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Cosas interesantes de inversion de bolsa, fondos..

La inversa del descuento de flujos de caja

LaVueltaAlGrfico - Jue, 11/09/2017 - 08:50
Soy bastante fan del método de valoración de flujo de caja aunque debemos tomarnos esta afirmación con ciertas reservas. No es perfecto, pero tampoco es tan horrible como muchos creen. Con todo, tiene sus pros y sus contras, pueden leer una explicación completa de uno de nuestros post sobre la valoración mediante flujos de caja. Siempre que conozcamos cada una, un modelo de descuento de

How to Deal With Market-Moving News

http://awealthofcommonsense.com - Mié, 11/08/2017 - 22:01
It’s now been a year since the presidential election. While many were predicting the end of the world, U.S. stocks are up 24%, foreign developed stocks are up 23%, and emerging market stocks are up 23%. Allowing political beliefs to guide your investment ideas is not a useful strategy but people also get caught up looking for signals from potentially market-moving news or events where none exist. This piece I wrote ...

Petróleo: Esta vez es diferente

LaVueltaAlGrfico - Mié, 11/08/2017 - 18:56
Es curioso, pero incluso después de tantos años me sigo sorprendiendo de cómo determinados "expertos" de los mercados, a los que se les llena rápidamente la boca de citas fáciles de Lynch o Buffet, siguen cayendo en la trampa de "esta vez es diferente". Supongo que es porque uno aparenta ser más inteligente cuando defiende un cambio de paradigma.

Considerations for Cashing Out of the Stock Market

http://awealthofcommonsense.com - Mar, 11/07/2017 - 20:34
There was a story in CNN Money last week about a 60-something part-time writer/librarian who cashed out all of the money she had in the stock market. Here’s what she did with it along with her reasoning behind the decision: Now all my money is stashed in U.S. Treasuries, Treasury Inflation-Protected Securities (or TIPS bonds), and laddered CDs, which, in the years to come, I can count on to earn me essentially nada....

Buffett 1972 Letter to See’s Candies

basehitinvesting.com - Mar, 11/07/2017 - 17:18

I recently came across a letter that Buffett sent to Chuck Huggins, the CEO of See’s Candies in 1972 (thanks to Marcelo Lima at Heller House for posting it). See’s is a case study that has been dissected from every angle, but this was a letter I hadn’t seen before, so I thought some notes I wrote while reading it.

In the letter, Buffett attempts to give some general advice on the distribution, merchandising, and marketing of the chocolates.

The two main takeaways I took from the letter:

  • Buffett was extremely concerned about protecting the See’s Candy brand
  • He recognized that the key to protecting the brand was to tell a good story about the product

Buffett knew that the brand was the company’s main asset and the only real reason for the attractive economics (lots of cash came out of the business and very little had to go back in). And of course, this high return on capital was the key ingredient that Munger used to convince Buffett that the business was worth paying a large premium over tangible capital – something Buffett was very reluctant to do up to that point.

2 Main Paths to High ROIC

Generally speaking, companies that produce high returns on capital do so in one of two ways: by earning above average profit margins, or by turning over its capital quickly.

This is basically the crux of the DuPont Analysis: ROIC = Earnings/Sales x Sales/Capital.

Firms generally derive their high returns on capital through either having an advantage on the consumer side (high profit margins) or on the production side (high capital turnover).

See’s great profitability stemmed from the former.

Where High Margins Come From

When Blue Chip Stamps (the Berkshire subsidiary) bought See’s in 1972, the chocolate maker had 13.4% pre-tax margins. Just five years later in 1977, margins rose to 20%, and are likely much higher today. There are numerous reasons why companies are able to consistently achieve high markups over their cost.

Some products are expensive, complex to change, and critically important to a customer’s business operations. Not every user loves SAP’s software, but the company’s tentacles are so entangled in most of its customers’ finance departments that it would be too disruptive and costly to switch vendors.

Some companies have built valuable two-sided networks that have very low costs for each new user, allowing the companies to extract significant value from those users directly (e.g. Visa) or indirectly (e.g. Facebook, Google, and Tencent don’t charge users, but collect high-margin revenue from companies that want to sell something to those users).

Some companies have a product that is the only game in town. Costar’s Loopnet is a commercial real website that acts as a property information gatekeeper for the commercial brokerage industry. Brokers have to list their properties on Loopnet because it’s the only real platform that has all of the buyers and all of the sellers. It’s basically the commercial real estate MLS, and it has given Costar massive (commercial brokers might say abusive) pricing power.

Some companies have a product that customers have difficulty avoiding, the so-called “toll road”. Buffett famously talks about his love for toll roads, sometimes literally (Detroit’s Ambassador Bridge) but usually figuratively (e.g. newspapers in one-newspaper towns – in fact the Berkshire-owned Buffalo News was once sued by a competitor, who used Buffett’s liking of toll roads against him (unsuccessfully) in court).

Verisign is an example of one such figurative toll road. My friend Matt Brice of The Sova Group calls it the internet’s phone book – one that we’re required to use when we “dial up” a website. It’s essentially a legal monopoly on the most popular “top-level domain” (i.e. the suffix that comes after the “dot” portion of any domain name). If you own a domain name that ends in .com, you pay about an $8 yearly toll to Verisign.

(I wrote about VRSN in this summary as well as in last year’s investor letter – Saber Capital owns VRSN).

Finally, sometimes companies are able to charge high prices because of a strong brand name.

Brands

I think strong brands can be divided into two main buckets:

  • Companies that offer a better product or service than competitors (e.g. Apple)
  • Companies that offer a product or service of similar quality to competitors, but are just better at telling a story about that product (I think Coke, Tiffany’s, and Nike are examples here)

I think most brands fall into the second category. Some companies tell an effective story (and the story then leads to better distribution, better merchandising, wider brand name recognition, etc… which further entrenches the “story” in people’s minds). Tiffany’s diamonds are high quality, but the premium price they get doesn’t come from possessing better-quality stones that other jewelers can’t match. The premium comes from the story Tiffany’s tells: the history, the reputation, Audrey Hepburn, and even the nostalgia that comes to mind when you think about Tiffany’s. In fact, the company has struggled recently, and part of their chosen remedy is to refocus their story (hiring Lady Gaga and others to tell it).

Nike’s shoes are good shoes, but they aren’t that much different than other brands that generally all manufacturer their products in Southeast Asia using the same general technology and materials. It’s true that Nike makes a good product, but Michael Jordan would still be Michael Jordan if Adidas hadn’t let Nike outbid them for Jordan’s shoe contract in 1985 (Nike paid Jordan a whopping $500,000 – surely one of the best investments in corporate history).

Again, Nike makes a great product, but the business is a $35 billion business because Phil Knight first excelled at telling a story (eventually getting athletes to relay that story to the public).

Now, there is nothing disingenuous about promoting your product – marketing is part of business strategy. Effective marketing – the swoosh logo and the “Just Do It” slogan were brilliant – sometimes is the difference between good companies and average companies.

I would say, however, that a business that depends on the “story” is often more likely to be vulnerable to shifting consumer behavior. 

Buffett Knew How Important the Brand Was

See’s Candies is an example of one of these companies that had a strong brand, but required a story that had to be told and an image to be maintained in people’s minds. While it made delicious chocolate, the chocolate itself wasn’t that much different than other available alternatives. I think Buffett knew this. He also knew See’s had a strong brand, but I think he knew that the brand was the result of an image and a story behind the image, which is why he emphasized this in this 1972 letter to Huggins:

“We might be able to tell quite a story about the little kitchen in California that has become the kitchen known ‘round the world.”

He even talks about making marketing pamphlets that should:

“form the basis of the legend that we eventually want to have permeate the country. Such a booklet, along with really classy display and appropriate advertising… could well enhance our image…” (emphasis mine).

I think the letter even hints at some fear that the brand could erode if, for example, it is placed:

“on a counter with 25 other offerings of cheap bulk candy, and other run-of-the-mill products.”

Unless the product was presented well, it would be just another piece of chocolate. There is no pricing power and much lower margins in the cheap bulk candy aisle.

I think Buffett’s comments imply that there is no guarantee regarding the sustainability of a brand, and while brands are very valuable, they are also very vulnerable. I don’t think he thought See’s was in a precarious situation, but I think he knew that the moat that See’s had could evaporate very quickly under the right circumstances.

Sees’ Edge Was Marketing

So for all the talk over the years about how tasty See’s candy is (and it is tasty), I think Buffett knew that the brand came not from making better chocolate, but from better marketing of that chocolate.

He tells Huggins that the way the chocolates are displayed in the stores impact the customers’ “impression of our quality”, and that the chocolates “have to be offered in a way that establishes them as something very special”.

He likens See’s to Coors when they marketed the fact that their beer came from one brewery, even though he always had the suspicion that 99% was in the telling and 1% was in the drinking.

In short, Buffett knew that the product had to be sold (distributed, marketed, and presented well). See’s chocolate tasted great, but that wasn’t enough to separate itself from competitors. Consumers had to associate See’s with some “legend”, or some hallowed kitchen in California that gave off the sense of history and nostalgia.

I think Buffett thought that his investment would be won or lost based on the effectiveness of this marketing effort.

To Sum It Up

  • Buffett knew the brand was the most important asset the company had
  • The product was great, but effective storytelling was critical to See’s success
  • I think most brands fall into this marketing category (as opposed to great standalone products)
  • The See’s brand could deteriorate if the product wasn’t marketed or presented well

Here is the letter: 1972 Buffett Letter to See’s Candies

Thanks for reading!

Disclosure: John Huber and clients of Saber Capital Management own shares of VRSN, AAPL, and TCEHY. This is not a recommendation to buy shares. 

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at john@sabercapitalmgt.com. 

 

 

 

The Constant Reminder

https://ofdollarsanddata.com - Mar, 11/07/2017 - 12:51
How The Right Decisions And Compounding Can Lead to Huge Results

Every 175 years something remarkable happens — Jupiter, Saturn, Uranus, and Neptune come into close alignment. An American aerospace engineer by the name of Gary Flandro discovered this while working at NASA’s Jet Propulsion Laboratory in the summer of 1964. More importantly, Flandro realized that the next time this alignment would occur was in the late 1970s, a little more than a decade away.

As a result of his finding, Flandro devised a Grand Planetary Tour that would allow a probe to fly by all 4 gas giants much faster and cheaper than previously estimated. The physics behind the tour was to use the planets as slingshots (gravity assists) in order to cut down on energy costs and the time needed to visit them. The end result was NASA’s Voyager program. After considering 10,000 possible trajectories, NASA decided upon two of them and launched Voyager 2 followed by Voyager 1 in the late summer of 1977.

Two things stand out about the Voyager program:

  1. Decisions made by NASA scientists 40 years ago have had a profound effect on the mission and its success through today. For example, despite launching after Voyager 2, Voyager 1 is currently the furthest man made object from the Earth at a distance of ~13.1 billion miles or 20 light hours (as of this writing). Every second Voyager 1 moves 10 miles further away from us. Tick. Tick. Ti — Voyager 1 just completed a marathon. The decision to have Voyager 1 start on a faster and shorter trajectory and then let nature run its course made this possible. All it took was some great decision making, the rest was physics.
  2. Once a successful process is put in place, the end results can be surprising. What started as a mission to check out the gas giants and their respective moons became a study of the edge of our solar system and deep space. Voyager 1 and 2 have continually sent useful data back to NASA and will continue to do so until 2020, when their ability to transmit information will finally fade. The goals achieved by the probes were not necessarily all imagined at the outset.

These two ideas from the Voyager program are highly relevant to investing and your personal finances. Just like NASA had to choose from thousands of trajectories for Voyager 1 and 2, you will need to choose from a seemingly endless supply of investment advice. And the decisions you make today will have compounded effects decades later. These small decisions are hard to notice in the short run, but impossible to ignore in the long run. The simplest example of this is your savings rate. Imagine increasing your savings rate from 5% to 10% (or 15%) of your income. For the first few years, the benefits of this will be almost non-existent:

I purposefully made the y-axis this large because this visually represents the psychological attention you place on smaller amounts of money. The difference between saving $2,500 and saving $5,000 for a few years won’t change your life in any significant way, so its easy to mentally ignore the difference. However, if we allow this difference to compound year after year, the true impact of this decision emerges:

I know what you might be thinking: “Wow Nick. So you’re telling me saving more money leads to me having more money in the future? That’s so original.” I agree with you. The point of this visual isn’t to convince you to save more. You already know that. The point is to show you that making the right choices and letting things run their course can lead to incredible results. Whether this means continual buying and holding (i.e. do nothing on most days), staying the course during rough times, or focusing on the right part of your finances, the right choices, when compounded, can help you succeed as an investor.

This idea is even more striking outside of investing where it can be difficult to measure smaller changes and their eventual impact. For example, it’s easy to see how a higher savings rate leads to more money because you can do the math and see how this would compound over time. However, it is not necessarily easy to see how running for 20 minutes a day is going to help you get fitter. You can’t just run the numbers and imagine what your health/body would look like.

This is what makes consistent actions and the power of compounding so amazing. When I think about creating a new habit in my life, I like to imagine all of the future benefits from that habit discounted back to the moment when the habit is formed. That’s what it’s like. When you increase your savings rate from 5% to 10%, you don’t get 5% more money at the end, you double the amount of money you have. The first day you form your exercise habit is the day you lose the weight. The first day you form your writing habit is the day you wrote your best work. It all compounds back to the moment when the habit is formed.

This is the constant reminder. The reminder that the little things you do, the actions you perform, the habits you build day in and day out will form your life. Remember, you are a fractal of yourself. What you do on one day you likely do on most days. You may not notice these actions on a daily basis just like you probably don’t notice yourself getting fitter and you don’t notice Voyager 1 moving away from us at 10 miles a second, every second. However, these effects are still there, compounding away.

The beauty of this is that by forming good habits, you can hit escape velocity from your former self to become an improved you. Just like Voyager 1 left Earth and went into space, that probe is now pushing the limits (literally) of where humans have gone. And by making the right decisions and letting natural processes take over, you can get some surprising results…

An Unexpected Surprise

As Voyager 1 was exiting our Solar System in early 1990, the noteworthy astronomer and author Carl Sagan asked NASA to turn the probe’s camera toward Earth to take a final picture. The resulting image, known as the Pale Blue Dot, is one of the most famous in all of astronomy. It is not easy to see, but if you look down the orange streak on the right side of the image you will notice a small blue blip halfway down. That blip is Earth:

Pale Blue Dot (February 14, 1990)

If this image doesn’t make you realize how small we are, I don’t know what will. The edge of the known universe is 13.7 billion light years away from us, yet the furthest we have ventured is 20 light hours with Voyager 1. If each light year we moved toward the edge of the universe earned us $1, we wouldn’t even have a 1/3 of a penny yet of the $13.7 billion available. But despite our smallness, we have produced incredible things. If this idea interests you, I highly recommend the video below based on Carl Sagan’s book Pale Blue Dot. Until next week, thank you for reading!

https://medium.com/media/73c45a01cf856757b62bf6544889ff7b/href

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 45. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

OfDollarsAndData.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com and affiliated sites.

The Constant Reminder was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Artículos recomendados para inversores 216

academiadeinversion.com - Lun, 11/06/2017 - 09:11

Recopilación de artículos recomendados para inversores en general y, en especial, para los seguidores del value investing, volumen 216.

La entrada Artículos recomendados para inversores 216 aparece primero en Academia de Inversión - Aprende value investing desde cero.

What If You Only Bought at Below Average P/E Ratios?

http://awealthofcommonsense.com - Lun, 11/06/2017 - 03:24
A few years ago I wrote a post that is still far and away my most popular called What if You Only Invested at Market Peaks? I still regularly receive comments, caveats, and questions about this one. A recent follow-up question from a reader asks: What if you only put your money to work at below average P/E ratios? In theory, it would make sense that investing at lower valuations would give you better results considering ...

Lecturas de domingo 05/11/2017

LaVueltaAlGrfico - Dom, 11/05/2017 - 11:32
Como cada domingo, os traemos las lecturas de mercados financieros (y más) que nos han parecido interesantes durante la semana. Recuerda: que lo enlazamos no significa que compartamos la opinión, sino que nos parece interesante de cara a formarnos una propia. TOP 10 Resumen de la semana (inglés). ¿Recesión inminente? (inglés). Jerome Powell (castellano). Fondos de M&A para

La Ley de Metcalfe y el Bitcoin

LaVueltaAlGrfico - Vie, 11/03/2017 - 21:03
Ya son varios los artículos que he encontrado por internet valorando el Bitcoin utilizando la Ley de Metcalfe. Pero como uno empieza a ser perro viejo, y ya había escuchado este cuento antes (sumado a todo lo que he leído sobre la burbuja .com, apoyada en esta ley).

6 Things That Made Me Laugh at EBI East

http://awealthofcommonsense.com - Vie, 11/03/2017 - 18:20
Investment conferences are usually a great way to network and meet people but often end up being fairly boring with little entertainment value in terms of subject matter. A lot of this stems from the fact that it’s difficult for most people to make this stuff exciting but a large portion of the finance industry probably takes themselves too seriously. At our EBI East Conference yesterday in NYC I found myself more ente...

ValueBilbao – Entrevista Francisco García Paramés

http://invertirenvalor.com/ - Vie, 11/03/2017 - 11:40

ValueBilbao – Entrevista Francisco García Paramés

Si quieres ser buen inversor tienes que ir contra tu naturaleza.

-Francisco García Paramés

De nuevo tenemos la oportunidad, gracias a Finect y la Sociedad Bilbaina, de disfrutar de otra entrevista de Francisco García Paramés.

Escuchar varias veces las charlas de los mejores inversores nos dará nuevas ideas y lo mejor, fijarán las anteriores.

Hace unos días leí que entre libro y libro hay que releer uno anterior para que fijen las ideas, haciendo una lectura activa.

Del mismo modo la primera vez que escuchamos una de estas charlas, escucharemos ideas interesantes, pero estas sólo se fijarán al volverlas a escuchar y releerlas varias veces, así es como crearemos un modelo mental adecuado para el proceso inversor.

De esta charla de Paramés lo que más destaco es que comience afirmando que las matemáticas no es lo más importante para ser un buen inversor, la clave está en tener la psicología adecuada.

De especial relevancia me parece que comente que no tiene WhatsApp. Esta idea está en línea con lo que ya veíamos como la idea principal del documental Becoming Warrenn Buffett cuando comentan que estar centrado (focus) es lo que ha hecho a Buffett una persona de enorme éxito, en medio del ruido de la sociedad actual.

¿Quieres leer más reflexiones como esta?

Consigue gratis mi ebook “¿Por qué invertir te va a cambiar la vida?” y descubre por qué deberías empezar a invertir en Bolsa.


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A Closer Look at Ray Dalio’s 1937 Scenario

http://awealthofcommonsense.com - Mié, 11/01/2017 - 18:46
Investors often evoke the old saying that history doesn’t repeat but it does rhyme. The problem is even when market scenarios do rhyme the differences far outweigh the similarities because every time is so different in the markets. Bridgewater Capital’s Ray Dalio has evoked the 1937 analogy for a few years now to describe the current market environment. While I have enormous respect for Dalio I wrote this piec...

El fondo de emergencia: Concepto, importancia, gestión y cuantía recomendada

academiadeinversion.com - Mié, 11/01/2017 - 18:05

Explicación sobre en qué consiste el fondo de emergencia financiero, su importancia, la cuantía recomendada y cómo debe ser gestionado.

La entrada El fondo de emergencia: Concepto, importancia, gestión y cuantía recomendada aparece primero en Academia de Inversión - Aprende value investing desde cero.

The Increasing Importance of the 401k

http://awealthofcommonsense.com - Mar, 10/31/2017 - 18:54
Over the past few weeks there have been rumors floating around about potential changes to the 401k retirement contribution limits via the current debate around tax reform. The first rumor was they were going to cap it at $2,400/year, which is ridiculous. Then last week it came out they’re considering increasing it to $20,000 (the current rules will see the annual limit will increase from $18,000 per individual to ...

The War Between Fear and Evidence

https://ofdollarsanddata.com - Mar, 10/31/2017 - 11:51
On Evidence-Based Investing and How You Can Profit From It

A war is currently being fought every day throughout the world. This war was here before you were born and will be around long after you are gone. I am talking about the war between fear and evidence. While humanity has access to more information today than any point in human history, facts continue to fall flat in the face of compelling narratives that rely on emotional appeal, especially fear. As The Science of Fear summarized so well:

Fear sells. Fear makes money. The countless companies and consultants in the business of protecting the fearful from whatever they may fear know it only too well. The more fear, the better the sales.

I completely agree. Humans are wired to respond to stories that rely on emotions, not cold, abstract numbers. The fact remains that it is far easier to relate to the death of a celebrity than it is to the deaths of thousands of people from a natural disaster on the other side of the planet. You don’t feel like you know those thousands like you “know” that celebrity. Or as Joseph Stalin so infamously said:

The death of one man is a tragedy, the death of millions is a statistic.

Despite our hard-wired tendency to react to emotional appeal, we can fight back. How? Evidence. Though fear is winning the war, everyday a small group of people win a few more battles using evidence. As I stated last week in Phil Huber’s post about evidence-based investing:

Fear is loud. Evidence is quiet. Listen to the evidence.

For example, consider the following “quiet” evidence:

And these are just a few examples of the overwhelming evidence that our biggest fears are not as bad as they seem and that human life is generally improving around the world. If you need more convincing, read Morgan Housel’s What A Time To Be Alive.

So, how is this related to investing? This is the primary goal of evidence-based investing (EBI) — to purse investment strategies backed by data and facts rather than narratives and emotion. EBI is about favoring history over uncertainty. Or, as my favorite investing quote of all time states:

Fear has a greater grasp on human action than does the impressive weight of historical evidence.-Jeremy Siegel

Read that quote again. Seriously. Let it sink in. Now, consider what Warren Buffett said regarding a similar subject:

In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

Do you feel the impressive weight of evidence crushing your fear? You should. If not, I can probably guess your counter argument. What about the Black Swan? The nuclear war? The apocalypse? What if Taleb is right? He might be, but it wouldn’t matter anyways. If the apocalypse happens, your financial assets are irrelevant. So, who cares? Anything else though, our society and financial markets will survive. Terrorist attack? Hurricanes? Pandemics? These are all awful, but we’ll be fine.

So What Does the Evidence Say?

This week I will attend the 2nd Annual Evidence-Based Investing Conference (EBI East) in New York where some of the best investment thinkers in the world will discuss the evidence surrounding a variety of investment topics. With this in mind, I wanted to share just a few of the key points from evidence-based investing that you can use to improve your investment outcomes:

  • Keep your fees low. It’s not about active vs. passive, it’s about high fee vs. low fee. Future returns are not guaranteed, but your future fees will be, so keep them lower.
  • Diversify adequately (even within equities). During financial panics riskier assets tend to fall together, but this can be mitigated by having some portion of your portfolio in much safer assets (i.e. U.S. Treasuries or cash). However, during normal times you will notice that global equity markets display a wide range of outcomes. This implies you should diversify across these markets as well (Many thanks to Jake from EconomPic for helping me get this data. Follow him on Twitter):
  • Some strategies can beat the market, but they are difficult to stick with. For example, there is plenty of historical evidence for factor investing (smart beta) strategies that beat the market. However, these strategies will regularly experience bouts of underperformance, making them difficult to stay invested in. Remember, even Warren Buffett underperforms for shorter periods of time quite regularly. If you decide to invest some money using a smart beta strategy, set your expectations accordingly.
  • Investor behavior matters more than investment analysis. Your ability to (1) not sell during a panic and (2) acquire income producing assets on a fairly regular basis (i.e. consistent savings), will do far more for your investment success than your attempt to find the next Amazon. Investing is a highly emotional game, so I would argue that knowing your investing self is just as important as knowing your investment portfolio.

We Are Trying to Get the Message To You

Despite the barrage of gloom and doom that comes from parts of the financial media, there is a group of people trying to turn the tide so that this:

Fear > Evidence

becomes this:

Fear < Evidence

And this group will keep fighting the war between fear and evidence. Day in. Day out. One blog post. One podcast. One book. One chart at a time. We are out there and we are spreading the word. Or, as Metallica so boldly said in their debut album in 1983:

We are trying to get the message to you

Thank you for reading!

➤ You can follow Of Dollars And Data via Email (1 weekly newsletter), Twitter, Facebook, or Medium.

This is post 44. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data

Disclaimer

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The postings on this site are my own and do not necessarily reflect the views of my employer. Please read my “About” page for more information.

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The War Between Fear and Evidence was originally published in Of Dollars And Data on Medium, where people are continuing the conversation by highlighting and responding to this story.

Analizando un diamante en bruto

http://invertirenvalor.com/ - Lun, 10/30/2017 - 20:34

Analizando un diamante en bruto

Por Adrián Godás.

El mercado bursátil es la historia de los ciclos y del comportamiento humano que es responsable de las reacciones exageradas en ambas direcciones.

-Seth Klarman

Hoy traigo un pequeño análisis de una de las mejores ideas de inversión que me he encontrado en meses (bajo mi punto de vista). Pero antes de empezar quiero agradecer a Javier, lector del blog, que me comentara esta idea y me ayudara a desarrollarla. Estoy seguro de que dentro de poco se animará a escribir.

El diamante negro de Canadá

Black Diamond Group es una empresa canadiense fundada en 2003 con un modelo de negocio muy particular. Sus operaciones están divididas en 4 unidades:

-BOXX Modular: alquila y vende construcciones temporales o permanentes como oficinas, aulas, centros médicos… En especial me gustaría destacar que vende módulos de alojamiento premium. Estos módulos van dirigidos a un público ejecutivo,o VIP, que busca alojamiento de calidad lejos de sus hogares. Estas “casas prefabricadas” incluyen de todo, desde cocinas a Internet.

-Camps & Lodging: realiza operaciones como catering, seguridad, mantenimiento… en los campos donde BD trabaja. Es la parte más importante del negocio y opera principalmente en sectores relacionados con la Energía.

-Energy Services: provee de equipamiento y servicios a empresas E&P (exploración y producción) del mundo del petróleo y gas. Por ejemplo: material de perforación, generadores eléctricos, tanques de almacenamiento…

-International: es la división que se encarga de Australia.

El principal negocio de la empresa es alquilar y vender módulos de alojamiento, principalmente al sector energético (Oil & Gas). A mayores, también ofrece una amplia gama de servicios y productos. También atienden a clientes de otros sectores como la minería, constructoras, educación… e incluso los gobiernos.

La distribución geográfica de las ventas no tiene mucho que decir: 81% Canadá, 15% EEUU y 4% Australia.

Como veis es un negocio algo peculiar. Black Diamond supo ver una necesidad muy interesante en las petroleras canadienses: los trabajadores necesitan un lugar donde vivir. Estas empresas suelen operar en zonas muy aisladas de Alberta, la zona Oeste del país, así que los trabajadores necesitan comer, dormir, relajarse, etc en algún lugar. Ahí apareció nuestro diamante al rescate.

Estos decidieron emplear un modelo de negocio basado en alquilar y vender los activos importantes (los módulos) mientras subcontrataban a otras empresas por los servicios no-core como el transporte, catering, suministro de agua, seguridad… Esto les ha permitido tener una estructura muy flexible, minimizar costes y por supuesto, aumentar la rentabilidad.

Reescribiendo a Dante

Me vais a permitir que haga una analogía con la Divina Comedia de Dante en este apartado (que le queréis, me gusta la literatura clásica). Y es que la empresa ha vivido su particular viaje esta última década:

Cielo: desde la salida a Bolsa en 2006 la empresa creció a un ritmo de más del 30% anual. Los fundadores encontraron una verdadera máquina de dinero.

Los beneficios netos aumentaron desde 1 simple millón a más de 50m en apenas 8 años.

Infierno: pero un día… bueno, un año, 2014 para ser exactos, empezaron aparecer nubarrones. Los ingresos se estancaban y los beneficios se desplomaban. Los precios de las materias primas (petróleo a la cabeza) se venían a bajo. Debido a estas caídas tan brutales las empresas cancelaron proyectos y redujeron costes.

Recordemos que lo que para las E&P es un gasto para las empresas auxiliares como BD es un ingreso. Esta es la razón de porque la empresa ha pasado de 50m de beneficios a entrar en pérdidas, -50m en 2016.

Purgatorio: la empresa después de estos años tan horrorosos ha tomado medidas… y es de lo que hablaremos en el próximo punto. De verdad, me parece que lo han hecho tan bien que merece la pena extenderse sobre ello.

¿Cielo de nuevo?: aquí nos encontramos amigos míos, en la disyuntiva de si la empresa regresará a su antiguo cauce y volverá saborear el Cash Flow o si el tramo por el infierno va para largo. Los datos de los últimos trimestres muestran que al menos la situación se ha estabilizado.

Antifragilidad o de cómo mejorar en plena debacle

La empresa desde 2015 ha adoptado multitud de medidas:

-Reeorganización: la empresa ha llevado, y sigue llevando a cabo una serie de reestructuraciones internas para reducir costes y ganar eficiencia.

Este último trimestre ya anunció que iban a fusionar varios departamentos y calculan que ahorrarán otros 3m al año.

-Adquisiciones: la empresa estos años ha adquirido módulos y empresas más pequeñas. Recientemente ha sido el caso de Britco, comprada a WesternOne. Con esta compra ganan 1896 unidades para el BOXX Modular. Además, que me parece que lo han logrado a precio de saldo.

Britco en 2015 generó uno 230m en ingresos y 11m en EBITDA. En la primera mitad de 2016 eran 70m y 1m. Por el negocio pagó 41m y dentro de unos años puede valer más del doble.

-Recompra de acciones: recientemente anunciaron un plan para recomprar hasta el 10% de las acciones. Los directivos ven luz al final del túnel y que el precio de la acción es de risa.

-Adiós dividendo: la empresa en su pasado empezó repartir dividendos en 2013 pero a medida que el negocio se deterioraba tuvieron que ir reduciéndolos. Hasta llegar este trimestre que lo cancelaron por completo.

Estos dineros ya dijeron que lo emplearían en la recompra antes mencionada, reducir deuda y seguir con adquisiciones.

-Reducción de deuda: en 2013 la empresa llegó a un total de 186m de deuda a largo plazo, sobre un Equity de 362m. Gracias a varias renegociaciones, pequeñas ampliaciones de capital y dinero recortado de los dividendos ahora ha pasado tener 118m.

-Ejecutivos apretándose el cinturón: no hago comentarios, sólo mirad la imagen.

Taleb se inventó el término antifrágil para referirse a aquellas cosas que se benefician del caos, la aleatoriedad, los estresores… No puedo evitar ver a BD como un organismo antifrágil, que a raíz de la situación del sector ha caído en desgracia, pero que se ha vuelto mucho mejor empresa: menos costes, más módulos, más eficientes…

El equipo que saca brillo al diamante

Encabezada por Trevor Haynes co-fundador de Black Diamond. Desde que nació la empresa siempre ha sido el Presidente y CEO. Tiene más de 20 años de experiencia en el sector ya que antes de fundar BD ya había trabajado en otras empresas.

Posee más de un 5% de la compañía y ha aumentado bastante su posición este año.

Del resto de directivos comentar que la mayoría tiene, aunque sea pequeña, una participación en la empresa; y además la mayoría lleva en el negocio más de 10 años. La experiencia media de los directores (según las cuentas anuales) es de 20 años en el sector.

He buscado en el SEDI (la SEC canadiense) y he encontrado que los directivos a lo largo de este año han comprado y ejercido una gran cantidad de stock options. Vamos, que han aprovechado para adquirir muchas acciones baratas.

En resumen, me parece una buena directiva que ha hecho bastante bien las cosas; ha sabido mejorar el negocio en tiempos de crisis; con una amplia experiencia en el sector y en la empresa; y que todos van cargados de acciones este año.

Los fríos datos

Pasemos a ver un poco más en profundidad las cuentas y los números.

La empresa durante esos maravillosos años obtenía un ROE medio del 15%. Si lo miramos en profundidad veremos que cerca de la mitad de la rentabilidad se debía al apalancamiento y la mayoría del resto a un margen neto muy bueno, 10-25%. Obviamente la rotación de activos en una empresa como esta es muy baja.

En el balance lo más destacado que hay que comentar es que la empresa para hacer todos los planes antes mencionados ha tenido que consumir mucha caja y actualmente sólo dispone de 3,5m. Ellos ya comentaban que tuvieron que reducir el working capital y vaya si redujeron. Uno de los peligros que vea en la empresa es que si el ciclo bajo se alarga podría tener problemas de liquidez (current ratio de 1,08).

La deuda como ya dije, la han reducido bastante así que la proporción Pasivos-Equity se mantiene en un sano 40-60. Es muy importante mirar esto porque las empresas relacionadas con materias primas al sufrir un ciclo bajista por la deuda pueden no soportarlo.

La empresa ha visto reducido sus ingresos a 1/3 de antaño y este último han entrado en “pérdidas” de -50m. Lo pongo entre comillas porque si nos vamos a nuestro querido Estado de Flujos de Efectivo veremos que sigue teniendo un Cash Flow operativo de más de 30m (es un caso similar a Noble Corp). La razón detrás de semejante diferencia son unos deterioros que declararon, y claro, se anotan como pérdidas, pero no es una salida de dinero real. Pero con esto hay un detalle que comentaré después.

“This longer than anticipated lag between pricing recovery and increased field level activity impacting Black Diamond’s operations resulted in the Company recording a $49.9 million non-cash impairment charge”

Ah, por cierto. No sólo sigue teniendo Cash Flow operativo positivo, si no que también tiene un Free Cash Flow de 18m. Algo difícil de ver en una empresa de este sector en la situación actual.

Eso sí, lo que no me gustó nada es como no han parado de ampliar capital. En 2006 tenían 15m de acciones, en 2012 ya había más de 40m. Que a ver, es comprensible. Estamos hablando de una empresa pequeña que tenía financiar un gran crecimiento, y en estas ocasiones suele ser mejor ampliar que pedir préstamos (ya vimos algo parecido con Canacol Energy). El problema es que, para sobrevivir y hacer los planes antes explicados, tuvieron que volver a ampliar. Pero estoy bastante seguro que sólo durará hasta que las aguas vuelvan a su cauce.

En resumen, la típica compañía cíclica que está en la parte baja del ciclo.

Los problemas del lag…

Alguno se preguntará porque la empresa no nota la subida de los precios de ciertas materias primas si ya sucedieron hace meses: los precios de los metales subieron más de 25% en los últimos meses, el petróleo pasó de 25$ a más de 55$ actualmente…

Lo que sucede es una cadena de procesos donde hay que tener en cuenta un factor poco visto en economía, el tiempo:

  1. El precio de la materia prima sube
  2. Las empresas de E&P empiezan a ganar dinero de nuevo
  3. Una vez que esas empresas están bien, vuelven a gastar en nuevos proyectos y a crecer (CAPEX)
  4. Ese CAPEX llega a los negocios relacionados con los Field Services (Black Diamond)
  5. Las empresas de Field Services empiezan a ganar dinero de nuevo

En general, el proceso puede demorarse más de 6 meses.

Además, por si no lo sabéis, los grandes gestores de AZ entre otros son muy alcistas con el petróleo (y yo también). Si queréis saber más sobre el sector podéis leer los artículos en Seeking Alpha de un hedge fund especializado aquí.

La empresa ya ha hablado de grandes proyectos que se iniciarán estos meses y en 2018 por lo que son muy optimistas con este año que se avecina: estructuras para la exportación de LNG (Gas natural licuado) desde el Oeste de Canadá, proyectos del gobierno canadiense y el australiano…

Cuando “enjuagarse” la boca puede estar mal

Antes os hablaba de los deterioros en los activos que la empresa ha declarado, que han sido tan grandes que si no los hubiera presentado el beneficio neto sería cercano a 0 e incluso con un pequeño beneficio. Lo que sucede es que había algo en mi interior que me decía que algo estaba mal. Algo me susurraba: big bath.

Para los que no lo conozcáis, el big bath o enjuague en español, se trata de una estratagema contable perfectamente legal y difícil de demostrar. Consiste en “engordar” las pérdidas en un año malo para así “inflar” los beneficios en el siguiente año bueno.

¿Pero qué ventajas tiene hacer esto, Adrián? Pues muchas.

Imaginaos que sois una empresa de minería, y sabéis que por los bajos precios 2017 va ser un año pésimo, y hasta el mercado lo descuenta bajando el precio de la acción. En ese caso podéis tratar de aumentar las depreciaciones y deterioros para entrar en pérdidas. La empresa sigue teniendo Cash Flow positivo, pero contablemente ha tenido pérdidas y tiene derecho a un crédito fiscal para pagar menos impuestos el año siguiente. De esta manera al siguiente año cuando los precios vuelvan subir ganareis más dinero por haber adelantado todos eses deterioros y por el crédito fiscal.

Y es que todo me cuadra en el caso de Black Diamond: un año que el mercado sabía que iba ser malo, una directiva que también lo sabía, perspectivas que 2017 y 2018 la cosa mejoraría, y buenas excusas para declarar deterioros…

Estos impairments se pueden realizar cuando los flujos esperados de un activo, descontándoles una tasa de descuento, son menores que el valor contable al que consta el activo. Indagando en las cuentas he visto que casualmente han reducido las tasas de crecimiento terminal y aumentado las tasas de descuento. Sólo estos hechos justifican el 25% de la cantidad deteriorada. Puede que sea un ignorante, pero ¿arriba me dices que esperáis nuevos grandes proyectos y abajo que los flujos esperados son menores?

Obviamente habría que tener contacto con la directiva, indagar más en la contabilidad… y tener muchos más conocimientos. Estas sospechas no son más que suposiciones mías, el que quiera que eche un ojo y me diga que le parece.

Riesgos

Después de analizar la empresa he llegado a la conclusión de que los principales riesgos son los siguientes:

-Las burbujas canadiense y australiana: quizá os pille por sorpresa, pero desde hace meses ya se habla de posible burbuja inmobiliaria en Canadá.

Varios hedge funds e inversores ya tienen avisado.

Por encima se da la casualidad de que también parece haber otra en Australia (mira que es mala suerte).

Los motivos son parecidos en ambos países. En los dos casos tienen muchas materias primas que exportan (mucho capital que entra en el país) y han cogido mucha fama como buenos países para vivir así que mucha gente ha emigrado a ellos.

No conozco bien los casos y es probable que acaben sucediendo sendos cracks, pero a pesar de eso dudo que afecte demasiado a BD. La razón es que los mercados de petróleo, gas… son más mundiales que regionales. Porque la economía vaya mal en ellos no tiene que repercutir en los precios de los recursos que son al final los que acaban guiando al CAPEX.

-Solvencia: la empresa como dije más arriba afronta un momento crítico donde o empieza volver a ganar dinero o puede tener problemas de solvencia para el pago de deudas. Pero la empresa ha reducido deuda y renegociado varios contratos, además que la mayor parte caducan en 2019 o 2020, por lo que dudo que haya problemas.

En caso de extrema necesidad podrían vender activos poco importantes como ya están haciendo, que por cierto, al parecer los están consiguiendo vender un 20% por encima del valor en libros, cosa muy curiosa.

-El ciclo bajista: que se alargue demasiado y las E&P no gasten. Lo dudo mucho porque ya muestran signos de recuperación, los precios vuelven a subir y una subida del precio del crudo me parece inevitable (revisar el link que puso arriba).

-Los gobiernos: en parte dependen del gasto público de los gobiernos. Trudeau, el presidente de Canadá está muy comprometido con atraer inversiones y mejorar el país, dudo que haya problemas por su parte.

Valoración

Tras todo este análisis empresarial llegamos a la parte de valoración. Como está en pérdidas hay muchas ratios imposibles de mirar actualmente. Así que he decidido normalizar los resultados, que en una empresa cíclica me parece de lo más importante.

Como veis son ratios bastante bajos, y es que además, la empresa en parte alta del ciclo llegó a cotizar cerca de 20 PER y 15 EV/EBIT. A esto sumarle que cotiza a P/B 0,33 cuando lo normal era 1-1,5. Y sí , habéis leído bien, cotiza a 1/3 del valor en libros.

No voy hacer valoraciones exactas ni cálculos raros. Pero sólo sabiendo estos datos me cuesta creer que Black Diamond valga menos del doble (siendo conservadores), 4 CAD.

Conclusión

Empresa relativamente de calidad que se ha vuelto mejor con la crisis; a un precio muy razonable; buena directiva cargada de acciones; precios de materias primas al alza… ¿Que más queréis?

Para terminar, dar las gracias a Javier por la idea y a @adrivalue que fue de su cuenta de Twitter de donde salió la tesis de inversión.

Cualquier pregunta podéis dejarla en los comentarios.

¿Quieres leer más reflexiones como esta?

Consigue gratis mi ebook “¿Por qué invertir te va a cambiar la vida?” y descubre por qué deberías empezar a invertir en Bolsa.


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Thoughts on Cost of Capital and Buffett’s $1 Test – Part 1

basehitinvesting.com - Lun, 10/30/2017 - 19:46

“I’ve never heard an intelligent discussion about ‘cost of capital’.” – Charlie Munger

I read something a few weeks back that referenced some comments that Charlie Munger once made on the topic of cost of capital. Maybe these comments will be yet another unintelligent discussion of cost of capital, but I thought I’d share some notes I wrote down this past week as I gave this concept some more thought. This post will touch on Buffett’s $1 test, which is how he thought about a company’s cost of capital, and then in the next post I’ll outline the cost of capital concept and how I like to think about it when thinking about investment ideas.

The cost of capital is a very simple concept, but it’s also one that for some reason becomes very confusing, theoretical, and abstract (especially if you consult most textbooks on corporate finance). The phrase “cost of capital” is often used in conjunction with “return on capital”, and both can be mired in either academic theory or the false sense of precision that comes from manipulating numbers in a spreadsheet.  

As usual, Buffett has some common sense things to say about the relationship between returns on capital and cost of capital, and sums it up best with what he has called the $1 test.

From Buffett’s 1984 shareholder letter:

“Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

So what is Buffett saying here?

Three things:

  1. Value creation comes from the returns that the company can generate on reinvested cash (incremental returns on capital), not just the returns they generate on previously invested capital (ROIC)
  2. Companies should only retain earnings if a dollar in the company’s hands is more valuable than a dollar in the shareholder’s hands.
  3. The only way a company achieves #2 is to earn a higher return on that dollar than shareholders could earn elsewhere (which is another way of saying companies must produce returns on capital that exceed their cost of capital)

When Buffett talks about a dollar of retained capital creating a dollar of market value, he’s talking about the stock price over time (he said later in that 1984 letter that he’d evaluate this over a five year period). He’s talking about a dollar of intrinsic value, but he’s implying that the stock market will be a fairly accurate judge of intrinsic value over time. And he’s saying that the market over time will reward businesses that create high returns on the dollars they keep (by giving them a higher market value, i.e. stock price), and the market will punish (with a lower valuation) those companies whose dollars retained fail to earn their keep.

Simple Example $1 Test

To look at a very simplified example, let’s assume an average stock market valuation of 10 P/E, or in other words, a 10% earnings yield (which was roughly what stocks were valued at on average when Buffett wrote these words in the early 1980’s). If a company valued by the market at $100 million earns a profit of $10 million and retains all of those earnings, the company will only increase the value by $10 million if it can earn an incremental return on that $10 million that exceeds what shareholders could earn elsewhere. In this example, shareholders have plenty of other alternatives to earn a 10% return on their capital (since the market average in this case has a 10% yield). So if the company can earn a 10% return on that retained $10 million, then its earnings will rise to $11 million the following year, and assuming the same valuation of 10 P/E, the business would now be valued at $110 million, thus passing Buffett’s $1 test. The $10 million of retained earnings created additional market value of $10 million.

This isn’t a great return, as Buffett would be looking for retained earnings to create more value than just matching the cost of capital, but this is the minimum requirement that the company must meet in his mind (note that if earnings were distributed, an individual would actually have to earn a higher return on those incremental earnings than what the company earns internally to account for capital gains taxes on the dividend, but this simple example illustrates what Buffett is trying to get across).

It’s worth noting that Buffett doesn’t use the phrase “cost of capital”, and he doesn’t think about the concept the way most people in finance think about it. Munger said they’ve never used that phrase in practice.

However, just like DCF’s (which is a tool Buffett is skeptical of in practice, despite agreeing with the general method in principle), Buffett and Munger essentially do the cost of capital calculation in their head. They implicitly use and understand both DCF’s and cost of capital calculations even if they don’t explicitly label them.

Return on Incremental Invested Capital

Value is created when companies earn returns on capital that exceed their cost of capital. In the next post, I’ll outline my own thoughts on how to think about cost of capital, and what that really means, but despite Buffett and Munger’s dislike for the term, they clearly understand and utilize the concept when they make investment decisions. But for now, I’ll review the other piece that Buffett is talking about, which is that the growth of a company’s intrinsic value depends on the returns it can earn on its incremental capital investments.

When I analyze companies, I always try to figure out what I think their returns on incremental capital will be going forward, as that is a key variable in determining the rate at which the company’s intrinsic value will compound at over time. I’ve written about the importance of ROIC in the past, in a series of posts (read them here), but basically, a firm’s value will grow at the product of its returns on incremental capital times the amount of earnings it can reinvest (plus any added benefit to allocating the portion of capital that couldn’t be reinvested back into the business).

Saber Capital’s Basic Investment Objective

My investment firm’s strategy is centered around the idea that companies can be put in one of two main buckets:

  1. Those companies that will be more valuable in five years or so, and
  2. Those that will be worth less.

As the former Michigan football coach Bo Schembechler once said, each day you’re either getting better or you’re getting worse, but you’re not staying the same.

So given this simple idea about two main buckets of companies, I try to stay focused on the first bucket – those companies that will have a higher intrinsic value (the present value of the future cash flows will either be higher or lower in five years). As we know, stock prices can fluctuate wildly in the short-run, but over time they will converge with their intrinsic value. And if that value is marching upward over time, it becomes a tailwind for me rather than a headwind. Another way of saying this is that my margin of safety (any gap between my purchase price and intrinsic value) widens over time.

One way of filtering the universe to find “1st Bucket” companies is to figure out if the company is passing Buffett’s $1 test.

Google’s $1 Test

Alphabet (Google) is a obviously a great business, and so I glanced at the last five years of numbers to see how it fared in Buffett’s $1 test. Buffett said in that 1984 letter that because the market is obviously volatile, he preferred looking at a longer period of three to five years to be able to draw conclusions on whether that dollar of retained earnings actually created real value.

So here is a look at the overall value GOOG created from each $1 of retained earnings:

This is just a quick way to glance at the returns that Google is generating from its incremental capital. It doesn’t measure the returns on capital specifically and obviously leaves plenty to be analyzed, but it does show that Google has been very productive with the earnings it has kept (creating nearly $5 of market value for shareholders for each $1 it retained during this 5-year stretch).

Note that this doesn’t include 2017, which has seen tech stocks soar to new heights (Google is up over 30% YTD). Some have quibbled with Google’s approach to “other bets” (financed through the huge cash flow of its incredibly profitable core search business – Google spent over $1 of every $4 of revenue on R&D and capex last year and still made around $20 billion of free cash flow!).

We’ll see how/if/when the other bets pay off, but I think it’s reasonable to conclude that Google is creating plenty of value for shareholders by retaining earnings.

Incremental ROIC and Buffett’s $1 Test

The way Buffett measures whether a firm can create $1 of market value for each $1 of retained earnings is to measure whether the returns on those earnings exceed what shareholders can earn elsewhere (at a given level of risk). So what Buffett is talking about here is the return on incremental capital, or ROIIC, which is really the entire point of trying to analyze a firm’s ROIC.

I outline a back of the envelope way to estimate a firm’s ROIIC in this post, but basically, the point behind this concept is that we want to know what returns the company will generate on its investments going forward. We can look at the return on capital it previously invested (which is what ROIC measures) as a proxy or guide for what the company might earn going forward, but what matters to us as investors is what the company will do with its capital from this point forward. It really doesn’t matter that a firm has a 50% ROIC if there is nowhere to invest earnings at that rate going forward. That still might be a good business that throws off a lot of cash flow, but what we really want to know as potential owners is what the future returns on incremental investments will be, as that is what will determine how quickly the earning power of the business (and thus the intrinsic value) will compound.

In the simple example above of the company that retains and reinvests $10 million of earnings and has $100 million market value (P/E of 10), if the company only earned a 5% return on that retained capital, then that $10 million would only produce $500,000 of earnings growth, or 5%, which is unlikely to be better than alternative options for owners. You could take your piece of that $10 million and invest it elsewhere at a rate higher than 5%. Over time, the market would likely begin to devalue these retained earnings such that each incremental dollar the company reinvested (that only produces 5% in a world where 10% is attainable) would wind up getting valued at less than a dollar in the stock market.

On the other hand, if the company earned 20% returns on that retained capital, then earnings would grow by $2 million for a total of $12 million of earnings, and the value of the business would be $120 million at the same P/E of 10, meaning that $10 million of retained earnings created $20 million of additional market value. $2 of market value was created for each $1 retained in this case. 

Now, P/E ratios obviously don’t remain static. In reality, the business that earned just 5% in a world of 10% earnings yields would likely see the valuation decline, thus not only failing to produce adequate ROIC, but the market would also value the earnings at a lower multiple, thus clearly failing Buffett’s $1 test.

And the business that generates a 20% ROIC will likely see its $12 million earnings garner a higher P/E. At 12 P/E, the business is now worth $144 million, thus creating $4.40 of value for each $1 it retained, and thus clearly passing Buffett’s $1 test.

To Sum It Up

So like so many other lessons, Buffett uses a common sense approach to thinking about returns on capital and cost of capital. With the $1 test, he is clearly talking about cost of capital, and he clearly is judging company returns on capital relative to that cost of capital, but he is doing it in a much more common sense way that has more practical use than trying to figure out industry betas, equity risk premiums, WACC, etc…

The next post will have some more notes on how I like to think about cost of capital including the differences between what companies estimate their cost of capital to be going forward and what it actually turns out to be (the difference largely due to the inefficiencies of the stock market). I’ll also mention why measuring your opportunity costs is the most logical way to think about cost of capital, and I’ll have an example of how Buffett thinks about cost of capital using one of his investment mistakes.

Have a great week!

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at john@sabercapitalmgt.com. 

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