RTCrawford's Weblog

I don't make this stuff up. I'm not that smart.

Adam(s) and SLP Question

with 2 comments

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.

Read the rest of this entry »

Written by rcrawford

January 13, 2011 at 9:06 am

Posted in General

Protected: Housing and Employment Info for Breckenridge Neighbors

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March 4, 2012 at 12:54 am

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Protected: Response to Alex in LinkedIn — Restricted Access

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Written by rcrawford

September 1, 2010 at 5:58 am

Posted in General

F Wall Street Hits #1 and Other Notes

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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.

Written by rcrawford

August 14, 2010 at 7:50 pm

Posted in General

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

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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.

Written by rcrawford

August 8, 2010 at 9:39 am

Posted in Art

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

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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.

Written by rcrawford

May 12, 2010 at 4:28 am

Posted in Investments

Tagged with ,

Sensitivity Analysis for Simulations Plus

with 32 comments

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

Written by rcrawford

April 17, 2010 at 8:58 pm

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