Gannon On Investing

Someone who reads the blog sent me an email asking about a specific Japanese net-net. Rather than trying to choose the best net-nets from among the entire hoard in Japan, I would suggest doing one of two things:

Bigger investors can simply collect all the Japanese net-nets they find.
Smaller investors can simply apply a tougher standard than mere net-netness.

In my own portfolio, I went with option #2. I bought 5 Japanese net cash stocks last year. I've since sold one of them. I have some cash. And am looking to add a couple more Japanese net cash stocks. Right now, they make up 30% of my portfolio. Again, I'm willing to go as high as 50% in Japan. We'll see what happens.

But that's me.

What would I suggest for others interested in Japanese stocks?

Here's how I would look at Japan. If you can find stocks selling for less than net cash with few/no operating losses in their long-term history, buy them. Don't so much look for net-nets in general. Start with an even higher standard. Start with profitable, net cash companies. They are close to non-existent in the U.S. But not Japan. After that, I'm not sure I would necessarily just look at net-nets. For example, there are some cheap Japanese gas companies that are not net-nets (most of their assets are PP&E) but are super reasonably priced on an EV/EBIT basis. To me, it is more important to find totally obvious bargains than to get caught up in the definition of what a net-net is or isn't.

Totally obvious bargains fall into a few categories. Here are 2:

Stock market says the business is worth more dead than alive (profitable net cash stocks)
Stock is much cheaper than its peers around the world (gas companies)

In fact, if you really look, you may find some gas companies, grocery stores, etc. that are very cheap on an EV/EBIT or EV/EBITDA basis that you like better than some of the net-nets. That’s fine. Buy the most obvious bargains. The things that are clearly selling for less than they are worth.

If you're only going to buy half a dozen Japanese net-nets, you should look for net cash bargains. Once we are talking about receivables, inventory, etc. you need to know more about the business. So it needs to be a simple business or a business you can learn about. That's harder. For me personally that means it makes sense to buy net cash bargains in Japan and look for net-nets on the basis of receivables, inventory, etc. in the U.S. Because in the U.S., I have a better chance of knowing the difference between a predictable business and an unpredictable business.

If I could find 10 consistently profitable companies selling below net cash in the U.S., I wouldn’t buy any Japanese stock. Because I understand American businesses better. But I also understand that a consistently profitable company selling for less than net cash will work out as an investment regardless of how well I understand the business. And, of course, the idea is to buy a handful of these companies.

Not just one.

Talk to Geoff about Japanese Net-Nets

Check out the Newsletter

Variation

Geoff Gannon — Sat, 31 Dec 2011 17:03:55 +0000

Someone who reads my blog sent me this email:

Geoff,

Reading your articles. I am confused between standard deviation and coefficient of variation. Standard deviation itself shows how much variation exists from the average then what does coefficient of variation tells us?

Gurpreet

Standard deviation shows the amount of variation. Not related to anything. The variation coefficient shows the relative amount of variation. The standard deviation related to the mean. You should always relate the standard deviation to the mean. Otherwise, you will think height varies a lot among NBA basketball players because they are all tall while height varies little among children because they are all short.

Standard deviation is not a number that ports well. The variation coefficient is. It’s a way of seeing how big the swings above or below the average have been in terms of the average. Have they been one-third of the average? Or have they been the same size as the average?

For example, two companies can both have a standard deviation of 10% in their operating margins over the last 10 years. If one company has an average operating margin of 10% and the other has an average operating margin of 30% – that same 10% swing is going to feel very different. The variation coefficient tells you this. The standard deviation does not.

I need to make two points here. One, I use stats to describe. Not predict. Two, I use stats to compare. To rank. Different people have different reasons for measuring the things they measure.

If your goal – like mine – is to describe the past and compare different company’s pasts to each other, the variation coefficient is the right number to use.

Talk to Geoff About Variation

Check out the Newsletter

Investor Questions Podcast: All Interviews and Episodes

Geoff Gannon — Tue, 27 Dec 2011 02:04:43 +0000

Someone who reads the blog sent me this email:

Hey Geoff,

Thanks for posting up your old podcast episodes! Any chance you can put up the interview series episodes as well? Thanks!

-Drew

Sure. Here are links to all the interviews and episodes. Remember, they are old. So any references to stock prices, market conditions, etc. are out of date.

Interviews

Tariq Ali of Streetcapitalist (Interview/Site)

George of Fat Pitch Financials (Interview/Site)

Asif Suria of SINLetter (Interview/Site)

Jon Heller of Cheap Stocks (Interview/Site)

Toby Carlisle of Greenbackd (Interview/Site)

Episodes

Talk to Geoff About the Podcast

Faith in Net-Nets

Geoff Gannon — Sat, 24 Dec 2011 17:10:35 +0000

My latest net-net article over at GuruFocus includes my clearest explanation of what to look for in net-nets – and more importantly – what it takes to make money investing in net-nets:

If the balance sheet is very liquid and insider ownership is very high – there’s a good chance something will happen. I have no idea what. And I have no idea when. But someday, something will happen to increase the return on those assets…Sometimes it’s as simple as returning the assets to shareholders, using net cash to make a management buyout super cheap, or using net cash to buy a totally different business…When you buy a net-net you are not buying future earnings. You are buying future assets. What I’m talking about here is asset conversion. At some point, you are expecting today’s assets will be converted into something you can profit from. Something a control investor will pay for. Or something the market will reward.

It’s very hard to imagine these events ahead of time. But you can still bet on them:

That’s the uncertainty in net-nets. Most of the best net-nets have this certain/uncertain duality. It is certain the stock is selling for less than it’s worth. It is uncertain how the stock will ever sell for what it’s worth.

Remember what Ben Graham told the U.S. Senate:

The Chairman: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – by advertising or what happens?

Mr. Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it one way or another.

Talk to Geoff about Faith in Net-Nets

Check out the Newsletter

3 Net-Net Articles

Geoff Gannon — Fri, 23 Dec 2011 18:06:29 +0000

Here are the 3 net-net articles I've written over at GuruFocus:

When Is a Bad Business a Good Net-Net?

Risk in Net-Nets

How Many Net-Nets Are There?

Expect a new net-net article each Friday. The net-net newsletter comes out once a month. The next issue is set for January 6th. The newsletter picks one net-net a month. And holds each pick for one year. Starting in April, I'll be writing about the performance of each net-net as it exits the portfolio. So you'll get to judge the newsletter's results for yourself.

So far they've been ugly. 2011 was not a good year for net-nets. At least not in the U.S.

On the bright side, it looks like one of my Japanese net-nets - Sanjo Machine Works - is going to be bought out.

Even though Sanjo is just one-fifth of my Japanese net-net portfolio the 140% return on Sanjo will end up making 2011 a good year for the group despite my other four Japanese net-nets doing absolutely nothing pricewise.

Talk to Geoff About Net-Nets

Check out the Newsletter

Net-Net Series Starts at GuruFocus

Geoff Gannon — Fri, 02 Dec 2011 19:09:35 +0000

Today, I wrote the first of what will be a weekly series of net-net articles over at GuruFocus.

The article is called "How Many Net-Nets Are There?"

And the answer is 142.

By the way, a new issue of GuruFocus's net-net newsletter comes out tonight. It's free for GuruFocus Premium Subscribers.

The weekly articles are – of course – free for everyone.

The articles will appear each Friday. The newsletter comes out on the first Friday of each month.

Talk to Geoff About Net-Nets

Investor Questions Podcast Episodes

Geoff Gannon — Sat, 26 Nov 2011 15:48:06 +0000

Some people have asked where they can find episodes of my defunct podcast.

Here they are:

Talk to Geoff About the Investor Questions Podcast

Japanese Net-Nets: 6 Months Later

Geoff Gannon — Tue, 11 Oct 2011 20:53:09 +0000

It’s been about 6 months since I bought a basket of 5 Japanese net-nets.

A couple people have asked about how my Japanese net-nets have done. I started making these investments around April of this year. I wrote the “Buy Japan” post before buying my 5 Japanese net-nets. And it took me about a month of bidding for these micro caps to get my orders filled.

Since then, in dollar terms, the 5 stocks are up: 6.41%, 7.53%, 12.80%, 18.35%, and 20.88%.

You can use the March 16^th date of my “Buy Japan” post as a convenient way of measuring the influence the Japanese Yen / U.S. Dollar exchange rate has had on the performance of those stocks. For Japanese investors, your results would obviously not include these Dollar exchange rate changes.

Let’s just say these Japanese net-nets have done better than my U.S. net-nets this year. It doesn’t matter if you are calculating returns in local currency or dollars. My Japanese net-nets have been my best performers this year.

I will re-evaluate the positions around June of next year.

I generally hold net-nets for at least a year before considering whether they should be sold. This gives them time to run.

Most people sell net-nets too fast because they dislike the underlying businesses and are not used to having such large gains in a single year.

Of course, the truth is that a net-net that rises 50% or even 100% is usually still a very cheap stock. So it’s silly to sell a net-net just because it’s gone up.

Talk to Geoff About His Japanese Net-Nets

Mr. Market’s Predictive Power – June 1914

Geoff Gannon — Mon, 10 Oct 2011 21:56:27 +0000

On June 30^th 1914 the New York Times ran the headline:

Trading Very Dull, with Prices a Little Lower

The article had this to say about Europe:

The assassination of the heir to the Austrian throne was an event whose consequences were closely considered by the markets abroad, but the calmness which they showed indicated clearly that political complications were not feared as a result of this incident. Indeed, the view that it would tend to lessen rather than to increase political strife in Southeastern Europe found wide acceptance.

Talk to Geoff About Mr. Market’s Predictive Power

How Should You Value Journal Communications (JRN)?

Geoff Gannon — Mon, 10 Oct 2011 18:03:31 +0000

Someone who reads the blog sent me this email:

Hi Geoff,

The thing I have been pondering is what are the tools in valuing a shrinking / dying business. The one I have been looking through is Journal Communications (JRN).

They trade under their book value, but only half of that is tangible so the market price would be about 1.5x tangible book. Most of that is PP&E so definitely no net-net situation. The bright side is that if you own 33 radio stations, 13 TV stations & a bunch of local newspapers there has got to be some intangible value there. Is it worth the 110m in the books is a whole other story.

I’m a bit stuck as what should I use to value the business. If I just take the average 10% FCF margin, apply that to current year revenues of ~370 & discount that to perpetuity with 22% (which is basically a hurdle rate of 10% + historical shrinking rate of revenues ~10-12%) I get something in the range of the current market valuation. The problem is that in real life your depreciation can´t exceed cap-ex till the end of days (if we ain´t liquidating) so the FCF would need to start to come down when they have to start to upkeep their PP&E. On the other hand the management has shown that they can keep ROE reasonable so the raising of cap-ex wouldn´t be such a bad thing IF they could maintain those revenues.

On second thought, am I barking the wrong tree here. Should I focus on the intangibles? I’m pretty sure the company is at least worth its book value (including the intangibles).

What got me to think about this was your article on Asset-Earnings Equivalence. Simplified I just see a lot of assets that have been historically successfully converted into cash (ok so there have been a couple of crappy acquisitions as always the case).

Best Wishes,
Pekka

One of the people I email back and forth with quite a bit is Gurpreet Narang. Here is his write-up on Journal Communications.

Gurpreet Narang's Report on Journal Communications (JRN)

And now my thoughts.

You're absolutely right when you say:

On second thought, am I barking up the wrong tree here. Should I focus on the intangibles? I’m pretty sure the company is at least worth its book value (including the intangibles).

What got me to think about this was your article on Asset-Earnings Equivalence. Simplified I just see a lot of assets that have been historically successfully converted into cash (ok so there have been a couple of crappy acquisitions as always the case).

That's really where you turned your thinking in the right direction. Asset-earnings equivalence is the way to understand Journal Communications (JRN). This is both good and bad. On the good side, the asset values – when you actually go out and look at what radio stations and TV stations sell for – are well above the value of the company's stock in the market.

But now the bad news. A company doesn't just earn money on its assets. Its earnings often become more assets. Over time, earnings are reinvested in the business as assets. This is not true of all businesses. The best businesses do not require much reinvestment. But – even when a company does not require reinvestment – management often chooses to reinvest in the field it sees itself operating in.

Many companies don’t define themselves in terms of what drives their profits. We call Google, Microsoft, and Apple tech companies. Really, Google is an advertiser supported media company. Microsoft is a business services company. And Apple is a luxury consumer goods business.

That’s how they make their money. But it’s not where they intend to put their money. They see themselves as tech companies. That tells you what new assets they will buy with their old earnings.

One of the concerns with any business is where the cash thrown off by the assets will eventually end up.

I have no special love for dividend paying stocks. But I do like it when you know – or think you know – where a company will put its cash. I write about a company like Birner Dental Management (BDMS) or Omnicom (OMC) or Fair Isaac (FICO) because I think I know the assets they have and the cash flows they will produce. That’s true.

But there's a bigger point. I think I know where they will put that cash. I think investment outside of their narrow field will be limited. I think BDMS will pay dividends, buy back stock, and buy or open some dentist offices every year. I think Omnicom will acquire some ad agencies – but will ultimately decide it can't reinvest most of its earnings. I definitely think that is true at FICO. Especially under the management that came in a couple years back.

What does this have to do with Journal Communications?

Everything.

Journal Communications is named for the Milwaukee Journal Sentinel. It is largely owned by employees. It only became a publicly traded company – with different classes of stock – in the last decade.

This is a business tied to newspapers. If you could separate that newspaper I would feel fine about the business. If you had Warren Buffett or Henry Singleton running the place, I'd feel fine.

The theory that you could reallocate cash flows from the newspaper, radio, and TV stations into buying more TV stations – that’s a great theory.

The math on that theory works.

But it's a theory. And I worry that it won't pan out in practice.

The key here – as in my Barnes & Noble (BKS) mistake – is the human element.

Just how much were they willing to sink into the Nook? As it turns out, B&N seems willing to sink years of free cash flow from the stores into the Nook if that's what it takes. They'll end up spending a good portion of the entire market cap of the company on this device. And you may have noticed Amazon came out with something even newer and better called the Kindle Fire. Amazon will keep doing this every year. Barnes & Noble will need to spend a lot to stay in place. That’s not the kind of business you want to own.

It will earn a lot. But then it will go out and blow those earnings.

We have the same sort of problem here.

The newspaper is making money. But it won't keep making money.

Newspapers in the U.S. only work as dominant local papers. They are advertiser supported. The death of classified advertising as much as circulation declines killed these papers.

This is sometimes misunderstood. People say that you have to make Americans learn to pay for their news again. The problem with that idea is that Americans never paid for general news. No one in the U.S. actually paid for the cost of their news. Subscribers paid maybe 25 cents per dollar of a newspaper company's revenues. That's less than half what it cost to produce the paper. You would've had to more than double the price of papers just to run them as non-profit enterprises. It was never about readers alone. Readers never valued newspapers enough to make them profitable. Advertisers valued readers. And newspapers had readers. So advertisers valued newspapers.

It was about having the biggest megaphone in town. And renting that megaphone out to advertisers. That's how profitable papers worked.

Online media works the same way. The business of Google, Facebook, etc. looks exactly like the business of local media. It just isn’t local. But you still have to be either broad and dominant or narrow and necessary.

The Milwaukee Journal Sentinel was broad and dominant. It was the Buffalo Evening News of Milwaukee.

That’s changed. The advertisers have moved on. The readers have moved on. The paper is making money for now. But it’ll start losing money soon. It could conceivably lose a lot of money. Exactly how much money it loses depends on how much the parent company is willing to subsidize losses in the newspaper with profits in TV and radio.

That's the question you should focus on here.

Do I understand this company? Its management? The culture?

How do they see themselves?

Do they have an interest in running a money losing paper for years and years as long as shareholders can subsidize those losses with TV and radio?

That's the question.

As for the value, it definitely exceeds the stock price.

If you had control of the company, you could profitably increase its value far beyond the current market cap. All you need to do is starve the newspaper, keep the balance sheet clean (a big advantage over JRN's competitors), and take the cash flow from radio and TV and direct it away from newspapers and toward intangible media assets that might actually hold their value over time.

This news about McGraw-Hill selling their TV stations to Scripps for $212 million might help you value that part of JRN's business.

Scripps says the effective price is really $190 million because of tax benefits. Scripps also says this is 8 times cash flow.

I would look at the price-to-sales multiple for something like a TV station. Free cash flow margins are very high at TV stations. The amount that needs to be reinvested is minimal. It's like having a government charter to exploit an area.

The multiple here is basically 2 times sales. If you believe Scripps about tax advantages the $190 million price tag is 1.96 times the $97 million in revenue those stations had. We can apply the same roughly 2 times multiple to JRN's TV stations – which had revenue of $105 million last year – and get a value of about $210 million for the TV stations JRN owns.

That just gives you some idea of how much these properties might be worth. You can do the same thing with the radio assets by searching Google News for reports of radio station sales or by checking the enterprise value to sales ratio for pure play radio station companies in the U.S.

All of these companies are heavily indebted. That's one of JRN's big advantages. Almost no one who just owns TV stations or radio stations in the U.S. has a clean balance sheet. They are totally unprepared for any long-term downward trend in station revenues. And they may become motivated sellers at some point.

This would be a big plus for JRN. If they were going the route of shutting down the newspaper when its time came and focusing on other media assets.

That’s the big question in this investment.

It's easy to fool yourself into thinking people will do the rational thing. Businesses are alleged to be much more rationally self-interested than they really are.

The truthth is: businesses have crazy hopes and fears just like the rest of us.

And they can be just as self-destructive when their identity is threatened.

Talk to Geoff About Journal Communications (JRN)

12 Stocks I’d Consider Buying

Geoff Gannon — Mon, 10 Oct 2011 17:38:45 +0000

Someone who reads the blog sent me this email:

Hi Geoff,

My question for you is about the recent market correction. I know you might not be comfortable talking about any stocks you bought, but I'd love to hear anything you can say about how you approached Mr. Market's most recent mood swing; what kind of actions did you take? Did you stick to pre-researched stocks on a watch list or did you go into overdrive with researching new businesses? I guess my question is mostly about mindset and preparedness. How do you prepare for this, and what does your thought process look like while it's happening?

Thanks,
Mike

I answered Mike’s question over at GuruFocus.

In my article, I talk about 12 stocks I’d consider buying:

1. Omnicom (OMC)

2. Regis (RGS)

3. Fair Isaac (FICO)

4. Moody’s (MCO)

5. Dun & Bradstreet (DNB)

6. Birner Dental (BDMS)

7. VCA Antech (WOOF)

8. Prestige Brands (PBH)

9. Carnival (CCL)

10. Dreamworks (DWA)

11. Nintendo (NTDOY)

12. CEC Entertainment (CEC)

Talk to Geoff About Stocks He’d Consider Buying

The 4 Questions to Ask Before Buying a Stock

Geoff Gannon — Fri, 07 Oct 2011 15:37:38 +0000

Someone who reads the blog wrote me this email:

In your recent article you wrote:

"Intrinsic value is a guess. Buying is the belief. You don’t need to
use a lot of math to prove exactly what something is worth. You just
need to present a convincing case for buying it."

Interesting observation. I've seen a few YouTube vids with Bill Ackman
in them. The interviewers have sometimes pressed him for what he
thinks a stock is worth. He never gives a numerical answer. I get the
distinct impression that he never has a definite intrinsic value X
when he buys a stock; only that a stock is "clearly undervalued" at a
current price. As Ben Graham would say: you don't have to know a man's
weight to know that he is fat.

All the best,
Mark

I think there are really 4 questions you answer before buying any stock:

Is it safe?
Is it a great business?
Am I getting a great price?
Can I hold this stock for as long as it takes?

The ideal stock would get 4 “yes” answers.

The 5 Japanese net-nets I own do not get 4 “yes” answers. But I made sure they passed questions #1, #3, and #4.

A lot of differences in style come down to how you answer these 4 questions. Someone emailed me saying he thought Mohnish Pabrai was more of a Ben Graham investor than a Warren Buffett investor.

Not really. Graham was obsessed with question #1. He wanted to know a stock was safe. Pabrai cares less about #1 and more about #3. Pabrai’s overwhelming focus is on getting a great price.

Graham wanted a great price. But safety always came first.

There are stocks Pabrai has owned that Graham wouldn’t. Nothing wrong with that. Different people invest differently.

We all rank these 4 questions a little differently. We obsess about one. And our standards are a little too loose on one of the others.

But I think most stock decisions come down to these four questions.

If you can answer those questions – you don’t need an exact estimate of intrinsic value.

Talk to Geoff About The 4 Questions to Ask Before Buying a Stock

Some Good Stock Analysis For You

Geoff Gannon — Fri, 07 Oct 2011 03:25:08 +0000

Here’s some good stock analysis for you.

Whopper Investments and Oddball Stocks spar over net-net ADDvantage (AEY). Whopper Investments owns the stock. Oddball Stocks explains why it’s a pass.

And Andrew August at The Frog’s Kiss writes about Dreamworks (DWA). It’s a 14 page report. After reading his analysis, I emailed Andrew saying it was “the best analyst report I’ve ever read.”

I’ll say that here too.

This is the best analyst report I’ve ever read.

You’ll notice Andrew never puts an exact value on the stock. Which tells you something about good analysis.

A lot of value investing blogs and articles calculate intrinsic value for you. If you read Ben Graham and Warren Buffett – you’ll see they almost never do this.

Intrinsic value is a guess. Buying is the belief.

You don’t need to use a lot of math to prove exactly what something is worth. You just need to present a convincing case for buying it.

Talk to Geoff About Stock Analysis

Valuing Financial Companies: ROIC, ROE, or ROA?

Geoff Gannon — Sun, 25 Sep 2011 16:48:15 +0000

Someone who reads my blog sent me this email:

All else being equal, which measure is preferred for financial firms such as banks: ROIC or ROE? I am using ROIC for non-financial firms but I didn't know if it gave a useful reading for financial firms or not.

Thanks,

Chad

ROIC is not useful.

For non-financial companies:

I know you like ROIC. But I think it’s too clever by half.

I use the pre-tax return on tangible invested assets.

In other words, I look at what a company earns and divide those earnings by the assets on its balance sheet excluding cash and intangibles.

For financial companies:

Normally you use return on assets. Then you multiply ROA by an appropriate leverage ratio.

Say Wells Fargo (WFC) has a long-term average ROA of 1.3%. If in the future you expect banks to be levered 10 to 1, you would multiply 1.3% times 10 to get a 13% ROE. If you expect normal leverage to be 12 to 1 – you’d multiply 1.3% times 12 to get a normal ROE of 15.6%.

And so on.

For a good discussion of financial companies, read Variant Perceptions.

Talk to Geoff about Financial Companies

Ted Weschler’s Portfolio

Geoff Gannon — Tue, 13 Sep 2011 08:59:40 +0000

Yesterday, Warren Buffett’s Berkshire Hathaway (BRK.B) announced it hired Ted Weschler as an investment manager. Weschler will manage between $1 billion and $3 billion of Berkshire’s money. He starts next year.

Weschler currently runs a hedge fund.

Here is his latest portfolio:

DirecTV (DTV): 25.98%

W.R. Grace (GRA): 25.11%

DaVita (DVA): 19.04%

Liberty Media (LCAPA): 11.83%

Valassis Communications (VCI): 7.74%

Cogent Communications (CCOI): 3.48%

Cincinnati Bell (CBB): 3.36%

WSFS Financial (WSFS): 3.04%

Fibertower (FTWR): 0.42%

These are long positions only. Weschler shorts stocks and uses leverage. For details, see Carol Loomis’s story.

Weschler is an investor after my own heart. His top 5 positions make up 90% of his portfolio. And he spent time at two of the companies he owns: W.R. Grace and WSFS Financial.

The W.R. Grace connection is well documented.

Weschler became a director of WSFS in 1992. He’s 50 now, so he must have become a director of WSFS at 31 or 32. By age 34, Weschler is shown as a director of 6 different companies. And described as “the general partner for several investment partnerships.”

Weschler worked for Quad-C which controlled Thrift Investors LP which in turn owned 24.81% of WSFS Financial back in 1996 (the earliest date when WSFS filed with EDGAR). So, in reality, Weschler was WSFS’s biggest shareholder as far back as the 1990s.

This supports the general impression that Weschler – like Buffett – buys what he knows. He holds few stocks. And he has relationships with some of these companies going back many, many years.

Talk to Geoff About Ted Weschler

Recent Articles at GuruFocus

Geoff Gannon — Wed, 31 Aug 2011 19:58:10 +0000

Barnes & Noble (BKS): Anatomy of a Screw Up

Invest with Style

Adapt!: Trial and Error Investing

I've gotten a lot of good email questions lately. Usually, my GuruFocus articles are based on questions sent in by people who read the blog.

So if you want to read more articles: Send me your questions!

Ask Geoff a Question about Investing

Interviews - Street Capitalist, Fat Pitch Financials, SINLetter, Cheap Stocks, and Greenbackd

Geoff Gannon — Thu, 02 Jun 2011 17:32:34 +0000

Interviews

Tariq Ali of Street Capitalist

George of Fat Pitch Financials

Asif Suria of SINLetter.com

Jon Heller of Cheap Stocks

Toby Carlisle of Greenbackd

Talk to Geoff about the Interviews

Asset-Earnings Equivalence

Geoff Gannon — Wed, 01 Jun 2011 19:33:51 +0000

Someone who reads the blog sent me this email:

When it comes to valuing a business, do you believe more in asset valuations or earning? Earnings aren't guaranteed to be there in the future (depending on the industry, of course), but assets are only worth what you can sell them to somebody else for. Do you think a pizza shop should be analyzed based on how much pizza they sell or the value of its real estate & bank account? Should they all be assessed when determining a value for the business? This is the question i've been thinking about in trying to understand valuation…

I think earnings and asset valuation are kind of the same, because operating (earning) assets generate earnings. So the value of those earning assets are the present value of future expected earnings (owners' earnings) generated by those assets…Then I think we need to add things like real estate, cash, marketable securities which i think are non-earning or non-operating (core) assets, then subtract liabilities to arrive at value of the firm as a whole.

Assets and earnings are equivalent.

You can always restate an asset in terms of earnings. And you can always restate earnings in terms of an asset.

You can always ask: what would this asset have to earn to be worth what the balance sheet says it's worth? And you can always ask what someone would pay for a certain amount of earnings. If they'd pay that amount that means they'd trade you cash today for those earnings. And that means earnings can be thought of as being worth their (cash) sale value. So earnings can always be thought of as if they were an asset.

In physics, mass is a measure of the energy content of a body.

In investing, value is a measure of the earning content of a specific instance of capital.

When I say a business will provide earnings of 40 cents a share pre-tax and a business is worth $4.00 a share – I’m really saying the same thing under special conditions (certain interest rates).

Intrinsic value is always relative.

You can't value anything without a reference point.

There are two ways you can value an asset. You can value it in static terms by comparing it to other assets and valuing the asset against them. This uses other assets as your reference point. Or you can value an asset by restating it as a flow of earnings and comparing that flow to the price-to-free cash flow multiples of other businesses. This uses other cash flows as your reference point.

Really, you’re just valuing the same thing – capital – in two different states.

This is very obvious if you look at businesses over time. Or if you look at special situations. Or deals of any kind.

Basically, capital starts its life in a business with no earnings and a lot of potential. Then it gets put into all sorts of specific forms (real estate, inventory, receivables, intangibles). These forms produce cash flows which throw off earnings that again build up as assets of some kind.

The process is constantly cycling.

Understanding this idea of asset-earnings equivalence will help you avoid errors caused by a one track mind.

Take the example of a business that has $4.75 in cash per share and 40 cents in pre-tax earnings per share. Let’s say the stock trades for $4 a share. Sounds fair, right?

After all, that’s a P/E of 15 after-tax. Hardly cheap.

Here’s the problem with that logic.

Let’s say businesses can be bought and sold for 10 times pre-tax earnings in our little investing universe. At first – from an earnings perspective – it seems fair for a stock with 40 cents in pre-tax earnings to trade for $4.

But then we remember that assets and earnings are equivalent. Obviously, if businesses really can be bought and sold for 10 times pre-tax earnings, the company we’re looking at can just use its $4.75 in cash and buy another 47.5 cents of pre-tax earnings by going out and acquiring another business. But then the stock would have 87.5 cents of pre-tax earnings, which would make the stock worth $8.75 a share. Not $4.

Again, we’re just saying the same thing two ways. An asset worth $4.75 plus 40 cents of pre-tax earnings equals $8.75 a share (if 10 times pre-tax earnings is a common multiple at the moment).

Capital on the balance sheet is just potential earnings on some future income statement.

But – and this is where we get into the softer side of the science of investing – capital doesn’t move as freely from each of its special forms.

Cash can turn into earnings very easily because it can be converted into any other form of capital instantly.

What about land? What about inventory? What about machinery?

It depends.

Some of these assets are stuck capital. Machinery is often such a special and rigid form of capital that it’s economically equivalent to a prepaid expense.

I pay my website hosting fees ahead of time and my website stays up for another month. It’s a prepaid expense. The only value I get out of this asset is the use I put the website to over the next 30 days.

Likewise, machinery may be carried on the balance sheet at its original cost less accumulated depreciation – but it’s really just worth however much use you can get out of it.

That’s not true of cash.

And it’s not true of assets like inventory and receivables if – and only if – they can be turned into cash and removed from the business under certain circumstances.

Often, when sales decline, inventory and receivables can be turned into cash and put to use in new lines of business.

That’s part of the genius of Ben Graham.

He focused on current assets. Under many – but not all circumstances – current assets that are underperforming in terms of earning production can be turned into other forms of capital that will earn the returns generally available in the economy.

You can apply this test to any stock you buy for its assets. Just pick a rate of return – I suggest using the 30-year AAA corporate bond yield – and apply it to the tangible invested assets of the stock you’re looking at.

Remember to separate invested assets from assets that have accumulated on the balance sheet – like cash – that aren’t being used in the business. Then apply the long-term rate on safe business bonds (today it’s 5%) to the invested capital inside the business.

So, take a business with $12 of invested tangible book value and multiply that $12 per share times 5% to get 60 cents in pre-tax earnings potential. That gives you some idea of what the business’s capital could produce in earnings if put to use someplace else.

Why does the earning potential of capital matter if the capital isn’t earning up to that potential now?

Two big parts of net-net investing are return of capital and transformation of capital. Return of capital means turning more and more assets into cash and kicking them back to shareholders. Transformation of capital means investing the same old capital in new and different ways.

So how should you value a business? Should you use earnings or assets?

I don’t look very hard at a stock’s earnings unless I think there’s something special about the kind of capital in the business.

Take FICO.

Each of those four letters F-I-C-O are probably worth between $100 million and $150 million. In other words, the FICO name is worth $400 million to $600 million easy.

Intangible assets are often carried on balance sheets at amounts that have nothing to do with their economic value. So when I look at a business like FICO, I look at the earnings. They give you a clearer idea of the value of the intangible assets the company controls.

The same would be true of a movie library. It’s often easier to look at the cash the library throws off than the amount the library is carried on the books at.

Talk to Geoff about Asset-Earnings Equivalence

LEAPS - And a Lack of Good Ideas

Geoff Gannon — Wed, 01 Jun 2011 14:27:29 +0000

Someone who reads the blog sent me this email:

Dear Geoff,

in your article "Should you Buy Microsoft?" on GuruFocus, you said, that it makes sense for some investors to use LEAPS instead of the stock.

After thinking long about that, I came to the conclusion, that LEAPS can be viewed as a form of leveraged investment with an insurance against a falling stock price included...So LEAPS would make sense, if you want to leverage your portfolio with relatively low risk.

I'm not endorsing LEAPS.

I think they make sense only in situations where there is a level of catastrophic risk in the underlying stock that is not priced into the option. In general, this means low volatility stocks that nonetheless can fail catastrophically if infrequently.

Like banks.

I would use LEAPS to buy a bank because there is always the risk that a bank will go to zero. In that sense, LEAPS leverage your investment and provide protection - basically an involuntary surrender - where you cut down a huge loss while still betting on a favorable outcome.

The problem with LEAPS is that they aren't long enough dated. 5-year LEAPS would be good. 10-Year LEAPS would be virtually indistinguishable from a stock in terms of a correct analysis resulting in profit. But 2 years is not long enough for a value investor. If Warren Buffett had bought Washington Post 2-year LEAPS instead of Washington Post stock in the 1970s he would have lost his entire investment. By buying the underlying stock, he had a return of 30% a year compounded over the first 10 years.

I’ve had stocks that didn’t work out for 2 years. But, boy, did they work out over 5 years. I would've lost money on the LEAPS.

Any bet that depends on the market recognizing something within 3 years is a bet where a value investor can be completely right in terms of analysis and yet lose everything simply because the clock runs out.

Value investing is largely based on being able to hold a position until the market changes its mind. I'd say it's very unreliable to assume mean reversion in the market mood on a stock within 3 years.

The exception to this is when you're diversifying both across a group of separate bets and across a period of time. For example, if you buy one stock a month every month and turn over the portfolio every year (by swapping out one stock each month), you may average an acceptable result because you're actually making a dozen different bets on a dozen different stocks that depend on prices at a dozen different future moments in time.

That's not what you're talking about. You're talking about making one bet on one stock that will succeed or fail based on whether or not the stock reaches a certain price fast enough.

Personally, I'm not interested in LEAPS.

And I really don't think it makes sense to buy LEAPS on a stock like Microsoft. It makes much more sense to simply put a huge part of your portfolio into the stock if you believe in it so much.

This is something people overlook. The best way for most investors to leverage a good idea is simply to bet big on it. If you look at Microsoft and then you look at the S&P 500 - it's very clear that right now you're not giving up much by putting a lot of your portfolio into Microsoft because the opportunity cost is very, very low.

The risk/reward on the S&P 500 specifically - and stocks generally - is lousy right now.

I don't really get why someone would want to put 5% of their portfolio into Microsoft LEAPS instead of putting 25% of their portfolio into Microsoft shares.

I'm not exactly drowning in good ideas over here.

But different people see these things differently.

Personally, I'd opt for 25% in Microsoft shares rather than 5% in LEAPS.

I don't own any of either. And have no plans to buy Microsoft in any form.

As far as LEAPS themselves, it’s probably best to look at LEAPS as offering you the ability to do two things:

Surrender
Buy something else

Putting less money down only offers two real benefits.

You get to have your cake and eat it too. Or, rather, you get a return on your capital without putting all of that capital out there. And you get the chance to lose only a portion of the capital that would be necessary to buy the underlying stock.

But that’s really all leverage offers. The idea that leverage is attractive when you don’t have more ideas than money is kind of silly. Leverage only works in situations where you wish you had more cash to buy stocks than you have now.

Looking at the opportunity cost of using capital, I’d say LEAPS don’t make much sense for most investors given today’s stock prices. They’re high. Future returns will be low. By holding cash you may have the chance to invest more in the future when stock prices are lower and returns on your investment will be higher.

So there’s strong logic behind the idea of holding cash right now (simply because there aren't better places to put it). And there might be strong logic to holding Microsoft shares right now.

But where’s the logic behind buying Microsoft without using a full serving of your own cash?

I don’t see it. There’s a big gap between the opportunity Microsoft offers and the opportunity most stocks offer right now. Since the opportunity offered by most stocks is so low, why not just use cash (and forfeit those bad options) to buy Microsoft stock outright?

If you’re buying LEAPS instead of buying the stock itself, you need to ask yourself what exactly you intend to do with the capital you’ve saved. Do you really have good uses for it? Uses that are worth the risk you are taking by greatly increasing the chance of permanently losing all the capital you put into the LEAPS?

I don’t think it makes sense to use leverage of any kind when the price of the assets you like to buy is high. It makes the most sense to borrow when the general price level of the assets you tend to own – presumably stocks – is especially low.

That’s when you’re likely to get the most bang for the bucks you invest. It’s also when the opportunity costs are highest because capital is scarce relative to opportunities.

I don’t see that right now. Capital is plentiful. Ideas are scarce.

So, if you find a good idea – like Microsoft – why not just load up on it with a big chunk of your own capital instead of making a leveraged bet?

I think most investors either have plenty of cash or plenty of fairly and – let’s be honest – overvalued shares lying around. Sell those to buy Microsoft.

Don’t buy LEAPS unless you’re sure you’ve got more good ideas that money.

You might.

I don’t.

So if I was buying Microsoft - I'd just buy a ton of the stock. I wouldn't buy the LEAPS.

Talk to Geoff about LEAPS

CCA Industries - Sardar Biglari

Geoff Gannon — Wed, 01 Jun 2011 13:20:13 +0000

Someone who reads the blog sent me this email:

Geoff,

I see you tweeted about CAW again. What about that company attracts you? I don't see that it is particularly undervalued and I am trying to understand what I am missing.

Sardar Biglari bought into the company. He will now have 2 board seats.

10-year average EBIT is about $5.75 million. So, the long-term average earnings would be about 50 cents a share after tax. Cash and securities is about $1.67. The stock trades around $6. That's maybe a little less than 10 times earnings (after breaking out the cash).

Here's the types of business they are in.

Dietary Supplement: 33%
Skin Care: 30%
Oral Care: 20%
Nail Care: 10%

Free cash flow tends to be equal to or greater than reported earnings. Cap-ex is virtually zero.

High management pay relative to the company's size hides how profitable the business is.

For example, David Edell and Ira Berman made $2.88 million in 2009. This is against - like we said - an average EBIT of about $5.75 million. So, we're talking more like $8 million+ in EBIT before these two get paid. Other executives are paid more what you'd expect the top folks at this kind of public company would normally make: $300,000 to $500,000.

I checked out the company's products at a local drugstore. Though there will always be lawsuits, I thought it was a decent space to compete in. In the past, I'd researched a couple companies with similar business models. They had better brands. But CCA Industries was much cheaper.

Given the circumstances, I felt Biglari's activism would lead to good things.

It's coattail investing.

Talk to Geoff about CCA Industries (CAW) and Sardar Biglari

How Does Warren Buffett Apply His Margin of Safety?

Geoff Gannon — Thu, 26 May 2011 07:32:32 +0000

Someone who reads the blog sent me this email:

Geoff,

In a previous email to me you explained how Warren Buffett values a company. The text that your wrote was:

"He wants his investment to increase 15% in value. For every $1 of capital he lays out today he wants a day one return of 15 cents. That means a 15% free cash flow yield or buying a bank with an ROE of 15% at 1 times book or buying something for less than a 15% initial yield as long as it is growing."

I understand that no problem whatsoever. However, I am just curious. How does he apply a margin of safety (for example 50%) to this fcf yield valuation? Thanks for the help.

Chad

He doesn't.

Buffett has said that with something like Union Street Railway - bought back in the 1950s - he saw the margin of safety was that it was selling for much, much less than its net cash. For Coca-Cola the margin of safety was the confidence he had in future drinking habits around the world.

Buffett felt sure people would drink Coca-Cola in larger and larger amounts per person per day in countries where Coke had been introduced more recently than in the United States. History was on his side. Per capita consumption of Coke had been rising everywhere for years. In contrast, history was not on the side of Union Street Railway.

Passengers - Union Street Railway

1946: 27,002,614

1947: 26,149,937

1948: 24,224,391

1949: 21,209,982

1950: 19,823,933

1951: 18,736,420

Bad trend.

But Union Street Railway had $73 in cash and investments – not a single penny of which was needed to run the actual business. The stock traded between $25 and $42 during 1951. So, even at its high for the year, Union Street Railway's stock was trading for more than a 40% discount to its net cash.

At its low, the company's cash covered its stock price almost 3 times.

Union Street Railway had a big margin of safety.

But so did Coke.

Buffett believed both Union Street Railway and Coca-Cola had an adequate margin of safety when he bought them.

With Coca-Cola it came from human drinking habits. With Union Street Railway it came from the cash and investments on the balance sheet.

Buffett was as confident in Coca-Cola as in Union Street Railway.

It's just that his margin of safety in one case was people's buying habits and in the other case it was the cash on the balance sheet.

Buffett doesn't apply some standard 50% margin of safety to an intrinsic value estimate.

He just looks for situations where he's confident his investment will earn an adequate return from day one far into the future.

And he wants to pay less than the stock is worth.

But that doesn't mean it's necessary to do an actual intrinsic value calculation and then slap on some percentage discount to that value.

It just means seeing the obvious.

It means seeing that Coca-Cola is priced like it's going to have a fine future when it's clearly going to have an extraordinary future. Or seeing that Union Street Railway is priced like the business itself isn't just worthless but worth such a big negative number that it offsetts the huge amounts of cash and investments the company piled up over half a century.

It's not about rules. It's about common sense.

Just ask yourself what's the chance you'll lose money on the stock - in the long run - if you buy it at today's price.

Buffett figured the chance was very, very low for both Coca-Cola and Union Street Railway. There was no rule to give him the right answer in both cases. He needed to apply a little common sense thinking to each stock's unique circumstances.

Talk to Geoff about How Warren Buffett Apply His Margin of Safety

Warren Buffett: Microsoft Looks Cheap - But My Relationship with Gates Means I Can't Buy

Geoff Gannon — Sun, 01 May 2011 16:02:17 +0000

Warren Buffett just did a video interview with Reuters.

Here's what he said about Microsoft (MSFT):

Reuters: You’re always looking for value. What about Microsoft? I know you say you don’t do tech. But given that it has a forward P/E right now that’s below 10, it seems like a value play.

Buffett: Yeah. I agree with you. I regard myself as precluded from either personally or having Berkshire buy Microsoft because if something good happened the following week people would think Bill had told me. So I just see no way that we can ever buy Microsoft and be sure that we won’t look like we had some kind of inside information or something. So it’s off limits. It did look pretty cheap.

Talk to Geoff About Microsoft

My Investing Checklist

Geoff Gannon — Tue, 26 Apr 2011 04:47:51 +0000

Risks

Catastrophic Loss
Failure to Snowball

Numbers

Altman Z-Score
Piotroski F-Score
Free Cash Flow Margin
Return on Capital
Free Cash Flow Margin Variation
Return on Capital Variation
Enterprise Value/10-Year Real Free Cash Flow
Enterprise Value/10-Year Real Earnings Before Interest and Taxes
Price/Net Current Asset Value
Price/Tangible Book Value

Questions

Is it crazy cheap?
Has it been profitable for a long, long time?
Does it do the same thing year after year?
Are folks who use the service happy to leave some cash crumbs on the table?
Is the value the company provides intangible?
Will existing customers stay even if a competitor lowers its price?

Talk to Geoff About His Investing Checklist

Stock Analysis Process - How Geoff Researches Stocks

Geoff Gannon — Mon, 25 Apr 2011 05:55:46 +0000

Someone who reads the blog sent me this email:

I'm interested to know when you analyse a company, do you follow a particular order? Do you always start from a screen? Do you look at its overall business and competition landscape before diving into its financials? And when you look at its financials, do you follow a particular order? Do you look at its income statement first and then balance sheet?

I don't have a particular order for finding a stock/company. I do screens and stuff like that. I read blogs. I look at company's competitors. I just go through some foreign stock exchanges from A to Z. Or some states from A to Z. Or some industries from A to Z.

Basically, I'm looking through lists of companies the way I figure Warren Buffett flipped through Moody's Manuals. I'm moving quickly to see if the company is really cheap compared to past earnings and current tangible assets and current sales. But I'm not doing any math, I'm just using websites like GuruFocus or Morningstar or MSN Money or the stock exchange sites, or the company's 5-year or 10-year financial summaries. You can find something like that online for a lot of companies and then you quickly just run your eyes over those numbers. Are they pretty ordinary looking? If so, just move on. If something pops, stop and look at the stock.

If any number catches my eye - like a ton of excess cash, or low p/b, or low p/s, or low EV to past EBIT, FCF, etc. I look at the company description. Usually I'll use Bloomberg for this or the company's own website. What does the company say it does? If it says it invests in real estate, copper mining, is an investment bank, etc. I drop it there. If it says it does something I think I can visualize if I work real hard at it, then I keep going. I look for words like "niche", "specialized", etc. I look for business descriptions that sound non-capital intensive. Do you test or monitor or score or report? That's good. Do you make capital goods? That's bad. Do you make something cheap and repeat purchased, that's good? Do you distribute? Good. Produce? Bad. Do revenues sound recurring? Are you a one of a kind company? A possible "hidden champion"?

This is all from the one paragraph description. Some are pretty inaccurate. But a lot aren't. You get interested in Bunzl real fast when you read about it, because of what the business does. This is the Bloomberg description for Bunzl:

Bunzl plc is a distribution group supplying a range of non-food consumable products for customers to operate their businesses but which they do not actually sell. The Company partners with both suppliers and customers in providing outsourcing solutions and service oriented distribution. Bunzl's main customer markets include grocery, foodservice, cleaning and safety.

Really, those are the only words I saw. They distribute. It's not food. It is consumable (great!). The customers need it, but they don't sell it. What could be better? And then who are the customers? They're "grocery, foodservice, cleaning and safety". I think I can understand those.

Then I probably go the LSE site if I haven't done that already and just run my eyes over operating income, return on capital, and whether revenue is up/down over last 3 years and magnitude of move. I still haven't calculated anything, just used my eyeballs.

Finally, I go to the company website. I want to make sure it's geared to customers instead of investors - unless it's a holding company or decentralized to the point where customers see name different from the one on the HQ. Except for that possibility, I want to make sure this isn't a promotional company. They can report their financials and have reports and stuff, but I'd rather not see a lot of investor oriented stuff on the front page. I want them to use the site to communicate with customers. I don't want it to feel like an IPO. The company should be unknown, unloved, unadvertised. That would be ideal.

Now, I go to the annual report (if the company has one - otherwise I settle for the 10-K). I open it up and peruse it. I read the entire letter from the CEO/Chairman. I glance at graphs/charts/table they include. What factors do they focus on? Do they talk about free cash flow? Good. Combined ratio? Good. Record Sales? Eh. Consecutive reading breaking years? Great.

At this point, I go to the financial statements and check operating cash flow and cap-ex. I'd like free cash flow to be positive. I check for operating income - though I probably saw this on the internet already - and want it to be positive too. I shouldn't see negative numbers anywhere. It should look like a business. Again, this is all eyeballs. I can tell a 15% profit margin from a 1.5% profit margin just by glancing at profit and sales I don't need a calculator. I can tell a 0.4 asset turn from a 4.0 asset turn. That's the kind of eyeballing we're talking about here. Nothing normal is interesting. I want especially high or low numbers in certain areas. I want a way to understand the business. If it has huge margins or really fast turns or something, I can start to understand it. If it has close to zero cap-ex I can start to understand it. If free cash flow is greater than reported earnings, I can start to understand it. I'm thinking how this could be even better than I first imagined. I want to know you can take capital out of the business every year and still grow the business. I want it to be like owning some timberland where maybe your land grows 7 new trees for the 100 you started with, you cut down six and next year you still have 101 trees instead of 100 trees. I'm looking for something like that. I'm not looking for something that grows but can't be harvested.

At this point, I've decided whether the company is really something I'm going to study as a possible investment or not. I've probably thrown out at least 95% of companies by this point. I'd say it's more like 99%. It's a big, big number. Very few stocks make it past this first impression of 10 - 20 minutes tops.

Once I get to this point, I create a folder on my computer to store all the company's annual reports. I download all the annual reports. Then I read them all, taking the data and putting it in a Microsoft Excel workbook I created. I use the last 11 years of data (really 10, but I need some year-end data from the 11th year for some calculations).

It can take me a while to enter all the data. For U.S. stocks, it's all in EDGAR. I just need their most recent 10-Q and their past 10 10-Ks. I have to do this all by hand, because I make adjustments to lines like "cash" to adjust for other marketable securities they have on the balance sheet that might be non-current. And I'm adjusting capital expenditures to add in certain spending on intangibles, pre-publication expense, etc. that a website might not include. Anyway, depending on how it goes this can take 20 minutes or 60 minutes. I do a split-screen in Windows 7, where I've got Excel on the left and the financial report on the right. I've gotten pretty fast with this. It would take a new person a lot longer, because they can't navigate the reports quite as fast as I can because I know where things normally are.

Within 20 minutes to 1 hour, I have all the 10-year data in. So now I have all the data I like to look at. I have the 10-year average free cash flow margin, return on capital, the F-Score, the Z-Score, the coefficient of variation on different stuff, price/multiples etc., I also have a sheet that shows me the DuPont analysis for all 10 years. And I can look at 10-year data for each of the variables I care about. I can basically do a Value Line type sheet with everything from free cash flow margin and return on invested capital to tangible asset turns to cash conversion...everything. I have these workbooks for every stock I've looked at. So, I can compare them on these numbers.

Finally, if I like what I see in terms of the numbers, I will then do 2 more things. I'll do a full historical workup on the company's past financial data. In the U.S., this usually means going back 15-17 years instead of just 10. So, I'll have a Value Line type page that goes back 15-17 years with earnings, sales, margins, turns, ROC, etc. I'll also do any bonus nuggets they throw in like store counts, square footage of retail space, unit volumes, etc. I'll look for any less common ratios that are important here, like railroads and cruise ships and airlines and hotels and movie theaters and store owners and stuff like that have industry specific ratios you want to look at going back 15-17 years and comparing to industry averages, competition, etc. So I spend another hour or whatever on that.

If I'm still interested, I read all the past annual reports from oldest to newest in order. Preferably, in one sitting. I'm not looking at notes to the financials and stuff like that. I'm reading everything other than the financial statements, notes, etc. I'm just looking for commentary on customers, segments, products, etc. I'm looking at capital allocation. I'm looking at management's way of talking about things.

Finally, I print out the latest 10-K, the latest 10-Q, and the latest 14A. I get a highlighter and a pen. I read the 10-K first, then the 14A, and finally the 10-Q. I go through highlighting and marking the margins with notes.

Once I do all that, I'll sometimes do other things like look for interviews with management, investor presentations, any references on the internet from trade publications, local newspapers, etc. Just looking for some additional coverage. When I'm doing this, I have specific questions. I probably want to know more about how/why customers choose between competitors.

Throughout this whole process I always keep a notepad on a clipboard with me wherever I go. I have this notepad, calculator and pen at my side at all times. And I just doodle calculation like say in 5-years the net margin is 4% on today's same dollar volume of sales, slap a 10 P/E on that, what's the compound annual return on the stock. Assume they don't pay any dividends, do buybacks, etc. for 10 years. Then a special dividend pays out all accumulated cash, what would that annual return be over 10 years. Is it better than the stock market overall is likely to do? Then, I can afford to get "stuck" in that stock. I sketch out scenarios real fast like that.

If I ever get to this point with a stock, I'm basically going to buy it. I would have dropped the idea earlier if I was ever going to drop it at all. I sometimes do other things like go through 8-Ks and 13Ds for the last few years. I'll check who owns a stock and what events have happened and stuff like that. But that's really only going to provide color on my investment at this point. Because if I made it this far, there's a much better than 50/50 chance I'll buy the stock.

So, I can't say there's one point where I have a real debate over buy/don't buy. Instead I just have a process that makes me eliminate 99.99% of stocks or whatever before letting me get to the end. I get uncomfortable about the stock at some point before the end of the process and then I just start over with the next one.

Talk to Geoff About Analyzing Stocks

A Different Perspective on Japanese Stocks

Geoff Gannon — Sun, 17 Apr 2011 23:10:29 +0000

Someone who reads my blog sent me this email:

Geoff,

I came from Japan to US for business school in 2001. I became extremely intrigued by Buffett's value investment philosophy. I wanted to read everything available about his philosophy and became more and more familiar with his investment philosophy. And I personally pick stocks too.

Anyway, about investment in Japan, I read your "Japanese stocks: Now 34% of My Portfolio - Plan to hold Them For At Least 1 Year", I see one part in "Buy Japan", you are talking about "Japan is barely a capitalist country." I see that you see Japan pretty well. They care much less about generating profits to shareholders than people do here in US. I imagine, that US investors who invest in Japan would feel slighted. They should be the boss, but not in Japan actually.

Here is the key point why I wrote. You say "It’s definitely the most investor unfriendly place on the planet – excluding a few countries that seize private property". In my view, Japan is a country that would seize private property away from you. Not by legitimate ways, but more subtle but practical ways. Who has the largest control over Japanese economy? The system of capitalism? Absolutely no. Bureaucrats have. They have tremendous control over businesses with both explicit laws and implicit powers.

They have ways to drag down companies performance that they don't like. If a business is strong enough and brave enough to openly fight against bureaucrats, like Softbank did in the past, there is chance to win. But most businesses are afraid of this structural, chronic bully that deprives Japan of economic flexibility over the years. But interesting thing to me is, this chronic inefficiency sometimes works well, but sometimes doesn't. Like it worked in our 70s to 80s. But not in the later decades. My father always tells me that this is just like fascism that drove Japan in WWII all the way to final disaster. When it works well, we are invincible, but once the ship turns to a wrong way, we are unstoppable. Being said that, I wonder how, like you mentioned, pre-war southern states unraveled their woven bonds and connections and became part of the rest of the capitalism world. Losing the war changed their way of business life completely? Then, maybe Japan also needs dramatic change like that.

In my view, the Japanese have strong fear of sticking out. If you stay in a crowd, you are invisible and no one would say anything. But if you stick out too much, bureaucrats will get you. Rising stars in business are always the easiest to go after for bureaucrats who are influenced by competitors. In US capitalism holds the power. This is the rule of the game and it seems that even the government cannot defy this rule. In Japan, bureaucrats rule the market most definitely.

And most obviously, this system is not working for our prosperity.

So, I just wanted to point out your assumption that Japan is not a country who seizes private property may not hold.

Shin

Talk to Geoff about Japanese Stocks

Why Don't You Write About Spin-offs? - Why "You Can Be a Stock Market Genius" is So Great

Geoff Gannon — Sun, 17 Apr 2011 22:43:40 +0000

Someone who reads the blog sent me this email:

I know you called “You Can Be a Stock Market Genius” the best investment book ever written awhile back on your blog, and now you're saying it again, so this has me wondering why you don't discuss similar ideas (or his/your framework) on your blog? I understand you like the book because it’s about a mental framework for investing / hunting for ideas, but still, a little surprising.

Also, I understand your view on why Greenblatt's latest book isn't practical (I somewhat disagree as I know several passive investors who simply stopped looking at their accounts during the downturn, yet they never once thought about selling), but is Stock Market Genius really practical anymore to the enterprising investor? Yes you like his book for the framework, but investors will read the book and then overpay for spinoffs, etc because that is what Greenblatt says to own. Every idea in that book is now a much more efficient market (in general) than it once was, with exception to the very small spinoff. Not saying money cannot be made in his ideas, but it is much, much tougher.

I know you're into your high quality small caps and net-nets (at present) but it would be interesting to see you discuss special situations if you ever look for/find them.

Yes.

"You Can Be a Stock Market Genius" is probably the most practical investment book out there. I'd say the 1949 edition of The Intelligent Investor - which includes a section on valuation - and Peter Lynch's books are probably the other practical books. Phil Fisher's book is also practical. But I don't think many people are going to actually adopt his approach. Almost no one I talk to is willing to limit themselves to just a handful of stocks that they research for hours and hours and hours before they buy and then hold for a long time. Even though I think – both for value guys and growth guys – that is by far the best way to go.

Back to "You Can Be a Stock Market Genius". I'm not sure why you think the spin-off market is much more efficient than it once was. It may be by some measurement. But all the estimates I've seen - there were some really good ones over at a now defunct blog called the special situations monitor - show that spin-offs still do better than the rest of the market. In addition, spin-offs (like net-nets) aren't that hard to separate the possible very, very bad performers from the rest of the pack ahead of time.

That's similar to net-nets where a stock with zero retained earnings, losses in most of the last 10 years, and some leverage is a lot more dangerous than a stock with a history of profitability and almost no use of liabilities at all. It may work out. It may even turn out to be one of the best net-nets. But, it doesn’t belong in the “safe” net-net category. Spinoffs – like net-nets – are a place where a little selectivity can remove a lot of risk. Obviously, that’s because they aren’t being very carefully scrutinized by the people selling the stock.

Spin-offs are a great place to invest. And when folks ask me how they can learn about analyzing businesses and what is the best place to do it my answer is spin-offs. The big reason is that you don't see the price ahead of time. You can evaluate the business before it trades separately.

There's no better learning experience than that.

I haven't written about spin-offs in a while, because there haven't been many that interested me. Right now, you have Huntington Ingalls – a spin-off from Northrop Grumman (NOC) – which is interesting in the sense that it might work out well. But it's not something I'm likely to write about. There are a few reasons for this. One, it's carrying a lot of debt relative to EBIT and it’s got slim margins. So, it really depends on EBIT expansion to survive and thrive. The stock is leveraged and that's where your returns will come from. You’re depending on an uptick in EBIT margins being multiplied by a lot of leverage – they’re borrowing at 7% in a low ROC business – to make you money. That might happen. And if you know a lot of about shipbuilding for the federal government, you might want to buy that stock. That one comes down to a qualitative analysis of how much of a risk there is that a business like that could ever get so bad it can't cover its interest. Basically, you’d have to feel much better about the risk that nothing especially bad can ever happen in that business than I’m ever going to feel. It’s just not something I know or feel I can know well enough when you’ve got that much debt.

I talked about Hanesbrands (HBI) when it was spun-off from Sara Lee (SLE) in 2006. That was definitely my favorite stock idea around the fall of 2006. I mentioned it in a roundtable discussion as being my favorite idea. It was (and is) leveraged. But it's got a good position in a good business. The competition in the U.S. is just Hanesbrands and Berkshire Hathaway owned Fruit of the Loom.

I understand underwear better than shipbuilding. That’s the difference there.

Part of the problem with writing about spin-offs is just the audience that I'm writing for. Spin-offs and special situations are - well - special. People would like to learn some tools in addition to some stock picks. Or at least I'd like to think I'm giving people the ability to find stocks on their own. Spin-offs are pretty simple. They just involve reading. You read about them yourself and then you value them. If they trade at a very much lower price from what you think is right, you buy them. That's it.

It’s not even that important exactly how you value them. You don’t need the perfect model. You just need to be able to read about a business, appraise a company, and tell an elephant from a mouse.

I mean, if you look at Hanesbrands, I think it was spun-off in the $18 to $19 a share range. It’s at $28 right now. It’s leveraged. That’s the part you can argue about. But it’s not like $28 is expensive. In fact, if it can handle the leverage it’s got, the stock is worth more than $28 a share. And yet $28 is about 50% higher than where that stock was spun-off. I wouldn’t say anything especially good has transpired at Hanebrands. You just had a brief period where people were willing to sell something for $18-$19 that was in all probability worth $30+.

So, the impediment to people understanding what I'm writing about enough to buy the stock really isn't some concept they don't get. It's just that a lot of people who read my blog or my articles at GuruFocus aren't going to read the SEC reports, the investor presentations, etc.

Spin-offs are very basic that way. You look at them and try to value them a bunch of different ways and then you just judge if the market is way off. If it is, you can buy stock.

I'd be happy to discuss spin-offs in the future. And this is an area where I think there should be a lot more coverage. Even bloggers don't write enough about spin-offs.

So, yes, spin-offs are an area I'm very interested in.

And yes, it's the general approach Greenblatt uses - and the way the book is written - that makes me say “You Can Be a Stock Market Genius” is the best investment book ever written. It's extremely practical.

It's really not about how great spin-offs are.

It's about how you just need to analyze a few situations independently of the market and have confidence in your independent analysis.

It's like Buffett says...

Don't look at the stock price before doing your analysis. Value the company. Then check the price:

Buffett Video on PetroChina

You can do that in micro caps as well as spin-offs; foreign stocks as well as domestic stocks.

The key is doing that totally independent analysis - just an honest appraisal of the business.

If you have the skill to make that honest appraisal of a business all you have to do is go looking for neglected stocks. They can be neglected because they are illiquid, family-controlled businesses with market caps under $100 million or $50 million or whatever. They can be neglected because they are spin-offs. They can be neglected because they are in Japan.

But the basic idea is that if you can understand the appraisal idea that Joel Greenblatt talks about in "You Can Be a Stock Market Genius" or Ben Graham talks about in "The Intelligent Investor" all you have to do is find neglected stocks and appraise them. That's it.

So, I don't really think of “You Can Be a Stock Market Genius” as being about spin-offs. I think of spin-offs as being places where people can easily - in a psychological sense - appraise businesses honestly, because they don't have the stock price and stock price history skewing their brains.

It’s just very natural to appraise assets where you don’t have a price quote.

And if you want to invest in stocks, you need to be able to appraise them apart from that quote.

You can’t rely on the market. You have to do the work yourself.

And spin-offs are all about working out what a company is worth on your own.

Talk to Geoff about Spin-offs

Japanese Stocks: Now 34% of My Portfolio - Plan to Hold Them For At Least 1 Year

Geoff Gannon — Fri, 15 Apr 2011 19:44:12 +0000

Just a quick update on Japanese stocks.

A while back I wrote a post entitled “Buy Japan”. A little later, I put out a report on 15 Japanese net-nets.

Some readers are curious about whether I’ve been putting my money where my mouth is.

Yes. Over the last couple weeks, I’ve been buying some of the smallest, most obscure – and least liquid (that's why it's taken weeks) – Japanese stocks.

So far, I’ve put 34% of my portfolio into a total of 4 Japanese micro cap stocks. There’s a fifth Japanese stock I’d like to buy. I’m willing to put 10% into it. If I get that order filled, I’ll have about 45% of my portfolio in Japan.

No. I’m not revealing which Japanese stocks I bought. Over the last couple weeks, I’ve been buying most of the volume of these stocks. They don’t trade much. So I have to be very patient. And very quiet.

All 4 stocks had negative enterprise values. In fact, I got my shares in each of the 4 stocks for less than 60% of net cash. Over the last 10 years, 3 of the 4 stocks had no losing years. One of the 4 stocks had an operating loss exactly 10 years ago. None had any losses in the last 9 years. And 3 of the 4 stocks were bought at less than 10 times normal after-tax earnings. All pay dividends.

Despite my feeling that the Yen could be overvalued against the dollar by as much as 25%, I decided not to hedge the currency.

All my other assets are in U.S. dollars. And I have no view about inflation in the United States. So having anywhere from a third to half of my assets in another currency isn’t the worst form of diversification.

I’ll hold my 4 Japanese micro caps for a little over a year. I plan to re-evaluate them in July 2012. I don’t know enough about Japan to evaluate their business performance in between.

I think it’s probably better to impose a trading ban on myself for a full year so I’m not tempted to sell based on headlines. I didn’t buy these stocks because of headlines. I bought them because they are the cheapest stocks I’ve ever seen. It would be a mistake to sell on news what I bought purely on price.

If any fat pitches come along they'll have to be funded through sales of the 50% of my portfolio in U.S. stocks (which is actually only 2 stocks).

Right now, having more ideas than money is definitely not my problem. There are almost no good net-nets in the U.S. I mean literally almost zero decent net-nets. Don't believe me? Ask Jon Heller.

But nothing lasts forever. One day, American net-nets will return.

Until then, at least we have Tokyo.

Talk to Geoff About Japanese Stocks