Archive for the ‘Investment Theory’ Category

Book review: When The Bubble Bursts

In Investment Theory on December 1, 2016 at 2:29 pm











Book review: When The Bubble Bursts: Surviving the Canadian Real Estate Crash
By Hilliard MacBeth

Investment advisor Hilliard MacBeth’s book about the coming Canadian housing crash is well researched and engaging. It is the scariest financial book I’ve read.

He starts with the observation that whatever his retail clients are fascinated by usually ends in epic disaster. In the early 80s it was oil and gas stocks; the mid 90s featured Bre-X. Tech stocks (including Nortel) took centre stage in the late 90s. Since the mid 2000s, his clients talk about one thing: real estate. What they say to him: “It keeps going up, it can’t go down, buy now before it’s too late.” Some of his clients own multiple properties which they rent out, often at a negative monthly cash flow in the hopes of future capital gains. Sound familiar?

MacBeth uses research and data to back up his arguments for a coming housing crash:

1. Over long periods of time, real estate tends to keep up with inflation. It doesn’t perform much better than that. Periods of price growth beyond basic inflation matching are unusual and often turn out to be bubbles. Canadian real estate, especially in major cities (Vancouver, Toronto, Montreal), have risen three-fold since 2000 which seems unsustainable; incomes and prices of other goods have not risen in proportion. Canadian house prices in relation to average household incomes have risen to some of the highest in the world, higher even than in the US at its housing bubble peak.

2. The bubble could burst for any number of reasons including higher interest rates or a recession. Interest rates are currently at historical lows. At higher rates, many people wouldn’t be able to afford their mortgage payments. In a recession, people who lose their jobs will be unable to meet their mortgage payments.

3. Structural shift. The large wave of baby boomers downsizing will create a large supply of homes. Boomers won’t want the upkeep, won’t be able to climb stairs, and will want to use those assets for retirement. This supply will be added to large supply that has been added in recent years due to the building boom. Taken together, this supply will overwhelm demand and prices will fall.

MacBeth tears apart commonly held opinions about real estate. These include the ideas that renting is wasting money (it’s cheaper than owning and the savings can be invested in stocks or bonds), that real estate always goes up (not true, look at USA/UK/Ireland/Spain/Japan/etc.), and that the Canadian market is somehow unique and immune from a downturn (sorry, it’s not).

MacBeth points to the government run CMHC mortgage guarantee program as one of the reasons mortgage lending and personal debt levels have gotten to this point. Without this program, banks would be more conservative in their mortgage lending because they would bear the risk of loss. In economics, this is called a moral hazard.

The people that will be most hurt by the crash are retiring baby boomers hoping to cash out and pay for their retirements, new buyers with high loan to value ratios, landlords trying to make money renting out condos, shareholders of Canadian financial institutions, those in the construction industry and last but not least the Canadian taxpayer (who will foot the bill for the CMHC losses and bank bailouts). But those won’t be the only groups affected. As housing is usually by far the largest asset for most households, the consumer, who drives our economy, will be negatively affected in a big way. Rather than continuing to enjoy the wealth effect from rising home values, they will feel poor. In response, they will start saving and spend less resulting in a dramatic effect across the Canadian economy.


Berkshire 2016 AGM Q&A

In Investment Theory, News, Uncategorized on June 8, 2016 at 10:03 pm
Berkshire Hathaway 2016 Annual Meeting

Berkshire Hathaway 2016 Annual Meeting

The annual “Woodstock” of capitalism, Berkshire Hathaway’s annual shareholders meeting was held in Omaha, Nebraska on Saturday April 30, 2016. The meeting was open only to investors in the Company and required meeting credentials to attend. But for the first time ever, Berkshire decided to live stream the event via Yahoo! Finance. You can watch the whole thing from the comfort of your living room right here:

And, as been the case for the last few years, some wonderful soul has painstakingly recorded every word said and made the full transcript available for download. Check that out here:

The highlight of the meeting is a six hour question and answer period with the Chairman and Vice-Chairman, Warren E. Buffett and Charles T. Munger. These are two of the brightest minds in investing. The Q&A session is entirely unscripted and shareholders from around the world who attend the meeting can ask almost anything they want. For six long hours, Warren and Charlie do their best to answer these questions whilst sipping Cherry Coke and munching on See’s peanut brittle.

Some abridged highlights:

Q: “In your 1987 letter to shareholders, you commented on the kind of companies Berkshire liked to buy: those that required only small amounts of capital. You said quote; “Because so little capital is required to run these businesses, they can grow while concurrently making almost all of their earnings available for deployment in new opportunities.” Today the company has changed its strategy. It now invests in companies that need tons of capital expenditures, are over regulated, and earn lower returns on equity capital. Why did this happen?”

A (Warren): “Well, it’s one of the problems of prosperity. The ideal business is one that takes no capital but yet grows. There are a few businesses like that and we own some, but we’d love to find one that we can buy for $10bn/$20bn/$30bn that was not capital-intensive and we may, but it’s harder and that does hurt in terms of compounding earnings growth. Obviously, if you have a business that grows, gives you a lot of money every year, and it isn’t required in its growth, you get a double-barrel effect: from the earnings growth that occurs internally without the use of capital, and then you get the capital it produces to go and buy other businesses.

A (Charlie): “Well, when circumstances changed, we changed our minds. In the early days quite a few times, we bought a business that was soon producing 100 percent per annum on what we paid for it and didn’t require much reinvestment. If we’d been able to continue doing that, we would have loved to do it. But when we couldn’t do it we went to Plan B. Plan B’s working very well…”

Q: “You’ve explicitly stated that you’ve not considered diversity when hiring for leadership roles in board members. Does that need to change?”

A (Charlie): “Years ago, I did some work for the Roman Catholic Archbishop of Los Angeles. And my senior partner pompously said, you know, you don’t need to hire us to do this. There’s plenty of good Catholic tax lawyers. And the Archbishop looked at him, like, he’s an idiot and said, Mr Peeler, he says, ‘last year, I had some very serious surgery and I did not look around for the leading Catholic surgeon’. That’s the way I feel about board members.”

Q: “With the rise of and others, there’s been a shift from push marketing to pull marketing – from millions of catalogues having been sent out in the past, to consumers now searching online for what they are looking for. What is your take on how this shift [affects Berkshire]?  ”

A (Warren): The development is huge – really huge – and it isn’t just Amazon. Amazon is a huge part of it and what they’ve accomplished in a fairly short period of time, and continue to accomplish, is remarkable.

We don’t make any decision involving even the manufacturing of goods, the retailing, or whatever it is without thinking long and hard about what the world will look like in five, ten, or 20 years. With that hugely powerful trend that you just described, we don’t look at that as something where we’re going to try and beat them at their own game. They’re better than we are at that.

The effect of Amazon and others that are playing the same game…the full effect on the industry is far from having been seen. It is a big force, which has already disrupted plenty of people and it will disrupt more.




A Primer On Valuation (Part 2 of 2)

In Investment Theory on October 26, 2009 at 7:35 pm


Books a Million (Nasdaq: BAMM)

Books a Million is a small chain of retail bookstores located in the South Eastern United States. The company operates 200 superstores and 20 traditional stores. BAMM was founded in 1917 and is based in Birmingham, Alabama.

Step 1

In order to determine free cash flow I start with cash flow from operations (from the cash flow statement) and deduct capital expenditures. The average FCF for the 2004-2008 period is $21.2m. I like to use an average from a few years and then adjust it to get a starting figure. My starting figure going forward is $22.8m for 2008.

Step 2

Let’s make some assumptions and then apply our formula.

I will assume a growth rate of only 2%. This is because although the past growth rate is higher, the book industry is very competitive and faces stiff alternatives from and other sources. I will also assume a required rate of return on 15%. Some analysts spend a great deal of time fussing about trying to determine the right rate of return. I believe 15% is more than adequate to compensate the common shareholder.

So let’s apply our growing perpetuity formula:

22.8 (1.02)
(.15 – .02)        = $178.9m

Shares outstanding = 16,302

Per share = 171m / 16,305 = $10.97

Step 3

We have determined that the shares are worth around $10.97

So how much does BAMM sell for?

BAMM stock chart

As we can see the price has fluctuated widely over the years. Many companies have much more unpredictable economic characteristics and would be much harder to value than BAMM. Yet even this simple bookstore chain’s shares have resulted in very low and very high valuations for the business. The shares have fallen as low as $1.38 and risen as high as $29.50.

I picked up my shares on October 17 2008 at for $3 and they rose dramatically in August of this year to north of $13. The large increase was due in part of the release of the latest Harry Potter book which is a boon to booksellers. But more significantly the rise was due to increased confidence in the economy and the perceived prospects for this and other businesses. At the end of July I happily unloaded my shares for $11.56

Some related links

Discounted cash flow valuation from Investopedia

1992 Chairman’s letter

Discounted cash flow analysis

A Primer On Valuation (Part 1 of 2)

In Investment Theory on September 29, 2009 at 3:18 am

A couple of years ago a good friend of mine bought me a subscription to the Rothery Report, a value investing newsletter. The newsletter is published quarterly and contains a model portfolio of value stock picks. It features a list of stocks along with value oriented price ratios such as price to earnings (P/E), price to book value (P/B), price to sales (P/S), price to cash flow (P/C) and dividend yield.

From this report I came across Book A Million (Nasdaq: BAMM) which I purchased in October of last year for $3.00 per share. It looked quite cheap based on its P/E ratio (3 times 2008 earnings) and dividend yield (12%). But was it really cheap?


Ratios are the lazy man’s way of investing. They serve as a great starting point to identify potentially undervalued companies. However, they do not have a strong theoretical footing when it comes to valuation. A retailer that sells for 0.8x sales versus another similar business that sells for 1.8x is not necessarily a better deal. You need to understand a lot more about certain key aspects of the business: the annual free cash flows, relevant growth rate, and capital structure (how much debt versus equity). Ratios also don’t convey by how much a company is over or undervalued.

Discounted free cash flow

So how do you value a business? In my opinion there is only one way that holds water. That method is to discount the free cash flows from the businesses. Free cash flows are the cash that the business generates in excess of all costs and what it needs to reinvest. Theoretically, the business should be able to pay out these funds in the form of dividends.

In fact, this valuation methodology has not changed much from when it was formally put forward by John Burr Williams in 1938. This is the approach that Warren Buffett uses:

In The Theory of Investment Value, written over 50 years ago,John Burr Williams set forth the equation for value, which wecondense here:  “The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”  Note that the formula is the same for stocks as for bonds…

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.

1992 Berkshire Hathaway Chairman’s letter

Clearly any investor worth his salt needs to be able value a business using a discounted cash flow approach. So let’s work through a simple example. Once we have mastered the basic case we can move on to looking at larger and more complicated businesses. Please bear in mind that this is a very simplified example.

An example valuation

The business: a profitable, private, one location coin laundromat business.

Revenue – $100,000
Costs – staff, rent, electricity, taxes – $80,000
Net income $20,000

We will assume that in this business there are no accounts receivable, accounts payable, inventory or other working capital items. Some more assumptions:

  • Depreciation (included in earnings) – $2800
  • Capital expenditures (capex) – $2000
  • Growth rate – 2% (to match inflation)
  • Required rate of return – 15%

Step 1

The first step in our example is to determine the annual free cash flow:

Net income                   $20,000
Plus: depreciation        $2,800
Less: capex                    ($2000)
Total                                $20,800

Step 2

The next step is to take the $20,800 of net annual cash flow and determine how much it is worth as an ongoing income stream. We will use the growing perpetuity formula to do this. This formula takes the annual cash flow and says that it will grow by a fixed percentage amount every year. Then it discounts the future values for each year back to today using the required rate of return. We are assuming a growth rate of 2% and a required rate of return of 15%.

Here is our formula

Value =

FCF (1+g)
r – g

Where “FCF” is the free cash flow in the base year, “g” is the growth rate and “r” is the required rate of return.

$20,800 (1 + .02)
(.15 – .02)

= $163,200

Step 3

Let’s review the results. So our business that generates $20,800 of free cash flow will be worth $163,200.

This could be realistic for a public company but unlikely for the coin laundromat in our example. A small private business requires owner involvement that could result in a higher required rate of return. Also this investment in not easily tradeable in pieces like common stock so requires a higher return. Plus there are no barriers to entry (easy for new competitors to open up next door) so it might not be realistic to expect that the cash flow will growth at the rate of inflation forever.

So let’s move onto a real public company and use the skills we just learned. Again we will keep our analysis simple.

To be continued…

ROE: Investing’s Magic Formula | “The secret to life, the universe and everything” – Douglas Adams

In Investment Theory on July 13, 2009 at 2:34 am

Ok, so maybe return on equity (ROE) isn’t the secret to life, the universe and everything. But in my opinion it is the single most important metric in investing. And it should be more widely discussed by investors, business owners and managers than it is.

A definition

Return on equity (ROE) is a simple formula. It is net income for a year divided by the average shareholders equity for that year (opening + closing / 2).

Net income represents profit after paying all expenses including income taxes. Shareholder equity represents the equity capital invested in the business plus all earnings on that capital since the business started which have not been paid out to shareholders in the form of dividends. ROE can be known by other names such as increase in book value or return on net assets. These terms refer to the same metric.

ROE tells us how much profit the business earned in relation to how much shareholder funds were required to earn that profit. According to The Motley Fool:

“By taking a year’s worth of earnings and comparing it to the amount of shareholder equity on the balance sheet, you get a measurement of how much was returned for every dollar of equity the business has created.”

Why it matters

A company with a high ROE is obviously attractive as it is able to generate more profit for a given level of equity investment. Higher ROE means more money is generated by the business that can be paid out as a dividend or reinvested to expand operations. Also, such businesses may have the ability to grow at faster rates than other businesses due to the reinvestment of retained earnings at high rates of return. (Think of a high ROE is like a super high interest rate bank account.)

ROE is also a great yardstick to use across different types of businesses so that we can compare one business or industry to another. Certainly not all businesses are created equal. Some businesses such as branded consumer products companies earn very high returns on shareholder funds. Other businesses such as airlines and automakers generally earn poor returns on shareholder funds. ROE is the great arbiter that tells the difference between a mediocre business, an average one and a great one.


A mediocre business

For Toys R Us during the period from 1995 to 2005, ROE averaged around 7%. This mediocre performance was the case despite revenue and earnings increases, market leadership in the toy industry, and a strong brand. At the end of the day, there is a lot of competition in the toy business from Wal-Mart and other retailers. Toys R Us doesn’t do something that others cannot. Thus it is unable to earn high returns on invested capital.

An average business

Similar to the mediocre business, some businesses provide a better value add but not enough to allow them to sustain an unusually high ROE. In some cases, too, their business model is capital intensive and has costs that scale with the level of revenue. Take the case of Hilton Hotels, which operates hotel chains in the medium and higher ends of the hotel business. The company is very large and not a niche player. The hotel business is very competitive and there are many participants. In order to compete, a hotel must provide a certain quality of service at a competitive price. In order to grow, more rooms must be added requiring additional capital investment. It would be unlikely that any large operator, Hilton included, would be able to command average room rate or occupancy levels above industry averages. During the period of 2000-2006, Hilton Hotels earned an ROE around 13%.

A superior business

Coca-Cola is a superior business because it is not constrained by pricing or capital investment in the same manner as most businesses. This does not mean that the company can set prices at any level it wants or that it doesn’t need to make investments in its business. But it does mean that prices do not have the same proximity to cost as in an average business. Coca-Cola, like other branded consumer products companies, has created a unique product for which customers are willing to pay a premium. A competitor may offer me a can of store brand cola for 25 cents but I would rather pay a dollar for a can of Coke. As well, many of the costs in the supply chain such as bottling, storage and product retail are not borne by The Coca-Cola Company but by bottlers and retailers. During the period from 1998 – 2008, The Coca Cola Company earned a whopping 31% ROE.

Setting a bar

So what is a good number? According to Henry Blodget, a well known securities analyst and blogger, the average ROE for companies in the S&P 500 has historically been 10-12%. In the last 15 years ROE rates have been higher and abnormally so due largely to the extended economic boom and the increased use of leverage.

Jensen Investment Management, a value oriented investment manager, comments on the importance of consistently high return on equity in their investment screening process:

“We require that each business considered have a history of at least 15% return on equity (ROE) in each of the last 10 years. This single requirement narrows the universe of publicly traded U.S. companies from 10,000 to approximately 125.”

The characteristics cited by Jenson for companies with a high ROE:

  1. Sustainable competitive advantages, or “economic moats” that surround the business.
  2. High ROE produces returns that are typically in excess of the firm’s cost of capital.
  3. High and consistent ROE companies typically create more cash than is required to fund their organic growth.
  4. Companies with consistently high ROE generally have the ability to grow at faster rates than other businesses.

Warren Buffett’s thoughts

“The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.  In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.”
Berkshire Hathaway letter to shareholders 1979


Use return on equity (ROE) to separate the wheat from the chaff! Use ROE as a starting point to identify great businesses. Follow up by doing individual company analysis and valuation.

In a future blog post:  ROE part 2

Breaking ROE into its components: profit margin, asset turnover and leverage.

Dealing with adjustments: goodwill (return on tangible net assets), accounting impairments, and non-operating assets