The Importance Of Capital Intensity And Thoughts From Einhorn

It seems as though there has been a recent debate on going within the value investing community pertaining to ROE, ROIC and net-nets. At one hand of the spectrum we have the argument that value investors are throwing in the towel and buying anything with a high ROE while using 20+ years discounted cash flows to support their thesis. The central argument is, there is no margin of safety if one pays more than NCAV or liquidation value. At the other end of the spectrum we hear that the most profitable way to invest over the long-term is continually buying and selling assets trading below NCAV, P/B or low P/E. I do agree that assets available below NCAV, low P/B or low P/E can be profitable but we must ask ourselves why is Mr. Market willing to offer us a business at a price that values the business higher dead than alive?

According to Buffett “the risk in buying poor businesses is that much of the bargain element of the initial purchase discount may well be dissipated by the time a catalyst comes along to unlock what appeared to be the initial excess value.”

This is because 1) the market has discounted the asset for a reason, likely because the expectation is for the business to continue to destroy value as it is capital intensive in a declining industry where business metrics are deteriorating 2) The economic value the business earns is not enough to cover the cost of the capital used to generate it and 3) The company has poor corporate governance, questionable management practices and bad capital allocation.

Take a textile manufacturer as an example. This is a very simplistic example ignoring depreciation tax saving among other things. The company is currently earning $1,000 while revenues are declining (or stagnant) at $10,000 and the NCAV is $10,000.

Cash: $8000

Accounts Receivable: $5000

Inventory: $2000

Long-Term Debt: $4000

Accounts Payable: $1000

The company is selling for $7,000 or a 30% discount from NCAV and a P/E of 7. Sounds like a good deal right? Not so fast.

We need to examine the capital needs of the business. What if the company requires $1,500 a year to remain competitive in terms of maintenance capital expenditures? Simply stated, the company needs new machines and equipment to remain productive and keep costs low or face losing market share to competitors who do. Now the company has negative $500 free cash flow a year and you get your equity in the form of machinery. Keeping all variables constant in 5 years the company will have NCAV of $7,500, cash will be $5500, sales will be $10,000 (or less) and income will be $1000 (or less).

Assuming the market revalued the company along the way (@ a 30% discount to NCAV), it will now be worth $5250. The company would experience cash burn and have to make the difference through a secondary offering, debt or both in the long-term. Is this adequate margin of safety?

So what is the point? Context matters and it is imprudent to invest blindly in anything.   

ROE and ROIC arguably don’t matter nearly as much if the company is not capital intensive. The most important variables are how long the competitive advantage will continue and the rate of growth on unit volumes. Here is what Einhorn had
to say about the matter.

“I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees…in fact, they probably wouldn’t increase at all. When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position.”

The place to find value in non-capital intensive companies is the earnings power. Think of Microsoft or another software company. The marginal cost associated with growing revenues are minimal, as the core infrastructure (the software) only requires small adjustments and tweaks overtime and costs pennies to duplicate. Each additional customer added or sold to actually costs less overall. Think if you could develop software for $100,000 total and sell each copy for $101 at a cost of $1. Once you achieve the break-even point of 1,000 customers, each additional customer sold to will only cost $1 or a hypothetical 10,000% ROE.

There are two main risks for non-capital intensive businesses, reinvestment risk and risk the competitive advantage will be lost. Do they return cash to shareholders? Do they attempt to diversify their revenue stream? More often than not the capital is squandered by investing in capital-intensive businesses after generating more cash than they know to do with. The blessing becomes the burden.

Let us circle back to Einhorn.

I believe it is very important to analyze ROE and marginal returns on capital…but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.

The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.

This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE.”

ROE can improve three ways: 1) better asset turns, 2) better margins and 3) by adding leverage. This analysis can be performed further in depth with the Dupont method. Now is there really no margin of safety in earnings power? If you and I were to agree to a deal where you lend me money ($X) for 10-years in return for $100, how much would you lend me?

I assume it wouldn’t be $100 or even $90. It would of course depend on the opportunity cost of your $100 during the next 10-years… but is everyone’s opportunity cost the same?

If I were in your situation I wouldn’t take less than $25 representing a 15% discount rate. If you were now to offer me $80 upfront for $100 in 10-years, I would take it and think of this as a margin of safety. Here is why. First the $80 represents a 2.25% discount rate or an ability to borrow at 1% less than the current prime rate. I would then invest the money during the next 10-years and collect the difference depending on the IRR.

Discount Rate Capitalization Factor Cash Flow Net Return Break Even Borrowing
6% 1.79 $143.27 $43.27 $55.84
7% 1.97 $157.37 $57.37 $50.83
8% 2.16 $172.71 $72.71 $46.32
9% 2.37 $189.39 $89.39 $42.24
10% 2.59 $207.50 $107.50 $38.55
11% 2.84 $227.15 $127.15 $35.22
12% 3.11 $248.47 $148.47 $32.20
13% 3.39 $271.57 $171.57 $29.46
14% 3.71 $296.58 $196.58 $26.97
15% 4.05 $323.64 $223.64 $24.72

Depending on my discount rate, for every $0.01 above the breakeven borrowing rate you offer me, I will be adding to my edge or margin of safety. Because the future is uncertain, and hard to predict we demand a higher margin of safety from intrinsic value and likely blend a range of values. I would rather be approximately right instead of precisely wrong.

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

This brings us to the Triple play. What is a triple play? Most baseball fans will understand the sports reference but how does it relate to investing?

There are three ways to earn an investment return.

1) Revenue growth

2) Margin or inventory turn expansion leading to higher net income

3) Multiple expansion

I like to invest in companies that I think are capable of all three to maximize my overall expected return. The point of the post is there is many different ways to build wealth each with its own risks. It is up to the individual investor’s style and personality to determine which strategy (or combination of strategies) he or she pursues.

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If I Ran A Value Investing Business School

“If I ran a business school there would be only 2 courses. How to value a business and how to think about markets. No modern portfolio theory, no beta, etc. You don’t have to be right on 4,000 or 400 businesses – not even 40. Circle of competence. Start with a small circle and slowly expand. Don’t spend time on companies that don’t lend themselves to valuation. Accounting is useful, but sometimes it is not meaningful. Durability of competitive advantage is the key. And market fluctuations. The market is there to serve you – not instruct you.”

 

The following quote lead me to think about my current education and how almost everything that is taught is a waste of time and ironically what is neglected is worth the most time examining. Luckily you can also receive a Masters degree from the Buffett-Munger Business School.

What is the curriculum of the BMBS?

Well if I was responsible for teaching the classes I would recommend a serious student of business or investing study the following:

 

(All classes, readings, case studies and videos would be mandatory)

 

1st year classes would be:

 

 

  • Introduction to Mr. Market and How to Think About Markets

–           Chapter 8 of Intelligent Investor (Mr. Market)

–           Case Study of Tech Bubble (1999), Junk Bonds (Drexel Burnham Lambert and Michael Milken 1980s), Housing (Eisman 2000s), Nifty-Fifty “Blue Chips” (1960s), Tulips (1630s), South Sea Bubble (1711-1721) Salem Witch Trials (1689-1692)

–           1929 Depression and speculation prior

–           October 1987 Flash Crash (20%+ loss in a day)

 

  • Warren Buffett

–                Snowball

–                The Essays of Warren Buffett

–                Early partnership letters

–                Berkshire Shareholder Letters

–                Warren Buffett Interviews (1, 2, 3) – Plenty others to add

–                The Super Investors from Graham and Doddsville

 

  • Ben Graham

–                Intelligent Investor

–                Security Analysis

–                The Interpretation of Financial Statements

–                An hour with Ben Graham

–                Lectures on Value Investing 

–                Two illustrative approaches to Formula Valuation of Common Stocks

 

  • Charlie Munger

–       Mental Models

–       The psychology of human misjudgment

–       Wesco Shareholder Letters

–       Seeking Wisdom from Darwin to Munger

–       Poor Charlies Almanac

 

  • Peter Lynch

We would read all Peter Lynch’s books and study Magellan Fund under his tenure. 

Learn to Earn

One Up On Wall Street

 Beat the Street.

Peter Lynch Interview

  • Balance Sheet, Income Statement and Cash Flow Statement

We would accomplish through reading 10-Ks, and the books creative cash-flow reporting, financial shenanigans and Quality of Earnings.

 

1) What does each accounting sheet/statement hold?

2) Learning the components that make up each line item

3) How each line item can be manipulated for better or worse

 

We would conclude the accounting lessons with case studies on Enron, WorldCom and Tyco as well as review Berkshire letters.

 

  • Intrinsic Value

–                NCAV

–                Discounted Cash-flow

–                Book Value

–                Margin of Safety (Ch. 20 Intelligent Investor)

–                Owners Earnings (Appendix 1986 Shareholder Letter)

 

That would conclude the first year classes for BMBS.

 

2nd year classes would be:

 

The classes would mainly be cognitive psychology, decision-making and behavior studies. The classes would be focused on writings from Kahneman and Tversky, Pavlov’s association experiment, heuristics, biases, persuasion, and other behavioral finance based experiments. Some of the required material would be:

 

Thinking Fast and Slow

Influence

Nudge

Predictably Irrational

Mind over Money (Video)

Schiller: The role of psychology  (Video)

Cognitive psychology textbook by Goldstein (Yes, I am recommending ONE textbook)

 

I would add a desire for continuous learning about heuristics, the subconscious, cognitive biases, behavioral economics and anything related to Kahneman and Tversky for the remainder of your studies.

 

A bulk of the time would be spent examining sentiment, individual investor behavior and the more important component, institutional herding. How professionals act out of line with your interests due to incentives and job security.

 

We would focus on absolute targets not relative ones, aiming for a simple 15-20%.

 

Nassim Taleb would also be introduced in the second half of the year and the ideas of the Black Swan, Antifragility, being Fooled by Randomness, the signal and the noise, statistics, decision trees and probability (Pascal and Fermat) would all be the focus in the second half of the year. Various interviews with Nassim Taleb would also be watched or conducted. [Another Here] We would conclude the year with a case study on LTCM, the perils of leverage and not knowing what you don’t know.

 

 

3rd year classes would be:

 

We would introduce the rest of the famous value investors [Gurus] and examine past holdings of the investors. We would start the year with five important books.

  1. Competition Demystified
  2. You Can Be a Stock Market Genuis
  3. Innovators Dilemma
  4.  The Most Important Thing
  5. Fooling Some of the People All of the time

 

We would then introduce Howard Marks, David Einhorn and Joel Greenblatt (although they would have briefly been introduced to the readers of their books) and assign reading of all of the Oak Tree Capital memos (1990-2013).

 

We would go on to introduce Henry Singleton, Walter Schloss, Prem Watsa, Mohnish Pabrai, Seth Klarman, Bill Ackman, Peter Cundill, Keynes, Templeton and Jim Chanos.

We would also throw in George Soros, John Paulson, Carl Icahn and Dan Loeb briefly to examine past track records and large investments that got them there. We would also talk about survivorship bias and introduce both the famous Adam Smith and John Maynard Keynes. Wealth of Nations, Essays In Persuasion and The General Theory of Employment, Interest and Money would all be required reading.

 

The Dhandho Investor and Mosaic would be recommended reading of Mohnish Pabrai as well as his interview with Boston College students and Columbia compounding presentation.

 

The bulk of the time would be focused on reverse engineering famous investments of the Guru Investors like the shorts in Allied Capital, Enron, or Lehman Brothers and the longs in General Growth Properties, Washington Post, American Express, Coca-Cola, and other large concentration holdings from the past. We would talk about investment “style” and the paradoxes of value investing between various strategies (although all have similar components).

 

Greenblatts class notes would be required reading.

 

All of the Fairfax financial annual reports and chairman letters would also be required reading.  

 

We would also examine case studies from the innovators dilemma and competition demystified with more rigor, eventually creating our own case study of a fallen angle or outdated industry. We would do a few more case studies of this nature and that would conclude our year except for a brief study of business and individual taxation policy.

 

4th Year classes would be:

 

The entire fourth year would be spent reading 10-Ks, 10-Qs, 13-Fs, 8-Ks and other filings. We would stay within our circle of competence, slowly expanding, as all knowledge is cumulative. We would conduct our own analysis and put together our own investment portfolio. We would judge others investment processes, as the classes would not last long enough to truly judge performance.

 

The days that we are not watching a pitch we would be talking in a group about how to spot durable competitive advantages and what kinds of competitive advantages there are. Durable meaning an ability to keep current market share or continually expand in the future. We would talk about the qualitative side of the business including management, the brand and the culture of the business.

 

This would be a weekly assignment for the entire year, no quizzes or finals. We would look at bonds, spin-offs, mergers and acquisitions, convertibles, other special situations and any other security within our circle of competence offering an attractive return.  

Also during the final year, studies in the history of commerce and money from 1600 till present day would also be required reading. The Ascent of Money would be the first book (or 4 hour documentary) that we would read followed by other books authored by Niall Ferguson. That would conclude your studies at the BMBS and we would recommend a continual attitude toward life long learning and as a bonus would recommend reading philosophy as well as business biographies.


“Live as if you were to die tomorrow. Learn as if you were to live forever.” 

The Buried Treasure in 13F Filings

“The person that turns over the most rocks wins the game. And that’s always been my philosophy.” – Peter Lynch

Warren Buffett has often said in numerous occasions not to be ashamed of riding “coattails” or borrowing ideas and that he has done so in the past when working at Graham-Newman Corporation in his early 20s. These coattails of famous investment managers can easily be found in 13F filings during the end of each quarter. It is very interesting to see what they have been up to, although it is never a great idea to follow anyone blindly but instead take the idea and do your own research, conducting your own opinion.

treasure-chest

A 13F is a quarterly report filed within 45 days of the end of calendar quarter (most waiting right to the exact day or last hours), by all investment managers with over 100M in (equity) assets under management. This is also required by all banks, insurance companies, pension funds, hedge funds and foundations in accordance with the SEC. Although this can be manipulated as only “long” positions have to be reported and investment vehicles are known to “fluff” the books for reporting, liquidating prior to reporting and then buying back the original positions afterwards. Another draw back is we do not have a chance to see securities that do not reach the threshold of $200,000 or 10,000 shares. Also the filing can be used in coordination with prior filings to asses changes in portfolio concentration or eliminated positions. Never the less it is something to be aware of and take into consideration when doing your research on 13F filings.

Some of my personal favourite 13F filings to look at are the following (files attached):

I follow other funds, banks, and insurance companies in particular when I am either a shareholder or interested in becoming one, increasing my scope on their holdings. Of all the filings from the period ended March 31st, 2013 the holdings that sparked interest for further research were Liberty Global Inc, Liberty Media, Elan plc, Einstein Noah Restaurant Group, Aspen Insurance Holdings Limited, Extreme Networks, Inc and Idenix Pharmaceuticals Inc.

Now you have gathered insight into where some rocks can be found, using the “smart money” as a paddle to navigate the rough waters of the stock market.