Undervalued Weekly

The Undervalued Reports Company’s weekly newsletter

Towson, MD

January 24, 2003

http://www.dynamicinvestors.net

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Welcome, back dear, reader to another edition of the Undervalued Weekly, coming to you straight from the snowy Mid-Atlantic state of Maryland. It hasn’t been warm enough to melt last week’s ice, so why not pile some more on. At least it looks nice.

In case you’ve lost your password to the Dynamic Investors Member Area, here it is:

Username: member

Password: only

I’m putting in a plug for a great restaurant we visited this week. (If you don’t live in the Baltimore-Washington area, you can skip to the next paragraph.) I know some of you live local to me, and I encourage you to visit this place. It’s called La Cazuela, located 1718 Eastern Ave, just east of Broadway in Fell’s Point. They serve authentic Ecuadorian food, and it’s excellent. The ambience is pure Ecuador, and twelve of us sat for 4 hours reminiscing and enjoying each other’s company. You have to bring your own alcohol, and I recommend a good bottle of red wine. The only menu selection you absolutely must get are humitas. Trust me, you’ll find it hard to stop with just one.

Moving on to actual financial news, things were fairly quiet this week. The markets were closed Monday, and the only really important economic news this week came from the Index of Leading Indicators and the new unemployment claims, both of which were good, but not phenomenal.

The Dow was down 0.3% this week, finishing at 10,568.29. The Nasdaq dropped almost 1% to close at 2,123.87. And the S&P 500 bucked the downtrend, closing up 0.15% at 1,141.55.

The dollar resumed its downward momentum, after correcting a bit last week, dropping 2.5 cents against the euro. The euro was trading hands at $1.2588 as I write this. Gold continued its correction this week, falling 1.2% to 407.60. Gold stocks took a beating this week, in sympathy with gold’s decline. The Gold Bugs Index (HUI) was down 2.8%, while the Philadelphia Gold and Silver Index fell 3.1%.

Gold has corrected about 4% off it’s highs earlier this month. There’s resistance at $400 per ounce, and depending on your point of view, now’s an opportunity to buy on a dip, or it’s vindication that the economy’s improving. Or maybe it doesn’t really matter. Who knows? I think gold, silver, and other precious metals are going to be much higher by the end of the year, but I’ve been wrong before.

I break all the numbers down in greater detail in the daily update. If you’re really interested in what I think, that’s the place to find out.

One last item. If you know anyone who’s interested in writing articles on financial analysis or personal finance, I’m looking for contributors. Tell them to contact me via chrismallon@dynamicinvestors.net.

Until next time, best wishes. And help support the Undervalued Weekly by visiting some of our sponsors.

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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.

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The Structure of the Balance Sheet, Part 2 – Liabilities and Shareholder Equity

Last week, we looked at the asset side of the balance sheet. Assets are the company's resources used to generate sales or reduce costs. Only resources with some historic cost or measurable future value can be classified as an asset. If can’t calculate a value with some amount of certainty, the resource isn't an asset. Some important resources don't make it to the balance sheet, such as brands, company reputation, or employees.

If you’d like to go back and review the asset discussion, it’s available here in the Undervalued Weekly archives.

This week’s article is the second part of the full balance sheet discussion, focusing on liabilities and shareholder’s equity, which are the sources of capital for purchasing assets. Liabilities are debts the company must repay, while shareholder equity is invested capital owner’s put at risk in the business.

The most significant difference between liabilities and shareholder’s equity deals with ownership rights. Shareholder equity represents ownership of the company and its assets. Liabilities are debts collateralized by the company’s assets, but don’t represent ownership in the business. However - and this is very important for investors to understand – if a company enters bankruptcy or for some other reason has to liquidate, the company’s liabilities must be paid off entirely before shareholder’s get a penny of cash for their shares.

This explains why it's safer to invest in a company's bonds than its stock. The bondholders get paid first under a contractual obligation, whereas the stockholder gets no guarantee. Therefore, bondholders assume less risk. On the other hand, bondholders have limited upside potential, while the returns for stockholders are potentially unlimited.

Liabilities

The text mentioned last week, Financial Reporting and Statement Analysis, has a good concise definition of liabilities. According to the authors a “liability represents a firm’s obligation to make payments of cash, goods, or services in a reasonably definite amount at a reasonable definite future time for benefits or services received in the past,” including the purchase of physical assets.

Liabilities are obligations to pay back borrowed funds that were used as a source of capital. Liabilities are also broken down into current and non-current categories, based on the same rules used to break down assets: liabilities payable in one year or less are current, while those payable in greater than one year are non-current. Here are the major categories of liabilities:

Current Liabilities

Accounts payable – Very short term borrowings used to finance the purchase of goods and services. Usually A/P takes the form of vendor financing, where the company will order product, and the vendor will ship the product with a bill payable in 30 days. You could think of accounts payable as similar to the “Bill me later” option on most magazine order forms.
Short-term debt – company borrowings that will mature within a year. This might include overnight borrowings, commercial paper, bank loans, or…
Current portion of long-term debt – this will sometimes be shown as a separate line item under current liabilities, or included with short-term debt. This is the portion of the company’s long-term borrowings that will mature within a year.
Other current liabilities – this is more of a catch-all category, and some of these items may be listed as separate items, depending on the relative size of the obligation. Other current liabilities might be warranty obligations, deferred income taxes, or salaries payable. Note that salaries payable only includes the cost of employee time already worked, but for which the company has not distributed paychecks.

Non-Current Liabilities

Long-term debt – Borrowings that are payable, or mature, in greater than one year’s time. These borrowings can take the form of corporate bonds, bank borrowings, or even personal loans (although this is rare).
Deferred income taxes – this is the difference between the amount of income tax expense on the income statement and the amount the company actually pays. One of the advantages corporations have - that you don’t get as an individual - is the ability to keep two sets of books: one for investors and one for the tax man. Companies are allowed to file different income statements with lower net earnings for tax purposes. Therefore, the actual taxes paid are less than that reported on the income statement, with the expectation that companies will "true up" sometime in the future.
Postretirement benefits – here is the monster stalking most of the US’s largest corporations. This is the net present value of all the company’s obligations under their retirement plans. This is a very subjective number, based on assumptions of future interest rates, investment returns, and retiree longevity. I call this a monster because these obligations grow every year, and many of the larger company plans are not fully funded. This means that some time down the road, companies will have to take money from earnings to pay these obligations.
Other liabilities – Another catch-all category that could include health insurance benefit obligations, lease obligations, or other quantifiable obligation.

Balance sheets can be misleading, particularly when it comes to the liability section. Not all obligations are identified on the balance sheet, and still others aren’t shown at accurate values. For example, some types of lease arrangements are not listed as liabilities, but are obligations nonetheless. Employment contracts aren’t listed on the balance sheet either, but the company is locked into them.

Commitments and contingencies don’t always find their way onto the balance sheet either. If a company makes a commitment “subject to” something, they may not be required under GAAP to identify it as a liability.

For example, suppose your company has a joint venture (JV) that wants to borrow money from a bank. The bank decides the JV can borrow the money, but only if your company agrees to pay the loan in full if the JV defaults. This commitment doesn't appear as a liability on your company’s balance sheet, and under normal circumstances, neither does the joint venture’s borrowing. The only place you will find mention of this is in the Notes to Consolidated Financial Statements section of the SEC filing.

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Shareholder Equity

The final section of the balance sheet is the Shareholder’s Equity. This is the residual claim on the company’s assets not necessary to meet the claims of creditors. A firm’s equity is determined by the valuation of assets and liabilities, and is subject to drastic upward or downward changes.

Equity is the shareholder’s interest in a company and is sometimes referred to as book value. In some cases shareholder equity can be negative, which is an indication of insolvency. When equity is negative, you can bet that bankruptcy isn’t far behind.

Shareholder’s equity is broken down depending on the source of the invested capital. Here are the major categories:

Invested capital

Preferred stock – Technically, preferred stock is a type of equity interest in a firm, but has more debt characteristics than equity. Preferred stock has a definite par value, commonly $100, and pays a fixed dividend. The preferred dividend takes precedent over common dividends, meaning the company must pay preferred before it pays the common. The company can choose to withhold payment of preferred dividends, but unlike common stock, these withholdings accrue and must eventually be paid, similar to deferred interest. The fixed dividend payment gives preferred stock its debt-like characteristics, making it sensitive to changes in interest rates.
Common stock – Each common stock certificate has a listed par value, say $1.00, that’s printed on the stock certificate and has no bearing on the actual market value of the stock. The common stock account is the sum of this par value for all outstanding common stock issued by the company. It is not the market value of the stock, nor is it even the value of the stock when first sold to the public. It represents only the arbitrary value listed on the stock certificates, and should be analyzed in conjunction with…
Additional paid-in capital – Sometimes called capital surplus, this is the value generated by the company’s sale of common stock to the public in excess of the par value. For example, suppose a company decides to sell 1 million shares of stock in an initial public offering for $20 per share. The par value of those shares is $1 each. In this example, $1 million dollars would go into the common stock classification, and $19 million would be classified as additional paid-in capital.

Operationally generated capital

Retained earnings – This is the cumulative net income in excess of dividends the company has generated since it began operations. In reality, retained earnings are shareholder capital that the owners decide should be reinvested in the company. Contrary to what many people believe, retained earnings are not a free source of capital, and shareholders require management to generate returns on them.
Accumulated comprehensive other income or (loss) – This category can go by several names, and is a catch all category. The revaluation of assets or the effects of currency translation might be included in this section. Also included in this section, if not in its own section, would be the write-down of impaired goodwill.

Reductions in capital

Treasury Stock – Treasury stock is the accumulated value paid to buyback common stock. Many companies institute stock buyback plans to limit the dilution from stock option plans, or to boost the earnings per share numbers. This value is listed as a negative, because it reduces the amount of invested capital in the firm. Theoretically, a company uses its retained earnings to buy back treasury shares, so you could look at it as a reduction in the firm’s reinvested capital.

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Quotes of the Week

"Crime has no better mask than outward respectability."

-Joe Sobran, January 1, 2004 column

“Work like you don’t need the money, love like you’ve never been hurt, and dance like nobody is watching.”

-Mark Twain

Until next week my friends, happy investing. Don’t forget to forward this newsletter to a friend.

Sincerely,

Christopher M. Mallon

www.dynamicinvestors.net

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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