Quality of Earnings Series

• Inventory & Accounts Receivables Analysis
• Earnings Made by Tax Rate Changes

Previously, I looked at analyzing the inventory and accounts receivables of a company which is a very simple yet highly effective method of detecting and predicting business performance. The method is not new but the extra work just isn’t performed by investors.

The good news is that I have created a stock spreadsheet version and I’ll be going through the methods described in the book ‘Quality of Earnings‘ to help detect warning signs and how much money a company is really making.

When this series is complete, and after some more thorough testing, the new updated financial statement spreadsheets will be released to existing spreadsheet buyers within their 1 year purchase timeframe as well as it being available for purchase.

Earnings Made by Tax Rate Changes

Wall Street is infatuated with EPS. If a company beats their estimates, the stock price is pushed up higher despite the fact that earnings is so easily manipulated by different accounting methods and hiding and/or delaying expenses.

Taxes also play a big role in the final EPS.

A company with a 40% tax rate one year, paying at 35% the next will create the illusion that growth has exceeded expectations, when in fact, the business did nothing but just get a tax break. The opposite is the same.

A company paying 35% in taxes and then 40% the next year will obviously report lower EPS and the consensus will be that the business is slowing down.

How to Calculate EPS Due to Tax Rate Change

Let’s use Boeing (BA: 67.24 -1.02%) as an example.

1. Calculate the tax rate

To calculate the tax rate of a company, find the income tax expense on the income statement and divide by the Earnings Before Income Taxes (EBIT).

Boeing’s tax rate was 33.7%, 33.6% and 22.9% in 2007, 2008 and 2009 respectively.

2. Calculate the difference in tax rates

Just subtract the previous year tax to the next year tax rate.

3. Calculate the gain or loss due to difference in taxes

Use the difference in tax % compared to the last period and multiply it by the income before tax (EBIT) number.

In BA case for 2009, multiply 10.7% and $1,731m to determine how much of EBIT was due to a lower tax rate.

You can see that BA made $185m in EBIT due to taxes compared to $4.16m the year before. In 2007, Boeing’s tax rate increased by 2.7% which is why the % difference is negative and shows a loss due to difference in tax.

4. Divide by Shares Outstanding and Adjust the EPS

Divide the gain or loss due to tax change by the number of diluted shares.

You can now see that in 2009, of the full year diluted EPS, $0.26 was made up due to a reduction in taxes. So while the market may have seen this as a great recovery, the actual EPS was actually $1.58.

Multiply the current PE of 36 to $1.58 and the stock price should be at $56.

The above method can be applied to quarterly results for comparisons and basically any other line item including non-operating and non-recurring expenses.

Let’s wrap things up with a stock valuation summary of Boeing for those that hold the company.
BA Boeing Stock Summary

Disclosure

None

You may also be interested in:

1. Choosing a Growth Rate
2. Bond Rate for Graham Formula
3. Calculating Maintenance Capital Expenditure

I was interviewed by Mariusz Skonieczny of Classic Value Investors and the author of “Why are we so clueless about the stock market” back in January and the interview is now up.

If you want to get some history on Old School Value and a feel for how I think when it comes to investing, be sure to check out the interview.

I’m no Buffett, Klarman, Ackman or Berkowitz but I tried to answer as best as I can

Read the interview.

You may also be interested in:

1. Has Fear Blinded Investors to Value
2. Accounting & Business Red Flags for Investors
3. Wellpoint (WLP) Valuation from Value Investors Club

Stock Screen Strategy and Backtest Series

• NCAV and NNWC Screen Strategy
• CROIC and ROIC Screen Strategy

Value Investing Screens

One of the most lacking aspects to all the widely available screens such as Yahoo, MSN, Morningstar etc are detailed screen criterias. They are all based on PE, PB, PS, ROE, BV and so on which don’t really help you find better investments than the next person.

This is where the Old School Value screeners try to fill this void. I’ve been working hard to come up with new value investing screen criterias and formulas to find the best strategies and opportunities.

One such strategy that I am very confident in is the CROIC screener.

CROIC – Cash Return on Invested Capital

As discussed in the previous CROIC and ROIC article, the formula for CROIC is shown below.

CROIC = FCF/Invested Capital

Invested Capital = Total Equity + Total Liabilities – Current Liabilities  – Excess Cash

Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets)

CROIC and ROIC Above 10% Screen Strategy

In this test, I tried two different strategies.

The first one was where a portfolio of 15 stocks were selected based on the current year and prior 2 years CROIC and ROIC being above 10%. Anything less than 10% didn’t make the screen.

I always tend to try and find companies with CROIC in the sweet spot which is usually above 10% as it indicates a strong executive team and company.

In the NCAV screen and NNWC screen, I only selected companies that had trading volumes above 30k, but for CROIC, since many of the companies are not illiquid micro caps, I’ve lowered the volume criteria to 20k.

CROIC and ROIC Above 10% Criteria

• CROIC and ROIC is greater than 10% for the past 3 years
• No OTC and financial stocks
• 15 stocks max in portfolio
• Volume is greater than 20k
• Slippage set to 1%
• Rebalance frequency set to 6 months
• Test period of 3 year time-frames

CROIC and ROIC Above 10% Results

The results show that companies able to produce high returns will beat or be consistent with the market. There is a good amount of volatility involved but the results are very respectable except for the 2007-2010 period where it just kept up with the market.

Over a 9-10 year period, the result is outperformance by a huge margin for the CROIC strategy but looking at the screen in different time frames, you wouldn’t have known.

Then it dawned on me that everyone looks for the above average companies. So I modified some more formulas and criterias to get the next screen.

CROIC and ROIC Increasing for 3 Years Screen

In the second screen, I removed the minimum CROIC and ROIC limit. This means that any company can make the screen, even if the CROIC and ROIC is negative. But my reasoning is that regardless of what the actual CROIC and ROIC numbers are, if the company has been increasing this metric for the past 3 years, the business is not only improving but management has done a good job of turning the boat around.

In other words, the screen should result in successful turnarounds which are often explosive opportunities.

CROIC and ROIC Increasing Screen Criteria

• CROIC and ROIC has increased each year for the past 3 years
• No OTC and financial stocks
• 15 stocks max in portfolio
• Volume is greater than 20k
• Slippage set to 1%
• Rebalance frequency set to 6 months
• Test period of 3 year time-frames

CROIC and ROIC Increasing Screen Results

As you can see, this second screen completely annihilates the first screen.

Assuming you followed this strategy the only down period would have been from 2007-2010 but overall had you started in 2001, your $100 would have grown to $850 by 2010 using the CROIC method and $385 using the ROIC method.

One thing is for sure on both accounts. CROIC is a much better indication of performance and better metric even in a screener.

I also added another criteria where FCF is increasing each of the past 3 years which also yield great results which I won’t display here as the results are very similar to above.

I’ll be looking at FCF related screens and strategies in the next strategy review but first, here are the companies that showed up in the screen.

5 Stocks that Pass the Increasing CROIC Screen

Disclosure

No holdings.

You may also be interested in:

1. NCAV NNWC Screen Strategy Backtest
2. ROE ROIC and CROIC
3. NCAV NNWC Backtest Refined

Forget ROE and use ROIC

Most people use ROE (Return on Equity) as a measurement of performance but ROE has a big drawback.

ROE = Net Income / Book Value

As you can see, book value is the denominator which means that if book value was to be reduced, the ROE would in fact increase. How would this happen? If a company writes down any of its assets, the book value would immediately decrease which results in a higher ROE.

The same would happen if the company increased its debt since book value is calculated as assets – liabilities.

The company didn’t perform any better, yet you are given a false picture. So ROE isn’t that great to use. Not even in a screen because you have a high chance of getting value traps.

Instead, ROIC (Return on Invested Capital) is a much better alternative performance metric to find quality investments as it measures the return on all invested capital , including debt-financed capital. It is the effectiveness of the company’s employment of capital.

ROIC is a lot of math but luckily it’s simple stuff without any of the Greek symbols that make your head spin.

ROIC = NOPAT/Invested Capital

For the numerator (the top part of the fraction)

NOPAT = Net Operating Profit After Tax = Operating Income x (1 – Tax Rate)

The denominator (a variation used by F Wall Street)

Invested Capital = Total Equity + Total Liabilities – Current Liabilities  – Excess Cash

where

Excess Cash = Total Cash – MAX(0,Current Liabilities-Current Assets)

CROIC Cash Return On Invested Capital

An even better metric that you can use is CROIC which I use to great effect in my stock value spreadsheets. CROIC is a.k.a CROCI but they both stand for Cash Return On Invested Capital.

You can also check out the CROIC ROIC screen backtest to see how it performs.

CROIC shows how much free cash flow per dollar the business generates from invested capital. I find this to be the ultimate performance metric as it shows so clearly how effective management is and the strength of the business.

CROIC = FCF/Invested Capital

The higher the CROIC, the more cash the company is generating and it also indicates that the business is a profitable one. Rarely do you see a high CROIC but low or negative FCF.

Of course you can use owner earnings instead of FCF.

How to Use CROIC

Until recently I’ve been looking for companies with high CROIC, usually above 10%, but with my latest screen and backtests, I’ve concluded that it isn’t the level of CROIC that is important but whether CROIC is increasing.

This makes sense because if a business has a CROIC of 15% in year 1 but then in year 2 it drops to 12% followed by a drop to 10% in year 3, the average is 12.3% but the picture is different to why I first liked the company to begin with.

Instead, if CROIC is low or even negative, assuming CROIC was to increase, it indicates that management is getting things back on track which will make for a much better investment.

This is something I’ll be going over I’ll be going over in the posts to come. I’ll detail the strategy and performance of stock screens based on ROIC and CROIC.

Update: CROIC strategy backtest has been performed.

You may also be interested in:

1. CROIC ROIC Screen Strategy Backtest

Old School Value Stock Portfolio Performance

Portfolio Performance

Things moved back in the right direction this month. Up 10.67% compared to the market’s 2.71%.

On an absolute basis, I am up 48.65% and outperforming the market by 50% since Oct 2007.

Portfolio Movers

The world economy isn’t in such a healthy state as most people would like to think. The issues facing Greece and Japan is very real and the US isn’t in such a rosy state of affairs either. So despite the 10% gain for the month, it was still tough. In times like this, opportunities need to be focused on event driven investments.

The main event driven catalyst to my portfolio was on my largest holding GGWPQ. Followers of GGWPQ already know all the details so I’ll skip it here. You can catch up on what’s been happening at Pakiya Funds who has been doing a great job of providing updates.

(MHH: 4.2001 -1.17%) released their full year results and things are still going very well at the company. The stock price however, has been going down steadily the past month on no news and low volume and I want to point out again that price is not an indicator. When you look at your holdings, you should always compare the value to the price and buy or sell accordingly.

I’ll provide an update on MHH when the 10-k is filed. I emailed investor relations but got no response. Not impressed in that respect since I doubt investor relations is being flooded with emails and calls from investors.

Portfolio Trades

1. Bought more GGWPQ

Bought more as the price kept dropping and was rewarded with the huge jump due to the buyout offer from (SPG: 79.79 +0.45%).

2. Sold (PDII: 5.83 +2.64%) @ $5.05 for a 48.97% gain

PDII never reached my intrinsic value but with what’s going on in healthcare politics and the industry, I wanted to convert the position into cash for better opportunities.

3. Sold (ETM: 11.63 -3.57%) @ $8.67 for a 144.92% gain

I sold ETM without waiting for the full year results and it turned out to be a mistake. I was getting impatient and sold without comparing price to value. ETM is the best of breed in the radio industry and their results showed improvements in the business. I still hold (ROIAK: 3.22 -1.53%) which should also do well when results are released.

Cash is now back to around 12%.

Others

This month I finished reading Payback Time and A Random Walk Down Wall Street. I also read Quality of Earnings again in January so that’s 3 books read so far in 2010. I’ve got books stacked up waiting for me on my desk so my free time is spent reading rather than analyzing these days.

I originally bought A Random Walk Down Wall Street about a year ago without knowing what it was about. I should have read it as soon as I received it 1 year ago so that I could have returned it. While there are some interesting sections related to behavioral finance and history of bubbles, most of it is about efficient markets which I found no use for. That’s about as much time I’ll spend writing about a book I don’t recommend.

Disclosure

I hold all stocks mentioned except sold positions.

You may also be interested in:

1. Portfolio Update January 2010
2. Portfolio Update December 2009
3. Portfolio Update July 2009

I’ve seen the author Phil Town on TV a few times and his first book Rule #1 has a big following but I never got into it because it spent a lot of time on technical analysis, trading techniques and an analysis method that didn’t resonate with me.

But when I was contacted to receive an advance copy of Phil’s new book Payback Time, I was happy to hear it was more about value investing and analysis and was glad to take a read.

Payback Time

The title refers to two things throughout the book.

1. Mutual funds are a waste of time and money where only the managers and brokers get rich

2. It is the price of the business that will be repaid in x number of years out of earnings

As with most books, it starts off by explaining why mutual funds are a bad idea backed up by data and Phil’s own personal experiences from the industry and then moves onto the main concepts of what he calls “stockpiling”.

I have to admit I liked the section on the mutual fund and Wall Street bashing It’s why you need to fire your financial adviser.

Stockpiling

Stockpiling is a term used frequently in the book. It’s where an investor buys a company they truly understand and believe in with a MOS and then continues to buy more if the price falls. Essentially, it is a buy low and sell high strategy which so many people know, but fail to do.

However, Phil does a good job of explaining the difference between price and value so that a beginner investor won’t be overwhelmed by the fear that a falling stock price will make them bankrupt, but rather a perfect opportunity to load up more as long as price inefficiencies exist.

Value Investing Principles

To decide upon which company to buy, you first need to find a company that you can understanding and be willing to work on as well. The book makes it clear that work is required to invest successfully but you don’t have to be a genius. He boldly states that any normal person can make 25% annual returns compared to the average 6-8% you expect to see with mutual funds.

While looking for a company, you need to find awesome businesses that contains the 3+1 M’s.

• Meaning (understanding the industry, company and business model)
• Moat (competitive advantage)
• Management (passionate, ethical, dedicated, honest)
• and Margin of Safety (which is introduced later in the book)

Valuation

The valuation method that Phil uses is a very simple method. He doesn’t use DCF valuation, Graham based formulas or EPV like I do. It’s very simple math, or you can use the tools on his site, but to summarize the method, you need to:

• Find the average PE
• Check BVPS (book value per share), sales, EPS and cash growth rate
• How many years does it take to repay debt from earnings

If the company passes the criteria that each one is supposed to meet, you can now value the company.

• Use a discount rate of 15% aways
• Get the TTM EPS, growth rate calculated above, PE, and discount rate of 15%
• Follow the examples and instructions in the book or use the Payback Time calculator

A Very Practical Book

Payback Time, isn’t a value investing book per se, but for someone wanting to learn how to invest, it is an extremely practical book. In fact, it is more like an instruction manual.

The book provides step by step instructions and screenshots of Yahoo finance to show you how to find companies you are looking for. The valuation section is also dealt with in a clear step by step manner. It even goes into teaching you how to use the MSN screener.

The downside is that if the websites change, then the book is immediately outdated. Just like how the MSN screener is no longer available today.

Who is it For?

What I liked about the book is that it fills a big void by providing instructions on how to find, value and select a company. While the methods are not perfect (if there is one), I can see the book being valuable to many new investors. I see the book more as a skeleton to investing. This will be a good way for many people to start and learn from.

The book is conversational and very easy to read which I finished in 2 days by reading at a fast rate. If anything, I felt there was a little too much self promotion.

You may also be interested in:

1. Investment Book Review: F Wall Street
2. Earnings Power Value EPV and Book Review
3. Investing Book Review: Why are we so clueless about the stock market

You may feel that you never have enough time to invest, but I believe otherwise. By utilizing time better and eliminating unnecessary distractions, you could increase the amount of time you spend analyzing a company.

Warning: You will be at risk of being called a geek.

1. Learn to Speed Read

What I want is to greatly improve the speed of my reading while still comprehending everything that I’ve read.

You may want to be a faster runner, so you practice and work at it to increase efficiency, or since you are reading this blog, you want to be a better investor, so you try to improve your skills.

Reading is the same, but a majority of people never realize.

Currently I can read about 400 wpm (words per minute) with a comprehension of 80%. The average person is 250wpm at 85% accuracy. My ultimate goal would be to get to 1000wpm.

Why: Rip through annual reports, conference call transcripts, letters to shareholders, books and other lengthy material.

2. Clean Up Your Blog List

If you read blogs, I bet you have far too many on your list. You don’t read more than 30% of them anyways.

Most blogs don’t help you with what you are trying to achieve. This goes the same for many of the news sites.

Why: You will never be a better investor by reading blogs. You may make some money following people’s moves, but you won’t understand why and your investing skill will be based on searching for people to follow.

3. Eliminate Noise

Is CNBC really that important to your investment and analysis?

Why: You learn nothing. Why not spend the 30min reading some good investment books instead?

4. Take reading Material with You

You likely spend your day with frequent idle times where you do nothing.

Try reading something when you are waiting in line at the bank or the post office, waiting for your wife while she is clothes shopping, doing your business in the toilet, waiting for your car to warm up, on the bus, train or plane etc etc

Print out an annual report, proxy, financial statement or take a book around everywhere you go.

Another way is to convert the sec filings to a PDF and then read it off your phone, e-book reader or any other capable gadget.

Why: You may only get to read 1 page at a time but it all adds up. It also sticks with you throughout the day and by the end of the day you could have read 20 pages.

That’s 20 pages more than the next guy complaining that they don’t have time to read and learn.

5. Eliminate Finance Podcasts

Listening to the news or an entertainment program via podcast is fine, but finance related podcasts I find to be a waste of time. Podcasts are much like verbal blogs so there is no set topic or structure that flows from one to the next.

I can never remember what was mentioned and it’s literally in one ear, out the other.

Why: Just another example of how impatient and demanding human nature is. Learn to speed read and you’ll never need podcasts, except maybe while you’re driving.

You may also be interested in:

1. How to Invest: Research and Valuation Process
2. Open Source Investing
3. All Intelligent Investing IS Value Investing

I first started the 2009 Forbes 200 small companies list in November of 09 and wanted to close out this series by listing all 200 companies in an easy to read and analyze format. You can view the previous analysis in each of the 7 parts below.

• 2009 Best Small Companies Part 1
• 2009 Best Small Companies Part 2
• 2009 Best Small Companies Part 3
• 2009 Best Small Companies Part 4
• 2009 Best Small Companies Part 5
• 2009 Best Small Companies Part 6
• 2009 Best Small Companies Part 7

Download the excel version or the pdf below.

You may also be interested in:

1. Forbes Best Small Companies Part 7
2. Stock Investments From Forbes 400 Best Big Companies
3. Forbes 200 Best Small Companies Project

NCAV & NNWC Backtest Criterias Updated

Following on from the great discussions and feedback from the initial NCAV NNWC strategy, I’ve made some changes to the screen testing criterias to make it more realistic.

The best way to go about the screens would be to screen for companies that had enough daily volume. A reader, Chroma, also mentioned that Graham stated that it was best to buy NCAV stocks trading at less than 66%. Absolutely right. So I included this margin of safety into the backtest.

Purpose of Backtesting

With the backtest, I went as far back as 10 years, but I realized that analyzing a backtested strategy for more than 10 years is misleading. The purpose of a backtest is to simply show you how a certain strategy works over multiple periods of time rather than a straight 10 year period. If at the end of 10 years, the strategy is up more than the market, the immediate assumption is that it must work.

There are of course many studies which already show the performance of the strategy for each calendar year, which is the correct way of going about it, but many services only display a single graph such as the one below from Magic Formula Investing.

These types of graphs are misleading. Why? Because your eyes immediately follow the blue line to the top.

However, to Greenblatt’s credit, he also includes the performance for each calendar year on another page.

I know that having a long term view is important, but to be honest, how many small investors in the world employ nothing but the same investing strategy for more than 10 years? Zero. Most people would give up after 3-4 years if a strategy didn’t work out which is very possible.

The time you start is also critical and changes the whole game. Had you invested $10,000 when Buffett took over Berkshire, supposedly you would have hundreds of millions, but this thinking is completely wrong. Besides, I wasn’t even born at that time. Instead, had I invested $10k when I was 20 years old in 2002 into BRK, I would be up about 50% after 8 years…

This is why comparing multiple short 3-5 years timeframes would be much more accurate in a practical sense. You also get an idea of what strategy to follow in different market conditions. After all, the advantage of small investors like us is the ability to move quickly.

Greenbackd also wrote an article perfectly timed with my first one where he analyzes Damodaran’s discussion of how fees eat away the real returns of backtests.

But back to the results.

Updated NCAV NNWC Screen Criteria

• Volume is greater than 30k
• NCAV margin of safety included
• Slippage increased to 1%
• Rebalance frequency changed to 6 months
• Test period remains at 3 years

NCAV & NNWC Stocks with Volume

2001 to 2004

2004 to 2007

2007 to 2010

Now that the NCAV stocks are only chosen when trading for less than 2/3 of it’s value, it acts much like a NNWC. This debunks my initial thought that NCAV doesn’t perform well. As long as you buy them with a margin of safety, NCAV stocks look to perform equally well.

Either way, if a recession ever comes around again, I better sell everything in my portfolio and load up on Graham stocks.

Top 10 NCAV Stocks

Disclosure

I own GRVY at the time of writing.

You may also be interested in:

1. NCAV NNWC Screen Strategy Backtest
2. CROIC ROIC Screen Strategy Backtest

How to Invest in the Stock Market: Part 1 | Part 2 | Part 3 | Part 4 | Part 5

(This is a guest post by Ernie, a friend, deep thinker and investor. This was an email sent to me which I received permission to publicly display.)

Here is the process I follow which is rooted in the Graham and Dodd approach:

Search

I usually scan for ideas reading print media such as the Wall Street Journal, Barrons, and websites such as Google Finance and blogs looking at 52-wk lows lists looking for headlines that just spell “bad news” and articles that may lead to ideas with catalysts, event driven ideas and sometimes macro-event driven ideas.

I’ll use screens if I don’t find anything in the headlines. If something peeks my interest a bit, I’ll try to gather more news and get an idea as to what is happening with the company, look at historical highlights, pull some efficiency, liquidity ratios and some basic numbers to look for consistency and I’ll think about the risks to the current situation a company is in and decide if I could potentially profit off the situation.

If I think I can profit off the situation, I’ll really do some due diligence.

Analysis

Financial Reports and Statements

At this point, I would grab at least the last three years of annual reports, 10K/Q’s, 8-K’s, proxies, conference calls transcripts and sometimes trade journals or magazines for additional information not included in the public documents.

Of all those documents, I start out with reading the three annual reports usually starting with the oldest and work up to the most current report to quickly scan the highlights to look for consistency and also get a “story” of the company leading up to the current year.

I’ll read the letter to shareholders (while taking it like a grain of salt of course) and scan for negative results or problems and again look for consistency in what the management has said and if they followed through on on-going issues.

Next, I’ll quickly breeze through the auditor’s report (again taking it with a grain of salt) and look for problems that they found with the accounting or any mentions of change in accounting methods, uncertainties, specific disclosures and going-concern problems.

Management Discussion & Analysis

If anything catches my eye, I’ll look for more info on that in the MD&A, financial statements and notes to the financial statements for explanations about any issue.

After reading the auditor’s report, I’ll read the Management’s Discussion and Analysis (MD&A), and sometimes I’ll have the 10K in my hand to read more about an issue discussed in the MD&A as SEC filings tend to have more detail. With the MD&A, I’ll read about how they recognize revenue (this is important for my own valuation purposes — garbage in/garbage out), restructuring charges, impairments to assets, pension plans to get an idea how they are financing it for their employees (this can be really helpful for the future financial landscape of the company), read about environmental and product liabilities in the case that if there is a problem in the future, the company can weather any future financial burden from liabilities.

I’ll also look at compensation to see how management is compensating themselves as it can be foretelling of a possible scandal such as dating back stock-options at below market rates and it will also show if they are shareholder friendly.

In addition, I read the discussion about sales increasing or decreasing and get an explanation, read about the company’s product lines (I usually try to match that with the reviews and feedback of customers), read about economic, market and sometimes political conditions that may have an impact on the company’s performance.

I’ll read about operational aspects such as distribution systems, R&D and changes to products to improve performance or appearance and how much they are spending on R&D and cost controls, manufacturing capacity and associate that with capacity utilization. I’ll also read about acquisitions and expansion plans to see if it makes sense and also how they will finance its current and new debt and effect cash going forward.

Lastly, I finish up the MD&A by looking for liquidity information. I want to see what they say about its cash position and its ability to pay its bills to see if it makes rational sense.

Scanning the Proxies

From there, I’ll quickly scan through the last three years worth of proxies just to get an idea of the board makeup, insider ownership, related party transactions and also see how management responds to shareholders. After reading the proxies, I’d want to see if there are any changes to any SEC filings via the most current 8-K.

Occasionally, I’ll look at the 13-D just for curiosity to see what major shareholders I am up against as someone smarter with more information could be on the other side of the trade with me or it could be an institution that can move a stock in either direction because of charter reasons and I could possibly take advantage of that.

After the first phase of going through the Annual Reports and SEC Filings, I usually have a comfortable idea as to what the company does, it’s key drivers, how they make money and if it’s profitable and organic, how they allocate capital and at what targeted return and if they can and have met it.

Phase 2 Analysis

My second phase is to get an idea of the market perception, general consensus and concerns of the company. I do this by reading the last five conference call transcripts (if available) and go to the company website and view any company presentations (if available).

I’ll read blogs, forums and email journalists who wrote articles about the company and get an idea as to what the general market thinking is. I do this to get a general idea of what the “crowd” is thinking or doing because it allows me to identify if the “herd mentality” is present and also this tells me if a possible mispricing may exist because of irrationality in the air.

After I get an idea of what the general market view is and if they are irrational or not which could lead to a possible mispricing, I do a bit of scuttlebutt research to try to confirm the mispricing. I will contact suppliers and try to probe them on their experience with working with the company and how they feel about them.

I also contact the actual stores to try to confirm issues discussed in the annual reports and SEC filings. I also contact the actual stores of the competition to get their views on the company. If I have trade magazines, I will try to contact authors for their views and any other details related to the company. It’s usually by this point that I’ll know that

(1) management is attuned to what’s really happening on the ground and
(2) management is able and honest and
(3) an indicator of a mispricing is now really possible.

The only issue with contacting people is that it is more of a waiting game and sometimes people are not cooperative.

After I have completed the first and second phase of due diligence on the subject company, I will do the same research on the competition which usually is three to four companies ranked by market position. After I have completed the same research on the competition, I’ll have a mental picture of the viability and economic value of the industry and who would likely be the winners and losers this way I’ll know who or what to handicap.

Then I do one last bit of scuttlebutt research and contact the investor relations department of all the companies and if possible executive management (subject to availability) and probe them on how they view the competition by asking them questions like

• if you were to merge with one competitor, who would it be and why?
• if you could buy one subsidiary of your competitor, who would it be and why?
• if you were given one wish where you could destroy a company, who would it be and why?”
• if you had the chance to trade places with the executive of a competing company, who would it be and why?

Asking these questions gives me an idea as to who is the real top dog of the industry.

After completing phase one and two, I will perform valuation exercises which is phase three.

My valuation methodology is rooted in the modern Graham and Dodd approach so I work with asset values, earnings power value (EPV) and view growth as either a margin of safety or buying it for free.

Here’s how I do it.

Valuation

Asset Values

I start with what kind of industry the business is in. If the industry is depressed or unsustainable, I will value the business at liquidation. This involves making necessary adjustments to the balance sheets from the top going down based on what I think assets will go for in a firesale or for scrap.

I will usually mark liabilities at book value and take that number and subtract it from my calculation of assets and get a net asset value or otherwise called liquidation value. The rule is to buy the security at 2/3 of that. Also, using liquidation value gives me a floor for the stock price if I think it can rebound from distress or bankruptcy.

To me, the floor of a price is more important than the top on price. Preservation of capital is key in this.

If the industry is viable and not going away, then I’d want to value it at a reproduction cost. Because of the nature of capitalism which really is creative destruction, the company making boat loads of money will attract competition. A person or institution with lots of money can start up the same business to compete with the incumbent. The entrant will have to assess what it would cost to start up and maintain the same business.

That cost is known as reproduction cost.

To get reproduction cost, again I have to make adjustments to the balance sheet starting with assets from the top going down this time based on what it would cost to make identical assets as the incumbent.

Making adjustments is dependent on the type of account on the balance sheet:

• For cash accounts, there is no adjustment needed as they are marked-to-market and represent fair value.
• As for accounts receivable, the rule is to add bad debt allowances and adjust for collections to get a realistic value of accounts receivable.
• Inventory is valued at FIFO basis and if the firm is using LIFO, then add LIFO reserve to the balance sheet number.
• With Property, Plant & Equipment, the adjustment is made on case-by-case bases, but the general adjustment is made with the original cost plus any adjustments such as previous comparable sales of similar PPE.
• When working with intangibles or goodwill, there is no adjustment number as intangibles or goodwill is based on the product portfolio and research and development. Since there is no replacement cost, I can use one of three ways to figure out a conservative book value estimate: (1) is to look at previous deals of a similar brand and see the acquisition price, (2)could also add up the costs of R&D spending attributable to the product or brand created from conception to deliverable or (3) add up the costs of three years worth of marketing and sales expenditures.
• As for deferred taxes, if the company is going to have a profitable year, perform a discount to present value calculation on the cash to be paid in the future for taxes or if the company is going to generate losses, push the payment further out into the future and do a discount to present value calculation as well.
• Lastly, for long term liabilities, there is no calculation to be done as it is marked at book value, unless otherwise, account for any new issues of debt. Then take the total liabilities and subtract from total assets and I get reproduction cost or reproduction value.

Earnings Power Value (EPV)

Earnings Power Value also known as just Earnings Power is I think a better way to analyze stocks as other forms of valuation such as discounted cash flow or present value calculations that relies on the rate of growth and cost of capital assumptions many years into the future. The thing I don’t like about the word assume is that if you break it apart, what you would get is “ass-u-me”. Assume makes an ass out of you and me. Making assumptions about a company is in my opinion not something to lean on for reliability even if we apply a higher margin of safety. Basically, how can anyone predict the future?

EPV uses a very basic equation which is (adjusted earnings) x (1/cost of capital) and it assumes no growth and it relies on the judgment that current and extractable earnings while leaving the business intact are expected to be sustainable and consistent from the operations of the business. But before we can start the equation, we have to clean up earnings and come up with a cost of capital.

Income Statement Adjustments

(1) We start with operating earnings or EBT/EBIT and make an adjustment to allow for the business cycle and it’s cyclicality affects by taking a 7-year average of operating earnings, which includes at least one economic downturn (basic economics assumes one downturn every decade) and apply it to the current year’s net sales.

Note: Although at the peak of a business cycle, adjustments reduces earnings and in a cyclical trough, the adjustment raises earnings, I prefer just to get an average because the assumption of economics implies a cyclical downturn.

(2) Deduct the 7-year average of non-recurring charges or normalize these expenses to reflect their economic nature (if applicable).

(3) Multiply the adjusted operating earnings by the 7-year average corporate tax rate usually somewhere between 30-33%

(4) Add depreciation of the most recent year. This depreciation is already calculated in the statement of cashflows by the accountants, but it does not take into consideration of any advancements in technology or manufacturing efficiencies which can have an effect on lower capital goods prices or it can have an effect in an inflationary environment where reproduction costs is higher.

This means we have to adjust this accounting depreciation to a true measure of depreciation by using maintenance capital expenses (CAPEX).

(5) Calculating Maintenance Capex

• A. Calculate the Average Gross Property Plant and Equipment (PPE)/sales ratio over 7 years
• B. Calculate current year’s increase in sales
• C. Multiply PPE/Sales ratio by increase in sales to arrive to growth capex
• D. Maintenance CAPEX is the capex figure from the cash flow statement less growth capex calculated above, which is the true depreciation for the company

(6) Once we have deducted the true (adjusted) depreciation from steps 1-4, we then have to come up with a cost of capital estimation (R). Because of one of the cardinal rules of Value Investing which is that income streams of companies and the operations themselves should be extremely predictable and consistent, simply choosing a rate like the federal bond rate (seen as risk-free) plus 2% is good enough. I tend to use a range of rates from 6% to 12% depending on what I feel is realistic for the company or average.

(7) Once I have both the adjusted earnings figure and my chosen cost of capital rate, I can perform the equation.

Earnings Power Value = Adjusted Earnings X 1/R, where R = Cost of Capital

or

Earnings Power Value = Distributable Cash Flow X 1/R, where R = Cost of Capital

(8) It’s at this point now that I have both the Asset Value and the Earnings Power Value, that I can tell if management is creating value for shareholders.

If EPV is higher than Asset Value, then it is said that management is creating value and the company is operating at a competitive advantage. If the reverse is true, then management is destroying shareholder value by earning less than the value of the assets and the company operates at a competitive disadvantage.

This difference between the EPV and Asset Value is known as the franchise value. This can also be expressed in per share values.

(9) If I find that the company is operating with a competitive advantage and management is creating value for shareholders, I am now at the point where I want to compare the EPV with the market price. But before I can make any comparison, I have to make one final adjustment.

That is to subtract out any corporate debt and add in cash in excess of operating requirements.

EPV + Cash/Debt Adjustment

(10) After adding in the cash/debt adjustment to EPV, then I would express EPV in per share value by dividing it by the amount of shares outstanding.

Then I can compare the EPV/per share to the market price. If the market price is below the EPV/per share, then the stock appears to be undervalued by the market.

Thesis

After completing my research, analysis and valuation in this fashion, I’ll have a picture of what the company does and how it makes money.

I’ll know if management is consistent, able, whether they are shareholder friendly and if management is really in sync with things happening on the ground. I’ll know how the accounting is done and if they fudged some numbers. I’ll have an idea as to what the general risks are to the company, how it affects cash and whether these things can be minimized. I’ll see the market perception of the company and I can decide to go either against them or hold off on the investment. I’ll see what their competitors thinks about the company and it will either change the way I think about the company, reinforces my conviction about the company or fill in holes on my analysis of the company.

The way I think about my valuation exercises is that I was using reliable earnings to come up with a conservative estimate of intrinsic value and if management is creating shareholder value.

I’ll have an idea where the margin of safety lies or know how to apply a margin of safety because I’ve read cases where people slapped a blanket margin of safety to a valuation and their estimates became way off that they missed out on some really smokin’ deals — basically an error of omission. And doing this type of valuation gives me a range of values without having to use assumptions about growth into the future. And since I don’t just value just the one company, I value the basket of companies since I have already done the homework on the basket, I could just wait for one of those stocks to get beaten up and pounce on them with vigor or if I want I could buy the basket if the industry had gotten beaten up for some irrational reason.

Disclosure

Credits belong to Francis Chou of Chou Funds, Hunter at Distressed Debt Investing, Bruce Greenwald of Columbia University, Joe Ponzio of F Wall Street and of course Jae of Old School Value. 70% of my “swing” came from them and the rest is from everywhere else.

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