Tag Archives: digest

The Free Capital Blog Digest (@guy_thomas, #valueinvesting)

The following is a digest of posts from Guy Thomas’s Free Capital blog from Feb 2011 through Jan 2012.  Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

How important is analytical intelligence in investing?

  • Equity trading is not as reliant on raw mental strength (IQ, analytical ability) as fixed-income trading; instead, equity trading is more dependent upon mental characteristics such as:
    • Actively seeking information from dis-confirming sources
    • Adjusting for one’s biases
    • Accepting uncertainty for long periods
    • Deferring decisions for as long as possible
    • Calibrating your certainty to the weight of evidence
    • Responding unemotionally to new information
    • Indifference to group affiliation
  • The mental characteristics which are helpful in investing are not universal positives and may be useless or negative characteristics in other endeavors

Max, min and average payoffs

  • Most activities can be categorized as max payoff, min payoff or average payoff
  • Max payoff means the activity is “positive scoring”, your payoff is your highest or best result and failure carries no lasting consequences
  • Optimal traits for max payoff are:
    • high energy
    • irrational optimism
    • persistence
  • Examples of max payoff activities include:
    • selling
    • leadership
    • most sports
  • Min payoff means the activity is negative scoring, your payoff is your lowest result and even a single failure may have lasting consequences
  • Optimal traits for min payoff are:
    • meticulous care
    • good judgment
    • respecting your limitations
  • Examples of min payoff activities include:
    • flying a plane
    • driving a car
    • performing brain surgery
  • Average payoff activities combine elements of both max and min; investing is an average payoff activity, with particular emphasis on the min aspects
  • A lot of success in investing comes from simply avoiding mistakes (min payoff)

Discussion of diversification (posts 1, 2, 3 & 4)

  • Diamonds and flower bulbs
    • Diamonds are companies with exceptional economics and long-term competitive advantages that you’d be happy to hold if the stock exchange closed tomorrow for the next five years
    • Flower bulbs are companies which are cheap at the moment but which have no exceptional business qualities (they often make a good quantitative showing but not a strong qualitative one); they can usually be counted on to bloom but should be bought in modest size because they require liquidity to get back out of the position and realize the value
    • Which should you buy? Diamonds are exceptionally rare and require outstanding foresight of long-term durability; flower bulbs are more common, simpler to spot and merely require patience and a strong stomach
    • “Investing is a field where knowing your limitations is more important than stretching to surpass them”
  • How many shares should an investor hold? Some theory…
    • The optimal number of stocks to hold, N, is a function of…
      • quality of knowledge about return dispersions (decreasing)
      • $ size of portfolio (increasing)
      • volatility of shares (increasing)
      • capital gains tax rate (decreasing)
    • Exceptional investors with exceptional quality of knowledge should hold a concentrated portfolio; Buffett from 1977-2000 appears to have held approx. 1/3 of his portfolio in his best idea and changed it annually
    • With a small portfolio, liquidity is not a concern but as your portfolio scales a large number of holdings becomes optimal to maintain your liquidity which enhances your optionality by giving you the opportunity to change your mind without being trapped in a position
    • If the companies you target have highly volatile share prices, it becomes attractive to switch frequently so that you can “buy low and sell high”, thus you want to restrict your position sizing (higher number of positions) and maintain liquidity
    • If the capital gains rate is high you are penalized for turnover so you want to keep your total number of positions low and hold them for longer
  • How many shares should an investor hold? Some practicalities
    • There is clearly a trade-off between the number of positions you have and your quality of knowledge
    • A portfolio which is higher in diversification may hold many lower quality businesses (flower bulbs) but the certainty of the analysis of each might be significantly higher than a concentrated portfolio of several high quality businesses (diamonds) whose analysis is extremely sensitive to long-term forecasting accuracy
  • Concentrated investors often “come a cropper”
    • Many investors eventually disappoint because they have concentrated their bets on companies the world turns against
    • This has happened even to great investors like Warren Buffett (ex., WaPo, which now looks like a horse-and-buggy investment)
    • The danger of concentration is that nothing grows forever, and concentration + illiquidity often make it hard to escape mistakes

Meeting management

  • Opportunity cost of time: is it better spent speaking to management or investigating other ideas?
  • Getting an edge: sometimes speaking with management helps to understand the picture in a way that gives you an edge
  • Buffett: if you need to talk to management, you shouldn’t own the stock
  • Don’t be schmoozed

Analytics versus heuristics; why I don’t use DCF models

  • Time is precious and DCF models take too long
  • A good buying opportunity shouts at you from the market; if you need a calculator, let alone a spreadsheet, it’s probably too close
  • Robustness is more important than refinement; it’s easy to find apparent discrepancies in valuation, but most are false– it’s more important to seek out independent insights which confirm or deny the discrepancy than to calculate its size; when info quality is good, focus on quantifying and ranking options, but when it is poor, focus on raising it
  • Non-financial heuristics are often quicker and sufficiently accurate to lead to correct decisions; you may make more errors than the rigorous analyst but you can work much faster and evaluate many more opportunities which is usually a good trade-off

Geoff Gannon Digest #5 – A Compilation Of Ideas On Investing (@geoffgannon)

The “Geoff Gannon Digest” is a series of posts highlighting some of my favorite wit, wisdom and investment advice from value investor Geoff Gannon. Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

Why I Concentrate On Clear Favorites And Soggy Cigar Butts

  • Graham and Schloss had >50 stocks in their portfolio for much of their career
  • They turned over their portfolios infrequently; probably added one position a month
  • To avoid running a portfolio that requires constant good ideas:
    • increase concentration
    • increase hold time
    • buy entire groups of stocks at once
  • With his JNets, Gannon purchased a “basket” because he could not easily discriminate between Japanese firms which were both:
    • profitable
    • selling for less than their net cash
  • Portfolio concentration when investing abroad is based upon:
    • which countries do I invest in?
    • how many cheap companies can I find in industries I understand?
    • how many family controlled companies can I find?
  • Interesting businesses are often unique

How Today’s Profits Fuel Tomorrow’s Growth

  • To elements to consider with any business’s returns:
    • How much can you make per dollar of sales?
    • How much can you sell per dollar of capital you tie up?
  • Quantitative check: Gross Profit/ ((Receivables + Inventory + PP&E) – (Payables + Accrued Expenses))
  • Once an industry matures, self-funding through retained earnings becomes a critical part of future growth; it’s the fuel that drives growth
  • A company with high ROIC isn’t just more profitable, it can more reliably grow its own business
  • Maintaining market share usually means increasing capital at the same rate at which the overall market is growing
  • Higher ROIC allows for the charting of a more reliable growth path
  • Industries where ROIC increases with market share present dangers to companies with low market share or low ROIC
  • The easiest place to get capital is from your own successful operations; tomorrow’s capital comes from today’s profits

Why Capital Turns Matter — And What Warren Buffett Means When He Talks About Them

  • Capital turns = Sales/Net Tangible Assets
  • Buffett nets tangible assets against A/P and accrued expenses; gives companies credit for these zero-interest liabilities, rather than assuming shareholders pay for all of a company’s assets
  • Buffett’s businesses tend to have higher sales per dollar of assets
  • Companies with higher sales per dollar of assets have higher ROIC than competitors even if they have the same margins
  • There’s more safety in a business in an industry with:
    • adequate gross margins
    • adequate capital turns
  • Industries dependent upon margins or turns open themselves to devastating attacks from the player who can maximize key variables you control:
    • price
    • cost
    • working capital management
    • etc.
  • Companies often compete on a specific trait; it has to be a trait that is variable and can be targeted for change

How to Lose Money in Stocks: Look Where Everyone Else Looks — Ignore Stocks Like These 15

  • It’s risky to act like everyone else, looking at the same stocks everyone else looks at, or by entering and exiting with the crowd
  • Don’t worry about which diet is best, worry about which diet you can stick to; find an adequate approach you can see through forever
  • Having Buffett-like success requires every day commitment
  • You should aim to earn 7% to 15% a year for the rest of your investing life if you aren’t going to fully commit like Buffett did
  • A good investment:
    • reliable history of past profitability
    • cheap in terms of EV/EBITDA
    • less analyst coverage
  • A list of such stocks:
    • The Eastern Company (EML)
    • Arden (ARDNA)
    • Weis Markets (WMK)
    • Oil-Dri (ODC)
    • Sauer-Danfoss (SHS)
    • Village Supermarket (VLGEA)
    • U.S. Lime (USLM)    
    • Daily Journal (DJCO)
    • Seaboard (SEB)
    • American Greetings (AM)
    • Ampco-Pittsburgh (AP)
    • International Wire (ITWG)
    • Terra Nitrogen (TNH)
    • Performed Line Products (PLPC)
    • GT Advanced Technologies (GTAT)

Geoff Gannon Digest #4 – A Compilation Of Ideas On Investing (@geoffgannon)

The “Geoff Gannon Digest” is a series of posts highlighting some of my favorite wit, wisdom and investment advice from value investor Geoff Gannon. Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

How To Think About Retained Earnings

  • Grab 15 years of data from EDGAR and compare receivables, inventory, PP&E, accounts payable and accrued expenses to sales, EBITDA, etc.; E.g., if receivables rise faster than sales, this is where “reinvestment” is going
  • For a quick comparison, look at:
    • Net income
    • FCF
    • Buybacks + dividends
  • Compare debt (total liabilities) between the start of the period and the end and subtract the difference to get growth in debt
  • Then, sum all dividends and buybacks over the period, and all net income over the period
  • Then, subtract the change in debt from dividends/buybacks; what is left is dividends/buybacks generated by the business, rather than growth in debt
  • Then, compare this to net income to see the ratio of earnings paid out to shareholders
  • You can compare the growth in net income to retained earnings to get your average return on retained earnings
  • Look at the change in net income and sales over 10 years and then the ratio of cumulative buybacks and dividends to cumulative reported earnings
  • You’re looking for the central tendency of return on retained earnings, whether it is approx:
    • 5%, bad business
    • 15%, good business
    • 30%, great business
  • Companies with single products easily generate high returns on retained earnings, but struggle to expand indefinitely

One Ratio to Rule Them All: EV/EBITDA

  • EV/EBITDA is the best ratio for understanding a business versus a corporate structure
  • Net income is not useful; FCF is complicated, telling you everything about a mature business but nothing about a growing one
  • General rule of thumb: a run of the mill business should trade around 8x EBITDA; a great business never should
  • Low P/E and low P/B can be misleading as it often results in companies with high leverage
  • P/E ratio punishes companies that don’t use leverage; they’re often worth more to a strategic buyer who could lever them up
  • The “DA” part of a financial statement is most likely to disguise interesting, odd situations; if you’re using P/E screens you miss out on companies with interesting notes on amortization
  • Control buyers read notes; why use screens that force you to ignore them?
  • FCF is safer than GAAP earnings or EBITDA because it’s more conservative and favors mature businesses
  • EBITDA misses the real expense in the “DA”, but FCF treats the portion of cap-ex that is an investment as expense, so they’re both flawed; investment is not expense
  • No single ratio works for all businesses in all industries; but to get started, EV/EBITDA is the best for screening
  • Example: cruise companies have huge “DA”, but no “T” as they pay no taxes
  • “Only you can calculate the one ratio that matters: price-to-value; there is no substitute for reading the 10-K”
  • Empirical evidence on ratios:

Blind Stock Valuation #2: Wal-Mart (WMT) – 1981

  • There is something wrong with believing a stock is never worth more than 15 times earnings
  • “Growth is best viewed as a qualitative rather than a quantitative factor.”
  • Buffett’s margin of safety in Coca-Cola was customer habit– repeatability
  • Buffett looks for:
    • Repeatable formula for success
    • Focus
    • Buybacks
  • “The first thing to do when you’re given a growth rate is not geometry. It’s biology. How is this happening? How can a company grow 43% a year over 10 years?”
  • Stable growth over a long period of time tells you a business has a reliable formula; look for businesses that behave like bacteria
  • Recognizing the value of changes after they happen is important, not predicting them ahead of time
  • You can’t post the kind of returns Wal-Mart did through the 1970s without a competitive advantage
  • Buffett gleans most of his info from SEC reports, things like 10-year records of gross margins, key industry performance metric comparisons, etc.

GTSI: Why Net-Net Investing Is So Hard

  • The challenge of net-nets is you often have no catalyst in sight and no wonderful future to visualize as you hold a bad business indefinitely
  • Graham’s MoS is integral– you can be off in your calculation of value by quite a bit but Mr. Market will often be off by even more
  • Focusing too much on time could be a problem in net-net investing
  • Two pieces of advice for net-net investing:
    • Put 100% of focus on buying and 0% on selling
    • Put 100% of focus on downside and 0% on upside
  • Money is made in net-nets not by the valuing but by the buying and holding
  • “You want to be there for the buyout.”
  • The hardest part of net-net investing: waiting
  • Graham and Schloss were successful likely because they built a basket, so they were always getting to buy something new that was cheap instead of worrying about selling
  • Focus on a process that keeps you finding new net-nets and minimizes your temptation to sell what you own

Can You Screen For Shareholder Composition? 30 Strange Stocks

  • Shareholder composition can help explain why a stock is cheap
  • A company’s shareholder base changes as the business itself changes; for example, a bankruptcy turns creditors into shareholders
  • Shareholders often become “lost” over the years, forgetting they own a company and therefore forgetting to trade it
  • Some companies go public as a PR ploy, so investors may be sleepy and inactive
  • Buffett understood this and understood that a stock could be a bargain even at 300% of its last trade price– National American Fire Insurance (NAFI) example
  • Buying a spin-off makes sense because many of the shareholders are stuck with a stock they never wanted
  • An interesting screen: oldest public companies with the lowest floats (in terms of shares outstanding); a lack of stock splits combined with high insider ownership is a recipe for disinterest in pleasing Wall St

How My Investing Philosophy Has Changed Over Time

  • Info about Geoff Gannon
    • high school dropout
    • bought first stock at 14
    • read Security Analysis and The Intelligent Investor at 14
    • over time, became more Buffett and less Graham
    • made most money buying and holding companies with strong competitive positions trading temporarily at 6, 10 or 12 times earnings
  • I like a reliable business with almost no history of losses and a market leading position in its niche
  • Geoff’s favorite book is “Hidden Champions”, which is part of a set of 3 he recommends to all investors:
  • Everything you need to know to make money snowball in the stock market:
    • The Berkshire/Teledyne stories
    • Ben Graham’s Mr. Market metaphor
    • Ben Graham’s margin of safety principle
    • “Hidden Champions of the 21st Century”
  • Once you know this, if you just try to buy one stock a year, the best you can find, and then forget you own it for the next 3 years, you’ll do fine; over-activity is a major problem for most investors
  • Bubble thinking requires higher math, emotional intelligence, etc.; that’s why a young child with basic arithmetic would make a great value investor because they’d only understand a stock as a piece of a business and only be able to do the math from the SEC filings
  • There are always so many things that everyone is trying to figure out; in reality, there are so few things that matter to any one specific company
  • One key to successful investing: minimizing buy and sell decisions; it’s hard to screw up by holding something too long
  • Look for the most obvious opportunities: it’s hard to pass on a profitable business selling for less than its cash
  • Extreme concentration works, you can make a lot of money:
    • waiting for the buyout
    • having more than 25% of your portfolio in a stock when the buyout comes
  • I own 4-5 Buffett-type stocks (competitive position) bought at Graham-type P/E ratios
  • “There is a higher extinction rate in public companies than we are willing to admit.”
  • Most of my experience came through learning from actual investing; I wish I had been a little better at learning from other people’s mistakes

Notes – AlephBlog Digest #1 – David Merkel On Corporate Bonds (@alephblog, #bonds

David Merkel, author of the AlephBlog, has an extensive background on Wall Street and is something of a value investor when it comes to his money management principles. There is a lot of good content on his site in various disciplines within the investment analysis and money management domains so this will likely be the beginning of a multi-part digest series. This one deals with his lessons about the corporate bond market. To read the entire original discussion, please click the title heading of each section.

The Education of a Corporate Bond Manager, Part I

How I learned the basics, and survived 9/11.

  • “Bond swap”– trading away an older bond of a company for a new issue
  • New deals almost always came cheap
  • Think about bonds as a put option on the equity
  • When selling a bond, look at what investment banks ran the books of the deal
  • Never make it look like there are two sellers (by working with two banks) or bids will vanish; bad etiquette to employ two banks without telling them they’re in competition with one another

The Education of a Corporate Bond Manager, Part II

How I learned to trade bonds, and engage in intelligent price discovery.

  • If you want to buy a bond not presently offered, find out who brought the deal and made a market in the bond issue
  • Price discovery toolkit:
    • Comparable bonds in the same industry
    • Credit spreads across rating categories
    • Credit spreads across the maturity spectrum within rating categories
    • Spreads on CDS on the same name
    • Value of scarcity vs cost of liquidity
    • Proper spread tradeoffs on premium vs discount bonds
    • Calculate spread on last few trades
  • There is a price to gain liquidity that the issuer pays
  • “One-minute drill” creditworthiness check on Bloomberg:
    • GPO, how has the stock price moved over the last year?
    • HIVG, how have option implied volatilities moved of late?
    • CH6, how is operating cash flow?
    • DES, what industry is it in?
    • DES3, major financial ratios of the company
    • CH2 or ERN, earnings declining?
    • CRPR, credit ratings?
  • If these tests are passed, odds of company doing badly while waiting for a credit analyst’s opinion are slim

The Education of a Corporate Bond Manager, Part III

What is the new issue bond allocation process like, and what games get played around it?

  • Speed of decision process when buying new bond issuance based upon:
    • complexity of deal
    • creditworthiness of issuer
    • speculative nature of market
  • When market runs hot, odds rise that the syndicate will overprice a deal and deliver losses to those asking for overly large allocations
  • Dealing in the gray market has taint, you don’t want to be seen doing it lest your allocations be reduced
  • Syndicates want to place bonds entirely with long term holders if they can, implies they priced it right, leaving little money for speculators

The Education of a Corporate Bond Manager, Part IV

On the games that can be played in dealing with brokers.

  • Poker aspects of the bond market:
    • be honest, keep your word on trades, don’t weasel out once you say “done”
    • have a fair reputation, that you don’t try to pull fast ones on the broker community
    • reputation for fairness should be reinforced by other actions
      • if ibank quotes price/spread out of market context, let them know what you know; only trade against them if they insist they’re right
      • if risk control desk comes to you with a trade to cover a short and you own the bonds, help them; make them pay a little more than the ask but don’t gouge, then they might offer you the long cross-hedge bond at a nice price
    • have an “openness policy”; reveal 80% and conceal 20%, the most critical 20%
    • your broker at the ibank is proud of his best clients; he doesn’t want to lose you if you’re bright, trade a lot, run a big account
    • never tell your whole story to any broker; break up your business among many brokers, with no overlap
    • it’s good to have a reputation for being bright, or at least not a pushover
  • It’s freeing to not think about whether a particular trade will generate a gain or a loss but rather how the portfolio can be improved

The Education of a Corporate Bond Manager, Part V

On selling hot sectors, and dealing with the dirty details of unusual bonds.

  • It takes time and effort to farm, but financial products can be whipped up in any season
  • If I am underweight, someone else must be overweight versus the index; someone has to absorb all the paper of a hot sector, don’t let that be you
  • Credit analysts understand the creditworthiness of bonds; what do PMs understand?
    • portfolio composition vs needs of the client
    • trading dynamics of the marketplace, whether good bonds might temporarily be mispriced
    • dirty details of the bond; covenants, terms, etc.
  • A lot of value is added by document review; in a time of panic, those insights are golden because other managers toss out illiquid bonds they don’t fully understand

The Education of a Corporate Bond Manager, Part VI

On dealing with ignorant clients, and taking out-of-consensus risks.

  • Optimal strategy for life insurers: interest spread enhancement with loss mitigation
  • Defaults are a fact of life; if you run with such a thin capital base that you can’t survive a few modest defaults, you’re running your insurance company wrong

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

  • Credit analysts are a corp bond mgrs best friend
  • Provide a necessary check on a PM trying to play “cowboy” and be a yield hog
  • Native tendency is to reach for yield:
    • a portfolio with more yield earns more
    • a higher yielding credit will rally, due to mean-reversion
  • The second is true about 50% of time, but rewards are assymetric; gains are small, losses are large– it doesn’t pay to be a yield hog
  • All analysts have biases; to overcome, give them a list of spreads for companies they cover and ask them to rank the credits in that sector
  • For Mr. Yes, ask him about risk factors; for Ms. No, ask what are the best names she’d invest in
  • Every investment shop tends to create a monoculture modeled off the PM at the top; to avoid bias:
    • have multiple analysts look at a conviction idea
    • have PM take it home and analyze it
    • look at Street research to find bears, and circulate the opinion to the team

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.  I never knew that I could haggle so well.

  • There may be 7000 actively traded stocks in the US but there are nearly 1,000,000 bonds, the last trade of which may have been a week or a month ago
  • After adjusting for default risk, the number one predictor of portfolio return is yield
  • Default risks are lower after the bust phase of the credit cycle, rise as the credit cycle gets long in the tooth
  • David does a trade: “But how to come to the right price/yield/spread?  I had a few trades, but they were dated.  I knew the spreads then, and used the spreads of more liquid similar credits to adjust it to a likely yield spread today.  I put in a fudge factor because illiquid bonds are higher beta, and then studied which of my brokers might have a bead on the bonds in question.  I would ask them their opinion, and if they were in my ballpark, I would back up my bid some, and bid for $1 or $2 million of the bonds.  The response would come back, and I would have a trade, or nothing, but maybe some color on where they would be willing to sell.  If a trade, I would back up my bid a little more, and offer to buy more.  If no trade, I would offer 50-70% of the distance between our bid/offer, and see what they would do.”
  • How to have a successful auction of bonds you own:
    • limit auction to dealers who have most interest
    • say you’re just raising cash, eliminates information risk, makes them willing to bid
    • cover level is the second place bid
    • can’t come back begging for love
    • ties are fine; no love, both brokers get half
    • not enough bids, cancel it
  • Limits to haggling: when you’re already getting an unreasonable deal, smile, say thanks and move on; it’s more important to be invited back
  • Bid/offer fewer bonds than wanted by the seller/buyer at the level, and ask for better terms at their size; makes them more willing to deal
  • Always pay your brokers, it makes them more loyal to you
  • Trading is an amplified version of character; try to be fair everywhere you can while still making money for the client
  • Playing for the last nickel costs 95 cents in the long run

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

  • You aren’t supposed to act like a market-maker; if it’s known you aspire to risk-free profits, they might use their power to hurt you:
    • lower allocations on new deals
    • tougher in haggling
  • Reputation matters
  • Gravitate secondary trading business to those who “walk the walk”

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.  Also, how to make money in the bond market when you reach the risk limits.

  • You can only do deal #2 if you’ve done deal #1
  • Macro theme: stability usually triumphs over discontinuity

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.  Also, on aggressive life insurance managements.

  • Bonds are assymetric
  • Paid to be cautious regarding failure
  • When in doubt, sell
  • Don’t always take your broker at face value

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.   Also, the end of my time as a bond manager, and the parties that came as a result.   Oh, and putting your subordinates first.

  • On timing purchases and sales:
    • the large brokers generally know who is doing what
    • be nice to sales coverage, you’d be amazed what they’ll tell you
    • keeping the VIX on screen helped accelerate or slow down purchases and sales in a given day; yield spreads lag behind option volatility
  • On time horizons:
    • Three horizons
      • daily
      • weekly-monthly
      • credit cycle
  • On scaling:
    • moving in and out of positions slowly, as market conditions warranted, is useful
    • “Never demand liquidity unless it is an emergency and you meet the strenuous test that you know something everyone else does not. But, make others pay up for liquidity where possible. You are doing them a service.”

Notes – Geoff Gannon Digest #3 – A Compilation Of Ideas On Investing (@geoffgannon, #ncav, #netnet, #valueinvesting)

The “Geoff Gannon Digest” is a series of posts highlighting some of my favorite wit, wisdom and investment advice from value investor Geoff Gannon. Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

Is Negative Book Value Bad?

  • Negative equity itself is meaningless (could be good or bad)
  • Compare net financial obligations to EBITDA
  • Think of borrowed money as the price of time; ask yourself if you’d rather they borrow money or spend time
  • Stocks in Geoff’s portfolio tend to:
    • have positive FCF
    • have unusually high ratios of FCF to reported earnings
    • buy back shares
    • pay dividends
    • have excess cash after the above
  • “I have found I do not make good decisions when I have to juggle 10 or more opportunities in my head at once”
  • “I don’t believe in taking a risk where I think if everything goes perfectly the upside is still going to be in the single digits”
  • How much debt is too much debt is a separate issue from whether the debt is being used productively
  • When soaring over the market trying to find bargains, these are useful as screening tools:
    • tangible book value
    • EV/EBITDA
  • If an entire country’s market has a low P/TBV or EV/EBITDA, this is important to know; you can buy indexes on this info alone
  • However, ultimately the following matter more:
    • liquidation value
    • market value
    • replacement value
    • Owner Earnings
  • Move beyond being a record keeper — an accountant — and become an appraiser
  • The assets that matter most on the balance sheet:
    • cash
    • investments
    • land
    • intellectual property
    • tax savings
    • legal claims
  • Cash flow protection is much better than asset protection
  • Businesses with special assets that are not separable from the operating business are most likely to not be reflected on the balance sheet and present hidden value
  • Being in a strong, safe liquidating position does not necessarily mean you are in a strong, safe operating position
  • Working capital needs and capital spending needs are part of the DNA of a business; “you can’t turn a railroad into an ad agency”
  • Negative equity itself is not a risk; poor interest coverage is
  • Non-aggressive long-run return assumptions:
    • stocks – 8%
    • bonds – 4%
  • When looking at companies with negative equity and stock buybacks, ask yourself the following:
    • Earnings yield of stock buybacks > interest rate on borrowed money?
    • Need to adjust financial obligations (such as unfunded pension liability) to determine true extent of liabilities?
    • Are net financial obligations (debt and pensions minus cash) a low enough multiple of their EBITDA?
    • How many years of FCF would it take to pay off all financial liabilities?
    • Is the price of the entire company in terms of EV/EBITDA low enough to justify investment?
    • How reliable is EBITDA, FCF, etc?
  • Common concerns in these situations:
    • Moat not wide enough
    • High risk of technological obsolescence
    • No pricing power/cost cutting potential to support margins
  • The right company can have negative equity and be investable if it is a wide moat business with almost no need for tangible investment:
    • Negative working capital
    • Minimal PP&E
    • A wide moat

Is It Ever Okay For A Company To Have No Free Cash Flow?

  • Four cash flow measures:
    • Owner’s Earnings (most important)
    • EBITDA
    • CFO
    • FCF
  • You can get a hint where a company is tripping up in delivering cash to shareholders (FCF) when:
    • EBITDA is positive
    • CFO is positive
    • Net income is positive
  • EBITDA measures the capitalization independent cash flow of the business; it doesn’t take into account spending today for benefits that won’t be realized until tomorrow; also misses working capital changes
  • Look for companies that are growing quickly in an industry that is not
  • Avoid companies that are fast growing in a fast growing industry; it will face more competition every year
  • To judge the future ROI of FCF reinvestment with a company that has no FCF, look at:
    • Will they be competitive?
    • Will competitors over expand?
    • Do they have a moat?
  • When a company spends so much on growth for so long, you really are betting on what the ROI will be way out in the future
  • “There isn’t necessarily a prize for being the last one to succumb to the inevitable. It’s usually more of a moral victory than an economic one”
  • Don’t short a great brand; if you want to short something, short a company:
    • with a product with inherently poor economics
    • a bad balance sheet
    • with deteriorating competitiveness
    • preferably in an industry with a high morality rate
  • When a company reinvests everything, you need to worry about what they’ll earn on their capital many years out

Value Investor Improvement Tip #1: Settle For Cheap Enough

  • A lot of people look for:
    • lowest P/Es
    • lowest P/Bs
    • highest div yields
    • new lows
  • This creates lists of companies that are quantitative outliers, instead of companies you know something about
  • You should feel comfortable throwing out 7/10 names found on a screen
  • Better to cast a wider net and then focus on companies you can learn a lot about by reading 10-Ks
  • Try a screen that combines (Ben Graham-style):
    • above average div yield
    • below average P/E
    • below average P/B
    • fewest unprofitable years in their past
  • Start with the company that sounds simplest, then move out slowly and carefully to those you understand less well; stop when you find something cheap that you know you can hold as long as it takes
  • Another screen:
    • EV/EBITDA < 8
    • ROI > 10%
    • 10 straight years of operating profits
  • You need a good reason for picking stocks that don’t meet this criteria
  • It’s hard to figure out companies with a lot of losses in their past; so don’t try
  • Familiarize yourself with a few stocks; what insiders have is familiarity
  • You want to find companies where you can think more like an insider
  • For long-term investing health, it’s better to find a slightly less cheap — but still cheap enough — stock you can get familiar with than a super cheap one that is a mystery
  • Anything less than NCAV is cheap enough
  • “Some of value investing is in the buying; most of value investing is in the holding; almost none of value investing is in the selling”