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No. of Recommendations: 13
(No, not me. But someone else over on the HG: SCSS board is. Here's what I told him/her. -HH)

If you have an intense, burning, nothing-will-stop-me desire to do well in the stock market over a long period, then you are nuts to drop your HG subscription.

Here's what I tell anyone who wants to do better in the stocks market: build a due diligence book that starts with revenue and ends with the footnotes. My DD is in an Excel spreadsheet, and is now 50 pages long. Every time I come across an interesting idea, I copy and paste it into my book. I have copied and pasted a lot of information from the HG newsletters (Phil Durell's Inside Value, too), as well as from contributors to the various discussion boards.

To give you some sense of my DD's level of detail, it has 4 pages on quality of revenue alone. I have another 15 pages on industry specific questions. In addition to financial statement analysis, other topics include competitive advantage, capital allocation, and valuation. I have built my DD over the last 10-11 years, because I want to try to understand a company better than everyone else (an ideal--you never really "know" a company).

So I want you to start creating your own DD, and use it every time you consider buying shares of a company. Then I want you to create an "ideal company" checklist; this is your list of everything you want in a company. Give points for each attribute, and then see how the company scores. So each month when you get your two HG picks, run them through your models. Do this type of critical analysis work every month and a year from now you will be a much better, more confident investor.

Tom Gardner, Bill Mann, Jim Gillies, and Bill Barker are very good analysts (and there are many others, too--apologies for not mentioning some great and generous folks). To think that you have no more to learn from them is foolish.

One of the best pieces of advice someone gave me about the stock market is that in the long run we all get what we deserve. You deserve better, so you need to improve your game, just as I force myself to keep trying to improve my game everyday.

Good luck.

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Hewitt, Im impress or maybe depress? You have 15 pages on revenue alone?
Boy, I need to start re thinking my DD. R u being serious? I need a lot to learn.
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No. of Recommendations: 11
Duxx -

Serious. I have 4 pages on revenue, 15 on key questions for various industries.

Here are my retailer questions, since I suspect a lot of TMF readers own at least one.


How many stores are there?
In how many states?
Avg. square footage per store?
Does company own the stores? Lease? How much of each?
Are leases at below-market rates?
What is avg. sale to customer?
How much does it cost to build a store? How long does it take to recover outlay?
How many stores will company build a year for next 3 years? Same square footage?
% Metropolitan Statistical Areas (MSA) coverage?
Will new stores cannibalize existing store sales?
Revenue, earnings growth per existing store?
Are stores clean? (Or, do they need refreshening?)
Are there reserves for store closings or defaults?
Can company grow from local to regional to national? (Risk: No room for growth.)
How many stores has company opened/closed every year for last five years?
Aggressive use of part-timers?
How often does company remodel its stores to stave off brand fatigue.
(Ex: Growth due to a combination of new-store openings (avg 13. per year), consistent 6% or higher comparable-store
Sales growth (sales at stores open at least a year), and strong growth in the catalog and Internet retailing business.)
When stores last upgraded?
3-pronged attack: 1) same-store sales increase; 2) open new stores; 3) gross margin increase
Is same-store data unreliable due to promotions, markdowns, weather, store closures, relocations and refurbishes. Also, no standard way all retailers compile the data, end date, etc.
Comparable same store sales growth trend?
Square footage growth rate trend?
Average weekly sales per store trend?
Is management getting sloppy about siting new stores? (What is their method for siting new stores?)
How does management train new employees? How does management know if they are properly trained?
How much time does customer spend in store? (CostPlus it is 40 minutes -- a long time.)
How many times a year does average customer visit the store?
Average person who visits store returns ____ months later? (12/04: Apple store is 3 months, vs. 2 years for Best Buy)
% stores located in neighborhoods with household incomes below $20K a year; $40K a year
Stores in ___ account for 50% of revenue
How many states in company in?
How many states would company like to be in?
Average age of stores?
How will this company insulate its franchise from Wal-Mart?
Compare market value, revenue and profits of stores on per capital basis to competition
How many locations does company have? How many locations does it own?

Fashion risk, etc.:
What are the important brands? (ex: Sears important brands are Martha Stewart and Joe Boxer)
How are these brands doing?
Does company have one product that accounts for disproportionate % of sales?
How often does company offer fresh merchandise? (Coach every 4 weeks.)
Who makes the merchandise? Does company or is it private label?
What are initial markups? If 65%, company can take 5-30% of list and still make money.
What are gross margins? Very rarely do you see it above 40%. (Higher the better; a tonic for cash flow.)
How many SKU's does a store carry? Competition?
Employee productivity: sales per employee
Revenue per square foot
Loss allowance as % of receivables
Net charge-offs as % of receivables
Average gross margins are 33% in the specialty retail industry.
Is company investing in store modernization, merchandising technology?
What is trend in average ticket over last 3 years?
How much does company spend on information technology?

Sales-to-inventory ratio:
Who has best sales-to-inventory ratio in the industry?

At a minimum, you want sales growing faster than inventory, says David Berman of the Dee-Bee Index
Berman believes this bodes well for future profit growth; the bigger the spread, the better
American Eagle's sales grew 37% Q!05, inventories 5%. This 32% spread is a "mind-boggling accomplishment"

Credit card portfolio:
Are credit card losses rising faster than delinquencies? (Red flag.)
Are charge-offs rising faster than reserves for credit card losses?
What is ratio of reserves to annualized net chargeoffs (anything under 1 is trouble--means co is substantially underreserved)
Is the growth from new stores and credit cards?
What is the direction of inventory per square foot? Compare to prior quarter, prior year.
Number of stores remodeled last five years?
How many stores does a company have to build a year to maintain its revenue, earnings growth?
What is a new store's average sales, operating profit contribution?
(Dollar Tree contributes about $300,000 of operating profit on $450,000 investment, for an excellent 67% first-year return)
High first-year returns enable company to fund new store growth through internally generated funds, vs. stock sales or debt
For stores open more than a year, check comps.
How long does it take for a store to reach profitability? How many additional years before reaching maturity?
How many stores does company close a year? In its history?
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This is great thanks for sharing. Does the 4 pages on revenue is on the qualitative side or a quantitative side. How long it takes you to analized a company?

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2 thoughts on hewitt's revenue checklist-

one: of course must look at the change in all these data points over time - probably more important than absolute numbers - and then the rate of change

two: this is why I don't do retail!

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No. of Recommendations: 13
I start with the financials, copying and pasting the last several years' worth into my Earnings Power Spreadsheet from a Reuters database. Then I go into the actual 10-Ks and double check the data, as well as pull out footnote items like operating leases. After deciding if there is any growth capex, what the cost of equity is (usually the 10-year Treasury yield plus 500 basis points), how long intangibles like R&D should be depreciated, etc., I build an Earnings Power Chart.

The Earnings Power Chart answers the first of my three questions: can I trust this company's numbers? Specifically, if GAAP profits are rising, is defensive (free cash flow) and enterprising (net return on capital) profits also rising. I am looking for a reasonably tight correlation between all three income types. This work usually takes 2 hours.

Step two is figuring whether a firm has a competitive advantage and, if so, how long will it last? If a company is situated in the Earnings Power Box's upper-right box, or even better, if it is forging an Earnings Power Staircase, then it probably has a competitive advantage (but not always).

Morningstar identifies four types of competitive advantages: 1) low-cost provider, 2) high switching costs, 3) intangibles (patents, brands, store locations, etc.), and 4) network effect. Having a competitive advantage is important, because it enables a company to have the best possible mix of "value drivers": sales growth, operating profit margins, and low investment rates in fixed, working capital, and intangibles. I also look at they are compensated, their capital allocation track record, this sort of thing. This work takes 3-4 hours, but you never really "know" a company. Also, this research is ongoing.

My last step is valuation. Here I estimate a range of intrinsic values (no decimal points!) to see if the company is selling for less than it is worth. I have 4-5 ways of estimating intrinsic value, including 2-3 DCF models. If you are able to get a rough sense of what the business is worth using conservative assumptions, then go one step further to decide what your "buy around" and "sell around" prices are.

The DCF models I use have several "margin of safety" features to protect me from overpaying (or should I say protect me from my inclination to want to buy everything) They are:

1. Using numbers I trust (Earnings Power Chart).
2. Three growth scenarios, with the high growth forecast based on analyst five-year forecasts. Analysts are usually wrong (read David Dreman), so my Low and Medium scenarios are less than what they forecast.
3. Have a "pothole" year in years 1-5, as most companies do not grow their earnings (GAAP, free cash, EVA) in an unblemished "hockey stick" straight line.
4. Earnings growth for all three scenarios declines over time to 3%, which is a proxy for the inflation rate.
5. 75% of my intrinsic value estimate is based on my Low and Medium growth forecasts.
6. Subtract debt, operating leases, and other contingent liabilities from firm value.
7. Pay no more than 65-75% of my intrinsic value estimate.

Valuation takes a few hours. Also, after every quarter's results are made available, I check to see if my estimates need updating.

Unless you are an experienced investor, you should not buy a full position right away. Buy in increments over time. Lost opportunities are better than realized losses.


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Rog -

Excellent points. One of my favorite pairs of ratios is return on capital and return on incremental capital. The latter measure the incremental return on management's most recent investment in the business--the rate of change, in other words. If the company is becoming less profitable, the return on incremental capital number will often turn south before the return on capital number.

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Hi Hewitt

Would you post the formulas you use for roic and ROI

Thanks there are so many different ways to do it would very much like to know what you use

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Wow, Hewitt, thank you for posting those retail questions. Great stuff.

I noticed that some of the questions can't necessarily be answered from information in the 10K, such as length of time a customer stays in the store, or how often they return. Where do you get this type of data?

Also, a private question (don't answer if you feel it's too private). How do you rate yourself as an investor? Do you consistently beat the market (S&P 500, e.g.)? I ask because the DD you do is time-consuming, so one would want to make sure they were getting a sufficient return on that much time invested. Are you able to share in a general sense how effective this DD is for you in numeric terms?
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Pirc -

Glad to help and thanks for the thanks.

Up 34% last 12 months vs. 12% for S&P 500, and up 59% last 2 years vs. 17% for the market. S&P 500 dividends excluded, so total return numbers are a little higher.

The DD is time-consuming, but the more you do the easier it gets. Also, doing a DD review helps a lot with valuation.

And you are right; the 10-K does not have the answer to every question. So sometimes I may ask management. If they don't know the answer, a red flag.

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Hewitt, silly question, but how do you ask management? Do you call Investor Relations? Do you participate in conference calls? Can you? Do you have personal contacts in high places? I read "Uncommon Stocks, Uncommon Profits" and agree with the idea of scuttlebutt, but even if I get through, say, the VP of Finance's gatekeeper, I can't think he'd be too thrilled spending his precious time answering questions from a small-time investor like me. Or maybe I'm wrong.

Can you tell us how you ask management?
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Hi KitKat -

Return on capital = NOPAT/Capital (avg. 2 years), where NOPAT = operating profits after taxes but before interest. Since I capitalize intangibles and operating leases, this affects my NOPAT and capital estimates. Capital is the sum of debt, equity, capitalized leases, capitalized intangibles, and a few other items.

ROIC = change in NOPAT/change in capital.

Hope this helps.

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Some will talk to you, some won't.

If you tell management you own the stock (provided you do), this helps. Also, write out the list of questions you have before you call. By writing your questions, you get a better sense of what you want to ask, which is important given everyone's time is limited.

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Why do you prefer after tax profits for ROC calculations versus a pre-tax figure?

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I do it both ways.

When I estimate ROIC (return on incremental capital), however, I use after-tax returns because taxes are as much a cost as salaries and raw materials.

But I also look at the tax rate to see if it varies a lot from one year to the next, or between companies. If the company is benefitting from a drop in its tax rate (which may not be sustainable), then I want to know it.


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Hi Hewitt

Have you noticed since you increase NOPAT by deducting the intangibles(I am guessing R&D and advertising?)and increasing capital by adding it, do you find they offset each other enough to make the differences negligible if you were to simply use an unadjusted NOPAT? Or do you find this makes a noiceable difference? And if so is it likely to give a greater or lesser value than the unadjusted value?

Do you deduct current lease expense from NOPAT?And then deduct current amortization for intangibles after adding back the expense?
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For ROC I use one calculation with the current portion of leases included in Net Working Capital, and one without, although to date I have concentrated on the pre-tax method. I do the same with EV/EBITDA calculations, where I've found it to make a big difference in some cases. Never trust a ratio on Yahoo!

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The reason I asked is that I have found when doing FCF valuations when I credit R&D spending to income, deduct amortization from income then add the capitalized amount to capex, its often times a wash.

The method of doing ROC by adding back intangibles(R&D,advertising)& lease expense to NOPAT, then subtracting the amortization and then adding the the research value of the R&D and debt value of leases to capex is very time consuming and I was wondering if it made a big difference. And if it did if there was a dominant direction. All that by way of saying I have limited time and take grievous shortcuts.

I agree that Yahoo is not to be trusted. In fact any source(even CapIQ) where you don't know the method leaves you at sea without a life jacket
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I too have struggled at times with the sheer time requirements necessary to calculate some of the finer computations. At times, results end up being non-material to the investment thesis, but occasionally there is enough of a divergence to make you ask questions about your assumptions.

Some investors espouse going into a great amount of detail in your analysis, while others keep it very simple. I tend toward the former, but then I read Joel Greenblatt's basic business case behind his investment in American Express. It was one page, and the value difference he believed he would achieve was so large that the minutae wasn't material. And this is for a position that is well over 25% of Gotham's portfolio. (I'm sure he did more work than the 1 page, but you get the drift).

I'm not as good of an investor as Joel, so I'm leaning toward collecting more data. If nothing else, it forces me to learn more about my portfolio companies. I'm in the process of building a master spreadsheet system to automate or simplify as much as possible for me, but it is certainly slow going. And since most data on the web today is suspect, I'm taking my figures from the SEC filings, which just adds more time.

But since this is my money, and I hate surprises that I could prevent thru analysis, it will be worth it.


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