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The Earnings Power Chart: Ben Graham and the Growth Investor What‘s wrong with EPS and why you should “measure twice, cut once”:  The Earnings Power Chart: Ben Graham and the Growth Investor What‘s wrong with EPS and why you should “measure twice, cut once” HEWITT HEISERMAN JR. www.EarningsPower.com Hewitt.Heiserman@EarningsPower.com The Earnings Power Chart and Earnings Power Staircase are property of Hewitt Heiserman Jr. All rights reserved. Copyright 2006 Presentation to Babson Investment Management Association (BIMA) March 2, 2006 Today’s Topics:  Today’s Topics The Earnings Power Chart to gauge earnings quality of a firm’s net income Earnings Power Archetypes The Earnings Power Staircase: A special kind of Earnings Power company A three (3)-step process to find a conservative growth stock Other ideas to improve your investing results Appendix Section I of VI:  Section I of VI The Earnings Power Chart Common Stocks and Earnings Power:  Common Stocks and Earnings Power All investors share a common aspiration: to own a stock that makes a difference A $10,000 investment in Microsoft in 1990 grew to $966,000 in next decade So how do we find “the next Microsoft” Many of us look for a company with rising earnings Microsoft: A Decade’s Worth of Rising Earnings:  Microsoft: A Decade’s Worth of Rising Earnings GAAP Earnings:  GAAP Earnings To create comparability, all companies follow generally accepted accounting principals (GAAP) GAAP is Robert’s Rules of Order for corporate America When you open an annual report, 10-K or 10-Q and look at the financials (including the income statement), that’s GAAP Like many investors, I used to take GAAP earnings at face value GAAP P&L has Four (4) Structural Limitations:  GAAP P&L has Four (4) Structural Limitations Free Cash Flow fixes Limitations 1, 2 :  Free Cash Flow fixes Limitations 1, 2 Cash Flow and Security Analysis (McGraw-Hill, 1995), by Ken Hackel and Joshua Livnat GAAP income statement has two structural limitations: it omits investment in fixed capital and omits investment in working capital Thus, use free cash flow. Like GAAP, free cash flow deducts normal operating expenses. In addition, it deducts investment in fixed and working capital Purpose: Is company able to self-fund via internally generated funds? If free cash flow loss, then what? Deplete checking account? Liquidate assets? Borrow money? Sell more stock? Because free cash flow expenses everything, pessimistic investors use it to avoid owning company that may run out of cash Economic Value Added (EVA) fixes Limitations 3, 4:  Economic Value Added (EVA) fixes Limitations 3, 4 The Quest for Value (HarperCollins, 1991), by Bennett Stewart GAAP income statement has two more structural limitations: intangibles are expensed and stockholders’ equity is free Thus, use Economic Value Added (EVA). Like GAAP, EVA deducts normal operating expenses. In addition, it capitalizes intangibles and expenses stockholders’ equity Purpose: Is company creating value; i.e., earning a profit after accounting for all the capital that it employs? If EVA loss, then what? Owners will seek better returns elsewhere, resulting in a falling stock price. Harder to attract/retain key employees, putting company at competitive disadvantage Because EVA capitalizes intangibles and expense equity, optimistic investors use it to find tomorrow’s most promising opportunities My Quandary?:  My Quandary? Both alternate income statements are superior to GAAP in some respects, but each also has its own structural limitations So when do I use free cash flow? When do I use EVA? Answer from unlikely source… Benjamin Graham (1894-1976):  Benjamin Graham (1894-1976) Graduated #2 in class from Columbia in 1914, then offered teaching opportunities in English, mathematics, and philosophy departments Instead, went to Wall Street. Nearly ruined by speculation before devising “value” strategy. Then averaged 21%/year for 20+ years  Began teaching popular investing class at Columbia in 1928. Warren Buffett’s teacher, employer, and friend Author Security Analysis (1934); The Intelligent Investor (1949) Helped found CFA program in 1960s Pithy, hard-boiled investment philosophy: “Margin of safety." “This century’s (and perhaps history’s) most important thinker on applied portfolio investment, taking it from an art, based on impressions, inside information, and flair, to a proto-science, an orderly discipline.” –John Train, The Money Masters Graham’s Two Personalities:  Graham’s Two Personalities “The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses.…the determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than average.” --Benjamin Graham, The Intelligent Investor (Harper & Row, 1973) My Interpretation of Graham:  My Interpretation of Graham Defensive investor is a commercial banker, Enterprising investor is a venture capitalist There are many instances when GAAP income statement is not well-suited to meeting the needs of either personality; i.e., GAAP too optimistic for defensive investor and too pessimistic for enterprising investor In honor of Graham, we refer to free cash flow as defensive income statement and EVA as enterprising income statement Neither alternate P&L in GAAP financial statements; you have to build them yourself A Proposal:  A Proposal Authentic earnings power = defensive profits (free cash flow) + enterprising profits (EVA) Case Study: Enron Corp.:  Case Study: Enron Corp. Per-share GAAP earnings up 9 of 10 years ending 2000 During the ’90s, total return 1,415% vs. 383% for S&P 500 One of Fortune’s “10 Stocks to Last the Decade” (August 2000) Board of directors rated among U.S.’s five best Limitation #1: Investment in Fixed Capital:  Limitation #1: Investment in Fixed Capital This $3.6 billion is an expense in the defensive income statement because it is a use of cash, but not it is not an expense in the GAAP and enterprising versions because it is an investment. Limitation #2: Investment in Working Capital:  Limitation #2: Investment in Working Capital This $1.1 billion is an expense in the defensive income statement because it is a use of cash, but it is not an expense in the GAAP and enterprising versions because it is an investment. Limitation #3: Capitalizing Intangibles:  Limitation #3: Capitalizing Intangibles This $72 million is an expense in the enterprising income statement because outlays from prior years were pushed into 2000, but it is not an expense in the defensive and GAAP versions because there was no spending according in 2000. Limitation #4: Enterprising Interest:  Limitation #4: Enterprising Interest Enterprising interest is equal to the sum of a firm’s interest-bearing debt and stockholders’ equity, multiplied by the weighted average cost of capital. For a cost of equity, I use the 10-Year Treasury yield plus 500 basis points. In the defensive and GAAP versions, interest is the cash cost of debt only. Step #1 of 3: Three Income Statements:  Step #1 of 3: Three Income Statements Step #2 of 3: Quality of Profits:  Step #2 of 3: Quality of Profits Step #3 of 3: Earnings Power Chart:  Step #3 of 3: Earnings Power Chart Enron: A Second Look:  Enron: A Second Look 2000 was a record year for revenue, net income; total return +89% vs. -9% for S&P 500 But then management declared bankruptcy in December 2001 after admitting 1997-2001 earnings were overstated; biggest U.S. corporate failure to date Stock falls from high of $85 to pennies 21,000 employees lose their jobs, pensions Despite GAAP profits, Enron does not possess authentic earnings power according to the Earnings Power Chart Business Week Results (12 mos. Apr. 1, 2005):  Business Week Results (12 mos. Apr. 1, 2005) Earnings Power Chart selected all Buys and Sells. Dividends excluded. Source: BusinessWeek, Apr. 12, 2004, "Twin Tests For Stocks That Measure Up" Motley Fool Results (Dec. 10, 2004-Dec. 9, 2005):  Motley Fool Results (Dec. 10, 2004-Dec. 9, 2005) Earnings Power Chart selected all Buys and Sells. Dividends excluded. Source: The Motley Fool, Dec. 23, 2005, “A Stock for Scrooge” Section II of VI:  Section II of VI Earnings Power Archetypes “Just 4 Kinds of Companies…”:  “Just 4 Kinds of Companies…” Regardless of size, industry, or capital structure, all companies situated in one of Earnings Power Chart’s four (4) boxes Lower-Left Box: Enron (down 99% from $85 peak in mid-2000):  Lower-Left Box: Enron (down 99% from $85 peak in mid-2000) Upper-Left Box: HealthSouth (HLSH) (down 83% from $30 peak in mid-1998):  Upper-Left Box: HealthSouth (HLSH) (down 83% from $30 peak in mid-1998) Lower-Right Box: Krispy Kreme Donuts (KKD) (down 88% from $50 peak in mid-2003):  Lower-Right Box: Krispy Kreme Donuts (KKD) (down 88% from $50 peak in mid-2003) Coal Mine Canary:  Coal Mine Canary "The way to win is by making fewer bad shots." –Tommy Armour (Source: “Tommy Armour on Investing,” Charles Ellis) Upper-Right Box: Wrigley (WWY) (up 41% 1998-2002 vs. –9% loss for S&P 500):  Upper-Right Box: Wrigley (WWY) (up 41% 1998-2002 vs. –9% loss for S&P 500) How to Use the Earnings Power Chart:  How to Use the Earnings Power Chart Source new ideas. “Long” prospects in upper-right box; “short” candidates in lower-left box. Monitor current portfolio. Which of 4 boxes is company in? Why? Are gains in GAAP confirmed by higher levels of defensive, enterprising profits? If not, why? Is there a tight or loose fit between GAAP and defensive, enterprising profits? What is long-term trend? Competitors. If your company’s competitors are weakening, your company may be next. Customers. See #3. Test management candor, realism. Do they say they had “good year” but company moved in lower-left direction? (See Enron) Thinking Like A Genius:  Thinking Like A Genius Creative thinking expert Michael Michalko cites 8 strategies in “Thinking Like a Genius” (The Futurist, May 1999) Strategy #1-Variant perspective. Leonardo daVinci believed looking at problem from many angles helped him understand it better Strategy #2-Use pictures. When Albert Einstein tackled a problem, he diagramed it. “Words and numbers….did not play a significant role in his thinking process.” Strategy #6-Think in opposites. Physicist and Nobel prize winner Niels Bohr believed if you hold opposites together and then suspend thought, your mind moves to a new level. The Earnings Power Chart may help you think like a genius; it uses variant perspectives, pictures, and opposing viewpoints. Section III of VI:  Section III of VI A Special Kind of Earnings Power Company: The Staircase Earnings Power Staircase :  Earnings Power Staircase Some upper-right box companies keep moving in upper-right direction every year to forge Earnings Power Staircase So-named because chart looks like profile of a staircase When company forges an Earnings Power Staircase, you may make 5-10 times your investment (or more) in 10-15 years “If you buy a few great companies, you can sit on your ass.” –Charlie Munger Earnings Power Staircase: Apollo Group (APOL) ($10,000 investment in August 1999 grew to $78,000 five years later):  Earnings Power Staircase: Apollo Group (APOL) ($10,000 investment in August 1999 grew to $78,000 five years later) Earnings Power Staircase: Cisco Systems (CSCO) ($10,000 investment in July 1990 grew to $631,000 six years later):  Earnings Power Staircase: Cisco Systems (CSCO) ($10,000 investment in July 1990 grew to $631,000 six years later) Earnings Power Staircase: Dell Computer (DELL) ($10,000 investment in January 1994 grew to $1.3 million five years later):  Earnings Power Staircase: Dell Computer (DELL) ($10,000 investment in January 1994 grew to $1.3 million five years later) Earnings Power Staircase: Microsoft (MSFT) ($10,000 investment in June 1990 grew to $966,000 in next decade):  Earnings Power Staircase: Microsoft (MSFT) ($10,000 investment in June 1990 grew to $966,000 in next decade) Earnings Power Staircase: Paychex (PAYX) ($10,000 investment in May 1992 grew to $257,000 nine years later):  Earnings Power Staircase: Paychex (PAYX) ($10,000 investment in May 1992 grew to $257,000 nine years later) Earnings Power Staircase: Quality Systems (QSII) ($10,000 investment in September 2000 grew to $204,000 five years later):  Earnings Power Staircase: Quality Systems (QSII) ($10,000 investment in September 2000 grew to $204,000 five years later) Getting Bigger and Better:  Getting Bigger and Better Company forging Earnings Power Staircase uses capital efficiently from view of both pessimistic defensive investor and optimistic enterprising investor "20% of U.S. large-cap stocks with lowest balance sheet accrual growth beat 20% with highest growth over the last 26 years by avg. 9.3% a year,“ per Alliance Bernstein May 2005 White Paper. [Accruals exclude cash, stockholders’ equity] Own “capital-light” companies Section IV of VI:  Section IV of VI How to Buy a Conservative Growth Stock 3-Step Process:  3-Step Process Use Earnings Power Chart to gauge quality of GAAP profits Figure out what is competitive advantage and how long will it last. The more durable the competitive advantage, the more valuable the business. Value the business. Does the company sell at a discount to its real, or “intrinsic,” worth? Case study: Blue Nile (NILE):  Case study: Blue Nile (NILE) Largest Internet retailer of certified diamonds, offering 60,000 styles for up to 40% off retail Bigger than next three largest online jewelers combined Management believes it has 3% market share of U.S. engagement ring sales, goal is 15% penetration Founded in 1999, IPO 2004 “Capital-light” balance sheet because it does not have inventory; instead, Blue Nile lets suppliers showcase their merchandise on its website and then buys when a sale is made High trust factor: Blue Nile says it routinely sells $50,000 engagement rings Market value: $585 million (3/1/06) Competitors: Amazon (AMZN), Tiffany (TIF), Zale (ZLC), Ice.com Pristine balance sheet: $115 million of cash, no debt CEO Mark Vadon owns 10%, CFO and COO own another 5% combined Step #1 of 3: Gauge Quality of GAAP Earnings:  Step #1 of 3: Gauge Quality of GAAP Earnings Step #2 of 3: Competitive Advantage:  Step #2 of 3: Competitive Advantage Schumpeter’s “Creative Destruction”: Who’s Working on 13-Corkscrew French Army Knife?:  Schumpeter’s “Creative Destruction”: Who’s Working on 13-Corkscrew French Army Knife? Step #3 of 3: Intrinsic Value:  Step #3 of 3: Intrinsic Value Many ways to appraise a company If Earnings Power Chart confirms quality of firm’s GAAP profits, then I use GAAP (as well as other approaches) $34 intrinsic value based on average of 3 growth scenarios Margin of safety: Buy at 75% of intrinsic value estimate, or $25; sell at 125% of forecasted “real worth,” or $42 Current price: $34 (3/1/06) Estimating intrinsic value is an educated guess. e.g., Morningstar’s intrinsic value for Blue Nile is $42 Have a watch list. If your company hits “buy” price, pounce. Section V of VI:  Section V of VI Some other ideas to improve your investing results Other Ideas to Improve Your Investing Results:  Other Ideas to Improve Your Investing Results Study the methods of great investors. Many ways to make money on Wall Street. What’s the best? Find an approach that suits your personality. My Earnings Power approach makes sense to me; it is disciplined, repeatable and explainable. Have an “ideal company” checklist. The more points, the better. Knock holes in your investment thesis. Understand the bear argument on your company. Every company has problems. Before you buy a stock, do a write-up. A good outline for conservative growth stocks is the ideal company checklist in #4. See Motley Fool’s discussion boards. Keep turnover to a minimum. Among all domestic equity funds, over 10 years the funds that traded the least beat the funds that traded the most by 171 basis points a year. (source: Bogle Financial Markets Research Center.) Buffett’s 20-idea “lifetime decision card” Benchmark your life. On Jan. 1 of every year record your net worth, what you learned during the past year, mistakes you made, your weight, how fast you can bicycle 10 miles, etc. “What gets measured gets done.” Summary: “Measure Twice, Cut Once”:  For Ben Graham, intelligent investing meant having a margin of safety in case of “miscalculation or bad luck.” This is why he bought companies selling at big discounts to working capital assets after deducting all liabilities (his famous “net-nets”) As Microsoft’s recent history shows, valuation is important; its shares fell from $60 a share in 2000 to $30 But also consider earnings quality. While earnings drive prices, not all earnings are created equal. The Earnings Power Chart can help, because it shows whether a company is profitable in the broadest possible sense of the word. Does company make money on both defensive, enterprising basis? That’s good. Is it forging an Earnings Power Staircase? Even better. To sum up, follow the advice of the master carpenter to the apprentice: “measure twice, cut once.” Summary: “Measure Twice, Cut Once” Questions?:  Hewitt.Heiserman@EarningsPower.com www.EarningsPower.com Questions? Section VI of VI:  Section VI of VI Exhibits Bio-Hewitt Heiserman:  Bio-Hewitt Heiserman Creator, Earnings Power Chart Author, It’s Earnings That Count (McGraw-Hill, 2004) Outside Contributor, RealMoney.com Cited in TheStreet.com, BusinessWeek, Herb Greenberg’s MarketWatch, Business 2.0, Better Investing, Motley Fool, Complete Growth Investor, Barron’s, Haverford Trust Company Adviser Member, Boston Security Analyst Society, CFA Institute Kenyon College (Gambier, OH), A.B. History with Distinction, Faculty Award for Distinguished Achievement About It’s Earnings That Count (McGraw-Hill, 2004):  About It’s Earnings That Count (McGraw-Hill, 2004) Challenges conventional wisdom that company has “earnings power” just because EPS keeps rising Introduces Earnings Power Chart to find conservative growth stocks for long-term capital gains Foreword by John C. Bogle, founder and former CEO of The Vanguard Group Endorsed by Charles W. Mulford, Motley Fool’s Tom Jacobs, Thornton Oglove, Morningstar’s Mark Sellers, Robert L. Rodriguez, Arne Alsin, Jim Rogers, John D. Spooner, Kenneth L. Fisher How to Build Your Own Earnings Power Chart:  How to Build Your Own Earnings Power Chart It’s Earnings That Count (McGraw-Hill, 2004) Cash Flow and Security Analysis; The Quest for Value Aswath Damodaran’s site http://pages.stern.nyu.edu/~adamodar/ Motley Fool’s IETC discussion board at: http://boards.fool.com/Messages.asp?bid=116735 Free Cash Flow vs. Economic Value Added (EVA):  Free Cash Flow vs. Economic Value Added (EVA) Limitation #1: Omits Investment in Fixed Capital:  Limitation #1: Omits Investment in Fixed Capital Fixed capital is buildings, trucks, telephone networks, etc. A company makes investment in fixed capital when capital spending is greater than depreciation. Key question: Will investment in fixed capital produce higher future sales, cost savings? 20% of companies with highest capital spending growth lagged market by 1.5% annually 1973-1996, while lowest 20% beat market by 1% a year. (Paul Sturm, Smart Money, June 2005) Limitation #2: Omits Investment in Working Capital:  Limitation #2: Omits Investment in Working Capital When receivables, inventory grow faster than payables, accrued expenses, this is an investment in working capital Investment in working capital is use of cash that does not appear in GAAP income statement; like fixed capital investment, it has to be financed somehow Key point: A profitable company can suffer liquidity squeeze if it can’t collect receivables and/or sell inventory in timely manner Limitation #3: Intangibles are Expenses:  Limitation #3: Intangibles are Expenses R&D, advertising, employee education, and pre-store opening Investment in intangibles enables management to boost revenue, charge higher prices (brand value), cut costs, improve employee morale and productivity, etc. But GAAP says intangibles are expenses, not assets Accounting irony: In 2004, Intel (INTC) deducts $4.8B of R&D but capitalizes $3.8B of capex. Which spending more valuable? (Intangibles not a big item for Enron) Key point: GAAP earnings for “brains” companies not comparable to “brick” companies Increased R&D led to both improved operating performance and superior stock returns, per study of 8,300 companies over 50 years. (Source: Journal of Finance, 2004, Vol. 59, No. 2, pgs. 623-650.) Enterprising income statement capitalizes intangibles to match current sales with current expenses, future sales with future expenses Limitation #4: Stockholders’ Equity is Free:  Limitation #4: Stockholders’ Equity is Free All companies financed by combination of debt and equity Debt comes from banks, bondholders; equity from owners Debt an expense but equity is free, per GAAP. Why? Noncash cost; also, different owners have different required rates of return. But GAAP-profitable company may not look so hot if you expense owner opportunity costs. Also, companies with different capital structures are not comparable Enterprising income statement expenses stockholders’ equity because it is a cost, albeit noncash Standard & Poor’s “Core Earnings” Not a Fix:  Standard & Poor’s “Core Earnings” Not a Fix Devised in 2002 to bring more “transparency and consistency” to earnings analysis and forecasts. Expenses include: stock options, pension costs, restructuring charges from ongoing operations, write-downs of depreciable or amortizable operating assets, purchased R&D, M&A related expenses, and unrealized gains/losses from hedging activities. Excluded from core earnings are: pension gains, goodwill impairment charges, gains or losses from asset sales, reversal of prior-year charges, and proceeds from litigation. But you still have GAAP’s four (4) structural limitations

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