More Thoughts On Lone Ranger Investing, Informational Asymmetries And “Going Private” ($AAPL, $NFLX, $BAC)

A few days ago I linked to a post from Hedge Fund News in which the author expressed some deep skepticism and reservations about common stock investments in the present era. The primary concerns were that the market is “rigged” to a large extent via Fed front-running and black-box trading algorithms. Stock market investing is largely about an informational edge. Without friends in high places, an army of analysts and a mainframe computer, how is the little guy supposed to have an edge anymore?

First, a contrarian take on the contrarian take.

Front-running the Fed works, until it doesn’t. Many try to front-run the Fed without any real, personal insight into what’s going on there (aka, having a whisper network that’s tapped in to the Fed) and those people get steamrolled in periods like the one we just witnessed in August 2011, when many market participants hit the “Eject” button all at once and the Fed isn’t there with a trampoline to catch everyone. Some do have those networks and their front-running is largely successful (though you have to wonder what the hell happened at PIMCO over the last two months with Alan Greenspan on retainer) and to that I have no response besides to observe that “Life isn’t fair, deal with it.” Some people are born with a Golden FRN lodged between their butt cheeks and some aren’t. It’s obviously not the majority of the market because if it were that’d defeat the whole purpose of having that kind of informational advantage.

For the average, little guy investor, all the Fed does is introduce extreme volatility into the picture. And volatility isn’t risk. In fact, volatility provides true opportunities for the value investor that he otherwise might never have gotten as the inevitable panics that ensue tend to drag down the good companies with the bad. Then, you buy good companies cheaply.

I look at the black-box trading the same way. So what if there are black-boxes? They add volatility to markets. Volatility is opportunity, not risk. Use limit orders if you’re worried about getting manipulated by these robots putting out false bids.

The concern about informational asymmetries caused by institutionalism and hedge fund analyst armies is more substantive. But it still doesn’t mean doom for the little investor (or maybe better to call him the “lone ranger investor”, because he might have a few thousand or he might have a few million). I am going to paraphrase a few points from Jason Zweig’s commentary from chapter 8 of The Intelligent Investor:

  • Institutions (and hedge funds) have billions of dollars under management; this massive AUM forces them to gravitate towards the same large-cap stocks
  • Investors tend to pour money into institutional vehicles as markets rise, and pull it out as it falls; this forces these players to buy high and sell low
  • Many institutions are obsessed with relative benchmarks, the performance and composition of which shape their trading patterns and selections; their creativity and independence is stifled as a result
  • Many institutions box themselves in with an arbitrary mandate or theme which forces them to make their investment decisions within a confined space, often without regard to absolute value found elsewhere in the market place

Now, let’s flip each of these points around to see how the lone ranger investor is advantaged by each:

  • The lone ranger has comparatively little AUM so he has the flexibility to allocate his portfolio into nearly any stock he wants, from nano-cap to mega-cap
  • The lone ranger is in sole control of his buying and selling as he doesn’t face redemption requests or sudden influxes of hot money like institutions do
  • The lone ranger doesn’t have to compete with any benchmark if he doesn’t want to, instead he can just chase absolute returns and not worry about how he measures against a given index or benchmark over a given period of time
  • The lone ranger is free to choose any style, theme and type of investment strategy he likes and never has to worry about a regulation or outside investors having a problem with it

A video of Ray Dalio over at Credit Bubble Stocks features Dalio riffing on the high degree to which average hedge fund returns are correlated with the broader markets. The implication is that hedge funds aren’t being creative and independent in their strategies and trades. What good is an army of analysts, in other words, if you’ve got them looking at the same exact companies (AAPL, NFLX, BAC, etc.) that everyone else is looking at? What good is it to be a hedge fund when all this really means is you can hold more than 5% of your portfolio in something like AAPL and then lever the hell out of it and cross your fingers hoping Ben Bernanke’s got your back?

Informational advantages come in three flavors:

  1. Investments no one else is interested in, ensuring you have little to no competition for information (for example, a micro-cap with no institutional sponsorship and no analyst coverage)
  2. Investments in which you have a special relationship with insiders or other connected people, ensuring you have better quality information
  3. Investments in which you have a unique perspective or framework for understanding, ensuring that even if information is fairly distributed amongst all participants, only you will know what to do with it

Number two is damn near impossible (and extremely legally risky) to get in the current era of financial market regulation for most people. But there is nothing to stop the lone ranger investor from focusing on numbers one and three. In fact, this is where he should be focused.

The real risk, and this was suggested in the Hedge Fund News piece, is that number two might be so pervasive in particular situations that it overwhelms number one and number three. But for the most part, those situations are fairly obvious and can be avoided. For example, don’t buy AAPL if that’s what everyone is trading.

So, that’s some of the advantages the lone ranger has, in spite of it all. But the HFN piece wasn’t total fluff and he’s right to still be skeptical. I was particularly struck by his suggestions about corporate governance. This is a big problem as I see it.

Yesterday I spent some time listening to Albert Meyer talk about his experience with uncovering numerous well-publicized frauds and accounting shenanigans of the last decade ($KO, $TYC, Enron and the New Era Philanthropy Ponzi). The way Albert made it sound, corporate governance in this country is in shambles and a true embarrassment to the idea of free and honest markets.

Albert talked about the problem with option issuance overhang. Even though these items are now expensed following a FASB rules change, Meyer insists that the true costs of executive compensation for many (most?) companies listed on US exchanges is severely understated. He called into question the practice of huge stock buybacks by most companies, which he said is really just the way in which companies cover up the inevitable dilution that would otherwise occur from executive stock option exercising– and it all comes at the expense of shareholders and mutual fund investors whose mutual funds buy the new shares of recently exercised options. One example he gave was $EBAY, which he said reported income of $800M in a particular period but should’ve reported an $800M loss (a swing of $1.6B) once you had factored in the option issuance and subsequent buybacks to prevent dilution.

Albert said there were only 7 companies in the US that do not compensate executives with stock options. He cited numerous examples of Congressional and regulatory (SEC) corruption with regards to the protective relationship these cretins have with American corporate boards and C-level management teams and the stock option issuance scam. He said there is a lot less of it going on outside of the US which is yet another reason why he finds himself seeking out investment opportunities there.

I’m getting into a digression here when I don’t mean to be, but I assure you this is all related. The point is this: the predominating corporate structure for business in this country, specifically amongst publicly-listed companies with career professional management teams who are not also owner-operators of the company, creates a uniquely perverse set of incentives that truly pits the interests of shareholders (the actual owners of the company, its assets and cash flows) against management and even their own boards! The reality in many cases is that executives and obedient, captured boards work together the milk the wealth of the company for themselves with outsized compensation packages based primarily on stock option issuance, leaving shareholders with all the risks and none of the rewards.

And as the HFN piece points out, the entrepreneurial spirit is particularly absent in these kinds of arrangements because it must be. There is no real connection between the performance of the business (good or bad) and the compensation of the board and management. In the event that the company does well, the gains are secretly dissipated through executive stock option exercising and subsequent colossal buybacks. In the event that the company does poorly, management and the board issue themselves numerous stock options at rock-bottom prices with long duration expirations, virtually guaranteeing that should the business ever turn around they’ll be there to siphon off all the gains for themselves and leave shareholders with nothing.

In effect, it’s a game, and a dirty one that the lone ranger investor doesn’t have many tools besides selectivity that he can use to win. It’s such a widespread practice that you really have to either get in at the absolute bottom or find a company where the corporate governance is much more shareholder aligned (high percentage of insider ownership, predominance of cash compensation for executives without major options issuance, share buybacks that occur at market lows not at market highs when management is cashing in their chips and exercising options, low percentage of institutional sponsorship and a truly independent board where ideally executive management doesn’t have many or any seats) if you ever hope to win it.

That is why I’ve been thinking a lot about “going private.” By going private, I don’t mean taking companies that are public, private, though that might be a good start as I honestly think that in many ways having access to public financing is simply an excuse for poorly managed companies to engage in Ponzi finance without it looking like such.

Instead, what I am talking about is being an enterprising, entrepreneurial investor primarily within the private investment space. This means not only starting your own businesses, but making contacts and seeking out investment opportunities that are not party to the public capital markets. In many cases, it means investing locally and investing in what you know about. It also potentially means outsize returns via informational asymmetries and reduced competition (amongst yourself and other potential investors).

In that vein, I was struck by this comment from Mark Cuban that I saw quoted on Tim Ferriss’s 4 Hour Blog in a post about rethinking investing:

YM: Do you have any general saving and investing advice for young people?

CUBAN: Put it in the bank. The idiots that tell you to put your money in the market because eventually it will go up need to tell you that because they are trying to sell you something. The stock market is probably the worst investment vehicle out there. If you won’t put your money in the bank, NEVER put your money in something where you don’t have an information advantage. Why invest your money in something because a broker told you to? If the broker had a clue, he/she wouldn’t be a broker, they would be on a beach somewhere.

Cuban’s sentiment echoes my own here and I find myself sharing this perspective with friends and family members who ask me for investment advice or what to do with their 401k.

The first thing I tell people is, don’t put your money in your 401k if you don’t know what you want to do with it once it’s there. People get taken in by the idea of pre-tax investing and employer matching, but ultimately those advantages are wasted if you are just going to make clueless, doomed-to-fail investments with that money. What good is having 6% matching or investing with 35% more money because you don’t pay taxes on the principal when you put it in, if you’re just going to lose 100% of it anyway?

The second thing I ask them is, what kind of options do you have and what kind of informational advantages do you have when you put your money into your 401k or the stock market in general? Most don’t have a clue. That’s a warning sign! If you don’t know what your informational advantage is, you don’t have one and you’re basically investing blind. Meanwhile, your opponents not only aren’t blind, they’ve got Lasik. They will take your money and run the first chance they get.

The final recommendation I make is, instead of investing in the stock market or a 401k (which the person admittedly knows nothing about), I suggest they save up to start their own business or invest in the business of a friend or family member who they know, trust and have tangible proof of their success. It would be much better to make private arrangements to invest equity or loan money privately in a situation like that than it would be to dump their hard-earned wealth into a Wall Street rucksack and then wake up 20 years later wondering where it ran off to.

When I make those suggestions to others I start to wonder if we would all be better off if we did the same.

Gary North Says “NO!” To Hyperinflation (#inflation, #economics)

In case you missed his previous missive on the subject, entitled “Which Flation Will Get Us?“, Gary North came out today firmly against the idea of a hyperinflationary experience in the US or any other industrialized country with a privately owned central bank. Instead, North is predicting “mass inflation”, which he defines as 15-30% money supply growth per annum.

North bases his conclusion on four premises:

  1. The central banks control inflation, the central banks are owned by the banks, hyperinflation destroys banks who are borrowed short and lent long
  2. There is too much public awareness of the role the Fed plays in promoting inflation nowadays (primarily thanks to Ron Paul), so they will get blamed if something goes wrong
  3. People have become accustomed to the boom-bust cycle and the pattern of recessions following inflations, so the public will be more tolerant and forgiving of a recession and the “return to normalcy” than the destruction and reset of a hyperinflation
  4. Members of the Federal Reserve System participate in a lucrative employee pension system which primarily holds US stocks (53% of plan assets) and bonds (34% of plan assets), which will be made worthless by a hyperinflation, giving the employees of the Federal Reserve System a vested interest in preserving the system and averting hyperinflation

North calls hyperinflation a “policy choice”. He believes the only thing that could change this outcome would be if the Congress nationalized the Fed. Then, all bets are off.

It’s an interesting prediction. It makes a lot of sense. I am not sure how mass inflation will avoid some of the problematic items mentioned above though (particularly #2 and #4).

If North is right, this should be good for gold and not so good for people invested in stocks as consumer price increases will likely outpace increases in stock prices. Stock prices may even get hurt short-term because of increased commodity prices for many businesses.


Robert Wenzel of fires back:

So don’t put me in the more unemployment camp or the mild inflation camp,or in the non-hyperinflation camp. Long term there are too many unknowns to be in any camp, especially when you have a machine known as the Fed that can shoot out billions trillions of dollars whenever it chooses. I just watch what the Fed is doing and adjust accordingly on a roughly six month basis. The constant adjustments are no way to live, but are necessary because of the fact that we do have a central bank, the Federal Reserve, that manipulates up and down the money supply. Right now, because of the new money accelerated growth that is occurring,  I anticipate that the climb in price inflation is going to escalate dramatically, where this spike in price inflation will stop, I have no idea. I just take it six months at a time.

Review – F Wall Street (#investing, #review)

F Wall Street: Joe Ponzio’s No-Nonsense Approach to Value Investing For the Rest of Us

by Joe Ponzio, published 2009

“There’s Got To Be A Better Way!”

If you’ve ever managed your own retirement investment portfolio such as a 401k or spent any amount of time watching the talking boxes on Bubblevision, you’ve probably reached several conclusions almost simultaneously:

  • Even though we’re told investing in stocks is a surefire way to get rich over time, it never seems to work for the average person
  • Investment options in the average 401k seem best served to satisfy the needs and profitability of the Wall Street companies that peddle the products, not the investor who buys them
  • In general, the whole game seems rigged against you, from the annual expenses of mutual funds to the incentives those mutual funds have to trade to the regulatory burdens which virtually guarantee they’ll never be creative or contrarian enough to earn the kinds of out-sized returns necessary to make a killing in the markets over time
And according to author Joe Ponzio, who started his career working at several of these brokerages and mutual funds, you’d be correct to think that the whole system functions like a racket:
The Wall Street firms convince you to buy their “preferred” or “recommended” mutual funds;  then the mutual funds go out and buy the great, mediocre and bad investments from the brokerages.
In order to have access to the trillions of dollars the brokerages control, mutual funds buy “aggressive” investments, pay some of the brokerages’ expenses, and even offer them kickbacks every three months.

Now you’re thinking, “There’s got to be a better way!”

Luckily, there is.

F Wall Street

Enter Joe Ponzio’s inexpensive but thorough primer on Buffett-style value investing, F Wall Street. This book is truly one of the unsung heroes of the value investment classics library that I think should be one of the first titles an aspiring value investor should familiarize themselves with. The book is divided into several conceptual sections.

First, the basics: the market is not perfectly efficient; bonds are not just for old people and stocks are not just for young people and everyone, young or old, should be looking for good investments, not risky ones; mutual funds are essentially designed to fail the average investor; the true risk in the stock market is overpaying for the value available at the time; cash is king.

A bit more on the last part might be helpful. Ponzio defines the value of a business as its current net worth as well as the sum of its future cash flows. As a stock owner, you are essentially a silent partner in the business and silent partners are paid with cash, not profits. Businesses need cash to grow, to acquire other businesses, to service debt, to increase their net worth and to pay dividends to their investors. The superior business, and consequently the superior stock, is the one that can generate the most cash flows, not the biggest earnings.

Owner Earnings and Intrinsic Value

As Ponzio says, focusing on cash flows allows us to “peak inside” the firm and see what management sees. Furthermore, it implies looking at the business like an owner, rather than an accountant or IRS agent– net income/earnings do not represent cash available to the owners because they include a number of non-cash items and they do not account for necessary CAPEX spending to grow and maintain the business.

Owner Earnings represent actual cash flows attributable to the owners of the company in a given period and can be calculated fairly simply:

Owner Earnings = Net Income + Depreciation/Amortization + Non-Cash Charges – Average CAPEX

Average CAPEX should generally be taken over a period of the most recent 3-5 years, though you could use as many as 10 years if that’s how you prefer to look at a business’s history. Owner earnings tell you whether a business is generating enough cash to pay its bills without new infusions of debt or equity, as well as whether it is generating sufficient cash flows to continue to grow. Further, Ponzio states that “For extremely large, stable businesses, free cash flow usually approximates owner earnings.”

Intrinsic value is a related concept which considers the combined value of the current net worth of the business as well as the present value of all discounted future cash flows the business with generate. As a value investor, your goal is to buy businesses trading in the market at steep discounts to your calculated intrinsic value. The difference between intrinsic value and the market price is your “margin of safety” (note that if you pay more in the market than your calculated intrinsic value, this implies a “margin of dissafety” represented by the negative value you’d get from the equation).

To calculate the present value of future cash flows, Ponzio recommends using your desired investment return as the discount rate and sticking to it consistently (so, for example, if you want your investments to grow at 15%, use a 15% discount rate, but be wary that the higher your discount rate, the less conforming investment opportunities you will find). If you have Excel, calculating the value of discounted cash flows is simple. You can enter the following formula into any cell in your spreadsheet,


By creating a matrix of future anticipated cash flows and then discounting them with the present value function, you can sum them up to get the total present value of present cash flows. When adding this to the business’s present net worth and comparing that amount to current market cap you can get an idea of whether or not the business is trading at a discount or premium to its intrinsic value.

Cash-yields, Buy-and-Hold, CROIC and “No-Brainers”

Ponzio suggests a few more ways to look at possible investments. One is the cash yield, which treats the stock like a bond for comparative purposes. Cash yield is defined as.

Cash Yield = Owner Earnings (or FCF) / Market Cap

Taking this yield, you can compare it to other investments, such as “risk free” government securities. Assuming the government securities are in fact “risk free”, if the cash yield is lower than the government securities the cash yield is telling you that you would likely be better off taking the “guaranteed” yield of the government security rather than assuming the capital risk of a stock. But if the cash yield is higher it could indicate a good investment opportunity, especially because that yield will typically improve over time as the denominator (your acquisition price) remains constant while the numerator (owner earnings/FCF) grows. But, as Ponzio states,

Cash-yield is not a make-or-break valuation; it is a quick and dirty “what’s this worth” number that applies more to slower-growth businesses than to rapidly growing ones.

Whereas cash-yield seeks to answer, “Is this cheap relative to other returns I could get?”, the Buy-and-Hold method seeks to answer “How much is it worth if I buy the entire business?” BAH is a more standard analysis and involves discounting future cash flows and adding them to the present net worth of the business, mentioned above.

A “no-brainer”, in Ponzio’s parlance, is an investment that leaps out at you as ridiculously undervalued– an excellent, growing business trading at a significant discount to its intrinsic value (net worth and discounted future cash flows). When searching for no-brainers, Ponzio suggests you stay in your sphere of confidence by sticking to what you know and asking yourself the following:

  • What does the company do?
  • How does it do it?
  • What is the market like for the company’s products or services?
  • Who is the company’s competition?
  • How well guarded is it from the competition?
  • Five and ten years from now, will this company be making more money than it is today? Why?

If you can’t answer any of those questions, you’re outside your sphere of confidence and probably won’t be able to identify a no-brainer.

There are many ways to identify growing businesses. Sticking to the theme of “watch the cash flows,” Ponzio’s favorite measurement is Cash Return on Invested Capital, or CROIC. CROIC is defined as,

CROIC = Owners Earnings / Invested Capital

(Ponzio suggests using long-term liabilities and shareholder’s equity to estimate IC– obviously if there was preferred equity or some other capital in the business like that, you might want to include it for a more accurate measurement.)

Ponzio recommends CROIC because it demonstrates management’s ability to generate owners earnings from each dollar of invested capital. The more efficient a management team is at generating owners earnings, the more resources it has to grow the business and pay shareholders. But be careful! An extremely high CROIC (such as 45%) is generally unsustainable. Look for anything above 10% as a good CROIC growth rate.

Portfolio Management Is All About The Percentages

You’ve found some great businesses. You know they’re growing and you know they’re trading at big discounts to intrinsic value, offering you your requisite margin of safety. Now you need to figure out how much of each you buy as you construct a portfolio.

A word of warning up front– there’s no science here, even though Ponzio refers to precise percentages. This aspect of investment management is even more art-vs.-science than judging which companies to buy in the first place. That being said, the principles themselves are sound and the truly important takeaway.

Ponzio divides stocks into three main categories:

  • Industry leaders: $10B+ market cap, demand 25% MoS, allocate 10-25% of your portfolio
  • Middlers: $1B-$10B market cap, demand 50% MoS, allocate up to 10% of your portfolio
  • Small fish: <$1B market cap, demand 50%+ MoS, allocate no more than 5% of your portfolio
The percentages are arbitrary but the idea is not. Industry leaders are companies that have proven track records when it comes to cash generation and cash flow sustainability through diverse business conditions. They won’t grow as much (they’re generally too big to do so) but if you can buy them at significant discounts to their intrinsic value, you will be rewarded. These are companies you can buy, read the annual report each year and otherwise sleep easy.

Middlers are companies that are in business limbo. They could grow quickly and become industry leaders, providing you with juicy returns, or they could be surpassed by smaller and larger competitors alike and shrink back to small fish size. Ponzio recommends keeping up with the quarterly reports on these companies and taking prompt action if you think you see any problems approaching.

Finally, small fish are capable of explosive growth… and spectacular failures. Many smaller businesses fail every year. Also, small businesses are often reliant or one or a few major customers for all of their business. If they lose that relationship, or a critical person dies or leaves the firm, their business can evaporate overnight. At the same time, because they are so small, the SF have the most room to grow and if you pick them right, they can turn into the magical “ten-baggers” of Peter Lynch lore. Ponzio recommends following every SEC filing and every news item on these companies as they can go belly up quickly if you aren’t careful.

The key thing to keep in mind is that, however you make your allocation decisions, you should always invest the most in the things you are most confident about. Diversification should be a consequence of your investing decisions, not an outright goal. You will make allocations as various opportunities arise. You don’t benefit yourself by being fully invested all the time, simply to keep your portfolio “balanced” amongst different business types.

Selling Is The Hardest Part

As the legendary Tom Petty once said, “the waiting is the hardest part” and while that’s certainly true of investing for some, what people consistently struggle with even more is knowing when to sell.

There are two times to sell:

  • when your investment has closely neared, met or exceeded your estimate of fair value
  • when the business you’ve invested in has developed some serious problems that will affect its present value and its future ability to generate cash flows

In the first situation, you must avoid getting greedy. If you had an estimate of intrinsic value when you bought the company (at a discount) and over time your forecast bore out, and if there is no completely new developments in the business which would cause you to drastically re-appraise upward the future value of the business, you sell. That’s it.

Similarly, if you make a forecast for the business’s prospects and you later realize you’ve made a big error in your conceptual understanding of the business and its value, you sell. Short term price volatility is not a “realization of your error”. Realization of your error would be the company generating significantly lower owner earnings than you had anticipated, or worse.

Finally, if you feel full of confusion and can’t sleep easily at night about your investment, tossing and turning trying to figure out what is going on, you sell. It’s not worth the stress and you won’t make good decisions in that state of mind. Just sell it and look for something you can understand a little easier.

And don’t be afraid to take a loss. You will not get every decision right. Luckily, you don’t need to– if you invest with a margin of safety, the reality of an occasional error is built in to the collective prices you pay for all your businesses. Never hesitate to sell simply because you want to avoid a loss. You will screw up now and then. Accept it, sell, and move on to your next opportunity.

F-ing Wall Street All Over The Place

There’s still more to this outstanding introduction to value investing but I don’t have the time or interest to go into all of it right now. In the rest of the book, Ponzio discusses arbitrage, workouts and other special investment scenarios and provides a great “how-to” on getting involved with these investments and taking your game to the next level. He also provides a short primer on bond investing and an exploration of the “different types of investors” ala Ben Graham’s conservative versus enterprising investor archetypes. Rounded out with an investor glossary and a short Q&A and this book is a true gem trading at a significant discount to intrinsic value.

More Warren Buffet than Ben Graham, Joe Ponzio’s F Wall Street is a classic and a great starting place for anyone who wants to jump into value investing head first.


Will A Future You Be Glad You Bought Some Stocks? (#expectations)

The anonymous author of Hedge Fund News has put out a rather pessimistic, hopeless sounding post in which he asks, “Why invest in stocks?

  1. The game is largely about front running the Federal Reserve or the ECB or the Bank of Japan. It seems that the way to make money is to buy before central bankers announce quantitative easing or some other scheme to juice asset prices.  However, since I don’t have high level contacts at any of these institutions, I will always be the last one to invest based on the liquidity injections.  Of course, there are people who do have contacts at the FED and thus they can essentially front run monetary policy. The question I ask myself is “if I can’t compete with the big boys, does it make any sense to play?” In any other sport, the answer would be a resounding no in order to avoid injury. I don’t think my investing in the stock market is any less dangerous then taking the field with the New England Patriots for training camp. I can get hurt…real bad.
  2. You also can’t compete with big hedge funds. A major hedge fund might have 100 analysts, key contacts at major brokerages. Paying massive trading commissions has it’s benefits and that benefit is information. The stock market is a game of information and most likely the big hedge fund has vastly superior information to you.
  3. I like founder owned and operated businesses.  I generally find “professional management” is too constipated and far too divorced from the risk taking visionary that usually founded the company.  Talk to a corporate middle manager and then talk to hungry entrepreneur working on his baby. You will quickly feel who you would rather back with your precious capital. By the time most companies reach the public markets, the ownership of the company lies in the hands of facelesss financial institutions that are totally divorced from the passion that built the business.
  4. The markets are run by machines. Insanely powerful computers constitute the majority of trading. Again, the hedge funds have a massive technological edge on the rest of us.
  5. the Warren Buffet stock analysis that favors buy and hold investing has not worked in the last decade that has been driven by Central banks and macroeconomics. Stock picking has been killed by the four reasons above.

I mention this post because I’ve shared the sentiment myself at times, and especially recently.

Stocks are not just forward-looking instruments, they are forward bets. If you buy stocks, you are making the assumption that, at least for the companies’ whose stocks you buy, things will be better in the future and therefore the prices will be higher. In that sense, Warren Buffett’s “bullish on America” rhetoric matches his investment action. He truly believes America as an idea, as a system, as an investment platform, can not fail because it has not failed, so he wants to buy stocks every time most other people are selling him because he believes his long-term prospects for capital appreciation are good.

And so far, that has worked– wonderfully!

But people like Buffett seem to be ignorant of certain economic truths and inevitabilities, especially with regards to the current problems facing investors, and so some of his optimism comes across as willful naivety.

This isn’t an anti-Warren post, however, so back to the point– what if the future is bleak? What if America is Japan? Some have made comparisons (Mish) and some of those comparisons are compelling. What if America isn’t Japan, but something worse and far more complex altogether?

What if we’re looking at an ongoing or a return to severe recession? What if this is followed by more inflationary antics which, by driving up commodity prices, serve to kill margins in many businesses and beat down earnings, even as general price increases rage on? What if stocks don’t even go up in nominal terms for awhile and then, by the time they do, they’ve lost so much in real terms that there’s no point in investing in them?

What if, what if, what if? A lot could go wrong. And knowing this, a value investor seeks a margin of safety in his investments. If he’s concerned about a depression, he tries to calculate what that might look like and price it in, raise his hurdle rate that much higher. Then, if it’s a good business and he can get it at a significant discount to his calculated value even when considering a rather hopeless scenario as a possible outcome, he buys. If it goes down, he buys some more.

If that worst case scenario plays out, and the world looks like it’s ending, if he’s got any more money left he throws it in the pot and then he goes off to war, or he goes fishing, or whatever and he doesn’t think about it anymore.


Why invest in stocks? Because tomorrow is always another day. Stocks are for the future and there’s always a future, so if you can buy them cheaply, you buy them and you stop worrying about everything else.

The only trouble, the thing that keeps me worrying, is what if the future is going to happen someplace else, not America? A lot of places that were once the future are now the past. It could happen. Invest accordingly.

Review – The Conscious Investor (#investing, #review)

The Conscious Investor: Profiting from the Timeless Value Approach

by John Price, published 2011

This book was not what I expected to be and it certainly was not what I had hoped it would be. The reviews I had read of the book left me waiting in eager anticipation of its arrival in the mail because it sounded like it would do two things I had been looking to do: deliver crushing criticisms of various technical and non-value based approaches to investing; and provide a concise “how-to” as far as preparing an intrinsic value-based financial analysis of business or investment idea.

With regards to the former, Price delivers, but not courageously. His breakdown of various analytical approaches, while thorough, ultimately is not very helpful. Each analytical methodology is described and then followed by a list of strengths and weaknesses, but no decisive conclusion is reached. Surely there’s nothing wrong with leaving it to the reader to make up his own mind, but there’s no objective scale provided or suggested for weighing the strengths and weaknesses of each– it’s hard to tell just from reading whether any particular strength outweighs a weakness, or vice versa. I would’ve liked it if Price had added his two cents about each rather than trying to be dry and officiously neutral.

As for a concise how-to on value investing, this was one of those books where you keep turning the page hoping the author is going to get to the point and suddenly you turn the last page and you’re confronted with the back flap of the book and all you can do is shout out in frustration, “That’s it?!”

The title of the book seems contrived in relation to its content. “The Conscious Investor”, as opposed to an unconscious one? I assume Price is suggesting a level of awareness, but there is an important qualitative difference about being aware of many different concepts and actually understanding their meaning and significance. I didn’t find the book to have much strength in that sense.

At one point, Price suggests that part of being a “conscious investor” means thinking about what it is, exactly, that you’re investing in, and what would be the implications of that investment succeeding. For example, say you invest in a company that manufactures ugly clothing. If the company is successful and your investment pays off, you’ll now be living in a world of ugly clothing everywhere you look. Is that the kind of world you want to live in?

It’s an interesting idea but a perhaps more important one is, “If the company is clearly undervalued, and I don’t invest in it for ethical reasons… does that mean no one else will recognize the undervaluation and invest, thereby preventing that world of [ugly clothing] from becoming a reality?” Whatever the answer to this question, this is clearly an aspect of being a “conscientious investor”, not a conscious one, so again I am left a bit perplexed by this book.

My disappointment and griping aside, there was some value in this book and I did highlight and underline a few things I had wanted to record here for future reference. But even at Amazon’s reasonable new book prices, knowing what I know now I see this book as overvalued, meaning I clearly overpaid and thereby suffered a permanent capital loss. But maybe that was what Price was trying to teach me the whole time, as a value investor.

Lesson learned!

Some notes and takeaways:

When reading financial statements and company filings, remember to “follow the money“, and ask (and try to answer) the following questions:

  1. How much money came in over the reporting period and where did it come from?
  2. What was it used for?
  3. How much money did the company manage to keep?
If time is limited, reading the Management’s Discussion & Analysis (MD&A) section of company filings is critical, and the aim is “to answer the question whether the management is honest, rational and acting in the best interests of shareholders.”

Further, in the Proxy Statement (Form Def 14A), you should attempt to determine

whether the presentation on compensation in the Proxy Statement is clear and easy to understand. The overall level of compensation to management and directors relative to the size and performance of the business is important.

When studying earnings growth, as a common stock investor it is important to look at growth in EPS, not net income, because the company may be issuing large number of shares and diluting current shareholders even if it is successfully growing net income.

The quality of earnings is in doubt when net income substantially exceeds cash flow from operations. Ideally, positive cash flow conditions would yield:

  1. Cash provided by operations which are positive and trending upward
  2. Cash flows from operations are more than sufficient to cover cash used for investing (CFO > CAPEX)
Share buybacks must be done intelligently if they are to create value.
If you own shares in a company, but don’t think that it represents value to buy more, then welcoming actions of the company to buy back its own shares is not logical.

Mismatches between net and comprehensive income are also a warning sign.

If in most years the comprehensive income is consistently below the net income… the company has been accumulating losses in comprehensive income aside from the regular income, which may indicate that the economic situation is worse than it would appear from an analysis of the income statement.

A higher current ratio is not always better– sometimes a high current ratio means that inventory is piling up, or the company is extending larger amounts of credit to its customers than it ought to be through growing A/R. A low or downward trending current ratio is almost always a cause for concern, however.

With retail companies, it is important to examine growth of same-store sales to determine whether the company is growing simply through the opening of new stores versus expanding its business within existing stores. Also, high asset turnover is critical in a retail business, which normally has low margins, in order to leverage its returns.

Be vigilant with companies whose primary assets are intangibles, which, if developed internally, may not be represented on the balance sheet. “The smaller the role of intangible assets, the closer to book value a company’s market price is likely to be.”

And a Warren Buffett quote:

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.

Further, according to Price,

Over time, whatever returns a company makes on its equity and capital will be approximately an upper limit on the return made by investing in the company’s stock.

Putting some of this together yields a few “rules” with regards to the P/E ratio:

  1. Know the history of the P/E ratio
  2. Do not buy unless the P/E ratio is toward the lower end of its historical range
  3. Compare the P/E ratio with the P/E ratios of competitors
  4. Compare the P/E ratio with the average P/E ratio for the same sector or overall market
  5. Be wary about buying when the P/E ratio is high
  6. Look at the earnings yield, which suggests a minimum return that can be anticipated if earnings remain steady, with anything more caused by growth in earnings

“Find companies with high and consistent return on equity and not too much debt. Try to determine what is special about them– what economic moats do they have?”


Review – How To Read A Financial Report (#accounting, #investing, #finance, #HowTos)

How to Read a Financial Report: Wringing Vital Signs Out of the Numbers

by John A. Tracy, published 2009

There isn’t too much to say about John A. Tracy’s “How To Read A Financial Report: Wringing vital signs out of the numbers”. It’s a basic guide to understanding the income statement, balance sheet and statement of cash flows that all businesses, public and private, rely on to internally control their business as well as report the condition of their business to other investors and third parties.

It’s set up in a wide (versus standard tall) format and goes step-by-step through the various financial statements, their sub-sections and sub-accounts and the way specific items on each financial statement interact with other items on other financial statements. There are a number of tables and figures for illustrative purposes.

Below, I have summarized some of the most important takeaways to serve as a quick reference for myself going forward.

Sales Revenue and Accounts Receivable (A/R)

The average sales credit period determines the size of accounts receivable.

Accounts Receivable Turnover Ratio = Sales Revenue / Accounts Receiveable

The accounts receivable turnover ratio is most meaningful when it is used to determine the number of weeks (or days) it takes a company to convert its accounts receivable into cash.

Cash Conversion Cycle in Weeks (Days) = 52 Weeks (365 Days) / ARTR

Excess accounts receivable means that excess debt or excess owner’s equity capital is being used by the business.

Cost of Goods Sold (COGS) and Inventory

The average inventory holding period determines the size of inventory relative to annual cost of goods sold.

Inventory Turnover Ratio = COGS / Inventory

Dividing this ratio into 52 weeks (365 days) gives the average inventory holding period expressed in weeks (days).

Average Inventory Holding Period in Weeks (Days) = 52 Weeks (365 Days) / ITR

If the holding period is longer than necessary, too much capital is being tied up in inventory. The company may be cash poor because it keeps too much money in inventory and not enough in the bank. If overall inventory is too-low, stock-outs may occur.

Accounting issues: the inventory asset account is written down to record losses from falling sales prices, lower replacement costs, damage and spoilage, and shrinkage (shoplifting and employee theft). Losses may be recorded in the COGS expense account.

Inventory and Accounts Payable

One source of accounts payable is from making inventory purchases on credit. A second source of accounts payable is from expenses that are not paid immediately.

Sellers that extend credit set their prices slightly higher to compensate for the delay in receiving cash from their customers. A small but hidden interest charge is built into the cost paid by the purchasers.

Operating Expenses and Accounts Payable

The recording of unpaid expenses does not decrease cash.

Operating Expenses and Prepaid Expenses

The prepayment of expenses decreases cash.

Accounting issues: a business may be on the verge of collapse and its prepaid expenses may therefore have no future benefit and may not be recoverable (so, a large prepaid expense account should maybe be discounted to 0 in an NCAV analysis). A business may not record prepaid costs; instead it could simply record the prepayments immediately to expense. A business could intentionally delay charging off certain prepaid expenses even though the expenses should be recorded in this period.

Depreciation Expense

The allocation of the cost of a long-term operating asset to expense is called depreciation. In financial statement accounting depreciation means cost allocation.

Accelerated depreciation results in depreciation over a period of time which is considerably shorter than the actual useful life of the asset. Accelerated means front-loaded; more of the cost of a fixed asset is depreciated in the first half of its useful life than in its second half. If useful life estimates are too short (the assets are actually used many more years), than depreciation expense is recorded too quickly.

Book value represents future depreciation expense, although a business may dispose of some of its fixed assets before they are fully depreciated. Chances are that the current market replacement costs would be higher than the book value of the fixed assets– due to general inflation and the use of accelerated depreciation methods.

An expense is recorded when there is a diminishment in value of a company’s intangible assets.

Accounting issues: if the business adopts a sales pricing policy for recapturing the cost of a fixed asset over X years, then an X-year depreciation life would be most appropriate.

Accrued Liabilities and Unpaid Expenses

Typical accrued expenses:

  • accumulated vacation and sick leave pay owed
  • partial-month telephone and electricity costs incurred but not billed
  • property taxes charged to the year, but not billed
  • warranty and guarantee work on products sold in the year, so future expenses related to current sales are matched in the present period

Accounting issues: if a business is seriously behind in paying interest on its debts, the liability for unpaid interest should be prominently reported on its balance sheet to call attention to this situation.

Net Income and Retained Earnings; Earnings Per Share (EPS)

Retained earnings is not an asset and certainly is not cash.

Retained Earnings = Net Income – Dividends Paid to Shareholders

Cash Flow From Operating (Profit-Making) Activities

Cash Flow From Operating Activities (CFO) is best thought of as cash flow from profit.

Drivers of cash flow:

  • A/R – an increase hurts CFO; extending customers credit uses cash
  • Inventory – an increase hurts CFO; buying inventory uses cash
  • Prepaid expenses – an increase hurts CFO; paying for expenses uses cash
  • Depreciation – an increase helps CFO; depreciation is a non-cash expense
  • A/P – an increase helps CFO; using credit from suppliers frees up cash
  • Accrued A/P – an increase helps CFO; delaying the payment of accrued expenses conserves cash
  • Income Tax Payable – an increase helps CFO; not paying the full tax burden conserves cash

Summary for the seven cash flow adjustments:

  • Increases in operating assets cause decreases in cash flow from operations; decreases in operating assets cause increases in cash flow from operations.
  • Increases in operating liabilities help cash flow from operations; decreases in operating liabilities result in decreases in cash flow from operations.

Profit generates cash flow; cash flow does not generate profit.

Cash Flow From Investing and Financing Activities

The second section of the statement of cash flows summarizes investments made by the business during the year in long-term operating assets. It also includes proceeds from disposals of investments (net of tax). These are assumedly one-time cash flows, not recurring like cash flows from operations.

The third section of the statement of cash flows reports the cash flows of what are called financing activities. These are cash flows generated outside the business (new equity sales, new borrowings) or cash flows paid to parties outside the company (stock buybacks, debt repayments, dividends to shareholders).

Profit can be viewed as the internal source of cash flow and is the only renewable, recurring one if the business is in good health as a going concern.

The important question to ask is, “What did the business do with its cash flow from profit?”

The other important question is, “Can the business support its other cash flows (investing, financing) with cash from operations?” If not, the business will not remain solvent and liquid in the long-run.

Impact of Growth and Decline on Cash Flow

Cash flow can be higher or lower than net income for the period. There are three main reasons:

  • depreciation and other noncash expenses and losses
  • changes in operating assets
  • changes in operating liabilities
Growth should be good for profit next year, but growth almost always puts a dent in cash flow for the year.

A business could speed up cash flow from profit if it were able to improve its operating ratios, such as holding a smaller stock of products in inventory. If anything, however, it may allow these ratios to slip a little by offering customers more liberal credit terms to stimulate sales, which would extend the A/R credit period. Or, the business may increase the size and mix of its inventory to improve delivery times to customers and to provide better selection.

Businesses with lower fixed costs have more flexibility to swiftly respond to business declines by reducing costs, thereby improving margins.

A huge net loss for the year may be due to huge write-downs of assets (or by recording a large liability).

The total cash outlays for expenses could be more than total cash inflow from sales revenue, even after the depreciation add back is considered. This is called negative cash flow. In this situation, a business is using up its available cash at the burn rate, which can be used to determine how long a business can live without a major cash infusion.

Financial Statement Ratios

Cash Flow as % of Net Income = CFO / NI

Cash Flow per Share = CFO / Shares Out

Current Ratio = Current Assets / Current Liabilities

The Current Ratio measures short-term liquidity of the business and should be 2 or higher.

Acid Test Ratio = Cash + ST Investments + A/R / Current Liabilities

Also called the quick ratio, should be 1 or higher.

Debt to Equity Ratio = Total Liabilities / Total Stockholders Equity

Debt-to-Equity is an indicator of whether debt is being used prudently.

Times Interest Earned Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

TIE tests the ability of the business to pay interest from earnings.

Return on Sales Ratio = Net Income / Sales Revenue

Also known as net margin, return on sales measures the ability of the company to earn profit per $1 of sales. It is a sales efficiency ratio.

Return on Investment = Profit / Capital Invested

This is a standard formula with several variants, measuring the profit generated from a particular amount of capital invested. Also,

Return on Equity = NI / Stockholders Equity

Return on Assets = EBIT / Total Assets

The ROA is compared with the annual interest rate on the company’s borrowed money. You want the difference between these two values (spread) to be higher rather than lower. An ROA – Interest Rate > 1 represents gain on financial leverage.

Asset Turnover Ratio = Sales Revenues / Total Assets

Represents the rate at which assets are being converted into sales revenue.

Massaging the Numbers

Businesses can play many games to manipulate their reported financial numbers.

Discretionary expenses, such as repair and maintenance costs, employee training and development, advertising expenditures. Managers have a lot of control over when and how these expenses are recorded by pushing up or delaying such actions.

Stuffing the channels occurs when the manager accelerates sales by shipping more sales to the company’s captive dealers even though they haven’t ordered the products.

Window dressing, whose purpose is to make the short-term solvency and liquidity of the business look better than it really was at the end of the year.

For reporting profits soon, the CEO instructs accountants to choose accounting methods that accelerate sales revenues and delay expenses. To be conservative, the accountants can be instructed to use accounting methods that delay the recording of sales revenue and accelerate the recording of expenses.

If reported earnings are backed up with steady cash flow from operations, the quality of the earnings may be deemed as high.

A quick litmus test for judging a company’s financial performance:

If sales increased by X%, did profit increase X% as well? Did A/R, inventory and long-term operating assets increase by X%?

For example, suppose inventory jumped by 50%, even though sales revenues increased only 10%. This may result in an overstocking of inventory and lead to write-downs later.


Investing: How To Do It (That’s What She Said) (#investing)

I’m reading two posts on how to put theory into practice from two different value investors. Here are Geoff Gannon’s thoughts on how to turn yourself from an armchair value investor into an actual value investor:

  • Have skin in the game; buy individual stocks you pick yourself, rather than mutual or index funds, so you have no one to blame (or cheer) but yourself for your results
  • Keep an investment diary; take ten minutes every day the markets are open and write what you are thinking, feeling, looking at, for future reference
  • Keep an investment bucket list; imagine you had to put your entire net worth into 5 stocks, regardless of price, and couldn’t sell. Try seeing how your thinking is distilled when you look at companies this way, and kick poor ideas off in favor of better ideas over time
  • Practice; work an absurd amount, be an expert. Read a 10-K every day. Find an area you feel especially comfortable in and focus on it
  • Invest with style; your circle of competence, don’t be afraid to find it and stick to it
  • Conclusion: stop reading, start working, grow your own style
As for Andrew Schneck, he recommends the same thing: do the work. You have to get your hands dirty, read some SEC filings and get used to looking at a lot of numbers from a lot of different companies.
He also recommends looking at Value Line as a tool for examining lots of companies, quickly. The more different companies you see, the more you’ll begin to recognize patterns and differences, which will ultimately help you to recognize value from lack of value.

Review – Value: The Four Cornerstones of Corporate Finance (#review, #finance, #value)

by Tim Koller, Richard Dobbs and Bill Huyett; published 2011

Part I is about the four cornerstones of value. In a footnote in Chapter 1, authors Koller, Dobbs and Huyett define value as:

the sum of the present values of future expected cash flows– a point-in-time measure. Value creation is the change in value due to company performance… we use the market price of a company’s shares as a proxy for value and total return to shareholders as a proxy for value creation.

Further, they explain that the book explores the “four cornerstones of corporate finance” which are:

  1. companies create value by investing capital from investors to generate future cash flows at rates of return exceeding the cost of capital
    1. the combination of growth and return on invested capital (ROIC) drives value and value creation
    2. for businesses with high returns on capital, improvements in growth create the most value, but for businesses with low returns, improvements in ROIC provide the most value
  2. value is created for shareholders when companies generate higher cash flows, not by rearranging investors’ claims on those cash flows
  3. the expectations treadmill– a company’s performance in the stock market is driven by changes in the stock market’s expectations, not just the company’s actual performance; the higher the stock market’s expectations for a company’s share price become, the better a company has to perform just to keep up
  4. the value of a business depends on who is managing it and what strategy they pursue

For a real-life application of these principles, the authors highlight the recent housing bubble, namely, that the mortgage-securitization model violated the conservation-of-value principle because it rearranged risk without affecting the aggregate cash flows of home loans, while the belief that levering up these types of investments increased their value was similarly erroneous because “leverage doesn’t increase the cash flows from an investment.”

Chapter 2 explores return on invested capital (ROIC) which the authors define in simple terms  in a footnote as:

return on capital is after-tax operating profit divided by invested capital (working capital plus fixed assets)

ROIC and revenue growth “determine how revenues get converted into cash flows.” Mathematically, growth, ROIC and cash flow (represented by the investment rate) look like this:

Investment Rate = Growth / ROIC

However, Growth and ROIC have an uneven relationship:

for any level of growth, value always increases with improvements in ROIC. When all else is equal, higher ROIC is always good.

When ROIC is high, faster growth increases value, but when ROIC is low, faster growth decreases value. The dividing line between whether growth creates or destroys value is when the return on capital equals the cost of capital. When returns are above the cost of capital, faster growth increases value.

The authors advise that “most often, a low ROIC indicates a flawed business model or an unattractive industry structure.” The growth-at-all-costs mentality is flawed.

high-return companies should focus on growth, while low-return companies should focus on improving returns before growing.

In Chapter 3, the authors focus on the conservation of value, namely,

value is conserved when a company shifts the ownership of claims to its cash flows but doesn’t change the total available.

To see how managerial decisions affect the value of the business look for the cash flow impact.

On share buybacks,

when the likelihood of investing cash at low returns is high, share repurchases make sense as a tactic for avoiding value destruction.

Caution, however, because

studies of share repurchases have shown that companies aren’t very good at timing share repurchases, often buying when their share prices are high, not low.

And why should they be any better at timing their purchases than any other market timer?

As far as acquisitions are concerned, they

create value only when the combined cash flows of the two companies increase due to accelerated revenue growth, cost reductions or better use of fixed and working capital.

In Chapter 4, the authors discuss the expectations treadmill, stating that

smart investors often prefer weaker-performing companies because they have more upside potential, as the expectations are easier to beat.

The key seems to be finding companies with a high ROIC and a low P/E ratio.

Chapter 5 discusses the best owner principle. For example, some owners add value:

  • linkages with other activities in their portfolio
  • by replicating such distinctive skills as operational or marketing excellence
  • by providing better governance and incentives for the management team
  • through distinctive relationships they hold with governments, regulators or customers
Further, there is a “best owner lifecycle”, meaning that most owners are only the “best” at a given stage in a business’s development. Some excel at the start-up stage, others the growth, others still the maintenance of empire and finally a group is best at the terminal stage where a business is dismantled and its assets are sold off to other entreprises, each owner finding unique ways to increase cash flows at each stage. The implication of this is that
executives need to continually look for acquisitions of which they could be the best owner; they also need to continually examine opportunities for divesting businesses of which they might no longer be the best owner.

Empirically, “the stock market consistently reacts positively to divestitures, both sales and spin-offs.”

Part II is about the stock market. Chapter 6 explores who the stock market is. There are a lot of different participants with differing aims, skill sets and knowledge levels but the authors conclude that ultimately

professional investors–whether they manage hedge funds, mutual funds, or pension funds– are the real drivers of share prices, accounting for virtually all large trades.

The authors estimate that “intrinsic” investors hold 20% of US assets and contribute 10% of the trading volume in the U.S. market. “Intrinsic investors ultimately drive share price, because when they buy, they buy in much larger quantities.”

intrinsic investors are resources for executives, providing an objective, circumspect view of their companies, industries, and competitors by virtue of their buying and selling decisions.

Chapter 7 is about the stock market and the real economy. Here are some aggregate observations:

  • much of the stock market’s stellar performance between 1983 and 1996 was driven by the decline in interest rates and inflation, and the resultant increase in P/E ratios engineered by Federal Reserve Chairman Paul Volcker
  • by 1996, if executives understood what was driving shareholder returns, they would have known returns had to revert to normal levels
  • adjusted for inflation, large U.S. equities have earned returns to shareholders of about 6.5 to 7 percent annually, over the last 100 years
  • this number is derived from the long-term performance of companies in the aggregate, and the relationship between valuation and performance as described by the core-of-value principle
  • over the longer term, shareholder returns are unlikely to deviate much from this number unless there are radical changes in investor risk preferences or radical changes in the performance of the economy
  • long-term GDP growth would have to increase or decrease significantly, or the ratio of corporate profits to GDP would need to change (it has been constant for at least 75 years)
If, as the authors state, “high interest rates increase the nominal cost of capital, while high inflation increases the proportion of earnings that must be invested for growth”, then the implications for the coming period in the markets where we might finally face a high interest rate environment with simultaneously accelerated money printing spells falling P/E ratios across the broad market.
This means that the market as a whole has a more narrow band of longer-term performance than many realize, and that exceptional bull markets will usually be followed by a down market, and vice versa

Chapter 9 deals with earnings management. The authors state that “excessive smoothness raises concerns” that earnings are being actively managed by company leaders. Further, “consensus forecasts aren’t very good” and “analysts’ earnings estimates are not accurate; they tend to be too optimistic, and they almost never identify inflection points.” Importantly, “there is no meaningful relationship between earnings variability and TRS or valuation multiples.”

Part III deals with managing value creation. Chapter 10 is about return on capital.
A company that has a competitive advantage earns a higher ROIC because it either charges a price premium or it produces its products more efficiently (having lower costs or capital per unit) — or both. Price premiums offer the greatest opportunity to achieve an attractive ROIC, but are more difficult to achieve than cost efficiencies.

Low ROIC industries are those with undifferentiated products, high capital intensity and fewer opportunities for innovation.

There are 5 major ways to get a price premium:

  • innovative products
  • quality
  • brand
  • customer lock-on
  • rational price discipline

There are 4 major ways to get cost/capital efficiency:

  • innovative business methods
  • unique resources
  • economies of scale
  • scalability/flexibility
Ultimately, the longer a company can sustain a high ROIC the more value it will create.
ROIC excluding goodwill reflects the underlying economics of an industry or company. ROIC including goodwill reflects whether management has been able to extract value from acquisitions.

Therefore, it might be useful to study both metrics to get a better understanding of management’s competence.

Chapter 11 is about growth.

growth from creating whole new product categories tends to create more value than growth from pricing and promotion tactics to gain market share from peers.

This intuitively makes sense because the former requires the bringing into the production system of previously untapped resources, while the former simply represents the freeing up of existing resources.

There are 4 sources of revenue growth:

  • market-share increase
  • price increase
  • growth in underlying market
  • acquisitions

The limits to the pursuit of growth:

  • sustaining high growth is much more difficult than sustaining high ROIC.
  • history suggests that many mature firms will shrink in real terms
  • U.S. companies have been globalizing, which is responsible for faster sustained growth rates of some U.S. companies than the growth of the economy as a whole
  • portfolio treadmill effect: for each product that matures and declines in revenues, the company needs to find a similar-sized replacement product to stay level in revenues, and even more to keep growing
Chapter 12 examines business portfolios. One study found that “it was better to have a competitive advantage (horse) than to have a good management team (jockey).” Another study found that “companies with a passive portfolio approach underperformed companies with an active portfolio approach.” This means “buy and hold” is a flawed strategy in the long-run, because the value of businesses change according to predictable cycles of birth, growth, flat-lining and death.

The ideal multibusiness company [think, investment portfolio] is one in which each business earns an attractive ROIC with good growth prospects, where the company helps each business achieve its potential, and where exectuives are continually developing or acquiring similarly high-ROIC businesses and disposing of businesses that are in decline.

To avoid depressed exit prices,

a simple rule of thumb can improve a company’s timing considerably: sell sooner

“When companies do divest, they almost always do so too late, reacting to some kind of pressure.” And a process suggestion for active portfolio management:

hold regular, dedicated business exit review meetings, ensuring in the process that the topic remains on the executive agenda and that each unit receives a date stamp, or estimated time of exit

As far as diversification is concerned:

  • diversification is neither good nor bad; it depends on whether the parent company adds more value to the businesses it owns than any other potential owner could, making it the best owner of those businesses under the circumstances
  • no evidence that diversified companies generate smoother cash flows
  • there is no evidence that investors pay higher prices for less volatile companies
  • diversified companies tend to respond to opportunities more slowly than less diversified companies
  • the business units of diversified companies often don’t perform as well as those of more focused peers, partly because of added complexity and bureaucracy

I noted in the margins that “even for investors, diversification raises transaction costs and provides more opportunities to make errors in decision process.”

Chapter 13 is about M&A. A few points about M&A value creation:

  • strong operators are more successful
  • low transaction premiums are better
  • being the sole bidder helps

Chapter 15 explores capital structure.

large amounts of debt reduce a company’s flexibility to make value-creating investments, including capital expenditures, acquisitions, R&D, and sales and marketing.

Before assuming debt, an investor or business owner needs to ask:

  • what are my expected cash flows?
  • what could go wrong?
  • what unexpected opportunities could arise?
Then, “set your debt level so that you can live through bad times in your industry while having the capacity to take advantage of unexpected opportunities.”
With complex structures and financial engineering, always identify the impact on a company’s operating cash flows and the distribution of cash flows among investors.
Finally, Chapter 17 addresses managing for value.
the only way to continually grow earnings faster than revenues is to cut necessary costs for growing the business, or to not invest in new markets that will have low or negative margins for several years

Review – The 4-Hour Work Week (@tferriss, #LifestyleDesign, #retirement, #wealth, #career)

The 4-Hour Workweek

by Timothy Ferriss; published 2009

A few important takeaway quotes from Chapter 1, “Rules That Change The Rules”:

  1. Retirement is an unsustainable notion: implies you do what you dislike during the most physically capable years of your life; the math doesn’t work; you’ll probably opt to look for a new job or start another company as soon as you retire, out of boredom
  2. Alternating periods of activity and rest is necessary to survival, as well as “thrival”; work only when you are most effective to be more productive and happier overall
  3. “Someday” is a disease that will take your dreams to the grave with you; if it’s important to you and you want to do it “eventually”, just do it and course correct along the way
  4. Ask for forgiveness, not permission; if the potential damage is moderate or in any way reversible, don’t give people the chance to say no
  5. It’s better to emphasize strengths than repair weaknesses; identify your best weapons and focus on wielding them more wisely
  6. The positive use of free time implies doing what you want as opposed to what you feel obligated to do
  7. Relative income uses two variables: money and time
  8. Eustress: role models who push us to exceed our limits, physical training, risks that expand our sphere of comfortable action; people who avoid all criticism fail

The value of money spent is determined by:

  • what you do
  • when you do it
  • where you do it
  • with whom you do it

In other words, quality, not quantity, is the major consideration in “psychic yield” from money spent.

In Chapter 2, Ferriss proposes some “rules that change the rules”. To start with, the concept of saving and sacrificing for an old-age retirement is a broken one because:

  • it assumes up to that point you spend a majority of your time doing something you dislike during the most physically capable years of your life
  • the math doesn’t work and you end up reliving your low-income lifestyle in old-age
  • you’ll likely get bored and look for a job or start a company just to keep yourself busy, negating the whole point

Instead, Ferriss proposes taking periodic “mini-retirements” throughout your life. This concept is consistently applied even down to the weekly and daily level, as he suggests that,

Alternating periods of activity and rest is necessary to survive, let alone thrive… By working only when you are most effective, life is both more productive and more enjoyable.

Many people push their dreams into the future and thereby let “someday” become “never.” Instead of waiting for the perfect time to take a break, Ferriss recommends following a passion as soon as you are aware of it and course correcting along the way.

To use your time wisely in life, focus on the things you are best at, rather than wasting time shoring up your weaknesses. This is an economic concept known as “competitive advantage” and it works for individuals just as well as companies or countries (obviously). Using free time efficiently implies doing what you want to do with your free time, not what you feel obligated to do. Finally, it’s important to seek out eustress, which is healthy stress that results in testing our limits and then pushing them out a little further afterward. In other words,

People who avoid all criticism fail.

Chapter 3 is about overcoming the fear of realizing your dreams. Ferriss opens with the quote,

Many a false step was made by standing still.

To overcome fear, we must define it. Often, we realize that what we fear going wrong is an unlikely, temporary 3 or 4 (on a scale of ten) disaster, in return for a probable and permanent 9 or 10 success. If you don’t like what you’re doing now, and you stick with it, how likely is your situation to be improved one year from now?

Instead of seeing how much definite pain you can tolerate now, Ferriss advises you to pull the cord, take a leap and try something different while you still have a chance. You must develop a habit of doing things you fear on a daily basis because “what we fear doing most is usually what we most need to do.” You should ask yourself,

If I don’t pursue those things that excite me, where will I be in one year, five years and ten years?

If you’re bored and dissatisfied with your life and not following your passions, and you define risk as “the likelihood of an irreversible negative outcome”, then it follows that “inaction is the greatest risk of all.”

You’ve decided to face your fears and challenge yourself by demanding more. What should you do? As Chapter 4 recommends, aim as high as you can, and never let admonitions that what you are attempting is “unreasonable” stop you.

The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.

The bigger the goal, the less competition you will face. The less competition, the better your chances of bagging the big one– “the fishing is best where the fewest go.”

When choosing goals and objectives, ask yourself, “What would excite me?” and then do that thing.

Ferriss’s preferred method for envisioning your future, exciting lifestyle is called “dreamlining”. You are to come up with a number of “having, being and doing” items, and then try to convert the “beings” into “doings” by coming up with specific actionable steps you could take (lessons, events, workshops, etc.) that will transform you into that kind of person. Then, you estimate the cost of these different items and divide each amount by 12 (or however many months you’re giving yourself to realize these dreams, though the shorter the better to avoid “someday”-fatigue) to get your monthly cost for each.

Adding the monthly costs of your dreamline to your current monthly expenses (multiplied by 1.3 to give yourself a savings buffer for something going wrong) gives you your Target Monthly Income (TMI) and gives you a real goal to shoot for in helping you understand how much more you need to make on a monthly basis to start realizing your dreamlines. This is the part where you get creative– sell stuff you don’t need and aren’t using anymore, reduce your expenses by not getting that latte every morning, and think up new sources of income by starting a side business or other passive income stream. You’ll often be amazed how close you are to your dreams when you look at them as a monthly figure and consider ways in which your current spending doesn’t really satisfy your dream desires.

Living your dream is about doing, and making bold decisions for yourself. This is why Ferriss ends the chapter by stating:

To have an uncommon lifestyle, you need to develop the uncommon habit of making decisions, both for yourself and others.

The next time someone asks you for a decision on something (where to go for lunch, what to do about that client, etc.), MAKE ONE and course correct if necessary. Almost everything is reversible.

Chapter 5 develops the theme of time management. The focus is on the 80/20 principle of Italian economist Vilfredo Pareto, namely, focus on eliminating the 20% of sources causing 80% of your problems while spending that freed up time on the 20% of sources responsible for 80% of your desired outcomes and happiness. Productive efficiency is about doing more by doing less ineffective stuff via selectivity.

The most important lesson: lack of time is actually lack of priorities.

Give yourself short, clear deadlines to work out critical tasks that contribute the most to your work or quality of life. Ignore or eliminate the rest. A few other tips:

  • Ask yourself, “If this is the only thing I accomplish today, will I be satisfied with my day?”
  • Never arrive at the office, your computer or anywhere else without a clear list of priorities– otherwise you’ll make up distractions to fill your time
  • Compile your to-do list for tomorrow no later than this evening
  • You should never have more than two mission-critical items to complete each day
  • Do not multitask

Chapter 6, The Low Information Diet, takes these principles and applies them further. Stop wasting time reading the news; start using, “Tell me, what’s new in the world?” as a conversation starter and let others read the news and summarize headlines for you.

If you need to learn how to do something, read the autobiography of someone who has done it. If you’re suffering from information overload, ask yourself, “Will I definitely use this information for something immediate and important?” And practice the art of nonfinishing– if something is boring or not useful, stop reading it/listening to it/watching it, etc.

Stop asking people “How are you?” and instead ask them, “How can I help you?” The former invites interruptions, the latter invites action.

Living The New Rich Lifestyle Starts With Mini-Retirement Jet-setting Practice

Paraphrasing (in Ferriss’s words) the first few paragraphs of the chapter about doing a life-reset by traveling abroad:

Some jobs are simply beyond repair. Improvements would be like adding a set of designer curtains to a jail cell. Most people aren’t lucky enough to get fired and die a slow spiritual death over 30-40 years of tolerating the mediocre. Being able to quit things that don’t work is integral to being a winner. The person who has more options has more power. Don’t wait until you need options to search for them. Take a sneak peek at the future now and it will make both action and being assertive easier.

Begin your new lifestyle of mini-retirements and following your life’s passion by relocating to one place for one to six months before going home or moving to another locale. This will give you time to relax and enjoy the new experiences without having to worry about catching your flight home, and without shortchanging yourself by assuming you won’t be around long enough to really submerse yourself in the local culture and language.

Chose a location where your money will go further than back home (such as Argentina, Thailand or Eastern Europe). To get there, use credit card miles or buy your tickets either far in advance or at the last minute, comparison shopping with or and the airlines’ own websites and then bidding on for 50% off, moving up in increments of $50 at a time. Consider using major airlines to get to travel hubs in foreign countries and then buying a local airline ticket to make the final leg(s) of the trip from there.

When you arrive, stay in a hostel or cheap hotel and query fellow travelers and hostel/hotel owners for the lay of the land. Tour around local neighborhoods with hop on/hop off bus tours or public transit, or rent a bike. Go look for an apartment (fully furnished and full of amenities) and set up your base for a few months.

If you’re relocating to a country where you can use dollar-arbitrage to your advantage, you can likely live much better than you do back home, enjoying a nice apartment, eating out at fancy restaurants and enjoying entertainment and nightlife you couldn’t dream of back home.

You should also look into local, private language instruction (several hours per week), as well as other local activities such as cultural dance, music, athleticism and exercise, that will allow you to learn from experts, mix with locals, learn the language and do it all for less money than you’d spend back home for equivalent experiences.

Practice taking less with you: take one week of clothes, no toiletries and allocate $100-300 to buy the rest of what you need when you get there. When you come home, leave the excess behind. You should be able to travel internationally with a carry-on and a backpack.

Final Remarks About Living Life Well

If you can’t define it or act upon it, forget about it.

Have at least one 2-to-3 hour dinner and/or drinks per week with those who make you smile and feel good.

Eat a high-protein breakfast within 30 minutes of waking and go for a 10-to-20 minute walk outside afterward, ideally bouncing a handball or tennis ball.

A good question to revisit whenever overwhelmed: Are you having a breakdown, or a breakthrough?

Rehearse poverty regularly. (You’ll fear it less when you know what it’s like and that you can handle it.)