Republic Cement as an Equity Bond with an Expanding Coupon

It's just a cement bag. No! For me, it's an equity bond with a powerful compounding/expanding coupon!

This is Part 2 of a Series. Go to Part 1: How to Quickly Assess a Likely Long-term Rate of Return Given a Stock’s Current Price

We turn ourselves to Republic Cement (PSE: RCM), a company I was able to purchase three years back then (and still holding) when it was still selling below book value.

Fast facts: It’s been in the business of manufacturing and selling cement for decades. It’s currently the market leader; majority holder is that worldwide leading French cement company called Lafarge. Catastrophe risk is almost minimal.

So let’s try to apply the simple appraisal steps noted earlier...

How to Quickly Assess a Likely Long-term Rate of Return Given a Stock’s Current Price

Foresight? In stocks, hindsight is clearer and easier. While we know by hindsight what the excellent business is capable of performing, we downplay our prospects of it, and content ourselves with the more likely, easily achievable, conservative scenario.

This is Part 1 of a Series.

I’m starting to be more inclined towards fast but very conservative approaches in rate of return and intrinsic value appraisals. Because no matter how detailed, elaborate, or complex our models are, if the assumptions, programming, or the projections themselves are too optimistic and aggressive, then the likelihood of achieving these forecasts would be thinner. And the same thing goes with achieving superior returns.

What we simply want to do is downplay our prospects, minimize our expectations, and be happy and content ourselves with the safe, very achievable, conservative scenario, and pay a reasonable price for that—all these despite knowing by hindsight that the business is much more capable and can offer more!

BIR Tax Legality, PSE Administrative Impossibility, Logistical Burden, Illiquidity Tendencies

This is Part 2 of a Series. Go to Part 1: The Philippine Stock Exchange Tax Dilemma—Clarifying the ½ of 1% Stock Transaction Tax and the 5 to 10% Capital Gains Tax

The Ayala Tower One & Exchange Plaza: seat of the Philippine Stock Exchange (PSE) in Makati. Implementation of the capital gains tax rule on traded stocks through the local exchange is problematic legal-wise, and poses administrative issues. It may actually deter liquidity than improve it.

Problematic Legal-wise. I still have my reservations on the applicability of the 5 to 10% CGT on traded shares of listed firms primarily because there’s no provision in our National Internal Revenue Code (NIRC) saying that when a listed firm falls below the MPO requirement, it should be subject to the CGT. Under Sec. 127 (A), the tax code was very clear and particular that shares traded through the local stock exchange shall be subject to a final ½ of 1% STT.

The 5 to 10% CGT stipulated under Sec. 24 (C) of the tax code, on the other hand, is actually intended for shares not traded in the stock exchange, and not for those traded through the local stock exchange. So even if the BIR issues a Revenue Regulation ordering and outlining the implementing guidelines, this would conflict against the provisions of the tax code. I’m not a lawyer, but by the rule of law, it’s going to seem null and void. The only way to put it into effect legally is to revise the tax code, and the tax code is law. Revision of law requires involvement, consent, and action of our legislature—the Congress and the Senate.

The Philippine Stock Exchange Tax Dilemma—Clarifying the ½ of 1% Stock Transaction Tax and the 5 to 10% Capital Gains Tax

This is Part 1 of a Series.

The Bureau of Internal Revenue Main Building. While the ½ of 1% stock transaction tax is applied on the gross selling amount, the 5 to 10% capital gains tax is imposed on, well, just capital gains, and not on the whole gross selling amount.

There seems to have a revived stir among Philippine Stock Exchange (PSE) investors on the insistence of the Bureau of Internal Revenue (BIR)—with the backing of the Department of Finance (DOF)—that a 5 to 10% capital gains tax (CGT) be imposed for traded stocks of listed firms that failed to comply the PSE minimum public ownership (MPO) requirement of 10 to 33% (depending on the company's market capitalization). It has been revived particularly because of recent news articles (e.g. that one from the Philippine Daily Inquirer) having a seemingly confirming tone that this ruling is already scheduled for implementation.

Currently, the tax being imposed on traded stocks in the local exchange is the ½ of 1% stock transaction tax (STT). Consequently, most have initially perceived that the CGT, being 5 to 10%, immediately leads to higher tax costs because at first sight, it does indeed seem that way (5 to 10% > ½ of 1%).

Yet these assumptions should be clarified. Because while the STT is applied on the gross selling amount (i.e. Selling price x no. of shares sold), the CGT is actually applied only on capital gains (i.e. Gross selling amount – gross purchase amount)—that is, 5% on the first Php100k capital gains, and 10% on capital gains in excess of the first Php100k.

The Purpose of the Margin of Safety is to Render Forecast Unnecessary

This is Part 8 of a Series. Go to Part 7: Phil Fisher-Type Growth Company at a Ben Graham-Like Price

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

Question from an Audience: I'm kind of interested in the scratch notes that you were talking about ... If someone who was very quantitatively-oriented and knows excel looked at that and put it into a model, do you think he could understand what's going on inside Warren's head when he's trying to value a company, and actually replicate that?

Alice Schroeder: There's a saying, let me call it to mind... I think it's from the Intelligent Investor: “The purpose of the margin of safety is to render forecast unnecessary.”

Yes. What you would see is a column that said sales, and a column that said expenses, and a column that said profits, and it would have Kentucky plant, Lulaville plant, Kansas City Plant, this plant, that plant, and it would have 1st quarter, 2nd quarter, 3rd quarter, 4th quarter, 1958, etc., and then it would end with the last quarter that was reported...

That's what it is.

That's all this is. And the difference from a model is that it would not add the quarters up, and it would not project anything into the future, nothing. In other words he looked at what had been reported, and he said they've earned a million in sales; they've earned this many thousands. I want this much. They earned this, I want this, can they do it? Yes/no? That's the decision.

Phil Fisher-Type Growth Company at a Ben Graham-Like Price

This is Part 7 of a Series. Go to Part 6: Buffett’s “Discounted Cash Flow Model”

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

And that was typical. I gave you this example in part because it was that other time, apart from Geico that he got a Phil Fisher-type growth company at a Ben Graham-like price. It was the most vivid example of that that I found. But it was a private investment and there's not a lot of public information about it available.

And he ended up putting $60,000 of his personal non-partnership money into this company which was about 20% of his net worth at the time. He got 16% of the company stock plus some subordinated notes. And the way he thought about it was really simple. It was a one-step decision. He looked at historical data, then he had this generic return that he wants on everything, it was a very easy decision for him, and he relied totally on historical figures with no projections. I think that's a really interesting way to look at it because I saw him do it over and over on different investments.

So what happened? Well, the company changed its name to Data Documents. he owned the investment for 18 years. He ended up putting up another million dollars over time. It was bought out by Dictograph in 1979 and he earned a 33% compounded return over the 18 years that he owned the investment. So it was not too bad.

Buffett’s “Discounted Cash Flow Model”

This is Part 6 of a Series. Go to Part 5: Handicapping—The One or Two Factors that Could Make the Horse Succeed or Fail

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

Okay, so what he did is, he incorporated his whole earnings model and compounding discounted cash flow into that one sentence: I want 15% on 2 million of sales. Why 15%? Because Warren's not greedy. He always wants a mere 15% day one return on investment and then it compounds from there. That's what all he ever wanted, he's happy with that.

And then he took all the historical data, quarter-by-quarter, for every single plant; he got this similar information as best he could from every competitor they had and he filled pages with little hand scratches of all this information and he studied that information and then he made a yes/no decision. He looked at it: they were getting 36% margins, they were growing over 70% a year on a million of sales. So that's where he looked at the historic numbers in great detail, just like a horse handicapper studying the tip sheet. And then he said to himself: I want a 15% rate of return on 2 million of sales. And then he said: Yeah I can get that.

Okay, so what he did is, he incorporated his whole earnings model and compounding discounted cash flow into that one sentence: I want 15% on 2 million of sales. Why 15%? Because Warren's not greedy. He always wants a mere 15% day one return on investment and then it compounds from there. That's what all he ever wanted, he's happy with that.

Handicapping—The One or Two Factors that Could Make the Horse Succeed or Fail

This is Part 5 of a Series. Go to Part 4: Assessing Catastrophe Risk—A Quick Way to Say Yes or No

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

Everybody that I know or knew as an analyst would have created a model for this company and would have projected out earnings and would have looked at its return on investment in the future. Warren didn't do that, in fact in going through hundreds of his files, I've never seen anything that resembled a model. What he did is: he did what you would do to a horse. He figured out the one or two factors that could make the horse succeed or fail. And on this case, it was sales growth and making the cost advantage continue to work.

Okay, so now, Warren is interested. Because the catastrophe risk element of the equation is gone. They are competing successfully against IBM. So he asked them the numbers and they explained to him that they were turning their capital over seven times a year. So a Carroll press costs $78,000. Every time they run off a set of cards through and turned their capital over, they’re making over $ 11,000. So basically, their gross profit a year on a press is enough to buy another printing press.

At this point, Warren’s very interested. Their net profit margins are 40%. It’s like the most profitable business that he’s ever had the opportunity to invest in. Notably, people are now bringing Warren special deals. It’s 1959. He’s been in the business two and a half years running the partnership. Why are they doing that? It’s not because they know he’s a great stock picker. They don’t know that. He hasn’t yet made that record. It’s because he knows so much about business, and because he started so early that he has a lot of money. So this is something interesting about Warren Buffett. By 1959, people are already bringing him special deals like what they’re still doing today with Goldman and G.E.

Assessing Catastrophe Risk—A Quick Way to Say Yes or No

This is Part 4 of a Series. Go to Part 3: Handicapping, Compounding, and the Margin of Safety—Alice Schroeder’s Take on Buffett’s Approach

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

He didn’t say no because it was a technology company. He said no because he went to the first step in his investing process. And this is where I think, what he does is very automatic and isn’t well understood. He acted like a horse handicapper. And the first step in his investing process is always to say: what are the odds that this business can be subject to any catastrophe risk that could make it just fail?

Before computers were digital, they actually read off of punch cards, they were called mark-sense cards, and these were big deck of cards that had holes punched in them and they would be stuck in the computer and, being non-electronic, they were sent mechanically through the computer. So this company was formed because IBM had to divest off this business. It was an incredibly profitable business. In fact, because these cards were trivial compared to the mainframe computers that IBM sold, it marked them up to get more than a 50% profit margin. This was IBM’s most profitable business.

So Wayne Eaves and John Cleary, two friends of Warren, saw that IBM was going to have to divest in this business and they thought they’re going to buy a Carroll press which was the press that makes these cards. They’re going to compete with IBM because they’re based in the Midwest; they can ship faster, and provide better service. They went to Warren and said: should we invest in this company and would you come in with us? And Warren said no.

Handicapping, Compounding, and the Margin of Safety—Alice Schroeder’s Take on Buffett’s Approach

This is Part 3 of a Series. Go to Part 2: The Margin of Safety Mentality—A Cornerstone of Value Investing

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

But there are three other factors to his success that I would like to talk about and focus a little bit differently than he normally explains the way he invests. That is, handicapping, compounding, and the margin of safety. These are three concepts that work together. He uses them in a slightly different way than he would think of describing them publicly

I think everybody, or everyone who’s read the Snowball knows, how hard Warren Buffett has worked and how much learning he’s done. But there are three other factors to his success that I would like to talk about and focus a little bit differently than he normally explains the way he invests. That is:

• Handicapping
• Compounding
• The Margin of Safety

These are three concepts that work together. He uses them in a slightly different way than he would think of describing them publicly; they’re all discussed in the book.

I’d like to take you through a case study on an investment called Mid-Continent Tab Card Co. This was a private investment that he did in his personal portfolio and this kind of shows you how I saw him invest based on his personal files and what he actually does, and I’ll update that up to the present day.

The Margin of Safety Mentality—A Cornerstone of Value Investing

This is Part 2 of a Series. Go to Part 1: The Quantitative Principle of the Margin of Safety

The Margin of Safety as a Conservative Mentality or Attitude. It's all about managing your expectations, toning them down, and being realistic about them.

A different way of viewing the margin of safety principle is to think of it as a qualitative concept—an attitude or mentality, if you may. It is that mentality of being bias towards conservative approaches of intrinsic value appraisal which would guarantee protection from permanent capital loss but at the same time exposure to that bonus of rational potency of earnings.

It is that attitude towards using conservative assumptions even if you know the underlying business is much more capable. It’s somewhat intentionally downplaying the growth prospects not because you don’t believe the company won’t grow or boom, but that you’d rather bank on something that can be easily ascertained/achieved by the proven earning capacity of the business, and content yourself with that. Because while you know there’s much more into the investment, you’d rather not delve into complex forecasts, since, after all, if it’s really that good, actual earnings and free cash flows will take care of themselves.

The Quantitative Principle of the Margin of Safety

Margin of Safety as a Percentage Discount. Say the intrinsic value estimate is Php100, a 50% margin of safety would net Php50, the safe price to buy the stock.

This is Part 1 of a Series.

I’ve been blabbering about capital preservation and rational potency of earnings lately. And while watching a Value Investing Conference 2008 video of Alice Schroeder (author of The Snowball: Warren Buffett and the Business of Life) talking about Buffett’s simple thought process in investing, I was particularly struck when she said: “The purpose of the margin of safety is to render forecast unnecessary.” It was a golden nutshell statement which succeeded elegantly in trying to communicate what I intended to point out when I wrote somewhat extensively about capital preservation and rational potency of earnings.

She described that most analysts would rely on a model that would forecast future cash flows then discount them at an appropriate rate. Surprisingly, Schroeder points out that Warren never bothered with financial models. What?! His thought process puts great emphasis, instead, on analyzing historical data in great detail (i.e. sales, expenses, profits in each plant, quarter-by-quarter) then he’d have this generic required rate of return of 15%, and glean whether the business is capable of achieving it or not. He compares—they earned this much, I want this much... Can they do it? Yes/No. It was a very simple decision.

Capital Preservation and Rational Potency of Earnings

This is Part 2 of a Series. Go to Part 1: On Discount Rates, Required Rate of Return, and Conservative Purchase Price.

The idea behind capital preservation is defensively allocating capital in a safe investment position (thus, preserving your money’s worth) but at the same time exposing it to the prospect of profits (or capital gains)—Simply, it is earning without risking losing money. The cardinal concern shouldn’t really be profits—it should first be preserving capital. Profits only come secondary after making sure we don’t lose money. If we start concerning ourselves on this primary consideration, then we’d undoubtedly be diligent and be very cautious in our allocations.

Earning without risking losing money. Capital preservation should remain top priority, with earning profits only being an afterthought.

So if that be the case, then why not just easily opt to hold hard cash, you may think? Well that’s hardly the solution. Complacently leaving your cash lying in the room or under your bed or pillow would diminish its worth because of that value-sucking animal called inflation—the real enemy. Capital preservation is therefore achieved only through placements in value-enhancing instruments which, at the least, beats inflation.

In the realm of stocks, capital preservation can be ascertained by banking on very conservative assumptions of underlying value. Why underlying value? Because that can only be your best bet towards consistency and predictability. If you rely on market value, you’d be subjecting yourself to the whims, emotions, and ups-and-downs of the market. And that would certainly not preserve capital. (An aside though: take note that this is only true if we exempt arbitrage plays; in arbitrage scenarios, the pursuit of value is not found on the underlying business, but rather on the difference between prevailing market price and the publicly declared market tender offer—the arbitrageur viewing the discrepancy as his source of value gain). Nonetheless, certainty is key.

On Discount Rates, Required Rate of Return, and Conservative Purchase Price

Why do we discount something? We discount a future value because we want to know the right price to pay now to achieve that discount rate as our required rate of return. Or maybe we don't necessarily want to accurately achieve our target rate; we just want, at least, to estimate a conservative purchase price that will preserve capital and put some potential earnings exposure, leaving most of the actual returns to chance... Just maybe.

This is Part 1 of a Series

Discount rates often seem too complicated when they should be not. Because the idea behind them is similar to an interest rate. Interest rates, for most of us, are easier to comprehend because of their familiarity in everyday practical use. Say we have Php100 and a bank deposit placement offers a 10% interest rate per annum. Should we decide to put it there and hold it for a year, our Php100 will be Php110 [Php100 x (1+10%)]. It’s very straightforward and helps to answer the question: How much money will we get in the end? Or algebraically, the unknown being sought is FV (future value):

FV = PV x (1+i)^n

By contrast, if what is known and offered to us, instead, is a future value amount, the question now is: How much are we willing to pay for it now? Algebraically, after transposing the variables, our unknown this time is PV (present value):

PV = FV / (1+i)^n

So if we are offered Php110 and we want to achieve a 10% rate of return after a year, we should be paying Php100 [Php110/ (1+10%)]. The interest rate and discount rate are thus one of the same nature. The difference can be attributed to the circumstance—that is, the term interest rate is used if we’re talking about finding the future value of a principal amount we would want to invest now. The term discount rate, on the other hand, is spoken if we’re talking about finding a present value we would be willing to pay now provided we know what the future value outcome would be.

On Realizing Gains, Compounding Value, and Equity Perpetuity

This is Part 2 of a Series. Go to Part 1: On Price, Value, Value Investors, and Equity Perpetuity

The following are excerpts from a discourse I had with a fellow investor with regards to realizing gains, compounding value, and equity perpetuity. Let me stress that I don’t claim these constitute canon—these are just my own personal views.

Realizing profits versus compounding value. On one hand, the impulse and instant gratification of realizing profits ironically brings you back to that burden of finding another bargain; on the other, you may have just held onto that stock and let compounding do its magic.

On realizing profits: If the intention is to compound value and amass net worth (i.e. to be rich), then you wouldn't worry about not realizing capital gains. That's the irony in selling stocks—on one hand, by impulse, you just want to realize your paper profits. Realizing your capital gains, however, would again bring you back to that burdening position of finding another bargain (and exposes you to taxes) if you intend to reinvest and further create value. On the other, you may have just indefinitely held onto that stock as long as the underlying business takes care of itself (which in turn takes care of the price). And what is easier and which I personally prefer is the latter case wherein you let the value compound within the business, i.e. that's why I prefer non-paying dividend companies able to retain earnings and compound them at sustainable high rates than businesses paying out all their earnings in dividends (which again exposes you to taxes) at the expense of growth.

On Price, Value, Value Investors, and Equity Perpetuity

This is Part 1 of a Series

The following are excerpts from a discourse I had with a fellow investor with regards to future price projection, focusing on business value, and the usefulness/relevance of the equity perpetuity theory. Let me stress that I don’t claim these constitute canon—these are just my own personal views.

Value investors don't project price, they project value. It should always be some underlying value you're anticipating to get. The difference maybe subtle, even trivial, but in my view, crucial and vital.

The whole intent behind the equity perpetuity concept is to find a safe purchase price (for an excellent business) to achieve your required rate of return. The intention is not to project a target sell price or predict the market. The intention, primarily is capital preservation (through sound business/fundamental basis as represented by forecasted flat earnings/cash profits—you can never rely on market swings/movements to preserve capital anyway) and exposure to rational potency of earnings. And that's primarily the focus and intent of value investing.

Indeed, the principle of value investing is purchasing excellent businesses at bargain prices and not to forecast a future stock price or predict what the market will do. And that being the case, value investors are first and foremost, naturally conscious and very focused on not losing money (that's why all the fuzz on buying a bargain price)—that is, capital preservation—but with the added benefit of exposure to rational potency of earnings (i.e. because of buying into a defensive stock position with an underlying profitable business).

Anticipating a future stock price should never be explicit. Because once you start throwing off some stock price projection tool, the focus tends to be just that: market price forecasting. And there's the peril of neglect where value comes in the first place—the underlying business.

Rate of Return on Equity Perpetuity: Dividend Yield and Free Cash Flow Yield

This is Part 2 of a Series. Go to Part 1: Intrinsic Value and the Equity Perpetuity Theory

If we start to think of stocks as perpetuities (i.e. if we intend to be passively enriched as the "equity" perpetuity unendingly pays us flat dough—regardless what the market is schizophrenically doing) then we might as well identify which "equity" annual payments we’d be considering and discounting. Once we identify these, we'll discover that the rate of return on our equity perpetuity is nothing more than two familiar, often used (but also often misunderstood) measures: the dividend yield and free cash flow yield.

Return Measures of the Equity Perpetuity. When we conservatively assume a stock is a perpetuity and try to derive a rate of return, we're mathematically bound to eventually use the Dividend Yield and Free Cash Flow Yield.

If we choose cash dividend payments, then we’re effectively using the dividend yield. If a stock has recently paid out dividends of Php100 and we assume that it’s gonna issue dividends year after year (since it’s been doing that for years already) and we also assume these will be flat, then we'd have to discount Php100 at a rate we'd want to achieve (i.e. 15%). Using this conservative frame of mind, the stock, obviously, has got to be worth Php666.67 (Php100/15%). On a flipside, if the same stock’s trading at Php500 and we bought it at that price level, then perpetuity-wise (i.e. assuming flat payments forever), our rate of return shall conservatively be 20% (imagine: that is regardless whether the market shuts down or commits suicide—you’re just relying on the fundamental dividend-paying capacity of the underlying business). The dividend yield shall be that equity perpetuity yield from a dividend-conscious perspective. Isn't the Dividend Yield more meaningful if taken from a flat-dividend-paying perpetuity standpoint?

Intrinsic Value and the Equity Perpetuity Theory

This is Part 1 of a Series

Flat cash payments into infinity. To think of stocks as "equity" perpetuities can be a useful, conservative mindset to quickly assess a reasonable purchase price. Despite projecting perpetual annual cash payments, they're still assumed, nonetheless, flat!

Thanks to that contemplation on how relevant and useful the P/E Ratio and Earnings Yields are, I’ve been thinking about perpetuities often these days. And because of that, I’m starting to think of stocks as perpetuities. It’s reasonable, after all, if you intend to indefinitely hold on to an excellent business which would continuously and unendingly generate you bucks passively year after year after year (and beyond). And the great thing about perpetuities is that, they’re conservative! They’re conservative primarily because of their flat or fixed annual payments assumption. We do all know that a good company shall be able to expand or grow its cash profits year after year. So if we’re going to assume flat earnings, then that’s definitely being conservative, don’t you agree? To think of stocks as perpetuities shall be a conservative, appropriate mindset, for a prospecting, long-term rational investor conscious of a reasonable purchase price.

Squeezing the Rationale Behind the Price/Earnings Ratio... or at least its Twin, the Earnings Yield

I’m not really a fan of the Price/Earnings (P/E) Ratio.Why would you want to divide the stock price by its earnings, anyway? Have we even really thought what kind of information we'll get from that? Or are we using it just because everyone else is. Let’s be honest.

P/E Ratio & Earnings Yield. The P/E Ratio personally doesn't appeal to my reason. Its reciprocal, the Earnings Yield, however, seems to be more logical. It's very reminiscent of the rate of return of a perpetuity annuity!

Well, I’ve been thinking about it... And the immediate, most seemingly logical explanation I can muster (to justify its use) is this: It essentially computes the breakeven period (in years) it would take to recover that stock price you’d be paying assuming the company continues to flatly produce the same earnings. Doesn’t it make sense from this stand point? But why would you want to know that, anyway?

The only way I can think of to make sense of the P/E ratio is by taking its reciprocal—that is, instead of dividing the stock price by its earnings, we do the opposite—divide earnings by the stock price. Thus, we get the Earnings Yield, P/E’s reciprocal twin. I have to admit I had my initial reservations on using this ratio. But after going through several valuation techniques and further pondering on the DCF approach/analysis, the simplistic rationale behind the earnings yield suddenly lit up!