How Does Warren Buffett Apply His Margin of Safety?

My Investing Checklist

Risks

1. Catastrophic Loss
2. Failure to Snowball

Numbers

1. Altman Z-Score
2. Piotroski F-Score
3. Free Cash Flow Margin
4. Return on Capital
5. Free Cash Flow Margin Variation
6. Return on Capital Variation
7. Enterprise Value/10-Year Real Free Cash Flow
8. Enterprise Value/10-Year Real Earnings Before Interest and Taxes
9. Price/Net Current Asset Value
10. Price/Tangible Book Value

Questions

1. Is it crazy cheap?
2. Has it been profitable for a long, long time?
3. Does it do the same thing year after year?
4. Are folks who use the service happy to leave some cash crumbs on the table?
5. Is the value the company provides intangible?
6. Will existing customers stay even if a competitor lowers its price?

Talk to Geoff About His Investing Checklist…

Stock Analysis Process – How Geoff Researches Stocks

Someone who reads the blog sent me this email:

I’m interested to know when you analyse a company, do you follow a particular order? Do you always start from a screen? Do you look at its overall business and competition landscape before diving into its financials? And when you look at its financials, do you follow a particular order? Do you look at its income statement first and then balance sheet?

I don’t have a particular order for finding a stock/company. I do screens and stuff like that. I read blogs. I look at company’s competitors. I just go through some foreign stock exchanges from A to Z. Or some states from A to Z. Or some industries from A to Z.

Basically, I’m looking through lists of companies the way I figure Warren Buffett flipped through Moody’s Manuals. I’m moving quickly to see if the company is really cheap compared to past earnings and current tangible assets and current sales. But I’m not doing any math, I’m just using websites like GuruFocus or Morningstar or MSN Money or the stock exchange sites, or the company’s 5-year or 10-year financial summaries. You can find something like that online for a lot of companies and then you quickly just run your eyes over those numbers. Are they pretty ordinary looking? If so, just move on. If something pops, stop and look at the stock.

If any number catches my eye – like a ton of excess cash, or low p/b, or low p/s, or low EV to past EBIT, FCF, etc. I look at the company description. Usually I’ll use Bloomberg for this or the company’s own website. What does the company say it does? If it says it invests in real estate, copper mining, is an investment bank, etc. I drop it there. If it says it does something I think I can visualize if I work real hard at it, then I keep going. I look for words like “niche”, “specialized”, etc. I look for business descriptions that sound non-capital intensive. Do you test or monitor or score or report? That’s good. Do you make capital goods? That’s bad. Do you make something cheap and repeat purchased, that’s good? Do you distribute? Good. Produce? Bad. Do revenues sound recurring? Are you a one of a kind company? A possible “hidden champion“?

This is all from the one paragraph description. Some are pretty inaccurate. But a lot aren’t. You get interested in Bunzl real fast when you read about it, because of what the business does. This is the Bloomberg description for Bunzl:

Bunzl plc is a distribution group supplying a range of non-food consumable products for customers to operate their businesses but which they do not actually sell. The Company partners with both suppliers and customers in providing outsourcing solutions and service oriented distribution. Bunzl’s main customer markets include grocery, foodservice, cleaning and safety.

Really, those are the only words I saw. They distribute. …

Why Don’t You Write About Spin-offs? – Why “You Can Be a Stock Market Genius” is So Great

A Different Perspective on Japanese Stocks

Someone who reads my blog sent me this email:

Geoff,

I came from Japan to US for business school in 2001. I became extremely intrigued by Buffett’s value investment philosophy. I wanted to read everything available about his philosophy and became more and more familiar with his investment philosophy. And I personally pick stocks too.

Anyway, about investment in Japan, I read your “Japanese stocks: Now 34% of My Portfolio – Plan to hold Them For At Least 1 Year“, I see one part in “Buy Japan“, you are talking about “Japan is barely a capitalist country.” I see that you see Japan pretty well. They care much less about generating profits to shareholders than people do here in US. I imagine, that US investors who invest in Japan would feel slighted. They should be the boss, but not in Japan actually.

Here is the key point why I wrote. You say “It’s definitely the most investor unfriendly place on the planet – excluding a few countries that seize private property”. In my view, Japan is a country that would seize private property away from you. Not by legitimate ways, but more subtle but practical ways. Who has the largest control over Japanese economy? The system of capitalism?  Absolutely no. Bureaucrats have. They have tremendous control over businesses with both explicit laws and implicit powers.

They have ways to drag down companies performance that they don’t like. If a business is strong enough and brave enough to openly fight against bureaucrats, like Softbank did in the past, there is chance to win. But most businesses are afraid of this structural, chronic bully that deprives Japan of economic flexibility over the years. But interesting thing to me is, this chronic inefficiency sometimes works well, but sometimes doesn’t. Like it worked in our 70s to 80s. But not in the later decades. My father always tells me that this is just like fascism that drove Japan in WWII all the way to final disaster. When it works well, we are invincible, but once the ship turns to a wrong way, we are unstoppable. Being said that, I wonder how, like you mentioned, pre-war southern states unraveled their woven bonds and connections and became part of the rest of the capitalism world. Losing the war changed their way of business life completely? Then, maybe Japan also needs dramatic change like that.

In my view, the Japanese have strong fear of sticking out. If you stay in a crowd, you are invisible and no one would say anything. But if you stick out too much, bureaucrats will get you. Rising stars in business are always the easiest to go after for bureaucrats who are influenced by competitors. In US capitalism holds the power. This is the rule of the game and it seems that even the government cannot defy this rule. In Japan, bureaucrats rule the market most definitely.

And most obviously, this system is not working for

Japanese Stocks: Now 34% of My Portfolio – Plan to Hold Them For At Least 1 Year

Just a quick update on Japanese stocks.

A while back I wrote a post entitled “Buy Japan”. A little later, I put out a report on 15 Japanese net-nets.

Some readers are curious about whether I’ve been putting my money where my mouth is.

Yes. Over the last couple weeks, I’ve been buying some of the smallest, most obscure – and least liquid (that’s why it’s taken weeks) – Japanese stocks.

So far, I’ve put 34% of my portfolio into a total of 4 Japanese micro cap stocks. There’s a fifth Japanese stock I’d like to buy. I’m willing to put 10% into it. If I get that order filled, I’ll have about 45% of my portfolio in Japan.

No. I’m not revealing which Japanese stocks I bought. Over the last couple weeks, I’ve been buying most of the volume of these stocks. They don’t trade much. So I have to be very patient. And very quiet.

All 4 stocks had negative enterprise values. In fact, I got my shares in each of the 4 stocks for less than 60% of net cash. Over the last 10 years, 3 of the 4 stocks had no losing years. One of the 4 stocks had an operating loss exactly 10 years ago. None had any losses in the last 9 years. And 3 of the 4 stocks were bought at less than 10 times normal after-tax earnings. All pay dividends.

Despite my feeling that the Yen could be overvalued against the dollar by as much as 25%, I decided not to hedge the currency.

All my other assets are in U.S. dollars. And I have no view about inflation in the United States. So having anywhere from a third to half of my assets in another currency isn’t the worst form of diversification.

I’ll hold my 4 Japanese micro caps for a little over a year. I plan to re-evaluate them in July 2012. I don’t know enough about Japan to evaluate their business performance in between.

I think it’s probably better to impose a trading ban on myself for a full year so I’m not tempted to sell based on headlines. I didn’t buy these stocks because of headlines. I bought them because they are the cheapest stocks I’ve ever seen. It would be a mistake to sell on news what I bought purely on price.

If any fat pitches come along they’ll have to be funded through sales of the 50% of my portfolio in U.S. stocks (which is actually only 2 stocks).

Right now, having more ideas than money is definitely not my problem. There are almost no good net-nets in the U.S. I mean literally almost zero decent net-nets. Don’t believe me? Ask Jon Heller.

But nothing lasts forever. One day, American net-nets will return.

Until then, at least we have Tokyo.…

Berkshire Hathaway’s David Sokol Resigns

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 …