On Shareholder Wealth

Bill of Absolutely No DooDahs, wrote this comment in response to my earlier post Google Price Target: $16,578.90:

Other than getting paid dividends, how does one extract wealth from a company one holds shares of?

Call me a cynic (I’ve been called worse), but with the exception of divs, what investors get from buying stocks is selling them at a higher price … meaning that we are not really extracting wealth from anyone except the buyer …

Here is my response:

I think the two of us may have encountered this difference of perspective before. So, you may disagree with some of what follows.

You do not extract cash from anyone but the buyer; however, the value of the security is derived from the value of the business you have an ownership interest in. A common stock represents an ownership interest, not merely a right to receive cash distributions. The fact that cash has not been distributed to the security holder does not mean that the holder’s wealth has not increased. Most public companies are primarily engaged in creating wealth through reinvestment in the business, not through distributing cash to shareholders. Some owners may do better than others in buying and selling their ownership interest; however, owners in the aggregate will only do as well as the underlying business.

I disagree with the idea that owners only extract wealth from the buyer. Although legally there is a separation between a corporation and its owners; economically, a corporation has no wealth that doesn’t belong to its owners. Owner’s earnings (whether distributed or retained) are wealth. Cash is extracted in the form of dividends. One form of wealth is converted into another (cash) at the time of the sale of the common stock. However, the owner’s wealth increases at the time the business earns the money (i.e., increases it net worth) not at the time of the sale. The stock sale does not create the wealth – it merely converts an undivided interest in the corporate assets into cash. Some of our laws (and accounting practices) may obscure this fact.

Although we (almost always) dispose of our ownership interests in corporations by selling them in the open market; they are more than mere pieces of paper that can be sold for ever higher amounts. Ultimately, shareholders have control over the assets of the business. They may choose to dispose of them (or encumber them) as they see fit. Distinct assets may be separated from the business as a going concern. Sale of the common stock is not the only way to transfer wealth into cash.

If your point is that to obtain cash a shareholder must either receive cash thrown off by the assets (i.e., dividends) or sell his interest in the assets, I agree. However, I think that’s true of the ownership of all assets.

If I want cash for any of my property, I must either sell the asset or collect a rent. In …

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On Some Lessons From Buffett’s Annual Letter

Warren Buffett’s annual letter to Berkshire Hathaway (BRK) shareholders was released over the weekend. Readers will find plenty of investing lessons among the twenty-three pages. Warren began this letter as he begins each letter, by stating Berkshire’s change in per-share book value:

Our gain in net worth during 2005 was $5.6 billion, which increased the per-share book value of both our Class A and Class B stock by 6.4%. Over the last 41 years, (that is, since present management took over) book value has grown from $19 to $59,377, a rate of 21.5% compounded annually.

Some may wonder why Buffett opens by announcing the change in per-share book value rather than the earnings per share number. Over long periods of time, the change in per-share book value should nicely approximate the returns to owners. You may remember that, in my analysis of Energizer Holdings, I applauded the company for reporting comprehensive income within the income statement. Although a company’s net income is often referred to as its bottom line, net income is, in fact, a (sub)component of comprehensive income. Energizer Holdings (ENR) literally reports comprehensive income as its bottom line.

FASB merely requires that “an enterprise shall display total comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements that constitute a full set of financial statements”. Unfortunately, despite the lack of attention paid to it by investors, the statement of changes in stockholders’ equity is considered “a financial statement that constitutes a full set of financial statements”.

Therefore, comprehensive income can be reported in a statement many investors either do not review or do not understand. Alternatively, a company may choose to report comprehensive income in a separate Statement of Comprehensive Income. This, of course, baffles many investors, who think they are reading a second copy of the income statement. After all, what is comprehensive income? Isn’t the net income number reported in a (traditional) income statement a comprehensive number?

No. The widely reported earnings per share number is not comprehensive. That isn’t to say the EPS number isn’t important. It is very important. In fact, for certain businesses, it may be the most useful figure for evaluating a going concern. This is especially true if the investor is only looking at the financials for a single year. A single year’s comprehensive income may actually be less representative of a business’ performance than a single year’s EPS number (both can be pretty unrepresentative).Remember, the earnings per share number does not tell you how much wealth was actually created (or destroyed). You need to look to the comprehensive income number to find that information.

Essentially, Buffett is reporting Berkshire’s earnings in that opening line. He is simply using a more comprehensive income figure. He’s saying here’s how much wealth we created, and here’s how much capital it took to create that wealth. When he writes “Our gain in net worth during 2006 was $5.6 billion, which …

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Suggested Link: Enough Whining For “Guidance”

Nearly all the investment pundits are blaming the recent decline in Google’s share price on the company’s refusal to provide guidance. But, one very familiar name isn’t. Today, former Wall Street internet analyst Henry Blodget writes: “I respect Google for not giving guidance, a practice that often reduces analysts to Excel-savvy parrots.”

Google (GOOG) has been mentioned surprisingly often on this blog, considering its lofty price. But, I don’t believe I’ve ever mentioned Henry Blodget before – and until today, I thought I never would. However, I find myself in complete agreement with the author of Internet Outsider.

I would love to write about other things besides Google, because it’s not a topic that’s likely to help you make a good investment. Later today, I will post an analysis of Pacific Sunwear (PSUN), a much better bet for investors, and a stock that’s more in keeping with my own value investing proclivities. However, I just couldn’t let the Google gaffe pass without writing anything about it.

Many of you already know the facts. If you don’t know them, I’m really not the one to tell you; I don’t pay much attention to Google and I don’t pay any attention to communications with analysts. So, for those that don’t know the facts, just Google “Google gaffe”.

I’m suggesting this link to Mr. Blodget’s post, because I reached the tipping point this morning, when I heard one analyst say a public company has a duty to instill confidence among investors. I’m paraphrasing here, I doubt he used the word “instill”. But, one hopes that confidence is the sort of thing that can only be earned gradually; so, instill would be the right word.

Obviously, I believe no such duty exists. Managers are not (or at least ought not to be) responsible for marketing shares. They have no duty to ensure a current owner rips off a future owner by dumping his shares at the highest price.A good management has the same two primary duties as a good agent.

Management has a duty to act on behalf of owners in exercising delegated powers (primarily those required for day-to-day business operations) and a duty to report back on its activities. Management does not have any duty to facilitate sales of stock on advantageous terms. Now, you could argue that the issue of confidence is larger than I’m making it out to be – that it goes beyond simply keeping the stock price up. However, I haven’t yet heard anyone argue that there is a lack of confidence among anyone but investors. In fact, this issue has nothing to do with Google’s business, which is management’s responsibility. The selling of shares is the investor’s responsibility.

I submitted this link to Fat Pitch News. So, if you like Mr. Blodget’s post, please bid it up over at Fat Pitch News so others will get a chance to read it as well (if enough people vote for the link, it will …

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Google Price Target: $16,578.90

Regular readers of this blog will immediately recognize this headline is a joke. For the rest of you, I was kind of hoping the ninety cents part would give it away.

If you’re reading this because you’re interested in what I have to say about Google (GOOG), you can stop now. I’m not going to say anything interesting about Google. Rather, I’m going to say something (that I hope is) very interesting about the wonders of compounding.

Warren Buffett’s annual letter to shareholders was released today; I’ll write a lot more about it tomorrow. For now, I’m just going to pull out one little nugget:

Between December 31, 1899 and December 31, 1999, to give a really long-term example, the Dow rose from 66 to 11,497 (Guess what annual growth rate is required to produce this result; the surprising answer is at the end of this section.)

I knew what Warren was up to, and had some idea of the historical growth rate for the Dow, so I guessed 6%.

Here’s the answer to the question posted at the beginning of this section: To get very specific the Dow increased from 65.73 to 11,497.12 in the 20th century, and that amounts to a gain of 5.3% compounded annually. (Investors would also have received dividends, of course). To achieve an equal rate of gain in the 21st century, the Dow will have to rise by December 31, 2099 to – brace yourself – precisely 2,011,011.23. But I’m willing to settle for 2,000,000; six years into this century, the Dow has gained not at all.

I wish I could tell you that my guess was close. But, it wasn’t even in the right ballpark. The difference between a 5.3% annual gain and a 6% annual gain may look relatively small. In fact, the difference is not small. If, during the 20th century, the Dow had achieved a gain of 6% compounded annually rather than a gain of 5.3% compounded annually, on the eve of Y2K, the index would have been sitting at 22,302.33.

The rallying cry of the bubble years would have been Dow 20,000. And what of Dow 10,000? The index would have added its fifth figure in 1987. That’s right, if the Dow had achieved a gain of 6% compounded annually during the 20th century, the index would have broken the 10,000 mark while the Berlin Wall was still standing.

Over a century, that extra 0.7% really adds up. I recently wrote an email to a member of my family who had just had her first child. You would think that blathering on as I do here each day, I would have a sea of investing advice to offer. In fact, I provided only a single drop: Time trumps money.

If you want to have more money than you will ever need, your best bet is to find a few places where you can deploy large sums of money that will earn good returns for …

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News Item: Pacific Sunwear

On Wednesday, shares of mall based specialty retailer Pacific Sunwear (PSUN), the company that operates PacSun stores, fell sharply on news that sales for the quarter were about $2.5 million less than analysts had expected. The earnings per share number matched analyst estimates.

Pacific Sunwear’s same store sales fell by 3.1% in February. Analysts expected a rise of 1.4% in same store sales. Generally speaking, teen retailers reported poorer same store sales in February than Wall Street had expected. Of course, Pacific Sunwear did not simply fail to grow same store sales as quickly as expected; the company actually saw same store sales decline for the month.

Pacific Sunwear now trades at about fourteen times earnings. The company has long been the one teen retailer I would like to own – at the right price. At today’s price, PSUN is the best bargain among well known American retailers. Expect a more detailed discussion of the company within the next few days.

Note: When discussing Pacific Sunwear (PSUN), all uses of the term “Pacific Sunwear” will be references to the company; all uses of the term “PacSun” will be references to the skate and surf themed chain. This practice is intended to avoid confusion as to whether a particular statement applies to the PacSun chain alone or to the PacSun, d.e.m.o., (and soon) One Thousand Steps chains collectively.…

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Suggested Link: Fat Pitch News

Some of you may have noticed a recent addition to the Gannon On Investing site. On the right side of your screen, you will see a “News” box subtitled “Fat Pitch News”. Within that box, you will find the top five value investing headlines courtesy of Fat Pitch News. These are clickable links that will take you to the brand new Fat Pitch News. From there, you can click on the headline (in the green header) and be taken directly to the story.

I’m really excited about Fat Pitch News. It’s a great opportunity for value investing blog readers and value investing bloggers alike. The service will only be as good as those who frequent it. The easiest way to support (and enjoy) Fat Pitch News is simply to check out the submitted links and vote for those you like best.

Of course, there is another way you can help. If you really want to do a great service for your fellow blog readers, you can submit any interesting links you run across. As more stories are submitted to Fat Pitch News and more votes are cast for those stories, the service will improve dramatically. Fat Pitch News will be a tailor made financial daily of sorts. Imagine the front page of the Wall Street Journal filled only with the value investing news you’re interested in. With your help, that’s exactly what Fat Pitch News will become.

I encourage everyone to check out the headlines on the right side of your screen. Click through the headlines; then, read, vote, discuss, etc. Before you do that, I want to make a few things clear about this service. Fat Pitch News is part of the Fat Pitch Financials site. It is not part of the Gannon On Investing site. Therefore, when you click these headlines you’ll be going off-site. I don’t mind, because I know they’ll always be plenty for you to come back for.

As I see it, if you’re interested enough in value investing to click on the Fat Pitch News headlines, you’re probably interested enough to find your way back to this site. Still, you should know that these links will not load Fat Pitch News in another window. They will take you off-site. If you’re enjoying my site and haven’t bookmarked it yet, you really should. Once you’ve bookmarked this site, you won’t need to worry about following links to other great sites like Fat Pitch News.

The first time you click a headline you might get a little confused, because you’ll be thrown right into things. That’s why I suggest you first read this description of Fat Pitch News taken directly from the Fat Pitch Financials homepage:

Today is the launch of Fat Pitch News, a new service provided by Fat Pitch Financials. Fat Pitch News is a community driven value investing news site. You can submit links to investment articles, “bid” up stories to the front page by clicking on the green up

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On Pre-Tax Return on Non-Cash Assets

This post was prompted by a comment to yesterday’s post on Sherwin-Williams.

PTRONCA = Earnings Before Taxes / (Total Assets – Cash & Equivalents)

Pre-tax return on non-cash assets is intended to eliminate any need for human judgment.

I understand why you might want to adjust for other assets, but you must not do this in calculating PTRONCA. I only intend the pre-tax return on non-cash assets as a quick first measure of profitability. There is no human judgment involved – that’s the idea. You can calculate PTRONCA in seconds and repeat the process over scores of businesses.

Obviously, there’s a lot you could adjust. You mentioned goodwill; there’s also excess working capital, marketable securities that you may believe are not really “available for sale” even though they may be so classified, etc.

The idea behind PTRONCA is to quickly measure the profitability of the business operations of both public and private companies. I think after-tax measures are not meaningful for most companies; because, except for the very largest American businesses, public companies can be taken private, financed with debt or equity, merged with other companies, move their HQs overseas, etc. Furthermore, companies like Journal Communications (JRN) could be broken up.

The pre-tax return on non-cash assets is often less variable for similarly profitable companies than the various profitability margins (e.g., net income / sales or FCF / sales). PTRONCA is very useful when there are differences in gross margins.

For instance, Village Supermarket (VLGEA) is an unusually profitable grocer that appears on the basis of its profit margin to be less profitable than many other grocers. Fixed costs and sales volume are important considerations in the groceries business. Obviously, you could look at sales per square foot and other industry specific measures, but I believe that’s more appropriate as a second step. It isn’t something you want to do until you’re starting to learn about the economics of the industry.

PTRONCA is not very useful if you already know something about the company or the industry. I agree sales are often more important. I’ve often cited sales numbers such as price/sales and the FCF margin. Both are essentially ways of valuing companies based on the belief that current sales are largely sustainable and a certain (minimum) normalized free cash flow margin is expected. For instance, with Overstock (OSTK), I was simply valuing a money losing business on the basis of expected free cash flow. That’s why sales numbers can be very important. If you’re convinced they can be sustained, or will grow at some minimum rate, you can even value loss–making businesses once you address the solvency issue.

Finally, the pre-tax return on non-cash assets obviously doesn’t consider the premium an investor is paying over the book value of the assets. It’s not intended to. Think of it like you would the return on capital half of Joel Greenblatt’s “magic formula”, it only provides part of the picture. You need to …

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On Sherwin-Williams’ Profitabilit

Sherwin Williams (SHW) scores well on just about every profitability measure. Some companies I’ve mentioned in the past are more profitable than Sherwin-Williams. For instance, Timberland (TBL) scores much higher than SHW on just about every measure of profitability. The clearest difference between the two businesses is their pre-tax returns on non-cash assets (PTRONCA).

This is one of my favorite profitability measures. For the last five years, Timberland has consistently had a PTRONCA of 35 – 55%; Sherwin-Williams’ PTRONCA has been in the 12 – 16% range. This post isn’t intended to be a comparison between Timberland and Sherwin-Williams. I wanted to introduce you to my preferred method of calculating return on assets, and Timberland is the obvious choice for a PTRONCA comparison. Very few businesses earn a pre-tax return on non-cash assets greater than 25%.

The easiest way to earn a very high pre-tax return on non-cash assets is to have very few tangible assets. Businesses with very high PTRONCAs can grow without retaining earnings. Generally, maintenance cap ex is minimal, and little investment is required beyond additions to working capital.

Sherwin-Williams’ pre-tax return on non-cash assets of 12-16% is very good. The company has not kept much cash on hand during the last few years, so SHW’s PTRONCA of 12-16% translates almost perfectly into the expected (traditional) ROA of 7.2 – 9.6%. I say “expected”, because a pre-tax ROA of 12-16% translates into an after-tax ROA of 7.2-9.6% at an effective tax rate of 40%.

In other words, my adjustments to the return on assets computation make little difference in this case. It’s clear Sherwin-Williams consistently earns an above average return on assets whether you use the traditional ROA measure or the pre-tax measure with the cash adjustment.

Sherwin-Williams’ has consistently earned a good return on equity while employing little debt. Over the last ten years, the company’s ROE has usually been in the 15-25% range. Sherwin-Williams has regularly bought back stock. The number of shares outstanding is about 20% less than it was a decade ago. Share repurchases and dividend payments have helped Sherwin-Williams increase its ROE year after year. For several years, the company’s ROE has been following a clear upward trend.

Sherwin-Williams has also been putting retained earnings to good use. Obviously, there is a correlation between a company’s return on retained earnings and its return on equity, because retained earnings increase shareholder’s equity. Looking at the amount of retained earnings in relation to EPS growth over various time periods can sometimes provide clues regarding the relationship between a company’s return on capital and its return on incremental capital. Sherwin-Williams’ returns on retained earnings match the company’s returns on equity very closely. Both the range (15-25%) and the trend (upward) of SHW’s return on retained earnings serve to confirm the company’s return on equity data.

Finally, as Rick of Value Discipline noted, Sherwin-Williams has regularly increased its dividend. I believe this year will be the 27th consecutive year in which the …

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Value Investing Directory: New Additions

The Value Investing Directory has a new navigation structure. The “Navigate Directory” section will remain at the top of your screen after you pick a new category. To navigate the directory, simply click on a category and then scroll down to see the listings within that category.

After you click on a category, the “category tree” will remain at the top of your screen; however, the listings below will change. Therefore, you need to remember two things: 1) Scroll down to see the listings 2) Choose “deeper” sub-categories to refine your search. For example, there are fewer listings in Blogs > Investing Blogs > Value Investing Blogs than there are in Blogs > Investing Blogs, because all value investing blogs are also listed as investing blogs.

The directory now includes 17 new listings. First, let me discuss the submission process. Then, you can view the list of new additions.

Submissions

To submit a site for inclusion in the Value Investing Directory please send an email to geoff@gannononinvesting.com with the site’s URL. All submissions will be evaluated within 48 hours; however, most submissions will be rejected.

Prospective sites are evaluated on the basis of utility alone; neither reciprocal links nor payment is required. Linking to the Value Investing Directory (or any other part of the Gannon On Investing website) will not affect the evaluation process.

If you would like to propose a new category, request a change to your site’s listing, or request the removal of any site, please send an email to geoff@gannononinvesting.com. All reasonable requests will be considered; however, I reserve the right to list and describe sites in whatever manner I deem to be most useful to my site’s visitors, provided my actions are consistent with the fair use doctrine.

New Additions

Personal Favorites: The Enterprising Investor, Groovy Stocks, Lloyd’s Investment Blog

All new additions by category:

Blogs > Investing Blogs > Lloyd’s Investment Blog

Blogs > Investing Blogs > Value Investing Blogs > Cheap Stocks

Blogs > Investing Blogs > Value Investing Blogs > Deep Wealth

Blogs > Investing Blogs > Value Investing Blogs > Groovy Stocks

Blogs > Investing Blogs > Value Investing Blogs > Mister Market

Blogs > Investing Blogs > Value Investing Blogs > The Enterprising Investor

Blogs > Accounting Blogs > 10Q Detective

Blogs > Accounting Blogs > Found in the Footnotes

Blogs > Accounting Blogs > The AAO Weblog

Online Resources > Investing Communities > The Motley Fool

Online Resources > Investing Communities > The New Wall Street Message Boards

Online Resources > Stock Research > Hoovers

Online Resources > Warren Buffett / Berkshire Hathaway > Sandman’s Place

Online Resources > Warren Buffett / Berkshire Hathaway > Berkshire Hathaway

Online Resources > Value Investing Sites > Focus Investor

Online Resources > Value Investing Sites > Permanent Value

Online Resources > Value Investing Sites > Whitney Tilson’s Value Investing Website

 

Visit the Value Investing Directory…

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On a Few Quick News Items

Energizer Holdings (ENR) reported earnings yesterday. The stock was up about 10%. I mentioned Energizer Holdings (among many other stocks) in three posts:

On Friday’s Price Drop

On the Rationale for the Overstock Post

On Thirty Interesting Stocks

Disney (DIS) is reported to be about to make an offer to buy Pixar (PIXR). According to some reports, the offer will be made today. Disney is also expected to accept an offer for its ABC radio assets sometime within the next two weeks.

Is Pixar worth $7 billion (or whatever the offer ends up being)? That’s a complicated question. First of all, you have to ask if $7 billion of Disney’s stock at today’s market price is actually worth more or less than $7 billion. What’s the chance that Disney’s stock is currently undervalued and Pixar’s is currently overvalued? It’s a real possibility.

On the plus side, this could mean Disney CEO Robert Iger wants to take Disney in a different direction from what we’ve seen lately. I’ve always thought the real value at Disney would come from providing content not distributing it. If the company really wants to be some sort of “diversified entertainment company” wouldn’t a company built around kids make more sense?

A company focused on animation, theme parks, the Disney Channel, etc. would make more sense to me. In fact, a few years ago, I would have been very happy if Disney announced an acquisition of a toy maker, video game publisher, or licensing company that had something to do with entertaining kids. Today, a lot of Disney’s business isn’t in places where Disney’s powerful kid – oriented properties can be leveraged.

Pixar fits into the kind of company I’d like to see Disney become, but that doesn’t necessarily mean acquiring Pixar is a good move for Disney. After all, Fox Family fits into the kind of company I’d like to see Disney become, but when Eisner decided to buy Fox Family and rebrand it as ABC Family, I though it made no sense (especially at the price he paid). We’ll have to wait for details on the acquisition, but it’s hard to believe Disney is getting much of a bargain here. Still, it’s a step in the right direction.

Over at Value Discipline, a new post just went up entitled “Valuation, Technical Analysis, and Expertise”. The expertise part is especially worth reading.

Happy Hunting…

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