Qantas' share price has soared over the past week. Does this yield a solid reason to be buying? I don't seem to think so. If you buy a bottle of water for $2 and you come back tomorrow and it's $2.2 is there now more of an incentive to buy the water? Probably not. Higher share prices reduces return, or equivalently, lower share prices increase future returns.
Well, maybe the quality has improved overnight. This may be the case for the bottle of water, but the long-term structural economics of the airline industry suggest otherwise. Focusing on Qantas' ROE over the past 10 years, you can see for yourself that it has declined, markedly. While revenues have only risen by about 20% (over the same period.) This isn't sounding like a great long-term investment to me. Maybe if you dig deeper you may find something which i haven't but with the number of analysts covering a stock like Qantas, chances are probably slim. Yes, they've come out saying that profits next year are meant to do this, or do that, but this shouldn't tempt the intelligent investor who invests on the basis of value over long periods of time. Airlines are a bad investment and this is due to the bad economics of the industry. The only exception i can think of is NetJets (owned by Buffett) but the business model is different.
My point is not to buy into companies solely on basis of price appreciation, you won't win in the long-run by doing so. The most important aspect should be valuation. Many people tend to forget this, including myself at times. You may come across an outstanding business but if you pay a too high price, you can make it a bad investment. So the bottom line is, pay attention to valuation and over the long-term, not the valuation of tomorrow.This is how you will win in the long term (where valuation is a reflection of rigorous analysis.)
Monday 27 October 2014
Tuesday 14 October 2014
An amcedemic ratio which signifies a high quality business
According to Novy-Marx, we can use two simple line items from financial statements to aid us in our search for high quality businesses. One comes from the income statement and one from the balance sheet. Interestingly, Marx uses Gross profitability instead of the traditional EBIT, or NOPAT metric(s). Marx calls it the Gross profit to total assets ratio. Defined as:
GPA = (Revenue - COGS)/Total Assets
Marx argues that Gross Profitability is the "cleanest" measure of underlying economic profitability. He continues:
"The farther down the income statement one goes, the more polluted profitability measures become, and the less related they are to true economic profitability. For example, a firm that has both lower production cots and higher sales than its competitors is unambiguously more profitable. Even so, it can easily have lower earnings than its competitors. If the firm is quickly increasing its sales through aggressive advertising or commissions to its sales force, these actions can, even if optimal, reduce its bottom line income blow that of a less profitable competitor. Similarly, if the firm spends on R&D to further increase its production advantage, or invests in organizational capital that will maintain its competitive advantage, these actions result in lower current earnings. Moreover, capital expenditures that directly increase the scale of the firm's operations further reduces its free cash flows relative to its competitors. These facts suggest constructing the empirical proxy for productivity using gross profits."
I've used this ratio for the stocks not only that i hold but for the ones that are on my radar. One of the companies stands out from the pact, which is somewhat surprising.
GPA = (Revenue - COGS)/Total Assets
Marx argues that Gross Profitability is the "cleanest" measure of underlying economic profitability. He continues:
"The farther down the income statement one goes, the more polluted profitability measures become, and the less related they are to true economic profitability. For example, a firm that has both lower production cots and higher sales than its competitors is unambiguously more profitable. Even so, it can easily have lower earnings than its competitors. If the firm is quickly increasing its sales through aggressive advertising or commissions to its sales force, these actions can, even if optimal, reduce its bottom line income blow that of a less profitable competitor. Similarly, if the firm spends on R&D to further increase its production advantage, or invests in organizational capital that will maintain its competitive advantage, these actions result in lower current earnings. Moreover, capital expenditures that directly increase the scale of the firm's operations further reduces its free cash flows relative to its competitors. These facts suggest constructing the empirical proxy for productivity using gross profits."
I've used this ratio for the stocks not only that i hold but for the ones that are on my radar. One of the companies stands out from the pact, which is somewhat surprising.
Monday 6 October 2014
Mount Gibson (ASX: MGX) the net-net case
In my previous post i talked about buying into Mount Gibson on the basis of value. My investment thesis is straightforward: buy as it is trading near net working capital. Any other assets including the going concern of the business would be considered a bonus. As most of their net working capital comes in the form of cash, there is a slight problem which is lingering. MGX's break-even point is $75 with iron ore prices around $79 it's a small margin. The larger miners, mainly the likes of BHP and RIO are by far the lowest-cost producers and are attempting to over-supply the market to drive prices down and essentially drive competition out with it. As there are question marks over China's growth rates (more specifically, steel production) the problem is exacerbated.
What does this have to with anything you may be thinking. Well, to weather the potential storm if the prices of iron ore trade below Mount Gibson's break-even point, then they might have to draw on their surplus cash position to maintain business. As the cash position reduces, my investment thesis also breaks-down (and as the cash represents a large portion of my thesis, the validity could diminish rapidly.) Some economists are arguing the price of iron ore has been oversold and that the prices may go higher. This is not my game and iron ore forecasting is out of my reach. If the investment decision trickles down to this sort of thing, then I'll leave it alone. I had an order in for this company for $0.43 but cancelled it as I'm unsure of the potential problems.
Although the lower dollar should help, and the mid-tier miners are rushing to cut costs, it may only be a matter of time. Another scenario may be that the company defaults without drawing on too much cash, then it would be fine (as they redistribute the money in the business back to the owners), but that's too much guesswork for me. Even though it surpasses my idea of what would be considered logical or "rational", i simply cannot rely on something like this. For now, I'm on the sideline until i can gather more information.
As a side note, if you do follow my writings, you may have noticed that when i talk about the "circle of competence" I've said that mining/resources and the like are out if it. However, on the basis of sub-liquidation valuation, i would buy into them. Never would i be forecasting miners EPS growth or anything like that. Because if you are forecasting miners growth rates, in essence, you're also indirectly forecasting commodity prices which is not something i partake in. This is an exceptional case of a traditional deep value investment where I'm paying for the business. In other words, I'm buying the balance sheet and that's all. Fund managers always tell you that you need an edge to outperform the market. What I've noticed is that many of them analyse industry's that are likely to experience structural tailwinds in the future and trickle the argument down to individual companies (top-down) that are likely to benefit. While it's not the only method, and investors should investigate a range of methods, it's one to consider. If you can find a situation where you have a range of benefits, you have a higher probability of excelling. This is extremely difficult and requires an inordinate amount of time, playing out scenarios, conducting "what if" analysis and thinking independently (this is, that from what I've read and realised, is something that many value investors spend a lot of time thinking about.)
This is extremely important, and many investor's don't pay enough attention to this part of the investing spectrum, which plays a key role in how fund managers do outperform. This is what i spend most of my own time on analysing, trying to get as much probability of success on my side, which isn't easy and there's not only one way of going about this. One piece of advice I'd like to share is that when conducting these types of activities, you should always have at the forefront of your mind the notion of capital preservation. By this i mean that if you were to invest in company A, how much can you lose (or gain) if it defaults? Naturally, you gravitate towards the balance sheet first. However, some businesses aren't very tangible and have wide economic moats in the likes of large network economics, for example Ebay, which are hard to crack. Drawing a line here is something that is tough and is something that i battle with consistently. I believe Warrem Buffett, is a somewhat cross-breed between the traditional value investor and the "growth" investor. He employs techniques from both schools of thought, but always has capital preservation at the forefront. He is willing to buy a terrible business, if the price is right. But, as good business are hard to find at good prices, he pays so-so prices for them. Ideally, you would want to buy these businesses during bear markets, which would most likely help maximise the probability success factor which i talk about.
Research shows that value companies (by value i mean companies that are trading at low price to book ratios) tend outperform the market over the long-term, and sometimes by a large margin. However, this doesn't mean you shouldn't be buying into businesses that have high price/book ratios because, as i mentioned before, they tend to be businesses that sell products which are highly desired, hard to replicate and have wide moats and at times, various moats working in their favour at one time which may be why you pay a premium for their earnings (subjective.) The best example i can give is Coca-Cola, which in my opinion is the best business the human race has ever seen.
This example also demonstrates a weakness in my investing acumen, namely, that I'm not pre-empting enough thought into my investment decisions prior to making them. This will need to be worked on. Luckily though, i haven't had to lose real capital before realizing this as my prior investments (which i still hold) have performed well. Although, the depth of my research on the other companies (ones that i have bought into) is much greater than my effort to date on Mount Gibson.
What does this have to with anything you may be thinking. Well, to weather the potential storm if the prices of iron ore trade below Mount Gibson's break-even point, then they might have to draw on their surplus cash position to maintain business. As the cash position reduces, my investment thesis also breaks-down (and as the cash represents a large portion of my thesis, the validity could diminish rapidly.) Some economists are arguing the price of iron ore has been oversold and that the prices may go higher. This is not my game and iron ore forecasting is out of my reach. If the investment decision trickles down to this sort of thing, then I'll leave it alone. I had an order in for this company for $0.43 but cancelled it as I'm unsure of the potential problems.
Although the lower dollar should help, and the mid-tier miners are rushing to cut costs, it may only be a matter of time. Another scenario may be that the company defaults without drawing on too much cash, then it would be fine (as they redistribute the money in the business back to the owners), but that's too much guesswork for me. Even though it surpasses my idea of what would be considered logical or "rational", i simply cannot rely on something like this. For now, I'm on the sideline until i can gather more information.
As a side note, if you do follow my writings, you may have noticed that when i talk about the "circle of competence" I've said that mining/resources and the like are out if it. However, on the basis of sub-liquidation valuation, i would buy into them. Never would i be forecasting miners EPS growth or anything like that. Because if you are forecasting miners growth rates, in essence, you're also indirectly forecasting commodity prices which is not something i partake in. This is an exceptional case of a traditional deep value investment where I'm paying for the business. In other words, I'm buying the balance sheet and that's all. Fund managers always tell you that you need an edge to outperform the market. What I've noticed is that many of them analyse industry's that are likely to experience structural tailwinds in the future and trickle the argument down to individual companies (top-down) that are likely to benefit. While it's not the only method, and investors should investigate a range of methods, it's one to consider. If you can find a situation where you have a range of benefits, you have a higher probability of excelling. This is extremely difficult and requires an inordinate amount of time, playing out scenarios, conducting "what if" analysis and thinking independently (this is, that from what I've read and realised, is something that many value investors spend a lot of time thinking about.)
This is extremely important, and many investor's don't pay enough attention to this part of the investing spectrum, which plays a key role in how fund managers do outperform. This is what i spend most of my own time on analysing, trying to get as much probability of success on my side, which isn't easy and there's not only one way of going about this. One piece of advice I'd like to share is that when conducting these types of activities, you should always have at the forefront of your mind the notion of capital preservation. By this i mean that if you were to invest in company A, how much can you lose (or gain) if it defaults? Naturally, you gravitate towards the balance sheet first. However, some businesses aren't very tangible and have wide economic moats in the likes of large network economics, for example Ebay, which are hard to crack. Drawing a line here is something that is tough and is something that i battle with consistently. I believe Warrem Buffett, is a somewhat cross-breed between the traditional value investor and the "growth" investor. He employs techniques from both schools of thought, but always has capital preservation at the forefront. He is willing to buy a terrible business, if the price is right. But, as good business are hard to find at good prices, he pays so-so prices for them. Ideally, you would want to buy these businesses during bear markets, which would most likely help maximise the probability success factor which i talk about.
Research shows that value companies (by value i mean companies that are trading at low price to book ratios) tend outperform the market over the long-term, and sometimes by a large margin. However, this doesn't mean you shouldn't be buying into businesses that have high price/book ratios because, as i mentioned before, they tend to be businesses that sell products which are highly desired, hard to replicate and have wide moats and at times, various moats working in their favour at one time which may be why you pay a premium for their earnings (subjective.) The best example i can give is Coca-Cola, which in my opinion is the best business the human race has ever seen.
This example also demonstrates a weakness in my investing acumen, namely, that I'm not pre-empting enough thought into my investment decisions prior to making them. This will need to be worked on. Luckily though, i haven't had to lose real capital before realizing this as my prior investments (which i still hold) have performed well. Although, the depth of my research on the other companies (ones that i have bought into) is much greater than my effort to date on Mount Gibson.
Friday 3 October 2014
Going long, a tradtional Ben Graham type of investment
In Benjamin Grahams book: The Intelligent Investor (more specifically, in chapter 7) he supposes some strategies for the defensive and enterprising investor. One of them comes under the title of "bargain issues" which are defined as companies selling below net current assets after accounting for long-term debt as well. The argument for this is to protect your principal (the initial money invested.) If you can find companies trading at below or near liquidation value, downside risk is reduced significantly. Even better, finding companies trading at less than net current assets means you get the fixed assets (PPE and the like) plus any goodwill for free. You get the going concern, free. Even better, because you're not including fixed assets, the subject of whether the assets on the balance sheet reflect their true "replacement value" is mitigated so there's no need to do adjustments ;). Cash of $100 is cash of $100, simple (if you want to learn more about accounting adjustments in practice have a look at Bruce Greenwalds book - Value Investing: From Graham to Buffett and Beyond.) Warren Buffett began doing this in the 50s and made a killing from it. Markets since then have become more efficient but not always. He recently bought South Korean companies that were trading at less than working capital (a typical "net-net" investment as it's called within the value investing literature.)
Well, what if the company defaults you may ask. Because you're subtracting all the liabilities and you also have non-current assets and intangibles on top, you can liquidate and get your principal back (in America you'd also have to subtract preferred stock from the equation, however, this isn't a big issue in Australia as it essentially doesn't exist here.) Sounds like a safe bet to me. I try explaining this type of investing as buying a farm for $5,000 but the farm has $10,000 sitting in the middle of it.
You see, Benjamin Graham was a very interesting man, at a time of financial mayhem and everyone asking the question "how much can i make" he turned the question on it's head and asked "how much can i lose?" (this is my interpretation of his work, but if you look at his 1934 preface of Security Analysis i believe it's not unreasonable to suggest what i am suggesting.) He then went out and formally detailed how you do that. He not only created a style of investing, he created a profession: the financial analyst.
The company that I've put an order in for (yet to reach my price) is Mount Gibson Iron (ASX: MGX). The problem with deep value investing (companies selling at least a 30% discount to firm value) is that you need a well diversified portfolio of them to do it successfully. Sometimes, the companies shares go to $0 and you lose everything. However, it's not all doom and gloom. This style of investing is one of the best if not the best in terms of shareholder returns. Another thing to note is that this type of investing is definitely not for everyone. The kinds of companies you focus on tend to have major problems at the moment, so iron ore companies may be a good place to start your search. Moreover, not only are they having problems but by nature, it's contrarian investing which means you tend to also be buying against the crowd.
Yes, i jumped around a lot, but i had a lot of things running through my head and i wanted to get them all out.
Well, what if the company defaults you may ask. Because you're subtracting all the liabilities and you also have non-current assets and intangibles on top, you can liquidate and get your principal back (in America you'd also have to subtract preferred stock from the equation, however, this isn't a big issue in Australia as it essentially doesn't exist here.) Sounds like a safe bet to me. I try explaining this type of investing as buying a farm for $5,000 but the farm has $10,000 sitting in the middle of it.
You see, Benjamin Graham was a very interesting man, at a time of financial mayhem and everyone asking the question "how much can i make" he turned the question on it's head and asked "how much can i lose?" (this is my interpretation of his work, but if you look at his 1934 preface of Security Analysis i believe it's not unreasonable to suggest what i am suggesting.) He then went out and formally detailed how you do that. He not only created a style of investing, he created a profession: the financial analyst.
The company that I've put an order in for (yet to reach my price) is Mount Gibson Iron (ASX: MGX). The problem with deep value investing (companies selling at least a 30% discount to firm value) is that you need a well diversified portfolio of them to do it successfully. Sometimes, the companies shares go to $0 and you lose everything. However, it's not all doom and gloom. This style of investing is one of the best if not the best in terms of shareholder returns. Another thing to note is that this type of investing is definitely not for everyone. The kinds of companies you focus on tend to have major problems at the moment, so iron ore companies may be a good place to start your search. Moreover, not only are they having problems but by nature, it's contrarian investing which means you tend to also be buying against the crowd.
Yes, i jumped around a lot, but i had a lot of things running through my head and i wanted to get them all out.
Wednesday 1 October 2014
A very interesting article on supply and demand, and their effects on asset prices
I've stumbled across a very interesting read. The article, essentially tells us to buy low and sell high, but due to various reasons (outlined neatly in the article) doesn't happen. I thought I'd share it because it ties in quite nicely to my previous post whereby i offered a different perspective on investing (namely, exactly what the whole article attempts to make you realise you should be doing, which is buying low and selling low.) However, it does so in a much more rigorous manner than i did. The author although he/she remains anonymous for "employment reasons" seems like a very interesting character with a wealth of knowledge.
The link for the article is:
http://www.philosophicaleconomics.com/2014/09/supply/
enjoy :)
The link for the article is:
http://www.philosophicaleconomics.com/2014/09/supply/
enjoy :)
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