Magic Formula

I have posted before about Magic Formula investing, with the help of Digital Look I have prepared a table of magic formula type shares in the UK.

I ranked companies by their ROCE, then by P/E, then combined the ranks giving a high rank to those with both a high ROCE and a low P/E.

The top 19 companies are:

Company	ROCE	P/E
Sport Media Group	129.06%	2
New Star Asset Management Group	290.10%	2.8
Charlemagne Capital	122.89%	3.3
Creston	107.44%	3
Synarbor	84.54%	2.2
Jacques Vert	108.37%	3.4
RDF Group	81.49%	2.5
Garner	483.33%	4.4
Yell Group	70.85%	2.3
Belgravium Technologies	125.06%	3.9
Somero Enterprises (Reg S)	86.60%	3.5
OPD Group	118.41%	4.1
Lincat Group	82.95%	3.6
Litcomp	79.18%	3.6
Celtic	68.53%	3.2
Castle Support Services	86.39%	4.1
Topps Tiles	82.28%	4.6
Solid State	75.17%	4.4
Avingtrans	75.09%	4.4

A Thought About Valuation and Multiples

A multiple is just someone else’s discounted cash flow – with all the messy maths and assumptions hidden behind a single number.

Market multiples (be it a price earnings, revenue or EBIT multiple) are just single number that hides the assumptions the market is making about that company’s expected future cash flow (and the level of risk associated with that cash flow).

Transaction multiples just hide the acquirers assumptions around the expected cash the asset will produce under their ownership / capital structure / management etc.

Berkshire Hathaway

Few highlights from Berkshire Hathaway’s 2007 annual report.

Charlie and I look for companies that have:

• a business we understand
• favorable long-term economics
• able and trustworthy management; and
• a sensible price tag.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great.

There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so.

[Talking about investments in different types of companies] To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

[On buying Dexter, a shoe business with Berkshire stock] In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion – to buy a worthless business.

[On buying Amazon bonds at 57% of par] Yes, Virginia, you can occasionally find markets that are ridiculously inefficient – or at least you can find them anywhere except at the finance departments of some leading business schools.

Cameron Partners

Just came across the Cameron Partners website . The part that caught my attention was the news section with a series of presentations. The most recent is Food Industry Acquisitions Set to Continue, by Hugh Cotterill - November 2007 (pdf).

While Premia in New Zealand Takeover & Offer Proposals, by Paul Dougherty and Stephen Kaiser - October 2007 (pdf) states the median premium for control (think take over premium, or the extra price paid when someone looks to acquire a listed company) in New Zealand (whether successful or unsuccessful) is 23.6%.

Which leads nicely to another article titled Boards Should Act on Control Premiums, NBR 28 April 2006 , by Paul Dougherty (pdf). This explains the premium for control exists if someone thinks they can extract more value from the set of assets owned by the company with the current business plan and/or management team .

The two main sources of this extra value are stand-alone improvements (cost cutting, growing existing revenue, new products, asset sales or new technology) or synergies (typically cost savings from combining the business with another entity).

The business can have a different value to the purchaser with access to these gains than the existing shareholders with the current management team and business plan.

The article goes on to say a number of advisers suggest there is only one true or “fair” value for a company. While value is in fact different for different owners, depending on the improvements or synergies they can achieve.

Important Variables

Interesting post at Gurufocus.com about important variables in valuation, including perhaps how Warren Buffett looked at his orginal investment in Coke.

“There are an infinite number of facts that you can learn about a company, but there are usually two or three very important variables that make the company succeed or fail. A lot of Wall Street gets so bogged down in the minutiae and details that it misses these two or three big things that make or break the investment. Part of what worked for me over the years is being able to distinguish what matters from what doesn’t. That’s one of Buffett’s great gifts. He focuses on the critical issues involved in analyzing. I don’t pretend to be able to do it like he does but it’s one of the most important things you can do.” – Wallace Weitz

When Buffett looked at Coca-Cola he was probably looking at the total servings sold per annum and the profit per serving of each Coke. Those are Coke’s key variables, the number of servings people consume and the profit per serving for Coke products. Buffett was certain that consumption would increase through taking share of other liquids consumed. As well, he figured they could squeeze more than a penny per serving, which they were earning out of the product over time.

Morningstar Investment Methodology

On looking around Morningstar’s website I came across two documents, Morningstar’s approach to equity research and their equity research methodology. They offer a great overview of how Morningstar think about company valuation and market prices.

Here is a quote from the start the document about equity research:

At Morningstar, we evaluate stocks as pieces of a business, not as pieces of paper. We think that purchasing shares of superior businesses at discounts to their intrinsic value and allowing them to compound their value over long periods of time is the surest way to create wealth in the stock market.

Key topics covered include:

• Economic Moat
• Discounted Cash Flow
• Discount Rate
• Fair Value
• Business Risk
• Margin of Safety
• Consider Buying/Consider Selling
• Stewardship Grades

Investment Tools

Here are a few investment tools I came across from Top 5 Hacks for Intelligent Investors and Valuation Tools from Financial Times from FatPitchFinancials.

Excel Add-In

This Excel Add-In lets you take financial data from Yahoo Finance, Google Finance, MorningStar, Reuters etc straight into Excel. For example you want the market cap of MSFT from Yahoo Finance in your Excel spreadsheet. Just install the add-in and use the formula “=RCHGetElementNumber(”MSFT”, 941)”. Quote from the orginal post.

You can turbo charge you stock financial spreadsheets using an excellent and free Excel Stock Market Functions Add-in. You can download this great tool that lets you add data from MSN, Yahoo, Google, Reuters, ADVFN, Morningstar, and more directly into your Excel spreadsheet cells by joining the smf_addin group.

Note to download the add-in you have to join the associated Yahoo Group.

FT – DCF model

The Lex column from the Financial Times has an online DCF calculator / model. This is good for people that don’t want to build a model in Excel and are happy to plug in a few high level assumptions to generate a valuation.

Common DCF Errors

Michael J. Mauboussin of Legg Mason Capital Management has an excellent article (pdf) about common errors in DCF models. Below is a summary of the eight main points and couple of quotes from the article (pdf).

1. Forecast horizon that is too short.
2. Uneconomic continuing value.
3. Cost of capital.
4. Mismatch between assumed investment and earnings growth.
5. Improper reflection of other liabilities.
6. Discount to private market value.
7. Double counting.
8. Scenarios. An intelligent investor needs to consider multiple scenarios. Investors should look to the value drivers—sales, margins, and investment needs—as sources of variant perception. Proper scenario analysis considers how changes in sales, costs, and investments lead to varying value driver outcomes.

Quote about valuation multiples

Multiples are not valuation; they represent shorthand for the valuation process. Like most forms of shorthand, multiples come with blind spots and biases that few investors take the time and care to understand.

General conclusion

Theory and practice tell us the value of a company is the present value of future cash flows. Investors primarily seek to buy a stream of cash flow for less than it’s worth—or sell a stream for more than it’s worth. Accordingly, an investor needs to be able to model cash flows intelligently and identify a variant perception: a well-founded belief the market has placed an incorrect value on a company.

Wide-moat Companies on the NZX

Here is my list of wide-moat companies listed on the NZX.

• ASB Capital Limited
• Auckland International Airport Limited
• Australia and New Zealand Banking Group Limited
• CanWest MediaWorks (NZ) Limited
• Contact Energy Limited
• Fisher & Paykel Appliances Holdings Limited
• Fisher & Paykel Healthcare Corporation Limited
• Fletcher Building Limited
• Freightways Limited
• Goodman Fielder Limited
• Hallenstein Glasson Holdings Limited
• Independent News & Media PLC
• Lion Nathan Limited
• Mainfreight Limited
• Michael Hill International Limited
• New Zealand Exchange Limited
• Northland Port Corporation (NZ) Limited (NS)
• Port of Tauranga Limited (NS)
• Sky City Entertainment Group Limited (NS)
• Sky Network Television Limited
• TeamTalk Limited
• Telecom Corporation of New Zealand Limited (NS)
• The Warehouse Group Limited
• Toll NZ Limited
• Vector Limited
• Westpac Banking Corporation

I plan to post a summary of each company and a ratio of price to fair value. This is based on the approach taken by Morningstar. And should help identify companies trading at a discount to fair value.

Models

Equityprivate has a post about the blog of an alleged associate at Elevation Partners. The post has a great comment about financial models.

Large unwieldy models are almost universally produced by financial “professionals” who have no clue whatsoever about their predictive value (hint: it is vanishingly small) and therefore the size of the model is, in my view, inversely proportional to the technical competence of the employee.

I agree. I have seen a lot of large models that when examined, don’t actually work. While a small well built model that is driven by a few key inputs can be very useful.