Benjamin Graham Balance sheet research part 2

Lesson 9 Balance sheet part 2

Current ratio was the most important figure for Graham, at least when he published the book Security Analysis. It measures the liquidity and financial buffers. He thought this ratio was a reasonably accurate view of how much money could the owners get by liquidating the company. There are three possible reasons and their combinations why the market cap is less than the possible liquidating value:

1. The price that market offers is too low
2. The company´s directors have made serious mistakes.
3. The owners have a wrong attitude toward there assets.

You should remember that debts are real and the value of assets has to be disputed. You also have to remember that there is no possibility to define the exact liquidation value. This value needs to be compared with the price the market is offering. If your valuation is close to the market price, you can´t make any conclusions. The liquidation is in the best use in the situation where the company or some of it´s parts need to be liquidated. When the company has economic difficulties, the most productive parts of the company will be sold in fraction of their real value. When there is no such need, the liquidation values are much higher.

Graham had some simple ways of valuing the company assets:

• Cash, cash equivalents and marketable securities 100% of book value
• Receivables 75-90%, approximately 80% on average
• Inventories 50-75%, approximately 2/3 on average
• Others like real estate, intangible assets, and machinery, 1-50%, 15% on average

Of course, these are just approximate numbers, but it is better to be roughly right than completely wrong. Getting these numbers is more an art than science, except the cash and marketable securities part of valuation. These numbers also depend on the industry. The values of Inventories in the electronics industry become obsolete very fast compared to some other industries. And the inventories of the oil refineries can become more expensive, when oil prices increases. Machinery can also become worthless before all the depreciation has affected the assets in the assets. Intangible assets are hard to evaluate. Sometimes brands are much more valuable than what is their worth in the assets. You can find more exact information from the Graham´s book Security Analysis.

It is hard to find businesses that has undervalued assets in modern days. Most undervaluations come from intangible assets and their values are hard to define. Most often, companies with undervalued assets are found after a longer decline of the market prices. Graham thought you should sell the business, if the price in the markets has been a lot more lower than the liquidation value. In this case, you should ask yourself that is there any basis for keeping a company public or what should the directors do to correct the undervaluation. This can happen in three ways of a combination of them:

1. Improving the earnings power. It can happen through the improvement of the business conditions of the industry or changing the business into more productive by having new directors or trusting the current ones. It is most probable that new directors can achieve this change.
2. Through mergers or acquisitions. Directors of the other company might have better chances to change the business into better direction. There can also have some synergies by having a bigger business.
3. A public offer for the company or for its parts

Stock price that is well below the liquidation value of the company doesn´t automatically mean that you should buy the stock of an individual company. Instead of buying individuals stocks, Graham recommended to buy a diversified portfolio in which all the stocks are bought below liquidation values. It is clear that not all these kind of stocks are worth buying. They won´t fulfill all the expectations. As an investor, you are still pretty much in the safe place, because you shouldn´t be too worried about losing all your money. Graham also mentioned that you should still be sure to do your homework before buying. These companies should have shown so much earnings power in the past compared to market price today that they are not destroying the assets in the balance sheet. For some reason Graham had an image that these companies were the most successful, when the market prices weren´t in their highs or lows.

I hope you can find some time to think about Graham´s simple ways of valuing the company assets. Do you find them applicable in today´s world?

-TT

Benjamin Graham Lesson 8 Balance sheet research

The balance sheet tells you about the assets and liabilities of the company at some point of time. It can also show how it has changed over a period of time. You should evaluate it critically. Graham says you should accept the company´s figures about liabilities. The real value of the assets can be different than company has announced. The value of some fixed assets, such as inventories are not always the same as found from the balance sheet. Some of them can have the same value company paid for them even though they are worthless. Intangible assets such as, mental capital of the employees and brand value are hard to evaluate. They can be either much undervalued or overvalued. Most often they are overvalued. You have to use your own judgment about the worth of such assets.

As an analyst, you will benefit at least in four ways. First, you can define the character and the amount of the resources that are used in a business. These resources are the basis of the earnings in the economically survivable business. A business without proper resources cannot have any significant earnings in a competitive industry. You can also use the balance sheet to find out how much an owner of a business can get from the liquidation of the company´s assets, when the business is not survivable.

Second, you can also use the resources in the balance sheet to figure out the character and stability of the company´s sources of income. Graham thought that the return of assets can only seldom create more income than the cost of capital. He believed that earnings estimates that are only supported by the balance sheet are realistic and accurate enough. The earnings of the business are short-lived unless the balance sheet support them. Graham believed that bigger profit margins were tempting for new competitors without a need for a strong balance sheet.

Third, the liabilities tell an analyst about the sources of financing and economical situation. The large amount of recurring debt or nonrecurring debt that needs to be paid in few years refers to coming financial problems. Even small variations can lead to a significant losses of enterprise value. Fourth, the changes in the balance sheet tells you about the quality of the earnings.

Cash flows should reflect on the changes in economic situations in the companies. You have to remember that balance sheet tells you the situation about the assets and liabilities right now. Without following the changes in the balance sheet, you cannot evaluate the development of the business and how it should happen in the future.

You can make an estimation about the value of the balance sheet in many ways. Graham had three different ways of doing it. He used a book value, a quick ratio, and current ratio. Graham defined a book value by adding all the fixed assets together and subtracts them with all the liabilities, preferred stocks, and their liabilities. Quick ratio adds up the cash and cash equivalents, and divide them with all the liabilities and preferred stocks. Cash includes all the marketable securities, etc. Current ratio adds up all the current assets and divides them with current liabilities.

Graham had mixed attitudes toward the book value during his investment career. He first ignored the book value in a book Security Analysis, because he thought that companies reported flawed estimated about the values of the assets in the balance sheet. On the other hand, he uses book values later in his career, when he was trying to find right securities for his diversified portfolio. He also believed that you should check the book value if you are interested about the stock of a company and want to make an estimation how much you should pay for it. You should never take a company´s valuation by itself. You have to know Quick ratio for a stock is seldom larger than how much you have to pay for it in the markets. These situations can be valuable for the investor, unless a company has large losses.

I hope you will find time to search through a balance sheet of a company for the last business cycle. You should find out how assets and liabilities have progressed through the cycle. Then make your own conclusions about them. For example find out if they have any discontinuities? If so, why?

-TT

Benjamin Graham, Lesson 7 Earnings trends

There are at least two dangers in using earnings trends. First danger is that they can be deceitful. Second danger is that you can use a trend to justify any value for the stock by assuming that it continues forever. You can get an insane value for the stock by assuming that a large earnings growth works for your advantage for decades. Using an average growth rate from the past do not tell much about the future. Especially, when the past has been very favorable for the business.

Earnings trend can be rising, declining, stable, or volatile. A stable trend does not have a large variation compared to the average growth in any single year. Graham used averages on the top and the bottom of the business cycle. When he evaluated the earnings trend he used the average of the last three years with corresponding figures ten years earlier. For example, average earnings from 2015-2017 compared to average earnings of 2005-2007. Using only the bottom of the cycle and compare that figure to the top of the cycle can give you an inflated number.

Rising earnings trend has some common enemies like harder competition, regulations, and the law of large numbers. No business can grow forever. The bigger the business, the harder it gets to maintain a rising earnings trend. As an analyst, you have to figure out why and how the business can have a rising earnings trend by overcoming the obstacles in its path. Is it because of new products, great management, etc? You should never think that rising earnings trend is maintainable for many business cycles in the future. The error rates of the evaluations stay manageable and you can justify your evaluations with a higher probability of being right. You should also be sure that you are not evaluating an earnings trend by the basis of abnormal business conditions. It doesn´t matter if these conditions happened in the past or are happening right now. You should always evaluate the business in normal conditions and you should ignore all the nonrecurring items.

Declining earnings trend needs different way of thinking than rising earnings trend. Graham recommends thinking the earnings trend by checking the expectations and some qualitative factors of the business. You cannot deal with the average earnings or the earnings trend from the longer time period. You cannot make an assumption that business will go bankrupt because of the declining earnings trend. Changes will be probably made after a period of decline. If you have a stable earnings trend, you should think about the durability of this trend. If this is the case, you can use an average earnings to evaluate the future earnings. A volatile earnings trend can give an edge for a competent analyst. It is more probable that markets are wrong in these cases. Some of the market participants forget these businesses. And you should do the same if you have no edge.

Graham didn´t exclude any businesses depending on the earnings trends. Trends do not mean any short-term changes in the businesses like nonrecurring items or fast declines or rises in the general business cycles. They are not significant, when trends are clear. Sudden earnings declines can offer some valuable opportunities for smart investors. You have to accept cyclical variations in earnings. If you are evaluating a rising earnings trend you have to see that earnings in the bottom of this cycle has to be bigger than in the last one. And the earnings on the top of the present cycle should be bigger than on the top of the last cycle. You should also never pay too much for the rising earnings trend. Expected earnings growth can be too large. Graham says that annual earnings growth should not be higher than ten per cent in the long run.

I hope you will find time to check some companies´ earnings statements for their business cycles and see how their earnings look like through the cycle. Then make your own conclusions if their trends will continue or are there possible trend changes happening.

-TT

Benjamin Graham Lesson 6 analysing earnings statement

You cannot only focus on the earnings statement and forget the balance sheet while you are analysing the earnings power of the company. Earnings statements change faster than the balance sheet. When you do it that way, the method of evaluating the real value of the earnings power varies more. It is easier to come to wrong conclusion about the real earnings power of the business. You will get a better evaluation by using the changes in the balance sheet to confirm the earnings statement. Checking the changes in the balance sheet in the long run produces better picture of the reality of the business.

Graham divides the analysis of the earnings to three different perspectives:

1. Accounting perspective: What are the real earnings in the period you are checking?
2. Business perspective: What signs of the earnings power of the future can be found from the earnings statement?
3. Financing perspective: What parts of the earnings statement you should take into consideration and what standards you should follow to get a realistic picture about the real value of the stocks?

You should forget the one time earnings when you are trying to find the real earnings of the year. These one time earnings are selling your assets, deferred taxes and the changes in the intangible assets like goodwill. These things do not tell much about the earnings power of the future. Most often, they just distort the conclusions of the analysis. You should also think about the real value of the subsidiaries´ depreciation and earnings. Consider their value for the company yourself. They can be over- or undervalued in the earnings report.

You can evaluate the earnings power of the future from the past earnings statements, including the last one. It doesn´t really mean that you should expect that everything will continue the same as before. Analyzing the past is the least satisfying part of the analysis. It can nevertheless be the most important part. In most cases, you cannot rely on the past in the future. The speed of change is accelerating in many businesses. You have to evaluate the earnings power in the long run. The most important factors for Graham were:

1. Physical volume
2. Unit price
3. Unit cost
4. Taxes

An analyst has to evaluate them. The result of the analysis cannot be very accurate. It only gives a direction where the business might be going. You should think about the range, not the accurate number. The list is pretty short. It does not give you all the details about the business. It can give you an illusion of being right. Sometimes simple ways are better. Single earnings statement is not enough to give you a reliable conclusion about the business. It can be usable if it gives you enough proofs about the future. Graham said that you can use a single earnings report if it fulfills the next conditions: The earnings report was not exceptional, business has shown an increasing trend for many years and the analyst is convinced that business is in the growing industry. This can give him a proof of a continuing trend in the industry and business.

Graham believed that the longer inspection period should have been something between five and ten years. He used the averages of from five to ten years. He changed his opinions throughout his career. The better way to think about the period is trying to figure out the business cycle of the industry and the business. If you happen to use the time period which is from the bottom of the business cycle to the top, average earnings growth can give you an inflated result. You have to remember that not all the businesses have the same business cycles in the same industry. And they can have more variation in the different industries. You also have to remember that business cycles are not always easy to figure out. Sometimes it is even impossible.

It is easier to forecast the business cycles of the industries than individual companies. The advantages of using the long period is balancing out the effects of the business cycles and making it easier to evaluate the continuation of the earnings trend. Sometimes there are dying industries and businesses and it is not always easy to figure out them on time. Fast changes make forecasting impossible. You have to take this into consideration, when you see great changes happening in the industry or business you are analysing. Sometimes it is better to find easier businesses to analyse and forget the hard ones.

Homework: Try to find a company and figure out the length of its business cycle. Then find out the earnings during the cycle for the company. Then, go through the earnings statements and look for any non-recurring items. See how much the real earnings are for the business cycle and compare this figure with the first one. Then, check the reasons for the non-recurring items. Are they one time only losses or profits or are they normal for the company? Has it done many restructurings of the business or mass-layoffs? Mass-layoffs are signs of poor management or complete changes in the business environment. Continual restructurings can also tell you about poor cost management in the company or management´s poor ability to understand the business.

Have a nice end of the week!

-TT

Benjamin Graham lesson 5 Quantitative analysis and dividends

Quantitative Analysis, dividends

Graham divides quantitative analysis for three parts:

1. Dividend ratio and record
   
2. Earning power
   
3. Balance sheet factors
   

Dividends

Investors have two sources of income: dividends and capitalized appreciation. The former is measured by the difference between the price used for selling and buying. Shareholders make decisions about the dividends in the annual general meeting. The board of directors gives a suggestion about the dividend and the shareholders either approve or they don´t by voting about it. Shareholder´s interest is not always the same as the interest of the company. Long term investor should always ask himself:

”Can the company invest the money paid as a dividend to the business better than the investor himself can earn by reinvesting it, when you take taxes into consideration?”

Big dividend is a good thing, when the answer to the question is no. The answer to this question isn´t simple. Different businesses have different needs for capital. When you make an analysis, you have to evaluate how good is the dividend policy compared to the capital needed. Companies with lots of net debt cannot pay so much dividends as the companies with no net debt. Good businesses pay dividends and can increase the rate in the long-term. The other possibility is to buy own stocks under the real value of future cash flows.

Companies have three reasons not to hand out the current earnings for the shareholders:

1. Strengthening the financial position of the company
   
2. Increasing productive capacity
   
3. Eliminating overcapitalization
   

First reason is for accumulating cash. When the management are not willing to hand out current earnings and increases its cash position, it delivers a message to the shareholders. This message is telling the shareholders that management can increase the dividends in the future. You have to analyse whether this cash could be invested in something else. You also have to check the track record of the previous cash accumulations of the management. Their signals may be completely wrong. In this case, there is always a possibility that the future earning power of the company doesn´t proportionately expand with the increasing surplus of cash.

Giving a small dividends starts from the assumption that the owner and the company have the same benefits. Capital surplus can be a benefit for the company, but for the owners´ benefits can be different. Sometimes, part of the capital surplus cannot be used to increase future earnings enough. Then, the owners lose a possibility to invest this cash to some other places. Future earnings potential is not completely correlated on the capital surplus. When the company retains a dollar into its capital, it has to create at least a dollar of added value in the future. When this doesn´t happen, all the extra dollars should be given to owners.

Directors can be the biggest obstacles in a rational dividends policy. Owners have to protect their rights. Usually, the board of directors make a proposal about the dividend for the general meeting. Mostly, owners are lambs who easily succumb to the proposal. This can cause wrong incentives to the directors to use the surplus in any way they want. For example, getting generous options programs. Many directors have also tendencies to expand their own sand boxes by using the surplus in acquisitions or some other ways that are too expensive for the owners. On average, Graham thought that dividends were the better option for the owners than accumulating surplus in cash. He thought that a company must use sufficient part from the profits to increase its earnings potential and dividends. If the dividends is small, owner has to demand an exceptional skill of reinvesting the retained surplus from the directors.

Some owners may benefit from the smaller dividend rate than others. Owners have different kind of incentives like different tax rates for dividends. Smaller dividend rate can keep stock price lower, because markets may not understand the benefits of smaller rates compared to other similar type of companies. Owners can also suffer from the rate that is too high, because reinvested profits are not creating new profits or the profits are obligatory reserves left to the company. Sometimes investors are confuse the real profits and these reserves, because they invest only to get dividends.

Owners should make wise decisions about dividends and not leave the profit sharing proposal for the directors. Sometimes there is a demand for special decisions. Sometimes it is wise to leave the profits for the company and other times it is not the smartest choice. Every decision is made in special circumstances. Every owner should consider profit sharing proposals from his/her own perspective and make a decision how to vote in the general meeting.

I hope you will check the dividend policy of the companies you are interested in investing. Think about how reasonable it is for the owners.

Have a nice week!

-Tommi T

Benjamin Graham Lesson 4 Qualitative factors in analysis

Graham´s expertise was not in a qualitative analysis. For example, he missed a durability of competitive advantage concept. Graham examined a company´s market share, its physical, geographical and functional features, the quality of the company´s directors, and finally a company´s, industry´s and common financial expectations. An analyst has to examine qualitative features from many different sources. He has to go through all the company´s press releases and annual reports. He has to check some expert opinions, trade magazines, competitors´ annual reports, etc. Sometimes, sources are opinions. An industry expert may give his opinion about the company or its directors. Different people can have different opinions about quality. Using individual sources can produce wrong conclusions. Graham thought qualitative analysis was less useful, because it was hard to him.

The qualitative functional features are the dependency of capital, competitive environment, regulations, the raw materials need, the need for research and development investments, etc. All these factors have an effect on the earnings prospects for the future. These factors change along industry´s and common financial cycles. You need to analyse these factors partly through the numbers. Graham thought that it was hard to find any useful information by analysing the industry. Every industry have many details to analyse. Analyst need to decide which pieces of information are the most important ones. Most of the industry´s numbers are known by everyone. Graham thought that the best informational advantages were found from the industries, which were going through changes. Bigger changes equal bigger risks and opportunities. If you didn´t understand these changes, Graham would recommend you to analyse other industries.

Graham believed that high profit margins in all the industries were going to be diminished in the long run into normal levels. This was going to happen because eventually these markets would get more competitors. They would bring lower profit margins. He thought there were no durable competitive advantages. Products like Coca Cola, have kept their competitive advantages for decades. There are no changes in the horizon. Graham also believed that all the biggest market shares would diminish through years.

He believed that the stability of the business was the most important qualitative factor. It means resistance to change and makes evaluating the future earnings prospects easier. Stability of the business doesn´t mean that future profits will stay the same as in the past in most of the earnings units. For example, the turnovers and the profit margins of the individual companies can have lots of variations. Companies with bigger market shares are more stable than companies with smaller ones. Increasing earnings are good signs. You can only make assumptions about the future from the earnings history.

All the businesses have their natural turnover and profit cycles. Without understanding them, analyst gets less accurate predictions about the future and the quality of the business. All the businesses need to be evaluated through their natural business cycles. A trend in earnings prospects can be over before the analyst notices it. Analysis cannot be based solely on the assumptions about the trends business is going through. But it can be a baseline in evaluating the future of the business. Graham thought that an investor should take into consideration changes in the future. But instead of trying to take advantage of them, he should protect himself from the changes.

Financial strength and capital structure have an effect on the quality of the business. Having a significant amount of cash or its equivalents and a reasonable amount of debt are factors of quality. A reasonable amount of debt gives leverage to the company. Too much debt, especially debt that has to be paid soon can become lethal to the company. Worst kind of debt comes from the banks. Big debts from them are the worst kind of debts for companies.

The abilities of the directors are hard to measure. Some of your ideas about directors are based on rumors and presumptions. Most outsiders cannot really know the directors without working with them. The best proof of the quality of the directors is found by comparing the success of the company with other companies in the same industry. This comparison should be made for the longer time period, like many years. It takes time to make changes for the companies. The best conclusions can be made, when the directors of different companies have managed to stay in their positions many years. You shouldn´t make any conclusions without having a possibility to see the track records of the directors.

Graham thought that members of the board of directors belonged to the five groups:

1. Directors who are mainly interested in their own good.
2. Investment bankers, whose first objective is to make money for their bank.
3. Normal bankers, whose aim is to keep their loans running
4. Persons, who are doing business with the company
5. Some people who are actually interested in owner´s assets

He also thought that most of the people in the fifth group have created friendships with other board members to get their position in the board. One of the most important qualitative factors is how the directors treat shareholders. All the profits from the business belongs to the owners. Directors should maximize the earnings of the owners in the long run. Graham believed that one factor of quality is how many consecutive years has the company paid dividends. Directors shouldn´t maximize the amount of cash in the business without finding profitable investment possibilities. They shouldn´t pay too much dividends either. Directors shouldn´t also pay themselves too much.

The owners shouldn´t suffer, when the business is growing. Acquisitions should happen only, when it maximizes the earnings of the owners in the long run. One factor of the quality of the directors is the way they pay for the acquisitions. Most of the times, it is not smart to use company´s stocks as a payment method. Graham also thought that most of the acquisitions should be paid with cash. Using your own stocks should happen seldom, and as a smaller part of the payment. You can also use quantitative analysis to see how the owners are treated. Most of these qualitative factors should be confirmed by the numbers in the income statements and balance sheets.

I hope you will find time to think about some company and its qualitative factors and compare them to its competitors. It will be beneficial to you.

©Tommi Taavila 2018

Benjamin Graham Lesson 3 Analysis

In analysis, you search the facts about the security and make conclusions based on them. These conclusions should be based on a sensible logic and the principles planned before the analysis. Analysis takes time. It can take anything from hours to months. Depending on how far you need to go in the analysis. Most of the time, you should understand quickly that there is no need for further examination. Most analyses never get to the point, in which there is a decision to be made, whether to sell or buy the security. You have to accept this ”waste of time” as part of the analyses. There is no way to avoid this. All the greatest investors make their own research about the securities. And they make their own conclusions. You can only get better in analysing securities by practicing. It is a skill like most of the components of successful investing.

Different securities need different analyses. For example, corporate bonds and stocks need to have different kinds of analysis. Bond analysis is focused on the company´s economical survivability. When you analyse stocks, you are interested in the future profits of the business and the price you have to pay for them. You need to use a lot more time to analyse the future profits than the economical survivability. Graham was particularly interested in bonds and stocks. Graham´s primary sources were financial reports from the companies. His analyses focused on the companies, their businesses, financial situations, results and competitors. He also analysed the industries they were focused on and their future prospects.

All the analyses are made in uncertainty. Nobody can predict the future precisely. Randomness has an effect on the correctness of the analysis. You need to evaluate the past, the present, and the future of the business. Future is the hardest part. Past and present give some clues about the future. Unrealistic expectations about the future of the businesses will likely cause the biggest failures in analysing them. Evaluation of the future cash flows must be done with different assumptions. The purpose of the evaluations is to define the range for the present values of the future cash flows. According to Graham, all the analyses should be based on preplanned principles. They should work in all the time periods, exclusive the great catastrophes. You cannot use only one method in every analysis.

Graham divided analysis into two different parts: Qualitative and Quantitative analysis. Qualitative analysis describes business at a common level. It means evaluating business through the quality of the directors and the future of the business and its industry. Qualitative analysis describes the security primarily through the numbers. It describes the security through the income statement, balance sheet, dividends, statistics of the business and the capital structure. It is easier to analyse the quantitative factors. Some of the qualitative factors are hard to evaluate. For example, the abilities of the directors are sometimes based on opinions rather than facts. You need to consider both, the qualitative and quantitative factors for making any useful conclusions. Qualitative analysis should confirm the quantitative analysis, and vice versa. Without this happening, conclusions are not very useful.

Two main limitations in analysing businesses

There are two main problems in doing the analysis. First, it takes time to analyse a business. Finding the necessary information about the business takes time. Going through it to find all the important things about it, like competition, future prospects of the industry, takes from days to even weeks. Many investors cannot spend so much time. Second problem is the bandwith of the brain. You and I have our own limitation about how much information we can process. Depending on the research the optimal amount of different pieces of information in decision making is between five and twelve. Too much information have been found to lead to bad selection of what are the most important things you should know. When you have an information overload, you start focusing on the less important things.

There are many tools to overcome these problems. You can specify the requirements for businesses, which you want to analyse in advance. For example, no net debt, no losses in the last five years, etc. And then you can use a stock screener which helps you to find those businesses. This saves a lot of time. The amount of businesses to analyse will be diminished. You can also use spreadsheet programs like Excel to combine some factors from the income statement or balance sheet into bigger ensemble. For example, you can design a system which collects all the relevant information of all small components over certain factor of the business like financial strength. You can combine these smaller components like net debt, cash, and so on, into bigger ensemble that describes the financial strength as a whole. Then you don´t have to consider so many pieces of information. This also saves time.

I hope you will take some time and choose a business you are interested in. I would like you to figure out the most important facts about the business. Then I hope you will analyse these facts. Do it shortly.

© Tommi Taavila 2018