fundamental analysis

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So in 2010 I undertook an analysis of BHP [here is the link to the original] reproduced below:

BHP is my proxy stock for getting short China, due to their supplying the basic resources to China that is fueling their infrastructure build-out with inflationary Yuan.

The capitalization ratios are good, no real problems here, the problems all occur elsewhere. The elsewhere is in the profitability.

%Profit margin……..5yrs Av………Current…..36%…….24%
%Earned on Capitalization………….4.6%…………………2.2%

Deteriorating. China, Germany, Japan are the big manufacturing bases. China is probably the only one that has continued to order vast amounts of resources, everywhere else is quiet. If China is a bubble, which I maintain that it is, then the popping of the China bubble will collapse BHP’s earnings.

The profit margins are not only contracting, they are also being manipulated. The COG has lagged Revenues very badly, this is always a very bad sign, and tends to suggest that Inventories are being held back from costing. When we look at inventory figures, they are growing faster than sales, they are jumping alarmingly, suggesting fudged figures.

Combine the rising Inventory picture with the slowing Receivables picture and you have further confirmation that something dodgy is taking place. Again rising Revenues, with falling Receivables, something is just not right.

In contrast to this poor picture, Cash from Ops/Operating Income ratio’s have improved. Cash from Finance is less, which is good. How then are they improving in this area? Again most likely from improper accounting of Inventories.

Management in the meantime have increased in a surreptious manner their compensation. SG&A has $2,231,000 that is purely discretionary in nature – where’s it gone? Hmmmm. Also a further $1,727,000 from CapEx, again, where’s it gone? Discretionary funds are accounted for under their line entries, but contradict cross-checks against other line entries leaving a trail.

One valuation method:
[i] Total Return Value = [earnings growth + yield] / P/E
[i] Total Return Value = [(-1.8%) + 2.1%]/94 = 0.00

Intrinsic Value = $27.63
Current Share Price = $79.00
Overvalued by some 65%

 And the current chart:
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Just starting to have a look at the fundamentals of this company. Nothing to do with the fundamentals, but look at that technical divergence.


How Warren Buffett Interprets the Income Statement

When it comes to analyzing the income statement, it is important to investigate further and drill down to detect what the quality of earnings are made up of and what the numbers interpret.

Gross Profit Margin: firms with excellent long term economics tend to have consistently higher margins

Durable competitive advantage creates a high margin because of the freedom to price in excess of cost
Greater than 40% = Durable competitive advantage
Less than 40% = competition eroding margins
Less than 20% = no sustainable competitive advantage
Consistency is key
Sales Goods and Administration: Consistency is key.

Companies with no durable competitive advantage show wild variation in SG&A as % of gross profit

Less than 30% is fantastic
Nearing 100% is in highly competitive industry
R&D: if competitive advantage is created by a patent or tech advantage, at some point it will disappear.

High R&D usually dictates high SG&A which threatens the competitive advantage
Depreciation: Using EBITDA as a measure of cash flow is very misleading

Companies with durable competitive advantages tend to have lower depreciation costs as a % of gross profit
Interest Expenses: Companies with high interest expenses relative to operating income tend to be either:

1) in a fiercely competitive industry where large capital expenditure required to stay competitive

2) a company with excellent business economics that acquired debt in leveraged buyout

Companies with durable competitive advantages often carry little or no interest expense.
Warren’s favorites in the consumer products category all have less than 15% of operating income.
Interest expenses varies widely between industries.
Interest ratios can be very informative of level of economic danger.
Important: In any industry, the company with the lowest ratio of interest to Operating Income is usually the one with the competitive advantage.

Net Earnings

Look for consistency and upward long term trend.
Because of share repurchase it is possible for net earnings trend to differ from EPS trend.
Preferred over EPS
Durable competitive advantage companies report higher % net earnings to total revenues.
Important: If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage.

If net earnings is less than 10%, likely to be in a highly competitive business

How Warren Buffett Interprets the Balance Sheet

Cash and Equivalents:

A high number means either:

1) The company has competitive advantage generating lots of cash

2) Just sold a business or bonds (not necessarily good)

A low stockpile of cash usually means poor to mediocre economics.

There are 3 ways to create large cash reserve.

1) Sell new bonds or equity to public

2) Sell business or asset

3) It has an ongoing business generating more cash than it burns (usually means durable competitive advantage)

When a company is suffering a short term problem, Warren Buffett looks at cash or marketable securities to see whether it has the financial strength to ride it out.

Important: Lots of cash and marketable securities + little debt = good chance that the business will sail on through tough times.

Test to see what is creating cash by looking at past 7 yrs of balance sheets. This will reveal how the cash was created.

Manufacturers with durable competitive advantages have the advantage that the products they sell do not change, and therefore will never become obsolete. Warren Buffett likes this advantage.
When identifying manufacturers with durable competitive advantage, look for inventory and net earnings that rise correspondingly. This indicates that the company is finding profitable ways to increase sales which called for an increase in inventory.
Manufacturers with inventories that spike up and down are indicative of competitive industries subject to boom and bust.
Net Receivables

Net receivables tells us a great deal about the different competitors in the same industry. In competitive industries, some attempt to gain advantage by offering better credit terms, causing increase in sales and receivables.

If company consistently shows lower % Net receivables to gross sales than competitors, then it usually has some kind of competitive advantage which requires further digging.

Property, Plant & Equipment

A company with durable competitive advantage doesn’t need to constantly upgrade its equipment to stay competitive. The company replaces when it wears out. On the other hand, a company without any advantages must replace to keep pace.

Difference between a company with a moat and one without is that the company with the competitive advantage finances new equipment through internal cash flows, whereas the no advantage company requires debt to finance.

Producing a consistent product that doesn’t change equates to consistent profits. There is no need to upgrade plants which frees up cash for other ventures. Think The Coca-Cola Company (NYSE:KO), Johnson & Johnson (NYSE:JNJ) etc.


Whenever you see an increase in goodwill over a number of years, you can assume it’s because the company is out buying other businesses above book value. GOOD if buying businesses with durable competitive advantage.

If goodwill stays the same, the company when acquiring other companies is either paying less than book value or not acquiring. Businesses with moats never sell for less than book value.

Intangible Assets

Intangibles acquired are on balance sheet at fair value.
Internally developed brand names (Coke, Wrigleys, Band-Aid) however are not reflected on the balance sheet.
One of the reasons competitive advantage power can remain hidden for so long.
Total Assets & Return on Total Assets

Measure efficiency using ROA
Capital is barrier to entry. One of things that make a competitive advantage durable is the cost of assets needed to get in. This is why we calculate the Asset Reproduction Value along with the EPV.
Many analysts argue the higher return the better. Warren Buffett states that really high ROA may indicate vulnerability in the durability of the competitive advantage.
E.g. Raising $43b to take on KO is impossible, but $1.7b to take on Moody’s is. Although Moody’s ROA and underlying economics is far superior to Coca Cola, the durability is far weaker because of lower entry cost.
Current Liabilities

Includes accounts payable, accrued expenses, other current liabilities and short term debt.

Stay away from companies that ‘roll over the debt’ e.g. Bear Stearns
When investing in financial institutions, Warren Buffett shies from those who are bigger borrowers of short term than long term debt.

His favorite ‘Wells Fargo’ has 57 cents short term debt for every dollar of long term
Aggressive banks (like Bank of America) has $2.09 short term for every dollar long term
Durability equates to the stability of being conservative.

Long Term Debt coming Due

Some companies lump their yearly long term debt due with short term debt on the balance sheet. This makes it seem like there is more short term debt than the real amount.

Important: Companies with durable comparable advantages need little or no LT debt to maintain operations.

Too much debt coming due in a single year spooks investors and can offer attractive entry points.

However, a mediocre company in problems with too much debt due leads to cash flow problems and certain bankruptcy.

Long Term Debt

Warren Buffett says that durable competitive advantages carry little to no LT debt because the company is so profitable that even expansions or acquisitions are self financed.

We are interested in long term debt load for the last ten years. If the ten yrs of operation show little to no long term debt, then the company has some kind of strong competitive advantage.

Warren Buffett’s historic purchases indicate that on any given year, the company should have sufficient yearly net earnings to pay all long term within 3 or 4 year earnings period. (e.g. Coke + Moody’s = 1yr)

Companies with enough earning power to pay long term debt in less than 3 or 4 years is a good candidate in our search for long term competitive advantage.

BUT, these companies are targets for leveraged buy outs, which saddles the business with long term debt
If all else indicates the company has a moat, but it has ton of debt, a leveraged buyout may have created the debt. In these cases the company’s bonds offer the better bet, in that the company’s earnings power is focused on paying off the debt and not growth.
Important: little or no long term debt often means a Good Long Term Bet

Total Liabilities & Debt to Shareholders Equity Ratio

Debt to shareholders equity ratio helps identify whether the company uses debt or equity (includes retained earnings) to finance operations.
Company with a moat uses earning power and should show higher levels of equity and lower level of liabilities.
Debt to Shareholders Equity Ratio : Total Liabilities / Shareholders Equity
Problem with using as identifier is that economics of companies with durable competitive advantages are so great they don’t need large amount of equity or retained earnings on the balance sheet to get the job done.
Important: if the Treasury Share Adjusted Debt to Shareholder Equity Ratio is less than 0.8, the company has a durable competitive advantage.

Retained Earnings: Warren Buffett’s Secret

One of the most important indicators of durable competitive advantage. Net earnings can be paid out as dividends, used to buy back shares or retained for growth.

If the company loses more than it has accumulated, retained earnings is negative.

If a company isn’t adding to its retained earnings, it isn’t growing its net worth.
Rate of growth of retained earnings is good indicator whether it’s benefiting from a competitive advantage.
Microsoft is negative because it chose to buyback stock and pay dividends
The more earnings retained, the faster it grows and increases growth rate for future earnings.
Treasury Stock

Carried on the balance sheet as a negative value because it represents a reduction in shareholders equity.
Companies with moats have free cash, so treasury shares are hallmark of durable competitive advantages.
When shares are bought back and held as treasury stock, it is effectively decreasing the company equity. This increases return on shareholders equity.
High return is a sign of competitive advantage. It’s good to know if it’s generated by financial engineering or exceptional business economics or combination.
To see which is which, convert negative value of treasury shares into a positive and add it to shareholders equity. Then divide net earnings by new shareholders equity. This will give the return on equity minus effects of window dressing.
Important: presence of treasury shares and a history of buyback are good indicators that company has competitive advantage

How Warren Buffett Interprets the Cash Flow Statement

Capital Expenditures

Never invest in telephone companies because of big capital outlays

Important: company with durable competitive advantage uses a smaller portion of earnings for capital expenditure for continuing operations than those without.

To compare capex to net earnings, add up total capex for ten-yr period and compare with total net earnings over the same period

Important: if historically using less than 50%, then good place to look for durable competitive advantage. If less than 25%, probably has a competitive advantage.

Summary of What to Look for

Income Statement (DCA = Durable Competitive Advantage) Comments
Gross Profit Margin >40% = D.C.A.
<40% = competition eroding margins
<20% = no sustainable competitive advantage Consistency is Key
(SGA as % of gross profit) < 30% is fantastic
Nearing 100% is in highly competitive industry Consistency is Key
(depreciation costs as a % of gross profit) Company with moat tend to have lower %
Interest Expenses
(interest expenses relative to operating income) Durable competitive advantage carry little or no interest expense.
Warren Buffett’s favorite consumer products have 20% = Long Term moat
BV d.c.a.’s never sell for less than BV
LT Investments can have valuable assets on books at valuation < market price (booked at lowest price) tells us about investment mindset of management
(Looking for d.c.a.?)
Intangible Assets Internally developed brands not reflected on BS
Total Assets + ROA
(Measure efficiency using ROA) Higher return the better (but: really high ROA may indicate vulnerability in durability of c.a.) Capital = barrier to entry
ST Debt financial institutions. Warren Buffett shies from those who are bigger borrowers of ST than LT debt
LT Debt Due d.c.a. need little or no LT debt to maintain operations
Total CL + Current Ratio higher the ratio, the more liquid, the greater its ability to pay CL d.c.a.’s don’t need ‘liquidity cushion’ so may have <1
LT Debt LT debt load for last ten yrs. ten yrs w/ little LT debt = d.c.a. earning power to pay their LT debt in <3/4 yrs = good candidates
Total Liabilities + Treasury Share-Adjusted debt to Shareholder Eq Ratio If <.80, Good chance company has d.c.a.
Preferred + Common Stock in search for d.c.a. we look for absence of preferred stock
Retained Earnings Rate of growth of RE is good indicator
Treasury Stock presence of treasury shares and a history of buyback are good indicators that company has d.c.a. convert –ve value of treasury shares into +ve and add shareholder eq.
Divide net earnings by new shareholders eq. give us return on equity minus dressing.
Return on Shareholder equity d.c.a. show higher than average returns on shareholders equity If company shows history of strong net earnings, but shows –ve sholder equity, probably d.c.a. because strong companies don’t need to retain
Cash Flow Statement
Capital Expenditures historically using
<50% then good place to look for d.c.a.
<25% probably has d.c.a. Add up total cap exp for ten-yr period and compare w/ total net earnings over period.
Stock Buybacks indicator of d.c.a. is a history of repurchasing/retiring its shares Look at cash from investment activities. “Issuance (Retirement) of Stock, Net”


On December 19, 2012, CNBC’s Kate Kelly first reported that hedge fund titan Bill Ackman, who runs Pershing Square Capital Management, has been shorting Herbalife because he considers the company to be pyramid scheme.

People knew for sometime that Ackman was short a company, but it wasn’t clear which one. Ackman, who is known for being a long-only investor, had told investors in Pershing’s Q1 letter in June that he had new short position. Then, in October, during a CNBC appearance on “Squawk Box” he wouldn’t reveal his short, but said the country would be better off when it goes out of business.

After CNBC reported Ackman’s short, the stock began to tank. That day, shares of Herbalife fell $5.16 yesterday, or 12.14%, to close at $37.34 a share.

Herbalife’s CEO Michael Johnson told CNBC in a telephone interview that Ackman’s “pyramid scheme” claim is a “bogus accusation” and that it’s “blatant market manipulation.”

The next day on December 20, 2012, Pershing Square gave an extremely in-depth three-hour long, 342-slide presentation at a special Sohn Conference event in Midtown Manhattan. Ackman explained that he thinks Herbalife is a pyramid scheme. He has a price target of zero and has pledged to donate any personal profits to charity. He also refuted Herbalife’s claim of market manipulation saying they didn’t own options.

Herbalife responded to Ackman’s presentation later that day calling it a “malicious attack” and accused him of using “outdated” and “inaccurate information.” The company also stated in a release that it is “not an illegal pyramid scheme.” The company said that it would hold an analyst/investor day to rebut Ackman’s claims.

Ackman’s attack on Herbalife didn’t stop with his presentation. He unveiled The website features documents, promotional material from the company, videos and depositions. He also took out some Google Ads when people search terms related to “Herbalife.”

On January 9, Daniel Loeb, the founder of Third Point LLC, filed a 13D with the Securities and Exchange Commission that his hedge fund had taken a 8.24% stake (8.9 million shares) in Herbalife. In a letter to investors, Loeb said Ackman’s pyramid scheme claim had “no merit” and called his short “preposterous.” The New York Post later estimated that Loeb bought Herbalife at $32 a share.

Other fund managers such as Robert Chapman of Chapman Capital and John Hempton of Bronte Capital disagree with Ackman’s short case, too. Hempton even published a blog post lambasting Ackman saying that he screwed up his short because he has a “misplaced silver spoon” and can’t talk to poor people.

There was also speculation that David Einhorn of Greenlight Capital might be short. Back in May, Einhorn raised some questions during an HLF conference call and the stock dived. The Wall Street Journal’s Juliet Chung reported that Einhorn shorted Herbalife last year and it was profitable for Greenlight. Einhorn does not currently have a bet on the multi-level marketing firm that sells nutrition products. It’s also unclear how big his short was and what the profits were, the report said.

The world’s greatest short seller Jim Chanos weighed in on the hedge fund war between Ackman and Loeb in a Reuters TV interview. He said he thinks it will come down to who can prove it’s a good business proposition or not. Chanos, who said he’s looked at the MLM industry, wouldn’t say if he’s short Herbalife.

On January 10, Herbalife hosted its analyst/investor day in Midtown Manhattan. The company gave a 102-slide presentation that aimed to debunk the points that Ackman made about their distribution, retail sales and accounting methods, among other things. Herbalife also claimed that Ackman was “misleading” and used “misinformation.”

Then, Ackman fought back. He said “the company distorted, mischaracterized, and outright ignored large portions” of Pershing Square’s mammoth presentation. He said Pershing Square would publicly release a series of questions and have another presentation.

On January 14, shares of Herbalife rallied back above the pre-Ackman short levels. They’re currently up about 1.7% since December 18, the trading session before Ackman confirmed his short. On December 24, the stock hit a 52-week low of $24.24 a share.

The most recent news is that Ackman’s rival Carl Icahn, who hasn’t publicly said if he’s long Herbalife or not, slammed him on Bloomberg TV for his “holier than thou” short calling him “disingenuous.” Ackman fired back in a press release saying Icahn is a good investor, but doesn’t keep his word.

As a medical practitioner I looked at Herbalife supplements and phytotherapy products as a possible line of products that I might hold in the practice to benefit patients and create a profit for myself.

This was about eight years ago.

At this time, there was an 0800 phone number to Australia, which should you require product advice/information you could phone. Herbalife provided me with their starter pack which was a range of some of their more popular products. At that time some of the formulations of the products struck me as odd and potentially dangerous.

The problem with medical herbs is that they [herbs] are complex molecules. A pharmacological manufactured medicine takes the most active constituent and increases its concentration.

With a herb, you have the whole complex structure that exerts a greater or lesser physiological interaction. When you start mixing herbs together you increase the potential for weird and unexpected interactions.

Many of the Herbalife products are hybrids of multiple herbs. One in particular had severe contraindications for pregnant women.

I phoned the 0800 number in Australia and spoke to their helpdesk person. Suffice to say they were grossly incompetent and should never have been placed in that position.

I cancelled my potential business relationship with Herbalife the next day and never sold their products.

As the HLF Hedge Fund war has warmed up I’ve been following the story. I have also looked at the financial statements for HLF. I have to say they look on the surface, pretty good, certainly not the financial statements of a company fast approaching receivership.

Having said that, I also am cognizant of the less than optimum formulations of their older products that I looked at. It has to be said that I haven’t seen their current product range. HLF have their distribution warehouse just down the road from me. I may pop in and grab their current product brochure to examine current formulations.

In addition I will crunch the numbers in the financial statements just to see if anything unusual pops out.

Often, a takeover deal, if taken seriously, will be greeted with a jump in the target company’s share, and a more muddled move in the acquiring company — particularly if the acquisition doesn’t seem to make obvious sense, or if there are worries about paying too much.

Lately, though, we’ve been seeing plenty of investor goodwill toward companies bold enough to try and swallow another company in the rocky environment. That suggests investors are liking the deals, and seeing plenty of value in these target companies, according to John Buckingham, chief investment officer at Al Frank Asset Management in Aliso Viejo, Calif.

Buckingham has been particularly encouraged by three recent deals. Last Monday, health-care giant Aetna shot up 5.6% after announcing it had struck a deal to buy Coventry Health Care. Aetna has since come back some, but remains higher than before the deal was announced. (Coventry, needless to say, jumped 20%.)

Merger’s can help the stock market. Essentially mergers should have the more efficient producers buying out the inefficient, and putting their capital to work more efficiently. In this way the total capacity of an industry is changed/modified for the better.

That’s only of course if the deals make sense. CEO’s have an unfortunate track record however of acquiring assets that don’t make much sense. Buffett and Berkshire are serial acquirer’s and have done very well from it. It is about cashflow.

In the above case, Insurance, the merger makes sense. Insurance is an industry that benefits from scale. Pooled risk is the name of the game, and purchasing another Insurer makes all the sense in the world as long as a few important caveats are observed.

Tail risk is the one you need to watch. Has the insurer that you have just acquired, carry long exposures into the past? The classic example was the asbestos risk that killed a number of private names in Lloyds syndicates a while back.

Mergers done well, indicate that there is value available. If there is value available, there is profit potential, which suggests careful, selective purchases in the market, will reap investment returns going forward. It also helps the bulls, especially if the spark triggers a fire.

I’m having an initial look at VLO for a possible position.

I’m going to add this common stock to the portfolio today.

Current P/E……….6.79
Dividend Yield…….6.6%
Current Ratio……..3.35
Return on Equity…..32.07% [the average is probably closer to 10%]
Credit strength……4.74

A solid common stock. There seems to be no ‘really bad news’ associated with the stock in the public domain. Possibly that it is a ‘German’ company, and the problems in the Euro area currently are contributing to its current ‘price’ malaise.

The stock gapped above my limit price. I will maintain a buy order, just in case it comes back enough to buy at my price.

The ‘numbers’ are toxic. Rarely do you see, except in the biotech’s such risk.

On the ability to create value, measured through a return on equity, the returns have been falling over the 4 yrs of statements to the current [-30.91%] The stock currently is creating no wealth, it is destroying it.

Cashflows are all negative, pushed even further into the red by capital spending requirements. This makes the stock totally dependent on outside financing, either debt, or new equity raising via additional shares, or some other method: grants, subsidies, etc.

This makes the liquidity risk enormous. The chance for bankruptcy is ever present. For all intents and purposes, it is bankrupt, so dependent on additional capital is the operation.

Not included in the numbers is the ‘what if”? What if it actually delivers the product that it is researching/developing? Diagnostics are not as sexy as ‘cures’ or rather treatments. Obviously this won’t necessarily impact revenues, but it may impact the multiple assigned to those earnings.

This is either a home-run, or bankruptcy.

Europe is already deep into the crisis and the Euro and likely Euro zone will cease to exist either sooner or later. America is in exactly the same position, save that they are able if they continue to follow the current inflationary policies, to defer the final day of reckoning slightly longer than Europe, who being fiat currency users, rather than fiat currency issuers cannot postpone that day much longer.

Fiat money collapse, while a scary thought, is far from unprecedented, and the recoveries from said collapses have been fairly swift, largely it might be said in that there have only been local collapses. The question is; in a collapse what would you want to hold to preserve any wealth that you may have?

Gold/Silver are obvious and rational choices, but if you are late to the game, the valuations have made them into highly speculative holdings currently. Land, primarily agricultural land is another asset that you could hold, again I believe that valuations have been bid up recently, add to that the specialist Knowledge required to buy quality land.

Common stocks: proportional ownership in productive assets. Have historically always performed well in post hyperinflations. That isn’t to say there won’t be failures, the latest tech wizzo application may or may not survive, and the same can be said for various retail outlets. That being said however, productive assets of consumer goods that will be still in demand are the way to go, particularly as valuations can be found that are compelling.

Value or Growth? There is a way to differentiate.

The academic version of value markets are those with broad, “rising tide lifts all boats” earnings growth. Cigar butt value investors outperform in these environments because, if most stocks in an index are capable of generating earnings growth, their approach is most adept at discovering undervalued companies. Referring back to our first principle, they are finding reasonable, relative earnings growth streams at the cheapest possible price. This type of market has broad depth, with the highest percentage of index constituents beating overall index performance. Correlations between sectors and stocks are also at their highest in these environments.

Growth markets, typified by the late 1990s, are narrow markets when earnings growth is concentrated in the fewest stocks and sectors. When very few companies are capable of generating decent-sized earnings growth, investment assets flow towards the few areas where growth appears sustainable, driving valuation levels substantially higher. Investors are forced, in other words, to pay a high price for earnings growth because of its scarcity.

There is a quick rule of thumb to determine which type of market, value or growth, is apparent – the performance of the equal-weighted benchmark versus the more widely-followed cap-weighted index. Equal-weighted will outperform in broader value markets and cap weighted will outperform in growthy, more narrow markets. Barry Ritholz’s The Big Picture had n update on the relative performance of these measures HERE, from March 2009 to May of 2011, showing that that the equal-weighted S&P 500 performance has crushed the cap-weighted, indicative of a value market.

Remember that during the first half of 2011, the more or less consensus view among economists was for a global economic recovery for the second half of the year. This is a perfect time for value investing – economic recoveries broaden earnings growth, raising all boats, – and many portfolio managers positioned accordingly.

Obviously when the ‘majority’ of the market, or broad participation, then we are involved in a more ‘value’ orientated market. Unlike the ‘tech’ bull market of the late 90’s where only a select few stocks drove the ‘market’ higher.

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