A Little Catch Up, and a Book Review

Hi everyone,

Sorry for the month and a half break, but now I’m back and excited for some new investment ideas. This year has been very exciting so far (AIG has been very kind to me), and I’m looking forward to the second half of the year and some more stock picks. I think you’ll find them very interesting!

But to re-start things, I thought I’d tell you all about a great experience I had a few weeks ago.

I had a very hectic two months, but the grand finale made it all worth it. A few weeks ago I went to Omaha to see the Berkshire Hathaway annual shareholders meeting. For most of my readers, that probably sounds slightly less interesting than a trip to the podiatrist, but for me, I was more excited than when I got my last job offer. This was an opportunity to see two of the greatest investors of our era speak live and answer questions both from financial professionals, and from average shareholders. My father met me at the airport in Omaha, and we went straight to the meeting to see Warren Buffett and Charlie Munger get grilled by an audience of thousands of people. It was remarkably entertaining.

The fun didn’t stop there, however. On my way home, my father and I were in the airport bookstore, and I felt compelled to pick up some of the literature that was available about Warren Buffett, value investing, and the subsidiary companies of Berkshire Hathaway. The books have been excellent so far, and I’d like to share a little bit about what I’ve learned with you. First up, How to Build a Business Warren Buffett Would Buy: The R C Willey Story. I recommend this book to anyone who has an interest in Buffett or in business. It provides some interesting insight into how to build the foundation for a solid business that provides real value to its owners for the long haul.

The book is the story of the RC Willey company-a furniture and appliance retailer on the west coast. From its humble beginning as a one-man operation in a garage just outside of Salt Lake City, to a company that Warren Buffett felt was a bargain at $175 million in the 90s when Berkshire bought it, the book follows Mr. Willey himself, and his successor as the head of the company, a man named Bill Child. Child took a company that was in debt and behind on its taxes, and saved it from total collapse.

This is not really a “business book” – it is a story, and a good one at that. That’s not to say there are no business lessons in the story (we’ll get to those later), but unlike management textbooks, or books like Common Stocks and Uncommon Profits, (a great book for sure), the book isn’t a list of dos and don’ts. The book does not explicitly lay down the structure of a good business, or draw a map on how to construct a solid business model the way a cookbook tells you how to make a meatloaf. Instead, the book chronicles the episodes of RC Willey and how Mr. Child managed the various events, crises, and periods of growth that the company went through over the decades he was at its helm. Within these episodes, several lessons emerge – avoid toxic debt, take care of your employees both financially and emotionally, delegate well, the list goes on.

The story aspect of the book makes it a compelling and easy read. Rather than simply focus on the business as an engine for profit and cash flow, the book focused on the people in the business. We learn about Mr. Child’s first marriage and how the death of his first wife effected him as a business leader, and as a father. We see how the company had to deal with its head of sales (Sheldon Child, Bill’s younger brother) being called away from business by his church and how the company transitioned from the leaders who created its incredible growth. There are lots of little stories, and they are all inspirational and educational.

The fact that the lessons of the book are served in the context of a story makes them far more interesting and far more memorable. The company’s early struggles with debt and back taxes are a powerful lesson about how toxic borrowing can be. When Mr. Child hired his first secretary and found that he was able to devote more time to the things he did well, and needed to do to run the business, he learned a powerful lesson about management and human leverage, and the reader picks it up vicariously through the pages. Some of the best lessons involve the company’s promises to its customers and its employees. In one case, the company that R C Willey used for its warranties went under and thus could not fulfill the agreements to replace or repair goods. R C Willey, rather than just abdicate responsibility, decided to stand behind every warranty that they had sold, even though that was not their original agreement. The result may have cost the company a lot of money, but every customer who heard about that decision became a regular repeat customer. I could tell you more, but I’d hate to spoil the surprise.

In my humble opinion, the best part of the story never made it into the book. It’s the story of how I found the book. I was in the airport with my Dad, waiting for his flight to Boston and my flight to Chicago, when we passed the bookstore and my Dad noticed a book entitled “Moats.” He pointed to it and asked if I could explain what a moat in business was, since he had heard the term several times from Buffett and Munger at the meeting the day before. Fortunately, a store employee heard the question. “Why don’t you come in and ask the author? He’s here and signing copies!”

We both went in and found that there were no fewer than four different authors there. All had come for the annual meeting, and we selling signed copies of their books. Naturally, I was thrilled. I met all of them, got all of their cards, and bought all of their books (expect reviews of each one in the following few weeks). Then, Bill Child himself walked in. This man was a CEO of a Berkshire Hathaway subsidiary for years, and the man responsible for building the largest furniture and appliance retailer on the west coast, and he was 15 feet away from me. I introduced myself and found out that his book was for sale too! I got a signed copy and started reading it as soon as I left I had finished before the end of the week. It was certainly educational, and very accessible.

Come back next week for my next stock analysis. Spoiler alert – it’s about spoiled stuff. Then we’ll be right back on track. I plan to write several book reviews, and I will make good on my promise to write about my investment process and inspirations.

- The Filosopher in Phinance

The Oracle Has Spoken, and the Filosopher Has Heard!

Friday marked one of my favorite days of the year! What was the occasion you ask? It wasn’t a holiday, a birthday, or even a day off from work. No, Friday was the day that Berkshire Hathaway’s annual report was published, including Warren Buffett’s letter to shareholders. For the investing geeks of the world, it was a second Christmas. Every year the Oracle of Omaha starts his annual report with a letter which goes over the events of the past twelve months in plain, simple English. It’s laced with great investment advice and perspective, and all the folksy charm that 80 years of Midwestern living can bring. This has become required reading for anyone who takes the stock market seriously, and it is easy to see why; over any given five year period, Mr. Buffett’s company has never underperformed the S&P 500 index (see page 103 of the annual report – link above).

What makes Mr. Buffett’s letter so important and enlightening is not just his talent and track record. Those do help, but there’s a lot more to it than that. I don’t simply love these letters because Warren Buffett has been such a success. There are a lot of very successful investors out there who regularly write to investors. No, what makes Warren Buffett’s letters so important is the way he writes them. His attention is always on his investors, whom he calls partners. He always points out his own mistakes, and takes time to praise his managers. As a result, the letter is not just educational, it also serves as a model – this is how good managers regard the stockholders: as their employers and as the company’s owners.

In this year’s letter, Mr. Buffett stuck to his standard themes, and gave a quick snapshot of how the company has been doing. Candidly, I think he sold himself a bit short. He expressed a great deal of frustration in that he was unable to land a major acquisition in 2012 despite numerous efforts. His luck may have turned around with the recent purchase of the H. J. Heinz company, and reportedly he isn’t done hunting for elephants. He did mention that he was unable to grow the book value of Berkshire Hathaway at a faster rate than the S&P 500, and thus he considers the company’s performance sub-par. Still, he expressed optimism for the future, and pointed out that the two men he has selected to manage Berkshire’s portfolio once he retires (Todd Combs, and Ted Weschler) both crushed the general market, and even left Mr. Buffett himself in the dust (that last bit was printed in slightly smaller font than the rest of the letter).

Buffett also reminded his partner-investors that owning a stock, any stock, is not about a sheet of paper, or a blip on TD Ameritrade’s webpage. When you own a stock you own something real and tangible. You own a share of a company, and that carries several important implications. When the company profits, you own a share of that profit. Whatever assets the company owns or controls – those are yours. No matter what the market may say about their price, you have something tangible that has a real value, and you should not part with it for less than that value. The market price of stocks (including Berkshire) moves up and down at a dizzying pace, but that doesn’t change the real, long-term value of what those stocks represent.

Buffett did make one economic prediction – he pointed out that if the US economy tanks, and everything truly goes to Hell, Berkshire Hathaway will be in trouble. Berkshire buys companies that generate cash flow, and if cash completely stops flowing in America, all of Berkshire’s investments will degrade quickly. However, he also made a prediction – that the American economy will not stop working. There may be recessions and depressions in the future (in fact, you can bet there will be), but the capitalist engine of America will keep moving forward. Buffett is fond of pointing out that over the last century, we endured the Great Depression, several recessions, and multiple market crashes and corrections. Through it all though, America has grown at fantastic rate. He sees no reason to believe that in the future, things will be any different.

The basic philosophy and plan behind investing has remained the same for almost 50 years at Berkshire, and that comes through in the letter. As an investor, reading it is a great way to take a step back from all the adrenaline-inducing headlines on marketwatch.com (generally a great resource) and reflect on what really is important in an investment. Every day there are headlines about big moves being made by various companies and hedge-fund managers, what Ben Bernanke is going to do next year, how the weather and the price of corn will effect GE’s manufacturing. All of it is very exciting, and (for some people) entertaining. None of it changes the fundamental thesis of a good investor: if you pay less than something is worth, you will be satisfied with the results, no matter what color tie the President of the United States is wearing.

An important thing to note with Warren Buffett’s letter is how humble he stays. Without question, Buffett is one of the smartest guys walking around today. His perspective on success in business makes him an excellent manager and stock picker. He isn’t afraid of what the market says about his decisions – he has enough confidence in his own judgment to wait out the swings in market value that are bound to happen with his stocks. Despite his brilliance and his record, he does not talk down to his investors. He speaks clearly and plainly about everything that is going on at Berkshire Hathaway. This is true throughout the entire annual report, but is especially easy to see in his letters. He makes a real effort to show his investors clearly what is going on at their company. He also speaks about investors as the company’s owners. This may not sound like a big deal – by definition the investors do own the company. However, because investors in a public company are not present every day, the way the owners of most small businesses are, management often forgets that they are supposed to serve investors, not the other way around. Any time a company’s management forgets that they are employed by stockholders, that spells doom for the investors (see: Enron). While Buffett and his partner Charlie Munger do have control of Berkshire Hathaway’s stock, they still treat the shareholders like his employers.

This is most evident with the list of mistakes that Buffett goes over. The very first thing he does in his letter is own up to anything that went wrong. As I said earlier, this year he mentioned two major disappointments. First – the company’s book value did not increase at a pace to keep up with the S&P 500. Then he goes on to own that “failure” (Berkshire did add $24 Billion to its book value, so failure is a strong word). He completely accepts responsibility for trailing the market in general. In his eyes, his job is to add intrinsic value to the company at a rate that beats the market, and this year he didn’t pull that off.  Second – he accepts responsibility for failing to make a major acquisition in 2012 (Heinz was purchased this year, not last year). Both he and Charlie have been trying to make large purchases in order to make effective use of Berkshire’s huge cash reserves. 2012 was a frustrating year for them.

I appreciate Mr. Buffett’s candor in acknowledging the goals that he missed. However, looking at his entire performance he has succeeded as a manager. He still runs an excellent business and has refused to give up on his value investment principles. In the long run, I think that Buffett will continue to produce excellent returns. What I like about his admission to these shortcomings is how honest and humble they are. He does not shift blame to his employees, market conditions, or managers at companies he tried to buy out unsuccessfully. The buck stops at his desk, and he makes no effort to shirk that responsibility. I can deal with a down year or two (especially if a down year involves a 30%+ increase in the stock’s market value), if I believe in the integrity of the company’s management. Buffett oozes integrity. I guess I’ll just have to settle with a 30% gain… oh well…

I strongly encourage all of you to take a look at this year’s letter by clicking here. It’s only 6 pages (the rest of the annual report follows) and should be required reading for anyone with even a distant interest in the stock market. If you have time, take a look at the first 24 pages – Mr. Buffett uses this space to explain the basic principles of how he runs his businesses, and includes some details about his various operations (such as definitions of a float and an underwriting profit in insurance). I frequently use his old letters to investors as a reminder of the attitude good management should have when communicating with shareholders. Too much of a focus on the market value of the stock – bad sign. Claiming that economic conditions are responsible for the lack of progress in business – bad sign. Using too much fancy, meaningless jargon to confuse investors – bad sign. Denying any mistakes were made – definitely a bad sign. Treating investors like normal people, and having enough integrity to own up to whatever went wrong – that’s what I look for.

Come back again next week to see another stock analysis. Then, in two weeks, I’m going to begin a four-part series of articles. Some of my friends have pointed out that while I mention some basic investment principles when writing, I haven’t taken any time to actually define my own investment style or identify how I developed my valuation principles. Those are probably things I should make explicit, so here’s the plan; first – an article giving the basic outline of how I look at stock valuation, and who inspired that view. Spoiler alert: their names are Benjamin Graham, Warren Buffett, and Peter Lynch. The next three parts will all be introductions to each of those men, and how they looked at buying stocks. Don’t worry, I’ll keep doing my analyses every other week!

Keep those suggestions coming. It helps me procrastinate actually coming up with my own ideas.

- The Filosopher in Phinance

Apple, inc.

Personal Computers and Mobile Communication Devices

NASDAQ symbol AAPL

Before we begin

Hello loyal readers (all five of you). Thanks for coming back again. I wanted to take a moment to share my plans for the next week or two. I received some great feedback from all of you. As you all know, I make no money doing this, so my time is limited by my job and other commitments. Because of this, some of these changes may take a little while. Please be patient and know that I am working on them as fast as I can.

1) I will be updating the page which shows what is on by buy and sell lists, which is currently titled “Picks and Puts.”

2) I’ve had many requests to add some visuals like graphs to illustrate total returns to this page. My hope is to add an interactive, real-time return visual. Unfortunately I’m not the most tech-savvy guy in the world. I’m teaching myself some tricks, and if I can figure out how to do it, I will. Until then, I hope text is enough here.

3) I’ve heard several requests for a glossary of finance and stock market terms. I love the idea, and I’m writing one right now. I promise to put it up soon and add to it frequently.

4) Many of you have asked for more lighthearted links and visuals, particularly the funny youtube clips I used to add to every article. Finding clips and fun links like those adds a certain amount of time to the writing process that I don’t always have. I loved doing it, I think pictures and video make the blog more interesting and help to break up the text. I will do my best. If you have any clips or comics that you think would be good to add, email them to me! I love requests! filosopherinphinance@gmail.com

5) Several people have given me suggestions for companies and articles I should look into. All of them have been really interesting, and would/will undoubtably make the blog better. The problem is a lot of them are given to me over lunch, or while I’m in my carpool to and from work. As a result, I forget many of them. Keep the suggestions for articles and companies coming, but if you can email them to me, or write them down and hand them to me, I’d appreciate it.

Speaking of requests, let’s get down to business (ha-ha! pun!) and look at a company my dad requested I analyze: Apple, inc.

The Short Version

Increased competition and the loss of Steve Jobs have concerned some investors, but Apple, inc. continues to sit at the head of its field. Its focus on user experience and its excellent branding are invaluable assets and its products are extremely accessible. With a rock solid balance sheet and over $100 billion in cash and liquid assets, the company seems like a safe investment, and could be fairly valued at $600. Until Apple hits $500 per share, it is worth buying.

The Long Version

Over the last few years, its been impossible to look at investing news without seeing or hearing Apple mentioned at least twice a week. The company’s stock had a meteoric rise since 2007, and just a few months ago it earned the title of most highly valued company in history. However, this year Apple has broken its fair share of hearts. Apple headlines shifted from “Apple will hit $1000!” to “Apple will go to $200!” Mr. Market’s wild mood swings seem to have kicked in at last for the late Steve Jobs’ baby. Since hitting its top at $780, the stock cratered to $440, where it has been hovering for a few weeks now. However, when a value investor (like me) sees an American icon drop and shareholders going nuts, it starts to look like a potential opportunity. Then Dad asked me if I could look into AAPL stock, and that sealed it – my next project was the world’s largest computer company. I powered up my old MacBook, plugged in my iPod, and got started.

Qualitative

Looking at Apple as a company, it is obvious that it is well organized and second to none in marketing and branding. Even after the passing of Steve Jobs, the greatest nerd communicator of all time, the company has remained the coolest brand on the market. The apple logo is universally recognized, and the company has fierce brand loyalty among many of its users. Looking around the coffee shop I am writing in, there are seven people with laptop computers here, and all of them are Apple products. While Tim Cook (Apple’s current CEO) may not have his predecessor’s charisma on stage, his marketing department still makes Apple look like the best brand on the market. Anyone who pays attention to consumer sales, or watches the show Shark Tank (fantastic program by the way) knows how invaluable a good brand is. Even Warren Buffett keeps a close eye on his company’s brand, though he refers to it as reputation. This helps Apple’s case as a potential investment.

Aside from just branding, Apple also has the advantage of having its own retail outlets. Unlike Microsoft, Google, and Samsung, who all rely on other companies to sell their material to consumers, Apple has built its own retail chain. Granted, retail is usually a tough, competitive field with low margins (which is why most tech companies have avoided it), but Apple’s retail gets all of its products into the hands of consumers. More importantly, Apple uses its retail outlets to help educate and serve its customers. If you have a problem with your iPad, you don’t have to wait on hold for customer service for an hour, you can simply carry it into the store and talk to a live person. If you don’t know how to use a program or an app, just go ask one of the geniuses, and they’ll be happy to explain it to you. If you have trouble with your google android phone, you have to search the whole internet for help, and it can be hard to weed through all of the information available to find what you need. That’s not a problem with Apple. Google and Microsoft are starting to look into developing their own retail chains, but even if they decide to follow through, Apple has a huge head start. Another qualitative point for Apple.

Not everything is rosy for Apple though. There are two major qualitative concerns with the company right now; the loss of Steve Jobs, and the looming shadow of competitors.

There is no question that Steve Jobs made Apple what it is today. His genius and vision defined the way we look at technology. Since he died, a lot of people (on and off Wall Street) have started to question whether the company lost its secret sauce. The last time Steve Jobs left Apple, the company started to struggle, and eventually lost out to Windows based machines. This time, Jobs can’t come back to save the company. The company has not introduced any products that weren’t inspired by Jobs, and is now facing competition from similar looking products made by Microsoft, Samsung, Amazon.com, and others. No one seems to have developed any game changing technology that will drive Apple’s product line into the ground, but without Steve Jobs, Apple’s rocket-powered growth is unlikely to return, and that worries some investors. However, Apple is still investing in R&D, and has great products and amazing brand loyalty, all of which will at least buy some time and keep the company competitive for the foreseeable future. It is also worth noting that Apple still has Philip Schiller (a fellow BC Eagle), who has been Apple’s senior vice president of Worldwide Marketing since 1997. Even without Steve Jobs presenting new Apple products in a black turtleneck, the company still has the same marketing mind that has built the Apple brand over the last ten years.

The second, and more troublesome concern I have with Apple is not internal, but external. Apple reinvented the way we listen to music, redefined the way we look at and use laptops and desktops, made the standard smartphone by which all other phones are now judged, and (for all intents and purposes) invented the tablet market. All of this has made Apple dominant in the tech field, and until recently, they were the only player in most of these industries. That is quickly changing. Google’s Android platform has taken the smartphone market by storm. Microsoft has started manufacturing its own tablets (the first hardware line developed by Microsoft). The increased competition was bound to happen – the amount of money Apple was (and is) making naturally attracted attention from other players in the tech field. This will make future growth for Apple difficult. Especially considering the resources that these companies have at their disposal. Both Microsoft and Google have considerable amounts of cash, and armies of bright, hardworking tech nerds working on making the best products possible. Apple is going to have to keep playing its A game if it wants to compete in the future, and will have to find a way to differentiate itself from competitors. For the last few years, Apple was the only real name in the smartphone market, the tablet market, and was the only computer brand that was considered reliable. None of those things are true anymore, so Apple has to find a new way to stay unique.

A third qualitative concern is the way Apple allocates its assets. Currently, Apple lists over $100 billion in liquid assets on its balance sheet, including a substantial amount of money in various investment securities. This worries me, especially nearly 12 billion in mortgage and asset backed securities, 5.5 billion in non-U.S government securities, and 46.26 billion in corporate securities. Not that these are silly things to do with spare cash – I might have bought some of these myself – but if the company isn’t using this cash, shouldn’t it go to investors? The investors own the company, and therefor own the money that the company has. If the company can’t find a good use for its cash, why not let the investors have it as a return on their investment? However, Tim Cook has started to fix this problem by declaring a quarterly dividend of $2.65 per share, and authorizing a $10 billion share buyback to help increase share value and return cash to investors.

One more important quantitative note: the company continues to take risks, even without Steve Jobs at the helm. Some of these risks have been unsuccessful (the Apple Maps fiasco comes to mind), but still the company shows that it is actively looking for new opportunities. Most recently, rumors have started to circulate about iPhones being sold in China to 1.2 billion potential consumers. This is all excellent news. Yes, Apple Maps was a failure, but at least Apple is still trying to innovate and improve. Some of those innovations will be flops, but those are part of the cost of doing business. If the company keeps taking risks in trying to develop new markets and products, some of those risks will pay off big time. In baseball, it is impossible to hit a home run if you don’t take a swing. You might miss a few, but at least you have a chance to hit a home run. If you don’t swing, you’ll strike out anyway. Quantitative points for effort at Apple.

I almost decided to give Apple the qualitative thumbs down. Not because anything was a deal breaker, but because I see a lot of competition looming on the horizon, and beyond good branding and marketing, I couldn’t see how Apple would hold other players at bay. Sure the company makes good products, but in the tech market now, making good products is the bare minimum. However, my opinion changed after a brief conversation with my friend Alex. Alex is one of those very tech-forward people who actually understands what a processor does and whatnot. I asked him what he thought of Apple products as compared to others in the marketplace. His response was very interesting, and important.

Alex told me that the way Apple designs its products is different from the way other companies do. Apple focuses on user experience instead of device power. Most companies in the tech market, especially in the mobile market, will simply try to cram as many specs onto a device and sell it that way – the fastest processor, the biggest memory, etc. Apple, however, is more concerned with how end users interact with their products. Apple products are designed to be easy to use and accessible to anyone who picks them up. Want to sync your iPad to you computer? Just plug it in! Your iPod? Also one simple step. Got 4 devices with calendars on them? No sweat, we’ll wirelessly link them all up for you. So Apple might not have the most powerful machines on the market, but in real terms, they are just as good (the extra half second it takes to load Angry Birds will not cost the company any customers), and much simpler. Sure, the really high-tech users who need to digitally remaster videos and work real computer magic might go for the Lenovo yoga tablet, but the average med school student, lawyer, salesman, etc. will reach for an iPad because it is simpler and sleeker than the competition. Apple has figured out that the medical students and cupcake artists of the world don’t need the fastest gadget, they need the easiest gadget, and the company uses this knowledge to separate itself from the competition. That’s why Apple puts so much focus on its retail outlets: they help make Apple products easy to understand and use. Suddenly the concerns I have about Apple’s increased competition didn’t bother me as much – Apple looks a lot safer in the future. Sure, there will be competition, but Apple looks ready to fight.

With this new information in mind, Apple looks like a qualitatively good company. It has great branding, great products to back the brand up, and an excellent ability to attract new customers by being the best experience on the market. Apple gets the qualitative thumbs up. Now all that’s left is to look at the numbers. How hard can that be? The company only has $178 billion in assets….

Quantitative

Looking at Apple’s numbers, it is easy to see why Wall Street was in love with this company for half a decade. The company has gone from earning less than $6 per share to over $44 – an increase of over 700%! Thanks to innovation in the way we listen to music, communicate, and use technology, the company has become a dominant player in the tech marketplace, and remains the standard by which all of its competitors are judged. That said, the company still needs assets, cash, and sustainable earning power to be a worthwhile investment. Time to check out the books.

I decided to start by looking into the company’s balance sheet. One of the things that has made Apple so popular on Wall Street has been the massive amount of cash that the company is sitting on, and the safe financial position of the company. Sounds great right? Well, I never take headlines at face value without looking into the details myself. Looking into the company’s financial reports, it turns out that the company is, in fact, as financially secure as possible – the company carries absolutely no long-term debt, and has liquid assets in excess of $100 billion! Even if sales drop to zero next quarter, the company is not in danger of going under. That would be a disaster, but it wouldn’t wipe out shareholders (fortunately, it does not look like Apple is going to have zero sales next quarter). First measure of safety checks out.

Looking into share value, however, I found my first real quantitative concern. When you look at the balance sheet, without adjusting for goodwill and other intangible assets, Apple carries a book value of $125.04 per share. That is certainly better than the negative book value that Clorox carries, but compared to its market price of $450 per share it seems low. This means that the stock trades at 3.6 times its book value, and has a significant amount of risk for shareholders (to give some perspective, Berkshire Hathaway trades at about 1.2 times its book value). However, book value is not the only way to value a company. The idea of holding a company is that the whole is greater than the sum of the parts. In order to really establish value for AAPL, we have to look to the company’s earning power.

Establishing the earning power of a company like Apple is tricky – for the last few years, Apple has been a real growth company. Earnings have gone up by as much as 50% each year. That kind of pace is unlikely to continue, seeing as Apple is the single biggest tech company in the world. Valuing the company as a growth company would be reckless and speculative. However, trying to value the company the way you value GE or Berkshire Hathaway is difficult because Apple has not had ten years of earnings as a tech giant, so you can’t look at the average earnings of the past and expect a reasonable picture of future earnings. What to do? Well, let’s apply some common sense, look at the present, and see if we can discern anything about what is likely to happen.

Looking through the annual report, the company is very upfront about costs, revenue, and profit margin. That was extremely helpful for a qualitative analysis. It turns out that last year, Apple had a 43.9% profit margin. Not bad! This was driven by the fact that Apple has established many of its retail outlets and production facilities, and has not had to invest in new equipment or real estate. These factors are unlikely to change. Looking forward, the company recognizes that competition and supply costs are likely to increase. On page 35 of their annual report they conservatively project that next year’s profit margin should come in around 36%. A big drop to be sure, but still a healthy number. Let’s use this to make some assumptions. If we assume that this margin is correct, and that the company experiences exactly zero growth this year in terms of revenue, we can get a rough sketch of what earnings will look like when the next annual report rolls out.

Taking this 36% margin and applying it to the company’s current revenue, it turns out that the company would earn $59 per share before income tax and other costs. Once all of those costs are deducted, that leaves a diluted EPS of $30. If we were to use a price to earnings multiplier of 20 (remember, that’s the highest P/E ratio acceptable for an investment grade security), that means Apple would be fairly valued at  $600 per share next year. That leaves us with a current margin of safety of $150 per share. Not too bad. Granted, this is based on projections and estimations, which could be wrong, but keep in mind – this assumes no growth at all for Apple. I doubt the company will have 50% growth again, but I wouldn’t be surprised to see it have 10% growth in revenue, maybe more. Also, the past few years have been hard on consumers, and yet Apple has stayed strong. If and when the economy starts to get better, Apple’s growth will get the same boost as everyone else. I think that with an American icon like Apple, no growth is a safe and conservative projection, and you could (therefore) safely value the company at $600 per share based on earnings.

All of this does assume that the company will continue to sell, but that is what the qualitative analysis is for. Apple looks good for the future, and its consistent investments in R&D, even without Steve Jobs, should produce some really cool new gadgets in the future. Just to play Devil’s advocate, what if I’m wrong? What if things start to deteriorate for Apple? Fortunately, Apple is priced at a discount by my current evaluation. Even if Apple doesn’t hit $600, or starts to struggle, the company is not going to crater to $0 tomorrow – there’s a $150 margin of safety behind my earnings valuation. That’s not a bad cushion, and since Apple is still marketing better than anyone else in the tech field, I feel comfortable saying Apple is a safe buy. It might not hit $1000, but it won’t drop to $200 either.

With all of this in mind, I’m giving Apple the quantitative thumbs up. Sure, there’s some competition and future innovation to worry about, but as Peter Lynch pointed out, there is always something to worry about. Odds are that Apple will keep earning money for a while.

Conclusion

Apple has new and different challenges ahead. New leadership and new competition will make the already dynamic tech market even more difficult to navigate, but the company seems well positioned to handle the future. Yes, things could go wrong, but things could go wrong for any company. Apple’s rock solid balance sheet and focus on the end user experience will keep Apple safe, and the company generously earns enough to justify its price. Until Apple hits $500, it’s a buy in my book.

- The Filosopher in Phinance

Disclosure - I have no financial interest in Apple. I have no plans to buy it only because I have no cash on hand for it. That may change though.

Six Mistakes in the Market

Last year, after starting this blog, The Gavel (one of the student news publications) at Boston College heard about it and asked me to write an article for them. I chose to illustrate some of the most common mistakes I heard about the stock market. Here are my thoughts on six common mistakes about stocks and investments.

Mistake #1: If you are investing, you are gambling.

Many people compare investing to gambling, particularly roulette or poker. “Well, it is just luck after all. Sometimes you lose.” While it is true that sometimes you may lose, and sometimes luck will swing your investments in the short-term, the truth is that investing and gambling are too dissimilar to invite a comparison. Yes, luck is helpful, even necessary at some point, but that does not mean you simply throw darts to choose your portfolio. The luck you need is similar to the luck you need in finding a job, or winning a tight sports game. Let me borrow an analogy from my friend Michael;  “Did Gerard Phelan get lucky when he caught Doug Flutie’s Hail Mary pass? The answer is yes. He is very lucky that three Miami defenders missed the ball before it got to him. Does that mean he and Doug had no skill involved in that play? Absolutely not. If Phelan had been picking his nose at the 40-yard line, he certainly would not have been lucky. Phelan put himself in the position to be lucky.” That is what investment is about. Doing research and carefully selecting stocks is about putting yourself in position for good luck to find you. Do enough work, and luck will come your way.

Mistake #2: Anyone who owns stocks is an investor.

Not the case. Many people own stocks because they have a gut feeling that they will go up, or because Uncle Charlie offered a hot tip at Thanksgiving, or because they like a new business and think it will grow in the future. These people are not investors, they are speculators. There is nothing inherently wrong or evil about speculating, so long as you accept that speculating is risky, and can be an expensive habit. Investors, by doing the proper research, are all but assured that in a worst case scenario, they won’t lose much. Investors buy stocks that are selling at or below their true current value.

Mistake #3  Investing is too complex for people who don’t specialize in it.

In each of his books, Peter Lynch argued against this idea. Investing can be done by anybody. Some knowledge of accounting and finance is required, but that can be acquired. Anyone with the proper time and effort can become a highly successful investor. What really makes informed investing difficult is that it takes considerable amounts of time and energy which some people cannot spare. No one blames a med-school student if he doesn’t get around to reading the newspaper, much less the quarterly reports for General Electric. Even for these people, however, there are ways to invest (aka investment vehicles) that save time and energy. Mutual funds and ETFs (exchange traded funds) are an excellent way for people who want to save money passively, so long as you choose good funds. Which leads me to my next point…

Mistake # 4: You don’t need to understand your investments

A basic understanding of the investments you make is critical to success. Different businesses have different business models, and you need to understand these differences in order to make intelligent investments. If you don’t know how insurance companies work, how can you say that your insurance company is a good investment which will make money? To give an analogy, when watching the high dive at the olympics, I think that all of the athletes are equally amazing. This is because I don’t understand the sport, and don’t know what to look for. The judges, however, can competently rate the athletes because they know what a good dive looks like. They may not be professional divers (or professional athletes), and do not train for hours a day, but they understand enough to distribute scores.

Mistake #5:  Some companies are always good investments.

This is a very dangerous thought. It leads people to believe that some companies are worth a high price, regardless of how well the company is truly doing, or what its business is worth. While an established business (like GE) might be worth a little extra because it is unlikely to go bankrupt tomorrow, it would still be foolish to pay $100 for a share if the company only earns $1 per share. Benjamin Graham pointed out that a stock’s attractiveness is a function of its price-to-earnings (P/E) ratio (the ratio of stock price to earnings per share). This has been echoed by every successful investor.

Mistake #6: The best investments are in the market/ real estate/ gold/ etc.

No matter what is happening with the economy, Warren Buffett’s mantra is always true; the best investment you can make is an investment in yourself. While this applies to your whole person (physically, mentally, spiritually, emotionally, etc.) it is certainly true in terms of your financial situation. Invest in your financial health and education, and you will never suffer a real loss. While money may not be central to your life, it is important to be able to pay rent, bills, and eventually support a family. These are a lot easier if you understand basic personal finance, and how investments work. Take some classes on the subject, or go to the library and start reading about it. Peter Lynch wrote three different books (Learn to Earn, Beating the Street, and One Up on Wall Street) specifically for ordinary people who want to learn how to invest. Benjamin Graham’s book The Intelligent Investor is a basic 101 on how to invest intelligently (go figure), which Warren Buffett called the most important book on investing ever written.

Invest in yourself by investing in your financial education!

- The Filosopher in Phinance

The Clorox Company

Household products

NYSE symbol CLX

The Short Version

Despite its iconic brands and nearly recession-proof bleach business, the Clorox Company is priced too highly to qualify as an investment, and the company’s long-term debt poses risks that do not make the company an attractive buy right now. The company may have too much diversity in its subsidiaries and will have to spend a substantial amount of effort to really maintain its current business model. Stable cash-flows and a seemingly safe dividend mean the company is not a sell, but I cannot consider buying the company until it drops below $70/share. Even then, it will require another careful analysis and a reduction in debt and brand diversity. Clorox goes on my watch list, not my buy list.

The Long Version

I had my latest idea for an analysis while cleaning my bathroom (yes, I do know how to clean a bathroom). After spraying down the entire shower with Clorox foaming bleach, and thanking God that I live in a world with foaming cleaner, I looked at the bottle in my hand and noticed “subsidiary of The Clorox Company.” It had never really hit me that Clorox was a company before that moment. I was due for a new analysis so I went to the internet (after rinsing the bleach off of everything), and found out that Clorox is a fairly diverse public company, currently valued at about $10 billion. How about that? I figured since I was a regular consumer, I might as well look into being a regular owner of the company as well. I packed up my laptop, hit the nearest Caribou Coffee (still a favorite) and started getting excited about cleaning products. Hear that, Mom? I learned about cleaning supplies! As always, I started with a qualitative analysis – what’s The Clorox Company all about anyway?

Qualitative

At first blush, there is a lot to like about The Clorox Company. They have brand recognition in a field that, candidly, I hadn’t associated with branding. Just like Kleenex has become synonymous with facial tissue (Puffs is trying to change that), Clorox has become a word for bleach. As I was typing this article, my word processor recognized “Clorox” as a word. When shopping for apartment supplies, even a poor bachelor with limited cleaning interest (like me) knows to reach for the Clorox bottle. Their foaming bathroom cleaner is a high-quality product that makes life easier for everyone, and their famous Clorox wipes are a popular product that has quickly become a “need” for american households. Even many of their non-bleach brands are dominant in their fields. Quick – name the first brand of wood cleaner you can think of! If you said “Pine-sol,” you proved my point – it’s owned by The Clorox Company!

There are parts of The Clorox Company that I find very attractive as an investor, particularly when it comes to their laundry and home care divisions. It doesn’t matter how good or bad the economy is, people will have to clean their bathrooms and will have to do their laundry, and while there are products that compete with bleach, there aren’t really any bleaches that compete with Clorox. In its niche, Clorox has a virtual monopoly on a necessary product. The only thing better for a long-term investment than a product line that people will always need and use, is a virtual monopoly on that product line.

However, upon looking through the company’s portfolio of brands, at least 45% of the company is vulnerable to economic cycles and competition. Clorox owns a diverse group of brands, including Kingsford, Glad, and Burt’s Bees. All of these companies are extremely vulnerable in the marketplace. If things are not good in America, we can easily stop having cookouts (not good for Kingsford), buy the non-name brand plastic wrap (bad news for Glad), and cut down on the expensive lip balm, or at least buy the cheap version (bummer for Burt’s). Not to mention all of the competition these kinds of brands face in good times. Burt’s Bees fights tough battles in the cosmetics market against dozens of companies, Glad has to compete against Saran and Ziploc, and Kingsford not only has to compete against other charcoals (a crowded field already), but also has to compete against the cheaper, cleaner, and more convenient alternative of propane. This doesn’t even touch on brands like Hidden Valley and Brita (both owned by Clorox). The point is that only 1/3 of the Clorox company enjoys the safe, recession-proof, brand dominance that makes the company so attractive at first glance. Not a deal-breaker, but not a great sign either.

This leads into another qualitative concern I have of the company – the number and diversity of its brands. Clorox owns a large number of subsidiaries in various industries from cleaning products to plastics to cosmetics. Some of these brands, particularly in the cleaning sector, make a lot of sense for the company’s portfolio. It isn’t a far jump from bleach cleaning products to wood cleaning products (like Pine-sol). However, it surprised me to see that the company owns Burt’s Bees (they were bought out in 2005) and Hidden Valley dressings. What is a cleaning company doing in the cosmetics sector? I get that Burt’s Bees is another common product found in many homes, but if that is your only thread to connect everything, then where does it end? Sinks? Furnaces? Mattresses? All of these things are found in every home, but fall far outside of the Clorox core business model of cleaning supplies. And more bothersome – why does a bleach company own a salad dressing company? Maybe I’m crazy, but what do making bleach and making food products have in common? I get why the company owns Formula 409 (tile cleaner), but I can’t understand why the company owns a charcoal company. This is another qualitative red flag. Any company that strays too far from its core business model ends up exposing itself to all kinds of operational and market risks that it does not understand.

Reading through the company’s annual report, I caught a line that struck me as very odd. In his letter to shareholders, the CEO said “[a]fter a thorough assessment, we made the strategic decision not to expand in certain emerging markets such as India and China at this time. These markets require large capital investments, and we currently believe there are better investment choices to drive economic profit growth and create value for our stockholders.” As a possible long-term investor, this bothered me a great deal. I am no economist, but I think it is safe to say that China and India are here to stay. They are two of the largest and fastest growing economies in the world, and together they have 2.2 billion possible consumers. Why shouldn’t a company looking for long-term returns jump at the chance to get 2.2 billion new customers? Ok, most of the people in those countries do not have the disposable income to buy bleach right now, but both countries have a growing middle class, and even if only 1% of that population qualify as potential customers, that still translates to 22 million people. That’s a lot of untapped potential. I would understand if the company said something about export law, concerns about dealing with Chinese or Indian trademark laws, or even expressed hesitation to enter China given that the country is still technically communist and may repossess/confiscate any investments that Clorox makes there at any time. However, the company pointed to the cash outlay it would require as its reason for not making the leap. Unless I’m missing something, that large cash outlay looks like it would be cash well spent. Management’s job is to take good risks with the company’s money, and this looks like a mistake on the management’s part.

Still looking through the stockholder information website for Clorox, I found some very interesting good news; on January 28th, the Clorox company was named on the 2013 Global 100 Most Sustainable Corporations in the World List by Corporate Knights. This is big news for investors. The list is not just made up of companies that make an effort to be ecologically sustainably; the companies on this list have to be financially stable enough to survive as well. Clorox has done a great job of making their products and production as ecologically friendly as possible, while never losing sight of the end goal: making money for shareholders for years to come. The company has reduced water and energy consumption, and many of its subsidiaries have started to release eco-friendly product lines. While I’m not thrilled with the number and breadth of Clorox’s subsidiaries, at least they are all doing good business, and making an effort to do good for the planet. As the environment becomes a more important issue for consumers and companies, Clorox should be in a position to benefit.

There are both pros and cons for this company. I like their core business model, and many of their brands. The company’s management is clearly interested in returning value to shareholders, and doing so in the best way possible for employees, owners, and consumers alike. Green initiatives and employee engagement (now at 88%) at the company are both great signs. On the other hand, the company has too many irons in too many fires, and it is hard for me to ignore that fact. Additionally, I can’t say I’m thrilled about the way the company has been investing its cash. Management used cash to buy back a large numbers of shares from investors, and purchased a cosmetics company. Why didn’t the management focus on reducing debt and establishing product lines in China and India? I realize these are expensive up front, but I have to believe that lowering debt will help with cash flow, and that 2.2 billion people in the two fastest growing economies in the world will generate some demand for bleach. It is a shame that Clorox was afraid to spend money on these potential opportunities. Overall, I could go either way on Clorox qualitatively, but I have to give it a thumbs-down. None of the problems I have are deal-breakers, but all together, they make me too uncomfortable to take the jump. The most important thing to remember when picking investments: never be afraid to walk away, there are plenty of great opportunities out there, so don’t be afraid to miss one.

All of that said, the numbers are just as important as the qualitative analysis. If shares of the company are cheap enough, maybe it could be a good investment anyway. Time to read the accounting mumbo-jumbo and see if Clorox is still worth buying.

Quantitative

A look at the qualitative picture that the company paints has a lot of attractive elements. Fundamentally, the purpose of any business in any field is to make money for the owners, and Clorox has consistently done exactly that. Over the past six years, the company has had a diluted EPS of at least $2.23 per share. That includes the catastrophic year of 2008, when the credit crisis threw most companies into chaos. That year, when many seemingly unshakable institutions were collapsing, Clorox managed to report diluted EPS of $3.24, and they raised their dividend. Stability like that is certainly attractive in a business. I’ll go into more detail about earnings analysis a bit later, but the fact that the company has kept earning money through some crazy years is a fantastic sign for a potential investor.

I can definitely see the appeal that the company’s stock has – Clorox (CLX on the New York Stock Exchange) currently has a healthy dividend yield of 3.17% – not a bad return for your money. For the many stock investors who are interested in dividends as a means of income, this makes the stock very attractive to own. More importantly, that number appears to be stable and protected. One of the most important factors for dividends is dividend security. A company that offers a dividend yield of 20% is only a good investment if the company makes enough money to actually pay that dividend. Fortunately for Clorox investors, the company makes enough to generously cover the dividend. Currently, the company pays $2.56 per share every year (quarterly dividends of $.64). With the exception of 2011, the company has made more than enough to cover that amount in every year since 2006. Even in the down year of 2011, the company had a diluted EPS of $2.23, and thanks to several lucrative years, had more than enough cash to cover the difference of $.33 per share. The company hasn’t stopped there, the company has raised its annual dividend every year since 2006, showing a real commitment to returning profits to investors, and if business keeps moving in the same direction, that pattern will not change. The management at Clorox clearly understand that the company is owned by the shareholders, and they have made great efforts to make sure that shareholders get a return on their investments.

Part of the effort to return value to shareholders has been a substantial buyback plan over the last 8 years. In their most recent annual report, the company pointed out that they have bought back nearly 40% of outstanding shares. This is a pretty bold statement of confidence on the part of the management, and once dividends are included, it means the company has returned about $5 billion in shareholder value since 2005. Not too shabby! When a company raises its dividend consistently, it is a sign that the company is doing well, and is able to make more money for its investors every year. Companies that buy back shares from investors are essentially making a claim that the stock is undervalued, and should perform well over the long-term. Clorox has done a lot to make investors happy over the last several years. However, neither dividend raises nor share repurchases on their own are sufficient to call the stock a good buy; the company must also have a stable financial position, and that is where Clorox starts to run into trouble.

One upsetting fact about the company’s finances became clear as I looked though several old balance sheets – the company has way too much long-term debt. Currently, taking the accounting statements at face-value, Clorox has assets valued at $4.36 billion, and liabilities totaling $4.49 billion, leaving the shareholders with negative book value. According to the books, each share of the company has a negative value of about $1. This is largely caused by the company’s long-term debt, which is currently $1.57 billion, much of which is coming due in the next few years. Additionally, the company has had at least $300 million in short-term debt in each of the last 5 years, which is over 7.5% of the company’s asset value. It is very hard to make money if you consistently have to borrow that much cash for short-term needs. That doesn’t even count the impact of long-term debt and other liabilities on the company’s financial situation.

Another way to look at debt is to look at how much debt the company has relative to assets. The company has $2.72 billion in total debt (both long and short-term), or 62.4% of its asset value. When you remove $1.75 billion of goodwill that the company carries on its balance sheet as an asset, that ratio jumps to 104%, which is dangerously high. Debt levels this high leave the company vulnerable. If things start to go wrong and the company’s earning power is shaken, this debt will quickly destroy the real value that the company has for shareholders. The company’s debt has to be paid before dividends are paid out or earnings are declared, so if the company fails to earn enough to cover both dividends and interest, the shareholders lose their precious dividend. This makes me question the management’s decisions to raise dividends and buy back so much stock over the last several years. Why not take that money and reduce the company’s debt? Sure it isn’t as sexy as sending fat checks to the owners, but eliminating debt helps to reduce risk and increase cash flow for long-term investors. Additionally, had the company focussed on reducing debt over the last five years, it might have had the financial flexibility to lay out the large amount of cash needed to enter China and India. Perhaps this was why management didn’t like the cash level needed to make that move.

Another worrisome factor is the company’s negative book value. While book value alone is not a perfect indicator of the company’s true worth, it helps gauge the risk associated with owning the company. I touched on this earlier, and even without carefully looking through the accounting statements to eliminate assets with no real value, the company has a book value of negative $1 per share. Once you adjust for assets like goodwill, which rarely translates into real money in a liquidation, that number changes to negative $14.21 per share. Yikes! Granted, if you buy a stock, you can never lose more money than you paid, so the real value of the stock cannot be a negative number, but the stock has a long way to go before it looks like a safe investment from an asset point of view. I know this is an oversimplification of the issue, but the basic idea is that there is a lot of risk associated with the stock. Not a good sign for an investment.

Finally, a look at the company’s earnings is important for a thorough analysis. Looking through the last five years, the company has managed to keep earnings relatively stable, and has had an average diluted EPS of $3.524. Using a price-to-earnings ratio (P/E) of 20, the highest average P/E I ever use for an investment, that means CLX has a maximum investment value of $70.48. This number doesn’t factor in things like extraordinary earnings and discontinued operations, but for the sake of an initial estimation, it helps to set a rough idea of the maximum that you can safely pay for a stock. At last check the company was trading at $80.74 per share. Even before you account for any accounting magic that might have inflated earnings over the last five years, the company appears to be too expensive to be considered an investment.

Given all this information, I have to give Clorox a qualitative thumbs down. It is too highly valued to be an investment, and as a speculative stock, it doesn’t cut it. A good speculation is one that has a shot to make a big price move, and the management at Clorox has shown that they are not interested in big changes like, say, investing in China and India. This doesn’t mean that I would short the stock, the company does have solid earning power. If I owned the stock already, I’m not sure I would sell it either – the bleach business isn’t going anywhere. However, it isn’t worth buying.

Conclusion

There certainly is a lot to like about Clorox as a company. The company fills several consumer needs, makes high quality products, has engaged employees, and focusses on returning money to investors, all of which are good things. However, the risks created by the company’s debt, the recent management decisions, and the seemingly scattered portfolio of brands, all make me worry about the company at its current price. It isn’t that any one of my worries about Clorox is a deal breaker. After all, there are always things to worry about. That said, all of my concerns put together are a deal-breaker for me. That’s not to say that the stock will go down, or that anyone who thinks it is a good buy is wrong. All I am saying is that I won’t buy the stock. There are plenty of opportunities out there, and there is no reason to take a chance on a stock I’m not sure about when there are plenty of wonderful opportunities out there. After all, the most important skill is knowing when to walk away.

- The Filosopher in Phinance

Disclosure – I have no financial interest in CLX, and no plans to change that in the future.

Four Companies I Would Buy in an IPO (and One I’m glad I Didn’t)

Last year, there was one event in the finance world that trumped every other headline. The whole market was in a frenzy about it, and everybody – even the people who don’t read marketwatch.com twice a day – was talking about it. I’m talking, of course, about Facebook’s initial public offering (IPO). Retail investors were finally given a chance to own a piece of the hottest tech company in the world. My co-workers were all excited about the event. Many of them, even though they weren’t “in to stocks” decided to join in the fun. Several of them knew that I was interested in the stock market, and asked me if I was going to buy Facebook. I responded, “No way am I buying it. It is way too expensive. I’m going to short every share I can.” Sadly, my broker did not let me go short.

Well, the big day came, and immediately the stock tanked. Everyone who jumped in so excitedly was unpleasantly surprised when a stock that started at over $38 per share shot straight down. Within three months, Facebook was trading at $20, which (to me) still looked over-valued. After the stock dropped, several of my friends and coworkers asked me what had kept me away, and why I still thought the company was too expensive as an investment. I explained that from an earnings and an asset standpoint, the company was highly overvalued. It currently trades at about 200 times earnings, and I usually look for less than 20 times earnings. Also, I didn’t like the business model, or rather, I didn’t like the lack thereof. By Mark Zuckerberg’s own admission, the company was not founded as a business, and he had no plans to start running it like a business – not exactly what you want the CEO of a company you own to say! A few friends pointed to the tremendous potential for growth. I responded with “What potential?” Everyone already uses the website, so how much can it possibly grow? Additionally, where is the potential to monetize? Clicks on side-banner ads are a primary source of revenue for the site, and very few people actually click on those. The company has made several attempts to try to increase revenue, from pay-to-promote-your-status, to pay-to-message-a-non-friend, but candidly they all seem poorly thought out. More importantly, they all depend on a stable and active user base, and if Facebook falls out of fashion, the company and its owners are in real trouble. Think that Facebook can’t fall out of fashion? Ask the founders of MySpace or Friendster how stable the social-networking business is. I like nothing about this company.

One of my friends, having heard all of my reasons to hate Facebook, asked what kinds of companies I would buy in an initial public offering (IPO). I responded that they would be the same kind of companies I look for in a normal investment. I would look for companies with a simple business model, with an established track record, that fill a need or niche, that are dominant players in their market, that have potential to grow, and that have an innovative culture. He asked me for some examples of private companies that fit the bill, but I couldn’t think of any on the spot. I took some time, and thought up a few examples that I figured would demonstrate my point. So, here are four companies that would be worth buying in an IPO.

Lego

As a little boy, I loved my Legos. Every little boy loved his Legos! In fact, I think I can safely say that every grown man wishes it was acceptable for him to have a big ol’ tub of Legos in his closet to play with. When I’m a father you can bet my children will get lots of Lego sets – if only so that I can play with them. The company is a staple in American culture. Nothing makes me happier when I look at a possible investment then a company that looks solid and has virtually no competition. Sure, there are other toy companies out there, but there is only one Lego. Tinker toys, K’nex, Lincoln Logs, none of them really have the same brand recognition, the same creative potential, the same “je ne sais quoi” that Legos possess. As long as there are little boys that like building and breaking things, Legos will be very popular. If the company ever sold its stock on the NYSE, I would be very excited to buy it up.

L. L. Bean

There are few companies that are as iconic in New England as L. L. Bean. The company sells clothes, boots, backpacks, and outdoor equipment, and is known for its high quality, durable products, iron-clad return policy, and great customer service. Initially the company had great success by selling its merchandise through its catalog (a medium it still uses), and has transitioned to the modern age very smoothly by using the internet effectively, and maintaining an excellent brick-and-mortar facility in Maine. Most people shy away from investing in retail. Retail has a very low barrier to entry and a lot of competition, which makes profiting very difficult. However, L. L. Bean has stayed strong in the face of competition from every direction. It has done this both with its excellent quality and service, which people are always willing to pay for, and with its branding. L. L. Bean may not have the sexy appeal of Ralph Lauren or Jimmy Choo, but it has high quality clothes that look good, feel comfortable, and aren’t pretentious. You won’t see the billionaires of the world in L. L. Bean outfits, but every soccer mom and tee-ball dad loves L. L. Bean. The outdoorsy people of the world love L. L. Bean. When it rains or snows, everyone wants a pair of L. L. Bean boots. Average people love L. L. Bean, and unless statistics change, we will always have a lot of average people. I like the niche L. L. Bean has carved for itself, and if the company ever decides to go public, you can bet I’ll call my broker and ask for information on that IPO.

IKEA

Taking a 180 degree turn on the durability and quality front, we see IKEA. The Swedish furniture company is not exactly known for having the highest grade furniture ever, built to withstand decades of use and abuse. IKEA is where you go for cheap, affordable furniture to fill your first apartment when you move away from home after college. Currently, every piece of furniture I own is from IKEA. It’s not the finest oak from France with maple wood trim and chrome fixtures, but it’s furniture, it works, and it doesn’t look awful. Looking around though, there are few companies that actually compete with IKEA. Oh sure, there are other places to buy furniture, but how many discount furniture warehouses have the sleek look and nice veneer of IKEA? How many companies have the brand recognition and distribution that IKEA has? I (hopefully) won’t buy IKEA furniture after I turn 30, but I’m quite happy with my dressers, desk, bookcase, bed, and mattress as a poor 20-something. As long as we have college students and poor 20-somethings, IKEA will be comfortably in business. That makes the company look like a great investment.

Fidelity Investments

The last company on my list is a giant in the world of finance. Fidelity Investments is a company that helps retail investors make money in the stock market. They do this by running several mutual funds to help average people save money for the long-term. The most famous of these funds is the Magellan fund, which rose to prominence in the 1980’s when Peter Lynch managed it and beat the S&P 500 every year for over a decade. Fidelity also runs a discount stock brokerage and provides research and analysis for its clients. This privately held company has an excellent selection of tools designed for people who are not professional investors, but want to reap the benefits of the market. They are not the only company to provide these services. T. Rowe Price and Vanguard both provide high quality mutual funds to investors looking for long-term returns, and companies like E*trade, Charles Schwab, and TD Ameritrade (my brokerage firm) all provide discount brokerage services and investment analysis tools. However, Fidelity has a long history of client-focused services and good results. While no one has had the kind of success Peter Lynch enjoyed since he left the helm of Magellan, the company has maintained a focus of serving its clients, and its management seems to be intent on keeping a focus on that mission. There may be a lot of competition in the world of financial services, but as long as average families want to save for retirement or for college, Fidelity will have work to do, and that bodes well for the company as an investment.

Of course, all of this depends on several other factors, most notably the price offered at the IPO. Benjamin Graham pointed out that there is no such thing as a good stock or a bad stock, there are only cheap stocks and expensive stocks. Any company, if sold for too high a price, can be a bad investment. Normally, I would take a very close look at the accounting statements and annual reports of a company before declaring it a good investment. Unfortunately, I can’t do that for any of these companies because that information is not public. When a company is publicly traded, its financial documents are published for all to see, but with private companies, only the investors get access. If these companies did decide to have an IPO, I would go straight to the numbers to do a complete quantitative analysis before I started buying. But assuming these companies went onto the New York Stock Exchange at a fair price, they would all be excellent for the long-term investor. I don’t know what the next big IPO will be, but I do know that if I don’t like the company selling its stock, or I don’t like the price, I will stay as far away as possible.

As always, I hope to hear lots of questions and comments from everyone. Don’t be afraid to email me, or leave a comment for the world to see below this post. Thanks for reading! Check back next week for another exciting stock analysis. What company will it be? Well, you’ll just have to come back and find out.

-The Filosopher in Phinance

American International Group Inc. (AIG)

Insurance

NYSE symbol AIG

The Short Version

After its disastrous performance a few years ago led to $100 billion in losses and a government bailout, AIG has avoided bankruptcy, become stable, and managed to post earnings for two consecutive years. On top of that, the company has a net current asset value of $28/share, and a book value over $68/share, making it (believe it or not) a safe investment by any standards, even Benjamin Graham’s.

The Long Version

The sub-prime mortgage and financial crisis of 2008 shook almost every company on the NASDAQ and the NYSE. The event brought about the end of Lehman Brothers, Bear Stearns, and shook the roots of the most stable components of the DJIA. Of all the companies hit by sub-prime mortgages going bust, AIG was arguably hit hardest. Once the largest insurance company in the world, AIG had to record a crippling $100 billion loss in 2008. That was billion with a “B!” The company would have gone under if not for the bailout and takeover by Uncle Sam. Only recently did the government finally sell its last remaining stake in the company. It’s hard to look at these events as an investor and think “yeah, but that’s all in the past now. Time to move on.” However, in order to “buy low, sell high,” you have to be willing to buy companies that are unpopular, and wait for things to get better. Granted, no matter how low the stock price seems, it can always go lower. As Peter Lynch said in Beating the Street, “Never bet on a come back while they’re playing taps.”

Fortunately for American International Group, the trumpets do not seem to be sounding at the moment. The worst is over, the losses have been recorded, and if nothing else, the company is almost guaranteed not to go bankrupt thanks to the intervention of President Barack Obama. For better or worse, the U. S. has assured that AIG will be around tomorrow, making the company an interesting candidate for a possible investment.

Of course, any company must pass my two tests to be considered a good investment – a qualitative test, and a quantitative test. Pencils out AIG, the exam begins now.

Qualitative

It is tough to do an unbiased and thorough qualitative analysis of AIG. The company continues to suffer a PR hangover from the financial crisis. To quote a friend of mine, “when I think of AIG, I think of the near collapse of the banking system, and all of economic consequences we’re still dealing with.” That isn’t really the association that any company wants, let alone a company in the financial sector. However, most of the factors that played into that image and those events are now moot. The old management is out, the toxic mortgages the company insured and bought have been written off, and the company has consolidated to focus on its core insurance businesses. All good signs. The big picture looks good, so let’s look more closely at the details

Fundamentally, AIG is running a solid business model: insurance. I love the insurance business. Insurance works on the principle that over long periods of time, using solid business basics, you can ride out the peaks and valleys of the short-term to great long-term profit. This is the reason Warren Buffett has made insurance the backbone of his investment vehicle (remember, Berkshire Hathaway was a textile company when he bought it). Of course, a good business model is not all that is required for a good business. The business has to execute well on that model. Fortunately AIG shows signs of running a good insurance business. The company made it through super-storm Sandy without falling into another crisis, and has managed to retain over 90% of its clients in spite of intentionally getting smaller. With an increased focus on the core insurance businesses, the company has been moving forward and making sure that it has a stable  base from which it can build a long-term profitable company. This is good for the present, and bodes well for the future, so long as the management is on the up-and-up.

Since the financial crisis, AIG’s management has changed greatly, and for the better. When the government took control of the company, the old CEO left, and was replaced by Robert H. Benmosche - who has been doing an excellent job moving the company forward in the face of its hangover from the financial crisis. Additionally, the company brought in Robert S. Miller as the Chairman of the board of directors. Mr. Miller has been involved in several great corporate turnarounds, including (most famously) the meteoric rise of Chrysler in the 1980’s. It looks like AIG is taking this turn-around idea very seriously.

The management made a pledge to make sure that U. S. taxpayers not only got back every dollar that they spent on the insurance giant, but that they made a profit on the deal too. A few months ago, when the Treasury sold its last stake in the company, that promise was fulfilled. Even looking into the company’s financial documents, it is clear that the current management wants to make sure that the company moves forward as a transparent organization. The level of detail and disclosure is promising, and the company did not bury all sorts of nasty surprises in the accounting notes to inflate their numbers. The consistent message from management has been, “thank you everyone, we will do our best to do right by you.” I like this management team.

There have been setbacks along the way, of course. A few years ago, the company came under fire due to some planned bonuses for derivatives-traders who had nearly destroyed the company and the American financial system. The management did not end up rewarding these people for their lousy work, but the PR damage was certainly done. More recently, the company came under fire when news leaked that it was “considering” joining a lawsuit planned the company’s former CEO Hank Greenberg (no, not the baseball player) against U. S. for, “unfavorable bailout terms.” The public’s reaction to the existence of such a lawsuit has been outrage, and I can see why. The company was saved by Uncle Sam and is now profiting, how bad could the terms be? However, AIG was quick to publicly say that they declined the invitation. The press statement politely made it seem like AIG “considered” the idea the way that my mother “considered” letting me get a shark tattoo when I was six (thanks Mom, you always know best).

All things considered, I like what AIG has done in the last few years, where it is now, and what the future seems to hold. There are certainly risks and challenges ahead, but Peter Lynch often pointed out that there are always risks, and too much “weekend worrying” will result in a portfolio that goes nowhere. AIG gets a big qualitative thumbs up from me. Now all we need to do is look at the books. Brace yourselves – this could get really boring.

Quantitative

Looking to the accounting statements of AIG was a long and tiring process. The company’s last annual report was nearly 400 pages detailing the company’s operations in excruciating detail. Fortunately, I will spare you most of the boring details, only to say that the management has clearly made a massive effort to clean up the company’s financial act. Aside from cutting down on the number of credit default swaps issued moving AIG back to its core business of insurance, the annual and quarterly reports show a great attempt to make sure that every detail is made clear to investors. The company went into detail on all of its operations, and all of its one-time charges (although there were not many in the last year), and made it clear that above all else, AIG was not just spouting smoke when it promised to do right by investors and customers. With that in mind, I took a look at the company’s earning power.

Income is the most important element of a business analysis. In a good business, the sum of the parts should be greater than the whole, and generating profits for the investors. Otherwise, why not just sell off the assets, pay off the liabilities, and let the investors have cold hard cash so that they can make real investments to pay off long-term? Fortunately, it seems that income is not a problem for AIG. The company has posted profits two years running, and they appear to be sustainable. Some of those profits the first year were due to large tax write-offs for losses, but AIG has managed to start recording profits without income tax write-offs to help. Granted, the company has drastically changed its business practices in the last four years, so it is difficult to look to the past to establish average earning power, but let’s take a realistic look to the future, and try to figure it out.

Looking to the last two years, the company has managed to establish operating income again. This is important because when looking to a business as a potential investment, I want to know that the business can keep generating the same kind of income without cannibalizing its long-term success. AIG has managed to generate enough sustainable, operating income to make an investor like me take a very hard look at the company as an opportunity. Last year, the company reported a diluted earnings per-share of $9.44 including a substantial income tax write off, left over from the financial crisis. Since then, the company has reported at least $1 diluted earnings per share each quarter, without any income tax write-offs (and had quarterly earnings as high as $2.95 per share). Looking forward, assuming that AIG manages to sustain its worst quarter’s earnings ($1.13 per share) without growth, and assuming that we value the company with the extra-conservative annual price-to-earnings ratio of 10 (Benjamin Graham believed that a P/E ratio of 20 was the highest acceptable ratio for an investment grade stock), we would see that AIG could be fairly valued at least $45.20 per share. Keep in mind that this estimate has a conservative price-to-earnings ratio, and assumes that the company does not buy back any more shares, or grow its earnings capability.

However, evidence suggests that this is an extra conservative estimate. The company has been buying back billions of dollars of shares, and has been establishing its core businesses as sustainable earning engines. With stock buy backs, the company may still make the same amount of money, but that money will be spread over fewer shares of stock, increasing the stock’s real, long-term value, and as the company earns more money, the effect is compounded. I’m not the only one who has faith in the company’s earning power for the future; hedge funds have been diving head-first into AIG, and all three major credit ratings agencies (Moody’s, Standard & Poor’s, and Fitch) have pegged the company’s debt as investment grade. With all of this in mind, and with more generous P/E ratios, one could establish a fair-market value of AIG well above $60 per share based on earnings! With all this in mind, I see AIG selling for between $35 and $36 per share, and I see a massive opportunity for a value buy, even if the company’s earnings growth slows down. Based on earnings, if things go poorly, I am still getting a great deal buying AIG now. If things start to get better (as I believe they will), then AIG looks like an amazing growth engine. Thanks to solid earnings AIG gets a buy.

However, just to play devil’s advocate, let’s say that I’m wrong about AIG’s earning potential. Sure, this all looks swell, but there is definitely a lot of conjecture about how rosy the future is for AIG and America. What if tomorrow the stock market crashes again, the company loses too many clients, and suddenly the management decides AIG has no earning power? What if the company decides to liquidate and all of those pretty future earnings vanish? A careful look at the company’s documents reveals that if all of this comes to pass, the common stock investors would still do just fine! Let’s go through some of the details.

Since the company is an insurance agency, a detailed analysis of the balance sheet gets very tough. The company deals with insurance policies and is exposed to risks based on worst-case scenarios for its clients. However, there is something that jumps out immediately to any good value analyst: the company’s Net Current Asset Value. If the company decided to liquidate tomorrow, and thus sold off all of its current assets (or converted them to cash), and then paid off all of its liabilities, the company would be left with enough cash to give each common stock investor $28 per share. The common sense conclusion is that the company is worth at LEAST $28 per share. That is even before the company starts to liquidate its non-current assets (such as real estate). Granted, non-current assets typically do not sell in a liquidation for their full value, but even accounting for heavy depreciation and fire-sale prices, once you add in the value of non-current assets, the liquidation value of the company is at least $48 per share. That is using extremely high discounts on assets like aircraft and real estate, which realistically could be sold for close to fair value. Looking to the number of shares bought back recently, and the company’s success with earnings in the past year, the liquidation value of the company could be as high as $55 per share. Some simple arithmetic shows the value upside to buying AIG. Taking the most conservative asset based number ($48/share), and the company’s current price ($35.09), we can see that the company has an upside of at least 36.79%. Not too bad, and that assumes the worst liquidation price possible!

Some of you are probably thinking, “this sounds fantastic, but I really don’t know if this kid knows what he is talking about. It seems too good to be true. I mean, this guy’s clearly an amateur, how would he know all this?” You would be correct – I am certainly an amateur (for now). Fortunately, you don’t have to take my word for it, you can ask Bruce Berkowitz. Bruce is the manager of Fairholme Capital Management, a fund that famously beat the S&P 500 every year for a decade. He is known for his old-school Benjamin-Graham style investing, and takes the term “conservative investor” to a level that would make Warren Buffett blush. A year ago, after coming under fire for putting half of his fund into AIG (an unheard-of proportion for one stock), Bruce made a rare public comment, “AIG is worth at least $45 per share. It could be worth as much as $55.” If you don’t believe me (and I don’t blame you, I’d be skeptical of a 24-year-old blogger too), you should definitely believe this guy. AIG looks like a great asset buy.

Of course, all of that analysis is based on the company’s last annual report, which came out nearly a year ago. Since then the company has issued billions of dollars of buybacks, and has earned a substantial amount of money. These two factors have increased the asset-based value of shares of AIG higher. It is hard to say what the exact asset based value of the company is now, and you can bet I will be reading the next annual report very carefully, but looking to the company’s last quarterly report, the company has a book value of $68 per share. Granted, this is a bit inflated with things like goodwill and non-current assets, but the it gives a good sense that the company should be worth substantially more than its current price of $35.09 per share. Looking to the company’s earnings, assets, and buybacks, AIG gets a massive quantitative thumbs-up!

Conclusion

Looking to the qualitative and quantitative factors that impact a company’s value, it is hard not to like AIG as it stands today. The company appears to be well run, and the stock looks cheap. The combination of the two makes it look like a great investment based purely on value, and if the market ever catches on to the bargain and the company starts to trade at a fair value, it could still be a great buy-and-hold investment. As far as I can tell, AIG is a screaming buy, and will be until it hits $39 per share (with a value buy, you have to leave some room for the stock price to go up). Even after it hits that number, it still looks like a great investment. Sorry Mr. Buffett, but your competitor looks really good right now. I hope this doesn’t change anything.

- The Filosopher in Phinance

Disclosure - I am long AIG stock. I don’t have any plans to buy more at present (I’m looking to diversify a bit), but that may change in the near future depending on the next annual report, due out in a few weeks.