Adam(s) and SLP Question

It has been some time since my last posting, but a question posted by Adams1135 on Yahoo! Finance concerning Simulations Plus (SLP) caught my attention.

Summarizing, Adam(s) questions whether the stock is fairly valued, and, if so, wonders whether the company can grow sufficient to warrant holding the stock.  It caught my attention because my earlier analysis of the stock was referenced in response by another poster.  Not referenced was a brief addendum.

With that as background, I’d like to respond to the question, because it provides an opportunity to explain something I increasingly view as important — the link between strategic management and financial management.  Having analyzed the question of fair value in the first blog posting, this entry will focus on making the strategic/financial link.  Consequently, there is just one graph, one graphic, and little quantitative analysis.  This will surely please most and annoy few.

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F Wall Street Hits #1 and Other Notes

First, a big congrats to my friend Joe Ponzio, whose book F Wall Street is the number one best seller on Amazon.com in the investments category. Joe and I worked on a small number of projects several years ago, and, to the best of my knowledge, I was the first to write a guest piece for his web site.  More importantly, Joe is the real deal as an investor and among the nicest people I know.  He writes about investing with such clarity and insight that it reasonably makes the rest of us envious.

Second, I haven’t posted much recently; although, I have several items in draft.  So, let me bring you quickly up to date on the investments front.

I am increasingly concerned about the US economy, having crunched the numbers concerning the current accounts deficit.  With debt-to-GDP at over 90%, with the consumer, government, and the banking industry trying to de-lever at the same time, and with another potential leg down for the housing market, this recovery has the strength of a COPD patient on oxygen.  Add to this the looming challenges related to Medicare, the retrenchment by the federal government in their support to the states for Medicare and Medicaid, and the austerity initiatives in Europe and China, and you have the potential for a market crash, a la 1929. 

For those who are return-visitors to this blog, you know that I am not prone to overt pessimism, but the numbers are problematic and inescapable, and they prompted me to read Liaquat Ahamed’s Putlizer Prize winning Lords of Finance:  The Bankers Who Broke the World.  While the title might suggest a recounting of the 2007/2008 crash, it is actually about the central bankers in Europe and the US during the inter-war period between the end of World War I and the start of World War II — primarily focusing on the run-up to the market crash of 1929.

The lesson from that history is that the predicates of crashes are set long before the lit fuse becomes visible, and the result is, either, inflation or deflation — depending on the physics of international capital flows and the responses by government.  During that time frame, the challenges confronting England, France, and Germany were high levels of sovereign debt.  Germany owed reparations to England and France, and England and France owed war-time-funding debt to the US.  Germany chose hyper-inflation and England and France, to varying degrees, chose deflation.  Debt owed to the US and capital flows into the US created a speculative bubble in the stock market, which crashed when Germany and England defaulted and went off of the gold standard.  This led to margin account insolvency in the US, followed by bank runs and the downward spiral you learned about in school.

Now, recognize that, depending on whether you believe inflation or deflation is the likely consequence of current government policy, your investment decisions will differ significantly. 

If believing in the inflation scenario, you want to be in excellent companies with strong financial positions.  By this, I mean companies that have little debt (won’t take a hit if interest rates rise to keep pace with inflation and don’t require debt financing to sustain operations) and those that have pricing power for their products (can increase prices to keep pace with inflation).  If you are uncertain about which companies possess these attributes, read up on Michael Porter’s Five Forces to better understand the strategic competitive factors that sustain companies during challenging times (whether the challenge comes from the economy, government policy, decisions by the Federal Reserve, or competitors).

On the other hand, if you are in the deflation camp (personally, I’m straddling this fence and it is uncomfortable), cash is king.  When deflation hits, the value of cash increases.

Either way, cash provides flexibility.   If the market tanks and inflation follows, I’ll jump into inflation-resistant stocks, such as XOM, TEVA, FCX, etc.  If deflation hits, I’ll sit on cash or, better yet, invest in an ETF of stocks in India, China, or Norway (countries with growing economies and little sovereign debt); although, the 1929 crash in the US arrived despite our strong national balance sheet (suggesting that China and India are not safe, either).

Regardless, I’ve been increasing cash.  My concerns about the economy and uncertainties about whether we are likely to experience inflation or deflation, prompted me to do what I did at the start of the last crash — namely, sell any position about which I am not abundantly comfortable.  Although most of that has been accomplished, I may have some additional paring to do.   The result is that my cash position has gone from 10% to 45% , as the market moved up recently.  While I did realize some losses, profits significantly out-weigh losses, and our tax bill will reflect it at the end of the year.

The most significant profits were from the sale of my largest position — McKesson (MCK).  In my judgment, MCK is hovering around fair value, but that is not why I sold.  Instead, I sold MCK to make another purchase — a condo rental investment.

“Real estate!?!????” you must be thinking.  Yes, but it is a great value investment.  Let me explain.

The property in question was worth around $120,000 at the peak of the local market.  Since then, similar properties are selling for around $100,000.  The local market, by the way, is a small college town in the mountains, where student-rented condos and apartments are in short supply and the dorms are terrible.  To insure sale of the condo, the previous owners were offering it for $90,000, and, when it did not sell after a month, reduced the price to $80,000.  Still, it did not sell, because the banks are not lending.

We bought it for $70,000 in an all-cash deal, and still had difficulty securing insurance (such are the dysfunctions of the current economy).  Of course, the real estate market may decline further, but the market for student housing is favorable (the condo is within walking distance to the school and has its own covered bus stop), the school has an excellent reputation and is a magnate for students seeking a quality education in a great environment (minutes from hiking trails and ski slopes), etc.  Additionally, the previous owners renovated extensively (all new appliances and furnishings), and, because we paid cash, we confront no downside due to leverage.  By every imaginable measure, this was a value investment, where we bought at a discount to intrinsic value and with a nice margin of safety.

Now, honesty compels me to mention that our first renters are my son and the adorable young lady that tolerates him — so, I have every expectation that the property will be well maintained for at least the next three years.  They are, indeed, paying a competitive rent (with a small family discount), and Mom and I are not paying dorm or meal plan fees.  The swing in cash flows amounts to about $10,000 per year, which, over the next three years, will reduce our break even resale for the property to around $40,000 (before considering the time value of money and any maintenance costs). 

So, we bought a $120,000 property for $70,000, and break even is $40,000 in three years.

I should note that, since purchasing the property, we have bought back into MCK at about 10% or our prior levels.  While MCK is fairly valued, its future prospects are excellent (as a distributor of pharmaceuticals), due to the changing demographics.

Buffett is famously quoted as writing:

Over the [past] 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.

There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

http://www.berkshirehathaway.com/letters/2004ltr.pdf
{Note: Extended quote due to desire to retain context. The emphasis is mine.}

Well, currently, there is no more fearful market than real estate, but fear, alone, is not sufficient to warrant investment. Fearful or not, demand a margin of safety, because, from time to time, the sky may really be falling … or on the verge of doing so.

Now, allow me to say that I have no special insight into how the market will perform this year or next year. The cards are stacked against us, but the timing of their fall is uncertain. In fact, they may not fall at all. Moreover, I have not turned into a market-timing guru — that is beyond my pay grade and competence. I know my limitations, and, if I forget them, my wife will remind me.

Instead, it seems abundantly clear to me that, as a nation, our debt challenges are nearly as great as following World War II (when debt-to-GDP was 120%, but most other nations were comparatively worse off and individual savings was higher). Today, the world economy is not limited to the US and Europe, and most American’s couldn’t buy War Bonds if compelled by law to do so. Surely, this increases market risk, and, if it increases market risk, the required margin of safety required by intelligent investors should increase appropriately. And that is why I’ve moved more prominently into cash and diversified by buying real estate (under unusually favorable terms).

As for the stock market, recognize that there are some exceedingly attractive values today. As Legg Mason’s Bill Miller recently noted, XOM is trading at uncommon values today, and, personally, I’ve been buying Cisco over the past week — how can you not buy when the company has 40+% market share, the next largest competitor has just 5% market share, the stock has been hammered in the market, and is selling below intrinsic value (by my estimations).

Regardless, I have more dry powder than usual, and that dry powder is available to short the market if necessary. When is shorting, as a hedge to protect long positions, appropriate? When the market exceeds the following ranges by 10% or more:

Wilshire 5000 — between 9970 and 12800
S&P 500 — between 1000 and 1300
DOW — between 8970 and 11520

If the news is dire and prompts these measures to decline substantially below the range or if the market significantly exceeds the high end of the range, it may be time to short. Otherwise, the market is just gyrating, as it always has.

This range is based on the convention that fair value for the market is between 70% and 90% of GDP, with appropriate conversions for the DOW and S&P 500. Beyond the problem of recognizing that ours is now a global economy, there are two further issues with this measure. First, the range needs to be updated as GDP rises or falls. This range is up-to-date as of the latest release, but it will quickly become dated; hence, the 10% buffer. Second, it is difficult to know when a decline below the bottom of the range represents a buying opportunity or constitutes a shorting opportunity. To do this effectively requires an assessment of the macro-economic steering winds, and that is a judgment call only you can make at decision time.

Finally, I should note that I have positions in all of the stocks referenced (XOM, TEVA, etc.), and, as always, this blog is not intended to promote buying or selling decisions by you as an individual investor. Do your own due diligence analysis, make your own investing decisions, and, if the market treats us unkindly, be adult enough to accept responsibility for your choices and realistic enough to recognize that the future is uncertain and predicting it accurately is, at best, difficult and, at worst, impossible. We (you and I) do the best we can with the resources available, and neither of us can know what can not be known.

RP Repost — Why the Critic(al) Popularity of Modern Art

For some time, I’ve been a member of the art discussion forum, Rational Painting — which is devoted to the education and advancement of traditional painting and art education, with its primary focus on the Munsell system of color theory.  When not discussing color theory, postings and conversations address a host of other topics related to art, with the moderators meritoriously demanding contributions rich in additive content — rather simple expressions of opinion.

Recently, a high school art teacher (Shawn) noted:

When my students would ask me ( I teach high school art) how artists or art movements make it into the history books, I would tell them one way is that a bunch of artists get together to share ideas, maybe their work shares some recognizable features, they start to work in studios in a particular area and pretty soon it becomes seen as a movement and critics take notice. All of these factors are currently taking place in a sort of grassroots movement known under the umbrella term “Classical Realism”. I could give a tour of areas of brooklyn and queens in NY where you can find enclaves of artists with just that kind of energy taking place, yet the periodicals are completely ignoring it.

And I responded:

Interesting question – in the first post.

There are, in fact, two questions in it.  The first is “why is realism not more highly regarded?,” and the second is “why is there a current preference among critics for non-realism?”  I’m sure we can deconstruct both even further, but, as a thought exercise, lets look at these in their pure form.

Why is realism not more highly regarded?

One would imagine that realism would catch a break, given the training and precision required.  The problem is that realism, alone, is the foundation of artistic training under the traditional system.  It is the equivalent of K-12 and college at the undergraduate level – the base level of training through which every traditionally trained artist matriculates.  The work produced by students at all of the major ateliers is impressive – even to the point that they are taught the components of beauty (composition, lighting, color harmonies, etc.).  With such high standards common, there is scant basis for assessing the exceptional, in which the exceptional is defined by increasingly small and, to the untrained eye, imperceptible differences in performance.  And this gets at two weaknesses in art criticism.

First, performance skill is not a requirement for critics – whether the critic is professional or pedestrian.  The fine differences in achievement that distinguish the exceptional from the competent graduate may fly under the radar for both types of critic and fail to earn appropriate recognition.

Second, in a Woebegone world, where every traditionally trained graduate is above average, the differences are not only imperceptible, they can easily glut the market and become common place – especially, in markets large enough to support art critics (New York, Los Angeles, London, etc.).  The critic, however, relies on a meritocracy to sell snob-appeal, and, where no evident meritocracy exists (i.e., an obvious basis of differentiation from one piece of work to the next), one must be created.  Otherwise, the critic is unemployed.  Yes, the King (as critic) has no clothes and is poorly endowed, but this recognition is more along the lines of George Carlin’s Willie Water, the sportscaster who proclaims, “I call ‘em like I see ‘em, and, if I don’t see ‘em, I make ‘em up.”

For both reasons, you hear art critics argue that traditional realism is bland, lacks originality, “has been done before,” etc.  Well, not only has it been done before, it is done currently, and, because there is little designed-obsolescence in traditional painting (the damned things last 800 years), the market for new and resold traditional paintings confronts few shortages in the major markets housing critics.

During normal times, wheat, as a commodity, is poorly valued, even though a great baker can do wonderful things with it.  With the drought in Russia, and this weeks decision by the Russian government to ban exports of wheat (to meet the needs of domestic consumption), the price of this common commodity has gone through the roof.  Such is the power of supply and demand on price.

Why is there a current preference among reviewers for non-realism?

Among academics, Newtonian physics applies … especially the law “For every action, there is an equal and opposite reaction.”  Transfer this to professors, and you have “For every professor, there is an equal and opposite professor.”  The reason is that Nobel Prizes are not awarded to those who break no new ground or generate no new discoveries.  New discoveries, however, do not arrive often or easily, and the bulk of research published in peer-reviewed journals does nothing more than confirm or marginally advance earlier research.  Confirmatory studies are insufficient to propel an academic into the pantheon of respectability and high regard.  Publish or perish, however, is the route to tenure (job security), so publish they must.

More impressive and more highly regarded are studies that debunk some portion of another’s thesis, and Nobel’s go to those who, both, debunk and blaze new trails of thought and prove the correctness of their thinking.  This certainly holds for the sciences, but what about the liberal arts, where proofs based on the pure logic of mathematics are not available?

In the liberal arts, it is better to break new ground than not, even if the newly broken ground is devoid of nutrients.  While we may have differing views about the nutritional value of the following examples, Hemmingway’s sparse style of writing and Pat Conroy’s passion and fluency in describing the most base of human motives represented departures from the established norms when first published.  The value and utility of the Pet Rock, also comes to mind as the paradigm departure, where the new idea was more important than the nutritional value.

Now translate this to the art critic.  Living and working in a major metropolitan area and writing for an educated audience, the critic seeks the new in order to feed the needs and interests of this rarified reader – a reader who will not be impressed or intellectually satisfied with status quo art, no matter how competently produced.

This only partly explains the allure of modern art – which, for much (perhaps, all) of its 50+ years, was new and different but might not have been intellectually interesting in itself.  That is why the psychobabble explaining an incongruous piece of modern art soon became as important as the work itself.  Defecate into a dog-food bowl and call it modern art (a la a Duchamp’s ready-mades) and, no matter how modern the deposit or attractive the bowl, it falls short of “art,” even to the modern viewer.  It isn’t “art” until the artist, curator, or critic writes that it is a “commentary on the quality of information and education fed to an obliging public through the school system and news media.”

Now, it is easy to deride this reliance on commentary until comparing it to the Renaissance art from which academic realism originates.  The subjects depicted during the Renaissance largely focused on scripture (because the church was the most prominent and prolific paymaster).  Subjects were not limited to the old and new testaments, however, but extended to metaphors from antiquity, Dante’s Inferno, and subjects depicting the persistent themes of the human condition – fear, love, hunger, etc.  Because the populous of that time were largely illiterate, no written explanation of a work’s “intent” accompanied the piece, but, quite often, nearly every aspect of a piece possessed meaning – where the choice of plants populating the back ground and foreground were understood to have meaning.  Depict the manger scene with the hemlock plant growing in the background, and you have a commentary on the fragility and impermanence of life that foretells the crucifixion.

Today, we lack the rich nuance of metaphor – there is simply too much to learn in the way of new knowledge (since the Renaissance) to sustain that word-of-mouth tradition.  So, artist-intent and commentary is required to take a piece beyond the obvious in its meaning and depth … something few realists do today.  In fact, many realists avoid commentary – contending that the work should stand on its own or argue that they do not want to limit the meaning a viewer can productively derive from it.  This practice, however, deprives the critic of material with which to describe and “sell” the work’s criticism when reviewed, and it requires a certain level of resourcefulness by critics lacking the artistic creativity to produce their own work.

Further, any piece that simply depicts the standard range of emotions and perspectives anchors the piece on that which has been abundantly done before.  Shakespeare borrowed plots from largely forgotten stories first written in antiquity or took them from stories published in other countries and languages (even if not from antiquity).   His works, therefore, might appear fresh or novel to his unread audience, and, while Marlow and a small number of others could compete on quality, the market was not saturated with such fluent, lush, and quotable language.

What I find most interesting about this scavenger hunt for novel ideas serving as the foundation for art (whether the idea precedes or follows creating the piece) is that it leads to Lateral Thinking – linking two or more incongruous ideas, often from unrelated fields or disciplines.  This approach to creative thought comes from Dr. Edward DeBono, MD, back in the 1940s, but it has witnessed a renaissance of its own more recently.  Certainly, the Pet Rock of the 1970s (a sarcastic and cynical critique of branding and packaging that was as much a comment on the over-scheduling that made/makes pet ownership difficult for modern professionals) was lateral in thinking, but the reference to Newtonian physics at the start of this section comports with lateral thinking, as well.  It is behind many of the non-fiction works making the New York Times best seller list today, and you’ll find it littered throughout the works of Steven Levitt, Edward Tenner, Malcolm Gladwell, and Geoff Colvin (all mentioned on this board in earlier discussions).

This practice (lateral thinking) is interesting because it notes the extent to which modern artists will go to create “meaningful” work, and it notes the largely untapped next-steps to which realists and traditional artists can go to make their work intellectually competitive for critic(al) assessment – if seeking to do so.   Consider realists who have made this shift and done so successfully.  Wyeth, Kassan, Monks, Koons, and others (to different degrees) make such a connection.

For Wyeth, the connection was often explicit (paraphrasing, “This hill represents the death of my father”), while Kassan’s backgrounds juxtapose the softness of the human condition with the textures and graffiti of a starkly dispassionate urban setting, Monks separates the water-borne nude from dry observation with a shower curtain, and Koons takes Andy Warhol to a disconnected extreme of trivial kitsch, writ large and obnoxious.  Like their work or not (and there is little that connects any two), each conveys additional meaning through contrast and lateral thinking and each has achieved a measure of market recognition, popularity, and critical attention – providing the critic with more than “This is an allegory of _______.”

In every era, there are icons of beauty – from Cleopatra to Mae West to Betty Grabble, to Fara Fawcett, to [name your favorite of our time], and each, before suffering the ravages of time, may be described as “eye candy” – recognizing that there are male equivalents, from Cary Grant through Paul Newman and Brad Pitt or Tom Cruise.  With art, there is merit to producing pieces of incomparable beauty, and many on this board achieve an extreme of that virtue that can melt knees and make a change of pants necessary, and the critic may assert that each is the artistic equivalent of “eye candy.”

But, beyond this, I suspect the critic is more easily sold on works possessing “mind candy,” because they allow the writer to fill column inches with more than a factual description of the technique employed, the subject depicted, the redundant theme chosen, etc., and they seek mind candy with which to interest increasingly modern and savvy readers.  Certainly, New York readers who purchase art pride themselves on the quality of their education (valuing it so highly that they allow their children to be interviewed for entrance into private grammar schools) and consider themselves smarter and more advanced than their counterparts in the heartland.  Los Angeles, and its art community, pride themselves on their creativity – seeking the New New Thing, in a culture influenced by Hollywood.  The elite of Atlanta, Chicago, San Francisco, and London rarely accord their success to pure dumb luck or, with the exception of Warren Buffett, declare their success follows from an average intellect or run-of-the-mill education.  Snob-appeal does not exist in a vacuum, where Lenny Bruce and Jerry Clower are deemed equally “important.”

And, beyond noting that these are the consumers of fine art, they are also the consumers of art criticism, to which the critic is compelled to pander if seeking professional longevity.  And this raises the question of whether, as an artist, you are prepared to pander (sell) to the critic.  Some may view it as a survival necessity in a competitive and recession-exposed profession, while others may place principle before purse (or view it as a contest between principle and purse).  The more interesting question, however, may be whether the realist, by dent of a psychology that values precision, tradition, technique, and attention-to-detail (left brain qualities) can readily connect the work to a right-brained explanation that is lateral in its construction.

Lastly, do not take this for a recommendation urging a change of style, approach, or philosophy.  There is nothing here that goes beyond seeking an answer to the original question and the two questions in my deconstruction – namely, why don’t critics value representational art more and why do critics favor “modern” art above the traditional.  Moreover, while presented as a sequence of assertions, this has been a thought exercise about which I am anything but certain.  It may be wrong in part or entirely, and it certainly possesses the detriment of opinion … as, unquestionably, will be opposing views.  But, to the extent that may explain the psychology of professional critics, it may also be worthwhile as a thought exercise, and I’d enjoy reading alternative explanations.

Visual Heads-Up Computer Navigation and Simulations Plus (SLP)

On April 17, I wrote about using sensitivity analysis and enterprise Enterprise Discounted Cash Flow (eDCF) analysis to identify intrinsic value for any given stock — http://caps.fool.com/Blogs/ViewPost.aspx?bpid=378650&t=01004821517556035447, with the actual description (along with charts and graphs demonstrating the concept) at my personal blog http://rcrawford.wordpress.com/2010/04/17/sensitivity-analysis-for-simulations-plus/ .

As with any presentation of a concept, it is typically necessary to use an example or two, and, in this case, I used Simulations Plus (SLP). Interestingly, I used SLP (a software company whose principal product calculates/predicts the metabolic effectiveness of potential medications in the human body prior to human trials) because the company is so small that is not covered by The MotleyFool. This is, after all, a $35 million company – selling at $2.11 a share. Moreover, last year the stock was selling at just above its delisting price of one dollar (which is roughly where I purchased it). Candidly, I used SLP as the example because the article was written to describe a largely unrecognized approach to valuing stocks, and I didn’t want readers to wrongly conclude that I was advocating its purchase.

That changed yesterday, when the company announced a new product offering – software that will allow the computer user to navigate visually, without a mouse.

Now this may seem like a nifty idea whose time has come (perhaps, even, one that is long overdue) but nothing ground shaking, and that is how I viewed it, as well. I was, however, intrigued enough to consider the changes likely to arrive with the company’s strategic posture and customer demand. As described on a different discussion board, here are my conclusions:

I’m always leery about writing glowing comments about a stock I own, since doing so is so blatantly self-serving, but, in this case, I suspect the news is being underplayed and underappreciated. While I would like to have more information about pricing of the new product, customer demand should be significant. I just looked up the figures for quadriplegia, for example. There are 5000 new quadriplegics for whom this product would be a benefit each year, with a further 1000 in the UK. Add to this the other first world countries (including nearby Canada), and you begin to have a grasp of the degree of potential customer demand. Quadriplegia, of course, is not the only diagnosis for which this product would represent a significant benefit to customers. The lifetime risk of developing carpal tunnel syndrome is 10% of the adult population. Add to this the sports injuries which effect arms and hands for, either, an extended period or as persistent/chronic conditions, and this number grows even further. Moreover, think about the extent to which computers represent viable employment options for those suffering from any of these conditions, the support requirements for afflicted workers under OSHA, and the degree to which computer use at home now represents a communications and information necessity, and the question of consumer demand becomes all the more clear.

This, however, represents just the first layer of consideration. As an early entrant, the company will enjoy significant strategic benefits based on the production model described in the announcement article (i.e., outsourcing production) — http://finance.yahoo.com/news/SLP-Subsidiary-Words-Launches-bw-56839333.html?x=0&.v=1. Specifically, if marketed aggressively, it will be easy to acquire significant share of mind in much the same way as Dragon Dictate with voice recognition software. Strategically, this model provides defensive benefits, as well. Based on contractual production, the company will have a clear picture of stepwise unit margins and various production volumes sufficient to defend the space with product positioning and pricing. There is, as well, the barrier to entry associated with research and development – which the company has already expensed. While it will be necessary to maintain the developmental edge, the upfront costs of initial product development are already accounted for in prior financial statements. In other words, the company has already paid to create the product. As sales increase, economies of scale and defensible margins should more prominently materialize, to the benefit of stockholders, customers, and, most pleasantly, society at large.

I may be wrong, but this strikes me as game changing in a way that Word+ (another SLP product) was not (in my view). If true (i.e., this is, in fact, game changing), earlier estimates of this being a $4-$5 stock seem conservative. At minimum, this product addition makes the $4-$5 range less speculative and, all else being equal, makes it more reliable due to cash flow expansion. Even if profit margins remaine stable at around 19%, the increased volume in sales and the resultant growth seem likely to expand return on assets prior to any consideration of the equity multiplier associated with return on equity.

Of course, others may see this differently, and I would be interested in reading the contrarian perspective. At this point, however, I do not see how this can be remotely perceived as a negative for the company, the stock, or consumers.

Sensitivity Analysis for Simulations Plus

Introduction

In the midst of grading season, I don’t have much time to blog or respond to comments, but, as I have in the past, I want to respond to a comment on a discussion board, and use this as an opportunity to do a little teaching.  The discussion board comment questioned whether Simulations Plus (a small pharmaceutical-research software company) has run up too much to still be considered a value stock.  When I first purchased it on October 21, 2008, I bought in at $1.06 and $1.07 a share and estimated that it was selling at more than a 50% discount to intrinsic value.  Today, the closing price was $2.35, and it is natural to wonder whether it is time to sell.

To answer this question, it is important to understand that my shares in SLP are not in a tax-efficient account, and, despite a market that appears to be marginally over-valued, my inclination is to hold stocks until they are demonstrably overvalued when they reside in this account.  Otherwise, the 15% capital gains tax hit reduces my proceeds on the investment by 15%.  Additionally, if selling, I would confront the dilemma of finding a replacement investment about which I am less familiar and, consequently, less comfortable.  So, if SLP is fairly-valued, I’ll hold, and, if it is overvalued, I’ll sell.

Background

Now, it should be understood that the stock hovered for sometime following purchase around the delisting price of $1 and eventually appreciated in value until hitting strong resistance around $1.80.  It meandered for a time at this level and just recently moved up strongly on increased volume, as it began to receive increased press and showed up on technical-analysis screens — where traders identify stocks that are trending higher, based on the stock-price movement and volume.  The catalyst for this appears, in part, to be attributable to the company hiring an investor relations PR firm — a move which was criticized by some on the discussion boards, with the assertion that doing so was tantamount to squandering investor value.  Personally, I take the view that you, either, trust the management or you do not, and, if you do not, then it is time to sell.  At minimum, you can buy US Government Bonds, where management can be trusted to print the money necessary to make good on its obligation to you as the bondholder.

In any event, the recent run-up was based on what seems to have been institutional buying; although, share repurchases may account for some of this move:

So, the question is one of whether recent buyers who began purchasing at an 80% premium above my entry price know a good thing when they see it or have been suckered into the stock at a fair or, for that matter, a rich price.

Weighted Cost of Capital (WACC)

To get at this, lets perform the analysis using a technique not previously covered on this blog.  Due to time constraints, I won’t explain the math, but the intrinsic value of the company can be calculated by multiplying the accumulated equity per share times (ROC-G)/(R-G), where ROC is Return on Capital, G is the growth rate, and R is the cost of capital.  To be conservative, I’ll use Cash Return on Invested Capital (CROIC) in place of ROIC (Return on Invested Capital).  CROIC is calculated as Free_Cash Flow/(Total Equity+Total Liabilities-Total Current Liabilities).

Weighted Average Cost of Capital (WACC) is normally considered the cost of capital, which I have calculated as follows:

Now, let’s look at WACC more closely.  There are two portions to this — a debt portion and an equity portion.  The debt portion takes into account the tax benefits of  debt (from the company’s perspective), but SLP has no debt and hasn’t for some time.  This means the bulk of the 13% WACC is attributable to the equity portion.

Is WACC the Best Measure?

Well, the equity portion of WACC is curious.  The company pays no dividend, so there is no cost to the company related to stock ownership when it comes to financing yearly operations.  The “Opportunity Cost” of the equity is just the investor’s required return, which, in the absence of a dividend, is the stockholder’s expected/desired price appreciation as shares are bought and sold in the market — something management can eventually influence with profits, retained earnings, growth, and increasing equity but, otherwise, management is largely powerless to guarantee a specific level of stock-price appreciation.

This 13%, however, is not a number pulled out of thin air — the air was more thick than that, even if just marginally so.  That 13% is based on the Risk Free Rate of Return (RFRR), which is the current yield on the 10-year bond, plus a buffer that accommodates market risk (8.6% is the number I use, and, by most accounts, it is indefensibly high).

Indeed, for a company with no debt and a nice cash stockpile, 13% or more strikes me as too high, and, for companies with a much weaker balance sheet, 13% strikes me as too low.  Given SLP’s strength, it seems reasonable to substitute the 20-year Single-A corporate bond yield of 6.25%.  Why?  Well, with no debt, ownership of the company is uncontested beyond just us stockholders, in that no creditors, preferred stockholders, and warrant-holders enjoy a senior claim on the company, and this makes the corporate bond yield a more reasonable measure of the true cost of equity capital — especially, since I am not using the lower rates (yields) associated with Triple-A bonds.  This seems (to me, at least) to represent a better balance between the opportunity cost of equity and the negligible effect of equity on the cost-burden faced by the company in its daily operations.

Would Warren Approve?

Now, you may assert that Buffett famously requires a 15% rate, but Mr. Buffett is notorious for allowing common sense to trump general rules of thumb, even when those rules are of his making.  In other words, he does not check his brain at the office door upon arrival each morning.  By his own admission, the purchase of Coke was made at a fair price (rather than a DCF-based cheap price) — allowing the franchise value of the company to serve as his margin of safety.  In the case of SLP, the company is the single producer of its leading product and the government, in addition to many leading pharmaceutical firms, is literally sold on it.  So, I’ll use 6.25% as the cost of capital, and, if you (dear reader) disagree, feel free to substitute any number you prefer.  In fact, that is one of the strengths of performing sensitivity analysis, as will soon be evident.  Sensitivity analysis will allow you to select your own inputs and quickly identify your own estimate of intrinsic value, based on your preferences.  Having settled on a cost of capital figure, we will, however, need to identify ranges for Growth and CROIC.

Returns on Capital and Growth Rates

As for which numbers we will use for return on capital and the growth rate, we want to lower both since this method of estimating intrinsic value seeks to identify the long-term rates.  In the case of growth, we will start with the average rate of inflation over the past decade (3%) and increase that up to Mr. Buffett’s maximum expected rate for the broader-market (6%).  While he hasn’t fully explained why he believes this is the maximum for the broader market, he has implied that this has to do with the US’s current account deficit, and, indeed, some economists expect inflation to rise to 5% due to increased government spending.  If expecting that SLP will earn returns that do nothing more than keep pace with inflation, we can use sensitivity analysis to calculate intrinsic value at different rates of growth, and our span of considered rates will run between 3% and 6%.

As for the return on capital, the yearly figures over the past decade are:

If we calculate the median of the rolling five-year and seven-year medians for CROIC, we get:

So, we will adjust off of 15.59%, and our adjustment will be downward.

This raises the question of just how far down we should adjust.  We know that, over time, the returns on capital will move down to meet the weighted average cost of capital, since the spread between them will attract competition.  While a price war may lower it further, a negative spread will promote industry consolidation in order to increase pricing power and a return to reasonable profitability.  While WACC was not appropriate when calculating the cost of capital (because investor expectations are not relevant to how the company operates daily), WACC is the appropriate measure for estimating the low-end of long-term returns on capital — because rates lower than that will bring on an investor up-rising (in the form of proxy fights, the arrival of activist investors, etc.).  Consequently, we will use 10% as our bottom returns on capital estimate and 15% as the top-end estimate.

Sensitivity Table/Analysis

The final preliminary step is to plug each of these assumptions into our equation for calculating intrinsic value.  Using 6.25% as the cost of capital, our two-way sensitivity table for growth and returns on capital becomes:

So, at 4% growth and 13% returns on capital, the stock is worth $2.49, which is a little above today’s price.  This suggests that recent buyers were not entirely delusional.  They may, in fact, expect a higher rate of inflation-driven growth, which would value the stock at $4.49 if inflation rises to 5% and long-term returns on capital decline to 13%.  With the company’s strong niche servicing the cost-reduction needs of the pharmaceutical industry (in this post-healthcare-reform environment), higher rates for either growth or returns may be warranted, depending on investor opinion about the company, its products, and their prospects in the competitive market.  A more important consideration for the institutional investor is calculating the down-side risk in comparison to the potential for appreciation.  Worst case (using 10% returns and 3% growth) is a price of $1.34 … unless expecting something worse to unfold over the life of the company.

Now, the table above color codes the cells based on whether the projected value is above (green) or below (red) the current stock price.

Down-Side Risk Graph

Raw numbers, however, are often difficult to visualize.  So, think about the graphing possibilities.

Want the ability to consider the down-side risk versus the up-side potential in light of these assumption?  How about:

In this case, the stock prices are listed along the y-axis, returns on capital are along the x-axis, and the diagonal colored lines are the various growth rates.  There are three horizontal lines.  The red-dashed horizontal line is my test assumption, which assumes 14% returns and 5.5% growth.  Do I expect this?  No.  It is just an example of what you can do with this sort of analysis.  The dashed-blue line is set at twice the current stock price.  As a deep-value investor, I tend to demand a 50% margin of safety when first buying a stock, and this line helps me determine the scenarios necessary to produce that margin of safety.  At 11% returns and 5.5% growth, intrinsic value doubles — both strike me as achievable, for the reasons explained earlier, but you may view things differently and this chart informs that consideration.  Lastly, for this chart, the black line is the current price, and, to the degree that the different growth rate lines are below the black line (compared to the degree to which they are above the black line) provides a sense of the down-side risk.  In this case, the upside seems abundantly larger than the down-side, but you may be exceedingly risk-adverse and see it differently … and that is fine.

Jacobi — Charlie Munger’s Hero, and Mine, As Well

Continuing with our graphical analysis, let’s do the Jacobi and invert:

In this case, the price remains along the y-axis, but the growth rate is along the x-axis.  Each of the variously-colored curved lines is the return on capital, and horizontal lines reflect the current price, double the current price, and the estimate — from bottom horizontal line upwards.  Note where the top and bottom lines cross the current price and the degree to which they are above and below it.  Next, do the same with the margin-of-safety price.  And, finally, note the change in slope as growth and returns on capital increase.

With some stocks, the slope becomes parabolic, asymptotic, and down-right exotic … and you never thought a graph could achieve such an alluring level of  sex appeal.  Well, if the graph seems too good to be true, consider the before and after pictures of May West, who was considered the sexiest woman of her era when she was young and became a real porker when the ravages of age struck.  The same is often true of fast-growing companies.  Attractive in youth, they tend to burn-out early through hard-living and, like Mae, unsustainable growth.  [Note:  The general rule is that growth in excess of 30% per year threatens detrimental burnout, but, as always, there are exceptions to this rule.]

Do I Need More Analysis or Am I Just Sensitive?

Another way to analyze this is the following:

Like the earlier table, this one is color coded.  It considers the projected intrinsic-value price in comparison to the current price and calculates the up-side return.  “Fair value” is the current price, and fair value equals 100%.  Below 100% is color coded as red.  The yellow squares range between 100% and 150%, and they are yellow because I consider this to represent an attractive valuation for only exceptional companies — where management walks on water, divides loaves and fishes, births babies, washes windows, and sheers sheep before the rest of us have had breakfast.  If Warren were younger or immortal, I’d buy Berkshire in the yellow zone.  The green boxes (without bolding and lines drawn around them) indicate an intrinsic value that is between 150% and 200% above the current stock price.  This would apply to much of the Fortune 100 in terms of their size, financial strength, market share, etc.  This tier is below my normal deep-discount threshold, and examples of recent purchases that fell into this range are Disney and Wal*Mart.  Lastly, the bolded and boxed-in green squares are 200% or above the current value.

A Final, But Important, Note

For the record, I tend to calculate these figures using several different methods of estimating intrinsic value.  Think of it as Sensitivity-Analysis-Squared.  Here is one of many possible examples, using the SLP data:

Credits and References

Finally, for a more complete explanation of the math behind the equation, read Value Investing:  From Graham to Buffett and Beyond by Bruce Greenwald and Judd Kahn, Paul Sonkin, and Michael van Biema.

The charts and graphs do not appear in the Greenwald book.  For good or ill, they represent my effort to incrementally improve on Professor Greenwald’s brilliance.

The purpose of this posting, beyond responding to an online comment, was to teach the concept of sensitivity analysis and take it a step beyond earlier efforts that focused on the Ponzio approach to Discounted Cash Flow analysis:

Example of Sensitivity Analysis Using Ponzio DCF Approach and SLP

The original idea for addressing this topic followed from a recent conversation with Bill Ellard.  Bill has written and published for a number of online investing Zines, while the Ponzio approach can be found at FWallStreet.com, where professional money manager Joe Ponzio is the chief cook and bottle-washer.  [Joe also runs Ponzio Capital and is the author of F Wall Street.]

Disclaimer

Now for the disclaimers, which have not been approved by any competent legal mind.  First, be an adult and do your own analysis and due diligence before investing.  I am neither perfect nor clairvoyant when it comes to investing, and I’ve made my fair share of errors in the past.   While not intending to fool anyone, I have made mathematical mistakes before (starting in first grade and continuing uninterrupted to the present day).  Consequently, there is no guarantee that the math presented here is perfect (I’ve checked it thrice or more, but I am, both, writer and editor, and, therefore, violate the tenet that no physician should have himself as a patient).  So, do your own thinking and ciphering, make your own decisions, and be adult enough to withstand the consequences of a mercurial market, an imperfect writer, and the potential that the financial Gods just might smote us both, no matter how good looking or worthy of wealth the two of us might be.  Please know that it is my preference that you not invest in any stock used as an example on this blog.  Instead, use the concepts to identify your own investment opportunities and send me a note with your best ideas … but only the ones that make a change of pants or panties necessary … and quantitatively explain your logic.  [Note: Good or bad, I will not post your recommendations.  Sorry, I shill for no one.]

_________________

Following publication of this piece, Mike wrote:

Thanks for a great report regarding Simulation Plus,Inc.. You inspired me to due my own due diligence in this company. I am new to investing but here are my results:
ROE over the past three yrs., 8.8%,14.3% & 14.5% ave. 12.5% Would like to see 15% or more;
Growth Rate for yrs 05/06 23.3%, 06/07 51.1%, 07/08 1.2%, and 08/09 1.89% Big drop here could be trouble.
Net Profit Margin is on ave., 15.6% not bad;
Asset Turn 0.76 cents,0,86 cents and 0.75 cents not good;
ROA last three yr. ave is 12.5 % could be better;
FCF 06/ -0.22,07/ +2.33,08/ +1.67 and 09/ +1.77 this seems lumpy;
Cash King Ratio for four yrs. is on ave., 15.11% which is very good;
Cash Conversion Cycle for Simulations is 116.7 days I don’t know if this is good or bad?
Because I am new at this I need your ideas if you still think SLP is still a good investment. Thank you for your time and consideration in this matter.
Respectfully, Mike

First, Mike, thank you for the compliment.  They are always appreciated.

Second, please recognize that I used SLP as an example to demonstrate an analytical approach.  While I own shares in the stock, SLP is a very small holding in a larger portfolio, and this strikes me as appropriate for a small value/growth company with a market cap significantly less than $100 million.  During a significant market down-turn, market liquidity could dry up quickly.  So, while the company is abundantly healthy (no debt, strong cash flows, etc.), don’t deploy your rent money or allocate Granny’s savings toward it.

Morningstar Data.  See Debt/Equity figures.

Third, your calculations differ from the Morningstar figures (marginally, in some cases, more significantly in others):

Now, let’s look at each of the items you mentioned, starting with Net Profit Margin.  At 15%, this is, indeed, healthy.  Next, you note that Asset Turnover is “not good.”  The reason we consider Asset Turnover is that it contributes to Returns on Assets when multiplied by the Profit Margin.  This tells us a great deal about the company’s pricing structure if you think of Asset Turnover as a surrogate for the volume of unit sales.  With a high profit margin product, you can sell a small number of units to achieve the same ROA as a low margin product for which you must sell a great many units.  This is the difference between Porche and bubble gum — one has high margins and low unit sales, while the other has low margins and high unit sales.  This, in fact, is recognized by Investopedia (the online dictionary of investment terms and concepts):

http://www.investopedia.com/terms/a/assetturnover.asp

Now, you note that ROA has a three year average of 12.5% (indicating that this “could be better.”)  Recognize that SLP is an early-life-cycle company in its formative years.  Consequently, the numerator (net income) will be depressed due to growth CapEx spending (plowing back into the company a greater portion of operating income to finance future returns), and the denominator of ROA (Total Assets) may be higher-priced (listed as more valuable or expensive) than for a longer-tenured firm.  For example, there is a great deal of uncertainty about the real estate value of Sears Holdings because much of the property was purchased more than 40 years ago, at much lower prices.  Credit Suisse values the real estate holdings at $4.7 billion today, while Sears lists them at $1 billion on the balance sheet.

Next, you note that the three year average ROE is 12.5% (the same as for ROA), and that you would like to see something greater than 15% by this measure.  The difference between ROA and ROE is literally the multiplier effect of debt:

http://www.investopedia.com/terms/e/equitymultiplier.asp

Recall from earlier that SLP has no debt.  Of course, debt can be a good thing or it can be a bad thing.  It is known as leverage for a reason.  It enhances profits and exacerbates losses.  Currently, corporations are stockpiling cash due to economic and tax-rate uncertainties, allowing them to reduce debt, and this is depressing ROE.  So, in this respect, SLP is not alone.  In fact, the company has indicated its interest in making strategic aquisitions, if the right deal comes along, and this explains why cash and short-term equivalents account for nearly 60% of total assets:

More importantly, the company should not take on debt if unable to convert that capital into new sales.  Doing so would depress ROA and ROE, and it would certainly depress any right-thinking investor.

The decline in growth rate is easily explained by the decline in the economy — the worse recession/depression since 1929 — and the uncertainties associated with healthcare reform legislation for SLP’s principle customers (the pharmaceutical and bio-med industries).  The question then becomes whether this represents a short-term condition or a long-term undermining of the company’s strategic position.  While this is largely a judgment call, note that SLP’s principle product significantly reduces R&D costs for its clients and the utility of the product is recognized by the FDA as a suitable surrogate for those R&D steps.  So, the question becomes one of whether you expect pharma and bio-med to cease R&D toward new medical advances — if so, be gentle when you break the news to their stockholders.

Next, you indicate that FCF is lumpy, and it certainly is.  Dive into the statement of cash flows, however, and the reason becomes fairly evident.  Note that the numbers are exceedingly small.  A change of $1 million in cash from investments can have a material impact on FCF, even though that $1 million expense was toward upgrading operating infrastructure, as happened a couple of years ago.  That decline in FCF, however, represented an internal investment toward future growth, for which the company and its owners should reasonably expect a future return on investment.  And, indeed, the new product announcements since then support this view — with one product already generating profits and the other new product just starting to enter the market, following the recently announced sales and distribution partnership agreement.

You note that the Cash King ratio (15.11%) is “very good.”  Candidly, I’m not familiar with this ratio.

As for whether SLP remains a value investment, I am of two minds about that.  At the current price it is fairly valued if expecting 6% annualized growth.  If, however, you anticipate a higher growth rate due to the company’s proven history of innovation, new products (generated internally), and the company’s past history of accretively successful and judicious acquisitions, then the stock is undervalued by 50% or more.  To see this most clearly, look at the Returns on Invested Capital and compare that to any reasonable measure of the company’s cost of capital.  The difference between the two reflects the franchise value of the company (what Buffett calls “The Moat”).

Now, I should offer two warnings to the approach you are using.

First, allow the ratios to help paint a picture of the company as a strategic entity in the market.  In other words, understand the strategic position of the company and its forward prospects and let the ratios support or disprove the mental picture you have of the company.  Because the ratios are backwards-looking (reflecting prior results), they will tell you about how management has positioned the company and whether the company is in financial distress, but they are often poor indicators of future performance.  This is especially true for early-stage firms.

During grad school, we did a case analysis of American Greetings.  The financial results and ratios were little different from one year to the next, and my team’s presentation of the case reached that conclusion.  Our professor (Dr. Doward Dowsma) then asked the key question — “Is American Greetings a stock or is it a bond?”  Well, of course, it is a stock, but its behavior was more akin to a bond — with a steady and predictable revenue stream and dividends.  Dr. Dow then asked whether it was easy or hard to value the company, and, because it behaves like a bond, we said it was easy.  “As investors,” Dr. Dow continued, “is there anything about the stock that you know that other investors do not, since the value is so easily determined?”  We could think of none.  “Is the stock fairly valued today?”  It was, we asserted.  “So, the market knows how to read a set of financials, calculate the ratios, discount the cash flows, and place a fair value on the stock?”  Yes.  “Is American Greetings a buy, sell, or hold?”  We said “hold.”  “Oh, really?” responded Dr. Dow.  “You can’t find a better use for your money than purchasing a fairly valued bond?”

Now, ask yourself, “Is SLP so predictable in its results that it behaves like a bond?”  Then ask, “Do you know something the market does not?”  Personally, I know that the company enjoys significant barriers to entry, that management is earnest and honest, that it occupies an industry that is more resilient to market down-turns than most, has a new product that may revolutionize workplace efficiency for disabled workers, and has consistently posted returns on invested capital that exceed the imputed equity cost of capital (maximally, 8.6%).  I also know that it is a small company that is under-followed by Wall Street analysts.  So, yes, I know something the market doesn’t … and I know the company is so small that it represents a speculative investment.  Consequently, I want exposure to the company, but I don’t want a lot of exposure.  That was my thinking when I bought the stock when it was selling near its delisting price of $1, and that is my thinking today at $2.35.  The difference between then and now is that the company was cheap on a book value basis at $1.

Second, if relying so strongly on ratios and conventional measures for them, you need to consider more than three years worth of data.  Three years is statistically meaningless and, worse, misleading.  Under the central limit theorem, you need 30 data points to determine when a single data point is statistically outside the normal distribution (i.e., to reject the null hypothesis).  Walter Shewhart, in the mid-1920s, demonstrated that you could use as little as five data points if the data was accurately collected and reflected a standardized process.  Well, the distribution of economic results is not captured by 10 years worth of data (the prior decade’s data was unhelpful in predicting the crash of 2007/2008), and it is certainly not captured with 5 years worth of data, and 3 years data is 40% less data than five years data.

This is why Benjamin Graham advocated requiring a significant margin of safety.  That margin of safety can come in different forms.  It can be based on a discount to the company’s balance sheet (Graham’s approach), but this entirely ignores the compounding benefits of future growth.  You can use John Burr William’s DCF to get at the value of growth, but this requires making judgments about growth and discount rates.  You can discount DCF (a la Joe Ponzio and Monish Pabrai), but this provides little protection during economic crashes that exceed 30% (or less, depending on your growth and discount assumptions).  You can do as Buffett does and combine Philip Fisher with Graham and Williams and add a heavy dose of Michael Porter’s “Strategic Forces.”  Or you can modify Buffett with Bruce Greenwald’s methods — adding layer upon layer of safety margins, where the value of each margin of safety is accorded its appropriate weight depending on the strengths of the company — something I’ve barely touched on in this blog, but I’m working on it with the latest series of quality improvement postings (but that won’t be evident until the end, due to the complexity of the theory and philosophy behind it).

In any event, I hope this is helpful.

The key takeaway is not that SLP is or is not a stock you should buy, however.  It is right for my portfolio, because I can accommodate a significant loss from a small and speculative investment, and, having experienced and navigated the crash of 2007/2008, I know with relative precision my tolerance for risk.  As a new investor, your tolerance may be lower (most investors believe their tolerance is high, until the market hits them hard) or your invested capital may be less discretionary.  So, please do not read this as a recommendation to purchase SLP.  That is not my intent, and it was not why I used it as a case study originally.  In fact, I chose SLP as the example because I believed most investors would elect against buying, due to the small market cap, low share volumes, early-life-cycle stage, etc.

Thanks,

Robert

PFE and Calculating Sustainable Growth of ROE

Never let it be said that, in this journal of my investing life, I was not prepared to describe my mistakes.

I am, in fact, thinking of Pfizer, which I purchased at $25.46 and $22.96 on March 9, 2007 and February 26, 2008, respectively, for an average price of $24.00.  Today, the stock is selling for $17.39 — down around 28%.  At the time, it seemed a reasonable purchase (they all do), selling cheaply based on discounted cash flows.

The problem was that, while I teach healthcare management, that doesn’t make me qualified to assess the strength of pharmaceutical products or their pipeline of compounds undergoing research and development.

In short, this stock should have gone into my Too-Hard pile … but it didn’t.  In fact, even if my resume included the earned-degrees PharmD and bio-physics Ph.d., I doubt pharmaceutical firms creating patent-protected medications would ever emerge from the Too-Hard box.

Today, the stock is undervalued based on DCF (Discounted Cash Flows).  With Lipitor’s expiration looming and the pipeline unimpressive to the market, DCF indicates the stock is undervalued by more than 60% — using a starting value of free cash flows of $15.3 billion, a free cash growth rate of 12.8% (the median of running three- and five-year medians over the past decade), a 5% growth rate for the second decade, a 15% present-value discount rate, and the current $95.56 billion in shareholder’s equity as the continuing value).

Even if basing DCF on Owner’s Earnings, rather than Free Cash Flows, and estimating future growth using sustainable ROE (i.e., normal ROE with dividends subtracted) the stock is selling at a 37.2% discount.

Lengthy Educational Aside That Delays Admission of Dufus Error In Judgment.

At this point, I should stop and, for the sake of explanation and reader education, describe something that hasn’t been put forward with prior postings — this education thing is, after all, one of the reasons for this blog (kind of a “look what I learned at camp” exercise).  Specifically, I should explain the concept of sustainable ROE (we will return to PFE as a mistake soon enough).

First, Return on Equity is defined by Investopedia as:

Return on Equity = Net Income/Shareholder’s Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferred shares.

ROE can be broken out based on three and five measures, using the Dupont Breakdown. For the three-item version, we have:

Net Income/Sales
Sales/Total Assets
Total Assets/Equity

Note that the first two items are the components of Return on Assets, where Net Income/Sales is the company’s Profit Margin and Sales/Total Assets is the Asset Turnover rate. The third item, Total Assets/Equity, represents a measure of the company’s debt and is known as the Equity Multiplier. This means the difference between Return on Assets (ROA) and Return on Equity (ROE) is the multiplier effect of debt.

For Pfizer, we get:

Note that, when I first purchased the stock in 2007, debt was declining and the other two items were stable — even though the Asset Turnover measure was down from 2000.  Since then, the Equity Multiplier has increased while Asset Turnover has dropped yet again.

The other breakdown of ROE involves five items:

Tax Burden = Net_Income/Earnings Before Taxes

Interest Burden = Earnings_Before Taxes/Operating Income

Operating Profit = Operating Income/Revenue

Asset Turnover = Revenue/Total Assets

Leverage Ratio = Total Assets/Total Equity

Note that the Leverage Ratio line from this chart and the Equity Multiplier from the previous chart are the same, as is the Asset Turnover line.  To make this chart an even more confusing jumble of lines, I’ve added a sixth line for the ROE.

Now, lets turn to the calculation of the Sustainable Growth Rate, which is the rate of growth the company can, theoretically, generate without taking on new debt, securing  other capital financing, or delving into savings.  Let’s start with the general spreadsheet:

I should note that all dollar figures are in millions.

The portion of the spreadsheet that pertains to Sustainable Growth is this part:

The first thing we need to do is to determine the percentage of free cash flows not distributed as dividends.  The company, after all, can only deploy the cash it has available for deployment (before taxes).  So, we use the percent of free cash not distributed as dividends:

I’ve provided the calculations, which reads:  =IF(B17=0,0,1+(B16/B17)).  This is an if-then statement, where the first part forces a zero response if the denominator in the subsequent equation is zero.  The meat of the equation is:  1+(B16/B17).  This has the effect of identifying the percentage dividends paid out of free cash, which is then subtracted from 1 (100%).  In other words, this is the percentage of Free Cash Flows left over after dividends are paid.

Because dividends are taken from the Statement of Cash Flows, where dividends paid are always negative numbers, I add the negative percentage of dividends divided by free cash flows to 1 (100%).    I could have calculated this as  1-(-1*(B16/B17)), but that would have been less elegant (which is computer-geek-speak for “needlessly complex”).

The rest of this is really very straight forward.

Specifically, just multiply ROE by the percent of free cash retained by the company.

By the way, you can do the same for ROA, but, instead of Sustainable ROE, this is known as the Internal Growth Rate.  Why?  Well, recall that the difference between ROA and ROE is the equity multiplier … i.e., debt … and debt represents external capital financing.

Note that, for companies with absolutely no debt, ROE and ROA will be the same.  AND, for companies that pay no dividends, sustainable growth will be no different than ROE, just as internal growth will be no different than ROA when no dividends are paid.  In the case of Pfizer, there is a difference for both:

Recognizing this distinction between ROE and ROA, on the one hand, and Sustainable Growth and Internal Growth, on the other hand, is important.  It implies that ROA and ROE are important measures when trying to determine the benefits accruing to the stockholder.  But, if viewing ROA and ROE from the perspective of the company, Sustainable and Internal Growth are the better measures.

Personally, I am more concerned with the company’s future growth than with the dividends paid to me as the stockholder.  If the company can grow and generate results at rates greater than I can produce with other investments, that is my preference.

Indeed, most companies can more easily generate superior results because they have a headstart of between 15% and 35% (the tax hit I confront when selling the stock or receiving dividends).  In fact, the company’s head start is even more pronounced  because it can invest profits toward future growth before paying taxes on those profits.  Add to this the miracle of compounding, and that head start is so pronounced that I stand a snowball’s chance in hell if hoping to easily find a superior investment alternative when the market is fairly valued or over valued.  It is only if the company can not generate productive returns at rates exceeding the norm (net of my tax hit) that paying a dividend benefits me, as the stockholder.

This is a recognition that appears to befuddle many investors.  On the online message boards, someone is bound to argue that management should pay a dividend or increase the dividend or repurchase shares as a way to improve the stock’s price.  Rarely do they consider the tax implications of their urgings or the impact of share repurchases on the company’s profitability and growth prospects over time.

Even if I plan to sell the stock in a year or two, I want the company to think and plan for the long-term — to act as though none of its stockholders will ever sell.  Why?  Eventually, the market tends to give a premium value to those companies possessing substantial promise for decades to come, while, conversely, the market discounts the value of companies that manage their investments as if they are to be sold tomorrow.

This is different from the conventional wisdom, of course, but think about the price demanded for the strongest firms — those with the most consistent returns and strongest reputations.  The price of JNJ may decline short-term if posting less than consensus results, but the price is unlikely to tank to the same degree as for firms with less-reliable or suspect prospects.

On the other hand, it may be imagined that the stock will sell at a higher price if the market anticipates that the company is for sale — expecting that an acquiring firm will pay a premium of around 20% or more.  That 20%, however, is a pittance compared to the compounded growth that quality companies can generate when reinvesting profits to the benefit of the owners.  It is only when the company is unable to do this and has an excess of cash (more than it can productively use) that paying a dividend or repurchasing shares makes sense for the owner.

So, when I decide to sell a stock, I want the market to pay an exceedingly dear premium for my wisdom in selecting excellence, and I want to sell at a profit sufficient to compensate me for the tax hit and market risk.  Selling, therefore, at a 10% or 15% profit falls short of that mark, and, if the company is bought out at a 20% premium, that 20% is barely enough to compensate me as the owner, after factoring in the capital gains taxes, the market risks, and my subsequent obligation of finding another investment that can generate an adequate and reliable return on my investment.  Great investment ideas are not so plentiful that being bought out for a 20% gain makes we weep with joy.

Perhaps a different perspective will prove helpful.  If inflation is expected to run at around 4% or 5% over the coming decade (due to increased deficit spending by government) and yearly market risk comes in at 6.8 percent, my minimum required rate of return is around 12%.  Add to this the risks associated with opportunity costs (the risk that I won’t be able to find another opportunity), and that increases my required rate of return to somewhere between 15% and 17%, depending on whether the market under-, fairly-, or over-valued.  If receiving a 20% premium over the current market price for the stock (the price at which I could sell regardless of whether the company is bought by an acquiring firm), my gain is just 17% after taxes (assuming a 15% capital gains tax).

In other words, my required rate and the return received are the same — making me agnostic on the acquisition.  If my acquired company is truly excellent, my agnosticism turns to angst — which is how I felt when NOV acquired Grant Pride Co several years ago.  Grant (which I owned) was a wonderful company (the financial ratios and performance were clear on this), while NOV was bigger but not nearly as impressive.  To be fair, NOV paid a 30% premium for Grant, but Grant was so good that I couldn’t help wonder whether I was being under compensated.  And, when NOV’s stock shot-up after the deal went through, my suspicions seemed confirmed.  Pleasantly, the deal was a combination of cash and stock, so I benefited from my newly-received NOV shares (a lucky break that had nothing to do with my skill as an investor).

By the way, all of this is different from conventional value-investing, where the lion-share of price appreciation is derived from having bought at a discount on the front end.  Buffett, however, seems to hold this same perspective — given his penchant for buying and holding long-term, preferring companies with well-defined and defensible moats, and his willingness to pay a fair price for an excellent company.

Back to My Mistake With Pfizer

Of course, I started this aside (tangent discussion above) just to note that DCF analysis can be based on other measures than discounting free cash flows, only.  This is something I learned from Bill Ellard, who I met on the AEO Yahoo Finance! board.  Bill didn’t suggest this specific approach (for good or ill, I came up with the idea of using owner’s earnings and the concept of Sustainable Growth and Internal Growth were pulled from an old business school text).  Nevertheless, it is interesting to note that Pfizer’s ROE and ROA have been declining over the past decade, and that the portion redeployable by the company has so eaten into the results that fostering future growth from such meager returns is questionable … sort of.

In the case of Pfizer, the company has a reasonable cash stockpile from prior years:

This indicates that 28 cents per share is in cash, versus a little less than 80 cents paid out in dividends.  This means that dividends are primarily paid out of free cash flows.  This is a positive, in that the company is not depleting accumulated cash to pay dividends (the dividend would be suspect if that were the case), but it does raise concerns for dividend sustainability in a post-Lipitor world.  The company, however, has been taking steps to diversify its product mix through mergers and acquisitions, even if internally-generated growth through its new-products pipeline has been uncertain.

And that is why my earlier purchase of Pfizer was a mistake.  Simply put, I didn’t know what I was buying when it came to the research and development pipeline.  Yes, the company is strong financially.  Yes, the company’s history is impressive.  Yes, it has sufficient size to pay a premium to purchase competitors and sustain itself while its researchers search for the next break-through.  But, at the end of the day, pharmaceutical companies are like financial institutions.  The investor is gambling on success without sufficient information on which to estimate the company’s long-term prospects.

Now, this is really interesting on a number of fronts.

Buffett has argued that he wants to have an excellent feel for where the company will be in 20 years.  For pharmaceutical firms, this is not possible.  Patent protection lasts 20 years, and, since the company must file for patent protection when first identifying a new chemical compound for testing, by the time lab research, animal testing, human clinical trials, and the FDA approval process are completed, the viable life of the resultant product is just 5 years or less.

Buffett, however, owns Pfizer.  Huh?  Warren must have a crystal ball.

Moreover, as noted in earlier postings (especially, one generated for Joe Ponzio’s FWallStreet), I argued that investing in financial firms is speculative because the investor has no means of judging the portfolio of loans and investments undertaken by financial firms (banks, investment banks, and insurance).  There simply isn’t sufficient granularity to make an informed investment decision.  This isn’t just my opinion, no less than Benjamin Graham agreed in, both, Security Analysis and the Intelligent Investor, and the consultant-authors of Valuation at McKinsey and Company have found no recent approach to overcome this problem.  Consequently, I have never invested in a financial firm.

Well, the same problem exists with pharmaceutical companies, because the investor has no means of determining the future prospects of R&D initiatives.  Think about all of the promising “blockbusters” that have failed to meet their targeted end-points during stage III trials.  Think of those that have been denied FDA approval.  And think of those which have earned blackbox warnings after FDA approval.  Terrorist attacks and natural disasters do not show up with the same frequency.  We’ve had fewer than 5 acts of terrorism over the last 20 years, average 11 hurricanes yearly (most fail to generate catastrophic claims at category 4 or 5), and there have been fewer than five earthquakes in the US over the past two decades, but the same may not be said of the hoped-for “blockbusters” than weren’t.

Now, this is appreciably different from the generics — which piggy-back on the brilliance of others (and they will soon be the beneficiaries of Pfizer’s Lipitor).  Indeed, we are all the beneficiaries of pharma’s efforts, but, as an individual investor, I’m pleased that I plunked down just $2 thousand on Pfizer (a relatively small percentage), and, as a value investor, I won’t be making this mistake in the future.  Pharma, candidly, can experiment on another’s dime.

Of course, you may argue that with R&D-intensive companies increased risk produces increased rewards.  This, however, is not an immutable law of physics.  Risk and reward are not balanced if playing blackjack at the Sands in Vegas.  The rewards are decidedly insufficient to support playing Russian Roulette (even if doing so in Hawaii) or having unprotected coitus with a partner of suspect affections.  And there is nothing about pharmaceutical R&D that guarantees a favorable balance between risk and reward for the investor.  In fact, the buying and selling of equities is, in most cases, a zero-sum-game, where one side pays too much or buys at a bargain and the other side receives a premium on the sale or sells prematurely.

Finally, I would be remiss if not noting that, after passage of healthcare reform legislation, Pharma is one of the few groups potentially benefiting from its enactment.  In fact, Pharma has benefited from the no-negotiations and anti-reimportation policies of the federal government (in the US).  Some have argued that this is a mistake, but, given the speculative and unreliable aspects of generating novel therapeutics, both make abundant good sense to me.  Opponents of both policies should be asked how many medical breakthroughs they have produced in their working careers and impolitely told to “shut up” if the number is zero.

For me, however, investing is not gambling; otherwise, my wife would never allow it.  It is about buying fractional ownership of real companies when they are selling at a discount, and selling when the buyer is prepared to pay handsomely.  With Pfizer, I violated that tenet on the front-end, and, unable to value the company today, the decision to sell is equally difficult.  If unable to value a company, the investor can be taken when buying AND selling and, given the dilutive effects of inflation during the interim, can be taken while holding a stock he hasn’t valued with reasonable accuracy.

Healthcare Cost and The Oracle

Earlier this week, Warren Buffett gave an extended interview to CNBC’s Becky Quick.  By extended, I mean three hours, with commercials.  During it, the Oracle was asked about healthcare costs, which he described as the tapeworm eating at American competitiveness.

A review of past postings on this blog, concerning the subject, will reveal that Mr. Buffett’s take on the subject and my long-standing views are nearly congruent in every respect.  This includes my view that neither party has put forward a workable solution to the problem of healthcare inflation because no proposal addresses the principle sources.

Transcript and Video of Buffett Interview:  http://www.cnbc.com/id/35643967

Casting Blame for Underwater Housing Defaults

According blame for unsavory circumstances is just human nature.  Blame is the ointment of the psyche — it relieves, if only moderately, the discomfort we feel when things go wrong and we suffer collateral damage as victims.

Even when there is no bleed-over that effects us directly or indirectly, blame is still a common psychological need.  When a surgery goes wrong, juries may compensate victims for medical errors due to nothing more salacious or untoward than simple human error — as though doctors should reasonably pay millions for something as common as human fallibility.

My wife lost her glasses this week, and my son lost his cell phone.  Both asserted that these events were a consequence of human error, and both objected to paying heavy fines for it.

Of course, surgical errors have heavier consequences and warrant higher remuneration, and, indeed, this explains a portion of the high insurance costs paid by doctors … costs which are passed down to institutional payers (insurance) and, eventually, to patients and employers in the form of higher insurance premiums, and, ultimately, to consumers and taxpayers in the cost of goods, services, and taxes.  Human imperfection is expensive.

Yes, blame is a necessary convenience, and, when there is no one else to blame, the victim is always an available target, under the logic of “Well, he should have … (fill in the super-human choice that you would ideally have made under the same circumstances).”  But, in the crisis or pivotal moment when the choice is upon us, it is human nature to make decision errors due to nothing more complex than the lack of complexity in human decision-making.  The logic center of the brain can only hold 7 ideas at a time (on average), and that means we are prone to error, because important decisions require more robust thinking than we are wired to produce.

Blessedly, we are also prone to amnesia when it comes to our errors — quickly forgetting our imperfections, while committing to long-term memory our successes.  If we had equal and vivid recall of our failures, we would avoid any measure of complexity or risk — which means we would not have children, start businesses, get married, turn on the stove, or have left the caves that provided protection to our forebears.

Of course, there are some people and groups who are favored targets for blame.  Mothers-in-Law come immediately to mind, as do lawyers, and bankers.  In fact, anyone who is more successful, good looking, powerful, or incongruously lucky represents a ripe target, because there must be an unsavory explanation for their more favorable position compared to our own.

With mortgage defaults due to underwater loans, this issue of blame is everywhere.  Underwater loan defaults follow from homeowners walking away from houses whose values have declined significantly below the loan amount — rather than due to an inability to pay the note each month.

The problem is large, and it impacts all of us.  High home-loan defaults make bankers leery of lending, and, if lending, increases the interest charged on loans.  Defaults lower the value of homes as resales glut the market and increase supply to the benefit of buyers motivated to purchase at the lowest price.  Reduced home values make consumers more reticent to consume due to a decline in the wealth effect — we are more confident consumers when the value of our investments is high enough to make us feel secure, solvent, and wealthy.  And, of course, lower home values undermine tax receipts to government, which promotes higher taxes.

Given all this fiscal carnage, someone must be to blame, and the candidates are numerous.  Some, for example, have argued that lenders are to blame, due to their lowered lending standards, aggressive marketing efforts, and willingness to lend to borrowers who lacked the necessary income to safely buy homes (financially).  So, the bankers are to blame.

Others maintain that the system which allowed lenders to off-load loans to secondary institutions (Fanny and Freddie, as quasi-government agencies, in particular) promoted lower standards by the original lenders.  So, government is to blame.

Some contend that breaking up large pools of home loans into investment vehicles — CDOs — and, thereafter, into secondary mixtures — CDO-squareds — is the cause.  So, Wall Street is to blame.

Of course, with no one in the financial chain prepared to take responsibility or suffer the losses, those who seek to legally limit the exposure of their clients bear some responsibility, and that, of course, would mean the lawyers are to blame.

Even more nefarious (frightening because it is mysterious, obscured by complexity, and international) are the derivatives, which provide default insurance for some parties and a means of gambling for others.  So, the Third-World Order must be responsible.

And perhaps the favorite target of blame is the homeowner.  If you were so poor you couldn’t afford the water necessary to generate a potty break — much less the pot to hold it –, it doesn’t take a rocket scientist to realize you have no business buying a home … even if the banker will lend you the money and begs you to take the adjustable-rate mortgage.  So, the homeowner is to blame.

Personally, I think all of this is wrong … not because each of these favored targets are without blame, but because those entrusted to prevent it were alseep at the wheel … and I’m not talking about Mothers-in-Laws.

Homes are also real estate, and, regardless of whether they were bought as investments, their value and potential for appreciation or decline make them investments.  They possess sufficient value that we treat them as we do other investment vehicles of substantial value.  At closing, we sign contracts for the property and, unless purchased with cash, the mortgage is a contract that must be signed and witnessed.  Thereafter, we insure the purchase against foreseeable disasters — such as the overflowing toilet in my son’s bathroom a couple of years ago.  In fact, the cost of a home and the property on which it sits represents the single largest investment of capital most of us will every make, and, after the empty nest arrives and retirement arrives, the home-value realized when it is sold constitutes a substantial portion of our retirement savings.  The homeowner is, therefore, right to consider the home as something of significant value and to give it a prominent degree of importance.

The lender, on the other hand, has an interest in making certain the homeowner represents a viable business partner.  Of course, this is less of a concern if the lender plans to offload the loan, but, under normal banking conventions, the lender wants assurance that the borrower can repay the loan and is a low risk of default.  That, however, is just one lender concern, but there are others to which we will turn when next considering the interests of the insurance company.

The insurance company is primarily interested in the value of the property and the risk associated with injury to it.  If the borrower fails to pay on the policy, the insurance company suffers only the loss of revenues, because the lender is under no obligation to cover damages incurred when the account is in arrears.  So, the insurer is primarily concerned with damage and, equally important, fraud.

The threat of fraud includes paying claims when no damage occurred, but it also includes arson arbitrage, where the home is destroyed in an owner-set fire for the insurance proceeds.  The financially solvent owner has little motivation to perpetrate this crime if the amount payed on the claim equals the replacement value of the property — even if there were no threat of incarceration.  Instead, arson arbitrage is only lucrative if the property is insured for a value greatly in excess of its replacement cost.

Consequently, the insurance carrier has an interest in making certain that the home is appropriately and accurately valued, and the banker has the same motivation, as well.  As the lender, the bank has little interest in issuing a loan that exceeds the value of the property.  The higher the loan amount, the higher the interest payments — which increases the threat of default.  This is partly why jumbo loans (covering homes costing more than $400 thousand) require higher interest rates — to compensate for the increased risk of default due to the higher loan amounts.

And the homeowner/investor has an interest in identifying an accurate value for the property.  Overpay for the property, and the returns on investment when the property is sold is greatly diminished and, more importantly, the higher the amount paid in total interest during the life of the loan.  During normal times, the threat of inaccurate valuation threatens the homeowner more than the lender or insurance, because the homeowner cannot diversify this risk across a large number of customers and because this unique purchase constitutes the single largest non-diversified deployment of capital for the party in this transaction with the skimpiest pockets (financially).

In fact, lets compare the purchase of a home with other common investments undertaken by non-institutional investors (you, me, and our neighbors).  Most invest savings in mutual funds –  effectively, hiring professional money managers to allocate capital and perform the valuations for us.  The managers of mutual funds, therefore, are expected to value the stocks and bonds and real estate and precious metals that form the core of their holding-choices.

By contrast, a smaller number of us invest on our own account, and, when we do this, we take responsibility for valuing our purchases.

Now, it must said that most individual investors do a poor job of valuing, primarily because they lack the training.  During the dot.com bubble, thousands of average investors were willing to pay a price for JDS Uniphase that was 120 times the company’s reported earnings.  Clearly, they never learned to sipher — add, subtract, multiply, or, in this case, divide.

Regardless, the competent individual investor values the revenue streams of the bonds they purchase (compared to the price), and, in the case of corporate bonds, consider the default risk of the issuing company and the value of the collateral designed to secure the bond.  If purchasing stocks (equities), the competent individual investor will consider the various reported or readily available ratios, such as PE, PB, PS, P/NAV, or, delving deeper, perform the discounted cash flow analysis to identify the approximate value of the company (on a per-share basis).

With real estate, this is more difficult.  If we were to value a prospective piece of real estate in the same way we would a stock, we would have to discard cash flows from consideration (assuming the property is not revenue generating).  The same holds for price to sales and P/NAV (unless undertaking significant modifications with P/NAV).  Even if valuing it on a price to book basis, the investor needs to be more accurate in the estimation of book value of a home than when doing so with long-established companies, because inflation related to book-value assets provides no margin of safety for the home buyer — as it does for the stock investor.

This means the competent real estate investor needs to value the current price for the building materials and labor, the pricing implications of builder taxes and fees, identify a reasonable ROI for the builder, and factor in the location premium, among other considerations.  In fact, those considerations would include the degree to which the market as a whole is over- , under- , or fairly-valued, in general.  These contributors to the price of a property are not publicly reported in a convenient Securities and Exchange filing, as it is with bonds and equities, and they certainly are not audited by an independent, certified, and bonded auditing firm.  Instead, the home buyer (to say nothing of the lender and insurance firm) would be operating under a system of Caveat Emptor (“Let the Buyer Beware”) if not for home valuation inspectors.

In fact, regardless of the degree to which the system became dysfunctional prior to the real estate crash, it relied on home valuation inspection to prevent the market from becoming an extreme and speculative bubble.  If the values had not represented a disconnect to intrinsic value, lenders would not confront the need to sell properties at such a substantial loss in comparison to the original loan amounts, the CDOs and CDO-Squared’s would not have been so severely undermined.  Instead, defaults would more closely represent an even exchange between the defaulted loan value and the actual value of the property.

In short, the system relied on valuation inspectors to do more than say “the house is sound and worth the price because the same model in the same neighborhood sold for a similar price last month … that will be $350 and I’ll mail you a copy of my report.”  In fact, what home buyer hasn’t thought, “The inspector spent 90-minutes looking at the house and is charging me lawyer’s rates for briefly climbing into the attic and doing a flash-light scan of the craw space … should I change careers?”

Well, the answer is that the fee was for more than just looking at the house and blessing the price, but, instead, included specialized knowledge about the costs of construction and the economics of the housing market.  It was on their independent and expert judgment that the whole of the system relied to serve as the trip-wire alarm if prices so severely exceeded intrinsic value as to make the loans suspect, the insurance invalid, and the buyer the victim of gouging.

And this is why most states passed legislation requiring home valuation prior to purchase.

When prisoners riot, we blame the felons, the guards, the parents, and the warden.  But after prisoners riot, we hire more counselors.  This strikes me as a mistake.  We should fire the counselors and promptly hire their replacements.  Why?  The counselors should have seen it coming.

In the case of Wall Street, it may have been the case that the SEC was understaffed and insufficiently trained.  With home valuation inspectors, the training may have been insufficient and the standards egregiously lax but the prices charged determined staffing, and none of us got what we paid for.

[Note:  I've written this piece as a thought response to an article read on an above-average investments discussion board.    The Crawford's have not lost their home, nor are we in jeopardy of that happening.  Contributions, however, to the Robert Wealth Enhancement Fund are always welcome, as long as they do not trigger gift taxes or IRS suspicions.  If you are a close relative and my wife or I are beneficiaries of our your estate, we would prefer to wait for your donation until after your regretable demise.  If it is true that "to whom much is given, must is espected," we would prefer to keep expectations low.  I know my limitations, even if my bride has none.]

A Better Approach to Valuing Net Income?

[Note to Readers: Since purchasing BOLT, an explosion, fire, and oil leak on/from a BP platform in the Gulf of Mexico occurred.  As of today, news reports indicate that the resultant leak threatens the coastline of the Florida Panhandle, Mississippi, and Louisiana with the volume of oil exceeding the Exxon Valdez accident.  Regrettably, news reports indicate that it will take some time to drill a relief hole and cap the leak.  Further, as of this writing, efforts to contain the spill before it reaches the coast have been hampered by turbulent waters.  I have, therefore, sold my position in BOLT this morning, taking a 1.88% loss on the stock. I am not, however, removing this article (which uses BOLT as the example case), because the approach described in it remains relevant to readers interested in undertaking more intelligent investments.  Indeed, even this unfortunate circumstance (which includes loss of life for several working on the BP platform) represents a learning opportunity for investors.  Warren Buffett has long maintained that he sells stocks when they become, either, overvalued or the prospects for the company become fundamentally impaired.  While I remain persuaded that BOLT remains undervalued and that the downside for the stock is likely limited, the informing environment for the industry now confronts significant challenges not previously present.  Indeed, just prior to this accident, the Obama administration announced the opening of a significant portion of the East Coast to drilling – a policy change that has been temporarily rescinded as government investigates the causes and considers regulatory changes.  Even if this is an expeditious process, the potential for news images of blackened Gulf beaches may be sufficient to alter the demand environment for BOLT services.  This change in the underlying environment seems likely to represent a significant strategic shift for the industry, in my judgment. On a seemingly related note, I took profits in BP Prudhoe Bay (BPT) today, as well.  The reasoning behind that move, however, was not based on the platform accident.  In fact, the accident is likely to increase demand for the products of drilling coming from the oil fields represented by BPT as a petroleum trust.  Instead, the stock had increased by 65% (85% after taking into account dividends accumulated during my holding timeframe), and, in my judgment, the stock had become overvalued. At present, there are three petroleum stocks that remain in my portfolio -- E, PVX, and XOM.]

Its UP.  Its DOWN.  Its UNCERTAIN!

That is the problem with earnings … the basis on which stocks are regularly valued.  Wall Street clearly cares about earnings, but “knowledgable” investors never use them.  NEVER!

Earnings are flawed as a measure.  They rely on items that can’t be deposited in a bank — such as “GOODWILL” and “AMORTIZATION.” Even their use of depreciation is suspect, as a measure of what should be spent in the way of capital expenditures to maintain plant, property, and equipment.  And this fails to account for actual capital expenditures that may include investments toward future growth, or Catch-Up CapEx designed to make up for delayed expenditures avoided in the past.

So, the earnest investor needs a better way to determine the value of earnings, and this posting addresses that important issue.  In fact, this approach is not one that I’ve seen mentioned in graduate business school classes — which is not to say that some other quant-geek hasn’t done it before, but, if so, I’ve never seen it.

First, earnings (or net income) represents a convenience for investors — a short cut that eliminates the need for more in depth calculations.  This short cut is the denominator in the famed Price-to-Earnings ratio, where stocks below 15 (chose a number) are deemed “cheap” and those above that number are considered “growth” stocks — because the market is evidently willing to pay a premium for that expected growth.  Earnings, however, are considered imprecise, for the reasons identified above (and other real and perceived failings).

To get beyond this litany of problems, many investors use Discounted Cash Flow analysis — the measure created by John Burr Williams.  As modified by my friend Joe Ponzio, the stock analyst considers Free Cash Flows (cash from operations minus depreciation and amortization) for some defined period of time.  Joe, sagely, uses 10 year data provided by Morningstar, and, for the purposes of this demonstration, we will do the same, using Bolt Technologies (BOLT) as our example case.

At this point, it is sufficient to note that Bolt provides services in support of oil drilling, but that is less important than what Joe does does next.  His goal is to identify the free cash flow growth rate over this time, and he does this by calculating the median growth rate during running three- and five-year periods and then calculates the median of this group of medians.

This growth rate moderates the effects of economic cycles and the variances from one year to the next, and it uses medians as a conservative measure of the intrinsic free-cash-flow growth rate for the company.  Joe then reduces this median-of-medians to provide an extra measure of conservative comfort.  Depending on the degree to which he considers the company and stock to be speculative, he may reduce this growth rate by 20 percent or 25 percent for the next three years, followed by further reductions in years four through ten.

The next step is to apply this growth rate in an effort to project free cash flows over the next decade, followed by projections of free cash flows over years 11 through 20 using a 5% growth rate.  These cash flow streams are converted to current dollars using a 15% discount rate.

Add all of these present-value contributions together, plus the net asset value of the company (its accumulated assets minus accumulated liabilities), and you have the total value of the company.  Divide the total value of the company by the number shares outstanding, and you have the per-share value of the company.  Divide this in half, and you have the price you would pay if demanding a 50 percent margin of safety.

In the case of Bolt, the company is worth $280 million (by this measure).  That equates to $35.05 per share.  And the abundantly cautious investor would expect to pay no more than $17.52 per share.  At the stock’s current price of $10.56, the company is selling at discount to intrinsic value of 69.87 percent, and, if the stock price increases to equal fair value over the next year (a big “if”), the potential gain is 331.91 percent.

Using this method, the investor may wonder what the compounded annual growth rate would be at various time-frames in the future.

With years along the x-axis and percent grain up and down the y-axis, we can expect an annualized compounded return of 49.17 percent if our expected holding period is 3 years.

But 20 percent is a very high growth rate, even if the company was able to deliver such exceptional results in the past.  What if the past is not prologue and the future is not as bright as the past?  Well, we can combine DCF with sensitivity analysis to identify the degree to which the stock is under or over valued at various free cash flow growth rates.

So, if you think Bolt will grow at just 5%, the stock is undervalued by 43 percent — being fairly valued at $18.54, with an upside increase of $7.98 and a potential gain of 75.57 percent.  In fact, you can compare the current price to identify the market’s expectations for future growth.  At a current stock price of $10.56, the market evidently expects the company will grow free cash flows at less than -15 percent per year for the next decade, followed by 5% growth for the second decade.  Clearly, the market is not impressed with Bolt, and the savvy investor would be smart to try and determine why.  Perhaps the market expects that oil will go out of fashion or that the management is incompetent and will drive the company into bankruptcy.  If interested in Bolt, that is for you to decide.  Personally, I’ve come to the conclusion that Bolt is a buy, but my goal with this posting is not to tout Bolt but to suggest a different (perhaps, new) approach to overcoming the weaknesses of DCF.

DCF, of course, uses past results to predict the future, and this is a weakness.  If the results in the past have been volatile, then using methods designed to value bonds (which have steady income streams) is a poor choice, and DCF seeks to treat stocks as an intelligent investor would treat a bond.  In the case of Bolt, the results have been fairly reliable — as reliable as a company that trends congruently with oil can be.

Warren Buffett, however, uses a different measure from Free Cash Flows to determine the cash contribution generated to the benefit of investors.  Buffett calls his measure Owner’s Earnings — Net Income minus Depreciation and Amortization plus Capital Expenditures.

Clearly, Bolt benefited from $150 oil prior to the market tanking in 2008, and the industry has not recovered along with the market last year.  Despite this, Bolt’s business in 2009 was pretty healthy — four times the owner’s earnings as the prior-era peak in 2002.

Well, we can substitute Owner’s Earnigs for Free Cash Flows and calculate Discounted Owner’s Earnings Flow (DOEF) using the same approach as Joe teaches with DCF.  In fact, we can use an assortment of other measures, such as Replication Value and Earnings Power Value from Columbia Professor Bruce Greenwald, and we can compare these to the current and past stock prices.

So, at $10.56, the stock is selling at 1.22 times its net asset value (NAV) and just above the 50 percent discount to its DCF value (the grey zone).  In fact, the grey zone is below NAV.  The green line is the DCF value, and the purple line indicates fair value by Buffett’s (normally) more  conservative Owner’s Earnings measure.  Replication value ($7.96) is close to NAV ($8.68), and Earnings Power Value (which takes into account the competitive advantages of an established company) is the most optimistic of the measures, at $43.08.

As a quick aside, stocks selling at or near NAV, Replication Value, and/or half their DCF value evidence a stock worthy of consideration.  Further due diligence into the company’s competitive posture, management, and financial strength are necessary, of course.  Poor management in a gang-busters industry represents a poor choice, as does a company overburdened by long-term debt coming due in short order.

As an additional aside, the question of when to sell is often the more difficult challenge confronting value investors.  Stocks at, over, or nearing their full DCF value warrant close consideration for selling.  As taxes increase, that threshold should increase, as the government lays greater claim to your takings when selling.  This would suggest giving greater consideration to the company’s Earning Power Value as a theshold for when to sell.   Buy and hold may be dead today, but it will rise from the dead when given mouth-to-mouth resucitation by higher capital gains tax rates in the near future.

Of course, no measure is perfect and there are problems with each.  We do know that last year’s performance tends to be a predictor of coming year (plus or minus some degree of growth or diminishing of growth — measurable by the second-order derivative for those who took and understood calculus).  Regardless, the informed investor will want a way to measure the return generated last year, if expecting that the current year will produce results worthy of investment.  And this is where my “new” approach comes in.

While earnings, free cash flows, and owner’s earnings may change significantly from one year to the next, shareholder’s equity tends to remain fairly constant — increasing or decreasing, to be sure, but to a lesser degree.  This is especially true of  long-standing companies with significant accumulated equity.  Given this, it makes sense to value shareholder’s equity differently than current contributions to owner’s wealth.  Indeed, of the two, shareholder’s equity is more akin to a bond in its stability, and this warrants segregating the two if seeking to determine the owner’s earnings return on investment.

In the case of Bolt, $8.31 of the $10.56 stock price is abundantly stable in that it represents accumulated per-share equity (ShE) — total assets minus total liabilities.  The remainder is the premium paid by the prospective shareholder, above and beyond a dollar-for-dollar purchase of the company’s equity.

The investor should reasonably expect a return on both accumulated equity and the premium, but the required return would be different, given their different levels of risk.  The equity portion, which behaves more like a bond in its volatility, should be valued accordingly, while the premium possesses all the volatility normally associated with the stock market.  So, let’s tackle the equity portion first.

Here are current and, for various prior periods, earlier corporate bond rates, taken from Yahoo! Finance.

Because I began writing this posting yesterday (February 28, 2010), I have highlighted yesterday’s corporate bond rate of 6.17 percent for the 20-year single-A bond. Out of an abundance of caution,  I have chosen the 20-year single-A because it has the highest interest rate.  If you believe the firm you are considering warrants better treatment (due to its abundant solvency or stability or both), that is fine, and you may want to use a lower and more appropriate yield.

I use this interest rate to determine the single-year rate of return expected for the equity portion of the stock’s price.

This is nothing more than multiplying the equity portion of the stock’s price ($8.31) times the 20-year single-A bond rate (6.17 percent) — producing $0.51 in expected return for the equity portion.

Next, I consider the appropriate return demanded for the premium portion of the stock’s price (in this case $2.25).  This calculation is only marginally more complicated, starting with the 30-year government bond yield (which I take as the Risk Free Cost of Capital).

Again, this is taken from yesterday and is borrowed from Yahoo! Finance (http://finance.yahoo.com/bonds/composite_bond_rates).  The rate for the 30-year US Government bond was 4.55 percent yesterday.

The premium paid portion of the stock price, however, possesses full exposure to the volatility of the stock market.  So, I add to this a premium for market volatility.  While some accord a 6 percent volatility rate with other calculations, the highest rate (based on past data) I have found is 8.6 percent, and, wanting to be conservative at every turn, I use 8.6%.

Now, some investors want to add a measure that accounts for the volatility of the stock price (Beta), and this is where that additional buffer may be added.  Personally, I do not, because I have absolutely no respect for the stock market and how it prices a stock from one day to the next.  In fact, at the risk of offending you, please know that I firmly believe (and assume) that you and the millions of investors that constitute the stock market are, collectively, idiots.  Over the past couple of years, you have valued the Dow at 14,000 and at 6,000, even though both constitute measures of the current value of publicly traded companies plus all of their future cash flow contributions to stockholder wealth.  If you (collectively) were not clueless, the Dow would not have dropped by more than 50 percent in a single year.  I’m sorry, but the market is bi-polar (exuberant one day and searching for razors with which to slice a vein the next), and, as a group, I find this sort of mercurial behavior unworthy of respect.  Nevertheless, if you want to factor the market’s schizophrenia into your assessment, simply plug in Beta, and add the two or three rates together to identify your required return.  For me,  I’ve accorded a beta of one — which means the stock’s volatility is no different than the stock market, in general.

This renders a required return of 13.15 percent.  Warren Buffett, by the way, famously tends to require a 15% rate of return for his DCF discount rate.  Buffett, however, told Bruce Greenwald (mentioned earlier) that this varies based on the risk free cost of capital, and he uses 15% as a lose rule of thumb for his calculations in recent years.

So, we take this 13.15 percent and apply it to the premium paid.

This is calculated as premium ($2.25) times the required rate of return (13.15 percent), and it renders $0.30.

Next, I calculate the portion of the stock price that is most at risk — adding the premium paid plus the required returns on equity and the required return on the premium.

That renders a cost basis of purchase of $3.06.  Now, you may want to increase this by, either, increasing the equity adjustment or increasing the premium-paid adjustment, in order to further account for any perceived risk on shareholder’s equity.  This strikes me as unnecessary because we have already used the highest yield for corporate bonds and, rather than using the 10-year bond as our Risk Free Cost of Capital, have used the 30-year US Government bond.  That, however, is your choice.

Next, I divide the cost basis of purchase into owner’s earnings to identify the effective return.

With owner’s earnings at $1.36 and the cost basis at 3.06, the yield on owner’s earnings is 44.59 percent.  For most companies, this yield is much lower (much, much lower), and that is the magic of this measure.  It allows you to identify stocks generating returns not captured by the PE ratio or DCF.

This measure alone is valuable, but you can take this a step further, by calculating the percentage of owner’s earnings translating into deployable shareholder’s equity — i.e., the year-over-year change in shareholder’s equity plus dividends paid (adjusted for the tax hit, since the company determines whether you, the stockholder, will be exposed to government’s tax bite on your earnings as part owner of the company).

That, however, is beyond the scope of this posting.  For now, you have a different measure that provides an alternative perspective.

PS.  The inquiring reader may wonder why I’ve chosen to use the premium paid in the cost basis figure rather than the actual stock price.  The reasoning goes back to disaggregating the risky/volitile portions of the stock price from the more reliable — treating shareholder’s equity as though it possesses the realiability of a higher-than-average-yielding corporate bond.  This works with most companies, but a small number have evidenced more significant down-side risk in shareholder’s equity, and, for them, the more stringent standard of using the current stock price in place of the premium would make sense.

In the case of Bolt, the results of this more-stringent approach would produce:

The Retained OE (Owner’s Earnings) Yield is that portion owner’s earnings over the past decade that translated to an increase in Shareholder’s Equity (set at the 50th percentile).  This calculation does include dividends paid (adjusted for taxes).  Dividends are included in the calculation because, like shareholder’s equity, they accrue to the benefit of the investor.  In fact, shareholder’s equity per share is typically the floor under which the stock price can be drawn, given the rarity with which stocks sell for less than ShE; otherwise, the market is effectively pricing in some degree of bankruptcy risk, and the investor should closely monitor company’s position in the sector, the debt exposure, and, of course, the Altman-Z Score.

Given my lack of respect for the market’s ability to value companies, however, there should be a tangible basis for making the shift between the two yield calculations.  While the recent market decline moderately undermined shareholder’s equity for many firms, it appears that most are (or soon will) rebound with the improving economy — indicating that, for many, recent reductions in ShE represent temporary or short-term events.  A better measure of the risk for permanent or longer-term harm to ShE value would be the company’s debt exposure and its ability to cover payment on that debt.

In Graham and Dodd’s Security Analysis, they advise such an approach to valuing corporate bonds — going so far as to set the threshold for bonds at depression levels of cash generation.  The Graham and Dodd standard, by the way, is 3 times interest earned interest earned for industrials, with lesser requirements for railroads and utilities (Chapter IX of Security Analysis).  For Bolt, with no debt, this is not a problem, but we needn’t (and shouldn’t) apply this standard to our yield calculation here because the company is not, in fact, using ShE as a debt-financing vehicle.

But this does raise the question of how high should the yield be to warrant investment or consideration of investment.  Clearly, this would vary based on interest rates and the return expectations of individual investors, but, having already factored in the required rates for both portions of the stock price, the remaining yield required by the investor should likely range between 10 percent and 15 percent if the yield is based on the premium paid and between 5 percent and 10 percent if it is based on the full stock price.  Technically, any yield greater than 0.0 percent when calculated using the full stock price renders greater returns than the market rate, but value investors should expect a greedy margin of safety on every investment.  That is certainly the lesson imparted by Graham and Dodd when it comes to bond investing, as well as investments in equities.  As they note in the early chapters, bond defaults during the two market crashes that produced the Great Depression were far more common than the reduced risk normally associated with bonds would imply.  Consequently, they use the same “margin of safety” language regardless of investment class.