DST Systems is largest mutual fund servicing and record keeping firm.
On the surface, DST has $6.8 GAAP per share earning in 2010, and $4.43 non-GAP per share earning, the P/E ratio is fairly good comparing to a $50 price.
However, its core business is declining. The registered accounts for Output Solutions declined 10% in 2010. Even though this core business represents only 48% of overall revenue, it is still could result in a 5% decline of revenue every year.
Looking deeply into its annual report and quarterly earnings conference calls, there are other details to be noted:
1. Like other software companies, its maintenance cash flow is bigger than income. The difference is around 50M in the last 5 years. Or $1 per share.
2. It has 1.4B long term investments. About $900M on stocks of 3 companies, and $500M on real estate. With 5% return on these, there are $70M look through earnings every year.
3. Combine #1 and #2, and add on to the non-GAAP earning $4.43, it gives a rough cash flow of $6.83, or 13.6% return each year.
4. However, since the business is declining, it needs to acquire new companies or buy-back shares to keep the per-share earnings from shrinking. The new growth on healthcare side and TRAC will offset the decline though. Plus, 10% decline in 2010 is a special case since it lost a big client which is 6.6% of their business. Also, it added another new big client in Canada. So conservatively, we can assume the business is declining 3% every year assuming no acquisition or significant re-investment. The actual figure is likely less than that. With 3% negative growth, the return is reduced to 10.6% assuming it can buy a business valued like itself in market, or its share price stay at or below $50.
So in conclusion, the conservative fair value is around $53. When doing evaluation, many people tend to forget about the look-through earnings on its long term investments, which is completely separate from its core business.
One of my favorite part is the CEO: Mr McDonnell. I don't know much about this person, but did some basic research on him. Here is what I usually do to study the top management:
1. Look at his basic profile:
He worked in this company for 37 years starting from 27 years old.
2. Hear what he said:
He mentioned many negative points about the company in the quarterly report and earning conference. He emphasized non-GAAP figures even though it is a lot less than the GAAP figure.
3. Watch what he did:
He provided good returns to share holders through share buyback, conservative acquisitions in the past. The share price 15 years ago was around $12 in 1995, comparing to the current $50, it is a 10% return each year, and its share price also goes steadily up if we exclude the impact from market index's fluctuations.
So he seems to be an honest person, with fairly good financial decisions in history.
The biggest individual holder (20% ownership) is ARGYROS GEORGE who seems to be adding to his position all the time for many years, and he also worked for this company for a couple of years in the past.
On the safety side (here "safety" means the probability of bankruptcy, or maximum downside under an extremely hash business environment), the long term investment is more than enough to cover the debt, not mentioning the relatively stable earnings.
For competitive strength, it is the largest mutual fund servicing firm. However, since the business is declining, this strength is not that important any more.
Overall, it is a good stable stock worth investing. The most significant draw back is the negative growth on core business, but with a good CEO, he should find a way to provide good returns to shareholders.
If Mr. Market allows us to buy this stock at $35-$41, it should provide a good safety margin and more appealing returns.
(Disclaimer: I don't own this stock at the moment, but is planning on initiating a position if the price is attractive)
Tuesday, February 22, 2011
Thursday, February 3, 2011
5 filters on value investments
1. Good Management.
Without a good management, no matter how compelling the valuation is, it is not investor's money. Bad management has many ways to destroy shareholder value, bad acquisitions, bad stock buy-backs, bad expansion strategy..., just to name a few. That said, a mediocre management is acceptable, if all the other aspects are very compelling. However, bad management is never acceptable not matter what, at least not for an "investment".
Good management means honest/integrity and competent. Among these two, honest/integrity is more important. An incompetent management might make a lot of mistakes and no smart decisions, but still it won't destroy too much value.
2. Safety.
This is considering the worst scenarios, or whether there is a significant chance for bankruptcy. Apparently, companies in cyclic sectors, with low profit margin or operating margin, with high debt ratio, rely on single supplier or customer have low safety and uncertainty. Low safety doesn't mean the risk-reward ratio is always bad, but it may not fall into the "investment" category. In that case, it becomes a speculation.
3. Valuation.
This means the stock is relatively cheap comparing to its growth, earning, asset and cash flow.
4. Durable competitive advantages.
Over long term, it is the durable competitive advantage that could maintain consistent high profit margin and above average growth. This is not a must-have though, if the valuation is more focused on current cash flow or asset, and the current earning is not subject major changes if other competitors enter the field.
5. Within circle of competence.
This is what Buffett emphasized in most of his talks. Without deep understanding of the industry, it is hard to really gain any advantage on information. And most retail investors don't have deep understanding of the industry, unless this is the field he/she worked on for many years. So a work-around could be getting some confirmation from some trustable gurus, plus a fair amount of understanding on the field. The effectiveness of this approach still needs to be tested though. This is probably the hardest part for normal investors.
Other non-mandatory filters include Catalyst and Growth. Having a catalyst will improve the efficiency of capital usage. And having good growth potential will increase the upside potential since the fair value varies a lot when the growth rate shifts a little bit. This part is especially important if the intention is to hold stock for many years without selling (like Buffett).
5 filters in the checklist seem to be a lot to remember, but underneath, there really is just one thing: "certainty". I use these filters to achieve high "certainty". That is what Buffett calls "never lose money", what Graham calls "investment, not speculation", and what James Rogers calls "do absolutely nothing unless there is something really worth doing"
Without a good management, no matter how compelling the valuation is, it is not investor's money. Bad management has many ways to destroy shareholder value, bad acquisitions, bad stock buy-backs, bad expansion strategy..., just to name a few. That said, a mediocre management is acceptable, if all the other aspects are very compelling. However, bad management is never acceptable not matter what, at least not for an "investment".
Good management means honest/integrity and competent. Among these two, honest/integrity is more important. An incompetent management might make a lot of mistakes and no smart decisions, but still it won't destroy too much value.
2. Safety.
This is considering the worst scenarios, or whether there is a significant chance for bankruptcy. Apparently, companies in cyclic sectors, with low profit margin or operating margin, with high debt ratio, rely on single supplier or customer have low safety and uncertainty. Low safety doesn't mean the risk-reward ratio is always bad, but it may not fall into the "investment" category. In that case, it becomes a speculation.
3. Valuation.
This means the stock is relatively cheap comparing to its growth, earning, asset and cash flow.
4. Durable competitive advantages.
Over long term, it is the durable competitive advantage that could maintain consistent high profit margin and above average growth. This is not a must-have though, if the valuation is more focused on current cash flow or asset, and the current earning is not subject major changes if other competitors enter the field.
5. Within circle of competence.
This is what Buffett emphasized in most of his talks. Without deep understanding of the industry, it is hard to really gain any advantage on information. And most retail investors don't have deep understanding of the industry, unless this is the field he/she worked on for many years. So a work-around could be getting some confirmation from some trustable gurus, plus a fair amount of understanding on the field. The effectiveness of this approach still needs to be tested though. This is probably the hardest part for normal investors.
Other non-mandatory filters include Catalyst and Growth. Having a catalyst will improve the efficiency of capital usage. And having good growth potential will increase the upside potential since the fair value varies a lot when the growth rate shifts a little bit. This part is especially important if the intention is to hold stock for many years without selling (like Buffett).
5 filters in the checklist seem to be a lot to remember, but underneath, there really is just one thing: "certainty". I use these filters to achieve high "certainty". That is what Buffett calls "never lose money", what Graham calls "investment, not speculation", and what James Rogers calls "do absolutely nothing unless there is something really worth doing"
Investment and Speculation
One thing that is mentioned repeatedly through the Security Analysis book (by Graham and Dodd) is the difference between "investment" and "speculation".
However, it is interesting that I didn't hear any other people talking about it right now. It may suggest that the current money managers, even they are following value investing methodology, are not considering this as an important point.
It seems to me that Graham considers "investment" as a stable and high certainty investment, but "speculation" is low certainty and volatile even if the risk-reward ratio is good, especially with diversification. Modern Portfolio theory has spent large effort on compose a portfolio to diversify the risk away, plus delicate method on risk calculation and risk control.
However, for value investing, the basic dilemma is still there. If one spends more time on gather as much information and do as much research/analysis as one can, only a small number of securities can be invested at any time. Thus the diversification is only up to a limited degree. If diversification is over a large number of securities, they will suffer from not gaining enough knowledge on the holdings.
My personal view is that "certainty" is the top priority for value investment. Therefore, the focus should be on those investments that are in a TRUE investment grade. That is not saying "speculation" is something one must avoid all the time, but it seems to be a different approach.
Also, without "certainty", it is hard to hold a stock for long time. This conviction definitely matters. That is also why Buffett says "The first principle is to never lose money". Without very high certainty, losing money will happen quite often, even if it is just 20%-30% of the trades.
However, it is interesting that I didn't hear any other people talking about it right now. It may suggest that the current money managers, even they are following value investing methodology, are not considering this as an important point.
It seems to me that Graham considers "investment" as a stable and high certainty investment, but "speculation" is low certainty and volatile even if the risk-reward ratio is good, especially with diversification. Modern Portfolio theory has spent large effort on compose a portfolio to diversify the risk away, plus delicate method on risk calculation and risk control.
However, for value investing, the basic dilemma is still there. If one spends more time on gather as much information and do as much research/analysis as one can, only a small number of securities can be invested at any time. Thus the diversification is only up to a limited degree. If diversification is over a large number of securities, they will suffer from not gaining enough knowledge on the holdings.
My personal view is that "certainty" is the top priority for value investment. Therefore, the focus should be on those investments that are in a TRUE investment grade. That is not saying "speculation" is something one must avoid all the time, but it seems to be a different approach.
Also, without "certainty", it is hard to hold a stock for long time. This conviction definitely matters. That is also why Buffett says "The first principle is to never lose money". Without very high certainty, losing money will happen quite often, even if it is just 20%-30% of the trades.
Think as a private owner
A common analogy Buffett used was to compare owning a stock to owning a farm. He said: "If you own a farm, you don’t think you need a quote on the farm selling price every day, and you don’t think the farm’s value gets down 80% because a couple of bad years, or the quote is low."
That analogy is the right altitude and first mentioned by Ben Graham. However, this is one big difference between owning a farm and owning a stock. In the first case, as the owner, you have full control on everything about the business. Not only you make full decision on operations and finances, you also hold full knowledge on the business itself. That brings the full confidence to you and makes you focus on earning power of the business rather than the market quotation.
On the other hand, people care the market quotation of stock because they don’t have full control and full knowledge about the company stock. Therefore, their only confidence lies in the ability of selling the stock "today" at the market price.
That doesn’t mean it is the right way to think about stocks. This is just to explain why they would think in that way naturally. The right way is acquire full control or let someone you can fully trust to take full control of the company, and try to acquire as much as information as you can about the company.
That is why good management is very very important.
Thinking as a private business owner, you only need three things to succeed:
1. Good average estimated return on the investment.
2. Control on the business or let someone you can trust to control the business
3. Diversification.
That analogy is the right altitude and first mentioned by Ben Graham. However, this is one big difference between owning a farm and owning a stock. In the first case, as the owner, you have full control on everything about the business. Not only you make full decision on operations and finances, you also hold full knowledge on the business itself. That brings the full confidence to you and makes you focus on earning power of the business rather than the market quotation.
On the other hand, people care the market quotation of stock because they don’t have full control and full knowledge about the company stock. Therefore, their only confidence lies in the ability of selling the stock "today" at the market price.
That doesn’t mean it is the right way to think about stocks. This is just to explain why they would think in that way naturally. The right way is acquire full control or let someone you can fully trust to take full control of the company, and try to acquire as much as information as you can about the company.
That is why good management is very very important.
Thinking as a private business owner, you only need three things to succeed:
1. Good average estimated return on the investment.
2. Control on the business or let someone you can trust to control the business
3. Diversification.
Quantitative analysis and Qualitative analysis
A common mistake made by beginners on value investing is too much focus on "Quantitative Analysis", but completely ignore the Qualitative Analysis.
Basically, the first one is putting all the numbers together. P/E ratio is the most common used figure. Of course, it would be very naive to just take one number to decide the fair value of a stock. Even you find out all the hidden facts behind the current earnings to get to the bottom of the future earning power. There are other factors on the balance sheet to consider, among them, three are most important:
1. Leverage.
Very high leverage puts the company into huge risk, if the business environment or the industry outlook changes, this is the way that leads to certain death.
2. Capital requirement.
Some business requires more capital input to fuel the growth. Good business has less capital requirement, such as food. But business like airline requires huge capital input which also leads to high debt and leverage usually. Another way to look at the capital requirement is to look at the "Return on Equity".
3. Operating Margin.
This is especially important in cyclic industries, because when industry slows down, only the one with highest operating margin can survive. For example, when housing starts decreases 66% and the whole wallboard industry is close to bankcruptcy, Eagle Material still ears good profit.
Even these three traits on balance sheet and income statement are still part of "Quantitative Analysis". The other part: "Qualitative Analysis" is very important too.
"Qualitative Analysis" focus on traits that are not reflected in any numbers, such as:
1. Management stewardship and ability.
2. Sustainable competitive advantages.
3. Industry outlook and economy outlook.
These traits are usually hidden behide the scene, and requires substantial understanding of the company and business. They are the proven indicators for the future outlook, because all the numbers we get is just the past and present, without these indicators to ensure the certainty, these numbers could be widely different from the future.
As an example, Bear Sterns was very profitable every year in the last several decades, but eventually get bankrupted suddenly. Without understanding the management and the nature of the business, it is very hard to forecast this kind of changes just based on the past earning figures.
Basically, the first one is putting all the numbers together. P/E ratio is the most common used figure. Of course, it would be very naive to just take one number to decide the fair value of a stock. Even you find out all the hidden facts behind the current earnings to get to the bottom of the future earning power. There are other factors on the balance sheet to consider, among them, three are most important:
1. Leverage.
Very high leverage puts the company into huge risk, if the business environment or the industry outlook changes, this is the way that leads to certain death.
2. Capital requirement.
Some business requires more capital input to fuel the growth. Good business has less capital requirement, such as food. But business like airline requires huge capital input which also leads to high debt and leverage usually. Another way to look at the capital requirement is to look at the "Return on Equity".
3. Operating Margin.
This is especially important in cyclic industries, because when industry slows down, only the one with highest operating margin can survive. For example, when housing starts decreases 66% and the whole wallboard industry is close to bankcruptcy, Eagle Material still ears good profit.
Even these three traits on balance sheet and income statement are still part of "Quantitative Analysis". The other part: "Qualitative Analysis" is very important too.
"Qualitative Analysis" focus on traits that are not reflected in any numbers, such as:
1. Management stewardship and ability.
2. Sustainable competitive advantages.
3. Industry outlook and economy outlook.
These traits are usually hidden behide the scene, and requires substantial understanding of the company and business. They are the proven indicators for the future outlook, because all the numbers we get is just the past and present, without these indicators to ensure the certainty, these numbers could be widely different from the future.
As an example, Bear Sterns was very profitable every year in the last several decades, but eventually get bankrupted suddenly. Without understanding the management and the nature of the business, it is very hard to forecast this kind of changes just based on the past earning figures.
Two Masters
Both Ben Graham and Warren Buffett are the characters I admire a lot, and both of them are successful on following value investing tracks, but they have quite different traits.
Warren Buffett focus mainly on business and don’t care the market fluctuation at all. In this sense, comparing to most of the hedge fund managers who also follow value investing, he is firmly on the main strategy. Others call him as "the philosopher in investment" because of that.
But actually, Ben Graham is truly a philosopher in investment, because not only he built the foundation of value investment, he is also a theoretical person who is interested more on logical reasoning itself than formulate a conclusion or strategy. While he has his own convictions and views, his most famous book "Security Analysis" always leave the topic to open discussion and critical thinking. Ben is both theoretical and practical. Sometimes I feel that he is a rare individual who was a professor and scientist figure, but also been put into wall street for many years.
Because my personal preference on research and critical thinking, I have to say I would admire Ben even more than Mr. Buffett.
Perhaps, there are 3 levels on value investment:
Top level: Focus on sound reasoning itself. No hurry on formulating a strategy.
Second level: Focus on a predefined good strategy, don’t care too much about individual positions and other distractions.
Third level: While having a strategy, a lot of energy is also spent on speculations on each individual positions and react to market fluctuations.
Warren Buffett focus mainly on business and don’t care the market fluctuation at all. In this sense, comparing to most of the hedge fund managers who also follow value investing, he is firmly on the main strategy. Others call him as "the philosopher in investment" because of that.
But actually, Ben Graham is truly a philosopher in investment, because not only he built the foundation of value investment, he is also a theoretical person who is interested more on logical reasoning itself than formulate a conclusion or strategy. While he has his own convictions and views, his most famous book "Security Analysis" always leave the topic to open discussion and critical thinking. Ben is both theoretical and practical. Sometimes I feel that he is a rare individual who was a professor and scientist figure, but also been put into wall street for many years.
Because my personal preference on research and critical thinking, I have to say I would admire Ben even more than Mr. Buffett.
Perhaps, there are 3 levels on value investment:
Top level: Focus on sound reasoning itself. No hurry on formulating a strategy.
Second level: Focus on a predefined good strategy, don’t care too much about individual positions and other distractions.
Third level: While having a strategy, a lot of energy is also spent on speculations on each individual positions and react to market fluctuations.
Methods of stock evaluation
The path of "value investing" makes it possible for "regular" investors to achieve a return that is better than index. Still, determining the fair value of a stock or its underlying business is never an easy task. Here are several approaches for evaluating a stock:
I. By Earnings.
P/E ratio is probably the most commonly used criteria. On the surface, it makes perfect sense for evaluating a business. However, the earning reported in accounting statement is almost never the true "earning" in a theoretical sense.
First, earnings didn’t count the capital reinvestment that is required to sustain the business at the same level. Some business require a lot of re-investment to stay in business (even without growth). This mandatory reinvestment is taken out from the earning and never meant to be a true "profit".
Second, earning is after deduction of depreciation and one-time charges. Depreciation is never meant to be accurate. Some depreciation on real estate is misleading since the value on many real estate properties actually goes up in general. There are all kinds of one-time charge (non-recurring charges), some are meant be really special and one-time only, and others are actually "recurring" "non-recurring" charges.
Third, Companies usually find all kinds of accounting tricks to make earning numbers look better. Making it hard to analyze until you really dive into the details.
Fourth, in theory, the earnings are profit, but for whom! Too often, the management of the company makes selfish and/or stupid decisions to use these profit in a way that destroys value. Dividend is at very low percentage nowadays, if not zero. The accumulated surplus is then used for stock buybacks or acquistion. It is claimed that this is shareholder friendly because dividend has to be taxed, but stock buybacks are more tax efficient. However, too often the buybacks are conducted at a price well above the fair value of the business. No matter what the buyback price is, the benefits goes to the management who usually holds largest amount of stock option which has a value closely tied to the stock price instead of dividend. "Acquisition" is another commonly abused way to spend shareholder’s profit. The price for "acquisition" is usually higher than what the business is truly worth, and many times the integration is poorly done. In the end, by expanding the corporate empire, the management secures a larger pay and essentially gains more power at shareholder’s expense.
Last, earnings fluctuate widely from year to year. Because of industry cycles and economy cycles, the earning numbers are quite different. The best thing to overcome that is to do an average of past 10 years’ average earning ratio relative to sales. This gives a rough guideline for stable business like Coca Cola, but not really very useful for business that changes dramatically like young companies in high tech industries.
II. By Cash flow.
By using cash flow instead of earnings, the first 3 drawbacks for using earnings are avoided. It may take some research to truly determine the capital reinvestment needed for sustain a business at current level, but for experts, this maybe not too tough to do. It still doesn’t answer the last two questions though.
III. By Price/Book ratio.
This seems better than P/E since book value doesn’t fluctuate too widely during cycles, and it seems to represent the "invested" value of the business. However, the book value may contain a large amount of good will or other intangibles. Even tangible asset can’t sell at the same price it is listed in the book. Inventories may be worth only half of the book value, and the fixed asset such as equipment and factory buildings may worth much less than listed value. Even the fairly liquidable asset may be sold at a tiny fraction of its true value in a fire sale (like Lehman Brother’s building was sold at 20% of the true value).
In another word, if book value is used to estimate the value of business, it must be calculated in detail and computed conservatively. Even in that case, if the business is not liquidated right away and it is surffering loss every month, the loss may be so large to eat up all the differences between book value and market price.
Price/Book ratio is more of a defensive judgement, since it is judged on liquidation basis, not on a on-going business profit and growth basis. This formula is usually suitable for special situations (like bankcruptcy) or form a defensive bottom line. Many great businesses don’t have much tangible book value at all, since the nature of the business doesn’t require much capital input to generate earnings, such as Coca Cola.
IV. By Price/Sales ratio.
Sales number doesn’t fluctuate as much as earnings do. It does have a implied assumption of the profit margin. If in a industry where the profit margin is generally low, it certainly will require a more conservative analysis. It is also better suitable for non-cyclic industries since cyclic industry has large swings of sales number too.
V. By dividend + growth + share number decrease rate
In theory, this is the ultimate formula for determining the value of a business, since the ultimate rate is the dividend rate + average growth rate over time, assuming there is no dilution on shares. However, "growth" is probably the hardest to estimate.
First, Growth in the future is always unknown. We get a series of growth numbers in the past, but it is often a mistake to interpolate and project a future growth number from the past. If we must project the growth rate, it has to be done in a very conservative fashion, just to not surprise ourselves in a bad way.
Second, the growth numbers in the past may be coming from more investment. It is crucial to pay attention to the total number of shares outstanding over the past years. If the company is buying back stocks and reduced the number of shares, it should be added as a investment return. On the other hand, if the company is issuing new shares to dilute existing share holders, it should be discounted as the growth is coming from more external investment.
Third, it is crucial to analyze the quality and characteristics of the growth. Some growth may be an industry-wide pattern for fast growing industries. This kind of growth is usually not sustainable since the product in the industry will sooner or later saturate the market (like cell phone maker). Also, a better return in such industry will invite more capital input and new competitors who will make it tougher to conduct the same business. Some growth is coming from management’s ability or corporate culture. This kind of growth is generally "good" and "reliable" growth, but attention has to be paid on the management changes. The best growth is probably coming from a sustainable competitive advantage or unique business model since this kind of strength can last many decades sometimes and not depend on a single good CEO. When we speak of "unique" business model, we have to understand why it is unique and why it is not copyable by others.
Conclusion: as we can see, it is never a simple or easy task to evaluate a business. A lot of uncertainty lies ahead for the business to change and all the numbers to change dramatically. The best way is to not rely on a single quantitative criteria, but instead, we need to use all of them and aware of their limitations. Qualitative criteria must be used as well, such as management ability and stewardship, durable competitive advantages, leverage and liability of the company, as well as the industry outlook.
Other than conquering emotions such as the impatience, fear and greed, doing hard work and due diligence to do thothough study on the business fundamentals, investment’s primary task is to find the certainties within a world that is full of uncertainties. That task requires constant re-evaluation of the business characteristics and making conservative estimates (including some margin of safety). In average, this prudence and alert to new development will not only find certainties in investment, but also react to real business changes much faster than wall street does, if the surprise does happen sometimes.
I. By Earnings.
P/E ratio is probably the most commonly used criteria. On the surface, it makes perfect sense for evaluating a business. However, the earning reported in accounting statement is almost never the true "earning" in a theoretical sense.
First, earnings didn’t count the capital reinvestment that is required to sustain the business at the same level. Some business require a lot of re-investment to stay in business (even without growth). This mandatory reinvestment is taken out from the earning and never meant to be a true "profit".
Second, earning is after deduction of depreciation and one-time charges. Depreciation is never meant to be accurate. Some depreciation on real estate is misleading since the value on many real estate properties actually goes up in general. There are all kinds of one-time charge (non-recurring charges), some are meant be really special and one-time only, and others are actually "recurring" "non-recurring" charges.
Third, Companies usually find all kinds of accounting tricks to make earning numbers look better. Making it hard to analyze until you really dive into the details.
Fourth, in theory, the earnings are profit, but for whom! Too often, the management of the company makes selfish and/or stupid decisions to use these profit in a way that destroys value. Dividend is at very low percentage nowadays, if not zero. The accumulated surplus is then used for stock buybacks or acquistion. It is claimed that this is shareholder friendly because dividend has to be taxed, but stock buybacks are more tax efficient. However, too often the buybacks are conducted at a price well above the fair value of the business. No matter what the buyback price is, the benefits goes to the management who usually holds largest amount of stock option which has a value closely tied to the stock price instead of dividend. "Acquisition" is another commonly abused way to spend shareholder’s profit. The price for "acquisition" is usually higher than what the business is truly worth, and many times the integration is poorly done. In the end, by expanding the corporate empire, the management secures a larger pay and essentially gains more power at shareholder’s expense.
Last, earnings fluctuate widely from year to year. Because of industry cycles and economy cycles, the earning numbers are quite different. The best thing to overcome that is to do an average of past 10 years’ average earning ratio relative to sales. This gives a rough guideline for stable business like Coca Cola, but not really very useful for business that changes dramatically like young companies in high tech industries.
II. By Cash flow.
By using cash flow instead of earnings, the first 3 drawbacks for using earnings are avoided. It may take some research to truly determine the capital reinvestment needed for sustain a business at current level, but for experts, this maybe not too tough to do. It still doesn’t answer the last two questions though.
III. By Price/Book ratio.
This seems better than P/E since book value doesn’t fluctuate too widely during cycles, and it seems to represent the "invested" value of the business. However, the book value may contain a large amount of good will or other intangibles. Even tangible asset can’t sell at the same price it is listed in the book. Inventories may be worth only half of the book value, and the fixed asset such as equipment and factory buildings may worth much less than listed value. Even the fairly liquidable asset may be sold at a tiny fraction of its true value in a fire sale (like Lehman Brother’s building was sold at 20% of the true value).
In another word, if book value is used to estimate the value of business, it must be calculated in detail and computed conservatively. Even in that case, if the business is not liquidated right away and it is surffering loss every month, the loss may be so large to eat up all the differences between book value and market price.
Price/Book ratio is more of a defensive judgement, since it is judged on liquidation basis, not on a on-going business profit and growth basis. This formula is usually suitable for special situations (like bankcruptcy) or form a defensive bottom line. Many great businesses don’t have much tangible book value at all, since the nature of the business doesn’t require much capital input to generate earnings, such as Coca Cola.
IV. By Price/Sales ratio.
Sales number doesn’t fluctuate as much as earnings do. It does have a implied assumption of the profit margin. If in a industry where the profit margin is generally low, it certainly will require a more conservative analysis. It is also better suitable for non-cyclic industries since cyclic industry has large swings of sales number too.
V. By dividend + growth + share number decrease rate
In theory, this is the ultimate formula for determining the value of a business, since the ultimate rate is the dividend rate + average growth rate over time, assuming there is no dilution on shares. However, "growth" is probably the hardest to estimate.
First, Growth in the future is always unknown. We get a series of growth numbers in the past, but it is often a mistake to interpolate and project a future growth number from the past. If we must project the growth rate, it has to be done in a very conservative fashion, just to not surprise ourselves in a bad way.
Second, the growth numbers in the past may be coming from more investment. It is crucial to pay attention to the total number of shares outstanding over the past years. If the company is buying back stocks and reduced the number of shares, it should be added as a investment return. On the other hand, if the company is issuing new shares to dilute existing share holders, it should be discounted as the growth is coming from more external investment.
Third, it is crucial to analyze the quality and characteristics of the growth. Some growth may be an industry-wide pattern for fast growing industries. This kind of growth is usually not sustainable since the product in the industry will sooner or later saturate the market (like cell phone maker). Also, a better return in such industry will invite more capital input and new competitors who will make it tougher to conduct the same business. Some growth is coming from management’s ability or corporate culture. This kind of growth is generally "good" and "reliable" growth, but attention has to be paid on the management changes. The best growth is probably coming from a sustainable competitive advantage or unique business model since this kind of strength can last many decades sometimes and not depend on a single good CEO. When we speak of "unique" business model, we have to understand why it is unique and why it is not copyable by others.
Conclusion: as we can see, it is never a simple or easy task to evaluate a business. A lot of uncertainty lies ahead for the business to change and all the numbers to change dramatically. The best way is to not rely on a single quantitative criteria, but instead, we need to use all of them and aware of their limitations. Qualitative criteria must be used as well, such as management ability and stewardship, durable competitive advantages, leverage and liability of the company, as well as the industry outlook.
Other than conquering emotions such as the impatience, fear and greed, doing hard work and due diligence to do thothough study on the business fundamentals, investment’s primary task is to find the certainties within a world that is full of uncertainties. That task requires constant re-evaluation of the business characteristics and making conservative estimates (including some margin of safety). In average, this prudence and alert to new development will not only find certainties in investment, but also react to real business changes much faster than wall street does, if the surprise does happen sometimes.
401k 101
When I was just starting my job, I didn’t earn a lot of money, plus I have to pay my wife’s tuition, and I may fail to get green card and have to go back to china in that case.
So I didn’t choose to contribute to 401k at the beginning. A lot of my coworkers couldn’t believe their ears when they hear I chose to not join 401k, to them, 401k is like tax shelter heaven.
One of the reasons I chose to pass-by is the fear of not able to withdraw the money when I need it (for education, buying house, layoff or simply going back to China). Later, I have learned that this fear is unfounded. First, if I get layoff, I can simply rollover 401k to IRA, and I can withdraw IRA money at any time as long as I pay the 10% penalty. Second, even though I can’t rollover 401k to IRA until I leave my company, in IT field, it is very common for people to change jobs, so my 401k money is easy to rollover to IRA because we simply change jobs quite often.
Still, 401k is not like what the fund managers would like you to believe. 401k is not good for everyone!
The first question is how soon you would expect to use the money. Ideally, we would like to save as much as we could for retirement or for whatever emergencies ahead. However, quite often people need a large lump sum to buy house or pay for education for themselves. If these events will likely happen very SOON, and you MUST withdraw 401k/IRA money to achieve that, 401k may be not for you. Of course, the hope is to use some other savings to do that, but the reality is you may not save enough to purchase a house as fast as you would like to. Assuming the housing market doesn’t have any bubble and house is not expensive, house is a good investment too, in that case, buying a house as early as possible is not a bad idea.
Assume a young couple really want to buy house within 4 years and the house is a good deal, and they can’t have enough money to buy house unless they use 401k money, then it is better for them to not enroll 401k at all. (Here, I assume you are a disciplined saver. For people who like to spend any extra dollar they get in pocket, 401k is a good way to force them to save for sure).
In all other scenarios, however, it is wise to enroll 401k. If they don’t need to buy house until 10 years later, or they don’t need to use the money until layoff, it is good to have money in 401k. In the layoff or early retirement case, the person would have lower tax brackets when they withdraw from IRA since the withdraw from IRA is much lower than normal yearly salary. So this lower tax brackets usually covers the 10% penalty. Considering the tax deferral over these years, it is still a gain for layoff case. In the case where the person doesn’t need the money until retirement, having money in 401k could end up in 100% or 200% more total balance (depending on your tax bracket) comparing to investing to non-retirement account with S&P 500 index fund, not mention that many people don’t invest into stock in non-retirement account.
If your employer offers some good match on your 401k, it is almost always better to maximize the 401k match, no matter if you need to use the money in short term (unless you really really have to use it before you leave the company).
After deciding whether to enroll in 401k, the next question is: what category to invest?
This is largely depend on two factors:
1. Do you likely need the money in short term?
2. Your loss tolerance.
If you have to use most of the money within next 5 years, you probably shouldn’t enroll in 401k at all. If you have to use most of the money within the next 10 years, you don’t want to put more than 50% into stock. If you don’t need most of the money until retirement (most people fall into this category), you should invest 80%-90% to stock fund unless you don’t have good tolerance to loss. Yes, most people don’t have good tolerance to paper loss, but in order to achieve good investment return, you have to have good tolerance to loss. You have to educate yourself and understand the basics of stock market and don’t panic when you have 50% paper loss. After all, in 20-30 years scale, investing on stocks almost certainly will give better returns than other alternatives. The long term capital gain is roughly determined by the sum of three ratios: GDP growth rate 3% + inflation rate 3% + dividend rate 2% = 8%. By buying to an index in long term, your gain is tied to the American business, nothing to do with the stock market.
However, if your loss tolerance is really bad and you just can’t help it, it is probably wise to have no more than 50% stock fund in 401k.
The third question is: what fund to pick.
As many *true* experts suggested, it is better to buy index fund with very low fees unless you really know the fund and the fund manager. 99% of the people don’t have enough skills to pick a good fund, given that 80% of the mutual fund can’t beat the index, it is better for regular folks just pick low fee index fund instead. These mutual funds couldn’t beat index because they have higher fees and because they actively manages the fund (not in a good way usually). I can bet that if normal folks truely know how the average mutual fund managers manage their portfolio and how the fee structures are determined, they won’t even want to touch the mutual fund again. Not many people are aware of these facts because news don’t want to let people know, after all, why offend some rich financial firms who had the money and power?
In 401k, the index fund could be vanguard SP500 index fund. In IRA, some low fee ETF 500 index fund could beat vanguard fund because they have even lower fees (because they are close-ended fund and has no redemption pressure and no redemption cost, in another word, they are even more passive in an already passive index fund). Some ETF fund’s fees goes to under 0.1%. Many people may not feel that 1% fee is a big deal, but consider this: the difference between bond and stock is only 3% return, so you risk your money to achieve 3% more returns per year in 20-30 years long term. Do you want someone who doesn’t do anything good to get 33% of that extra return from you? After all, 1% per year adds up can make a big difference after 30 years.
Once bought into the SP500 index fund, it is better to not time the market for normal people and never sell the fund until the "extreme". The "extreme" happens when the bubble gets too big (150% above fair value and everyone around you are extremely excited about stocks and never worry about losing money at all). If you can’t determine the bubble, you shouldn’t sell the fund at all until you need to use the money.
Since there is a chance for US dollar crush, it may be OK to move 10% – 20% from SP500 to international stock index fund, but international market is currently overvalued (I believe), so it is hard to say which is better.
The other 10-20% could be put to some safe bond fund like government bond fund. However, for right now, the bond rate is very low already, so a long term bond fund may not be as good as money market, since money market has the flexibility of getting higher interest rate later. The reason we need at least 10% on cash or very safe bond is to prevent some catastrophic events. 10% may not seem to be a lot right now, but imagine in some real catastrophic events, if stock market goes down by 80%, 10% becomes 33% of your portfolio at that time.
Last, for young people, even if they chose to not save in 401k, they still need to decide whether to enroll in roth IRA, or completely use non-retirement account. Almost always, it is better to enroll in roth IRA. Roth IRA’s principle can be withdrawn at any time without penalty (but interest on the principle is subject to tax and 10% penalty), and for most near term urgent needs, principle is enough (since the interest is small anyways in near term), so the penalty and tax should almost never incur. However, Roth IRA limit is $5000 per year, so you may still have to put some money to non-retirement account if you have more than $5000 to save. If your employer offers roth 401k, and you have more than $5000 to save, and you need to use the money within 5 years, and you assume you will leave your current employer before you need the money, you can consider roth 401k too. (Anyone wants to add to this list?)
Some last piece of advice, never rollover a 401k to another 401k, and never rollover an IRA to 401k. When you leave your company, always rollover the 401k to an IRA.
First, 401k has more restrictions on withdraw, but IRA can be withdrawn at any time as long as you pay the penalty.
Second, 401k usually has more fees (in many small companies’ 401k plans, the same fund would charge 0.5% – 1% more fees than IRA account).
Third, 401k can only select a limited selection of funds. Some funds have pretty bad management and they will destroy the performance rather than help it. In IRA, you can buy almost anything, from thousands of mutual fund, to individual stocks, bonds and preferred stocks.
Plus, you can always rollover from IRA to 401k if you really want to later, but you can’t rollover 401k to IRA unless you leave the company. I am sure this comparison is something the 401k fund manager doesn’t tell you.
So I didn’t choose to contribute to 401k at the beginning. A lot of my coworkers couldn’t believe their ears when they hear I chose to not join 401k, to them, 401k is like tax shelter heaven.
One of the reasons I chose to pass-by is the fear of not able to withdraw the money when I need it (for education, buying house, layoff or simply going back to China). Later, I have learned that this fear is unfounded. First, if I get layoff, I can simply rollover 401k to IRA, and I can withdraw IRA money at any time as long as I pay the 10% penalty. Second, even though I can’t rollover 401k to IRA until I leave my company, in IT field, it is very common for people to change jobs, so my 401k money is easy to rollover to IRA because we simply change jobs quite often.
Still, 401k is not like what the fund managers would like you to believe. 401k is not good for everyone!
The first question is how soon you would expect to use the money. Ideally, we would like to save as much as we could for retirement or for whatever emergencies ahead. However, quite often people need a large lump sum to buy house or pay for education for themselves. If these events will likely happen very SOON, and you MUST withdraw 401k/IRA money to achieve that, 401k may be not for you. Of course, the hope is to use some other savings to do that, but the reality is you may not save enough to purchase a house as fast as you would like to. Assuming the housing market doesn’t have any bubble and house is not expensive, house is a good investment too, in that case, buying a house as early as possible is not a bad idea.
Assume a young couple really want to buy house within 4 years and the house is a good deal, and they can’t have enough money to buy house unless they use 401k money, then it is better for them to not enroll 401k at all. (Here, I assume you are a disciplined saver. For people who like to spend any extra dollar they get in pocket, 401k is a good way to force them to save for sure).
In all other scenarios, however, it is wise to enroll 401k. If they don’t need to buy house until 10 years later, or they don’t need to use the money until layoff, it is good to have money in 401k. In the layoff or early retirement case, the person would have lower tax brackets when they withdraw from IRA since the withdraw from IRA is much lower than normal yearly salary. So this lower tax brackets usually covers the 10% penalty. Considering the tax deferral over these years, it is still a gain for layoff case. In the case where the person doesn’t need the money until retirement, having money in 401k could end up in 100% or 200% more total balance (depending on your tax bracket) comparing to investing to non-retirement account with S&P 500 index fund, not mention that many people don’t invest into stock in non-retirement account.
If your employer offers some good match on your 401k, it is almost always better to maximize the 401k match, no matter if you need to use the money in short term (unless you really really have to use it before you leave the company).
After deciding whether to enroll in 401k, the next question is: what category to invest?
This is largely depend on two factors:
1. Do you likely need the money in short term?
2. Your loss tolerance.
If you have to use most of the money within next 5 years, you probably shouldn’t enroll in 401k at all. If you have to use most of the money within the next 10 years, you don’t want to put more than 50% into stock. If you don’t need most of the money until retirement (most people fall into this category), you should invest 80%-90% to stock fund unless you don’t have good tolerance to loss. Yes, most people don’t have good tolerance to paper loss, but in order to achieve good investment return, you have to have good tolerance to loss. You have to educate yourself and understand the basics of stock market and don’t panic when you have 50% paper loss. After all, in 20-30 years scale, investing on stocks almost certainly will give better returns than other alternatives. The long term capital gain is roughly determined by the sum of three ratios: GDP growth rate 3% + inflation rate 3% + dividend rate 2% = 8%. By buying to an index in long term, your gain is tied to the American business, nothing to do with the stock market.
However, if your loss tolerance is really bad and you just can’t help it, it is probably wise to have no more than 50% stock fund in 401k.
The third question is: what fund to pick.
As many *true* experts suggested, it is better to buy index fund with very low fees unless you really know the fund and the fund manager. 99% of the people don’t have enough skills to pick a good fund, given that 80% of the mutual fund can’t beat the index, it is better for regular folks just pick low fee index fund instead. These mutual funds couldn’t beat index because they have higher fees and because they actively manages the fund (not in a good way usually). I can bet that if normal folks truely know how the average mutual fund managers manage their portfolio and how the fee structures are determined, they won’t even want to touch the mutual fund again. Not many people are aware of these facts because news don’t want to let people know, after all, why offend some rich financial firms who had the money and power?
In 401k, the index fund could be vanguard SP500 index fund. In IRA, some low fee ETF 500 index fund could beat vanguard fund because they have even lower fees (because they are close-ended fund and has no redemption pressure and no redemption cost, in another word, they are even more passive in an already passive index fund). Some ETF fund’s fees goes to under 0.1%. Many people may not feel that 1% fee is a big deal, but consider this: the difference between bond and stock is only 3% return, so you risk your money to achieve 3% more returns per year in 20-30 years long term. Do you want someone who doesn’t do anything good to get 33% of that extra return from you? After all, 1% per year adds up can make a big difference after 30 years.
Once bought into the SP500 index fund, it is better to not time the market for normal people and never sell the fund until the "extreme". The "extreme" happens when the bubble gets too big (150% above fair value and everyone around you are extremely excited about stocks and never worry about losing money at all). If you can’t determine the bubble, you shouldn’t sell the fund at all until you need to use the money.
Since there is a chance for US dollar crush, it may be OK to move 10% – 20% from SP500 to international stock index fund, but international market is currently overvalued (I believe), so it is hard to say which is better.
The other 10-20% could be put to some safe bond fund like government bond fund. However, for right now, the bond rate is very low already, so a long term bond fund may not be as good as money market, since money market has the flexibility of getting higher interest rate later. The reason we need at least 10% on cash or very safe bond is to prevent some catastrophic events. 10% may not seem to be a lot right now, but imagine in some real catastrophic events, if stock market goes down by 80%, 10% becomes 33% of your portfolio at that time.
Last, for young people, even if they chose to not save in 401k, they still need to decide whether to enroll in roth IRA, or completely use non-retirement account. Almost always, it is better to enroll in roth IRA. Roth IRA’s principle can be withdrawn at any time without penalty (but interest on the principle is subject to tax and 10% penalty), and for most near term urgent needs, principle is enough (since the interest is small anyways in near term), so the penalty and tax should almost never incur. However, Roth IRA limit is $5000 per year, so you may still have to put some money to non-retirement account if you have more than $5000 to save. If your employer offers roth 401k, and you have more than $5000 to save, and you need to use the money within 5 years, and you assume you will leave your current employer before you need the money, you can consider roth 401k too. (Anyone wants to add to this list?)
Some last piece of advice, never rollover a 401k to another 401k, and never rollover an IRA to 401k. When you leave your company, always rollover the 401k to an IRA.
First, 401k has more restrictions on withdraw, but IRA can be withdrawn at any time as long as you pay the penalty.
Second, 401k usually has more fees (in many small companies’ 401k plans, the same fund would charge 0.5% – 1% more fees than IRA account).
Third, 401k can only select a limited selection of funds. Some funds have pretty bad management and they will destroy the performance rather than help it. In IRA, you can buy almost anything, from thousands of mutual fund, to individual stocks, bonds and preferred stocks.
Plus, you can always rollover from IRA to 401k if you really want to later, but you can’t rollover 401k to IRA unless you leave the company. I am sure this comparison is something the 401k fund manager doesn’t tell you.
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