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How many parents have followed a neighbor’s bad advice and bought shares in a gold mining enterprise or a commercial real-estate partnership instead of following their children to the mall, where they would have been led straight to the Gap and its 1,000 percent return from 1986 to 1991?
Any growth stock that sells for 40 times its earnings for the upcoming year is dangerously high-priced, and in most cases extravagant. As a rule of thumb, a stock should sell at or below its growth rate—that is, the rate at which it increases its earnings every year. Even the fastest-growing companies can rarely achieve more than a 25 percent growth rate, and a 40 percent growth rate is a rarity. Such frenetic progress cannot long be sustained, and companies that grow too fast tend to self-destruct.
The best way to handle a situation in which you love the company but not the current price is to make a small commitment and then increase it in the next sell-off.
In a retail company or a restaurant chain, the growth that propels earnings and the stock price comes mainly from expansion. As long as the same-store sales are on the increase (these numbers are shown in annual and quarterly reports), the company is not crippled by excessive debt, and it is following its expansion plans as described to shareholders in its reports, it usually pays to stick with the stock.
Since the owners of fat-cat houses included newspaper editors, TV commentators, and Wall Street money managers, it’s not hard to figure out why the collapse in real estate got so much attention on the front pages and the nightly news. Many of these stories had to do with the collapse in commercial real estate, but the word “commercial” was left out of the headlines, giving the impression that all real estate would soon be worthless.
A technique that works repeatedly is to wait until the prevailing opinion about a certain industry is that things have gone from bad to worse, and then buy shares in the strongest companies in the group.
A stronger balance sheet made it very unlikely that Pier 1 would be going out of business anytime soon, which is what frequently happens to more heavily indebted retailers during recessions.
Since initial public offerings are often sold out, you have to figure a lot of investors are ignoring the highlighted paragraphs. But in addition to those, there’s useful information in a prospectus that shouldn’t be overlooked.
One way to estimate the actual worth of a company is to use the home buyer’s technique of comparing it to similar properties that recently have been sold in the neighborhood.
When insiders are buying, it’s a good sign—unless they happen to be New England bankers.
The goodwill is the amount that has been paid for an acquisition above and beyond the book value of the actual assets.
If half of General Host’s total assets consisted of goodwill, I would have no confidence in its book value or in its shareholders’ equity. As it turns out, $22.9 million in goodwill out of $148 million in total assets is not a troublesome percentage.
What you want to see on a balance sheet is at least twice as much equity as debt, and the more equity and the less debt the better.
In a highly leveraged company, bank debt is dangerous, because if the company runs into problems the bank will ask for its money back. This can turn a manageable situation into a potentially fatal one.
You don’t want a company to have too much inventory. If it does, it may mean that management is deferring losses by not marking down the unsold items and getting rid of them quickly. When inventories are allowed to build, this overstates a company’s earnings.
A hefty accounts payable is OK. It shows that General Host was paying its bills slowly and keeping the cash working in its favor until the last minute.
General Host described how it was engaged in a vigorous campaign to cut costs in order to become more competitive and more profitable—like everybody else in America. Although most companies make such claims, the proof is in the S, G, and A category (selling, general, and administrative expenses) on the income statement (see Table 9-2). You’ll note here that General Host’s S, G, and A expenses were declining, a trend that continued into 1991.
When a business as old-fashioned as Frank’s is modernizing on all fronts and expanding at the same time, there are several chances for the earnings to improve.
Calloway’s, with 13 stores, was valued at $40 million—or roughly $3 million per store. General Host owned 280 Frank’s Nursery outlets, or 21 times as many stores as Calloway’s. The Frank’s outlets were older, smaller, and less profitable than the Calloway’s stores, but even if we assume they were half as valuable ($1.5 million per store), the 280 Frank’s stores ought to have been worth $420 million. So General Host had a $420 million asset here. Subtracting the company’s $167 million in debt leaves you with an enterprise worth $253 million. With 17.9 million shares outstanding, this means that
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Since this was a franchise operation, the money to set up the new Supercuts would come from the franchisees. This was another big plus: Supercuts could expand rapidly without using its own capital and without excessive borrowing.
A great industry that’s growing fast, such as computers or medical technology, attracts too much attention and too many competitors.
In a lousy industry, one that’s growing slowly if at all, the weak drop out and the survivors get a bigger share of the market. A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market.
In business, competition is never as healthy as total domination.
The greatest companies in lousy industries share certain characteristics. They are low-cost operators, and penny-pinchers in the executive suite. They avoid going into debt.
50 percent of the U.S. population lives within 500 miles of Columbus.
“The fact that a company you put your money in has a big building doesn’t mean that the people in it are smart, but it does mean that you’ve helped pay for the building,” says investment adviser William Donoghue.
While other airlines were flying their widebodies over the same routes to Los Angeles, New York, and Europe, Southwest found a niche: the short hop. It called itself “the only high-frequency, short-distance, low-fare airline.” As the others killed themselves off, Southwest grew from a four-plane operation in 1978 to the eighth-largest carrier in the country. It was the only U.S. airline to have made money every year since 1973. For return on capital, Southwest has yet to be outdone.
The stock price tripled from the 1987 low to $10 a share before the Saddam Sell-off, when it lost much of those gains and fell to $6. Investors ignored the fundamentals to focus on the sad future for tires after the world came to an end. When that didn’t happen, the stock rose fivefold to $30.
All else being equal, invest in the company with the fewest color photographs in the annual report.
Might be a bit dated now
Yet for the scores of S&Ls that have stayed out of trouble or survived it, it still is a wonderful life. Based on equity-to-assets ratio, the most fundamental measure of financial strength, more than 100 S&Ls are stronger today than the nation’s strongest bank, J. P. Morgan.
There are also plenty of S&Ls in lousy financial shape, which is why it’s important to make distinctions. I’ve identified three basic types: the bad guys that perpetrated the fraud, the greedy guys that ruined a good thing, and the Jimmy Stewarts.
The tried-and-true scheme, which was quickly duplicated by connivers across the nation, worked as follows. A bunch of people got together, let’s say 10 for simplicity’s sake, and put up, let’s say, $100,000 apiece to buy the In God We Trust S&L on Main Street. With their $1 million in equity, they could take in $19 million in deposits and make approximately $20 million worth of new loans.
Sounds similar to Lithuanian bank in 1990s
With some notable exceptions, such as Charles Keating’s, the vast majority of the fraudulent S&Ls were privately owned. The owners and directors involved in the dirty tricks couldn’t have tolerated the scrutiny of a publicly held company.
There are two explanations for my indiscriminate and sometimes fatal attraction for S&Ls. The first is that my fund was so big and they were so small that to get enough nourishment out of them I had to consume large quantities, like the whales who are forced to survive on plankton. The second is the unique way that S&Ls came public, which made them an automatic bargain from the start.
When even the analysts are bored, it’s time to start buying.
The most important number of all. Measures financial strength and “survivability.” The higher the E/A, the better. E/As have an incredible range, from as low as 1 or 2 (candidates for the scrap heap) to as high as 20 (four times stronger than J. P. Morgan). An E/A of 5.5 to 6 is average, but below 5, you’re in the danger zone of ailing thrifts.
an S&L with a high E/A ratio makes an attractive takeover candidate. This excess equity gives it excess lending capacity that a larger bank or S&L might want to put to use.
Price-Earnings Ratio As with any stock, the lower this number, the better. Some S&Ls with annual growth rates of 15 percent a year have p/e ratios of 7 or 8, based on the prior 12 months’ earnings. This is very promising,
When high-risk assets exceed 5–10 percent, I begin to get nervous. All else being equal, I prefer to invest in an S&L that has a small percentage of its assets in the high-risk category. Since it’s impossible for the casual investor to analyze a commercial lending portfolio from afar, the safest course is to avoid investing in S&Ls that make such loans.
it’s possible to do your own calculation of high-risk assets. Check the annual report for the dollar value of all construction and commercial real estate lending, listed under “Assets.” Then find the dollar value of all outstanding loans. Divide the latter into the former, and you’ll arrive at a good approximation of the high-risk percentage.
90-Day Nonperforming Assets These are the loans that have already defaulted. What you want to see here is a very low number, preferably less than 2 percent of the S&L’s total assets. Also, ...
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He described a sneaky method by which unscrupulous banks and S&Ls camouflage their problem loans. If a developer, say, asks to borrow $1 million for a commercial project, the bank offers him $1.2 million on the basis of an inflated appraisal. The extra $200,000 is held in reserve by the bank. If the developer defaults on the loan, the bank can use this extra money to cover the developer’s payments. That way, what has turned into a bad loan can still be carried on the books as a good loan—at least temporarily. I don’t know how widespread this practice has become, but if Sidhu is right, it’s
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All things considered, I’d rather invest in an S&L that’s proven it can survive in a depressed state than in one that thrives in a booming economy and has never been tested in bad times.
The rise and fall of the aluminums, steels, paper producers, auto manufacturers, chemicals, and airlines from boom to recession and back again is a well-known pattern, as reliable as the seasons.
With most stocks, a low price/earnings ratio is regarded as a good thing, but not with the cyclicals. When the p/e ratios of cyclical companies are very low, it’s usually a sign that they are at the end of a prosperous interlude. Unwary investors are holding on to their cyclicals because business is still good and the companies continue to show high earnings, but this will soon change. Smart investors are already selling their shares to avoid the rush.
When the price drops, the p/e ratio also drops, which to the uninitiated makes a cyclical look more attractive than before.
Soon the economy will falter, and the earnings of the cyclical will decline at breathtaking speed. As more investors head for the exits, the stock price will plummet. Buying a cyclical after several years of record earnings and when the p/e ratio has hit a low point is a proven method for losing half your money in a short period of time.
Just when it seems that things can’t get any worse with these companies, things begin to get better. The comeback of a depressed cyclical with a strong balance sheet is inevitable,
Unless you’re a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic.
Everybody wants to be a capitalist these days, and it’s hard to be a capitalist without a telephone.
