January 18, 2011 § Leave a comment
Ok, so we got the “is it selling cheap” down and the “what is the intrinsic value” down and we have talked about margin of safety and all those good things. But it’s still not time to buy. Being wise about your investments is more to do with keeping your emotions in check and making sure that you aren’t doing really stupid things because of any kind of psychological reasons then it is making sure everything fits into a numbers box.
This is probably why I am more inherently attracted to Charlie Munger than I am Warren Buffett. Sure Buffett is the granddaddy can-do-crazy-math-in-his-head super investor, but Charlie Munger is good ol fashioned don’t-be-a-one-legged-man-at-an-ass-kicking-contest common sense kinda guy. In fact the best thing I have yet to read on investment has come from a lecture he gave at Harvard in 1995 called The Psychology of Human Misjudgment.
So I think the most important thing you can do once you think something may be a good investment is to have this emotional check list that you go through. Give the investment some time. Think it over. Ask questions. Plot out the best case, good/likely case and worst case scenario and see if you could live with the worst. Be really honest about whether you are doing this because it would be risky not to as opposed to any number of outside factors, like herd mentality or whether you say things like “man I’ve put so much time into this. It’s gotta pay off. I’ve worked so hard.” No. Be zealous about staying as objective and conscientious to the context as possible.
I separate my questions into two chunks. Chunk one is more technical stuff:
-is there stable market share? As in, is there enough ways that they can get money and do what they do
-are they dominant or secondary in their industry
-do they have a strong brand? Is the brand being factored in to the price. Are you ok with that? (think Apple. Or Netflix. Or Coke.)
-do they use the power of the network/social media. Can they fit into a world dominated by google/twitter/facebook. Or does it not matter to their industry.
-Do they change fast. If yes, that’s bad. Don’t give yourself big hurdles to clear.
-Can they change their price, or are they in a dead heat with competition
-Do they have a moat beyond a brand identity?
-Do they have high inside ownership (I love inside ownership. Nice for them to have skin in the game. This is why I love Nordstrom as a company. Too bad they are always so freaking fairly priced. Man I should have bough in 08. Huge regret. Good lesson to learn. Trust your checklist.)
The second grouping of questions is…um…slightly less technical.
-Are you being stupid?
-Are you overconfident?
-Dividend? If not, justify your buy
-Is your margin of safety high enough?
-Are you buying for your own reasons, or because of someone else?
-Are you relying too much on past performance? (Just because they have a ROE of 20% for 5 years or have grown x amount of time in no way means they are a good buy.)
-Have you daydreamed about what living with the worst case scenario would be like?
-Is the stock falling or fallen. Remember the National Bank of Greece
-is this a concept stock or are they actually doing something. Don’t fall for the TSLA foil. (hey-o! see what I did there?)
-can you hold this for 3 years? Cuz you should. Now obviously, true value could be realized in 3 days, at which point you would sell. But it usually takes about 3 years for all the shoes to drop. Their hitherto unseen awesomeness is either revealed or you are revealed for not doing your homework.
The psychology of human misjudgement is something I am going to dedicate my investing life to. The emotional side of things is that important. Right now what I’m fighting against is the “omigosh the market is crazy rising! Buy buy buy!” Mix that with my youthful exuberance and my bias feelings of “hey, I’m the protagonist of this story. Of COURSE my portfolio is going to be awesome!” and you’ve got a recipe for crappy returns and buying things too expensive. So that explains why all is quiet on the CAPS front for me these days.
And I hope to update my emotional/common sense checklist every once and a while. I’ll let you know as I do.
*I don’t own anything I mentioned. Especially TSLA. Sell some cars, then we’ll talk.
January 5, 2011 § Leave a comment
Ok, so in the first part of this methodology survey we looked at some of my favourite metrics and the tests that businesses need to pass in order for me to consider them a good business qua business and also at a potentially a good value.
The second part of my methodology is to now really home in on that intrinsic value and see if I want to buy it at the price that is being offered.
Now, intrinsic value is not math. I mean, there is a lot of math involved, but there is no exact number you can reach. You can reach a ballpark figure, and if you have a big enough margin of safety, you don’t have to be perfect, just close. If you’ve calculated the intrinsic value of Graemecorp to be $25.50 a share and it is trading at $21 you don’t want to buy because you–like me–are probably wrong. Accept it. Respect the complexity.
Now, if Graemecorp is trading at $8 you may want to start thinking about buying. But the calculation of $25.50 that you reach is not infallible, no matter how much work you put into it.
But how do I determine intrinsic value? Well, its tricky, because the methodology is going to vary for different companies in different circumstances. Getting a good idea for fair value of a shipping company (which generally trades close to book value and low P/E) is going to be way different than for a venerable company like Johnson and Johnson, who has such a consistent history that you can feel comfortable if they are quite over book or have a higher P/E. So, sorry, you can’t just plug in a bunch of numbers into some sort of divine formula and get the perfect intrinsic value number. It’s an art!
So what I try to look for are floors and ceilings. A good floor to look for is what is called the liquidation value of a business, or in other words, what the business would be worth if you sold ever last paperclip, pencil and cleared out the inventory. (What this doesn’t take into effect is the value of the future profitability of the business.)
Two good numbers to give you a potential liquidation value are the Net Current Asset Value (NCAV) which is simply the Current Assets – Total Liabilities. If the number is positive and if the per share price of the NCAV is higher than what is on the market, man you may have a good thing on your hands (note: often times the NCAV is positive is the company has a ton of cash on hand. Cash on hand is very good, but if it is just sitting there not doing much, not being reinvested nor being paid out in a dividend, you may question whether you want to pay for money to be sitting around.
The second good number you can find is the Net Net Working Capital. This was Benjamin Graham’s (go read him now) pet figure. It is perhaps the best detailed number you can find for a liquidation value.
NNWC = Cash + Short Term Investments + (0.75 * account receivables) + (0.5 * inventory) – liabilities
The logic of this formula is that if you are liquidating a company, you wont be paying full price for account receivables or inventory, so these are some pretty conservative haircuts Graham uses to measure the value. Again, if the per share price is below this, then the business is worth looking into. If you feel that they wont go bankrupt, then you may have a good pick on your hands.
Now, that being all said, these are floors for me. If prices are below these floors (rare) then they are falling into a “special interest” category and should be looked at further. It could be awesome, but it could be deadly and the company is in serious trouble.
But once you have a good ballpark on liquidation value, you can now start looking for a good ceiling. For me, a good ceiling is what the company is worth when skies are blue and all they need to worry about is not screwing up. They don’t need to be heroes; they just need to run a healthy business. If they still look cheap after passing this test, then we’re really sitting on something nice.
So what I run are two different valuation tests: the Discount Cash Flow (using a normalized CROIC as my growth rate) and the Ben Graham Intrinsic Value calculation. To get a great handle on the DCF, read about it here. (Fun fact: I didn’t know you could find really easy DCF calculation tools online, so I did a whole spreadsheet exactly like the one on Investopedia. It was a disaster. Total unmitigated disaster. I didn’t know a thing about Cash Flow. I think I valued Coke at like $17 a share. That was a grumpy evening.)
With a DCF there are two big numbers you need to make a decision about: the growth rate and the discount rate. For me the growth rate is pretty easy: you can either choose the 10 year average of revenue growth, EPS growth, FCF growth etc. But what I like to use is the 10 year average CROIC rate (with a bit of a haircut for safety). So I use a 80% of the 10 year CROIC average for my growth rate. My reasoning is that CROIC really tells you about the worth of a company and not just what the company says they’ve done.
Now the discount value is a bit tricky. Investment banks churn out crazy greek numerical values and something that is called a Weight Average Cost of Capital (or WACC) in order to find the number that you will discount future earnings by. But for me it’s simple (common theme eh?). I tend to use a discount value between 12% and 15% because it is insanely high. But seeing as I would be really happy with an annual 12-15% appreciation on my invested money, this is a further built in margin of safety. I also look at a DCF model using the average 30 year corporate bond rate (around 6%) just to see the ballpark range I’m playing with.
The second valuation I run is the Graham Intrinsic Value metric. Ben Graham talked about this a lot in his book and Jae Jun over at Oldschool Value has a great updated version of the formula that he uses (and that I stole!)
So let’s recap. I now have:
a NNWC value
a NCAV value
a DCF using CROIC and with a discount value
a Graham Intrinsic Value calculation.
So now I have a pretty good idea of my floor (NNWC, NCAV and a book value per share) and my ceiling (DCF) with my Graham value somewhere in the middle. All things being equal, my intrinsic value should be closer to my ceiling than my floor, so if I want to get good value I need to buy at a healthy discount of my ceiling. So I look for a 50% off of the DCF and I try to practice what Graham preaches with a 66% off of his intrinsic value calculation but it’s rare to find something like this.
So that’s my check list! You can see the breakdown here:
Now, all this being said, each business and each circumstance around the business is unique and they are all treated differently. These are just my checklists, but there are instances where the company doesn’t pass the checklist, but still seem an attractive buy. And also there are companies that pass the checklist, but I don’t jump in because I’m not gung-ho about the business model. So in order to compensate for this, I have a bunch of questions/emotional checks and balances that I ask myself in order to see if I’m being a smarty-pants or actually being wise.
More of that in post 3
January 4, 2011 § 2 Comments
I gave myself a couple of investing challenges this past week. Not so much New Years resolutions, as more a guideline of good habits (and breaking bad ones) that I want to implement into my financial life. One of the bad habits to break was to stop playing around with leveraged commodity ETF’s, my favourites being HOU.to (which follows crude oil prices) and HKU.to (which follows copper.) They are definitely not value plays and therefore I shouldn’t be playing around with them. But having the type of disposition I have (being pretty calm when people go nuts about something) means that I do pretty well with tracking crude oil hysteria and price jumps.
But it’s not a science and I shouldn’t get into the habit of playing with it too much. And they fall way out of my investing worldview bubble, so I should just cut them out. You know…sometime. (Note: Yeah, so writing this out has made me rethink the whole short-term commodity trading and I realized I’m playing with fire. Sold all my positions in HOU.to (had none in HKU.to.) Made some money, but it’s guilt money! Lesson learned: do not stray from your worldview.)
But a good habit I’m implementing is to actually formalize my checklist and have the businesses I invest in pass my criteria. The checklist is designed to look for devaluation in price, gauge financial health, ballpark intrinsic value and have all the info at my fingertips so I can make a decision.
Now, there are plenty of awesome spreadsheets out there that can do all of this for you. The best one I’ve ever encountered is put together by Jae Jun at oldschoolvalue.com. He’s been tinkering with that sucker for a while now, and it is so worth the price he charges for it. If you want to save some time, go there and get it.
Now, there are two negative things that happens when you buy a ready made checklist. The first is that you are following what the author deems to be important (Jae sidesteps that problem by putting every freaking thing you could ever want in it!) The second, and more serious consequence is that you never learn how to do this stuff yourself. So that’s why I decided to clack out my own spreadsheet of the metrics that I use to gauge intrinsic value.
So lets talk about the process!
For me, investing is about one simple concept: each stock represents a business (this in itself can be a revelatory idea for some people) and that business is worth something. The money they generate, the monetary value that they can produce by means of their product, service and combined intelligence is worth something in a dollar sense (aside: magic happens when the value created is monetary and a social value to the world. But that’s another blogpost). I as an investor am trying to figure out what that money is worth, what it will be worth in the future, and how much of it in the future the business will generate.
Then when you have that all important figure, you go and see if the market is selling the stock at a greatly reduced price to what you deem the intrinsic value of the business to be. Basically, you are trying to buy a dollar for 50c. (Props to Joe Ponzio).
So I am trying to do 2 things:
1. See if the market is potentially undervaluing a business.
2. Find a fair value for that business and compare my price to the market.
Part 1 is below. Part 2 will be in post 2.
So what I do is give a company tests to pass trying to determine if the market is under-valuing them and to gauge financial health. If they pass the tests then I try to figure out a good price (pretending that I wanted to buy the whole company for myself.)
These tests they need to pass. And warning: we’re gonna get technical now, so if you are a new investor–a mere youngling in the world, you’re gonna have to look these puppies up on Investopedia.
ROE >15% for the past ten years. I look at the average. This shows me what sort of return they are generating. It shows that they can at at the very worst manipulate their EPS every year, or, hey, at the best are actually adding value! But this number is not to be trusted. So that’s why he’s first. (Think of it this way: if you sold a TV with a year guarantee that if they hated the TV after a year they could return it for a refund, you as the TV salesman could report that sold TV as earnings this year. But if they return it and you have to pay them back, well, you can still call it earnings for your EPS, but just have the money flowing out in another section of your balance sheet. Sneaky eh!? So be careful with this one.)
P/E <10 A good indicator that the market is undervaluing the business. Again, be careful as different industries tend to trade at different P/E ballparks. But as far as I am concerned, once you start moving north of 10, 12, 14 you are getting into non-value zone.
FCF growth >10% for the past 10 years. You can’t argue with cash. Sure you can manipulate earnings, but not the movement of cash.
Assets > 1 and a half liabilities. Nice to know the outhouse isn’t overflowing.
Debt to equity ratio under 1. Debt can kill a business just as fast as it can kill a grad student.
FCF to debt > 10%. Good to see that they can manage the debt they do have.
If a business passes these tests, man they are worth a closer look to see what sort of price you’d like to pay for em.
I’ll show you how I try to find that intrinsic value in post 2.