Wednesday, April 30, 2008

Mason Hawkins Speech

Below are some notes from Mason Hawkins' speech at the Ben Graham Center for Investing he gave in 2005.


GOOD COMPANIES
Moats and hidden assets
Quantitative undervaluation and qualitative appeal - competitiveness of business and quality of management

Read trade journals.
Reprice most attractive companies so you have target prices
Read every word of the k/s and read the last five to six.
Read the no. 1 competitors' ks too.

Be careful of combining operating and financial leverage mixed together as you don't know when a recession will occur.
One or the other is reasonably handleable.

Most oil & gas companies have horrible economics.
Coca cola bottlers are good businesses. (Not too sure why?)
 
Ad companies good because of high FCF generation and ROIC ability
Look at the concentration of business in clients tho.
Saatchi & Saatchi got smacked coz Delta & BA were main clients and then came Gulf War and stock tanked.
Service companies assets are their people - you need LT contracts and no compete agreements in there to ensure you can keep generating high ROICs.


SEARCH STRATEGY
Some screens:
1. ROC over 12% and sell for less than 8x
2. Low price to FCF. i.e. below 10x (average of last 3 years capex and working capital charges is what you take out)
3. All companies below book after intangibles taken out

Look at:
- all companies on new low list
- 10 best investors 13-Fs, e.g. Peter Cundill, have stocks gone down since they bought them?
That warrants attention.
 

VALUATION
3-methods:
I. Balance Sheet valuations based on today's economics
Inventory adjusted for LIFO + tax liabilities
Receivables etc.
You need to make good adjustments
Intangibles can be incredibly valuable.
What you pay for intangibles should be DCF based.
 
Liabilities should be cross-checked with footnotes; litigation exposure, pension fund financing etc
What is debt coverage? Is debt manageable?
 
Buying even a poor business at 1.2 of adjusted book can be a great investment.


II. DCF
The five steps: 
1. Use FCF this is cash flow minus working capital charges and maintenance capex
2. Grow out FCF for next 8 years, say they have been growing at 9%, then you wanna grow it out at 6%.
3. Your terminal multiple will be assigned at GDP figures.
4. Then discount at levels way higher than treasuries.
5. Then buy at 60c on the dollar of your valuation.
 
You do this five hurdles of conservatism and then chuck in qualitative factors, YOU WILL BE FINE.
You need this conservatism coz there are so many inponderables - what rates will be, what management will do etc etc.
Parsimony is also very profitable
Buying at 50c on $ gives you extra compounding effect as business grows.
(If it takes four years to realize value as Hawkins says some businesses can then the compound growth rate here will be 13.6%, this shows why steeper the MOS not only is it safer but the return potential is better) 
 
Discount Rates
In March 2005 US 10-yr treasury yielded 4.5%
Treasury and a few points of risk premium.
But be cautious in low rate environments.
Historically yields have been nearer 6% if risk premium of a few % is tagged on this gives Southeastern's 9% DCF hurdle rate back in March 2005.
N.B. If a business looks too risky don't either bother running a DCF and valuing it, can it.

Terminal Multiple 
Terminal multiple should gen be based on LT GDP growth figure and assumes very little/no growth.
So once you hit year nine you multiply projected FCF for year 8 by LT GDP growth rate and then multiply by inverse of your discount rate to get terminal multiple.
E.g. Say company is conservatively expected to grow FCF by 4%pa up to year 8. Year 8 FCF flow is estimated to be $100 and LT GDP growth rate is 2% pa, and you are using a 9% discount rate your terminal multiple is:
(100 x 1.02) x 1/0.09 = $1,133.33 for all cash flows out past year 8 into infinity.
This is then discounted back to present.
You can see more about how Southeastern do their DCF modeling here
(BTW - The various "discount factors" in the table in the linked article are just the discounts that the present value cash flows have compared to their future values)


Problems with DCF Models & Why Good Management Is Important.
The DCF model is essentially a FCF yield model for companies and is thus similar to YTM calculations for bonds.
YTM assumes all coupons occur under steady interest rate environment, this almost always false
You need to grasp what will happen with your coupons in order to gauge your returns.
Unlike a bond where the holder gets the payout and can invest it themselves it is up to company management to invest the FCF coupons on your behalf (this is why competent management is important).

Management needs to be able invest FCF intelligently.
Is working capital eating business up?
Has management done intelligent things like buying back shares when they were cheap e.g. below book?


The company has five choices in how it will invest these FCF coupons:
1. Put in treasuries or pay off debt - usually the yield on treasuries and the cost of their debt will be below your discount rate.
(I.e. not a fantastic use of cash)
2. Put it in earning asset base - i.e. reinvest in business. This will probably earn more than discount rate if company is good.
(Good)
3. Buy shares - worth doing if shares are undervalued by more than the discount rate. (Good)
4. Go on acquisitions - this uses coupons and principal, this can be bad news. Have they made intelligent acquisitions?
5. Return as dividends - if YOU can reinvest at higher than YTM/discount then this is good.


3. Comparable Sales
You adjust comp sales for interest rates in period in which they occured.
Arms-length transactions etc
 
 
C/ Discipline and patience - specific price to value settings and ability to wait it out.
2% returns aren;t attractive but 50% losses are even worst.
Great investments are made when you have liquidity and others don't
 
  
 
MARGINS OF SAFETY
If you understand a business PERFECTLY then there is no need for MOS.
The more uncertain you are the more MOS you require.
The bridge 6" above the ground and bridge 2 miles above.
If you don't know how far you can fall, you want a hell of a lot of MOS - that means the bridge has got to be rock solid.
 
MOS revolves around spectrums of confidence:
The balance sheet at the top is your most confident so you can absolutely load up at this level.
But say with Coke you have to do a DCF so then you are going to be less confident than a company with a wedge of cash on the BS.
Remember the future requires way more MOS.

If there is doubt you can forgo an opportunity


WHEN TO SELL
You can sell when you are fully invested and you find 40c dollar then you sell your 80c dollar to buy into it.
It's the 100% rule you will only swap out if you think upside is 100% on replacement otherwise you stick with it.
Remember you get a ton of frictional costs when you sell.

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