Barry Schwartz on Valuing a Business

Baskin Financial Services is one of the finer investment outfits in Canada.  Both David Baskin, the company's namesake, and colleague Barry Schwartz have much to offer knowledge-hungry investors.  The two make regular appearances on BNN Market Call and Market Call Tonight, and correctly emphasize the competitive strengths of businesses, and important metrics such as return on capital.  In addition, both men contribute regular articles on the firm's blog, where they've had wise things to say about ignoring headline news, being patient, the perils of over-diversification, and much else.

A recent article by Barry Schwartz considers an important question: How do shareholders decide whether management ought to pay a dividend or repurchase shares?  If they pay a dividend, he points out, shareholders must pay tax, but are given control of the investment decision.  They have the option of buying more shares of the dividend paying firm, but if they believe that the newfound dollar in their pocket is better invested elsewhere, they can do exactly that.  A share repurchase saves owners the tax, but robs them of the alternative of investing elsewhere.  His narrowly framed question can stand in for a broader one: How should investors determine if a company is undervalued, regardless of whether management returns money to shareholders (via dividend or buyback) or if they retain all earnings to reinvest.

The formula he offers to resolve this question, unfortunately, is unsound.  Schwartz argues that a company ought to repurchase shares only if the P/E ratio is lower than its return on equity.  As he knows, P/E measures how expensive a stock is, and ROE gauges the profitability of the underlying business.  Though both are critically important, the two metrics are not on the same plane, the way, say, P/E and earnings growth are combined to form the PEG ratio.

To illustrate, in 2011 IBM posted adjusted earnings of $16.3 billion, on an equity base of $20.1 billion, for an ROE of 81%.  By Schwartz's logic - he prefers to pay no more than 75 cents for each percentage of ROE - management is wise to pay up to 60 times earnings to buy back shares of IBM.  That's $1000 per share, for a company now trading at $200, with a P/E ratio of 12x earnings.  A little rich, I think.

In fairness, I've used an extreme example, since IBM's ROE is radically high.  And, in practice, an investor that purchased only stocks with, say, an ROE of 20% and a P/E of 15 would likely do well over time.  In fact, the three companies that he cites as passing his test - CSX, Viacom, and Tim Horton's - are all superb companies, and probably undervalued, too.  Schwartz is profoundly right to covet companies offering both a high ROE and low P/E ratio.  Still, the formula he has concocted is flawed.

Disclosure: At the time this article was published, the author was long IBM stock.

Here is an article on how Mason Hawkins values a business.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Mohnish Pabrai on Investing Mistakes

Investors should listen when Mohnish Pabrai speaks.  He recently gave an enlightening interview, in which he discussed his personal experiences as an entrepreneur, and the relationship between being a businessperson and an investor; his "all-in" bet on financial companies; his "two-outta-three-ain't-bad" philosophy of investing errors, borrowed from John Templeton, and, affirmed, he claims (not convincingly, in my view) by Warren Buffett's experience; and the opportunity costs of committing capital, among other things.

I'd like to highlight, though, his candid exploration of his mistakes, a few of which led to substantial and permanent losses of capital.  One was Sears Holdings, which sits on real estate that's worth far more than the company's market cap, but can only be monetized by liquidating the business.  Despite a prominent theory which holds that people act only according to the cold calculus of economics, most CEO's are not hot on the idea of liquidating the firm they preside over (or perhaps this affirms the theory: after all, why dismantle the company that's paying you such an appealing salary?).  Either way, the alternative that's best for shareholders is not always the option that's pursued by management.

A second misstep was his investment in Pinnacle Airlines, a contract operator that flew on behalf of traditional airlines, including Delta.  While Pinnacle had a cushy cost-plus arrangement, shielding it from the challenges of the airline industry, making money from customers that are losing money is not a recipe for long-term success.  When they fall, so do you.  Pabrai concedes that he should have better understood the full economic ecosystem that Pinnacle was operating in (Charlie Munger would greatly respect this lesson, as the ecosystem is among the 100-odd "Big Ideas" that he draws wisdom from).  Finally, his worst failure was his position in Delta Financial, a company that wrote, bundled and securitized mortgages, and was felled by the recent financial crises.  His position, 10% of his portfolio, went to zero.

Nearly all prominent investors will concede that they've made mistakes, but when pressed to provide specific examples, few are keen on discussing them in detail.  Post-mortems are grim, after all.  But kudos to Pabrai for doing so, and allowing the rest of us the opportunity to learn from his mistakes for free, rather than paying to do so first-hand.

Here is a review of Pabrai's book The Dhandho Investor

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Terex - 2012 Fourth Quarter Update

Terex recently reported fourth quarter and annual earnings, both of which were significantly better than the year-ago periods, though the improvement was due in part to easy comparisons.  More importantly, management forecasted 2013 earnings of $2.40-2.70, and published their internal "goal" of reaching $5 in EPS by 2015, but insisted that this wasn't "guidance."  The CEO, in the past a bit of a shop-a-holic, promised to move towards the goal by focusing on operational improvements, not through acquisitions.  In addition, the company is aiming for a 15% return on invested capital in 2015.

Just as important as the P&L is the balance sheet, which has been strengthened considerably over the past few years, and the company pledged further improvements in the years to come.  Indeed, the 2015 EPS goal appears to assume little or no remaining debt (management forecasted operating income in 2015 of $1 billion, and assuming a 35% tax rate and 120 million shares outstanding, EPS would amount to around $5.40, leaving little room for interest payments).

The $5 goal is a bit light, so Terex shareholders must be hoping that management is under-promising with the intention of over-delivering.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Valuing a Business - Mason Hawkins on Dell

Valuing a business is part art, part science.  Since determining a business's true worth is subtle enough to resist any hard-and-fast formula, it's always useful to learn how successful investors do it.  After all, investors who have outperformed the market over an extended period of time must know how to identify undervalued assets.  The consensus these days is that most of a business's value lies in the free cash flows that it will generate in the future, albeit adding on surplus assets, and subtracting long-term liabilities.  

Warren Buffett pegs the value of a business on the earnings that will be generated "from now to kingdom come," though he's deliberately vague on specifics.  It appears that he doesn't employ any standard discounted cash flow model.  In fact, biographer Alice Schroeder, among the most well-informed and shrewdest of all Buffett-watchers, has suggested that when gauging a business's value he looks forward mostly by looking backward, focusing on a business’s past ability to generate profits as a predictor of future results.  If he's confident that the business has an enduring competitive advantage, and the industry it's operates in is unlikely to undergo major change, he assumes that tomorrow will look much the same as yesterday and today.  

However, there are other valid ways of assessing a company's worth.  One of North America's foremost investors is Mason Hawkins, of Southeastern Asset Management.  He is currently campaigning on behalf of Dell shareholders, maintaining that the proposed leveraged buyout, led by founder Michael Dell, "grossly undervalues" the company.  In fact, he argues in a recent publication that the tech giant is worth nearly twice what's being offered.  Given that Southeastern is the largest outside shareholder, owning 8.5% of Dell's stock, the business world will be watching closely as events unfold.

Happily for investors and students of investing, Hawkins not only makes explicit what he thinks Dell is actually worth - $23.72 per share - he offers details about he arrives at his conclusion.  Essentially, Hawkins breaks Dell down into its constituent parts - no longer merely a purveyor of low-priced desktops, the company now sells servers, software and services, in addition to its financing operation - and attaches a multiple to current operating income.  The multiples applied are different for each business, reflecting the going rate for comparable companies in their respective industries.  He sums up these numbers, adds net cash plus an estimate of the value of recent acquisitions, then subtracts unallocated financing and corporate expenses.  While Hawkins doesn't attempt to quantify it, he notes that Dell's distribution network offers the company a competitive advantage, adding further value.

Number-loving investors will be fascinated by Hawkins' analysis, but the important work is actually qualitative.  Taking apart Dell piece by piece forces Hawkins to carefully consider each of its component businesses, and how they compare to competitors in their respective industries.  While this analysis focuses on today's earnings, rather than attempting to predict what may happen tomorrow, it has one crucially important thing in common with a future cash flow estimate: it places a company's value in its ability to sell products and services to customers.  Hawkins goes on to suggest several scenarios that may unlock latent value, but the value itself resides in the quality of the business.

Source: http://www.longleafpartners.com/downloads/dell-board-letter.pdf

Here is an earlier article on Dell.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

A Summary of the IMF's Survey of Canada's Economy and Housing Market

The International Monetary Fund recently released an economic report on Canada that included an analysis of Canada's housing market.  Based on a detailed study that included immigration trends, household income, mortgage rates, and the rental market, the IMF concludes that Canada's housing market is overvalued by 10-15% (as of the third quarter of 2012).  While the report suggests that there has been some overbuilding, it concludes that excess supply remains modest.  

Overall, the authors do not express any particular alarm.  While they cite downside risks, their "baseline" scenario is a "soft landing," where nominal house prices are flat, or down slightly, over the next few years, with inflation slowly closing the gap between price and value.  While reduced housing starts and softening prices will drag on economic growth, it will not dramatically reduce expansion.  The (mostly) responsible lending practices and homeowners' significant equity mean that it's unlikely Canada will suffer from a US-style housing crash, the report concludes.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.