 10%. That’s unusual. And it reinforces the need for using common – human – sense rather than relying on a screen.
When looking at a company economically – rather than as an accounting entity – we often want to ask what spending at the end of the chain is on these products, what sales by others dependent or controlled by the company etc.
Economically, a DreamWorks movie should be broken down from the ticket price collected from the moviegoer, then we look at the take for the theater, the agreement with the distributor, and then finally DWA’s revenue number comes into play.
In other words, we can – using widely available data that isn’t in the financial statements – easily create a picture of how a movie makes money. We should do that. Just as we should consider the quality of an auto parts maker in terms of the price of their product relative to the price of the product it’s going into and what it …
Read moreTwo Posts Worth Reading
Here are two posts worth reading.
One is about the outperformance of “glamor” over “value” stocks these last few years. I’ve felt this. On a relative basis, the last couple years have been the hardest time ever for me to pick stocks.
The other post is about Sanborn Map. It’s a classic Buffett investment. And the post does a good job of breaking down the logical arguments that were probably running through Buffett’s head.
Armanino Foods of Distinction (AMNF)
A few people have emailed me asking for my thoughts about Armanino Foods of Distinction (AMNF). I don’t have any right now. But Whopper Investments does:
I think Armanino is undervalued at today’s prices. It’s growing pretty fast and creating tons of value from that growth, so that value gap should (hopefully) grow over time. And, as an added kicker, there’s the potential for a merger at a huge premium, which would be easily supported by the synergy potential, and/or a big special dividend to lever the company up.
I lied. I do have one thought. At one point, Whopper says:
I tend to think that their frozen products fall more into the “commodity” segment than the “branded” segment, but their returns on capital actually suggest other wise. Pre-tax returns on capital are well over 50% and gross margins are in the 35% range. Those tend returns tend to indicate some form of brand strength or competitive advantage.
That’s true. However, it is imperative that when you find empirical evidence of a competitive advantage you back it up with a rational explanation for that competitive advantage.
You always want to combine abstract reason with concrete evidence to prove something’s practical existence.
If you fail to do this, you will end up taking the magic formula approach. Many companies earn excess returns. Some have durable moats. Others do not. It may work out on average to simply assume moats based on high returns on capital. In fact, the historical data Greenblatt used says that the approach did work in the past.
But you must never beg the question. You must never argue that this company has a moat because only a company with a moat could earn the returns this company is now earning.
Instead we must look for both a rational theory and empirical data that are reasonable when considered separately and agree when put together.
Articles
Where Does a Stock’s Future Return Come From?
Should Buy and Hold Investors Worry about EV/EBITDA?
How Today’s Debt Lowers Tomorrow’s Returns
Why I’m Pessimistic about Stocks
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How to Read a 10-K
A blog I read, valueprax, reviewed How to Read a Book. I had never read the book before. So I thought I would give it a try. It is – of course – mostly about reading books. And while investors read a lot (in fact, that’s most of what they do) it rarely comes in book form.
Still, a lot of what you’ll find in How to Read a Book can help with reading 10-Ks, S-1s, investor presentations, earnings call transcripts, annual letters, newspaper articles, trade journals, etc.
I think this quote sums up the problem new investors have:
Most of us are addicted to non-active reading. The outstanding fault of the non-active or undemanding reader is his inattention to words, and his consequent failure to come to terms with the author.
SEC reports are not known for being communicative. But in most cases where someone emails me asking about a part of a 10-K they do not understand – the answer can be found in the same 10-K. You just have to read the footnotes, understand how the income statement and cash flow statement and balance sheet relate, and know whether the company is using GAAP or IFRS. With the internet, you don’t even need to know all the actual norms of GAAP and IFRS – since you can always just google “IFRS biological assets” if you’re confused.
This sounds like a lot to keep straight. But if you come to every 10-K armed with a pen, a pad of paper, a highlighter, and a calculator – it’s so much easier. When I see something out of the ordinary I just scrawl “Depreciating too fast?”, “Why did marketing expense double?”, “When was building bought?”, etc. right in the margin.
It is easy to miss the relevance of depreciation method, useful life, residual value, etc. in a depreciation footnote if you read it the way you would read a newspaper article, novel, etc. Most people read most things passively.
Read the 10-K actively.
A depreciation footnote takes on a whole new meaning when you are looking through the 10-K specifically making calculations based on questions you came up with yourself about depreciation. You now read it in the context that matters to you.
Here’s one other great piece of advice from How to Read a Book. Just read the whole thing straight through first. It’s amazing how few people read a 10-K twice. If you’ve ever seen a movie straight through twice – within the same week or so – you’ll realize you missed a lot the first time through. Popular movies are not made to be dense or difficult to understand. But I don’t think there’s anyone who can see even a very superficial seeming movie twice in the same week and not find something in the rewatch they missed the first time through.
Why?
Context. The best context in which to analyze something is to already be familiar with it. The first time …
Read moreHint: Read the Oldest 10-K
I recently mentioned something in an email that I’m not sure I’ve said before on this blog. I always read the newest and oldest 10-K for a company when I start analyzing it. Reading the oldest 10-K gives you perspective.
This little habit will make you a better investor.
EDGAR has 10-Ks going back to the mid 1990s. So, you’ll have the experience of reading a 2012 annual report and something like a 1996 annual report.
This always gives me added perspective on the business. And it gets my thinking about how the business has changed over time and how it will change in the future.…
Read moreJohn Byrne, Former GEICO CEO, Dies
The man who turned around GEICO died:
John Byrne, Geico CEO Buffett Cited for ‘Brilliance,’ Dies at 80…
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