Security Analysis Series: Introduction to Part IV Summary

“Go With the Flow”, by Bruce Berkowitz

Chapter Summary

  • Berkowitz makes the analogy of a large corporation to a tiny variety store. While massively different in scope, they are fundamentally the same, in that sales less expenses equalled profit for the variety store owner, and that profit can be divvied up to reinvest in the business, pay down debt, or be taken out of the business by the owner all together. (pg 339).
    • That excess cash, or profit, is Graham’s concept of “earnings power”; the profit is the “free cash flow” of the business.
    • Examining assets and earnings power allows an investor to determine the value of future returns.
  • “The fundamental problem of equity investing is how to value a company.” (pg 340).
    • The 1930’s, this was done via measuring tangible assets; this is because the dominant industries all held clear, tangible assets to value. This is a contrast to today’s service economy, where there are whole businesses built on intangibles.
  • Adjustments to free cash flow are necessary; some, or all of the values will naturally be over or understated, either intentionally or accidentally. It is the job of a good value-investor to investigate. (pg 341).
  • Free cash flow can be substantially different from GAAP earnings. Berkowitz cites the case of the industrial company Mohawk Industries. (pg 343).
    • Charges can serve to reduce net income, but not actually take cash out of the business; for example, depreciation and amortization.
  • A key aspect of free cash flow evaluation is an analysis of how management spends cash, and if they are maximizing shareholder value in that way. Today, buying back stock is preferable to dividends; however, this preference is entirely relative to price. (pg 345).
    • Buying back over-valued stock is a detriment, whereas undervalued stock buybacks help the long-term investor.
  • Dividend policy is the ultimate window into management’s opinion on the durability of free cash flow. (pg 346).
    • If changes in free cash flow are considered temporary, the dividend should theoretically not be adjusted, and vice-versa.
    • Be wary of overly-manipulative management teams that make late dividend cuts in an attempt to steer investors off the trail of poor performance.
  • A large amount of cash surplus in a company is excellent, however, everything must ultimately be viewed under the light of benefiting the shareholders. Sitting on cash does not create value (pg 347).

Chapter Analysis and Thoughts

  • The rise of intangibles in creating value in our economy presents a double-edged sword of opportunity and difficulty. Firstly, opportunity in the sense that current accounting policies, based on knowledge from my undergraduate program, are woefully inaccurate in representing the ability of intangibles to generate income in the future. Often if an intangible offers some value, it is capitalized at cost and subsequently amortized. But this measurement makes no rational sense; if an intangible offers value, obviously this would have to be at an amount greater than its cost! This brings us to the difficult edge of the sword. What is our process for ascribing value to an intangible? How do we know if we are in the correct ballpark?
  • Dividends as a signal is a useful concept, however we should proceed with caution in applying it as a strict rule. There must exist times when the future brings optimism, but at present the company must cut dividends.
  • It is particularly egregious for companies to sit on cash in periods of inflation. Deploying that cash into assets that offer at least some kind of return is certainly beneficial in creating value for shareholders. This is somewhat relatable to the current situation in the resource industry. Companies are depleting their ore bodies to cover their losses and enhance cash positions, while also continuing to operate under the pretense that prices will rise. Cognitive dissonance at its finest.

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