>All the Magic U Need for Investing. Once again..!!

So, what should you think?
If you want to be a successful stock market investor, you should think about buying pieces of "good" businesses at "bargain" prices.

Yes, that sounds simple, but if you actually could find a good business at a bargain price, wouldn't it make sense to buy it?
Doesn't that sound like an investment strategy that should work.

The only problem is figuring out what's a "good" business?
Well, a "good" business is a business that can earn a high
return on capital.
What's that? It's a pretty simple concept really.

Say you own a gum store (yes, a store that sells only gum--don't ask!). Anyway, say that store costs 400,000 to build (including inventory, store displays, etc) and last year that store earned 200,000. This works out to a 50% yearly return (200,000 divided by 400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital. Without knowing much else, earning 200,000 each year from a store that costs 400,000 to build, sounds like a pretty good business.

But what if we compared that to another kind of store, say a store that sells only Broccoli (we called that store, Just Broccoli, for obvious reasons). What if it also costs 400,000 to open a Just Broccoli store? But what if that store only earned 10,000 last year? Earning 10,000 a year from a store that costs 400,000 to build works out to a one-year return of only 2.5 percent, or a 2.5 percent return on capital.

So here's the tough question. Which sounds better--a business that earns a 50% return on capital or one that earns a 2.5% return on capital? Of course, the answer is obvious. You would rather own a business that earns a high return on capital than one that earns a low return on capital.

So, now we know what "good" is--a business that earns a high return on capital.

But what's cheap?
In the book, we defined cheap as a business with a high earnings yield. What's that?
Take two businesses, one earned 300,000 last year, one earned 100,000. Both are for sale for 1 million.
If we buy the first, we get an earnings yield of 30% (300,000 in earnings divided by the 1 million purchase price).
The second has an earnings yield of 10% (100,000 in earnings divided by the 1 million purchase price).

Which is cheaper? All other things being equal, the company that earns more relative to the price we're paying is cheaper than the one that earns less. In other words, getting a 30% earnings yield is better than a 10% earnings yield--a high earnings yield is better than a low one.

And that's it. Now you know the "magic formula"! What do I mean? If you just stick to buying "good" companies (those with a high return on capital) but you buy them only when they are available at bargain prices (when they have a high earnings yield), you can more than double the market's average annual return. And you can do it with very low risk.

Having trouble believing that it's that easy? Well, how about this? A study over the last 17 years shows that holding a portfolio of stocks with the best combination of a high earnings yield and a high return on capital produced over 30% annual returns vs. just 12% for the overall market during the same period

Over 17 years, earning 30% a year means 11,000 would have turned into over 1 million! Not bad.

Actually, maybe not. With me being such a blabbermouth, if everyone "knows" the "magic formula" maybe it will stop working? After all, how can any strategy keep working if everyone follows it?

Well, here's the answer.
=> The great thing about the "magic formula" is that it isn't that great! It doesn't work all the time. That's right.
=>Over long periods of time, it's true, the results are amazing.
=>But...there are still 1, 2 and even 3 years periods when the formula doesn't work at all!
=>Most people just don't have the patience or the discipline to stick it out during those tough periods.
=>After a year or two of following a strategy that underperforms the market, most people simply give up!

That means for the "magic formula" to work for you, you must "believe" that the formula makes sense and that it will continue to work over the long term--even if it hasn't worked for months or even years.

For that, you'll have to understand why the magic formula makes sense. (yes it does makes a lot of sense)
You'll have to continue to believe that it still makes sense even when friends, experts, the news media, and Mr. Market indicate otherwise. That's tough to do! Unfortunately, to really "believe", I mean really, truly "believe", you'll have to be convinced that buying above average companies at below average prices actually makes sense. I believe it does. I hope you "believe" too.

If you do, I know you'll become a more successful investor.

Related Articles.

***>An Essential Questionaire

Magic Formula for Value Investing?

***>ROIC + Earnings Yield?

>24 Buffet Ideas to win 365 battles every year

>Value Analysis: What is Fundamental Analysis?

>Free cash flow. A great valuation tool.

>Valuation: Reverse the Thumbnail


>Indian Plans and Hope for Future from PM

Some key take aways form Prime Minister Manmohan Singh address.

Unveiled plans for

Rs 60,000 crore (Rs 600 billion) investment in the port sector.

Rs 40,000 crore (Rs 400 billion) for modernisation of airports in the country.

Rs 175,000 crore investment plan for expanding the highways programme.

Assured the industry of better tax administration.
On the issue of raising the level of 30 per cent income tax to incomes of above Rs 500,000, the prime minister said, "I promise to address these concerns over the next year."

On Labour Policy

PM said the government was committed to 'unleash a new surge of investments' by encouraging enterprise and creativity through reforming the public sector and enabling private and public partnerships.

"If it requires modifications to our labour policies to provide greater flexibility, which in turn will generate more jobs, we will work with all stake holders to generate a consensus on it," he said.

Need to pay attention to social safety nets because it was incumbent on the state to take care of the weak and vulnerable for those who cannot bear the shocks of market economy. "Social welfare legislation must go hand in hand with labour market flexibility. This will help increase employment opportunities while taking care of employees' concerns," he said.

On taxation
Over the last two years the economy had moved towards lower tariffs, uniform tax rates and easier procedures.

He told the industrialists that the government would work towards improving the tax administration in the country so that "your interface with the tax system is pleasant, smooth, problem-free and conducive to easy tax compliance."

On power situation
"I hope we can initiate a speedier process in case of power sector policy reform through the mechanism of an Empowered Committee of Chief Ministers. I am going to propose to our chief ministers to forge a similar all-party consensus in the power sector," he said.

Singh said he was happy that many states, which initially kept out of VAT, have opted to join the system. He said revenues have been buoyant, setting at rest worries about its feasibility.

Need to move towards greater rationaliation of VAT and Cenvat rates, and most importantly, towards a common goods and service tax," he said. "This would enable India in to becoming a genuine common market, a dream of our founding fathers. I hope to see this happen in next three to four years, an event, which will be a landmark in our economic development," Singh said.

On investment in Railways
The feasibility studies for dedicated freight corridors on Delhi-Mumbai and Delhi-Kolkata are nearing completion.
"We will be shortly setting up a new firm to implement these corridors in addition to allowing private container trains on these routes," he said.
The prime minister said the basic institutional framework for a surge in infrastructure investment was now in place with a special purpose vehicle for the sector, viability gap funding programme, a separate approval procedure for public-private partnership projects and model concession agreements.
He said transparent competitive systems were in place and were paying off. Singh said the government was expanding the highways programme with an investment plan of Rs 175,000 crore (Rs 1,750 billion).

On roads
He said entire Golden Quadrilateral is being made six-laned and against a target Built-Operate-Transfer projects this year, the contracts have been awarded for 31 projects.
"Compared to a high of 3,500 km golden quadrilateral road contract given in 2001-02, the level has gone up to 6,000 km this year, Singh said. The prime minister said the United Progressive Alliance government had inherited golden quadrilateral being built with old contracting approach, which has now undergone changes.

On manufacturing
Manufacturing sector should not be ignored as it created large employment opportunities. Inadequate growth in manufacturing has had its adverse impact on employment generation. "The current mismatch between distribution of workforce and value added in agriculture was one of the main reasons for large number of poor. This needs urgent correction," the prime minister said. "Manufacturing has to be like a sponge, which absorbs people who need to move out of agriculture in pursuit of higher incomes," he said.

"I do not accept the proposition that India can skip the manufacturing stage of development and go from being an agrarian society directly to become a services and knowledge based society," he said adding: "This is a mistaken view."

He said a substantial manufacturing base is essential to absorb the work force and ensure sustainable growth of the economy.
"India can target to process over 25 per cent of its agriculture produce in next five years as compared to a lowly 2.0% today. This will generate jobs, reduce wastage and enhance rural incomes," Singh said.

On textile exports
he end of Multi Fibre Agreement regime in textile must translate in to greater output and far more jobs in textiles and garments.
Stating that there were reports of mixed results in textile this year, Singh said: "We cannot miss the opportunities, which we once did in 1960s. I urge industry to have faith and take the plunge. Few will regret."
The prime minister foresaw greater competitiveness in small and medium enterprises sector in the coming years. He said large-scale industries must think global even as they act local. On forging international cooperation, he said: "I have a vision of Asia in which India has to play a key role -- a vision of a resurgent Asia; an Asia of inclusive societies and open markets."

The prime minister said he felt the emergence of a virtual Asian economic community.

On the economy
On the buoyancy in the economy, the prime minister said the state of business confidence and expectations is 'very positive.'
He said during his recent interactions with business representatives, he had been encouraged by the new sense of confidence that many now exude. "It is therefore, heartening to see the faith being reposed in the prospects for the Indian economy -- not only within India but outside," he added.

Singh said the decade ahead must be a decade of investment that should convert India into a ' first rate agricultural, industrial and service economy.'
He desired that the share of manufacturing in national income should rise in the range of 25-35 per cent for which the sector should grow at the level of 12-14 per cent in the next decade.
The prime minister assured that the government would be mindful of the interests of domestic industry even as "we enable our economy to integrate itself with the global economy." He said the industry should not only look at the threat of competition from imports but also the opportunity of accessing new markets through exports. "If we look at new opportunities, the old threats become less daunting. I urge Indian industry to adopt a forward-looking approach in preparing for a brave new world of competition."


>Truth Of Trading

The following brief excerpt from a legendary trader brings out the essence of trading.







>Investment Axioms

Some axioms based on several excellent books on the vast and fascinating subject of stock market investment like "One Up the Wall Street"; "Beating the Street"; both by Peter Lynch; "Zulu Principle" by Jim Slater; "The Warren Buffet Way"; to name only a few of them.

Axiom One:
Where there is profit, there is always risk. Greater the opportunity of profit, greater the possibility of loss:
There is a close direct relationship between the risk and the reward. Higher the reward, greater the risk. Though this is fairly simple, it is always observed in breach.

Axiom Two:
Gentlemen who prefer BONDS, don't know what they are missing. On Bonds, there is no return ON our money; there is only return OF our money:
Bonds being Debt instruments unlike equity, yield only fixed return and with inflation and income tax factored in, there is often no return at all.

Axiom Three:
Equity Investment is "risk" investment:
Investing in equity shares of companies is risk related because returns are linked to the company's profits unlike investing in bank deposits or bonds or debentures where the returns are fixed and accrue to investors regardless of the company's profits.

Axiom Four:
Stock market behaviour is unpredictable:
Stock market behaviour is dependent on human behaviour and since times immemorial, it has been established that human behaviour can never be predicted with any reasonable accuracy; and hence we have fluctuations in prices of commodities, things and stocks based on greed, emotions, hopes, fantasies, fear and dreams resulting in opportunities of making money out of such fluctuations!

Axiom Five:
ot all common stocks are common:
Though equity shares as an investment class is one, each company has a distinct identity and performs differently and therefore rewards its investors also differently.

Axiom Six:
Investing is nothing but arbitrage of ignorance:
Investing is basically profiting from pricing and difference in market perception of a given product at a given point of time. Stock market is one place where the buyer and the seller both think that they are smart in their decision.

Axiom Seven:
Elephants don't gallop, zebras do:
Stock prices of big companies with large capitalizations move up or down rather slowly compared to smaller companies because there is not much of market ignorance on big companies to capitalize on. Hence smaller companies tend to reward its investors more handsomely.

Axiom Eight:
Equity investment is not for everyone, nor for all times of a person's life:
One needs not only "cash" but also "courage" to be an equity investor. There has to be a positive mental temperament and willingness to absorb occasional losses. Those prone to panic at losses should remain invested in fixed deposits with banks and Government Bonds. If you don't know who you are, stock market is too expensive a place to find it out! Even for a risk loving investor, there is no single static investment strategy valid from his "cradle" to "crematorium".

Axiom Nine:
Investors make mistake in buying not good stocks at high prices but in buying bad stocks at low prices.
A lay investor tends to buy unsound companies at cheap prices instead of solid companies at high prices.

Axiom Ten:
Equity investment can't maximize your "income"; but it can maximize your "wealth".
Actual yield by way of dividends on equity shares with reference to their market value is often as low as 1 percent on our investment. But capital appreciation in equity values can be mind blowingly high. Ask initial investors of Infosys, Pantaloon to name only two companies.

Axiom Eleven:
Saving for investment is not a punishment.
Investing is making conscious choices about how you will use your money. It is not about choosing to live rich or die rich. It is about how you want you and your dear ones should live during your lifetime and thereafter.

Axiom Twelve: (On Stock Prices)
  1. There is no "high" price or "low" price of a stock. There is only the "market" price of the stock nor any price too "high" for you to buy or too "low" for you to sell.
  2. In isolation, price of a stock is not relevant. What is important is whether a share is "underpriced" or "overpriced", overvalued or undervalued.
  3. We do not invest in Stock Market Index; nor in Stock Market; nor in individual companies. We invest in a stock at a price at the correct "time".
  4. You can't control the "market" nor the individual stock prices; but you can control your "reaction" to the market.
  5. Intelligent investing is knowing "what" to buy; smart investing is knowing "when" to buy.
  6. Your profit is determined by your purchase price and not your sale price. Timing your purchase is important.
  7. Don't ask the price of the stock, ask what is the worth of the entire company to know whether the stock is worth investing.
Axiom Thirteen: (On Share Brokers)
  1. Don't expect your broker to help you to earn "for" you. He is there to earn "from" you.
  2. The sub-broker made money and the main broker made money and two out of three making money in a single transaction is not a bad bargain.
  3. Never ask a broker whether you should buy a particular stock, it is like asking a barber if you needed a haircut.


>An Essential Questionaire

The sign up page for http://www.valueinvestorclub.com has a very concise set of questions every fundamental investor should try to answer for his stock picks.


It takes long time to get the fundamental appraisal methods to sink into one DNA's...
but I hope if it sinks deep once it should remain embeded for a long time.

a few lines with some added thoughts from the same page

=>Value Investing does not necessarily require or imply that a stock must be selling at a low P/E or a low Price/Book ratio (although such opportunities may make fine investments).
=>Excellent companies selling at a discount to their intrinsic value may also qualify as "value" investments irrespective of current P/E, Price/Book or similar ratios (e.g. the notion of value as articulated by Buffett).

Some measures of Valuation
Every body in this world knows what PE is, so lets look at other stuff.

=>Forward P/E
Same as PE with the difference that, one would try to imagine how the PE would look 1 year ahead.

=>Total Enterprise Value ("TEV")/EBIT
Total Enterprise Value -is defined as
(market capitalization plus interest bearing debt plus preferred stock minus excess cash
This measure is used when trying to compare companies with different debt levels.
What we get to know is inverse of ROIC or how much a company returns when compared to total capital in the hand of management. I consider this a very important criteria when trying to compare companies.
EBIT is earnings before Interest and Taxes. and thus
Analyzing TEV/EBIT is a shorthand way of looking at the multiple of total "cost" of the company (market price of equity plus assumed debt) to the pre-tax cash flow generated by that company.

we can enhance of this ratio to find
TEV/(EBITDA-maintenance cap/ex) which further accurately reflects the true valuation.

=>TEV/(EBITDA-maintenance cap/ex)
EBITDA (Earnings before interest, taxes, depreciation and amortizatio)
Why use EBITDA? since we got to
add back the non-cash expenses associated with depreciation and amortization to EBIT.
This is often used as a way to measure how much cash a company generates to cover interest expense.
Amortization is often a legitimate add back to earnings when trying to determine a company's cash generating ability.
However, adding back depreciation to cash flow is only valid when considered in conjunction with the amount of capital spending (a cash outlay) necessary to sustain the current business (see maintenance cap/ex).
Therefore, EBITDA minus maintenance cap/ex is a more accurate way of arriving at cash generated to cover interest expense.

Maintenance cap/ex- this is a figure that represents the amount of capital spending necessary to "sustain" a company's current level of sales and earnings.
Capital spending necessary for growth is not included in this number. This number is usually not disclosed and must be estimated based on information available through the company or other means.
Using EBITDA as a cash flow measure without subtracting the capital expenditures necessary to keep the business running at the current level will always overstate a company's cash generating ability. The cash outlay of maintenance cap/ex can be higher or lower than the non-cash depreciation charge.

thus TEV/(EBITDA minus maintenance cap-x) is sometimes a better way to determine the multiple of total "cost" of the company (market price of equity plus assumed debt) to the pre-tax cash flow generated by that company.
Capital spending for growth should usually not penalize the analysis of current cash flows because the benefits of that spending will not be seen until a future time and did not influence the current year's earnings. It is the analyst's job to determine whether the return from new capital spending for future growth will be adequate to justify the amount of spending.

=>Return on Equity and/or Assets


=>Price/Free Cash Flow
Free Cash Flow - this figure represents cash available to shareholders before changes in working capital. It is computed by taking the net income, adding back depreciation and amortization and subtracting maintenance cap/ex.

Some other things one should also keep in mind are
  • Normalized earnings and/or free cash flow if different than current
  • Future growth rates of sales, earnings and/or free cash flow
  • Relative value to similar companies
  • Private market value
  • Break-up analysis
  • Asset valuation
  • Heavy insider ownership,
  • Recent open market transactions,
  • Special option grants or
  • Other evidence of extraordinary management incentives should be noted.
  • Whats are the Catalyst
    CATALYST - should explain what action, event, situation or future realization will cause the market to recognize the value discrepancy that you observe.
    Examples could include an
    =>impending regulatory/legal change,
    =>expected sale/merger,
    =>large buyback,
    =>product introduction,
    =>management change, or other.
    =>Sometimes no catalyst is identifiable, but value discrepancy is too large to ignore.

Note: when i stop posting such things then you should know that i have digested value investing fully...


>Invetsing in great new technology in commodity industry

Extract from Charlie Munger's speech-Textiles

The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you.And most people do not get this straight in their heads.But a fellow like Buffett does.

For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles ‑ which are a real commodity product.And o­ne day, the people came to Warren and said, "They've invented a new loom that we think will do twice as much work as our old o­nes."

And Warren said, "Gee, I hope this doesn't work because if it does, I'm going to close the mill." And he meant it.

What was he thinking?He was thinking, "It's a lousy business.We're earning substandard returns and keeping it open just to be nice to the elderly workers.But we're not going to put huge amounts of new capital into a lousy business."

And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles.Nothing was going to stick to our ribs as owners.

That's such an obvious concept ‑ that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy.The money still won't come to you.All of the advantages from great improvements are going to flow through to the customers.

The important thing to see how a normal person (layman) and thoughtful person like Buffett thinks about the same issues. This DeepThought is what helps in accumulating DeepWealth..!!


>Value Investing? Hunt for SPIN-OFF's..!!

Lets think more..!!!

A great idea from the famous book is investing wisely in Spin-Off's.

In an investment classic “You can be a Stock Market Genius”, the author, Joel Greenblatt, writes about spinoffs.

“The first investment area we'll visit is surprisingly unappe­tizing. It's an area of discarded corporate refuse usually re­ferred to as "spinoffs." Spinoffs can take many forms but the end result is usually the same: A corporation takes a sub­sidiary, division, or part of its business and separates it from the parent company by creating a new, independent, free­standing company. In most cases, shares of the new "spinoff" company are distributed or sold to the parent company's ex­isting shareholders.

There are plenty of reasons why a company might choose to unload or otherwise separate itself from the fortunes of the business to be spun off. There is really only one reason to pay attention when they do: you can make a pile of money investing in spinoffs. The facts are overwhelming. Stocks of spinoff companies, and even shares of the parent companies that do the spinning off, significantly and consis­tently outperform the market averages.

One study completed at Penn State, covering a twenty­-five-year period ending in 1988, found that stocks of spinoff companies outperformed their industry peers and the Stan­dard & Poor's 500 by about 10 percent per year in their first three- years of independence. The parent companies also managed to do pretty well-outperforming the companies in their industry by more than 6 percent annually during the same three-year period. Other studies have reached simi­larly promising conclusions about the prospects for spinoff compames.

What can these results mean for you? If you accept the as­sumption that over long periods of time the market averages a return of approximately 10 percent per year, then, theo­retically, outperforming the market by 10 percent could have you earning 20-percent annual returns. If the past ex­perience of these studies holds true in the future, spectacu­lar results could be achieved merely by buying a portfolio of recently spun-off companies. Translation: 20-percent an­nual returns-no special talents or utensils require.

But what happens if you're willing to do a little of your own work? Picking your favorite spinoff situations-not merely buying every spinoff or a random sampling - should result in annual returns even better than 20 percent. Pretty signifi­cant, considering that Warren Buffett, everyone's favorite bil­lionaire, has only managed to eke out 28 percent annually (albeit over forty years). Is it possible that just by picking your spots within the spinoff area, you could achieve results rival­ing those of an investment great like Buffet?

Nah, you say. Something's wrong here. First of all, who's to say that spinoffs will continue to perform as well in the future as they have in the past? Second, when everyone finds out that spinoffs produce these extraordinary returns, won't the prices of spinoff shares be bid up to the point where the extra returns disappear? And finally-about these results even greater than 20 percent-why should you have an edge in figuring out which spinoffs have the greatest chance for outsize success?

0ye of little faith. Of course spinoffs will continue to out­perform the market averages-and yes, even after more peo­ple find out about their sensational record. As for why you'll have a great shot at picking the really big winners-that's an easy one-you'll be able to because I'll show you how. To un­derstand the how's and the why's, let's start with the basics.

Why do companies pursue spinoff transactions in the first place? Usually the reasoning behind a spinoff is fairly straightforward:

Ø Unrelated businesses may be separated via a spinoff transaction so that the separate businesses can be better appreciated by the market.

For example, a conglomerate in the steel and insurance business can spin off one of the businesses and create an in­vestment attractive to people who want to invest in either in­surance or steel but not both.

Of course, before a spinoff, some insurance investors might still have an interest in buying stock in the conglom­erate, but most likely only at a discount (reflecting the "forced" purchase of an unwanted steel business).

Ø . Sometimes, the motivation for a spinoff comes from a desire to separate out a "bad" business so that an unfet­tered "good" business can show through to investors.

This situation (as well as the previous case of two unrelated businesses) may also prove a boon to management. The "bad" business may be an undue drain on management time and focus. As separate companies, a focused manage­ment group for each entity has a better chance of being ef­fectiv

Ø Sometimes a spinoff is a way to get value to shareholders for a business that can't be easily sold.

Occasionally, a business is such a dog that its parent com­pany can't find a buyer at a reasonable price. If the spinoff is merely in an unpopular business that still earns some money, the parent may load the new spinoff with debt. In this way, debt is shifted from the parent to the new spinoff company(creating more value for the parent).

On the other hand, a really awful business may actually receive additional capital from the parent- just so the spin­off can survive on its own and the parent can be rid i.

Ø Tax considerations can also influence a decision to pur­sue a spinoff instead of an outright sale.

If a business with a low tax basis is to be divested, a spinoff may be the most lucrative way to achieve value for share­ holders. If certain IRS criteria are met, a spinoff can qualify as a tax-free transaction - neither the corporation nor the in­dividual stockholders incur a tax liability upon distribution of the spinoff shares.

A cash sale of the same division or subsidiary with the proceeds dividended out to shareholders would, in most cases, result in both a taxable gain to the corporation and a taxable dividend to shareholders.

Ø A spinoff may solve a strategic, antitrust, or regulatory is­sue, paving the way for other transactions or objectives.

In a takeover, sometimes the acquirer doesn't want to, or can't for regulatory reasons, buy one of the target company's businesses. A spinoff of that business to the target company's shareholders prior to the merger is often a solution. In some cases, a bank or insurance subsidiary may subject the parent company or the subsidiary to unwanted regula­tions. A spinoff of the regulated entity can solve this problem

The list could go on. It is interesting to note, however, that regardless of the initial motivation behind a spinoff transac­tion, newly spun-off companies tend to handily outperform the market. Why should this be? Why should it continue?

Luckily for you, the answer is that these extra spinoff prof­its are practically built into the system.

=>The spinoff process itself is a fundamentally inefficient method of distributing stock to the wrong people. Generally, the new spinoff stock isn't sold, it's given to shareholders who, for the most part, were investing in the parent company's business. Therefore, once the spinoff's shares are distributed to the parent com­pany's shareholders, they are typically sold immediately without regard to price or fundamental value.

=>The initial excess supply has a predictable effect on the spinoff stock's price: it is usually depressed. Supposedly shrewd institutional investors also join in the selling. Most of the time spinoff companies are much smaller than the parent company. A spinoff may be only 10 or 20 percent the size of the parent. Even if a pension or mutual fund took the time to analyze the spinoff's business, often the size of these compa­nies is too small for an institutional portfolio, which only con­tains companies with much larger market capitalizations.

=>Many funds can only own shares of companies that are included in the Standard & Poor's 500 index, an index that includes only the country's largest companies. If an S&P 500 company spins off a division, you can be pretty sure that right out of the box that division will be the subject of a huge amount of indiscriminate selling. Does this practice seem foolish? Yes. Understandable? Sort of. Is it an opportunity for you to pick up some low-priced shares? Definitely.

=>Another reason spinoffs do so well is that capitalism, with all its drawbacks, actually works. When a business and its management are freed from a large corporate parent, pent­-up entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course. After a spinoff, stock options, whether issued by the spinoff company or the parent, can more directly compensate the managements of each business. Both the spinoff and the parent company benefit from this reward system.

In the Penn State study, the largest stock gains for spinoff companies took place not in the first year after the spinoff but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spinoff's stock can perform at its best. More likely, though, it's not until the year after a spinoff that many of the entrepreneurial changes and initiatives can kick in and begin to be recognized by the marketplace.

Whatever the reason for this exceptional second-year performance, the results do seem to indicate that when it comes to spinoffs, there is more than enough time to do research and make profitable investments.

One last thought on why the spinoff process seems to yield such successful results for shareholders of the spinoff company and the parent: in most cases, if you examine the motivation behind a decision to pursue a spinoff, it boils down to a desire on the part of management and a com­pany's board of directors to increase shareholder value. Of course, since this is their job and primary responsibility, the­oretically all management and board decisions should be based on this principle. Although that's the way it should be, it doesn't always work that way.

It may be human nature or the American way or the nat­ural order of things, but most managers and boards have tra­ditionally sought to expand their empire, domain, or sphere of influence, not contract it. Perhaps that's why there are so many mergers and acquisitions and why so many, especially those outside of a company's core competence, fail.

Maybe that's why many businesses (airlines and retailers come to mind) continually expand, even when it might be better to return excess cash to shareholders. The motives for the ac­quisition or expansion may be confused in the first place. However, this is rarely the case with a spinoff. Assets are be­ing shed and influence lost, all with the hope that share­holders will be better off after the separation.

It is ironic that the architects of a failed acquistion may well end up using the spinoff technique to bail themselves out. Hopefully, the choice of a spinoff is an indication that a degree of discipline and shareholder orientation has returned. In any case, a strategy of investing in the shares of a spinoff or parent company should ordinarily result in a pre­-selected portfolio of strongly shareholder-focused com­panies.

amazing things people think...!!
Hope I am spared for the copy-paste.
I love this. :-)


>ROIC + Earnings Yield? Magic Formula for Value Investing?

Definition of a Company:
A company is a system which converts cash into inventory into revenues and back into [more] cash again.
Some companies do this conversion very fast, some do it slowly.
Cash is king and how a company creates cash using the capital it has is what seperates diamond from coal.

Lets see where we can go from here...
Greenblatt's backtesting shows that

buying stocks that rank highest in a combination of
=> earnings yield (the inverse of the price-to-earnings [P/E] ratio) and
=> return on capital.
have doubled the market's returns.

Its important to pay close attention to return on invested capital for a long time.
Since this is the most simple measure of the effectiveness of the whole company.

Buying low-priced stocks (low P/Es = high earnings yield) that also are the best at making profits on their invested capital is something that has a great deal of intuitive appeal.

More on ROIC
Return on invested capital (ROIC) is a measure of financial performance.
=>Looking at economic earnings -- free cash flow (or return on invested capital) minus a charge for the use of that capital -- produces a much better view of the economics and value of a company than just looking at earnings growth.
=>After all, earnings growth comes at a price in many instances -- whether that's heavy investment in working capital, fixed assets, or the issuance of stock to acquire other businesses.
=>It's not profit margins that determine a company's desirability, it's how much cash can be produced by each dollar of cash that is invested in a company by either its shareholders or lenders.
=>Measuring the real cash-on-cash return is what ROIC seeks to accomplish.

Why not use ROE?
ROI is sort of like ROE, but greatly improves upon it. Return on equity (net income divided by average shareholders' equity in use over the period being looked at) takes into account in the denominator only the net assets in use by the corporation. A major problem with this is that certain liabilities mandated by GAAP (Generally Accepted Accounting Principles) reduce the amount of resources at the company's disposal in the ROE equation. Depending on the circumstances, though, these liabilities should not be counted as a reduction in the capital working for the benefit of shareholders. They should be counted as an addition to capital in use by shareholders. That being the case, moving an amount out of liabilities and into owners' equity necessarily increases the denominator of the ROE equation and thus lowers the company's return on equity.

Not all assets are funded by owners' equity, so looking at just owners' equity as a measure against which return is compared is going to miss the boat at times. Those companies that finance their assets with just a sliver of owners' equity and a boatload of liabilities can drive the value of owners' equity to zero pretty quickly with just one misstep. A 20% return on owners' equity in a company with very low leverage (defining leverage for these purposes as the ratio of assets to owners' equity) is a much different and preferable result to a company with very high leverage generating an ROE of 20%. We need an alternative definition of capital that measures the full amount of capital in use by a company's managers, whether that capital was raised through equity or through debt. In other words, we want to look at the company's performance independent of its financing decisions. ROIC is the way to do that.

Looking at ROIC tells an investor how efficiently the company is being run and how much cash is being generated per dollar of investment, independent of how management chooses to finance the company. Whether the company is financed with equity (by selling stock) or debt (by drawing on a bank line of credit or selling debt directly to interested investors), ROIC doesn't care. The idea is to have some sense of what the company's operating performance is regardless of the particular way that the company has financed its invested capital. This allows you as a potential shareholder (and business owner) to discern between the actual operating performance of the business and the side effects of how that business was financed.

You want to look at operating performance independent of financing because conventional accounting does not treat all financing costs equally. While interest, the cost of debt, is reflected on the income statement, the more intangible (but no less real) cost of the equity capital is not reflected at all. What? You mean equity costs money? You bet your sweet belled cap it does! When a shareholder like yourself gets equity (or stock, for those inclined toward the less pretentious version), do you expect that the stock will increase in value? How much do you expect it to increase in value? That percentage increase is the cost of equity capital -- if investors do not get the return they expect, they will sell the stock to a new investor, who comes in expecting to earn his target return on the lower share price. The consensus expectation of all investors who own the stock is the cost of equity capital. Just because it is not deducted out of earnings like debt doesn't make it any less real.

Cost of Equity? Isnt Equity Free?
Though the cost of equity does not show up on a company's income statement, it is not free. Investors expect a rate of return on equity that is in line with the Nifty50 or Nifty500 and that also takes into account the specific risks of the company in question. Say for a company that has an average debt-to-equity ratio of 109% in the year 7 and may also be operating in a slower-growth industry with poor economics to begin with. In that case, we would demand a rate of return on equity of about 1.2 times the Nifty 500's historical return to compensate for the extra risk. That means that the equity being used by this business will cost it 13.2%. A lower return on equity will hurt the valuation of the company's equity and ultimately the multiple the market will pay for all the capital invested in the business as well as its earnings and cash flow.

How to add up up the capital at work,
=>According to the theoretical work of Bennett Stewart III in The Quest for Value: The EVA Management Guide
=>You can add up the capital in use by a firm by focusing primarily on the right-hand side of the balance sheet (where you find liabilities and owners' equity)
=>or by looking primarily on the left-hand side of the balance sheet, which is where assets are found.
=>Remember, assets minus liabilities equals owners' equity -- the bottom line on a balance sheet. Rearranging the equation, though, gets us to an expression of how all assets are funded on a balance sheet: assets = liabilities + owners' equity.

So, we can calculate invested capital as being equal to all financial capital.
We can also look at it starting from the asset side.
Start with all assets and deduct non-interest bearing current liabilities.
The liabilities of accounts payable and accrued compensation expenses do not represent capital invested in the business by either equity or debt holders.

While they are debt under the most stringent forms of looking at the balance sheet, they don't represent invested capital. As long as a company pays its vendors within standard or agreed upon terms, accounts payable are not interest-bearing liabilities.
As for accrued compensation expenses, any company that doesn't pay by the day is going to operate with an average level of these liabilities all year long. The value of work that an employee renders is found in inventory, if the company is a traditional manufacturer. Since many people are paid on a bi-weekly schedule, the value that the employee renders in labor between paydays is accrued. It's pretty much an interest-free short-term loan of labor.

Now we have to adjust the return before dividing it into invested capital to calculate ROIC. The net income figure that is used in the calculation of return on equity is not directly analogous to the "return" in ROIC. That's because ROE is concerned with the return on equity after all other financing sources have been taken care of.

Net Income? lets find it carefully.
Net income is net of interest expense as well as other expenses below the operating income line on the income statement.
We want to measure the income the company generates before considering what capital costs.
In this way, we are looking at the pure earnings power of a corporation before taking into account the decisions that were made to finance the business.

the formula for ROIC is:
After-tax operating earnings
= --------------------------------------------------------------------------------------------
[total assets minus non-interest-bearing current liabilities - Cash - GoodWill]

Why is ROI so PowerFull
ROIC looks at earnings power in the context of how much capital is tied up in a business and what sort of return that capital is generating.
The whole idea of "earnings growing by such-and-such" takes on less importance as a stand-alone concept when you're looking at how much capital is being poured into a business.
It is real easy to grow your earnings by investing more money into the business.
However, it is not quite as easy to grow earnings by investing capital if you intend to maintain your current level of return on invested capital.

Say there's a company that is able to grow operating earnings by 20% per year for six years, and you purchase it a P/E of 10. "Such a deal," you might think.

The conventional wisdom of investing teaches that P/E is a determinant of value and that a company growing at 20% per year should be worth far more than 10 times trailing earnings. However, while you're focusing on all that earnings growth, you might miss a deteriorating underlying trend of declining economic performance -- or in English, you may not notice that return on invested capital is dropping like a stone as the company invests in projects that earn smaller and smaller returns.

An example which shows how EPS growth can get misleading while ROI shows the true pic.
     After-tax     Invested                 Operating
operating Capital ROIC Earnings
earnings Growth
Year $500

1 $100 $600 18.2% 20%
2 $120 $740 17.9% 20%
3 $144 $999 16.6% 20%
4 $172.8 $1,398.6 14.4% 20%
5 $207.36 $2,097.9 11.9% 20%
6 $248.83 $2,986 9.8% 20%
7 $298.60 $3,881.8 8.7% 20%

(ROIC is calculated on average invested capital for each period)

At the end of the period, the company's operating income is 199% higher than in year one. However, the company is currently investing in new projects that earn far less than what the original, core business did. In fact, given how low ROIC has dropped, the new projects are probably earning only 5% to 6% -- about what an investor can get in 100% secure, U.S. Government-issued 30-year bonds. What kind of fool would be happy that management is investing new money at a rate of return that an investor can get in a bond? Not very many, which is probably why the stock only trades at 10 times earnings.

Companies Destorying Value?
The above company hasn't built shareholder value because it has invested in projects with ROIC that is below the rate of return investors expect. That's because it has had to increase capital invested in the business at a faster rate than earnings and revenues have grown.

Receivables, inventory, building warehouses, and other capital assets such as presses and trucks have all been necessary investments to create the 20% earnings growth that shareholders have demanded. Over the intervening years, the company has had to take on lines of credit, issue commercial paper, and issue long-term debt and preferred stock to finance the expansion because internally generated funds were not sufficient to finance the growth. In spite of the fact that management has focused on earnings growth, the horrible returns on new capital being invested in the business are causing smart investors -- "lead steers," as Bennett Stewart calls them in his book -- to look elsewhere.

What exactly are these "lead steers" looking for in a company? These investors want a company that is "beating" its "cost of capital" -- investing new money into projects that have ROIC that is higher than the expected returns shareholders demand.

Is Growth always good for shareholders return?
Rather than acting as a stand-alone conception of how well a company is operating, ROIC should be looked at in relation to the company's cost of capital. Companies such as Coca-Cola have operated on this system, called Economic Value Added, or EVA, for a number of years (as have leveraged buyout financiers).

The philosophy doesn't make these companies successful -- it's the implementation of it that makes a difference.
Not all successful companies operate based on EVA, either. Some managements think in this way to begin with. However, the readers should know that some of the biggest generators of shareholder value over the last two decades have embraced this philosophy. The company in our example would have stopped growing at a certain point to preserve shareholder value, forgoing growth for growth's sake. Taking too much debt which does not generates return near or more than cost of equity would slowly destory a companys shareholder equity. At a certain point, more of the value of the enterprise goes to its creditors than to its shareholders.

When ROIC starts to drop, investors should pay attention. It can signal anything from a momentary blip in the company's progress to a decay in industry or company fundamentals. Successful companies in more mature industries (the characteristics defining success for companies in hypergrowth industries are much different) generate ROIC above and beyond their cost of capital -- in fact, this is one reason why the Nifty50 is priced the way it is and why it has outperformed the small and mid-cap universes. Companies in the Nifty50 are simply the creme de la creme of business and show a better spread between their return on invested capital and the cost of capital they use.

In addition, the very good companies are able maintain excellent returns on invested capital even as they increase invested capital year after year, while others rationalize their operations and sell off those units that can't generate the ROIC that they see elsewhere in their company. By dumping such operations, a company's earnings can shrink, but the valuation on the remaining earnings and capital invested in the business can increase so that the company is now worth more.

How to account for Cash in ROIC calculations
Whether it's funded by liabilities or owners' equity, the cash represents capital that has been invested in the business. However, there is a difference between invested and deployed, which is where some investors and analysts differ in their view of ROIC.

the formula for ROIC is:
After-tax operating earnings
= --------------------------------------------------------------------------------------------
[total assets minus non-interest-bearing current liabilities - Cash - GoodWill]
Some feel more comfortable with this definition because cash represents capital that hasn't been deployed in other assets or represents potential to reduce liabilities or owners' equity. I stand by this definition depending on the application. A distinction should be made between financial capital and invested capital. This is needed since mant times a large amount of cash may remain on the sidelines waiting to be invested !

In the case of a fast-growing company that has issued securities but has not yet deployed the cash from those issuances, we don't want to get too racy with what we consider as excess capital. We also don't want to unduly penalize the company's valuation just because we are taking a snapshot of the financials at a time when it has not yet had the chance to invest all the capital that it has at its disposal. A compromise is in order.

Depending on the capital intensity and the speed at which a company can turn inventory into cash (its cash conversion cycle), the invested capital base of the company should reflect only the cash balance that a company needs to have on hand to cover day-to-day cash outlay needs. For instance, most restaurants that aren't going under need to retain very little cash on hand because they operate in a cash business. Their inventory is turned into cash very quickly, while the payables for the inventory operate on a cycle not all that different from any other business with a good credit rating.

the new formula for ROIC is:
After-tax operating earnings
= -------------------------------------------------------------------------------------------------------
[total assets - non interest bearing current liabilities - Excess Cash - GoodWill]
5% of sales in cash is probably a prudent level of cash to hold and anything beyond that can be deducted from the invested capital base.

In sumamry
Its cash-on-cash returns are what we're looking for in calculating ROIC.
The cash-on-cash return is literally the amount of cash you get back compared with the amount of cash you had to invest in the business.

After removing all of the distortions created by accounting, looking at return on invested capital allows you to accurately measure how much cash you get out of a business for every dollar you put into it. The general rule is that the more cash you can get per dollar of investment, the better the business is. Now, whether the cash you are investing into the business is called an "expense" and simply deducted from revenues (like Cost of Goods Sold or Sales, General & Administrative expenses on the Statement of Income) or whether those expenses are "capitalized" and turned into an asset that is placed on the Consolidated Balance Sheet, ROIC can let you see how well the company is actually doing, independent of the accounting method chosen by a company's management.

By looking at a company's financials from the standpoint of ROIC, an investor considers what's going on with both the income statement and the balance sheet. The various ratios that an investor considers (leverage, cash conversion cycle elements, margins, asset turnover) are brought together under the unified ROIC model. ROIC also allows an investor to look through the various accounting choices that a company can make to portray earnings. As most accounting regimes are rich in balance sheet accruals, ROIC is able to identify the real economic return a company generates. Those expenses that don't go into net income stay home on the balance sheet as part of the company's invested capital. So, what doesn't get considered in the numerator in ROIC has to be considered in the denominator.

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>When Value Goes Wrong

By Stephen Bland

Sometimes, an ostensibly attractive value share goes completely wrong, may even go bust in the worst case. The question is whether the value investor can detect the signs of this prior to purchase and thus avoid losing money.

There is no prophylactic of which I am aware that will obviate the risk of losing money occasionally for those that buy shares in order to trade them short term. Shares are risk investments and thus by definition that risk will work against the investor at times whatever the approach. Although to some naïve beginners, risk investments might, especially in certain boom periods, seem like something which appear only to rise, that can never be the real situation in the end.

Once you engage in trading shares regularly and do so over a long period, you have to accept that it will go wrong sometimes. You accept that, in return for the hope that it will go right much more often than it will go wrong, making on balance decent profits over a long series of trades.

Value already carries with it the methods to lower risk as much as possible. My approach actually started off a long time ago by first minimising the downside. I saw the first step to making money as not losing it, or at least limiting that risk. So long before I started wondering what circumstances might drive a share up, I set criteria, the pyad features, which I regarded as reducing considerably the chances of it being driven down too much should things not work out. The idea is to seek significant upside potential coupled with downside protection whilst accepting that this downside protection can never be anywhere near perfect.

If a value share goes very wrong, it can only be because the fundamentals upon which you based your downside protection reliance have failed. For example an unexpectedly severe downturn in business such that net cash has been spent and turned into debt and losses incurred. This actually reduces in one swoop what I consider to be the two most desirable of my four pyad value legs, both net cash and net assets. To sweeten the mix, the third leg of low P/E will have disappeared entirely with quite likely the fourth, a decent yield.

But hang on, you bought because eps forecasts were rising. Well, analysts' forecasts can sometimes go wrong, not just slightly but catastrophically. This is much more likely with small caps in my experience because fewer forecasts are being made, sometimes only one from a tame house broker. Thus in such a situation, not only has the forecast rising eps upon which you relied as an outer been busted, but the safety value features upon which you relied to limit the downside should the outer fail to materialise may largely have been dissipated as well.

Allied to this are the rare circumstances where such events have not arisen merely from an unexpected collapse in the trade, but the directors themselves deliberately and dishonestly set out to mislead analysts and the market. This has happened in the past and not only with small caps either.

But can the investor do anything about all these risks?

Not a lot but there is some. You might wish to avoid very small caps because these risks are I believe more prevalent in that area. Having said that though, small caps are where deep value is most frequently to be found so if you stick with them you need to own a larger portfolio to trade off their individually greater risks. Try to test for forecast quality to see whether past forecasts have been met. A history of frequent failure to do so is not exactly encouraging. Pay attention to particular assets, not merely the overall book value. For example a significant property element, especially if you sniff that it may be undervalued, is obviously far preferable to a load of old machinery.

If you decide to move up into medium and big caps in order to reduce risk, very deep value is much rarer so you need to ease up on the filters but that is a trade off against the probably greater reliability of the information. Other value techniques may be help to lower the risks in the big cap field. An example may be the PEG approach combined with the other value criteria which works better with big caps. The aim as always with value is to find those shares that stick out by being cheaper than their peers, but for no good reason other than market sentiment, and having some sort of outer.

Despite taking all precautions though, you will still go wrong at times. I have on many occasions in the past. You have to be able to roll with the punches and keep on coming back. Consequently maintaining a decent sized value portfolio is perhaps the best way of all to avoid any particular failure having too much of an impact. Doesn't need to be huge but I would increase the size for a small cap portfolio. Maybe up to ten small caps say, but a lot less might be acceptable for a large cap value portfolio.