Fundamentals of Value Creation

This section is heavily borrowed from the book "Valuation: Measuring and Managing the Value of Companies". In my opinion, this book has one of the clearest explanations on the drivers of value creation for a company. I say this after reading many books to try to understand this topic. At close to 800 pages, this is not an easy read, but if you are into this kind of thing, I promise it is worth the effort. 

Consider the following two hypothetical companies Value and Volume, whose projected revenues and earnings are identical. Both companies earn $100 million in year 1 and increase their revenues and earnings at 5 percent per year in all future periods, so their projected earnings are identical. Assume that shares outstanding for both companies are the same, so projected EPS for both are also identical. Here is a question - are the two companies' values also the same, or in technical terms, do they deserve the same P/E multiple? The investment community's fixation with EPS growth and P/E multiple would make you believe it to be true, but let me dispel this myth here.

Future growth does not come for free. Both companies have to reinvest a certain percentage of their earnings for the year to achieve future growth. Let's assume that company Value has to invest only 25% of its earnings back into the business but Volume has to reinvest back 50% of its earnings to achieve the same rate of growth as company Value. Thus, company Value creates higher cash flows (Earnings - Investments into the business for future growth) relative to company Volume. 

What remains for the shareholder are these streams of cash flows that she can expect to earn in future periods (through dividend payments for instance). Since "a bird in hand is worth two in the bush" you discount back (using the company's cost of capital) these future expected streams of cash flows to the current time and sum them up to get the intrinsic value for these two companies. Assuming that the cost of capital for both companies are the same, since company Value creates higher cash flows it is more valuable and deserves a higher P/E multiple than company Volume even though both have identical projected EPS' in future periods.

I can't tell you how often I listen to analysts saying "this company trades at 18x P/E and hence it is not cheap, look at this other company that trades at 10x P/E it is much cheaper". In an ideal world where all companies are required to put in same percentage of investment to achieve same rates of future growth, it makes sense to make these types of comparisons, but otherwise it is totally nonsensical.

Company Value achieves 5% of Growth each year by investing back 25% (also known as Investment Rate) of its earnings each year. The ratio of Growth / Investment Rate is known in the financial literature as ROIC (Return on Invested Capital). Thus, Value's ROIC is 20% and Volume's ROIC is 10%. 

Let's look at the valuation matrix for a company that earns $100 million in year one, has a long-term growth rate of 2% to 4%, ROIC of 10% to 16%, and a cost of capital of 10%.

A few observations - (i) the blue column shows that growth has no effect on value when ROIC is same as cost of capital, (ii) the two green cells show that a company with lower growth rate but higher ROIC can be just as valuable as one that has higher growth but lower ROIC, and (iii) the red cell shows that any growth below ROIC destroys value. 

With this new (and correct) way of looking at a business, you will find the constant touting of EPS growth for such and such a company on CNBC to be completely worthless information, especially since CNBC does not talk about ROIC or cost of capital for the business.

Let's talk about how I calculated the valuation matrix above. First, I need to introduce a few new terms. 

• NOPAT (Net Operating Profit less Adjusted Taxes): represents profits generated from company's core operations after subtracting the income taxes related to the core operations
• Invested Capital (IC): represents the cumulative amount the business has invested in its core operations - property, plant, and equipment, and working capital
• Net Investment is the increase in investment capital from one year to the next
• Free Cash Flow (FCF): is the cash flow generated by the core operations of the business after deducting investments in new capital. So, FCF = NOPAT - Net Investment
• Return on Invested Capital (ROIC): is the return the company earns on each dollar invested in the business. So, ROIC = NOPAT / Invested Capital. ROIC can also be defined as the incremental return on new or incremental capital. However, for now we assume that both are the same. If not, then the later definition is known as RONIC (Return on New Invested Capital). 
• Investment Rate (IR) is the portion of NOPAT invested back in the business. So, IR = Net Investment / NOPAT.
• Weighted average cost of capital (WACC) is the return that investors expect to make from investing in the enterprise and therefore the appropriate discount rate for FCF.
• Growth (g) is the rate at which NOPAT and cash flow grow each year. Investing the same proportion of NOPAT each year also means that the company's free cash flow grows at rate g.

Since company's free cash flow grows at a constant rate g, we can begin valuing the company by using the well-known formula for perpetual growth:

Enterprise Value = FCF / (WACC - g)  .........(1)

Next, lets define FCF in terms of NOPAT and IR.

FCF = NOPAT - Net Investment =>

FCF = NOPAT - NOPAT * IR   =>

FCF = NOPAT * (1-IR) ..............(2)

In the section on Value vs. Volume, we had seen that 

ROIC = g / IR =>

IR = g / ROIC ............(3)

so putting equation (3) and (2) in (1), you get

Enterprise Value = NOPAT (1 - g/ROIC) / (WACC - g)

If you put ROIC = WACC in the above formula, you get Value = NOPAT / WACC, a formula that is independent of g as we had seen in the blue column of the valuation matrix. 

If you divide by NOPAT on both sides, you get:

Enterprise Value / NOPAT = (1 - g/ROIC) / (WACC - g)

The Enterprise Value to NOPAT ratio (similar to the ratio used in Joel Greenblatt's ratio EV/EBIT but its pre-tax) is a more meaningful way of thinking about the appropriate multiple for a business instead of the usually quoted P/E multiple. As you can see the key drivers of this multiple are long-term growth rate for the business, ROIC, and the cost of capital. 

Lets apply this to one of the businesses I own today - MasterCard. I expect MasterCard to grow at 15% to 20% for the next 5 years and do it at a very high ROIC of 40% to 50%. However, this cannot last forever. Growth rates slow down as markets get saturated and ROIC goes down as opportunities to invest capital go down. It seems unlikely that new competition can come in and start competing with MasterCard in the foreseeable future for a long time (for reasons I will not go into here, but you can look at my MasterCard write-up from December 2010). Thus, once the fast growth period ends, I expect MasterCard to be able to continue growing at least 1% to 2% above inflation of 2% (due to pricing power in absence of competition) and continue to do it at ROIC of 15% to 20%. I use 10% as the WACC for MasterCard. Plug this into the formula, you get a multiple of 11x to 13x of 2016E NOPAT. Since NOPAT can grow at 15% to 20% in the 5 years from 2012-2016, 2016E NOPAT will be at 2x to 2.5x of 2011 NOPAT. Hence, the fair value of MasterCard is between 22x to 30x of 2011 NOPAT + sum of free cash flows generated for the years 2011 through 2016 discounted to present (which we'll ignore for simplicity sake). When I purchased MasterCard in Dec 2010, it was trading at 14.5x of 2010 NOPAT. It's up 60% from my purchase price and today it is trading at 19x 2011 NOPAT. 

Let me give you another example. For the period from 1968 to 2007, net income at the pharmacy chain, Walgreens, grew at 14% annually and it was among the fastest growing companies in the United States. During this period, the average annual shareholder return (including dividends) was 16%. Now, contrast this with performance at the chewing gum maker Wm. Wrigley Jr. Company during the same period. Wrigley's net income during the same period grew much slower at about 10% a year, but the average annual shareholder return of 17% a year was higher than at Walgreens. The reason Wrigley could create more value than Walgreens despite 40% slower growth was that it earned a 28% ROIC, while the ROIC for Walgreens was 14% (which is quite good for a retailer).

Next time you hear the words "this company is trading at only 10x P/E, it must be cheap. Or this company that is at 18x P/E must be expensive", I urge you to think about this article. In all likelihood the conclusion may be the correct one, but think about the business' ROIC and what about its structure causes it to have a high (or a low) ROIC before drawing that conclusion.

Tableau Software: Amazing Tool for Data Analysis and Viewing

I downloaded the free trial of a new software called Tableau yesterday. It is one slick tool - you use your excel sheet as the data source and connect Tableau to it. Once done, you can quickly slice, dice and view your data in more ways that you imagine. I was pretty impressed. It costs a thousand bucks, so I am not sure if I'll make the jump yet, but I am a sucker for these kinds of things. Here is what I put together in under 10 minutes - a tool that shows My U.S. Portfolio performance relative to Vanguard's S&P500 index fund. You can use the slider to move the reference start date and then click on the points on the two line charts to get cumulative performance from the reference date.

American Business Bank: Growth at a Reasonable Price

I initiated a new position in a tiny L.A. based bank, American Business Bank (OTC:AMBZ), recently at an average price of $21.60. It is now a 4% position in the portfolio. AMBZ trades over-the-counter and has no SEC filings, but no reason to worry since its financials can be verified with call reports that AMBZ is required to file with FDIC.

American Business Bank operates in the niche of banking middle market companies. The narrow focus has served AMBZ really well - assets have grown from less than 100M when the bank opened its doors in 1998 to over a billion dollars today. Net income has grown from less than a million to over ten million today. If you looked at its financials, you would not know that the US banking sector just experienced the worst crisis since the Great Depression. It has had virtually no non-accruals, no OREO, or net charge offs. Despite this, the balance sheet today has close to 2% of net loans in reserves for future loan losses. Furthermore, its cost of funding is among the lowest, if not the lowest in the nation at 35 bps. It has achieved these enviable results by consistently doing a ROAE of 12% to 14%. 

Despite this, AMBZ trades at a very small premium to tangible book value of $18.80 and at 9x TTM P/E of $2.33. I believe that a position in AMBZ today presents the opportunity to make a total return of 50% to 200% as it grows its asset base to $1.5 to $2 billion by 2016 with no downside in any scenario that I can imagine (market volatility is not considered as downside - we are talking about chances of permanent loss).

Here is a link to the detailed write-up. 

Nicholas Financial: Quality on Sale

I recently added to my previously held position, Nicholas Financial (NASDAQ:NICK), at $9.74. Nicholas is in the business of making sub-prime auto loans.

Contrary to the business description, it is one of the highest quality financial that I have come across - it has continued to stay profitable over the past decade consistently doing Returns on Average Equity (ROAE) of 10% to 15% (with the exception of 2008 when ROAE dropped to 6%), despite this period being one of the worst for financials since the depression. It is one of the few financials that continues to grow in this dismal environment of poor loan demand and does not face as big a risk of net interest margin compression as the conventional banks.

At current valuations, the upside is of 70% to 150% over the next 5 years, or an IRR of 11% to 20%. Add to this a dividend yield of 4%, you get a very compelling IRR of 15% to 24%, and a very limited chance of permanent loss of capital, thanks to its conservatively reported book value of $10 per share.

For a full write up, I recommend you read my submission for Gurufocus' October Value Contest here. 

2011 Portfolio Update

This is first post in four months since my write-up on CVS Caremark. Yes, I am still alive and kicking. I have been very busy in the past few months learning about the banking and insurance business, researching for new ideas, and writing new ideas at www.valueinvestorsclub.com (VIC). Unfortunately, writing on the blog fell to the bottom of my list of things to do.

For those who are unfamiliar with VIC, it is an exclusive forum of only 250 value investors who share long and short ideas on the forum.  The club was started by the renowned author and hedge fund manager Joel Greenblatt. To be selected to the club, one writes up a “deeply researched” long or short position to be judged by a panel of VIC judges. I got selected to the club based on my write-up on MasterCard. I feel extremely fortunate to be part of the club – in less than 6 months I feel like I have learnt more than I ever have in my investing career by interacting with one of the smartest groups of value investors out there. One of the restrictions of VIC is that ideas posted there cannot be shared publicly. Unfortunately it means that, going forward, ideas that I post there or I learn of there will not show up in much detail on this blog.

Uncertainty and volatility has returned to markets. Correlation between asset classes has increased dramatically and almost all investing decisions today seemed to be made on increasingly short time horizons. The prevalence of algorithmic trading has reduced the already short-termed nature of a large number of market participants to holding periods of minutes, if not seconds! The only thing I know I will be doing is what I know to do – buy good businesses that are low in leverage, have low risk of obsolescence, and are offered by Mr. Market at an attractive price. Undoubtedly, this will be accompanied with a mark down in market prices of businesses we own today and will own through this environment. I will not let this bother me much since I continue to be confident that Ben Graham was right when he said “Mr. Market is a voting machine in the short-run, and a weighing scale in the long-run.”

Next, I want to talk about the portfolio’s performance. Even though portfolio’s YTD performance has beaten S&P500, it has been dissatisfactory to say the least – portfolio -6.8% YTD compared to S&P500 (with dividends reinvested) -10.39% YTD. To congratulate oneself based on comparisons with other indices is idiotic, since we do not eat from the plate of relative performance. Looking at a more longer horizon, the portfolio held up much better, +12.15% cumulative growth since 1/1/2010 relative to –0.52 cumulative growth in S&P500 (with dividends reinvested) since 1/1/2010. My longer term goal is to have the portfolio CAGR at inflation plus 10%.

Let me update you on the changes in the portfolio from the last time I reported. I sold out of four positions – three of them had reached their “intrinsic value” and the forth one, FUR,  I was wrong on and sold at a reasonable profit.

FUR is structured as a REIT – meaning it has to pay out a large portion of the FFO to the owners – causing the REIT to keep coming back to the capital market every time it wants to grow. FUR had become a 25% position in my portfolio, and the only way I could stay undiluted was to participate in the capital raise. I was super uncomfortable with a position larger than what I already had. The reason for selling out had more to do with the function of a REIT in my portfolio rather than Mr. Ashner’s skills, who is one of the smartest real estate investors I have come across. If the price becomes right, I may start a very small position again in the future.

Now, let me turn your attention to the current positions in the portfolio.

Note: Foreign holdings such as Accor and Edenred have been converted to USD on a mark to market basis. The Gains % column indicates gains in market value of the security including dividends yielded since the time of purchase of the security.

I will make a comment on my thesis on each of the holdings starting with a long comment on the ones that had the largest negative impact on the portfolio and a short one on the ones that have had the largest positive impact. I believe that we learn more from our “failures” than our “successes.” (All of the above is just mark to market – so failures and successes have limited meaning).

Kirkland’s (KIRK) – I initiated my position in KIRK, a specialty retailer, in Nov 2010 when it got really cheap (2x EV/EBITDA) due a couple of factors – gross margin compression due to higher than expected discounting and promotional activity, and operating margin compression due to deleverage caused by falling same-store-sales. The closest comp, Pier 1 (PIR) was trading at 5x EV/EBITDA. My wife and I have been shopping at KIRK since the time we bought our home a few years ago, so I was familiar with their concept. I viewed their problems more short term in nature and viewed this as a 2x given that KIRK had a long runway in front of it as it expanded its store count. KIRK has about 300 stores whereas Pier 1 has about 1200 stores, so it wasn’t unreasonable to assume that KIRK could get to 400-500 stores by 2015, as long as the economy remained somewhat stable. KIRK moved up by 30% in less than a few months, but I didn’t sell out, because I viewed it as a compounder over the next 5 years. Mistake #1 – valuation is not an exact science, hence the need to invest using a margin of safety. I should have taken 30% gains and got out. KIRK was back to where I started my position by the time it reported next quarterly results. Old issues (which I viewed as temporary) were still a concern but no new issues came up on the call other than a slow down in growth of new stores due to difficulty in finding new locations. KIRK management was now projecting growth of 20 net new stores in 2011 rather than 40. 20 new stores still got you 100 new stores in 5 years. My thesis remained intact, so I doubled up on my position. Mistake #2 – I should have nibbled at it, rather than doubling up. A small store like KIRK has massive operating leverage at work, so a lot of little issues can cause major swings in their margins (even though they may be temporary) causing volatility in the stock price as the street is focused on those little things. The volatility meant that I could have added to my position as it went down, and if it didn’t go down I still had a reasonable sized position to get a good enough upside. There was no reason to double up on one shot. A few weeks later, KIRK was down 25% primarily due to macro concerns. Today, KIRK is insanely cheap – EV of 85M, fortress balance sheet with no debt, and a EBITDA ranging from 30-60M in 2008-2010. KIRK reported its quarterly results on Aug 19, 2011 and nothing much has changed business wise. They are working through their issues – by changing merchandise mix to help lower the promotional activity and stabilize same-store-sales. They also announced that they will be using 40M of excess cash on balance sheet for buybacks in the next 18 months. When the stock is so cheap and the issues are temporary, use of excess cash to do buybacks is highly accretive to the shareholder. 40M of cash at today’s price will buyback 25% of their outstanding stock! Even if net income does not grow from 2011E of 20M, EPS grows from by 33% from $1 to $1.33. If they fix their issues in the next 18 months, Mr. Market will come back and award KIRK with the multiple it deserves of 10x – $13. In addition they will have generated another 30M or $2 of cash by then. So, conservatively we should see it go back to $13-$15 in 18 months – an IRR of 16% from my cost basis, or if you are starting a new position an IRR of 40% from today.

POSCO (PKX) is a one of the lowest cost producers of steel in the world based in Korea. It is the third largest in terms of production, and among the most profitable, if not the most. In an industry that is highly cyclical, it has achieved the rarity – consistently earned returns above the cost of capital for over a decade. In 2010, it reported one of the lowest margins in the last decade due to weakness in steel prices and increase in raw material costs. POSCO is taking the right steps to lower its raw material costs, so I am expecting that margins will eventually revert to mean. In my estimate, POSCO (ADR) is worth about $150 – 40% higher than my cost basis and 70% higher than today. Not baked into this valuation is a free option on India growth. POSCO has in-plans the largest foreign direct investment of 12B USD in India to create a FINEX plant with 12M capacity in the state of Orissa. FINEX is POSCO’s proprietary technology of steel making that can operate at 15% lower operating costs and 20% lower capex than traditional blast furnace.

With the new macro concerns surfacing, if we do double dip into a global recession, steel demand will continue to stay weak putting pressure on margins. Margin reversion-to-mean will take longer than I originally thought (five years instead of three) lowering my IRR in POSCO from 11% to 7%. My mistake on this position was one of incorrect sizing – even before the dip of 17% - at my cost basis, I was expecting a low double digit IRR which clearly did not justify a 8% position in the portfolio. I wonder now what I was thinking when I picked such a large position size! If POSCO goes back to my cost basis, I will reduce my position size. I will add to this position only if it goes below $50 (to bring my cost basis to $75 and an expected IRR of 15%).

Look for the second part of this post for comments on the next 4-5 positions, hopefully by the next weekend.

CVS Caremark: Toll Booth on Prescription Drug Spending Highway

CVS Caremark (NYSE:CVS) is the newest position in the portfolio. The position was initiated at an average cost of $33.50 and now occupies 8% of the portfolio. It represents the largest purchase since the Leucadia purchase in July 2010 resulting from a very deep analysis of its business and industry dynamics. My wife thought I was getting ready to take some exam during my research, because I spent non-stop six days a week staying up till 4:00 am for about a month.

CVS Caremark operates the largest retail drug store and the second largest PBM (prescription benefits manager) in the nation. It is the largest purchaser of prescription drugs in the world making it the Wal-Mart of the prescription drug supply industry.

To understand briefly on why this position was initiated, refer to the Summary section of my report at www.gurufocus.com (submitted for their monthly Value Contest). 

The full-report is also published at the link above, but to go through the report in its entirety, you will need patience along with a cup of coffee. The 40 page long report may seem over-the-board to some people, but when you purchase a stock, somebody else is on the other side of the trade, and only one of you can be right. It better be you if you are putting 8% of your net worth into the purchase.

Wendy's/Arby's: Business Analysis & Valuation

Recently, I initiated a position in Wendy's/Arby's (NYSE:WEN) at an average cost of $4.79. WEN is led by the activist investor Nelson Peltz. He is well known for his ability to turnaround under-performing businesses by forcing changes that help improve operations. At the price WEN was purchased, the risk/reward profile is very attractive, especially in a frothy market like today where value has become very difficult to find. The downside is close to 0% and the upside is in the range of 35-50%. 

For a full report on WEN, refer to my article at www.gurufocus.com. For those who are not familiar with this website, it is well known among the value investing circle as a valuable resource for tracking activity of top value managers. This article was written as my contribution for a monthly contest that they run for best value ideas.