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Author: FDWBaltimore Two stars, 250 posts CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 5655  
Subject: Re: Getting Close Date: 1/26/2002 12:28 PM
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I would try to stay away from a scoring system. Investing is inherently a subjective pursuit that should draw upon a number of disciplines, not just a few security analysis ratios.

There are two characteristics suggested that might be mutually exclusive: Cash from operations and ROIC>WACC. A company that is growing might not be generating any cash from operations but could generate incredible returns on capital. I would suggest looking at the history of a company such as Jabil or Sanmina, too very fine companies with outrageously good returns over the last decade. These companies are maturing these days, but this is was the perfect Boring set of companies around 1993-1994 before they were really discovered. Outsourced manufacturing? How Boring. But a great solution for customers.

I also would not say current ratio is a very good factor to rely upon. It's great to have cash, but watch out when the current ratio is made up of inventories and the like. Some companies work on a low working capital model and some don't. For instance, when the Rule Maker guys were pushing Pfizer to get their DSOs down, that was mistaken, in my opinion. Longer DSOs for a contract with another company could be part of the contracted terms of the agreement. If you're getting the margin you need for that investment in working capital to be positive, it's silly to suggest they should get the DSOs down, because without his DSOs, that agreement wouldn't exist or would exist with a lower margin structure. This is where return on capital analysis is very helpful, which is something the Rule Maker analysis at that time completely ignored.

A similarly bad rule is price/sales < 1.0 or 1.5 or whatever. This totally depends on the industry. In a high margin business, you'll almost never see that sort of level of valuation. Take Paychex circa 1992, for example. Or look at the newspaper industry. Or look at transaction processing companies. If you run an operating margin of 25%, the after tax, you'll run a net margin of 16% unlevered. To get a price/sales ratio under 1.0 in this sort of business, you'd need a price/earnings ratio of 6x. Paychex at a price/sales ratio of 2.0 and a P/E of 12 would still be an incredible bargain. So it totally depends on business model here.

I think you have to be flexible with these sorts of things. When you look at a company and you've never looked at that kind of company, doing a comp sheet can be incredibly helpful. Then mapping out the historical financials is the next step, so you can get a good feel of the cash flow through the business, the cost structure, the balance sheet changes over time, etc.

I would suggest, and I think I did in the past, that "Boring" is a matter of process, not a matter of the sort of company you're looking at. It involves detailed, rational analysis of a business and valuation more than it involves investing in a certain kind of company or below a certain valuation ratio. Would Berkshire Hathaway have been an incredible bargain at 5x book value in 1971? You bet. Would Wal-Mart have been a great investment at 40x earnings at that time? Absolutely. I'm not suggesting that the probability of making a good investment is anything other than very low when you see these sorts of levels of valuation, only that intrinsic value for the best companies is sometimes well in excess of what looks reasonable based on today's P/E or book. When Buffett saved GEICO, there was no P/E and the book value really meant nothing, since it was on the verge of bankruptcy. The intrinsic value of McDonald's in 1965 was probably 20x book value (defining intrinsic value as the equity value that would have resulted in a market rate of return over a given holding period. See Stocks for the Long Run).

Now, most business are not the sorts of businesses these are, so I would suggest that a low factor-based level of valuation is most often a requirement for a margin of safety to exist. Most often, I invest in companies that look very cheap based on price/earnings, cash flow, book, assets, and whatever. But I would say that shouldn't confine your research process to these. If someone came to you and said "hey, I've got this company, Executive Jet, that is selling equity at 2.0x book, 2.0 sales, and a P/E of 15, what would you say? I would probably say "sign me up."

So, I would say on all these valuation things, "It depends." A Boring company is one that you've researched well, quantitatively and qualitatively. Boring is a process, not a straightjacket. If anyone would like a spreadsheet containing the above principles, just send me a note at FDaleWettlaufer@aol.com and I'd be happy to send it to you. I've sent out this spreadsheet before -- it's on Southwest Airlines (a company that's in my personal Boring Hall of Fame). This contains comp-based stuff, backward-looking modeling, and forward-looking modeling based on conversations with company management, analysts, and hopefully some common sense. This allows you to do "what if" scenarios for future operations and financing and assists in determining intrinsic value.

I would suggest that if you do enough of these sorts of analyses, you can in the future get a better idea of the merit of an investment opportunity within a few minutes or hours of studying that opportunity. I have no idea if Buffett has done this sort of thing, but what I am suggesting that the more detailed analysis you do over a number of years, the better you will become at pattern recognition in business models and financial analysis in the future, whether or not you're doing an extensive spreadsheet analysis on something.

My personal experience in this area started at the Fool. While I had participated in a family business from the time I was 14 until about two years ago (at the age of 31), that gave me the opportunity to study only one company and its set of financials. My real education started in 1993, when I worked for a broker analyzing limited partnership prospectuses and financials. I saw a lot of scams and a few good things. The real rapid-fire education began at the Motley Fool, where Randy Befumo and I would look every day at stocks that were making a 5% move or better. We would try to ascertain why these moves were happening – in 90% of the cases, it was noise. But there would be about 15 companies a day where some corporate action was happening or some market-related things was happening.

Randy and I would look at the financials of these 15 companies and try to figure out what was good or bad at it. This happened every market day for a few years. Over that time, we got to see a lot of different business models and had the opportunity to get comfortable with financials in a number of different industries. Within a three year time frame, you get to see a number of industries cycle through the process of ups and downs.

Practically speaking, I think this process should be adopted by anyone wanting to learn security analysis and how to invest. Just look at what's moving on a particular day and look up their financials on EDGAR. Think critically about what you are looking at. Why is a particular company good and how does that show up in the financials? Why is it bad and how does that show up? How does the cash flow through a business and what does the balance sheet look like over time? This sort of study program takes about two years to really start to pay off if you do it each and every day, which is a major commitment for anyone to make, but I really think it's a highly effective program for learning how to do this.

Once again, this returns me to the theme of a process. “Boring” is an investment program informed by diligent study of companies, their financials, and the greatest thinkers in the investment world. The best place to start is Warren Buffett's letters. You also have to read Ben Graham and also get a good accounting text. You have to remain flexible, too. You should ideally seek to apply learning from other disciplines to investing. How do the workings of an ecosystem apply to investing? How does the behavior of bees apply to investing? What about anthropology and behavioral psychology? All of these are important – I would agree 100% with people like Charlie Munger and Bill Miller that investing is necessarily a sub-discipline in a larger set of worldly wisdom. Business is the interaction of humans and the result of human choices and choices not made. Napoleon's Russian defeat and the rules of blackjack can shed just as much light on the implosion of Providian Financial as will the financial statements of FirstPlus Financial. I wouldn't choose one over the other two, but rather read about all three for insights.

In closing, I will just reiterate that “Boring” is a process, not a rules-based algorithm for selecting investment opportunities. As a set principle, that would be the only one that I would choose at the outset.
Best,
Dale
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