MD Capital Management's Blog

WSJ Article – Smoke Signals From the Stock Rally

mdcapitalmanagement — Mon, 28 Sep 2009 17:04:33 +0000

The link below contains an interesting article from the Wall Street Journal.

I agree with the general sentiment and tone of the article, but the statistics quoted were even more interesting to me. Bear in mind, I spend all of my time looking at individual companies/stocks, but rarely focus on the movements of the overall market. So when I read that the S&P 500 is now trading at 27x LTM EPS and 20x 2009 estimated EPS, I can understand why it has been difficult for me to find bargains over the last several months. Normally I am not interested in a stock that is priced materially above 10x EPS. This article gave me some solace that I am not becoming pickier when selecting stocks, but instead the increase in the stock market has made it harder for me to find bargains. That said (as evidenced by last month’s recommendation) I am still finding opportunities in out of favor sectors like healthcare. Proving that even in a heated market, there are always pockets of opportunity.

A Note on Free Cash Flow Yield

mdcapitalmanagement — Sat, 28 Feb 2009 00:00:58 +0000

In my last newsletter, I mentioned that I targeted a 14% pre-tax equity free cash flow yield on investments. One important concept that I failed to mention is that the 14% applies not only if the investment is in a good company, but a good company without significant amounts of debt. Debt increases the risk of owning the equity, as lenders receive interest and principal payments before the equity holders receive their return. I will use Susie and Alice’s bakeries to illustrate this concept. Let’s say it costs Susie and Alice $100k each to open their bakeries, and that each generate $30k of cash flow (their return on invested capital is the same). However, let’s say Susie borrows $50k of the $100k at a 10% interest rate and Alice finances it all with equity. Below is an illustration of the cash flows the equity investors in Susie’s and Alice’s bakeries would receive.

	Susie Alice
Cash Flow Prior to Interest Payments	$30,000	$30,000
Interest Payments	($5,000)	$0
Cash Flow to Equity Holders	$25,000	$30,000
Equity Invested	$50,000	$100,000
Equity Free Cash Flow Yield	50.0%	30.0%

Leverage looks pretty good at this point. However, let’s consider what happens if everyone in Susie’s and Alice’s town decides to try the latest “no cupcake diet fad” for a year and cash flows decline to $0 for one year.

	Susie Alice
Cash Flow Prior to Interest Payments	$0	$0
Interest Payments	($5,000)	$0
Cash Flow to Equity Holders	($5,000)	$0
Equity Invested	$50,000	$100,000
Equity Free Cash Flow Yield	-10.0%	0.0%

Now leverage doesn’t look so great, when Susie is $5k short of paying her creditors. Since leverage is a double-edged sword, investors demand higher returns on companies with significant borrowings in order to compensate them for this added risk. So, while an equity free cash flow yield of 14% works for a good un-levered business, it is likely inappropriate for the businesses with large borrowings.

I will usually refrain from investing in companies with large borrowings due to the increased risk, but will at least require a higher expected return when investing in them.

Investment Philosophy

mdcapitalmanagement — Mon, 26 Jan 2009 00:00:54 +0000

Invest in Good Businesses

Good companies have two major characteristics: (i) they earn high returns on capital and (ii) those returns are defensible over long periods of time.

To illustrate why returns on invested capital are important, let me provide a simplified example. Two aspiring bakers, Susie and Alice, have approached you about opening separate bakeries in the same town. It will cost $100k to open each bakery. Being a good sport, you invest all the capital necessary to start both. After the first year, Susie has generated $20k of cash flow from her bakery and Alice has generated $10k of cash flow from hers. In other words, Susie has generated a 20% return on your capital and Alice has generated a 10% return. Now, Susie takes the $20k generated an opens a smaller branch in a neighboring town that generates another 20% return or an additional $4k per year. Now, Susie is generating you the $20k from the original bakery plus $4k from the new branch, totaling $24k per year or 24% on your original $100k investment. Assuming Susie keeps investing in new branches and continues to earn these high returns, she will be generating $103k per year after 10 years or over 100% on your original investment, whereas if Alice follows the same course, but only earns 10% returns, she will only be generating $24k or 24% in 10 years.

This concept can be extended to public equities by carefully examining a company’s assets employed and its cash flows over long periods of time, and ensuring they earn high returns on that capital (15%+).

However, just knowing that a company historically earned above average returns on invested capital isn’t enough. You need to know why, and if generated those returns will continue over time. For instance, if Susie’s returns are because everyone loves her personally and nobody likes Alice, then the returns will only be sustainable for as long as you can retain Susie (which will likely become expensive as Susie realizes her value). However, if Susie is successfully branding the bakery as the bakery with the best and most unique cupcakes in town, then maybe her returns are sustainable even after she is gone. Susie’s branding effort is an example of what Warren Buffett calls a “Moat”, as in a moat around a castle that protects it from invaders. A Company’s moat helps keep competitors, customers, suppliers, substitute products, new entrants, and/or inflation from reducing the Company’s returns on invested capital. As I present my ideas to you, I will point out what moat I believe each company has, the threats to its moat, and why I feel the Company will be able to maintain their historical returns on capital.

Investing with Management Teams Who Allocate Capital Wisely

Good businesses are relatively easy to manage from a day-to-day/operational perspective, however they require managers with a rare trait – wise capital allocation discipline. In the bakery example above, Alice should send all the cash flows generated from her business back to you (the Company’s owner), so that you can send that money to Susie and earn 20% returns with Susie, instead of 10% returns with Alice. However, given you will likely own only a small ownership stake in the public companies I recommend, you will not be able to direct management to take such actions. Therefore, the public market investor must assess management’s willingness to make tough decisions, like returning capital to shareholders who can put it to a more profitable use. When evaluating management teams, I analyze how they have made capital allocation decisions in the past, and also whether they have historically taken actions to increase the Company’s moat and its return on invested capital. Perhaps most importantly, I also assess whether they are incented to do so in the future.

The Business Can Be Bougt at a Cheap Price

Occasionally, good businesses meeting the above criteria trade in the public markets for cheap prices. Perhaps this occurs because the business hasn’t been growing as fast as Wall Street expected, or is being sold as part of the market’s overall downturn. A company’s value can be unrecognized by the stock market for years, but if you invest in a business with the above traits, eventually the market will recognize the value of the business and the stock will rise to reflect that value. I am seeking to buy businesses with pre-tax equity free cash flow yields (pre-tax normalized cash flow to shareholders / market capitalization) of ~14% (Warren Buffett’s target) assuming no growth in earnings. Pre-tax equity free cash flow yields average ~7% for business with the above traits. In other words, buying at a 14% equity free cash flow yield, means that the stock’s price will double as it reaches its appropriate value.

A Few Notes on Portfolio Management

I aim to invest in 10 companies by the end of the year. Continuing to hold each investment will regularly be evaluated against purchasing other potential investments, the tax consequences of selling, and the benefits of diversification. I do not try to time the market or individual equities, as I am a long-term investor who doesn’t pay attention to the fluctuations of the market, but instead to the underlying values of the businesses I invest in. For instance, I am recommending McGraw Hill this month, which announces earnings on January 27^th. While the stock price may move dramatically on that day, I don’t know if earnings will beat or miss Wall Street expectations, but I do believe that McGraw Hill is a great company trading at a cheap price, and if held over time will represent an attractive investment. Again, I neither encourage nor discourage you from investing in McGraw Hill today before the earnings announcement, but I will be purchasing it today for my own portfolio, and do not know whether or not after the earnings release you will be able to buy it at a cheaper or more expensive price. However, I do know that I am comfortable with the price I will be paying.

Introduction

mdcapitalmanagement — Mon, 26 Jan 2009 00:00:18 +0000

I have started a newsletter that provides, via e-mail, one investment idea every month to my readers, thereby gaining a forum to discuss those ideas and establishing a public track record for my investment decisions. I select investments based on the value investing principles espoused by Warren Buffett, Joel Greenblatt and Glenn Greenberg, (i) investing in good businesses (ii) with management teams who wisely allocate capital (iii) that can be bought at a cheap price. I will scour the market for investing ideas every month in order to present one to you, but I will not lower my standards of what constitutes a good business, management team, and/or price out of a forced necessity to have an idea every month. If I do not have an idea for a particular month, I will inform you of what investment ideas I looked at and passed on, and discuss the reasons I was not able to find a suitable opportunity. Also, because the price paid determines the ultimate return of the investment, newsletters will go out as soon as I make a buy or sell decision to ensure you buy or sell at an acceptable price, and thus publication of this newsletter will not follow a typical periodic schedule. For instance, it is possible that the November newsletter will come out on November 1st, but the December newsletter may not be published until the 21st, as the timing of the letter is dictated by me finding of quality ideas, not the other way around. Also, I plan to invest in every idea that I send to you, and will invest one or two business days before or after this newsletter is sent to you. This newsletter represents a summary of several weeks of extensive due diligence and valuation work, so please feel free to contact me if you have any questions or would like further details on the work I performed. I have not included the detailed build-up of calculations, etc in order to make the newsletters less cumbersome to read.

Important Note:

I will not be posting the newsletter to this blog, but instead will include commentary on articles, market movements, and events that influence the way I invest.

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