This post is not about a stock valuation. This post is about what it takes to be a great value investor. Lots of people believe it requires a genius brain. That helps, but I still say if you're in the top 3% in the world in terms of brains, please just make the world a better place. You can make your fortune that way, and help the world. However, there is one other reason. Humans are hardwired to look for patterns even if none exist. Let me prove it to you. There is no pattern in the set of numbers I am going to give. 1,2,3,4. What is the next number? Did you guess 5? If you did, you're wrong! It's pi. Didn't guess that did you? You may argue that the set of numbers was increasing by 1, but remember what I said. There is no pattern. Even if one appears, it is by random chance. This is the problem faced with the top 3% of geniuses. You still have that bias where you think there's a pattern, except you're so smart you refuse to think you cannot find it, it's just nobody else has. So you keep looking, but in reality there is no pattern. You use your technical analysis to find a price, and then are wrong. You say it didn't follow the pattern, but again the reality is there is no pattern. This is why I say value investing should not be done by people that are in the top 3% or bottom 10% in terms of brainpower.
You may still succeed if you are in the top 3% but for that you need to learn how to control your emotions. This is a lot easier said than done. In fact when lots of people are telling you the opposite of what is true, you may want to consider changing your ideas because you think its wrong, but it isn't. Let me give you an example. When RIMM was at $120, I told a friend of mine it is overvalued. He laughed at me saying that it is worth whatever people are willing to pay for it. Most people at that time saw blackberries as the best device and said it's worth whatever price it's selling at. Remember, just because somebody is willing to pay a lot of money for a stock doesn't mean it's worth that much, however, you can sell it and make a nice tidy profit. In the end I was proven right, stunningly so. The stock crashed to $18 at which point I thought it was undervalued. People laughed at me. The same people who laughed at me when I said $120 was too much. Logic eludes them. After all it's still the exact same company and they think it's fairly priced at $120 and overvalued at $18. Now to be fair it fell further and now is around $13-$14. At this point people are starting to stay it may be undervalued after it doubled in the last month. I'm not saying they're right or wrong, I just find it interesting the way they're valuing it. When it had gone up a lot people said it was worth buying, after it went down a lot people said it should be sold, and now that it has doubled in a month people say it should be bought. This reminds me of something Peter Lynch wrote in One up on Wall Street. He said we always prepare for what has already happened. So if prices have gone up at a ridiculous rate, we think it will continue going up at that rate, even though we should know that is unlikely. This is because after prices go up a lot it has probably (though not certainly) hit it's fair value or more and will probably go down.
So what do we take away from this? First, we must ignore the market and make our own decisions. That is important. We have to analyze the companies ourselves and determine a fair price. Don't just take my analysis, if you disagree, all the better because you probably understand it better than I do. The RIMM thing shows the popular sentiment is not always right. So it is better to ignore it altogether. What you need to succeed in the market is to ignore everyone else and do it yourself. I know it helps if someone better than you analyzes it, but unless you understand his analysis don't follow him because he can change his mind, or even be wrong. Even Warren Buffett's been wrong. So the key is to analyze it yourself and ignore people unless you understand what they're saying and they're right according to you. Also notice that people buy when stock prices go up and sell when stock prices are going down. This is because they are emotional. You must not get emotional about stocks. That is key. As always if you disagree the comments section is below.
Thursday, December 20, 2012
Wednesday, December 12, 2012
Tim Hortons Inc. Is Undervalued
Today I am going to talk about a very interesting investment. The returns from Tim Hortons Inc. (THI) will not come over the next 3 years or less like most investments would. Instead I think this company will return 20% per year over the next 10 years or so. You may not think that's a lot but keep in mind that Buffett has "only" averaged 22% per year for more than 50 years so this is nothing to sneeze at. What's really interesting about this company is that it is a safe bet. There are no problems with this business at all at this time. In fact, we can only say good things. Let us start with the financial statements.
As always we start with the balance sheet. Here you may note that the current assets is not double current liabilities. That is a small problem but they have cash and net receivables that can more than cover their current liabilities. I don't always like to use inventory because we don't actually know how long it will take to convert it to cash but in this case we can assume it'll be fast because historically THI has done a good job with inventory. But even ignoring that they have enough to cover debts. Furthermore, the total assets are twice total liabilities. Some of you may be concerned that the debt is increasing over the last 2 years (especially the long term debt), but profits have gone up. Interestingly the debt has gone up 26% whereas profits have gone up 30% or so. So they have just been financing some profits with debt. I would give the balanche sheet a B+. I can't give it an A because of the current liabilities being too close to current assets, but it is somewhat justifiable in this case.
Now let us go to the income statement. Remember how I said I hate retail businesses? This is in a way retail. It retails food and drinks. However, the margins are not low. With the niche THI has discovered they get margins of 12%-13%. Not bad eh? In the last 3 years SBUX has gotten anywhere between 9%-16%. So while some of their margins were higher, THI was more consistent. Thus we can expect this level of profits in the long term. I am not saying SBUX was bad in terms of margins, just less predictable. This is probably due to the recession thus causing margins to dip for expensive SBUX as opposed to cheap THI. But it has come back and THI margins have not gotten lower so we should expect it in the long term to be 12%-13%. I like higher margins but for retail this is solid. In case you were wondering I look for 15% or higher profit margins typically. Also the nonrecurring charges are negligible for THI. So I would give the income statement an A-.
Now we look at the cash flow statement. Here you will notice that the free cash flow is lower than profits. Typically this is a problem. Not in this case. First of all you will notice that the free cash flow is not increasing in the last few years. Year ended 2009 FCF was $268 million, year ended 2010 FCF was $390 million, and year ended 2011 FCF was $206 million. This gives you an average FCF of $288 million. However, remember that THI is growing a lot and much of the capital expenditures is due to expansion. As a result, we cannot say it is bad that they're spending their money to expand, especially with the margins they are getting. Also in the last 4 reported quarters FCF was $371 million. So P/FCF is anywhere between 26.4 and 20.5. But with P/E at 20, which in this case may be more accurate than P/FCF, we have to consider that you are getting returns of 5%. Sounds bad doesn't it? Not if you pay attention to the next few paragraphs. In conclusion I rate the cash flow statement a B-.
So now we must do the qualitative analysis. As you must have noticed you are only expected to get returns of 5% if there is no growth. But I expect plenty of growth. The reason is that while THI is very prevalent in Canada they are also expanding to the US which is a market ten times bigger. And I would not believe they would be successful growing there, unless they had already been there and done that, which they have. Their growth in the US is outstanding. Furthmore, they are refusing to give franchises to anyone who does not already own a THI franchise. This helps because you have experienced people handling the business who have been successful before (otherwise they would not have the money for another franchise) so you can expect them to duplicate their success. This also makes sure they don't grow too fast, because when companies grow too fast they cannot get the right people to implement that growth (Good to Great, Jim Collins). People may worry about competition from Dunkin Donuts, but I've been to those stores. Sadly, they are not as good at this as THI. Their stores are typically dead (as in very few customers) whereas THI is almost always packed. So regarding growth strategy this is outstanding. As for competitors, they would have to build their own stores which would take a while, and as Peter Lynch points out in One Up on Wall Street these businesses can grow by 20% per year for 10 years. That would give you a compounded return of 20% annually for 10 years. This is typical and as for looking at the ceiling on this business just look at SBUX profits and sales. They are at $1.4 billion in profits for now and they have far more stores so it's not unlikely that THI gets to the same profits as they have one fourth of the number of stores as SBUX. Thus the growth strategy is solid and I give it an A+.
Now we come back to the old dilemma of where's the niche? Remember this is still a bad industry (retail). I gave you the niche for HPQ in that they make cost effective laptops. What is the niche market for THI? The answer is the low end coffee shop frequenters. Lots of people meet over coffee at SBUX, but it's expensive. As money is always tight the less wealthy among us, and even the wealthy who are thrifty would come to THI over SBUX. SBUX has their own niche of wealthy clients and a brand name they've built over many decades, but THI has separate niche allowing them to compete. I think this niche market is larger than the one captured by SBUX so THI can grow quite well.
In conclusion I expect this business to grow at around 20% per year for 10 years. You may say that after that time the P/E will fall so our returns won't be as high. I respectfully disagree. Look at SBUX P/E ratio. It's 30. Even if THI maintains it's 20 it would give you 20% returns, while the market typically averages 10% per year. So that is what you can expect from THI. As always if you disagree or would like to add something please do so in the comments below. Thank you.
As always we start with the balance sheet. Here you may note that the current assets is not double current liabilities. That is a small problem but they have cash and net receivables that can more than cover their current liabilities. I don't always like to use inventory because we don't actually know how long it will take to convert it to cash but in this case we can assume it'll be fast because historically THI has done a good job with inventory. But even ignoring that they have enough to cover debts. Furthermore, the total assets are twice total liabilities. Some of you may be concerned that the debt is increasing over the last 2 years (especially the long term debt), but profits have gone up. Interestingly the debt has gone up 26% whereas profits have gone up 30% or so. So they have just been financing some profits with debt. I would give the balanche sheet a B+. I can't give it an A because of the current liabilities being too close to current assets, but it is somewhat justifiable in this case.
Now let us go to the income statement. Remember how I said I hate retail businesses? This is in a way retail. It retails food and drinks. However, the margins are not low. With the niche THI has discovered they get margins of 12%-13%. Not bad eh? In the last 3 years SBUX has gotten anywhere between 9%-16%. So while some of their margins were higher, THI was more consistent. Thus we can expect this level of profits in the long term. I am not saying SBUX was bad in terms of margins, just less predictable. This is probably due to the recession thus causing margins to dip for expensive SBUX as opposed to cheap THI. But it has come back and THI margins have not gotten lower so we should expect it in the long term to be 12%-13%. I like higher margins but for retail this is solid. In case you were wondering I look for 15% or higher profit margins typically. Also the nonrecurring charges are negligible for THI. So I would give the income statement an A-.
Now we look at the cash flow statement. Here you will notice that the free cash flow is lower than profits. Typically this is a problem. Not in this case. First of all you will notice that the free cash flow is not increasing in the last few years. Year ended 2009 FCF was $268 million, year ended 2010 FCF was $390 million, and year ended 2011 FCF was $206 million. This gives you an average FCF of $288 million. However, remember that THI is growing a lot and much of the capital expenditures is due to expansion. As a result, we cannot say it is bad that they're spending their money to expand, especially with the margins they are getting. Also in the last 4 reported quarters FCF was $371 million. So P/FCF is anywhere between 26.4 and 20.5. But with P/E at 20, which in this case may be more accurate than P/FCF, we have to consider that you are getting returns of 5%. Sounds bad doesn't it? Not if you pay attention to the next few paragraphs. In conclusion I rate the cash flow statement a B-.
So now we must do the qualitative analysis. As you must have noticed you are only expected to get returns of 5% if there is no growth. But I expect plenty of growth. The reason is that while THI is very prevalent in Canada they are also expanding to the US which is a market ten times bigger. And I would not believe they would be successful growing there, unless they had already been there and done that, which they have. Their growth in the US is outstanding. Furthmore, they are refusing to give franchises to anyone who does not already own a THI franchise. This helps because you have experienced people handling the business who have been successful before (otherwise they would not have the money for another franchise) so you can expect them to duplicate their success. This also makes sure they don't grow too fast, because when companies grow too fast they cannot get the right people to implement that growth (Good to Great, Jim Collins). People may worry about competition from Dunkin Donuts, but I've been to those stores. Sadly, they are not as good at this as THI. Their stores are typically dead (as in very few customers) whereas THI is almost always packed. So regarding growth strategy this is outstanding. As for competitors, they would have to build their own stores which would take a while, and as Peter Lynch points out in One Up on Wall Street these businesses can grow by 20% per year for 10 years. That would give you a compounded return of 20% annually for 10 years. This is typical and as for looking at the ceiling on this business just look at SBUX profits and sales. They are at $1.4 billion in profits for now and they have far more stores so it's not unlikely that THI gets to the same profits as they have one fourth of the number of stores as SBUX. Thus the growth strategy is solid and I give it an A+.
Now we come back to the old dilemma of where's the niche? Remember this is still a bad industry (retail). I gave you the niche for HPQ in that they make cost effective laptops. What is the niche market for THI? The answer is the low end coffee shop frequenters. Lots of people meet over coffee at SBUX, but it's expensive. As money is always tight the less wealthy among us, and even the wealthy who are thrifty would come to THI over SBUX. SBUX has their own niche of wealthy clients and a brand name they've built over many decades, but THI has separate niche allowing them to compete. I think this niche market is larger than the one captured by SBUX so THI can grow quite well.
In conclusion I expect this business to grow at around 20% per year for 10 years. You may say that after that time the P/E will fall so our returns won't be as high. I respectfully disagree. Look at SBUX P/E ratio. It's 30. Even if THI maintains it's 20 it would give you 20% returns, while the market typically averages 10% per year. So that is what you can expect from THI. As always if you disagree or would like to add something please do so in the comments below. Thank you.
Tuesday, December 11, 2012
Is Microsoft a Good Investment?
Originally this post was supposed to be on how Microsoft Corp. (MSFT) was a great company to invest in. The idea had formed a few months ago because the financials were fantastic. However, some of the things they have started doing has made me completely change my mind. To be fair, the financials are fantastic, but the business has deteriorated to the point where I can no longer recommend them. First let me show you what I loved about the financials. Then I'll show you why the business is underwhelming. This is one of many technological companies that have shown me it is almost impossible to value a company related to technology because their valuations can change fast as the technology shifts.
So let us discuss the balance sheet. In the last 2 years the current assets of MSFT have grown by $30 billion while total assets have grown by around $35 billion. We also see that short term investments and cash combined have gone up by $26.5 billion. This is good because it means the increase in assets is not tied up in long term investments, thus allowing MSFT to optimize the use of their assets. On the other hand debt has also gone up by $15 billion, so that increases equity by $10 billion per year. Some may worry because MSFT has earned roughly $40 billion over this period and not the $20 billion increase in net worth, but they also have to look at the roughly $23 billion returned in dividends and stock buybacks. This shows that half the money is going back to the shareholders. The business has grown for a very long time so to say we can return 50% profits to the shareholders and still grow the business makes it fantastic. Also note that the current assets are more than twice current liabilities and long term assets are quite a bit more than twice long term liabilities. I rate the balance sheet an A. The only bad thing is that their long term debt has gone up in the last 2 years.
Now let us look at the income statement. Look at the profit margins for the last 3 years, they are 30% for year ended June 2010, 33% for year ended June 2011, and 23% for year ended June 2012 but in June 2012 there was a nonrecurring charge of $6 billion which was bad, but MSFT does not have it often enough to make me worry. I would have looked more into it, but the products turned me off from the company before that. Anyways, supposing $6 billion is really nonrecurring we have a margin of around 31%. So business as usual. Even if we take the supposed 23% as normal, that is a fantastic margin. So the income statement I would actually give an A+ to because there is so little that has gone wrong.
Now we look at the cash flow statement. Always remember that the cash flow statement is the most important statement. It shows how much money you really made, not just what the income statement allows you to. And if free cash flow is consistently a lot less than net income there might be fraud at the company, or it's just a bad business. Either way, it's a bad sign. Now in Microsoft's case the FCF year ending June 2010 is around $22 billion, year ending June 2011 FCF is $24.5 billion and year ending June 2012 FCF is an astounding $29 billion! Not bad huh? All years these values are more than the net income. The net income over the last 10 years has grown by more than 10% compounded. People may be more enamoured with AAPL but remember that they were much smaller 10 years ago. So the Cash Flow Statement is also given an A+.
Now realize if we think that FCF can be sustained at $29 billion we get a 12.6% return or P/FCF of around 8, and considering that the growth rate of this business has been 12% it has a PEG (price to earnings to growth) ratio of around 1. Which makes it fairly priced and for an outstanding company like MSFT it is a buy. Also if we take the average FCF of around $25 billion you get a yield of 10.8% or a P/FCF ratio of 9.2. So you would expect me to rate this a buy under normal circumstances because it can reasonably return 12%-15% and thus beat the market over the next 5-10 years. Not a bad return. However, the new products worry me. Let us discuss them.
The first new products that I saw were the new Windows Surface Tablets. I'm not going to go into whether it is a good product or not. The reality is time will tell. I personally prefer Windows 7, but that's probably because I'm used to it. The problem I have is that they're more expensive than the latest Ipad. To be fair a lot of them come with keyboards, but come on! That's not enough to make it more expensive than the Ipad. So I think there is a higher than expected price. The second issue is that they are making the tablets themselves. This is foolish. Remember the laptop market. Microsoft did well because they sold the software all laptops needed and let the others compete on price. Apple can charge more because they have built it themselves for many years and have shown what they can do, nobody knows what will happen with a Microsoft built tablet. Secondly, as everyone is getting into it now, we can expect them to start the ferocious price wars that will lower the prices on all tablets. So why get into it? Just make the software and reap the rewards. I would have also made 2 types of software, one for touch screens, and one without. However, that's just me. It is possible that Microsoft is fantastically successful with these, but this gets them away from what they are strongest and makes me nervous. I give the tablets a D-.
The second new "product" that Microsoft has unveiled is the new retail stores. As anybody will tell you retail is a ferocious business. If you ever watched Dragon's Den, any time a new entrepreneur would propose a retail strategy, the wealthy businessmen would refuse to invest in that business unless it was proven (only 1 was, all others were rejected, and they still had a hard time with the one proven guy). Now you may wonder why this is and the answer is your competitors are endless. Seriously. Have you seen a retailer's margins? Typically less than 5%. Secondly, even when Apple first went into it their first design was so bad that Steve Jobs thought they would never succeed. To be fair they eventually did, but not before many design changes. What they did was build one store, and kept changing and changing it until they got it right. Then they mass launched the stores all across the country. Now to be fair that may be Microsoft's plan as they don't have too many stores, however they have it in many different cities including Toronto, Canada. So the question is did they already get the concept right, or are they still experimenting. After visiting the Microsoft Store, I really hope they're still experimenting, because it sucks! It's like an Apple Store but worse. I am not good with descriptions, so if you don't understand what I'm saying go to your nearest Microsoft Store, and then describe it for me in the comments section so others understand. But the store is just bad, and I hate the retail business. Few succeed and the margins are terrible. So in my humble opinion bad idea. I give the retail store an F.
So with all these reasons you must now be confused. The financials are fantastic but the stores and tablets are a bad idea. So what would I do? Well in my opinion the stores and tablets are bad ideas, but let us remember this is Microsoft. They are a talented company and has always done very well. The question is without Bill Gates how well will they do? The tablets and stores may be a good idea but I don't see it. So I say neither go long or short on this business because it could go either way. However, if I had to go one way I would lean towards buying, but not enough to actually recommend doing it. If anybody knows why the stores or tablets are a good idea, let me know in the comments section. But for now we should wait and see how the stores or tablets play out. If they do really well, then maybe buy.
So let us discuss the balance sheet. In the last 2 years the current assets of MSFT have grown by $30 billion while total assets have grown by around $35 billion. We also see that short term investments and cash combined have gone up by $26.5 billion. This is good because it means the increase in assets is not tied up in long term investments, thus allowing MSFT to optimize the use of their assets. On the other hand debt has also gone up by $15 billion, so that increases equity by $10 billion per year. Some may worry because MSFT has earned roughly $40 billion over this period and not the $20 billion increase in net worth, but they also have to look at the roughly $23 billion returned in dividends and stock buybacks. This shows that half the money is going back to the shareholders. The business has grown for a very long time so to say we can return 50% profits to the shareholders and still grow the business makes it fantastic. Also note that the current assets are more than twice current liabilities and long term assets are quite a bit more than twice long term liabilities. I rate the balance sheet an A. The only bad thing is that their long term debt has gone up in the last 2 years.
Now let us look at the income statement. Look at the profit margins for the last 3 years, they are 30% for year ended June 2010, 33% for year ended June 2011, and 23% for year ended June 2012 but in June 2012 there was a nonrecurring charge of $6 billion which was bad, but MSFT does not have it often enough to make me worry. I would have looked more into it, but the products turned me off from the company before that. Anyways, supposing $6 billion is really nonrecurring we have a margin of around 31%. So business as usual. Even if we take the supposed 23% as normal, that is a fantastic margin. So the income statement I would actually give an A+ to because there is so little that has gone wrong.
Now we look at the cash flow statement. Always remember that the cash flow statement is the most important statement. It shows how much money you really made, not just what the income statement allows you to. And if free cash flow is consistently a lot less than net income there might be fraud at the company, or it's just a bad business. Either way, it's a bad sign. Now in Microsoft's case the FCF year ending June 2010 is around $22 billion, year ending June 2011 FCF is $24.5 billion and year ending June 2012 FCF is an astounding $29 billion! Not bad huh? All years these values are more than the net income. The net income over the last 10 years has grown by more than 10% compounded. People may be more enamoured with AAPL but remember that they were much smaller 10 years ago. So the Cash Flow Statement is also given an A+.
Now realize if we think that FCF can be sustained at $29 billion we get a 12.6% return or P/FCF of around 8, and considering that the growth rate of this business has been 12% it has a PEG (price to earnings to growth) ratio of around 1. Which makes it fairly priced and for an outstanding company like MSFT it is a buy. Also if we take the average FCF of around $25 billion you get a yield of 10.8% or a P/FCF ratio of 9.2. So you would expect me to rate this a buy under normal circumstances because it can reasonably return 12%-15% and thus beat the market over the next 5-10 years. Not a bad return. However, the new products worry me. Let us discuss them.
The first new products that I saw were the new Windows Surface Tablets. I'm not going to go into whether it is a good product or not. The reality is time will tell. I personally prefer Windows 7, but that's probably because I'm used to it. The problem I have is that they're more expensive than the latest Ipad. To be fair a lot of them come with keyboards, but come on! That's not enough to make it more expensive than the Ipad. So I think there is a higher than expected price. The second issue is that they are making the tablets themselves. This is foolish. Remember the laptop market. Microsoft did well because they sold the software all laptops needed and let the others compete on price. Apple can charge more because they have built it themselves for many years and have shown what they can do, nobody knows what will happen with a Microsoft built tablet. Secondly, as everyone is getting into it now, we can expect them to start the ferocious price wars that will lower the prices on all tablets. So why get into it? Just make the software and reap the rewards. I would have also made 2 types of software, one for touch screens, and one without. However, that's just me. It is possible that Microsoft is fantastically successful with these, but this gets them away from what they are strongest and makes me nervous. I give the tablets a D-.
The second new "product" that Microsoft has unveiled is the new retail stores. As anybody will tell you retail is a ferocious business. If you ever watched Dragon's Den, any time a new entrepreneur would propose a retail strategy, the wealthy businessmen would refuse to invest in that business unless it was proven (only 1 was, all others were rejected, and they still had a hard time with the one proven guy). Now you may wonder why this is and the answer is your competitors are endless. Seriously. Have you seen a retailer's margins? Typically less than 5%. Secondly, even when Apple first went into it their first design was so bad that Steve Jobs thought they would never succeed. To be fair they eventually did, but not before many design changes. What they did was build one store, and kept changing and changing it until they got it right. Then they mass launched the stores all across the country. Now to be fair that may be Microsoft's plan as they don't have too many stores, however they have it in many different cities including Toronto, Canada. So the question is did they already get the concept right, or are they still experimenting. After visiting the Microsoft Store, I really hope they're still experimenting, because it sucks! It's like an Apple Store but worse. I am not good with descriptions, so if you don't understand what I'm saying go to your nearest Microsoft Store, and then describe it for me in the comments section so others understand. But the store is just bad, and I hate the retail business. Few succeed and the margins are terrible. So in my humble opinion bad idea. I give the retail store an F.
So with all these reasons you must now be confused. The financials are fantastic but the stores and tablets are a bad idea. So what would I do? Well in my opinion the stores and tablets are bad ideas, but let us remember this is Microsoft. They are a talented company and has always done very well. The question is without Bill Gates how well will they do? The tablets and stores may be a good idea but I don't see it. So I say neither go long or short on this business because it could go either way. However, if I had to go one way I would lean towards buying, but not enough to actually recommend doing it. If anybody knows why the stores or tablets are a good idea, let me know in the comments section. But for now we should wait and see how the stores or tablets play out. If they do really well, then maybe buy.
Monday, December 10, 2012
Hewlett Packard is Undervalued
Let us now delve into the actual value investing process and start analyzing stocks. I apologize for the delay in doing so. I had gotten busier than I had expected. Today I will be showing you why I believe
Hewlett-Packard Company (HPQ) is undervalued.
First we must assess the quality of the businesses. They make their money from selling laptops, printers and a few services to businesses. There are other things they do but this makes the bulk of their money or will in the future make the bulk of their money. Regarding services to businesses it is very profitable but HPQ does not make as much money off of this as IBM and others do. This line of business is very profitable but this line more or less may make HPQ more valuable in the future. The laptops and printers are the present.
So let us start with laptops. There are desktops too, but we know that far more laptops are sold so let us not expect much from their desktop business. Let us just analyze the laptops. Here in my opinion the business economics are poor. You have a lot of businesses trying to sell laptops (ACER, ASUS, Dell etc.). So naturally there are price wars and also this competition leads to a lot of problems because now customers can find someone who do what you do and get it cheaper. So it sounds like a bad business to be in, and it is, but HPQ has done an outstanding job in it. What they realized is that they can be the low cost producer. Even the laptop I own is from HPQ because it's cheap. People tell me it's a bad idea because HP laptops stop working after around 4 years. I point out 2 things to them, mine has lasted longer, and every 4 years or so Microsoft comes out with a new Windows so I can use that as an excuse to get a new laptop anyways. HP's strategy is not to be the high quality laptop, just wanted to mass produce and sell them. However, in recent years you will have noticed that people would pay more for a laptop because you can download the new Windows from the Internet for free (yes I know it's illegal, but people still do them). So hopefully HPQ has learned to make higher quality laptops cheaper but right now it's anyone's guess. As a result HPQ has found a niche in the laptop market and as such will be able to make good profits from them.
Now on to the printers. There really isn't much to say except that HPQ dominates the printer market. They own 40% of the printer market. Furthermore, other printer companies use gimmicks like the printer will not print unless it has working ink of both colour and black & white even if you have black & white ink working and you only need that. HPQ doesn't use such gimmicks. Brother printers are the first serious threat they've ever had, but with the low cost of HPQ printers and the brand name itself they are expected to continue to dominate the industry. In case you were curious, Brother owns 6.5% of the market last time I checked. Not bad, but not there yet.
So we've established that the businesses are stable and that the future of the business may depend on the business services division. So, how do I analyze the fundamentals of this business? First I look at the balance sheet. Typically I want twice as much current assets as current liabilities and twice as much total assets as total liabilities. And here you notice that HPQ fails that test. But remember, failure of one test does not mean it's a bad investment. So why is the balance sheet so bad? Here we have to understand that the current CEO has been in for a short amount of time. Here predecessor made a very bad move in spending $11 billion to acquire Autonomy which is almost completely a write-off. However, over the last few quarters we see that the debt has been going down though mostly it's the short term debt like A/P going down. That is bad because you want to pay your vendors as late as possible to maximize use of your cash. Assets have also gone down, especially current assets like A/R, but that is good because you want to collect from your customers as quickly as possible. Also cash has gone up by about 20% in the last 3 quarters. Not bad. However, the balance sheet needs to improve. Here I find that mostly the huge acquisition of Autonomy along with an aggressive dividend and buyback strategy has hurt the balance sheet in the past. The new CEO, Meg Whitman has stated she will not be that aggressive so we can expect the balance sheet to improve in the future. Of course nothing is certain, but while I grade the earlier businesses an A, I grade the balance sheet a C-.
Now on to the income statement. Here we must tread carefully. We must remember one time write-offs cannot be considered as normal income. On the other hand you cannot dismiss them, especially if they occur repeatedly, because then they are not really non-recurring charges. Now HPQ has non-recurring charges in all of their last several quarters including the last one, but again this is mostly the Autonomy case, and some other small points. If we ignore the Autonomy profits are actually quite nice. You'll notice that the profit margins are around 5%. Some bad businesses, but the laptop business must have brought it down a lot as well as their margins are typically low. While I prefer high margin businesses, this business has dominated one industry and done very well in another, so this is not bad. Think of it like Walmart's low margins even though they rule the retail industry. The income statement gets a B from me. Would like better margins but better.
Cash flow statement is the final area. And here is where you measure how much money the business truly made. Income statements may have some shenanigans but cash flow statements show how much more cash you have. So without outright fraud, it is hard to manipulate. Here you will notice that the free cash flow from the business for the last 3 years has been $7-$10 billion per year. If that keeps up the current market value of $28 billion will mean you are getting between 25% and 35% returns which is outstanding. We have to keep in mind that the Autonomy gone wrong acquisition was a problem but it was a one time thing. If we look at the free cash flow from the last 4 quarters we get $6.3 billion. Not bad considering this temporary problem. As such we can project it to be a worst case scenario to earn $6.3 billion per year and that averages 22.5% per year as a return. That is an outstanding scenario. I would recommend buying shares in this company.
Hewlett-Packard Company (HPQ) is undervalued.
First we must assess the quality of the businesses. They make their money from selling laptops, printers and a few services to businesses. There are other things they do but this makes the bulk of their money or will in the future make the bulk of their money. Regarding services to businesses it is very profitable but HPQ does not make as much money off of this as IBM and others do. This line of business is very profitable but this line more or less may make HPQ more valuable in the future. The laptops and printers are the present.
So let us start with laptops. There are desktops too, but we know that far more laptops are sold so let us not expect much from their desktop business. Let us just analyze the laptops. Here in my opinion the business economics are poor. You have a lot of businesses trying to sell laptops (ACER, ASUS, Dell etc.). So naturally there are price wars and also this competition leads to a lot of problems because now customers can find someone who do what you do and get it cheaper. So it sounds like a bad business to be in, and it is, but HPQ has done an outstanding job in it. What they realized is that they can be the low cost producer. Even the laptop I own is from HPQ because it's cheap. People tell me it's a bad idea because HP laptops stop working after around 4 years. I point out 2 things to them, mine has lasted longer, and every 4 years or so Microsoft comes out with a new Windows so I can use that as an excuse to get a new laptop anyways. HP's strategy is not to be the high quality laptop, just wanted to mass produce and sell them. However, in recent years you will have noticed that people would pay more for a laptop because you can download the new Windows from the Internet for free (yes I know it's illegal, but people still do them). So hopefully HPQ has learned to make higher quality laptops cheaper but right now it's anyone's guess. As a result HPQ has found a niche in the laptop market and as such will be able to make good profits from them.
Now on to the printers. There really isn't much to say except that HPQ dominates the printer market. They own 40% of the printer market. Furthermore, other printer companies use gimmicks like the printer will not print unless it has working ink of both colour and black & white even if you have black & white ink working and you only need that. HPQ doesn't use such gimmicks. Brother printers are the first serious threat they've ever had, but with the low cost of HPQ printers and the brand name itself they are expected to continue to dominate the industry. In case you were curious, Brother owns 6.5% of the market last time I checked. Not bad, but not there yet.
So we've established that the businesses are stable and that the future of the business may depend on the business services division. So, how do I analyze the fundamentals of this business? First I look at the balance sheet. Typically I want twice as much current assets as current liabilities and twice as much total assets as total liabilities. And here you notice that HPQ fails that test. But remember, failure of one test does not mean it's a bad investment. So why is the balance sheet so bad? Here we have to understand that the current CEO has been in for a short amount of time. Here predecessor made a very bad move in spending $11 billion to acquire Autonomy which is almost completely a write-off. However, over the last few quarters we see that the debt has been going down though mostly it's the short term debt like A/P going down. That is bad because you want to pay your vendors as late as possible to maximize use of your cash. Assets have also gone down, especially current assets like A/R, but that is good because you want to collect from your customers as quickly as possible. Also cash has gone up by about 20% in the last 3 quarters. Not bad. However, the balance sheet needs to improve. Here I find that mostly the huge acquisition of Autonomy along with an aggressive dividend and buyback strategy has hurt the balance sheet in the past. The new CEO, Meg Whitman has stated she will not be that aggressive so we can expect the balance sheet to improve in the future. Of course nothing is certain, but while I grade the earlier businesses an A, I grade the balance sheet a C-.
Now on to the income statement. Here we must tread carefully. We must remember one time write-offs cannot be considered as normal income. On the other hand you cannot dismiss them, especially if they occur repeatedly, because then they are not really non-recurring charges. Now HPQ has non-recurring charges in all of their last several quarters including the last one, but again this is mostly the Autonomy case, and some other small points. If we ignore the Autonomy profits are actually quite nice. You'll notice that the profit margins are around 5%. Some bad businesses, but the laptop business must have brought it down a lot as well as their margins are typically low. While I prefer high margin businesses, this business has dominated one industry and done very well in another, so this is not bad. Think of it like Walmart's low margins even though they rule the retail industry. The income statement gets a B from me. Would like better margins but better.
Cash flow statement is the final area. And here is where you measure how much money the business truly made. Income statements may have some shenanigans but cash flow statements show how much more cash you have. So without outright fraud, it is hard to manipulate. Here you will notice that the free cash flow from the business for the last 3 years has been $7-$10 billion per year. If that keeps up the current market value of $28 billion will mean you are getting between 25% and 35% returns which is outstanding. We have to keep in mind that the Autonomy gone wrong acquisition was a problem but it was a one time thing. If we look at the free cash flow from the last 4 quarters we get $6.3 billion. Not bad considering this temporary problem. As such we can project it to be a worst case scenario to earn $6.3 billion per year and that averages 22.5% per year as a return. That is an outstanding scenario. I would recommend buying shares in this company.
Thursday, November 22, 2012
Why Value Investing?
In this first post I will try to answer the question of why I picked value investing over other types of investment strategies. After all people have gotten rich investing in real estate, index funds, and some people even got rich under-performing the stock market. So why did I pick value investing?
For starters I recommend buying a house because you need a place to live, and the prices are only going up because you cannot manufacture more land. However, taking care of more properties is somewhat difficult and I realized that stocks give you more scope for investing. So buy a home, and maybe 1 rental property but after that you should invest in stocks.
Now why not index funds? And the answer to that is actually surprising. I recommend index funds like the S&P 500 to the majority of people. The reason I say this is that if you put away a small portion of your income say $5 per day from when you start working full-time, and you put it in an index fund averaging 10% compounded yearly, 40 years later (I'm assuming you retire in your 60s) you are a millionaire. Furthermore, your investments are averaging several hundred thousand dollars per year in profits. You can definitely retire on that. You may worry about inflation, and the idea that a few hundred thousand dollars is not a lot, but if your salary stays up, you can put more away and make a lot more. Also, use tax deferred accounts so you get the most out of your money. That way you only incur charges when you take money out of your account.
Now I have already recommended buying a house and index investing. So why value investing? Well, again with the house, you need a place to stay, so may as well own it, and having maybe one or two rental properties is a good idea. But then we need something that has scope to make more money with less effort to manage. Stocks take almost no effort to manage, you just need to vote on the issues such as who to elect to the board of directors. And for most people you should invest in index funds. However, there are a handful of people who can beat the market. Be honest when assessing yourself. More than 50% of investors under-perform the market. To assess yourself, do not look for how smart you are. If you are really, really smart I recommend becoming a doctor or doing things that will change the world. You'll make a lot of money still, and you would have been a much better person than an investor like me. However, even if you have average intelligence or less it should not deter you. However, you have to see if you can be unemotional about your investments. I recommend a stock simulator to see how you react. Do you panic and sell too early, or are you able to hold on? In the mean time just invest in index funds. You'll do fine. If in the simulator you see yourself beating the market over 5 years then consider picking individual stocks. And make sure it wasn't just 1 really good year, make sure year in and year out you tend to outperform and you have used the same methodology throughout. I did it for 7 years and got compounded rate of return of 40% per year so I decided I was good enough. What this does is lower your risk as you risk nothing to test whether or not you are one of the few who can do this.
Now if you can do this write down your methods. Make sure it is fundamental analysis because even with all the technical analysts out there, I have yet to hear of even one who has beaten the market consistently for 5 years. And of course the reason I picked value investing is that if I beat the market I can get to my financial goals faster. Now understand the compounded rate of 40% was quite a bit of luck. My target is always 12%-15%, but I never buy a stock that I do not think will return 20% or more so I have a bit of a margin of safety. This is in case I was wrong, I miscalculated something, or perhaps something unexpected happens down the road.
So this was my analysis on why I chose value investing. I expect future posts to be much shorter because it will be on specific subjects like the HP scandal. I look forward to any and all comments.
For starters I recommend buying a house because you need a place to live, and the prices are only going up because you cannot manufacture more land. However, taking care of more properties is somewhat difficult and I realized that stocks give you more scope for investing. So buy a home, and maybe 1 rental property but after that you should invest in stocks.
Now why not index funds? And the answer to that is actually surprising. I recommend index funds like the S&P 500 to the majority of people. The reason I say this is that if you put away a small portion of your income say $5 per day from when you start working full-time, and you put it in an index fund averaging 10% compounded yearly, 40 years later (I'm assuming you retire in your 60s) you are a millionaire. Furthermore, your investments are averaging several hundred thousand dollars per year in profits. You can definitely retire on that. You may worry about inflation, and the idea that a few hundred thousand dollars is not a lot, but if your salary stays up, you can put more away and make a lot more. Also, use tax deferred accounts so you get the most out of your money. That way you only incur charges when you take money out of your account.
Now I have already recommended buying a house and index investing. So why value investing? Well, again with the house, you need a place to stay, so may as well own it, and having maybe one or two rental properties is a good idea. But then we need something that has scope to make more money with less effort to manage. Stocks take almost no effort to manage, you just need to vote on the issues such as who to elect to the board of directors. And for most people you should invest in index funds. However, there are a handful of people who can beat the market. Be honest when assessing yourself. More than 50% of investors under-perform the market. To assess yourself, do not look for how smart you are. If you are really, really smart I recommend becoming a doctor or doing things that will change the world. You'll make a lot of money still, and you would have been a much better person than an investor like me. However, even if you have average intelligence or less it should not deter you. However, you have to see if you can be unemotional about your investments. I recommend a stock simulator to see how you react. Do you panic and sell too early, or are you able to hold on? In the mean time just invest in index funds. You'll do fine. If in the simulator you see yourself beating the market over 5 years then consider picking individual stocks. And make sure it wasn't just 1 really good year, make sure year in and year out you tend to outperform and you have used the same methodology throughout. I did it for 7 years and got compounded rate of return of 40% per year so I decided I was good enough. What this does is lower your risk as you risk nothing to test whether or not you are one of the few who can do this.
Now if you can do this write down your methods. Make sure it is fundamental analysis because even with all the technical analysts out there, I have yet to hear of even one who has beaten the market consistently for 5 years. And of course the reason I picked value investing is that if I beat the market I can get to my financial goals faster. Now understand the compounded rate of 40% was quite a bit of luck. My target is always 12%-15%, but I never buy a stock that I do not think will return 20% or more so I have a bit of a margin of safety. This is in case I was wrong, I miscalculated something, or perhaps something unexpected happens down the road.
So this was my analysis on why I chose value investing. I expect future posts to be much shorter because it will be on specific subjects like the HP scandal. I look forward to any and all comments.
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