July 16th, 2014 | Josh Sauer
“To succeed in business, you have to have a genuine interest in profitability. And most people don’t.”
I’ve heard it said that water flows uphill toward money, but I’ll spare you a lecture on hydrogen bonding and cut straight to the point: There’s money in water.
A former professor once told me a story about perception:
He was pumping gas on a hot summer day when a car pulled up to the pump adjacent him. A man got out of the car and proceeded to look up at the gas station price board. A face of disbelief accompanied a slew of words inadmissible to the scores of young children who will undoubtedly read this post one day. Mumbling curses at OPEC, George Bush, and those “damn commies,” the man made his way back to my professor where he proceeded to tell him that prices were getting out-of-hand and they were crazy for paying them(or something along those lines).
Eventually, the man went back to his pump and proceeded to fill up his vehicle. He was ready to leave, but not before going into the gas station and purchasing a bottle of water.
Seemingly innocuous, right? Oh the irony.
What’s crazy now?
How about this:
Earlier in this post I said that “There’s money in water. ”
Perhaps a more apt phrase would be “There’s margins in water.”
In addition to high margins, it seems that America’s thirst for bottled water cannot be quenched:
While domestic growth remains steady, Global consumption of bottled water is growing at an incredible 10% a year.
So what’s the take away from this post?
Invest in a liquid asset? Nope!
- Consumers have different degrees of price sensitivity. Companies can maximize profits by identifying these opportunities and offering high margin products at opportune times.
- Buy a good filter and use it!
July 2nd, 2014 | Josh Sauer
The balance sheet is the second statement examined in the book, “Warren Buffet and the interpretation of Financial Statements. Click here, to review Mr. Buffet thoughts on the Income Statement.
The Balance Sheet
Cash and Equivalents:
A high number means either:
1) The company has competitive advantage generating lots of cash
2) Just sold a business or bonds (not necessarily good)
A low stockpile of cash usually means poor to mediocre economics.
There are 3 ways to create large cash reserve.
1) Sell new bonds or equity to public
2) Sell business or asset
3) It has an ongoing business generating more cash than it burns (usually means durable competitive advantage)
When a company is suffering a short term problem, Buffett looks at cash or marketable securities to see whether it has the financial strength to ride it out.
Important: Lots of cash and marketable securities + little debt = good chance that the business will sail on through tough times.
- Test to see what is creating cash by looking at past 7 yrs of balance sheets. This will reveal how the cash was created.
- Manufacturers with durable competitive advantages have the advantage that the products they sell do not change, and therefore will never become obsolete. Buffett likes this advantage.
- When identifying manufacturers with durable competitive advantage, look for inventory and net earnings that rise correspondingly. This indicates that the company is finding profitable ways to increase sales which called for an increase in inventory.
- Manufacturers with inventories that spike up and down are indicative of competitive industries subject to boom and bust.
Net receivables tells us a great deal about the different competitors in the same industry. In competitive industries, some attempt to gain advantage by offering better credit terms, causing increase in sales and receivables.
If company consistently shows lower % Net receivables to gross sales than competitors, then it usually has some kind of competitive advantage which requires further digging.
Property, Plant & Equipment
A company with durable competitive advantage doesn’t need to constantly upgrade its equipment to stay competitive. The company replaces when it wears out. On the other hand, a company without any advantages must replace to keep pace.
Difference between a company with a moat and one without is that the company with the competitive advantage finances new equipment through internal cash flows, whereas the no advantage company requires debt to finance.
Producing a consistent product that doesn’t change equates to consistent profits. There is no need to upgrade plants which frees up cash for other ventures. Think Coca Cola, Johnson & Johnson etc.
Whenever you see an increase in goodwill over a number of years, you can assume it’s because the company is out buying other businesses above book value. GOOD if buying businesses with durable competitive advantage.
If goodwill stays the same, the company when acquiring other companies is either paying less than book value or not acquiring. Businesses with moats never sell for less than book value.
- Intangibles acquired are on balance sheet at fair value.
- Internally developed brand names (Coke, Wrigleys, Band-Aid) however are not reflected on the balance sheet.
- One of the reasons competitive advantage power can remain hidden for so long.
Total Assets & Return on Total Assets
- Measure efficiency using ROA
- Capital is barrier to entry. One of things that make a competitive advantage durable is the cost of assets needed to get in. This is why we calculate the Asset Reproduction Value along with the EPV.
- Many analysts argue the higher return the better. Buffett states that really high ROA may indicate vulnerability in the durability of the competitive advantage.
- E.g. Raising $43b to take on KO is impossible, but $1.7b to take on Moody’s is. Although Moody’s ROA and underlying economics is far superior to Coca Cola, the durability is far weaker because of lower entry cost.
Includes accounts payable, accrued expenses, other current liabilities and short term debt.
- Stay away from companies that ‘roll over the debt’ e.g. Bear Stearns
When investing in financial institutions, Buffett shies from those who are bigger borrowers of short term than long term debt.
- His favorite ‘Wells Fargo’ has 57 cents short term debt for every dollar of long term
- Aggressive banks (like Bank of America) has $2.09 short term for every dollar long term
Durability equates to the stability of being conservative.
Long Term Debt coming Due
Some companies lump their yearly long term debt due with short term debt on the balance sheet. This makes it seem like there is more short term debt than the real amount.
Important: Companies with durable comparable advantages need little or no LT debt to maintain operations.
Too much debt coming due in a single year spooks investors and can offer attractive entry points.
However, a mediocre company in problems with too much debt due leads to cash flow problems and certain bankruptcy.
Long Term Debt
Buffett says that durable competitive advantages carry little to no LT debt because the company is so profitable that even expansions or acquisitions are self financed.
We are interested in long term debt load for the last ten years. If the ten yrs of operation show little to no long term debt, then the company has some kind of strong competitive advantage.
Buffett’s historic purchases indicate that on any given year, the company should have sufficient yearly net earnings to pay all long term within 3 or 4 year earnings period. (e.g. Coke + Moody’s = 1yr)
Companies with enough earning power to pay long term debt in less than 3 or 4 years is a good candidate in our search for long term competitive advantage.
- BUT, these companies are targets for leveraged buy outs, which saddles the business with long term debt
- If all else indicates the company has a moat, but it has ton of debt, a leveraged buyout may have created the debt. In these cases the company’s bonds offer the better bet, in that the company’s earnings power is focused on paying off the debt and not growth.
Important: little or no long term debt often means a Good Long Term Bet
Total Liabilities & Debt to Shareholders Equity Ratio
- Debt to shareholders equity ratio helps identify whether the company uses debt or equity (includes retained earnings) to finance operations.
- Company with a moat uses earning power and should show higher levels of equity and lower level of liabilities.
- Debt to Shareholders Equity Ratio : Total Liabilities / Shareholders Equity
- Problem with using as identifier is that economics of companies with durable competitive advantages are so great they don’t need large amount of equity or retained earnings on the balance sheet to get the job done.
Important: if the Treasury Share Adjusted Debt to Shareholder Equity Ratio is less than 0.8, the company has a durable competitive advantage.
Retained Earnings: Buffett’s Secret
One of the most important indicators of durable competitive advantage. Net earnings can be paid out as dividends, used to buy back shares or retained for growth.
If the company loses more than it has accumulated, retained earnings is negative.
- If a company isn’t adding to its retained earnings, it isn’t growing its net worth.
- Rate of growth of retained earnings is good indicator whether it’s benefiting from a competitive advantage.
- Microsoft is negative because it chose to buyback stock and pay dividends
- The more earnings retained, the faster it grows and increases growth rate for future earnings.
- Carried on the balance sheet as a negative value because it represents a reduction in shareholders equity.
- Companies with moats have free cash, so treasury shares are hallmark of durable competitive advantages.
- When shares are bought back and held as treasury stock, it is effectively decreasing the company equity. This increases return on shareholders equity.
- High return is a sign of competitive advantage. It’s good to know if it’s generated by financial engineering or exceptional business economics or combination.
- To see which is which, convert negative value of treasury shares into a positive and add it to shareholders equity. Then divide net earnings by new shareholders equity. This will give the return on equity minus effects of window dressing.
Important: presence of treasury shares and a history of buyback are good indicators that company has competitive advantage
June 30th, 2014 | Josh Sauer
About two years ago, a friend recommended that I read “Warren Buffet and the Interpretation of Financial Statements.” I read it. I re-read it. And I read it a third time last week just for good measure. The book is wonderful and I can’t recommend it highly enough. Below, you will find the first installment in a three part summary guide to how Warren Buffet evaluates financial statements.
The Income Statement
Gross Profit Margin: firms with excellent long term economics tend to have consistently higher margins
- Durable competitive advantage creates a high margin because of the freedom to price in excess of cost
- Greater than 40% = Durable competitive advantage
- Less than 40% = competition eroding margins
- Less than 20% = no sustainable competitive advantage
- Consistency is key
Sales Goods and Administration: Consistency is key.
Companies with no durable competitive advantage show wild variation in SG&A as % of gross profit
- Less than 30% is fantastic
- Nearing 100% is in highly competitive industry
R&D: if competitive advantage is created by a patent or tech advantage, at some point it will disappear.
- High R&D usually dictates high SG&A which threatens the competitive advantage
Depreciation: Using EBITDA as a measure of cash flow is very misleading
- Companies with durable competitive advantages tend to have lower depreciation costs as a % of gross profit
Interest Expenses: Companies with high interest expenses relative to operating income tend to be either:
1) in a fiercely competitive industry where large capital expenditure required to stay competitive
2) a company with excellent business economics that acquired debt in leveraged buyout
- Companies with durable competitive advantages often carry little or no interest expense.
- Warren’s favorites in the consumer products category all have less than 15% of operating income.
- Interest expenses varies widely between industries.
- Interest ratios can be very informative of level of economic danger.
Important: In any industry, the company with the lowest ratio of interest to Operating Income is usually the one with the competitive advantage.
- Look for consistency and upward long term trend.
- Because of share repurchase it is possible for net earnings trend to differ from EPS trend.
- Preferred over EPS
- Durable competitive advantage companies report higher % net earnings to total revenues.
Important: If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage.
- If net earnings is less than 10%, likely to be in a highly competitive business
June 1st, 2014 | Josh Sauer
On Monday I packed up my car with everything I could squeeze into it and started the long drive to Houston, Texas.
Four days, lots of snacks, a broken gas cap, and a slew of curse words at Arkansas’s traffic, my roommate (Nate) and I finally made it to Houston where we’ll be living this summer.
Our apartment is nice. In fact, far to nice for someone in college without a job. I was hoping to work for myself this summer, but the line of Jaguars next to my Civic signals that I should probably get a job.
I don’t know what the summer has in store, but my plan is to update this website regularly with my latest happenings and random ramblings.
Stop by soon!
p.s. – If you’ve got a free moment check out this video. I don’t agree with everything in it, but it’s an interesting watch.
May 31st, 2014 | Josh Sauer
Over the past couple of months I’ve been building Fundamental Dashboard.
I’m not an experienced coder, nor investor, but I hope that in the future, this website can serve as a tool were “fundamental investors” research equities in a simple straightforward manner.
Check it out and let me know what you think!
For all the Calvin and Hobbes fans out there, checkout The Hobbes. I’ve put up a few Calvin and Hobbes wallpapers that I’ve made/collected over the past couple years.
November 24th, 2013 | Josh Sauer
The term “return” is often used in finance. While technical jargon has a tendency to make “returns” sound complicated, the word simply means a change in value.
Companies are often complex and investors use “return ratios” to gauge the past profitability of a specific part of the company, or the company as a whole. This information can then be used to compare different investment opportunities.
The three ratios below are some of the most popular “return ratios” investors look at. While each one is valuable, no single ratio should be used as an gauge of the overall prospect of a firm.
Return on Assets (ROA) is net income divided by total assets. ROA illustrates how efficiently a firm is using its assets to generate earnings. This ratio is often used for comparing firms within the same industry and with a similar capital structure. A higher number is indicative of a company that is producing larger profits from fewer assets. Investors should be weary that a company holding excess cash or assets can have a lower ROA. Check a firm’s balance sheet for clarity.
Return on Equity (ROE) is net income divided by shareholder’s equity. ROE is expressed as a percentage and shows how profitable a firm is with the money given to it by equity investors (aka shareholders). Again, this ratio is useful for comparing the profitability of a company to that of other firms in the same industry. Averaging past ROE’s can give an investor a better idea of historical growth.
Return on Invested Capital (ROIC) is net operating profits after taxes (NOPAT) divided by invested capital. ROIC demonstrates how efficient a firm was in investing its capital in different projects. Unfortunately, this metric doesn’t specify if the return is from a onetime event or a recurring event, but to find out, simply read a company’s recent annual and quarterly reports. Unlike ROA and ROE, this ratio can be used to compare firms with different capital structures across industries.
While ROIC on its own can be useful to investors, comparing it against the weighted average cost of capital (WACC) can reveal if a firm is creating or destroying value for shareholders. While WACC is fairly complicated and very well could be the subject of its own post, it is simply the minimum rate of return that a firm needs to return to the shareholders. When ROIC is greater than WACC, shareholder value is being created, and when the inverse occurs, value is being destroyed. A firm with a higher spread between ROIC and WACC tends to create more value than its competitors.
Want to learn more about value investing? Check out The Intelligent Investor by Benjamin Graham.
November 18th, 2013 | Josh Sauer
“By the streets of by and by, one arrives at the house of never.”
Our tendency to do it can waste away hours. In fact, there’s a good chance that you’re doing it right now.
Facebook, Twitter, Reddit… even Joshsauer.com. The list of websites we can spend our time on is endless, and despite the seemingly trivial nature of these sites, we often find ourselves spending hours on end browsing through them the night before a big test or essay is due.
We’ve all been there before, but why?
As it turns out, human motivation is highly influenced by how imminent a reward is perceived to be. The further away a reward is, the more we discount its value. (Similarly, when dealing with the time value of money, a dollar today is worth more than a dollar in the future.) This process is known as Hyperbolic Discounting, or more commonly as Present Bias.
Our tendency to place a higher value on short-term events makes surfing the web, talking with friends, or just about any mindless activity more important than studying for that big exam.
As your 8 a.m. test approaches, you begin to place a higher value on getting a good grade (studying). When this reward is greater than the one presented by checking Facebook, you have defeated procrastination. This phenomenon is known as Temporal Proximity. Unfortunately, for most of us this process takes place around three in the morning, which leaves us little time to adequately prepare ourselves.
So, now that you know why procrastination happens, you probably want to know how you can beat it. Ultimately, it comes down to willpower. Nevertheless, here are 4 strategies that can help you defeat procrastination:
Ditch the distractions. Turn off the music, close your browser and get focused.
- The Pomodoro Technique
I know this sounds like it was invented by a famous bull fighter, but it’s just a fancy way of saying work in intervals.
Set a timer for a set period of time and stay concentrated on your work until the timer goes off. When it does, reward yourself. A food break, 5 minutes of internet- something that is short, yet rewarding. Gradually increase the time in-between breaks and you’ll become disciplined in no time.
- Get Started
Studies show that the greatest barrier to productivity is actually starting a task. A phenomenon known as the Zeigarnik Effect suggests that humans are compelled to finish a task once they’ve started it.
These techniques will work for some, but everyone functions differently. Now that you understand how procrastination works and acknowledge that you do it, you can develop your own personal techniques to overcome it.
August 5th, 2013 | Josh Sauer
The minimum wage is currently $7.25.
The unemployment rate is currently 7.4%.
These figures have more than the number seven in common.
The idea behind FDR’s 1938 establishment of the minimum wage was simple: increase the earning power of workers. In theory that sounds great; I mean, who wouldn’t want more money? But why don’t we raise the minimum wage to $20? Heck, why stop there? Why not raise it to $100?
Numbers like these help to more clearly illustrate the red headed step brother of minimum wage: Unemployment.
Behind every worker is an employer. Businesses will only operate when revenues are greater than expenses. In other words, they need to make a profit:
Revenues- Expenses = Profit
When hourly pay is increased, expenses rise accordingly. For some businesses, expenses become greater than revenues. If that trend continues for a prolonged period of time, the businesses will eventually close their doors and layoff their workers. As fewer businesses operate, fewer workers are needed.
Note: The difference between Supply for workers and the Demand is Unemployment.
If the minimum wage was lower- or better yet, did not exist- more businesses would be able to afford workers. Cheaper businesses would operate, and the forces of supply and demand would determine the “minimum wage.” Given the choice between unemployment and a lower wage, I venture to say workers would select the latter.
Legislation like the Fair Labor Standards Act of 1938 is often enacted with good intentions. Unfortunately, good intentions are not synonymous with good ideas; the fallacy of the minimum wage is an unfortunate example of this fact.
Like this post? Then you’ll love A Common Sense Guide to the Economy by Thomas Sowell.