Free College Educations from the Best Teachers

Posted on May 25, 2012 | 1 comment

An educated person is one who has learned that information almost always turns out to be at best incomplete and very often false, misleading, fictitious, mendacious – just dead wrong. –Russell Baker

An education isn’t how much you have committed to memory, or even how much you know. It’s being able to differentiate between what you know and what you don’t. –Anatole France

Data is not information, information is not knowledge, knowledge is not understanding, understanding is not wisdom. –Clifford Stoll

Develop a passion for learning. If you do, you will never cease to grow. –Anthony J. D’Angelo

Free University-Level Courses from Great Teachers

http://mjperry.blogspot.com/2012/05/3-best-websites-to-get-free-college.html

1. Khan Academy

2. Coursera

3. Academic Earth

Mark Cuban on the coming revolution in education

http://blogmaverick.com/2012/05/13/the-coming-meltdown-in-college-education-why-the-economy-wont-get-better-any-time-soon/Soon

This is what I see when I think about higher education in this country today:

Remember the housing meltdown ? Tough to forget isn’t it. The formula for the housing boom and bust was simple. A lot of easy money being lent to buyers who couldn’t afford the money they were borrowing. That money was then spent on homes with the expectation that the price of the home would go up and it could easily be flipped or refinanced at a profit.  Who cares if you couldn’t afford the loan. As long as prices kept on going up, everyone was happy. And prices kept on going up. And as long as pricing kept on going up real estate agents kept on selling homes and finding money for buyers.

Until the easy money stopped.  When easy money stopped, buyers couldn’t sell. They couldn’t refinance.  First sales slowed, then prices started falling and then the housing bubble burst. Housing prices crashed. We know the rest of the story. We are still mired in the consequences.

Can someone please explain to me how what is happening in higher education is any different ?

Its far too easy to borrow money for college.  Did you know that there is more outstanding debt for student loans than there is for Auto Loans or Credit Card loans ? The point of the numbers is that getting a student loan is easy. Too easy.

—

As an employer I want the best prepared and qualified employees. I could care less if the source of their education was accredited by a bunch of old men and women who think they know what is best for the world. I want people who can do the job. I want the best and brightest. Not a piece of paper.

The competition from new forms of education is starting to appear. Particularly in the tech world. Online and physical classrooms are popping up everywhere. They respond to needs in the market. THey work with local businesses to tailor the education to corporate needs. In essence assuring those who excel that they will get a job. All for far far less money than traditional schools.

—

Update:

Let me add some clarification here based on some of the comments. I include the Online For Profit Mills that live off of the government delivering student loans as part of traditional education. Phoenix, Strayer, etc, they are not the new generation of Branded Education I am referring to. They are a big part of creating the bubble. i should have gone into more depth here. I will save it for another post.

As far as the purpose of college, I am a huge believer that you go to college to learn how to learn. However, if that goal is subverted because traditional universities, public and private, charge so much to make that happen, I believe that system will collapse and there will be better alternatives created.

Online video classrooms with lively discussions don’t need a traditional campus to teach kids how to learn. Discussion groups built around Khan Academy like classes don’t require a traditional campus to teach kids how to learn. I’ve seen better discussions and interactions on twitter than in some of the traditional classrooms I have visited. The opportunities for online interactive video classrooms is going to grow quickly and will be far more cost-effective than traditional universities. Hooray for http://academy.mises.org/ as one example.

Leave the for profit online schools that create more employment for debt collectors than their students out of the equation and we still have an enormous bubble in Higher Education that is having a horrible impact not just on the economic life of their students, but on the economy as a whole as well

The Higher Education Industry is very analogous to the Newspaper industry. By the time they realize they need to change their business model it will be too late. Higher Education’s legacy infrastructure, employee costs /structures and debt costs will keep them from being able to re calibrate to a new generation of competitors.

Saving Money

For those that want to fork over $100,000s to go to a typical university over four years, you should start saving now. This blog will help: http://mjperry.blogspot.com/2012/05/five-money-saving-websites.html

The Economy

http://blog.yardeni.com/

http://scottgrannis.blogspot.com/2012/05/slow-progress-but-not-recession-and.html

The underlying problems of Greece–a Welfare State and Rigid Wages

http://cafehayek.com/2012/05/greece-malpass-and-hayek.html

http://www.mises.org/daily/6052/The-Systemic-Siesta

1 Comment

Posted in Economics & Politics

Tagged , , , , , ,

Turning $100 to $15,000 + over 25 years

Posted on May 24, 2012 | 5 comments

Yesterday http://wp.me/p1PgpH-MW

I asked what we could do with $100 if held for 25 years. The best performing stock since 1987 is Fastenal (FAST), a nuts and bolts distributor. The high and low for FAST after its IPO in 1987 was 38 to 20 cents. FAST traded at 20 cents after the 1987 crash but let’s say we take a rough mid-point of 30 cents per share. NOT INCLUDING DIVIDENDS, you would have compounded your funds at a 22.2% rate or turned your $100 into $15,000 so far.

Look at the beautiful financials on the above compounding machine: FAST_VL and FAST_MORN. Read the President’s Letters to Shareholders: President’s Letters: http://investor.fastenal.com/letters.cfm. Read the past four letters in sequence 2008 – 2011. Are you clear about what the company does, its goals, strategies and how its management allocates capital?

What’s the point except for hindsight bias and to make us jealous. I was aware of Fastenal during the 2009 crisis but had always dismissed investing in Fastenal due to its “high” P/E multiple. Yet, during 2009, the company kept investing in its operations while the price dropped to 13xs to 14xs normalized non-growth cash flow per share. What would stop the company from growing or taking continuing market share due to its competitive advantages of scale, low-cost, and reach?  I missed this opportunity in 2009.  Investing is simple, but not easy.

Don’t YOU make the same error. Study great companies so you have an awareness of what greatness is and be ready when opportunity knocks on your door.

Lessons?

But what can you use now to help you find such companies? Buffett once said that compounding was the eighth wonder of the world.   http://www.buffettsecrets.com/compound-interest.htm

Companies that can earn high returns on capital while also redeploying capital back into their businesses while continuing to earn high rates are indeed special. Buffett said he understood the chewing gum market (Wrigley) or the soda market (Coke) better than Microsoft (MSFT).  Look for businesses doing extraordinary thing in prosaic industries where the need and demand won’t change much while the company can strengthen its competitive advantages through scale and customer captivity.

Articles on Fastenal

http://blogs.hbr.org/taylor/2012/04/to_win_big_it_helps_to_be_a_l.html

To Win Big, It Helps to Be a Little “Nuts”

Wednesday April 18, 2012 |

Here’s a simple question for all you students of business success and stock-market returns: What has been the best-performing stock in the United States since the “Black Monday” crash of 1987? If you said Apple or Microsoft or Walmart or Berkshire Hathaway, you’d get credit for a reasonable answer. But you’d be wrong. The best-performing stock in the United States over the last 25 years is a company that most of you, I’d be willing to guess, have never heard of — a company called Fastenal, based in the quiet town of Winona, Minnesota (population: 28,000), located on the banks of the Mississippi River 30 miles northwest of La Crosse, Wisconsin.

In what glamorous, high-margin, cutting-edge business has Fastenal made its mark? Not software, healthcare, or aerospace. Fastenal is the country’s dominant distributor of nuts and bolts. That’s right…If you’ve got the proverbial screw loose, if you’re a major construction company or a small contractor or individual homeowner desperate for an exotic nut or bolt to complete a job, Fastenal is where you turn.

According to a recent article in Bloomberg BusinessWeek, the company has more than 11,000 sales people in 2,600 stores along with an online catalogue that extends for 10,700 pages. It also has more than 5,500 “fully customized and automated Fastenal stores” on job sites and at customer locations — essentially, vending machines for nuts and bolts. The result of this overwhelming reach is truly overwhelming business performance. According to BusinessWeek, the company’s share price is up 38,565 percent since October 1987. Microsoft, by contrast, is up less than 10,000 percent over that same period (still not bad!), and Apple is up by 5,500 percent.

What’s the lesson to draw from Fastenal’s growth and prosperity? I suppose you could wax rhapsodic about the virtues of low-tech components in a high-tech age, and remind yourself that not every growth company is based in Silicon Valley or some other Internet hotspot. But the real lesson is more universal than that. The Fastenal story reminds all of us of the power of making big bets and staking out an “extreme” position in the market — in this case, offering a wider variety of products through more channels at a greater number of physical and virtual locations than anyone else in the business.

Fastenal has thrived because it has carved out a truly one-of-a-kind presence in its field. As its founder, Bob Kierlin, told BusinessWeek, “It was the craziest thing to ask people to invest in a company selling nuts and bolts” — especially one that aspired to sell anything to anyone virtually anywhere. But as it turns out, if you want to win big, it helps to be a little, ahem, nuts.

That’s a lesson I’ve learned over and over as I’ve studied hugely successful companies in brutally tough industries. It’s just not good anymore to be “pretty good” at everything. The most successful companies figure out how to become the most of something in their field — the most elegant, the most simple, the most exclusive, the most affordable, the most seamless global, the most intensely local. For decades, so many organizations and their leaders got comfortable with strategies and practices that kept them in the “middle of the road” — that’s, in theory, where the customers were, that’s what felt safe and secure. But today, with so much change, so much pressure, so many new ways to do just about everything, the middle of the road has become the road to nowhere.

Just to be clear, being the “most of something” doesn’t have to mean being the biggest or most dominant player in your field. It means being the most deeply committed to a one-of-a-kind strategy and a distinctive presence in a world in which most companies and their leaders are content with doing business more or less like everyone else. As Jim Hightower, the colorful Texas populist, is fond of saying, “There’s nothing in the middle of the road but yellow stripes and dead armadillos.” To which we might add companies and their leaders struggling to stand out from the crowd, even as they play by the same old rules in a crowded marketplace.

One of my favorite bankers in the world, Vernon Hill, who created the one-of-a-kind Commerce Back several decades ago (which he sold to Canada’s TD Bank for a cool $8.5 billion), and is now creating the truly unique Metro Bank in London (the first new bank launched in London in 138 years), has a simple reason for why he strives to become the most of something among banks — in his case, not the biggest, but the most colorful, the most entertaining, the most intensely focused on service and convenience. “Every great company,” he likes to say, “has redefined the business that it’s in. Even though I was trained as a banker, I don’t think like a banker. I do things that conventional bankers think are nutty.”

What goes for nutty bankers goes for retailers selling nuts and bolts. If you want to win big, you have to stand for something special — whether that’s the widest selection and most comprehensive reach, or the most focused offerings and most memorable service. There are countless ways to design the kind of unique profile and strategic presence that Fastenal has in its business and Vernon Hill has in his business. All it requires is a commitment to originality, a willingness to challenge convention and break from standard operating procedure, that remains all-too-rare in business today, precisely because it can look a little “nutty” to the powers-that-be.

If you do business the same way everyone else in your field does business, why would you expect to do any better? So ask yourself: What are you the most of in your business — and how do you become even more of that?

BusinessWeek

According to a recent article in Bloomberg BusinessWeek:

There’s no shame in not knowing the top-performing stock since the crash of ’87. It’s neither Apple (AAPL) nor Microsoft (MSFT), and deprived of the obvious candidates, most people draw a blank. That includes Bob Kierlin. When told that the answer is actually Kierlin’s own company, Winona (Minn.)-based hardware supplier Fastenal (FAST), the 72-year-old founder responds with typical Midwestern understatement: “Oh, wow. Gee. Well, thanks. That’s great news.”

Kierlin, 72, surely knows how well his stock has done: He owns 13.6 million shares, now worth almost $700 million. In the past quarter-century, Fastenal is the biggest gainer among about 400 stocks in the Russell 1000 index that have been trading for at least 25 years, surging 38,565 percent, not including dividends, according to data compiled by Bloomberg. Adjusting for splits, the stock has gone from 13¢ on Oct. 19, 1987, to $50.85. It gained 60 percent over the past year.

Fastenal edged out UnitedHealth Group (UNH), whose stock gained 37,178 percent and far outstripped Microsoft’s 9,906 percent, Apple’s 5,542 percent, and the Standard & Poor’s 500-stock index’s 506 percent. Not bad for a company that literally sells nuts and bolts. “I can understand the disbelief,” says Jonathan Chou, a vice president at mutual fund company T. Rowe Price Group (TROW), which started buying Fastenal stock many years ago and now owns a 12 percent stake in the company.

Chou attributes Fastenal’s success to its stranglehold on the fastener-supply business: There is simply no other distributor that offers so many products in so many locations. The company has 2,600 stores that serve retail and wholesale customers, while its biggest rival, W.W. Grainger (GWW), has 450. Fastenal’s 11,000-plus sales force is technically sophisticated and responsive to customers, Chou says. The company also boasts the kind of scale that allows it to buy hundreds of thousands of items at low-cost from suppliers around the globe.

Fastenal’s website lists 17 categories of fasteners spanning 10,701 pages. Click on bolts, and you’ll see 18 subcategories across 2,471 pages. The breadth of offerings is an almost insurmountable barrier to competitors. “It would be very difficult to replicate this type of product assortment,” says Chou. “The economic moat in this business grows as Fastenal grows.”

While Fastenal’s products may be mundane, companies can’t live without them. “What Fastenal stocks and sells is essential,” says Morningstar (MORN) analyst Basili Alukos. “If you don’t have enough or the right kind, your plant will shut down. Factories are willing to pay a huge convenience premium to a single distributor that can make sure their supply is safe.”

Kierlin says that the idea for a store that offered a vast variety of nuts and bolts—threaded fasteners, as they’re known in the trade—came from his childhood. His father’s auto parts shop was across the street from Winona’s main hardware store. Customers, Kierlin says, kept bouncing between the stores to order hex-cap screws, axle nuts, and cotter pins. In 1967, one year after he returned from a stint with the Peace Corps in Venezuela, that memory inspired him. “Here I’m thinking,” he recalls, “why can’t you have a store that sells everything?”

Originally he thought to sell the fasteners in cigarette pack-size boxes from vending machines placed around town. When he found that no machine could hold enough boxes, Kierlin resolved to raise money to start a conventional store. “It was the craziest thing to ask people to invest in a company selling nuts and bolts,” he says. Even so, Kierlin persuaded four high school friends to chip in a total of $30,000 to found Fastenal. “We didn’t have a lawyer,” he says. “We tried to do it on the cheap.” One of his pals vetoed Kierlin’s preferred name—Lightning Bolts.

Fastenal’s first delivery vehicle was a banged-up Cadillac Coupe de Ville that always veered to the right. The company’s first office desk was a wooden rolltop Kierlin bought for $25 from a laundry that had gone out of business. The original shop had 1,000 square feet on one floor, plus a similarly sized basement (rent was $50 a month) and was lined with kegs that each held 5,000 nuts or screws. When that store filled up, Kierlin rented seven residential garages around Winona and bought 30,000 surplus cardboard toothpaste cartons to hold hardware. “Had you visited our stores in that era,” says Kierlin, “you would have thought we were selling toothpaste rather than fasteners.”

By 1987, Fastenal had 45 stores, mostly in small and midsize towns, and the owners decided to take it public. The stock started trading in August 1987, two months before the market crashed. While the company’s shares fell about 20 percent in the rout, it made up most of that loss by the end of the year. Fastenal had 250 employees at its initial public offering and allocated 100,000 of the offering’s 1 million shares to its employees. Kierlin and his partners also earmarked proceeds to set up an educational foundation for their alma mater, Cotter High School. The company estimates that it provides about $100 million a year to Winona (population 28,000) in employee compensation and dividends paid to local shareholders.

Today, Fastenal has a market value of $15 billion. Net income grew to $358 million in 2011 from $6.4 million in 1990; revenue climbed to $2.77 billion from $52 million. It has stores in all 50 states and has also moved into Mexico, Canada, Central America, Asia, and Europe, often by setting up facilities near U.S. customers that are expanding in those markets. And it finally rolled out a version of that vending machine Kierlin dreamed up 45 years ago, pitching it as a “fully customized and automated Fastenal store within the customer’s location.” Fastenal installed nearly 5,505 of them last year.

None of this means that Fastenal’s stock will keep scorching the market. Charles Carnevale, chief investment officer of EDMP, a money manager in Lutz, Fla., calculates that Fastenal’s shares now trade at 42 times the previous 12 months’ earnings, more than double the company’s expected earnings growth of 19 percent. He also thinks Fastenal’s dividend yield of 1.3 percent is too low. “Fundamentals,” he says, “don’t compensate for the risk.”

That doesn’t bother Kierlin. He says that for all of its success, Fastenal has less than 3 percent of a $150 billion U.S. market, giving it plenty of room to boost sales. And he’s excited that demand for its vending machines is torrid. Fastenal is growing even faster overseas than it is domestically, he adds, so “the best years are still ahead.”

The bottom line: Launched with $30,000, Fastenal has grown into an industry giant with 2,600 stores and a $15 billion market value–over a 5,000 to 1 return so far.

http://investor.fastenal.com/

5 Comments

Posted in Search Strategies, Valuation Techniques

Tagged , , , , , , ,

So What Can You Do With $100?

Posted on May 23, 2012 | Leave a comment

“And right here let me say one thing:  After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this:  It never was my thinking that made the big money for me.  It always was my sitting.  Got that?  My sitting tight!  It is no trick at all to be right on the market.  You always find lots of early bulls in bull markets and early bears in bear markets.  I’ve known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit.  And their experience invariably matched mine – that is, they made no real money out of it.  Men who can both be right and sit tight are uncommon.  I found it one of the hardest things to learn.  But it is only after a stock operator has firmly grasped this that he can make big money.  It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance.”  — Jesse Livermore http://www.gold-eagle.com/gold_digest_03/hamilton110303.html

What would you say?

If I said to you RIGHT after the October Stock Market Crash of 1987 when the market fell by more than 500 points in one day: http://wiki.mises.org/wiki/Black_Monday_%281987%29 give me $100 to put into a growing company with a profitable, understandable and focused business, excellent management and prospects, but I will pay 20 times owner earnings for it, would you think about it? But what if I said, “The catch is that you must not sell a single share for 25 years or until 2013. Also, during this time there will be massive stock market booms and busts, a huge credit crisis, wars and uncertainty, There will be periods of 50% to 60% declines in the stock market.  Can you sit tight?

Stay tuned to what happened and is happening….

 

Leave a comment

Posted in Investor Psychology, Risk Management, Search Strategies

Tagged , , , , , ,

The Crisis of Interventionism and Government Spending

Posted on May 23, 2012 | 1 comment

There are two articles that pertain to our current economic crisis from two outstanding writers, Henry Hazlitt and Ludwig von Mises.

I combined both of these excellent articles for easier reading in a PDF here: Govt Spending and Deficits

What Government Spending and Deficits Will do by Henry Hazlitt

http://www.thefreemanonline.org/features/what-spending-and-deficits-do/

Henry Hazlitt, noted economist, author, editor, reviewer and columnist, is well-known to readers of the New York Times, Newsweek, The Freeman, Barron’s, Human Events and many others. Best known of his books are Economics in One Lesson, The Failure of the “New Economics,” The Foundations of Morality, and What You should Know About Inflation.

The direct cause of inflation is the issuance of an excessive amount of paper money. The most frequent cause of the issuance of too much paper money is a government budget deficit.

The majority of economists have long recognized this, but the majority of politicians have studiously ignored it. One result, in this age of inflation, is that economists have tended to put too much emphasis on the evils of deficits as such and too little emphasis on the evils of excessive government spending, whether the budget is balanced or not.

So it is desirable to begin with the question, What is the effect of government spending on the economy–even if it is wholly covered by tax revenues?

The economic effect of government spending depends on what the spending is for, compared with what the private spending it displaces would be for. To the extent that the government uses its tax-raised money to provide more urgent services for the community than the taxpayers themselves otherwise would or could have provided, the government spending is beneficial to the community. To the extent that the government provides policemen and judges to prevent or mitigate force, theft, and fraud, it protects and encourages production and welfare. The same applies, up to a certain point, to what the government pays out to provide armies and armament against foreign aggression. It applies also to the provision by city governments of sidewalks, streets, and sewers, and to the provision by States of roads, parkways, and bridges.

But government expenditure even on necessary types of service may easily become excessive. Sometimes it may be difficult to measure exactly where the point of excess begins. It is to be hoped, for example, that armies and armament may never need to be used, but it does not follow that providing them is mere waste. They are a form of insurance premium; and in this world of nuclear warfare and incendiary slogans it is not easy to say how big a premium is enough. The exigencies of politicians seeking re-election, of course, may very quickly lead to unneeded roads and other public works.

von Mises on The Crisis of Government Interventionism

http://www.mises.org/daily/6030/The-Crisis-of-Interventionism

Mises in Human Action (1949) explains how repeated failures of government interventions just bring forth more cries for intervention by government propagandists.  Massive bailouts for banks and auto companies will always be justified no matter what the outcomes.

Mises, “The interventionist policies as practiced for many decades by all governments of the capitalistic West have brought about all those effects which the economists predicted. There are wars and civil wars, ruthless oppression of the masses by clusters of self-appointed dictators, economic depressions, mass unemployment, capital consumption, famines.

However, it is not these catastrophic events which have led to the crisis of interventionism. The interventionist doctrinaires and their followers explain all these undesired consequences as the unavoidable features of capitalism. As they see it, it is precisely these disasters that clearly demonstrate the necessity of intensifying interventionism. The failures of the interventionist policies do not in the least impair the popularity of the implied doctrine. They are so interpreted as to strengthen, not to lessen, the prestige of these teachings. As a vicious economic theory cannot be simply refuted by historical experience, the interventionist propagandists have been able to go on in spite of all the havoc they have spread.”  

Sound familiar? Just read Paul Krugman’s articles: http://www.mises.org/daily/6055/Charting-Fun-with-Krugman

 

1 Comment

Posted in Economics & Politics

Tagged , , , , , , , ,

A Reader’s Question on ROIC and MROIC, Goodwill and Clean Surplus Accounting

Posted on May 22, 2012 | 7 comments

S.A. Nelson’s little book, The ABC of Stock Speculation, cites the basic opportunity for manipulation in these words: “The great mistake made by the public is paying attention to prices instead of to values.” What do we mean by paying attention to prices rather than values? Human nature is one of the few constants in an ever-changing world:  “It is only fair to say that the public rarely sees value until it is most markedly demonstrated to them, and the demonstration comes generally at a pretty high price. It is easier for them, as experience shows, to believe a stock is cheap when it is relatively dear, than to believe it is cheap when it is more than cheap.”

A Reader Asks about ROIC and MROIC (Marginal Return on Invested Capital)

I have been thinking about return on capital. My understanding is that one thing Greenblatt is trying to do come with in his Magic Formula is an incremental return on capital – that’s why he excludes things like goodwill. He’s arguing that it’s the return he can get on the assets that actually exist that’s important.

JC: True

I’ve expressed scepticism about this before, arguing that increases in earnings often come through acquisitions, and therefore goodwill was/is a true capital cost (if the company didn’t need to spend money on goodwill, then why did it?).

Well, this got me to thinking – if what you’re really trying to ascertain is a company’s incremental return on capital – then why not CALCULATE an incremental return on capital, rather than some surrogate? The formula is simple enough (and nothing new, I didn’t invent the idea):
(EPS1-EPS0)/(ASSETS1 – ASSETS0).

JC: AGREED!

There are some nuances, like whether you want to use EBIT figures or net income, adjusting for share issues, and so on. But you could use something like EBIT in the numerator, and total capital in the denominator.

What are your thoughts on this?

JC: You should look at a company both ways. What are the returns on the net tangible assets employed AND what are the incremental returns on capital employed in the business.  We only have a few more chapters in Competition Demystified and then I will begin a long series on valuation-the death march.

For now, you may get some insight here:Dale Wettlaufer on ROIC and MROIC, EconomicModel of ROIC_EVA_WACC and ROIC and the Networking Industry.

You are not the only investor to be skeptical about IGNORING GOODWILL. See page four in this article:Why bad multiples happen to good companies. Cisco (CSCO) CSCO_VL, for example, has a high ROIC–so you will find it on http://www.magicformulainvesting.com/welcome.html but much lower ROC (Return on total capital) due to many acquisitions that were acquired with goodwill. Yes, investors are laying out real dollars, so you need to track the success over time (rolling average of a few years) of those acquisitions.

Question on Clean Surplus Accounting

OK, very interesting John. I’m reading the book Book-on-Buffett-Methods-of-Clean-Surplus . I’ve only got to page 65, but I’m seeing the idea. The author uses a LOT of words to describe a very simple concept.

JC: Agreed. The author says in 230 pages what he could say in 3.

What’s very interesting is that by stuffing a lot of so-called one-off charges through the P&L, a company is able to “juice” its returns for the year, creating an artificially high ROE for subsequent years. Does it mean that clean surplus accounting paints too rosy a picture of a company? The answer is: probably not. With clean surplus accounting, all that “juicing” gets accumulated into the retained earnings of the company, so that in subsequent years, assuming the absence of further exceptional items, returns will actually come out lower. So in effect, clean surplus accounting isn’t being fooled by these non-recurring charges into over-estimating ROE.

The drawback seems to be that you have to go back into the mists of time to find out what the true retained earnings should be, and scrupulously adjust for capital issues, and suchlike. To make matters worse, you need a good set of accounts, which you can probably only get for 5 years. Sites might give you net income, but they wont give you comprehensive income – information which you need to see what’s been shifted around where.

JC: Well, once you are interested, you can always go back at least ten years with the SEC filings.  Also, watching margins, buybacks, prior use of capital allocation can give you a further clue. Also, how clean is their accounting? Track what management says vs. what they do.  You have to put together a mosaic on the company.

Also, what’s you view on goodwill? Should it be treated as a non-recurring charge?

JC: No, because some businesses like Cisco (CSCO) or Seacor (CHK) are making acquisitions as part of their ongoing operations. Better to understand the particular business rather than apply a one-size-fits all approach.

What about exceptionals that seem all-too-frequent? Would you treat them all as non-recurring, or might you assign a proportion as recurring, and a proportion as non-recurring? Maybe you could say a proportion of sales would count as non-recurring, and a proportion as recurring. Maybe you could take a proportion as recurring – say 20% – and the rest non-recurring. You could, of course, argue that over the long term, all exceptional items are recurring to a first order of approximation.

JC: I am a little lost on this question. Can you provide an actual example? In the end, you are trying to get to “normalized” earnings. What is the basic owner’s earnings (cash you can take out of the business without hurting the business in its competitive environment). Many businesses are too tough to figure out what their normalized earnings will be so you walk away. There is a reason why Buffett invests in a chewing gum company (Wrigleys) and not Microsoft. He wants to know where the business will be in ten years. People will still chew gum but will they still increase their use of Microsoft Office?  I am not implying that you not invest in Microsoft–just be ware of the risks in your assumptions.

JC: We will have a long, brutal slog in analyzing how to value growth in a few weeks. You have to know this as an investor, but the real fun is in understanding a business so you can have some confidence in your assumptions.

Thanks for the questions.

7 Comments

Posted in Accounting, Valuation Techniques

Tagged , ,

The Dark Side of a Value Investor, Prem Watsa of Fairfax Financial

Posted on May 22, 2012 | 9 comments

A reader sent me this link of a great blog on forensic accounting. There are lessons here from morality, survival instincts, to overplaying a hand, to accounting shenanigans and to my loss of yet another value  investing icon–Prem Watsa. Did he engage in a sham transaction to save his company from collapse during 2003?  See for yourself.

The Financial Investigator

http://www.thefinancialinvestigator.com/?p=702&utm_source=rss&utm_medium=rss&utm_campaign=the-miracle-on-wellington-street

The dark side of a well known value investor

Fairfax’s purchase of 4.3 million shares of Stamford, Ct.-based Odyssey Re, increasing its stake to just over 80% from 74%, was the most consequential transaction in Watsa’s career. Though few understood it at the time, the March 2003 deal allowed the then money-losing Fairfax to take advantage of a little understood maneuver called “tax consolidation,” enabling Fairfax to claim (and receive) the profitable Odyssey Re’s tax payments.

Between 2003 and 2006, these payments amounted to more than $400 million.

That cash stream helped Fairfax avoid a brutal accounting charge that might have proven its undoing and boost its share price over several months to almost $250 from a January 2003 low of $57.

Ecstatic investors and nine-figure wealth was only the half of it for Fairfax and Watsa: The company launched a furious legal campaign in 2006 against a group of short-sellers who had (in some instances) quite publicly bet on the insurer’s demise, a campaign now entering its sixth year. Though developments and rulings in the case have recently been sharply unfavorable for Fairfax, its opponents have been silenced and their short-sales unprofitably covered. (Lessons here for Short-Sellers and investors in insurance companies)

With the breathing room the cash afforded, Fairfax was able to access the capital markets, allowing it the flexibility to wager more than $340 million on credit default swaps that exploded in value as the credit crisis worsened in 2007 and 2008. The bet paid off brilliantly and Fairfax ultimately reported a $2.1 billion gain, completing a five-year metamorphosis that saw almost $6 billion added to its book value.

Fairfax is now a full fledged cult stock among value investors, and its success led at least one well-known investor to announce his switch from being short to proudly owning the shares (he has since sold the stock.)

The Odyssey Re share purchase was born in the desperation of a looming collapse.

Because of insurance losses from the September 11 attacks, the need to increase reserves and a bad acquisition, Fairfax’s auditors at PWC had concluded that an arcane tax asset then crucial to its balance sheet was going to have to be written down.

Called net operating loss carryovers (NOLs), they represent a company’s accrued operating losses that can be applied against future income to lower the company’s taxable income. Here’s how they work: a company with $500 million in taxable income and a $250 million NOL could apply it to cut the amount of taxable income in half. NOLs are certainly handy but they come with a firm proviso: they have a defined shelf life and can be used only when a company is “More likely than not” to generate the income to offset them, usually within seven years.

In other words, PWC had real doubts Fairfax could generate enough income in the future to warrant keeping the NOLs attributable to its U.S. operations. So in February 2003, the auditors informed the company that as of June 30, they were recommending half of its $795 million worth of U.S. NOLs on the balance sheet–or $348 million–be written down.

To be sure, companies large and small are constantly shifting the value of assets on their balance sheet for dozens of valid reasons.

But this was different. Did Watsa engage in a sham tax transaction?

PWC was demanding a material valuation allowance which would be accounted for as a charge against earnings. The charge would have given Fairfax their second massive annual loss in three years and prompt further share price declines–its market cap was around $1 billion at the time, and had dipped down to about $750 million that January–but where the real trouble lay was in the specter of credit downgrades, both on its corporate debt and its financial strength ratings, a key barometer of its claims paying ability. In early 2003, declining liquidity prompted Standard & Poor’s to reduce Fairfax’s credit ratings even further below investment-grade. Its insurance ratings from A.M. Best were affirmed only after the Odyssey Re deal was complete, a process Ambridge had spent weeks communicating with A.M. Best’s Joyce Sharaf about.

Thus buying the 4.3 million Odyssey Re shares that would take them to 80% ownership and tax consolidation was no longer an option, but a necessity.

There was a hitch, however, as Fairfax didn’t have the cash to spare.

To get around this, Fairfax’s Watsa and his staff, in conjunction with a Bank of America Securities team, came up with a three-step, cashless (oh no!) proposal whose final iteration was this:

1. NMS Cayman Services Ltd., an offshore affiliate of Bank of America Securities, borrowed the 4.3 million shares from 10 different institutions and then re-loaned the stock to Fairfax.

2. In lieu of cash, Fairfax issued a $78 million note to the same BAS affiliate as payment.

3. Fairfax then pledged the newly acquired Odyssey Re shares back to Bank of America Securities as collateral for the notes.

To outsiders, the Odyssey Re note deal was designed to appear like a convertible bond: It bore an interest rate and in March 2005 (two years after the transaction) was exchangeable into Odyssey Re stock, giving the holder–NMS, the Bank of America Securities affiliate–the right to swap back into the shares.

To insiders, including Bank of America’s credit analysis unit and Fairfax’s leadership, there was little doubt that the exchange would be made in two years: The Fairfax bonds carried a below-market interest rate of 3.15% and, according to then CFO Trevor Ambridge, the bonds represented “an inferior risk exposure” for Bank of America. Had Bank of America Securities held the bonds and not exchanged them back into stock, they would have been short 4.3 million, or 33% of the remaining Odyssey Re float, something the firm estimated would have taken 20 months to buy back in the open market and, quite likely, cost their trading desk tens of millions of dollars in losses.

Per Ambridge, in a July 2003 E-mail to a PWC partner, the transaction was structured to secure a block of stock for a limited amount of time for tax consolidation purposes without reducing the public “float,” or shares available for trading. He did not even want the extra 6% worth of Odyssey Re’s earnings included in Fairfax’s income statement since it was inevitable that Bank of America would exercise its exchange privilege and take the shares back in two years.

The transaction’s structure also casts doubt on whether Fairfax’s Odyssey Re maneuvers allow it to claim true ownership of the stock.

Robert Giammarco, a Bank of America Securities banker who helped design the deal, noted in an E-mail to colleagues that one of the transaction’s “disadvantages” was it “Does not provide true economic ownership” of the Odyssey Re stock to Fairfax. [Giammarco would go on to serve a 19-month term as CFO of Odyssey Re before joining Merrill Lynch prior to its purchase by Bank of America Securities in 2008. Fairfax asserted to the New York Times that he recanted his description of the deal in a 2011 deposition.]

Recall that Bank of America Securities did not sell Fairfax the securities, but borrowed the shares and then “sold” them to Fairfax for what both parties understood was to be a defined period; neither party ever exchanged cash as part of the deal because of the anticipated use of the conversion feature. Fairfax did not own them in any broadly understood sense of the word since it was not entitled to profit or loss from the 4.3 million Odyssey Re shares nor could they re-lend (or, in Wall Street parlance, re-hypothecate) them out. The company was also forbidden to sell any of the share block. Put simply, for all the deal’s complexity and hard work, the additional shares gave Fairfax no obvious economic privileges nor exposure to Odyssey Re.

Similarly, in agreeing to compensate Bank of America Securities for all of its hedging costs or losses, Fairfax was engaging in economic behavior entirely outside of market norms for a purchaser of securities. Edward Kleinbard, Third Point Management’s expert witness, noted in his opinion, “No bona fide owner of stock would agree to cover a short-sellers cost of maintaining its open short sale.”

The economic exposure argument is key since it appears there was no way Fairfax could profit from the Odyssey Re deal. If the stock price went up, Bank of America Securities would simply exercise their conversion privilege, without incurring any additional cost. On February 7, 2003, Prem Watsa wrote an E-mail to Sam Mitchell (a friend who would later become an executive with Hamblin Watsa, Fairfax’s investment subsidiary, and a board member of companies Fairfax had substantial investments in, Odyssey Re and Overstock) discussing an earlier version of the deal, noting that the “Purchaser [of the notes, i.e. seller of the stock] maintains upside/downside in ORH….”

Kleinbard terms this deal a “borrow to hold” because, in his view, its only conceivable goal was to show enough shares to convince the Internal Revenue Service to grant tax consolidation.

The one benefit that Fairfax did obtain from the Odyssey Re transaction was voting rights. Looked at plainly, however, the applicable law governing tax consolidation, IRS code 1504(a), offers the company little comfort, stating that tax consolidation applies only to companies owning 80% of the value of shares outstanding and 80% of the total voting power of those shares. At the end of the transaction, Fairfax still owned 74% of the shares outstanding and had constructed a proxy on 6.6% of the rest.

_____________________________________________________________________

The circular path to regulatory approval for the March 2003 Odyssey Re deal began with Trevor Ambridge’s assertion to Ernst & Young–hired to write an opinion of the deal–that Fairfax “Will acquire good and marketable title to the Purchase Shares, free of any mortgage, lien, charge, encumbrance or adverse or other interest.” To comply with the IRS regulations above, Ambridge also wrote that, “Members of the Fairfax Consolidated Group will own Shares [of Odyssey Re Stock] representing at least 80 percent of both the total voting power and the total value of all of the issued and outstanding shares of Odyssey Re’s stock.”

Fortunately for Ambridge and Fairfax, E&Y’s opinion was entirely based on the assumption that share ownership was a settled matter.

Richard Fung, part of the E&Y team that worked on the opinion for Fairfax, said in a deposition that much of his firm’s work was based on a so-called rep letter from management asserting exactly what Ambridge claimed above. According to Fung, E&Y never examined how Fairfax obtained the shares and, had he and his colleagues understood that the entire goal of the transaction was based on exchanging the shares back to Bank of America Securities in two years, their opinion likely would have been different.

In a footnote at the end of Kleinbard’s opinion, he discusses his examination of Fairfax’s E-mails and internal correspondence in light of their assertions before the Internal Revenue Service about the transaction.

According to Kleinbard, Fairfax broadly misrepresented the deal to the IRS.

One example cited was the company’s claim that, “Fairfax had complete risk of loss with respect to the purchased shares, and the possibility of benefiting from their long-term appreciation.”

Ambridge, in the July 2003 E-mail above, argued a very different conclusion to the PWC auditors.

Even if the Odyssey stock price drops sharply, he wrote, there is no valid economic reason for Bank of America Securities to elect to hold Fairfax’s low interest-rate, then junk-rated debt. He estimated that the Odyssey Re “break-even” share price, or the point at which it would be reasonable to hold off on the exchange and keep Fairfax’s 3.15% debt, was $13.49. Even so, Ambridge (as Kleinbard argued) the price would be likely much lower than that since a drop to that level–Odyssey was then trading at about $18–would certainly imply Fairfax was also under economic stress, making ownership of its subordinated debt an even riskier proposition than taking the stock back.

______________________________________________________________________

A casual observer would conclude that Prem Watsa and Fairfax have matters well in hand.

The ledgers run thick with black ink (with some exceptions due to spikes in catastrophe claims) and if the lawsuit against short-sellers has not proceeded seamlessly, Watsa certainly has a much better reputation among investors than fellow short-selling litigants Patrick Byrne of Overstock and Eugene Melnyk of Biovail, both of whom have poor track records of building shareholder value.

So the IRS Whistleblower suit from 2007 pressing claims about the Odyssey Re transaction more than nine years later might well look futile given the scope of Watsa’s recent achievements with Fairfax. Investors, enjoying the recent elevation of the share price, and Fairfax’s legal and media advisors, who have earned tens of millions of dollars in fees from its legal, reputational and regulatory battles, may well downplay a complaint filed in an office known for its lethargy.

But it is unlikely Prem Watsa will. After all, few executives should have a keener appreciation of how narrow the line really is between good and ill fortune and desperation and the miraculous.
______________________________________________________________________

Fairfax was approached for comment on this article via E-mail through its longtime outside public relations advisors at Sitrick & Co. They declined comment.

A few words of disclosure: I was the first reporter to write about this transaction in July 2006 and I am the financial journalist described in their suit against analysts and hedge funds. In the summer of 2011, Fairfax subpoenaed me for a deposition but I fought it and won.

—

The whole saga is an amazing case study and morality tale:

http://www.thefinancialinvestigator.com/

Lawyers, Guns and Money

I’ll send Mr. Watsa this: http://www.youtube.com/watch?v=XgyMUChgcbU&feature=related

9 Comments

Posted in Accounting, Investing Gurus, Risk Management, Valuation Techniques

Tagged , , , ,

Every Picture Tells a Story–Wall Street “Strategists” Say Sell

Posted on May 21, 2012 | 1 comment

Why didn’t they tell me a month ago?

The above is a good example of why you should buy right and hold tight.

1 Comment

Posted in Investor Psychology

Tagged

Volatility at World’s End or the Alchemy of Risk

Posted on May 21, 2012 | 3 comments

Volatility at World’s End

Deflation, Hyperinflation and the Alchemy of Risk

Artemis Capital Q12012_Volatility at World’s End

The above 18 page report will help you understand how huge debts can either cause deflation or hyperinflation. A thought-provoking read that I highly recommend.

Thoughts?

Earlier I posted on hyperinflation here:http://wp.me/p1PgpH-1h

When NO ONE accepts a fiat currency then the inflation is infinite. No amount of paper currency–even by the ton–will be used as a medium of exchange. ….Back to barter we would go until a new medium of exchange is found or used.

Current Market Situation

http://scottgrannis.blogspot.com/2012/05/eurozone-update.html

http://scottgrannis.blogspot.com/2012/05/what-tips-say-about-future.html

3 Comments

Posted in Risk Management

Tagged , , , ,

Pat Dorsey and Buffett on Moat Investing; Great Blogs

Posted on May 21, 2012 | Leave a comment

DORSEY on MOAT INVESTING

Moats: http://www.youtube.com/watch?v=ptIGzhgIE3o

  1. Customer switching costs: A customer would have to take a lot of time or money to switch like Microsoft’s Office Software.
  2. Network effect: credit cards which benefit by increasing units. Ebay.
  3. Cost advantages: A low cost producer. Process based cost advantages like Dell’s build to order are not as durable. Scale based cost advantage like UBS with a dense network of vans and shipping points.
  4. Intangible assets-brands, regulatory approvals, patents-that provide pricing power.

How management affects moats: http://www.youtube.com/watch?v=bQkcT0hSzY0&feature=relmfu

It is better to invest in a great business. Common attributes of management teams that have built or destroyed competitive advantages.  A view of businesses along the commoditization spectrum–Oil service businesses to Disney.  Management has more influence on a commoditized business. Ask whether management understands what drives the moat.

Wal-Mart’s laser-focus on low price.

Strayer Education—has a focus on educational quality. Focus on key metrics of the business.

Always widen the moat. Don’t deworsify. ADP’s bad acquisitions.

Value or Value Trap: http://www.youtube.com/watch?v=kTw7by4Z8As&feature=related

Annual report forensics: http://www.youtube.com/watch?v=_hg1MEltp58&feature=relmfu

Buffett’s Criteria for Investments

How Buffett identifies a good investment: http://www.youtube.com/watch?v=14SK4CX_KYY

Buffett says, “Throw at my head”: http://www.youtube.com/watch?v=2a9Lx9J8uSs&feature=related  What Buffett looks for in an investment–the chewing gum market. I want to know about what the economics of the business will look like in ten years.

Great Blogs

http://brooklyninvestor.blogspot.com/2011/09/directory-of-posts-on-ideas.html  A value investor who seeks the nooks and crannies of the market. Some excellent articles found here.

http://www.marketfolly.com/2012/05/notes-from-ira-sohn-conference.html

Leave a comment

Posted in Risk Management, Search Strategies, Valuation Techniques

Tagged , , , ,

Warren Buffett’s Father Tried to Teach Him about ABCT–The Panic of 1819

Posted on May 19, 2012 | 4 comments

Facebook’s shares finally went public Friday and the first trade was entered at $42.05 a share.

ABCT stands for Austrian Business Cycle Theory.

Howard Buffett’s Letter to Murray Rothbard, Austrian Economist

See the letter here:http://www.economicpolicyjournal.com/2012/05/warren-buffetts-father-tried-to-teach.html

Warren Buffett’s Father Tried to Teach Warren About Austrian Business Cycle Theory

Political philosophy

Howard Buffett is remembered for his Libertarian stance, having maintained a friendship with Murray Rothbard for a number of years.[6] He “would invariably draw ‘zero’ ratings from the Americans for Democratic Action and other leftist groups.”[7]

Buffett was a vocal critic of the Truman Doctrine and the Marshall Plan.[3] Of the Truman Doctrine, he said: “Our Christian ideals cannot be exported to other lands by dollars and guns.”[8] Buffett was also “one of the major voices in Congress opposed to the Korean adventure,”[7] and “was convinced that the United States was largely responsible for the eruption of conflict in Korea; for the rest of his life he tried unsuccessfully to get the Senate Armed Services Committee to declassify the testimony of CIA head Admiral Roscoe H. Hillenkoetter, which Buffett told [Rothbard] established American responsibility for the Korean outbreak.”[9]

Speaking on the floor of Congress, he said of military interventionism that,

“ Even if it were desirable, America is not strong enough to police the world by military force. If that attempt is made, the blessings of liberty will be replaced by coercion and tyranny at home. Our Christian ideals cannot be exported to other lands by dollars and guns. Persuasion and example are the methods taught by the Carpenter of Nazareth, and if we believe in Christianity we should try to advance our ideals by his methods. We cannot practice might and force abroad and retain freedom at home. We cannot talk world cooperation and practice power politics.[9][10] ”

In the summer of 1962, he wrote “an impassioned plea… for the abolition of the draft” in the National Review.[5] Buffett wrote:

“ When the American government conscripts a boy to go 10,000 miles to the jungles of Asia without a declaration of war by Congress (as required by the Constitution) what freedom is safe at home? Surely, profits of U.S. Steel or your private property are not more sacred than a young man’s right to life.[5] ”

In addition to non-interventionism overseas, Howard Buffett strongly supported the gold standard because he believed it would limit the ability of government to inflate the money supply and spend beyond its means.[11] His son Warren Buffett is not an advocate of the gold standard.[12][13]

Letter

Lew Rockwell has posted a fascinating letter (below) from Howard Buffett, Warren’s father, to Murray Rothbard. The letter comes from the Rothbard Archives at the Mises Institute. Note the second to last paragraph where Howard Buffet writes:

Somewhere I had read that you wrote a book on the “Panic of 1819”. If this is correct, I would like to know where I can buy a copy of it. I have a son who is a particularly avid reader of books about panics and similar phenomenon. I would like to present him with the book referred to.

Here is a link to the mentioned book, The Panic of 1819,  http://mises.org/rothbard/panic1819.pdf  A facinating read.

The Panic of 1819

In 1819 a financial panic swept across the country. The growth in trade that followed the War of 1812 came to an abrupt halt. Unemployment mounted, banks failed, mortgages were foreclosed, and agricultural prices fell by half. Investment in western lands collapsed.

The panic was frightening in its scope and impact. In New York State, property values fell from $315 million in 1818 to $256 million in 1820. In Richmond, property values fell by half. In Pennsylvania, land values plunged from $150 an acre in 1815 to $35 in 1819. In Philadelphia, 1,808 individuals were committed to debtors’ prison. In Boston, the figure was 3,500.

For the first time in American history, the problem of urban poverty commanded public attention. In New York in 1819, the Society for the Prevention of Pauperism counted 8,000 paupers out of a population of 120,000. The next year, the figure climbed to 13,000. Fifty thousand people were unemployed or irregularly employed in New York, Philadelphia, and Baltimore, and one foreign observer estimated that half a million people were jobless nationwide.

Read more: http://www.digitalhistory.uh.edu/database/article_display_printable.cfm?HHID=574

Austrian Business Cycle Theory (“ABCT”)

A seven minute video described http://www.youtube.com/watch?v=5K4Os5eXPw4

ABCT briefly explained here:http://mises.org/daily/672

And refuted here: http://econlog.econlib.org/archives/2008/01/whats_wrong_wit_6.html

Remember to always seek out ideas, thoughts and conclusions DIFFERENT from your own or the original premise that you are investigating.

Note the comment about Warren Buffett’s avid study of panics. Hint.

Enjoy your weekend

4 Comments

Posted in Economics & Politics

Tagged , ,