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Gregory Speicher is an Ohio-based investor. His career has primarily been in technology start-ups and small growth companies, including an Inc. 500 Company which he cofounded. He received his bachelor's degree in philosophy Magna Cum Laude from the University of St. Thomas in Rome, Italy, and... More
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  • The Mark of a Good Business: High Returns on Capital (Part 3)
    Joel Greenblatt’s Magic Formula looks for good companies that are available at a cheap price. To determine if a business is cheap, Greenblatt looks at the company’s earnings yield, which he calculates by dividing a company’s earnings before interest and taxes (EBIT) by the company’s enterprise value.


    To determine if a prospective investment is a good business, Greenblatt looks at the company’s return on invested capital, which is very similar to the general approach taken by Buffett. However, the way Greenblatt calculates return on capital is different from Buffett. Greenblatt uses the ratio of EBIT to tangible capital employed.

    Greenblatt uses EBIT instead of GAAP earnings so businesses with different tax rates and capital structures can be more easily and rationally compared. When calculating EBIT for the purpose of screening for Magic Formula stocks, Greenblatt makes the assumption that depreciation and amortization are equal to capital expenditures. This is done to simplify the calculations.

    However, if you’re doing a more thorough analysis and not doing formula investing, it’s more accurate in lieu of EBIT to use the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) less maintenance capital expenditures. This approach gives a more accurate view of a business’s free cash flow and, by subtracting only maintenance capex, you can get a better look at the core business without taking into account capital that is being reinvested in the business for growth.

    When looking at the Magic Formula, it is important to keep in mind that it is attempting to normalize different businesses so they can be compared on a level playing field. That way you can more clearly see which ones have superior economics, without the distortions that can come from the level of reinvestment in the business and the capital structure of the business.

    Now let’s consider the denominator in Greenblatt’s equation for return on capital. As we saw in part 2 of this series, Buffett uses average equity employed by a business less goodwill and intangible assets as a proxy for the amount of capital the business is using. Goodwill and intangible assets are eliminated from the equation because, unless a business is going to grow in the future through acquisitions, the business will not need to pay a premium to reinvest earnings in order to grow organically.

    Greenblatt goes farther than Buffett and only includes net working capital – current assets minus current liabilities – plus net fixed assets, which is called tangible capital employed. Greenblatt’s rational for using net working capital is that current liabilities functions as a kind of interest-free loan that reduces dollar for dollar the amount of capital needed to fund current assets. In addition to net working capital, he adds fixed assets because these are the long-term assets directly involved operationally in the generation of earnings and this is the area that will require additional capital to grow the business. It makes sense to see how productively these assets have been utilized on an historical basis.

    I believe he leaves other long-term assets out of the equation not because they aren’t important in analyzing a business, but in order to again facilitate the comparison of different businesses so as to find those that are using their capital most productively.

    For purposes of screening for Magic Formula stocks, based on the data provided by Greenblatt, this approach appears to successfully select cheap, good companies whose stocks outperform. Those doing active, focused investing will want to use this screen as a starting point for their own in-depth research.

    All the tools we have looked at in this series are useful and should be part of your analytical toolkit. As I have stated before, no metric or ratio is a substitute for deeply understanding a business which only comes with thorough analysis and, typically, a good deal of work.

    Nov 02 8:12 AM | Link | Comment!
  • My Watchlist – October 25, 2010

    I have reviewed issue 9 of Value Line and added companies that have exceptional returns on equity. I am moving the posting of this list to Monday in order to make it more timely. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

    The idea here is to have a dashboard of substantially all the larger-cap high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

    Here is the updated watchlist.

    Stocks Added This Week

    Caterpillar Inc. (CAT)

    Donaldson Company, Inc. (DCI)

    Graco Inc. (GGG)

    The Middleby Corporation (MIDD)

    Stanley Black & Decker, Inc. (SWK)

    The Toro Company (TTC)

    AMETEK, Inc. (AME)

    Danaher Corporation (DHR)

    Honeywell International Inc. (HON)

    ITT Corporation (ITT)

    3M Company (MMM)

    United Technologies Corporation (UTX)

    POSCO (ADR) (PKX)

    Goldman Sachs Group, Inc. (GS)

    TD Ameritrade Holding Corp. (AMTD)

    Check Point Software Technologies Ltd. (CHKP)

    Matthews International Corporation (MATW)

    A few thoughts…

    Many stocks are close to new highs and are well above their lows. Some caution is in order.

    The key to getting the most out of the list is to review it on a regular basis. In time, some obvious opportunities will emerge.

    The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

    Tags: CAT, DCI, GGG, MIDD, SWK, TTC, AME, DHR, HON, ITT, MMM, UTX, PKX, GS, AMTD, CHKP, MATW
    Oct 25 10:11 AM | Link | Comment!
  • Francis Chou: Canadian Superinvestor
    In the past, I have mentioned the great Canadian value investor Francis Chou. Chou has been part of Prem Watsa’s investment team at Fairfax Financial for over twenty-five years. He also runs the Chou Funds where in 2005 he was named the Canadian fund manager of the decade.

    I came across an article on Chou in Canadian Business Online that contains some good information on Chou.

    Chou invests using three different tactics:

    First, he keeps his eyes peeled for what he calls “special situations” — companies facing short-term problems that result in temporary mispricings under unusual circumstances.

    Second, he likes to buy shares in what he jokingly refers to as CRAP (Cannot Realize A Profit) companies. Chou says the market is prone to overreacting when stocks are heading for the toilet, so failing companies are often irrationally valued for less than they would be worth if they liquidated their assets. He buys baskets of such companies, knowing that he may lose money on three out of 10, but more than make up for those losses with profits on the other seven.

    His final tactic is more akin to the way that Warren Buffett invests and it’s increasingly Chou’s favorite. It entails spending countless hours searching for well-run companies with growth potential that, for some reason, are trading for much less than they’re worth. Because the market is so efficient, such companies are extremely rare and often only found among those with short-term problems, but they offer excellent long-term prospects if they’re blessed with strong management. Chou is lucky to find one or two during a whole year of searching. But once he’s found one, Chou doesn’t hesitate to bet 5% or more of his portfolio on that single stock. “When you know you’re buying a good company, it’s like getting a straight flush,” he says. “They’re hard to find, so when you’ve got one, you have to capitalize on it.”

    Here are some additional observations from the article:

    1. Chou thinks most investors make the mistake of buying a stock because its price is going up instead of buying stocks when they are on sale – the way people like yo buy their groceries or other merchandise.

    2. Chou wants his investments to be made with a margin of safety. He typically wants to buy a stock when its is selling for a 40% to 50% discount from his estimate of intrinsic value.

    3. Chou is not averse to making a concentrated bet when he has conviction and a large margin of safety. At one point he had 16% of his fund in Sears Holdings. Chou estimated that the company’s real estate holdings were worth $40 to $50 per share and Chou was able to buy it at $25 per share.

    4. Chou does not attribute his investing success to having a high IQ. “George Athanassakos, professor of finance and the Ben Graham Chair in Value Investing at the Richard Ivey School of Business in London, Ont., thinks that Chou might be right: perhaps he’s not outperforming because of superior intelligence, better connections or charisma. Maybe it’s because Chou’s natural disposition just happens to be a perfect match to the investing style he’s chosen.”

    According to Buffett, “Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

    For many, this may be the X-factor that is the key to outsized returns.

    More on Chou:

    Semi-Annual Report 2010

    Class Act of the Year

    Follow the Leader

    Oct 20 9:32 AM | Link | Comment!
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