1. No category

Ben Graham and the Growth Investor
Presented to Bryant College
April 10, 2008
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 2008
Preface
Why We Have to Be at the Top
of Our Game
2
Which Asset Class Is Better Value Today?
Stocks:
Bonds:
S&P 500: 1355
S&P earnings (TTM): $66
10-year Treasury: 3.52%
S&P 500 earnings source is Barron’s. Market data as of Apr. 9, 2008
3
Stocks Better Value Than Bonds—P/E Basis
4
Stocks:
Bonds:
21x (1355/$66)
28x (1/3.52)
P/E Misleads If Economy At Inflection Point
Real 10-Year P/E: The Stock-Bond Gap Narrows
S&P 500
Real 10-Year Earnings (avg.)
Bond yield (10-year Treasury)
P/E
Source: IrrationalExuberancecom, EarningsPower.com
6
Stocks
1355
$59
23x
Bonds
3.52%
28x
Repetitive Cycles of Enthusiasm and Despair
Will History Repeat?
Peak
8
Trough
Contraction
S&P
Years
S&P
CAGR
Date
10 Yr.
P/E
S&P
Date
10 Yr.
P/E
6/1901
25x
239
12/1920
5x
74
19.5
-6%
9/1929
33x
383
6/1932
6x
74
3.75
-36%
12/1968
22x
635
7/1982
7x
238
13.6
-7%
4/10/2008
23x
1355
?
?
?
?
?
55-Yr. Avg. 300bps Above Current 3.52% Yield
If 10-Year Reverts, Then Bonds Offer More Value
S&P 500
Real 10-Year Earnings (avg.)
Bond Yield (55-year avg.)
P/E
Stocks
1355
$59
23x
Bonds
6.44%
16x
As the cost of money rises, corporate earnings and P/E multiples get
punished
10
We Need to Be at Top of Our Game



11
If market reverts to “generational” trough P/E’s of 5x7x, expect tremendous loss in wealth or time; either we
have i) explicit bear market of 430 today or ii) decade
of flattish S&P while earnings catch-up.
We do not have benefit of P/E expansion ca. 19821999, when it climbed to 44x from 7x and produced a
13% CAGR.
Introduce Earnings Power 1-2-3 Process to help you
navigate choppy investment waters
Resources:
Prof. Robert Shiller’s website:
http://www.irrationalexuberance.com/
To view the Real 10-Year PE Data, click here:
“One can access an Excel file with the data set (used and
described in the book) on stock prices, earnings, dividends
and interest rates since 1871, updated.”
Section I
The Growth Trap
13
Many Ways to Make Money on Wall Street
14

Net-net

Sum-of-the-parts

Risk arbitrage

Catalyst

Activist

Short selling

Technical analysis

Growth
Growth Stock: Company with Rising EPS
EPS to $1.42 in 1999 from $0.07 in 1990
15
Benefits of Growth Investing
16

Defer capital gains taxes, so your principal compounds faster

Save money on commissions, bid-ask slippage costs

Trade less, which improves investing results

No “exquisite timing” required; you can build a position over
many years

Asymmetrical risk-reward. Worst-case, investment goes to zero.
Best-case, multiply your capital several-fold. $10,000 in
Microsoft in 1990 grew to almost $1 million over next ten years.
But Beware of the Growth Trap
10-Year Avg. Annual Real Returns for S&P 500, 1926-9/2007
12%
10%
8%
6%
4%
2%
0%
Highest P/E (growth)
17
Source: Jeremy Grantham, GMO, Oct. 2007
Lowest P/E (value)
Three (3) Obstacles Confronting Growth Investor
18
1. Poor
earnings
quality
GAAP income statement has four (4) structural
limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.
2. Competitive
advantage
wanes
Successful companies attract imitators. This is good
for consumers, bad for owners.
3. Premium to
intrinsic value
We predict by extrapolation, so growth stocks often
get pushed beyond real worth.
Section II
Obstacle #1: Poor Earnings
Quality
19
The GAAP Income Statement
 To create comparability, all companies follow generally accepted
accounting principals (GAAP)
 Robert’s Rules of Order for corporate America
 When you open an annual report, 10-K or 10-Q and look at
financials statements, that’s GAAP
 Many investors take GAAP at face value; they think EPS is “hard”
number, like…
20
…height of Fenway’s Green Monster (37 feet)
But EPS is a “Soft” Number
 GAAP income statement has four (4) structural limitations
 A dollar of earnings for one company’s may not be comparable to
a dollar of EPS from another company, or for same company from
one year to next
22
GAAP P&L’s Four (4) Structural Limitations
1.
2.
3.
4.
23
Investment in fixed capital is ignored, so when capital spending
is greater than depreciation the company may be profitable on
GAAP basis but short cash.
Omits investment in working capital, so when receivables and
inventory grow faster than payables and accrued expenses the
company may be profitable on GAAP basis but short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders’ equity is free even though owners have an
opportunity cost.
GAAP P&L’s Four (4) Structural Limitations
1.
2.
3.
4.
24
Investment in fixed capital is ignored, so when capital
spending is greater than depreciation the company may be
profitable on GAAP basis but short cash.
Omits investment in working capital, so when receivables and
inventory grow faster than payables and accrued expenses the
company may be profitable on GAAP basis but short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders’ equity is free even though owners have an
opportunity cost.
Notes on Capital Spending
 Fixed capital is buildings, trucks, telephone networks, etc.
 When a company buys fixed capital, it spends the cash today but
for accounting purposes depreciates outlay over asset’s expected
useful life. Depreciation enables companies to match current sales
with current expenses, and future sales with future expenses
 If capex is greater than depreciation, a company makes
investment in fixed capital. Investment in fixed capital is a use of
cash. This cash outlay has to come from somewhere; e.g.
checking account, liquidate other assets, borrowings, or stock
sales. Will investment produce higher future sales, cost savings?
 Beware of capital-intensive companies. The 20% with highest
capital spending growth lagged market by 1.5% a year during
1973-1996, while lowest 20% beat market by 1% a year. (Paul
Sturm, Smart Money, June 2005)
25
TheStreet.com (TSCM)
Structural Limitation #1: Investment in Fixed Capital
TheStreet.com (TSCM)($mls)
Capital spending (real cash they spent in 2007)
- Depreciation (a noncash charge in GAAP P&L)
= Investment in fixed capital
27
2007
$5
3
$2
Expensing Investment in Fixed Capital Usually Reduces
GAAP Earnings
TheStreet.com (TSCM)($mls)
Net income (inc. $3M of depreciation)
- Fixed capital investment
= Adjusted net income
28
GAAP
Expense
$31
n/a
$31
$31
2
$29
Sidebar: Are Acquisitions a Capex Equivalent?
TheStreet.com (TSCM)(millions)
Net income
- Fixed capital investment
- 20% of 2007 Acquisition ($30/5 years)
= Adjusted net income
GAAP
Expense
$31
n/a
n/a
$31
$31
2
6
$23
Acquisitions are 1) a use of cash, 2) a substitute for capital spending,
and 3) their payoff is uncertain. Depreciate deals over 5 years.
29
GAAP P&L’s Four (4) Structural Limitations
1.
2.
3.
4.
30
Investment in fixed capital is ignored, so when capital spending is
greater than depreciation the company may be profitable on
GAAP basis but short cash.
Omits investment in working capital, so when receivables
and inventory grow faster than payables and accrued
expenses the company may be profitable on GAAP basis but
short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders’ equity is free even though owners have an
opportunity cost.
Notes on Working Capital
 Working capital assets include receivables, inventory,
other current assets (but not cash, marketable
securities); working capital liabilities are payables,
accrued expenses. Working capital is WCA - WCL
 While it is good to have more assets than liabilities,
when working capital increases from one year to next,
this is an investment in working capital
 Investment in working capital is use of cash that does
not appear in GAAP income statement. Still, like fixed
capital investment, it has to be financed somehow
 A profitable company can suffer liquidity squeeze if it
can’t collect receivables and/or sell inventory in timely
manner
31
Crocs (CROX)
Structural Limitation #2: Investment in Working Capital
Crocs Inc. (CROX)($mils)
Working capital assets:
Receivables
Inventory
Total WC assets
Working capital liabilities:
Payables
Accrued Expenses
Total WC liabilities
33
Net working capital
Investment in net working capital
12/31/06
12/31/07
$66
86
$152
$153
248
$401
$44
31
$75
$83
57
$140
$77
$261
$184
Expensing Investment in Working Capital Usually
Reduces GAAP Earnings
34
Crocs Inc. ($mils)
2007
Net income
- Investment in working capital
= Adjusted net income
$168
184
$(16)
Sometimes WC is a Source of Cash
Blue Nile (NILE) ($mils)
Net income
- Investment in working capital
= Adjusted net income
2007
$17
(14)
$31
A negative investment in working capital is wonderful; it’s like having
a job that pays you today for work you will do in two weeks.
35
Structural Limitation #2: Investment in Working Capital
36
Blue Nile (NILE)($mils)
12/31/06
12/31/07
Working capital assets:
Receivables
Inventory
Total WC assets
$2
15
$17
$4
21
$25
Working capital liabilities:
Payables
Accrued Expenses
Total WC liabilities
$67
7
$74
$86
10
$96
$(57)
$(71)
$(14)
Net working capital
Investment in net working capital
GAAP P&L’s Four (4) Structural Limitations
1.
2.
3.
4.
37
Investment in fixed capital is ignored, so when capital spending is
greater than depreciation the company may be profitable on
GAAP basis but short cash.
Omits investment in working capital, so when receivables and
inventory grow faster than payables and accrued expenses the
company may be profitable on GAAP basis but short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders’ equity is free even though owners have an
opportunity cost.
Notes on Intangibles
 Intangible growth-producing initiatives are R&D, advertising, and
employee education. We call them “intangibles” because we can’t
weigh, touch, or measure these assets, in contrast to fixed capital
 Companies invest in intangibles to boost revenue, charge higher
prices (brand value), cut costs, improve productivity, etc.
 But GAAP says intangibles are expenses, not assets. Thus,
GAAP earnings for “brain” companies are not comparable to
“brick” companies
 “Increased R&D led to both improved operating performance and
superior stock returns,” per study of 8,300 companies over 50
years. (Source: Journal of Finance, 2004, Vol. 59)
 When we capitalize intangibles we are not eliminating the cost.
Instead, we are deferring it to a later period. This is the “matching”
principle of accrual accounting: align current sales with current
expenses, future sales with future expenses
38
Google (GOOG)
Depreciation Intangibles Over Expected Useful Life
Usually Increases GAAP Profits
40
Google (GOOG)($mls) - 2007
GAAP
Depreciate
Profit before R&D
- R&D
= Operating income
Increase (%)
$7,204
2,120
$5,084
$7,204
1,316
$5,888
16%
Structural Limitation #3: Intangibles are Expensed
Google (GOOG)($mls)
2005
2006
2007
R&D (GAAP)
$599
$1,229
$2,120
3
3
3
Depreciation
$200
$410
$707
Year 1
Year 2
Year 3
Total
$200
132
$410
200
132
$707
410
200
$1,316
Depreciation period
41
Depreciation period is the useful life of the asset. If you depreciate
over three years, then you need three years’ worth of R&D.
GAAP P&L’s Four (4) Structural Limitations
1.
2.
3.
4.
42
Investment in fixed capital is ignored, so when capital spending is
greater than depreciation the company may be profitable on
GAAP basis but short cash.
Omits investment in working capital, so when receivables and
inventory grow faster than payables and accrued expenses the
company may be profitable on GAAP basis but short cash.
Intangibles like R&D, advertising, employee education are
expensed even though the benefits will last more than one
accounting period.
Stockholders’ equity is free even though owners have an
opportunity cost.
Notes on Stockholders’ Equity
 All companies financed by combination of debt and
equity
 Debt comes from banks, bondholders; equity from
owners via retained earnings (GAAP profits minus
dividends)
 Debt an expense but equity is free. Why? Noncash
cost; also, different owners have different required
rates of return.
 But GAAP-profitable company may destroy value if you
expense owner opportunity costs.
43
Playboy (PLA)
Playboy’s Stock is No Miss April
Structural Limitation #4: Stockholders’ Equity
Playboy (PBA)($mls) - 2007
Pre-Interest income (EBIT + investments)
- Interest - Debt Only ($115)
- Interest – Debt & Equity ($283 x 7.1%)
= Pre-tax profit
GAAP
(equity free)
Expense
Equity
$12
5
n/a
$7
$12
n/a
20
$(8)
If the accounting treatment for equity is same as debt, then pre-tax
profit turns into a pre-tax loss
46
Estimating Playboy’s Interest – Debt & Equity (1/2)
Debt*
Equity
Total
Avg. 2
Years
1
Capital
Weighting
$115
168
$283
41%
59%
100%
2
1x2
AT Cost
Wtd. Avg.
of capital* Cost of Capital
2.8%
10.0%
*Pretax cost of debt = $5 million/$115 million = 4.3%; after-tax cost =
4.3% x (1-35%) = 2.8%. Cost of equity = 10-year Treasury + 500 bp,
or minimum 10%.
47
1.2%
5.9%
7.1%
Estimating Playboy’s Interest – Debt & Equity (2/2)
Playboy (PLA)($mls)
2007
Total Capital
X Wtd. Avg. Cost of Capital
Interest – Debt & Equity
$283
7.1%
$20
The more equity a firm employs as a percentage of total capital, the
less money it makes if you think equity has a cost
48
Summary
Structural limitation…
As a result…
1. Omits investment in Company may be profitable on a GAAP
fixed capital
basis but run out of cash if capex is much
bigger than depreciation
2. Omits investment in Company may be profitable on a GAAP
working capital
basis but run out of cash if it can’t collect on
receivables, or if inventory doesn’t sell
49
3. Intangibles are
expensed
Penalizes forward-looking companies
investing for higher future sales, earnings
4. Equity has a cost
The more equity a firm employs as % total
capital, the less intrinsically profitable it is
How Do We Fix These Structural Limitations?



50
Do we re-build income statement to 1) expense investment in FC,
2) expense investment in WC, 3) depreciate intangibles, and 4)
expenses stockholders’ equity?
We could, but then we create other problems; e.g., we penalize
companies that are investing in FC, WC. Also, who is arbiter of
cost of equity? (Elvis still alive, some think.)
No single income statement is cure-all. Instead, let’s add the
strengths of two alternate P&L’s that have been devised in recent
years to our analysis…free cash flow and Economic Value Added
Metric Wars: Which Alternate P&L is Best?
51
Free Cash Flow
Economic Value Added
Adjustments
1. Expenses investment in fixed
capital. 2. Expenses investment
in working capital
3. Intangibles depreciated over
useful life 4. Stockholders’ equity is
an expense
Goal
Self-fund? A company does so
when it produces more cash
from ongoing operations than it
consumes.
Create value? A company does so
when it produces a return on capital
that is greater than its cost.
Not this
Ben
Graham
52
This Ben
Graham!
53
Benjamin Graham (1894-1976)
 Graduated #2 in class from Columbia in 1914 at age 20, then offered
teaching jobs in English, mathematics, and philosophy departments
 Instead, went to Wall Street. Nearly ruined by speculation before
devising “margin of safety” strategy of buying companies selling at twothirds of net working capital after subtracting all liabilities Then made
20% a year for two decades.
 Taught popular investing class at Columbia 1928-1956
 Warren Buffett’s teacher, employer, and friend
 Turned class notes into Security Analysis (1934). The Intelligent Investor
published in 1949.
 Goal to take advantage of “Mr. Market’s” occasional manic personality
 Helped found CFA program in 1960s
 “Wanted to do “something foolish, something creative and something
generous” every day.” Gave presents to employees on his birthday,
“figuring that he was the lucky one”
54
The Intelligent Investor: Graham’s Two Types



55
“The defensive (or passive)
investor will place his chief
emphasis on the avoidance of
serious mistakes or losses…”
Pessimistic commercial banker
Expenses investment in fixed
and working capital because they
are uses of cash; also, who
knows if investment will pan out



“The determining trait of the
enterprising...investor is his
willingness to devote time and
care to the selection of securities
…more attractive than average”
Optimistic venture capitalist
Intangibles expensed over useful
life because they are key driver
of higher future sales, earnings;
also, equity is an expense
because stockholders have
opportunity costs
Source: The Intelligent Investor (Harper & Row, 1973)
In Honor of Graham…
56
Personality
Pessimistic
commercial
banker
Optimistic venture
capitalist
Income
statement
Defensive
(free cash flow)
Enterprising
(Economic Value
Added)
To learn
more
Cash Flow and
Security Analysis,
Hackel and Livnat
The Quest For Value,
Stewart
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
57
Step 1a of 3: Three Income Statements
Enron Corp. year ending Dec. 31, 2000 (millions except per-share)
Income statement
Revenue
- COGS, SG&A, other
- Investment fixed capital (#1)
- Investment working capital (#2)
- Intangibles (#3)
- Interest expense (#4)
- Other
- Taxes
Total expenses
Profit (loss)
Source: Company reports, EarningsPower.com
58
Defensive
GAAP
Enterprising
$100,789
98,836
3,555
1,071
0
838
(1,093)
684
$103,893
$(3,102)
$100,789
98,836
n/a
n/a
0
838
(215)
434
$99,893
$896
$100,789
98,836
n/a
n/a
72
2,609
(55)
765
$102,228
$(1,439)
Step 1b of 3: Quality of Profits
59
Step 1c of 3: Earnings Power Chart
60
Enron: A Second Look





61
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 to pennies from high of $85
21,000 employees lose their jobs, pensions
Despite GAAP profits, Enron does not possess authentic
earnings power according to the Earnings Power Chart
Section III
“Just Four Types of
Companies”
62
Lower-Left Box: Enron
63
Upper-Left Box: HealthSouth (HLSH) (down 83% from $30
peak in mid-1998)
64
Lower-Right Box: Krispy Kreme Donuts (KKD) (down
88% from $50 peak in mid-2003)
65
Coal Mine Canary
Defensive:
Enterprising:
Both:
Autozone (’92-’99)
Bethlehem Steel (’96-’00)
Allou Health & Beauty (’98-’02)
Centennial Technologies (’93-’97)
Boston Market (’93-’97)
Bombay Company (’91-’94)
CML Group (’92-’97)
CKE Restaurants (’95-’97)
Enron (’96-’00)
EDS (’00-’02)
Crown Cork & Seal (’95-’00)
Polaroid (’95-’00)
Fine Host (’95-’96)
HealthSouth (’96-’01)
Sunbeam (’93-’98)
Gap, The (’96-’02)
Ikon Office (’93-’98)
Warnaco (’94-’99)
Gateway (’97-’01)
Rite-Aid (’95-’00)
Xerox (’96-’00)
Krispy Kreme Donuts (’02-’04)
Sherwin-Williams (’91-’00)
Lucent Technologies (’97-’00)
WorldCom (’97-’01)
Measurement Specialties (’98-’01)
Tyco (3/00-12/01)
United Airlines (’94-’01)
66
Source: EarningsPower.com
Upper-Right Box: Wrigley (WWY) (up 41% 1998-2002 vs. –9%
loss for S&P 500)
67
How to Use the Earnings Power Chart
1.
2.
3.
4.
5.
68
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)
Tripe from Enron’s Last Annual Report:
“Enron’s performance in 2000 was a
success by any measure….Our talented
people, global presence, financial strength
and massive market knowledge have
created our sustainable and unique
business.” – Ken Lay and Jeff Skilling
69
Key Points:





70
The Earnings Power Chart fixes the four (4) structural limitations
of the GAAP income statement
Regardless of size, industry, or capital structure, all companies
are situated in one of Earnings Power Chart’s four (4) boxes
Which box are the companies you own in? Why?
The Earnings Power Chart is like looking both ways before you
cross the street; it provides a margin of safety.
There are companies in the lower-right, lower left, and upper-left
boxes that will be great stocks. But life is short and our capital is
limited. So unless you have a compelling reason, stick with
upper-right box. These “twice-blessed” companies have the
authentic earnings power that Wall Street prizes.
Source for an Earnings Power Chart Spreadsheet:
http://www.filespace.org/Sand101/IETC1.2.zip
n.b., I did not make this spreadsheet so user beware. Also,
do not ask me questions about this SS as I use my own
proprietary version.
71
Section IV
Hallmark of Profitable
Growth: The Earnings Power
Staircase
72
Microsoft ca. 1990’s: Authentic Earnings Power +
Earnings Power Staircase
$10,000 grows
to almost $1
million
73
Apollo Group: $10,000 grows to $78,000
74
Apple: $10,000 grows to $106,000
75
Cisco Systems: $10,000 grows to $631,000
76
Chico’s FAS: $10,000 grows to $73,000
77
Dell Computer: $10,000 grows to $1.3 million
78
First Cash Financial: $10,000 grows to $86,000
79
Garmin: $10,000 grows to $44,000
80
Google: $10,000 grows to $51,000
81
Paychex: $10,000 grows to $257,000
82
Quality Systems: $10,000 grows to $70,000
83
Not All Great Stocks Are Staircase: $10K to $200K
85
Section V
Best Stock: 1997-2006
86
The winner is: Hansen Natural
$10,000 grows to $2.6 million
88
Authentic Earnings Power + Earnings Power Staircase
89
Section VI
Putting It Altogether: The
Earnings Power 1-2-3 Process
90
Three (3) Obstacles Confronting Growth Investor
91
1. Poor
earnings
quality
GAAP income statement has four (4) structural
limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.
2. Competitive
advantage
wanes
Successful companies attract imitators. This is good
for consumers, bad for owners.
3. Premium to
intrinsic value
We predict by extrapolation, so growth stocks often
get pushed beyond real worth.
Our Case Study: American Eagle (AEO)
Highlights








93
Mall-based retailer with 926 stores in U.S., Canada
Three concepts: American Eagle, aerie, and Martin + Osa
HQ’d in Pittsburgh
Founded 1977
Ranked #2 “coolest brand” among 12-19 year olds
“We compete on trend but not ahead of trend.”
Schottenstein family with AEO since 1980; owns $750 million of
stock.
One of 10 best stocks for decade ending 2006
Three (3) Obstacles Confronting Growth Investor
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1. Poor
earnings
quality
GAAP income statement has four (4) structural
limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.
2. Competitive
advantage
wanes
Successful companies attract imitators. This is good
for consumers, bad for owners.
3. Premium to
intrinsic value
We predict by extrapolation, so growth stocks often
get pushed beyond real worth.
Step 1b of 3: Earnings Power Staircase
95
Step 1c of 3: Earnings Power Staircase
96
Three (3) Obstacles Confronting Growth Investor
97
1. Poor
earnings
quality
GAAP income statement has four (4) structural
limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.
2. Competitive
advantage
wanes
Successful companies attract imitators. This is good
for consumers, bad for owners.
3. Premium to
intrinsic value
We predict by extrapolation, so growth stocks often
get pushed beyond real worth.
Step 2 of 3: Competitive Advantage





98
“Strategies, skills, knowledge, or resources” that differentiate a
business from its competitors
If a company has a competitive advantage, it probably has
authentic earnings power and may even forge an Earnings
Power Staircase
Warren Buffett says competitive advantage is “moat around the
castle.” Wider the moat, the more protected the castle
Use the Quality of Profits and Earnings Power Charts to gain
insights into whether company has competitive advantage
The more durable the competitive advantage, the longer we
can project above-average growth in Step 3, Valuation
Morningstar’s 4 Types of Competitive Advantage
99
Types
Examples
1. Low-cost provider
Wal-Mart, Dell (?)
2. High-switching costs
Paychex, Microsoft
3. Intangibles (e.g., patents,
mindshare, locations, addictive
product, management,
employees)
Pfizer, Starbucks, International
Speedway, Berkshire Hathaway,
Altria (Philip Morris), Best Buy,
Disney
4. Network effect
eBay, Chicago Merc
Most Competitive Advantages Wane over Time: Who Is
Building the 13-Corkscrew Version?
American Eagle Has “Mild” Competitive Advantage?
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1
Competitive advantage
Examples
1. Low-cost provider
no
2. High-switching costs
no
3. Intangibles (e.g., patents,
mindshare, locations, addictive
product, management,
employees)
Jay Schottenstein is long-time
board chair; and family’s
interests are aligned with outside
stockholders. But not the most
durable competitive advantage.
4. Network effect
no
If no competitive advantage, keep your forecast period short
Three (3) Obstacles Confronting Growth Investor
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2
1. Poor
earnings
quality
GAAP income statement has four (4) structural
limitations. So just because a company is profitable
in the traditional sense of the word does not mean
that it has authentic earnings power.
2. Competitive
advantage
wanes
Successful companies attract imitators. This is good
for consumers, bad for owners.
3. Premium to
intrinsic value
We predict by extrapolation, so growth stocks often
get pushed beyond real worth.
Take Analyst Forecasts With a Grain of Salt


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3
“There is no persistence in long-term earnings growth
beyond chance….growth forecasts are overly
optimistic and add little predictive power.” (Source:
The Level and Persistence of Growth Rates, Louis
K.C. Chan, Jason Karceski and Josef Lakonishok)
David Dreman: The average error was 44% annually,
based on 500,000 quarterly estimates of more than
1,500 companies between 1973-1996. (Source:
Contrarian Investment Strategies, Dreman)
Step 3 of 3: American Eagle’s Intrinsic Value
Low
Medium
High
This Year Earnings
-4%
-4%
-4%
Next Year Earnings
7%
10%
13%
Earnings Years 3, 4 & 5
7%
11%
14.3%
Earnings Years 6-10
3%
4%
5.6%
Earnings Terminal Period
3%
3%
3%
Share Count – annual growth
-1%
-1%
-1%
Intrinsic value (inc. net cash)
$36
$41
$47
40%
35%
25%
Weighting
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4
Wtd. Avg. Intrinsic Value
$40
Valuation: 5 Margins of Safety
1.
2.
3.
4.
5.
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5
Cost of equity (discount rate) is 10%
High growth = consensus; Low, Medium growth is
50%, 75% of High
Growth in years 6-10 is 50% of years 1-5
Intrinsic value estimate 40% based on Low Growth,
35% on Medium, and just 25% on consensus.
Buy when companies sells at 50%-70% of intrinsic
value, depending upon quality of earnings and
durability of competitive advantage
American Eagle’s Price-Intrinsic Value (PIV)
Stock price
Intrinsic Value
= PIV
$17
$40
43%
Authentic earnings power on sale: At $17, you get $1 of
intrinsic value for $0.43.
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American Eagle’s Expected Return
Expected Return
= ($40 - $17)/$17
= 134%
• The lower your price-intrinsic value (PIV), the higher your
expected return (ER)
• Portfolio management: Rank all your companies by ER, from high
to low. Does the company you are thinking of buying offer a higher
ER than the lowest-ranked company you own? If not, then why
buy it?
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7
Sell Discipline
• Earnings quality: Quality of profits permanently
deteriorate
• Loss of competitive advantage
• Stock climbs to intrinsic value
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Summary
Why “Ben Graham and the
Growth Investor?”
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9
What’s Your Process?
“It al starts with a well-defined process that is executed with a high
degree of discipline.
“There are a lot of smart people in the investment business, but not
very many of them are consistently successful.
“We think the reason is that not many of them have a truly well-defined
process and are truly disciplined in executing it.
Source: “He Recruits Managers with Passion and Focus For Stocking-Picking
Teams,” Wall Street Journal, Nov. 7, 2005
Avoid “Growth Trap” - Use Multiple Margins of Safety
 “Next Microsoft” won’t be cheap on a Ben
Graham net-net basis.
 To protect against “miscalculation or bad
luck,” include multiple margins of safety in
your well-defined process: 1) seek out
authentic earnings power, 2) look for a
durable competitive advantage, and 3)
buy at a discount to intrinsic value
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Bonus Material for Bryant College:
- Useful Writing Tips
Useful Writing Tips
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3
1. Its vs. it’s
“Its” = possession. Example: “its dog”
“It’s” short for “it is.” example: “It’s exciting when my stocks
double in an afternoon”
2. Show me, don’t tell
me
No: “U.S. Global Investors went up a lot in 2006.
Yes: “U.S. Global Investors went up 338% in 2006”
3. No “quite’s” or
“very’s”
No: “It’s quite/very hot here in Las Vegas.”
Yes” “It’s 92 degrees in the shade here in Las Vegas”
4. No adverbs
No “I honestly believe…,” or “I personally think….”
5. Key info at
beginning of sentence,
then cite source
No: According to data from TowerGroup, more than half of all
U.S. investors make fewer than five trades per year. (TMF,
1/30/07)
Yes: More than half of all U.S. investors make fewer than
five trades per year, according to data from TowerGroup,.
and please!
Don’t send a cover letter explaining how much you admire
Warren Buffet. Buffett has 2 “t’s”
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,
Tom Jacobs, Thornton Oglove,
Morningstar’s Mark Sellers, Robert L.
Rodriguez, Arne Alsin, Jim Rogers,
John D. Spooner, Kenneth L. Fisher
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Biography
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5
Hewitt Heiserman Jr. conceived the Earnings Power Chart and the
Earnings Power Staircase, which are featured in his book "It's Earnings
That Count" (McGraw-Hill, 2004). He also writes a column on earnings
power for RealMoney.com. Heiserman graduated from Kenyon College
with Distinction in History, and also received the Faculty Award for
Distinguished Achievement. Heiserman is a member of the Boston
Security Analyst Society and the CFA Institute. Heiserman's work on
earnings quality has appeared in TheStreet.com, BusinessWeek, CBS
MarketWatch, Business 2.0, Better Investing, The Motley Fool, Complete
Growth Investor, Barron's, and the Haverford Trust Company Adviser.
Heiserman has spoken to the New York Society of Security Analysis, the
Boston Security Analysts Society, Fidelity Management an Research, the
Babson Investment Management Association, the American Association of
Individual Investors, and Complete Growth Investors on "Ben Graham
and the Growth Investor." Heiserman is a finance instructor for GersonLehrman Group. He is a trustee for a land conservation group. To learn
more, visit www.EarningsPower.com
Questions?
Hewitt.Heiserman@EarningsPower.com
www.EarningsPower.com
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