RTCrawford's Weblog

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

Sensitivity Analysis for Simulations Plus

with 32 comments


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.


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.]


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):


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:


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.



Written by rcrawford

April 17, 2010 at 8:58 pm

32 Responses

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  1. Thanks RT, this is quite interesting !

    Bob G.

    April 18, 2010 at 5:56 pm

  2. “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.”

    Walking on water is a tall item for any mortal!

    Walt, our Simulations Plus CEO, did reduce his salary down to $34,000 back when things were marginal and he was determined that his vision would be fulfilled.

    Later he canceled his bonus because he determined that his stock holding was worth more with the additional amount to the bottom line.

    Then he purchased an airplane with his own money and uses it for company business but does not receive reimbursement for the expense.

    All 3 of these “shareholder friendly” items were formally disclosed and are available by reading the SLP press releases and SEC filings.

    Walt does not walk on water but he is breath of fresh air when it comes to setting an example on representing the stock holders! Simulations Plus is a good candidate for the yellow zone and if the sales and earnings accelerate the green area is a possibility.

    Dick Milde

    Dick Milde

    April 18, 2010 at 7:59 pm

  3. Thank You

    SLP is a gem of a company. It placed first on the EPA testing out of 200 companies. 1 billion in work is going to be handed out over the next ten year’s from the EPA . Hopefully SLP get’s just 10% .

    Michael Lleshaj

    April 18, 2010 at 8:21 pm

  4. Dear Robert,
    Jae Jun told me about your wondering analysis and your blog. He said you may not invest in banks but you know how to analyze them. With real estate market stablizing right now, the savings and loans banks seem to be cheap at this time. Would you please give me some advice on how to analyze them? Right now I pick banks with less than 50% of price/safe book value, and nonperformers less than 4% of total loan, and Texas ratio less than 0.3. Allowance for loan losses/nonperformers had better be greater than 40%, but 20% is ok. By “safe book value”, I mean I will deduct goodwill, intangible, and discount bonds with less than A rating by 30%.
    Could you please tell me if there is any other criteria I can look at? Right now with the market so high, only 6-8 small banks fall into my selection criteria.
    I do appreciate your help!

    Yours sincerely

    Zehua Zhou

    April 21, 2010 at 11:14 pm

  5. Sorry I forgot to add that I also don’t want to buy banks with negative FCF. But FCF for banks seem to be hard to understand for me as well. For example, STU’s net income is positive every year, but their operating cash minus capex is negative for the past few years, and their quality of earnings seem to be poor, as they use a large sum of loans sold and loan securitized as the net income, which seems fake income to me.

    Zehua Zhou

    April 21, 2010 at 11:18 pm

  6. Currently, concerns over the lack of transparency with financial institutions is growing. The recent market crash, especially with Lehman’s use of off-balance-sheet accounts, appear to be attributable to this lack of granularity and clarity. If the federal reserve, the securities and exchange commission, and Wall Street analysts were unable to identify the problem and appropriately value the equity of financial institutions, it would be a mistake for the average investor to believe they stand a competitive chance of doing better. This problem has been with us since Benjamin Graham described it in Securities Analysis, and I doubt that we will ever get beyond it. The strength of any financial institution is only as good as the investments constituting its book of business. To assess that this would require access to that book, and, even if access were available, it would represent an enormous financial analysis challenge (as a strict matter of logistics, alone). So, no, I do not invest in financial institutions.

    It should be noted that this lack of clarity and granularity represent a significant threat to the US economic system. If unable to continually persuade investors to demploy capital in financial institutions, the system confronts considerable harm. Therefore, the conservative exercise good judgment by financial-institution leaders has long constituted an additional expectation among investors. The president of a bank must evidence greater character than the president of firms operating in other economic sectors. Rupert Murdoch and Donald Trump could not lead a banking institution — devoted, as they are, to the competitive spirit of the free market –, given the natural concerns over the soundness of financial institutions.

    This was a significant concern following the market crashes in the late 1920s and middle 1930s, as government sought to reassure investors and patrons that their money was safe in, both, banks and other financial institutions. Today, similar concerns are present, and our political leadership and the Federal Reserve has gone out of its way to reassure the public. This is why reform and regulation of the financial system is such a high priority by policy makers of both parties — explaining why Republicans (normally considered friendly to business) now favor significantly tighter regulation and oversight. Wall Street may maintain that both parties are exercising political opportunism to curry favor with voters, but, instead, the implications of a failure to act are so great that neither party can risk the consequences.

    Yet, despite this, you’re still interested in valuing financial institutions, the best available references I can identify are contained in https://rcrawford.wordpress.com/2008/03/19/financial-institution-valuation/


    April 21, 2010 at 11:53 pm

    • Thank you so much, Don! I will look at that link. All of the other sectors have gone up so much in 2009 that value stocks are scarce. Bank shares are still cheap at this time, so I think I will have to spend more time to learn valuation of banks, instead of looping through other sectors day and night, and still couldn’t find a value stock to buy.

      Zehua Zhou

      April 26, 2010 at 12:45 am

      • Your brief note raises several items worth discussing.

        First, the assertion that there are few value stocks currently available makes an important assumption – namely, that the stock can be valued. Of course, we know what the stock is selling for in the stock market, but to determine whether that stock is a value (i.e., undervalued) requires that we value the company as a whole and compare that value (on a per-share basis) with the price of the stock.

        Second, the value of the company (its valuation) is the net present value of the capital that may be taken out of it over its lifetime. We typically think of this as a combination of its current equity value and the net present value of its cash flow streams (current and future). Of course, we must make certain adjustments and assumptions to this rather simple definition, and those adjustments and assumptions lead different investors to different conclusions about the intrinsic value of a given company. Specifically, we must adjust the asset side of net asset value (total assets minus total liabilities) at the moment of sale, and we must make assumptions concerning the growth rate of cash flows and the discount rate used in the net present value calculations.

        Third, these adjustments and assumptions represent a combination of trending past results into the future and estimating the future economic environment. Both may be easy or difficult depending on the company and the economic environment. If the company’s past results have evidenced little variation/volatility, trending becomes relatively easy and reliable, but if those past results evidence significant volatility, the reliability of trending becomes suspect. Similarly, in highly volatile economic circumstances, where that volatility is likely to continue into the foreseeable future, the company’s future performance becomes less predictable.

        Fourth, each of the previous points applies to relatively simple companies, but the exercise becomes increasingly difficult with more complex firms. For example, conglomerates, possessing an assortment of service lines and divisions, often require the investor to value each service line and division individually in order to identify the company’s intrinsic value.

        Given this, it is reasonable to question where along the continuum between simple and complex banking stocks reside. Are they simple, are they complex, or do they reside someplace between those two extremes? While banks are financial institutions and operate within the financial sector, their products tend to more closely resemble that of conglomerates than companies that produce a single product or provide services to a single customer base. Banking products span the gamut between simple passbook savings accounts, brokerage accounts, insurance, and lending for mortgages, autos, business startups and expansions, among other products.

        In each case, the value of the bank in question is as strong or weak as its book of business. As we saw during the recent market meltdown, banks retained residual exposure to the risk of default with mortgage lending, and the insurance arm of banks is only as strong as the driving skill of the insured motorists or the businesses and homes in comparison to their exposure to catastrophic events – are they located on tectonic fault lines, in hurricane or tornado regions, or, in the case of businesses, is there a heightened risk of fire or explosion. Even with brokerage services, lending occurs on margin accounts, with a risk of default.

        All of this suggests that financial institutions (including banks) reside at the high end of complexity, and this makes them exceedingly difficult to value. So difficult, in fact, that there are an assortment of independent rating agencies and government bodies whose purpose is to perform the function of identifying the bank’s soundness and stability. Aside from Wall Street analysts, there is no such equivalent for retailers, auto parts manufacturers, fast food restaurants, information technology firms, pharmaceutical and biotech companies, etc.

        Presumably, however, the rating agencies can perform this function because, as independent firms, they enjoy access to the bank’s book of business and because their employees possess the specialized skills and training necessary to perform this function. Despite this, the rating agencies have a poor track record, having failed to predict the insolvency of many financial institutions over the last three years. This, of course, raises the question of whether the average “retail” investor, who lacks this degree of access or specialized training, can more successfully value financial institutions.

        Personally, I’ve come to the conclusion that I lack the inside knowledge and access necessary to make informed investment decisions with financial institutions, and, even if having the access and possessing the specialized knowledge, the labor necessary to appropriately value financial institutions would represent a full-time endeavor. While that is a personal opinion, many experts on valuation of financial firms have come to that same conclusion (the sources in support of that assertion are provided in the referenced article I wrote previously).

        Ultimately, if unable to find a sufficient volume of value stocks among non-financial institutions and companies, that, in itself, is telling – implying that the market is overvalued. In fact, I can think of no more reliable predictor of a pending market correction than a poverty of available value stocks.

        Of course, it may be that the value-investor’s standards are too high or his skills to low to appropriately identify value opportunities. This would suggest the need for an alternative measure indicating whether the market is, in general, over-, under-, or fairly-valued. In previous postings, I have suggested two approaches – regressionary trending of the market indices and a comparison between US GDP and the Wilshire 5000. By both measures, it appears that the market is marginally overvalued at current levels, unless believing US GDP will grow dramatically over the next year. Personally, I do believe that US GDP will grow – in part, due to an increase in inflation attributable to the current account deficit.

        This suggests that the hunt for value stocks will become increasingly difficult, with a small number present at any given time. More importantly, this recognition indicates that investors should avoid selling stocks purchased at a significant discount to their intrinsic value until the selling price significantly exceeds intrinsic value or, alternatively, a superior opportunity becomes available. Further, it appears likely that a smaller portfolio of value stocks is the likely outcome.

        Over the past year, finding value stocks has been a relatively easy exercise. Currently, more than 30 occupy my portfolio and I’m kicking myself for not purchasing a number of others. Several in my portfolio have risen significantly and are now fairly valued. This raises the question of whether to sell and book the proceeds or, alternatively, continue to hold. If unable to find replacements, my better choice is to retain the stocks (hold) while the company compounds growth through reinvested profits tax-free to me is the investor. It is only in my best interest to sell if the market price so exceeds intrinsic value as to overcome the tax hit and the declining value of the cash proceeds from the sale.

        I may be wrong about this attribution, but I believe it was a presentation by Lew Sanders at Columbia where he described meeting Warren Buffett for first time. He asked Buffett to describe the single most important lesson to investing success, and Buffett responded that the thing most investors overlook is the cost of selling a stock. Not only is there the commission and capital gains taxes, there are at least two forms of opportunity cost. The first form comes with the recognition that, once the stock is sold, the investor confronts the necessity of deploying that capital toward the next stock. The next stock, however, may represent a challenge, either, because value stocks are in short supply or, alternatively, because the investor’s understanding of that company is less complete than the one just sold. And the second opportunity costs comes in the form of the foregone compounded growth in the future generated by the sold company .

        Not long ago, Buffett gave an interview on CNBC in which he was asked about the sale of stock in a Chinese petroleum company. As you may recall, purchase of the stock was protested because of the company’s relationship with one or more suspect governments in Africa. Buffet was asked whether the sale of a stock was in response to the protests, and he responded that, no, he sold the stock because it had more than doubled in price and was selling significantly above its intrinsic value – somewhere between 30% and 40%.

        During normal times, the market is exceedingly efficient, and this makes value stocks a rarity. Both Buffett and Munger have stated that they are exceedingly happy if they can identify one or two stocks that meet their criteria in any given year. If that is the case, the investor needs to be as focused on selling criteria as a on purchasing criteria, and, if able to identify only a small number of value stocks each year, the frequency of selling (on average) should not significantly exceed the frequency of buying if hoping to maintain a diversified portfolio.


        April 26, 2010 at 9:52 am

  7. Don,

    I responded to your note via a private e-mail, since a portion of it was off topic.



    April 21, 2010 at 11:57 pm

  8. […] leave a comment » 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 https://rcrawford.wordpress.com/2010/04/17/sensitivity-analysis-for-simulations-plus/ . […]

  9. This is an amazing blog. I discovered it on the SLP message board on yahoo.

    You are very intelligent but yet your writing is relatively easy to comprehend. I love everything about this company and I reccommend it to everyone i know (fundmentals, insider ownership, management competence, etc).

    I would love to chat further about some of your opinions through email and find out more about your ideas.

    I am a 21 year old finance major who wants to do securities analysis for a living, but very few things I have learned in school up to this point have been as informative or pratical as this.

    Please email me back when you have a chance.

    Sam Othman

    Sam Othman

    June 25, 2010 at 8:34 pm

  10. 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


    July 29, 2010 at 2:10 am

    • Mike, I took the liberty of responding to your note at the end of the original piece/posting. This was to allow me the luxury of posting captured images, which I believe add much to the response and its utility for other readers. I did not use it to create a separate posting, however, because it should be considered in context and because my goal with using SLP was not to tout the stock or the virtues of the company. Instead, it was to explain an equity-valuation approach described recently by Professor Bruce Greenwald, which can be applied to other equities, and to describe the use of decision analytics with the Greenwald method.

      Happy reading.



      July 29, 2010 at 11:46 pm

      • Robert:
        Thank you for a truly outstanding reply to my post!!! Your response was informative, insightful and very useful, especially the narrative regarding your analytical approach to value investing. Reading your reply and the other articles pretaining to Simulation Plus was educational and your suggestions will be taken seriouly.
        I have had e-mail correspondance with the company and their replies have been punctual and helpful. As of today I am leaning toward buying some shares but not too many maybe 200-300.
        Once again, thanks and continued success.
        Respectfully, Mike


        July 31, 2010 at 12:25 am

  11. Robert:
    Another short note of interest about Simulations Plus. In a reply to one of my inqueries regarding compeitors the Investor Relation Department stated the following:
    WORDS+ the competition comes from Dynavox,PRC and TobiiAti;
    GASTROPlus the competitors are SimCYP,PK-Sim,and Cyprotex.
    The following companies compete indirectly: MedChem Studio,Tripos,Molecular Networks,IDBS,BioSolveIT,ACDLabs/Pharma Algorithims and Schrodinger.
    Only two Dynavox and Cyprotex are public owned the rest I believe are private. Hope this is of some interest to others.
    REspectfully, Mike


    August 1, 2010 at 11:05 pm

  12. Robert:
    Because I am a newbie to value investing I am wondering if you could suggest an approach in determining a company’s valuation that isn’t too far in the weeds.
    I am a retired construction worker with fair math skills, but far from a MBA.

    Any input will be greatly appreicated. Thanks for your time and consideration.
    Regards, Mike


    August 18, 2010 at 11:20 pm

    • Mike, thanks for the question. Nearly every investor has their own list of favorite books on investing — so, the three I am about to list will certainly differ from what others would recommend. Keep in mind that these are my recommendations for those just starting to learn about value investing, without prior experience in financial analysis and valuing companies or equities (stocks).

      First, allow me to suggest F Wall Street by Joe Ponzio. This is an odd recommendation because I have not read it! I have, however, spent hours reading Joe’s writings on the subject at FWallStreet.com, and, simply put, Joe is the best writer on value investing for the newbie I’ve ever encountered. I should mention that Joe and I are friends, but our friendship followed from his blog. In other words, I was impressed by Joe before we worked on a small number of projects together. So, visit the blog and, if impressed, buy the book — which recently earned number one status at Amazon.com for books on investing.

      Second, if Joe’s book and approach strike you as too involved, try Joel Greenblatt’s The Little Book That Beats The Market. It describes the “Magic Formula” for identifying value stocks. Essentially, you do a query for the 1000 largest companies by market capitalization and rank them based on two ratios (ranking them 1 through 1000 for both ratios separately). Then you add the two rankings together and buy the top two or three companies every few weeks or months until you have a portfolio of around 30 stocks. The two ratios are Price to Earnings and Return on Capital. With Price to Earnings, you want to rank the lowest first and the largest last, and with Return on Capital, you want to rank the highest first and the lowest last. Nearly every stock screener on the web will provide the Price to Earnings ratio, but many do not list Return on Capital. If Return on Capital is not a screening option, you can use Return on Equity instead (or, if very conservative, you can use Return on Assets). Expect that you will have some major winners and major losers with this approach, because it does not assess the company’s bankruptcy risk, but, with a diversified portfolio of 30 or more stocks, no stock will have more than a 3.4% impact on your overall performance. Besides, high return companies are normally not bankruptcy candidates (unless they have a great deal of debt and the economy takes a nasty dive).

      The third is Phil Town’s Rule #1. There is a good deal of information in it, and it is written simply. Personally, I don’t agree with a small number of fairly big points, but, where we disagree, the difference has more to do with technicalities than vital substance, and most are judgment calls (where Town is evidently trying to make things as simple and accessible as possible).

      You should be able to buy each of these cheaply on Amazon.com or elsewhere — especially, if purchasing used copies. While still new, Joe’s book is cheap enough (under $11) new that a used version shouldn’t be necessary (if no used versions are available). Because he is a friend, I hope you’ll buy it new, but that is something best left to you and your wallet.

      Thanks, Mike, and best of luck to you.



      August 19, 2010 at 7:41 pm

  13. Robert:
    I took your advise and bought all three books, FWall St.,The Little Book that Beats the Market, and Rule#1. All three where informative and useful.
    I am now in the process of distilling the important info., and points of each book on paper. Sort of a Cliff’s Notes, if you will, so I can have them handy when doing research.
    Right now, I am wondering whether one could make a hybrid approach to value investing by combining some of the best from each book? What are your thoughts regarding this attempt? As of now I like and feel more comfortable with Rule#1 methodology. However, I am open to your suggestions.
    By the way do you still hold Simulations,Plus in your portfolio? I recently, bought some based on my reseach and your article. I know you don’t recommend stocks, but I hold no one responsible for losts, except me.
    Thanks again for your help and guidiance in value investing.
    Respectully, Mike


    September 16, 2010 at 9:49 pm

    • Mike, there is nothing wrong with creating your own hybrid model, but I wouldn’t bet the farm until it proves successful during, both, an up market and a down market. Moreover, recognize that the three recommended books followed from your request for foundational reading. No matter what any of them suggest, investing competently is complex, and few can do it consistently or easily. At all times, make certain that you can identify the intrinsic value of each investment,that you are buying with a substantial margin of safety, and that you have a grasp of why the company enjoys a defensible competitive-advantage. There are a truckload of stocks selling cheaply but few where the market has mispriced them, given their competitive prospects. Make certain that you know something the market has overlooked or that you are buying when the market is unreasonably depressed.

      As for SLP, I have not sold a single share and have no plans to do so.

      Finally, you may find this masters thesis on the investing approaches of Warren Buffett informative — http://www.ticonline.com/temp/philip-gilfillan-warren-buffett-methodology.pdf . You can quickly skim through to page 14. From 14 to the concluding summary, closer reading is warranted. Philip Gilfillan is the author/former-student, and he has done an excellent job identifying the underlying research supporting/informing Buffett’s methodology. I found it because I was considering a blog entry describing the background sources, and, while I believe I can do better than Mr. Gilfillan, I don’t have time at the moment.




      September 17, 2010 at 10:10 pm

  14. Robert:
    Once again SLP had very good earnings report and guidance seems positive for the future. However, the stock has not performed accordingly. Do you have any thoughts on this? I still find it a very good stock.


    December 10, 2010 at 8:45 pm

    • Mike, I don’t have a great deal to add to my earlier analysis. The stock price is up more than 200% from the lows in December two years ago. The PE (at 22.54) is in line with its demonstrable growth rate over the last year or so, and the price-to-book is now over 3. By these common measures (among retail investors), the stock is fairly valued today, and, if believing the growth rate is not sustainable, the price is over-valued. Management has aggressively repurchased shares from a cash stockpile that grew 28% last year, and there has been some conjecture about a dividend. Both indicate that the company has more money than it can fruitfully deploy in pursuit of productive growth for the shareholder/owners, and, while the share repurchases serve the best interest of the stockholders (increasing our ownership stake without compelling a dividend-driven capital gains hit), this tacitly admits that the company is unlikely to increase growth beyond the low-to-mid-20% rate — much higher and they are likely to outgrow their ability to manage the expansion for more than a year or two … five at the most. If viewing the stock as fairly valued today and if believing the company can successfully grow in the low-20% range, year-over-year price appreciation should achieve mid-teen to low-20% on average. If the hands-free product takes off (and initial results look favorable), the company may reasonably achieve a $4.50-to-$5.00 per share value, even if sales for longer-standing/tenured products moderately ratchet back in their sales growth.

      The key to understanding the stock and its appreciation prospects is to recognize that the upside is now dependent on management execution, rather than viewing the stock as a deep discount value play (which is what it was when I bought it at just over $1 per share). Consequently, appreciation in share price is likely to follow from the compounding of reinvested capital to achieve beneficial returns. This, in my view, easily makes the stock a hold for current partners in the business (versus trading). To support that assertion, note that Returns on Invested Capital have risen to just over 18% — easily exceeding the Required Internal Rate of Return for stockholders and the company’s Weighted Average Cost of Capital.

      This raises the question of whether the company can sustain this attractive and lucrative level of performance on our behalf. Producing patented products which enjoy low costs of production and substantial operating leverage, where the founder and brain-trust leader is actively managing the company and is unlikely to jump ship, the company and its products enjoy significant barriers to entry and competitive advantages. Their leading position (nearly monopolistic) in a high-demand market (lowering R&D costs for firms beleaguered by high R&D expenses and pricing pressures) makes defense of their market position simpler if SLP possesses a narrowly defined market footprint, switching costs for clients, and sufficient deploy-able cash with which to undertake such a defense (further increasing barriers to entry through intimidation of prospective new entrants). Well, their market is narrowly defined for each product (i.e., they are not all things to all customers and will not find it necessary to defend across a broad front or multiple fronts), switching costs for clients familiar with and reliant upon their technology-based products reduce the prospects of a pricing war, operational economies of scale (operating leverage) allow them produce at lower cost than a new competitor, and, if competitors should arrive (ignoring the evident threats arrayed against them), the company can increase marketing or lower prices to levels sufficient to make new arrivals regret the decision.

      So, if the company can grow at 15% (below the low-20% rate recently posted), the value of the company doubles in 5 years. At 17.5%, it doubles in 4 years and four months. At 20%, compounding doubles the value in 3 years and 10 months.

      Of course, you may know of a superior place to park the capital now deployed in SLP. The be superior, it would need to have a similarly large and favorable gap between returns and costs, a superior ROIC, an equally stellar growth rate, and a competitive position possessing a nearly unassailable moat. In fact, now that I think about it, you would need to find a minimum of five such alternatives if interested in diversifying your market risk exposure.

      Bottom line: I agree with your assessment of the company and its performance, but I understand why the market believes the current value is reasonable. Despite this, selling the stock at this point is not something I’m remotely considering. After capital gains taxes, I would have to find a replacement investment capable of appreciating by 45% if it were to equal SLP’s year-one growth prospects. Believing the market is fairly valued today (over-valued, in fact), I can’t find five superior alternatives. The next best alternatives, in my view, are JNJ, E, PG, and XOM — with APT and SPAN serving as undervalued options that lack SLP’s growth, shareholder focus, management excellence, and forward prospects. I do, however, have stakes in each and may add to JNJ, E, and PG.



      December 11, 2010 at 12:38 am

  15. Robert:
    Thank you for your swift and detailed response to my inquiry? I do not intend to sell any shares. I have much to learn about investing especially how the market sees(if that’s the right word) this particular stock from a valuation point of view.
    Your insights are well taken and deeply informative thank you for time and consideration in this matter.
    Best regards, Mike
    P.S. Do you recommend any new investment books? If, so please post their titles.


    December 12, 2010 at 10:12 pm

    • Thanks, Mike.

      Nothing new to offer in the form of recommended reading. I remain impressed by Liaquat Ahamed’s Lords of Finance, which recounts the interplay of central banks and leaders between the end of World War I and the early days of FDR’s first term. It won a Pulitzer, and many see links between that time (the years before, during, and after the market crashs of 1929 and 1937, and the sequence of depression and cascading recessions between 1927 and WWII) and today.

      My reading of it is marginally different. Rather than believing that history is destined to repeat, The Lords of Finance indicates that the crash and depression should have been predictable as early as 1923/1924 for knowledgeable investors and as early as 1920 for the more astute or prescient. It also indicates that international financial crises (versus those limited to a single country, economy, or currency) can have unexpected trajectories for those lacking a grasp of capital flows.

      For example, the US was a large net exporter with a favorable balance of trade following the end of WWI, but the Depression was as prominently felt in the US as in Europe (where England, France, and Germany had large, negative trade balances). The reason? Germany and England defaulted in late ’28 and early ’29, which made earlier US bank loans financing WWI nearly worthless. Those loan repayments were dependent on German reparation payments to England and France, and the financial burden for Germany was unsustainable — leading to a new government each year, the arrival of the Brown Shirts, and, in one memorable year, 1000% inflation. When Germany defaulted, England had no choice but to follow suit. And both left the gold standard. The net effect was to make US bank solvency suspect, leading to the runs on the bank (which didn’t end until Roosevelt took us off the gold standard and turned on the printing presses to reverse the deflationary spiral).

      How is this helpful for investors today? Well, it suggests that China is as fully exposed to a US default as we were exposed to defaults in Germany and England in ’29/’30. I am not, therefore, willing to invest in countries possessing large exposure to US sovereign debt. This isn’t to say that I’m predicting a meltdown in the US, however. I just believe the risk is high enough that cowardice is a synonym for prudence under Buffett’s two rules of investing … namely, lose no money and, of course, lose no money [borrowing from Herman’s Hermits “Henry The Eighth,” “Second verse, same as the first.”]

      The second text that continues to impress is Bruce Greenwald’s Competition Demystified, coupled with his text on Value Investing. Unfortunately, the reader can only gain full benefit with an in-depth understanding of the original source materials.

      Have a great holiday.



      December 23, 2010 at 11:17 pm

  16. Robert,
    I am thinking on purchasing about 1000 shares of SLP. Judging from the recent earnings report it seeems management is performing well and the future prospects of its products will be in demand.
    Do you plan to do the same? If, yes or no would you care to elaborate?
    Best regards, Mike


    January 15, 2011 at 2:19 am

    • Mike, I’m not aware of any reason to avoid buying SLP if the purchase is based on the fundamentals. The stock price has moved up significantly over the time I’ve held it (average purchase price of $1.06 per share), and this, along with the common metrics of valuation (P/E, P/B, etc.) may prove sufficient to promote market uncertainty about its intrinsic value at current prices. When I purchased it, the company was strongly undervalued, and the decision to buy shares was easy. The challenge was determining the percentage of my portfolio to devote to this one position. My wife and I discussed it, and, due to the size of the company, smaller size of our savings at that time, and the uncertainties then present with health care, I deployed less than I should.

      What I didn’t know then was the quality of the management — which I considered suspect due to the price split that put the price near de-listing –, and, sitting just six cents above delisting, delisting would have been the result if the stock price had declined below $1 and remained there for 90 days.

      I do believe the stock is worth something between $4 and $5 per share. For a company of this size, this would ordinarily provide less than the margin of safety I require of a new purchase. With the arrival of the new product, however, I currently believe intrinsic value is $5 or above, but this is reliant on management’s ability to corner the market. That ability is not a proven strength, however … in my judgment.

      As for whether I am deploying new capital toward SLP, the answer is no. I tend to put capital toward the most under-valued investments I can find (possessing the strategic attributes described earlier). Concerned about the US economic situation (stimulus spending aside), my stock investments have focused on strong large caps and, to a lesser extent, real estate. That said, I have no intention of selling SLP, either.

      Moreover, I can’t recommend that you invest in SLP, either. That is a decision only you can (and should) make. Recognize its size and consider the potential that its market liquidity could dry up quickly if the market were to experience a crash (i.e., an insufficiency of shares traded, enabling exit at a reasonable price). The general rule that you should purchase an equity stake only in companies you are comfortable holding for a decade or longer is doubly true of small companies — something my wife and I considered when first buying SLP. For example, I own shares of SPAN and APT — two healthcare-related small-caps. Both strike me as well-managed; although, I would not make the same purchases today, due to the absence of barriers to entry for both. Both have been down over 20% since purchase. CRDN, at one point, was down more than 20%, but is now up over 70%. So, the market can under-appreciate your selections (even the most meritorious) for years, and, with small caps (and their attendant risks), you may be reticent to double down. With APT and SPAN, I am certainly reticent to exercise my convictions (due to size), but that was not the case with CRDN. In fact, I doubled my position twice — so, that 70+% appreciation, on paper, looks nice … and it allows me the luxury of not feeling too bad about APT and SPAN.

      Now, I should say that the latest quarterly results for SLP were good. One short indicated that the company missed meeting expectations, even though earnings per share was up 34%. Personally, I don’t care whether the results please or displease analysts, and I certainly don’t base my investments on quarterly results. In fact, 34% growth is unsustainable for most companies, but it won’t cause the analysts to moderate their “expectations.” If anything, the analysts are likely to project marginally better results in the future and continue doing so until their expectations outpace delivery. If, however, the street expects the company to grow by 34% but the company’s results come in at 20%, only an idiot would view 20% growth as disappointing and unsatisfactory when the larger economy is projected to grow at 4% and needs government stimulus spending to realize that paltry result.

      So, the bottom line is that I see no reason to view the original analysis as flawed and requiring downward adjustment. The results, if anything, have been better than expected.

      While writing this, I just posted a piece on SLP that addresses the strategic positioning and, toward the end, provides data about whether the market is fairly valued. There is also a listing of the stocks in my current portfolio, along with the unrealized performance results as of January 1 of this year.

      Thanks, Mike.



      January 15, 2011 at 7:52 am

  17. Robert,

    Once again SLP has had a very good quarter in fact the last fourteen in a row. I now own 1000 shares and I glad to be a partner in Simulation,Plus.

    After listing to the conference call I still feel that the company is fundamentally sound with a strong balance sheet and future prospects look promising. But as you stated in an earlier post the future grow of the company will depend upon management’s execution of their business model. Question? Do you feel that management is moving in that direction?

    In one of my weaker moments I visted the Yahoo message board for SLP and found a couple of your posts there. I must say, they for the most part, were the only thought out and informed posts on the whole board. Normally, I search on the Motley Fool website for information regarding SLP, but there is little chatter.

    Hope this post finds you in good health and continue success with your great blog. Thanks for your efforts in educating on finances,stocks and many other things. Respectfully, Mike


    April 26, 2011 at 12:14 am

    • Mike,

      I am, indeed, concerned about the company’s business plan of execution for the hands-free product (only), with the announcement by Lenovo concerning imminent release of a hands-free computer – using similar technology. Lenovo’s product, however, is not slated for release during the next two years, which provides SLP with a narrow window of opportunity.

      This, however, addresses only the decision of whether to purchase additional shares at current prices, and, for this reason, I am not adding to my position at the present time.

      As for the decision to hold or sell shares purchased previously, please note that return on invested capital continues to hover between 18% and something just in excess of 21%. Return on invested capital takes into account the totality of assets and liabilities, to include the accumulated cash stockpile. If requiring a return in excess of the company’s weighted average cost of capital (which is around 10%, given the complete absence of debt), returns that, on average, are double that cost of capital place an exceedingly high threshold on selling the stock, because you will find it exceedingly difficult to locate alternative investments generating similarly impressive results and selling at a stock price that provides an abundant margin of safety. In other words, I remain persuaded that, as a long-term investor, my partial ownership of the company benefits from compounding of returns at something between 8% and 10% above the cost of capital.

      This realization is something Warren Buffett has emphasized throughout the totality of his investing career, and it is why he has remained invested in Coca-Cola and his other long-term investments. Many investors wrongly assume that he persists in holding those stocks because of abundant loyalty to, either, the company or management. There is, however, a reason that his approved biography is titled “The Snowball.” The Snowball recognizes the abundant power of compounding over time. If you sell prematurely, you lose the upside potential of compounding.

      In his recent letter to investors, Buffett notes that the yearly dividends currently paid on one stock purchased decades earlier now exceed the price per share paid for the stock originally. Those dividends are a consequence of compounding growth by the company and the willingness of that company to deploy the proceeds to the benefit of the investor.

      Note, as well, that SLP’s PE ratio has declined based on the latest earnings report. Previously, it was in excess of 23, and, today, is in the upper teens. While the price has not appreciably changed from levels prior to the latest report, earnings did grow, based on an increase of sales and expansion of its client base.

      Lastly, please note that I remain convinced the market is overvalued (as a whole), have taken profits in all but a small handful of stocks, am more prominently in cash than in any individual equity holding, and have one third of my portfolio in a market short position. In other words, I have no aversion to selling stock and realizing profits or losses, and my disposition is not permanently optimistic or rosie. Despite this, I have not sold a single share of SLP and, presently, have no intent of doing so.

      Best of luck to you, Mike.




      April 26, 2011 at 1:41 am

  18. Robert,

    After reading “FWall Street” by Joe Ponzio I thought it would be a good first time exercise for me to do a Owner’s Earnings analysis of SLP. I have calculated OE, FCF and Buffett’s OE as set forth in the book on pages 80 thru 83. Furthermore, I used Phil Town’s Sales Growth Rate calculator to derive at eachs Growth Rate. I hope I am not mixing apples and oranges here, but at least I am trying.

    Here are my results:

    Owner’s Earnings 2001/0.2; 02/-1.39/; 03/.31; 04/-0.69; 05/-0.66; 06/-0.69; 07/0.19; 08/0.51; 09/0.71; 10/1.91 for a G.R. of 28.50%

    FCF 2001/-1.19; 02/-1.39; 03/-0.99; 04/-0.89; 05/-0.09; 06/-0.34; 07/1.48; 08/246.51; 09/247.51; 10/1.42 for a G.R. of 13.77% and

    Buffett’s O.E. 2001/-1.39; 02/-0.79; 03/1.21; 04-0.49; 05/-1.26; 06/-0.45; 07/0.57; 08/0.93; 09/0.88; 10/0.53 for a G.R. of 10.12%

    Assuming these Numbers and Growth Rates are true and that’s a big assumption, my questions for you are as follows: 1) What do I compare OE and GR to, in order, to know if they are bad,good or great numbers?;2) If these figures are correct, how do you feel about them as stated by my exercise? and 3) Any imput and/or suggestions would be appreciated to further along this novice’s education in due diligence and stock analysis.

    Thank you for your time and consideration in this matter. Respectfully, Mike


    May 19, 2011 at 2:08 am

    • Mike, you have asked an exceedingly important and tremendously complex question. The best and clearest answer is contained in Bruce Greenwald’s “Value Investing.”

      I’ll send you a private note to make arrangements for discussing this in greater detail.




      May 19, 2011 at 9:58 am

  19. Hey just wanted to give you a brief heads up and let you know
    a few of the images aren’t loading correctly. I’m not sure
    why but I think its a linking issue. I’ve tried it in two different browsers and both show the same results.


    May 19, 2013 at 9:55 pm

    • Edmund, I’ve looked into the problem and am unable to duplicate it on my system, using Chrome or IE. While there may be an internal linkage issue, there should be no external linkage issue. Each of the images was captured as a JPG image and uploaded to WordPress. This holds for, both, analytic images I created in Excel and with the small number of captures from other sites (the Investopedia definition, for example). The key images that explain the use of sensitivity analysis with investments were all created by me on my computer — none were drawn from other sites or created by others on secondary computers.

      In the past, there have been problems with images loading correctly, but the most recent appearance of that problem was years ago when WordPress was still a new online offering. Your’s is the first indication of a current problem. If it resides with WordPress, I’m confident they will resolve it in short order.

      I appreciate your note.



      May 21, 2013 at 9:25 pm

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