Waste Management

Toxic Waste Disposal and Recycling

NYSE symbol WM

The Short Version

At first blush, Waste Management seems to have a lot of attractive qualities for a long-term investor. The company is the dominant player in a field that has almost completely inelastic demand. However, after reviewing the annual report (available for download here) and digging through the company’s prospects, several concerns came up, such as the management’s lack of attention to detail in their communication, and the company’s exposure to highly volatile commodity prices. Looking to the accounting statements, it is possible for an optimistic value investor to justify a price of about $38.40 per share, but no more, making the current market price too high to qualify as an investment. Waste Management isn’t a screaming sell, but I’m not rushing to put my money in either.

The Long Version

I was rereading some of my favorite investment classics when I came up with my next investment analysis idea. In his book One Up On Wall Street, Peter Lynch advised that the best investments are always in boring companies and boring industries. The only thing better than a boring industry was a disgusting one – if the business made people wretch, it was worth looking into.

Lynch mentioned Waste Management specifically as a great example of his filosophy (… erm… philosophy). Because the company was involved in the disposal of toxic waste, he thought it was a great opportunity. Here was a company that did business that no one else wanted any part of, and provided a necessary service. I decided that if the company was good enough for Peter Lynch to look into, it was good enough for me, so I set down the book, downloaded WM’s annual report, and got to work doing what I always do – a quantitative  and qualitative analysis of the company.

 Qualitative

Right from the start, Waste Management has a lot of attractive features for a potential investor. While the company does not have the star-power or brand-fame that comes with Coca-Cola, Disney, or even Clorox, it is in a fantastic position. The company manages waste. While some companies are vulnerable to the changing times (technology companies in particular), there are some things that technology will never be able to change. We have people in this country, and people make waste. Someone has to deal with that waste. I don’t care how fast the next iPhone is, the only thing that will jeopardize WM’s core business is if people start to disappear (and if that happens, we have bigger problems than a declining stock market on our hands). It may be kind of gross to think about, but all the various forms of waste we generate every day must be handled – even as a bachelor I don’t just let trash pile up in my kitchen, bathroom, and bedroom – so Waste Management will always have work to do. As the earth’s population (and America’s population) grows, and as resources become more scarce, WM will have a constantly expanding market with more and more opportunities to create value for its customers in managing their waste.

Not only is the company in a business with inelastic demand, WM has become the largest player in the field. The company has been expanding for years into various new markets, and provides a whole suite of services on the management of waste. The company operates landfills, transfer stations, recycling plants, and several waste-to-energy plants that generate both electricity and natural gas from our waste. The company even mines landfills and waste dumps looking for reusable materials such as glass, metal, and plastic, and sells the material commodities. This is a double benefit in that it extends the life of a landfill with finite space, and also brings additional cash into the company. The fact that it helps save the planet by reducing our toxic waste is an additional bonus. Doing well by doing good – not too shabby!

In fact, the company has been embracing the green and sustainable push that has become ubiquitous. The company has been working to improve its single stream recycling and its waste-to-energy facilities. The CEO’s letter to shareholders is largely devoted to the company’s green initiatives and the push for WM to be more sustainable itself, and to offer sustainability to customers small and large. It is promising to see that WM views sustainability not as a luxury or a public relations gimmick, but as a fast approaching necessity. WM may not be in a flashy industry, but the management of waste is starting to undergo a very interesting change for the better, and it was good to see that the company is embracing this change.

Once I started going through the information in more detail however, the glow of Waste Management (a nasty image to begin with) started to fade. There are several concerning factors that popped up as I got deeper into my research. As I went on more questions were raised than were answered.

The first thing I read (as always) was the annual letter from David Steiner, CEO and President of WM, to shareholders. The letter goes through several of the usual motions, highlights the company’s progress towards various goals, lays out the plans for future expansion, and touches on plans to cut costs in the future. All fine and good, but something felt off when I read the letter. At first it was hard to put my finger on it, but on my second read-through, I managed to pinpoint some details that bothered me.

I noticed that while Mr. Steiner did make note of the company’s free cash flow (a critical metric for companies), he provided no detail about it, or how it compared to last year’s cash flow. This immediately raised a red flag – if the cash flow looked favorable compared to last year’s results, that would (or should) have been mentioned. Why wasn’t there a report comparing this year’s cash flow to previous cash flows?

More unusual – Mr. Steiner did not report diluted EPS in the shareholder letter. Instead, he provided an “adjusted diluted EPS” of $2.08 per share. Why was an “adjusted” version reported? What had happened to normal diluted EPS that made the management decide not to report on this number in detail? Unfortunately, my questions were unanswered. There were no other mentions in the annual letter about financial statistics, and no explanation of how good (or bad) the reported numbers are. Part of effective communication in a shareholder letter is explaining what metrics are used to measure corporate progress and why they are used.

This was not the only thing that I thought was missing from the letter. After reading it a few times, it finally struck me that though Mr. Steiner had mentioned shareholders several times, and had talked at length about the company’s green initiatives, there was nothing in the letter about the company’s employees. This was another red flag. There are nearly 44,000 employees at the company, and I presume that they are all doing something relatively important to the organization – if they aren’t doing important things, why the hell are they employed in the first place? It only seems natural that the people who make the company run every single day would be worthy of mention in the CEO’s annual communication to shareholders. Whether this was the result of oversight or arrogance or something else is irrelevant. It makes me question the management. I may be overly harsh here, but I prefer to lean towards overly critical than overly optimistic when analyzing a company – after all, you can’t lose money on a stock you don’t own.

At the end of the letter, I was left feeling that I hadn’t learned anything I couldn’t find from other sources. The whole letter was too sterile, and not detailed enough for me to really learn any information about the company’s plans and progress. To quote a friend of mine who had the same reaction as me, “it was clearly over-edited. It reads like a cheesy P. R. stunt.”

I walked away feeling Mr. Steiner’s letter was written either to distract or placate the investors of the company. Fortunately (for me at least), this did shed some light on the company and its management. First, the management doesn’t value the investors and employees as much as they should. Maybe it just didn’t occur to management to write about employees or to provide detailed analysis of their financial results. Maybe they actively avoided both subjects. Whatever the case is, I do not think it reflects well on Mr. Steiner and his team. Maybe these omissions don’t shed much light on the company’s operations, but they do reveal enough about the management for me to say that I don’t want them managing my capital. All in all, Waste Management gets a qualitative thumbs down.

Of course, if you know me (and given my small reader-base, I have to assume that you do know me), you know that any company’s stock might be a good buy if it is cheap enough. There’s only one way to figure out what “cheap enough” means exactly – an examination of the accounting notes. Let’s take a look.

Quantitative

A quantitative analysis of Waste Management takes a little bit of digging, but is comparatively easy next to large holding companies like Berkshire Hathaway, or diversified brands like Clorox. For all my qualitative qualms with the management of the company, they have done a fine job of sticking to their fundamental business and keeping their account records as simple as possible It’s still over 100 pages of stuff to read through, but I’ll keep it brief.

The first thing I always do is look to the balance sheet. Sometimes a bargain can be found if a company is selling for less than its tangible asset value – remember, the whole is worth at least the sum of the parts (and hopefully more). Waste Management’s balance sheet was kind of unique to analyze for a few reasons, but chief among those reasons was the nature of WM’s assets.

Because of WM’s line of business the assets of the company aren’t a completely fair picture of the company’s fire-sale price. WM owns lots of assets that usually would be considered safe long-term assets – most notably real estate. It is usually safe to say that while the real estate market rises and falls, if you own real estate you always at least have something tangible and usable. Unfortunately that is not the case with Waste Management’s landfills and transfer stations. As landfills are filled with waste, their real estate value is actively (and very quickly) destroyed. This isn’t necessarily a problem for the company if it brings in a healthy profit on that real estate, but it does make the book value of the shares a shaky way to value the company. The real estate might have cost a certain amount, but it has virtually no resale value.

Additionally, landfill real estate that the company owns now carries the double whammy of a set of future liabilities. A landfill only lasts an average of 43 years, and after it is filled, there are costs associated with capping the landfill and maintaining its closure safely. These are costs that WM has to bear for as long as they persist. Granted, the company does set aside assets to help pay for this maintenance, however it remains to be seen if this will be enough. The amount set aside is, by the company’s own admission, based on its own estimates of how much maintenance and closure will cost in the future, and how much interest can be gained on the capital set aside for the purpose. This exposes the company’s long term asset value to risk – if the company hasn’t set aside enough money, then earnings will suffer. With approximately 10% of all landfills expiring (filling up) within 5 years, this is a real concern.

With this in mind, a quick calculation of book value is very revealing. Taking the company’s stated assets ($23,097 million), and subtracting all liabilities ($16,422 million), the company winds up with a book value of $6.675 billion. Looking into the assets the company has, however, there is $6,291 million listed as assets under “goodwill.” Goodwill is a number listed on the balance sheet to represent the price paid for acquisitions in excess of book value. In a liquidation, goodwill is unlikely to pan out as a solid, reliable asset, so in calculating the firm book value, I always subtract it unless given a good reason to leave it in. Taking that number out, we are left with a “real” book value of only $384 million for the entire company. This number does also includes “intangible assets” worth $397 million on the company’s balance sheet. Intangible assets, while often real, rarely have any real value outside of the company – if we deduct these from the company’s “real” book value, the remaining figure is negative $13 million dollars for the entire company. It might be unfair to take out all of the goodwill on the company’s books when calculating value (or all of its intangibles), but even if I were to leave those line items in, the book value per share of the company is only $14.38 – just over a third of the company’s current market price ($41.39/share). That leaves a wide margin of danger, especially when we remember that many of the assets that WM owns are quite literally toxic. Benjamin Graham would not have been pleased. From a purist’s standpoint, WM does not qualify as a value investment.

However, a business is often worth more than the sum of its parts. If the business can create a steady stream of earnings consistently into the future, then the business has real value (even if it does not have any assets to speak of). Looking at Waste Management, the company seems to have some solid earning power. Going back 10 years, the company has always earned between $1.60 per share, and $2.23 per share, with the exception of 2003 (when it earned $1.21 per share). This is particularly promising given the massive financial crisis of 2008. While giants like AIG, GM, and GE were brought to their knees, Waste Management did not have a sizable shift in earnings (in either direction). That speaks to the safety of the line of business. If we take these figures at their face value, it turns out that WM had an average diluted EPS of $1.921 over the past ten years. Assuming that WM has the same basic earning power going forward that it had in the past (a big assumption which I will discuss in a moment), a value investor could pay up to 20 times the company’s average EPS and call it a fair price. This yields a maximum fair value of $38.42 per share in my eyes. An optimistic investor or speculator who believes in the company’s future growth prospects may even stretch to 25 times average EPS ($48.03 per share), but I can’t say that I’m too optimistic about WM’s current earning power, much less its future earning power, for a few reasons.

First, let’s remember that WM relies greatly on its landfills, 10% of which are within 5 years of closure unless they are expanded. Even if expansion occurs, it will require some extensive capital outlays to keep them in operation, and the ones that are closed aren’t simply left for dead. Closed landfills require capital to cap off and to maintain. These factors are sure to eat into Waste Management’s ability to earn in the future. How much they will impact the company exactly remains to be seen, but they certainly will impact the company.

Additionally, WM has a great deal of exposure to the volatile commodities markets. When WM recycles material, it sells the reclaimed products as raw materials. These include aluminum and paper – two commodities with prices and demands that have been falling lately. The price of natural gas and energy, two other commodities that WM sells, have also been falling, which is bad for revenues at the company. That is not to say that these prices will continue to fall forever, but the company’s exposure to these markets puts its future earnings on slightly shakier ground, since commodities prices are notoriously hard to predict.

Finally, the estimates above are based on the assumption that we can take WM’s diluted EPS at its face value over the last ten years. I’m not sure that this is a wise decision. Here is where the importance of a qualitative analysis comes into play. If I thought the management of WM was brilliant, and really excelled at capital stewardship, I would be willing to trust (but verify), the numbers in the books. As it is, I’m already skeptical about the company’s presented earnings. They might be legally accurate, but do they present the most accurate picture of earnings, or just the prettiest picture? Is the management’s judgement of how they tally earnings reliable? These are important questions. For example: this year’s diluted EPS was $1.76. The annual shareholder letter never once mentioned this number, instead reporting “adjusted” diluted EPS of $2.08. In the form 10-K, the adjustments that went into this difference are listed. Some make sense, and are only worth noting briefly (such as a few cents per share related to legal settlements). However, some piqued my curiosity but were not expanded upon. Most notably, there was a charge against earnings related to medical waste that had a negative impact of $.17 on EPS. Why was this charge against earnings singled out? What exactly did it entail? Why did management feel this medical waste issue was a one-time issue investors shouldn’t worry about? I’d love to give you more detail, but I have none to give. This general attitude towards earnings makes me too skeptical to automatically pay 20 times average reported earnings for the company.

It is also important to note that while revenues at the company have been reportedly growing, that growth is at least partially manufactured. Revenue grew over 2012, but only due to acquisitions. If you take out revenues created by acquisitions, it turns out that revenues decreased for the company by $43 million. That means the company’s existing core business has been declining. This is bound to happen in some years, but it certainly does not inspire a great deal of optimism in the company’s current direction – especially when that information is not addressed in detail by the management. A short explanation of why revenue from ongoing businesses declined would go a long way towards improving my opinion of the stock’s prospects.

An investor with more faith, or more knowledge of what is going on, might be happy to pay 20 times earnings, but no more. That would bring the maximum purchase price to $38.42 per share, lower than the company’s current market value of $41.39 per share. I am not sure what the price would make WM investment grade, but I am fairly confident that that price is l

Conclusion

All things considered, I’m not thrilled with WM as a stock. The company’s management has not demonstrated an appreciation for their role as capital stewards for the investors, and if they value the company’s employees, they certainly don’t show it. Also, the company’s earnings and cash flow are shrinking, and aside from acquisitions, the company doesn’t seem to have a roadmap on how to fix that problem. Yes, WM has a nice dividend, but that alone does not make the stock attractive. After all, a large dividend is only attractive if it is a safe dividend. On top of that, the stock simply looks over-priced relative to earnings, and why should I pay too much when there are fantastic bargains out there?

Maybe I am missing some details, maybe I am being to harsh on the company, but regardless, WM is not a buy as far as I’m concerned. It isn’t worth shorting – I don’t think the stock is going to $0 tomorrow – and it isn’t necessarily a stock I would rush to sell if I did own it, but I’m going to stay away and look for greener pastures.

- The Filosopher in Phinance

Disclosure - I have no financial interest in Waste Management, and no plans to change that fact.

PS – My attorney (Dad) has suggested that I remind my readers that while I do mention several statistics from the annual report, any analysis thereof is simply my opinion. This is a blog, so you shouldn’t assume that anything here is gospel.

Coming up on my next post – a new book review on Investing Between the Lines, by L. J. Rittenhouse. After that – a look at an American icon that has been through the ringer: Sears.

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