October Press On Research Issue – The Next GE?

October Press On Research Issue – The Next GE?

I don’t hype investments.  And my biggest fear while the investment newsletter was courting me last year was I would have to hype.  Use hyperbole to explain how you’d gain 10,0000% owning XYZ stock in the next three days.  Or even outright lie.

But I got lucky.

While I learned a ton of investment newsletters are terrible.  And will lie and promise returns they can’t hope to deliver.  The investment newsletter I worked for wasn’t one of those.

One of the biggest rules all analysts had to abide by was “Write about the biggest returns you want and the investment time frame you want.  But you have to be able to prove the investment thesis and returns out or we can’t use them.”  In other words don’t promise what you – or we in that case – can’t deliver.

I was relieved when I found out this was one of the biggest rules analysts had to follow the company.  And while I still don’t hype investments.  I learned it’s not hype if you can prove your thesis out.

Even though you might think a title of The Next GE? for an issue is hype its not. In the October 2015 Press On Research issue releasing today I prove that this company could become the next GE.

If this still isn’t enticing enough how about an excerpt from the upcoming issue where I lay the groundwork for my thesis.  The unfinished excerpt below is from the October 2015 Press On Research issue being sent out to subscribers today.

October 2015 Press On Research Issue

By Jason Rivera

Press On Research Volume 1 Issue 7

The Next GE Pays You A 10% Dividend Now

While We Earn 34.5% In The Next Year

If you’ve studied business and management you’ve read or seen GE from the early 1980’s talked about a huge amount.  And have learned how Jack Welch saved the company by introducing a radical concept.

GE was going to number one or two in each business it operated.  Or it was going to sell or close down the businesses.

This was a drastic – but necessary decision – because GE had become an inefficient bureaucratic nightmare.

Quoted below from Wikipedia.  Emphasis is mine.

“During the early 1980s he was dubbed “Neutron Jack” (in reference to the neutron bomb) for eliminating employees while leaving buildings intact.

In Jack: Straight From The Gut, Welch states that GE had 411,000 employees at the end of 1980, and 299,000 at the end of 1985.

Of the 112,000 who left the payroll, 37,000 were in businesses that GE sold, and 81,000 were reduced in continuing businesses.

In return, GE had increased its market capital tremendously. Welch reduced basic research, and closed or sold off businesses that were under-performing.”

And this changed fortunes for GE shareholders in a huge way going forward  During Welch’s tenure from 1981 to 2001 the company’s share value rose 4,000%.

That’s not a typo.

Whether you thought his slash and burn tactics were humane or not; for GE shareholders Jack Welch’s tenure was amazing.

And because of how well GE did during his tenure Mr. Welch is regarded as one of the best business leaders of the 20th century.

But why did this approach work so well?

Because it enforced strict competition standards within GE.  It forced every subsidiary to work towards becoming the best company it could be.

GE employees at all subsidiaries knew if they didn’t work towards becoming great.  And achieve those goals.  That its business may be sold to another company.  Downsized.  Or shut down.

This led to more innovation.  Better productivity.  Less bureaucracy and more efficiency at all subsidiaries and GE.  And this led to better margins, compounding of value within the company, and higher returns for shareholders.

But Press On Research is about small, safe, undervalued companies, which have management I can trust.  And we can’t buy GE from the early 80’s today.

So why am I talking about it in Press On Research?

Because today’s recommendation operates using Jack Welch’s rule of being number one or two in each business unit it operates in.  And because of a multi trillion trend within its industry could become the next GE over time.

But before we get to what the company is.  I need to tell you what it does.

Investing In Picks and Shovels

“During the Gold Rush, most would-be miners lost money, but people who sold them picks, shovels, tents and blue-jeans (Levi Strauss) made a nice profit.” Peter Lynch

In the August 2015 Press On Research issue I told you about a great company in the tech sector that works with some of the biggest tech companies in the world.

But it wasn’t a typical tech company…

It didn’t have a social network.  Introduce a new game or app.  Or even improve graphics or processing speed for games and computers.

It operates in what’s referred to as the picks and shovels part of the technology industry.

What does this mean?

The picks and shovels part of any industry is something that’s necessary to the survival of the industry.  But most people don’t think about.

To continue the example from the Peter Lynch quote above; when people flocked to the gold rush they wanted to get rich by focusing on finding gold.

But most people didn’t.  And the people who didn’t lost fortunes and became destitute.

The people who made out best during the Gold Rush were people who sold things like tents, jeans, picks, and shovels.

The same thing is happening in today’s tech arena…

Everyone is focusing on the next big app, game, or social network.  But most of these ventures fail.  And while we have greater social and economic safety nets today than we did in the 1800’s.  Vast fortunes are still being lost today chasing the quick cash.

That is unless you’re in the picks and shovels part of the industry.  And like (NAME REMOVED) from the August 2015 Press On Research issue.  Today’s company operates in that same necessary semiconductor and processor packaging industry.

Handle With Care Part 2

The number one tenant of value investing is buying companies selling at a discount to their intrinsic – or true – value.

This is done so that even when making a mistake in our analysis we still have a good chance of making some money.  Or at least not losing much.

Different value investors also incorporate things like profitability.  Management trustability.  Cash generation.  Trends.  Etc. into their analysis.

But the biggest thing for value investors after buying a company with a margin of safety is the ability to understand the business the company operates in.  And the stability of that industry.

These two concepts are why most value investors keep away from investing in the tech industry.  Where valuations are higher than average.  And the industry changes at a rapid pace.

The best kinds of businesses are ones that are necessary.  Today’s business is.

As with (NAME REMOVED) in August, today’s pick packages microchips and processors for the tech industry.  And as I said in the August 2015 Press On Research issue:

Companies manufacturing parts going into computers and other electronics have to make sure the parts work when finished.

Since most of these hardware manufacturers have assembly lines set up only to make chips, processors, and memory. They have to outsource the testing of their products to third parties

Without third-party specialists like our pick today testing and packaging products.  The part and product manufactures would have to test them in-house.

This would take money away from R&D for new products.

So not only does outsourcing save the tech giants and manufactures money and time.  But it also brought to life an entire specialized packaging, testing, and assembling industry.

Combined this industry does billions of dollars worth of work.  And saves the tech giants billions of dollars.

This industry will experience wild swings when giant chip makers like Intel and Micron slow down.  But it will remain necessary for the foreseeable future.

This is one of the reasons why I have no problem investing in “tech” for the second time as a strict value investor.  But there are a lot more great things about this company.

Today’s pick is a $640 million company.  It has better margins than (NAME REMOVED).  It could turn into the next GE in time.  It’s undervalued by as much as 40% now.  Will pay us a 10% dividend while we wait for its shares to rise.  And produces and has a ton of cash compared to little debt.

All the above combine to make this an ultra safe investment. None of this considers the huge trend that could explode its shares.  And turn the company into the next GE.

But before I tell you what the company is let’s do a quick comparison…

To see the rest of this issue.  Get all six prior issues.  And access to a new Press On Research pick every month over the next 12 months.  Subscribe to the service here.

And remember if you’re a Value Investing Journey subscriber you get a 50% discount on a one year Press On Research subscription.

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To subscribe to Value Investing Journey go here.

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*Repost* Why The P/E Ratio Is Useless – And How To Calculate EV

*Repost* Why The P/E Ratio Is Useless – And How To Calculate EV

I’m moving my family across country and am unable to post anything new until settling down in the Tampa area.

For more information on how this will affect anything go here.

I hope you enjoy these older posts in the meantime.  And please feel free to contact me.  I’ll get back to you when I can.

To subscribe to the Value Investing Journey newsletter go here.

To subscribe to the Press On Research exclusive newsletter go here.

Thanks so much.

Jason

Earlier this week I posted a 12:49 video case study part 1 on Armanino Foods (AMNF) showing how I analyzed the company on a preliminary basis.  What everything meant.  And why each metric is important.

But I didn’t explain how to calculate EV/EBIT and EV/FCF when I talked about them in the video.  In this post I will.  But before I do that I need to show you why the P/E ratio is useless.  And why you should never rely on it as a long-term value investor.

Why I Hate The P/E Ratio

Last week I got a couple questions from a Press On Research subscriber.  The first question was why I didn’t use P/E when detailing the company I recommended. And the second question was how the company could be cheap when it had a P/E of 17.

I won’t detail what I said to the subscriber because I would have to reveal the company and industry it’s in.  But below I will show you the reasons I hate the P/E.  And why I never use it in my analysis.

P/E Is Turrible

The P/E ratio is two components.  P is price per share and E is earnings per share.

You find price per share by dividing the total market cap of the company by the amount of shares the company has.  And earnings per share is net income divided by the total number of shares a company has.

You then divide the price per share by the company’s earnings per share over the last year to find its P/E.  The example below is from Investopedia.com.

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

Don’t worry you won’t have to calculate this.  All financial sites report P/E ratio for you when you look up the stock ticker.  And many investors – including me when I started investing – thought this was the best relative valuation to look at.

But it isn’t…

The P/E ratio is a misleading and dangerous metric.  And it’s one of the worst metrics to rely on as a long-term value investor.

Why?

Because of debt, cash, and manipulation…

Why P/E Ratio Is Useless

Below are examples I made up to illustrate why P/E is a useless metric.

Company 1 Company 2
P/E Ratio 10 20

On a P/E basis company one looks better right?  But what happens when you add in important things like cash and debt to the equation?

Company 1 Company 2
P/E Ratio 10 20
P/E stays the same under the below scenario.
Cash and Cash equivalents 0 40
Debt 40 0

Which company would you rather buy now?  The company with a lot of net debt or the company with a lot of net cash?

But this isn’t the only reason P/E is misleading…

Earnings Are Easy To Manipulate

The E in the P/E equation is earnings like I showed above.  Another reason I don’t like P/E is because earnings are easier to manipulate than EBIT, FCF, and owner’s earnings.

One example is a company “smooths” earnings over time to make it look like the company is earning consistent good profits.  Rather than lumpy profits that fluctuate a lot.

This is a huge discussion that goes beyond the scope of this post.  But if you want to learn how companies manipulate earnings read this from Investopedia.  And read the great book Financial Shenanigans.

But these aren’t the only downfalls of using P/E…

The earnings part of P/E is after all costs, taxes, and expenditures.  EBIT, FCF, and OE are all after costs and expenditures but before taxes.  Another way companies can manipulate earnings is with the tax rate the company states it has to pay.

If you work hard enough you can make the tax rate whatever you want it to be.  Just ask General Electric (GE).

And because EBIT, FCF, and OE is profit a company makes from its operations.  These metrics show a much truer picture of how profitable a company’s operations are.  And if a company is operating in a healthy way.

So P/E is not only a terrible metric to rely on with any company that has debt and cash. Which is of course all companies.  But it’s also easier to manipulate than other metrics.  And it doesn’t show how profitable and healthy a company’s operations are.

This is why I use enterprise value (EV) instead…

So How Do You Calculate Enterprise Value?

I calculate enterprise value as…

  • EV = market cap + preferred shares value (if any) + debt – cash and cash equivalents.

My calculation of EV is the same as the picture above but in easier to understand terms.

Why is EV better than P/E?

Which Metric Is Better?

I love enterprise value when evaluating businesses.  It shows the true picture of what a company should be valued at if you were going to buy the whole business.

This is how I evaluate all businesses for investment.  If I was able to buy the whole company, what price should I pay for it in total?  And per share?  EV helps us find this number.  And when combined with EBIT, FCF, or OE it’s also a better relative valuation to use than P/E.

So instead of using the flawed P/E you should use EV/EBIT, EV/FCF, or EV/OE to find what a company is worth on a relative basis.

EV replaces P in the P/E equation.  And operating margin (EBIT), free cash flow (FCF), or Owner’s Earnings (OE) takes the place of E in the equation.

EBIT, FCF, and OE can all replace earnings in the P/E equation.  And all three tell you different things when compared against EV.

EV/EBIT shows you what the company is worth compared to its operating profits.  EV/FCF shows you what the company is worth compared to the free cash it generates from operations.  And EV/OE shows you what the company is worth compared to the value you could take out of the company if you owned it.

Let’s keep things simple and only worry about EV/EBIT and EV/FCF today though.  I will explain how to calculate owner’s earnings when we get to that point in the case study.

Another name for EBIT is operating margin.  But it’s also called operating income or operating earnings.  You can find this by going to a company’s income statement under the financials tab on Morningstar.  FCF is on the cash flow page under the financials tab on Morningstar.

I use EBIT and FCF because they are harder to manipulate.  And show what a company earns from its operations in the case of EBIT.  Or in the case of FCF – show how much cash the company has left after paying for things to upgrade and improve the business.

So what does this all mean when continuing the example above?

Why I Love EV/EBIT and EV/FCF

If we were to continue the above example we would just need the company’s market cap.

Company 1 Company 2
Market Cap 100 100
P/E Ratio 10 20
P/E stays the same under the below scenario.
Cash and Cash equivalents 0 40
Debt 40 0
EV = 140 60
  • Company 1 EV = 100 + 40 – 0 = 140
  • Company 2 EV = 100 + 0 – 40 = 60

Which Company Would You Rather Own?

Now that we have found EV for the made up businesses above.  Let’s take this further and see which company is the better buy now…  At least on a relative valuation basis.

Company 1 Company 2
Market Cap 100 100
P/E Ratio 10 20
P/E stays the same under the below scenario.
Cash and Cash equivalents 0 40
Debt 40 0
EV = 140 60
EBIT = 10 10
FCF = 10 10
Company 2 is a lot cheaper when considering EV
EV/EBIT = 14 6
EV/FCF = 14 6

EV above is the estimated price you would have to pay to own the whole company.

Now that we’ve found EV for both businesses we can bring in EBIT and FCF to find EV/EBIT and EV/FCF.

Now that we’ve replaced the terrible P/E ratio with EV/EBIT and EV/FCF.  We’ve got a better look at what the company truly is worth on a relative and intrinsic basis.

This is how business owners evaluate businesses.   And we as long-term value investors should consider ourselves business owners.

Which company looks like the better buy now?  And what is your favorite relative valuation metric? Let me know in the comments below.

***

Don’t forget, if you want to receive two free gifts that will help you evaluate companies faster.  Get all future blog posts. Get future case study information first.  And be entered to win a hard copy of: The Snowball – Warren Buffett and the Business of Life and a $50 AMEX gift card. Sign up for the Value Investing Journey newsletter here.

*Repost My Answer To How Do You Find Stock Opportunity

*Repost My Answer To How Do You Find Stock Opportunity

I’m moving my family across country and am unable to post anything new until settling down in the Tampa area.

For more information on how this will affect anything go here.

I hope you enjoy these older posts in the meantime.  And please feel free to contact me.  I’ll get back to you when I can.

To subscribe to the Value Investing Journey newsletter go here.

To subscribe to the Press On Research exclusive newsletter go here.

Thanks so much.

Jason

Below is my answer on Quora to someone who asked How Do You Find Stock Opportunities?

*Repost* Why Is Valuation Important?

*Repost* Why Is Valuation Important?

I’m moving my family across country and am unable to post anything new until settling down in the Tampa area.

For more information on how this will affect anything go here.

I hope you enjoy these older posts in the meantime.  And please feel free to contact me.  I’ll get back to you when I can.

To subscribe to the Value Investing Journey newsletter go here.

To subscribe to the Press On Research exclusive newsletter go here.

Thanks so much.

Jason

Over the past few weeks I’ve seen a ton of people asking “why valuation is important?”

I’ve seen others answers, but I want to hear from you…  Do you think valuation is important?  Why or why not?

In the short  57 second video below I start a conversation about valuation.  Next week I’ll post my thoughts on this.  And then get back into the case study.

Let me know what you think in the comments below.

*Repost* Don’t Be A One-Legged Person In An Asskicking Contest – My Answer To Why Valuation Is Important

*Repost* Don’t Be A One-Legged Person In An Asskicking Contest – My Answer To Why Valuation Is Important

I’m moving my family across country and am unable to post anything new until settling down in the Tampa area.

For more information on how this will affect anything go here.

I hope you enjoy these older posts in the meantime.  And please feel free to contact me.  I’ll get back to you when I can.

To subscribe to the Value Investing Journey newsletter go here.

To subscribe to the Press On Research exclusive newsletter go here.

Thanks so much.

Jason

Last week I asked your thoughts on valuation.  If you think it’s important?  Why or why not?  I asked this because I’ve seen a lot of discussion on the topic in recent weeks.  This post is my answer to that question.

Asking if valuation is important to deep value investors like us is like asking if we follow the teachings of Ben Graham and Warren Buffett.  The answer of course is yes.  But why is valuation important?

Once we understand how to do valuation most of us never think about this question again. And it’s important to understand why.

To show why valuation is important let’s continue with an example from the earlier post.  Why The P/E Ratio Is Useless – And How To Calculate EV.

Why Valuation Is Important

Below is an example of two company’s made up for the example.

Company 1 Company 2
Market Cap 100 100
P/E Ratio 10 20
P/E stays the same under the below scenario.
Cash and Cash equivalents 0 40
Debt 40 0
EV = 140 60
EBIT = 10 10
FCF = 10 10
Company 2 is cheaper when considering EV
EV/EBIT = 14 6
EV/FCF = 14 6

P/E, EV/EBIT, and EV/FCF are all relative valuations.  Companies that have lower relative valuation multiples are cheaper than others.  And companies that are cheaper are better to buy.  Why is this?

To find out why lets invert both EV/EBIT and EV/FCF to find each companies earnings yield.  I explain earnings yield in the following section.

Earnings Yield Estimates Expected Rate Of Return

For those who don’t watch the short video above I’ll paraphrase. Earnings yield is the estimated return you should expect to earn in one year on an investment.

The higher this number is the better. This is because the higher this number is the more a company is undervalued.

Company 1 above has an earnings yield of only 7.1%. Not good enough. I look for earnings yields above 10%.

Company 2 above has an earnings yield of 16.7%. 2.35 times company ones earnings yield. And above the 10% I look for when considering an investment.

This means you should earn 2.35 times more if you invest in company two instead of company one. But this isn’t all…

By doing the work above with EV and earnings yield, not only do you see that company 2 will get you a higher return. But doing a bit more work allows you to see that company 2 is a less risky investment.

Company 2 is safer because it has no debt, while having a lot of cash. The saying that the more you risk the more you gain is a fallacy. This “advice” needs to die because it leads many investors into unnecessary danger.

But these aren’t the only concepts you need to consider when evaluating an opportunity.

EBay And Amazon Businesses

Many of you who’ve followed this blog for a while know that I also run an EBay and Amazon reselling business.  The example below is something I found and sold last year.

I use the concepts talked about in this article every day.  And you can use them whether you’re analyzing a stock.  Or buying something to sell in your business.

Let’s say we have two of the same Giorgio Armani jeans.  Same size, color, condition, everything.  And both are real Giorgio Armani jeans.

Each pair of jeans looks brand new but does not have the tags on them still.  These jeans sell for more than $100 brand new.  But for this example let’s use $100 because it’s an even number.

So both pairs of jeans are the same and sell brand new for the same amount.  But what if I said you could buy one of the pairs for $80 and the other pair for $2.  Which would you buy?

The one that’s selling for $2 of course.

But if you had an EBay and Amazon business how would this change things?  You would need to keep thinking…

One pair we bought for $80 and the other we bought for $2. We can resell both for $100. This means we have the potential to make $20 on one pair and $98 on the other.

The pair we bought for $80 and sold for $100 gives us a 20% return. Not bad. But the pair we bought for $2 gets us a return of 4900%. Or a 49 bagger in a short amount of time. We’ll get back to the time aspect later… This is a spectacular return. And is why valuation is so important.

All else remaining equal, the cheaper a company is the higher return you should expect in the long-term.

This is why it’s important to value businesses. Without doing valuation you can’t know if you’re getting a good deal. Or taking unnecessary risks with your capital.

In the above example is risking your $80 to make a $20 profit worth your time? Or would you rather buy the $2 pair of jeans and get a 4900% return on the same item while risking far less money on a safer investment?

But there’s still more…

You also need to think about the amount of time it will take for your investment thesis to play out. And consider what you can’t invest in while you invest in this opportunity.

This last concept is opportunity cost.

The Opportunity Cost of Investing

As investors we have to consider several choices every time we think about buying an investment.

  • Is the investment safe?
  • Am I getting a high enough return compared to the capital I’m risking?
  • Am I getting a high enough return for the amount of time I expect to hold this investment?
  • Do I already own another company that would be a better investment?
  • If I invest in this company now, am I comfortable holding it for the long-term? Another – possibly better- company may come along and I need to be comfortable losing out on that opportunity.

These are just a few of the many things you need to consider when investing. But for now I want to concentrate on the last bullet point.  It’s the concept called opportunity cost.

DEFINITION of ‘Opportunity Cost’

1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.

2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment – say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% – 2%).

Below is a video from Study.com giving a real world example of opportunity cost.

The example of choosing between two jobs is too simple.  But it’s a good starting point.

The thoughts I would’ve added to help me decide which is a better job would be: Which job would I be happier at?  Which one has more room for advancement?  How many hours do I have to work at each?  Etc.

When considering an investment you need to consider more than just valuation.

For example: Which one is safer?  Which one is offering a higher return?  Which one do I have more capital tied up in and for how long?  Which company has higher profits and cash flow compared to valuation?  Am I willing to pay up for a better company?  And much more.

This is how you begin to analyze the opportunity cost of an investment.  And get closer to a decision.

But without valuation you’re only considering part of the equation.  And without valuation you’ll have to rely on gut instinct and emotion.  Two things that will kill you when making investment decisions.

Don’t Be A One-Legged Person In An Asskicking Contest

Yes I know when picking businesses and stocks to invest in not everything is equal like in the examples above.  But this is why you need many tools in your mental toolbox while evaluating things.

And if you don’t consider valuation, opportunity cost, and the other concepts in this article, you’re missing some of the best mental investment tools.  Or as Charlie Munger says:

If you don’t have the proper mental tools then you go through a long life like a one-legged man in an asskicking contest.”

To learn more about mental models.  And start adding tools to your mental tool box so you don’t go through life like a one-legged person in an asskicking contest, go to the earlier post. Car Wash Psychology, Mental Models, and The Power of Habit.

What do you think about valuation?  And did I miss anything in my explanation?  Let me know in the comments below.

***

Don’t forget, if you want to receive two free gifts that will help you evaluate companies faster.  Get all future blog posts. Get future case study information first.  And be entered to win a hard copy of: The Snowball – Warren Buffett and the Business of Life and a $50 AMEX gift card. Sign up for the Value Investing Journey newsletter here.