GDP Number

Seems everyone is satisfied with the second release of GDP today. Down 1% in Q2. However, when you read the details, it's not so rosy. Federal government was up over 10% and government overall was up 6%! That's not sustainable, especially as tax receipts continue to fall. Bottom line is take that piece out of the equation and you're looking at down over 2.5%. Then, another savior is the declining trade balance, slipping on account of more timid personal consumption and much less private investment. That shifting trade balance has limited the damage significantly. But when things start to head the other direction, the imbalance will again widen and act as an anchor (presuming the dollar doesn't take an enormous beating).

I like reducing the GDP to what really creates wealth for people, by looking at income side. Starting with disposable personal income, I net out interest and transfers (fair to net these since they are included as income and are excluded from GDP), I add undistributed corporate profits and wage accruals less disbursements, since these are essentially someone's yet realized income, and finish it off by netting off government lending/borrowing, since that ultimately belongs to everyone. Finally, I deduct out the money made by Americans overseas, and add in that made by foreigners here, to make this an index of 'domestic' income, as opposed to 'national' income. All of this ends up being similar to net national factor income with some adjustments-mainly government borrowing and direct taxes. At any rate, that number on a per capita basis is now lower than at any point since Q3 of 2003. That's pretty bad. Additionally, this number was -3.8% annualized in Q2, that decrease similar to the trailing 4 quarters of -4.0%, and it's now been negative seven straight quarters. In nominal dollars the past 2 years has been the worst for this index since BEA started quarterly data, but not in real terms (that happened during the 1973-1974 crash, thanks to double digit inflation).

WACC

One thing you must know if you want to estimate the intrinsic value of a company is the expected return on investment. To use a model on current value of future cash flows, you must have a discounting rate. One approach often used is the Weighted Average Cost of Capital (WACC). Basically, it looks at the capital structure of a company to determine the overall discount rate. That includes more than just the return on the common equity, but the return on other invested capital as well, most significant the debt (If one includes the value of all invested capital in valuation, it's also important to include interest payments as cash flow since this is a return for the debtholder). For example, a company that is financed by 50% debt and 50% equity capital and that has an expected return rate of 6% for the debt and 10% for the equity would have a WACC of 8%.

If you take this a step further, you could see how a company could have an optimal debt load. As more debt is added, the marginal rate for each new dollar of debt generally increases. At some point that marginal rate reaches the return necessary for the equity and that's where the debt load is optimal.

The return required for the equity usually depends on the beta, standard deviation or some other factors that consider risk.

My opinion of this is straight forward. First, in valuing a company, I'm interested in only the intrinsic value of the common equity and thus the only cash return of importance is that which flows to the common equity (that is, not interest, preferred dividends, etc.). Second, I think 'risk' for equity is not tied to any technical factor such as beta. Technical data that describe price fluctuation is not that important for me, since the only technical info I care about is the current price and whether it represents a discount or premium. More important is (1) what is the variation in the cash flow (the bigger the variation, the easier to err in valuing a company) and (2) what is the risk that my capital will be protected from loss. This second item is where debt comes in for me. Just as more subordinated debt carries a higher rate due to the higher risk, so too does equity carry a higher rate based on the amount of debt 'ahead of it in line'.

For example, take two companies of the same industry and size that should have the same return requirement for the capital. In fact, I would argue that theoretically both SHOULD have the same average rate of return regardless of capital structure. If A is 100% equity, it may have an 8% required return for that equity. If B is 50% debt, it may have a 6% return on debt and 10% on the equity. Again, what is not important is what the debtholders require, but what does matter is how much debt there is. The way I create a scale on this is thus: If I had $10,000 invested as debt in company A and I was the only debt and there was $10 billion in equity as well, I should probably expect no more that the treasury rate. My capital may be safer in that scenario that a treasury note. On the other hand if I owned all the equity $10K in company B and it had $10B in debt, I'd expect more or as much return as the most subordinate debt, which would be junk bond level. Usually your average case is somewhere in between. But when you buy debtless Google, you essentially have capital at both extremes and everywhere in the middle too. When you buy a debt-laden company, you still get the junk bond end and some portion of the middle of the continuum, but not the safe end. Those seats are taken.

Generally, I think 8% to 10% is a reasonable expectation for return in the safest companies and that rises maybe to the high teens for those companies that make you wonder how long it will be before bankruptcy wipes you out.

Options can be less risky than stocks

Given this is a value investing blog in name, talking options may not be what you'd expect. And such ridiculous statements like "Options can be less risky than stocks" just show I don't know what I'm talking about. Well, let's look at the math of some scenarios. There are four basic options positions: long/short call/put. Here's how each could reduce risk as compared to holding the same equity.

Buying a put to 'insure' your long stock position - this is the most obvious. You pay some premium, but you assume no downside risk south of the strike price. If the equity crashes, you come out smelling like a rose compared to those with a simple long position, and if it goes up, you still benefit. All for a bit of premium.

Covered call - this is essentially the opposite of the above position. Here you own the stock, but are short a call. If the stock skyrockets, it does so without you, as the call you sold will be exercised away. And you still are on the hook if the thing tanks. But, you get paid for this position. So, if things turn bad for the equity, you'll be hammered. But at least you have a little premium in your pocket. Again, your maximum loss will always be less (by the value of the premium) than just holding the equity.

Cash covered put - This is a scenario in which you essentially hold cash in order to insure someone else's stock. If the stock tanks, it's yours. And if it goes up, it's not. But this is insurance, and you get paid to provide it. So if the equity drops, both you and your friend holding the stock will both lose, but at least you'll have the premium.

Long call with cash to purchase - Most people probably don't do this. The glory of buying calls is that you get all the upside on the stock, but you don't have to come up with the full price of buying it. This lets you control 1000 shares for the price of 100, for example. If the price drops or is even flat, your investment can be a total loss. (This is the most common options position, and why options are seen as risky). What if you were satisfied just buying calls on the 100, though. How would that compare to buying 100 shares? The chart would essentially be the same as the put-protected long equity position. If the stock drops hard, your options are worthless, but you still have the cash. And that puts you ahead of the long stock guy.

So that covers all four basic options and how you can structure each to be safer than simply holding the stock. Each have lower maximum risk and lower maximum gain. What's interesting is that in order to do any of them, you often need greater permissions from your broker than for just buying and selling stocks. Particularly the cash-covered puts will often require quite a bit more permission. Now this just covers the risk, return is a different story that I'll get to in a later post.

An economics rambling

I had a conversation recently with someone and I brought up how automation in the industry I work in may prove to someday be the way to go since labor costs tend to go up (generally unionized industry) and technology costs tend to go down. His response was essentially that doing so would be short-sided because once everyone did this, no one would have a job. I'm not one to argue, so I left it at that.

But frankly this kind of thinking could have come from an economist. They frequently think like this (I remember the 'economics' articles on how even wasteful stimulus money could be beneficial.) Let's just think of this in very simple terms. In planet A, they have all kinds of stuff that they build with their hands; on planet B, they have the exact same stuff, but all of it is built by machines they built years ago that require only limited maintenance. Planet B is a better place to live without any doubt. But Planet A has more jobs. So what, both places have the same stuff-that's the point of money and jobs and profits-to improve lifestyle materially. And those on Planet B have greater leisure. Classic case here of making the means the ends. But given the prevalence of the mindset (and other ridiculousness), more so that this recent conversation (the person who I had this discussion is actually very sensible and thoughtful), I'm commenting on it.

Of course the wonderful example today of great economics is Cash for Clunkers. Like World War II and Hurricane Katrina ended up helping the economy, our government essentially paying way to much for cars and then turning around and destroying them is supposedly a good thing. People buy new cars with the money, and that puts autoworkers back on the job, etc., etc. The bottom line is we are going to collectively pay, sorry borrow $3 billion for the right to tear stuff up. And yes, there was a supposed green component in getting "guzzlers" off the road, but the first tenet of being authentically green is to conserve and reuse what already exists and not waste (also a good tenet of sound fiscal management).

I've seen a GDP fallacy argument that the government could just hire people to dig a trench and others to fill it. GDP goes up, and overall nothing actually changes. Always saw that as a ridiculous hypothetical, but it may be coming.

Cash Flow Valuation

As many legendary investors have stated, when you buy stocks, you buy a piece of a business. And as such, it's a good idea to know something about the business. For most retail investors, you can't buy power to even partially control these companies, so you're essentially buying the quality of the business as it is or will be. Someone who buys a business may see a failing company, but have big ideas on how by buying he could turn it around. Not so when investing in corporations.

No all you can do as an investor is buy and sell, make money on dividends and make money on capital appreciation. As with anything you are trading, your goal is to buy at a discount and/or sell at a premium. Since you have no idea really what the market will be buying at a premium in the future (if you did, you would not need research to make money), the only thing you can know is the current trading value of the equity and what it is truly worth. That second piece is the trick.

In valuing businesses, a very common method, perhaps even the standard method, is by looking at the cash flow. The value of the Caterpillar plant isn't what it cost to build it, as the balance sheet says, but what kind of money will accrue due to what happens at that plant in the future. Now cash flow is a lot of things and the bottom line on a cash flow statement is the change in cash which is frankly not very useful. There's operating cash flow with it's several components, investing cash flow, and financing cash flow. Generally, free cash flow is used, and this has a standard definition of operating cash flow less capex, but there are variations. Some call EBITDA cash flow, cash flow metrics are calculated using only the operating cash flow without the capex adjustment. There's free cash flow to the firm and free cash flow to the equity. Warren Buffet uses something similar he calls owner earnings.

Cash flows from the future (once you pretend to know what they'll be) must be discounted at a rate of return. Since different companies have different levels of risk, you must evalute this piece as well. This blog is meant as a brief intro to future blogs looking at varying pieces of a puzzle that combine to give my thoughts on what goes into a comapny valuation. There is no single place in the annual report to find the answers, because the only current number that really benefits you is the cash on hand, which is rarely much and usually has bondholders who would get it first anyway. Everything else gets it's value from the cash it produces in the future.

Market Timing

Market timing is an interesting topic. Is it possible? Dan Frishberg, who I listen to quite a bit, not only says you can be successful timing the market, but states you must be. Buy-and-hold is for Investor 1.0, which is no longer a winner.

I myself am quite skeptical, since I have investigated some common mathematical technical tools on broad indexes and found they don't work. To be more specific, they were very good tools up to the mid 1980's more or less, with some models seriously outperforming the market. But those some models always slightly underperformed from that point forward. These inlcude stochastic oscillators, MACD, moving average, etc all of varying time period inputs.

And I think this is how many of these became popular. People over time find a strategy that performs well using past data, but that is no guarantee of future return. Also, I think momentum is easier to bet on when people wait for the monthly reports on their portfolio vs. the real-time quote world of today.

Reading charts isn't all about these mathematical models, but surely certain charts looks would create a certain set of numbers, and I tested pretty much everything.

The other thing is that I find little correlation with the general mood of the market timers I see and listen to and what actually happens afterward. Listening to Dan himself, I swear good money could be made going contrary to his general mood. When he thinks we're in a good run to the upside, sell and do the reverse when he expects a pullback. This is purely an opinion formed based on casual observation.

I'd like to do more research on fundamental analysis and how that predicts future prices, but that exercise requires far more data. Maybe more to come on that.

Health Care Debate

It seems that all politicians want some health care change, but no one has a good idea of what their goals are. For Democrats, who have long been primarily about providing health care to all (or at least as many as possible), they seem to be more interested in changing the policies of those who already have care. (They want to apparently want to get rid of the high deductible plans, of all things, which are purchased by the most financially savvy among us.) This is dangerous, as most Americans agree their is a problem in general, but most also like what they've got. Republicans have always wanted to introduce more competition to lower overall costs. But then they criticize ideas to tax employer paid plans, which would likely push people out of the big group insurance and into shopping for it themselves.

Frankly, I'm not sure what's so difficult. The simple way would be to have a basic public plan that is free to the public...GASP. Publicly funded hospitals, clinics, etc. It wouldn't nor shouldn't be great service, but it wouldn't compromise needed care. Then allow anyone else to buy their own, including the existing employer funded care, but eliminate any tax breaks. But if you can prove you own your own insurance, you receive a credit equivalent to the average per person full cost of the public plan. (If after you take the credit and subsequently show up at a public ER, you or your insurance will pay the bill back to the government.) And unlike members of the public plan, the government can make no mandates on you as far as healthy living, which they could for those on the public plan. Hey if you want taxpayer funded cancer treatment, you can cut back on the smokes.

But the one issue with this is the cost. First, I'm not sure there will be that many more people taking this than currently are on Medicaid or Medicare combined. Frankly, I think some older folks would prefer to go out and get their. The credits would be expensive for sure, but you will also collect more in taxing employer provided medical benefits. The remainder can be funded through a VAT-like tax, which I actually believe should be the only non-tariff revenue for the feds, but that's another topic.

In the end those who truly need more care than they can afford will take the public plan, and we can all be assured they will get the coverage they need. Others of us can pay a reasonable premium for catastrophic coverage, get a credit for not burdening the public system, and then buy our day-to-day care from pocket. When doctors start posting prices of routine procedures, you'll know we have competition, and like all other truly competitive services (LASIK is a great example from the world of medicine), prices will not go wild.

One footnote is the AMA. Every time I hear someone from this group, they continue the mantra of needing to invest more in prevention and less on treatment. That's probably very good for helping people live longer and may have some small cost benefits. They talk about medical malpractice BS. I know that's a good chunk of costs. But they never talk about the need for doctors and hospitals to compete with one another on price. And that's where the real savings are.

Update on Index

After about 3/4 of the month of July, the S&P is up 6.2% while the index I created is up 4.1%. Not a great start, but it will literally take years to find out if this strategy works. One thing that hurts the performance compared to the broad market is that the index is pretty much devoid of financial stocks while happen to have had a good run, or cyclical materials.

Value Index

Tomorrow is the first of July, and we will begin tracking the Value Index. For purposes of this, only S&P 500 companies are eligible. This basically keeps the number of stocks to be evaluate to a reasonable number. The index will reconstitute at the end of each month. At any rate, these are the stocks.

AKAM, AMGN, BCR, BIG, BIIB, BMY, CEPH, CF, COH, COL, DO, ESV, FII, FLIR, FLS, FRX, GD, GME, GPS, HRS, HUM, JEC, JNJ, KG, LLY, LO, MDT, MRK, MSFT, NKE, NOV, PCP, PFE, PSA, RDC, RSH, RX, SYK, TSS, ZMH.

Without going into too much detail, the companies picked are those that are profitable and will remain so, can be bought at a good price, and have what I consider good balance sheets.

EBITDA Multiple

Looking at the Dow 30, and going with 6.5 as a standard for which to judge value, there are 4 stocks that are under that multiple. The EBITDA is TTM and EV is MRQ.

Chevron (CVX), Exxon (XOM), AT&T (T), and Merck (MRK) are the four. The oil companies are on the list because of EBITDA from April to Sept. last year. Even so Chevron makes the cut based on last 2 quarters as well. AT&T has a large capital requirement which of course is disregarded in EBITDA. Merck is just an all-around good value. For one the Enterprise Value is not much more than the Market Cap, and secondly it's PE is strong.

We'll open an index tomorrow with the 4 stocks and check performance compared to the broader market. EBITDA Mult.<6.5. No weighting; just 25% for each until the index is modified. Modification will come based on (1) a stock has increased in price or has released new financials and is no longer eligible or (2) a new stock is found to be included or a previously rejected stock has either decreased in price or released more favorable financials to make it qualify.

2 new valuations

Pfizer (PFE) has been rated and is the new best value company, replacing XOM.

Boeing (BA) came in lower, ranking between Microsoft and GE.

Continuing with New Ratings

Adding to the last post of ranking some leading blue chips. This second group has fared a bit better than the last.

1. XOM
2. CVX
3. INTC
4. JNJ
5. HD
6. MSFT
7. GE
8. BAC
9. JPM
10. WMT

Some more blue chip rankings

Looking at 5 large blue chips from different sectors, a new valuation standard results in the following rankings.

1. XOM
2. MSFT
3. GE
4. JPM
5. WMT

Value in the Dow

I've gone through a valuation of each Dow component. I then split them into 5 equal groups depending on how the market value of each compares to the calculated intrinsic value. Here is the list:

Best value: BA, HD, MRK, MSFT, PFE, XOM

Next group: CVX, DD, DIS, INTC, PG, TRV

Middle group: HPQ, IBM, MCD, MMM, T, VZ

Next group: CAT, CSCO, JNJ, KFT, UTX, WMT

Worst value: AA, AXP, BAC, GE, JPM, KO

So energy and pharmaceuticals, with the exception of JNJ, are near the top. Finance stocks are right there at the bottom-which is partially attributable to the methodology and also the result of the problems in the sector over the last year.

Adding stocks to the index

Basically, I will add stocks as I find those that have a positive intrinsic value-to-market value ratio. Intrinsic value follows a specific formula. The index can add or delete holdings as conditions change or when new good value stocks are found.

Pfizer Profile

Pfizer (PFE) is next. Key stats:

Price/Book: 1.65
PE: 12.50
Price/Sales: 2.10
Price/Cash Flow: 5.50
Free Cash Flow Yield: 16.7%

Quick Ratio: 1.90
Current Ratio: 2.32
Financial Leverage: 2.04
LT Debt to Equity: 35.00%
Total Debt to Equity: 47.65%

ROA: 6.48%
ROE: 13.24%
ROIC: 16.89%

Gross Margin: 90.31%
Operating Margin: 36.16%
Net Margin: 16.80%

Profitability: A-. Best margins we've seen so far.

Financial condition: B+. On one hand there's a good percentage of investment in front of the common. But on the other, there is a lot of working capital as a percentage of price.

Value: D+. A price to sales ratio over 2 shows that even at $14 to $15, shares aren't cheap (there's a lot of them). The price to return ratios are pedestrian given the high profitability.

Overall: This is the first company who has a higher intrinsic calculation than market value. Looking deeper however, Pfizer seems to have one of the poorest growth prospects of the major pharmaceuticals, according to analysts. Since I don't consider growth in my analysis, this is an important consideration.

3M Profile

3M Corp. (MMM) is next for the profiles.

Price/Book: 4.35
PE: 14.17
Price/Sales: 1.77
Price/Cash Flow: 10.01
Free Cash Flow Yield: 6.64%

Quick Ratio: 1.05
Current Ratio: 1.83
Financial Leverage: 2.50
LT Debt to Equity: 52.25%
Total Debt to Equity: 61.97

Return on Assets: 12.29%
Return on Equity: 30.71%
ROIC: 22.11%

Gross Margin: 51.79%
Operating Margin: 20.32%
Net Margin: 12.51%

Profitability: C+. I sort of set the range for the letter grades on this with the first 2 profiles. 3M is right in between.

Financial Status: B-. There's a good bit of debt on the books, though not overwhelming. There's also a good bit of cash here.

Value: C-. It's a bit expensive, particularly the P/B.

Well, basically 3M falls right in between our first 2 profiles, GOOG and WMT in each category. However, it seems to be the best buy of the 3, though only marginally so. I still don't think we've found a qualifier for the index, but we're getting closer.

WMT Profile

Key stats:

Price/Book: 3.12
PE: 14.64
Price/Sales: 0.48
Price/Cash Flow: 8.44
Free Cash Flow Yield: 5.8%

Quick Ratio: 0.18
Current Ratio: 0.85
Financial Leverage: 2.60
LT Debt to Equity: 57.31%
Total Debt to Equity: 69.37%

Return on Assets: 8.18%
Return on Equity: 21.31%
ROIC: 15.25%

Gross Margin: 25.11%
Operating Margin: 5.70%
Net Margin: 3.28%

Profitablility: C-. The plus for the company is the sheer volume of sales, which will be reflected in value. Per sale, the margins are slim-typical of discounters.

Financial Condition: C. You'd think a store that appeals to the thrifty would keep the debt load low. They don't keep around much cash either. Nothing that has them worried about missing payments, but there's plenty of capital in front of the common.

Value: A. Sales only equaled by Exxon, and at 60% of the price.

Bottom line is Wal-Mart looks strong in all the places Google didn't. It has 20x the sales at 1.5x the price of Google. But the balance sheet is more ordinary, and there's not much pocketed on each transaction. It is similar in that it is a good play in stormy weather, not because its a cash cow, but because its sales are pretty much unphased by downturn. Indeed, they're a bit countercyclical.

GOOG Profile

The first profile is for Google (GOOG). First some key values:

Price/Book: 4.49
PE (TTM): 30.90
Price/Sales: 6.06
Price/Cash Flow: 16.12
Free Cash Flow Yield: 4.9%

Quick Ratio: 9.31
Current Ratio: 10.11
Financial Leverage: 1.12
LT Debt to Equity: 0%
Total Debt to Equity: 0%

Return on Assets: 13.0%
Return on Equity: 14.5%
ROIC: 17.1%

Gross Margin: 68.09%
Operating Margin: 32.06%
Net Margin: 19.63%

And now some evaluation of some key points:

Profitability: B+. Google's margins are very solid all the way around.

Financial Condition: A+. Google is about as good as it gets. No debt. No other equity competing with the common. And lots of extra cash.

Value: F. Unfortunately for the value investor, everyone is well aware of the stellar condition of this company. And it is expensive. Google has nowhere near the revenues of other companies in its price class.

Overall, this won't make the portfolio on the index. From the perspective of value, it simply is too expensive to have a great upside. If a big sell off were to send stocks to lower levels, this may make more sense as a safety net. But not now.

Some important disclaimers

First, this is a post about investing. Thus it is reasonable to describe who should and who shouldn't invest. Since even the best investors lose money, money put in the market should be money you can afford to lose. If someone struggles to pay their monthly bills, investing is not a way out of that situation; in fact it will make it worse. Try budgeting, reducing your consumption, finding another job, paying down your debts - these all have far better track records at improving someone's financial condition.

Second, this site is an experiment. Nothing should be viewed as a recommendation to buy or sell this or that. I have investments and they may or may not be what's included in the index. As items are added or deleted from the index, I'll post whether I have any personal position.

Third, the data I use in my calculations are publicly available. Yahoo!, CNBC, Reuters, MSN, Mornigstar, TD Ameritrade, Fidelity are some of the places I go to look at financial statements, price quotes, valuation ratios, analyst estimates, and other information. No secret or insider information and/or data available for a fee.

More intro info

While our principle goal is to create a value index through specific metrics on companies, the blog would be pretty dull if it included nothing else. So there will be commentaries on news with particular interest to the markets. There will also be explanations of some of the concepts being used to measure value. And frankly I'll probably post on many other things as well.

Welcome to my little experiment

The concept here is to create an index of investments designed to beat, on a risk-adjusted basis, the most common US equity indices. There are no restrictions on what the index may track - equities, ETFs, options, futures, currencies, commodities, bonds, etc.

With that said, investments will chosen systematically, based on the fundamental value of the underlying assets for each investment. The selection formula may change somewhat though time, but the intention is for this to be infrequent, and only when research suggests the change is a clear enhancement.

So nothing is picked on a hunch, or based on what someone said or wrote in the media. And nothing is picked with the intention of realizing some quick profits and then ditching. We don't look at charts or what the big investors are doing. There's nothing wrong with any of that, but our intention is to demonstrate lasting value in companies with certain qualities.