How to Calculate Free Cash Flow – 5 Illustrated Examples From Actual 10-Ks

How to Come Up With Investing Ideas

A reader sent me this email:

Hi Geoff,

…I was wondering if there was any other advice you had on how to pick what companies I should look into. You mention a few blogs that I should look to for ideas but what about stock screens? Should I employ those in order to get a rough list of stocks and then choose a few and analyze them by reading their 10-K, etc.? I am just worried I am not sure how to get all the stocks to read their 10-K…

Best,
Phil

You won’t run out of ideas.

Start with one idea and follow that thread wherever it leads. Don’t obsess about any one stock. Just sketch the investment idea quickly in your mind. Does it grab you? No. Then move on.

You can use screens. I recommend Magic Formula Investing, GuruFocus, Morningstar, and RobotDough.

GuruFocus also has 2 newsletters for subscribers to the site. One is about Ben Graham NCAV bargains. The other is about Warren Buffett / Charlie Munger bargains.

Use Bloomberg to “watchlist” stocks. Whenever you find an interesting company, go to Bloomberg.com. Type the company name in the blank box in the upper right of the screen. It will give you the symbol (and exchange) of the stock you want. Click on that stock. To the right of the stock price, you’ll see an option that says “+ Add Security to your Watchlist”. Do that. You’ll need to create a Bloomberg.com account for this. It’s free.

The beauty of the watchlist is that Bloomberg tracks the stock’s percentage price move since you watchlisted it. Once a week, log into Bloomberg and just look at the stocks that are red. If the company was interesting when you first saw it, it’s even more interesting now that it’s cheaper.

Bloomberg is the best place to follow foreign stocks. So enter any names you get from reading Richard Beddard’s blog over there. Don’t try to track foreign stocks at sites like Yahoo and Google. Or at your American broker.

That brings me to another point. Pick the right broker. If you’re looking to invest like Benjamin Graham and Warren Buffett, don’t use Charles Schwab. Go with an online discount broker that does international and over the counter stocks well like Noble Trading or Interactive Brokers.

Here’s the big mistake most investors make. They refuse to follow their best ideas!

Right now, some people reading this thought: “Really? I have to switch brokers?”

Nutty, I know. But totally true.

Someone will hear about some little company that trades in New Zealand or Denmark and realize Morningstar, GuruFocus, EDGAR, etc. doesn’t have financial data on that stock. Or their broker won’t do a trade there. So they don’t follow up on the idea.

Never limit yourself because you can’t get data on the company. Screens limit you. Pretty soon you’re focusing only on screens that are running in just the universe …

Reed Hastings – CEO of Netflix (NFLX) – Responds to Whitney Tilson’s Short Case

Reed Hastings, the CEO of Netflix (NFLX), wrote a response to Whitney Tilson’s article on why he’s shorting Netflix at $180 a share.

I was working on an article about Tilson’s short position in Netflix for GuruFocus when I saw Reed Hastings’s response.

I’ll probably end up writing an article that talks about both their points.

I don’t short stocks. Never have. Probably never will. There are a few reasons for this. One, I’ve looked at value investors who do short – and in most cases – they could have done at least as well if they never shorted a single stock. That was certainly true for Benjamin Graham. It wasn’t worth the trouble.

And that’s point number two. There are some things I can do in investing that I don’t do simply because the trouble of doing them isn’t worth the reward they bring. Once in a very long while I arbitrage an all cash deal. So far, the success rate has been great. But I haven’t had much fun doing it. It’s an oddly unenjoyable experience, buying into something for a small profit and then following it through a minefield of problems till it comes out the other side. Even when it works, it just makes me want to curl up with the annual report of some quality company I can buy and hold for a bit.

There’s a little of that in why I don’t short. Maybe a lot. I’ve seen people short stocks. And what they go through isn’t something I want to go through.

I would never short Netflix. I think it’s an amazing company. I might be biased here since I’m a long-term customer. I’ve basically switched over to instant only – I keep a one DVD plan just so I have that option – but mostly I just watch instantly. And it’s amazing how it’s changed my life.

Amazon (AMZN) is the only other company that comes close. The way they both deal with their customers actually conditions their customers to behave differently. Netflix and Amazon have molded my habits in ways no other company has.

It’s hard to explain. But I know Netflix and Amazon are the two stickiest relationships I have as a customer. They will keep getting my money for a long, long time.

Hastings and Bezos are also the two businessmen that impress me most. That’s outside of the usual suspects – guys like Warren Buffett who are really just investors. I have to admit I’ve gone through the archives and watched both Hastings and Bezos on Charlie Rose.

A few years back, Netflix was trading pretty cheap. It was clearly a Charlie Munger bargain. But it wasn’t trading at a Ben Graham price. And, as you know, I don’t pay up for growth. I don’t pay up for quality. I’ll buy the best stuff that’s quantitatively cheap based on its past numbers and current assets. But I don’t like paying for tomorrow. So I didn’t buy …

Should You Learn Investing By Reading or Doing? – Geoff’s Advice to a College Junior

A reader sent me this email:

Hi Geoff,

I am a junior in college who only recently has stumbled upon the realm of value investing.  At this point, I have read Margin of Safety, You Can Be A Stock Market Genius, parts of The Intelligent Investor, and have recently begun Warren Buffett’s essays.  As a part of my schoolwork, I have taken basic courses in corporate finance, financial accounting, and capital markets.

What I am wondering is how I can best allocate the free time I devote to learning about investing in order to maximize its learning potential, as I am a busy college student now, and will hopefully be a busy employee in the future.  But far from not knowing where to turn, I am rather overwhelmed by the wealth of good resources there are out there concerning value investing, between books, articles, and blogs such as yours.

So my question is: what activity would best serve my education in investing right now, given my elementary exposure to the field?  I am under the impression from my research that the best way to learn about value investing is to do it.  However, value investing is a long and tedious process, involving a lot of searching and reading, often times about company-specific knowledge that in themselves don’t really teach much in terms of the art of investing.  Would it be more educational for me to simply pick good ideas from books and blogs and try to “reverse engineer” the thought process at this point?  Or have I gotten ahead of myself, and should read more classics / take more advanced courses in corporate finance before going further?

Best regards,
Vincent

Learn by doing.

Don’t worry about abstract theories. Start work on specific stocks. Steal someone else’s ideas and study those stocks. I wrote a post about four microcaps: Birner Dental Management Services (BDMS), George Risk Industries (RSKIA), Solitron Devices (SODI), and Bancinsurance (BCIS). Three of those four companies are still around.

Pick one of those three companies. Go to EDGAR and find their latest 10-K. Print it out.

Take the 10-K, a pen, a calculator, and a highlighter to the library. Highlight any phrases that sound worth remembering. Don’t overdo it. Be honest. Just highlight the stuff that sounds like it could swing you one way or another on buying the stock. A good way to do this is to imagine you’re running a conglomerate that is considering buying this business in its entirety. You’ve asked someone working for you to study the company and present the acquisition opportunity to you – in conversation, not a written report – tomorrow morning. What would you want him to highlight?

That’s what you highlight.

Use the pen to write notes in the margin. For me, these are usually questions or calculations.

Don’t take random notes. Follow a thread. Like an interviewer. Imagine the 10-K isn’t just written text but a real person sitting …

Sold My Barnes & Noble (BKS) Stock Today

I sold my Barnes & Noble (BKS) stock today. The average sale price was $14.82. I bought Barnes & Noble back in August at an average cost of $15.36 a share. In the meantime, I received $0.50 a share in dividends. The round trip was a loss of 4 cents a share – or 0.26% – while the S&P 500 was up more than 10%.

The reason I sold out of Barnes & Noble is to buy a stock I like better. Since I’m not done buying that stock – and it’s a lot less liquid than BKS – I won’t be telling you about the new stock today.

I’ll let you know the name when I’m done buying the stock.

But, for now, just know that I have sold out of Barnes & Noble.…

Tariq Ali of Street Capitalist Interviews Dave Carlson About Insurance Stocks

Tariq Ali of Street Capitalist has a great interview with Dave Carlson of Tourmaline Advisors about insurance stocks. You may remember, I interviewed Tariq a while back.

The interview is full of helpful advice, like when Tariq asked Dave what metrics investors should use to analyze insurance stocks:

Price to book and combined ratio are good starting points. Return on equity, underwriting leverage ratio and investments to equity are other metrics that I look at. On combined ratio, it is also useful to look at the difference between what is reported on a GAAP basis and what is reported on a statutory basis. The “stat” basis is more conservative than GAAP, it’s what the regulators look at, and is a better measure.

Dave mentions 3 insurance stocks: Penn Millers (PMIC), Donegal Group (DGICA), and Seabright Holdings (SBX).

He also talks a bit about Prem Watsa’s Fairfax Financial Holdings (FFH):

As for relying on investment income, yes, Fairfax does rely on it more than most. In their annual report, Prem Watsa mentions the net premiums written to statutory surplus ratio, a.k.a. the underwriting leverage ratio. The ratio at the end of 2009 was around 0.5 for Fairfax whereas most insurers are well over 1.0 and closer to 1.5. Watsa has purposely structured Fairfax so that the underwriting contributes less to results. That’s a good thing because it is a lousy business! This also means that the Fairfax insurance companies are overcapitalized relative to premiums written. Once they satisfy the regulatory/rating requirements for safe investments, they are free to invest the excess capital in things besides bonds. The Fairfax business plan comes straight from Buffett.

Read the full interview at Street Capitalist.

Talk to Geoff About Insurance Stocks…

ayback Machine Archive For Gannon On Investing: Geoff’s Posts From 2005-2008

Today I’m going to do something scary. I’m going to take you back in time. Way back.

Over at Gurufocus – where I spend most my time writing daily articles – someone asked about an old post I wrote. When I say old, I mean old. Real old. Like 5 years.

The first thing I ever wrote on the internet was on Christmas Eve 2005. This fellow was asking about a post I wrote just two weeks later. To show you how much my posts have changed – I was under the impression blogging meant tons of short, opinionated posts – here’s my January 2006 post “On Chicken Stocks”:

Chicken stocks were in the news yesterday as Pilgrim’s Pride warned of poor earnings. These stocks may appear cheap, but appearances can be deceiving. It is not a question of if margins will contract; it is a question of when margins will contract. Some value investors will take Pilgrim’s announcement as a buying opportunity. It may be just that.

However, I wouldn’t be buying Pilgrim’s Pride (PPC). When trouble comes, the much smaller, much more conservatively financed Sanderson Farms (SAFM) will be in the stronger position. Sanderson Farms has the better recent record when it comes to earning a good return on capital. On the other side of the scales, Sanderson Farms does trade at a higher price to sales ratio than Pilgrim’s Pride. In a business like this, price to sales can be an important number, because there is little reason to expect any one company to consistently maintain a wider profit margin than the rest of the industry.

I won’t pretend I understand this industry. I don’t. I won’t pretend I have any clue as to what these firms will earn over the next few years. I don’t. What I do know is that if I were looking at chicken stocks, I’d start with Sanderson Farms. I suggest you do the same.

You’ll notice there are no numbers in that post. Back then, I thought readers hated numbers. Do they? I’m still not sure. All I know is that I love writing numbers. So readers will have to take my posts with numbers mixed in or go find themselves another blog to read. You’ll also notice there are no dashes in the post. There’s even a semicolon. Maybe I was going through a Herman Melville stage. Yes, even my punctuation has changed. Half a decade of writing for the internet will do that.

Anyway, here is the Wayback Machine archive for Gannon On Investing. You can read my old posts and see all the things I got wrong. History is a harsh mistress.

Talk to Geoff About his Old Posts…

What Jobs Prepare You for Running a Value Fund? – Geoff’s Advice to a College Senior

A reader sent me this email:

I am currently a senior in college and well underway with my job search. I have, since grade school, been devoted to the works of those prominent within value investing…Since about the same time I have managed a personal portfolio geared toward their ideas. Ideally, I see myself within the next ten years starting a value-oriented hedge fund. The issue that I have been pressed with lately is what type of job to get now, knowing… managing people’s money through a fund is eventually what I want to be doing…do you have any perspective or advice in terms of the types of jobs that would better prepare me for eventually running my own fund?

It’s hard to know what experience will be worthwhile.

Graham started as a bond salesman. He was a terrible salesman. But he learned Lawrence Chamberlain’s bond book. You can read Graham’s early writings and see that all Graham really did was apply the ideas of bond investing to common stock investing. That was revolutionary. If Graham had learned stock investing the way it was practiced in his day, would he have taken the same revolutionary approach?

Probably not.

Peter Lynch was an analyst. That probably taught him how to run a fund his way. Lynch was big on meeting with management and finding the exact moment when a company’s fortunes were turning. That’s analyst stuff.

Charlie Munger was a lawyer. Michael Burry was a doctor. What does this tell us? Nothing really. The important thing is that at some point you get completely and totally focused on investing. What you did professionally – even if it was in finance – is often very secondary. It might be meaningless. A lot of investors learned more in their off hours than at their job.

But can you combine learning investing and a career?

You can certainly try.

Here’s how…

Find people you respect. Phil Fisher was not a value guy. Warren Buffett had a lot of respect for him. Try to work for someplace you think does what they do well.

My other advice is to choose someplace smaller and younger.

You can always go to a bigger place later. If you have a choice, pick someplace where they might actually let you do something. Go someplace where there’s more work than workers.

And then just stay in touch with all the value people you meet. Don’t just send me one email. Keep emailing me whenever you have an idea.

Write down the names of any bloggers, analysts, reporters, fund managers, anyone you come across that you respect. You like an insight of theirs or whatever. Write the name down and keep the name. Contact them. If you can make it about a specific stock and tell them something they don’t know, they’ll listen. Keep talking. Do the maximum amount of socially acceptable conversing about stocks.

Make it a rule to never say “no”. If someone asks you to do anything …

Tim Welland: 4 Great Investing Articles For You – From a Seeking Alpha Contributor

In an earlier post I said: “Feel free to send me anything you write. I’ll give you my thoughts. If it’s good – I’d be happy to share it on the blog.”

Well, Tim Welland – a contributor at Seeking Alpha – sent me 4 things he wrote. They’re all very good. So – like I said – I’m sharing them on the blog.

Obviously, you’re most interested in reading the articles to learn about the stocks Tim analyzes: Aerosonic (AIM), Hallwood (HWG), AmSurg (AMSG), and Air T (AIRT).

Should I buy? Should I sell? All that stuff.

Then go ahead and read them now:

Aerosonic: Rough Past, Bright Future

Hallwood Group: Compelling Valuation but Dangers Lurk

AmSurg: A Healing Investment

Why I’m Not Buying Air T (Right Now)

But for anyone reading this blog who happens to write their own investing blog – or is thinking about it – Tim’s articles are really good examples of really good investment writing. A lot of the stuff at Seeking Alpha – and elsewhere – is pretty weak. Very superficial.

I’ve been writing about Barnes & Noble (BKS) lately. You’re probably sick of hearing about it. Maybe you disagree with me. That’s fine. I don’t mind people disagreeing with me.

I do – however – mind a lot of the coverage of the Barnes & Noble story. When you’re doing investment writing you can’t just write from the top of your head. You can’t give us the same stuff everybody else gives us. You can’t say “my read of the market is…” without maybe, you know, citing some facts or figures. Or at least giving us a new line of analysis. Give us a new question to ask. A new stock to dig into. Give us something we can use.

Tim does that.

Each of these 4 articles is really, really good. And I’m not saying that because Tim was nice enough to read my blog and send me his articles. I’m saying it because part of what I do all day is read investment writing. And most of it is bad. Most of it is worse than bad. It’s financial furniture polish.

Honestly, I think we need more investment writing. And if you’re reading this blog and not doing some of your own writing, please consider it. We need you.

If you’re a terrible writer, I absolve you in advance. I’ve read investment articles by some pretty awful writers and I’ve enjoyed doing it. And I’ve read some investment articles by some pretty good writers and I’ve hated doing it.

So what is good investment writing?

Investment writing is thinking aloud.

All you have to do is write the way you think. Not the way writers write. Not the way you talk in real life. Just lay out your thoughts on the page. That’s it.

The tough part is the prep work.

More time goes into getting ready to write an investment article than the …

Bill Ackman Tells Borders (BGP) to Bid $16 a Share for Barnes & Noble (BKS)

Just wrote an article for GuruFocus, so you may want to read that first.

Bill Ackman – the hedge fund manager who runs Pershing Square – just filed a 13D with the SEC saying he wants Borders (BGP) to buy Barnes & Noble (BKS) for $16 a share. Ackman would provide the cash. Borders itself could never pull off this kind of deal. They are in much worse shape than Barnes & Noble.

These are the two biggest booksellers in the U.S. The third place player – Books-a-Million (BAMM) – is a very distant third. There are a couple interesting angles to this story. Obviously, as a Barnes & Noble shareholder I tend to focus on that side. Barnes & Noble is auctioning itself off right now. And Ackman’s offer will let us see if there are any other bidders. It will certainly encourage Riggio and Burkle to get off the fence.

If it looks like such a combination really was going to happen, it would also mean some soul searching for companies like Bertelsmann. Do we really want a single customer that big? Do we really want only two real retail paths – Barnes & Noble and Amazon – to our readers. And, of course, those two paths would be both print and digital.

I think we can say that if Borders merged with Barnes & Noble the idea of any serious e-reader other than Kindle and Nook is dead. I’m talking from the publisher’s perspective here. I’m sure we’ll see other devices. But as a realistic distribution system, it would only be Amazon and Barnes & Noble. It’s a scale business. And you need both the content and the relationship with the reader. I’m sure other folks will engineer e-readers of exquisite technical excellence. It won’t matter.

I have a gold coffee filter at home. I put a paper filter in it. Gold is pretty. Paper does the job I ask.

Anyway, this has me thinking about the likely and immediate scenarios and the less likely more long-term scenarios. Obviously, actually consummating a marriage between Borders and Barnes & Noble for $16 a share in cash is an unlikely and distant scenario. The immediate issues are the reactions from others at Borders and the reaction from Barnes & Noble. Barnes & Noble is tenuously controlled by Riggio – he had a narrow majority of the September vote and since then the stock price has gone down with a lot of Nook spending and little news on the buyout front.

There was also a report in the New York Post that Riggio wasn’t very interested in buying the whole company. If that’s true, coming out at the very beginning and making a big show of the fact that he might be a bidder is unlikely to have endeared him to the few outside shareholders who supported him.

And, obviously, if Barnes & Noble is in play, then basically no one has control of the company. You need …