Broaden your knowledge by reading a lot.

That’s what you’re told.

And that’s the secret that Buffett tells anybody willing to listen and take up the challenge.

But let’s be honest. Reading the annual report is boring.

It’s filled with useless words like “innovative” and “industry leader”. In the S&P500 alone, there are 500 innovative industry leaders.

Maybe my math is bad, but that doesn’t add up.

The point is that annual reports are boring, unless you are Warren Buffett.

You invest in order to earn a rate of return and reading annual reports may not give you a huge edge, but it will help you make educated decisions about a company.

Seasoned investors know the gravity of reading SEC filings but even veterans may not know what beneficial information to look for because it is so disorganized.

So let’s take a look at four qualitative factors from the annual report you should look at.

Tip #1: Beware Fancy Charts in the Annual Reports

Photographs and charts are great. It helps to visualize the data but some companies use it all wrong and sometimes in a purposefully sneaky way.

The problem with charts is not the data, but the way it is presented.

Look at this example below.

Pies are good. Pie charts are bad.

The Verna model is killing it with 56,486 units sold.

The problem is that the yellow explosion isn’t as big as it seems.

In fact, it’s really just 31.4% but the graph make it look like 40% or so. The intention of such charts is to make you think “wow the Verna is the most popular car. That should be my next car.”

Compare the above chart to a fair and balanced version below.

Bars are good and yummy. Bar charts are also tasty.

That looks much better. The big difference is that instead of making a statement of “the Verna model rocks!”, the message is now, “the Verna is doing much better than other models”.

A big difference in the message, no?

Next time you come across a chart in an annual report that is all full of bling, 3D and explosions of colors, ask yourself what the chart is trying to tell you.

Management wants to lead you into a particular line of thought to try and impress investors.

After all, what type of company wants to show that their company is suffering and in serious trouble?

Even the worst companies paint themselves in magnificent pictures.

Tip #2: Use the Letter to Shareholders as a Screen for CEO Trustability

The letter to shareholders is a great way to really get to know how the CEO presents his company to shareholders.

If you follow a stock, you know what problems the company has been going through.

Here’s what you want to ask yourself:

• Does the CEO discuss problems openly?
• Is the CEO defensive in his writing?
• Is the CEO too optimistic and making light of bad situations?
• Does the CEO refer to vanity numbers to make the business look better than it really is?
• Did the CEO deliver on what he is talking about?

This is a technique brought up in Quality of Earnings, a must read book for all value investors.

You should also think about these questions while listening to conference calls.

Here’s an example of open and honest management of LAKE.

We have sold some real estate assets at book value. Jesus Christ, everybody is saying we’re not worth book value, but we can sell our real estate at book value. So if we can sell real estate at book value and you can collect receivables at their stated value, then you have cash. And again, you have people saying, “Well, if you’re a company with $100 million of cash but no EBITDA, you’re still worth nothing.” That’s their attitude. So what can I say? I guess we have to build up some EBITDA, and then they’ll have another reason why they can’t pay at the market price.

Is there frustration? Yes.

But it’s coming from honesty and passion.

And that’s what you need to decipher when reading those letters to shareholders and conference calls.

Tip #3: Do Not Trust Auditors

Another tip from Quality of Earnings is to not trust the statement from auditors.

Auditors are a double-edged sword.

You need them to sign off on the numbers, but the whole signing off process isn’t trustworthy.

When was the last time an auditor came out and blew the whistle on a company that was paying them millions?

I haven’t come across a single example.

In all cases where financial fraud was detected, the auditor signed off on it and then resigned when it blew up in their face.

Classic example is Enron. Their auditor was in on the action.

Tip #4: Check Consistency of Footnotes

Reading footnotes is important, but it’s a pain.

Footnotes are valuable and filled with information but the key is to look for consistency.

Important information is buried among 100 pages of tiny text and it is going to be a nightmare to try and keep up to date with past filings manually.

A tutorial to quickly detect changes in the footnotes has been written by Jae, but here’s a quick primer.

1. Open up two consecutive years of annual reports on the SEC website
2. Copy and paste the html annual report into a word processing document
3. Save the two documents
4. Use the compare feature to open up both of the documents you just created
5. You get a final document with any changes that have been made highlighted

The final output looks something like the image below.

Quickly see changes in the footnotes

Four quick and easy tips to include in your qualitative research.

What special tip do you use aside from these?

This post was first published at old school value.
You can read the original blog post here 4 Things to Look at when Reading the Annual Report.

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To get quick updates and see what I’m reading throughout the week, connect with me via any of the following methods.

• google+ page
• old school value facebook
• twitter

Investing Lessons from Bernie Madoff

Read good books. You have to educate yourself on the market. People are very gullible. Scamming investors has been going on since the beginning of time, and I don’t think it’s going to end.

Bernie Madoff

Case Study of Geico Graham and Buffett

The company is a fascinating case study is that it made a fortune for both Ben Graham and Warren Buffett. Not only that, but GEICO, for most of its storied history, was considered a high flying expensive growth stock. Buffett occasionally got interested in growth businesses, more so as his career evolved, but Graham was basically allergic to stocks selling for high price to earnings ratios or high price to book ratios.

Buffett’s Stock Write Up on Geico PDF

This short one page PDF was included in the article above, but I wanted to highlight it separately for those that may skim part it.

This 28 Year Old is Rumored to be Buffett’s Successor

Buffet, 82, hired 28 year old Tracy Britt four years ago as his financial assistant and many are speculating she’s being groomed to take over from him when he retires.

Tracy Britt, is currently Warren Buffett’s go-to girl with an office next to his, and chairwoman of four of his companies which bring in a combined $4 billion annually.

This post was first published at old school value.
You can read the original blog post here 4 to Read: Lessons from Bernie Madoff and Warren Buffett.

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Jae Jun

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By popular request, a new screen has been added to old school value.

The Magic Formula stock screen.

I’ve put up a couple of articles discussing the validity and performance of the magic formula.

Catch up with the articles below.

• Does the Magic Formula really work?
• Magic Formula Stocks Performance Year to Date

Magic Formula Stock Screen Performance

Here are the annual performances from 2000 to 2012.

Magic Formula Stock Screen

There is an interactive chart of the annual performances on the Magic Formula screener page. You can play with it to see how the screen performed over various time frames.

Extra Notes on Performance

When you compare the results with the market side by side from 2000 to 2012 and YTD, the overall performance isn’t staggering at 9.79%.

The reason is that I included into the screen a 2% slippage setting with a carry cost of 1%.

This is so that the magic formula stock screener simulates a real portfolio. On paper, results always look better than they are in practice because you won’t be able to buy the stock at that exact price.

Some you’ll pay more for, others you’ll buy cheaper. Also add in commissions which affects the screen performance.

If I change the slippage to 0% and the carry cost to 0%, the annualized return then becomes 12.3% which is very respectable.

This is how fees and over trading eat away at performance and why you should look into low cost options if you haven’t already.

Using the Magic Formula Screener

You can use it as a source of ideas, or simply stick to what Greenblatt says.

Buy it, hold it for one year and then sell it.

Greenblatt holds 25 stocks in his portfolio, but I advocate 20 holdings.

In the first year, this will come out to 40 trades a year which isn’t bad.

Year 1: Buy 20 on the first trading day of Jan, sell 20 on the last trading day of Dec.

Year 2: Buy 20 on the first trading day of Jan, sell 20 on the last trading day of Dec.

Year 3: Repeat

Go get ideas from the Magic formula Screen now >

If there are proven strategies you know of that you would like to see in a screen, leave your suggestion in the comment section below.

This post was first published at old school value.
You can read the original blog post here The Magic Formula Stock Screen that Beats the Market.

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Photo Credit: Left by STEVE MARCUS. Right by JACK CUSANO
http://www.vanityfair.com/business/2013/04/bill-ackman-dan-loeb-herbalife

Move over Mr Ackman.

Dan Loeb of Third Point is the new man in town taking the activist crown.

It’s funny because Ackman and Loeb are both billionaires, well regarded activist investors, once friends, but now labeled enemies.

I followed Ackman regularly starting from 2008. He is definitely a smart guy and the one that helped me get my first 1,000% return off GGP. I owe him big for that. But over the past couple of years, none of his picks have resonated with me.

Earlier in the year, I bought HLF after reading what he said and wrote, and again, I should thank him for that too.

Introducing Mr Loeb

Dan Loeb is the new investor to watch.

He moves deftly. He is a cold blooded hound when it comes to investing. And that’s what we need to witness.

While Ackman goes all in on one stock whether he is right or wrong, Loeb chooses his battles wisely.

What impressed me with Loeb is that he took a big position in HLF. Many viewed it as a way to get back at Ackman, but after the stock rose 50% from his purchase price, he promptly took his gains and moved on.

No chest beating at all.

That’s class.

So let’s take a look at 3 new stocks that fall into Mr Loeb’s Top 10.

Virgin Media Inc. (VMED)

Provides entertainment and communications services in the United Kingdom through broadband internet, television, and phone services.

• Bought 11 million shares of Virgin Media in the first quarter
• Total weighting of 10.1% in his portfolio

Virgin Media is Loeb’s second biggest position after Yahoo.

VMED has had a terrific run thanks to Liberty Global’s buyout. The deal is now approved and the company will be delisted.

This is a big win for Loeb. Although Third Point holds about 35 stocks, the top 5 is heavily concentrated.

• 27.5% in Yahoo
• 10.1% in VMED
• 9.9% in AIG
• 5.8% in IP
• 3.7% in NWSA

As I mentioned at the beginning of this post, Dan Loeb is deft and that’s why I’m impressed with this transaction.

Accumulating 10.1% as a new position anticipating the closure of the merger is no easy task.

I said that for hedge funds, most companies fall into the illiquid category. Simply because these funds have a lot of cash and buying volume. Unless they want to start moving the market, patience and discipline must be observed.

That’s why you also have to read the guide to buying illiquid stocks.

With the merger over, let’s take a look at the numbers to see whether Liberty got a good deal.

VMED Valuation Ratios – old school value Stock Analyzer

Not bad. I removed PE since a company like VMED has too much leverage. Best to use EV/EBITDA in this type of situation for pretax and pre depreciation.

Although taxes and depreciation is a real part of the business, when it comes to buyouts, the company is merging into an existing business so excess fat will be eliminated and tax savings can occur.

The Piotroski score shows improvement in the business since the recession.

VMED Piotroski Score – old school value Stock Analyzer

But with all the different business segments, accruals look to be a mess.

Best to check out whether there is anything to worry about.

VMED Accruals – old school value Stock Analyzer

Here’s a a quick pointer on interpreting the Sloan Ratio.

Sloan Ratio = (Net Income – CFO – CFI) / Total Assets

CFO = Cash From Operations

CFI = Cash From Investments

If the Sloan Ratio is between -10% and 10%, the company is in the safe zone and there is no funny business with accruals.

If the Sloan Ratio is less than between -25% and -10% on the negative side, and between 10% and 25% on the positive side, this is a warning stage of accrual build up.

If the Sloan Ratio is less than -25% or greater than 25%, and this ratio is consistent over several quarters or even years, be careful. Earnings are highly likely to be made up of accruals.

Read about the Sloan Ratio and accruals if you want to know what these numbers mean in deeper detail.

Tiffany & Co. (TIF)

Sells upscale jewelry.

• Purchased 2.7 million shares of Tiffan
• Sixth largest holding at 3.5% of his portfolio

Recession proof company.

Women with money will spend for the brand name or husbands/boyfriends will pay the extra price for that extra surprise factor.

I sure did.

TIF Selected Financials – old school value Stock Analyzer

TTM numbers are struggling, but there is nothing bad to say about the company as a whole.

Jewelry isn’t the quickest selling product and you can see that from the inventory turnover numbers.

TIF Fundamental Ratios – old school value Stock Analyzer

But how well does TIF stack up against competitors?

TIF Competitors – old school value Stock Analyzer

Higher growth, stronger margins, better returns.

The one part that trips me up is the valuation. For a company with such stable margins, the bottom line free cash flow is wildly inconsistent. FCF is all over the place caused by increases in capital expenditures.

TIF Free Cash Flow – old school value Stock Analyzer

My estimate of intrinsic value is $60 on the low side to $80 on the high side.

B/E Aerospace Inc. (BEAV)

Makes cabin interior products for commercial aircraft and business jets worldwide.

• Loaded up on 2 million shares
• 10th largest holding
• Average purchase price of $54

At the moment, BEAV isn’t the cheapest company to own.

For the line of business it’s in, I can’t justify the expected 20-25% growth that the market is expecting.

As a side note, for mostly all stock valuation methods that you use, you can do a “reverse” of it to find out the expectations.

A quick way to find the expected growth is to perform a reverse discounted cash flow or reverse Graham formula valuation.

It’s a great way to first value the company you normally would, and then to compare your numbers with what the market thinks.

Getting back to BEAV.

From an absolute valuation standpoint and using optimistic assumptions, I can see the intrinsic value ranging between the mid 40′s to 50′s.

Plus, most of the growth is coming through acquisitions.

And because of this there is a lot of debt used to finance the acquisitions.

If acquisitions are smart, then taking on debt isn’t such a bad thing, but the company also has a habit of diluting the shares.

Although the dilution speed has slowed, it’s not as good as seeing a reduction.

I know I’m only looking at a few things here, but when looking at their financial statements, I don’t see any compelling value arguments to get me excited.

BEAV Fundamental and Valuation Ratios

So Dan Loeb added three stocks to his portfolio. Big new bets as all three are in the top 10 of his portfolio.

The difference could be his buy price and the current market price. If he bought at cheap enough prices, then it looks like a good deal, but at the moment, with so many other stocks out there, a quick look through VMED, TIF and BEAV doesn’t get me excited with any at the moment.

Click the image below to get a summarized tearsheet of all three stocks.

click to download summary

Disclosure: None

This post was first published at old school value.
You can read the original blog post here 3 New Stock Picks by Dan Loeb. Here’s a Quick Look at Each..

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It’s been a while since I’ve put out a reading list.

Here’s some quality articles worth reading.

• Why you never learn from your investment mistakes
• The 5 Most Important Finance Rules
• How to Beat Warren Buffett – 3,000% Over 20 Years
• Do you know what’s going on with the global markets?
• Warren Buffett’s Letter Discussing His Initial Purchases Of Washington Post Shares

Other Old School Value News

Aside from a few small buys early in the year and selling of some positions, my portfolio is sitting in plenty of cash.

Cash makes up 30% of my portfolio.

Is it because I can’t find anything to invest in? Not really.

A few weeks back, I mentioned that some things are happening behind the scenes.

The cash is idle in my portfolio because I just haven’t focused much on stocks this past year. Outside of my core holdings, I haven’t been flipping over as many stones as I used to.

Instead I’m diversifying my cash into other investments.

Stock ticker: OSV

Don’t look up Google Finance for OSV, it’s just old school value.

Throughout the year, I’ve been investing a lot of money, time and effort into building up old school value.

No quite where I want it to be, but it’s moving along and more investment is required. This will be by far my biggest investment and the one I’m rooting for the most.

Over the long run, I’m expecting OSV to be the biggest multibagger. Just need management to execute better.

Come Check it Out

Old School Value is now hosted on a new server, and after two months of non stop work, I’ve got a new logo, layout and the new site design is in place.

Still need to make adjustments to make the design fit in with what I had before, but for the most part, it’s all there.

So if you are an email reader, come venture over and check out the new design and tell me what I need to improve.

This post was first published at old school value.
You can read the original blog post here 5 Brain Food Articles and Other OSV News.

The below analysis came to my attention because the user is a premium member of Old School Value.

I know that AAPL is written about all over the internet, but Einhorn is loading up shares for a reason and there is always enough room for value focused write ups.

I also want to highlight for current OSV members to take a look at how this user is utilizing the spreadsheet in his analysis and other tools such as the EBIT calculator.

The link below is for a PDF report.

AAPL Target Price is $600

Here are the topics covered in the report.

• Investment thesis summary
• Company description
• Key figures
• Why the bear case is most likely wrong
• Apple’s strong and growing moats
• Valuation – what’s in the price today?
  • Peers
  • Multiples
  • Reverse DCF
  • EPV
  • DCF
  • EBIT multiple analysis
• Conclusions
• Apple’s cash and potential uses
• Pre-mortem: a summary of risks and negatives

Click to open the PDF report or click the image below.

Source: http://klarmanite.com

This post was first published at old school value.
You can read the original blog post here AAPL Price Target is $600.

Written by

Jae Jun

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In the last post I showed that the Magic Formula is a good screen for finding ideas.

I originally started writing that article believing that the Magic Formula was just hype and exaggeration.

But hey, my thesis turned out to be incorrect and I’m fine with that.

To refresh your memory, here are the results that I discussed.

Magic Formula CAGR from 1999 to 2009

• Joel Greenblatt’s Magic Formula: 18.57%
• Backtest Magic Formula: 17.33%
• Backtest Magic Formula (including slippage and fees): 13.74%
• S&P 500: 0.87%

If Greenblatt included slippage and fees into his own Magic Formula, that would bring his numbers down to the 14% range.

I also firmly believe that testing a strategy over 10 years is completely adequate. I receive some comments that the backtest needs to be lengthened in order to be valid, but I have to disagree.

Think of it this way.

If your personal track record over 10 years is stellar, are you going to claim it as proven or still too early to tell?

2013 Magic Formula Performance YTD

Here is a look at how the strategy has been performing so far this year.

(click to enlarge)

It’s just surpassed the market this year, but according to the stats below, with such high volatility, the alpha of this strategy is negative by a large margin.

This is a strategy that requires you to buy the stocks, and then keep your eyes closed for the whole year unless you can stomach the wild ride.

Here are stocks that passed the screen at the beginning of the year and make up the 2013 portfolio.

(click to enlarge)

Top 5 Picks

This is the magic formula so I’ll just present the two numbers that matter.

• Earnings Yield = EBIT / Enterprise Value
• Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

#1 PDL BioPharma (PDLI)

As the name suggests, PDLI is a bio pharmaceutical company.

• Earnings Yield = 28.3%
• Return on Capital = 189.6%

Earning royalties from a drug is a hugely profitable business. Since 2008, PDLI hasn’t performed any R&D so it’s all be royalties since then.

Best of all, revenue has continued to increase since 2008 while SG&A has decreased. FCF is being milked by the company. This gives the company an operating margin of 93%.

Financial statements is barebones. Check it out for yourself.

#2 Bridgepoint Education (BPI)

BPI is a for profit education company in a despised industry.

Very profitable mind you, but there are external risks always in play in this industry. You know it’s a risk when the president is out to get you.

Since July of 2012, Bridgepoint’s Ashford University has been under review and in danger of losing its accreditation. Uncertainty surrounds the company which is bringing down the valuation.

Despite the uncertainty, BPI has been able to increase revenues from

• Earnings Yield = 64.4%
• Return on Capital = 45.5%

#3 InterDigital (IDCC)

IDCC is a company that is in the business developing wireless patents and then selling it.

In 2011, IDCC spiked to $70 a share as speculation about monetizing its patents took a frenzy. That transaction didn’t go through but the company still owns a great deal of IP.

Book value is $12.30/share compared to a $48 share price at the moment. That’s a good amount of assets making up the valuation.

In 2012, revenue doubled along with nice increased in net income and free cash flow over the past few years.

• Earnings Yield = 23%
• Return on Capital = 58.8%

#4 ITT Educational Services (ESI)

The second for profit education company in the top 5.

Here’s a video analysis and valuation of ESI from Dan Myers. His comments are all still relevant and the video goes through their financials, debt, the drop  in revenues, valuation and the risks in the industry.

Check out his other video analysis on his youtube channel too.

• Earnings Yield = 30.8%
• Return on Capital = 59.4%

#5 Kulicke and Soffa Industries (KLIC)

Makes equipment and tools used to assemble semiconductor devices.

About 90% of its sales are from Asia and it after a tough recession, the company has been performing strongly since 2009.

Gross margins are at its peak at 46.4%. From 2003 to 2009, gross margin was slowly ticking up to 40% until the recession hit so a 6% increase in a few years is a great achievement.

• Earnings Yield = 45.1%
• Return on Capital = 25%

Compare with Formula Investing Fund (FNSAX)

Although investors are able to pick and buy the stocks themselves, there is an official magic formula fund managed by Greenblatt.

It started in November 2011 so it still needs more time to prove itself commercially.

Interestingly, none of the official top 5 match my top 5 which does prove that Greenblatt has a special algorithm for ranking the stocks.

He spelled out that stocks are ranked based on:

• Earnings Yield = EBIT / Enterprise Value
• Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

That’s as easy as it gets, but seeing how only PDLI is the only stock listed in his official holdings, it is clear that Greenblatt has another metric or ranking criteria only available for himself.

Disclosure

Interesting ideas to check out but no positions.

Please Share if You Find this Useful

If you find this useful, please help out Old School Value by sharing this article using the social sharing buttons.

The more you share, the more I know what type of content you really like and I will be able to provide more quality content.

This post was first published at old school value.
You can read the original blog post here Magic Formula Stocks YTD and the Top 5.

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Jae Jun

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Magic.

That’s what you need to beat the market and that’s what the Magic Formula is supposed to do.

As a result of brilliant marketing, promotion and becoming a New York Times bestseller in 2005, Joel Greenblatt has turned the Magic Formula into a key strategy for many in the value investing and mechanical investing community.

Buy at least 20 stocks from the Magic Formula screening tooland then rebalance at the end of the year. Do this and you will beat the market, the book says.

The Little Book that Beats the Market

Greenblatt wrote The Little Book that Beats the Market for his children who were aged between 6-15 at the time.

It’s written in plain English and 6th grade math to make it easy to follow along. This is the strong point of the Magic Formula theme.

Everything is very easy to understand. The concept is simple, the explanation is simple, but most important of all, the execution for investors is simple enough to do on their own.

In it’s most naked form, the Magic Formula is described by Greenblatt as

a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.

The Ingredients to the Magic Formula

Here is the formula courtesy of wikipedia. From beginning to end, it consists of 9 steps.

1. Establish a minimum market capitalization (usually greater than $50 million).
2. Exclude utility and financial stocks
3. Exclude foreign companies (American Depositary Receipts)
4. Determine company’s earnings yield = EBIT / enterprise value.
5. Determine company’s return on capital = ebit / (net fixed assets + working capital)
6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
9. Continue over a long-term (3–5+ year) period.

Pay close attention to step 4 and 5 because they are the key driving formulas for it all to work.

• Earnings Yield = EBIT / Enterprise Value
• Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

Earnings Yield is used because it targets companies with below-average prices. The idea behind of Return on Capital is to select good companies that are outperforming. This fits in line with what Greenblatt said

a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.

The Magical Performance

So how magic is this Magic Formula in terms of performance? This table of values is from the revised 2010 version of the book.

and a better representation.

Starting with $10,000 the Magic Formula would have made you a millionaire by 2009.

The Magic Formula is famous for returning a 30% CAGR. From 1988 to 2004, it did achieve a 30.8% return, but the CAGR has declined significantly. No strategy can sustain a CAGR of 30%. Although the backtest in the book only provides data up to 2009, I wouldn’t count on 2010-2012 results showing vast out-performance.

The Magic Formula is a Fraud?

By popular demand, the Magic Formula will soon be added to the list of value stock screens, but the one thing that has held it back is the reliability of the backtest performed by Greenblatt.

I just don’t believe the results are as good as it seems.

What’s more, other blogs have tried to simulate the Magic Formula performance from the book, but none of them  have come close.

• Magic Formula that JUST beats the market
• Turnkey Analyst tests the Magic Formula
• Another article suggesting that the Magic Formula beats the market by 4.5%

Backtesting the Magic Formula Using Portfolio123

Portfolio123 has a very good predefined Magic Formula screen which I’m going to use for some more numbers and graphs.

Although the screen uses the same fundamental formula and tries to follow the Little Book, it ends up being slightly different to Greenblatt’s version.

Here is how the screen is constructed.

• No OTC stocks
• No ADR’s
• No financial companies
• No utilities
• No real estate companies
• Market cap greater than $50m
• 5 year average of ROI ranks in the top 35%
• Slippage of 2%
• Carry cost of 1%
• 100% long
• Stocks selected based on ranking of Earnings Yield = EBIT / Enterprise Value and  Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

To try and compare apples to apples, data from 1999 to 2009 is used as the data only goes back as far as 1999, and 2009 is the latest year provided in Greenblatt’s Book.

(click to enlarge)

Although the backtest version kills the market over the same period, it doesn’t match or beat the Greenblatt version.

However, if I adjust the slippage to 0%, it comes awfully close. CAGR over the same period then becomes 17.33%, which is oh so close to the original 18.57%.

But I’m willing to bet that the original formula does not include factors such as fees and slippage in the results. If it did, it would fall to a level similar to my backtested results.

Either way, there goes my earlier comment about not believing in the results.

Sure it’s not the 30%+ CAGR that Greenblatt wrote about in the book, but there is magic in the air.

Additional Links

• Gurufocus Magic Formula Newsletter and Screen
• Magic Formula White Paper
• Greenbackd analysis

This post was first published at old school value.
You can read the original blog post here Does the Magic Formula Really Work?.

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Jae Jun

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The market has been on fire this year. Up 15% and still going strong. However, there is a small cap stock screening strategy that has appeared out of no where and has achieved a performance of 27% YTD.

The fact that this strategy is focused on value small caps means that the strategy is still flying under the radar, and I bet it will continue to fly under the radar.

The secret sauce used in the screen is centered on Net Net Working Capital aka NNWC.

Net Net Working Capital Background

The original concept of NNWC came from Benjamin Graham as he loved to pick up stocks trading at dirt cheap valuations. Put simply, NNWC stocks are those that trade below their net asset value. In the value world, these stocks are called “net nets”.

Net nets = dirt cheap stocks with problems causing it to sell at less than a discount to its assets.

The mathematical formula is:

Net Net Working Capital = Cash and short-term investments + (0.75 x accounts receivable) + (0.5 x inventory) – total liabilities

As  you can see, a net net must be in a dire situation to be selling below cash, 75% of accounts receivables, 50% of inventory minus liabilities.

But I lied.

This isn’t the strategy that is performing at 27%. The actual strategy is one where the stocks are seeing their NNWC value increase from the previous period.

This makes things a lot different.

The whole focus changes from finding cheap stocks, to finding cheap stocks where there is tangible evidence that the business is improving.

An unloved business which can increase its current assets faster than its liabilities is in a situation to turn it around.

If a stock is unloved as much as net nets, even slight positive news can send it rocketing up and that’s what has been happening with the NNWC increasing strategy this year. Note that this has some severe ups and downs.

Definitely not for the faint hearted.

Screener Set Up

I use portfolio123.com for my screening so here are the details of how I set it up.

• Remove Chinese stocks
• Remove ADR’s and financial stocks
• Remove OTC stocks
• Current quarter NNWC is greater than zero
• Current quarter NNWC is greater than the previous quarter NNWC
• Daily volume is greater than 30k

To do this yourself, here is the guide on how to backtest and screen using portfolio123.com.

The strategy has been under performing over the past couple of years, even during a rising market, so it is nice to see it trying to bounce back this year.

But it does go to show that it’s very difficult for any single screening strategy to beat the market year after year. However, with a longer term view, there is possibility of significant outperformance.

For the statisticians, here is a detailed look at how the portfolio has been performing this year.

The 2013 NNWC Increasing Stocks

I disagree with screens and strategies showing that you have to buy and sell stocks every 4 weeks.

It’s unrealistic to trade that often.

Instead, the value screens I post are rebalanced only once a year. Max holding is 20 stocks.

Here is the list of 2013 NNWC increasing stocks doing so well this year. Let’s see if it can hold up for the rest of the year.

Note: ORCC buyout offer occurred on Jan 31.

Disclosure

None

This post was first published at old school value.
You can read the original blog post here The Small Cap Strategy Returning 28% YTD.

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Jae Jun

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At the Ira Sohn conference on Wednesday, Jim Chanos gave a presentation on being short Seagate (STX). Chanos has been negative on the entire PC industry citing the explosion in smartphones and tablets are eroding PC sales.

In June 2012, he called HP (HPQ) the ultimate value trap as it meets all five points of the characteristics for a value stock.

• Cyclical and/or overly dependent on one product
• Hindsight drives expectations
• Marquis management and/or famous investor(s)
• Appears cheap using management’s metric
• Accounting issues

Regarding PC’s, he presents that PC sales numbers peaked in 2012 and has reversed into a decline in sales from the first quarter of 2013.

Here is a summarized version of his short thesis on Seagate and then I’ll get into some numbers to poke and see whether there are any signs of a failing industry.

• Stock price is inflated due to higher prices. Chanos cites that hard drive prices are approaching 10% of PC prices.
• PC industry operates on thin margins and as sales and prices come down, the price of hard drives is not sustainable. Chanos cites that Toshiba has announced its hard drive margins will be drop by half this year.
• Pricing will come under pressure from competition of digital storage space

A Dangerous Short?

Although Seagate is hitting new highs, check out these numbers taken from the Old School Value valuation and analysis spreadsheets.

I have learned not to short, or claim a company is overpriced, based on stock price alone. Same thing applies to Seagate when looking at these numbers. You wouldn’t know that judged on the latest figures that Seagate is at all time highs. Even at these levels, these ratios are within value stock ranges.

Since Chanos is not claiming Seagate to be a good short because it is overpriced, but rather than business is bound to fail due to a fall in margins and drops in sales, let’s analyze those two areas.

Analyzing the Margins

The easiest thing to do is to draw a simple graph depicting the gross, operating and net margins.

Let’s just say for the sake of giving Seagate the benefit of the doubt, that the recession in 2009 is an anomaly. If this is the case, the operating income of Seagate from 2003-2008 was averaging 9.2%. In the last three years and TTM, it has jumped to 15.6% and Chanos’ question comes into mind.

Are the price of hard drives sustainable?

Seagate now offers SSD which comes at a higher price point, but it is bound to come down further in price. There is competition from digital storage which offers the convenience of accessibility from anywhere.

Physical storage is a commodity business with no moat so I find it difficult to believe that prices can stay high enough to maintain the current margins.

Does the DuPont Analysis Show Anything?

Taking it one step further, does the DuPont analysis point to any signs that the growth and increase in business performance is coming from anything other than improvements in margins?

See the  3 step and 5 step DuPont analysis below.

Looking over the golden years, the increases in ROE were due to

• increase in margins
• increase in asset turnover
• reduction of interest
• reduction in leverage

From a business and operational perspective, Seagate is on fire. They are doing everything right.

So far, Chanos certainly isn’t shorting Seagate based on fundamental deterioration. He is taking a top down approach by believing that the downfall of the PC industry will cascade into the hard drive space.

Inventory Analysis and Interpretation

Since the ROE didn’t show anything strange, let’s take a look at Chanos’ angle of sales set up to fall.

One of the leading indicators of sales is inventory and the way to do that is to analyze the details of the inventory to predict whether the company is expecting a boom or bust in sales.

Inventory is made up of raw materials, works in progress, purchased components, and finished goods.

(click to enlarge)

If you take a look at the area I highlighted, the latest quarter is showing a disturbing difference compared to the same period over dating back 10 years.

The last time there was such a drop in works in progress was back in 2004. Seagate was making more products even during the recession. Is this what Chanos was talking about?

Now that finished goods for the latest quarter is up 94% compared to one year ago, the next few quarters will be a telling sign depending on whether the inventory sells.

Here is another look by reviewing the quarters sequentially.

(click to enlarge)

The way the inventory line items integrate with each other is like this.

• Company buys raw materials when prices are cheap or when there is an expected increase in orders and sales
• As orders come in, “works in progress”.
• Finished goods decrease as it is sold off and then replaced with new inventory once the works in progress products are complete

Additional interpretations to know:

• Raw materials up, works in progress up, finished goods same or down = Good sign. More orders are coming in. Company is selling quicker than they can make.
• Raw material up, works in progress up, finished goods up = Need to watch. If the following quarters continue to show finished goods going up, then that’s bad as the company can’t sell its inventory or is making too much. On the flipside, if finished goods go down, then it has become a good sign.
• Raw materials down, works in progress down, finished goods down = Bad sign. Business is slowing down. Could be cyclical, but expect lower turnover or sales.
• Raw materials down, works in progress down, finished goods up = Horrible sign. There is a glut of inventory that needs to be cleared. New orders are not coming in and current inventory will likely be sold off at a discount.

Applying this interpretation to Seagate, the line that draws my eye is works in progress. Compare it to the previous periods and there are big differences.

When it comes to inventory for Seagate, Chanos may be onto something, but there is nothing concrete at the moment.

Accounting Manipulation Checks

Running a quick earnings manipulation check via the Beneish M score, the score comes out to be a solid -3.03.

While the Beneish score or models can never replace a thorough and manual investigation, a cursory look reveals that Seagate doesn’t have any earnings manipulation factors to worry about.

If you are adventurous, here is a list of 52 techniques you can perform for detect financial manipulation.

Is Chanos Right or Wrong?

It is too early to tell.

Because it seems like he is shorting based on a top down approach, we’ll see whether his thesis plays out. I’m just not in the game of predicting industry trends.

If Seagate was showing fundamental flaws and a breakdown in fundamentals, then it could be come a compelling case, but Seagate does not fit into a value trap mold or one to short at this time unless you have deep pockets and can ride out margin calls.

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The more you share, the more I know what type of content you really like and I will be able to provide more quality content.

This post was first published at old school value.
You can read the original blog post here Jim Chanos is Shorting Seagate. Should You?.

Last week I posted my thoughts on the importance of learning how to invest. It must have connected with some people based on the emails I received.

One that caught my attention was from a reader who shared with me his experience and was kind enough to allow me to share it with you.

This reader in particular is interesting because he has plenty of analysis experience coming from the a private equity background and has now changed from a top down investor to a more fundamental, bottoms up investor.

See if you can take away anything from what he is sharing.

An Investor has to be Realistic but Pay a Discount for “Pessimism”

A few underlying theses that a lot of investors in emerging markets go with are

• multiples will expand
• the market will re-rate the stock since it is  a market leader
• the management is world class

but you can’t go into the show banking on it.

Investing on the back of an expected tailwind from the market is like buying  a car hoping for crude oil to fall to $50 a barrel once there is peace in middle east.

When extraordinary management meets an average business, it is always the business that wins, at least most of the times. Many high quality entrepreneurs have tried to turn around things in retail, aviation, commodities. However, the business quality outlasts their efforts.

Look at JC Penney.

Capital Allocation Skills are ALWAYS Different to Execution

These are two very different skill sets often mistaken as the same.

People who are good at execution tend to be “alpha males” – aggressive, focused who get stuff done. Similar to what Charlie Munger describes as a “locker room culture” which is a culture of always trying to win and be right.

On the other hand, great investors are cerebral, relaxed and do not focus on reaching the end-goal all the time. They have a wide view of what goes on around them.

Capital allocators go into a situation to calculate the potential and walks away if the return is not there. Executors go into a situation and the only goal is to turn it around and to come out on top.

In a way, the capital allocators are the more ruthless ones. Emotionless, cold and calculated seeking a profit over ego.

Liquidity Can’t Solve a Business Model Problem

Too many times, businesses that are losing cash get happy about raising cash and continue with their model.

It’s like filling up your car with a leaking gas tank.

You won’t get far.

You need to fix the problem.

My favorite whipping boys of these types of business are the ones in retail, aviation, social media, consumer brands going against a giant without any different proposition.

Understanding Why You Made or Didn’t Make Money is More Important than Making Money

You hear this too often in the venture capitalist world.

“We got this deal cheap at 100 x sales – our competitor fund paid 200 x sales for their investment “.

This is common especially in new and upcoming industries where there are no comparable benchmarks or demonstrated track records of FCF and ROE.

This type of relative comparison and anchoring bias leads to situations where you think the investment is worth a billion dollars whereas the actual market value is a million.

Given the lack of liquidity and any mechanism to discover price, such mispricings stay hidden for 5-6 years before the entire rug gets pulled out from under your feet in one go.

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The more you share, the more I know what type of content you really like and I will be able to provide more quality content.

This post was first published at old school value.
You can read the original blog post here Value Investing Lessons from a Reader.

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Jae Jun

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The Altman Z score is useless.

It’s outdated.

It no longer works.

That’s what these reports argue. They say that the Altman Z method is dead and here is an honest limitation of the model.

And another really good pdf report on why the Altman Z model does not work for turnaround companies.

The Unloved Altman Z Score

where

X_1 = Working Capital / Total Assets

X_2 = Retained Earnings / Total Assets

X_3 = EBITDA / Total Assets

X_4 = Market Value of Equity / Total Liabilities

X_5 = Net Sales / Total Assets

Here are the rules for interpreting the Z score.

• When Z is >= 3.0, the firm is most likely safe based on the financial data.
• When Z is 2.7 to 3.0, the company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.
• When Z is 1.8 to 2.7, the company is likely to be bankrupt within 2 years.
• When Z is <= 1.8, the company is highly likely to be bankrupt.

Does that mean the Altman Z score is useless?

Regardless of what those reports say, I still plan to use it.

The reasoning is simple. The reports above dive into the Altman Z score and concludes that the variables that make up the Altman Z score are no longer predictive of bankruptcy.

It may be true when it comes to determining bankruptcy, but for most investments, it’s the quality that matters not whether it is going bankrupt. For companies teetering on the edge of bankruptcy, you already know from the overloaded debt and other burdens that bankruptcy is a clear risk.

Think of each part of the Altman Z formula as its own separate ratio and you can see that it is indeed useful in what it tells you about the business you are looking at.

The components of the Z score isn’t rocket science. Just simple, well thought out ratios.

Let’s take a look at each of the variables and see what it can indicate in a company.

X_1 = Working Capital / Total Assets

A simple ratio to understand.

This ratio provides information about the short term financial position of the business.

The more working capital there is compared to the total assets, the better the liquidity situation.

With working capital you still have to remember two points.

Point #1: Negative working capital isn’t always bad

Companies with high inventory turnover can have negative working capital. If you take a look at Wal-Mart (WMT), it has leverage over their suppliers with favorable payment terms so their current liabilities can outweigh their current assets.

Other examples include telecom companies such as Verizon (VZ) and airlines like Southwest (LUV) and Allegiant (ALGT).

Point #2: High positive working capital isn’t always good

Just because working capital is high, it doesn’t automatically mean that it is good. It could indicate that the company has too much inventory or they are not investing their excess cash.

It all comes down to being able to interpret the financial statements instead of just taking it at face value.

X_2 = Retained Earnings / Total Assets

What is retained earnings?

It’s the percentage of net earnings that isn’t paid out as dividends, hence the word “retained” by the company. The company will use it to operate the business whether it’s to be reinvested or pay off debt.

By combining it with total assets, the purpose of the ratio is to measure how much the company relies on debt.

Makes sense.

If a company has little to no retained earnings, then it has to get money from somewhere to continue with operations. Where does that money come from? Debt or dilution.

The lower the ratio, the company is funding assets by borrowing instead of through retained earnings.

This ratio is also a cousin to the equity multiplier used in the DuPont analysis. Grab the spreadsheet while you are there.

X_3 = EBIT / Total Assets

If you squint hard enough at EBIT/Total Assets, it will look familiar.

It’s a variation of a common ratio that you see everywhere.

Don’t see it? Neither did I.

EBIT / Total Assets is a variation of ROA. Instead of net income, EBIT is used for the numerator.

The definition is the same though.

This ratio looks at the company’s ability to generate profits from its assets before deducting interest and taxes.

X_4 = Market Value of Equity / Total Liabilities

Out of the 5 components, this one is the most controversial.

This ratio is supposed to show you how much of the company’s market value could decline before liabilities exceed assets.

Yup.

This one relies on market cap, which is the stock price x shares outstanding. If the stock price is high, then this ratio also goes up.

Here are two examples

LinkedIn (LNKD)

• Market Cap: 19.7B
• Total liabilities: 473.9M
• Market Value of Equity / Total Liabilities = 19.7/0.4739 = 41.6

Apple (AAPL)

• Market Cap: 436.2B
• Total liabilities: 58B
• Market Value of Equity / Total Liabilities = 436.2/58 = 7.5

Mind you, in terms of PE, LNKD has a PE of 940 compared to 11 for AAPL.

I would bet that AAPL can hang around longer than LNKD despite the lower ratio.

X_5 = Net Sales / Total Assets

This ratio is just asset turnover.

I use it all the time outside of the Altman Z score as well as it is a great indicator of business quality when comparing it with previous years.

Quite simply, it is the amount of sales made by the company for every dollar of its assets.

The more money you can generate from assets, the better.

If two people have the same amount of resources, but one person is able to produce more output, that is a sign of efficiency and what this ratio measures.

There is Also a Free Spreadsheet

Now you know exactly how the Altman Z score works.

However, there is no such thing as a clear bankruptcy indicator. If there was, I’d be shorting everything and becoming the next Jim Chanos.

It all comes down to how you put it into context and make use of it. Use it blindly and you’ll get bitten sooner or later. Understand how it works, and you’ll be like the man that knows how to fish.

Put it into practice with the free Altman Z score spreadsheet you can download when you sign up with your email at the bottom of the page.

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The more you share, the more I know what type of content you really like and I will be able to provide more quality content.

This post was first published at old school value.
You can read the original blog post here Altman Z Score is Useless? Here’s Why I’m Still Using It.

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AEY: 9,978
GRVY: 20,003
RHDGF: 363
YNGFF: 21,209
IEHC: 2,402

These are my illiquid holdings and their respective 30 day average volume.

Scary huh?

Compare that to something like this.

AAPL: 16.84M

But I managed to buy all of them for the full position I wanted despite the low volume.

So if you buy small caps or just fear buying illiquid stocks because your money will be “stuck”, read on.

Inverting the Typical Line of Thought

Let’s do a Charlie Munger and turn the definition of illiquid stocks upside down for a sec.

Are Coca Cola, Amex, Wells Fargo and IBM illiquid stocks?

Yes they are.

To Warren Buffett they are. In fact, every stock is illiquid to him. For big buyers, all stocks are illiquid so there is no reason to believe in the myth that your money is lost because you can’t take it out.

If you manage to buy a hidden gem and the price starts to creep up, people notice and so does the volume.

With GRVY, as anticipation grew for the release of RO2, a horde of people suddenly bid the price up.

Volume spiked.

I could have sold, but I didn’t. Stupid me, but that’s a prior mistake.

Illiquid Stocks Are Not as Illiquid as You Think

Geoff Gannon has written a lot on how to buy illiquid shares, and that’s where the idea for this post came up, so I’ll be using some of the ideas that he has brought up in the past.

Say you wanted to buy into AEY.

The last closing price is $2.30 with an average monthly volume of 10,000 shares. (I’m rounding off numbers to make it easier to follow)

This means that in an average month, $23,000 worth of stock is traded. $23,000 in a month is more than enough to build a position around.

The only problem is that you aren’t the only one waiting to buy the stock. There are other smart people like yourself that knows value when they see it.

The trick is to be patient.

Put in a limit order, set it to Good Til Canceled and then forget about it. Don’t bid up the price and be the greater fool that pays the higher price.

As you can see below, illiquid stocks don’t move in a linear fashion.

Set your limit price and forget it, because there is a good chance that you will get your fill.

Ben Graham Already Taught You About Mr Market

Even for low volume stocks like AEY, there is enough volume for most investors to take a full position. Remember that the public market is like a real market.

There are buyers and sellers.

Somebody like you is on the other end, holding out their goods (the shares) for sale. Just like how you would haggle at a real market, you should do the same. Don’t accept the asking price.

Put your bid out there and if the seller is desperate and wants to clear his goods, your bid will get filled.

Too Late. You Missed Out.

The only enemy when it comes to buying illiquid stocks is yourself and the psychology of missing out. I’ve done it myself. I put in a bid and then after 30 minutes of not getting it filled, I increased my bid slowly and eventually bought at 3-4% above my initial price.

At the end of the day, the stock had actually dropped 3-4% below my initial starting price. So I’m already starting down 6-8%. Way to go.

This sense of missing out, getting urgent is what causes you to buy at a higher price.

Companies use urgency all the time making you feel like you are going to miss out.

Say you found a good looking laptop bag at Zappos.com. The quality is excellent and best of all, it’s on sale.

Bingo.

Your eyes roam to the add to cart button, but above it, there are the words, “only 2 in stock”.

Sold.

The airlines do this all the time too – “Only 4 tickets left at this fare”.

Now that you are aware of the psychological behavior when it comes to buying shares, consciously make the effort to set your price and walk away.

Do that in a live market and the seller will run out to sell his goods to you.

Tips to Grabbing Illiquid Shares of Great Companies

• Always buy stocks using the limit order
• Use the good til canceled option
• Don’t use All or None. If you are trying to buy 1,000 shares, what’s the chance that you will get all 1,000 shares in one order? Build your position in blocks if you have to. That’s why you need a good discount broker with cheap fees like optionshouse. $3.95 per trade. Yum.
• Try to keep commissions below 1% of your order. Again, it’s why I use optionshouse. As long as my order blocks are at a minimum of $400, I don’t have to worry about fees eating my returns.
• Don’t bid up stocks. Set it and forget it. You should get an email notification if a trade goes through.
• A stock is always liquid enough for small investors.
• If the stock price of AEY is $2.30, instead of putting in a bid price of $2.30, put in something like $2.31 or $2.32.
• If you want to sell a stock like AEY, put in something like $2.29 or $2.28 to make the probability of the trade going through higher.
• Most important of all, chill out and take it easy.

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The more you share, the more I know what type of content you really like and I will be able to provide more quality content.

This post was first published at old school value.
You can read the original blog post here The Value Investors Guide to Buying Illiquid Stocks.

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I posted an old investing process guide and checklist of mine the other day on facebook and it got plenty of clicks so I’ll share the whole series with you.

This one is all about checklists.

Save it, print it, use it.

Investment Checklist for Stock Selection

An investment checklist based on a flow diagram. Also includes a list of items to do at each step of the analysis process.

15 Points to Look for in a common stock

The original checklist by Philip Fisher. This is a list of 15 questions you should ask for qualitative research.

40 Point Stock Selection Investment Checklist

This is an extended stock analysis checklist covering many aspects.

52 Techniques for Finding Fraud

The mother of all checklists. This is an advanced checklist because it requires lots of digging into the financial statements. The central focus is to uncover signs of fraud so any failures is a red warning flag.

Please Share if You Find this Useful

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The more you share, the more I know what type of content you really like and I will be able to provide more quality content.

This post was first published at old school value.
You can read the original blog post here 4 Checklist Posts Worth Your Time.

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I am a fan of Tim Ferriss and his obsession with doing things better, smarter and more efficiently.

Reading through some old material related to The 4 Hour Chef, it is amazing to see examples of ordinary people doing extraordinary things.

• A 132lb girl deadlifting 400lbs
• Shinji Takeuchi, a Japanese man who started swimming at the age of 37, is the #1 watched swimmer on youtube. Blows Michael Phelps and Ian Thorpe out of the water. But why?

The theme throughout Ferriss’ book is that ordinary people can excel beyond the pack and achieve phenomenal tasks by knowing how to train instead of what to train.

I found myself thinking how relevant this information is for people wanting to learn or get better at investing.

A lot of investing blogs, books, papers and other materials tell you what to learn, but not how to learn it.

This simple concept can be the difference between struggling for years to break through a learning plateau and leaping through it into newfound confidence.

Too Many Big Ideas

As much as I admire Buffett, the only difficulty that I have with his letters, speeches and books about him is that there is no real practical information on how to invest for the small investor.

This goes for a lot of the value gurus. It is understandable because gurus have moved onto a different level and have different agendas. They don’t have the luxury of writing weekly newsletters or blogs to explain every detail.

This is why, when they do put out reports, books, paper, interviews etc, it is all based on big ideas. Nothing small and actionable enough for people like you and me to handle easily.

The Investment Gurus are Cursed

To really improve your investing, you have to understand that Buffett was going to be successful no matter what happened. He was born with investing and businessman blood.

Ask the most muscular guy in the gym how he works out and do the same routine. It won’t work for you. The gym guy was born with great genes, while some people gain weight just drinking water and others find it difficult to gain and maintain muscle unless they consume 4,000 calories a day and ultimately become sick.

Same concept with the gurus. They may be gurus but they are cursed.

They have the curse of knowledge. They forget what it’s like to be a beginner.

I once listened to my vet talk for one hour about the structure of my dog’s teeth and the surgery involved. All I realized at the end was that my wallet was $1,000 skinnier.

Buffett is a great role model for analysts and investment managers, but not a relevant role model for retail investors who are trying to get to know more about their own stocks. He was born to be an investor, as this timeline of his life shows.

His words are gold, but it can confuse and mislead you unless you know exactly what context he is talking about. After he says something, there is still great debate about what he meant.

You need to find the Shinji Takeuchi’s of the investing world because you will learn exactly how to invest through these people.

There is no confusion. It’s just clear.

It’s people like Joe Ponzio of F Wall Street that you need to identify and cling to.

My Personal Story

If you are fairly new to old school value, you may have the wrong perception that I’m some smart numbers guy. That couldn’t be further from the truth.

I didn’t study in the USA, and if I converted my academic score to a GPA, it is probably between 2.5 – 2.8.

As you can see, I didn’t thrive in my studies. The world is full of people smarter and better than I.

Combine that with never having taken any finance, business, accounting or economics classes and it’s amazing to see how I got here.

It just turns out that the educational system does not suit my style of learning.

It was only after I figured this out, that things started to turn around because I found a method that worked for me.

So What’s my Secret?

First, take a look at this familiar question from Quora.

I’m 18 years old and want to learn how to invest my money. How do I get started?

Here is the top rated answer.

Great advice?

If I was that 18 year old, would I follow that advice? Absolutely not.

Although the very first investing book I read was the Intelligent Investor, it was a horrible experience. I didn’t understand anything, the text was extremely dry and there was no practical advice that I took from it. The only thing I remember is the concept of Mr Market. Nothing else.

My secret?

It all came down to how I learned. Not what I learned.

I realized I needed to write notes to organize and clarify the jumble of information I had been reading. I started with this blog and publicly posted notes, articles and analyses for critique. I got slammed and chewed in the beginning, but it helped with learning and growing a thicker skin.

The second vital part was realizing that investing is extremely tedious and redundant. Being an efficiency nut, I needed a way to simplify and speed up repetitive tasks.

That’s when I started making excel spreadsheet models like the ones you can download for free by signing up with your email. In the process of building financial models, I combed through books and technical papers to understand how a specific model worked.

Figure out what your strength is and twist it in a way so that you can apply it to investing.

Know Your Strengths, Weaknesses and Situation and Take Advantage of It

Make investing relevant to your interests.

Just want get better at writing investment analyses?

• Find a stock analysis style that you like, break it up into manageable sections, find the information and fill up the sections.
• It will get better the more you do it.

Are you a small business owner?

• Think of your business as a public company instead of a small family business.
• Find public companies in the same industry and see how they run the business.
• What key performance indicators are important?
• Learn the strategies and competitive advantages
• Go through your accounting books and try to convert it to a full set of financial statements

In no time, you’ll be an expert in your industry and will be confident in analyzing and investing in such companies.

Same thing applies to any day job. Don’t just do it. Think of yourself as the CEO and look at the bigger pictures.

Do You Handle the Money in Your Home?

• Personal finance is just like a business. Think of your household as a business.
• Go through your bank statements and try to create your household financial statements.
• Budgeting, projecting, allocating, depreciating is something you do everyday already. Why not think of it like managing a business?

Here’s what I did to monitor my household cash flow using a cash basis method.

Are You a Programmer?

• Why not try to program simple tasks? That’s what I did with my spreadsheets.
• Create an easy investment game
• or just a simple stock portfolio spreadsheet

Don’t Have a Good Memory or Weak with Numbers?

• Don’t try to improve your memory.
• Investing math is just plus, minus, division and multiplication.
• Create a simple glossary of the terms that you hear and use all the time from investopedia. Keep it as a cheat sheet. This isn’t school. It is encouraged.

Never Have Enough Time?

• I recently hired a part time virtual assistant for $300 a month. A part time employee for $300 a month is a steal.
• My virtual assistant goes through company reports, writes up point form summaries which I can read and analyze quickly.

Do You Travel Regularly?

• Get some audio investing books and listen to it on the road.
• Convert Khan Academy youtube videos to MP3 format and take it with you.
• Download podcasts like Sound Investing by Paul Merriman that are short and focused on specific topics.
• There are lots interesting people at the airport. Find someone reading investment news and talk to them.

Or Start Your Own Simple Business

• By starting even something small and insignificant like selling on ebay, you will learn about an entire industry.
• Try to import something cheap and sell it on ebay. You’ll learn what companies have to go through in the import/export business. Or just try to sell things around the home.
• Selling on ebay requires that you know how to position your product, market it, word it and make a successful sale.
• Shipping multiple items gives you insight into the shipping industry.
• Starting your own business opens a can of worms and you will be a better investor for it.

There are Countless Possibilities

I don’t know everything about your situation so it’s difficult to try and come up with a recommendation for every scenario, but you get the point.

No matter what your skills are, there is a way you can benefit from learning how to invest. And best of all, doing it your way will make it stick.

Make Use of How to Tutorials

Still not sure? Then start with these topics and keep filtering down.

• How to value stocks
• How to perform financial statement analysis
• Learn the specifics of accounting concepts for investing
• How to improve productivity in investing

Summing Up

• Learn the how, not the what.
• Follow and learn from people who are like you but managed to make the jump to elite status. These are the people who will understand your situation and can help you get to the next level.
• Gurus are not good role models for the layman.
• You know what you are good and bad at. Use it to your advantage and make it relevant to investing.

This post was first published at old school value.
You can read the original blog post here The Importance of Learning How to Invest, Not What to Invest..

Written by

Jae Jun

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Here’s an analysis of a company that I came across which I struggled to value at first. But as I continued to read and learn about the industry, it continued to raise my interest. Take a read and see whether this is an idea that can suit you at the right price.

Quick Summary

FleetCor is a company with a strong moat in an attractive industry and performing well for shareholders.

The company has more room for growth but some questions have to be asked as to whether this will make it a good investment.

What is FleetCor Technologies?

Having missed out on Visa and MasterCard, stumbling upon FleetCor is a pleasant surprise.

FleetCor Technologies is a company that provides fuel cards and payment products used by employees. They also have lodging cards, but since the overall concept is the same, I will focus most of the discussion on fuel cards.

The important thing to understand is that although I’ve included Visa and MasterCard into the conversation, fuel cards and credit cards are different in many ways.

First, what is a fuel card?

Differences Between Credit Card and Fuel Card

A fuel card, as the name suggests is mainly used for fuel.

Companies that require lots of travel in their line of work gain a lot of benefits with issuing fuel cards to their employees instead of standard credit cards.

Here are the pros and cons taken from wikipedia.

Pros:

• Discount fuel prices (i.e. wholesale prices)
• Ability to choose from multiple providers like Shell, Esso, Keyfuels, Texaco etc. This enables better pricing due to competition.
• Need for carrying cash (or giving cash to drivers) eliminated
• Prevention of fraud
• Increased security
• Filling patterns can be customized by Smartchip technology
• Fleet efficiency & MPG reporting
• Reduced administration via management tools
• Ability with some card management tools to capture private/business driver mileage split

Cons:

• Card stopping/cancellation periods can sometimes be longer
• Greater liability for fraudulent transactions often placed on customer
• Credit periods typically shorter
• Retail cards typically offer pump prices (usually higher than wholesale) and occasionally additional surcharge
• Annual or monthly card provision charge sometimes applied (usually bunkered)

The pros far outweigh the cons and should now provide a clear picture of the business model.

FleetCor’s Business Model is a Competitive Advantage

FleetCor has been around since 2000 and has grown mainly from acquiring smaller fleet card companies around the world.

The company does business in over 18 countries and such an extensive network of where its cards are accepted that it would literally take a decade to replicate anything in the same size and scale.

There is also switching cost involved in such a network. Once you have gas stations equipped with hardware and software to work for these type of fuel cards, it’s very difficult to switch.

It’s different to just accepting credit cards and performing transactions.

Based on the data that fuel cards track, the data provided to the system from every gas pump is much more than the average credit card transaction.

This is a Very Profitable Business

Visa and MasterCard are very profitable businesses. They receive a percentage in fees for every swipe.

Since I sell stock valuation tools on this site, I have to accept credit cards. So I understand how powerful this industry is in terms of profitability.

The fee per swipe racks up and I understand why little mom and pop shops don’t like to take Amex cards or why they make you spend at least $10 before you can use a credit card.

Actual numbers showing profitability can be seen below.

High Insider Ownership is a Good Sign

The CEO holds a 5.5% stake in the company of a current $6B company which is more than $300m.

Two members of the board are also part of Summit Partners which owns 28% of the company.

These insiders have a strong interest in the company and with key investors on the board of directors, it’s pretty clear intentions are aligned with shareholders.

There are Always Risks

The majority of FleetCor’s revenue is dependent on fuel prices. Since they receive a percentage of the sale, if fuel price drops, then the fee also decreases.

I don’t see this playing out though. As the government continues to bring in more regulation and stricter practices, the cost to refiners will go up which will get passed onto the customer at the pump.

Another big risk is from competition. If companies like Shell or BP really get aggressive and try to launch their own version of the fuel cards and prevent their gas stations from accepting FleetCor’s cards, it will be a huge blow.

But this is something that the management have always known about and although it’s been tried before, it has not succeeded.

The balance sheet is full of goodwill and intangibles from all the acquisitions. It makes up 51.1% of total assets and the debt to equity ratio is at 71%.

Fundamental Numbers

What better way to identify profitability than ROE and CROIC which is an improved version of ROIC.

Some numbers to bring it all together.

Strong returns for any business but let’s take it a step further. I have been using the DuPont method a lot to really dig into whether the ROE is organic or artificial.

The five step DuPont analysis shows in better detail that the drivers behind the ROE increase comes from an increase in operating margins and an increase in debt.

If I were to decrease the equity multiplier from 2.98 down to 2010 levels of 2.3, the ROE goes down from 23.7% to 18.3%.

Brief Valuation

With the company still growing and investing cash for growth, using the standard DCF valuation is not the best idea.

A better way to value FleetCor would be based on its income statement.

Here is an EBIT multiple calculation assuming 20% revenue growth in the next year.

Based on this valuation, even by using the aggressive assumptions, FLT looks to be overpriced at this point.

Overall Verdict

A picture is worth a thousand words.

Summary

FleetCor has performed amazingly for shareholders since its IPO in December 2010 but rather than just jumping on board, I am watching this from the sidelines.

The business is attractive but the price paid determines whether a stock is a good or bad investment.

At current prices, I have to make aggressive valuations and assumptions but still it falls short of the desired valuation range.

I will gladly put it up on my watchlist though.

Disclosure

None

This post was first published at old school value.
You can read the original blog post here You Missed Out on Visa and Mastercard. Then Keep an Eye on This One..

5 Minute Video on the Book that Changed Warren Buffett’s Life

In 5 short minutes, Buffett talks about:

• how this book changed the way Buffett’s investment philosophy
• Buffett went to work for Graham for free but was told he was overpriced
• Just being around Graham everyday was a life changing
• Graham influenced security analysis but he was also generous

Charlie Munger Reveals Secrets to Getting Rich

A 10 minute interview with Charlie Munger where he discusses:

• that if you can’t stomach market volatility, you shouldn’t be a shareholder
• how political idiots get in control
• on Alan Greenspan and the Federal Reserve
• Wall Street culture
• and other topics where he gets straight to the point

This post was first published at old school value.
You can read the original blog post here The Book that Changed Warren Buffett’s Life.

by Dan Myers

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There is a lot of controversy on whether or not the profit motive should play a role in the education of society.

Those against it claim that corporations will just churn students through and not care whether or not they actually learn.

The pro side claims that if the corporations do not create value for the students, long term profits would decline and thus there is a motivation to provide the best education possible.

As that battle rages on, for profit education companies have taken a beating in the market.  Those on the negative side seem to have the upper hand today.

The question now becomes:  Is this the “blood on the streets” time to buy into these companies or is this the next buggy whip industry?

Introducing ITT Educational Services (ESI)

ITT Educational Services, commonly known as ITT Tech, provides post high school education in various fields.

Their programs range from Information Technology, Electronics, Drafting & Design, Business and Nursing.

ITT Tech has been around since the 1940’s so they have a well-established brand and business model.

What’s Explained in the Video

• ITT Tech’s business model
• Review of their financials
• Why a high debt ratio is different from debt to free cash flow
• Why there is a drop off in revenue recently
• Valuing a business based upon only the parts we think are viable
• The risks inherent in the education industry
• Identifying businesses as Graham value investments vs. Buffett value investments

Enjoy the Discussion on ITT Tech

Part 1 | Part 2 | Part 3

This post was first published at old school value.
You can read the original blog post here [Video] Is For-Profit Education Profitable? ITT Tech Valuation.

Written by

Jae Jun

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Being able to take things into context is important.

Many companies and investors love to throw around numbers that sound impressive, but it ultimately means nothing.

In other industries, it’s called vanity metrics. Not sure what it’s called in finance.

Let me give you an example of a vanity metric.

The average time a visitor spends at oldschoolvalue.com is 2min 49s per visitor compared to 1min for other sites.

This means OSV is performing better than the average site by 183%.

Impressed? Don’t be, because it means nothing.

A visitor could have stumbled upon this site, started clicking all sorts of things, go for a coffee break, or simply wait for some big files to download.

Same concept with investing. Many companies boast about earnings growth, subscriber growth or improving operations, but these are just “power” words. Words meant to convey importance without much context or relevance.

Vanity Fundamentals and Investing Ratios

Previously I wrote about why you need to learn accounting.

To sum it briefly, it is the language of business. If you want to live in a foreign country, you must learn the language to be able to understand and interpret it.

Knowing the accounting concepts is like knowing the business vocabulary, but the important part is knowing how to interpret it.

Having a good understanding of accounting and how it all ties into business will help you avoid vanity fundamentals and investing.

But there are still fundamentals and ratios that

• mislead investors
• do not add value
• should not be used on its own

Some Examples of Vanity Investing Ratios

I do use the below ratios but I want to show you the proper way of using it.

• EPS (Earnings Per Share)
• PE (Price to Earnings)
• PB (Price to Book)
• ROE (Return on Equity)

Vanity Metric #1: Earnings Per Share

Earnings growth. Loved by Wall Street and most investors, but it really doesn’t tell you much.

There is so much to earnings, but boiling it down to just a single value is overkill. The important factors have been eliminated and looking at earnings growth as a measuring stick for business growth is pure vanity.

Look at the following two companies.

• Company ABC and Company XYZ both achieved $100k in earnings from $1m in revenue.

Now look at the two companies again.

• Company ABC achieved revenues of $1m and net income is $100k.
• Company XYZ’s revenue came in at $800k with other income of $200k making up a total of $1m revenue. Net income is also $100k.

With this extra information, you can see how different the two companies are. But most people simply look at the earnings line and judge the company based on a single number without taking the number in context.

For this reason, when it comes to judging EPS, I always recommend the book Quality of Earnings. It goes into great detail of how to adjust the EPS to factor in changes due to tax rates, non-operating and non-recurring income.

Instead of taking EPS at face value, go beyond the vanity number and get to the core metric.

Look at earnings growth next to account receivables growth and inventory growth to see trends in the business.

You could do something like the format below to better gauge the business.

Owner earnings is an alternative to earnings you can use.

Vanity Metric #2: PE Ratio

On its own, the PE ratio is absolutely meaningless.

It is a relative measure so it is only useful when you compare it to another PE ratio. Plus, it is difficult to figure out what a company is worth with just the PE ratio.

The best it can do is give you an approximation of whether the stock is cheap or expensive.

Somebody telling you that Netflix is a sell because it has a PE of 609 sounds smart, but it doesn’t answer questions such as what the fair PE is and why the PE is so high to begin with.

The PE ratio is just Price divided by earnings per share and you just read what I thought on EPS. This is why PE is just as useless as a standalone investment ratio. It is the most misleading, misused and abused metric.

Instead, you could use something like the Absolute PE valuation method. This method forces you to think about the different aspects of the business and growth to determine the fair value PE which you can then use to judge whether the stock is over or undervalued.

Or consider using alternatives like P/FCF or EV/EBITDA. Both are similar but offer more insight.

Vanity Metric #3: PB Ratio

Here is one more inclined to value investors but still often misused.

One thing is that Graham never spoke of finding just low PB stocks. He specified net net stocks because he wanted companies trading at a low price to tangible assets.

Graham even took it one step further by looking for net net working capital stocks where assets are of high quality and easily convertible to cash.

With that in mind, when looking at PB, it’s always best to eliminate intangibles and goodwill from the equation.

Unless you are dealing with a company where the brand sells itself like Coke, Pepsi and Windows, or necessary for business like Expedia (EXPE), most goodwill and intangibles is not as valuable as the company makes it out to be.

Best thing to do is remove it.

PB would then become Price to Tangible Book which depicts a much clearer view of the company.

Vanity Metric #4: ROE

You may be surprised that ROE is on this list. If I wrote this one year ago, it wouldn’t be on here.

Although ROE is a very helpful measure, it can do better. By understanding the drivers behind ROE it goes from an OK metric to a powerful one.

The best way is to use the DuPont analysis to break up ROE into 5 segments as shown below.

Via the five step model, the interest burden is increasing, but the main culprit is due to a decline in operating margins.

By using ROE alone, you may have deduced that the company is just doing poorly, but by dissecting the vanity metric, you get to see that the core operation of the business is leading the drop in ROE.

Also consider using CROIC as well as ROE with the DuPont analysis.

Bringing it Together

It is very important that you don’t just accept data at face value. Take things into context. You invest to make money.

There is no need to start with a conclusion and then pick data to match your conclusion. I’ve only lost money that way.

One of the quickest ways is to find the metrics that you think if important and really ask yourself whether it adds value to the overall investment.

If you saved a stock analysis and looked at it again 30 days later, are you confident that you will know why you saved it in the first place?

This is a problem I see with Wall Street analyst reports. I try to read it again a couple of months later and I have no idea what the report is trying to say because the numbers are filled with sales growth of 25%, earnings growth or 19% year over year. Impressive but fluffy duffy stuff.

Please Share if You Find this Useful

If you find this useful, please help out Old School Value by sharing this article using the social sharing buttons.

The more you share, the more I know what type of content you really like and I will be able to provide more quality content.

This post was first published at old school value.
You can read the original blog post here 4 Vanity Metrics that Feels like Investing but Means Nothing.

Written by

Jae Jun

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I have a treat for you today. I had the pleasure of speaking with Paul Merriman this week and wanted to share some content that he has available.

Paul is a retired financial advisor and also the author of several personal finance books including Financial Fitness Forever.

What I admire most about Paul is that he loves to teach and share. He is also retired so 100% of the money he earns through book sales and royalties goes directly to his foundation dedicated to financial education.

I want to highlight two pieces of content.

But first..

Who Will Benefit Most from the Below Resources?

The content is mainly focused on personal finance. It is great for

• People who don’t know much about finance
• New investors
• and retirees

If you know of such people, feel free to pass the message along.

101 Investment Decisions Guaranteed to Change Your Financial Future

Download a free copy of the book. It’s an easy read with 101 short pieces of personal finance advice.

It answers a truckload of questions that any new investor or retiree may have on their mind.

Sound Investing Podcast

Mr Merriman is  also the voice behind the Sound Investing podcast which you can also listen through iTunes.

Voted best podcast by Money in 2008, the podcast comes out weekly, with plans for 3 podcasts per week a little later in the year.

Some topics that the podcast covers include

• How much higher can the market go?
• Is it time to sell gold?
• 10 things every investor should know
• 2012 in review: how did my predictions do?

Please Share if You Find this Useful

If you find this useful, please help out Old School Value by sharing this article using the social sharing buttons.

The more you share, the more I know what type of content you really like and I will be able to provide more quality content.

This post was first published at old school value.
You can read the original blog post here Free Personal Finance eBook and Sound Investing Podcast.