New Site!

This blog has been MOVED, enjoy!

Help Grow The Community!

I've just added a whole lot of social networking options to the site in a way that I hope will benefit current and future readers. Please make use of these as they should make your experience as a reader of this site more enjoyable and they will hopefully drive new traffic to the site as well. My thinking is that the more readers we get to visit the site the better the discussion is, and the better the learning experience for all of us.

Here are the ways you can now interact with the site:

• RSS - Click the orange button to the right in order to subscribe to the RSS feed. This will ensure you get the latest articles as soon as they are published.
• Twitter (follow) - Follow me by clicking on the twitter button to the right. Not only will you be informed of new developments on this site but you will also receive thoughts of mine while conducting investment analysis, reading news and thinking about value investing. Many of these updates will only be found on Twitter and will not make their way to the site.
• Twitter (re-tweet) - If you are currently a Twitter user you can now re-tweet articles of your choosing directly from the site. Just click "retweet" under the Twitter counter to the left-side of the post you would like to re-tweet. I would really appreciate you doing this on as many posts as you can and would like to share.
• Share - There is a share button under each article that allows you to submit the article to a variety of aggregators, social networking services, etc.
• LinkWithin - I found this great tool that automatically places links to relevant posts from the site under each article. This is a great way to explore the entire site and I hope it enhances your reading and learning experience while visiting.

Thank you so much in advance for helping us grow the community of friendly, knowledgeable readers we are always attracting to the site. The site grows every day and with your help it will grow even faster, which will greatly enhance the experience for all of us.

If you have any comments about the additions or if you have suggestions that will help attract more like-minded individuals to the site then please share. Enjoy the rest of your weekend!

Calculations of Return (ROA vs ROE vs ROIC)

Return on assets (ROA), return on equity (ROE) and return on invested capital (ROIC) are the three most prevalent metrics used to obtain an idea of the returns a company generates, and to compare this return generation to the company’s peers. While important information can be learned from each one of these metrics, there are some significant differences between them.

ROA, calculated as net operating profit after tax (NOPAT) divided by total assets, shows the returns the company is able to generate relative to its entire asset base. While generally a good metric to use in comparing companies in same industries, this metric can be skewed when a company is holding lots of excess cash or assets for sale. These assets, while not expected to generate income are used in the calculation thereby causing the return on assets to appear lower than that which the company’s actual productive assets generate.

ROE, calculated as net income after tax divided by total equity (excluding preferred shares), demonstrates the percentage return earned on each dollar invested by the shareholders of the firm. This metric is very relevant when comparing companies with similar capital structures but outside of such a scenario it should not be relied upon. As Assets = Liabilities + Equity, the more debt a company has in its capital structure the smaller the equity will be as a percentage of total assets. Unlike the ROA metric, which remains stable throughout all capital structures, ROE can appear extremely high or extremely low when comparing a company to another employing a very different percentage of debt to equity.

My personal favorite of the three is ROIC, calculated as NOPAT divided by ‘operating net working capital plus operating fixed assets’. Operating fixed assets are any assets that are expected to contribute to earnings such as equipment, land (if not excess), goodwill, intangible assets, etc. Using operating net working capital, calculated as ‘current assets’ minus ‘excess cash’ minus ‘current liabilities’, also ensures that current assets that aren’t expected to generate earnings (such as excess cash) are not included in the calculation. This metric is my favorite as it gives a good indication of a company’s actual capacity to generate returns through utilization of its productive assets. Also, this metric can be used to compare companies employing varying capital structures. My main use of this metric is in comparing it to a company’s weighted average cost of capital (WACC), an estimation of the return expected by the debt and equity holders of the firm on a weighted average basis. The purpose of comparing the two is described in a previous article.

Pivotal Stock Market Earnings Season

Dshort.com published an interesting article recently that calculated what is known as the P/E10 of the S&P 500. The P/E10 is essentially the current real price of the index divided by the average earnings over the past 10 years. Benjamin Graham created this ratio to be a more robust measure of the market’s value, as during times of extreme market fluctuation the regular trailing P/E is prone to somewhat illogical results. For example, the market currently shows a trailing P/E of 137.3, obviously due to the severely depressed earnings we’ve had this past year as well as to the recent run-up the market has seen in anticipation of future earnings. What is somewhat disconcerting is that the P/E10, while showing a more reasonable P/E of 19.1, still indicates the market to be overvalued in a historical context – the historical average P/E10 is about 16.3 while that of the trailing P/E is 15. This is even after the worst stock market decline in recent history; perhaps the stock market is getting ahead of itself?

Many of us will be watching for evidence of increased revenues this quarter, alongside hopefully increased earnings. Last quarter's earnings may have met already decreased expectations, but much of the earnings came about by way of cost cutting rather than top line growth. Since businesses likely had a stronger call to action for cost cutting than ever in our recent history, I would be surprised if the majority didn’t trim all that they could as quickly as they possibly could. Going into this earnings season there likely aren’t too many avenues left to cut costs. If the consumer isn’t the heavy-lifter this quarter that the market is expecting, and if revenues stay flat or decline as a result, then there isn’t much hope for even meeting expectations this time around. I wouldn’t be too eager to see the effect such a disappointment would have, especially after the strong run-up we’ve just had in the markets since March.

Every time in the past that the P/E10 went from the 1st to the 4th quintile (quintiles divide the P/E10 into 5 groups with the 1st being the highest P/E group and the 4th being the lowest P/E group) it’s ultimately declined to the 5th quintile where it bottomed in single digits. In March, the P/E10 of the S&P hit the 4th quintile after a long way down from the 1st and we are currently back into the 2nd quintile where the market is looking expensive. If a drop to the 5th quintile was to occur, it would come about from either a decline in the S&P to below 600 or alternatively from a strong resurgence in corporate earnings. If Q3 earnings didn’t have you waiting in anticipation before…

As an aside, in the past these declines have lasted anywhere from 3 to more than 19 years. The current decline is in its 9th year. I wonder how long earnings can remain weak for until the market decides to take fate into its own hands. In this environment I wouldn’t bet on it taking its time.

Lecture Summary - Irving and Thomas Kahn

The following article is based on the inaugural video lecture given to the new value investing class at the Richard Ivey School of Business in 2005. Mr. Irving Kahn delivered the lecture alongside his brother Thomas. Irving served as the second teaching assistant to Benjamin Graham at the Columbia University Business School and he has over 78 years of experience in the investment business. Irving and his brother founded their investment firm, Kahn Brothers & Company, in 1978.

---------------

The Kahn brothers are firm believers that value investing is an art, not a science. In making this point they allude to an artist that paints masterpieces as this artist will surely have some poor paintings along the way. If value investing were a science then it would be replicable. One would be able to run equations in a machine all day and consistently right answers would emerge, but since it doesn’t work this way it has to be an art.

As value investing is more art than science, a value investor has the greatest chance of success studying industries that they understand. The Kahn brothers recommend paying attention to smaller cap and obscure companies, as these will offer the investor who takes the time to learn more about the company, than does the public, a chance for great profit. This means looking at places where the markets are not overpriced and where there are companies that will enable a value investor to truly benefit. Sometimes to find these opportunities one must be patient and not necessarily have their portfolio invested all the time. Ultimately, the value investor has to stay strongly contrarian, as sometimes not committing capital to the markets is the best thing to do. You don’t need all your money on the table all the time and if markets are high don’t invest. Be very selective and keep your standards. At the time of the lecture (2005), the Kahn brothers were not finding a general theme in which they invest that they can say to go and look into. They are very adamant that while occasional themes evolve, all they can say is that they maintain that very strict contrarian approach. If something is very popular and everyone is buying the same stock they are, they stand back and ask themselves what they’re doing wrong. Half the price of a common stock is probably current fashion so if you can buy what’s currently out of favor, you are well on your way to investing successfully.

The Kahn brothers have a few important factors that they keep in mind when evaluating a potentially undervalued company:

• The company should either be obscure or out of favor. It can be a big company that is not obscure though if it is very much out of favor.
• Their analysis is very much balance sheet oriented. They are not interested in companies with excessively levered balance sheets and they like companies with little to no debt.
• Management should be on the same page that the brothers are on. If management can own a lot of stock and are incentivized as shareholders that is a big positive.
• They avoid companies that have, in combination; volatile cash flows, are excessively levered and have management that are not too swift. This would be a very bad combination.
• The brothers are not so focused on the income statement initially. What they would ask is, what’s the earnings potential of the business? If it were run properly, if management succeeded in their plan to close a losing division, etc then what would be a reasonable earnings level? They check to see if the stock is cheap based on this earnings level and if they are confident that management can achieve this goal.
• The brothers really don’t care if a company is losing money and they actually would like a company to be losing money (although not hemorrhaging cash) because that knocks the stock down and presents some wonderful investment opportunities.

The newspaper seems to be a major source of investment ideas for the Kahn brothers. Thomas points out that the new highs and lows lists, and their relative size to one another, give a good indication of the direction of the general market. While shopping the new lows list doesn’t seem like a hi-tech, sophisticated way to invest it can actually bring forth some interesting ideas. Events that will also be presented in the paper are if certain companies are having problems and their stock tanks as a result, or if entire industries are affected by a current event. When you find a problem in a company or industry, pull out the financials, do some work and see if any of the stocks have gotten knocked down to where they are attractive. You must then decide if they are attractive investments. The value investing philosophy has nothing to do with what’s on TV (i.e. the talking heads) as the journalists are interested primarily in which stocks are moving.

Value investing will not go away. One may think that with so much information out there, and available to the public, that for instance standard value screens such as price/earnings and price/book may not be as effective. In reality however it’s not about opening up Yahoo Finance and looking at the latest data. The Kahn brothers have positions in some very complicated to understand companies. They also have a position in a company that hasn’t filed in a year. Institutions can’t hold this company and one can’t pull the latest data up online. As a result, if you’re confident that management is sound then this presents an interesting buying opportunity. You ultimately have to look behind the situation and you have to do your homework to get a leg up on other investors.

Once value is found, the brothers tend to ease into a position rather than to buy in all at once. They like to buy a small stake and get to know the company better. Frequently shares they buy will go down, so they will do their homework and see if they were right in their analysis but just maybe bought too early. If so then they stick to their convictions and they buy some more. Some of the brothers’ best capital gains have come from this process of averaging down. They warn to not be fooled by “snake oil salesmen” who advertise making money extremely quick. Most of the Kahn brothers’ investments have a holding period of 3 to 7 years, and sometimes longer. There comes a point, where as with a plant, the company begins to wither. Management may no longer be good, competition may be getting worse; you can see this in advance and make a profit. Personally I would sell an investment as it approached my estimate of intrinsic value, as there are likely other underpriced opportunities where I can put this capital to work for above average returns. This is even for companies that remain strong.

When it comes to placing a value on the notion of growth, the Kahn brothers don’t see a point. They want to grow their capital and don’t care whether it’s by way of a growth company or not a growth company or whether earnings are growing quickly or not, they just want their capital to grow. If a company has clearly defined, great prospects then it’s common knowledge already. How can one determine how many of these great prospects are already priced into the stock? The brothers don’t feel particularly comfortable paying up for those great prospects as they don’t have a way of figuring out what they’re worth. As a result of avoiding stocks like these, the firm has very successfully grown their capital over the years and can postulate that they’ve taken less risk than the overall market. Everyone is enamored with growth stocks, but how about just growing your capital with non-growth stocks? That’s alright too.

Don't Panic Sell, Beat Mr. Market

The markets MAY have started a long awaited correction today, but then again it's impossible to tell for sure. Know the value in the companies you own, don't panic sell, and use major dips in the market as buying opportunities.

By trying to time the market's daily fluctuations you are playing a game that you can not win. This is how people end up buying high and selling low; the exact opposite of what you want to do. So please, have conviction in the companies that you own. If something material changes in one of your holdings then re-evaluate but otherwise do not let "Mr. Market" faze you. If anything, I get a little excited on days like today because it means we may finally have some more buying opportunities than we've had for the past couple of months. You should have a list of companies you would like to own, and then when the market finally serves them to you on a silver platter for the price you've wanted to pay for them, take it. If the market continues to drop, then buy some more. Over the long-term you WILL beat Mr. Market this way.

Stay strong my friends... we may have some exciting weeks ahead.