Sorry folks. I’ll be back soon. PROMISE!
I appreciate your patience! -Joe
Filed under: Miscellaneous
Interested to hear the details on ponzio capital and leaving the meridian business group.
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Anyone feel free to chime in here, as well as Joe.
I’ve read Fwallstreet, and while it provides an easy to follow value investing plan. It mixes buffetts strategy of late, with his early strategy. Which I don’t believe is the optimum method of value investing.
The FWallStreet strategy is to buy good businesses, with strong cash flows… At a low value, and sell when they reach fair value.
All well and good.
But… If the bulk of your earnings are from the market re-valuating an out of favor security. Why even look for a good business?
Why not look at bankrupt companies, spin-offs, debt and instead of buying 50 cent dollars… Buy 30 cent dollars like Pabrai/Klarman etc.
If you sell most businesses after 1 or 2 years, when they are at fair value… I would tend to believe you barely benefit from the fact the business is a good business.
Buffett buys good businesses and earns the rate of return of that business, because he has a large amount of capital. If he was stripped of it, I believe he would be looking in the nittier grittier area’s, and probably achieving 50% returns.
Thoughts anyone?
Cliffs: Strong cash flow businesses easy to evaluate, but are they the best way of managing a small amount of capital?
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Yes Alex, it can be much more profitable searching in the areas where there is forced selling and/or strong catalysts. We have the ability to do that until we work with millions of dollars.
The reason why Joe concentrates on great businesses is that it’s much easier to predict future cash flows. Mediocre businesses (ie, low margins, low barriers to entry, etc) can lose a lot of their profitability from the entrance of competition. If you expected an 18% growth rate for a company that had 6% profit margins and there were low barriers for competition then another firm would likely come in and directly compete. If it did, let’s say that it’s profit margins fall from 6% to 4% (this can happen by a 2% decrease in selling cost at equal unit volume) which would decrease your profitability by 33%! This means you might have dramatically overpaid for that stock.
Joe keeps it simple, great businesses will have less meaningful competition precisely because they are great businesses. Walmart every day low price will still be there generating higher returns tomorrow but joe blow retailer in a small town might be completely whiped out by a new walmart.
If you think you understand all the other factors affecting the company and future profitability and can predict its future cash flows with certainty then you can do just as well investing in mediocre companies. It is just a lot harder to predict them with certainty and margin’s of safety can be quickly and sometimes completely eroded.
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Yep RelativeFactor, good answer… Though I’d counter that’s the reason you need a catalyst. So that the “bad” business doesn’t erode it’s assets etc.
i.e:
Joe Ponzio Way: Good business strong cash flow
Pabrai/Klarman/Greenblatt etc: Mediocre business catalyst
The Ponzio way is definitely a good starting point, as it is easier to grasp. I’m just wondering what the consensus is on the preferable method ceteris paribus.
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You’re also forgetting that: “Time is the friend of the wonderful company, the enemy of the mediocre.”
When you don’t know how long it’s going to take the market to value your stock fairly, you really don’t want to be holding on to a crappy company.
Re-learning Buffett’s advice sucks.
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Good discussion but as they say,managing an investment portfolio is equally an art as well as a science and a portfolio can be a mix of turnarounds,fast growers,stalwarts,cyclicals etc etc.Even Joe picked Volt Information Services which he admits is hardly a world class business.
In Hong Kong during the crash,small caps were being valued at the cash on their balance sheet or at net cash plus two times recession hit cash flows so they might not have been world class companies but you picked certain stocks because you were betting against Mr Market that they would be around for more than the two years that they were being valued at.
At such irrational valuations,the odds of an outsized return on your investment is high and guess what,Mr Market repriced them when the panic was over!
I find it interesting that George Soros and Anthony Bolton are opening funds and offices in Hong Kong but the time to have bought was last year – Hong Kong stocks are not overvalued but all the bargains were last year – it is a bit like coming to the party in the last hour when most of the beer and people have gone.
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Should FCF include changes in working captial?
When analysing small companies, often changes in working capital are a large part of free cash flow.
Should these be included or excluded?
If you’re going to smooth over cash flows over many years as Joe suggests, then such an element will not matter. But when analyzing the last periods FCF in a comparably unstable company….Should we include or exclude these changes in working capital?
I’d particularly like to hear Joe’s take on this if he has a moment…
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Hey Alex,
I can’t speak for Joe, but Buffett’s definition of Owner Earnings is: “These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less (c) the average annual amount of capitalized expenditures for plant and equipment…”
Changes in working capital are part of the “other non-cash charges.”
Also, Joe does not suggest smoothing over cash flows, but rather “smoothing over” capital expenditures.
I suggest you buy the book for a better explanation of Owner Earnings vs. FCF.
-Adam Gaglio
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Hey Adam,
Thanks for the reply. I had read Buffett’s definition of Owner Earnings.
I don’t believe he does include changes in working capital.
Take a look:
If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)
The sentence in the brackets implies he only includes changes in working capital if they were investments in working capital to keep unit production at its normal level (i.e. similar to maintenance cap-ex).
Your thoughts?
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An off topic coment but… I’m currenty wading through Bruce Greenwalds book (“Value Investing from Graham to Buffett”) – I’d recommend it to anyone here.
The book attempts to dissuade you from the DCF method and puts forward a “Assets Earnings Power” method of valuing companies.
While I don’t think DCF should be written off, the Greenwald method is much more conservative, which I like.
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Missed your posts and insight.
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