Valuation Case Study-American Dental Partners, Inc. (ADPI)

Posted on November 7, 2011 | 24 comments

Here is a chance to test your valuation skills.   Remember there are two ways that are theoretically sound:

  1. Discounting ALL future cash flows back to their present value using an appropriate discount rate for risk (“DCF”). A DCF may be a theoretically correct method to value a company but extremely difficult in practice.  A slight change in assumptions and your method becomes similar to using the Hubbell Telescope, you are looking at a different galaxy. Small changes in discount rates and/or cash flows change your valuation drastically.
  2. A second method is what would the business trade for in a CASH transaction between two equally informed buyer and seller. Here you have a real transaction to anchor your valuation.

Do NOT look at the price of ADPI. Go to the documents and based on the financials try to figure out what you would pay for the entire business. Support your assumptions.

I will post the answer in a few days.

For an overview of ADPI go to the Value-Line here: http://www.scribd.com/doc/71933981/ADPI-Sept-2011

View the ADPI 2010 annual report here: http://www.annualreports.com/Company/2610

If you are lost, then you can view past research reports on the company here at www.valueinvestorsclub.com. You will have to become a member but it is free. Once you login, type in ADPI in the search box for companies and two research reports will pop up. The Value Investors’ Club (“VIC”) is highly recommended as a learning tool.

Good luck! Test your skills.

ADPI_Research_Notes_Recap_-_John_Chew

 

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Central Planning at Work in China

Posted on November 6, 2011 | Leave a comment

The charade of government spending to spur economic growth:http://www.economicpolicyjournal.com/2011/11/on-chinas-bizarre-and-nutty-quest-for.html.

Can government EVER create jobs?  How about building sand castles at low tide?

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Wall Street Protests, Black Death and The Case Against the Fed

Posted on November 6, 2011 | 10 comments

Wall Street Protests

On my way home I stopped to speak to several Wall Street protestors. Many seem angry and confused over bailouts for fat cats, banks, and the corporate elite while they struggle to find work, pay off debts, and redress unfairness.  I don’t blame them for their fears and protests. Several told me that capitalism was corrupt. Socialism would work much better instead.  Oh, how people never learn from history.

First, I find it ironic that Cubans are desperate to flee in make-shift rafts across shark infested waters to leave a crumbling socialist state to reach America. Second, how can capitalism fail when we don’t have free markets in the U.S.?  Our cartelized banking system reflects corporatism. If you believe that prices matter in their ability to send signals to freely exchanging participants about how to allocate resources most efficiently and you believe that centralized planning ultimately fails (as shown by countries like Soviet Russia, North Korea, Communist China, etc.), then the Federal Reserve should be abolished.

Some of the protesters remind me of those who burned people alive at the stake to stop the bubonic plaque in the 1300s rather than fight the real cause—fleas on rats. Three minute rap video of the Bubonic Plague of 1347 (“Black Death”) http://www.youtube.com/watch?v=rZy6XilXDZQ

Question Everything

Before I provide an example of why the Federal Reserve’s debasement of the U.S. dollar is devastating to the poor and middle classes which is—I believe—the cause of the protests, I ask that you never accept what I say at face value. Seek out counter-arguments to disprove even your own most cherished beliefs.

I am not saying you should attack yourself like Jim Carrey in Liar, Liar’s bathroom scene:http://www.youtube.com/watch?v=95CiLobvTj8

Nor will disagreeing without a basis help you find the truth. http://www.youtube.com/watch?v=Dx32b5igLwA&feature=related

I will put forth an Austrian argument of the case against the Fed but here is an article on, Why I am not an Austrian Economist (a critique on Austrian principles) http://econfaculty.gmu.edu/bcaplan/capdebate.htm

A discussion of the above article both defending and attacking Austrian economic theory. http://mises.org/Community/forums/p/3841/52624.aspx

An extensive reading list: http://mises.org/Community/forums/t/762.aspx

Of course, seeking out counter arguments against your investment thesis is critical to improving your thinking process and investing. Stress test your ideas.  Be as astute in laying out the arguments against your idea as for your idea.

The Case Against the Fed

An example of the devastating effects of the Fed’s Dollar debasement on America’s poor and middle-class is excerpted from Murray Rothbard’s
The Case Against The Fed. Found here for free at: http://mises.org/books/fed.pdf  (164 pages). 

In real life, then, the very point of counterfeiting is to constitute a process, a process of transmitting new money from one pocket to another, and not the result of a magical and equi-proportionate expansion of money in everyone’s pocket simultaneously. Whether counterfeiting is in the form of making brass or plastic coins that simulate gold, or of printing paper money to look like that of the government, counterfeiting is always a process in which the counterfeiter gets the new money first.

This process was encapsulated in an old New Yorker cartoon, in which a group of counterfeiters are watching the first $10 bill emerge from their home printing press. One remarks: “Boy, is retail spending in the neighborhood in for a shot in the arm!”

And indeed it was. The first people who get the new money are the counterfeiters, which they then use to buy various goods and services. The second receivers of the new money are the retailers who sell those goods to the counterfeiters. And on and on the new money ripples out through the system, going from one pocket or till to another. As it does so, there is an immediate redistribution effect. For first the counterfeiters, then the retailers, etc., have new money and monetary income which they use to bid up goods and services, increasing their demand and raising the prices of the goods that they purchase. But as prices of goods begin to rise in response to the higher quantity of money, those who haven’t yet received the new money find the prices of the goods they buy have gone up, while their own selling prices or incomes have not risen.

In short, the early receivers of the new money in this market chain of events gain at the expense of those who receive the money toward the end of the chain, and still worse losers are the people (e.g., those on fixed incomes such as annuities, interest, or pensions) who never receive the new money at all.

Monetary inflation, then, acts as a hidden “tax” by which the early receivers expropriate (i.e., gain at the expense of) the late receivers. And of course since the very earliest receiver of the new money is the counterfeiter, the counterfeiter’s gain is the greatest. This tax is particularly insidious because it is hidden, because few people understand the processes of money and banking, and because it is all too easy to blame the rising prices, or “price inflation” caused by the monetary inflation on greedy capitalists, speculators, wild-spending consumers, or whatever social group is the easiest to denigrate.

Obviously, too, it is to the interest of the counterfeiters to distract attention from their own crucial role by denouncing any and all other groups and institutions as responsible for the price inflation. The inflation process is particularly insidious and destructive because everyone enjoys the feeling of having more money, while they generally complain about the consequences of more money, namely higher prices. But since there is an inevitable time lag between the stock of money increasing and its consequence in rising prices, and since the public has little knowledge of monetary economics, it is all too easy to fool it into placing the blame on shoulders far more visible than those of the counterfeiters.

The big error of all quantity theorists, from the British classicists to Milton Freidman, is to assume that money is only a “veil,” and that increases in the quantity of money only have influence on the price level, or on the purchasing power of the money unit. On the contrary, it is one of the notable contributions of “Austrian School” economists and their predecessors, such as the early-eighteenth-century Irish-French economist Richard Cantillon, that, in addition to this quantitative, aggregative effect, an increase in the money supply also changes the distribution of income and wealth. The ripple effect also alters the structure of relative prices, and therefore of the kinds and quantities of goods that will be produced, since the counterfeiters and other early receivers will have different preferences and spending patterns from the late receivers who are “taxed” by the earlier receivers.

Furthermore, these changes of income distribution, spending, relative prices, and production will be permanent and will not simply disappear, as the quantity theorists blithely assume, when the effects of the increase in the money supply will have worked themselves out.

In sum, the Austrian insight holds that counterfeiting will have far more unfortunate consequences for the economy than simple inflation of the price level. There will be other, and permanent, distortions of the economy away from the free market pattern that responds to consumers and property-rights holders in the free economy. This brings us to an important aspect of counterfeiting which should not be overlooked. In addition to its more narrowly economic distortion and unfortunate consequences, counterfeiting gravely cripples the moral and property rights foundation that lies at the base of any free-market economy.

Are you surprised with the government’s and banker’s lust for inflation at the expense of the poor?  Imagine if the Afghanistan and Iraq (undeclared) wars had to be paid for through sur-taxes rather than the hidden taxes of debasement? Think of the lives saved as Americans rebelled against paying for ten years of military conflict.

The status quo press and economists say here in this New York Times article:http://www.nytimes.com/2011/11/06/opinion/sunday/worldly-philosophers-wanted.html that “UNFETTERED” capitalism caused the global crisis.  With flawed thinking (logically false premises can not make an assertion true) like that is it any wonder the Fed has the cover of legitimacy?

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Good Value Investing Web-Site and Ray Dalio Interview

Posted on November 5, 2011 | 1 comment

In case you are not aware of this site:http://www.santangelsreview.com/ you are missing out.

Also, an interesting Charlie Rose interview with hedge fund manager, Ray Dalio. Note his thinking process.

http://www.charlierose.com/view/interview/11957

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Who Are You and What is Your Background?

Posted on November 4, 2011 | 4 comments

Who Am I?

Excuse this egocentric post. Several readers have asked, “Who are you and what is your experience in investing.”  I don’t believe the who is important. You have to take what is useful and prove everything asserted here to yourself.  I purposely have taken out the names of some great investors for two reasons:

  1. To protect their privacy
  2. To have you focus on the concepts and principles rather than the notoriety of the speaker.  Never cease to do your own thinking.

I wrote a parody of my investment career and how I fell into value investing when I submitted this article to www.fool.com a few years ago.

How I Became a Value Investor

In my peripatetic life I have been a ruby smuggler, commodity trader, securities analyst, investment banker, and entrepreneur. Each role taught me more about value investing.

As a ruby smuggler, I moved product to where demand was greatest. I operated in the world of supply and demand which translates into reversion to the mean for an investor. For example, I would buy rubies for x and sell them for 2x. The
market naturally brings in capital until the opportunity vanishes. I learned
not to mindlessly extrapolate current results into the future.

Commodity trading taught me that the role of the marginal buyer and seller sets
the price: “Mr. Market” at work. When bond traders at the CBOT wade into the
soybean pit because that is where the “action” is (high prices and volume),
then I saw the most anxious buyer set the highest prices. Prices often diverge
widely from value because people just can’t help themselves; they go crazy
sometimes.

Later, I found myself at an obscure securities firm writing reports and raising
money for companies. Brokers were desperate to sell stories to gullible
investors. Action and excitement ruled and incessant activity was the lifeblood
of the firm, but where were the customers’ yachts?

I was a pimp with tasseled-loafers when I sold the firm’s over-hyped
merchandise to institutional investors who rarely did their own work. In my
reports I predicted next quarters’ earnings. A fool’s game. Even if by some
miracle my guess was close to actual results, it didn’t matter if the expectations
were even higher. Ah, the danger of momentum investing.

If I ran naked onto Cramer’s Mad Money show while waving a shrunken head,
ripped the mike from his clenched fist and predicted the direction of the
market, my predictions would be just as prescient as his. Predictions are the
sound and fury of Wall Street predicting nothing. Experience taught me to focus
on business value.

There had to be a better way. I had been reading about this guy in Omaha, but
the lessons didn’t really sink in until I left Wall Street in disgust to start
several businesses. As a businessman I had to worry about hiring, firing,
generating sales and strategy. Buffett’s focus on business, competitive
analysis and management started to resonate: the right people are everything,
operational efficiency is a constant task, capital allocation is tied into
strategy and management incentives matter a lot. Businesses usually don’t fit
neatly into spread sheets or our assumptions. Becoming a rational businessman
is quite different than gazing at flashing stock prices.

Rationality and knowledge will eventually triumph over fear, euphoria and
emotionalism. Try going into your local store and offering the owner half the
cash in his till, then tell him to get out because you own the business now.
Crazy? Mr. Market offered some Internet companies at half their cash value in
2002/2003. That is what I call a margin of safety!

Once a value investor, you never go back.

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Answering A Reader’s Question on Buffett’s View of Catastrophic Risk

Posted on November 4, 2011 | 2 comments

Back to work………..

A Reader Asks about Buffett’s Analysis of Mid-Continental Tabulating Company

A reader asks an intelligent question on the Mid-Continent Tabulating Company case study found here at:

http://csinvesting.org/2011/09/17/buffett-investment-filters-and-cs-on-mid-continent-tabulating-company/

Reader: I’ve read this case study several times before, but I am not sure I fully grasp Schroeder’s point. I would like to compare notes with you.

Schroeder identifies 3 key steps in WEB’s investment process:

  • The first filter is catastrophic risk
  • The second is identification of the 1-2 factors that will determine the success of the investment
  • The third is whether the company can hit his hurdle rate, 15% on $2M of sales.

Do you agree with me thus far?   John Chew: Yes.

Reader: If so, step #1 makes perfect sense.

John Chew: Buffett, instead of looking at the attractiveness of the investment and then asking what could go wrong, begins with catastrophic risk as his first filter. Buffett initially saw start-up risk so he immediately passed.

Reader: I don’t fully understand step #2. Are we to assume that this company had a big cost advantage over its competitors? And WEB identified this cost advantage as the biggest factor in determining the success or failure of his investment? Why would this company have a big cost advantage? Presumably all market entrants are using the same Carroll Press. Was it the lower shipping costs because they were located in the Midwest and only serving customers in that region? If so, why didn’t WEB identify pricing power as the key factor? Wasn’t WEB concerned that other would see their 100% ROIC and rush into the business? What were the barriers to entry?

John Chew: I believe the company had regional economies of scale within a specific geographic region thus their cost structure including speed of service could be lower than other producers outside their area.  Of course, high profit margins attract competition like bears on honey. Perhaps entrants would not see enough of a market to bother going into the mid-West or the cost to take market share was too onerous.  We don’t have enough information like market share within the region or costs for shipping, but I am taking Schroeder’s words on faith.  I presume from the fact that IBM had to divest the business and that the market may not have been large, these entrepreneurs had sizeable market share within their region. Thus, potential entrants may have seen taking market share away as too costly.

Reader: I’m also confused about #3. I think she is saying that he flips around a conventional DCF and looks at yield. This is not novel as WEB has talked many times about the “equity bond” concept. But why 15% on $2M of sales? Where does the $2M come from? Does WEB think that if this start-up can get to $2M in sales it has “made it?” That is, it has reached a comfortable level of substantiality? Beyond this why is he concerned with 15% net income on $2M of sales? I would think he would be more concerned with a 15% ROIC.

John Chew: I believe Ms. Schroeder says that with the business’ 70% historical growth rate and 36% to 40% net profit, Buffett could receive 15% or better return on his capital with a considerable margin of safety because net profit margins were more than double his targeted return and sales would reach $2 million within 18 months of his investment at a 70% annual compounded growth rate if current trends continue. I, on the other hand, would be concerned about reaching market saturation quickly–so the growth rate could be very rapid then decline even faster as the regional market is filled.

In addition, Buffett wouldn’t have to worry about what management would do with the excess cash flow since the business was self-financing and any excess cash could presumably be paid out to him.

Reader: Am I over thinking this and the key lesson learned is simply that WEB doesn’t model future earnings?

John Chew: Yes. Buffett doesn’t do DCFs or project future earnings.  He looks at the history of the business and sees whether he has enough of a margin of safety in terms of returns on capital and competitive advantage to exceed his 15% hurdle rate. Here he had huge growth and profits margins–enough to drive a truck through–that his margin of error was great.  Once the catastrophic risk was eliminated (a start-up competing against IBM), he saw how profitable this investment was.

Buffett invested $60,000 at the time–20% of his net worth–for 16% of the company. If Mid-Continental just continued to its 70% growth at 36% to 40% net profit margins, then his investment would be worth approximately $98,000 within a year for a 64% annual return ((($1 million x 1.70%) x 36% profit margin)) x 16% ownership share). He looked at historical data and he had this generic return that he wants on everything. It was a very easy decision for him. He relied totally on historical figures with no projections.

If you would like to ask Alice Shroeder to clarify further go here: http://www.aliceschroeder.com/ and ask.

Thanks for your questions.

Excerpt on Mid-Continent Tabulating Company

So when Wayne Ace and Warren Cleary who were two friends of Warren’s saw that IBM was going to have to divest in this business, and they thought, “We are going to buy a Carroll Press which was a press that makes these cards. And we are going to compete with IBM because we are based in the Mid West, we can ship faster. We can provide better service. And they went to Warren and they said, “Should we invest in this company and would you come in with us? And Warren said, “No.”

Well, why did he say no? He didn’t say no because it was a technology company. He said no because he went through the first step in his investing process. This is where I think what he does is very automatic but it isn’t well understood. He acted like a horse handicapper. The first stop in Warren’s investing process is always to say, “What are the odds that this business could be subject to any type of catastrophe risk—that could make it (the business) fail? And if there is any chance that any significant part of his capital would be subject
to catastrophe risk, he just stops thinking. NO. He just won’t go there.

It is backwards the way most people think because most people find an interesting idea and figure out the math, they look at the financials, they do a project and then at the end, the ask, “What could go wrong?”

Warren starts with what could go wrong and here he thought that a start-up business competing with IBM can fail. Nope, pass, sorry.  And he didn’t think anymore about it.  But Wayne and Cleary went ahead anyway and
within a year they were printing 35 million tab cards a month. At that point,
they knew they had to buy more Carroll Presses so they came back to Warren
and said, we need money—would you like to come in?

So now, Warren is interested because the catastrophe risk is gone.  They are competing successfully against IBM. So he asks them the numbers, and they explain to him that they are turning their capital over 7 times a year. A Carroll Press costs $78,000 dollars and every time they run a set of cards through and turn their capital over, they are making over $11,000.  So basically their gross profit on a press (7 x $11,000 = $77,000) is enough to buy another printing press. At this point Warren is very interested because their net profit margins are 40%. It is one of the most profitable businesses he has ever had the opportunity to invest in.

Notably people are now bringing Warren special deals to invest in—it is 1959. He has been in business for 2.5 years running the partnership. Why are they doing that? It is not because he is a great stock picker. They don’t know that. He hasn’t yet made that record.   It is because he knows so much about business, and he started so early he has a lot of money. So this is something interesting about Warren Buffett—people were bringing him special deals like they are today with Goldman Sachs and GE.

He decided to come in and invest in the Mid-Continent Tab Company but, interestingly, he did not take Wayne and John’s word for it because the numbers they gave him were very enticing. But, again, he went through, and he acted like a horse handicapper.

Now here is another point of departure. Everyone that I know or knew as an analyst would have created a model for this company and
projected out its earnings or looked at its return on investment in the future.

Warren didn’t do that. In going through hundreds of his files, I never saw anything that looked like a model. What he did is he did what you would do with a horse….he figured out the one or two factors that determined the success of the investment. In this case, it was the cost advantage that had to continue for the investment to work. And then he took all the historical data, quarter by quarter for every single plant and he obtained similar information as best he could from every competitor they had, and he filled several pages with little hen scratches with all this information and then he studied that information.

Then he made a yes/no decision. He looked at—they were getting 36% margins, they were growing over 70% a year on a $1 million of sales—so those were the historical numbers. He looked at them in great detail like a horse handicapper would studying the races and then he said to himself, “I want a 15% return on $2 million of sales and said, Yes, I can get that.” Then he came in as an investor.

OK, what he did was he incorporated his whole earnings model and compounding (discounted cash flow or DCF) into that one sentence.  He wanted 15% on $2 million of sales (a doubling from $1 million current sales). Why does he choose 15%? Warren is not greedy, he always wants 15% day one return on investment, and then it compounds from there. That is all he has ever wanted and he is happy with that.  …You are not laughing, what’s wrong? (Laughs)

It is a very simple thing, nothing fancy about it. And
that is another important lesson because he is a very simple guy. He
doesn’t do any DCF models or any thing like that. He has said for decades, “I want a 15% day one return on my capital and I want it to grow from there-ta da! The $2 million of sales was pretty simple too. It had a million in sales already and it was growing at 70% so there was a big margin of safety built into those
numbers.

It had a 36% profit margin—he said I would take half that or 18%. And he ended up putting in $60,000 of his personal, non-partnership money which was 20% of his net worth at that time. He got 16% of the company’s stock plus some subordinated notes.   And the way he thought about it was really simple. It was a one step decision. He looked at historical data and he had this generic return that he wants on everything. It was a very easy decision for him. He relied totally on historical figures with no projections.

I think that is a really interesting way to look at it because I saw him do it over and over again in different investments.

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More Video Lectures….

Posted on November 2, 2011 | 4 comments

to be sent to all who wish to view privately. However, I must first post the supporting case studies in the next few weeks with solutions before I send out the videos or else you won´t have the maximum benefit.

Many readers have been gracious in their praise of the videos. Thanks, but I never found just viewing them to be as good a learning tool as trying to value the companies mentioned myself. Then I would go back and listen again and again.

Perhaps viewers gain an emotional boost watching Great Investors discuss their craft?

The additional videos should be available (another 5) before Thanksgiving.   Ever think of how the life cycle of a turkey is similar to the chart of Enron?  The turkey´s growth rises until that final day-then it’s over.

Thanks for your patience. To tide you over, you can view other investors discussing their methods at the Ben Graham Center (Ivey Business School in Canada): http://www.bengrahaminvesting.ca/Resources/audio.htm

Another great resource.

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Placing a Greek Default into Perspective

Posted on November 1, 2011 | Leave a comment

Terror strikes two days in a row over Greece’s potential default and political puppet show.  I recommend a read of http://scottgrannis.blogspot.com/

This blog is written by a former economist for Western Asset Management. I don’t always agree with his conclusions, but he does pull together many statistics into readable charts. Scan his  recommended  blogs on the left. You need to place his information into your understanding of economic theory.  Note the post on money supply growth!   Don’t be surprised by faster NOMINAL economic growth. Scroll down for his article on Greece.

Greece’s economy is too small at $300 million to be of consequence but it does force the market to realize that no solution will occur until ALL western governments abandon their welfare states. Governments have outgrown their economy’s ability to support them. The parasite has outgrown its host. Government spending is suffocating economic vitality.   In the end, the markets are helping us face reality and that can’t be a bad thing after all.

Volatility is Your Friend

I hope readers could cherry pick and buy a few shares of quality companies during these times of panic.  A trick I learned is to place orders at silly prices, good til cancelled, below the market of companies that you would love to own at that price.  Place the orders while the market is closed and you are calm then be patient. You never know on days like today what fish you will hook.

Day of the Dead

Down here Mexico way watching the Day of the Dead. Mexican families bring food, drink and have a party on their loved ones’ graves. Rockin on Granny´s grave!  I´m told this day has religious significance, but the Mexicans make a fiesta of the occasion. Creepy or a celebration of death or a way to deal with your own impending passing.  I leave it for you to decide.

Pass the Mezcal please…………….

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Attribution, Sharing and the Education Bubble

Posted on October 31, 2011 | 3 comments

I am off the beaten track down in Mexico but occasionally I reach an Internet Cafe with dial up. Who cares if it takes a week to download a file?   Upon return I will post more case studies and supporting material  for additional video lectures. Then, if you wish, I will send you other video lectures.

Housekeeping

Just a housekeeping matter: a reader alerted me that www.valuewalk.com posted some of the lectures on this blog without attribution. Anyone can share and post these lectures, make critiques, and discuss the material here or on their own site with or without attribution. I believe in the creative commons approach to information. Many great investors helped me and if I can share my material as a way to give back then great. Please feel free to share the lectures with anyone. The videos are the exception for privacy reasons.

Education Bubble

The other goal of this blog is to learn how to become the best investor you can be.  You do not have to go to a fancy MBA program, obtain a Chartered Financial Analyst certification (¨CFA¨) or have gone to Harvard to become a good investor.   You do have to study the right principles, keep diligently applying those principles through your own circle of competence and the opportunities in front of you or in the future, don´t firtter away your time (listening to the pundits on CNBC for investing ideas might qualify) and track of your progress.

Acquiring knowledge is important but there are many ways to learn. The article below describes the bubble in traditional education: http://lewrockwell.com/bonner/bonner515.html

An excerpt:

A zoo economy keeps the old animals alive as long as possible.

Let’s look at education. Now, there’s an industry – we can all agree – that adds value. You could look at it as a charitable activity. Or as a profit-making business. Either way, education has to be a plus for the individual and for the society, right?

Wrong on both points. Education is only a benefit when freely floating prices are allowed to determine what it is worth. First, let us look at the whole industry…..

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Bill Miller, Uber Genius or Empty Suit?

Posted on October 28, 2011 | 1 comment

Here is another blog, Prudent Speculation, you should bookmark. The writer is a savage critic of conventional wisdom, politics, and Wall Street.

In the link below, he rips Bill Miller.  This is another lesson on how the financial press operates and the marketing of institutional money managers. Oh how nothing ever changes on Wall Street–just the players.

http://prudent-speculation.blogspot.com/2011/10/wall-st-uber-genius-bill-miller.html

What do YOU think?

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