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Learning to Invest / Reading Financial Statements
|Subject: Re: The Little Book That Beats the Market||Date: 12/31/2005 12:11 AM|
|Author: BenGrahamMan||Number: 3136 of 3916|
here are my notes from a recent conference I went to with Joel Greenblatt as the speaker.
I know what Working Capital is but what the heck is Net Working Capital?
I asked Joel at the post conference gathering what "net working capital" was. I think he mentioned it was as follows:
Net working capital = Current Assets - Current Liabilities - cash and short term investments + required cash to run the business
this was very confusing for me. But, after reading this post and checking this link, it seems much clearer to me.
here is what the link says about "net working capital"......
" More specifically, for industrial companies, "net working capital" equals cash tied up by a company's short term operating assets, netted against short term operating liabilities.
For any year, then, we add and subtract the following to calculate a company's net working capital:
1. Required cash. We usually assume that a company needs to have some cash on hand to run its business. We can estimate that sum as a fixed amount of cash, or an amount as a percentage of sales. Thus, we add required cash to calculate working capital.
2. Accounts receivable (A/R). Accounts Receivable equals money owed to a company for goods or services purchased on credit. As A/R grow, then, a company needs to tie up cash in its business as it effectively lends this money out. Thus, we add accounts receivable to calculate working capital.
3.Inventory. Any company selling a physical product will have to tie up cash in raw materials, work-in-progress and finished goods inventory. Thus, we add inventory to calculate working capital.
4. Other current assets. A company may have to tie up cash in other current assets, such as insurance pre-payments. Thus, we add other current assets to calculate working capital.
5. Accounts payable. Accounts Payable equal bills from suppliers for goods or services purchased on credit. A company benefits from accounts payable just like consumers benefit from a charge card: you enjoy the merchandise now, and pay later. Thus, we subtract accounts payable to calculate working capital.
6.Deferred or Unearned Revenue. Some companies get paid in cash by their customers before those companies deliver a promised product or service. As an example, you may have purchased a warranty for a product, whereby you gave a company cash in advance for a promised service: the ability to have that product replaced or fixed in the event it became defective. Until the warranty ends, the company has the obligation to provide this service to you, so it must recognize this cash received as a liability. Thus, we subtract deferred revenue to calculate working capital.
7. Other non-interest bearing current liabilities. Various companies may have assorted non-interest bearing current liabilities such as accrued wages, accrued expenses, accrued royalties, or "other accrued liabilities." These non-interest bearing current liabilities generate cash as they increase. Thus, we subtract other non-interest bearing current liabilities to calculate working capital.
Here are my notes from the link I provided above.
1. "Buffett took Graham to the next level.'
2. 5 to 8 securities account for greater than 80% of his portfolio. ( I wonder what his turnover is)
3. Preference for ebitda - maint cap ex
on average ebit is the same, but not always the same as above.
4. first few things he looks for in 10K
a. returns on tangible capital
c. 10Ks are boring
d. like searching for a buried treasure
e. if looks like finding a buried treasure, 10k's become exciting.
5. "don't look at the macro world."
6. Sometimes he spends lots of time researching before buying, sometimes they pounce quickly, "ready, aim, fire."
7. he met lots of management. he always said the management seem like nice guys. thats why he prefers financials.
8. always try to figure out human nature. if insider is making big salaries, and also selling lots of shares, then there very well could be something not so great.
It was a nice event.
his magic formula includes, EBIT / (Net working capital + Net fixed assets).
aptvictoria wrote in post 3135
1) what is Net Fixed Assets? 2) Since Operating Profit = EBIT, can one also say that Operating Profit equals EBITDA, since EBIT is also before depreciation and amortization?
Net Fixed Assets = Fixed Assets (tangible only) - accum depn.
In regards to ebitda, he was very specific about EBIT. One could also look at ebitda and work various numbers.
he also uses the formula.....
Earnings yield = Ebit/Enterprise Value
THE FOLLOWING ARE NO LONGER MY NOTES AND ARE CUT AND PASTED FROM SITE LISTED BELOW.
lastly, here is an awesome summary of the conference. Mine is extremely pale compared to these notes. BTW, shai has a great site.
http://www.shaidardashti.com/ The following really should be viewed at Shai's site. I posted below, but do yourself a favor and read the article at Shai's site. I am not affiliated with Shai, have no interest in you going to his site other than by seeing what I cut and pasted below, in a much easier to read format. Shai, if you happen to read this, (I hope you don't mind me posting below. if you do, just give me an email and let me know that I shouldn't do such. Based on some recent posts, I felt it best to do it this way. your post on your site, was an afterthought after I responded to this post.)
Joel Greenblatt speaking at NYSSA
Joel Greenblatt (left) and Brian Zen
by Brian Zen and Garret Hamai
In the freezing cold evening of December 7th, 2005, Joel Greenblatt of Gotham Capital, armed with delightful jokes and a magic formula, warmed the hearts and souls of about 200 security analysts in a seminar organized by New York Society of Security Analysts (NYSSA.org). We are pleased to bring you the financial enlightenments captured from that event:
Crunching Data, Searching Magic Formula During his years at Wharton, Joel Greenblatt manually entered stock data based on 9 years worth of S&P Stock Guides and created their own database for research.
Cleaned up the data by eliminating certain things. Now they use Compustat database.
Richard Pzena figured out how to enter those data into the mainframe computers at Wharton Business School. At that time, the computers were about the size of two conference rooms.
Sometimes, the market throws off bargains because it is unreasonable about the prospects of certain companies.
Buying Cheap Stocks Works Over Time
In the 70's, they tested Benjamin Graham's Net-net Formula and found that picking stocks below liquidation value worked well. (Liquidation value = Current Assets - All Liabilities.)
Not every cheap stock performed well individually, but as a basket they did well.
However, these types of opportunities are practically extinct in today's market.
Many other studies have shown the strategy of buying cheap companies works over time.
Buffettized: Buying "Cheap" and "Good"
Starting out as a die-hard value investor, Greenblatt became "Buffettized" in early 90's. Why not look for the good ones amongst the cheap companies?!
Greenblatt says that he didn't realize that trying to find cheap and good companies, rather than just the cheap ones, was so important until the 1990s. While Graham was looking for starkly cheap companies, Buffett wants only the good ones.
Greenblatt's friend, Richard Pzena, remains committed to buying troubled companies at dirt cheap prices, the cigar butt approach. You see this saggy cigar butt on a dirty corner of Wall Street. You pick it up and get one last puff out of it. The puff not very tasty. The act is not very elegant. But it's free (Laugh).
The Magic Formula Was Born
By combining Graham and Buffett, Joel Greenblatt's magic formula is a computerized system to invest in good companies whose stocks are cheap.
Good companies = High return on capital (ROC defined as operating profit divided by net working capital plus net fixed assets.)
Cheap stocks = High earnings yield (Earnings yield defined as pre-tax operating earnings divided by enterprise value.)
ROC = EBIT/(Net working capital + Net fixed assets)
Earnings yield = EBIT/(Enterprise Value)
If net working capital is negative, use zero.
Here, EBIT is last 12-month's earnings before interests and taxes (EBIT).
Two key issues addressed by his magic formulas: (1) What is the return on the price you paid? (2) What is the return on the capital the company is investing?
Ranking the "Cheapness" and "Goodness"
Greenblatt turned to his computers to rank companies by two factors, good (high ROC) and cheap (high earnings yield). Ranking Method: If company XYZ ranked 10 out of 3,500 companies in terms return on capital, and it ranked 20 in terms of earnings yield, the combined ranking of XYZ would be 10 + 20 = 30.
Greenblatt's "Not-Trying-Very-Hard" Model Buy the top 30 of the highest ranked companies. Hold them for one year. Turnover the portfolio at year end to buy a new list of 30 highest ranked stocks based on one-year's worth of new financial data.
Sell losers right before a year is up, and sell winners right after 12 months for tax benefits.
Why the One-Year Holding Period?
It is interesting to note that more stocks worked out over one-year rolling periods, rather than two-year periods. Maybe the time window that a value stock stays undiscovered is being shortened towards one year as more and more people start searching for values.
Besides, after one year, you get a complete set of new earnings data. It would be a good time to run the rankings again.
Selling has always been difficult. The other day, Greenblatt and his partners went on and on talking about the stocks that made a huge move after they sold at intrinsic value. To remove the uncertainties and difficulties of selling, a one-year holding period was picked. "I call it the Not-Trying-Very-Hard Model (Laugh). My mantra is to keep things simple," said Greenblatt.
Besides, trading cost is cheap now.
Sell close to intrinsic value.
Sell if something even cheaper is found.
"We never mastered the art of selling. We are semi-bubbling idiots at it," confessed Joel.
The Magic 30.8% Per Year for 17 Years
Magic formula works! Using stocks of all sizes, it produced a 17 year annual return of 30.8%. Using only the largest 1,000 stocks, the annual return was 22.9%.
When ranked by 10 deciles (250 stocks in each, higher deciles consistently outperformed those below them from top to bottom.
The cheap portfolio tends to have less volatility also.
The magic formula beats the market 96% of the time.
Magic Formula Investing:
The Operating Steps
In his new bestseller: "The little Book that Beats the Market", Joel Greenblatt also discussed in detail the operating steps of the magic formula investing:
Go to magicformulainvesting.com (Nice plug!)
Specify your criteria for minimum company size.
Get a list top-ranked companies based on high return on capital and high earnings yield.
Invest 1/3 or 1/5 of your money into 5 to 7 top-ranked companies every 2 to 3 months. (Dollar-cost-average into the "good and cheap".)
After 9 to 10 months, construct a portfolio of 20 to 30 stocks.
Sell each stock after holding it for one year. For tax purposes, sell winners a few days after the one-year holding period. Sell losers a few days before the one-year holding period.
Reinvest the proceeds into new top-ranked companies. Stick to this simple and mechanical system for at lease 3 to 5 years to give the magic formula a chance to work.
Greenblatt's Personal Investment Process
Looks for value with a catalyst, so nice things happen sooner. Special situations are just value investing with a catalyst. They are simply different places to find cheap stocks.
In his own hedge fund, Greenblatt uses the basic principals in the magic formula: Look for high ROC and high earnings yield.
Tries to figure out what "normalized earnings" will be 3-4 years into the future.
Makes sure the stock is very cheap based on normalized earnings.
5 to 8 securities can make up 80% of his portfolio. One position could be up to 30%.
Having a concentrated portfolio works well for lazy people. Not that many stocks to track.
Thinks about how much he could lose if he's disastrously wrong.
No formal process or time frame for purchase decisions. Usually spend one month or so to do research. In difficult situations for which he and his partners have time, research could take months.
If there is a great opportunity which, in their opinion, won't last, and if they feel they understand it, they sometimes use the approach of "Ready, Fire, Aim!"
Has financials and utilities in the portfolio.
EBITDA Minus Maintenance CapEx
For his own investment practice, Greenblatt uses a different input for earnings.
He thinks that "EBITDA - Maintenance Capital Expenditure" would be a better measure of earnings power, but it can be difficult to calculate.
No Edge in Foreign Markets
Greenblatt prefers to invest domestically because it's within his circle of competence and he hasn't run out of opportunities.
He does acknowledge that you could probably find cheaper companies internationally and it is a good idea if it is within your area of expertise.
If he was younger, he may do more with international investing.
On Long-Short Strategies
Q: "How about long the top deciles of cheap stocks and short the bottom deciles of expensive stocks?"
A: "I am not a fan of shorting. The long-short guys blow up every eight years. I call it the 'I got it! I got it! I ain't got it!' Strategy."
Fair Bet Yet Unfair Investing
Look for a big mess that seems too complicated, not well understood, not well followed, and requires too much work. People don't want to do the work, but once you do the research, you will be at an advantage.
Look for semi-complicated situations. The key is to identify what cuts to the core.
Numbers Are More Important than People
First look at the numbers as they don't lie. You can learn a lot about the management by looking at what they've done though the numbers.
Meeting the management in person and determining their abilities is not easy. "I used to meet a CEO and say to myself: 'This guy is smart.' Next day I meet another CEO and say to myself: 'This guy is smart, too.' (Laugh) In the end, I feel meeting CEO is not very important because I am not good at reading people," said Greenblatt.
What is more important is: (1) What the management has done with the cash? (2) What are the incentives? (3) Is the salary too high? (4) Is there heavy insider selling? (5) What is their trackrecord?
Compare "what they do" with "what they say".
Bad signs: high salaries and insider sellings.
The Macro Picture Is a Distraction
In 1999 and 2000, there were plenty of non-internet values out there. If you were worried that the burst of the internet bubble would have dragged those values further down, you would have made a big mistake. "Fortunately, we ignore the macro picture," said Greenblatt.
In 2002 and 2003, there were plenty opportunities in small caps. If you were concerned that the bear market could go on further, you would make another mistake.
"Now the value is in big caps. But if you look at the macro picture, the consumers could drop dead, the housing bubble could drag everybody down?- We ignore those. We have no macro view," said Greenblatt.
Everything is cyclical. Values can always be found somewhere.
Ignore Volatility and Stock Prices
Taking your clue from the stock prices is crazy. If you could value companies, you should ignore the noises from volatility and stock prices.
Things such as volatility have nothing to do with buying a good, cheap company for the long run. Greenblatt said, "It is kind of ironic that, the older I get, the longer time horizon I look at." (Laugh)
The Efficient Market Theory is a crazy way to look at the market. "Pick and choose. You can beat the market. It is worth the work."
The Vogue of Return on Capital
There seems to be a movement towards high return on capital.
The low P/B stocks haven't work very well in the past 10 years.
Don't know if or when this trend will reverse.
One More Trick
Greenblatt disclosed: "We have one more trick. When we have gains, we look at before-tax numbers. When we have losses, we look at after-tax numbers. (Blank stare?-pause.) That was trying to be funny. (Laugh)"
Brian Zen, CFA, PhD, is the founder of Zenway.com Inc., an investment research and advisory firm that publishes Enlightened Investor Digest. Brian appreciates your feedback at: firstname.lastname@example.org
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