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No. of Recommendations: 12
In today's version of the Hidden Gems update, Bill Barker writes:

"Last night, I was reading The Market Masters, which is a series of interviews by author Kirk Kazanjian with some very successful and intelligent investment professionals. In the "Value Masters" section of the book, Andy Pilara of RS Investments engages in this exchange with the author:

Kazanjian: "Does that mean that if the price drops 15 percent and something has changed for the worse you'll get out?"

Pilara: "If the fundamentals have changed, we get out. Part of our philosophy here is that we're low-expectation investors. I tell my guys, 'If you fall out of a window, fall out the basement window. Don't fall out the top-floor window.' Most times we go into stocks with low expectations. We're all about losing less, not making more. For the most part, when one of our companies misses its earnings, nobody cares because it's not a high expectation stock."

Two points here:

First, I like this new HG feature, which Bill and Jim Gillies edit. Whoever had the idea for changing the bi-weekly update to a daily, give him/her a raise. A further enhancement would be e-mailing the update, because I sometimes forget to go into the HG site. Also, my PDA can read e-mails, but is too slow to go online.

Second, when Pilara talks about buying companies with low expectations, it gets me thinking about First American (FAF). I like the title-insurer for several reasons, as you may know, including earnings quality, clean balance sheet, management, and future growth opportunities.

Another plus is valuation. At today's close of $46.47, First American sells for 70% of my $68-a-share intrinsic value estimate.

Base year earnings (GAAP): $438M (TTM)
Earnings growth: Years 1-10 is 5% a year; Years 11-20 is 4% a year, and terminal is 3%
Share count growth: 1% a year during forecast period
Discount rate: 10%

I credit First American for its $1,629M of cash, and 80% interest in First Advantage (FADV). At $28 a share, FADV has a $1,550M market value, none of which appears on First American's balance sheet. Claims that reduce intrinsic value include $875M of debt, $412M of operating leases, a $117M stock option liability, and $392M of minority interests.

As an aside, my valuation may be too tough on First American, as Wall Street is looking for 12% annual earnings growth for the next five years, according to Yahoo Finance. Time will tell. I'd rather be pleasantly surprised than unpleasantly surprised.

Another test of First American's cheapness is that you can get its future growth value for free. To illustrate, we first estimate the Santa Ana, CA-based firm's realizable net assets:

(in millions)

Cash $1,629 x 100% = $1,629
Receivables $542 x 80% = $434
Net fixed capital $636 x 60% = $382
Title plants $527 x 60% = $316
Net goodwill $1,849 x 50% = $925
Investments $1,578 x 100% = $1,578
Loans receivable $92 x 80% = $74
Deferred taxes $41 x 50% = $20
Other assets $514 x 50% = $257
FADV $1,240 x 50% = $620 (FAF owns 80% of its $1,550 market value)
Total adj. assets = $5,635

Liabilities & equivalents = $4,463 (all at 100%) (inc. operating leases, unfunded pensions, and stock option liability)

Realizable net assets = $1,771 (total adj. assets minus liabilities & equivalents)
Shares outstanding = 95.86
Per share = $18.47

With a $46.47 stock and realizable net assets of $10.20, First American's operating value is $36.27 ($46.47 - $10.20 = $36.27).

Next we want to know how much of this operating value is due to current operations, and how much to future growth. The higher the percentage of current operations to total operating value, the less we are stand to lose if future earnings gains do not materialize.

To estimate current operating value, divide First American's GAAP earnings (TTM 9/05) of $4.56 a share by your cost of capital. My required rate of return is 10%, which means First American's operating value is $45.60 ($4.56/10%). If First American earns $4.56 forever and I want to earn 10% a year, then I'll pay up to $45.60 a share to own this company.

Now here's the exciting part. If we add subtract First American's realizable net assets of $10.20 a share and its current operating value of $45.60 a share from its current $46.47 stock price, then future growth is $(9.33) a share. In other words, Wall Street is so bearish on First American that if the company does make more than $4.56 a share, we get those incremental earnings for free.

Stock price = $46.47
Realizable net assets = $10.20
Current operating value = $45.60
Future growth value = $(9.33) (i.e., future growth for free!)

Although First American's stock is up 32% in the last year, I believe this company is still undervalued. Not only does First American sell at a discount to intrinsic value, you also get any earnings increases for free.

To learn more about the future growth value appraisal method, I recommend Value Investing: From Graham to Buffett and Beyond (Wiley Finance), by Greenwald, Kahn, Sonkin, and va Biema.


long FAF
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