Conclusion and Further Recommended Reading – On Float Part 7

Conclusion and Further Recommended Reading – On Float Part 7

This post is the last one in the On Float series started way back on February 2nd 2016.  Yes that date is correct.  I posted the first article in this series Charlie Munger On Deferred Tax Liabilities and Intrinsic Value – On Float Part 1 seven months ago.

If I’ve done my job well in the seven parts, more than 12,000 words, and 60 pages of content including this post we all should know the following now.

  • What float is.
  • Why it’s important.
  • How companies can use float as positive leverage.
  • How Buffett got so rich using float.
  • How to find float on a balance sheet.
  • How to evaluate float.
  • How float affects a company and its margins.
  • Maybe the most important thing why float affects a company and its margins.
  • How float affects a company’s value.
  • And answered the question is float ever bad?

But as with any great thing in life and investing there’s always more to learn and improve on.  Knowing this I’ve included the things I’ve learned the bulk about investment float from below.

Also make sure to read the comments sections of any of the following as well as there is usually great commentary there on the specifics of float.

All the following are in no particular order.  Have been added to the Recommended Reading and Viewing page.  And are designated as MUST READS!!! on the Recommended Reading and Viewing page.

My posts about float.

I specifically want to thank Warren Buffett, Charlie Munger, Professor Sanjay Bakshi, and The Brooklyn Investor for sharing their knowledge on float.  Without their knowledge none of my posts would have happened.

Reading the above things and taking notes where necessary will help you further understand the nuances of float.

But if you really want to continue learning about float make sure to read company filings, take notes, analyze the company fully, analyze its float, and value the company.

Doing this over and over – like with almost everything in value investing – not only ingrains these concepts in your thought processes.  But the more you do it the more nuances you’ll spot.  And the more intimate knowledge you’ll have of investment float and its immense power.

If I’ve done my job well over the last 60 pages we should now have a huge advantage over other investors who either don’t know what investment float is.  Don’t know how to value and evaluate it.  Or won’t take the time to learn how to do these things.

But as always there’s always more to learn and improve on so on to the next one…

Please leave any comments, questions, or concerns you have about float in the comments section below.

***

Remember if you want access to my exclusive notes and preliminary analysis you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

Is Float Ever Bad? On Float Part 6

Is Float Ever Bad? On Float Part 6

The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day.  The hope being that our knowledge will compound over time so we’ll have huge advantages over other investors in the future.

The aim of today’s post is to continue this process by talking about a topic few investors know about.  And even fewer understand.

Most people overlook float when evaluating companies because they either don’t know what it is.  Don’t know the power it can have within a business.  Or don’t know how to evaluate it.

This won’t be an issue here.

Press On Research subscribers already know this as I talk a lot about float in many of the issues I’ve written.  But I want to begin talking about it more here because float is one of the most powerful and least understood concepts of business analysis.

Today’s post is a continuation of the earlier posts:

Today we’re going to answer the question “Is Float Ever Bad?

Is Float Ever Bad?

I’m a guy who likes to live by the above quote.  If I can make things simpler I always do.  Not only does this make things easier to understand but it also can save a ton of time.

When analyzing investments and dealing with complex topics like investment float this isn’t always possible.

Understanding the good things about investment float is definitely one of those things you can make only so simple.  The concept is simple to understand but the there are a ton of different nuances to understand which leads to complexity.  You can likely tell since it’s taken me 51 pages thus far in the five earlier posts to explain the good things about investment float.

Luckily the answer to the titled question is a simple one.  And also involves simple and easy to understand concepts as well.

Yes, certain investment float is bad.  And no, not all float is equal.

The heuristic or mental model I use when evaluating float is that if the company isn’t profitable – or near profitability – its float is useless.  And can even be a negative burden for a company.

Why?

Remember, float are liabilities that can become positive leverage if used well by management and the company is profitable.  But always remember leverage can go both ways as well.

If a company isn’t profitable and hasn’t produced profits in several years float turns into negative leverage.  This is because in the long run float are liabilities the company will have to pay at some point.

The longer a company goes without earning profits the longer it will take a company to pay its liabilities because it’s not earning enough money.  This also makes it harder to fund operations and grow in a healthy way without taking on a ton of debt or even more liabilities.

Let’s go through a quick example to show this.

Let’s say we have two insurance companies.  Company A has an average combined ratio of 90% over the last five years and Company B has an average combined ratio of 110% over the last five years.

Not only does this mean Company A’s profits are 20 percentage points better on average than Company B.  But it also likely means that Company B has continued racking up liabilities it can’t afford to pay when due or when a catastrophe strikes.

This is because Company B hasn’t earned a profit on average over the last five years.  And of course all else remaining equal a company earning 20 percentage points better profit’s on average is the higher quality company.

The same general rule goes for non insurance companies as well.  If they aren’t, haven’t been, and show no signs of becoming profitable float should be viewed as negative leverage for a company.

I use the following rules when evaluating all companies float…

  • To view float as a giant positive for any company I like to see consistent profitability in the last five years.  And/or seven of the last 10 years.
  • If a company has off and on profitability I view float as neutral.
  • And if the company is consistently unprofitable I view float as a huge negative for the company.

I consider profitability of operating margin, ROIC, ROCE, and FCF/Sales.  The company doesn’t have to produce huge excess profitability in each category.  I look for consistency and trend of profits more than anything when evaluating float.

This idea is a lot simpler to understand than the concept of what float is and makes it potentially great for companies and investors.

One last thing to remember when evaluating float is that whether the company has positive or negative acting float doesn’t matter if the company doesn’t allocate capital well.  And the management doesn’t know what float is or how to use it.

To evaluate these potentials see the previous five posts on this topic.

Summary

If I’ve explained everything well enough in the series so far we should understand –

  • What float is.
  • Why it’s important.
  • How companies can use float as positive leverage.
  • How Buffett got so rich using float.
  • How to find float on a balance sheet.
  • How to evaluate float.
  • How float affects a company and its margins.
  • Maybe the most important thing why float affects a company and its margins.
  • How float affects a company’s value.
  • And answered the question is float ever bad?

In the next and final seventh chapter of this series I’ll share the best resources I’ve learned from about float with you.

Knowing what we know now we should have a gigantic advantage over other investors who either don’t know about float.  Or aren’t willing to put in the time to learn what it is and what it can do for a company and investment.

If you have any questions, concerns, or comments on float up to this point please let me know in the comments section below.

***

Remember if you want access to my exclusive notes and preliminary analysis you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

How Does Float Affect Valuation? On Float Part 5

How Does Float Affect Valuation? On Float Part 5

The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day.  The hope being that our knowledge will compound over time so we’ll have huge advantages over other investors in the future.

The aim of today’s post is to continue this process by talking about a topic few investors know about.  And even fewer understand.

Most people overlook float when evaluating companies because they either don’t know what it is.  Don’t know the power it can have within a business.  Or don’t know how to evaluate it.

This won’t be an issue here.

Press On Research subscribers already know this as I talk a lot about float in many of the issues I’ve written.  But I want to begin talking about it more here because float is one of the most powerful and least understood concepts of business analysis.

Today’s post is a continuation of the earlier posts:

Today we’re going to talk about how float affects valuation.  The issue brought up way back in part 1 of this series linked above.  But before we get to this let’s go back to On Float Part 4 to continue this talk about valuation with those companies.

Insurance Company Float and Valuation

Below is the unedited float analysis I did on an insurance company I wrote about in the April 2016 Press On Research issue.

All numbers below are in USD $ millions unless noted.

Assets

  • Financial Assets: Fixed maturity securities of 94.3 + equity securities of 4.9 + trading securities of 0.1 + loans of 1.9 + cash and cash equivalents of 6.8 + accrued investment income of 0.8 + premiums and other receivables of 11.3 + deferred income tax assets of 3.8 = 123.9
  • Operating Assets: Deferred policy acquisition costs of 8.5 + PP&E net of 2 + other assets of 13.9 = 24.4
  • Total Assets = 148.3

Liabilities

  • Equity of 44.9
  • Short-term debt of 0.9 and long-term debt of 17.4 = 18.3
  • Float: Future policy benefits of 35.2 + policyholder funds of 1.6 + unearned premiums of 29.9 + taxes payable of 0.1 + other liabilities of 18.3 = 85.1

Total liabilities are 103.4

Float/operating assets 85.1/24.4 = 3.49.

Float supports operating assets 3.49 times.

And Float is “free money” because (NAME REMOVED) earns consistent underwriting profits as it’s earned underwriting profits in six of the last nine years.

Pretax profits have changed to underwriting profit below because normal pretax profits mean nothing for insurance companies.

(NAME REMOVED) had an underwriting profit – profit from operations before taxes here – for the full 2015 year of 6.4.

Underwriting profit/total assets = ROA

  • 6.4/148.3 = 4.3%
  • Compared to a Morningstar ROA of 3.2%

Underwriting Profit/(total assets – float) = levered ROA

  • 6.4/63.2 = 10.1%

If I were to rely only on Morningstar to get estimates for margins (NAME REMOVED)looks below average at only 3.2%.

Yes I know this isn’t an apples to apples comparison.  But normal profit metrics mean nothing for insurance companies.

When considering underwriting profit.  Its ROA is a still below average 4.3%.

But (NAME REMOVED) float magnifies its ROA higher.

When considering float, its levered ROA goes up to 10.1%.  Or 43% higher than what I calculate it’s normal ROA as.

Having a levered ROA of 10.1% isn’t great compared to normal companies I invest in… But for an insurance company this is a great margin.

One of my investment icons the great insurance investor Shelby Davis looked for insurance companies having an ROA above 10% so this meets his threshold.

Another important metric for insurance companies is ROE.  Most great insurance companies fall in the 10 – 15% ROE range.

I calculate (NAME REMOVED) ROE – underwriting profits/shareholders equity – as 14.3% not levered by any float.  Compared to Morningstar’s ROE estimate of 10.7.  This puts (NAME REMOVED) into the great insurance company category.  And there’s still more.

***

I continue on from here detailing this great small insurance company but now let’s get back to talking about how float affects valuation.

The unedited valuations below are from the April 2016 Press On Research issue except for the removal of the company name and ticker.

My notes talking about float now are bolded and capitalized.

How Does Float Affect Valuation?

As Warren Buffett once said, “Price is what you pay, value is what you get.”

The price of a company is what the market says it is. But how do I establish value?

When I recommend a stock, I try to find its “intrinsic value.” Intrinsic value measures a company’s true value considering tangible and intangible assets and the company’s operations.

Think of intrinsic value this way: What would this company be worth if we were to buy it outright? It’s like appraising the value of a house or car.

If I find the intrinsic value of a company to be higher than its market price, that’s a good sign of an undervalued stock.

I valued (NAME REMOVED) four ways.

The first is by assuming 1% interest rates for the long-term.  And that (NAME REMOVED) float won’t grow over time.

The second is an asset reproduction valuation.

The third is adding the reproduction value of (NAME REMOVED) to 1/5th of its float and then dividing by its number of shares.

And the fourth is adding (NAME REMOVED) float and equity together then dividing this by its number of shares.

Valuations done using (NAME REMOVED) 2016 10K. All numbers are in millions of US$, except per share information, unless otherwise noted.

(NAME REMOVED) current market cap is (REMOVED; BELOW $100 MILLION) and its current share price is $15.20 per share.

Float X 1% Interest Rate + Equity Valuation

This valuation is expecting 1% interest rates for the long-term and no growth in float over time.

  • (float X 10%) + Equity = estimated value/number of shares.
  • (84.9 X 10%) + 44.9 = 53.4/2.5 = $21.36 per share.

This valuation is the minimum (NAME REMOVED) should sell for because interest rates won’t stay as low as they are forever.  And it still shows (NAME REMOVED) is selling at a 28.8% discount.

(NAME REMOVED) has consistent underwriting profits and conservative managers so float should grow over time as well.

JUST THIS COMPANIES FLOAT EQUALS $33.96 A SHARE.  OR 223% HIGHER THAN ITS THEN TOTAL SHARE PRICE.  REMEMBER THOUGH THIS NEEDS TO BE DISCOUNTED IN MOST CASES BECAUSE OF THE LONG TERM NATURE OF MOST FLOAT AND BECAUSE THEY’RE LIABILITIES.  WE’LL TALK ABOUT THIS FURTHER BELOW.

Next up is the asset reproduction valuation.

Asset Reproduction Valuation

Assets Book Value Reproduction Value Notes
Fixed Maturity Securities 94.3 84.9
Equity Securities 4.9 3.9
Trading Securities 0.1 0
Loans 1.9 1
Cash and Cash Equivalents 6.8 6.8
Accrued Investment Income 0.8 0
Premiums and Other Receivables 11.3 6.9
Deferred Policy Acquisition Costs 8.5 5.1
Deferred Income Tax Assets 3.8 2
PP&E Net 2 1
Other Assets 13.9 8.3
Total Assets 148.3 119.9
Minus
Future Policy Benefits 35.2 21.1
Policyholder Funds 1.6 0
Unearned Premiums 29.9 17.9
ST Debt 0.9 0
LT Debt 17.4 10.4 I could have discounted this even further since its not necessary for insurance companies to carry debt.  This would have made reproduction value even higher below.
Taxes Payable 0.1 0
Other Liabilities 18.3 11
Total Liabilities 103.4 60.4
Equals 44.9 59.5 The note above also explains why reproduction value is higher than net asset value.  This is rare when I find this.
Divided By Shares 2.5 2.5
Equals $17.96 $23.80
Current share price = $15.20 $15.20
Discount to current share price = 15.40% 36%

This valuation does not take into account any of (NAME REMOVED) float.  This is an asset – at least in the short-term – because of (NAME REMOVED) long sustained history of underwriting profits.

And as mentioned throughout this issue these act as a cost-free form of positive leverage which boosts (NAME REMOVED) value.

Even in this still ultra conservative valuation (NAME REMOVED) is selling at a 36% discount to its current share price.

Asset Reproduction + 1/5 of Float Valuation

Add float (1/5 of float after reading this discussion in part 1 of the On Float series here) asset reproduction value gets us to:

  • 59.5 + (84.9 X 20% = 16.98) = 76.48/2.5 = $30.59 per share. Or more than a double from its current $15.00 share price.

This also considers no growth in float.  Any rise in interest rates.  Or a turn to a better insurance market.  All which will help (NAME REMOVED) shares explode but this valuation still shows it’s selling at a 50.3% discount.

REMEMBER THE DISCOUNTING TALKED ABOUT ABOVE?  HERE IT IS.

USING ONLY 1/5TH OF THIS COMPANIES FLOAT – OR $6.79 PER SHARE – FLOAT ADDS SUBSTANTIAL VALUE TO THE COMPANY.

IN THE CASE OF THIS VALUATION 22.2% TO THE COMPANIES VALUE.  1/5TH OF FLOAT MAKES UP 45% OF THE COMPANIES THEN CURRENT SHARE PRICE.

AS TALKED ABOUT THROUGHOUT THE APRIL 2016 PRESS ON RESEARCH ISSUE THIS COMPANY IS CONSISTENTLY PROFITABLE AS WELL.  AND THIS VALUATION DOESN’T COUNT ITS VALUABLE OPERATIONS AT ALL.

I DON’T WHEN EVALUATING INSURANCE COMPANIES BUT IF I WERE TO ADD A MULTIPLE OF ITS TTM UNDERWRITING PROFIT TO THIS VALUATION SO THE VALUE OF ITS OPERATIONS ARE CONSIDERED IN THIS VALUATION IT WOULD BE WORTH…

  • 6.4 x 8 + 76.48 = 127.68/2.5 = $51.07

THIS IS A CONSERVATIVE ESTIMATE OF THE COMPANIES REAL INTRINSIC VALUE.  THE VALUE A CONTROL INVESTOR MAY EXPECT THE COMPANY TO BE WORTH WHEN ACQUIRING THE WHOLE COMPANY.

PROFITABLE OPERATIONS COMBINED WITH LOW COST OR COST FREE FLOAT HAS IMMENSE VALUE AS SEEN FROM THIS VALUATION.

AND REMEMBER THIS ALSO ASSUMES NO GROWTH IN FLOAT GOING FORWARD.

AGAIN, THIS IS THE POWER OF FLOAT ILLUSTRATED.  THIS WILL ALL HELP COMPOUND THE VALUE WITHIN THE COMPANY OVER THE LONG-TERM BARRING SUDDEN POOR MANAGEMENT.

Float + Equity Valuation

  • Float + Equity = estimated value/number of shares.
  • 59.5 + 44.9 = 129.8/2.5 = $51.92 per share.

This high end valuation doesn’t discount float at all.  But also doesn’t expect any growth over time.  And still shows (NAME REMOVED) is selling at a 71% discount to its current share price.

So not only is (NAME REMOVED) an ultra conservative and safe to own insurance company.  But it’s also undervalued by as much as 71%.  And we should expect to earn at least 28.8% owning them.

But there’s still more that makes (NAME REMOVED) a safe investment…

***

From here I continue detailing the company in the issue but let’s finish talking about the insurance company above.

All insurance companies have a lot of float that makes up the value of the company.  This is because most of any insurance company’s balance sheet and operations are based on float.

Now let’s go to the non insurance company talked about in On Float Part 4 to see the contrast here.  And also that float can still add substantial value to non insurance companies.

Non Insurance Company Float and Valuation

All numbers below are in millions of dollars unless noted.

  • Financial Assets: Cash and cash equivalents of 2.7 + deferred tax assets of 1.9 = 4.6
  • Operating Assets: Accounts receivable of 39.1 + Inventories of 12.6 + prepaid expenses of 1.1 + other CA of 0.3 + net PP&E of 73.7 + goodwill of 2.4 + other IA of 0.6 = 129.8
  • Total Assets = 134.4

Liabilities

  • Equity of 86.2
  • Debt of 14.4
  • Float = Accounts payable of 13.3 + Taxes Payable of 0.5 + accrued liabilities of 8.9 + other CL of 1.3 + deferred tax liabilities of 1.4 + pensions and other benefits of 8 = 33.1
  • Total liabilities 47.5

Float/operating assets = 33.1/129.8 = 25.5%.  This means (NAME REMOVED) float supports 25.5% of its operating assets.

Pretax profits/total assets=ROA

  • 7/134.4= 13.9%
  • Compared to a Morningstar ROA of 10.1%

Pretax profits/ (total assets-float) = levered ROA

  • 7/101.3 = 18.5%

Now that we remember this let’s continue to show how float affects this companies valuation.

The information below is an unedited excerpt from the January 2016 Press On Research issue except for the removal of the company name and ticker.

***

As Warren Buffett once said, “Price is what you pay, value is what you get.”

The price of a company is what the market says it is. But how do I establish value?

When I recommend a stock, I try to find its “intrinsic value.” Intrinsic value measures a company’s true value considering tangible and intangible assets.  And the company’s operations.

Think of intrinsic value this way: What would this company be worth if we were to buy it outright? It’s like appraising the value of a house or car.

If I find the intrinsic value of a company is higher than its market price, that’s a good sign of an undervalued stock.

I valued (NAME REMOVED) five ways.

The book value per share valuation talked about above.  An asset reproduction valuation.  A float plus equity valuation. A 8 and 11 times EBIT + cash – debt valuation.  And a combined asset reproduction and 8 and 11 times EBIT + cash – debt valuation.

Book Value Per Share Valuation

The first way I valued (NAME REMOVED) from earlier shows (NAME REMOVED) should be worth $11.18 a share.  An 11.5% premium to what its selling at now at $9.90 a share at the time of this writing.

This is the absolute minimum (NAME REMOVED) should be selling for because it doesn’t count any of its valuable and profitable operations at all.  Or any growth.

Next up is the asset reproduction valuation below.

Asset Reproduction Valuation

Assets Book Value Reproduction Value
Cash and Cash Equivalents 2.7 2.7
Accounts Receivable 39.1 33.2
Inventories 12.6 7.6
Deferred Income Taxes 1.9 1
Prepaid Expenses 1 0
Other CA 0.3 0
Net PP&E 73.7 44.2
Goodwill 2.4 1
Intangible Assets 0.6 0
Total Assets 134.3 89.7
Minus
Short Term Debt 4.1 4.1
Accounts Payable 13.3 6.7
Taxes Payable 0.5 0
Accrued Liabilities 8.9 4.5
Other CL 1.3 0
LT Debt 10.5 6
Pensions And Other Benefits 8 6
Total Liabilities 46.6 27.3
Equals 87.7 62.4
Divided By Shares 7.6 7.6
Equals $11.54 $8.21

While (NAME REMOVED) is selling above its reproduction valuation – and it should since it’s a great company – it’s selling below its net asset valuation.  The middle bar above.

This is also an ultra conservative valuation that shows (NAME REMOVED) is undervalued by 14.2% now.

Float Plus Equity Valuation

The third way I valued (NAME REMOVED) was by adding float to equity and then dividing by its numbers of shares.

  • 33.1 + 86.2 = 119.3/7.6 = $15.70 per share.

This again is an ultra conservative valuation because it doesn’t include cash.  Or (NAME REMOVED) valuable and profitable operations.

But this still shows (NAME REMOVED) is undervalued by 37% now.

EBIT Valuation

The fourth way I valued (NAME REMOVED) is by using its TTM EBIT.  Multiplying this by eight and 11.   Adding cash.  Subtracting debt.  Then dividing this by the number of diluted shares outstanding.

  • 8X 19 + cash of 2.7 – 14.6 = 140.1/7.6 = $18.43. This means (NAME REMOVED) is undervalued by 46.3% now.  Almost a double from current share price.
  • 11X 19 + 2.7 – 14.6 = 197.1/7.6 = $25.93. Or undervalued by 61.8% now.  Or more than a double from current prices.

Yet again this doesn’t show the whole story because this valuation doesn’t include its valuable assets.

EBIT Plus Reproduction Valuation

Adding in the net value – after debt – of its estimated reproduction assets gets us values of:

  • 140.1 + 62.4 = 202.5/7.6 = $26.64 per share. Or 2.69 times higher than its current share price.
  • 197.1 + 62.4 = 259.5/7.6 = $34.14 per share. Or 3.45 times higher than its current share price.  Or a 3.45 bagger from current prices.

THIS COMPANIES THEN CURRENT SHARE PRICE WAS $10.  ITS FLOAT EQUALS $4.36 PER SHARE.  THIS MEANS JUST ITS FLOAT MADE UP 43.6% OF ITS THEN CURRENT SHARE PRICE.

IN OTHER WORDS FOR ONLY $5.64 YOU GET THIS COMPANIES CONSISTENTLY PROFITABLE GREAT MARGINS, ASSETS, OPERATIONS AND EVERYTHING ELSE OTHER THAN FLOAT.

WHEN EVALUATING NON INSURANCE COMPANIES I DON’T INCLUDE FLOAT IN THE VALUATIONS MOST OF THE TIME BECAUSE AS ALWAYS I LIKE TO BE AS CONSERVATIVE AS POSSIBLE.

BUT IF I WERE TO ADD 1/5TH OF THIS COMPANIES FLOAT ($6.62 MILLION OR $0.87 PER SHARE) TO THE EBIT PLUS REPRODUCTION VALUATION THIS WOULD GET US VALUES OF $27.51 AND $35.01 RESPECTIVELY ABOVE.

1/5TH OF FLOAT ADDS ~3% TO THIS COMPANIES VALUE.  NOT MUCH IN THE SHORT TERM BUT REMEMBER IF FLOAT IS USED WELL OVER A LONG TIME IT COMPOUNDS AND COMPOUNDS THE VALUE WITHIN THE COMPANY.

MOST PEOPLE DON’T CONSIDER FLOAT AT ALL WHEN EVALUATING NON INSURANCE COMPANIES.

AT THE TIME THE COMPANY WAS A ~$75 MILLION COMPANY.  IF THE COMPANY CONTINUES TO COMPOUND FLOAT AT 3% OVER 10 YEARS THE COMPANIES INTRINSIC VALUE WILL COMPOUND BY ~$26 MILLION TO $101 MILLION.

AND THIS ASSUMES NO GROWTH IN FLOAT.  NO GROWTH FROM ITS VALUABLE OPERATIONS.  AND NO ADDITIONS OF NEW CAPITAL FOR 10 YEARS.  ALL SHOULD CONTINUE TO GROW AT THIS GREAT COMPANY.

THIS COMBINED AFFECT OF COMPOUNDING FLOAT, INTERNAL VALUE, AND OPERATIONAL PROFITABILITY COULD EXPLODE THIS COMPANIES SHARES OVER TIME.

BUT I DON’T COUNT ANY OF THIS POSSIBILITY IN ANY VALUATIONS DUE TO CONSERVATISM.

THIS IS WHY FLOAT IS IMPORTANT EVEN FOR NON INSURANCE COMPANIES.  IT CAN ADD SUBSTANTIAL VALUE TO A COMPANY EVEN IF ITS ONLY ICING ON THE CAKE AS I OFTEN VIEW IT.

The above means that we’re buying (NAME REMOVED) at a massive discount to its true value.

***

Again, from here I continue detailing this great company.  For now let’s sum this all up before moving on to the next part of this now extended series.  Is Float Ever Bad?  On Float Part 6.

Summary

If I’ve explained everything well enough in the series so far we should understand –

  • What float is.
  • Why its important.
  • How companies can use float as positive leverage.
  • How Buffett got so rich using float.
  • How to find float on a balance sheet.
  • How to evaluate float.
  • How float affects a company and its margins.
  • Maybe the most important thing why float affects a company and its margins.
  • And how float affects a company’s value.

In the next and sixth chapter – yes I’ve now added two more parts to this now extended series – I’ll answer the question is float ever bad.

Knowing what we know now we should have a gigantic advantage over other investors who either don’t know about float.  Or aren’t willing to put in the time to learn what it is and what it can do for a company and investment.

If you have any questions, concerns, or comments on float up to this point please let me know in the comments section below.

***

Remember if you want access to my exclusive notes and preliminary analysis you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

What Is Float? On Float Part 2

What Is Float? On Float Part 2

The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day.  The hope being that our knowledge will continue to compound over time so we’ll have huge advantages over other investors in the future.

The aim of today’s post is to continue this process by talking about a topic few investors know about.  And even fewer understand.

Most people overlook float when evaluating companies because they either don’t know what it is.  Don’t know the power it can have within a business.  Or don’t know how to evaluate it.

This won’t be an issue here.

Press On Research subscribers already know this as I talk a lot about float in many of the issues I’ve written.  But I want to begin talking about it more here because float is one of the most powerful and least understood concepts of business analysis.

Today’s post is a continuation of the earlier post Charlie Munger On Deferred Tax liabilities and Intrinsic Value – On Float Part 1.  And we’re going to answer the question today, what is float?

But before we get to that next is an excerpt from the July 2015 Press On Research issue where I talk about float extensively.

The Biggest Investment Secret In The World

How Warren Buffett Got So Rich And How You Can Too

Warren Buffett’s admired around the world for his philanthropy as he’s going to donate 99% of his $70 billion plus net worth to charity when he dies.

He can donate so much money because of how great an investor he is.  But almost no one knows how Warren Buffett made his fortune.

Yes, most investors know about his investments in Coke (KO), Johnson & Johnson (JNJ), and Wells Fargo (WFC).  But this isn’t how he built his fortune.

Investor’s who’ve studied Buffet know he built his partnership, and then Berkshire Hathaway, buying small companies.

But this still isn’t the true secret to Warren Buffett’s success.

Today I’m going to tell you how he grew $100,000 into more than $70 billion.  And tell you how we can start doing the same.

But before we explain the exact companies Buffett built his fortune on.  We need to talk about why Press On Research concentrates on small caps.

A University of Kansas student asked Buffett about this in 2005:

“Question: According to a business week report published in 1999, you were quoted as saying: “It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”…would you say the same thing today?”

Here’s Buffett’s answer emphasis is mine:

“Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.”

Yes, I’ve said this before many times.  But it’s an important concept to understand.

Small ultra safe investments that produce a ton of cash.  Have little to no debt.  Pay dividends and buy back shares.  And are cheap are my favorite investments.

These kinds of businesses are what Value Investing Journey and Press On Research is all about.

Today’s recommendation has no debt.  Owns more cash and cash equivalents than its entire market cap.  And just its net cash and cash equivalents make up 77% of its market cap.

This doesn’t count any of its property, plant, and equipment, future premiums earned, or cost-free float.  And this company is undervalued by 29% to 70%.

But this still isn’t all…  It’s also much more profitable than competition.

Today’s pick isn’t just a great company with all the above traits.  It’s also in Buffett’s favorite industry to invest.

Investing In Insurance

Most people won’t research insurance companies.  I wouldn’t early in my investing journey.  And many professional analysts stay away too.

This is because insurance companies are hard to understand at first.  Have new and confusing terminology to learn.  And normal profit metrics don’t matter much for them.

But if you learn how to evaluate them not only will you learn they’re easy to evaluate once you know what you’re doing.  But you can use the same repeatable process on every insurance company.  And Buffett has continued to buy into insurance – his favorite industry – constantly over the decades.  And it’s why he’s so successful.

In reality insurance companies are easy to understand.

Insurance companies take money – premiums, the insurance version of revenue – as payment for insuring things like businesses, equipment, health, life, etc.

The insurance company doesn’t have to pay you a dime of the money it earns over the years until there’s some kind of damage or theft of whatever’s insured.

When this happens they pay the agreed upon insurance rate out to the policyholder.

While the company continues to earn money – premiums again – it invests some of it so it can pay back your policy in the future.  And also make a profit in excess of the amount earned, invested, and paid out.

If the company writes its policies and invests well over time it will earn underwriting profits.  And grow the assets it can use to write more policies and invest more money.

If it doesn’t, the company will go out of business when a major disaster strikes.

Think of insurance companies like investment management companies.  But instead of only earning management fees.  Insurance companies earn premiums on top of investment earnings.

These effects can double profits over time…  If management is great at what they do.

The insurance business while easy to understand is one of the hardest businesses to be great at.

Other than being a low-cost operator like GEICO.  Owned by Berkshire Hathaway.  There are no competitive advantages in this industry.  And it also experiences wild swings of huge profitability than massive losses.

But if the company writes policies and invests money well over a long period they can grow to great sizes at almost no extra costs.  The only new costs may be to hire more staff.

Insurance companies also hold the greatest secret in the investment world…  Float.  This is how Buffett built his fortune.  And how we’ll start to build ours.

But before we get to this we need to know why float is so important.

Brief Berkshire Hathaway History

Buffett began buying Berkshire Hathaway stock in 1962 when it was still a textile manufacturer.  And when he still ran his investment partnership.

He bought Berkshire stock because it was cheap compared to the assets it had.  Even though the company was losing money.

He continued to pour millions of dollars into Berkshire to keep up with foreign and non union competition.  But none of this worked.

In time Buffett realized he was never going to make a profit again in the textile industry.  So whatever excess funds Berkshire did produce he started buying other companies.

The first insurance company Berkshire Hathaway bought was National Indemnity Company in 1967.

Since then Berkshire’s float has grown from $39 million in 1970 to $77 billion in 2013.

Float compounds like interest does if you use and invest it well.  But not only does float compound, if you use it right it also compounds the value of the company that owns the float.

Since 1967 when Berkshire bought National Indemnity, Berkshire’s stock price has risen from $20.50 a share to today’s price of $210,500.  Or a total gain of 10,268%.

This is the power of insurance companies when operated well.  And today’s recommendation is an insurance company that operates the right way too.

But before we get to that I need to explain how float makes this possible.

The Biggest Investment Secret Revealed

‘Float is money that doesn’t belong to us, but that we temporarily hold.”  Warren Buffett

Float is things like prepaid expenses.  Billings in excess of expected earnings.  Deferred taxes.  Accounts payable.  Unearned premiums.   And other liabilities that don’t require interest payments.
But they are the farthest thing from liabilities.

MY UPDATED NOTE HERE… I’LL TALK ABOUT THIS MORE IN DEPTH IN A LATER POST AND DETAIL WHAT I MEANT TO SAY AND DIDN’T EXPLAIN WELL ENOUGH HERE.

Instead of paying this money out now like normal liabilities.  Companies can use these “liabilities” to fund current operations.

Float is positive leverage instead of negative leverage like debt and interest payments.
Think of float as the opposite of paying interest on a loan.  Instead of paying the bank for the cash you’ve borrowed.  The bank pays you interest to use the money you loaned.  And you can use this money to invest.
Using cost-free float to fund operations can improve margins by up to a few percentage points.

MY NOTE HERE: I’LL EXPLAIN THIS BETTER IN A FUTURE POST TOO.
The best way to explain why float is so important is with the following quote:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of free – other peoples money – in highly productive assets so that return on owners capital becomes exceptional.”  Professor Sanjay Bakshi adding to something Warren Buffett said about great businesses.
I said in last month’s issue: “When a company’s float/operating assets ratio is above 100% it means the company is operating with “free” or cost-free money.”

But this isn’t true with insurance companies.

For an insurance company to operate on a cost-free basis it has to produce underwriting profits for a sustained period.

I look for underwriting profits of at least five years straight to consider its float cost-free.

And the company I’m going to tell you about today has earned an underwriting profit every one of the last 10 years.

When you come across companies that are able to do this on a consistent basis you should expect exceptional returns in the future.

This is because when a company operates its entire business on a cost-free basis it means several things. 1)  It’s a great business.  2.)  It’s an efficient business.  And 3.) float magnifies profit margins.

So what is this great company?

I go on here to detail the company I recommended – and bought for the portfolios I manage – in July to subscribers.

So What Is Float?

To summarize the above float is anything listed in the liabilities section of its balance sheet you don’t pay interest on.

Interest based liabilities – NOT FLOAT – include capital leases, and short and long-term debt.

Most of the time these are the only interest based liabilities on a company’s balance sheet.  Make sure by checking the off-balance sheet transactions and total obligations notes – if any – in the companies footnotes.

Examples of non interest based liabilities – FLOAT – include prepaid expenses, accounts payable, taxes payable, accrued liabilities, deferred tax liabilities, unearned premiums, etc.

These vary more but remember if the company doesn’t have to pay interest on the liability it’s float… Money the company has to pay later but in the mean time can use to invest in and grow the business.

Think of float as normal debt without the negative effects.

In the short to medium-term – long-term for most insurance companies – float while listed as a liability on the balance sheet should be considered an asset to the company.  Why?  Because while the company owns the float it can use these “liabilities” to invest and grow the business.

How though?

Because while the company lists the liability on its balance sheet – and still owns the liability – it can use the float as positive leverage to grow the company or invest in other businesses.

Sometimes at a better than cost free basis as mentioned above… But we’ll talk about this in a future post on float.

Next up I’ll go through a company’s balance sheet to separate float from non float.  And show you how to value and evaluate it.

What do you think of float at this point?  Do I need to explain anything better?  Let me know in the comments below.

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Remember if you want access to my exclusive notes and preliminary analysis you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

Charlie Munger On Deferred Tax Liabilities And Intrinsic Value – On Float Part 1

Charlie Munger On Deferred Tax Liabilities And Intrinsic Value

On Float Part 1

The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day.  The hope being that our knowledge will continue to compound over time so we’ll have huge advantages over other investors in the future.

The aim of today’s post is to continue this process by talking about a topic few investors know about.  And even fewer understand.

Below is an unedited thread from the value investment forum Corner of Berkshire and Fairfax discussing Charlie Munger’s thoughts on deferred tax liabilities and intrinsic value.

Bolded emphasis is mine below.

So, I’ve been reading Munger’s Wesco letters (they are quite repetitive).  However, while reading, I found the following section pretty interesting:

Consolidated Balance Sheet and Related Discussion

As indicated in the accompanying financial statements, Wesco’s net worth increased, as accountants compute it under their conventions, to $2.22 billion ($312 per Wesco share) at yearend 1998 from $1.76 billion ($248 per Wesco share) at yearend 1997.

The $459.5 million increase in reported net worth in 1998 was the result of three factors: (1) $395.8 million resulting from continued net appreciation of investments after provision for future taxes on capital gains; plus (2) $71.8 million from 1998 net income; less (3) $8.1 million in dividends paid.

The foregoing $312-per-share book value approximates liquidation value assuming that all Wesco’s non-security assets would liquidate, after taxes, at book value.  Probably, this assumption is too conservative.  But our computation of liquidation value is unlikely to be too low by more than two or three dollars per Wesco share, because (1) the liquidation value of Wesco’s consolidated real estate holdings (where interesting potential now lies almost entirely in Wesco’s equity in its office property in Pasadena) containing only 125,000 net rentable square feet, and (2) unrealized appreciation in other assets (primarily Precision Steel) cannot be large enough, in relation to Wesco’s overall size, to change very much the overall computation of after-tax liquidation value.

Of course, so long as Wesco does not liquidate, and does not sell any appreciated assets, it has, in effect, an interest-free “loan” from the government equal to its deferred income taxes on the unrealized gains, subtracted in determining its net worth.

This interest free “loan” from the government is at this moment working for Wesco shareholders and amounted to about $127 per share at yearend 1998.

However, some day, perhaps soon, major parts of the interest-free “loan” must be paid as assets are sold.  Therefore, Wesco’s shareholders have no perpetual advantage creating value for them of $127 per Wesco share.  Instead, the present value of Wesco’s shareholders’ advantage must logically be much lower than $127 per Wesco share.  In the writer’s judgment, the value of Wesco’s advantage from its temporary, interest-free “loan” was probably about $30 per Wesco share at yearend 1998.

After the value of the advantage inhering in the interest-free “loan” is estimated, a reasonable approximation can be made of Wesco’s intrinsic value per share.  This approximation is made by simply adding (1) the value of the advantage from the interest-free “loan” per Wesco share and (2) liquidating value per Wesco share.  Others may think differently, but the foregoing approach seems reasonable to the writer as a way of estimating intrinsic value per Wesco share.

BREAK HERE.  BELOW THIS IS THE WRITERS – NOT MUNGER’S COMMENTS.

It immediately struck me that such an evaluation could easily be applied to Berkshire, although Berkshire at this point is much more complex than Wesco was then.  Turns out, someone had already done the analysis for 2011 and 2012:

http://seekingalpha.com/article/282116-berkshire-hathaway-worth-its-salt
http://seekingalpha.com/article/740931-berkshire-hathaway-worth-its-salt-2012-update

(As a side note, I had trouble following Dan Braham’s line of thinking on this evaluation in the comments of the first article)

This evaluation contrasts from the “investments per share” and “earnings from owned companies” approach, which I believe was advocated by Buffett more recently.

BREAK… BELOW HERE ARE MY COMMENTS.

The Importance of Float

‘Float is money that doesn’t belong to us, but that we temporarily hold.”  Warren Buffett

Why does Munger think the above is a good approximation of Wesco’s intrinsic valuation then?  Because while the company “owns” these liabilities on their balance sheet the company can use them to grow the business.

This is an example of float and the power it can have on a company.

Munger only used an estimated 1/5th of the value of Wesco’s float in his valuation.  Why?  Because when these “assets” are sold it comes off Wesco’s balance sheet.

I agree with Munger that this is a necessary and conservative way to look at valuing float within a company.

And most people overlook float when evaluating companies because they either don’t know what it is.  Don’t know the power it can have within a business.  Or don’t know how to evaluate it.

This won’t be an issue here.

Press On Research subscribers already know this as I talk a lot about float in many issues I’ve written.  But I want to begin talking about it more here for a simple reason.  Float is one of the most powerful – and least understood – concepts when evaluating businesses.

We can gain a gigantic advantage over other investors by knowing what float is.  How to evaluate it.  And and how to value it.

Also, contrary to common belief float can be found in any business.  Not just insurance companies.

But we’ll get to this in a later post… In the next post I’m going to explain what float is in more detail.

Remember if you want access to my exclusive notes and preliminary analysis you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

Let me know your thoughts on deferred tax liabilities and other float in the comments below.