Blind Stock Valuation #3

A company Quan has talked about a lot lately – DreamWorks Animation (DWA) – has a movie out called Madagascar 3: Europe’s Most Wanted. I’ve also chosen Europe as the setting for the third installment of my little series.

One of my favorite blogs, Distressed Debt Investing, recently mentioned the idea of blind stock valuations. I’ve posted two of these practice exercises in the past.

They turned out to be – spoilers ahead – Waltington Waterworks and Wal-Mart circa 1981.

I employed a little trickery in both cases. I figured no one reading the blog would know Watlington Waterworks (it only serves the island of Bermuda). And I figured most people would not recognize Wal-Mart’s record from the 1970s as long as I renumbered the years so it looked like the company achieved that growth record in the 2000s.

I haven’t done anything sneaky this time. The numbers shown here have not been tampered with. I have changed no dates. I haven’t multiplied the numbers by ten, divided by ten, etc. Click the table to make it bigger:

This company uses debt. So, I’m not looking for a per share intrinsic value estimate here.

Just tell me what you think the enterprise value is. Or – if you’re feeling particularly adventurous – try to guess both the market cap and the amount of debt.

While this isn’t a blue chip name – especially for American investors – it is a stock some people reading the blog know. I’ve even mentioned this stock’s name in the past.

So some of you can easily identify the stock if you want to. Resist the urge. And try your best to value the stock blind.

I’ll tell everybody the stock’s name next week.

That’s also when I’ll share a few of my favorite emails attempting to value the stock.…

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If Dividends Don’t Matter – What Does?

Geoff here.

There’s a good blog post over at The Interactive Investor Blog by Richard Beddard. It talks about how divdends are both everything and nothing in investing.

 

Dividends, Value, and Growth Can all Be Sources of Long-Term Returns

The point is that you don’t need to get a return on your investment from dividends. You can get it from someone else – in the form of capital gains – when you sell the stock. You can get it from the company directly – in the form of dividends – when they pay you cash.

For me, there are two extreme views of how investors make money in stocks.

 

The Pure Value Approach

You buy a stock at a discount to its value and expect to sell it when the stock price reaches that static intrinsic value sometime in the future. Your return is therefore the compound annual rate required to close the gap between price and value over the time you hold the stock.

Illustration: You pay a third of what a stock is worth today. Intrinsic value stays the same. Over the next 15 years, the stock price rises to meet intrinsic value. You sell. And make 7.6% a year over 15 years.

 

The Pure Growth Approach

You buy a stock and expect to sell it sometime in the future. The stock has a dynamic intrinsic value. So you hope it will be worth more in the future than it is today. Your return comes from the interaction of the price-to-value ratio you paid today and the intrinsic value growth over the time you own the stock.

Illustration: You pay three times what a stock is worth today. It grows intrinsic value 20% a year for the next 15 years. You sell. And make 11.5% a year over 15 years.

It’s worth mentioning that the item of interest to most academics, society at large, etc. should be the pure growth approach. The value approach is of most interest to practitioners. The entire investing public can benefit from holding growing companies. They can’t benefit (together) from buying businesses at one-third of their value. We can.

These are pure approaches.

Where you buy a stock at a deep discount to its value, the company’s growth can be very poor – and you can still make money.

And when you buy a stock with very fast growth, the price you pay can be very high – and you can still make money.

Most investments fall in between. Value and growth both matter. If instead of getting a stock at one-third of its intrinsic value, a value investor buys a stock at four-fifths – he now has to worry a lot about growth.

Likewise, if a growth investor buys a stock growing 10% a year instead of 20% a year – he now has to be very careful about the price he pays for the stock.

How do we deal with stocks that fall in this gray area? They …

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How to Become a Better Analyst – One Hour at a Time

Geoff here.

Over at Portfolio14, there is a good question about spending time researching new stocks as opposed to just adding to the same old positions:

Charlie Munger always says diversification is diworsification. My dilemma here is whether I should diversify in order to reduce my exposure to one single company. No matter how high my conviction is, there are always “unknown unknowns”. There is also this unhelpful thought urging me to divest: “Earning outstanding returns requires hardwork. If I keep on adding to just the same old position and not spending time to dig deep into other companies, I’m not working hard enough.”

(Portfolio14) 

This is a great question to ponder. On the one hand, I agree that diversification often leads to diworsification. On the other hand, it is important to practice, practice, practice:

A little over a year ago, Geoff Gannon wrote a post where he gave readers the salient financial information of company, but didn’t give the ticker/name of the company. He then had readers guess the stock price. It was an amazing little experiment derived from a quote of Warren Buffett where WEB goes on to say he likes to guess the stock price before looking at the actual price when he analyzes investments.

As always, WEB was well ahead of his time. Much work and study from behavioral finance/economics, like that of Daniel Kahneman, discusses the effects anchoring has on each of us. If we see a stock price before valuing the company, we will unconsciously fix our valuation near the actual price.

Ever since Geoff’s original post I have been fascinated by the experiment. I even went as far as making an Excel program that would randomly generate ticker from the Russell 3000, display the financial information with ticker and price hidden. I could then go about valuing the company and check my work to see how I was doing.

(Distressed Debt Investing)

What’s the solution here?

 

Be Focused in Your Buying – But Omnivorous in Your Research

Should you buy a lot of different stocks? Analyze a lot of different stocks but don’t buy them? Or take the Peter Lynch approach and buy tiny amounts of many stocks just to keep them on your radar – then only load up on the ones you really love?

It’s a tricky question. To gain experience you need to do something similar over and over again. But it can’t be exactly the same. Otherwise, you will become experienced just at that one task. If you become an expert at analyzing Microsoft (MSFT) – you will know how to analyze Microsoft, not how to analyze stocks generally.

 

Use Real World Examples to Master Abstract Concepts

There’s another complicated issue that has to do with patterns.

I think two of the surest signs of real mastery of a subject are:

• Ability to talk fluently about the subject in everyday language without use of jargon; ability to use short sentences; having

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Why I Concentrate on Clear Favorites and Soggy Cigar Butts

Geoff here.

The choice between concentration and diversification is a personal decision. But it is also a process decision.

There is nothing wrong with having 50 positions – if you can do that well – or 20, or 10.

I think people fool themselves into thinking they need to have 25 or 50 ideas. But there is nothing wrong with choosing to have that many.

 

Our Investing Heroes Thought Longer and Traded Slower – Check Their Turnover

Ben Graham and Walter Schloss both owned more than 50 stocks for most of their careers.

However, they turned their portfolios over much less frequently than people do today. So, even when operating at what was for them a frentic pace, they were still probably only adding one new position a month. Certainly not much faster than that. And sometimes much, much slower.

I think there is a limit to how many amazing decisions you can make in a month, a year, etc.

Running a portfolio in a way that requires a good idea every couple weeks is far beyond my abilities.

 

Limit the Number of Good Ideas Required – Not Necessarily the Number of Stocks Owned

But there are many ways to solve that problem. You can increase concentration. You can increase how long you hold a stock. Or you can buy entire groups of stocks at once. Buying a group of stocks sometimes qualifies as a single decision. I bought 5 Japanese net-nets at once, because I did not know enough about Japanese business to discriminate between Japanese companies that were both:

1. Profitable
2. Selling for less than their net cash

So I just bought up 5 such stocks at once. That was my way of making really just one big decision – going more than 40% into Japanese net-nets – without actually having to put 40% or 20% or something into a single Japanese stock.

There was no Japanese stock I felt comfortable putting 20% of my portfolio into. And I did not know how to get comfortable doing that – having never visited Japan and not being able to speak Japanese.

Language was actually the least of my problems investing in Japan. The divide in business culture between Japan and the United States was my biggest problem.

Sometimes, this can be a big issue in Europe as well. Especially when analyzing some companies in southern European countries.

 

There are Little Exceptions Hiding Everywhere – Europe, Asia, the Midwest

But it is best not to paint countries with too broad a brush.

I think a foreign investor’s image of American business includes stock analysts, earnings calls, and press releases. But there are thousands of public American companies – often far from either New York of Los Angeles – that are as tight lipped as any company you’ll find in less bombastic parts of the world.

I have found Japanese companies with the kind of business culture an American can understand and I have found Portuguese companies with the …

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One Good Idea a Year is All You Need to Beat the Market

Geoff here.

Someone who reads the blog asked me a question about why I don’t just use Joel Greenblatt’s Magic Formula to invest instead of picking my own stocks.

This lead to a discussion of what kind of results you can achieve picking your own stocks.

It’s a question closely related to portfolio concentration. I’ve never figured out how to perform well while holding a lot of stocks. When I’ve outperformed the market, that outperformance has really boiled down to just a few decisions.

Over the last 3 years, I’ve averaged less than one such performance powering investment.

 

The Power of One Good Idea a Year

I started managing a new account in January of 2009. That’s close to the perfect timing imaginable for having good returns. So these numbers are wildly inflated over what anyone can expect in the future.

Because it’s a single account, I have exact results for each year. Here are my returns:

2009: 41%

2010: 33%

2011: 21%

YTD: 0%

You can see I’m underperforming the S&P 500 this year.

The average number of stocks I’ve held has been about 5. The highest I ever owned at once was 11 – and that included some positions that never reached the size I wanted. My lowest number of positions at one time was 1, but that was when the majority of the account was in cash.

My outperformance was driven entirely by a few major successes:

1. IMS Health
2. Bancinsurance
3. Sanjo Machine Works (and Japanese net-nets generally)

 

IMS Health

IMS Health was a fairly large – over $1 billion market cap – stock with a wide moat. It was selling for less than 10 times free cash flow when I first bought it. Eventually, it was bought out by a private equity firm.

 

Bancinsurance

Bancinsurance was a niche property and casualty insurance company. It usually had a combined ratio under 100. Meaning it made a profit on underwriting. Not just on its investments. It was selling at about 60% of book value when I first bought it. Eventually, the CEO bought it out.

 

Sanjo Machine Works

Sanjo Machine Works was a Japanese company. I first bought it around 50% of its cash.  Eventually, the CEO bought it out.

 

Japanese Net-Nets (Generally)

My Japanese net-net investments were a departure for me in that I diversified across 5 stocks at once. They did better in Japanese Yen than I ended up doing because the Yen fell against the dollar. They still did fine. Sanjo was the star performer. The rest had modest positive results in dollar terms.

 

3 Years of Outperformance Really Just Due to 3 Decisions

I made other investments over the last 3 and a half years. But very few of them mattered. There were no big losses. Many of the other investments slightly outperformed or slightly underperformed the market while I owned them. But, together, they were pretty much a wash relative to the stock market.

So, my entire outperformance …

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Some Links You’ll Like

Geoff here.

I started this blog on Christmas Eve 2005. Back then, I used to link to things. I’d tell readers what interesting blogs were out there, etc.

I haven’t done that much lately. Mostly because of Twitter. If you aren’t following me on Twitter – you aren’t seeing links to the stuff I’m reading.

But sometimes a few interesting links pile up at once and I decide it’s worth mentioning them on the blog – not just on Twitter.

Today is one of those times.

 

Practice Truth, Fear Nothing – A Wall of Great Value Investing Posters

The creator of this site – Practice Truth, Fear Nothing – sent me a link to his “wall” of value investing and creative thinking/advertising. He’s in the advertising business. You may or may not like the stuff that applies to advertising. You’ll love that stuff that applies to value investing. Check it out.

 

Market Folly: Top Finance People to Follow on Twitter

Market Folly is a blog I always read. And I don’t talk about it enough on this site. If you follow me on Twitter, you know I read it. But if you just read this blog – you’d probably never know I read Market Folly.

Hopefully, this will change that. Twitter is a great resource for seeing what other value investors, bloggers, etc. are reading. Whenever I Tweet, there’s a link. I use it mostly to share reading material.

You can get a lot out of using Twitter for your investing. And you can start by following the folks on Market Folly’s list.

 

Interactive Investor Blog: A Must Read Blog Getting Even Better

I read Market Folly all the time. But I rarely talk about it on this blog. No idea why. I read Richard Beddard’s blog all the time. And I do talk about it on this blog. Again, no idea why one gets mentioned here all the time and the other doesn’t.

I hadn’t given it much thought until writing this post – when I thought about all the people who read this blog but don’t follow me on Twitter.

Anyway, Richard’s blog has been great for years. And I’ve been reading it for years. So I feel kind of silly recommending it over and over again.

That’s changed in the last year or so. Richard’s blog has been getting even better. One of my favorite features is Richard’s two minute drills. These are based on advice Peter Lynch gave.

Peter Lynch is underappreciated by value investors. Maybe his name is too well known or something. Maybe his advice is too simple. I don’t know. The guy always made sense to me.

Like Warren Buffett, Peter Lynch was especially good at thinking about how to think about stocks. He was good at knowing that it wasn’t enough to have the most info – you had to act right on the info you had.

Lynch was always really quick …

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Who is this Quan Hoang Guy? – And Why Is He on My Blog?

Someone who reads the blog sent me this email:

Geoff,

Who is this Quan Hoang guy? And why is he in your blog!!!!

Regards,

Gurpreet

Quan Hoang is someone I’ve emailed with since March 2011. So, well over a year now. He was a college student then. When I moved to Texas, Quan wanted to move out here and work with me.

Now, we get together each day and write. I will be blogging every day. And Quan will be writing too. So, you’ll see 2 posts a day at the blog.

The blog will be much more active than usual.

I think you’ll like it.

If you want to get to know Quan better, you can:

• Follow Quan on Twitter
• Talk to Quan

He’ll be a permanent fixture at Gannon On Investing. Which – you may have noticed – has been renamed Gannon (and Hoang) On Investing.…

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How Western Digital (WDC) Can Be a Good Investment – Even When It’s Not a Net-Net

Geoff once expressed a controversial opinion that he would only buy Western Digital (WDC) as a net-net. I totally agree with him. I consider buying WDC as one of the mistakes I made during the period that I formed my investment style. But defending his opinion is not the purpose of this post. On the contrary, I think WDC can be a good investment. So, I’m going to ponder over my mistake and talk about what changed my mind.

I bought Western Digital in September 2010 at $26. Without a full understanding of its margin of safety, I bought WDC for these reasons:

 

• Return on invested capital was always high, even in 2009.
• WDC is the best managed company in the industry.It has a more stable margin than its competitors.
• WDC had steadily grown market share while maintaining high profitability in an extremely competitive market. And became market leader soon after my purchase.
• P/E ratio was low and I thought Mr. Market’s view  would turn once  supply and demand balanced.
• I thought the iPad and other mobile devices are complementary goods, not substitute goods to the PC.
• I thought it would take a long time for solid-state hard drives to replace hard disk drives (HDDs), and WDC would have time to catch up with the first comers.

 

Another reason I bought WDC was its better financial position than Seagate (STX), which I bought later after a LBO rumor (another mistake!). I actually made 40% and 25% from WDC and STX, respectively, but those are my biggest mistakes. Why?

 

Buying The Right Stock is Not Enough – You Have to Hold It Too

Holding WDC and STX was stressful.

I waited for the balance between supply and demand. But then the earthquake in Japan disrupted the supply chain that affected PC sales.

Then data proved that I was wrong about mobile devices. Mobile devices did hurt PC sales. Lesson: don’t ever bet on something uncertain. You can be either right or wrong. I was wrong in this case. Perhaps a diversified portfolio of stocks with higher upside (when we are right) than downside (when we are wrong) will perform well but I think holding such a portfolio is too hard for most humans.

And a bigger problem. A lot of WDC’s assets are tangible assets, which has little use other than producing HDDs. With the condition at the time I bought, WDC  could have been undervalued but what if HDDs became obsolete by the time the stock price returned to intrinsic value? Its plants would become useless. Its past earnings would be meaningless. That’s why buying WDC at lower than net current asset value can provides a margin of safety. I’m not sure buying at a low P/E will.

A more simple risk, what if something bad happens to the plants? Then came the Thai flood which severely interrupted WDC’s operation. I was right about buying WDC as a cyclical. Earnings did increase by double digits. But …

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One Ratio to Rule Them All: EV/EBITDA

For understanding a business rather than a corporate structure – EV/EBITDA is probably my favorite price ratio.

 

Why EV/EBITDA Is the Worst Price Ratio Except For All the Others

Obviously, you need to consider all other factors like how much of EBITDA actually becomes free cash flow, etc.

But I do not think reported net income is that useful. And free cash flow is complicated. At a mature business it will tell you everything you need to know. At a fast growing company, it will not tell you much of anything.

As for the idea of maintenance cap-ex – I have never felt I have any special insights into what that number is apart from what is shown in actual capital spending and depreciation expense.

When looking at something like:

• Dun & Bradstreet (DNB)
• Omnicom (OMC)
• Carbo Ceramics (CRR)

I definitely do take note of the fact they trade around 8x EBITDA – and I think that is not where a really good business should trade. It’s where a run of the mill business should trade.

I guess you could get that from the P/E ratio. But when you look at very low P/E stocks – like very low P/B stocks – you’re often looking at stocks with unusually high leverage. And this distorts the P/E situation.

 

Which Ratio You Use Matters Most When It Disagrees With the P/E Ratio

The P/E ratio also punishes companies that don’t use leverage.

Bloomberg says J&J Snack Foods (JJSF) has a P/E ratio of 21. And an EV/EBITDA ratio of 8. Meanwhile, Campbell Soup (CPB) has a P/E of 13 and EV/EBITDA of 8. One of them has some net cash. The other has some net debt. J&J is run with about as much cash on hand as total liabilities.

They can do that because the founder is still in charge. But if Campbell Soup thinks it can run its business with debt equal to 2 times operating income – then if someone like Campbell Soup buys J&J, aren’t they going to figure they can add another $160 million in debt. And use that $110 million in cash someplace else.

And doesn’t that mean J&J is cheaper to a strategic buyer than its P/E ratio suggests.

That only deals with the “EV” part. What about the EBITDA part? Why not EBIT?

 

Don’t Assume Accountants See Amortization the Way You Do

The “DA” part of a company’s financial statements is usually the most suspect. It’s the most likely to disguise interesting, odd situations.

Look at Birner Dental Management Services (BDMS). The P/E is 21. Which is interesting because the dividend yield is 5.2%. That means the stock is trading at 19 times its dividend (1/0.052 = 19.23) and 21 times its earnings. In other words, the dividend per share is higher than earnings per share. Is this a one-time thing?

No. The company is always amortizing past acquisitions. So, the EV/EBITDA of 8 is probably a more honest gauge of …

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Best Place to Run Screens: StockScreen123 – Bloomberg.com Underrated

Someone who reads the blog sent me this email:

Geoff – 

Nice article on EV/EBITDA – no qualms here. I’m curious, however, where you run your screens? Being the cheap bastard that I am, I don’t subscribe to any specific data sites, so I’ve typically begun with google finance, which isn’t very helpful when it comes to non-GAAP criteria.

Thanks,

Jay

 

StockScreen123 is the Best Place to Run Screens – But It Takes Time to Learn

The best place to run screens – for the price – is StockScreen123. It is not user friendly. You need to read about how the functions work, etc. and experiment a bit. But it’s the best site by far.

I highly recommend it.

For U.K. stocks I use Sharelockholmes.

For worldwide, I don’t have a good (cheap) solution. A lot of people use the FT screener.

 

Bloomberg.com is Actually a Super Handy Site – If You Know What It’s Best At 

Blommberg’s (free) website has great coverage of just about every stock on planet Earth. They don’t have much data. But if you type in a public company name – that trades anywhere in the world – you’ll get basic info like EV/EBITDA.

Here are some obscure examples to prove my point:

• Precia (PREC:FP) 
• Otec (1736)
• Paradise (PARF)
• Watlington Waterworks (WWW:BH)

If they’ve got those companies – they’ve got everything.

So Bloomberg is a great resource when you know a company’s name but you aren’t sure whether it’s public or private, where it trades, etc.

I often start my stock research at Bloomberg.…

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