Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
November 1, 2003
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Hello again, dear reader. We've seen an exciting week on the economic front, and there's no shortage of good news to be found. GDP growth rocketed ahead 7.2% in the third quarter, beating all estimates. The President was so proud that he couldn't help but take credit for it.
Have you ever noticed how politicians are always responsible for the good news, but the bad news is always someone else’s fault? It kind of reminds me of the two people who know everything, but can’t agree on anything.
Unfortunately, our president was off by a quarter. The second quarter GDP was driven almost exclusively by government spending. The third quarter showed growth in business spending of 11.1%, while government spending was relatively flat. But give the guy a break. He's a busy man, and it's hard to keep up with where all the money goes.
This week also gave us the most merger activity we've seen in years. By far the biggest merger story was Monday's announcement that Bank of America will buy FleetBoston for $45 a share.
Oh, to be a FleetBoston shareholder this week. The executives at Bank of America must know something that the rest of the market doesn't. How else to justify the 45% premium for the FleetBoston shares? Now, I'll take a 45% premium on my shares anyday, but I can't help wonder what the Bank of America shareholders are thinking? I certainly don't think they woke up Monday thinking, "You know what I want to do today. I want to go out and pay $45 for a stock I could have bought Friday for $32." Maybe that's why Bank of America was down 10% by the end of the day Monday.
This merger announcement dredges up memories of the Great Bubble. This is the largest premium for a merger target since the insanity of the late 90's, and represents the type of management ego-stroking that destroyed so much shareholder value. I'm just glad I'm not a Bank of America shareholder. Stocks may not be as ridiculously overpriced as they were near the end of the bubble, but they're getting close. (By some measures, we're actually in more danger now than we were in late 1999.) This merger only proves the point.
In other news, the Dow was up 219 points, the S&P 500 up 18, and my favorite manic-depressive market, the Nasdaq, rocketed ahead by 67 points. All's well in the new bull market, for sure. The economy is roaring ahead, so don't you go saving for a rainy day. Spend, spend, spend! Borrow the money you don't have; the government will make more.
That's exactly what the American consumer did last quarter, adding $398 billion in mortgage debt, and $40 billion in credit card debt. (That's about $1500 in additional debt for every man, woman, and child in the United States in just three months.) How will this get paid back? I guess we'll make it up on volume.
But what's this I see? Treasury yields are all up this week, and bond investors are worried about the little devil that sometimes accompanies a recovering economy. It could be that they read the fine print in the GDP report. The gross domestic purchases price index rose at 1.9% in the third quarter, and the price index for personal consumption rose at a 2.4% rate, both up dramatically from the second quarter.
Is that inflation we see sneaking in?
I've always thought the bond investors were smarter about the macro economy than the stock investors. They have to be, since their bond prices are directly related to the rate of inflation. When inflation goes up, so do interest rates, and then bond prices fall. Obviously, we're talking long-term here. We all know that, short-term, interest rates can be kept artificially low by the Federal Government.
What's that you say? Yes, that is exactly what's happened over the last few years. Like a coiled spring that can only be held tight for so long, interest rates are just waiting for the Fed to lose its grip. And just as the spring can hurt you when it finally uncoils, so too will interest rates hurt when they finally pop. The difference being, that when your body gets bruised you put a band-aid on it. I fear there won't be any band-aids for the economy.
But lest you think I'm totally down on the economy, I'm not. There are places to put your money that will generate big returns should things turn out poorly. Gold and silver are good options. Commodity businesses; companies dealing in raw materials; mining companies; US companies that do much of their business overseas. These are all areas to look for investments right now. Don't wait until the inflation takes hold, and commodity prices start going through the roof. You'll miss out on the important early gains.
Dr. Marc Faber discusses the importance of getting in early on the long-term trends in his book Tomorrow's Gold. I recommend it highly.
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Book Recommendation
This week’s book is a compilation of Warren Buffett’s wisdom, called The Essays of Warren Buffett: Lessons for Corporate America. Edited by Lawrence Cunningham, this book compiles the investing and management advice Buffett has provided in his annual letters to shareholders of Berkshire Hathaway.
There’s more advice about valuing companies in these letters than you’ll find in any textbook. The letters are broken down by topic, and re-released in this fascinating and valuable book. If you want to invest like Warren Buffett (which means you want to make money), this book is THE source for insight into his methods.
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Feature Article
While reviewing the third quarter financial statements for the companies in the Dynamic Investors portfolio, I came up with an idea for this week’s newsletter. I have some shortcuts that I use when evaluating financial statements, and I figured I’d share some of them.
This week we’ll look at the income statement, which is the most deceptively simple of the major financial statements. I say simple because it’s just a list of all the revenue, minus all the expenses, to calculate what’s left over in profit. It’s no more difficult than putting your family budget together, right?
That’s where the deceptive part of the description comes in. The items on the income statement are easily manipulated by, say, less-than-honest management, and don’t necessarily represent the true situation at a company. Even totally honest companies can have income statements that don’t represent economic reality. Cash flows define economic reality, revenue and expenses define accounting reality.
You see, the difference between your household budget and a company’s income statement is their relationships to actual cash flows. Your household budget will generally match your cash inflows and outflows. Not so with an income statement. Income statements can vary significantly from the company’s cash flow, meaning that a company in economic trouble can show a very “good” income statement up until the day it goes bankrupt.
Generally speaking, though, the income statement is a good place to start when evaluating a company. In my forthcoming e-book, Fundamentals of Financial Statement Analysis, I lay out the process for evaluating the health of a company through the financial statements. I’m shooting for publication in the beginning of 2004, but in the meantime, here are some tips and strategies for evaluating an income statement.
What’s a common size statement, you ask? It’s the income statement, only with each line item represented as a percentage of sales. This is easy to do with a spreadsheet on your computer, but you can do it on paper just as well. Net Sales is always 100% at the top, and each of the expenses is divided by total sales to arrive at a percentage. For example, if a company has $100 in sales and $50 in cost of goods sold, the common size statement will look like this:
Sales 100%
Cost of Goods Sold 50%
Gross Profit 50%
The importance of the common size statement can’t be overstated. It gives you the calculation of all your profit margins, from gross to net, and shows how much each cost item takes away from your profits.
The next step is to make a year-to-year comparison statement. You can’t evaluate financial statements for just a single year; they have to be compared to previous years. The only formula you need to know for these calculations is:
(current year / previous year) – 1 = % change
Again, a spreadsheet makes this process so much easier, but it can be done by hand. I like to have five years of data, which yields four years of comparison data. This way you aren’t just looking at an exceptionally good or bad year for the analysis. Plus, you can get a reasonable estimate of future growth when you do your discounted cash flow analysis. (I’ll have more on the Discounted Cash Flow in the future.)
If you take the time to read the MD&A, you’ll have an advantage on most investors. A majority of individual investors simply skip this part, and go right to calculating ratios or looking at the EPS. Seasoned investors know that the MD&A provides the backup data for the income statement line items, and they will take time to read it.
A good Management Discussion and Analysis will give you the details you need to understand the items on the income statement. You should get segmented sales data, cost drivers, etc. in this section. If you can’t make sense of the MD&A, that should set off alarm bells in your head. If you don’t find the information you need in the MD&A, you should…
The footnotes tend to be more difficult to understand than the MD&A, but you get really detailed information here. The footnotes are where management hides the dirty laundry. And when you’ve got guys making today’s corporate salaries that laundry pile can get pretty big. Here’s where you’ll likely find what you couldn’t in the MD&A, it’s just that in the notes you may have to do some putting of two and two together.
Take your time sifting through this section, and try to identify the income statement items that relate to the footnotes you’re reading. You can do it the other way around, as well, and look for the footnotes that relate to the income statement item.
If you still can’t figure out what the company is doing, after going through the MD&A and the footnotes, you may want to consider looking at another company. This one may be too complicated (or too devious) for your abilities. Don’t feel bad about not understanding the business, either. Even the great Warren Buffett admits that he doesn’t understand some businesses, and he never lets his ego run away from him. If he can’t understand it, he won’t invest in it. I recommend you do the same thing.
I always like to look at segmented sales and profit figures to determine which product lines, or operating businesses, are growing sales faster than the others. This information is usually in the MD&A. If you can, try to find the operating profit for each business segment as well. Then look at the profit margins for each segment of the business.
You may be surprised at the different profitability levels of each business segment. Compare the segment with the fastest growing sales versus the segment with the highest operating profit. If these are the same segment, that’s good news. If they aren’t, that’s okay too.
You do want to watch out for companies that have the lowest operating profit in their fastest growing segment. This could cause a decline in the company’s overall profitability as sales grow faster than profits. For example, a segment that’s growing 5% a year, but has a 10% margin, will contribute more to total operating profit growth than a segment growing at 20% a year with a 1% margin.
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Commonly called the Asset Turnover, this is a good check to see if the company’s assets are generating a positive return. If the Total Sales divided by Total Assets is less than one, you have a company that’s not generating a dollar of sales for each dollar invested. As a rule of thumb, you like to see asset turnover greater than one, which means that the assets are generating more in sales than they cost. Asset turnover is also one of the three key ingredients to calculate Return on Equity.
Don’t count a company out totally if they don’t have an asset turnover greater than one. Look at the change in this value over the last few years to see if the company has improved. If so, it usually means they’ve found better performing assets, shed underperforming assets, or gotten better productivity out of the assets they have, which are all good situations.
This is a good check for how honest the company is in their income statement. The operating cash flow can be found on the Cash Flow Statement as the total for the Cash Flows from Operations section. Obviously the two numbers won’t be the same due to non-cash expenses, like depreciation, in the income statement. Still, the closer net income plus depreciation is to operating cash flow, the less likely there are hidden items in the income statement.
Also look at the change in each of these items over time. If one seems to be increasing at a greater rate than the other, you should probably find out why, especially if net income is growing faster than operating cash flow.
Here’s where your common size statement is most helpful. You can look down the common size statement and note which cost elements are increasing faster than sales. Increasing costs are bad news, because each percentage increase in cost is a percentage decrease in profit. And at the end of the day, profits are what matter. After all, we’re not Communists here.
When you identify the cost elements that are increasing, look for an explanation in the Management Discussion. There may be a perfectly acceptable reason for the increase. Or there may not.
Sometimes companies have to take special charges to earnings for one-time issues. A company might sell a loser subsidiary and have to take a charge for estimated future losses. Or a company might be going through a restructuring, and decide to expense the costs all at one time. In most cases, these are reasonable, one-time charges.
But some companies make a habit of taking non-recurring charges on a regular basis. Hence my name for them: recurring, non-recurring charges. These are the companies to watch out for; because they might be hiding systemic problems by saying they’re one-time issues.
These tips will help you get started evaluating an income statement. You should always start with common size and year-to-year statements, and try to identify the elements that stand out as abnormal. Then read the detailed information in the MD&A or the footnotes to understand what you’re seeing. And don’t get discouraged if you don’t get it at first, because like any skill, financial analysis takes practice to get right. You’ll do fine if you stick to it.
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Quotes of the Week
“No man ever became great without many and great mistakes.”
-William E. Gladstone
“One of the disadvantages of being in the military is that stupid leaders can get you killed for no good or useful reason.”
The Fab Five
This week’s focus is on small-cap value stocks. I was looking for companies that are under $1 billion in market capitalization, have a P/E ratio under 10, and generated positive free cash flow over the last 12 months. Here’s this week’s list. Remember, these are not recommendations to buy, but simply a starting point for further analysis.
Symbol Name Price (COB 10/31/03)
CSTR Coinstar $14.70
INVN Invision $27.17
DRRA Dura Automotive Systems $ 9.57
NAFC Nash Finch Co $16.02
SGY Stone Energy CP $36.14
Until next week my friends, happy investing.
I am, and continue to be,
Christopher M. Mallon
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