30-Nov-2005

>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.

http://www.valueinvestorclub.com/value2/signup.asp

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
=>Price/Earnings
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/Book

=>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.

=>TEV/Sales
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,
    =>spin-off,
    =>split-off,
    =>restructuring,
    =>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...

29-Nov-2005

>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..!!

26-Nov-2005

>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
e.

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. :-)

25-Nov-2005

>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.

_________________________________
for detailed reading visit
http://magicformulainvesting.com

http://www.fool.com/School/roic/roic.htm
also visit http://www.fool.com/School/HowtoValueStocks.htm to find more gems and ideas.

>When Value Goes Wrong

By Stephen Bland
http://www.fool.co.uk/valueinvesting/2005/vi051125.htm?ref=foolwatch

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.

Kirk's 2005 Reading List

Kirk's 2005 Reading List


visit http://www.thekirkreport.com for more..

BooksAt least once a year I like to publish a list of investing & trading books that I think are worth reading. This year's list comes directly from books that currently sit on my book shelf as well as those frequently recommended by readers of this website:


  • Reminences of a Stock Operator by Edwin Lefèvre

  • Technical Analysis of Stock Trends by Edwards and Magee

  • Trading Rules by William F. Eng

  • Fortune's Formula by William Poundstone

  • How I Made 2,000,000 in the Stock Market by Nicolas Darvas

  • The Only Investment Guide You'll Ever Need by Andrew Tobias

  • Hedge Fund Masters by Ari Kiev

  • Yes, You Can Time The Market by Ben Stein

  • Studies in Tape Reading by Rollo Tape

  • The New Market Wizards by Jack D. Schwager

  • High Probability Trading by Marcel Link

  • Trading For A Living by Alexander Elder

  • Methods of a Wall Street Master by Vic Sperandeo

  • The Secrets of Economic Indicators by Bernard Baumohl

  • Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein

  • The New Trader's Tax Solution by Ted Tesser

  • Bollinger on Bollinger Bands by John A. Bollinger

  • The Master Swing Trader by Alan S. Farley

  • Sun Tzu on Investing by Curtis Montgomery

  • The Stock Market Jungle by Michale Panzner

  • Screening the Market by Marc H. Gerstein

  • When To Sell by Justin Mamis

  • Fire Your Stock Analyst by Harry Domash

  • Ugly Americans by Ben Mezrich

  • The Art of Low Risk Investing by Michael Zahorchak

  • Secrets For Profiting in Bull and Bear Markets by Stan Weinstein

  • Technical Analysis Explained by Martin Pring

  • Trade Stocks & Commodities by Larry Williams

  • Trend Following by Michael W. Covel

  • The Future for Investors by Jeremy Siegel

->Some links to articles

some interesting articles.

Warren Buffett Trip


Value investing: Updating the magic formula

The Tragedy of the Commons


Atricles from Paul Krugman




24-Nov-2005

>What Most People Don't Know About Gold

What Most People Don't Know About Gold by Doug Casey

Historically, gold has never been viewed as a speculation. It was simply money: cash in the most basic form. It was a medium of exchange and a store of value. People did not accumulate gold because it could make them wealthy, but because it was a convenient, liquid way to keep the wealth they had.

It's only very recently, since 1971-when the U.S. government proved unable to keep the price at $35-that gold has been viewed as a speculation. In those days gold was an ideal speculation, with minimal risk but a huge upside.

Gold has been in a free market for three decades now; the frenzy of the '70s that took the metal from $35 to more than $800 disappeared, and was followed by a 21-year bear market. As a result, an entire generation of investors has grown up thinking that gold is not only not money but an investment dog. Their thinking is about to change. I believe that not only will gold again be used as money, but that it has entered a new long-term bull market.

Before looking at where the metal's price is likely to go over the next few years, however, it's worthwhile to consider some of the fundamentals… fundamentals that not 1 in a 1,000 people understands.

The Questions. Any discussion of gold always comes back to certain basic questions: Why is gold money? Why is gold valuable? Why can't money be whatever we say it is? (The last question is usually asked by government officials because they don't know the answers to the first two.) Why does gold give rise to all kinds of controversy not associated with, say, platinum or lead? Why is the stuff an emotional, political statement for those who love it and for those who hate it?

The Answers. Over thousands of years, in billions of transactions by millions of humans, many commodities have been used as money: stones, salt, cattle, and seashells among them. But wherever gold was available, it tended to displace other media of exchange. Like any successful money, gold never needed to be decreed "legal tender" by a government; it was recognized as the most desirable money by common consent because of its unique properties.

Certain materials have proven especially well suited for certain uses. Aluminum is good for airplanes, bricks for construction, paper for books, and gold for money. If bricks were used for airplanes and aluminum for books, the results would be as suboptimal as when paper is used for money.

In fact, the properties required of money were first described by Aristotle in the fourth century BCE.

  1. It is durable. It won't evaporate, mildew, rust, crumble, break, or rot. Gold, more than any other solid element, is chemically inert. This is why foodstuffs, oil or artwork can't be used as money.

  2. It is divisible. One ounce of gold-whether bullion, coin, or dust-is worth exactly 1/100th of one hundred ounces. When a diamond is split, its value may be destroyed. You can't make change for a piece of land.

  3. It is convenient. Gold allows its owner physically to carry the wealth of a lifetime with him. Real estate stays where it is. An equivalent value of copper, lead, zinc, silver, and most other metals would be too heavy.

  4. It is consistent. Only one grade exists for 24-carat gold, so there is no danger of owning 24-carat gold varying in quality. Twenty-four-carat gold (pure gold) is the same in every time and place since gold is a natural element, unlike gems, artwork, land, grain, or other commodities.

  5. It has intrinsic value. Gold finds new industrial uses each year. Of all the metals, it is the most malleable (able to be hammered into sheets less than 5-millionths of an inch thick), most ductile (a single ounce can be drawn into a wire 35 miles long), and the least reactive (it can stand indefinite immersion in seawater, does not tarnish in air, and can withstand almost any acid). Next to silver, it's the most conductive of heat and electricity and the most reflective of light.
  6. One important last point was not listed by Aristotle, probably only because he lived before the creation of paper and banking.

  7. Gold cannot be created by government. Gold can, of course, be debased with impurities or falsified in weight, and governments strapped for revenue have tried those tricks. But a trader can protect himself with a pair of scales or a vial of acid, although a familiar and trustworthy hallmark of a coin saves him that trouble. Unlike currency, gold cannot lose value because of government mismanagement. On the contrary, it tends to gain value because of government mismanagement.

I have no doubt that gold will again regain its traditional role of money, but only after it is trading at far higher prices than it is today. Wait and see.

Until then, there is nothing wrong with viewing gold as a speculation… which is doubly true of the gold shares we follow in our International Speculator newsletter. That's because every $1.00 increase in the bullion price of gold translates into an exponential increase in the value of a mining company's profits, or an exploration company's blue sky potential.

>Greatest Investing Stories, Some exceprts

Some interesting excerpts from investment classic “Greatest Investing Stories” by Martin Whitman.

1. “We don’t carry a lot of excess baggage,” he says in the flatted vowels of his native Bronx. “A lot of what Wall Street does has nothing to do with the underlying value of a business. We deal in probabilities, not predictions.”

2. “The record entitles him to argue that “There are only two kinds of passive investing, value investing and speculative excess.” For the last two years, like 1928-1929 and 1972-1972,” continues Whitman, “we’ve had nothing but speculative excess.”

3. “These days, argues Whitman, management has to be appraised not only as operators of a going business, “but also as investors engaged in employing and redeploying assets.”

4. “As a long-term investor looking to a number of possible exit strategies, Whitman glories in the freedom to ignore near-term earnings predictions and results. Acidly, he argues that Wall Street spends far too much time “making predictions about unpredictable things.”

5. “His search is for companies backed by strong financials that will keep them going through hard times (“safe”), selling at a substantial discount below private business or takeover value (“cheap”). Buying quality assets cheap almost invariably means that the company’s near-term results are rocky enough to have turned off Wall Street. “Markets are too efficient for me to hope that I’d be able to get high-quality resources without the trade-off the near-term outlook not being great,” says Whitman. He chuckles and runs a hand through a fringe of white hair. “When the outlook stinks, you may not have to pay to play.”

6. “It’s a lot better than being called an indexer or an asset allocator,” he says, taking another poke at standard Wall Street dogma.”

7. “Whitman’s job is to sniff out what is wrong, and figure out the trade-offs against what is right, particularly in terms of some form of potential asset conversion.”

8. “Among the most common wrongs Whitman tries to avoid:
Ø Attractive-seeming highly liquid cash positions that on inspection prove to be in the custody of managements too timid to put surplus assets to good use;
Ø Seductively high rates of return on equity that often signal a relatively small asset base;
Ø A combination of low returns on equity and high net asset value that may simply mean that asset values are overstated;
Ø High net asset values that may point to a potentially sizable increase in earnings, but which just as often point to swollen over-head.”

9. “Whitman’s willingness to take on companies like the stereotypical “sick, lame, and lazy” he treated as a pharmacist’s mate – the old salt, in Navy slang, still thinks of himself as having been a “pecker checker” – is not unalloyed. Buying seeming trouble at a discount, Whitman ignores market risk (current price swings). Whitman worries all the time, though, about investment risk (the possibility he may have mis-judged a temporary illness that will prove terminal).”

10. “As smallish niche producers, often protected by proprietary tech­niques, the equipment manufacturers seemed less vulnerable to shake out, and had better "quality" assets. Unlike the far more capital-intensive chip makers, with their heavy investments in bricks and mortar, the equipment producers operate out of comparatively low-cost clean rooms, and buy, rather than make, most of their components. Research and development costs are high, but Whitman cannily focused on com­panies that expensed rather than capitalized them. Those running charges understated earnings, making them seem particularly weak in the down cycle. So much the worse for Wall Street.”

11. “Whitman continued to buy a cross section of equipment producers at quotes he regarded as "better than even first stage venture capitalists have to pay, and for companies already public and very, very cash rich."

12. “Whitman was averaging down, a key part of his strategy, but anathema to Wall Street's momentum players.”

13. "Most," he thought, "ought to do okay and a few ought to be huge winners, but there would be a few strikeouts." The exit strategy for the strikeouts, in a consolidating industry, would almost certainly be acquisition.”

14. “Beyond diversification, Whitman protected himself by loading up on management that fit his two acid tests: good at day-to-day operations and equally good as asset managers.”

15. “Once again scoffing at market risk, Whitman underlines the com­forts of being cushioned by strong financials. "When you're in well­-capitalized companies, if they do start to dissipate, you get a chance to get out." "On the other hand," he continues, "when you're in poorly cap­italized companies, you better watch the quarterly reports very closely."

16. “That's because he thinks in terms of multiple markets. What may seem to be a very rich price to an individual investor can be a perfectly reasonable one for control buyers looking to an acquisition. They can afford to stump up a premium because of the advantages control brings. Among them is the ability to finance a deal on easy terms with what Whitman calls "OPM" (Other People's Money) and "SOTT" (Something Off The Top) in the form of handsome salaries, options, and other good­ies that come with general access to the corporate treasury.”

17. “Shop depressed industries for strong financials going cheap and hang on. By strong financials Whitman means companies with little or no debt and plenty of cash. What's cheap? No hard and fast rules. "Low prices in terms of the resources you get," he generalizes.”

18. “Some of his other pricing rules of thumb:
Ø For small cap, high-tech companies, a premium of no more than 60 percent over book - about what venture capitalists would pay on a first stage investment.
Ø For banks, Whitman's limit is no more than 80 percent of book value.
Ø For money managers, Whitman looks to assets under management (pay no more than two percent to three percent).
Ø For real estate companies, he zeros in on discounted appraised values rather than book.”

19. “Whitman, thumbing his nose at convention, has clearly established himself as an outside force on Wall Street. Despite the philosophical linkage, he even backs off from identification with what he calls Graham & Dodd Fundamentalists. The basic similarities are striking: long-term horizons, a rigorous analytic approach to the meaning behind reported numbers, and an unshakeable belief that probabilities favor those who buy quality at the lowest possible price. Like Ben Graham, Whitman scoffs at the academicians who hold that stock prices are set by a truly knowledgeable and efficient market. Acknowledging his debt to Graham, Whitman argues that his calculated exploitation of exit strategies has added a new dimension to value investing.”

20. “Whitman says, "I couldn't be a trader. I'm very slow with numbers. I have to understand what they mean."

21. "It's the art of the possible," he says. "The aim is not to maximize profits, but to be consistent at low risk. I never mind leaving something on the table."

22. “In a cliffhanger, both companies scraped by-at least for the moment. In a little over two years, Whitman doubled his money, com­ing out with a gain of some $15 million. The profit was a gratifying tes­tament to the distinction between market risk and investment risk. When the fix at Public Service of New Hampshire proved to be only temporary, Whitman went back for more. The second helping centered on third mortgage bonds trading at around 60c on the dollar and yield­ing around 13.75 percent.”

23. “Whitman, look to a credit against the probability of a default. He looks beyond the credit to see what can be got when it does default-yet another variant on "safe and cheap."

24. “Whitman backs this contention with a notably unsentimental view of how Wall Street really works. He argues that heavy reliance on short-­term earnings predictions as the key to market values makes trend play­ers of money managers. Such linkages are the stuff of stock market columns. The Genesco shoe chain allows that fourth quarter earnings will "meet or exceed" analysts' estimates, and the stock pops with a gain of almost 25 percent. Sykes Enterprises, a call-center specialist, signals that earnings will be down, and the stock falls by a third.”

25. "Making forecasts about future general market levels," writes Whitman in Value Investing, "is much more in the realm of abnormal psychology than finance."

26. “Analysts who focus on earnings trends to the exclusion of asset val­ues, continues Whitman, tend to think laterally. "The past is prologue; therefore, past growth will continue into the future, or even accelerate." Unfortunately, the "corporate world is rarely linear," and becomes a particularly dangerous place for trend players who leave no 'margin of safety in concentrating on high multiple growth stocks.”

27. “Mammon at what he saw as one huge asset play. His hope: that finan­cial engineering would burst into full flower in Japan.”

28. “Was it too farfetched to think that Japanese capital markets might see financial engineering as an answer to the structural rigidity that has been throttling economic growth for a decade?”

29. “Whitman was caught up in a concept of his own, of course-notably that the dynamics of money are much the same everywhere. It was only a matter of time before the immutable law of convergence began to push Japanese market prices into line with investment values. Also, of course, there was that pile of new money burning a hole in his pocket.”

30. “This seems to have been especially faulty analysis on my part," he said. "There was never any chance that LTCB could have been like its U.S. counterparts. Though I now have the ben­efit of hindsight, I really should have known better."

31. “Whitman hopes to see open in Japan will also remain nailed shut? The questions go to one of Whitman's favorite aphorisms: "If after 10 minutes at the poker table you do not know who the patsy is, you are the patsy."

32. “A bargain that stays a bargain isn't a bargain."

33. “As Whitman's Japanese initia­tive shows, value investing is a useful tool, but not quite ready for uni­versal export.”

34. “In this inside-out world, Third Avenue Value is in fact a best buy when asset values are flat on the deck. That's when qual­ity assets generally are going cheap.”

35. “Money managers who strive to maximize performance consistently pretty much have to be traders, acting and reacting based on market judgements."

20-Nov-2005

>Trading on the Equity

Trading on the Equity

“In a speculatively capitalized enterprise, the common stock holders benefit—or have the possibility of benefiting—at the expense of the senior security holders. The common stockholder is operating with little of his own money & with a great deal of the senior security-holder’s money; as between him & them it is a case of “heads I win, tails you lose.” This strategic position of the common stockholder with relatively small commitment is an extreme form of what is called “Trading on the Equity.” Using another expression, he may be said to have a “cheap call” on the future profits of the enterprise.”—Benjamin Graham.

A “Cheap call” on the future earnings. How?
I will use a hypothetical example to illustrate Graham’s assertion. Consider a steel company “Cyclical Business Inc” with the following financial statement numbers (I have for the sake of simplicity used only the numbers which are important in this case)

Debt

$75 m at 8%

Equity

$25 m

OPM

12%

No of shares

1 m


Scenario A
: Bad year of a typical cyclical business.
Scenario B: Good year of a typical cyclical business.

$ m

A

B

% Increase

Sales

100

200

100

EBIT

12

24


Interest

6

6


PBT

6

18

200

EPS

$ 6

$18


P/E

2

3


Market price

12

54

350


What is relevant in above table is the sensitivity of the EPS as compared to sales growth and the prospective markets returns. Having said that I would like to clarify that the sensitivity holds even on the downside (ie) if earnings drop we can expect that the drop in market price will be more as compared to drop in the sales. So it is all about where you catch the pendulum when it is swinging.

Leveraged Buyouts (LBO):
Apart from the advantages of speculative capitalization structure and sensitivity of EPS, LBO comes with an added advantage. Will use pie charts to illustrate,

(Table below represent the capital structure of a LBO company at the start of the buyout and after a few years)


While buying

After reducing debt

Equity

$ 10m

$ 10m

Debt

$ 90m

$ 40m




EBITDA

$ 20m

$ 20m

EBITDA * 5 (Value)

$100m

$100m

Market Value of equity

$10m

$20m

The advantage:
Generally it is the free cash flow from operations or sale of non productive assets that is used in paying off the debt. Thus we can probably expect that the EBITDA is atleast same even when the debt is down to $40m. Suppose we can sell out the company at the same multiple of EBITDA at which we got into it then our profit is atleast 100% (non-annualized)

LBO & Leveraged Arbitration:
We can apply the concept discussed above in increasing our return substantially from arbitration opportunities. Again will use a simplified example:

Expected return from arbitration

20 %

You have (equity)

$ 100

You can borrow (900% of your equity)

$ 900 @ 10% (say)

Total Profit after interest on leverage

$ 110

Return on your Equity

110 %

I am not saying that whenever an arbitration opportunity comes up we should borrow money and play the game, rather, only when the odds make it sensible enough to do so.

Conclusion:
A conservative capital structure is a must for a good business, I used to think, but when it comes to making a good investment “Price changes everything”. In other words,

“Safety does not reside in titles, or forms, or legal rights, but in the values behind the security issue”—Benjamin Graham.