Tuesday, December 25, 2007


Greenblatt's ROIC formula in The Little Book That Beats The Market is
ROIC = EBIT/Net Working Capital + Net Fixed Assets

For the 20-30 stock TLBTBTM portfolio this is a good quick and dirty calculation. But if you run more concentrated portfolios and do single stock selection then I think it may need tweaking.

Firstly, Greenblatt notes in TLBTBTM's epilogue his version of Roic is unsuitable for utilities or financials. Beyond this McKinsey's observations (see last post) on low capital base firms apply.

The next issue with Greenblatt Roic is it assumes EBIT is approximate to FCF, i.e., Depreciation and Amortization are equal to capex. This should be so most of the time but there are cases when it is not.

Some companies also may have different depreciation policies, e.g. DDB versus SLD, which may distort EBIT comparisons and may need adjustment.

Companies where capex is higher than D&A are investing increasing amounts in their business (assuming the line item for D&A is mostly depreciation). By itself, this is neither good nor bad -- it depends on how wisely the firm deploys the money.

Actually, Mr. Greenblatt himself thinks EBITDA - Maintenance capex
may be a more useful metric for pre-tax discretionary free cash flow.

Acquisitions used to grow or run the business may also need to be factored in as capex.

Another issue may also arise when companies utilise capital leases as opposed to operating leases, their 'lease expense' will instead appear as an interest expense lower down the P&L, distorting EBIT. Here one needs to go into the cash flow statement and find the real lease expense and adjust accordingly.

These issues should have a minor impact but they are worth being aware of.

Finally, the denominator of the formula may not account for all capital and assets required in the line of business. Some companies will rely on off-balance sheet arrangements, such as, operating leases, take-or-pay agreements, use of subsidiaries, sales of receivables and so on.

For companies with large amounts of operating leases McKinsey's criticisms of Roic may apply or one could correct the net fixed asset figure. This can be done either via conversion of the operating lease payments to a capital lease or seeing what other similar companies' asset bases are and the cost of those assets.

Sale of receivables without recourse (revealed in the footnotes) will distort net working capital, profits from such sales should be added back into current assets.

Take-or-pay/throughputs. Best to look at similar companies here and see how widespread these funding agreements are. You may want to take the present value of these payments and add them into the company's fixed asset or working capital base.

Perhaps an improved Greenblatt Roic calculation for picking single stocks would be;
EBITDA adjusted for capital leases - (capex + relevant acquisitions)/Net Working Capital + Net Fixed Assets

Where in the denominator
Net working capital = (current assets - liquidity on hand + funds from sale of receivables) - (current liabilities - short term borrowings)


Net fixed assets = tangible fixed assets adjusted for use of operating leases & throughput agreements- construction in progress.

Monday, December 10, 2007

Return On Invested Capital (ROIC) measures the levels generated by each dollar of capital invested in a company's operations and how profitably management is able to allocate capital to generate cash flow over its weighted cost of capital (WACC).

ROIC-WACC spreads are KEY to value creation. Firms whose ROIC exceed their WACC generate positive net cash flow, creating value; while a company whose ROIC equals its WACC neither creates nor destroys value.

Generally, companies with higher ROIC-WACC spreads are more valuable and command higher multiples.

If a company is selling for, or below, book you can be fairly sure it has not earned its WACC in the recent past.

Firms can create value by one of three avenues:
1. Reallocating/improving use of existing capital to increase the spread.
2. Deploying more invested capital into current operations or investing in new projects provided returns generated by either generate marginal ROIC in excess of WACC.
3. Lowering their WACC.


Increasing industrywide and extraordinarily high ROICs are hallmarks of young, strong and growing sectors. In contrast, sequential declines, or marginal ROICs below historical ROIC (barring seasonal factors), may indicate a mature industry where long-term investment opportunities are waning.

Consistently high ROIC-WACC spreads generally equate to the 'moats' that many investors seek. One very rough way of gauging a 'moat' would be to look to see whether a company maintains a high ROIC-WACC spread for several years.

Again, as a rough rule of thumb, WACCs for most U.S. companies range between 9-13%, so ROICs consistently in the mid to high teens allude to something Moat-like and worth digging into.

ROIC solves some of the P/E ratio's pitfalls, particularly, PER fails to illuminate whether firms are producing value, or how much capital firms consume to produce earnings. But like all metrics ROIC has its pitfalls.

First off, you obviously need to monitor the trend. ROIC in the high teens may be great, but less so when its come off a base in the 20% range.

More critically, ROIC can be problematic for companies with very low invested capital bases. E.g., companies that outsource production, like software development firms, and most services firms, like advertising agencies, will have very low invested capital bases.

McKinsey & Co. point out for companies with invested capital below 25% of revenue ROIC may not be a fantastic benchmark as small changes in capital requirements can cause the ROIC to be both very large and volatile from period to period.

Some solutions would be to;
1. Normalize capex over a period to smooth out volatility
2. Or not use ROIC altogether, McKinsey offer an alternative calculation for those interested, in the above link.

It is also not helpful to compare ROIC across industries. In 2004, system software development companies' median invested capital as percentage of revenue was -3% compared to 163% for hotels, resorts and cruise liners, according to McKinsey.

There are two equations used for calculating ROIC that I have seen used most frequently:

1. The standard ROIC formula
Net Operating Profit After Tax/ Average Invested Total Capital

2. The Greenblatt Method
EBIT/Net Working Capital + Net Fixed Assets

I'm going to focus on the second method in my next post as it seems to have captured value investors' attentions recently. Handily, the Greenblatt method is, I think, more intuitive than the traditional method and easier to calculate.

Wednesday, December 5, 2007

Back Again and some stuff to come on ROIC

Sorry for being away for almost six months. Have been studying for the CFA level one, which was quite time consuming.

Anyway, thankfully it is now all over and done with and its december, which means stuff has quitened down and Xmas rolls around... and I now have some more time on my hands to post. I will be posting some stuff on Return On Invested Capital calculations over the next few days....

Thursday, June 28, 2007

Spac Structure

Below is a rundown of the typical Spac structure, variants do exist though: be sure to check the S-1. In fact, it’s usually Spacs with unusual features that make good investments. That's why Baupost probably went for Star Maritime Acquisition (SEA) (links to Value Investor Club write up, membership required).

Spacs are sold in “units”, which are composed normally of one common stock and one or two in-the-money warrants. Check in what kind area the Spac is looking to make a deal in, what the composition of the units are, and how many are being sold to the public. You also want a solid management team; that’s who you are betting on to go get an acquisition together.

You can find what Spacs are coming to market by going to the SEC website and doing an Advanced Search under S-1 filings in Form Type. In “Search for Text” type “blank check company”.

Sometimes, the underwriter will defer all or part of their IPO fees (usually 6% of market cap) and wait till an acquisition/merger is sealed before collecting. This is likely to also put pressure, or incentivize (depending on your perspective), management to bag a deal - it's hard to imagine iBankers doing a deal if they didn't think there would be some fee payoff.

In addition to funds raised via the IPO of units, management typically buys 20% of equity in a private placement, which may or may not be in the form of common stock or warrants, and normally sold at way below the public offering price of the units. Yes, they benefit a disproportional amount if a deal pulls off, but then they have to go scour for the deal plus warrants cannot be exercised until a deal has been completed. Management's warrants sometime come with a 2-3 year lock-up. Basically, this prevents them from off-loading and doing a runner if they get bored.

In some cases, management must buy warrants at a set price on the open market, supporting warrant prices for investors, and ensuring management has more of their money on the line. Management thus has some “skin in the game” whatever the flotation's intricacies.

Spacs are working against a ticking clock, they must seal a deal in 18 months with a 6-month extension if a deal has been announced but not completed within the initial 18 months.

Also it is normal for at least 85% of proceeds from the IPO to be kept in trust, so management can't cane the money on margaritas and lap dancers in Cancun. So while management are hunting for a target the cash accumulates interest, although not always at full money market rates – you need to check the interest payments in the financials to gauge what the trust acct pays.

Theoretically, the money in trust is safe… but it has been pointed out those funds may not be immune to third party claims and shareholders claims may be secondary to other claimants. That having said, I haven’t heard of a case where a Spac has been successfully sued over funds in trust and if the Spac is purely equity-financed its hard to see who else is likely to be above the shareholders in terms of claimants. (If you know of any incidents where shareholders claims have been made secondary to another party, or the funds in trust have been subject to third party claims PLEASE LET ME KNOW).

Once a deal is announced management needs 80% (exceptions exist though) of shareholders backing. The Spac must also use up 80% of cash in their trust for the deal. If a proposal is rejected the Spac shareholders can also force the vehicle to liquidate.

While it is rare, investors have shot down deals before. In December 2006 investors at TAC Acquisition Corp (TACAU) gave the thumbs down for an acquisition of Aviel Systems. In February shareholders approved a dissolution of the company. Obviously, the warrants went up in smoke as they were contingent on a deal being sealed, but the common stk got reimbursed. Holders of common stock received $5.6941 in cash per share; units had originally gone for $6.

Nonetheless, even if YOU don't like the deal and it still gets an 80% thumbs up from other investors you can still cash out (assuming you hold common stock in the Spac) and receive cash in proportion to your slice of funds in the trust. There may be some charges however if the deal receives shareholders' blessing but you decide to liquidate.

One issue which I'm not entirely sure on and would be interesting to check is if you decide to liquidate in the event a deal goes through and you are still holding the original units, presumably your common stock is dissolved but do you still get to hold onto your warrants? Does anyone know?

Anyway, that's the basic lowdown on Spac structure. If you're interested in a much more detailed breakdown of Spacs then check out this link.

In the next post I'll look at why value investors may be interested in these vehicles.

Wednesday, June 27, 2007

On Running A Concentrated Two-Book Portfolio

I was looking at Amazon the other day for new books to read and thought I would do a quick search for Seth Klarman's Margin of Safety and Mohnish Pabrai's Mosaic. Both are regarded as must-read value investing books, and both also happen to be out of print.

Klarman's book was published in 1991, it cost $25 (according to the best information I could find) and now goes for $1,700 on Amazon. Pabrai's tome was first released in 2004 - I think for $15 but correct me if I'm wrong - and sells for $340 (also on Amazon).

Put another way Klarman's book has logged an annual return of 29.1% over the past 16 and half years, while Pabrai has clocked up an annual return of 144% since it has been published. The S&P 500 meanwhile has returned 9.8% annually since 1991 and 9.2% since 2004. In fact, I think the returns on both these books is probably even better than the returns on the funds that Pabrai and Klarman manage themselves.

So, what is the lesson here? Well, basically all you need to do is either:

a) diversify by buying a basket of books from good hedge fund managers and wait a bit for some capital appreciation


b) (what value investors prefer to do) conduct fundamental analysis of a universe of money managers who have publishing deals, read the books you believe to be promising and then buy only those you consider to be both of sufficiently high quality and likely to go out of print. You should then go onto bag returns in excess of 25% per annum with far less volatility than the S&P 500.

OK I admit, the last part on volatility was made up. I haven't tested what the price volatility for either of these two books since their publications has been, what their covariance is or what the standard deviation of a two book portfolio composed of Mosaic and Margin of Safety is - and yes a two book portfolio could only have existed since 2004 when Pabrai published Mosaic. Still whichever way you look at it you would need to run a very concentrated portfolio of value investing books to generate these returns.

But hey, both Pabrai and Klarman run concentrated portfolios so no-one could fault you for not trying to emulate their investing style.

Actually, I've read both these books, and while both are very good reads - and I think both of these guys are very good investors who I admire greatly - these two books are definitely NOT worth their price tag.

I guess that's easier said when you've read them as that's the only possible way you could really know whether they are worth their price.

Actually no. I can think of no book on investing that is worth $1,700. I might shell out a few hundred bucks for a Ken Kesey and Tom Wolfe-autographed copy of The Electric Kool Aid Acid Test, but $1,700?

What are people thinking? Well, I admit, at one point I did consider shelling out substantial sums for Margin Of Safety. Luckily I got my hands on a loaned copy and read it.

Yeah, it's a good read and has an interesting slant; I liked the focus on being aware of risk, also the section on valuing a spin-off was useful. But it's nothing that I couldn't have got from doing a lot of Google searches and reading other decent books not out of print, like Greenblatt's How To Be A Stock Market Genius.

(Brilliant book btw, but talk about a value trap; price appreciation on it has been terrible since its publication in 1997, you would have lost money on it as you can get a second hand copy for $6.55 on Amazon and its regular retail price is $14.00, although not sure what the 1997 original price was. Still if they take it out of print maybe it will rise, I'm still holding onto my copy till then.)

Why would I have bought MOS then? Well given Klarman's record and all the newspaper articles, and hype surrounding the book it seemed pretty tempting in a perverse way. Hey and when I was looking at it the thing was only $700 bucks a year and a half back so I could have bagged a decent return too (are book sales capital gains tax free btw?).

So who is paying so much for this stuff? Well I guess, mainly speculators (sorry rare book collectors) and people convinced that the stuff in both books is worth the price tag on them and a route to becoming a great investor, which it ain't.

Let's face it, if you really are a value investor there is no way in hell you should be paying that much for these books, however great the authors are and however sound the content is. Don't be swayed, cast around and you'll find the same information elsewhere and most likely for free.

These book prices are in a bizarre way a good lesson in value investing, there is a difference between price and value. However good the company is, at some point it becomes overpriced; don't be tempted into overpaying for something because of the hype and rarity factor (unless you're a rare book collector, or something).

Oh and by the way, past performance is no indication of current or future performance/results. Your two book portfolio may tank tomorrow unless you know what fair value for them is.

(Also my comparative return statistics may be slightly off the mark as I was only able to get the year that the two books were published in, not the exact month and day, so I assumed both were published on January 1 and then compared to it to the S&P's return over the same period.)

Net/Nets Any Good? And Where Are They All?

The net current assets investment selection criterion calls for the purchase of stocks which are priced at 66% or less of a company's underlying current assets (cash, receivables and inventory) net of all liabilities and claims senior to a company's common stock (current liabilities, long-term debt, preferred stock, unfunded pension liabilities etc. etc.).

So if a company's current assets are $100 per share and the sum of current liabilities, long-term debt, preferred stock, and unfunded pension liabilities is $40 per share, then NCAV would be $60 per share.

Notice how long-term assets aren't in the equation. I.e. intangible assets and in particular, real estate and equipment are not included. Nor is any going value ascribed to prospective earning power from a company's sales base. That's a high bar to begin with, Graham then adds another hurdle to clear; he would not pay anymore than 66% of $60, or $40, for the stock.

Since most companies have negative NCAVs you have a thin field to begin with but when you're fishing only for stocks at 66% NCAV you can often end up with no companies on the field at all, especially in bull markets like now, albeit one that is starting to look a little weary.

So why go for the 66% level, why not shoot for 80%? That is an option but Graham's reasoning was if you go for firms trading so cheap that there is little danger of them falling further, it's pure margin of safety investing. Still 80% may be a tempting level but we'll come to that later.

What about the other equally important component of investing - knowing when to sell? Given that a lot of NCAV companies tend to be shot to pieces or heavily out of favor the safest strategy (if you're not going to do much detailed analysis of the companies you are buying) is to sell once the company hits its 100% NCAV.

So how did Graham run this strategy back in the day? Luckily for him he started doing this shortly after the Great Depression so there were tonnes of companies that fitted the bill. In fact, at one point he apparently had up to 100 of these companies in his portfolio.

Now I don't know if this is true and what those 100 stocks were, but assuming this is correct I would imagine that's a diversified bunch of companies he had in there. You can diversify away most company specific risk with about 15-20 stocks upwards if you are picking stocks purely using some kind of filter system - so 100 names seems pretty diversified to allow for duds that would blow up on you. Graham reported the average return, over a 30-year period, on a DIVERSIFIED portfolio of NCAV stocks was about 20% per annum.

As some of you may also have noticed though the key word in Graham's portfolio returns is diversified (in case you hadn't noticed I capitalized the word). Graham himself recommended buying a large number of stocks to diversify the risk. The NCAV strategy in Graham's day was thus essentially a forerunner to Greenblatt's Magic Formula system; there will be some real gems in there but if you're not doing a whole load of homework on them best to buy the basket as the stocks on average should give you a decent bang for your buck, actually Greenblatt mentions NCAV in passing on this video... http://merlin.gsb.columbia.edu:8080/ramgen/video3/admin/alumni/Reunion_2006/Reunion_4-8-06_Greenblatt.rm.

That seems to roughly chime with this post over at Cheap Stocks - http://stocksbelowncav.blogspot.com/2007/01/top-10-netnets-four-years-later-we.html
They report a 33.5% return on a basket of the biggest 10 Net/Nets by market cap back in Feb 2003, but there were a few duds in there - with one halving in value and one essentially flat. Standard deviation for the group was a hefty 78.7%, i.e. if you bought just one of these stocks you probably shouldn't expect a return anywhere near 33.5%!!

The biggest risk is the company folding and a complete wipeout of its stock price. Stocks that get down to NCAV territory probably didn't get there because management were on the top of their game. Indeed, there's a real risk some of them will go up in smoke even with your 66% selection criteria.

How real a prospect is that?
Well, I did a google search on NCAV stocks and found an article on the subject over at http://iamamazing.wordpress.com/2006/12/19/the-problem-with-netnets/ This was published seven months ago on Dec 19 2006. It turns up four NCAV candidates;
1. Dominion Homes (DHOM)
2. CET Services (CETR)
3. TransNet Corp. (TRNT)
4. Taitron Components (TAIT)

I decided to take a look at what these stocks did since then... and of those CET Services seems to have imploded. Auditors gave the company a going concern qualification back in April, and it is being delisted from the American Stock Exchange. I haven't poked around into the balance sheet of this company - it may have some pretty decent stuff to give out in the event of a liquidation but that's the stuff of bankruptcy investing, which is a different ballgame.

So of the four names seven months ago one is up in smoke, that's means in order to get a 20% return, like Graham's portfolio had, the other three names are gonna have to be absolutely on a roll over the next five months. Who knows, they may well be, then again they may well join CET in going belly up.

With a lack of candidates (i.e. less than 10 companies at the very least) the 66% NCAV basket buying strategy can be downright dangerous. So how many 66% NCAV are there are out there today?
One place to look is over at http://www.grahaminvestor.com/screens/grahams_result

That yields as of today June 13, two candidates! Relaxing a bit to 80% gives us five names, still not a whole load, and then once we start going above that... well there don't seem to be much of a margin of safety folks if you're just going on a pure stock screen based portfolio.

As it stands NCAV screens for the U.S. market, or screens for stocks trading around or near to it, looks like a good idea generator rather than anything else. That is you need to have a proper look at the names thrown up and judge if the actual companies themselves are decent bets as I suspect buying the basket of 10-15 trading at or nearest to NCAV probably won't be great. Of course, I have no proof of that unfortunately, it's just a hunch. It would be interesting to see a study of how buying a basket of 10 plus Net/Nets at 80% NCAV perform over a one-year plus period. Does anyone know of such a study or some fund that does this kind of strategy?

Finally, the lack of 66% NCAVs may just suggest the market is expensive. After all, the post at Cheap Stocks infers there was a fairly decent wad of them back in 2003. So if there is a market meltdown, which may not be so unlikely, then we could end up with a whole load of 66% NCAV companies and you could snap up 15 plus stocks and sit it out without a load of effort.

Actually, one place which may be fertile hunting ground would be small cap and retail shares in Japan, which have been having an appalling time over the past 18 months after a high-flying internet conglomerate there called Livedoor imploded in a most likely politically-motivated investigation into the company's business practices. The Mothers Index there is down 68% from its lifetime high on January 16th.

But to invest in small cap Japanese stocks you will probably need to have a Japanese brokerage acct - not the easiest thing for non-residents and if you don't read and speak Japanese finding these stocks may be a bit of a beeatch.

Thoughts and comments welcome!

Sunday, June 24, 2007


Has anyone had any experience in investing with SPACs (Special Purpose Acquisition Companies), aka 'Blank Check Companies'?

The area seems to be quite interesting and offer a number of investment possibilities. I would be very interested to hear some thoughts on the area as I am mulling writing on it soon....


Saturday, June 9, 2007

Festival Of Stocks

Maybe a bit late but the last festival of stocks (#39) is over at stock rake. Check it out at http://www.stockrake.com/festival-of-stocks-39~2007~06.html.

Monday, June 4, 2007

Stock Screens - Do You Use Them?

I am interested in using a variety of stock screens as an entry point into choosing stocks for a concentrated portfolio.It seems there are any number of screens one can run in order to dig up potential investments, which can end up overwhelming you in terms of choice. So I guess you first need to concentrate on a handful of screens and then wade through them for decent ideas. A few I am looking at are:

1. Magic Formula Investing at http://www.magicformulainvesting.com/, this is the website for Joel Greenblatt's great book "The Little Book That Beats the Market" (http://www.amazon.com/Little-Book-That-Beats-Market/dp/0471733067).The screen turns up stocks based on high earnings yields and high ROICs, you can choose what market cap you are after.While a portfolio of 20-30 stks chosen from this should in aggregate beat most benchmarks, obviously not all of the stocks will be winners... I'm interested in using the screen as a starting point to discover potential gems. One useful blog to see what stocks have been added to the site is http://magicformulainvestor.blogspot.com/ which posts a list of the latest additions to the site on a weekly basis.

Some of the names crop up on the Motley Fool's Inside Value newsletter as well as at Value Investor's Club website.

2. The American Association For Individual Investors at http://www.aaii.com/ has a whole load of interesting screens on its site (subscription only but at US$290 for lifetime membership it is a bargain). I'm most interested in some of the value screens... Perhaps they could be used in conjunction with the MFI screen above to get good results? I've read elsewhere that some people are combining the Piotrsoki screen (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=249455) with the MFI names to help select stocks...Does anyone have an opinion on this?I've come across this fool post http://www.fool.com/community/pod/2006/060727.htm. Some of the other AAII screens look very solid, such as the John Neff or P/FCF screen, as starting points.

3. In his book "Mosaic" Mohnish Pabrai (http://www.amazon.com/Mosaic-Perspectives-on-Investing/dp/0974797413) talks about a number of screens he uses such as stocks trading below one a price to sales basis....He argues that sales (i.e. revenue) tends to be the least tampered line on an income statement so is fairly trustworthy...You can get a P/S ratio screen on Yahoo... I haven't really looked at this as a starting point yet. Does anyone out there use P/S ratio as their jumping off point for promising investments?

4. There is also the 52-week low list, which many people look at but needs to be used with some care as stocks there tend to be at their lows for a reason, it's picking up the bargains here that is the key. Stockpickr has an edited 52-wk low highlight list it publishes here... http://www.stockpickr.com/today/52-Week-Lows/. The full monty of 52-wk lows is available on morningstar at http://quote.morningstar.com/highlow.html. Again back to Mohnish Pabrai, he recommends focusing on stocks one knows rather than all the small cap names and unknown dross that may be settling at these levels.

5. Finally, The Graham Investor has a number of interesting screens such as large/mid-caps trading at or below Net Current Asset Value. The NCAV one can be found here http://www.grahaminvestor.com/screens/grahamsv_result

Also this blog is a good source for stks below NCAV (as the name somewhat suggests)

I think NCAV could be a very promising lead too, take a look at this link from the above blog...

Does anyone have any experience with these screens as leads or thoughts on the matter. Would love to hear your thoughts.

Friday, June 1, 2007


Thank you for visiting Vale Tudo Investing! This is my first blog and I hope to use it to share my investment and money saving ideas. The name comes from a Portugese phrase meaning "Anything Goes" and is used to refer to a style of competitive fighting with minimal rules.

Using fundamental analysis and a value investing philosophy I hope to analyse a few stocks and find a few good companies in U.S. and global markets.

Right now, I'm holding a lot of cash but that is because this is the beginning and I am just starting out as an investor so I welcome your feedback and comments. And thanks for coming.