Sunday, April 25, 2010

Value Investing

Investing is so elementary and yet only few people are able to make money over long period of time and survive the vicissitude of the market. Most people try to make a quick buck chasing stock tips from punters in the market and unfortunately end up losing their shirts. For most investors stock symbols are just ticker symbols moving across their computers. However for investors willing to perform a little due diligence before investing I recommend a disciplined path for investors to follow and that is a value investment philosophy which has a long history of delivering excellent results with very limited risk. Value Investing is basically the strategy of buying securities for a price far below their underlying value and trying to minimize their downside risk. Simply put, the cheaper you buy a stock the less one stands to lose and less is the downside risk. So the risk is not in the volatility of a stock but in the price at which you buy a stock. Risk as defined my most value investors is the permanent loss of capital and not the volatility of the stock. There is no reason to be worshipful of stock market
quotes. They are simply prices to be taken advantage of or ignored,as the case may be. This is what the old master Benjamin Graham, the father of value investing meant when he said the average investor would be better off without constant stock quotes — because the average investor makes too much of these prices.One common characteristic of value investors is that they take advantage of the volatility and that enables them to buy stocks at a cheaper price. The cheaper the merrier is the credo, of course the stocks must have a strong underlying fundamentals.
As defined by Graham and Dodd, an investment operation is the one which upon thorough analysis promises safety of principal and a satisfactory return. Operation not meeting these requirements are speculative. The vital parts of the definition are "thorough analysis" and "safety of principal."
Thorough analysis involves studying various quantitative and qualitative aspects of the business and estimating the intrinsic value of the business and then waiting to buy it a significant discount.
In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffet wrote:
"We think the very term ‘value investing' is redundant. What is ‘investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening)."

Two Basic Value Investing Tenets
1) Each share of stock is an ownership interest in the underlying business. A stock is not simply a piece of paper that can traded recklessly. Most investors don’t even realize that they are not investing and have become speculators by playing a "greater fool game" buying overpriced securities and then hoping to find a greater fool than you to sell it at a still higher price. Graham used what has become a famous metaphor called "Mr. Market" to explain how the stock market works. It is still the best way to understand how the stock markets work and how one should take advantage of the manic-depressive Mr. Market. The concept of Mr. Market goes like this : Imagine that in some business you own a small share that cost you around 1000 rupees. Mr.Market is one of your partners and is very obliging indeed. Everyday he comes to you to and tells you what he thinks your share in the business is worth and on that basis offers either to buy from you or sell you an additional interest in the business. The catch is that Mr. Market is a very strange dude and does not always price your share of business the way a sensible businessman would appraise. Instead his mood swings from being euphoric some days and the other days he is very depressed. Everyday he comes to you and offers you deal depending on his mood. Sometimes he might want to overpay for a share of your business and sometimes he might offer you an opportunity to sell you his part of the business at a ridiculous price far below its underlying value. Since you know the worth of the business based on fundamentals you are free to accept his offer or ignore him if you don’t like the price. The choice is simply yours. The more manic depressive Mr. Market is the more the more opportunity you will have to take advantage of him. Even though he might have wild mood swings he is a good business partner to take advantage of. In a nutshell, if you find a company that he is offering for less than it is worth, take advantage of him and buy a truckload of those shares as long as you have a strong conviction of what is the company's true worth. Investing is most intelligent when it is most businesslike. This is a quote from Benjamin Graham's "The Intelligent Investor". That is the way most of the legendary investors like Benjamin Graham, Warren Buffet , Charlie munger et al made a fortune, buying partial interest in business at dirt cheap prices by taking advantage of the Mr. Market.

2)Margin of safety is the most critical aspect in value investing and is the most widely shared tenet among the value investors. Graham's definition of margin of safety is essentially the discrepancy between price and underlying value of the business. Margin of safety is required not only to limit the downside risk but also because of our inability to predict the future and the inherent biases in the investors which causes them to commit mistakes. Having a margin of safety is critical to a disciplined approach towards investing because it acknowledges the inherent flaws that we as humans have. It is like an insurance policy which helps to mitigate the damages caused to investors by some stroke of bad luck, imprecise and over-optimistic estimates or the vicissitudes of the economy and the stock market. Valuing a business is an art and not science because the value of business depends on numerous factors and cannot be captured by a mathematical equation and one can only come up with a ballpark estimate of the value of a business based on the assets and earnings power of a business.
According to Graham, "The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. For in most such cases he has no real enthusiasm about the company's prospects. If these are bought on a bargain basis even a moderate decline in the earning power need not prevent the investment from showing satisfactory results,the margin of safety will then have served its purpose."
Buffett describes margin of safety in terms of tolerance. "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks cross it. And that same principle works in investing.
How large should be your margin of safety? Here's how it works: Suppose you appraise the value of a stock to be around 100 rupees and the stock is trading at 60 rupees then your margin of safety is 40 percent. Now the appropriate size of margin of safety required depends upon the underlying qualitative and quantitative aspects of the business and the level of confidence one has after performing adequate due diligence on the fundamental aspects of the business.
The quantitative analysis involves studying the key financial ratios ushc as return on invested capital, profit margin, debt –equity ratio, earnings power and cash generating capacity of the company. The qualitative aspects cannot be ignored as no business operates in vacuum and therefore it is necessary to study the competitive scenario in which the business operates and the actions of the customers to which the business caters to.
There is no secret to investing as every important aspect of investing is available in the public domain. For more wisdom on the art of investing refer to the book "Security Analysis" by Graham and Dodd, also known as the bible of Value investing. Though to some the book might seem outdated but its wisdom are very much applicable in today's market.

Monday, January 4, 2010

Goodwill Hunting: How Good is Goodwill

Goodwill? When a company is purchased for more than its tangible book value then the accounting rules require the buyer to record the purchase price over the goodwill as an intangible asset called goodwill on the balance sheet and it is supposed to represent all the intangibles like trademarks, customer relationships etc. I don’t know why these accounting guys call it goodwill bcoz in fact all it does is mislead investors. Sometimes investors just don’t realize that they are also including this intangible while calculating the book value (yeh I admit, earlier I used to make this mistake). But further digging in the balance sheet reveals that sometimes most of the book value consists of goodwill and that’s the first warning sign. Even veteran value investor Michael price in his early days once failed to exclude goodwill from the book value. The story goes like this when he was working with Max Heine, another noted value investor, he came across a company, F&M Schaefer Brewing Company which was trading below book value. Michael was very excited about this and believed it to be a value stock. however Max heine advised him to look closer and so Michael called the guys at Schaefer to know more about the huge intangible stuff they had piled up on their balance sheet. He called and said "I am looking at your balance sheet. Tell me What does the $40 million of intangibles relate to?" to which the Schaefer guy replied "don’t you know our jingle, Schaefer is the one beer to have when you are having more than one."
Be highly skeptical of firms where a significant portion of book value consists of goodwill. Unlike inventories, accounts receivables, Property and other tangible assets goodwill is not an asset that can be readily sold or used to raise cash and therefore doesn’t give enough protection to investors in tough times.
Also a large amount of goodwill inflates the book value and if the management decides that the goodwill is somehow impaired then it would have to be written off and a substantial part of the net-worth would be wiped off in a single stroke. Eventually the write-off would lead to a violation of certain debt covenants causing a liquidity crisis.
Goodwill might be nothing but the desperation of a testosterone crazed CEO to expand his empire and boost his ego. Most acquisitions are overpaid and lack claimed synergies and ultimately they don’t work out.
In 1999 Worldcom had a market value of $125 billion and a book value of
$51 billion which almost entirely consisted of shares issued for acquisitions.
Around 85% of the book value was goodwill and the company was trading at 15 times its tangible net equity. So how did the company fare over the next few years? Well in the summer of 2002 it filed for bankruptcy. Why didn’t the intangibles save it from such a situation? Those weren’t valuable enough once the company found itself in a tight financial spot. It had piled up substantial amount of debt and couldn’t repay it. It just couldn’t use its goodwill to raise cash and repay its debt like it could have done with rest of its tangible assets.
Also the company didn’t have any moat to protect it from the fierce competition in the industry which didn’t allow it to generate adequate amount of cash flow to service its debt. In this case the goodwill essentially was of no advantage to the company.
In 2001AOL Time Warner had around $200 billion of assets of which $128 billion comprised of goodwill from the merger between AOL and Time Warner.
On the balance sheet it had around 64% in goodwill. Over the next few years much of this $128 billion goodwill was written off, which had finally shrunk to $37 billion. This shows that the company admitted that it overpaid for the merger.
So next time beware when you find lots of goodwill on your balance sheet. It might not be good for you.


People think focus means saying yes to the thing you’ve got to focus on. But that’s not what it means at all. It means saying no to the 100 other good ideas that there are. You have to pick carefully. I’m actually as proud of the many things we haven’t done as the things we have done.
-Steve Jobs

Monday, December 21, 2009

ITEX, a barter exchange system

ITEX (itex.ob), is a leading marketplace for cashless business transactions across north America. The company services small businesses thru their independent licensed brokers and franchise network. It's services enable small businesses to trade goods and services without exchanging cash. These products and services are instead exchanged for ITEX dollars which is a closed loop system and can be redeemed only within the ITEX network. It has 24,000 small business members, more than $200 million of annual trade volume, and franchised operations across the United States and Canada. Small business members buy and sell using ITEX’s proprietary currency, the ITEX dollar. ITEX’s payment processing platform ensures that trades are settled properly and that members can easily review their account activity and balances. ITEX also issues an annual tax-reporting document to each member. Members pay ITEX a fixed monthly fee and a transaction-based fee. All fees are payable in U.S. dollars. The business generates revenue by charging members percentage based transaction fees and fixed monthly subscription fees. Generally the company charges its members 5-6% of the total transaction, both to buyers and sellers in the itex marketplace.

Why would someone barter in an ITEX marketplace?

The ITEX marketplace has approximately 24,000 members in the United States and Canada. The majority of members are businesses with fewer than 10 employees. Members may choose to participate in the marketplace for a no of reasons including to attract new customers, increase sales and market share, and to utilize unproductive assets, surplus inventory, or excess capacity. The Marketplace is especially useful to businesses where the variable costs of products or services are low, such as hospitality, media, medical care and other service related businesses. ITEX could benefit from recession as it helps small businesses save cash.
For example, a hotel that has not filled its rooms by the end of the day has lost potential revenue but still has nearly the same overhead associated with owning and maintaining its facility. Selling these unused rooms for ITEX dollars is beneficial for both the traveler (buyer) and the hotel (seller). The traveler receives a hotel room without spending USD and the hotel fills an empty room, with the ability to use the ITEX dollars earned to purchase other products or services in the Marketplace.
Bartering helps restaurants fill seats, reassuring prospective customers who might be turned off by the sight of a vacant eatery. It's hardly a permanent fix for ailing restaurants, which still need cash to cover such expenses as rent, mortgages,taxes and utilities. But bartering is an especially useful tool for small independent businesses that lack access to corporate credit lines or cash.
A movie theater could accept ITEX dollars for seats that otherwise would not be filled. This gives the movie theater free ITEX dollars while allowing the theater to avoid formally discounting the price of tickets.


The primary competitors of ITEX are other barter exchanges and internet distribution channels like ebay, craiglist, Travelocity and ITEX is is the largest barter exchange in North America, ahead of New Berlin, Wisconsin-based International Monetary Systems Ltd. The industry in which ITEX operates is highly fragmented. The services which ITEX provides serve only as a supplementary tool to small businesses in addition to cash,cheques and credit cards.
I believe the barter market is too small and not worth that much to well established credit card companies. It only serves as a marginal channel to carry out transactions which would have not been possible with cash, in fact it creates trade for small businesses which without the barter system would have not been possible.
Also the company benefits from some network effects and because new smaller competitors can launch their own barter exchanges at a relatively low-cost since technological and financial barriers to entry are low network effects is the only competitive advantage they have. However there is also a steep learning curve to manage a marketplace and might create some barriers to entry to new competitors.

A typical ITEX transaction
A dentist wants to remodel her office. Through the Marketplace, she hires a contractor who agrees to perform the remodeling work for $1,500 ITEX dollars. The dentist has ITEX dollars in her account to spend because she had previously provided dental work to the owner of a vacation resort, a restaurant owner and a lawyer, all members of the Marketplace, in exchange for ITEX dollars. These other members originally acquired ITEX dollars by providing products or services for other Marketplace members.

Sunday, February 15, 2009

Buffett's Early Tech Investment

Alice Schroeder; author of the biography of Warren Buffett entitled The Snowball made a presentation at the Value Investing Conference in Virginia university. The video of the presentation can be found at the link below:

She provided a fascinating case study of one of the early investments of Buffett made in a tech company in 1959. The company was in the business of manufacturing tab cards which were used in the computers back in the old days. Becoz of the anti-trust problems and monopolizing the market IBM was compelled to divest one of the units involved in this business and it was one of the most profitable businesses of IBM which earned around 50% margins. A couple of Buffets friend had started the tab card business in the 1950s and they approached Buffett to invest in it. But Buffett didnt invest in it considering it was a startup firm and was competing against an already established player and maybe buffett was not sure whether they could compete with IBM.
A decade later his friends again approached him but this time they had some financial history with them. It was earning around 40% margin and they were growing at a rate of 70% and turning capital 7 times per year. I guess this performance metrics got him interested and finanlly he invested in it. Alice Schroeder observed during his reasearch that unlike other analysts buffett didnt make any kind of financial projections or use Discounted cash flow method to value the company. He just analyzed on a quarterly basis and plant by plant basis, the historical financials relative to its competitors. His ultimate question or the mininmum yardstick for investment was whether he could earn 15% return on his investment. Buffett invested abt 20% of his non-partnership money in this stock. Buffett held the investment for 18 years earning a 33% compounded annual return.
The interesting thing abt this investment was buffetts though process behind evaluating the value of business which was different from wat most ppl think. It is believed that he projects earnings 10 to 15 years into the far future and then uses DCF to value it. Even his partner Charlie munger never found him doing such calculations. however some people very strongly believe that DCF is a correct way of valuing business, even going to the extent of saying that buffett does all these silly calcualtions in his head.
Also there were no barriers to entry in this business and this was evident from the fact that any entrant like the one in which buffett invested could easily enter the industry and compete with fairly entrenched competitors like IBM and still continue to earn above average returns. What could have prevented other players from entering this business? Were there any moats or barriers to entry for other players.

Tuesday, December 30, 2008


A few spin-offs on my radar screen

1) Dr. pepper snapple
2) ticketmaster
3) Brinks security holdings
4) home shopping network inc