Owner-Oriented Investment Research and Commentary - Have a private comment or question? Email us at commonstocksense@gmail.com

Monday, April 27, 2009

A Few Explanations Related to Our Approach

To better understand our approach, a few definitions/comments that correspond to numbers noted in our Approach:
  1. High quality – inferred through high returns on equity and invested capital, which demonstrate both the power of the franchise (business) and the quality of capital allocation by management.
  2. Franchise – we like Warren Buffet’s succinct explanation: “If your customer will walk across the street to purchase your product instead of buying a competitor’s product where they are, then you know you have a good thing.” In this situation, economic goodwill usually accrues over time.
  3. Return on Equity (ROE) – trailing four quarters net income divided by average shareholders’ equity over the period.
  4. Free cash flow (FCF) – net income plus depreciation and amortization minus normalized working capital requirements and normalized capital expenditures. Companies that consistently generate excess cash flow can use cash to (1) pay a dividend, (2) repurchase shares, (3) reduce leverage, (4) reinvest in the business, or (5) make acquisitions. An alternate definition is cash flow from operations less capital expenditures, although this figure is impacted by changes in working capital (positive or negative). Both require careful analysis and adjustment for nonrecurring items.
  5. Capital expenditures – companies that require limited investment in physical plant and equipment have more funds available for items 1 - 5 noted in definition 4, which tends to yield high shareholder returns.
  6. Management – honest and capable management is imperative since corporate executive team acts as stewards of shareholder capital. Both attributes can be reasonably ascertained through management’s long-term track record and history of public disclosure/communications.
  7. Fair value – a handful of approaches can triangulate fair, or intrinsic, value per share, including (1) discounted cash flow analysis; (2) earnings and free cash flow yields relative to historical levels, peer group levels, and the market; (3) John Neff’s total return approach: earnings growth plus dividend yield divided by P/E compared to market’s implied total return; (4) Mario Gabelli’s private market value (PMV) approach: utilize market based multiples that a private market buyer would assign cash flows; and, (5) reproduction cost as measured by required input costs to reproduce franchise, including hidden assets.
  8. Limited to no debt – we prefer to invest in companies that, if required to do so, could repay all debt from excess cash flow within a short period of time. With less leverage, bankruptcy risk is greatly mitigated and more cash flow is available for return to shareholders (rather than to repay creditors).
Jeffrey Walkenhorst

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