Questions and Concepts in Value Investing

By Joe Ponzio on August 7, 2009  |  12 comments

It's been quite a while since I've written an article, and for that...I'm sorry! The past few weeks have had me extremely busy — reading, researching, and ripping apart companies. We've made a few investments this quarter, but I haven't had time to write about any of them here. Sadly, F Wall Street's portfolio has gone from largely ignored to entirely ignored.

Of course, I couldn't ask for more out of a lazy man's portfolio. Being some 17% in cash brings me no joy; but, this portfolio has continued to outperform the S&P 500 Total Return Index (the S&P 500 with dividends reinvested) by 19.7% a year, growing 4.2% annually versus the S&P 500's -15.5% annual return. That said, the F Wall Street portfolio is going bye-bye. Though I will continue to write about investing and individual companies, I can't maintain the portfolio in real-time (or even somewhat real-time).

Still, this "value investing" stuff works. And though we've only been going two years, if you don't believe by now that buying good businesses on the cheap and ignoring the markets is the way to go, it will probably never sit right with you. As Buffett says: You either quickly get the concept of buying $0.50 dollars, or you never do. Let's jump into some interesting questions from visitors, and concepts in intelligent investing.

Did You Miss The Recent Rally?

Two of the great things about intelligent investing are:

• you never "miss the boat" because there's always going to be another boat, and
• your results, though volatile, will be largely independent of the market's returns.

Think about that for a second. If you're lamenting the fact that you weren't fully invested in March and you missed the rally — that you "missed your chance" — think about who is promoting that idea, and then remember back not only to March, but to the dot-com bubble, burst, and recovery.

When the markets are flying high, they say that you have to get in — you're missing the action. When the markets are at their lows, you should "keep some powder dry" because they're going lower. Then, a massive recovery comes and everyone says, "We told you to buy! You missed the action!"

Interestingly enough, it's the same people that scream, "Get in! Stay in cash! We told you to get in!" They don't put a guy like me on television because I' not fast and actionable.

Reporter: Joe, what should investors do today?
Joe: Buy assets for less than they're worth.
Reporter: But the markets are [up/down] 40% in the last year, and you said that a year ago!
Joe: Yep.
Reporter: Thanks for another scintillating interview.

I won't name names, but it's all garbage. When I talk about Rose in the book, I mention some of the crazy markets she saw — up 40% in a year, down 50% in a year. Rose never concerned herself with the markets. She never timed anything. She paid good prices for good businesses, and ended up a wealthy woman.

But It's Different This Time!

Bull.

The "September Event" that occurred after Lehman Weekend was different that anything we've seen in 80 years. But that's behind us now (it was behind us a while ago). And even still — had the world economy stopped completely, had everything collapsed, your money market, your stocks, your gold ETFs — all worthless. Even those gold bars they're selling on television — they'd only be as good as the ammo you have to protect them.

If you're still looking for the end of capitalism and wondering how to profit from it, get in the ammo business. Otherwise, keep looking for good businesses at cheap prices.

At this point, the economy is still ugly. Unemployment is still rising. Foreclosures. Volatility. Inflation or deflation — take your pick. Rates will go up in the future, putting added pressure on stocks. These things — all of these things — we've been through them before, in varying degrees.

It's not different, it's just scarier because the internet and the media throw it in our faces more often than they could twenty years ago. And our next crisis, whenever that may be, will seem even more dire and hopeless because we'll have more information from more sources, adding to the fear and confusion.

Is everything we're seeing now unprecendented? Yes. But it doesn't change the game. It's not "different."

The markets work. Definitely not on a daily basis. Sometimes not even on a yearly basis. But over the long run, an asset purchased on the cheap will usually work out just fine regardless of whether or not we "retest the lows" or hit Dow 10,000 before the end of the year.

Questions from Visitors

Jason asked about the value of goodwill and intangibles. When figuring out "invested capital," you should ignore the cost of intangibles and goodwill as you try to determine what the business can earn regardless of what management does with the excess cash. For example, Johnson and Johnson makes a lot of acquisitions; but, you shouldn't bet your retirement on the hope that they'll continue to make acquisitions to grow. In determining CROIC, you want to know what the business can earn from its operations as a healthcare company, or retailer, or whatever.

A prime example — and I hate to keep picking on these guys — is Lucent. Lucent doesn't seem to have a very good business; so, they constantly try to grow through acquisitions. What happens when the financing runs out and they can't make any acquisitions for a while? You're stuck with Lucent's business, and whatever returns they'll generate on the existing capital.

ajay asked a few questions. Question 1: Do we include X, Y and Z in shareholder equity, and is it the same as net worth, book value, etc.? Shareholder Equity is all of the assets minus all of the liabilities. There is a difference between Shareholder Equity and book value in that book value is often considered the tangible book value — the net value of the tangible assets minus all of the liabilities. Book value excludes certain accounting "assets" such as goodwill or the value of trademarks. That distinction is critical when investing in break-ups, bankruptcies, and net-nets. (More on net-nets in another post.)

He also brought up Pfizer, a topic discussed recently at a book signing I did. Is it a good investment? My two cents on pharmaceutical companies is that they're generally only as good as the drugs coming out of their pipeline. They have to invest massive amounts in research and development, and often seek growth through acquisitions. Every product they make generally has a very limited revenue stream, as opposed to a Coca-Cola. If you can predict the value of their pipeline, you can invest in a pharmaceutical company...but you have to have a thesis on the pipeline, just as you have to have a thesis on where oil is going before you buy a company that makes money on oil.

Joie asked about whether or not goodwill should be included in shareholder equity, and the answer is: it depends. If the goodwill is truly valuable, then it should be included. If not, ditch some or all of it. When I wrote about Adobe Systems, I talked about their goodwill from their purchase of Macromedia. The goodwill was the difference between the purchase price of Macromedia and the value of its actual, tangible assets. I felt that Macromedia was so integrated in Adobe's business that the goodwill carried was much too high relative to the ongoing, resale value of Macromedia in the event of a sale; so, I reduced the goodwill somewhat.

Joie also asked about capital expenditures. Some companies break down their capital expenditures for you so you can easily deduce which ones are required and which are temporary; some don't, and you have to use some math and logic to work it out. (See this post on Wal-Mart.) When looking through annual reports, look at the notes to the financial statements. And don't be afraid to skip it if it's too hard to figure out!

Ari Greenberg also asked about capital expenditures, but more specifically: Does depreciation equal maintenance capital expenditures. Answer: No. Over the course of the business' lifetime, depreciation will equal capital expenditures because that's how the accounting works. Depreciation allows a company to spread out an expense over a certain period of time, and that depreciation works out to the purchase price minus the sale or scrap price of that asset. There will also be costs in upgrading the equipment, maintaining it, etc. which may be significant. The fact that the accounting regulations allow the company to write off a piece of equipment over a number of years doesn't mean that the ongoing expense of maintaining, upgrading, and repairing that equipment can be ignored — and that's the number you want to figure out as well.

Avishek asked about moats and Morningstar. The "moat" you want is that key ingredient that virtually ensures that the business will be profitable in the future. I wouldn't rely on anyone but my own research, because most people get it wrong which is why you have the opportunity to buy a great asset on the cheap. If you're not comfortable reading annual reports and identifying moats, you can learn over time by continuing to look and read. Start with big companies and work down the line. And on that note: It won't all be in the annual report. Avishek mentioned "switching costs." You don't necessarily learn that in the company's filings, but in learning about the industry, how it works, and who the customers are.

Finally, Ron asked why I thought that Harley Davidson had high capital expenditures versus a Wal-Mart. Make sure you check out this post about Wal-Mart to understand the growth vs. maintenance capital expenditures. HOG, like most auto manufacturers, airlines, and heavy steel/iron operators, have to rely on massive, old, clunky machines to build their products. These machines require constant maintenance, upgrades, and repairs. This leads to large capital expenditures. Wal-Mart, on the other hand, merely needs to buy a building and set up shop. The massive jumps in capital expenditures over the past few years was largely due to growth capex (including expansion into China) and, perhaps moreso, due to their revamping and building out of their massive distribution center — a cost that isn't likely to occur indefinitely in the future. When looking at two similar businesses at similar prices, you'll likely be better off with the company that doesn't have to spend huge amounts just to keep the doors open.

That leads me to the second part of his question: What is a good inventory turn rate to profit margin? It depends on what you consider a good profit margin. A business with one inventory turn a year and a 20% profit margin is no better or worse (at least from a profit margin standpoint) than a company with two turns and a 10% margin, or four turns and a five percent margin. Don't rule out a company solely because of profit margins. Wal-Mart's margin is about 3.5%, but it is wildly profitable because it turns its inventory seven or eight times a year, for a "true" profit margin of 26% or so.

Think of it this way: If you buy a rock for $100 and sell it for $102, you've made one inventory turn and a 2% profit margin. If you're doing that once a year, close up shop because your shareholders are better served if you stop buying rocks and invest solely in U.S. Treasuries. But, if you're buying and selling these rocks twice a month — twenty four times a year — you're laying out $100 to earn $48 a year. Though your profit margin would still be 2%, your "true" margin would be 48%. That's one heck of a business.

And of course, don't take it all at face value. Two companies with "true" profit margins of 40% won't necessarily grow rapidly. The one that has to lay out more in capital expenditures is going to grow more slowly (all else being equal).

Keep On Trucking

There are values out there. I recently purchased a stock around $7.80, even though it was up some 92% from its March low. Think we've "come too far too fast"? I don't know. What if we fell too far to fast?

There is no way to know what the markets will do next week or next month. The nice thing is: So long as you keep investing intelligently, you'll never have to worry about it.

Also Filed Under "Our Portfolio & Performance"

• Is Buy and Hold Dead? Performance Update.
• Questions and Concepts in Value Investing
• Timing Purchases; Portfolio Changes
• F Wall Street Investment Performance