As promised here’s the snippet from Thurdsay’s Podcast:
The intrinsic value of a business can not be determined through clairvoyance or calculus, prescience or projections. For even the best projections sit precariously atop a mountain of complex assumptions. Determining the intrinsic value of a business requires simple arithmetic, common sense, and a careful analysis of the past performance and current financial position of the firm. Most importantly, it requires the separation of those things which are both constant and consequential from those things which are either mutable or meaningless.…
I admit I’ve been watching newspaper stocks with some interest; but, I am not yet convinced of anything. However, I can say to those who have not yet taken a good look at newspaper stocks that they ought to do so.
I have no greater insight into the future than those who are selling these stocks. But, I do know that at times like these, when a general consensus is reflected in the quotations of certain stocks, those few investors whose analysis is both correct and unpopular will be rewarded, if and only if, they have the courage to eschew the flock and act upon their own judgment.
While there are not as many stocks trading at astronomical evaluations as there were half a decade ago; there are not many cheap stocks either. This is not the sort of market you throw darts at. Newspaper stocks are a rare oasis of pessimism in a desert of optimism. Whether that pessimism is undue or not is a matter for you to decide.
I’m not saying these are necessarily any more promising than the rest of the group. But, if you are looking for bargains, they are a good place to start.
Recently, Tommy Hilfiger Corp (TOM) accepted an offer of $16.80/share from private investment company Apax Partners. Not long after hearing this, I was talking to someone who I had suggested the stock to almost a year ago. I asked him if he still had his shares. “No”, he said – he’d already sold.
Now, it would be easy to let the blame for this rest solely upon the impatience of that investor. However, I have to admit I deserve the lion’s share. You’ll rarely be successful buying a stock on someone else’s advice unless you understand the logic behind the purchase. I did a god awful job of explaining the logic behind buying shares of Tommy Hilfiger.
I never believed Tommy Hilfiger was a great company. Nor, did I have any illusion it would perform well in the long – run. I simply recognized that the company was selling for less than it was worth. All the profit from such a purchase would be derived not from the firm’s ongoing success but from a one time increase in the stock to close the value gap (between the market price of the stock and the intrinsic value of the business). As you can see on the right side of this three year stock chart for Tommy Hilfiger, that’s exactly what happened.
My mistake was confessing my lack of confidence in Tommy’s future prospects, without adequately explaining why this investor needed to hold onto those shares. I should have insisted upon showing him a balance sheet and statement of cash flows; I should have explained to him why the intrinsic value of the business still exceeded the market price despite the firm’s mediocre prospects. I didn’t. I just told him it was cheap, but it wasn’t a company I had any confidence in going forward. That was a terrible mistake.
Whenever you make a stock purchase for yourself or (in my case) when you recommend a stock to someone else, you have to clearly and simply state the argument that the intrinsic value of the business far exceeds the going price. In the case of Tommy, that argument was very clear to me, but not to the investor I was talking to. That’s because while estimates of Tommy’s discounted future cash flows were etched into my mind by the process of research and analysis, I never explained to this poor investor why there are times when the purchase of a mediocre or even sub par business can make sense.
I could have, and should have, taken the statement of cash flows and Tommy’s market cap, written them down on a piece of paper, and circled the value gap that was so clear in my mind. I didn’t. Remember, clarity and honesty are essential to good investing.
You can purchase a stock expecting your returns to come entirely from a one time run up that erases the value gap. As long as you’re honest with yourself – that is,
Investors in stocks are faced with two very different types of risks: business risks and market risks. Business risks can be managed through selectivity and spatial diversification. First, only the best (and best understood) firms are selected. Then, an investment is spread over several of these firms to ensure that the very small risk of a loss of principal inherent to each of these stocks does not adversely affect the portfolio. Five to ten stocks are more than adequate, provided they are businesses of the finest quality obtained at bargain prices. Market risks should not be combated with spatial diversification, because this forces the investor to accept issues of inferior quality. Instead, market risks must be managed through temporal diversification. Eventually, the market will recognize a firm’s intrinsic value. Therefore, a superior business will always command a superior price – in time. As long as an investor can hold a stock forever, he needn’t worry about market risks, and can devote himself entirely to an analysis of business risks.…
If you have heard fund managers talk about the way they invest, you know a great many employ a top down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is not until all these decisions have been made that they actually get down to analyzing any particular securities. If you think logically about this approach for a moment, you will recognize how truly foolish it is.
A stock’s earnings yield is the inverse of its P/E ratio. So, a stock with a P/E ratio of 25 has an earnings yield of 4%, while a stock with a P/E ratio of 8 has an earnings yield of 12.5%. In this way, a low P/E stock is comparable to a high – yield bond.
Now, if these low P/E stocks had very unstable earnings or carried a great deal of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. However, many low P/E stocks actually have more stable earnings than their high multiple kin. Some do employ a great deal of debt. Still, within recent memory, one could find a stock with an earnings yield of 8 – 12%, a dividend yield of 3- 5%, and literally no debt, despite some of the lowest bond yields in half a century. This situation could only come about if investors shopped for their bonds without also considering stocks. This makes about as much sense as shopping for a van without also considering a car or truck.
All investments are ultimately cash to cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top down approach to investing is nonsensical. Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left handed or right handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; it’s false. Even if pitching left handed is inherently more effective, the general manager is not comparing apples and oranges; he’s comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitcher’s handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitcher’s handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the form of security. It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all retailers over all banks) than it is for a general manager to prefer all lefties over all righties. You needn’t determine whether stocks or bonds are attractive; you need only determine whether a particular stock or bond is
Generally, I don’t like investing in retailers, because it is nearly impossible to find one with a durable competitive advantage. I do, however, like to invest in companies generating tons of truly free cash flow and consistently earning good returns on invested capital while maintaining a pristine balance sheet. When one such company is priced at less than a dozen times earnings (and a part of that price is attributable to the cash in its coffers) my heart begins to patter.
The object of my affection: preppy teen retailerAmerican Eagle (AEO). AE recently reported dismal numbers, and there is no reason to believe things will get better; in fact, they’ll probably get worse. But, at this price, the issue is not whether sales growth is slowing. In fact, at this price, the issue is not even whether sales are declining. Even If AE’s sales do decline, the stock could still be cheap. The issue is whether AE can, on a continuing basis, generate enough truly free cash flow to justify the current price. If, in the long – run, AE can throw off cash at a rate similar to that of the recent past, its shares are cheap. Of course, if AE’s ability to generate free cash has been permanently and materially impaired, its shares are wildly overpriced. Which is it? If you know, tell us by commenting below.
