Valuation Engine (Checklist) - Please recommend updates

[Myth465]

I am posting this for purely selfish reasons  ;D. I would like for you all to offer recommendations. Please let me know what you think is worth adding, and more importantly what you think offers little value. Also feel free to post any questions or steal. I stole 103% of this  :).

 

Regards.

 

Also unfortunately these are typically completed prior to my investment, but typically documented after my investment. Its a bad habit that isnt likely to be broken. I believe the quarterly updates and key metrics (tailored per investment) offers the most value add.

 

 

Analysis To-Do

 

1) Valuation.

2) Key Metrics to Review.

3) Investment Sentiment / Catalyst.

4) Business Background.

5)  Investment Description.

6) Detailed Risk Analysis.

7) Potential Catalysts / Upside Potential.

8) Time Frame / Exit Strategy.

9) Buffet's 4 Filters - 1, 2, 3, 4.

10) Other Investment Data.

 

Valuation as of ….

 

Current Thoughts on the Valuation of the Stock.

 

Investment Sentiment / Catalyst

 

Currently on watch list due to lack of excess capital. I will watch management and gain a better understanding of them and their business.

 

Shares Held = None.

 

Key Metrics to Review = Update and note the key metrics which should be reviewed each quarter. These metrics should be controllable by Management and should be used to gauge the investment. The metrics will very depending on the company and will need to be reviewed quarterly and annual.  Some things which should usually be reviewed include FCF Trend, Reduction / Management of costs, Management's decision making skills and Honesty, and usage of FCF.  Review Metrics and Questions Below.

 

Quarterly - Review

 

1. Metrics Below,

2. Earnings Release,

3. Conference Call,

4. Scan the 10Q / 10K.

 

Quarterly - Update

 

1. Investment Allocation (Excel),

2. Investment Valuation (Excel),

3. Investment Sentiment (OneNote).

 

Key Metrics In Millions Period Q?

Quarterly EBITDA   Market Cap & Share Price  

Current Cash Levels   YTD FCF  

Current Total Debt   YTD EBITDA  

 

FCF Allocation and Capex Management -

 

General Thoughts on Company, Market, and Business -

 

Thoughts on Investment and Stock Performance thus Far - Update Valuation, Shares, and Sentiment as needed.

 

-----------------------------------------------------------------------------------------------------------------

 

Updates, Actions, & Findings

 

xx.xx.2010 - Any stock update

 

xx.xx.2010 -  Date stock was first purchased.

 

xx.xx.2010 - Date Due Diligence was completed or date the stock was added to watch list. Current  stock price. 

 

-----------------------------------------------------------------------------------------------------------------

 

Summary, Catalyst, Risk, Time Frame

 

Business Background

 

○ Introduction - A brief introduction to the company, its business lines, its competitors, and its near / long term outlook.

 

Investment Description

 

○ Investment Analysis  - A brief summary of the investment analysis. Detail why Wall Street has written off the company and why those reasons are largely overblown / invalid.

 

○ Thesis Paragraph - Write on the on qualitative aspects of investment. Write on the quantitative aspects of investment. Write on the major catalyst which will cause intrinsic value.

 

Detailed Risk Analysis

 

○ Risks which may cause Permanent Impairment of Capital. As Bruce Berkowitz would say. If you can easily kill the business then don’t own it. Avoid suppliers with limited customers, highly leveraged, and otherwise crappy business.

 

1) A

2) B

3) C

 

Consider the Following Types of Risks

 

1) Financial Risk (Risk of Bankruptcy), (DFC).

§ Does the company generate a decent FCF yield?

§ How long will it take the company to pay back debt, is it within 7 years?

§ How is the company capitalized, consider structure & does it require access to capital markets?

 

2) Operating Risk (Business Risks), (USMO).

§ Mitigate this by buying at a large discount.

§ Is there a competitive advantage and will margins, sales, & estimates hold up?

 

3) Concentration Risk (Risk of a good business blowing up)

§ Think back to JNJ during the 1980's laced drug scare.

§ Mitigate this risk by applying a reasonable level of diversification.

 

4) Market Risk (Psychology of the Masses which causes you to act irrationally)

§ Mitigate this risk buy buying in chucks. This should help reduce the pain of being early.

§ Thoughts such as, I cant buy because the market is going down and I cant buy because the market is going up. Volatility causes value to appear so when the markets are down you should be buying.

 

5) Quality of Earnings Risk (Do you understand the financials) (Enron)

§ How realistically do the financials represent economic reality?

§ Does FCF mirror the earnings report? Also look at deferred tax reconciliations.

 

6) Is the company overly reliant on a few customers? In what shape is the industry / customers that the company relies on in? (Think ATSG or NOBLE).

 

 

○ Remember more money has been lost trying to handicap the outcome of political, union, take over, and other types of situations then simply investing in quality growing businesses which happen to be down on there luck. Look for businesses which are growing profits each year and avoid businesses which are basically liquating or require a significant turn around. If the business does require a turn around then wait until it has already begun to turn.

 

 

Potential Catalysts / Upside Potential.

 

○ Value is its own catalyst but, its nice to have others.

 

1) A

2) B

3) C

 

Time Frame and Exit Strategy

 

Buy  Strategy - Move into positions overtime as catalyst and knowledge grows. Wait for that blood in the street moment to really push all in (even then still average in on those heavy bets). There is never a need to rush. The stock will still be quoted tomorrow and may even decline further.

 

Sale Strategy - Move out of positions as intrinsic value is reached and the margin of safety declines.

 

 

-----------------------------------------------------------------------------------------------------------------

 

Buffet's 4 Filters Plus a Few

 

We make quick decisions because we have filters before we get to the point of making a decision.

 

Filter #1 – Can we understand the business?

 

Note - Warren Buffet, "To understand a company is to understand its products, its competition, and its earning power." Do you know what drives cash flow and is it sustainable?  Do you understand what factors drive the stock price & the firm's bottom line in both the short and long term? What will it look like in 10-20 years?

 

 

Filter #2 – Does the business have a durable competitive advantage?

 

This is why I won’t buy into a hula-hoop, pet rock, or a Rubik’s cube company. I will buy soft drinks and chewing gum. This is why I bought Gillette and Coke.

 

Since 1972 we have made no change in the marketing, process etc. Take See’s candy. You cannot destroy the brand of See’s candy. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness. You don’t see See’s candy sponsoring the local funeral home. We are at the Thanksgiving Day Parades though.

 

 

Filter #3 – Does it have management I can trust?

 

Note -Bruce Berkowitz, Has management been tested by rough business cycles and are they rational owner-managers with skin in the game. Does management over deliver or over promise? Is management significantly selling shares or diluting ownership through aggressive stock options? What does management plan to do with FCF?

 

Also check the proxy to see how Management is compensated, does the plan make sense?

 

Note - You own this business but, do not control it so make sure that Management is smart and focused on its owners. It helps if Management owns a lot of stock because they will then have similar interests as you. Make sure Management is properly allocating FCF and responsibly managing the business. Also ensure that Management understands ROIC.

 

 

Filter #4 – Does the price make sense?

 

 

 

Note - Warren E Buffett "If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety…"

 

No Growth Valuation - Monish Pabrai regarding FCF calculation. "There is no need for Excel. If a business has zero growth and consistent stable cash flow, that business is worth 10x FCF plus any excess capital."  This assumes approximately a 10% discount rate and results in a 10% free cash yield. 

 

Conservative Growth Valuation - Monish Pabrai regarding FCF calculation. If there is growth, depending on how much and how consistent, I’d be willing to value it at 12-15x plus excess cash.

 

A Few – What did I miss, why is this so cheap?

 

Did you browse the 10k, read the 10k notes, and read the proxy for compensation info?

 

An additional filter based on Li Lu's lecture at Columbia business school. Also covers Munger's Invert Invert Invert.

 

A Few - What's the best way to play this?

 

Look at other securities in the capital structure (Bonds, Equity, Warrants), and also consider options or leaps.

 

A Few - Is this a 50 cents dollar that’s growing or could it be dead money?

 

Note - Warren Buffett - “If we were working with $25 million – so we could sort of look at the whole universe of stocks – I would guess that you could find 15 or 20 out of three or four thousand that you would find that were A) selling for substantially less than they’re worth, and B) that the intrinsic value of the business was going to grow at a compound rate which was very satisfactory. You don’t want to buy a dollar bill that’s sitting for 50 cents, and it demands positive capital, and it’s going to be a dollar bill ten years from now. You want a dollar bill that’s going to compound at 12%...And, you want to be around some competent people. Just the same thing as if you went in and bought a Ford dealership in South Bend. The same exact thought processes goes through you mind if some friend called you tonight and said “I’d like you to go into the Ford dealership” or whatever, is exactly the kind of thought as goes through mind about all the other businesses that are in Standard and Poor’s. When I was 20, I went through Moody’s and Standard and Poor’s page by page – twice – because that is it, that’s the universe. The universe is much smaller now, unfortunately.” 

 

A Few - Is this idea really worth your capital? Does it have the right odds considering your cash levels and quality requirements (See quotes below) ?

 

Note -Charlie Munger - We look for a horse with one chance in two of winning and which pays you three to one.

 

Note -Charlie Munger - You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.

 

○ Note -Charlie Munger - "It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities."

 

○ Note -Charlie Munger - "There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash — and I don’t want to go back."

 

Note - Monish Pabrai - Regarding cash positions.  0%-2%  (Market Undervalued), 5-10% (Market Fairly Valued), 10-20% ( Market Overvalued). When cash falls below 10% investment ideas need to have 3x upside. For cash to fall below 5% investments should have 4x to 5x upside.

 

 

Other Investment Data

 

[Guest Bronco]

I am not smart enough to play this yet, but my comments are for maybe for another thread - seems like all the greats keep lots of cash and wait for the fat pitch. 

[merkhet]

Three comments:

 

(1) I'm stealing a lot of this for my own checklist, so thanks.

 

(2) Do you really care about why Wall Street has written off the company?  There's a difference between doing thorough research so that you are familiar with the pitfalls and listening to Wall Street's siren song of short-term-ism.

 

(3) The content here is really good, but it might benefit from being streamlined into more of a checklist.  Right now it seems like more of a worksheet as opposed to a checklist.  I think that a reorganization might be helpful.  Perhaps make it flow from a general view to a specific view.

 

So, for instance:

 

(A) Do I understand the industry? (Yes - No)

(B) Is the industry a good industry? (Yes - No)

© What is the company's position within the industry? (Leader - Middle - Turnaround)

(D) etc.

 

The way that the checklist is currently formulated, it looks like you're trying to value the company before asking if it's even worth it -- something that could cause anchoring, confirmation bias, etc.

 

Just my 0.02.

[RRJ]

Myth,

 

This is excellent, and mirrors my own basic list almost eerily, but in a more concise and organized way.  Thanks for posting.  

 

You might consider:  Templeton:   recommended using many different valuation measures, -- P/E, P/S/ P/B, P/FCF etc.  I think he mentioned he looked at a dozen different ones.  I like to look at at least 4 or 5 of the most common, and when several or all flash undervalued as compared to historical valuations for that stock or the industry, then it is a real confidence builder and has helped me a lot.  

 

Also, I look for value gurus i respect to have bought in, which also builds confidence.  I suspect you are trying to get away from this though, as am I, so I do not think I would add that to the list.  Better results from finding your own.

 

Also, Fisher's 15 points are helpful for that kind of growth investment, which I am not able to do quite as well yet.  And Munger's "find the extremely talented entrepreneur while they're small" model is a different one as well, and would flout most of these valuation rules most of the time. 

 

 

 

 

[Myth465]

merkhet - Thanks for your comments.

 

I can see how its a bit confusing.

 

This is actually more of a journal then a checklist. I complete the checklist first and then update it quarterly on on major events. I sometimes suck and do the checklist 6 months after my initial investment. I look for all the items but rarely complete the documentation. I want the valuation at the top so I know what its worth as of last quarter. ATSG is the best example.  

 

It was purchased with almost no experience in investing and quickly went from $6 to $8 to 11 cents. I prefer to track my thoughts on it throughout the ownership, almost like a journal. The thesis is more historical but what I need to know when I look at the stock each quarter is the prior valucation, key metrics, and my prior review.

 

Attached are examples and a better formatted checklist.

 

-----

 

(A) Do I understand the industry? (Yes - No)

(B) Is the industry a good industry? (Yes - No)

© What is the company's position within the industry? (Leader - Middle - Turnaround)

(D) etc.

 

These are answered within the 4 filters. Also I pick most of my ideas from other investors / past holdings / screens / VIC / Here / Sum Zero. Most ideas come prescreened. 90% of the time, something sticks out at me and I already know I am going to buy.

 

INMO the chef is more important than the recipe. The journals are great though. I can look back and know exactly how I got screwed. Its interesting also seeing your development overtime. I can safely say I knew next to nothing in 2007 and shouldnt have been managing my own money. Interesting read when I look at my history with ATSG.

 

------

 

Also Wallstreets valuation / thesis is very important. As you can see from my SSW writeup I dont have much capital. I only get paid via dividend and WS. I want to know what they think, and more importantly why they are wrong. They have to change their opinion for me to win.

 

My big focus these days is a catalyst. I cant afford to have dead capital for years on end.

[Myth465]

Myth,

 

This is excellent, and mirrors my own basic list almost eerily, but in a more concise and organized way.  Thanks for posting.  

 

You might consider:  Templeton:   recommended using many different valuation measures, -- P/E, P/S/ P/B, P/FCF etc.  I think he mentioned he looked at a dozen different ones.  I like to look at at least 4 or 5 of the most common, and when several or all flash undervalued as compared to historical valuations for that stock or the industry, then it is a real confidence builder and has helped me a lot.  

 

Also, I look for value gurus i respect to have bought in, which also builds confidence.  I suspect you are trying to get away from this though, as am I, so I do not think I would add that to the list.  Better results from finding your own.

 

Also, Fisher's 15 points are helpful for that kind of growth investment, which I am not able to do quite as well yet.  And Munger's "find the extremely talented entrepreneur while they're small" model is a different one as well, and would flout most of these valuation rules most of the time.  

 

Thanks RRJ. One issue I have with multiple historical valuations is I can generally only get 1 to go. I think book value 60% of the time leads to value trap. As an accountant I dont place much faith in book value. Also most of the time the assets can only really be used in that business and arent worth much in a liquidation (KSP, HAWK).

 

Alternatively companies with real asset value that are underpriced typically have horrible earnings / FCF records. Look at SD, and ATPG. My thesis typically hedges on 1 or 2 valuation techniques with a focus on downside and catalysts.

 

With regard to Gurus. I steal as much as possible, but dont focus on their buys and sells. I find that they make decisions rather quickly and tend to turn on a dime so I buy based on my opinion. It definitely helps watching them though.