Phil Town

Valuation: Looking Back and Looking Forward

KYC30090 wrote a comment you can read from Oct 9th that included this thought: "Valuation is out of the book. Phil Town's method is growth and valuation which is totally thrown out of window. The method is backward looking as far as 10 years!! You can't even look back yesterday." 

I really want to address this for you guys.  I sort of suck at writing but I try to get out the ideas coherently.  What I tried to say in Rule #1 and on this blog is that you must follow the 4Ms: Meaning, Moat, Management, MOS.  All four of them. 

Part of the process is looking back ten years.  Twenty would be better.

And what are you looking for?  Coherence.  Predictability.  A solid return on the capital these guys are investing.  Low to no debt.  We want to see that this thing has a moat.  And we have to know what it is and that it's a durable moat.  And from those numbers and our expertise in this business and in this industry we can sometimes, SOMETIMES, come up with a solid value. From that we can derive a MOS price.

If You Get it Right, You Will Make Money

Especially now, guys, contrary to what KYC is suggesting, let me suggest that valuation is everything.  If you buy $10 of value and only pay $5 for it, you will make money.  I don't know when, but I know it's certain that you will make money. 

But something in what KYC says about looking backward is important: You can't drive the car by looking at the mirror.  The road ahead is different than the road behind.  The view out the front windshield of this sort of vehicle is always unclear in the short term, but should be quite clear in the long run.  It's sort of like the hood of the car is in the fog, but we can see that far down the road the fog clears and the road is there.  We might not stay on it perfectly because of the fog, but we can see we're headed in the generally right direction. 

Part of the issue of how well the car will do is how well the car is made and who is driving it.  You can know quite a lot about both of those things.  Meaning, Moat, Management.  But you can't know all.  So what to do when we're in a particularly foggy stretch?  Reduce your speed.

An Example: GOOG

In investing terms, to reduce your speed means to lower your expectations for this business for the long term.  If we've been expecting Google to grow at 22% with a 44 PE, slow down.  We're in the fog here.  Let's lower our expectations for the speed that Google can go down the road.  Take a look at the lowest growth expectations from analysts.  Look at the industry growth rate long term through good and bad time. 

I'm no expert on Goog.  When I own it I own it in my risky biz portfolio.  The most pessimistic analyst has 15%.  I'm quite sure that GOOG can grow slower than that in this mess. I'd be surprised if it grew it earnings at all.  But it has $12 billion in cash and almost no liabilities.  So let's assume it can grow long term at, say 12% and will handle a 24 PE.

What is the value then?  $280.  It's selling for $332, about 4 times its book value.  So it's not cheap if we reel our expectations in. 

Let's say we buy it somewhat below this low retail value.  Small MOS.  $250. We get 40 shares with $10,000.  And we're wrong in the short run.  The stock plummets to $200.  BUY MORE. Another $10,000.  50 shares.  And now it's at $100.  BUY MORE.  100 shares.  And finally it hits bottom at $50 and you buy another $10,000.  200 shares.  Assuming you bought $10,000 each time, you would have $40,000 in it and you own 390 shares.    Your average price was $102.

Let's assume Google survives the meltdown and comes out the other end a better company with a nice solid 12% long term growth rate and a 24 PE.  Five years down the road its earnings are nearly $30 a share; so by then your Yield is $30/$102 – about 33% per year and growing.  If you owned it all, you'd be making 33% a year on your investment in Google. 

It's turned into what Buffett calls an "Equity Bond".  But even better, the market has the stock at $600 again.  And your return is 600% in five years.  That is a compounded return of 43% per year.  And all that happened is that Google stock price melted down in a bad economy and then went back up when things straightened out.

Know Your Business

But is GOOG your bag, baby?  Or is it JNJ or Pfizer or MSFT or BNI?  What do you love?  What are you willing to dig into and learn about?   You want to be an expert on car credit deals?  Look at ACF. It's selling below book.  But know your business, gang.

Hang in there.  Today we really melted down.  We bounced off the floor from 2003.  If the low 8000's hold I'd start to consume if I were you.

I'm not, though.  The wild swings are gut wrenching.  I'm waiting and I'm gearing up to buy private companies.  It's a lot less volatile because there is no liquidity.  You think the deals look good in the public market?  You should see what we're seeing at our private equity company.  PE's are way into single digits and the businesses are rock solid.  This is going to be a very stressful but very good time if you know what you are doing.  I'd say a once-in-a-lifetime sort of time.

Stay tuned.  I'll write more about it as it unfolds.  And do you think valuation is important in buying a private company?  Duh!

Now go play.

Phil Town

Buffett and BNI

A few weeks ago, Ven left the following comment:

Phil Town,

I just read Michael Brush's article "How Buffet is Playing This Market" on MSN. He says that Buffet is investing in BNSF Railway, but according to Investools, the BNI stock is not a bargain. In fact at the present it is at 77.00, with a valuation of 73.77. Of course I know Buffet knows what he is doing, but is this a good investment for me because Warren says it is?

Thanks,
Ven

Ven asks how it is that Buffett could buy BNI in spite of its price being higher than its value. 

Well, we have to ask, what is the value of BNI?  Buffett has been buying it in the high $70s and low $80s.  Is the value really less than the price? 

Stock Splits: How They Work

Rule #1 Reminder: How do stock splits work?

Originally published 6/23/05 as a response to a Homework submitted by a reader to Phil Town.

Stock splits are the same as taking a dollar and splitting it into two fifty cent pieces.  You still have a dollar of value but it's been broken into more easily traded currency.  Stock is split so that it can be more easily bought in blocks of 100 shares by options traders, people doing covered calls and so on.  It is just an accounting process, not a real change in price.

Shortly after the stock split you will see the entire charted history of the company change to reflect the new price per share relationship.  That means that the stock chart which showed the price at $100 in June, will now show it at $50 in June.  Everything else that is calculated on a per share basis like EPS will be recalculated to reflect the new number of shares.  But the actual value of the business stayed the same.

So.  All your calculations that were done on the old EPS of $6 will be redone to reflect the new EPS of $3.  The old Sticker of $100 become $50.  The old MOS of $50 becomes $25.

Make sense?

Phil Town

Related Posts:

The Stock Split Game (Starbucks)

Answers to Your DNA Questions

Well, I’ve been doing what ever I want these last four weeks.  Pretty much ignoring the market.  I was on Maria Bartiromo’s show a while back and suggested that you mutual fund buyers get out because the big guys were heading for the door.  Hope you did it.

By the way, this is one of the great perks of Rule #1 investing: doing what you want, including hanging out in cash.  You can take time when you want.  Trust me on this: It's worth the trouble learning to invest well to be able to take time with your kids, read a novel, snowboard, fly in friends and family for the holidays.

I spent part of the holidays rehabbing an injury that I got by falling off my horse.  I took Cowboy up a hill and asked him to jump up a couple of feet over embedded railroad ties onto a flat table top landing.  A dog ran under his feet on the landing, Cowboy shied to the right, and I went spinning out of the saddle.  I did manage to stick the landing like some 18 year old gymnast, but the impact cracked my L-3.  Put me in a brace for a while.

I was feeling pretty good a couple of weeks ago and Jackson Hole was getting huge powder dumps every night, so I took off the brace, got out the snowboard and went up in the deep stuff, and it was good.  Real good.  Too good.  I got carried away, popped a small jump on the Jackson Faces, and landed with my right butt cheek on a rock that was about 8 inches under the snow.  Lit me right up, but after x-rays it was nothing a shot of morphine wouldn’t take care of.  But it's still got me limping around, so here I am at home with a sore ass and time on my hands and I just don’t have any excuses left to keep me from answering all those really good questions about Genentech (DNA).  So here we go -- answers to your comments:

Rule #1 Looks at Forbes View of America's Best Big Companies

In keeping with some sort of theme here at the beginning of 2008, I took a look at Forbes Best 400 Businesses list with a focus on the ‘honor roll’ list of the 29 best.

Usually when you read about the best picks for next year, what you don’t see is something about the value of the business.  In fairness, Forbes isn’t telling us that these businesses are on sale.  Just that they are really good businesses and have performed well in the past.  Still, since we are paying for something when we buy a stock, doesn’t it seem odd that you almost never read a discussion of what the stock is worth?

This may be a throwback to a very influential old school theory of valuation that was taught in almost all business schools for thirty years… right up until recently… and it is still defended by some real old school econ profs. 

The theory is that in a large marketplace where all the information is known about the things that are on sale, the price of the things being sold is what they are worth.  The reasoning goes that since everyone knows everything, there is no reason that anyone would pay too much or take too little.  In this perfect marketplace, price equals value. 

The marketplace that was held up as the ideal market for this theory is the stock market, and the proof that it is correct is that the professionals who manage mutual funds almost never beat the market returns over any long period of time.  The logic is that since the pros can’t beat the market, the market must be pricing things perfectly. 

Good argument if it wasn’t for one small thing: the pros ARE the market. 

They control so much stock in any given investment that the price of the stock goes down when they sell and goes up when they buy.  Also, almost all fund managers own hundreds of stocks at any one time.  If you own hundreds of stocks, you are the market.

This theory is further discomforted by the fact that individual investors like Warren Buffett, Eddie Lampert, Bill Ruane, Bill Nygren and many more like them do beat the market, and not by just a little. They slaughter the market.  $10,000 invested in the market in 1969 is now worth $134,000.  The same $10,000 with Buffett in 1969 and held to today would be now be worth $44 Million. 

That difference demands that we learn what Buffett knows.  And what Buffett knows is that when you buy a wonderful business at a great price, you are certain to make money.  This is the essence of Rule #1 style investing.

So let’s take a look Rule #1 style at what look like the best businesses in America for 2008, according to Forbes.

Phil Town-Rule #1 Look at DNA

You know that Phil Town would want you all to invest in businesses you understand.  I'm a river guide.  What I understand well is pretty much limited to burgers and Harleys, but I do like to venture into things that have a lot of potential from time to time.  And I get tips from friends.  It's the tips from friends thing that gets me sometimes.  You know, friends who are insiders someplace or at least they know people.  My kid knows her friend whose mom used to work there.  That sort of thing.  Stuff you can really trust.  Right.  But still.

So here we go on DNA -- Genentech -- which came highly recommended by friends who built a nice life by getting DNA stock before it went public and selling a bit here and there as it went up to $100.  Now it's dropped down to $70, and unless Genetech is about to hit a wall, it's looking pretty much like a very good business that is on sale.

Here's how I looked it over this morning (and I'm using Investools here, just for time's sake):

5 Stocks: A Rule #1 Analysis of Jim Jubak's Picks

One way to learn about investing your own money is to do your own analysis on investing advice from the pros.  It's kind of fun to do a Rule #1 analysis on a list of stocks that some professional has just claimed will be high return investments and find that the results of the analysis show you that the stocks are either highly speculative or way overpriced. 

And it's even more fun when you discover an occasional wonderful business that's on sale.

Jim Jubak writes a column on investing on MSN Money called Jubak's Journal.  Today (Dec. 7) he picks five stocks that should do well as the dollar falls in value against other currencies.  Let's take a look at the five and see if any of them is a great business that's on sale.

Update on WAG

Note: I wrote this on Oct. 23 (so noted because I cite a price from the 23rd below.)

Some of you have written in to ask what's going on with WAG.  Hopefully you guys are using good tools like I taught you in Rule #1.  Those tools and price strategy will have put you in WAG at $45 and out of WAG at $41.  It's now at $38.

First question: Is WAG a wonderful business to own for the future?  You have to answer that yourself, but there is no question that it has been the best run drug store business for many years.  It has a consistent growth rate at 15% for two decades, and that is unchallenged in the industry and almost without peer in the market. 

It's got issues with generic drugs cutting into profits, but that may not be that big a deal.  You need to do your homework and decide what you think because you have to know if you can price this thing. 

WAG Valuation Competition Results

Here are the results for WAG's Value as posted by the four of you who took up the challenge (if I missed anyone, my apologies):

Adolfo        $58
Doug          $42
Benjamin    $61
Frank         $39

The first thing that should jump out at us is a big WOW… that we are now able to kind of figure out the value of a business.  We might not all agree, but we're making progress.

Second, we cannot price a business unless we think it is a predictable business.  Or I should say, we won't price it.  We can price an unpredictable business but not with any kind of certainty because the current value of the business is a prediction about its future, isn’t it? 

If we don’t know what the heck the future might be, we don’t have much of an idea about its value, other than that it is probably worth something.  We don’t want to be guessing like that with our hard earned money.  We want certainty.  Fortunately, WAG has been predictable historically, so it's a good candidate for a fairly accurate valuation.

For starters, let’s set a growth rate for WAG.

War of the Worlds, Part Three - The Price is Not Always The Value

These days, no one will admit that they believe that the price of a stock is always also the value of the stock, but it wasn’t all that long ago that "PRICE = VALUE" was taught as gospel in most business schools.  And even today, in spite of the fact that the stock market drop from 2000 to 2003 proved that stocks are sometimes badly overpriced (and which also produced the implication that stocks must also sometimes be badly underpriced), books continue to be written which explain in great statistical detail why it is impossible for anyone to have better long term returns than the market itself. 

This paradigm is utter and total baloney, which is only sustained by a lot of hot air about "statistical exceptions".  These "statistical exceptions" allow the academic to "prove" that Graham, Buffett, Nygren, Ruane, Lampert and many more great investors only beat the market because in all random systems there are occasionally long streaks that appear to be caused by something when in fact they are caused by nothing.  In other words, it isn’t Buffett’s strategy that is successful – it's just random luck that had to land on somebody.

Buffett’s response to this absolute nonsense is to point out that all of the guys who are "statistical exceptions" invest with pretty much the same strategy.