The Value of Corporate Events

I started to realize that hunting for value is a strategy well suited for, mostly, undervalued markets. Generally these situations appear abundant in these markets, therefore increases the odds of positive performance. However, searching for undervalued companies ala Buffett in markets that seemed to be fairly valued is not a strategy I am willing to undertake. I reckon undervalued markets like the one we had in 2008 is like shooting fish in a barrel but otherwise you need to be really a sharpshooter with strong set of skills or a lot of luck to do well.

Off course the obvious alternative is to stay on the sidelines waiting for those undervalued markets, but what if they do not materialize.

successful value investing requires significant diligence. Investing is not hard or rocket science but requires a lot of time and resources to come up with single idea. I reckon, based on my limited experience, to produce a single good idea you have to vet at least 10 with the same intensity and diligence. One of the most critical aspect of investing is generating ideas. Idea generation can't be random it has to be systematic otherwise you will never know what works. It is the pane of my investing existence is how to find those ideas? how to build a pipeline of company to analyse? do you start with A's and work down the alphabet? or do you run screens that will uncover good companies in the past? So needless to say it is important to have a "search technology", as Prof. Greenwald puts it in his book "Value Investing: from Graham to Buffett and beyond".

That is why event driven strategies is what I observed to be the best search strategy for individual investors. It is all about odds. Event driven investing puts the odds slightly in my favour. I get a concrete set of ideas with good probability of out performance. I have been concentrating on two events:

1. Spin-offs,
2. Post bankruptcy equity, and
3. Index Deletion.

For example, spin-offs offer great hunting ground. I do not use spin-offs investing as a blanket approach, although I wish I did I would be better off for it. I need to vet the presence of good business and competitive advantage. Spin-offs will have duds, that's why they are being spun off. However, the odds to pick good performers over the next 3 years are much better than picking from the entire market universe. Most of the time markets fear from the uncertainty of smaller and unproven companies are wildly exaggerated.

From the spin-offs I followed, I have invested in some but not all, it out performed the S&P by 23%. That is not unusual. Most studies find 15-20% out performance for spun off companies. The reasons for the out performance vary from better focus to better information transparency.

There is a busy calender for spin-offs this year, I will post if any seem interesting.

Practice Investing

Investing is just like any other discipline you need practice to develop the skills to be good at it. For awhile I have been thinking about a framework of skills and how do I practice to improve my game. I have broken it down to three elements that need to be developed and worked at constantly:

1. Knowledge
2. Skills
3. Behaviour

Knowledge:

If you have read Poor Charlie's Almanac, which I recommend highly, you will see that he harps on what he calls "mental models". This is the equivalent to knowledge in my framework. However, I want to further detail these models into two elements:

1. Systems Knowledge: similar to Munger's description, it is your knowledge of the necessary sciences to enable you to decipher your way through events, readings and decisions:
• Accounting
• Mathematics
• Psychology
• Language
2. Domain Knowledge: Munger did not explicitly break out this element as a distinct "mental model" but he emphasized reading a lot. Domain knowledge is the structure of information and data or "insights" about a specific industry. You can't be knowledgeable sufficiently about several domains so you have to keep your efforts focused on few ones, the less the better investor you will be.

How do you practice your knowledge building capacity? By writing down notes about what you read. What you need to write is not a summary of the information but an answer to the questions: so what? What will be the impact of the news item on you, your business and the companies involved?

Skills

To develop the knowledge required, you will need to read and read a lot, this has to be evident by now. Here are the skills that you need to work at as well to be more effective and efficient:

1. Speed reading: you need to read quickly because knowledge has one limitation and that is time. The skill is hard but you need to work at it to continuously improve the yield on your time by acquiring more knowledge for each unit of time spent.
2. Memory: what is the point of reading if you can't remember the information you need to analyze a particular situation or identify a unique opportunity. This is a skill that can be improved by practice as well.
3. Creativity: Munger in his book said to "invert, always invert" well to do so you need imagination. Creativity is needed in order to develop future scenarios and imagine possible risk for business.

Behaviour

I have identified three behaviours or personality characteristics that need to be nurtured as well:

1. Passion: your passion should be about the process not the outcome. If you are passionate about the process you will think and have perspective on how to improve it rather than use it in a mechanical fashion.
2. Adaptation: one of the most valuable traits of humans is their ability to adapt to their circumstances and learn from their mistakes. But this require that you take responsibility and internalize errors and mistakes rather than blaming it on chance or others.
3. Determination: because you will fail but you need a combination of strong will, ambition, and discipline to keep going as what I outlined here is a lot of hard work.

Train hard!!!!

Short vs. Long: Kettle meet Pot

Those who short are no different than longs. In fact shorting is much harder than being long on so many levels. Shorting require more skill, research and discipline than being long. Actually I can argue that dedicated shorts are better investors than longs.

Sometime shorting is lumped incorrectly with trading and speculation. To short stock based on valuation or speculation is to make a bet on market conditions. But proper short is to short fraud, hype and bad management. These things require a lot of fundamental analysis to uncover.

Shorting is no different than going long. You do the research, more of it actually. Uncover unsustainable business models and bad management. Recognize hype from what is logical and sustainable. Once you complete your process, usually longs pull the trigger at this point. However shorts, do that process over and over again until there is no i left undoted. Then you wait and wait until you the perfect time and here is the art of short selling is when to pull the trigger.

A successful short has to master two things, timing and selection, while the long side can live with selection only. A long investment that depreciate in value hurts performance but does not pressure you to sell, as time can make you whole again. However a short does not have that luxury. A short position that moves against you, require more margin and more capital to hold. How long can you continue holding is a function of how much capital can you come up with.

I recommend reading a book about short selling called "The Art of short selling". It is not much about short selling rather than fundamental analysis. You will be surprised how detailed shorts can be be.

Strategic buyout Mistakes

I typically do not like companies to undertake spectacular acquisitions or mergers. Large mergers and acquisitions have so many inherit risks that could derail them. Actually any merger of any size has the same issues and risks that can scuttle the transaction but with smaller acquisition the impact can be negligible. 

Mergers can appear wonderful on paper as they offer new markets, synergies...etc. However their success or failure rest on implementation and execution of the integration plan. And I think the biggest threat for the success of these mergers is the resistance to change. It is human nature to keep at the same ways of doing things; you are comfortable and you have the know how, why change. This is a big hurdle to overcome. And that is why most mergers fail. 

Management execution plans must be set with the mindset of "plan to fail and manage for success". In the book "Billion Dollar Lessons" the authors detail some of the misguided actions and red flags to the management's strategic plans. Those red flags can serve investors as well in assessing the value of their investments.

Illusion of synergy

Trying to archive a better distribution network, economies of scale, cutting overhead...etc are all good reasons to undertake an acquisition. But rarely do these synergies materialize. The authors offer these red flags:

• The synergy may exist only in the mind of strategists and not in the mind of customers.
  
• ....overpaying for an acquisition
  
• ....clashes of culture, skills or systems can mean that synergies that seem easy to achieve can be impossible to get.
  

Rollups strategy

Some companies adopt the strategy of rollups in fragmented industries. It makes sense for a company to operate more efficiently by merging tens or hundreds of smaller businesses given them economies of scale:

• better bargaining with suppliers,
• lower cost of capital,
• lower overhead costs as you spread them over many entities, 
• more efficient distribution networks,...etc

However unless the industry are of the right characteristics and management have the skills to execute, this again will mount to nothing. Some red flags offered by the authors:

• Rollups went for scale that would not produce economies. sometimes, rollups wound up with diseconomies of scale. 
  
• Rollups required an unsustainably fast rate of acquisitions
  
• Companies did not allow for tough times- and it seems that every rollup runs into tough times at some point.
  
• Companies assumed that they could get the benefits both of decentralization and of integration. ...[they] often found, that they could choose either decentralization or integration but not both.
  

Adjacent markets

Companies, often, to achieve growth expand to adjacent markets and products. For example  a passenger bus transportation company moving to ambulance services as both businesses are about moving humans from point A to B. More often than not management are surprised that these adjacent markets are not similar at all to their core business and the venture end up costing them dearly. Some takeaways from the book:

• The move is being driven more by a change in a company's core business rather than a great opportunity in the adjacent market. 
  
• The company lack expertise in the adjacent market, leading the company to misjudge acquisitions and mismanage the competitive challenges of the new market.
  
• the company overestimates the strength or importance its core business capabilities will have in the new markets.
  
• A company overestimates its hold on customers, leading to expectations of cross-selling or up-selling that won't materialize.   
  

Fumbling technology

Following the "killer app" vision can be tremendously costly and horribly unsuccessful. The desire to lunch the next Netscape or Ipod can lead to disastrous results. Management has to think what business are they in rather than what technology or idea is more sexy.

• They [companies] evaluate their offerings in isolation or at a single point in time, rather than in the context of how alternatives will evolve over time.
  
• They confuse market research with marketing, allowing their entrenched interests and hopes to colour the analysis of true market potential.
  
• They find false security in competition,...presence of rivals equates to a validation of the potential market.
  
• They design the effort as a front-loaded gamble, foreclosing possibilities for adaption and severely limiting the option to stop.  
  

Consolidation in distressed industries 

Maturing industries or more bluntly in trouble industries like News papers,  news print media and news print paper more often consolidate. These industries are facing decreased demand for their products and industry overcapacity. Most adopt the consolidation strategy to cut overcapacity, achieve economies of scale and raise prices if they can. The trouble is :

• you may not be buying the assets you think you are buying; you may also be buying problems. 
• ...there may also be disconomies of scale because of increased complexity.
•  ...you may not able to hold onto customers.

I tend to not like serial acquirers or vision builders but I sometimes get suckered into the sales pitch of management. The above list should give me a solid checklist to keep the analysis honest. 

Consumer Brands as Competitive Advantage

Brands names have been considered as a competitive advantage for companies. Companies like Kraft, Heinz, P & G, Coke, Pepsi...etc all own the who's who in consumer brands. But do all brands count as a competitive advantage? The answer is no.

Case Study: Packaged Foods Brands

Packaged or consumer food products have limited value or competitive advantage on its own. In order for brands to be a competitive advantage it must be coupled with any of the following (see my earlier post here):

• low cost producer or economies of scale,
  
• high switching costs, or
  
• consumption habits.
  

However with the exception of soft drinks, the brand is coupled with consumption habit, most consumer branded food items lack any competitive advantages. Most brands are higher in price because companies want to bill the quality in the minds of the consumer, it is expensive then it must be better mentality. But that is not the case and consumer are better informed and can't afford not to be.

P&G products, for example, are about 40% more than the store brand, but perform the same. If you shop compare, for example, laundry detergents Tide is nearly $20 for 96 loads(used to be $14), Costco's store brand, Kirkland, was $12 for ~120 loads with similar quality.

The Kirkland Butter is $1.44 per pound and as good as Land O Lakes that goes for $3.24 at the supermarket. The Kroger, Meijer and Spartan brand butter is gross and still over $2 per pound, all three come from the same plant, 324 is I remember the label correctly where Kirkland comes out of 55-307.

The proof is in market share and consumer buying habits.

• Kroger  has had significant success with its private-label program, with 27 % of its grocery sales and 35% of unit volume coming from its store brands in the fourth quarter, up from 26% and 32%, respectively, in the prior year.
  
• Safeway  intends to drive corporate brands harder if packaged food companies do not lower their prices.
  
• Wal-Mart is revamping its Great Value brand by introducing new products and reformulating 750 other products. Great Value is the country’s largest food brand in both sales and volume.
  
• ConAgra's consumer-foods segment, sales volume -- the amount of food sold -- fell 4ConAgra Foods had to cut the prices of its Pam cooking sprays, Wesson cooking oils, Egg Beaters and some other products to compete.
• Kraft Foods Inc. lost about 2.5% of its sales volume in the fourth quarter because people bought fewer of its products. Since then, the Northfield, Ill., company has lowered prices on some nuts, cheeses and coffee.
  
• Sales volume at H.J. Heinz Co. declined 6% in its most recent quarter as consumers and retailers bought fewer Heinz products.
• Nielsen data from the Private Label Manufacturers Association ahsows that private-label sales of food and other grocery products in the U.S. grew 10.3% to $82.9 billion in the twelve months ended in November.
  

Moreover, packaged foods are at a disadvantage as...

All the major packaged food companies make at least 10% of their sales to Wal-Mart, so it is a concern that as Wal-Mart increases shelf space for its own products, it is likely to reduce space for national brands from packaged food companies.

Packaged foods companies need a shift in their product strategies. There has to be a revamp in their marketing and operations to  address the following:

• Rethink their pricing strategies. A clear question need to be answered is what is their value to consumers, a brand is not value that can command a premium; it must be combined with something.
• Infinite customer segmentation that drives costs higher and leads to lower sales. Store brands are generic and one size fits all and they seem to be taking share from branded foods.
• How to deal with excess capacity? Brand companies make private label goods to fill in excess capacity at factories; even at a loss. The problem is that this is very low margin business and sales go to retailers who go bankrupt with regular frequency. Message to branded firms: use capacity to lower the costs of your products.

________________________________________

Sources:
http://www.researchrecap.com/index.php/2009/03/31/store-brands-squeezing-us-packaged-goods-companies/

http://online.wsj.com/article/SB123807261203947597.html?mod=wsjcrmain

http://myvalueidea.blogspot.com/2007/12/brands-and-competitive-advantages.html

Distress Investing

Please consider reading Third Avenue Funds shareholders letter about investing in the distressed assets and investing in this new era.

He details a case for investing in debt instruments of the financially distressed companies. Distressed investing is highly rewarding but you have to consider its fit for your own competence and abilities. Distress investing needs sophistication and expertise in areas of law, accounting and negotiation, or access to talented resources that can provide you with the help needed. Investors need to understand their abilities before buying these issues. In my opinion distressed security investing is best left for those who specialize in it. In such markets where information is scarce, those who are informed will take advantage of those who are not.

Please consider chapter 12 of Seth Klarman's Margin of Safety for a premier on the subject. You can read the whole book as it is a good summary of how an investing process should run.

Distressed Investing

Below is quote from an interview conducted by CNBC with Wilbur Ross, the fame distressed investor. I do like particularly his perspective on how he views risk.

For the complete interview go here.

CNBC: Also you're not afraid of distressed businesses, which I think most people are.
WILBUR ROSS: No, we're not afraid of them if we've analyzed them properly. What we are afraid of is the question that we forgot to ask.

CNBC: Can you talk a little bit about your system?
WILBUR ROSS: When we're looking at an opportunity, first of all we look at it on an industry basis, because we've learned over the years that when companies go bad, they generally go bad as a whole industry. At one point it'll be all the airlines that are bad, another point all the steel companies, and another point the textiles. That's because what happens is you have industries that have been high users of leverage and then some catalytic event occurs, so the industry tends to have problems simultaneously. This creates two sets of opportunities, one is to fix the individual company, and second is the potential for changing the dynamics of the whole industry. If you can do both, then you get two big increments to value. So that's what we really try to shoot for.

CNBC: I read that you have a chart system? How does that work?
WILBUR ROSS: We use charts, not stock trading charts but business charts, and the way they work is, when we're looking at an industry we try to put down in paper everything we can imagine that's wrong with the industry. Usually it's quite a long list. We then go over it, and over it, and over it, and over it till we're pretty well satisfied that we've identified everything that is wrong or is very likely to go wrong. Then we start work on a second chart, which is if we have control of this industry, what would we do to fix these problems. When the two charts get more or less similar in length, that's when we get serious about investing.

What is Risk?

A discussion about risk and return came up in the comments section of a blog, which gave me the idea to put my thoughts on the subject in this post.

Majority of investors talk about risk and return in the same breath, the saying goes " no risk no return". I find that one of the most erroneous terms coined by Wall Street, and there are many of them. Actually the way I see is by limiting my risks, I will earn above normal returns.

Investors should distinguish between risk and volatility. Volatility is backward looking and pertain to price movements day-to-day, it is actually defined as the standard deviation of prices around their historical mean. There is not much insight from that figure, if any, to your investment decision making process.

However, Risk in investing should be future looking in nature and not backward looking as volatility. Price movements and historical financials bear little on an investment's risk profile. One thing is clear in my mind Risk does not equal volatility and more certainly risk does not equal more returns. Wikipedia defines risk as:

.... a concept that denotes a potential negative impact to some characteristic of value that may arise from a future event, or we can say that "Risks are events or conditions that may occur, and whose occurrence, if it does take place, has a harmful or negative effect". Exposure to the consequences of uncertainty constitutes a risk. In everyday usage, risk is often used synonymously with the probability of a known loss.

And it is calculated as:

Risk comes from the assessment of the company operations and economics accompanied with probable future adverse scenarios that the business might endure. Your analysis of these scenarios and their affect on the financial health of the business is how you assess how risky a business is. I try to find businesses that have limited probable risks associated with their operations. In this case more risk does not mean more return, it actually means exposure to more possible losses, which I am certain most investors want to avoid.

The example best used with the saying "more risk more return" applies to choosing between various types of asst classes, for example money market vs bonds vs stocks. Wall Street argues that with stock you will make more returns due to more risk involved with owning equities. To illustrate my point how erroneous that saying is, I ask you which asset will you hold: a GM bond or P&G common stock?

The best Advice I ever got...

Courtesy of Harvard Business review June 2008 edition. This article demonstrate the value of research and preparation in making investments. I always say to my self it is OK to do nothing if I am not confident in my research and preparation as opportunities will come and go but the loss of capital is permanent

I grew up in a small town outside Philadelphia and went to the local high school, where I ran track all four years. Our team practiced outdoors, and in the winter, in the bitter cold, the experience was pretty miserable. The school was set on a hill, and as we ran around the parking lot the wind would come whipping around the building and hit us. We had to watch our steps carefully so as not to slip and fall on the ice. While we were doing our laps, the coach—a 50-year-old named Jack Armstrong—would stand against one wall protected from the wind, bundled up in a huge coat and wool hat and gloves, clapping and smiling cheerfully. Every time the pack shuffled past, he’d shout, “Remember—you’ve got to make your deposits before you can make a withdrawal!”

Now, this was a public school with no special facilities, and the team was made up of average athletes with differing levels of intelligence and motivation. But we never lost one single meet. And because of that success, and maybe because of the way in which the advice itself was delivered—I remember it when people yell at me—Coach Armstrong’s words resonated. I’ve thought of them a million times throughout my career in finance, and they’ve guided this firm, too.

Coach Armstrong came to mind in one of my first weeks on Wall Street, 35 years ago. I’d stayed up all night building a massive spreadsheet to be ready for a morning meeting. These were the days before Excel, and it was a huge feat for someone as bad at statistical stuff as I was to do this all by hand; I was pretty proud of myself. The partner on the deal, however, took one look at my work, spotted a tiny error, and went ballistic. As I sat there while he yelled at me, I realized I was getting the MBA version of Coach Armstrong’s words. Making an effort and meeting the deadline simply weren’t enough. To put it in Coach Armstrong’s terms, it wasn’t sufficient to make some deposits; I had to be certain that the deposits would cover any withdrawal 100% before we made a decision or did a deal. If I hadn’t done all the up-front work and made completely sure that my analysis was correct, I shouldn’t have put anything forth. Inaccurate analysis produces faulty insights and bad decisions—which lead to losing a tremendous amount of money.

Today, whenever I’m under pressure to make a decision on a transaction but I don’t know what the right one is, I try desperately to postpone it. I’ll insist on more information—on doing extra laps around the intellectual parking lot—before committing. I take the same approach with people, too. For example, when we were looking for a manager to start up our long-short hedge fund, we interviewed for a year and a half. The timing was ripe for that asset class, and if you weren’t doing something with it, you were losing out. It took a huge amount of time and effort for Blackstone, but we found a young money manager we were comfortable with, and he’s become an enormous asset.

Every year I speak to our new associates and give them this advice, although in my own words. This isn’t like school, I tell them, where you want to get your hand in the air and give an answer quickly. The only grade here is 100. Deadlines are important, but at Blackstone you can always get help in meeting them. As a firm, we can always figure out how to do another lap around the parking lot. Because what’s true when running track is true when doing deals: The person who’s the most ready for game day will be the one who wins.

The Value in Spin-offs

I have written and evaluated spun-off companies as value ideas. In this post I want to elaborate on the rationale and the value in spin-off investing. A good book that details this subject is Joel Greenblatt's book "You can be a stock market genius". If you can bypass the book's over-the-top title, it is actually a very good book in value investing with case studies and good search strategies for undervalued investments.

Joel argues that spin-offs are good hunting ground for value and his three criteria for picking good spin-off companies are:

1. Institutions don't want it not because of investment reasons,
2. Insiders participation, and
3. Hidden investment opportunity is revealed.

Security holders often times invest in parent company for a variety of reasons that may not hold true in the spin-off company, for example, industry, size, leverage...etc. So those holders are motivated to get out from the spun-off company as soon as possible. Typically in the few months after the spin-off there is tremendous selling pressure on the spun-off company for no economic reasons. Selling is done due to investors policies and other limitations.

The rest of the post is an article I saved awhile back but I did not source, so for the author, Please forgive me for not posting credit.

Fundamentals

Spin-offs have a limited operating history, which means there’s relatively little for investors to look at as a benchmark for future performance. Moreover, the track record that does exist is likely to be unimpressive, since the parent firm has a strong incentive to clean up its books by allocating lots of ‘grey area’ costs to the spin-off. With a limited and often unimpressive operating history, the market’s expectations are relatively low, which again leads to a lower valuation.

Analysts usually apply a premium to ‘pure play’ niche businesses which spin-off represent. However, this said, analysts will almost certainly never pick up initial coverage. Why? because, the spin off entity does not fall under the initial analyst who covers the parent company’s coverage. E.g. a medical company spinning off a chemical division. The chemical maker will not be under the medical analysts coverage and be too small, or go unnoticed to fall into another’s. This period of ‘wilderness’ for the divested entity is typically 0-9mths after spin occurs. Interesting to note, spin-offs typically appreciate 30% or more in this time. Then a re-rating begins.

Spin-offs are often cheap when they come to the market. Every single one is temporary and most will have nothing to do with the underlying intrinsic value of the business. The hype will eventually pick up if the company performs well, the selling pressure will abate as shareholders of the parent company finish dumping the spin-off’s shares. Analysts will eventually pick up coverage, the company will develop a track record and management generally finds a way to improve a business dramatically after the first year or so. The result is a improved cash-flow generation and sometimes a bit of a valuation improvement as well which often means a nicely appreciating stock price.

• Often, spin-offs are a growth story. If the old management was holding back expansion and the new team has a clear strategy for building businesses that were starved for capital, you can bet the market will reward the risk. Also frequently, there are hidden assets, not reflected in book value, such as land holdings or lucrative brands.

Don’t forget carve outs! They are often a prelude to a full spin-off. In about half of carve outs, the parent eventually leaves the picture.

And don’t forget the parent either! Value can often be released in the parent. It will often set a business free for the most obvious reason. It’s troubled and unprofitable. Usually, the parent unloads the spin-off with baggage ranging from heavy debt to rusting plant and machinery. Incidentally, big debt isn’t a killer if the new company has the earnings to carry it.

Spin-Off Pricing Inefficiency/Technicals

Spin-offs don’t receive much publicity or hype. Typically the parent announces a spin, makes some filings, AGMs, shareholder meeting happen for approval etc.. Then the spin-offs shares quietly show up in the accounts of investors and institutions who own the parent. There’s generally not much news coverage when a spin-off hits the investor’s accounts and the valuation is set by the parent.

The spin-off process itself is a fundamentally inefficient method of distributing stock to the wrong people. Once the spin-off’s shares are distributed to the parent company’s shareholders, they are typically sold immediately without regard to price or fundamental value.

Structural selling of spin-offs happens due to index fund selling (because the spin-off is not in the index) Lack of yield limited old lot selling and limited liquidity.

• In the Penn State study, the largest stock gains for spin-off companies took place not in the first year after the spin-off but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spin-off’s stock can perform at its best. Most likely, though, it is not until the year after a spin-off that many of the entrepreneurial changes and the initiative can kick in and begin to be recognised by his marketplace. Whatever the reason for this exceptional second-year performance, the results do seem to indicate that when it comes to spin-offs, there is more then enough time to do research and make profitable investments.

Insiders

When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course. After a spin-off, stock options, whether issued by the spin-off company or the parent, can more directly compensate the management of each business.

• Shares of a spin-off are distributed directly to parent-company shareholders and the spin-off’s incentives-stock-option plan is based on this initial trading price. The lower the price of the spin-off, the lower the exercise price of the incentive option. To promote interest in the spin-off’s stock after this price is set by the market, not before.

  Do not expect bullish pronouncements or presentations about a new spin-off until a price has been established for management’s incentive stock options when the price of management stock options is to be set.

  There are few investments areas where insiders have such one-sided control in creating am new publicly-traded company.

Many spin-offs are run a lot better as independent companies than as wards of huge corporations. You attract far better managers to a spin-off than to a division of a company. People can really see they’re making a difference in the value of the stock and their own stock options.

These four criteria can hint at an attractive spinoff:

Unattractive factor. Something unattractive is a plus. Too small, too obscure, or too different from the parent -- something that makes investors want to sell. Sometimes it's because investors are only interested in owning the parent; other times, it is because institutional investors have strategies that don't allow for holding companies below a certain size or outside of their area of focus. The end result of their disinterest is to sell, which can temporarily depress the price of even a very good business. For this reason, you want to closely track a spinoff in the first few weeks after it begins trading. But when it really gets interesting is when the spinoff has one of the following traits as well.

Growth. Some spinoffs are simply freeing a growth business to shine. The beauty of these spinoffs is often that they are free of the parent's capital allocation decisions. Once spun off, the growth business is free to retain the cash flow it generates and plow it back into the growth opportunities it sees. This was part of the strategy behind Sara Lee spinning off Coach (NYSE: COH) a number of years ago.

Leverage. Parent companies often use their spun-off children as a way to unload debt. It's somewhat counterintuitive, but a spinoff that is saddled with debt can be a very good investment, because that leverage amplifies the impact of sales growth and margin improvement, promoting debt repayments and lowering future interest expenses. Debt also unquestionably makes the spinoff a riskier investment, because if sales or margins fall, the interest payments get tougher to cover. Hanesbrands(NYSE: HBI), another company sprung from Sara Lee, fits this mold with $2.5 billion in debt and a sliver of equity.

Incentives. To catch this one, you have to be paying attention to the prospectus and filings of a spinoff. Many times, management has plenty of incentives in place to make sure the stock price of a spinoff performs. This can be an ownership stake, options, restricted stock, or stock appreciation rights. Just because incentives are in place doesn't mean a spinoff will be successful, but it increases the odds that management will be keen to decrease costs and take other actions that increase shareholder value.

Circle of Competence

Buffett talked at length about investing within your "circle of competence". Warren has never let himself get excited about a deal that he doesn't understand. In the height of the tech boom in the late 90's Buffett stayed out of tech companies. Media have wrote him off as a savvy investors as illustrated by Barron's headline "What's wrong Warren?". He understands his weaknesses, limitations, and the types of businesses that he gets. He said that it is critical that investors clearly recognize what they don't understand, and place their time on businesses that allow them to bet big on what they do understand. He said that it's

... not so important how big the circle is, but it's important that you know where the perimeter is, and when you're outside of it.

So in my investment journey I need to articulate what is it that I am comfortable with and what should I stay away from. I think every investor should do an inventory and articulate that list, it will be very rewarding.

What I am not good at:

• Spotting undervalued businesses with growth potential. Unlike Buffett and others, I am not able to find these business like Buffett find in railroads and BNI. As a result I need to have an event to trigger the idea like spin-offs, restructuring, and other corporate events. Other ideas can come from copying other investors smarter that I am, but I have to go through the process of valuing these businesses on my own and understand for myself why I am owning it.
• I have time and resource limitation to analyse large businesses and understand them, so I try to avoid large cap businesses with different operating line of businesses and complexities. I will always strict myself to businesses in a single industry.
• I am not good at realizing or discovering new emerging trends to profit from.
• I have no knowledge of complex industries with technical details as I have limited knowledge in technical fields. As a result I will refrain from investing in pharma, bio-tech, technology and other related fields where science is key factor.
• I have limited knowledge of legal implications and details so my ability to understand and asses risks in certain events will be limited. As consequence I will avoid investment opportunities where legal issues are paramount to valuation like bankruptcies.
• I am not comfortable in forecasting revenues and analysing growth prospects, so I will always look "down rather than up". Risk is easier to assess and can be derived from good information rather than looking at your magical ball to arrive at growth forecasts.

What I am comfortable with:

• Accounting and analysing financial statements.
• I have knowledge of good valuation methodologies and their pitfalls.
• I have a background in few industries that I can leverage to assess the business. I have good knowledge in commercial real estate, consumer businesses including retail and transportation businesses.
  
• I think in scenario and what if situations, so that should be the basis of my evaluation for any business.
• I understand equities more than debt and derivatives, so my portfolio focus will be in equities.

The list of competencies are much shorter than what you are not good at. It is only logical that you have fewer things that you know and you should ground yourself in that fact. Another thing is the amount of effort, time and energy to learn a new discipline is much more involved than to strengthen and deepen your understating of what you know. Therefore I will not try to learn new industries rather I will focus to deepen my knowledge of what I already know.

Probably my list of what I am not good at will grow with time. Do you know the edge of your circle of competence?

Behavioural issues in investing

The following is a quote from John Mauldin book "Bull's eye investing. It is a list of several emotional traps that investors get tangled in their investing process. I believe that 90% of success in investing is emotional discipline rather than intelligence or identifying the next "big thing".

I do not endorse some of John's views on investing as they come with certain self-serving biases. For example his view on index funds. To promote his hedge fund business he slams index funds for the benefit of active management of hedge funds. I think that index funds should be a stable of any retail investor who is busy enough not to be able do business research. Moreover the long-term historical evidence of their effectiveness is irrefutable, no matter how the hedge fund industry tries to challenge it.

However the read fromthis particular section of the book is very interesting. From time to time I like to reread some of these behavioural issues and try to identify them within my behaviour. I have been guilty of some of them. Can you find some of the mistakes in yours?

1. "Fear of Regret - An inability to accept that you've made a wrong decision, which leads to holding onto losers too long or selling winners too soon." This is part of a whole cycle of denial, anxiety, and depression. As with any difficult situation, we first deny there is a problem, and then get anxious as the problem does not go away or gets worse. Then we go into depression because we didn't take action earlier, and hope that something will come along and rescue us from the situation.

2. "Myopic loss aversion (a.k.a. as 'short-sightedness') - A fear of losing money and the subsequent inability to withstand short-term events and maintain a long-term perspective." Basically, this means we attach too much importance to day-to-day events, rather than looking at the big picture. Behavioral psychologists have determined that the fear of loss is the most important emotional factor in investor
behavior.

Like investors chasing the latest hot fund, a news story or a bad day in the market becomes enough for the investor to extrapolate the recent event as the new trend which will stretch far into the future. In reality, most events are unimportant, and have little effect on the overall economy.

3. "Cognitive dissonance - The inability to change your opinion after new evidence contradicts your baseline assumption." Dissonance, whether musical or emotional, is uncomfortable. It is often easier to ignore the event or fact producing the dissonance rather than deal with it. We tell ourselves it is not meaningful, and go on our way. This is especially easy if our view is the accepted view. "Herd mentality" is a big force in the market.

4. "Overconfidence - People's tendency to overestimate their abilities relative to
individuals possessing greater expertise." Professionals beat amateurs 99% of the time. The other 1% is luck. The famous Clint Eastwood line, "Do you feel lucky, punk? Well, do you?" comes to mind.In sports, most of us know when we are outclassed. But as investors, we somehow think we can beat the pros, will always be in the top 10%, and any time we win it is because of our skills and good judgement. It is bad luck when we lose.

Commodity brokers know that the best customers are those who strike it rich in their first few trades. They are now convinced they possess the gift or the Holy Grail of trading systems. These are the people who will spend all their money trying to duplicate their initial success, in an effort to validate their obvious abilities. They also generate large commissions for their brokers.

5. "Anchoring - People's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs." If you believe that NASDAQ stocks are the place to be, that becomes your anchor. No matter what new information comes your way, you are anchored in your belief. Your experience in 1999 shows you were right.

As Lord Keynes said so eloquently when forced to acknowledge a shift in a previous position he had taken, "Sir, the fact have changed, and when the facts change, I change. What do you do, sir?"

We expect the current trend to continue forever, and forget that all trends eventually regress to the mean. That is why investors still plunge into index funds, believing that stocks will go up over the long term. They think long term is two years. They do not understand that it will take years - maybe even a decade - for the process of reversion to the mean to complete its work.

6. "Representativeness - The tendency of people to see patterns within random events." Eric Frye did a great tongue-in-cheek article in The Daily Reckoning, a daily investment letter (www.dailyreckoning.com). He documented that each time Sports Illustrated used a model for the cover of their swimsuit issue who came from a new country that had never been represented on the cover before, the stock market of that country had always risen over a four-year period. This year, it is time to buy Argentinian stocks. Frye evidently did not do a correlation study on the size of the swimsuit against the eventual rise in the market. However, I am sure some statistician with more time on his hands than I do will brave that analysis.

Investors assume that items with a few similar traits are likely to be associated or identical, and start to see a pattern.

McQuill gives us an example. Suzy is an English and environmental studies major. Most people, when asked if it is more likely that Suzy will become a librarian or work in the financial services industry, will choose librarian. They will be wrong. There are vastly more workers in the financial industry than there are librarians. Statistically, the probability is that she will work in the financial services industry, even though librarians are likely to be English majors.

Risk vs. Uncertainty

I tend to evaluate and buy risk but I ignore uncertainties when thinking about equity valuation. The difference between the two is subtle yet very important. The market tend to hate and avoid both, which can create opportunities. The current market situation contains a lot of uncertainty and risks as well. I am willing to take on risk in face of uncertainty while many investors are willing to take neither and that's why you see treasuries are yielding negative real returns.

Uncertainty, in my mind, is when you can't articulate a set of finite scenarios and attach a probability to those scenarios. Risk, on the other hand, is where an intelligent investor can outline a set of outcomes with expected probability of occurrence. With this definition in mind, the uncertainties facing the investment environment in the short run today are :

• Political uncertainty : who wins the US election, what kind of tax regime will be instated, fiscal budget management ...etc. All these issues are uncertainties as you can't pin point accurate outcomes with realistic attached probabilities.
• Economic uncertainty: the rise and fall of economic activity and which sector is under pressure, job loss ...etc are another set of uncertainties that companies or investors have no control over nor can they do anything about.
• Financial bankruptcy uncertainty: you do not know who will it be and what will be the impact. It could be a benign event if some small regional bank went under or even a big investment bank. The impact is not quantifiable so it is uncertainty for me.
• Regulatory uncertainty: with the introduction of new banking regulation, its impact on financial is uncertain as the details of these regulation are unclear.

So what kind of risks in the short term are facing the markets:

• Credit risk: There are a lot of credit risks and issues that face certain sectors more than others. The Banking sector faces more credit risk than any other sector due to its nature. There are risk in commercial real estate defaults, although as I wrote before I think it will be benign. There are increasing consumer loan defaults and mortgage ARM resets that can lead to more write downs. You can attach an estimate of $100- 200 Billion in write downs for this risk.
• Inflation risk: This has become more acute in recent periods. An increase in inflation will reduce your real return so once factored in your analysis it will affect return expectation.
• Earning risk: the risk of decline of corporate earnings has increased with slowing economy. This risk will lead to lower valuation of equities.

However in face of these risks there is an upside :

• credit improvement: there are signs of thaw in the credit market. You can see a lot of risk spreads coming down as well as a lot of the credit default swaps on banks have declined significantly. If credit environment improve you can see a lot of upside in bank earnings as a lot of the write downs will become write up.
• Cash has been accumulating in money markets and low yielding treasuries; the question is how long will investor be satisfied with meager returns before they accept risk? These funds can give a boost to equities and other depressed asset classes like real estate.

Given these risks I think there is room for an opportunity in the most beat up and distressed areas of the market that being banks, retailers, real estate and credit instruments. If you have been following my posts and investment you can see that I have bought the risk into these areas in face of the uncertainties that the market is worried about. Risk vs uncertainty is an important distinction. Knowing which is which can allow the investor to earn good return.

Investing Errors

If you're like me, your most valuable lessons came from first hand experiences rather learning from other people mistakes. Generally speaking people learn better through the mistakes they make. I have read about the same issues that I am writing about elsewhere but sometimes you need to make these errors to realize what it means.

In this post I will review some mistakes and how I adjust for them. I will go through these mistakes by category:

Valuation errors:

• Not accounting properly for the business cycles. I used to take 5 years average of EBIT margins to do my Earning Power Valuation, while 10 years average is more appropriate as it includes at least one full cycle of economic activity. A 5 year average can distort valuation by including either the most favorable margins of the economic cycle or the worst. A 10 year cycle will almost guarantee including a business cycle from bottom to peak and will reflect the most likely EBIT margins for the business going forward for the next decade.
  
• Relying too much on one valuation technique. Valuation is very illusive and can differ from one person to another. I used to use Discounted Free Cash Flow approach exclusively to determine a business intrinsic value, however the approach is as good as the estimate I use for it. Now I deploy several other approaches to validate my results. I use Earning Power Value, liquidation value if appropriate, and sum of the parts, again if appropriate.
• Not using IRR and ROE concepts to measure my return on investments. I use these concepts all the time when I evaluate capital decisions for my business, however I failed to use them to choose between stock investments. Buying a stock is no different from buying real estate or machinery for the business and should be treated as such. You need to buy the stock that will maximize your IRR and ROE ratios.
• Intrinsic valuation changes; it goes up or decline it never stays put. I started to update intrinsic values of my holdings and targets at least on an annual basis.
  

Business Analysis

• Now I understand the value of equity analysts. I used to dismiss their analysis altogether but I have learned to use the good parts. I completely ignore buy/ sell recommendations, price targets, and earning estimates, however some qualitative analysis and risk assessment contain value added information.
• Good businesses do not make for good investments. Investing in a well run company in the absence of a distress situation would not yield exceptional returns. If the same company came under selling pressures due to a crises of some sort, for example a product liability suit such as Merck's Viox, it will be far better investment potential.
  

Investment process

• Patience in establishing positions. I used to go all in, once I find a business I like, but now I am establishing my positions over time this way it will ensure that I may still get it cheaper over time.
• Straying away from my comfort zone into industries and companies that I do not understand or far way too complex for me to value. This will always prove detrimental to my returns.
• Not trusting my own analysis and thinking "I must be missing something". This happened several times, as I develop an investment thesis and arrive to my conclusion but I second guess myself because market prices do not provide me with any validation. However I learnt that market prices are the last place to look for any validation of any sort. If I have checked and double checked my analysis this is the only validation I need.
• I used to invest in undervalued business independent of the reason why it is undervalued. I have learnt what is meant of the term "value trap"; some businesses fall in this category for a reason or another. These are lousy investments. Now I focus on investment that became undervalued and distressed due to macro or micro circumstances.
• Concentration of holdings and portfolio. Having too many positions to track will dilute my analysis and increase the risk profile of my investment and make my actions more susceptible to emotions rather than logic. Deep and through assessment of a business gives you a piece of mind and an ability to analyse company specific events with more depth than the market.
  

Analyzing Consumer Packaged Goods Company

In today's post I will list several factors and criteria I use when I look at a consumer packaged good company. Examples of a consumer packaged goods companies are the likes of P&G, Unilever, Colgate, Clorox, Avon, Loreal...etc. A company in this industry typically hold a portfolio of various household products with slow but steady revenue growth as a result they have a low price earning multiples relative to the overall market. Currently the industry is concentrated in few large players that I think production costs are not enough to produce a competitive advantage between the players. I will even be bolder and say that cost structures are similar across the industry so cost in any analysis can not be the determining factor to invest in a company. So what is important?

Key to Analyzing Consumer Goods Companies

In my mind these are the most two important keys to pick a good investment in this space:

1. Management ability to read and understand shifting consumers' tastes and preferences.
2. Marketing skills and talents are what ensures success between industry players. As more or less cost and the function of the products themselves are relatively the same. Marketing is the true weapon that created brand loyalty and occupies consumer mind share.

There is not a lot of number crunching in analyzing these companies at the end it comes to your judgement and ability to spot key marketing and sales skills. Success in sales and gaining market share in this industry comes down to flair, insight and market research and strategy.

Steps to Analyzing a company

1. Evaluate a companies existing product lines by answering the following: How does the company maintain its current market share and growth rate? Does the company achieve this by spending a lot of money on promotion and advertising? Is sales directly correlated to its advertising spending?
2. Analyze the company's research and development capability to introduce new products: Like any company, consumer goods companies introduce new products and invest heavily in promoting these products reducing their profits for years to come until they reach critical market share and consumer loyalty so they can reap future profits. These products will age and consumers will wander for better and newer competing products, the company must offer either product extensions to prolong the life cycle of these products or offer completely new products to offset the decline in revenues from mature products. So you have to answer questions like: does the company spend enough on research and development? Does the company have an adequate product pipeline to offset declines in mature product revenue? Are the company's product lines old and tired?
3. Understand management ability to adapt to change and sense consumer preferences: Good managers are able to have a keen understanding of their customers habits and preferences by performing effective marketing research. Do management have insight into the feeling and attitudes of their buyers? Does the company have a strong and accomplished management team compared to the competition?

Questions to ask yourself before investing:

1. What is the company marketing strategy? Does it fit their product lines use by consumers?
2. What is the competitive strength of the company's major brands?
3. What is the percentage of revenue spent on R&D?
4. Does the company sells oversees? If yes what is the breakdown? and what is the percentage of their earnings attributable to currency fluctuation?
5. What is the depth of management talent? Do management have talent on the top only or are they developing their file and rank?
6. What is the company's market share for its existing product lines?
7. Does the company depend on limited distribution channels or does build a product franchise so it frees itself from the dependence on few large retailers?

A last issue for you to consider is there are two main categories of consumer goods companies: the personal and the utilitarian. There is a lot of differences between the two. Utilitarian like toiletries are price-sensitive and impersonal; a consumer can replace one for another based on price only. On the other hand, personal items like cosmetics are more preference driven and depends on individual tastes. As a result utilitarian products have low barrier to entry to new competitors and any investment in a company in this space should be made with great care.

Pricing Risk II

Risk planning, in my opinion, is the only thing investment should be about. Success in investment is about risk management and assessment more so than picking good ideas. In my view there are 4 types of risk:

1. Business specific risks: where you lose because of management incompetence, increased competition, and financial insolvency.
2. Valuation risk: there is an adage that says "not all good companies make good investment". This means that you can find an absolutely great management, fantastic product, great prospect, and good sustainable competitive advantage. So where is the risk? The company is overvalued by investors leaving no room for good return and little margin for error.
3. Systemic risks: these risks are general economic risks that are not unique to one company but rather impact most companies to one degree or another.
4. Your own liquidity risk: there may be circumstances that could force you to sell great undervalued businesses prematurely at depressed market prices, therefore you realize losses.
   

All of these risks are present in any investment you make. Realizing their existence and planning for them is as important as researching and analyzing any business idea.

Risks # 1 and # 2 are under your control entirely by performing prudent due diligence you can eliminate these risks. Some will argue diversification can illuminate them as well, sure it can but it comes at the expense of your portfolio performance. I would rather invest my time to analyze and research one great company rather than buy two average businesses. And to avoid #2 simply do not overpay. Avoid companies that are in the headlines news or the ones that your annoying brother in law recommends to you.

Risk # 3 is outside of your control but you can plan for it nonetheless. You can have a good asset allocation mix between equities, bonds, and real estate to diversify this risk as generally in rescissions bonds tend to do better than equities.

Risk # 4 sometime no matter how you plan for it, it will happen but again you can minimize this by only investing the sum of money that you can do without for indefinite amount of time. You should not invest if you are running a startup business, or your foresee you need capital for an upcoming financial obligation. Any investment should be made with the assumption it is forever.

Risk and investment is two faced coin. You have to be able manage both well to succeed.

My Portfolio Managament

Yesterday I have talked about managing your portfolio as if you manage a business. The goal is always to grow the business or the portfolio by maximizing your returns. In this post I want to share with you my overall guidelines for managing my portfolio to see what readers think; am I on the right track or is there something I am missing.

Goals:

My goals for portfolio are the following:

1. Achieve an overall portfolio of 3-3.5% dividend yield on book value.
2. Maintain asset allocation requirements on a yearly basis.

Asset Allocation:

I divide my portfolio to two sub portfolios that I will rebalance quarterly:

1. Core portfolio that will hold index funds, fixed income and cash divided to
• Fixed income and cash up to 20% of the overall portfolio.
• US market index 12% of portfolio
• Canadian Market index 12% of portfolio
• International Market index 10% of portfolio
• Emerging Market index 6% of portfolio
2. non core portfolio that will hold individual stocks. This sub portfolio will be 40% of my overall portfolio.

Buying Process:

• Generating Ideas: I will use screens, reading or general observation of my day to day life to come with investment ideas. What I will not use is media and analyst recommendation.
• Analysis: I must figure the competitive advantage of the business and management track record by analysis its prior actions results.
• Valuation: the company must offer compelling value to its market price for one reason or another for me to be interested.
• Initiate position: buy incrementally and frequently into a stock.

Portfolio rebalancing Guidelines:

The following are my overall portfolio restraints that need to be observed to minimize over exposure to the risk of a certain investment class, once a position is over the goal it needs to be rebalanced by selling/ buying part of the position to achieve the following:

• The overall core holding to be in the range of 60% ( this is split to 40% equity indices and 20% income producing assets and cash)
• The overall non core holdings not to exceed 40%
• The overall Cash position goal: no more than 5%
• There will be no investment in more than 10 businesses in the non core portfolio at any time.
• The overall Emerging Markets positions not to exceed 15 %
• The overall fixed income positions to be in the range of 5 – 20% from total portfolio
• Any individual company in the non-core position to be limited to 10% of the overall portfolio
• The overall total small cap positions not to exceed 15-20%
• The Major market indices (e.g. S&P, NASDAQ, TSX) not to be less than 30%
• Rebalancing time frame: on quarterly basis on the following months: December, March, June, and September.
• If an asset-class allocation reaches 150% of original allocation, cut it back to below the target allocation - 75% of target allocation.
• If asset class then falls to 50% of original allocation, restore it to 150% of the original allocation(1).
• Increase cash position/ reduce positions to specified limit when yield Curve flattening or inverting. Negative differential between 10 year Treasury and 3 month TB indicate a high probability of a recession in the next 4 quarters.

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1. [SA1]The rationale is as follows. If one asset class is appreciating much faster than the others in your portfolio, you want to ride the momentum to 150% of your target allocation. But when you are ready to trim back the asset class, it’s probably become overvalued relative to your other assets. So sell more of it than would be required to return to your “normal” asset allocation. Similarly, if the asset class then depreciates significantly, it has probably become cheap relative to other asset classes, in which case you can overweight it.

Valuation Technique: Earning Power Value (EPV)

I have discussed in a previous post the discounted free cash flow valuation method. Another technique I use and prefer is the Earning Power Value and reproductive asset value (EPV). The reasons why I prefer this technique are many among them:

1. It ignores growth and future projections of sales. Growth projections are always faulty and if they materialize it is by sheer luck.
2. Discounted cash flow models ignore the balance sheet and this one incorporate it as part of the valuation.
3. This method is more conservative.
4. It gives me an indication if management is able to exploit effectively its assets and competitive advantages.

In the following I will give an overview step by step guide to conducting the valuation. Valuation is conducted in two separate steps:

1. Estimation of asset reproductive value
2. Determination of EPV

1. Asset Reproductive Value

Asset reproductive value is the cost of assets needed by a new entrant to compete in an equal manner with an incumbent in the industry. This step can be very involved and need some industry and company insight. You need the company's most recent balance sheet to begin. Valuation will be easiest for current asset and liabilities in general, however more involved with the fixed assets portion of the balance sheet.

You start with book values of the balance sheet, generally it is easier to value the top items and it gets harder as you go down the account list. In the following I will present a table with each major category of assets and the needed adjustment to be made to arrive at a reproductive asset value.

Account	Adjustment
Cash and marketable securities	Generally there is no adjustment needed as cash is cash and marketable securities are marked to market and represent fair value
Account receivables (AR)	the reproduction cost is greater than the book value generally, as companies write off bad debt and apply doubtful debt allowance to AR. At a minimum you add the allowance of bad debt to book value of AR as any new entrant will experience defaults and such expenses.
Inventory	In a liquidation scenario it is valued at zero but at an operating level you have to value it at FIFO basis. If the firm is valuing it using LIFO then add the LIFO reserve back to the balance sheet number to arrive to reproduction value.
Deferred tax assets	PV of cash savings if the company is anticipating to use them if the company is in no position to use these assets then value them at zero.
Building & Land	Generally this item will never be replaced at less than original cost. If the land and buildings are a critical then you have to asses the market value and it is usually upwards as land are booked on the balance sheet in historical terms and undervalues current market values. For example retailers like Home Depot and Sears have purchased all their location years ago therefore their balance sheet value understates the true economic cost for a new competitor that want to compete against them. To get proper value you need to apply similar transaction values to the company's buildings and land on a location by location basis. This can be one of the hardest steps in the process and the more research intensive.
Plants & Equipment	In general there is a long term trend of equipment efficiency and advancement so historical value of plants and equipment may be higher than what a new entrant into the industry might have to pay. Here a familiarity of the industry production method and technologies will help. On going plants use the price for unit production capacity value. What is the market value or production price per unit of output for other comparable companies. Example, what is the price of tonnage of aluminum in the market multiplied by how many tonnage does the plant produce gives a reproductive value for the aluminum plant.
Intangibles	How many years in R&D spending to reproduce a product? Depends on the industry, in consumer it takes 3 years, in car business it takes 6 years. Brands: what is the cost to reproduce the brand? What is the comparable acquisition price of brands in the same industry? The acquisition price of some deals per each dollar of sales of the acquired brand and apply that multiple to the company sales you are valuing. Or simply 3 years of marketing and sales expenditure of the firm
Deferred taxes liabilities	PV of cash to be paid in the future if the company is profitable. But if it is anticipated to generate losses then you have to push payment into the future further and will be valued less.
Accounts payable	Book value is a good reproductive value for this account and no adjustment is needed.
Long term liabilities	Market value of debt as a new entrant will have to issue debt at current interest rates which may be different than the historical prices of the company debt. You can look these up using yahoo finance.

Please note that if you are attempting this valuation on a viable industry then it is reproductive valuation. However if the industry is not viable then liquidation values should apply, in other words serious discounts should be applied to the assets.

2. Earning Power Value

Earning power value: is the second aspect of the valuation of a business. Basically EPV is...

A business's ability to generate profit from conducting its operations. Earnings power is used to analyze stocks to assess whether the underlying company is worthy of investment. Possessing greater long-term earnings power is one indication that a stock may be a good investment.

or in a mathematical equation EPV= Adjusted Earrings/ cost of capital

The calculation assumes no growth and current earning is sustainable over the long run. This is one of the great advantages of the technique as it does not muddy the valuation process with future predictions. It evaluate a company based on its current situation. However to arrive at EPV there are several adjustments to be made to the Earnings figure as follows:

1. Operating earning or EBT is the start point.
2. You need to adjust EBT for the business cycle and cyclicallity by taking a 7 year Average of operating earning, which will include at least one economic downturn. You can do this by averaging the company's EBT margin over 7 years and apply it to current year's sales, and viola it will adjust for cyclicallity and business cycle.
3. Next deduct the 7 year average of non-recurring charges or normalize these expenses to reflect their economic nature. Non recurring charges are part of doing business and they will arise in the future so I do not see why you need to exclude them.
4. Apply Tax rate the figure derived in step 3, which is the average tax rate of the company over the last 7 years. Alternatively use the general 33% corporate tax rate to avoid tax schemes implemented by different companies.
5. Add depreciation of the most recent year.
6. Next deduct adjusted Depreciation: true depreciation is the cost to the company to make it at the end of the year in the same situation at the beginning of the year. Accounting depreciation is irrelevant as it can be higher because capital goods prices go down due to technology advancement, or it can be lower in inflationary environment where reproduction costs is higher then accounting depreciation underestimates true economic cost, so you have to adjust for it by using maintenance capital expenses (CAPEX) as the true measure of depreciation. You can calculate maintenance CAPEX by:

• Calculate the Average Gross Property Plant and Equipment (PPE)/ sales ratio over 7 years
• Calculate current year's increase in sales
• Multiply PPE/Sales ratio by increase in sales to arrive to growth capex
• Maintenance CAPEX is the Capex figure from the cash flow statement less growth capex calculated above, which is the true depreciation for the company

7. Cost of capital estimation: estimate by judgment or use company cost of capital as discussed in my earlier post here.
8. Divide the adjusted earnings calculated in step 6 by cost of capital in step 7 to get EPV.

The final step is to compare the per share reproductive asset value in step 1 (Assets-liabilities/ # of shares) to EPV per share calculated in step 2 and you got a value of the business. Companies with sustainable competitive advantage should have a higher EPV than asset value and the difference is the franchise value. If the reverse is true management is destroying shareholder's value by earning less that the assets capability and you can conclude that the business is a commodity business with no attractive ROIC profile.

If you require more details on this technique, I recommend buying Bruce Greenwald's book: Value Investing: from Graham to Buffett and Beyond. I also recommend watching the following lecture by Prof Greenwald about the subject, you can view it here.

I hope the above helps.

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Sources: Value Investing: from Graham to Buffett and Beyond by Bruce Greenwald, Security Analysis by Graham and Dodd, Investopedia.com

Brands and Competitive Advantages

Brand names are often linked to the existence of strong competitive advantage in business and in turn command premium valuation. Companies spend billions of dollars to create, promote and sell their brands to consumers. Developing a great brand can be a long and substantial process to gain customers trust and mind share. A company with a recognizable brand can gain significant economic benefits. Products with brand names can outsell their cheaper generic competitors. For example, Coca-cola's market share is far superior to any generic or store bough soda. In fact, Coca-cola is the most valuable brand in the world with a value of $63.4 Billion according to recent BusinessWeek research. Another example, is Advil, which outsells the generic and much cheaper Ibuprofen bottles.

In this post I want to examine the role of brands plays in valuing a business. Does a brand name lead always to competitive advantage? Do brands deserve a premium valuation? Brand names indeed may lead to competitive advantage, but not always. One need to evaluate the industry, pricing points, competing products and consumer usage to determine the brand value in creating sustainable competitive advantage.

There are several cases where brands do not translate into competitive advantages. Here are some cases:

• Highly competitive industries: You can always bet that industries with too many alternatives of equal quality and product specification, brands do not translate into competitive advantages. Rarely that any company in similar industries has created sustainable advantages over its competitors. Here you can probably think of car brands. One of the most successful and quality cars is the Mercedes Benz, but the brand of Benz did not translate into leading market share or added value to investors as many luxury car makers followed into this segment and took customers away from Benz.
• Commodity industries: Any firm that invests in branding in a commodity industry will destroy value. No one really cares what brand of plumbing, wires, screws...etc they are buying. You just buy the cheapest one.
• Typically capital goods items where they are purchased infrequently and require large investment do not have brands with sustainable competitive advantages. Long lasting goods are purchased less frequently, often cost a lot, and you are therefore more likely to take the time to carefully consider your options before purchasing.
  

When do brands lead to Competitive Advantage?

Branding by itself is not sufficient to create a competitive advantage for a business. A new entrant to the industry with sufficient resources can create an equally competitive brand in terms of quality and reputation. In order for a brand to create sustainable competitive advantage, it has to be coupled with captive consumer behaviour that locks them into buying the same brand over and over. A business needs to be able to convert a product brand into something the customer connect with at many levels by coupling it with one of the following:

• User Habit: think of a smoker and his preference for Marlboro cigarettes or a Coca-Cola drinker who got accustomed to the taste, Buffett can attest to that as he drink 5 cokes a day. It is very hard or nearly impossible to change consumer habits and behaviour. Products associated with habitual purchases create some of the strongest competitive advantage for a business that exists.
• Switching costs: customer will be captive to a brand if it has high switching costs associated with changing brands, particularly for low cost and frequently purchased products.
• Search costs: customer is tied to a specific brand if his search costs for an alternative is too high. Car insurance is a great example. Have you tried to compare quotes between providers? It takes too long and you come up with different policies that you can't compare.so you stick with the provider or the brand that you have. Also, brands that are frequently purchased are more likely to lead to strong competitive advantage. A consumer is more likely to be brand loyal with low cost items, since the cost and the effort to research alternatives outweigh the purchase itself, so you stick with what you know.

How to value brands?

I always place a valuation on brands for companies that demonstrate some of the characteristics listed above. Brands in these cases are as or more valuable than fixed assets. There are no rules how to value brands and it is almost a judgment call to the strength of the brands. BusinessWeek does an annual survey for the best 100 global brands that can be a starting place if the company is listed there. If it is not, I usually take the sum of the last 5-7 years of marketing and advertising expenditure and capitalize it on a declining balance, i.e. reduce earlier years expenses by a percentage factor. The sum is added to my valuation on per share basis. This figure will replace whatever goodwill written into the balance sheet as it is more accurate and relevant than book value of merger and acquisition premiums.

Sources: "Competition Demystified" by Bruce Greenwald, Brands-vs-franchise by fatpitchfinancials.com, "best Global Brands" by Businessweek