Category Archives: Valuation Techniques

Op. Leverage; Geico and Berkshire Case Study; In Gold We Trust; Overconfidence

ego

Mauboussin on Operating Leverage is a review on margins and operating leverage.  I recommend reading pages 19 to 21 in addition to my prior post: ROIC and more

Berkshire CS_wedgewood partners 1st quarter 2016 client letter

geico case study and presentation 2016

Incrementum-signal-768x439

Do not focus on forecasts but learn from history and economics about gold: In_Gold_we_Trust_2016-Extended_Version

In_Gold_we_Trust_2015-Extended_Version (Referenced in 2016 Ed. Why miners struggled to gain investor respect.)

Avoid Overconfidence

A lesson in trading

A lesson in valuation

It is never different this time

Happy Fourth of July Holiday.  

I will answer the option questions upon return.

Returns of 100 to 1? First Understand Returns on Incr. Capital; Reader’s Question

Cap investments

The best long-term investments tend to be companies that can reinvestment over and over again at high rates of return.  Those high rates of return attract competitors so you must also understand barriers-to-entry.  But first study how to calculate incremental returns on capital or marginal returns on invested capital (“MROIC”).   There are several links and documents below to help you.  The effort is worth it if you can find: WMT_50 Year SRC Chart (up to 2000). WMT had regional economies of scale until it out-grew them. 

From John Huber of Base Hit Investing

  1. Eridon855 says:

May 30, 2016 at 10:44 am

Is there a way to calulate return on reinvested earnings?

  • John Huber says:

May 30, 2016 at 2:57 pm

One quick and dirty way is to look at the amount of capital the business has added over a period of time, and compare that to the amount of incremental growth of earnings. Last year Walmart earned $14.7 billion of net income on roughly $125 billion debt and equity capital, or just under 12% return on capital. Not bad, but what we really want to know if we are going to buy Walmart is a) how much of their earnings will they retain and reinvest in the business going forward? and b) what will the return on that reinvested capital be?

10 years ago in fiscal 2006, Walmart earned $11.2 billion on roughly $83 billion of capital, or around 13.5%. But in the subsequent 10 years, they invested roughly $42 billion of additional debt and equity capital ($125b invested in 2016 and $83b invested in 2006), and using that incremental $42 billion they were able to grow earnings by about $3.5 billion (earnings grew from $11.2 billion in 2006 to around $14.7 billion in 2016). So in the past 10 years, Walmart has seen a rather mediocre return on the capital that it has invested during that time (roughly 8%).

We can also look at the last 10 years and see that Walmart has retained roughly 35% of its earnings to reinvest back in the business (the balance has been primarily used for buybacks and dividends). As I’ve mentioned before, a company will see its intrinsic value will compound at a rate that roughly equals the product of its ROIC and its reinvestment rate. So if Walmart can retain 35% of its capital and reinvest that capital at an 8% return, we’d expect a modest growth of intrinsic value of around 3% per year. Stockholders will see total returns higher than that because of dividends, but the value of the enterprise will likely compound at roughly that rate. And we can see that over the previous 10 years, Walmart’s stock has grown around 45% not including dividends. So unless you are banking on an increase in P/E ratios, you’re unlikely to achieve a great result buying a business that can only invest a third of its earnings at 8% returns.

This is a really rough measure, and this back of the envelope method works okay with a large, mature company like Walmart. But what you really want to know is what will the business retain going forward and what will the return be on the capital it retains and reinvests? Of course, there are different ways to measure returns (you might use operating income, net income, free cash flow, etc…) and there are many ways to measure the capital that is employed. But hopefully this is a helpful example from a general point of view.

Calculating Incremental Returns on Capital

ALSO, read and study these articles:http://basehitinvesting.com/tag/roic/

For extra study go here:

Reader’s Question

Hi John,
I love the “no hope” strategy for finding ideas. See http://csinvesting.org/2016/06/04/search-process-no-hope-dry-bulk-shipping/

I suppose there is always headline risk with things that have been in multi-year bear markets.

I am curious if you have any thoughts about political consequences of increased isolationist sentiment in the US and Europe?   Reply: Actually, the recent sell-off in the shippers this past week (June 17th, 2016) has partially been (I believe) due to Brexit.  You always want to look where sentiment is the worst and then try to determine if the price reflects the known news.   So on the one hand the rising fears over isolation give me comfort that a lot of bad news is being priced in.  Also, if the EU breaks up, why should trade go down?   Britain already sells more to the EU than it imports.   Switzerland isn’t in the EU and it has one of the strongest economies in Europe.   The EU makes no logical economic sense–how can central planning EVER work?  Nations have a natural interest to trade with each other since individuals benefit. What Trump says and can do (even if elected) are two separate issues.   I really don’t know how to handicap.   What I want is terrible news to encourage ship owners not to order new ships and to scrap the ones that they have.  

Also curious about your thoughts on the surge in low-cost vessels that came from Chinese ship makers in the last several years.   Reply:  This has been one of the reasons this shipping cycle has been the worst in forty years.   Easy credit/subsidized loans created a boom in Chinese ship builders (See May 7th, 2016 Economist issue and http://www.economist.com/news/leaders/21698240-it-question-when-not-if-real-trouble-will-hit-china-coming-debt-bust.  Now some Chinese ship builders are close to bankruptcy.   So, yes, this oversupply will make this cycle–already a long one–drag out, but who knows for how long?.

I subscribed to Trade Winds (shipping trade magazine) a couple of years ago, to keep abreast of the industry and try to find when industry sentiment started to pick up. So far, it’s still been abysmal, although this years spike in iron ore was pretty interesting. Especially because Wall Street analysts are still telling everyone iron ore is going lower and this is just a blip.  Reply: Wall Street just tells you AFTER the fact or projects the trend/obvious.    As one ship owner said (Diana Shipping) said, “The bulk shipping market will turn when no one believes it will turn.”   

Ordered the book just now. Really interested to learn more about the industry, and it’s cool that it’s in novel form. I think some of these shippers may start getting close to scrap value pretty soon.  Reply: The Shipping Man was an educational and enjoyable read.   I may even search for other book like Viking_Raid_Excerpt

Explore:

Just remember that the shipping industry has big demarcations. A company like Navigators’ Holdings (an LPG shipper) has different market dynamics than a dry-bulk shipper like Scorpio Bulkers.   One shipper operates in more of a oligopoly market than a purely competitive one though both, obviously, are cyclical.

I highly recommend the 800 page opus, Maritime Economics (3rd Edition) by Martin Stopford. If you wish to dig into the shipping industry, then read the annual reports/presentations of several shippers.   I have a ways to go to understand this market. The author: https://youtu.be/e2TToPf5iDs

Speculating in shippers is a bit like playing poker.  You don’t want the ship owners to start ordering new ships if freight rates start to rise.   You want the other owners to disbelieve a sustained rise.  When supply is constrained for a few years coupled with a spike in demand, the shipping market explodes like in 2007–no wonder a large supply of ships eventually came into the market and the boom went to bust.  The SIZE of the prior boom has led the depth of this bust.

A Reader’s Question on Modelling (Munger and Buffett’s View)

politics

A READER’S QUESTION

Just wanted to shoot you a quick email applauding you for putting together the “Ultimate Investor Checklist.”  investment_principles_and_checklists_ordway This may be the most valuable word document I have on my computer.

munger

Quick question, I’m a huge fan of Charlie Munger (currently am reading Poor Charlies Almanack)- In the checklist when he describes being a business owner Charlie says:

      • Ignores modeling forecasts for the next quarter, next year, or next ten years.
      • Ignores forecasting completely.

http://www.mymentalmodels.info/charlie-munger-reading-list/ (Search through this link on Munger’s Mental Models.

If Charlie Ignores modeling and forecasting, how does he go about estimating Intrinsic Value? I know Charlie has said in the past that he has never seen Warren Buffett use DCF, so how do they go about estimating Intrinsic Value?

John Chew: A good question.  First, a model is not reality but a metaphysical description of reality.   You probably should build a simple spread-sheet of sales, capex, taxes, etc. to understand the economic model of the business you are looking at–we are not all geniuses like Buffett or Munger.

But rather than have me say what I think Buffett would say, read the source. Note his analysis of Coke and Sees Candies:

Buffett_Lecture_Fla_Univ_Sch_of_Business_1998  Hope that helps!

Arbitrage by Buffett_Research  (just for Buffaholics)

Coal’s Sunset/The Capital Cycle; Graham Bangs the Table

millenniumforce02wide

http://csinvesting.org/2016/01/13/more-on-the-capital-cycle/ was our last discussion on the capital cycle.

Coal_Haul_Truck_at_North_Antelope_Rochelle

Now, look at these two excellent posts on Coal.

A perspective on current conditions in other markets:

The Big Long – Final Feb 28 2016 The writer promises a follow up to discuss catalysts–which, I believe, will be the change in supply and demand dynamics and the capital cycle. See article referred to here: 2_Buffett and Graham Call the 1974 Market Bottom

and for more historical and emotional perspective:

 

More on the Capital Cycle

FMQ for blog

We last left off here: follow-the-capital-cycle-as-a-contrarian

Gold and the capital cycle_2 Edward Chancellor discusses the fall-off in supply in precious metals which bodes well for FUTURE profits for miners.

The future turn in oil prices: http://www.resilience.org/stories/2016-01-12/arthur-berman-why-the-price-of-oil-must-rise

Over or mal-investment in the commodity cycle: Commodity Crash due to Monetary Supernova_Stockman

Buy disappointment and sell popularity  Don’t do this reflexively but place into context.

Peabody from hero to zero_case_resolution_fictconsulting

FCX_AR_2014 Note the increase in the rapid increase in assets before the stock price collapse. Note the research on how rapid asset growth usually precedes declines in future profitability  Robin Greenwood Investment and Ship Prices and asset_growth

Contrarian Investing (Part II)

swimming-against-tide-one-man-figure-walking-contrary-to-group-crowd-walking-wooden-figures-people-d-rendering-white-35054169

“Bull markets are born on pessimism,” he declared, they“grow on skepticism, mature on optimism, and die on euphoria.” –John Templeton

John Templeton paid attention to the emotion of the stock market. The first half of his philosophy was “The time of maximum pessimism is the best time to buy.” When everyone else was selling, he bought low during the Depression and in 1939 at the onset of World War II . . . and he made millions.

The second half of his philosophy was “the time of maximum optimism is the best time to sell.” He sold high during the Dot.com boom when everyone else was still buying. Founded in the 1950s, his Templeton Growth Fund averaged 13.8% annual returns between 1954 and 2004, consistently beating the S&P 500.

I think there are a few ways to make many times (10x to 100x +) your money over a long period of time.   The first would be to own emerging growth companies that have owner-operators who are both excellent operators and capital allocators who grow the company profitably at a high rate over decades.   The business generates high returns on capital while being able to deploy capital into further growth. Think of owning Wal-Mart in the early 1970s or Amazon after its IPO or 2001.   There will be a post on 100 to 1 baggers soon. I prefer this approach.

Wal-Mart 50 Year Chart_SRC

The second way would be to buy distressed assets and then improve those assets or create efficiencies by creating economies of scale. Carlos Slim, Mexican Billionaire, would be an example of this type of investor. Think activist investing. Note that Carlos Slim has operated at times as a monopolist in a government protected market.  Most of us do not have his options.

The third way would be to buy deeply-distressed, out of favor, cyclical assets and then resell upon the top of the next cycle. Gold mining is a difficult, boom/bust business, for example–see Barrons Gold Mining Index below. All businesses are somewhat cyclical, but commodity producers are hugely cyclical with long multi-year cycles due to the nature of mining-it takes years and high expense to reopen a mine and even if I gave you $2 billion and several years, you and your expert team may not be able to find an economic deposit. Note the five-to-ten year cycles below.

gold mining bgmi

We are focusing on the third way, but in no way do I suggest that this is for you. You need to be your own judge.  There is a big catch in this approach, you need to choose quality assets and/or companies with managements that do not over-leverage their firms during good times or overpay for acquisitions during the booms (or you could choose leveraged firms but be aware of the added risk and size accordingly becasue when a turn occurs, the leveraged firms rise the most). You also need to seek out a period of MAXIMUM pessimism which is difficult to do. How do you know that the market has FULLY discounted the bad news?  Finally, YOU must be prepared to invest with a five-to-ten year horizon while expecting declines of over 50%. That concept alone will make you unique.   Probably most will turn away from such requirements.

We pick up from http://csinvesting.org/2015/12/14/contrarian-dream-or-nightmare/.  Before we delve into the technical aspects of valuing cyclical companies, think about what it FEELS like to have the CONVICTION.  Here is an example:

We last studied Dave Iben, a global contrarian investor, in this post: http://csinvesting.org/tag/david-iben/.   You should read, Its Still Rock and Roll To Me at http://kopernikglobal.com/content/news-views and listen to the last few conference calls at the right side of the web-page.   Note Mr. Iben’s philosophy, approach, and Holdings. His portfolio is vastly different than most money managers or indexers. But being an contrarian takes fortitude and patience. Kopernik Global performance since inception:

koper spy

Next preview the readings below.

First you need to understand Austrian Business Cycle Theory to grasp how massive mal-investment occurs. Why does China have newly built ghost cities? Distortion of interest rates causes mal-investment (the boom) then the inevitable correction because the boom was not financed out of real savings.

Why is the bust so severe for mining/commodity producers?   Read Skousen’s book on the structure of production.  Think of a swing fifty feet off the ground and 200 feet long.   If you are sitting near the center of the swing’s fulcrum (nearest the consumer), then the ups and downs are much less than being on the end of the swing furthest from the consumer (the miners and commodity producers).

4 files were sent to you.
Read Ch. 19 Security Analysis.pdf
Boom/Bust Austrian business cycle theory.pdf
Damodaran Valuing Cyclical Commodity Companies.pdf
Must Read Structure-production.pdf

Sorry: here is the Hooke book (chapter 19 on resource companies)

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File Icon Business Valuation Methods – Jeffrey C. Hooke.pdf Download
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Even if you are an expert in valuation, investing in a cyclical company can be lethal: Vale: Go Where it is darkest (Damodaran)

ValeBig Vale

Then Throwing in the towel on Vale. I am not picking on Prof. Damordaran because we all make mistakes, and he graciously has provided a case study for us.  Study the posts and the comments.

Can you think of several research errors he made (BEFORE) he invested?

Remember in the prior post, the long-term chart of the CRB index showing commodities at 41-year lows since the CRB Index is below 175 or back to 1975 prices?  Then why, if gold is a commodity,  doesn’t gold trade at $200 or at least down to $500 to $700 as the gold chart from that time shows?monthly_dollar

Why, if gold is money, doesn’t gold trade in US Dollars at $15,000 or the estimated price to back US Dollars by 100% in gold?  You can change the amount to $10,000 or $20,000, but you get the idea.gold monetary base

 

Gold during the boom of 1980 rel. to Financial Assets in 1980 the price of gold at $800 per ounce allowed for the US gold holdings to back each US dollar then outstanding.

Try thinking through those questions.  Can we use what we learned from gold to value oil?

I will continue with Part III once readers have had several days to digest the readings and at least three readers try to answer at least one question.  Until then……………………….be a contrarian not contrary.

Update on 21/Dec. 2015 http://fortune.com/2015/12/21/oil-prices-low/

Avoiding the Death Zone–the Four Horsemen and the Nifty-Fifty

everest-top

Climbers say that when you are over 24,000 feet, you enter the “Death Zone. Mistakes become lethal.

The death zone is the name used by mountain climbers for high altitude where there is not enough oxygen for humans to breathe. This is usually above 8,000 metres (26,247 feet).[1] Most of the 200+ climbers who have died on Mount Everest have died in the death zone.[1] Due to the inverse relationship of air pressure to altitude, at the top of Mount Everest the average person takes in about 30% of the oxygen in the air that he or she would take in at sea level; a human used to breathing air at sea level could only be there for a few minutes before they became unconscious.[1] Most climbers have to carry oxygen bottles to be able to reach the top. Visitors become weak and have inability to think straight and struggle making decisions, especially under stress. WIKI

So what does this have to do with investing?  When you pay too much for growth or quality, you may never recover. VALUATIONS MATTER ALWAYS!

First review the Nifty-Fifty Era when fifty stocks were “must own” for institutions in the 1970s due to their growth and quality.  Money managers herded into them similar to this: Money Managers Herding Video.

valuing-growth-stocks-revisiting-the-nifty-fifty  (Note page 22, you as an investor would have eventually broke even, but almost no one would have been able to seat through the 1980’s UNDER-PERFORMING a declining stock market!

Nifty Fifty   Ignore the second half of these notes.

Now think about how the pattern repeated in the Internet years of 1996 to 2000 when MSFT and INTC were the must own stocks of their era.

MSFT Monthly

INTC monthly

Congratulations! If you bought back in 1999/2000 when the press was lauding these “must own” stock for the future, you are now in the black.

Even if you pay too much for stable, high quality companies, you can lose even as the companies grow sales, cash flows and earnings year after year after year. Note: KO_VL_Jan 2013 (See P/E ratio as a proxy for investor enthusiasm and compare to financial metrics).   What is not to like?  So why did the price go sideways for almost a decade after 1998?   Investors adjusted their expectations.

Sun MicroSystems Case Study

One thing to never forget is that the market is mostly efficient but not ALWAYS efficient or correct. 2 plus 2 equals 4 not 10.   The last Internet frenzy gives a perfect case study in Sun Microsystems (SUN).

Sun Microsystems has always intrigued me. For a number of years, it seemed as if the company could do no wrong. During the early 1990′s, Sun occupied the top position in high performance computer workstations, a category of computing that has since virtually disappeared thanks to advances in PC hardware. Despite desperate attempts to unseat it from its leadership position by worthy competitors like HP, DEC, and IBM, Sun was able to prevail.

If you had purchased Sun stock in May of 1994, you’d have seen it skyrocket to nearly 100 times its value by August of 2000, just 6 years later. Had you kept it at the historical high price of $253/share, you’d have seen your investment lose more than 98% of its value when it came back down to just $3.17 a share by October 2008.

SUNW/JAVA stock price meteoric 100x rise and fall

Sunmicro

It is easy to pull out a historical chart and say, “Look at the bubble popping.”  But note what the CEO had to say about the price of his company’s stock in 2002:

Q: Sun’s stock hit a high of $64 or adjusted in the chart above of $250. Did you think what tech stocks were doing two years ago was too good to be true?   (Date of the interview was March 2002).

A: No, she trained me well, and the stock made a nice move since we got married. But two years ago (2000) we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

Now, the same music is playing but the players have changed. 
New Four Horsemen1


New Four Horsemen

Are now driving the performance of the general stock indexes:

Fab Five

The Fab Five are “NEED TO OWN” stocks for money managers who wish to NOT underperform in the short-term.

  1. AMZN VL
  2. Goog_VL
  3. FB_VL
  4. MSFT VL
  5. GE_VL   certainly the the financial metrics, growth, and rising stocks prices make these easy “one-decision” stocks.

Let’s take AMZN because this company has a dominant position in retail that seems to be growing.

Amazon Key Stats

  • Trailing PE: 950.63
  • Forward PE:  117.65
  • Market Cap: $311.04 billion
  • Book Value: $26.50 per share
  • Share Price: $663.54
  • Price/Book: 24.27

Read more at How Amazons Long Game Yielded a Retail Juggernaut. Can’t you see many Americans becoming addicted to Amazon’s Prime service? Poor Wal-Mart and other retailers. However, IF AMZN doubles in market cap over the next 10yrs or a 7% annual return, and ends up trading at 21.9x earnings (current SPX p/e) in 2025, it needs to grow net income 55%/yr! Since 1973, 0.28% of companies have grown earnings at 55% for 10 years (Source: O’Shaughnessy). Do you like those odds?  Or are you so smart that you can tell that AMZN will win the lottery?

While valuation augur for CAUTION for stocks IN GENERAL:

GMO 7-Year 2015-11

The Bubble Right in Front of Our Faces

The True Contrarian

A MUST-READ ARTICLE:  The Nifty Fifty Becomes the Feb Five

Because when you enter the death zone you need to remember:

avalanche

Have a great weekend and Thanksgiving for those in the USA!   How is your analysis of Valeant progressing? I hear crickets.

Update: The top 10 stocks in the S&P 500 are +13.9%. The other 490 are -5.8%. Largest spread since the late 1990s. Can you hear the bells ringing?

Research on a Cyclical Business; The bubble in front of our faces

debt fueled buybacks

commodities pct below all time high

1-Incrementum-Inflation-Signal

Repeat after me: All markets are cyclical, all markets are cyclical, all markets are cyclical.

xau spx

A good example of research for a simple, cyclical business

JAC_Simple Digressions Oct 25 2015 46 cents ENERGOLD

More here: http://prostedywagacje.blogspot.com/2015/10/impact-silver-cheap-stocks-but.html

Perspective on the mining market and gold: Van Eck Joe Foster Gold-Public-Monthly-Commentary-2015-10

And be careful, The Bubble in front of our faces………http://hussmanfunds.com/wmc/wmc151116.htm

The Valeant Saga, Part III; Master Class in Deep Value Investing by Icahn

ackman

Part II on Valeant  Let’s pretend you are asked to evaluate the situation for Mr. Ackman.  He is in deep #$%^& and has brought in fresh eyes to advise him. Pershing Square has had to install two hotlines–Hotline 1: for investor suicide calls and Hotline 2: for investors who wish to phone-in death threats.

image002

All bad joking aside, you have a huge pile of information to present the critical issues.  Do you advise Mr. Ackman to buy more, sell immediately, sell down to a “more reasonable amount,” or hold?  Use reason not opinion or emotion to guide you.

Step back and ask what are the important issues?  What is Valeant worth? Can you know that?   Pretend you are an investigative journalist trying to uncover the story.

You can start here with company documents:

What does Valeant do?  Does Valeant have assets or a business method that gives the company a higher sustainable return on capital?   What roll-ups/acquisition firms have been very successful in the past and how was success achieved?

Then you can read all the rumours and commentary swirling around Valeant, but be quick to focus on what you determine to be important.  There are several links in the documents for you to follow further.

If anyone has other information to share please post in the comment section.

Also follow the links to the prior posts on Valeant to read the comment sections.

In a week, we will go through this exercise.   Now YOU have the chance to do the work.

Good luck and have a great weekend!

Excellent Video of Carl Icahn below.

http://greenbackd.com/2015/11/05/icahns-masterclass-on-deep-value-and-activism/

Valeant Case Study in Progress

wisdom

There is an ongoing battle over Valeant’s (VRX) valuation and business model between short-sellers and investors.   This opportunity allows us to improve our analysis skills and understanding of business models.  Also, how will Sequoia, an owner of over 20% of Valeant’s equity, handle their portfolio?

My first question is whether Valeant is a franchise with durable competitive advantages or a roll-up of commodity products dressed-up in a fancy industry (Pharma)?   We should use this case to learn how experienced analysts present their opposing views.

First: What’s not to like?  Valeant has rapid growth with huge profit margins? Of course, the PERFECT investment is a company that has high returns on capital and can constantly redeploy its capital at the same high returns.  The classic case would be the early (pre-2000) history of Wal-Mart (WMT) as the high returns generated from its stores could be redeployed into new stores on the borders of their regions which had economies of scale in administration, advertising, and management costs per unit of sales.  WMT did not have, for example, advantages in gross margins, but net profit margins. See WMT_50 Year SRC Chart.

What would be the source of Valeant’s high returns and competitive advantages?

Sequoia (a well-known value fund with an excellent long-term record) saw strong competitive advantages.  See their recent investor transcript:

Sequoia-Fund-Transcript-2015-August  Note the date of the transcript and the questions regarding Valeant concerning Philador and Sequoia’s 20% concentration.

Other investors (Charlie Munger, Citron) disagreed:

April 2, 2015 from www.fool.com

…..Recently, during a shareholders meeting for the Daily Journal Corporation, a newspaper where he serves as Chairman, Munger had this to say about Valeant Pharmaceuticals Intl Inc. (TSX:VRX)(NYSE:VRX): “Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time.”

What exactly does Munger mean by this?

A little history lesson

Who exactly was Harold Geneen? And what did he do at ITT that’s so infamous?

Geneen took over ITT Corp in 1959 when it was still mostly a telegraph and telephone company. After being blocked by the FCC in an attempt to buy the ABC television network in 1963, Geneen decided to diversify away from the company’s traditional business and completed more than 300 acquisitions during the decade in areas such as hotels, insurance, for-profit education, and the company that made Wonder Bread.

Geneen used cheap debt to finance these acquisitions, which later proved to be the company’s downfall. After Geneen’s retirement as CEO in 1977, subsequent CEOs spent much of the next two decades paying off the debt by selling most of Geneen’s acquisitions.

Is Valeant really comparable?

On the surface, Valeant looks like it could be pretty comparable to ITT. Since merging with Biovail in 2010, Valeant has made more than 30 different acquisitions, most of which were paid for with debt or by issuing shares.

Since the end of 2010, Valeant’s debt has skyrocketed from US$3.6 billion to US$15.3 billion. Shares outstanding have also gone up considerably from 196 million to 335 million. It’s obvious that Munger is onto something.

But on the other hand, I’m not sure Valeant is anywhere close to being as bad as ITT was. For one thing, all of the company’s acquisitions are at least in the same sector. ITT was buying up hotels and car dealerships, while Valeant is buying up pharmaceutical companies. Valeant’s efforts scale up a whole lot better than ITT’s ever did.

There’s also a bit of hypocrisy coming from Munger on this issue. Munger is actively involved in a company that does pretty much the same thing as ITT did back in the 1960s. Sure, Berkshire doesn’t use much debt or engage in hostile takeovers, but Berkshire and ITT have more in common than Munger is willing to admit. Both attempted to dominate the business world using a roll-up acquisition strategy; Buffett and Munger were just a little more patient with their plan.

But just because Munger exaggerates how bad Valeant’s acquisition spree has been doesn’t mean the stock is necessarily a buy at these levels. The company had earnings of just $2.67 per share in 2014, putting the stock at a P/E ratio of nearly 100 times. Yes, earnings are expected to grow substantially in 2015, but the outlook is simple. For the stock to continue performing, the company must continue to make acquisitions.

After making more than 30 acquisitions in just a few years, it’s hard to keep finding deals that will not only be big enough to make a difference, but will also prove to be good long-term buys. There’s so much pressure on management to keep buying that a serious misstep could be coming. If that happens, this hyped stock could head down in a hurry.

Although I don’t buy Munger’s alarmist concerns about Valeant, I agree with him on one thing. The stock just isn’t attractive at current levels.

A potential acquisition target, Allergan, Inc., points out its worries over Valeant’s business model. investor-presentation-may-27-2014-1 on VRX

Citron, a short-seller, attacks with a report: Valeant-Part-II-final-b. Valeant is another “Enron.”  Use the search box on this blog and type in Enron and follow links to review that case.  Enron never showed the profit margins that Valeant is currently showing.   NEVER take another person’s statement on faith.  Check it out for yourself. 

Valeant today (October 26th, 2015) counters Citron and answers investors’ concerns with 10-26-15-Investor-presentation-Final4 Valeant and video presentation:  http://ir.valeant.com/investor-relations/Presentations/default.aspxeep.

Ok, so what is Valeant worth?   Can you make such an assessment?  How do you think Mr. Market will weigh-in?   If you owned a 20% stake in Valeant, how would you manage the position?   What are the main issues to focus on?

This may be too difficult to analyze for many of us but we have  or will have many documents and reports to provide insights.  Remember that there are two sides to every narrative. Can we move closer to reality or the “truth”?

Note www.whalewisdom.com and type in VRX.   What type of investor owns Valeant?   Will momentum investors stick and stay?

Your comments welcome.

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