Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
January 17, 2003
http://www.dynamicinvestors.net
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Good Saturday to you! I hope this week was as productive for you as it was for me. Your editor had his first article published on The Motley Fool Friday, and in a shameless bit of self-promotion, here’s the link. I have been a huge fan of The Fool for many years, going back to the days before the bubble burst. If you want good, readable, financial news and insight, there’s really no better place than the Motley Fool.
I’m making a plea for feedback this week. I really want to hear your thoughts on this newsletter. Some of you have e-mailed me with helpful comments, and I truly appreciate it. But I need more. Let me know what you like and what you don’t like. Are the articles too long? Do you hate the introduction? Do you like it? What could I add or take away? Let me know, so I can continue to produce a product you want to read. You can e-mail me via chrismallon@dynamicinvestors.net.
The markets had a strong showing this week, boosted by a number of strong economic indicators. Consumer confidence is high, manufacturing output is up, and the trade gap is narrowing. Inflation appears to be in check, although I explain in Wednesday and Thursday’s updates why this isn’t really the case. The aggregate inflation numbers are hiding a trend in rising costs for food, energy, and medical care – what I call the “things people need” indexes.
The trade gap narrowed in December from $41 down to $38 billion, boosting the dollar and wreaking havoc in the gold markets. For the week, gold was down almost $20 per ounce, a 4.6% drop and is dangerously close to falling below the $400 mark. Silver held up a little better, down 4% from $6.56 to $6.30. The dollar was a big winner this week, rebounding strong against the Euro and other currencies. The dollar gained 1.6% on the Euro, finishing the week at $1.2568/Euro.
While the economic news has been mostly good for a number of weeks, I still refuse to give up my bearish position. I firmly believe that the markets are overvalued, and that a major correction is coming our way. The drop in gold and the dollar’s rise this week are corrections that were fully expected, but the longer term trend is in place for higher gold prices and a lower dollar. Private and public debt levels are ridiculously high, while interest rates are ridiculously low. Stocks trade at record P/E levels, AGAIN. At some point it all has to give way and correct itself.
Even if you don’t believe the economy is going to slow again (as I do), you have to look at the markets and at least feel some sense that things are overstretched again. With interest rates at current levels, they have nowhere to go but down, so bonds are about as high as they’re going to get. Stocks, too, are trading at price multiples that are outrageous by all standards. What kind of money do people expect to make buying stocks at 25, 35, or even 300 times earnings? Finally, if you want proof that the bubble is back, check out Friday’s action in Juniper Networks. I rest my case.
Anyway, I had to rant. Have a nice weekend, and if you live in the Northeast United States, try to keep warm. If you’d like to read more of what I think, be sure to check out the daily update.
I’m beginning a series of articles looking at financial statements and how to analyze them. This week we’re focusing on the asset side of the balance sheet in what I hope is an informative article. I’m also preparing an e-mail series that will provide you with good analysis tools. I’ll have more information on this next week.
Until we meet again, best wishes to you and yours.
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Book Recommendation
The Rise and Fall of the Greatest Hedge Fund in History
In When Genius Failed, Roger Lowenstein chronicles the rise and fall of Long-Term Capital Management, the notorious hedge fund that nearly bankrupted the world economy in the 1990s. Founded in 1993, LTCM was hailed as the most impressive hedge fund in history, run by the successful bond trader John Meriwether. The fund included two Nobel Prize winning economists and a number of Wall Street’s best trading minds.
But the arrogance of the fund’s managers eventually caught up with them. After four years of spectacular returns built on precise mathematical models, and tremendous leverage, they were convinced that they had eliminated risk from their portfolio. When the bottom fell out in 1998, the losses were so catastrophic they threatened not only the biggest banks on Wall Street, but the stability of the banking system itself.
Lowenstein draws on internal memos and interviews with dozens of key players to recreate history. He explains in detail how the fund made and lost money, and how the personalities of the Long-Term’s partners, the arrogance of their mathematical certainties, and the culture of 1990’s Wall Street all contributed to their rise and fall. When Genius Failed is certainly the cautionary financial tale of our time.
For more must-have books, check out the Dynamic Investors Required Reading.
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The Structure of the Balance Sheet, Part 1 - Assets
The corporate Balance Sheet, sometimes referred to as the Statement of Financial Position, is one of the “Big Four” required financial statements prepared by public companies in their quarterly and annual reports. It’s basically a snapshot of the company's financial health at a specific point in time. But it’s also much, much more.
This week’s article is the first in a series of three that break down the balance sheet and define the different parts. I was originally going to publish this as one long article, but even I couldn’t handle all of it at one time. Needless to say, it can be a bit dry, so instead of 2500 words of humorless accounting 101, I’ve decided to lighten it up and publish it over the course of 3 weeks. This week we’ll focus on the asset side of the balance sheet. Next week we’ll do liabilities, and the following week we’ll wrap up with shareholder’s equity.
As you may already know, the corporate balance sheet is broken down into three major categories: Assets, Liabilities, and Shareholders' Equity. As the name implies, there is a balance between these three categories, such that the assets are equal to the sum of the liabilities plus the shareholders' equity.
The balance sheet always satisfies this equation:
Assets = Liabilities + Shareholder's Equity
Liabilities and shareholder's equity represent the capital both creditors and investors have put into the company. They are very different sources of capital, which you'll see next week. For our purposes here, though, understand that liabilities are borrowed capital and equity is invested capital. Equity represents the ownership of assets, which in turn are collateral against the liabilities. If a company decides to liquidate its assets, the cash generated is used to pay off all the liabilities first, with the remainder distributed to shareholders. Of course, by the time a company has to liquidate, there’s usually no value left for the shareholder anyway.
Assets
A good definition of assets comes from an old finance textbook which I still keep around titled Financial Reporting and Statement Analysis. It’s written by Clyde P. Stickney and Paul R. Brown, and is one of the better texts I’ve used.
As an aside, if you're a college student and you find a good textbook with lots of useful information, keep it. I can't tell you how many times I've referred back to some of my Master's texts for definitions, equations, or just to remember how to do something. It's worth many times the few bucks you pass up by not selling it back to the school.
Anyway, back to the definition of assets. The text defines assets as "resources that have the potential for providing a firm with future economic benefits: the ability to generate future cash inflows (as with accounts receivable and inventories) or to reduce future cash outflows (as with prepayments). A firm recognizes as assets those resources (1) to whose future use it has acquired rights as a result of a past transaction or exchange, and (2) whose future benefits the firm can measure, or quantify, with a reasonable degree of precision."
Essentially, an asset is something the firm has acquired and uses to generate sales or reduce costs. To be classified an asset the company has to be able to put a value on something, which is usually the cost to acquire it. In many cases, a company's most valuable resources - brand name and employees - don't show up on the balance sheet, because their value isn't quantifiable to any reasonable degree.
Assets fall into two broad categories: monetary and non-monetary. Monetary assets include cash, accounts receivable, and fixed-payment securities such as another company's corporate bonds. Monetary assets are always listed on the balance sheet at the present value of the future cash flows. Non-monetary assets include resources that don't have a series of fixed cash flows associated with them. These would include inventories, buildings, land, equipment, and investments in other company's common stock. Non-monetary assets are most often listed at the historical value paid for the asset. Sometimes the real value of non-monetary assets, such as land, is much higher (or lower) than book value. This will occasionally offer the savvy investor an opportunity to buy companies for less than they're worth.
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Balance sheets classify assets into current and non-current. Current assets are those assets the company expects to turn into cash within one year. The major types of current assets are:
Cash is just that: cash.
These are very short-term, very liquid, instruments that will be turned into cash quickly. Money markets are a good example.
Investments that will mature, or that the company expects to liquidate, within one year. This could include T-bills and or corporate bonds with short maturities.
Inventories include raw materials, work-in-progress, and finished goods that haven't yet been sold.
Companies will occasionally pay some portion of a future liability in advance. This prepayment becomes an asset because it reduces future cash outflows.
Current assets will always be listed within their own section on the asset side of the balance sheet with a subtotal. The remaining assets on the balance sheet are considered non-current and include:
This is the company's land, buildings, equipment, facilities, etc. These items are usually listed at historical cost. Accumulated depreciation is subtracted from the historic value to arrive at the net PP&E. Here is where a good analyst can find value. Land that’s on a company’s books at historic cost can be worth a good deal more than book value, but the market rarely recognizes this in the short term. You can sometimes find very good investments this way.
These are investments that will mature in greater than one year, or that the company expects to hold longer than a year. Included here are long-term bond investments and equity holdings in other firms.
Goodwill is essentially the excess payment for an acquisition over the value of the acquired assets. For example, if the purchased company has assets valued at $1 billion and our company pays $2 billion to acquire it, we will add $1 billion in tangible assets and $1 billion in Goodwill to our balance sheet.
This may include patents, trademarks, franchise rights, or contractual rights to future use of another company's property. This is the most troublesome of all asset categories because there is a good deal of subjectivity that goes into determining whether an intangible can be valued as an asset.
What you should take away from this discussion is that assets are the productive resources a company uses to generate sales or lower costs. Only resources that have a reasonably calculated value are listed as assets on a balance sheet. The value on the balance sheet usually represents the historical purchase cost of the asset, less accounting depreciation in the case of PP&E.
Company's also have productive resources that aren't shown on the balance sheet. Brands, trademarks, and reputation in the marketplace are all excluded, but can actually be very valuable to a company. Additionally, employees are a company's most important resource, and they don't show up anywhere on the balance sheet.
Next week we’ll delve into the Liabilities section.
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Quotes of the Week
"It’s not whether you get knocked down; it’s whether you get back up."
-Vince Lombardi
“Never stop learning. If you learn one new thing everyday, you will overcome 99% of your competition.”
-Joe Carlozo
Until next week my friends, happy investing. Don’t forget to forward this newsletter to a friend.
Sincerely,
Christopher M. Mallon
P.S. – If you’d like to learn about some investments that will protect you during the coming storm, check out Four For ’04 – The Undervalued Reports Company’s Guide to Defensive Investments for 2004. It contains detailed analysis on four quality defensive investments. And it’s only $10 for UW subscribers.
Have you checked out the Dynamic Investors Marketplace?
How about the Required Reading?
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Attention advertisers!
If you’d like to advertise in the Undervalued Weekly, please send e-mail to chrismallon@dynamicinvestors.net. My rates are reasonable, and I’m willing to work deals for ad swaps and joint ventures.
Attention authors!
The Undervalued Weekly is always looking for quality original content. If you’d like to write an article for publication in the Undervalued Weekly, send a copy of your article to undervalued@dynamicinvestors.net. Include a one-paragraph abstract of your article, and a working e-mail address. I will contact you if your article is approved. I reserve the right to correct any grammatical mistakes.
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