Ebay’s current price has sparked me to consider a few things. First, am I “correct” on eBay? My general thesis on the company is that it is an undervalued market leader. The other question that comes to mind stems from the first one. If I am correct, why am I correct and the market wrong? It certainly isn’t that I possess some supernatural intellect or clairvoyance. (Trust me.) All I know is that I have looked at eBay’s operating performance numbers and to me the numbers just don’t spell 30 bucks per share.

What numbers am I referring to? Well primarily I’m referring to eBay’s free-cash-flow (FCF) figures. Recognizing that there is a plethora of ways to arrive at FCF and keeping in mind that exact numbers give a false sense of preciseness, I estimate that eBay produces about $1.4 billion in FCF. And over the last few years the company has been able to grow those figures at extraordinary rates – by at least 40% and by as much as 90%.

Using the discounted cash flow (DCF) method, I arrived at an estimated intrinsic value for eBay of about $60 per share. Of course, this method of valuation is very sensitive to the assumptions made. To come up with my estimate, I assumed a discount rate of 9% which is my optimistic view of what the market itself will return over the next decade or so. I also assumed that eBay’s FCF growth rate would substantially decrease over the next 10 years - falling from 25% in the early years to 12.5% in the later years. And then I assumed a terminal growth rate of 3%, about the historic rate of inflation. With those factors, all of which I think are reasonable, I came up with an estimated value of $60. So the market must be missing something…possibly. Click chart for larger view.



But what if I’m wrong and the market is correct? Perhaps I’m missing something. One way or another the market is saying that eBay will not be able to perform in the future as it has in the past. The market seems to be saying that some external (or internal) force will do one or a combination of several things. The forces will depress eBay’s margins or retard its sales growth or cause it to have to substantially increase its capital expenditures.

I think one thing the market is saying is that it doesn’t like eBay’s purchase of Skype for $2.6 billion. I agree with the market here. I like the company, I just don’t like the price eBay paid for it. That said I doubt that any failure in Skype will be enough to sink eBay. The market may also be saying that the Google-monster will surely do eBay in. I doubt that pressure from competitors like Google or Yahoo will be significant enough to substantially hurt the company. Not in the long run anyway. And certainly not enough to justify the $30 price tag eBay now sports.

In my own analysis, I assume that eBay’s FCF growth falls off a proverbial cliff and I still came up with a value that is at least twice the current market price. In other words, I think eBay represents the dollar being sold by Mr. Market for 50¢. Yet exploring the reasons Mr. Market is selling eBay so cheaply are worth some thought.

I had a thought. If I had a (figurative) gun to my head and needed to answer this question...

Whose business moat is larger and more treacherous to cross? Google's paid search and Ebay's online auctions?

...what would my answer be?

I won't tell you what my answer would be (hint: I and my clients own shares of Ebay) but, I think the knee-jerk answer is probably the correct answer in this case.

I came across a nice synopsis of PACCAR (PCAR) on the Seeking Alpha blog. PCAR is one of our holdings but hasn't done much lately. The article is worth a read.

A sound selling discipline is an oft-neglected part of a sound investing approach. A sell discipline will get the investor out of situations that show little promise and allow him to be available for situations that do. One of the sell criteria we employ at Brick Financial imparts us to sell a stock if “we have made a mistake in calculation or judgment.” Last August the clients of Brick Financial saw the criteria at work.

In August I wrote,

“We were cautious when we bought [JetBlue: (JBLU)] back in the spring of 2003… at the time it was trading at about 35x earnings which we thought was expensive… What we did not fully appreciate were some of the challenges that JetBlue faces. One was its vulnerability to rising oil prices. Although all transportation businesses were affected, airlines seemed to be especially so, and JetBlue was no exception. The other issue was the realization that although JetBlue’s operating and labor costs are presently low - as planes age, as employees become unionized, as new markets become more scarce – the company’s costs are bound to rise...

We made several mistakes on this purchase... [ultimately] we did not provide ourselves a wide enough margin of safety [and] we should have weighed JetBlue’s rich valuation more heavily in our analysis…”

Since then, JetBlue has declined from a split-adjusted price of $12.71 to $9.69 at today’s (May 2nd) close. That move represents about a 24% decline. The company’s last two quarters were net losses, with the latest loss reaching $32 million. I would not say that I am clairvoyant, but some of the concerns I covered last summer have come to fruition. Larger competitors are pilfering the company’s business model and the company’s costs are catching up to it. The company, though nimble compared to other carriers, could not escape the ever-increasing rise in oil prices. It has also been forced to scale back on its expansion plans, sell some of its planes and shorten many of its routes.

A recent Wall Street Journal article underscores the company’s difficulty:

“ ‘We haven't done a good job at managing our business’ with aviation fuel costing more than $2 a gallon, said David Neeleman, JetBlue's founder and chief executive officer. The company's fuel bill rose 85% in the first quarter compared with a year earlier, and the average cost per gallon jumped 43% to $1.86. But the ‘silver lining’ in the record fuel price is that it is ‘helping us focus on becoming a better company,’ he said.”

A sound sell discipline, and the ability to admit I was wrong, saved some money.

Last week I wrote that I would be running a few companies through Phil Town’s criteria for Rule #1 investing. To recap,

Town suggests that the way to adhere to Buffett’s first rule is to look at five different things about a company. They are:

• return on invested capital (ROIC),
• revenue (sales) growth,
• earnings per share (EPS) growth,
• equity (or book value) growth, and
• free-cash-flow (FCF) growth.

He says that we should be looking for companies with at least 10 years of history, and except no less than 10% per year in each of the growth figures. We should also look for companies with an ROIC of at least 10%.

I decided that the first two companies I’d look at would be Wal-Mart ( WMT ) and Target ( TGT ). These are two of the major players in the retail industry.

Unless you’re Paris Hilton , you’ve heard of Wal-Mart. Wal-Mart interests me because so much of the value investing community has become enamored with the company. Wal-Mart concentrates its products for very price sensitive consumers, usually in rural and “non-urban” areas. Although recently, the company has made great efforts to expand its operations into more “city-fied” areas. Target on the other hand, caters to a more urban, fashion conscious consumer. Usually, their consumers are a little higher up on the disposable income scale and are less price sensitive.

Full disclosure: Although I (and the clients of Brick Financial ) do not own either company, both are on my watch list. My current outfit however consists of socks, underwear and a belt from Wal-Mart and jeans, a shirt and a watch from Target.

Each seeing the other as a threat, they have recently (in the last few years) found themselves competing more and more with one another. Selling products and services designed to poach the others customer base. Will either be successful? Of course, only time will tell.

Here’s how the stocks of the two companies have performed over the last 5 years. [ Click on the image for a larger view .]

As we can see, over the last 5 years, Target has returned over 40% while Wal-Mart has lost market value. To peer into the reasons why this happened, we need to look at how each company has performed operationally over the last few years. Here is where Town’s Rule #1 criteria may help us. For each company, we collected the figures using MSN Money and listed them in the table below. [For most of the multi-year figures, we used a geometric growth rather than an average growth.]

You should note that if I were doing this analysis for actual investment, I would use each company’s actual financial statements. But in order to keep it simple, and to try and follow Town’s book as closely as possible, I just used MSN.

You should take note of two more things. For the free-cash-flow (FCF) figures, I used the more traditional calculation of cash from operations minus capital expenditures. MSN also subtracts out dividends. Additionally, I included Warren Buffett’s calculation of “owner earnings” which is net income plus depreciation and amortization minus capital expenditures. This is his definition of free-cash-flow. These figures are from the latest annual financials statements. [ Click on the image for a larger view .]

After looking at these figures, and grading them against Town’s criteria, I would say that each company probably gets a passing grade on the level of a B- or C+.

Wal-Mart averages over 10% in growth for most of the figures except for FCF and owner earnings. These two figures have declined over the last few years. And nearly all of the growth figures have trended downward.

On the plus side, Target’s EPS an equity growth are much higher than Wal-Mart’s and far exceeds Town’s minimums. But its sales growth and ROIC haven’t consistently beaten Town’s 10% floor. Whereas Wal-Mart’s FCF has been declining ever so slightly, Target’s FCF took an astronomical leap in the last year. But I wouldn’t get too excited about that since the previous year’s FCF was so low. (Gotta watch those base year figures.) For the 5 year period, Target only had one year where the company had a positive FCF or owner earnings figure. But the trend in FCF and owner earnings is good, as Target is growing its cash at a faster rate than its capital expenditures are increasing.

From the operational figures, neither Wal-Mart nor Target distinguishes itself from the other (using Rule #1) criteria. Thus, I don’t think these figures give us any insight into why Target’s stock may have performed better over the last 5 years. My guess, without the benefit of looking back, would be that Wal-Mart’s stock was richly valued 5 years ago relative to Target. Or it could be that investors think that Target has a brighter future. Or perhaps, everyone is crazy.

What I also want to know is, at this point, which would be the better investment. I want to know the value investors I admires are raving about Wal-Mart and Target...not so much. This is where the ever important valuation of the companies comes in.

I will explore these points in a future post.

I cannot see how the unequal representation which is given to masses on account of wealth becomes the means of preserving the equipoise and the tranquillity of the commonwealth.

-- Edmund Burke, "Reflections on The Revolution In France"

Did you know that for every 100 millionaires who don't "budget", there are about 120 that do. More than half of the nonbudgeters invest first and spend the balance of their income.

Many call this the "pay yourself first" strategy. These people invest a minimum of 15 percent of their annual realized income before they pay the sellers of their food, clothers, homes, credit and the like.

When asked [of millionaires], "Do you know how much your family spends each year for food, clothing, and shelter?" almost two-thirds of millionaires answer yes.

Source: The Millionaire Next Door , by Thomas Stanley

The following commmentary is an excerpt from Brick Financial Management's February 2006 client letter :

"...The Zealot answer to the problem would be to create a portfolio set with some fixed percentage in stocks, some in bonds and some in cash without regard for valuation. This would be executed through some investment combination in index and actively managed mutual funds. The practice commonly referred to as asset allocation (or the Investment Policy decision), thought by the Zealots to be the most important decision an investor can make. The Zealot believes that the asset allocation decision, and not security selection, is the most important determinant of long term performance.

The Zealots and asset allocation
As proof they reference one (that’s right, one ) study. We’ll call the study BHB. The Zealots tell us that BHB says that of the determinants of performance - asset class selection, security selection and market timing – asset selection determines 93.6% of long term portfolio performance . [We find it odd that BHB did not consider management fees, transaction costs and taxes among the determinants.] They also went on to say that security selection determined less than 5% of portfolio performance. The Zealots love BHB as it seems to support EMH which states that security selection is pointless.

Variation in returns is not total returns
But we (the Heretics), being skeptical by nature and being unable to ignore the success we’ve had with security selection, didn’t buy the interpretation of the BHB study. So we actually read the thing. What did we discover? At no point does the BHB study measure total long-term returns. What it measures is the total variation in quarterly (short-term) returns . In other words, BHB measured how much a portfolio went up and down over short periods and not how much money it made in the long term. BHB determined the successful portfolio as one that didn’t fluctuate a lot. Whether or not the portfolio actually made any money was not a determinant of investing success. Hmm…interesting.

Variation in returns means little
We must keep in mind that the variation of quarterly returns alone tells us practically nothing about the prospects of investors achieving their financial objectives. Funding financial objectives comes from portfolio contributions and the compounding of returns over time. In other words, returns should not be ignored, even in the short-term. [Further, even if short term volatility is of utmost concern, we must realize that extreme diversification does not necessarily eliminate it. A more effective technique would be to choose investments that havesimilar returns but do not move in tandem. In other words, they should have a high negative correlation.]

Traditional asset allocation fails
When using the material in the BHB study, and interpreting the results correctly, we find that the asset allocation decision determines only 15 percent of returns over a 10-year period . This little tidbit damages the credibility of the asset allocation process as practiced today, which is to say that long term investors should automatically be invested mostly in stocks and short term investors should automatically be invested in bonds and cash. This portfolio management by autopilot is nonsense. In our Client Education Brochure, we point out thatover 10-year periods, stocks perform better than bonds and cash over 80% of the time. But turned on its head, we see that bonds and cash perform better than stocks 20% of the time. If your time horizon is only 10-years long, wouldn’t you want to know which assets would perform best over the coming period? What you wouldn’t want to do is make an assumption that history will repeat itself. We think it important that we account for those times when stocks underperform.

Using, better yet, misusing the BHB study the Zealots set portfolios with rigidity (i.e., 20% large cap stocks, 10% foreign stocks, 15% small cap stocks, 10% short term bonds, etc). They wind up owning stocks from every corner of the market. Should any one piece of the portfolio advance or decline too significantly away from the original asset allocation, Zealots either buy or sell accordingly. This would seem to make sense if it were not for differing time horizons, valuation and costs.

As we just mentioned, there are occasions when both bonds and cash perform better than stocks, usually during extended bear markets. Thus the problem arises when arbitrarily selling (or buying) a portion of a portfolio that has advanced (or declined) significantly. The problem is exaggerated when valuations of the securities and the time horizon suggest just the opposite action should be taken. Extreme diversification, as traditional asset allocation requires, would always have the client in some asset that was underperforming. At best theportfolio would do about average with the market. As Heretics we can’t shake the belief that we should try and can do better than the market.

Value allocation succeeds
Brick Financial believes that most investors should have some exposure to stocks, bought at low valuations, at all times. But when we create portfolios we will let the valuations of groups of stocks, bonds and cash, determine the asset allocation. This process is sometimes called “Tactical Asset Allocation”(TAA). A more fitting title would be “Value Allocation” (VA) which accounts for valuation of securities, investment time horizon, costs and fees..."

Read the entire commentary by clicking this link >>