Ben Graham Interview – March 6th, 1976

I came across this great article on the internet (not exactly sure where anymore as I saved the URL to a reading list) but figured I would share it anyway as I came across it tonight organizing my reading list. I have posted the first page below with a link to the full text.

AN HOUR WITH MR. GRAHAM

by Hartman L. Butler, Jr., C.F.A. La Jolla, California
March 6, 1976

lIB: Mr. Graham, I do appreciate so much being able to come and visit with you this afternoon. When Bob Milne learned that Mrs. Butler and I would be in La Jolla, he suggested that I not only visit with you but also bring along my cassette tape recorder. We have much I would like to cover. First, could we start with a topical question-Government Employees Insurance Company-with GEICO being very much in the headlines.

Graham: Yes, what happened was the team came into our office and after some negotiating, we bought half the company for $720,000. It turned out later that we were worth-the whole company–over a billion dollars in the stock market. This was a very extraordinary thing. But we were forced by the SEC to distribute the stock among our stockholders because, according to a technicality in the law, an investment fund was not allowed more than 10 percent of an insurance company. Jerry Newman and I became active in the conduct

HB: Do you think GEICO will survive?

Graham: Yes, I think it will survive. There is no basic reason why it won’t survive, but naturally I ask myself whether the company did expand much too fast without taking into account the possibilities of these big losses. It makes me shudder to think of the amounts of money they were able to lose in one year. Incredible! It is surprising how many of the large companies have managed to turn in losses of $50 million or $100 million in one year, in these last few years. Something unheard of in the old days. You have to be a genius to lose that much money.

– Full and Original PDF file 

Don’t be a Turkey for Black Swans

All to often we see history in some form used as a indicator of future outcomes, wether it be in the market using/measuring volatility or relying solely on Technical Indicators (most lagging, using past price, volume and volatility) to aid in predicting future outcomes. Other examples may be found in government legislation based on past outcomes or Supreme Court Rulings based on previous case outcomes. Stress testing business models is based on the worst past recession or depression or conceivable outcome but the risk models do not account for the future being worse or having more bleak consequences, as most times it is the case. Another great example of this is water levels tested in areas with swelling bodies during seasonal periods (rivers, streams, dams), using past water level averages not accounting for the once in a 1000 year storm that floods the entire city and is not included in the data set.

Statistical probabilities extrapolated from past data may be beneficial for guiding the captain through the form of a map, but should not be used as the ship, controlling where the researcher/captain travels.

A black swan for a turkey may not be a black swan for the butcher. The butcher routinely feeds the turkey every morning over a period of time, as each day passes the turkey grows even more trusting in the hand that feeds him and the life in which he lives. At the height of the turkeys trust (the night before slaughter) it is actually the period of time that possesses the higher risk for the turkey. All the while the butcher has been fully aware of the future outcomes of the turkeys life while the turkey became more naive and complacent. In the end the black swan event for the turkey was not a black swan for the butcher (it was a delicious meal or profit).

Using past data or outcomes to shape our judgements may be harmful if you are not aware of the biases that contribute to those interpretations of the events/data (I.e. Hindsight bias or confirmation bias) or the unknown & unknowable risk that is so often “calculated & understood.”

Remember the story of the Turkey next time you use past outcomes or data to estimate future events and outcomes, not all is how it seems or seemed.

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Used from “AntiFragile” by Nassim Taleb

EBIX – Exponential Bargain In Exodus

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Im going to skip right to the chase. Exodus by definition is a “A Mass departure of people.”

Ebix is a leading international supplier of On-Demand software and E-commerce services to the insurance industry. Ebix provides end-to-end solutions ranging from infrastructure exchanges, carrier systems, agency systems and BPO services to custom software development for all entities involved in the insurance industry. Ebix uses a growth by acquisition strategy.

“Our future growth may depend in part on acquiring other businesses in our industry.”

Fortune ranks EBIX 6th fastest growing technology company in America – 2012
Fortune ranks EBIX 4th fastest growing technology company in America & 19th fastest across all industries – 2011
Fortune ranks EBIX 3rd fastest growing company & 3rd best investment in the world – 2010

Some of the more recent acquisitions are outlined below by closing date.
June 1st, 2012 – Closing of acquisition of California-based PlanetSoft Holdings, Inc. for 35M in cash and 296,560 shares valued at 16.86 PPS.
November 15th, 2011 – Merger of Fresno, a California-based Health Connect Solutions for 18M in cash with the right to an additional 4M if revenue targets are achieved over the following two-year period.
February 7th, 2011 – The merger of Atlanta-based ADAM was closed for a fixed exchange ratio of 0.3122 Ebix shares for 1 ADAM share. ADAM is a leading provider of health information and benefits technology in the USA.

During the fiscal year 2012 Ebix continued to actively buyback shares at a rate of 983,818 shares or aggregate purchase price of 18.4M. I would continue to view buybacks as very accretive to shareholders based on a ROIC of 20% vs P/E of under 6.

The dividend is not anywhere near at risk with a payout ratio of 10.6% for 2012 funded from FCF. I continue to believe Ebix will be an amazing dividend grower over the next 5-10 years based on FCF growth and ROIC. If credit facilities become reluctant to continue to lend, or FCF is drastically reduced through lack of revenue growth (roughly 35% of Revs convert to FCF) or a higher effective tax rate, it could lead to problems for Ebix (all of which are unlikely to occur). Capital expenditures are relatively small to maintain current infrastructure with the majority of goodwill coming from past acquisitions, customer accounts and proprietary software.

Financial Health is by all means stable, with a current ratio of 1.56 and a quick ratio of 1.44. The debt to equity ratio is also fairly low at 0.18.

In fiscal year 2012 Ebix earned 1.80 dilutes EPS and is currently trading at 5.28 P/E or 18.93% earnings yield. It is not everyday you find high growth companies with above 20% 5-year avg. ROIC trading at extinction fundamentals.

2012 Revenue (199.37M) was derived from 4 segments, exchanges (159.67M), broker systems (18.61M), business process outsourcing (16.14M), and carrier systems (4.94M).

Running various sets of data, both conservative and aggressive through the DCF model (basic & more advanced) I have come to the same results of over 50% margin of safety and as high as 90%.

I have also used two assumptions when running various calculations, one being 40% tax rate on initial cash flow (competitors highest effective tax rate) and another assumption, shares outstanding diminished to 27M through the active 24 month buyback effective June 30th, 2011(Note 10 of the Annual Report). Also note incorporating an effective tax rate of 40% in the DCF allows for “double taxation” as FCF already accounts for tax, depreciation, change in working capital and CAPEX.

$EBIX – Insurance Software
40 Percent Tax Buy Back
Initial Cash Flow: $70,000,000
$42,000,000 $70,000,000
Growth Rate: 10%
10% 10%
Discount Rate: 15%
15% 15%
Shares Outstanding: 37,170,000
37,170,000 27,000,000
Present Value of All Cash Flows: $1,540,000,000
$924,000,000 $1,540,000,000
Intrinsic Value: $41.43
$24.86 $57.04

Now with the more accurate model I used 3% growth for terminal as well as 15 year growth of cash flow, assumed a cancelled buyback, incorporated all outstanding liabilities as outstanding debt, used a 13% discount rate and still came up with $15.23 IV compared to 9.52 PPS.
If I use more accurate data that is still conservative I arrive at 45.65 IV by making simple changes to share float (reduced to 27M), growth rates 5,10,15 years of 20,10,5 percent respectively & increased the Terminal rate 100BPS. Of the 45.65 IV 36% is attributed to terminal value.

$EBIX – Insurance Software
Initial Cash Flow: $70,000,000
Years: 1-5 6-10 11-15
Growth Rate: 20% 10% 5%
Terminal Growth Rate: 4% Discount Rate: 13%
Shares Outstanding: 27000000 Margin of Safety: 50%
Debt Level: $155,000,000
Year Flows Growth Value
1 84,000,000 20% $74,336,283
2 100,800,000 20% $78,941,186
3 120,960,000 20% $83,831,348
4 145,152,000 20% $89,024,440
5 174,182,400 20% $94,539,228
6 191,600,640 10% $92,029,337
7 210,760,704 10% $89,586,081
8 231,836,774 10% $87,207,689
9 255,020,452 10% $84,892,441
10 280,522,497 10% $82,638,659
11 294,548,622 5% $76,788,134
12 309,276,053 5% $71,351,806
13 324,739,856 5% $66,300,351
14 340,976,848 5% $61,606,521
15 358,025,691 5% $57,244,997
Terminal Year $372,346,718
PV of Year 1-15 Cash Flows: $1,190,318,501
Terminal Value: $661,497,746
Total PV of Cash Flows: $1,851,816,248
Number of Shares: 37,170,000
Intrinsic Value: $45.65
Margin of Safety IV: $22.83
What Percentage of IV comes from Terminal Value: 36%

On a discounted cash flow basis no matter how I slice it I can find 50-60% ROI and as high as 450% through common equity (assuming IV is reached). The pessimistic DCF growth scenario has not much to do with actual company fundamentals and was meant to show an absurd valuation discrepancy.

The prior SEC investigation yielded no accounting irregularities and no wrong doing on disclosure related complaints. Ebix should continue to ignore short sellers with shoddy research, clearly conducting bias and selective studies and bias/selective in presenting the information (obviously motivated by personal incentives). One thing that cannot be faked on the balance sheet is cash, cold hard cash, and Ebix is making plenty of it. Dividend growth, share buybacks and continued acquisitions will lead Ebix from the current irrational market valuation towards a more appropriate valuation.

A great article/response to GCR and explanation of EbixExchange IP asset sale to Ebix Singapore.

The tax implications are widely known that Ebix uses Singapore (As well as Brazil and India) as a tax strategy to reduce expenses through transfer pricing agreements. The Effective 2012 tax rate was 9.6% derived from a statutory rate of 35% decreased by 15.6% (India Tax Holiday through 2015), further decreased by 8.1% (through foreign subsidiaries, primarily Singapore), and finally 3.1% by Sweden permanent passive income exemption.

“The Company also has a relatively low-income tax rate in Singapore in which our operations are taxed at a 10% marginal tax rate as a result of concessions granted by the local Singapore Economic Development Board for the benefit of in- country intellectual property owners. The concessionary 10% income tax rate will expire after 2015,at which time our Singapore operations will be subject to the prevailing corporate tax rate in Singapore, which is currently 17%, unless the Company reaches a subsequent agreement to extend the incentive period and the then applicable concessionary rate.”

The company must pay a MAT (minimum alternative tax) rate in India of 19.94% but using the tax paid under MAT will be carried forward up to seven years against future tax liabilities. More on the tax matters under Note 9 of the 2012 10K. Essentially Ebix is able to utilize such a low global effective tax rate due to the worldwide product development operations and intellectual property being located in Singapore and India as well as having the majority of pre-tax income originate/reside there.

Because of the indefinite nature of investments in business subsidiaries intended to finance on going operations, domestic income tax expenses are not recognized to the full extent. If deferred US tax liabilities were provided because indefinite invested earnings were not indefinite, Ebix would have 71.8M of deferred U.S income taxes. As of December 31st, 2012 the company had domestic non operating losses (NOL) carry forwards of 47M of which 35M attributable to the ADAM acquisition. Portions of the NOL’s are set to expire through 2020-2027.

In regards to tax I believe the company is strategically and fiduciary responsible to minimize taxes for shareholders.

In July 2011 a class action lawsuit was filed based on derivative stock option awards, or so I presume based on the disclosure provided. IF that is all the lawsuits pertains to, I believe it will be likely settled or dismissed during the discovery phase based on 2010 Ebix Equity Incentive Plan approved by shareholders.

YEAR Diluted EPS Free Cash Flow
2002 0.08 2.5
2003 0.08 2.79
2004 0.08 2.44
2005 0.15 5
2006 0.21 3.61
2007 0.4 12.72
2008 0.76 26.21
2009 1.03 30.75
2010 1.51 51.03
2011 1.75 68.46
2012 1.8 70.33
10-Year Avg. YOY % Growth 40.88556306 55.47420128
5-Year Avg. YOY % Growth 38.17588803 45.24284245

 

I believe the hard times will pass and Ebix will continue to grow FCF at impressive clips. I am comfortable buying under $20 (recently @ 8.40 1/3 position) or 12x earnings but am trigger happy when FCF is under 6-10x in a presumable growth industry. I will continue to play with the DCF model adjusting for realized disclosures in future 10-Qs and 10-Ks. Currently I am comfortable assigning an IV of $35 with 50% margin of safety being under $17.50 and estimating 2.00+ EPS @ 13-15x P/E gives $26-30 PPS target.

7 Investment Research Rules to Know & Understand

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Following the standards below an intelligent investor will make sure he obtains a minimum of quality in terms of the earnings, assets , past performance, and the current financial position. From the Intelligent Investor by Benjamin Graham, chapter 14 examines “Stock Selection for the Defensive Investor” and summarizes some key parameters of equity valuation screens.

1) A dividend record paid consecutively for 20 years or longer.

2) No net losses in earnings over the course of a 10-year period

3) A moderate price to earnings ratio that does not exceed more than 15x average earnings for the past three year period.

4) At least an increase of 33% in earnings per share over the last 10-year period, using 3 year averages for the first three and last three years.

5) Adequate size of the company, no less than 100M in sales or 50M in assets for utilities. Another approach Graham suggests is only including top 33%+ percentile in sales size within the given industry.

6) The company should have strong financial condition. Current ratios twice that of current liabilities or a current ratio of 2:1. Also long-term debt should not exceed working capital and finally for utilities debt should not exceed two times the book value.

7) The market price should not exceed 1.5x book value and a Price to B/V ratio multiplied by the P/E should not exceed 22.5. Graham suggests 22.5 due to a 15x P/E multiplier & a 1.5x B/V ratio.

By following the parameters proposed by Benjamin Graham you will ensure you have a portfolio with an average P/E ratio of 13x or less. The result provides what graham calls a “factor of safety”  in regards to the known price that must be paid for the future earnings growth.

In this post I go through the parameters above with one variation using 25+ years of consecutive dividend payments. Initially narrowed from a field of 15 I find a few prospects worth further research, one of which was Exxon Mobile and another Aflac Inc.

25+ Year Dividend Champions at under 15x P/E

Using the parameters from this post, I was able to find 15 companies that have paid a 25+ year consecutive dividend and are priced at under 15x earnings. All companies also meet annual sales requirements.

  • ITW: Illinois Tool Works Inc with 3.1 B/V & 13.1 P/E classifies as too high a price (40.61 vs 22.5) but on a side note has a compelling ROE in relation to P/E and a 3:1 current ratio
  • PH: Parker Hannifin Corporation with 2.7 P/B & 15.2 P/E indicates still too high a price.
  • CINF: Cincinnati Financial Corporation with 15.5 P/E and 1.3 P/B would make the cut of 22.5 ( although B/V above 5-year average of 1) and no current ratio available.
  • CB: Chubb Corp has a p/e ratio of 13.7 and P/B of 1.4 slightly making the cut but with no current ratio available.
  • WMT: Walmart is priced at 3.5x P/B and 14.8 indicating it would not meet our required thresholds.
  • XOM: Exxon Mobile Corporation would just slip in with 9.2x p/e and 2.4 B/V = 22.08 but unfortunately would be cut due to the 1:1 current ratio although net current assets could easily service long-term debt. A personal hunch on first glance, liquidity may not be an issue.
  • AFL: Aflac Inc makes the cut with room to spare with 1.7 P/B and a price to earnings ratio of 9.1 but no current ratio is available.

Now try it on your own and see how many companies you can find that meet the requirements proposed HERE by Benjamin Graham.

More Dividend Champions under 15 times P/E worth analysis —-> CBSH UVV ABBV UBSI WGL CTBI WEYS NC
exxon