When to Sell

When you buy a stock, the ultimate goal is to realize a profit by eventually selling it. While there is a plethora of information on selecting the right stock and determining when to buy it, the subject of selling remains somewhat ignored. Prudent selling, like buying, is an art that requires a strong stomach, thorough analysis, and faith in your decision. Waiting too long to sell a stock and seeing the price drop or dumping too soon and seeing the price rise is just as painful as making a buying mistake. With that said, here are some good (and not so good) reasons to sell:

Good Reasons To Sell

You have achieved your goal

Oftentimes when buying in a stock, you determine an exit point. This may occur if you invest in a company that is trading at a significant discount to its net asset value, or some other “cigar butt” situation. In any case, if the stock price has hit your target, then you should take your profits and sell.

You realize you made an error in your analysis

Before investing in a stock, you have hopefully carefully scrutinized the company’s financial statements. You have looked to make sure it has a healthy balance sheet, it is consistently profitable, it has growth potential, and it is an overall quality business. However, you may realize after you have purchased the stock that you have made a mistake somewhere. You may have overestimated future growth or profit margins, and it may or may not have already affected the stock price. Nonetheless, it is best to get out in this case.

High valuation

You may be invested in a truly superb business that has performed well in the past and is poised to do well in the future. However, if everybody else is similarly optimistic or even euphoric about the prospects of the company, then there is a good chance that it is highly overvalued. If you have done a valuation yourself and the current market price is significantly higher than the fair value that you’ve determined, then it might be time to trim your position or even sell the whole thing and wait for a more appropriate entry point.

The company is losing its long term luster

The best companies to own are those with strong competitive advantages in industries that are projected to grow well into the future. These advantages don’t hold forever though. If they did, then Sears and General Motors would still be thriving components of the Dow. If you can see that the company’s economic moat is deteriorating due to higher competition or some new technology that is threatening its livelihood, then you should consider selling the stock.

You found a better opportunity

This is my favorite reason to sell a stock. If you’ve found some other stock that you believe has fantastic potential but you don’t have enough cash to buy it, then you should sell your stock with the least promise to fund the purchase. You may only need to sell a portion of your holding, but you can rest assured that your overall return will be greater as a result if your analysis is correct.

Bad Reasons To Sell

The stock price is volatile

If you have done your analysis and are confident in the price at which you bought the stock, then you should do your best to ignore short term volatility. If the market overreacts to quarterly earnings or if the price unexpectedly drops five percent, you should not be deterred as long as your original convictions about the stock still hold.

The stock price is stagnant

For me, impatience is a greater sin than skittishness. If you’re concerned that the price “hasn’t moved” in a while and you’re not getting immediate results after buying the stock, you need to reconsider why you invested in the first place. If you invested at the right price with the intention of being a long term holder, then you may have to endure a couple of years of stagnation. You will be rewarded in due time, but getting bored and selling the stock is no way to profit for the long haul.

Net-Net Idea: Defense Industries International (DFNS)

I wrote earlier about the pitfalls and potential opportunities of net-net stocks. Well, I've come across what I think could be a winner. The name is Defense Industries International, and it's a tiny (and I mean tiny) Israeli manufacturer of civilian and military personal protective equipment. This is mostly body armor, but they also sell things like shields, tents, ballistic wall covers, and collapsible liquid containers. Its largest customer is the Israeli military, but it also has a diverse client base across North America, Europe, Africa, and Israel in both the civilian and military markets.

Test #1: Does It Make Money?

Like I said before, this is a small company, but a profitable one nonetheless. Over the past five years, it's averaged only about $15 million in revenue and a couple million in net profits and free cash flow. The growth isn't really anything to write home about either. Over those five years, revenues have grown by a total of about 55%, but the last year has shown a slowdown, naturally due to the poor condition of the worldwide economy. Also, it doesn't seem like a lot of these revenues are recurring, and the company is fairly dependent on business from the Israeli military.

Test #2: Are The Assets Valuable?

In a word, yes. Defense Industries has about $14 million in current assets, half of which are cash or short term investments. It only has $4 million in inventory, which I highly doubt will become obsolete anytime soon. As far as liabilities, the company has about $5 million in total liabilities on its books, almost none of which is long term debt. In net-net terms, this leaves a net current asset value of anywhere between $6 million and $8 million, depending on how conservatively you want to value the assets.

Test #3: Is It On Sale?

As of recently, Defense Industries International has a market cap of under $3.4 million ($0.12 share price). With about $7 million in net current assets, a million in earnings, and some extra PP&E that wasn't included in the net asset calculation, it looks like this could be a steal.

Conclusion

Of course, rarely is a net-net a complete slam dunk. There are clearly huge risks with a stock like Defense Industries, even if it does look like a bargain from the financial statements. First and foremost, it is a miniscule company that is up against much larger competitors that sell the same if not superior quality products. Its revenue base is diverse, but that does not mean it is particularly strong. This could mean that the slim profits could quickly turn to losses, eroding those valuable cash reserves. Furthermore, the stock trades very thinly and has lately been in a very tight range. Shares might only change hands once or twice every other day. Additionally (and probably most troubling to outside investors), the chairman owns about 70% of the stock, so the company is essentially at her mercy.

However, I think that the company does have a potential catalyst. I believe that the fact that it is in Israel and sells to the military there offers some upside potential considering the country is seemingly in a perpetual state of war. This might not mean much, but I certainly believe this fact coupled with the enticing valuation warrants some additional research on Defense Industries International.

Net-Net Investments: Buyer Beware

Benjamin Graham, commonly thought to be the father of value investing, utilized a simple tool to identify cheap stocks. He looked for companies that were trading at less than two-thirds of their net current asset value. The net current asset value, as Graham defined it, is calculated as the cash on the books plus 75% of the value of the accounts receivables value plus 50% of the inventory value plus 1-50% of the long-term asset value (depending on liquidity, etc.) minus all of the liabilities. A simpler way to calculate the net current asset value is to simply subtract the current assets from the total liabilities. It really doesn't matter which one you choose since the two methods will typically lead you to a very similar valuation.

These criteria represent the essence of Graham and his brand of value investing. He liked looking at liquid, tangible assets when valuing a company rather than uncertain future earnings. However, times have changed since Graham first advocated this investing methodology. The universe of these "net-net" stocks, as they are sometimes called, has shrunken considerably and now consists primarily of tiny companies laden with financial, managerial, and/or legal issues. It is very likely that you will not recognize any names on the list of net-nets. Nonetheless, you may come across one or two diamonds in the rough that will provide outstanding returns.

Inventory Quality

I have found that one of the most common issues with these net-nets is that the inventory on their books is either extremely difficult to sell, expensive to store, obsolete, or some combination of these things. Plenty of homebuilders have fallen into this category over the past couple of years and remain there to this day. They have massive amounts of materials in their warehouses with which to build new houses, but demand has slowed to a trickle. As such, the inventory is really worth next to nothing as it cannot be turned into cash and costs quite a bit to store.

Negative Earnings = Burning Cash

Another common issue is not the amount of the net current assets, but rather the permanency of those assets. Many of the net-nets have lots of cash on their balance sheets, yet they have terrible businesses that consistently lose money. They have negative earnings and negative cash flows which quickly deplete the cash on their books.

The Debt Problem

Another issue that sometimes burdens these net-nets is a high level of debt. While heavily indebted companies are always worrisome, net-nets are particularly sensitive to high debt levels as they are typically small companies with unstable earnings. Furthermore, hefty interest expenses can do a lot of damage to cash balances.

Low and No Volume

The fact that these small net-nets are completely ignored by Wall Street is both a blessing and a curse. It is a blessing in that a nonexistent analyst following allows for huge price inefficiencies. However, this is worth nothing if the price does not eventually rise to its true value. For the very small companies that comprise most of the list of net-nets, it is unlikely that they will grow into larger companies that will eventually be recognized by institutional investors. More frequently you will see value realized by a company being bought out or deciding to go private. Additionally, since there is such low trading volume, there may not be an opportunity to buy stock at the current price due to a huge bid-ask spread.

Not All Bad

Although research on this topic is far from extensive, there have been some studies that show that buying a diversified basket of these net-net stocks will indeed outperform the market. Additionally, there is some proof that Warren Buffett bought some of these net-nets, or what he called "cigar butts," for his investment partnership during his early career. Although it is rare that you will find a good net-net investment opportunity, they do pop up from time to time and can be extremely lucrative. The key is to look for a company with an understandable business, positive earnings, manageable inventory, low debt, and some kind of catalyst that will drive the price up to its true value. This is a lot to ask for, and you may have to wait as long as a few years to find such an opportunity. But when they come, which they seemingly always do, make sure you are ready.

Price to Free Cash Flow: A Useful Valuation Tool

When considering a quick valuation method, most people will turn to the price to earnings ratio or the price to book ratio. However, earnings can be manipulated easily and book value is far from the best true measure of value. Instead, I believe that comparing the price to the free cash flow (what's left over for shareholders after normal expenses used to keep the business running) is just as simple to calculate, but much more useful in identifying cheap stocks.

There was an intriguing back test done last year by Peter George Psaras to see if stocks with low price to free cash flow ratios truly outperformed the overall market. He did this by creating a hypothetical portfolio in which at the beginning of each year from 1950 to 2007, he "purchased" an equal weighting of the companies in the Dow Jones Industrial Average that had a price to free cash flow ratio of under 15, and then sold them at the end of the year. The results were startling. This portfolio outperformed the Dow for 53 of 58 years and had an average gain of 23% versus 8% for the Dow. A $10,000 investment in this hypothetical portfolio in 1950 would have been worth $974,617,645 by 2007, or 1434 times more than what the Dow would have returned.

Not only does this show the power of this particular tool, but it is a testament to simplicity when choosing an investment philosophy. It would take no time at all to manage this portfolio, yet it has yielded results that professional money managers would kill for.

Don't Mimic Buffett

Warren Buffett's words and actions attract the attention of the masses and sway world markets. He cannot even hint at what he is considering buying as investors would flock to the stock and push up the price. Every quarter the revised holdings of Berkshire Hathaway are anticipated by thousands. Normally, any new positions receive a boost just from his endorsement alone. People tend to believe that if they follow Warren Buffett's investment moves and buy into stocks when he does, then they will be able to share in his impressive returns.

What people tend to forget is that the pond of investments from which Buffett can fish from is significantly smaller than that of the average investor. Berkshire Hathaway is one of the largest corporations in the world with tens of billions of dollars to deploy. It therefore is limited to investing exclusively in large cap stocks in order to maintain a decent return on its capital. Buffett simply does not have the time or resources to swallow up and keep track of thousands of little companies to recreate the fantastic returns he enjoyed decades ago.

Most of us are in a completely different situation than Buffett, so why do we insist on copying his every move? We are not constrained by such large sums of money (lucky us) and therefore have a massive universe of stocks to choose from. Buffett said the following in 2007: "Were I working with a very small sum...I'd be doing almost entirely different things than I do...You can earn very high returns with small amounts of money." As he stated in 1998, he advises to instead "look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market" when dealing with small sums of money. With this strategy, he guaranteed that he could compound $1 million at 50% per year.

There is a paper written by Gerald Martin and John Puthenpurackal called "Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway" in which they study 261 of Berkshire investments from 1980 to 2003. Now, Berkshire was already somewhat large during this period, but nowhere near its current size. During this period, Martin and Puthenpurackal identified 59 of these 261 stocks as arbitrage investments with an average holding period of under six months compared to an overall average of about 32 months. These arbitrage opportunities produced an astounding average annualized return of 81%, dwarfing the overall average of 39%. I would guess that if you looked at his investment activity from the 1950's and 1960's when he had a considerably smaller sum to invest, the returns from arbitrage investments would have been even more impressive.

While I believe that the growth of the investment management industry and the ubiquity of information that we have at our fingertips has shrunken the number of arbitrage opportunities and other "market wrinkles," I by no means think that they are gone. In addition, we don't have to leaf through thousands of pages of Moody's manuals to find an opportunity like Buffett did; there are many free online stock screeners that can help us hone in more easily, and there are many more publicly traded companies nowadays to choose from.

Now, I must give a small dose of reality, and another reason why we should not mimic Buffett's moves: we are not Warren Buffett. As I wrote earlier about him, Buffett is a genius and probably knows more about investing than anybody on the planet. As such, it would be unwise to dive into arbitrage or deep value opportunities without having a firm knowledge of the target's financial situation and business.

Lastly, I have to say that while I don't think copying his specific investments is wise, I do believe we should absolutely emulate Warren Buffett's investing principles. The vast majority of his investments throughout his career have been long-term stakes in well run, highly profitable companies trading at a discount to their intrinsic value. These opportunities are more plentiful and ultimately more profitable for the average investor.

Inflation Hurts Stocks Too

The massive amount of liquidity that has been pumped into the economy lately in order to battle a depression has left us vulnerable to severe inflation in the near future. Whether we will be able to withdraw these monetary injections has yet to be seen, however the risk of inflation poses risks to all types of investors. In 1977 when our country was in the midst of crippling stagflation, Warren Buffett wrote an article for Fortune called How Inflation Swindles the Equity Investor. In it, he details how inflation not only harms bondholders, but also stockholders.

It is commonly known that bond prices decrease with inflation because the fixed coupon payments quickly lose their purchasing power. People sometimes believe that stocks are a hedge against inflation since they do not have fixed payments but rather have earnings that can rise with inflation. The truth is that over periods of both high inflation and no inflation, the return on equity for stocks, like the coupons on bonds, hasn't really moved from its historical level of about 12%. This essentially leaves us with infinite, 12% bonds that pay out some of the coupon and reinvest the rest. Of course, investors only see these 12% returns if they purchase the stock at book value, however this is rarely the case. Overall, the market prices trade at a premium to book values.

So let's look to see if earnings can increase in periods of inflation. Buffett has identified five ways that earnings can rise:

• Higher asset turnover
• Cheaper leverage
• More leverage
• Lower taxes
• Wider operating margins

Now let's see if these scenarios come true during periods of inflation. As far as asset turnover, you won't see any change in inventory or accounts receivable turnover since they move proportionately to sales, regardless if the sales increase due to inflated prices or more volume. Fixed asset costs, however, will rise slower than sales because they have to be replaced less often. So we may see modest gains due to asset turnover at best.

Cheaper leverage is certainly not going to occur since the cost of borrowing rises with inflation. More leverage seems unlikely as well as American corporations are already heavily burdened by debt, and more debt would likely cause a drop in credit ratings, thus pushing borrowing costs up even higher.

Lower taxes seem unlikely as well. Federal, state, and local governments have a claim on the earnings of corporations that are both retained by the companies as well as those paid out to shareholders. They have the power to unilaterally change the size of their claim on these earnings whenever they wish, so why would they choose to lower it over the long term regardless of inflation?

Lastly, we come to operating margins. This is where many see the opportunity for earnings to outpace inflation. In real life the idea that large companies have pricing power in the market simply doesn't hold true in the aggregate, despite what theoretical models might show. Furthermore, the majority of their costs, namely labor and raw materials, will most certainly rise during periods of inflation.

So we can then conclude that as a whole, earnings can't really beat inflation. Thus, assuming the market trades on average at book value, the average investor can expect, after taxes, about 7% returns. In 1977, Buffett was expecting 7% inflation "in the future." For eight years following the article's writing, inflation did in fact average 7%, bringing real returns down to nothing.

While time has shown that historical inflation over long periods is actually lower than 7%, Warren Buffett indicated a few months ago that inflation might be coming again. It would be wise to heed his warnings and think twice before blindly rushing into the stock market if inflation is indeed on the horizon.

Cheap Stocks Don't Outperform?

Well, I have to amend that title a bit. Cheap stocks have outperformed over the long term for the most part, but quality is the more reliable driver of superior performance. Jeremy Grantham, chairman of the $100+ billion asset management firm GMO, illustrates some of the pitfalls of investing purely on traditional Grahamian valuation metrics in his quarterly newsletter (starting on page 6). He certainly makes some compelling arguments, even if I don't necessarily agree with all of them. While I highly recommend reading the whole thing, I've also summarized his thoughts below:

Grantham begins by stating that we cannot ignore the massive booms and busts of the market and simply focus on individual stocks. He says that unappreciated, contrarian stock selections don't always "revert to the mean," thus it doesn't always pay to pick them out. On the other hand, each and every bubble at the asset class level has eventually popped.

He then goes on to attack the "traditional" Grahamian value tenet to invest in companies trading at a cheap price to book and price to earnings ratios (he focuses more on price to book). Grantham claims that low P/B (price to book) stocks are priced that way because their assets are of poorer quality, and therefore have more of a chance of financial strain in a recession or depression. He therefore labels P/B and P/E as risk factors, and shows that low P/B stocks took over twice as long as high P/B stocks to recover from the Great Crash in 1929.

He goes on to point out that with the exception of the Great Depression and the recent Great Recession, you typically made money buying these "cheap" stocks. However, he makes the point that when the "spread" between the highest P/B stocks and the lowest P/B stocks is wide, the cheap (low P/B) stocks tend to outperform, as they did in 2000. Conversely, if the "spread" is narrow, as it was in the early 1980's, then the cheap stocks will not outperform the market (they didn't for nearly 20 years).

Grantham claims that there are essentially three reasons why the "cheap" stocks outperformed for so long. First off, they carried a higher risk of financial failure. Secondly, many money managers faced career risks by buying these unattractive "cheap" equities. Lastly and most importantly, the investment community was more risk averse, thus overdiscounting the poor quality of these stocks. These factors ceased to exist starting in the 1980's as people realized that cheap stocks were outperforming.

Instead, Grantham shows that high quality stocks (classified by him as companies with high, stable returns on equity and low debt) have always outperformed the market. They recovered five times faster than low quality stocks after the Great Crash and have outpaced the market for as long as there is data.

While the points he makes are intriguing, I believe that cheap stocks and high quality stocks are not always mutually exclusive. Furthermore, I think that a selection of individual stocks that are both cheap and of high quality will eventually have their value recognized by the market. What are your thoughts?

Why Warren Buffett is So Rich

Warren Buffett is a king, an oracle, and a God to the financial world. I personally idolize him; you will see more of him quoted and paraphrased on this blog than any other person. Over his long life, he built up an unimaginable fortune, mostly by investing in or swallowing up undervalued, unappreciated companies. The premise seems so simple, yet nobody has been able to amass anything close to his fortune using his methods. While there are plenty of self-made billionaires who founded their own companies, nobody has quite done it like Buffett has. Just as the Earth has just the right composition, temperature, and atmosphere to sustain life that a billion other planets cannot, Warren Buffett had the perfect combination of temperament, intelligence, upbringing, and passion to make him one of the richest men in the world.

Intelligence

While it is undeniable that Buffett is savvy, he is also a genius in the intellectual sense. He has a high IQ, is excellent at math, reads at a lightning pace, and possesses an incredible memory. As a college student, he would read all of his accounting textbooks cover to cover and memorize the material before the semester even started. Today, he reads five newspapers every morning, a feat which would take many adults (and probably some financial professionals) a good portion of the day to complete. He also spends hours every day reading annual reports, from which he can often glean accurate valuations within a matter of minutes. He can compound interest and discount cash flows in seconds, without the use of a computer or a calculator. These natural gifts are an incredible asset to have in the financial world as it allows him to internalize massive amounts of information and simplify everything to a few calculations.

Passion for Investing and Business

Warren Buffett has been focused on one thing and one thing only ever since he was a small child - making money. He started selling gum and soda at six years old and bought his first stock at 11. He read all of the business books in his house, and was particularly enamored with the book One Thousand Ways to Make $1000. Instead of having normal teenage hobbies, he instead found pleasure in starting and running his own businesses. The most infamous example was his pinball machine business in which he and a partner bought pinball machines for $25 apiece, placed them in local barbershops, and maintained them for a portion of the profits. He later sold the business for $1,200 or the equivalent of over $11,000 today. In high school he partnered with friends and ran multiple businesses, including golf ball wholesaling and selling food at the local ballpark. It is safe to say that he acquired much of the business acumen a man might get in graduate school before he turned 18.

Hard Work

Buffett also had (and still has) a tireless work ethic, mostly driven by his passion for business and his desire for success. He worked an early morning paper route for many years as a teenager, and eventually came to manage other paper boys in addition to running his own route. This job in addition to his other businesses net Buffett about $5,000 before he left for college, which is nearly $50,000 in today's dollars. After completing his graduate education at Columbia, he was determined to get a job working for his mentor and former teacher, Benjamin Graham (even offering to work for free) and was eventually offered a job. By the time Graham closed shop a few years later after, Buffett, only 26, was already a millionaire by today's standards by saving and investing his salary wisely.

Frugal Lifestyle

Warren Buffett would not have gotten off to this incredible head start had it not been for his lack of interest in material things and his penchant for frugality. He has simpler taste than most middle-class Americans, even as a billionaire today. By not squandering his earnings on frivolous things, he was able to begin compounding his wealth early, which ended up paying massive dividends down the road.

Business Genius

Buffett has always been able to earn extraordinary returns by not only investing and compounding his own money, but also by finding access to additional sources of capital. When Buffett started his investment partnership, the precursor to Berkshire Hathaway, he invested a mere $100 of his own money. However, unlike many money managers, he took the fees that he was being paid and reinvested all of it back into the partnership. Having enough in his personal account to live on, he allowed the power of compounding to take hold on his snowballing partnership stake. Just six years after he started the partnership, his share had grown to $1 million, and when he liquidated it eight years after that, his stake was worth $25 million, or around $140 million in today's dollars. Later with Berkshire Hathaway, he made insurance the foundation of his company. This allowed him to make massive returns by investing not only the cash generated by his businesses, but also the float from the insurance premiums. He continued making investments and purchasing undervalued companies that he understood, earning him a 20% annualized rate of return at the helm of Berkshire Hathaway.

So why is Buffett one of the richest people in the world? It's simple. Warren Buffett's passion was business, and his true profession was investing his own wealth; he simply let some other smart people along for the ride. He harnessed his business intelligence to amass a small fortune at a young age, and then invested it better than anyone else possibly could, turning it into billions.

Buying Stock at a Discount

Warren Buffett has said that it is always better to buy a wonderful company at a fair price than a fair company at a wonderful price. If you are investing for the long haul, it is more important that you first make sure that you have identified a sustainably profitable business before you try to put a price on it. Only by thoroughly analyzing a company can we truly understand how much its worth.

The most common way to value a business is by using a discounted cash flow model. In a nutshell, this is done by projecting the free cash flows into the future, then discounting those cash flows back to the present at the weighted-average cost of capital (WACC). You then compare this value to the market price to determine whether or not it is trading at a discount to its true value. If it is trading at a significantly lower price, then it would most likely make for a good investment.

This may sound all rosy and simple, but in reality the discounted cash flow model is inherently rife with errors due to estimation and prediction. Projecting cash flows one or two years out is difficult enough; estimating them five or ten years out is impossible. Calculating the WACC is also nearly hopeless as there is no viable way of accurately computing the cost of equity (the CAPM model has been empirically proven wrong).

Tinkering slightly with growth rates and especially discount rates can land your valuations all over the place, so I have found it most useful to look for conservative ratios and yields when determining whether or not a stock is cheap. A simple metric to use is the price to free cash flow ratio, which is simply the market capitalization divided by the free cash flow. If the cash flows have been inconsistent over the past few years, it may be better to take an average rather than using the trailing year's numbers. If the stock in question is trading for less than around 10 times free cash flow, then it is usually a safe bet. The threshold should be adjusted slightly higher if you are confident that the cash flows will continue into the future and grow at a good pace. Remember that the lower the ratio, the higher your margin of safety will be in case of some inevitable error in your analysis or predictions.

Feature on 20smoney.com

I have written a guest piece, which can be seen here, for 20smoney.com regarding the correct and incorrect reasons to sell your stock. As the decision the sell (or not sell) is just as important as buying a stock, I believe that you should use the same careful analysis and patience when going about this process.

20smoney.com is a well-established personal finance blog that I highly recommend checking out. It has some good insight into investing as well as a number of other topics.

How to Identify Quality Management

Oftentimes when we are evaluating a stock to purchase, we focus most of our attention on the more tangible aspects of the business. We look at how well the company has performed in the past financially, how healthy the balance sheet is, the future prospects of the company and the industry outlook. While these factors are important, it is also essential to assess the captain and crew that are steering the ship. Management is often overlooked because either a) its quality is too difficult to quantify or b) we figure that we can infer its level of quality from past results. While there is some truth to these statements, I believe that with a bit of sleuthing, we can identify certain characteristics that make up a good management team.

Performance

The simplest metric by which we can evaluate management is how well the company has performed under its tenure. As I've mentioned previously, a good management team is able to increase the per-share intrinsic value of the company by consistently employing larger and larger amounts of capital at high rates of return (see my previous post on evaluating businesses for more details). Simply increasing earnings while proportionately increasing the capital employed at the same rate is no special feat. If the management team has been able to consistently capitalize on increasingly profitable growth opportunities, then this will be reflected in the financial statements. Only then should the managers be praised.

Compensation

On the 10-K report that all public companies must submit to the SEC (which can be found here), there is a section detailing how the executives are compensated. Normally, this is a combination of a base salary, an annual incentive bonus, and some form of stock or options. This last form of compensation is used to "alight the interests of management and shareholders," but investors should be wary of excessive option grants. Stock options are like free lottery tickets that offer all upside and no downside; true shareholders experience the lows as well as the highs. Furthermore, long term, fixed-price options provide incentives for withholding dividends and repurchasing stock to drive up per-share earnings, rather than creating value for shareholders. Use common sense when you evaluate the compensation packages and make sure the incentives are truly in line with improving business performance.

Stock Ownership

You want managers that walk in the shoes of owners. By investing in companies that have significant insider ownership, you are paying for a management team that has its interests aligned with yours. You can easily determine who owns how much and view track recent insider transactions on Yahoo! Finance and other sites. If you are looking at a larger company worth several billion dollars, you're less likely to find management that owns a large percentage of the outstanding shares, however you can still find managers who have a large percentage of their net worth invested in the business.

Past Experience

Lastly, since you likely won't be able to physically meet or speak with the management team, you should, at the very least, look into the background of the CEO. If he has been with the company for less than five years, look to see how he has performed at his previous jobs. See if he has always been involved in the industry or if he gained his expertise in some other field. Also, while you don't have to do a full background check, see if he has been directly or indirectly involved in any lawsuits or scandals. If you see any red flags as to the integrity of the chief executive or the CFO (the man in charge of accounting...), then you may want to reconsider investing.

Checking the Financial Vital Signs

While a company may have a good, sustainable business model that generates a lot of cash, you must also make sure that it's not taking unnecessary risks by overloading itself with debt. It is important to look at the cash on hand and the other current assets in relation to the long term debt and overall liabilities on the balance sheet. If the company does not carry much cash on hand, if a lot of its capital is tied up in inventory, or if it has a large accounts receivable balance in relation to the rest of its current assets, then it might have more difficulty making interest payments in a pinch. Here are some useful ratios to evaluate the financial health of a company:

Quick Ratio

The quick ratio is a simple, conservative way to measure how easily a company can cover its current liabilities with its current, most liquid assets. To calculate the ratio, simply divide the current assets minus inventory by the current liabilities on the balance sheet. Generally, the higher the ratio, the more financially sound the company. A ratio well over 1 is always nice to see. Of course, since the ratio includes the accounts receivable, it is not a perfect indicator. More on this in a bit.

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Interest Coverage Ratio

This metric is exactly what it sounds like. It measures how easily a company can make interest payments on its outstanding debt. To calculate this, divide the earnings before interest and taxes (EBIT) by the interest expense, both of which can be found on the income statement. If this ratio is hovering around 1 or below, then it is in serious danger of defaulting on its debt, especially if earnings are erratic.

Interest Coverage Ratio = EBIT / Interest Expense

Inventory, Receivables, and Turnover

Comparing current assets to current liabilities is an easy way to determine the liquidity of a company, but it may not tell the entire story. While cash and short term investments are almost always extremely liquid, the same may not be true of inventory and receivables. In order to determine how efficient a company is at converting its inventory and receivables to cash, we can simply look at the turnover ratios for these two accounts. Simply divide net sales by the average inventory to see how many times over a company's inventory is sold for a certain period. This metric should be compared to its industry average, as different industries turn over their inventory at very different rates (think of a jewelry store versus a Wal-Mart).

Inventory Turnover = Net Sales / Average Inventory

Similarly, dividing net sales by the average accounts receivables will show you how effective a company is at extending credit and collecting debts. Again, a high ratio is good, but should be compared to the industry average.

Receivables Turnover = Net Sales / Average Accounts Receivable

Seeing either of these turnover ratios fall year over year is a red flag as it indicates that a company is becoming less efficient in how inventory and receivables is being converted to cash. Additionally, seeing inventory or receivables increase drastically as a percentage of sales over the years may be a warning sign as well.

Conclusion

While these ratios will cover many aspects of a company's financial health, they are far from complete. Depending on how much time you have or how well you understand accounting, you may choose to further scrutinize a company's financial statements by checking the due dates of certain debt or looking at the inventory valuation method, among other things. Also, it is important to remember that while lower debt and more cash on a balance sheet decreases risk, they may also inhibit growth. If a company is profitable and has promising growth prospects, then taking on a bit of debt and tying up capital in lucrative projects is a good thing. Analyze a company's financials conservatively, but keep the big picture in mind when you do.

Feature in Carnival of Personal Finance

The post "'Buy and Hold' is Immortal" has been featured in the latest Carnival of Personal Finance. Check it out here.

Does the Company have Staying Power?

When you are looking to invest in a company for a long period of time, it is important that the business has what Warren Buffett calls an "economic moat," or a sustainable competitive advantage. While a past performance of strong profitability and robust revenue and earnings growth may constitute a solid castle, the long term investor must also determine whether the company has a wide economic moat that will protect it against competition and margin erosion. These competitive advantages are qualitative aspects of the business and can therefore be very difficult to identify. As a prerequisite to any moat analysis, you must have a good understanding of the inner workings of the company as well as how it fits into its industry. Here are some common examples of moats:

Brand Equity

A well-established and respected brand name is one of the most powerful tools to ensure long term profitability. Loyalty to Procter & Gamble's portfolio of billion-dollar brands such as Tide, Crest, and Duracell will ensure that they continue to outsell cheaper generic rivals for years to come. Also, a premium brand image such as that one that Apple has cultivated will allow it to charge high prices and reap fat margins on iPods, iPhones, and whatever other iThings they decide to sell in the future.

Network Effect

Imagine a snowball rolling down a hill, gathering mass and speed as it accelerates. The power of the network effect is essentially the same: as more people come to use its good or service, the more valuable that good or service will become. As the network builds, it becomes more and more difficult for competitors to break into the market. Microsoft's Office software and eBay's online marketplace are two examples of well-established networks. You must also be wary of network mirages and the risks that network effects entail. For example, network effects built on the internet can be more transient than you think. Those who think that Facebook's network is impenetrable should remember the rise and fall of AOL. Also, some physical network effects tend to bring regulation (the telecom industry) as they can create natural monopolies.

High Switching Costs

This competitive advantage occurs when it would cost the customer a lot of time, effort, and/or money to switch from one product or service to a competitor's. This allows a company to lock in customers, even if a competitor brings a slightly cheaper or higher quality product to market. For example, Autodesk's leading design software has become the standard for the architecture and engineering industry. Knowledge of the software is essential for success in these fields. It would be very expensive and time-consuming for a whole architecture firm to retrain their staff with an entirely new product.

Cost Leadership

While making something at a cost lower than your competitors may appear to be a straightforward strategy, it is actually tends to be the most complex. Many low-cost producers are borne from economies of scale; high fixed costs and low variable costs allow them to produce higher volumes at lower average costs. However it is usually a combination of factors that allows a company to maintain a low-cost competitive advantage. The most obvious example is Wal-Mart, which has the power to undercut its competitors by utilizing an innovative inventory and warehouse system, building massive superstores, and using its size and clout to negotiate with suppliers.

Other Examples

There are some companies that may not fit neatly under any umbrella, and others still that can fit under more than one.

• Intel maintains its huge market share by pouring tons of cash into R&D and manufacturing, thus allowing it to constantly develop better chips and bring them to market faster that its competitors. It also helps that it has one of the worlds most valuable and recognizable brands.
• Moody's Corporation is the world's largest provider of credit ratings of debt instruments. The SEC limits the number of players in the credit ratings industry, and since many loan agreements and investment funds require certain credit ratings, they have no choice but to give Moody's their business.
• In addition to possessing one of the most reputable brand names in banking, Goldman Sachs' moat lies mainly in the quality of its employees and their amalgamation into a successful corporate culture. They are able to attract and retain top talent and promote a philosophy of "long term greed," which translates into long term profits.
  

The list goes on. Essentially, the strength of each of these competitive advantages can be summarized by answering one question: how much would it cost a competitor to replicate the business? While it is impossible to calculate this figure exactly, a rough estimate will likely be enough. (In fact, the closer you can get to an exact number, the lower the probability that you have a wide moat business.) Nonetheless, any company that possesses one of these wide economic moats can be relatively assured that they will continue to have profitable businesses in the future.

Evaluating a Good Business

Historically, stocks have provided the highest returns of any asset class over most extended periods of time. It is also widely known that individual stocks can be extremely volatile over the short term, thus the general conviction that "stocks are risky." It makes sense however that if you have a long investment horizon and are able to endure the daily, monthly, and even annual price fluctuations, your portfolio should be primarily comprised of equities. Here is the first of some basic principles that should be followed when selecting individual stocks.

Is It a Good Business: High Return on Invested Capital

Stocks are not simply floating ticker symbols with moving prices. They represent ownership stakes in companies. As such, you should be looking for companies that are able to consistently generate a lot of free cash (i.e. profits left over for the owners) relative to what the stock and bondholders have invested in the business. This metric is also known as the return on invested capital. In order to calculate this return, simply divide the free cash flow (excluding any irregular or nonrecurring capital expenditures) by the sum of the total shareholder's equity and the interest-bearing liabilities.

ROIC = Free Cash Flow / (Shareholder's Equity + Interest-Bearing Liabilities)

If these cash flows are consistently upward of fifteen to twenty percent of invested capital, then you are probably looking at a good business. If the company is regularly blessed with much fatter returns, then you likely have a great business on your hands. Furthermore, it would be ideal to see those returns on invested capital increasing year over year. This is a sign that management can deploy incremental capital at higher and higher rates of return.

Stock Idea: Emergent Group (LZR)

The company is Emergent Group (ticker: LZR), and it provides surgical equipment and technicians on a fee for service basis to hospitals and surgical centers. Their over 800 customers include small hospitals that can't afford to purchase the equipment outright as well as large hospitals that choose not to because of low utilization rates for certain procedures. The customer base of 800 is spread over 16 different states, and no one customer has represented more than 10% of total revenue.

Cash Machine

Revenue for the past year was about $31 million and has grown at a rate of over 20% over the last nine years (and even faster recently). More important in my opinion is the free cash flow that the company produces. It is an absolute cash cow because of its business model. While net income for the previous year was only $3.3 million, it produced $7.6 million in free cash. This discrepancy is largely due to the depreciation costs that it must incur on its equipment. The return on invested capital was huge this past year at 63%, which is even better than its already high five year average ROIC of 49%. Furthermore, Emergent has managed to increase this free cash flow by over 30% per annum over the last eight years (from the first year it had a positive free cash flow). It has used some of this cash to acquire two smaller medical device suppliers over the last three years, which I believe is a key component of its growth strategy. Last but not least, it throws off some of this cash in the form of a nice dividend (yield of 5.4%).

Managers Eat Their Own Cooking

This fantastic performance over the past decade is no accident. The management team is very experienced and also has a significant ownership stake in the company. The CEO, Bruce Haber, has been involved in the medical device supply industry for 29 years, the last seven of which were as the head of Emergent. The President and COO, Louis Buther, has been working in tandem with Haber in the industry for 27 years, including the last seven at Emergent. Haber owns 22% of the shares outstanding and Buther owns 11%, much of which has been accumulated over the past two years in the form of direct acquisitions, not option exercises. Not only do they appear to put their money where their mouth is, but they’ve backed it up with strong performances over the years.

Financial Health and Volatility

As far as the financial health of the company, I believe that it has a sound balance sheet. It has current assets of $13.3 million including $7.4 million of cash to cover $11.8 million in total liabilities. It has $2.7 in long term debt, which should be no problem considering the cash on hand as well as the cash flow it is capable of producing is plentiful. Despite being a small company and trading fairly thinly (only about 15,000 shares per day), Emergent has a beta of 0.65, so the price fluctuations are minimal.

Potential Headwinds

Of course, the big change to the medical device sector comes in the form of the new health care bill that has been passed. There is a new tax on medical equipment producers, however this may not apply to Emergent Group as it only purchases the equipment and then rents it out. The new law may in fact help Emergent in that 32 million more Americans will now be covered, meaning more surgical procedures will be needed. To be honest, I don’t really know the ramifications of the health care reform on Emergent. Since these are just guesses, I believe that the most uncertainty and risk lies with this issue. I also believe that as a small company, Emergent faces a lot of competition in a price-sensitive sector that probably has a lot of bigger players.

Cheap Valuation

While the company is too small to have growth projections and analyst followings, this also means that it is not well followed by Wall Street. As far as valuation, the company currently has a market cap of about $50 million, so while the P/E appears uninspiring at 16, it is trading at a mere seven times free cash flow. Even using a ridiculously high discount rate (15%) and a very conservative future projected growth rate (5%), the company still appears to be undervalued at its current price. I believe that there is a significant margin of safety to make up for the risks that the company faces.

Conclusion

As you can see, I really like this company, especially at its current price. While it has potential downside risk with regard to the future landscape of the health care industry as a whole, I think this risk is offset by its strong performance, dedicated management, and low valuation.

"Buy and Hold" Is Immortal

Go ahead and Google "buy and hold is dead" and you will see some interesting results. I find that most of the articles and blog posts published with these keywords were written sometime between March and May of 2009, when the stock market was at its lowest point in over a decade. I'd bet that many of these writers are in their thirties or forties and began investing ten to fifteen years ago by steadily buying mutual funds or individual stocks. I would certainly be pessimistic too if I were them! Over the last two or three years of recession, the market has seen some dizzying drops in share prices that have certainly made stomachs churn.

People continuously point out that the 10 year total return on the S&P 500 has been negative. Well, that's not especially surprising considering stocks were garnering record high valuations ten years ago. The average P/E ratio of the S&P 500 from 1998-2000 was around 40, which is about double the average P/E over the last half century.

Similarly, the 10 year total returns for the mid to late 1970's were very low. If we look to the beginning of those ten year periods, the mid to late 1960's, the S&P 500 was also trading at an above-average P/E of about 23.

Nonetheless, even if you bought into the stock market at high valuations in the 1960's, the 20 year annualized returns were still above 6%, which were even high enough to consistently outpace the rampant inflation of the time. Even stocks bought right before Black Tuesday in 1929 would have yielded a positive real return by the end of World War II.

I'm trying to make a couple of points here. The first is that even over somewhat long periods (10 years or so), stock prices can widely deviate from their intrinsic values. This means that a peak as high as that of the Internet bubble to a trough as low as that of the Great Recession may produce a negative return. In order for traditional buy and hold to work in the passive, broad index investing sense, you must have a lifelong investing time frame. The United States and world economies will continue to grow because growth is inherent to human nature and we as a species are, for the most part, intelligent, rational, and resilient.

I personally like to tweak the term "buy and hold" to something more like "buy cheap and hold." Here's an eye-opening example. Imagine you had $200,000 in cash to invest in 1990 and had the following possibilities:

Scenario 1: Put $10,000 in the S&P 500 each year for 20 years

Scenario 2: Put $20,000 in the S&P 500 each year its trailing P/E is below 25

Scenario 3: Put $40,000 in the S&P 500 each year its trailing P/E is below 20

At the end of 2009, here is how much you would have:

Scenario 1: $409,040

Scenario 2: $589,854

Scenario 3: $637,426

These results speak for themselves. In every 20 year period over the last half century, Scenarios 2 and 3 have vastly outpaced Scenario 1. So not only is "buy and hold" over the long term is very much alive, but "buy cheap and hold" is alive and thriving.

The Effects of Saving, Investing, and Time

Imagine you are a recent college graduate. Say you find a job that pays the average starting salary for a new graduate, around $50,000 per year and grows at a rate of 5% thereafter. For the sake of simplicity, let's also say that your expenses will run at around $40,000 per year for this first year and will also increase at 5% (this is obviously excluding major events like buying a house or sending your children to college). Imagine that you invest the difference between your salary and your expenses every year in an index fund that produces a return of 8% annually. At this rate, you will accumulate your first million in 22 years, or roughly by the time you turn 44. Your second million will come in 29 years and your fifth will come in 39 years. While this is a very respectable outcome, let's change a few of the factors and see what will happen to your overall wealth.

Saving More

First, let's assume we increase the savings rate. Say you can really live frugally and cut back an extra 10% of your spending per year. Just by doing that and holding everything else equal, your first million will come three years earlier (age 41), and your second and fifth will come four years earlier (age 47 and 57). Cut another 10% and you will be a millionaire by 38, a millionaire twice over by 44, and a millionaire five times over by 53.

Investing Smarter

Now let us say that in addition to saving 40% of your salary, you are able to make some wise individual stock selections that give you a 10% annual return on these savings. Your first million now comes in 15 years (age 37), your second in 20 years (age 42), and your fifth in 28 years (age 50). Now say that you devote most of your portfolio to your shrewd stock selections and are earning 12% each year. This higher return will not only earn you your first million a year sooner, but it will nearly double your wealth by age 65.

Earning More

Finally, let's say that you are able to land a more lucrative job out of college that pays you a 20% bonus each year. If you simply invest this bonus each year along with your normal savings at a rate of 12%, you will be a millionaire in 12 years. By working hard, cutting your expenses, and investing intelligently, you have gone from being a millionaire by 44 to a millionaire by 34. By 44, you will be worth nearly five million and by "retirement age" at 65, you will have accumulated an astounding $65 million.

Conclusion

The lesson here is if you earn an average amount of money out of college, save consistently, and invest passively you can live well, have a million by your forties and many millions by retirement. However, if you can go the extra mile and work to earn a bit more, wisely cut your spending, and make smart (yet simple) investment choices, the power of compounding will make you very wealthy.

Welcome

Welcome to my blog. My goal is for the pieces that I post on this blog to be in some way helpful and thought-provoking to the people that read them. The articles will primarily be centered around value investing with a few thoughts on frugality and other things thrown in as well. I believe that by saving money and investing it intelligently, we can not only become financially independent, but allow ourselves more time and energy to focus on the things that truly make life fulfilling.

I hope you enjoy what is to come and welcome your feedback on anything that I post.