Blind Stock Valuation

One of the bloggers I follow on a regular basis over at Gurufocus has put up a blind stock valuation challenge here.   In any case, I took a stab at valuing the company which I have copied out below.  You’ll probably want to check out the actual article first though just to see what information was provided.

What do you think?  Am I in the ballpark or wildly out of line on my estimate of intrinsic value?  In any case, here it is:

Blind Stock Valuation:

Based on the conditions in the article, here as the major assumptions I’ve used:

  1. 35% tax rate.
  2. No other significant assets or liabilities on the balance sheet other than what is reported in the table.
    1. Given the fast growth of the company, it is unlikely that they maintain a significant cash & equivalents position.
    2. No debt is assumed as stated in the article.
  3. The share count has been assumed to be relatively constant over time.
    1. This is generally confirmed by the change in book value (using the asset & liability assumption above) in comparison to retained earnings over the 10 years after assuming a 35% tax rate.

Using those assumptions, we can come up with CAGR’s for the following metrics.

 

1-year

3-year

5-year

10-year

Sales

32%

35%

36%

42%

Gross Profit

32%

35%

36%

43%

EBITDA

34%

33%

35%

40%

EBIT

33%

32%

33%

39%

Net Income

33%

32%

33%

39%

Book Value

28%

30%

32%

36%

Working Capital

37%

26%

25%

34%

Total Assets

20%

30%

36%

38%

The first thing that stands out is the growth rate over the last 10 years.  It is extremely high and was maintained above 30% for the entire period which is very impressive.  Now, let’s take a look at some financial metrics.

Year

1

3

5

7

9

11

Ave.

Profit Margin

4.9%

4.9%

3.9%

4.6%

4.3%

4.2%

4.5%

Asset Turnover

3.18

2.85

3.32

3.97

3.74

4.01

3.46

RoA

15.7%

14.1%

12.8%

18.2%

16.2%

16.7%

15.6%

Leverage Ratio

1.50

1.31

1.35

1.43

1.54

1.54

1.46

RoE

23.5%

18.5%

17.2%

26.0%

24.9%

25.7%

22.7%

The first thing that stands out here is that we have a very high asset turnover rate compared to most other businesses.  Profit margins are average which results in a very good RoA.  Given the relatively minimal operating leverage, also a very respect RoE.

So essentially we have a company earning around 23% on the book value of equity in a relatively unleveraged scenario that is retaining all of its earnings to grow.  As the business matures, it is likely that the leverage ratio could be increased by between 0.5 and 1.0 giving a levered return on equity of between 34% and around 45%.  Now, let’s assume that a normal rate of return for the market is approximately 7% over the long term.  Based on the unlevered (current) situation, this would suggest a fair market value of around 3x book value or $30.19 per share.  In a leveraged case, this may double to approximately $60 per share.

Since this is such a high growth stock, we can also examine pricing the company using a PEG approach or Graham’s approach.  Based on the last year’s growth rate of 32% (as it is the lowest in the series), a PEG of 1 would yield a fair price of $67.52 whereas applying Graham’s formula yields $153.2.

Now that we’ve come up with a few estimates of fair value that cover a wide range, let’s look at what the expected return on the stock would be if you bought and held for 10 years at various PE’s assuming that it would end at a market average PE of 15ish assuming different CAGR’s for EPS over the time span.

10-Year EPS Growth / PE

10

15

20

25

30

35

0%

5%

0%

-3%

-6%

-7%

-9%

5%

10%

6%

2%

0%

-2%

-4%

10%

16%

11%

8%

5%

3%

1%

15%

22%

17%

13%

10%

8%

6%

20%

28%

22%

19%

16%

13%

11%

25%

34%

28%

24%

21%

19%

17%

30%

40%

34%

30%

26%

24%

22%

Now, what this illustrates is that if you expect the hyper growth (30%+) of this company to continue, really almost any PE is going to make out well.  In fact, with that growth rate a PE of 110 would still net you compounded returns of 7% per year even with PE compression to 15 at the end of the 10 year time span.  Looking at this, really Graham’s estimate is not out of line if you expect hyper growth to continue.

Now, most companies can’t sustain this type of growth for long, so let’s assume a relatively conservative (in this case) compounded growth rate of 15% per year.  So long as the stock could continue to grow at 15% per year, if you bought at a PE of 30 and experienced a PE compression of 15 over 10 years, you would still make an 8% return on your investment.  A PE of 30 is about 63.39, so let’s put that at our ‘conservative’ estimate of intrinsic value on the high side.

So, what do we have?  Well, I would peg the intrinsic value of the company at around $65 per share based on the PEG and assuming that the company’s growth will slow in the future, but average 15% over the next 10 years.  Depending on future growth, the range of intrinsic value I think may fall anywhere from $30 per share to well over $100 per share.  A better idea of the sustainability of their business, their customers, competitive position, etc. would be needed in order to make this determination.

At $60 per share, this gives the company a market cap of somewhere around $2.1 billion, with the intrinsic value range falling between around $1 billion and say $4 billion+.  That’s big enough to be out of the micro-cap space, but not large enough to prevent them from growing quickly for many years into the future (depending on their industry, scalability, etc.).  Even at 30% a year for the next 10 years, that ends with a maximum market cap of around $32 billion.

In terms of what I would pay, I am looking to buy at around a 50% discount to what I would consider intrinsic value, so in this case I would be a buyer at around $32 per share.  Given at this price that there is basically no consideration given to high continuing growth, or the potential for increasing leverage on the shareholder base, I think that at this price the company would turn out to be a relatively safe investment to hold for the long term with at least a market return and the potential for a much, much higher return if the company can keep performing.  In any case, I think this is an interesting example as a lot of deep value investors would likely skip it as it never will seem cheap enough on a straight earnings yield basis to consider.

Until next time,
Nathan @ EngineeringIncome.com

 

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Stock Picking Contest – 2012 Q1 Update

I haven’t posted anything for awhile, but I’m starting to get some free time again and have a bunch of half written articles, so if you’re lucky, I’ll get some of them finished up and posted soon.  Anyway, an easy one to do is simply an update on the stock picking contest that gets run by a bunch of blogs that I read. Though I’m not ‘officially’ in the race, I threw my hat in with them at the beginning of the year to see how I would do. The ground rules were that you had to pick four stocks or stocks or ETFs from the Canadian or US exchanges, and then track them over the year.  Now, as the contest was only for a year, a typical value strategy may underperform, so I went crazy and made some macro calls on the economy.  Let’s see how things went.

#1 – Bank of America (BAC)

The only stock I picked for the contest that I actually own has done very well.  It continued its rebound off of its December lows and is trading at closer to what I would consider fair value. It’s still below tangible book value though and I think it has further to run (not like I could sell it anyway for this contest).  Anyway, it closed on December 30th, 2011 at $5.56 and closed the first quarter at $9.57 for a gain of $4.01 per share.  Throw in the 1 cent dividend for a total return of $4.02 per share or 72.3%. Note that I didn’t adjust for changes in the Canadian dollar.  I’m going with US dollar returns only just because it’s easier.

#2 – Research in Motion (RIMM)

Amazingly enough RIMM eked out a 1.4% return in the first quarter even with all the bad news.  Who knows what it’s going to do in the future, but if their new BB10 release exceeds expectations at all, this could end up a big winner.

#3 – FAS– US 3x Bull Financial ETF

Time for the fun stuff.  I figured the financial sector in the US was beaten down too much at the end of the year.  This is why I tend for this leveraged ETF, which would normally be terrible to buy and hold.  Anyway, so far my bet has worked out with this ETF returning 72.7% in the first quarter.  Now, the performance of this holding the rest of the year will be interesting as the US financials are more reasonably priced in general.  In any case, two big winners so far so can’t complain.

#4 – UPRO– 3x Leveraged S&P 500 ETF

For my last choice I went with the broad S&P figuring that the sell off last year was overdone. So far my choice has paid off as the S&P put up its best quarter since the 90’s.  What does that mean for this ETF?  A quarterly return of 40.9%.  Not bad for betting on the index.

So where does that leave me?  Well, combining everything together, I end up with a quarterly return of 46.9%, handily beating the other bloggers so far.  For reference, here’s the ‘official’ results for the bloggers and links to their sites for those who may be interested.

  1. Where Does All My Money Go: 35.91%
  2. Intelligent Speculator: 16.37%
  3. Dividend Mantra: 13.71%
  4. Wild Investor: 11.78%
  5. My Traders Journal: 11.17%
  6. Beating The Index: 10.87%
  7. Million Dollar Journey:  7.84%
  8. The Passive Income Earner:  4.77%
  9. Dividend Growth Investor: 4.43%
  10. The Financial Blogger: 0.10%

Now, there’s no way I see myself repeating this performance in the 2nd quarter, so I guess we’ll have to see if my early lead holds up.  Just remember, this is all for fun and not the way I would actually construct a portfolio for myself (though perhaps I should given the results).

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure:  Long BAC as of the time of this writing.

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Mistakes

So I’ve been at this value investing thing for awhile now, and along the way I can definitely say that I’ve made my share of mistakes.  Or growing pains as I like to think of them.  Anyway, I’m going to go over two of these mistakes (really the same mistake twice…) today.

And so it begins…

On at least two occasions in the last year, I’ve bought into stocks that I identified as being materially undervalued, and of high enough quality that I actually wanted to own them.  So far, so good.  The thing is though, after I’d done all my due diligence and research and established my positions I sold out of them early, and received far less than what I consider to be fair value for them. And because of it, I reduced my total return in 2011 by about 10%.  So there’s the cost of these mistakes.

Now, I actually made money on both of these trades. The thing is, I only made around 20-30% when on the first I should have made around 100% and the second, around 60%. So, why did I bail out early? I was too focused on macro events and worried about the possibility of “the market” going down that I wanted to try sell and then re-buy later at a lower price. What I should have been focused on is the fact that I owned stakes in two companies that I knew were worth more than I paid for them and been confident in my research and sit and wait.  Now, the thing is, the market actually did go down, but these stocks traded up to fair value due to improved quarterly results and the announcement of a corporate restructuring.  It was a stark reminder that ‘the market’ and the companies that make up the market are two completely different things.  The market itself can be overvalued, but likely at least some of the companies that make up “the market” won’t be.  And once you find them, you need to hang onto them until Mr. Market wises up to his errors and agrees to buy them at fair value.

So, what have I learned?  I’d like to think I’ve increased my discipline to sit tight once I’ve found positions that I’m happy with (unless something cheaper or higher in quality comes around).  I’ve also learned to trust my analysis, at least a little bit, as both these investments played out how I thought they would, just on a much shorter timeline.  The other thing I’ve learned is that you never really know how you’re going to act in the market until your own money’s actually on the line.  Now that I’ve experienced that as I’ve been investing in stocks that I pick on my own for over a year now, hopefully I won’t make the same mistakes again as I’m sure there’s plenty more out there to experience.

Until next time,
Nathan @ EngineeringIncome.com

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Stocks for 2012

One of the blogs I read on a semi-regular basis participates in a stock-picking contest each year. In the contest, bloggers from a number of different finance sites pick four stocks that they ‘own’ for a year. Any stock or ETF on Canadian or US exchanges are fair game. To get in on the fun, I figure I’ll throw out my top four stock picks for this year and see how I do. Note that due to the relatively short timeframe associated with this contest, and the lack of consequences for being wrong, the portfolio I’m outlining is not one that I would recommend in general. Though I do think that each of the stocks / ETF’s picked are no more than fairly valued at the very least.

#1 – Bank of America (BAC)

My #1 pick is Bank of America. It’s probably one of the most hated stocks out there now. It’s also trading at a substantial discount to both book value and tangible book value. My only reservation in picking this for the contest is that I have no idea whether or not it will go anywhere in a year.  If you give me 10 years, I’d be much more confident.

#2 – Research in Motion (RIMM)

My #2 pick is Research in Motion. It’s also an extremely hated stock. Now this one I’m going out on a limb for as I’ve decided to avoid buying RIM for a number of reasons. However, I think the stock if RIM’s strategy and management begins to perform at all, their fortunes should pick up.  It’s also trading near book value which should provide a bit of a floor to the price. I picked the US listed version as I’m guessing that the Canadian dollar will end the year higher against the US dollar which would add a few extra percentage points if I’m right. Not that it matters much.

#3 – FAS– US 3x Bull Financial ETF

Now this one is cheating a bit, but in the rules it says you can pick any stock or ETF on the Canadian or US markets. This is just a bit of a broadening of my #1 pick. Basically, I think US financials are some of the most beat down stocks out there. This just buys a basket of them and then leverages it up.  Easy peasy. If the US avoids a recession and Europe doesn’t blow up too badly, this should turn out okay so long as the rebalancing and ETF fees don’t bite too badly.

#4 – UPRO– 3x Leveraged S&P 500 ETF

I was thinking of putting some of the stocks that I’m currently looking at in here, but as there’s only a 1 year time horizon, it was time to go big or go home. Basically, this is a bet that the US will do okay and muddle along. At the end of 2011, the S&P finished with an estimated P/E of around 12.5 as long as the quarterly earnings for the fourth quarter hold up. If they do, this will be the first calendar year in awhile that the P/E of the S&P has been 15 at the end of the year. So, this is basically a bet that price reverts to earnings and not that earnings come down to meet price. I’ve also leveraged it up to ensure that if I’m right, I win big. Then again, that can bite both ways.

Anyway, I’ll be tracking my picks on a quarterly basis along with the other bloggers to see how I do. Note that this is not how I would actually throw together a portfolio, but since it’s all for fun (and bragging rights), why not.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer. (link)

Full Disclosure:  Long BAC  as of the time of this writing.

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Housekeeping

So now that another calendar year has almost passed, it’s time to reflect on the year that has gone by. And by reflecting, I mean crunching some good hard numbers to figure out what happened in your financial life this year.

The end of the year is a great time to perform a financial update of your life. First of all, you typically get a few days off, so why not take advantage of it, and secondly, after eating all that food, you’re probably just going to sit around on the couch anyway, so why not be productive when you’re doing it?

Getting Started

So, having cajoled you into action, what things should we concern ourselves with?  Well, one of the things that important for any self-directed investor to check is their yearly performance.  How do you do this?  Well, you compile the balance of all your accounts at the beginning of the year, figure out how much money you added to them and when, and then take the closing balance at the end of the year.  After compiling all this data, you throw it into Excel, use the XIRR function, and it’ll spit out an annualized rate of return for your accounts.  Not too shabby huh?

Now that we have a number (that is hopefully positive), what do we compare it to?  Well, that depends.  What do you think you should benchmark yourself against?  If you’re only investing the equity part of your portfolio and have bonds or fixed income components elsewhere, I’d compare your performance to the total return of the S&P TSX index of Canadian equities, and the S&P 500 of US equities.  The easiest way to do this is to pull up Yahoo Finance, plug in the appropriate ETF’s (XIU for the TSX or SPY for the S&P 500) and then look at the adjusted close numbers for January 1 and December 31 of the same year.  Personally I tend to adjust the return of the S&P 500 to account for the value of the Canadian dollar, but that’s neither here nor there.  Anyway, by doing this, you’ll get a good feeling of whether you’ve “beaten the market”.  This is a good exercise, as if you underperform the market for a long period of time (say 5 years), then you should probably either a.) give up picking your own stocks and just buy index funds, b.) spend more time making your stock selections and maybe use a different strategy, or c.) find a financial advisor to help you out.

Now, what if you have a more balanced portfolio?  Well, I’d wander on over to Canadian Couch Potato, and download the returns for his model portfolios.  They’re basically just balanced portfolios of index funds, but they serve as a good proxy of the return that you would make in a balanced portfolio over the year, so throw that in your comparison bucket as well.

Warming up

So, we’ve figured out our annual return on our investments, and compared them to some benchmarks.  What next?  Well, the next thing I would look at is your net worth.  Basically, figure out the value (as close as you can) of everything that you own (think bank accounts, real estate, cars, investments, etc.), and then subtract everything that you owe (mortgages, credit cards, things like that).  That’ll give you your net worth.

Now that you’ve figured that out (and hopefully it’s positive), a more interesting comparison is the increase in net worth over the year.  So you need to try to figure out your net worth at the beginning of the year.  This may be a bit harder to do, but dig back in your online bank statements and things and hopefully you can come up with a good guess.

Having calculated your net worth at the beginning and end of the year, you now know how much more ‘wealthy’ you are than you were a year ago.  Feel free to work out a percentage increase if it makes you feel better, I know I do.  Now, with you feeling nice and confident, we’re almost done.

Cooking with Fire

There’s a few other things you can check depending on how much time you want to spend and how much you care, these are a.) your free cash flow for the year, and b.) a breakdown of all your expenses for the year.

Now, calculating your free cash flow basically just gives you an idea of how much your net worth changed due to savings vs. investment returns.  Interesting information, but nothing you really don’t already know if you’ve actually been doing what I’ve outlined above.  Calculating a breakdown of your annual expenses I think is a little more interesting, as it can be quite eye opening to find out what you actually spend money on.  Now again, if you don’t track your expenses routinely, this is going to be very painful to do.  But, if your net worth increased less than you thought it should, this would give you an idea why.

Looking Forward

One final thing before we go is we want to set reasonable targets for the next year.  Basically, what do you want your net worth to look like a year from now?  Decide, and then plan how you’re going to get there. You’re probably going to have to have a handle on how much you can save per month, and a target for your investment returns in order to do this step, but I think it’s one of the most important ones.  Once you have your goal, you can now track your progress towards it on a monthly basis.  And if things aren’t going well for one reason or another, you can find out why and hopefully fix it.

So now when you’re sitting around during the holidays with nothing to do, you can pull up this post and get cracking.  Knowing where you’re starting from and where you’re going is one of the most important steps in investing.  Good luck with it!

Until next time,
Nathan@EngineeringIncome.com

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Tenets of Value Investing – Mr. Market

For those of you unfamiliar with Mr. Market, he is an analogy that Ben Graham introduced to explain volatility in the markets.  Every day, Mr. Market provides a price for every stock in the market that he is willing to buy at and sell at.  Some days, Mr. Market is exuberant, and will gladly buy or sell stocks at fair or even lofty prices.  However, some days Mr. Market is depressed and will only buy or sell at depressed (low) prices to reflect his mood.  The key is to take advantage of Mr. Market when he is depressed by buying from him to cheer him up, and then wait until he is exuberant and willing to buy back those shares at a fair price.  Buy low, sell high.  The difficulty in all of this of course, is emotion and the nature of the public market itself.

If you owned a 50% stake in a private company, it would be very strange to have your partner come up to you every day and offer to either buy or sell an addition stake in the company to you at a different price.  If you think about it though, this is essentially what the stock market does for public companies.  Someone is providing a price that they are willing to pay for the stake in a business that you own.  Correspondingly, they are also offering to sell you a larger stake or a new stake in many other businesses.  However, just because they are making an offer does not mean you have to accept it.

Warren Buffett has a great quote relating investing to baseball where he says that investing is a no-called-strikes game.  What this means is that as an investor, you don’t have to accept any of the offers thrown your way on any given day.  You have the luxury of simply sitting at the plate watching Mr. Market offer up prices day after day.  If you do this long enough, and are prepared, one day you are assured that Mr. Market will give you a great pitch (company) at a great price that you can hit out of the park by buying as much as you can.  You then simply sit at the plate waiting again until Mr. Market recognizes the error of his ways and offers up a fair price for the company that you just obtained on the cheap.

And that is the entire trick to investing.  Doing your homework so you can recognize a great investing opportunity when it comes along, patience to wait for that opportunity, and then confidence to bet big when you see that perfect pitch coming your way.

Until next time,
Nathan @ EngineeringIncome.com

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My aren’t we picky…

Something I’ve been thinking about a lot recently is how to rank a lot of seemingly cheap companies against one another.  Due to the recent market turbulence, there have been a lot of companies trading at very low levels in comparison to their earnings power.  So, the question I’ve been asking myself is:  Out of all of the businesses trading at attractive valuations, which one(s) am I most interested in investing in?

Even though I consider myself a value investor (which means that I look to buy businesses for less than their intrinsic value), I find myself constantly tweaking how I actually apply value investing principles in my own investing decisions.  Part of this is due to the fact that I tend to read a lot of investing blogs and books so I’m constantly exposed to other people’s ideas and thoughts.  But the greater part I think comes from accumulating experience in the market and seeing how your own decisions play out and how comfortable you are with them.

As I muddle along, I’m tending towards owning fewer, higher quality, more predictable businesses than I did in the past.  A lot of this has come from the fact that it’s actually hard to come up with a dozen or more businesses that are trading at an attractive valuation, have some semblance of predictability as to what the future will look like for the business, and have management teams that aren’t going to squander the money that the business brings in.

Get your Yields Here!

To start, I’ve decided that I’m only interested in opportunities that have a chance of providing a 15% compounded return into the future.  This means that I only want to buy stocks that have earnings or cash flow yields greater than this hurdle rate.

Now, there are many ways to come up with a stock’s yield.  The one I’ve currently adopted involves a company’s 10-year average free cash flow margin and current price-to-sales ratio.  In layman’s terms, I figure out how much cash profit the company produces per $1 of sales in an ‘average’ year, and then how many dollar’s worth of that company’s sales I can buy for a given dollar investment.  So long as the combination of these two numbers is higher than 15% (for example – FCF margin of 15% and price-to-sales ratio of 1), the company’s passed my first test.

Now, to find companies trading at or above your target yield you can either use a stock screener, or better yet, you can keep a watchlist of companies you’re interested in owning and the prices they’re available at in the market.  In any case, depending on the hurdle rate you’ve chosen, the list of stocks to evaluate further is likely going to be narrowed down significantly after this initial screening stage.

Back to the Future

So, now we have our list of possible investment candidates trading at attractive prices.  What next?  Well, something I like to think about is what each company does and what it will continue doing.  The reason this is important has to do with that average profit margin we calculated up above, and the sustainability of their results.  You see, even if we buy a company when it has a 15% earnings yield, we won’t make 15% on our investment if their operating results begin to suffer.  For example, Apple (AAPL) is on a lot of people’s list as a great stock to own.  And at first glance it may be as it sports a relatively low price-to-earnings ratio for a company that is growing so quickly.  However, I have two problems with Apple that I’d have to get comfortable with before I would consider investing.

First off, I have no idea what Apple will be doing in 10 years.  Probably something to do with phones, or music, or computers, but maybe not.  10 years ago, not many could have predicted that they’d now make most of their money on cell-phones, music, tablets and not their Apple computer line that had been their mainstay for decades.  In another 10 years who knows what they’ll be doing.  And this brings me to my second point.  Apple currently has very high margins – somewhere around 25%.  This means that for every dollar of sales they make, they have about 25 cents in pure profit.  Now, if you’re not impressed, you should be.  Very few companies have profit margins that are this high.  The reason I mention Apple’s current profit margin is that if I was investing in the company, I would be worried that they may not be sustainable.  For example, when the iPhone first came out, it had a lot of features you couldn’t find on any other phone, and so it was easy to charge a lot for it and have people pay.  However, other smart phones are now very close feature-wise to iPhones, but can typically be bought for hundreds of dollars less.  So the question is, can Apple keep charging much more than its competition for a similar product into the future?  Maybe, but maybe not.  And if competition erodes their margins, there goes your margin of safety.  Now this isn’t saying that Apple won’t be successful into the future, they very well may be, and people who buy their stock at these levels may make out very well.  But I can’t predict their sales or margins with any confidence 10 years into the future, and because of that, I won’t invest.

For me, if I can’t envision with relative confidence what a company’s sales and margins will look like at least 5 to 10 years in the future, I pretty much set the company aside.  A lot of investing is not just finding undervalued companies to buy, but being able to hold onto them until you get an offer for your shares that you’re satisfied with.  As companies may drop over 50% from where you first buy, and getting a good price to sell at may take years, being confident in a company’s future and their competitive position can be very important to the ultimate success or failure of an investment.

It’s Good to Have Friends

So, say we’ve got a company with a good yield, and we’re pretty sure we can make a guess of what they’ll be doing in 10 years and how profitable they’ll be.  What now?  Well, shareholders only really make out well if they actually see some of the profits that the business generates.  And that comes down to management.

In theory, the shareholders are the owners of the business and have the final say in how the profits of the business are used.  In practice, this is rarely the case.  From an owner’s perspective, profits that cannot be effectively reinvested in the business should be returned to shareholders through either buybacks or dividends.  However, many companies seem to pursue a value destroying ‘growth at any cost’ strategy in which they make acquisitions at outrageous prices to ‘grow’ or ‘expand’ the business.  In many cases, they later then have to write off much of the purchase price of these acquisitions as the acquired companies never achieve high enough profitability to justify their purchase price.  To provide an example of management pursuing this strategy, let’s take a look at HP (HPQ).

HP is a cash cow.  It spits out a ton of free cash flow each year.  Has for a long time.  So, what have they done with it in the last 10 years?  Well, first, they bought Compaq.  Then they recently announced they want to get out of the computer business.  They bought Palm and then used its technology to develop the HP Touchpad.  Then they killed that off within 6 weeks of release.  Now they’re acquiring Autonomy, an enterprise information management software company, for 10 billion dollars.  Though I wish them the best with this acquisition, they paid almost 10 times Autonomy’s 2010 sales for the company.  At this price tag, it’s hard to see how this acquisition will ever be ‘profitable’ for HP shareholders.  If instead, HP’s management used the $10 billion for the Autonomy acquisition to buy back shares, long-term shareholders would be much better as every dollar HP invested in their own stock at current prices results in an immediate 13% return on investment (HP’s current earnings yield).

So, how can you tell whether management is owner friendly?  Well the first is to check the share count over the last 10 years and figure out if it has been decreasing year over year.  It has?  Good.  Next, do they pay a dividend?  Yes?  Another positive.  Thirdly, look at executive compensation.  How do the managers get paid.  Is it mostly cash?  Bad.  Do they have a large ownership stake in the company compared to their pay?  Good.  If they have stock options, do they vest over 5 years?  Good.  Over 1 year?  Bad.

What you really want is a company that is focused on long-term value creation.  And the best way to ensure this is to make sure that the executives of the company are paid commensurate with this goal.  As value investors, we don’t want management making dumb decisions to try to increase the short term profitability (and stock price) at the expense of the long term.  Instead, we want management to think as owners themselves and have a significant portion of their compensation tied to how ‘owner’s of the business do over the long term.

For an example of what I would consider ‘shareholder friendly’ management, take a look at Gap Stores (GPS).  So long as their business continues to be profitable and you buy shares at a reasonable price, it’s hard to see how you won’t make out well over the long term as management consistently returns very high percentages of their free cash flow to shareholders through annual dividends and buybacks.

Now that it’s all said and done

So, I started out trying to explain what I look at when I evaluate stocks and why I’ve started to think that it’s better to own relatively few stocks, than to widely diversify.  If you use the three steps I’ve outlined above to really evaluate companies on your investment list, you actually rarely come up with any companies that fulfill all of the criteria.  And when you do, so long as you’ve done your due diligence, you know that they’re companies that are worth more than you paid for them, and that will continue to be worth more than you paid long into the future.  That way, you can be confident putting a large portion of your portfolio into them, and then holding until you get a good offer, whether it comes in 6 months or 6 years.  Though I was initially hesitant to throw away the typical mantra of ‘diversification’, I really do think that it can result in ‘diworsification’ in a lot of situations.  What do you think?

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:

The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure:  Long GPS as of the time of this writing.

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