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.

Does the company have a worthwhile profit margin?

To hammer the importance of this point home, you need not look further than traditional auto manufacturers.

Does the company have a worthwhile profit margin?

Auto manufacturers have historically low profit margins. MSN Money reports a 5-year industry average of just 3.4% for auto manufacturers versus 11.5% for the S&P 500. That is, for every dollar of sales at the auto manufacturer, just $0.03 ends up in net income. The rest is spent on costs of goods sold, operational expenses, etc.

Take, for example, General Motors. In its fiscal year ended December 31, 2007, General Motors reported $178.2 billion of automotive sales. To make the vehicles sold, GM reported “Automotive Cost of Sales” of $166.3 billion. Simple math would tell you that GM generated about $11.9 billion in revenue, after taking into account the cost of the materials to make the vehicles.

Here’s the problem: In the three years leading up to the end of last year, GM had to spend an average of $13.7 billion on “Selling, General and Administrative” expenses – the costs to keep the lights on, to keep the salespeople motivated, to advertise, etc. $11.9 billion in, $13.7 billion out. Starting to see the problem?

When Margins are Slim

If your company doesn’t have a “worthwhile” profit margin, it has a problem: When tough times surface (as they always do from time to time), weak margin companies will probably start burning cash rather than generating it. When things begin to turn around, your company’s ability to generate cash will be delayed relative to its high profit margin competitors.

As your company begins to use cash rather than generate it, your ownership is in jeopardy. I’m not just talking about negative free cash flow; your company will have to sell assets, fire people, take on debt, and/or sell more stock. The result: Less sales as capacity to fill orders is diminished, lower profit margins and excess cash as interest expenses increase, and dilution of your ownership resulting in less value going forward.

Check out GM’s balance sheet on Morningstar, and specifically look at the changes to shareholder equity. Here’s a company that has spent the last ten years trying to keeps its head above water, struggling to find a balance between too big to be profitable and too small to maintain unit volume. When margins are too thin, the slightest breeze can knock your business around.

The Owner’s Margin

Profit margins are important when looking at the industry and at historical figures for a company; the Owner’s Margin looks forward.

Calculated as owner earnings (or free cash flow) divided by total revenues, the Owner’s Margin can help you judge whether or not your business will be able to sustain prolonged periods of slowed sales or unusually high expenses.

In the case of General Motors, sales slipped and any excess cash they might have been able to eek out when times were good is now a pipe dream. Let’s turn our attention to Pfizer.

Generating about $10.6 billion in owner earnings last year on sales of $48.4 billion, Pfizer’s Owner’s Margin is 22%. That is, for every dollar of sales that Pfizer recorded, it generated about $0.22 in excess cash. Think of it this way: If sales at Pfizer sank 20%, or $9.7 billion, to $38.7 billion, Pfizer would still be able to crank out more than $900 million in owner earnings without firing a single person, selling a single asset, or assuming a dime of additional debt (if it’s business as usual).

A 20% hit to sales, and the company is still generating excess cash without making a single adjustment to its business? Now that’s a worthwhile margin.

Of course, some adjustments would likely be made. At that level, Pfizer would definitely have to kill its $8 billion annual dividend payments (unless management wanted to foolishly assume $8 billion a year in debt to keep the dividend). Furthermore, Pfizer would likely cut staff and take other measures to return to a more worthwhile margin. Still, the company has the operational capacity to sustain a very serious hit to sales without sustaining a commensurate hit to operations or its balance sheet.

When Times Get Tough

Going back to troubled companies. If you are attributing GM’s tough times to tighter consumer spending and higher gas prices, let’s move out of the beaten down auto sector and move to another business – Blockbuster.

For its fiscal year ended December 31, 2006, Blockbuster reported total revenues of $5.5 billion. It generated just $183 million of owner earnings – an Owner’s Margin of 3.3%. For the record, 2006 was a “business as usual” year for BBI.

Here’s where it gets hairy: To generate cash and actually have any sort of value for investors, Blockbuster needs to keep sales extremely high, to keep expenses extremely low, and to operate at perfect efficiency. Any slight change can have a dramatic effect on the business.

Well, it got hairy for Blockbuster. Revenues and most expenses in 2007 were largely unchanged. However, Blockbuster’s costs of sales increased by about 8%, from $2.5 billion to $2.7 billion. Owner’s Margin of 3.3%; cost of sales increase of 8%. Doesn’t look good for this fragile business.

Sure enough, Blockbuster’s operations swung from generating owner earnings of about $183 million to requiring an additional $114 million after all expenses were paid. Its Owner’s Margin dropped to a negative 2%. For every dollar of sales Blockbuster generated, it had to cough up $1.02 to keep the doors open.

In the highly competitive world of movie rentals (think Netflix, Wal-Mart, Apple TV, Comcast On Demand, etc.), a 3% Owner’s Margin is definitely not worthwhile. And Blockbuster shareholders have suffered because of it.

What Is “Worthwhile”?

The term “worthwhile” is relative, and depends on your estimation of how bad things can get at your company. If you are expecting a 50% hit to Pfizer’s total sales or a doubling of expenses at some point in the future, a 22% Owner’s Margin is definitely not worthwhile. If, however, in the ordinary course of business and economic cycles, you would not be surprised by 10% swings in sales, a 13% or 15% Owner’s Margin may very well be worthwhile.

As with everything in investing, look for a margin of safety. The higher the Owner’s Margin, the better.

The goal of R&D is to produce new products, services, or processes that will “still further increase total sales potentials” for the company. Not an easy question to answer, Fisher asks:

How effective are the company’s research and development efforts in relation to its size?

This is very much an industry-specific question with a near-unanswerable solution – one of the reasons there is so much art (versus pure science) in investing. Since both annual sales (revenue) and research and development expenses are published on financial statements, it’s fairly easy to come up with a mathematical answer by dividing R&D by total sales to see how much the company and its competitors spend each year.

Remember: The value of a company lies entirely in the future. The past does little more than offer insight into how the business has performed under various conditions. Still, we can look to the past to help us see into the future. So, let’s look at the above formula applied to a few companies. First, however, we qualify this discussion with Fisher:

Figures of this sort can prove a crude yardstick that may give a worthwhile hint that one company is doing an abnormal amount of research or another not nearly enough. But unless a great deal of further knowledge is obtained, such figures can be misleading.

Pfizer vs. Glaxo vs. Lilly

Ignoring dollar amounts for now, let’s compare the percentage of R&D spending at three of the industry’s major players. From 2000 to 2007, sales at Pfizer grew some 62% compared to 51% for Eli Lilly and 17% for Glaxo. Pfizer had the best gross margin – 83% – versus about 79% for the other two. In essence, Pfizer had a lower cost of goods sold which helped convert more sales into cash.

Of that after-sales cash, Pfizer spent about 19% on R&D versus 18% for Glaxo. Lilly was the clear winner on a percentage basis, spending about 24% of its gross profit margin on research and development.

As a percentage of sales, Lilly is spending the most on R&D – about 19% of gross sales and 24% of gross profits versus 15% of gross sales and about 18%-19% of gross profits for Pfizer and Glaxo.

R&D Growth

But who has been spending more and more in an effort to increase product lines? Over the past eight years, Pfizer’s R&D spending has increased about 72% – ten points more than sales. Lilly has increased R&D about 60%, or nine points more than its sales growth. Glaxo comes in with a 28% increase, a full eleven points above its sales increases.

On a percentage basis, Glaxo has been ramping up R&D the fastest (in relation to sales), Lilly spends the largest portion of its gross margin on R&D, and Pfizer has been ramping up R&D the fastest on an overall, absolute basis.

So, Let’s Try to Answer the Question

How effective are the company’s research and development efforts in relation to its size?

For the four full years from the beginning of 2000 through the end of 2003, Glaxo spent £10.9 billion (US $21.5 billion) in R&D, which translated into £6.7 billion (US $13.3 billion) in additional sales from 2004 through 2007.

During that time, Lilly spent $8.8 billion on R&D which resulted in $16.8 billion in additional sales from 2004 through 2007. Pfizer spent $22 billion in R&D and generated an additional $58 billion in sales.

You can’t look at these as a dollar-for-dollar translation; rather, focus on the results. They all have brilliant teams working long hours trying to develop the next blockbuster drug. Pfizer spent the most on an absolute dollar basis and enjoyed the greatest sales growth. Based on sales, Glaxo and Pfizer are roughly the same size. But Pfizer spends 17% (or $1.2 billion) more on R&D. Assuming researchers at both Glaxo and Pfizer are equally as smart, Pfizer is giving itself a better chance at developing a new wonderdrug and giving investors a better chance of benefiting from a new revenue stream.

But let’s not ignore Eli Lilly. With R&D spending of $3.2 billion a year – less than the other two, but still a full 20% of sales – Lilly is spending as much as it can to compete with its larger rivals.

Which Looks Best?

Out of the three choices, it’s a toss up between Pfizer and Lilly. In relation to its size, Lilly is spending the most on R&D. On the flip size, Pfizer is spending a comparable amount, but much more on an absolute dollar basis.

Then again, it’s research and development. With a much smaller budget, a tiny competitor can develop (or even stumble across) a wonderdrug and beat Glaxo, Pfizer, and Lilly to market. In that case, the money spent by the big boys on that particular drug is largely wasted. This is why the breadth and depth of the pipeline is so critical.

(For that and other reasons, a company like Amylin – with just $270 million in R&D and four drugs in the pipeline – are so speculative. If any or all of them fail or are beat to market, Amylin has to start from scratch.)

Think Outside The Pillbox

Looking at pharmaceuticals right now? Why not include TEVA in your research? While all the big boys are spending crazy money on R&D, hoping to develop the next wonderdrug and beat everyone else to market, TEVA sits back and scans the patent database to see when blockbuster patents are expiring. Then, it simply cranks out a generic and starts raking in the dough.

While Pfizer frets over its Lipitor patent, TEVA is licking its chops. Reverse engineering a drug to make a generic is nowhere near as expensive as the R&D required to create a new drug, as can be seen by TEVA’s relatively small R&D expenses. And since the Lipitor brand and results will be well known and documented, TEVA will have little to do but slap a label on a bottle and blow some money on marketing – and probably less than Pfizer will have to spend to try and keep its Lipitor market share.

How effective are the company’s research and development efforts in relation to its size?

When a major patent expires, you are rolling the dice, betting on which big pharma will have the next blockbuster. All the while, companies like TEVA are piggybacking big pharma’s R&D spending, without all the failures. To answer Fisher’s question above, I’d have to rank TEVA first, followed by a Pfizer and Lilly tie for second, with Glaxo coming in fourth.

Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

There are two schools of thought on this subject – the rational, business-like approach and the “other” approach.

The “Other” Approach

There is an old saying in business: Throw enough sh*t at the wall, and something’s gotta stick. In practice, many business owners (i) struggling to get by on their primary business, or (ii) poor at allocating excess capital, will expand into other areas. The thought process is simple (yet quite absurd): Business A can only go so far, so I’ll start Business B, C, and D and make a small living from each.

You see it all the time in publicly traded companies. Management has no idea what to do with their present business or excess cash, so they try to expand into other areas – most likely because they want to impress investors. (Think “Institutional Imperative”) Need an example? Check out Citigroup’s list of subsidiary companies as of their 2007 annual report. Let me break it down a bit.

Citigroup has 2,259 subsidiaries on that list. With 2007 revenues of $81.7 billion, that means that its average business generates about $36.1 million a year in revenue. Furthermore, it averaged about $15 billion in net income from 2003 through 2007, or about $7 million from each business.

Those Numbers are Skewed

You bet! We know that Citigroup has some very major, very core businesses – CitiFinancial and Smith Barney come to mind. It’s fair to assume that these core, massive businesses contribute the lion’s share of the revenue. So why does it own Southern Graphics Systems – a graphic design and packaging company – and how much do businesses like this contribute to the owners / stockholders?

No wonder Citigroup shareholders are up in arms, screaming that the company needs to dump some of its less-profitable businesses.

The Institutional Imperative

Citigroup is a classic case of the Institutional Imperative that Buffett speaks of. You have this wonderful investment business, and you go and do something stupid – like buy or start 2,200 more businesses.

Citigroup vs. The Rational, Business Approach

Warren Buffett is the embodiment of “rational, business approach” to growth. Berkshire has 50% more revenue, 2,200 less subsidiaries, and twice the market capitalization of Citigroup. Why? Buffett and Munger read Fisher.

Without any real products to sell, Berkshire’s “product” is capital allocation. To paraphrase (and slightly twist) Fisher, Buffett, Munger, and company have the determination to continue to allocate capital (via acquisitions) that will increase total sales potentials (read: cash flow for more capital allocation) when the growth potentials of current product lines (subsidiaries) have largely been exploited.

Berkshire owns Forest River – a trailer and RV company. Buffett and Munger know it doesn’t have the potential to be as big as Coca-Cola; still, it is an investment that will serve the company’s ultimate goal – to provide the two with more capital to allocate.

What Will Your Managers Do?

It’s not a question of whether or not the company has a lot of subsidiaries. It comes down to focus – does your management have it or not? To expand into new product lines or to make intelligent acquisitions, your management needs to be focused. The deals need to make sense.

When Coca-Cola owned shrimp farms in the late 1970s and early 1980s, it didn’t make sense. On the one hand, food and drink go together. Still, shrimp and Coca-Cola / wine / juice? It didn’t make sense. There could be very little resource sharing; Coca-Cola couldn’t minimize expenses because it had to run two very different businesses.

Look at Pfizer. 441 subsidiaries (yes, I know some of them are joint venture or other LLC/partnership-type arrangements). But they are pretty much all drug, research, or healthcare related (except Site Realty, which still has me scratching my head). Pfizer has been beaten down some 60% over the past eight years. Wall Street is worried that the November 2011 expiration of the Lipitor patent will effectively wipe out all $12 billion of Lipitor’s revenues, and destroy the company entirely. Granted, Lipitor generates about 25% of the company’s revenues; still, odds are, neither Lipitor nor Pfizer are not going to disappear entirely.

So, What is Pfizer To Do?

Right now, Pfizer is plowing $8 billion a year into research and development. The ultimate goal: “to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines [Lipitor] have largely been exploited.”

Pfizer is generating about $10 billion a year in owner earnings, with only about $2 billion in annual capital expenditures. With the Lipitor patent gone in three years, owner earnings are likely to decrease. What is Pfizer doing to prepare for that? Research and Development (here’s their “in the pipeline” report) and acquisitions of related businesses. Will it pay off? There is no way to know for certain; still, Pfizer management seems to be focused on the right process, and that’s all a shareholder can ask for.

If we start seeing products or acquisitions in unrelated businesses, or if it appears like Pfizer is giving up hope and content to do little more than battle the generics for Lipitor market share, get out of the way. Otherwise, Pfizer seems to fit Fisher’s Point 2 very nicely. It’s not enough to go on, but it’s a start.