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...

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.

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.

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.

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 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.

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!

Money-Weighted Rate of Return: It's All About Absolute, Actual Returns

This is Part 3 of a Series. Go to Part 2: Time-Weighted Rate of Return: It's All About Relative, Simple Yields

Note: The following is a letter addressing my partners which clarifies the money-weighted (MW) and time-weighted (TW) measures of performance. I would recommend that you read first the earlier letter before proceeding.

March 6, 2011

TO MY PARTNERS:

The Money-Weighted Rate of Return. This rational measure of performance tries to capture the internal rate of return (IRR) of the portfolio. It is therefore sensitive to the timing and size of cash inflows (outflows) and accurately depicts absolute returns per actual fund results.

My January 12, 2011 letter presented how my personal portfolio has yielded since its inception in 2008. My number-crunching, while honest and innocent, failed to mention two ways in which fund returns maybe measured: the money-weighted (MW) and time-weighted (TW) approaches. For everyone’s information, the 17.15% rate of return previously presented considered the time-weighted method. Through this letter, I intend to further delve into this issue of measuring performance. I cannot overemphasize the importance of this matter to the investing partner; although I have to apologize in advance should this presentation be too technical.

Essentially, TW captures this scenario: had I started the fund with a pioneer partner in 2008 and that partner did not make any deposits to and withdrawals from the fund, he should be earning a 17.15% compounded annually. In reality, however, this may often not be the case: he may be making additions or withdrawals (these can dramatically magnify his profits or losses depending on how the fund performed after the additions/withdrawals)—this is the essence of the MW approach; it captures and weighs the timing and money amounts committed for any given period and pinpoints the real absolute returns per actual fund results.

Intrinsic Value and the Equity Bond Theory

This is Part 2 of a Series. Go to Part 1: Intrinsic Value and Bond Valuation

Equity Bond. A stock can likewise be thought of as a bond whose worth is just the sum of all its discounted free cash flows. The difference from your regular bond being: the equity bond yields expanding coupons!

Following the line of rational thinking usually applied in bond valuation, a business, in the same manner, is only worth all the discounted future cash flows it can provide. A business, therefore, can be thought of as an “equity” bond. The question now is: which cash flows should we consider and discount?

An extreme take on this paradigm is the Dividend Discount model. Taking on the assumption that the significant cash flows are only those dividends actually paid to the shareholders, the model intends to value a stock based only on these dividends. The immediate problem on this extreme view is how detached it is from the real, internal cash-generating capacity of the business. For one, it can be deceptive since dividends by themselves say nothing of the operating realities of the underlying asset—they can even be financed through externally sourced debt at the immediate pleasure of naive, detached “owners”, but at the immense detriment of long-term, business sustainability. Another reason is that, there's also those companies which are really good at making money but are not in the habit of disbursing them as cash dividends. It's not that they don't want to share the profits, but that even the board of directors and the shareholders favor income retention because management is capable of further deploying these profits in investments that would further compound wealth.

FEU’s Cash Hoard. And They Said School is Boring...

This is Part 3 of a Series. Go to Part 2: So Where Have All Those Free Cash Flow Gone?

Majestic Campus. FEU is one of those few quality businesses that routinely produce and hoard free cash for the wealth enrichment of its owners.

I can’t blame anyone who thinks school is boring. Be it on what one may have experienced back in high school or college (e.g. boring classes and teachers/professors), or in stocks (i.e. boring, illiquid issues that hardly move in the market). But let’s take on the shoes of a prospecting investor interested in the fundamental cash-generating dynamics of a school as a business.

Disclosure: I'm currently a shareholder of Far Eastern University—yes, it is listed in the Philippine Stock Exchange (PSE: FEU).

Grasping the core business model of a school seems easy. Schools teach and prepare students for the real world, and in return collect tuition fees for this education service. As many are aware, they collect these fees upfront; before a student can walk into a classroom to learn, he must first pay the registrar a visit and write the accounting department a check. Not mentioning its other sidelines (such as leasing certain properties owned and deploying excess cash into other non-core business investments), that's how a school primarily makes its money.

Being Intimate with Equity Value

How does a stock market investor, as a businessman, despite all the stock market noise, immerse himself and connect his consciousness in the underlying wealth of a company he invested in? Or to ask simply, what value does he immediately get upon acquisition of the stock? Crudely, the simplest, and easiest reference of shareholder value can be observed in the balance sheet account called equity. Equity, in theory, represents that residual value attributable to owners after paying all company debts or liabilities. Of all measures of value, it is perhaps the most objective, readily available financial figure for the inquiring investor (in contrast to an intrinsic value estimate which may have been derived from a financial spreadsheet model which in itself is prone to the “garbage in, garbage out” risk.

Value of the book. Equity value or book value is that residual value attributable to the shareholders. Increase in it through internally-generated earnings has a lot of business sense in it.

The idea is to view the value of one’s interest in a business not in terms of what its stock price is doing, but in terms of what its book value is doing. With this frame of thought, you’ll have the luxury and peace-of-mind to view your wealth in book value terms, and be able to subscribe to the idea that each increase in book value enhances the value of the business. Although I am well aware there are a lot of ways to measure value (e.g. discounted cash flow model), I foster this straightforward mentality (at least for now) for the sake of bluntly psyching the price-obsessed, market-conscious investor into a simple, rational business paradigm.

Focusing on equity (or book value as it is commonly referred to by accountants) gives the investor an idea or easy reference of how much value he gets from what price he pays for. Assuming this is the immediate value you get, one will have an easier time to accept that earnings—that which adds internally-generated value (i.e. by virtue of business) to book value—do really have a direct impact on the value of the enterprise, and consequently, your wealth (since you are a shareholder); thus, when the company earns, you do really have a share in those earnings. Commitment in internally enhancing book value engages the company to focus on profitable operations. Plainly, book value has a lot of business sense in it.