As suggested I’ve created an “anything goes” blogosphere club. Please go to Marketocracy and join with whatever you think your best fund is. If you don’t have a fund yet, you can start one just for this club. I’ve joined with DAVD (that’s my fund limited to stocks with a market cap of less than $1b).
I only ask that you keep the funds compliant. Otherwise, diversification is not an issue.
I’m still keeping the 20 Ideas Club and 100 Ideas Club as well. But, they do have specific requirements. If you like the “anything goes” approach, please join the blogosphere club.…
Although I have previously discussed companies with heavy debt loads (e.g., Energizer), I generally seek to buy shares in companies of unquestionable financial strength. I agree with Marty Whitman, who wrote in his book The Aggressive Conservative Investor that a strong financial position has more to do with the absence of liabilities than with the presence of assets. Businesses with substantial future obligations, whether these obligations are stated on the balance sheet or not, often prove to be disappointing investments.
An absence of liabilities is not merely a safeguard against insolvency. A strong financial position is a first class asset. It allows a company to borrow when money is cheap, rather than when money is needed. Even more importantly, it encourages long – term thinking. There are times when big investments in the future are required. A financially sound firm is in the best position to make such investments.
One of the greatest benefits of a strong financial position is the protection it affords the common stock holder. Countless times, I have mentioned the damage done to shareholders by new equity and debt financing. New equity dilutes; while new debt imperils.
Growth is an important part of the value equation. But, it only counts insofar as the shareholder reaps the rewards. No owner benefits on the basis of total revenues; each benefits to the extent of the profits attributable to his share of the business. Siphoning profits off to creditors or divvying them up among new owners effectively destroys that growth.
Buying stocks when they trade at low earnings multiples does help minimize an investor’s downside risk. But, that isn’t the only way to minimize risk. The future is always uncertain. There are a few companies who possess such wide moats that an investor can largely confine his analysis to the earnings record. He can feel secure in his belief that thirty years from now the business will remain much as it is today. But, these companies are few and far between. Mr. Market rarely offers them at bargain prices.
A strong financial position offers a kind of freedom. It also acts as a safeguard against uncertainty. If an investor buys stock in a company with a strong financial position when it is trading at low price – to – earnings, price – to – sales, and price – to – book ratios, he will greatly limit his risk.
Companies that are both highly profitable and relatively unencumbered can prove to be spectacular investment opportunities, even when the industry in which they operate faces great uncertainty. It is not unreasonable to expect that a financially sound firm generating large amounts of free cash flow will eventually find a way to productively use those cash flows.
A financially sound firm has the luxury of time. It can play the nimble competitor. A highly encumbered business faces greater risks in a period of upheaval.
Insolvency is not the only threat. Often, a highly leveraged company will be able …
You’re missing out on a great opportunity to talk stocks with people who love doing exactly that.
I am terribly disappointed in the response to my earlier post regarding the Marketocracy experiment. I expected the readers of this blog to be very interested in such an experiment. The opportunity to pick stocks, see how they perform, and discuss them in forums on Marketocracy and on this blog seemed like a good idea to me.
Well, I’m going ahead with the experiment despite the lack of interest. Bill of Absolutely No DooDahs has joined me. I hope some others will as well, including some of the other value bloggers out there.
To join, sign up at Marketocracy and then click on either of the clubs to join. Once you apply to join, I’ll accept you into the club(s), and we can get started.
I’ll try to put direct links to the clubs below, but I’m not sure it will work. You’re best bet is to go to Marketocracy and register there first. Then, go find the clubs. Anyway, here are the links, in case they do work:
Journal Communications (JRN) consists of seven essentially separate businesses: The Milwaukee Sentinel, Community Newspapers, Television Stations, Radio Stations, Telecommunications, Printing Services, and Direct Marketing. The company’s five reportable segments do not exactly match these seven businesses; however, I believe an investor should analyze JRN on the basis of these seven businesses and their constituent properties, rather than as a single going concern with five reportable business segments.
Additional reasons for this belief will be outlined below. For now, it is sufficient to say that if Journal Communications were to split into seven separate public companies, the combined market value of those companies would be substantially greater than JRN’s current enterprise value. Simply put, the sum of the parts would be valued more highly than the whole.
Journal Communications has an enterprise value of just under $1 billion. Pre-tax owner’s earnings are probably around $125 million. So, JRN trades at eight times pre-tax owner’s earnings. That’s cheap.
Journal’s effective tax rate is 40%. That is an unusually high rate. Journal’s media properties would likely generate more after-tax income under different ownership. The difference would be material; but, for anyone other than a highly leveraged buyer, tax savings would not be a primary consideration. When evaluating Journal as a going concern, it is perfectly appropriate to treat the full 40% tax burden as a reality. These taxes reduce owner’s earnings by $50 million.
With after-tax owner’s earnings of $75 million and an enterprise value of $1 billion, Journal’s owner’s earnings yield is 7.5%. Remember, this is the after-tax yield. The pre-tax yield is 12.5%. When evaluating a company, it’s best to use the pre-tax yield for purposes of comparison. Last I checked, the 30 – year Treasury bond was yielding 4.63%. So, looking at JRN’s current earnings alone, the stock appears to offer a large margin of safety.
This is especially true if you consider the fact that earnings yields offer more protection against inflation than bond yields. They don’t offer perfect protection. But, with stocks, there is at least the possibility that nominal cash flows will increase along with inflation. The cash flows generated by bonds are fixed in nominal terms, and therefore offer no protection against inflation.
When evaluating a long-term investment, such as a stock, I do not use a discount rate of less than 8%. This reduces JRN’s margin of safety considerably. Instead of being the difference between 12.5% and 4.63%, Journal’s margin of safety is the difference between 12.5% and 8%. Is such a margin of safety sufficient? Maybe.
When evaluating a prospective investment, I first look at the risk of a catastrophic loss. What is the magnitude? And what is the probability? For my purposes, a catastrophic loss is defined as any permanent loss of principal. The risk that I’ve overvalued a business is always greater than my risk of catastrophic loss, because I insist upon a margin of safety. A catastrophic loss is one that wipes out the entire margin of safety.…
I thought a discussion of the possible causes of Journal Communications’ undervaluation by the market might help us find other similarly undervalued stocks. In the Gannon on Investing Podcast: “Why Small Caps” I stated that undervalued stocks usually suffer from either contempt or neglect. JRN suffers from both.
Journal Communications (JRN) is a relatively small company, despite the diversity of its media assets. The company owns a collection of low profile media assets. The same size company with a well known flagship would not go as unnoticed by investors. Although the Journal Sentinel is a big paper, I don’t believe most investors know the name. Of course, most daily newspapers are only known in and around the city in which they are published. That brings up another possible cause of JRN’s undervaluation. Perhaps the location of the company’s assets has helped it fly under the investing public’s radar.
Maybe. But, I’m not so sure. All of those factors could contribute to the lack of interest in JRN. However, I doubt they are the primary cause.
One of the best possible explanations for JRN’s undervaluation is the company’s lack of debt. Journal Communications is not debt free; however, for a media company, it is very lightly encumbered. Actually, the company also has a low debt load relative to the S&P; 500. But, I want to focus on the company’s debt relative to other media companies, particularly other newspaper publishers, because I believe that is a key cause of the undervaluation.
The stock market doesn’t totally ignore debt. However, it sometimes fails to fully account for the differences in debt levels between companies. In general, unduly leveraged companies are punished by the market. All other things being equal, the stock of such companies trades at a lower P/E ratio. In this way, the stock market does account for debt.
However, punishing companies with a lot of debt is not quite the same thing as rewarding companies with very little debt. That’s where mispricings can occur. Some businesses in exceptional financial condition are not awarded the premiums they deserve. Such businesses are better able to make acquisitions, buy back stock, increase dividend payments, and weather tough times. Just as importantly, they also have the capacity to take on more debt.
On occasion, I have read the argument that excess cash on the balance sheet may be a bad sign, because it suggests management is not running the business in the way that would best maximize returns on equity. It is true that some companies have more cash and less debt than would be best for the maximization of shareholder returns. However, from this, it does not necessarily follow that such companies are less desirable investments.
I have touched on enterprise value a few times before. There is a reason for this. A business’ enterprise value is a better measure of price than its market capitalization. Generally speaking, a company’s cash can be treated as a reduction to the price paid …
I’m pessimistic about newspapers. But, that doesn’t mean I’m opposed to buying newspaper stocks. The two most interesting offers from Mr. Market are for Journal Register Company (JRC) and Journal Communications (JRN). Expect a write – up on each soon.
There was a recent piece on Journal Communications over at the Motley Fool. Mr. Simpson thinks JRN should dump its telecom business. I have to agree. In fact, I’d like to go a step further. Why not split the whole thing up? The parts are worth more than the whole. So what if it the company isn’t big? It’s cheap, and the value is in specific local assets that could be run just as well if each business was spun off, or if the different businesses were sold to a few bigger companies. There’s value in JRN. Separating the telecom, TV, radio, and newspaper assets should make that value obvious.
I don’t expect it to happen. For now, the value isn’t obvious. That means it’s a good time to dig into JRN. We might just find a bargain.
On a separate note, most newspaper stocks don’t look insanely cheap if you assume decreasing revenues (which I do). The big names may not be your best bet here.…
Today, I’d like to invite you to join me in an interesting experiment. To test the importance of focused investing and both its positive and negative effects, I’ve decided to set up five simulated funds with varying restrictions and see how they perform. There’s a site that allows you to do this sort of thing called Marketocracy. I can’t yet vouch for the service, but it’s free.
I’m more interested in testing my funds’ performance against each other than I am in testing their performance against the markets. The restrictions to be tested are:
1. A Home State Fund (only invests in companies headquartered in one’s home state – mine is NJ)
2. A Top 20 Ideas Fund (spreads assets evenly over one’s top 20 ideas)
3. A Top 100 Ideas Fund (spreads assets evenly over one’s top 100 ideas)
4. An Over 10b Fund (only invests in companies with market caps > $10 billion)
5. An Under 1b Fund (only invests in companies with market caps < $1 billion)
I hope to create five groups on Marketocracy that will allow us to track each type of fund and discuss the difficulties caused by these limitations. All funds should also meet Marketocracy’s compliance rules.
I hope some of you will join me in this experiment. We might learn something.
(I know there are readers outside the U.S., for you the Home State Fund will simply be a Home Country Fund. This isn’t a huge advantage, remember some U.S. readers could be from states like California – so, they’ll have a big economy to play in too.)
You can start by joining any or all of the first three clubs:
(I will set the other two clubs up as soon as Marketocracy gives me permission to go beyond the three club limit).
You need to be invited to join these clubs. Anyone can get an invitation by sending an email to: geoff@gannononinvesting.com asking for an invite. All readers will be welcomed.
You can also request an invite from inside Marketocracy.
Please tell me what you think of this idea by commenting to this post.…
Energizer Holdings (ENR) owns two of the world’s great brands: Energizer and Schick. Currently, about 70% of the company’s sales come from the battery business and 30% come from the razor and blades business. International sales (from both businesses) account for almost exactly half of all sales.
Energizer’s acquisition of Schick was a steal. In 2003, the company bought Schick – Wilkinson Sword from Pfizer (PFE) for just under $1 billion. In 2005, Schick contributed just under $120 million in profit. This figure does not properly allocate certain shared costs to Schick; but, it does include depreciation expense in excess of maintenance cap ex. Therefore, I believe $125 million is a good estimate of the true economic benefit provided by Schick in 2005. Over the next few years, further margin improvements are likely at Schick; because, between product launches, fewer razors and more blades will be sold. Energizer’s cost of capital for the Schick acquisition was very low. Most of the purchase price has been refinanced as fixed debt carrying an interest rate of less than 5%.
Over the next thirty years, Energizer will become primarily a razor business and primarily an international business. When looking at Energizer today, this fact is difficult to see; however, it is an important truth. Here, I disagree with many other commentators on Energizer’s business. They are far more optimistic about the battery business and far more pessimistic about the razor blade business than I am. We both have access to the same information, so why the disagreement?
I believe Energizer’s highly profitable battery business will slowly wither away. It will remain in some form. Even decades from now, there will still be Energizer batteries sold all over the world. But, how many will be alkaline batteries?
A lot of analysts note that Energizer is particularly well positioned in the markets for lithium and rechargeable batteries, and therefore believe a transition to such batteries would not necessarily spell doom for the little pink bunny. Energizer’s sales of these products has recently been growing at a 20% clip. With so many personal entertainment devices finding their way into consumers’ hands (and under their Christmas tress), it looks like Energizer has a wonderful growth opportunity to exploit.
Unfortunately, that’s not how I see it. Energizer will look to grow its sales of lithium batteries – as it should. But, don’t let the flashy growth fool you. There are two parts to the growth factor equation: growth and profitability.
Lithium batteries are unlikely to be anywhere near as profitable as alkaline batteries. They are more durable and less visible. This is a deadly combination for the likes of Energizer and Duracell. A battery that is bought by the manufacturer rather than the consumer is not something these companies look forward to. There is very little price competition in alkaline batteries. Energizer’s brand name and its distribution system is the key to its ability to charge high prices on alkaline batteries. Those advantages are …
There are several ways to value a business. Investors often disagree on which to use.
I’ve already mentioned using a DFCF analysis based on a free cash flow margin estimate and a sales estimate for a series of years. I used this method explicitly with Overstock.com (OSTK) and implicitly with Lexmark (LXK). Before reading further, you may wish to review those two examples: “On Overstock” and “On Lexmark”.
The free cash flow margin method has several important benefits:
The analyst needs to focus on only two things: revenue growth and the free cash flow margin. The estimate of the free cash flow margin can be based on quantitative data such as the company’s historical FCF margin, the industry’s historical FCF margin, or gross margins within the business. It can also be based on qualitative data like the variability in those margins, the ability of the business to raise prices in a period of inflation, the nature of competition within the industry, and the company’s competitive position. In cases in which the FCF margin has been consistently and extraordinarily wide or narrow, the quantitative and qualitative data will likely agree.
The analyst is forced to make his assumptions explicit. By using exact projections of sales and the free cash flow margin for each year, the analyst is forced to see just how reasonable or unreasonable his assumptions are. Static multiples and simple equations based on a company’s growth factor let the analyst arrive at a valuation without necessarily knowing what his projects for any given year are.
When projecting growth rates into the future, it is very easy to overlook the cruel realities that mitigate the continuance of any trend. Both static multiples and DFCF calculations based on returns on capital and growth rates will often lead to projections of unachievable sales numbers. You may think you are being very conservative in your growth projections for Google (GOOG); however, when you look at the actual revenue needed to support your valuation, you may find you are assuming far more than you thought. That is why I went over the resulting revenue numbers in the Overstock analysis. I wanted to demonstrate that the revenue growth assumptions were not unreasonable, even going out thirty years.
The factors that determine a business’ free cash flow margin are the keys to understanding, and properly valuing, that business. In coming up with an estimated free cash flow margin, the analyst must ask questions about the nature of competition in the industry, the relation of tangible assets to intangible assets, the profitability of the business, the capital spending required to maintain that level of profitability, the stickiness of a business’ customers, the differentiation of its products, and the business’ ability to raise prices. These are important questions. They need to be asked regardless of the method of valuation used. So, why not use a method of valuation that is inherently focused on these crucial questions?
