DCF, Crooked Management, Portfolio Construction

DCF, Crooked Management – On Several Questions from a Reader by David Merkel, CFA of AlephBlog

As time has gone along, I realize that my blog is different.  I do things that most bloggers don’t do, e.g. book reviews, answer e-mails publicly, and a few other things.  Also, my audience is far more international than most, with a large contingent from India.  Well, here is another e-mail from a reader in India:

Hi David,

I am a big fan or your articles and read regularly when I get time. I respect you for what you are trying to do with your blog – it is a free education for people like us. I also write a blog but it is mostly a commentary sorts than educating blog like yours.

I am writing to you today because I want to seek out your advice on my portfolio (and my ongoing investment education). 

Screening technique

I normally use Reverse DCF with 15% discount rate, 3% terminal growth rate and future growth assumption of a quarter of historical (5 or 10 years) FCF growth rate. For eg. if historical FCF growth rate of a company is 40%, and reverse DCF suggest market is factoring 10%, that company gets shortlisted.

I also try to invest in companies with 5 years avg ROCE of more than 25% – assumption being management being prudent and high quality will generate good returns on capital available to them.

When I am done screening the stocks, I read their previous 2-3 annual reports to get the feel of the business, how do they money and what are the underlying risks etc. I also read their commentaries on the business prospects and any extraordinary or hidden/ contingent charges they might have. I try to find out what makes the business earn so consistent results.

The screen I use normally allow me to avoid the folly of forecasting. I avoid making an elaborate model and try to forecast future earnings and cash flows. I just try to buy the security at a good discount to what my Reverse DCF model suggests.

Selling strategy

Now, lot of my stocks (8/13) have doubled in 1-3 years duration. I, as a rule, take out my capital when my stock doubles i.e sell half of my holdings. I assume that whatever I have thought about the future prospects of the business could be wrong. Some of my stocks are trading below the level I took out my capital and some of them have turn out to be multi-baggers. What are your thoughts on this selling strategy.

I also have issues with a stock if it has been on my watchlist and has run up a bit. I think this is anchor bias everyone talks about. But I still want to know your thoughts. Do you buy in a single trade or do you build your position slowly.

One more thing, I know you write a lot about portfolio structure, what do you suggest to do if the business you have made the highest allocation to is generating lower returns and vice-versa.

I know I am bothering you a lot, but knowing your thoughts will help me a lot.

I also tried my hands on liquidation analysis that Peter Cundill speaks about in his book – There’s always something to do.

I bought a stock, which was trading way below its liquidation value ( if you buy the entire market cap, sell all the assets at half the prices, and pay off all the liabilities, you still will be left with some cash). I have read their ARs and have found nothing wrong with management, of course their business is not generating lot of profits. I have put a google alert on company’s name if there is some news report or some analysis on the company that may alert me if they’re fraud. So my question is how do you (or a retail investor like me) make sure that management is not fraud or accounts are not cooked.

I know these are lot of questions – that too from a stranger sitting in India but I’ll be happy if you give me some sense of direction – whether I am doing things right or what should I change.

Keep writing and educating,
Thanks,

I don’t use DCF or reverse DCF because of the many assumptions employed in DCF.  I am happier using simpler techniques like P/E, P/B, P/S, and then trying to critique them considering what I know about the company and industry in question.

As for you insistence on a high ROCE — that can work in India, but is less likely to work in the developed world, because few companies can beat the 25% threshold, that have reasonable valuations.

I take out assets from companies as they rise.  I do it more regularly and slowly than you do — it is a risk control mechanism.  On the downside, it is a way to make more money, by buying quality companies when they are down.

For more thoughts on selling, look at my portfolio rules seven and eight.

Regarding watchlist assets that have risen in value, I follow portfolio rule eight, and only buy assets that would be a net improvement to the portfolio.  Timing will almost never be right, but if you have a favorable valuation for the asset in question, and a sound balance sheet, you will do well.

Regarding portfolio construction, I only look at the likely future.  I will hold onto a company that has done badly, but still offers an opportunity of doing well in the future.  The objective is to be forward-looking.

I buy positions all-at-once, or as close to it as I can, because a few positions are illiquid.  There is no reason to delay in investing if your thesis is a good one.

Regarding crooked managements — the first question to ask is how are you going to grow revenues.  If the answer is at all unbelievable, run away.  There are other tests:

1) look at their results over many years, and compare it to their commentary.  Don’t give any credit for one-time (negative) events because over the long run, managements that have too many one time events are bad managements.

2) use statistics like normalized operating accruals to see if the accounting is conservative or liberal.

3) Analyze growth in book value plus dividends versus earnings.  Growth in book value plus dividends is a better measure of value than earnings is.

4) look at management incentives — the best managers are idealists.  They love what they do, and would do it for free. if they could.  You want a management team that is hungry; you son’t want a management team that feels full.

Thanks for writing me, and I hope you prosper in your investing in India.

Sincerely,

David

 

DCF, Crooked Management, Portfolio Construction



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.