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Written by rcrawford

March 4, 2012 at 12:54 am

Posted in General

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

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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

with 2 comments

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.

{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

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

PFE and Calculating Sustainable Growth of ROE

with 2 comments

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

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

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

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

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

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

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

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

First, Return on Equity is defined by Investopedia as:

Return on Equity = Net Income/Shareholder’s Equity

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

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

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

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

For Pfizer, we get:

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

The other breakdown of ROE involves five items:

Tax Burden = Net_Income/Earnings Before Taxes

Interest Burden = Earnings_Before Taxes/Operating Income

Operating Profit = Operating Income/Revenue

Asset Turnover = Revenue/Total Assets

Leverage Ratio = Total Assets/Total Equity

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

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

I should note that all dollar figures are in millions.

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

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

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

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

The rest of this is really very straight forward.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Back to My Mistake With Pfizer

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

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

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

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

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

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

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

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

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

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

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

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

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

Written by rcrawford

March 26, 2010 at 11:12 am

Posted in General

Healthcare Cost and The Oracle

with 12 comments

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

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

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

Written by rcrawford

March 5, 2010 at 1:02 pm

Posted in General