Cameco Thesis: Appendix

Methodology for the NPV Calculations

The NPV calculations were conducted in the following order:

1. Price forecasts for spot, with Cameco’s corresponding realized price from their 2016 annual report, were created under four separate scenarios:

Price Forecasts
Base Case @ Spot Cost of Production in Three Years Growth @ 15% Aggressive Growth @ 30%
Year Spot ($USD) Realized ($CAD) Increase % Spot ($USD) Realized ($CAD) Increase % Spot ($USD) Realized ($CAD) Increase % Spot ($USD) Realized ($CAD) Increase %
2016 $27.5 $50 $27.5 $50 $27.50 $50.00 $27.5 $50
2017 $27.5 $50 0.0% $27.5 $50.0 0% $32.20 $52.50 5.0% $36 $54 7.5%
2018 $27.5 $50 0.0% $38 $55 10.0% $37.03 $55.00 4.8% $47 $64 18.6%
2019 $27.5 $50 0.0% $49 $64 15.9% $42.58 $57.50 4.5% $62 $73 13.7%
2020 $27.5 $50 0.0% $60 $70 9.8% $48.97 $62.50 8.7% $80 $83 13.8%
2021 $27.5 $50 0.0% $60 $71 1.8% $56.32 $70.00 12.0% $104 $99 19.7%

2. A WACC was developed using three separate (7%, 10%, 15%) risk premiums to debt and equity:

WACC Assuming: 7% rpe, rpd 10% rpe, rpd 15% rpe, rpd
         
Market Value of Equity (yahoo finance)   5.96B 5.96B 5.96B
Market Value of Debt 2.99B 2.99B 2.99B
Risk free rate 2.20% 2.20% 2.20%
Equity beta 0.87 0.87 0.87
Market risk premium 7% 10% 15%
Cost of Equity Ce = rf + Beta * (Rm – Rf) 6.38% 8.99% 13.34%
Cost of Debt 6.73% 8.92% 12.57%
Cd = (rf + rp) * (1-t)
 
Cost of Equity 6.38% 8.99% 13.34%
Cost of Debt 6.73% 8.92% 12.57%
Marginal tax rate (from annual report) 26.9% 26.9% 26.9%
Equity Ratio 71.6% -28.4% -128.4%
Debt Ratio (from ycharts) 28.4% 128.4% 228.4%
WACC 6.49% 8.96% 13.08%
= (equity x Ce) + (debt x Cd) / (Equity + Debt)
Where equity, debt = market value of equity, market value of debt
Ce = cost of euqity, Cd = cost of debt

3. Free cash flow was calculated by adjusting earnings to cash-only effects, and incorporate growth in revenues and variable costs. This chart is an example at the spot price:

DCF: Base Case @ Today’s Spot
Items 2017 2018 2019 2020 2021 2022-2040 (per year)
Spot Price ($CAD @ 1.25$USD/$CAD) $34.4 $34.4 $34.4 $34.4 $34.4  $34.4
Growth (% based on change in realized price) 0.0% 0.0% 0.0% 0.0% 0.0%
Revenues (constant production @25m lbs.)  $2,431,404  $2,431,404  $2,431,404  $2,431,404  $2,431,404 $2,431,404
Production Costs (constant volume @25m lbs.) $1,577,764 $1,577,764 $1,577,764 $1,577,764 $1,577,764 $1,577,764
Operating Costs (excluding non-cash, 2% growth) $263,691 $271,601 $279,749 $288,142 $296,786 $279,994
Earnings (loss) from Operations $589,949 $582,039 $573,891 $565,498 $556,854 $573,646
Net: Other Cash Income, Costs (3% growth) -$48,396 -$49,848 -$51,343 -$52,883 -$54,470 -$51,388
EBIT $541,554 $532,191 $522,548 $512,615 $502,384 $522,258
Tax Rate (%) 26.9% 26.9% 26.9% 26.9% 26.9% 26.9%
Less: tax $145,678 $143,159 $140,565 $137,893 $135,141 $140,487
NOPAT $395,876 $389,032 $381,982 $374,721 $367,243 $381,771
Change (%) -1.7% -1.8% -1.9% -2.0%
Gross Cash Flow $395,876 $389,032 $381,982 $374,721 $367,243 $381,771
less: Capital Expenditures (3% growth) $287,693 $296,324 $305,213 $314,370 $323,801 $305,480
Free Cash Flow ($CAD) $108,183 $92,708 $76,769 $60,352 $43,442 $76,290.60
Total $457,744

Note that changes in working capital was not included because the company had extremely variable history in WC changes, giving the number no effective meaning. Additionally, revenues and variable costs were assumed to grow by the % change in realized price (a cool feature of this NPV calculation, in my opinion) to account for production volume increases in a stronger uranium price environment.

4. The DCF was then calculated by applying different WACC rates and free cash flows, adding cash assets, then subtracting debt. Here is an example at the 15% spot growth price forecast:

DCF per Share – 7% discount rate 2017 2018 2019 2020 2021 2022-2040
Free Cash Flow $501,367,570 $635,284,852 -$72,247,486 $267,643,756 $1,715,246,749 $949,459,088
WACC @ 7% 6.49% 6.49% 6.49% 6.49% 6.49% 6.49%
Discounted FCF $470,800,118 $560,181,999 -$59,822,384 $208,103,035 $1,252,357,230 $6,794,850,396
Sum of Discounted FCF $9,226,470,394
less: Debt $1,965,628,000
Add: Cash & Cash Equivalents $584,810,000
Total $7,845,652,394
Outstanding Shares  395,790,000
DCF per Share (in $CAD) $19.82
DCF per Share – 10% discount rate 2017 2018 2019 2020 2021 2022-2040
Free Cash Flow $501,367,570 $635,284,852 -$72,247,486 $267,643,756 $1,715,246,749 $949,459,088
WACC @ 10% 8.96% 8.96% 8.96% 8.96% 8.96% 8.96%
Discounted FCF $460,124,962 $535,066,314 -$55,844,629 $189,860,813 $1,116,668,797 $4,979,009,360
Sum of Discounted FCF $7,224,885,617
less: Debt $1,965,628,000
Add: Cash & Cash Equivalents $584,810,000
Total $5,844,067,617
Outstanding Shares  395,790,000
DCF per Share (in $CAD) $14.77
DCF per Share – 15% discount rate 2017 2018 2019 2020 2021 2022-2040
Free Cash Flow $501,367,570 $635,284,852 -$72,247,486 $267,643,756 $1,715,246,749 $949,459,088
WACC @ 10% 13.08% 13.08% 13.08% 13.08% 13.08% 13.08%
Discounted FCF $443,369,653 $496,807,280 -$49,963,392 $163,680,151 $927,630,953 $3,091,548,486
Sum of Discounted FCF $5,073,073,132
less: Debt $1,965,628,000
Add: Cash & Cash Equivalents $584,810,000
Total $3,692,255,132
Outstanding Shares  395,790,000
DCF per Share (in $CAD) $9.33

5. Lastly, a matrix was created by pulling each DCF at different WACC and price forecasts:

Cameco Corporation: NPV Matrix
Price Assumption for Five Years of Production
Sustained Spot 15% Annual Growth in Spot Three Yr. Industry Cost of Production 30% Annual Growth in Spot
WACC 6.49% -$4.73 $19.82 $34.92 $68.55
8.96% -$4.88 $14.77 $26.95 $53.65
13.08% -$4.95 $9.33 $18.33 $37.41

This is how I developed my NPV figures. I believe it offers a good approximation of value.

Maximum conservatism was applied in the estimates. Costs were suggested to grow, and production increase only marginally in the face of a much higher price environment.

 

Metals & Mining: Copper Price Fundamentals & Outlook

Copper Price

The copper industry, as shown by the price charts below, has been in a bear market since 2011. Today’s spot price sits at $2.06/lb ($4,546/t), with a 52 week high/low of $1.96/$2.74. The spot price is down roughly 55% from an all-time high of $4.58 in 2011.

5 Year Copper Price Chart

17 Year Copper Price Chart

Those 2011 highs were primarily demand driven by China, and particularly their roaring housing market. Since that time, the price has steadily declined due to a surplus in the market, which was created by slower-than-expected growth in consumption, and increasing production. 2015 saw an actual surplus of approximately 350,000 tonnes according to a Thomson-Reuters, and predicts a surplus of around 150,000 tonnes per year from 2016 to 2018. (1.)

Demand

Demand for copper is heavily influenced by macro-economic trends, and the commodity is considered an excellent litmus test to overall economic health given its uses in transport, construction, housing, and electricity. The depressed spot price seen today is partly a consequence of lack-lustre global consumption, where growth shrank to 1.9% in 2015, down from 3.8% in 2014.

Asian consumption contributed to 66% of total consumption in 2015, with China alone consuming 46%. Refined consumption from China has slowed in growth over the previous 5 years, with the country facing serious macro-economic headwinds. GDP has fallen from 12% in 2010 to a meagre 6.7% in April of 2016. Poor macro conditions are likely to continue in the near-term, with hopes that the government making significant liquidity injections can boost demand in the medium to long term. There are also questions as to when China’s housing market will recover and resume consuming the copper materials it once did, which drove the price to its 2011 highs. There is currently a glut of supply in the Chinese housing market.

Europe and Russia account for 19% of total 2015 consumption, while North America accounts for 9%. European consumption saw moderate growth in 2015 after shrinking from 2010-2013. Russian consumption fell by 5% in 2015, while North American demand experienced virtually no growth.

The short term prospects for a demand-driven rally in price are precarious at best. Any significant uptick in demand will have to be driven by a rapid improvement in economic conditions, yet there is little cause for optimism. Chinese growth has been falling since 2010, and while the recent liquidity stimulus might bring about a boost to future growth, the housing market will remain seriously over-supplied. European GDP hasn’t exceeded 1% since mid-2010. The United States’ GDP in the first quarter of 2016 was a frightening .5%. And as Thomson-Reuters points out, should the United States’ slip into a recession, the consequences for the price of copper would be devastating. The metal’s price has fallen in each of the last nine recessions, the most recent example in 2008 bringing a 60% decline.

Over the medium to long term, however, a brighter picture is presented for demand. Developing Asian economies offer attractive long term fundamentals to the metal. Copper’s use in the expanding electric vehicle market also allows for long term optimism as controlling air pollution continues to become popular amongst governments and consumers. The lower price level of copper should serve to stimulate future demand to some extent, while also maintaining copper’s utility in various infrastructural uses. The years beyond 2018 are promising to the price of copper in this regard.

Supply

On the supply side, there is continued growth in production despite the falling price environment. In 2015, mine production grew 3.5%, as compared to 2.1% in 2014. This was largely attributable to production increases in Asia, with Mongolia and Indonesia, who faced export difficulties, leading the pack. South American countries such as Peru also saw a meaningful increase in production.

The depressed price of copper is shrinking producer margins substantially. Globally, net cash costs are down 4%, and total costs down 2%. Despite these cuts, the cash cost margin has fallen to 35% in 2015, down from 57% in 2012, while total cost margins are at 16%, down from 47% in 2012. The marginal net cash cost of production over the last four years was $2.32/lb, sitting above current copper prices.

Copper Industry Cost Structure

The typical net cash cost for a major producer ranges between $1.25-1.75, which sits below the current price level with some room to breathe. But these cash costs do not tell the whole story. There also exists off-site costs, taxes, interest expense, and head office costs, among other items, which will boost the true unit costs of production, shrinking an already thinning level of profitability. The substantial depreciation, depletion, and amortization charges found on financial statements also should not be ignored. In an environment where both capital and profit margins are extremely tight, my suspicion is that companies will fail to make adequate expenditures in both exploration and mine sustaining costs, shrinking long term supply.

The cost crisis is here, and if an estimated 10% of companies are losing money on a cash basis at $2.40/lb copper, the implications for the industry are even worse near $2.00/lb copper. (2).

To take an example, I present Freeport McMaRon’s North American copper production (their most profitable). Total unit costs sit at $2.16/lb on a co-product basis. Ignoring inventory adjustments, depreciation, depletion, and amortization costs, unit costs still sit at $1.82/lb, offering extremely thin margins. Gross profit compared to 2014 declined immensely. Understanding that interest, management, and sustaining costs are still relevant to overall profitability, and whether or not mines remain in production, how much longer can operations be sustained? And how much lower will the price need to go before closures are a necessity?

Freeport North American Unit Costs

Source: Freeport-McMoRon 2015 Annual Report

In spite of the real impact of declining copper prices, production has yet to see many substantial cuts. The largest cuts came from major producer Glencore, who temporarily closed the Mopani and Katanga mines to make plant upgrades, hoping to bring down costs. Other major producers, such as Coldelco, Rio Tinto, and BHP Billiton have vowed to maintain production in hopes of holding on to their market share using low-cost assets. (3,4.)

Copper Production Cuts

The truth is, however, that many of these producers will have major difficulties in maintaining production at a copper price near $2.00/lb. Despite the steadfast sentiment, Coldelco admitted that it would have to consider cutting production at that price level, and the company may have their hand forced by recent losses and asset write-downs.(5.) Additionally, it would not be surprising if Glencore chooses to keep their mines closed at $2.00/lb copper.

If $2.00/lb copper sustains, I predict there will be more production cuts faster than is expected given the producers’ attitude. No one wants to be the first to move, but it is inevitable given how under-water many of these companies are (see: Freeport McMoRan, Glencore). And even if the price can stay above $2.00/lb, the long term economics of the price level favour supply destruction in the future. Companies sustaining production are depleting their reserves, and a decline in the average grade of copper used in production is both damning for long-term supply, as well as near term operating and capital costs. (6.) Additionally, copper mines enjoy a long average delay (time between discovery and production) relative to other metals at 17.1 years. This long delay time, compounded with low prices and slowing discovery rates, offer the future copper market protection to new sources of supply. (7,8.)

Average Copper Grade 2012

Source: http://.snl.com/cache/18324405.pdf – Metals EconomicGroup 2012 Copper Study

 

Conclusion

The Thomson-Reuters report offers a quote that sufficiently summarized my position:

“…delays today will have implications for supply tomorrow. Clearly a bullish argument for copper, but equally clear is that this is all about one’s time horizon. In the short term, the next two to three years or so, the incentive price argument is just not topical. Consumption is slowing, while mines from the last boom are still ramping up. Furthermore, operations suspended, downscaled or mothballed may restart, some with expanded capacity to enable lower costs, so that the potential shortfalls in mine supply (as demand ratchets up) will not be so dramatic. Further out, towards 2020, the fundamental metal balance starts to look more interesting.” (9.)

If prices continue to fall, or stay around $2.00/lb copper, I believe supply destruction will commence within the next year or so. If prices rise moderately to $2.25/lb, there may be a delay in capitulation as major producers clearly seem eager to maintain market share. While I do not pretend to know where near term prices will go, there appears to be a fair risk of a price decline from a demand side catalyst, such as an American recession or continuing Chinese struggles.

This industry has a year or two to go before the bull market returns. However, the long term fundamentals make copper an absolutely undeniable quality of investment for someone with an extended time horizon, and I am more than happy to be exposed to the industry at current price levels despite the potential for more headwinds to the industry. One can only sell high by buying low, and assets at this price level are extremely attractive.

Sources

(1.) GFMS Copper Survey 2016; Thomson-Reuters

(2.) http://www.mining.com/copper-minings-deepening-costs-crisis/

(3.) http://www.mining.com/codelco-vows-not-to-cut-copper-output-even-if-prices-keep-falling/

(4.) http://www.reuters.com/article/us-chile-copper-output-idUSKCN0X328V

(5.) http://www.mining.com/worlds-no-1-copper-miner-codelco-posts-historic-loss-of-1-4bn-in-2015/

(6.) http://ofccolo.snl.com/cache/18324405.pdf)

(7.) http://www.minerals.statedevelopment.sa.gov.au/__data/assets/pdf_file/0018/251604/20150505_PDF_Richard_Schodde_presentation_to_Copper_Summit_May_2015.pdf

(8.) http://www.minexconsulting.com/publications/Schodde%20presentation%20to%20IGC%20Aug%202012.pdf

(9.) GFMS Copper Survey 2016 (pg. 32); Thomson Reuters

Security Analysis Series: Chapter 45 Summary

“Balance-Sheet Analysis (Concluded)”

Chapter Summary

  • The primary role of balance sheet analysis in valuations is typically to detect weakness in the financial position of the company, rather than confirming strength. What threats might come to fruition as a result of future developments or events? (pg 591).
  • The appropriate amount of working capital must be determined by the investor rather than a strict, inflexible generalized ratio. It varies from industry to industry and company to company. Graham generally recommends at least a 2:1 WC ratio, but encourages the investor to develop his own number for an appropriate margin of safety. (pg 592).
  • Significant amounts of short term bank loans or debt is frequently a signal of a company under pressure. Placing bets on companies that are heavily indebted yet offer attractive upside in the case of growth is unwise. This is because the debt is “very real and very menacing”, while growth is only prospective. (pg 595).
    • If earnings are substantial, a company will rarely become insolvent from bank loans, but rather suspend the dividend instead. (pg 595).
    • Indebtedness to parent or affiliate companies are “theoretically as serious” as other short term liabilities, but it is rare to see payments actually claimed. It is less problematic than bank loans. (pg 596).
  • “Maturing funded debt is a frequent cause of insolvency.” Beware the company’s bonds hold a very high yield, as this is a sure sign of trouble ahead if the price is exceptionally low. (pg 597).
  • Balance sheet comparison of the same company over time is key to determine the effect of profit and loss, and the relationship between earning power and the balance sheet. Appropriate restatements and adjustments of certain accounts are required to make this comparison relevant. For example, frequent charges to surplus across a number of years can be a significant detriment to earning power in future years. The analyst must determine if those charges will have that effect. (pg 598).
    • Years of loss instead of profit can represent a good buying opportunity if the financial position of the company has improved so dramatically over the years as to offer a greater margin of safety. (pg 600).
    • Taking losses on inventories might actaully serve to strengthen financial position. This is because liquidating value of inventory is calculated at something close to 50-75%, while the cash earned from the losses on inventory will be 100% represented in liquidation calculations. In other words, an operating loss to the company might represent a gain in liquidating valuation for the investor. (pg 602).
  • Graham presents an interesting conundrum, in that if the market price of an inventory good has gone down by 50%, and writedowns are necessary, shouldn’t the fixed assets that generated that inventory also be marked down? He doesn’t provide an answer to this, but rather presents it as a question for the reader. (pg 604).
    • Conversely, inventory inflation profits should be viewed with care. Significant advancements in the price of inventory will lead to more and easier credit based on the overvalued inventories, which may bring about trouble if the price returns to normal. (pg 605).

Chapter Thoughts and Analysis

  • The summation of Graham’s section on the balance sheet essentially repeats the mantras that have filled the entire book. And primarily that is the principles of conservatism and logic. Are the current assets fit enough to cover future threats? What are those future threats, and the signs of them? What could this stock be liquidated for today, and are the percentages we have applied to the asset values appropriate in the context of the company? I think the answers to many of these questions are easily answered by simply knowing the company and the industry. Perhaps this is why Buffett always stresses this idea in interviews: it seems to be one of the main underrated lessons of Security Analysis.

Security Analysis Series: Chapter 44 Summary

“Implications of Liquidating Value. Stockholder-Management Relationships

Chapter Summary

  • This chapter deals with the point that liquidation value is mostly unimportant, because almost all companies do not intend to liquidate. Thus it examines the relationship between a shareholder and management. (pg 575).
  • The purchase of a common-stock is a single act, but far more importantly, the ownership of it is a continuing process! Care, judgement, and analysis is just as important when being a stockholder, than when becoming one. (pg 575).
  • While it is true that management might be in the “best position to judge which policies” are optimal at a given time, it does not mean that those policies are always followed or adopted, or that those policies will ultimately benefit shareholders. A conflict of interest can exist in a number of different situations:
    • Compensation to management, expansion of the business, dividend payments, etc. (pg 578).
    • Thus, clearly management should not be given free reign to make all decisions unquestionably in running a company.
  • Directors in a company also can have a conflict of interest with shareholders. Often times, they have close ties to management if they are not already an officer. Thus, absolute trust cannot be afforded to them, either. (pg 578).
  • The primary lesson to be learned in this skepticism of management is to conduct as much analysis as you can on their history, and what their current views for the company are. Have they historically returned capital to shareholders when deemed necessary? Or are they “loath to return any part of the capital to its owners”, in Graham’s words? (pg 580).

Chapter Thoughts and Analysis

  • The best lesson this entire chapter had to offer, in my opinion, was the single paragraph that emphasizes that due diligence on a company must be maintained well after the original purchase. It is not enough to simply sit and wait. Companies and markets and economies are all dynamic and ever-changing, and a security analyst that stops his work after buying is sure to be burned.
  • The other thought that this chapter brought to my attention is that when analyzing management, history and experience ought to be examined thoroughly. How did they act in similar situations before? The past is the most accurate yardstick we have to predicting the future. Successful, honest management teams that, in past experiences, placed a primary focus on returning value to shareholders.

Security Analysis Series: Chapter 43 Summary

“Significance of the Current-Asset Value”

Chapter Summary

  • Current asset value is a good metric in determining the true liquidation value of a company, particularly as compared to book value, which includes illiquid, difficult to appraise fixed assets. Stocks that sell below their liquidating value is “fundamentally illogical”. Error is being committed by the market, company management, or shareholders of the company, or a combination of the above. (pg 559).
    • Stocks typically trade at a price well above liquidating value. Those trading below are called “net-nets”.
  • To calculate liquidation value, liabilities are generally not questioned, but asset values must be. The value ascribed to assets varies on their character, and the nature of the business. Graham prescribes the following approximate percentages to book value in finding liquidation value: (pg 560).
    • Cash assets = 100% of book value;
    • Receivables = 80%;
    • Inventories = 66%;
    • Fixed assets = 1-50%, varying on their nature;
  • Generally speaking, the reduction from current asset value to liquidation value of current assets is made up for by non-current assets, hence the assertion that current asset value is an accurate depiction of liquidation value. (pg 562).
  • In 1932, Graham believed that approximately 40% of American industrial companies were quoted at less than their net current asset value! (pg 562).
  • If a company is trading below liquidating value, either the price is too low, or the company ought to be liquidated. (pg 563).
    • Focusing on these types of companies is a particularly attractive technique in security analysis, and one applied by Graham frequently.
    • The objection to this strategy is that there is a possibility that earnings will continue to decline, and the value of remaining resources dissipated.
      • Graham’s counter-argument is that the range of developments that can occur generally tend to favour higher price movements. This can include liquidation, sale/merger (which generate at minimum a return of liquidating value), general industry improvements, favourable changes in company operating policy, etc. (pg 564).
  • While on the whole this strategy offers profitable opportunities, due diligence is absolutely still required to find signs that liquidation value is rapidly decreasing. (pg 569).
    • Caution should also be exercised when applying this technique to markets that are generally over-valued. An ensuing market decline has potential to wipe out much of the current asset values of companies that don’t comprise wholly of cash. (pg 571).

Chapter Thoughts and Analysis

  • While certainly rare in current times, net-nets still doubtlessly exist. There are companies out there right now that even trade at a discount to cash in various commodity industries, though they are likely to be junior or medium sized companies. It is simply a matter of finding the industries that are trading on a depressed basis, where market sentiment is aggressively low.
  • The net-net technique is often regarded as the crux strategy of value-investing by the general public. And the shrinkage of net-net opportunities might very well be the cause of value-investing’s disregard by most investors. But I think Graham would take issue with those who only know value-investing for that technique alone. It is an entire philosophy, rather than a cheap and quick investing gimmick.

Security Analysis Series: Chapter 42 Summary

“Balance Sheet Analysis. Significance of Book Value”

Chapter Summary

  • There are five different sources of information one can derive from the balance sheet (pg 548):
    • 1. How much capital is invested in the business.
    • 2. Work-capital position.
    • 3. Capital structure details.
    • 4. Check on validity of reported earnings.
    • 5. Offers a basis for analyzing the sources of income.
  • Book value per share = (Common Stock + Surplus Items – Intangibles) / # of Outstanding Shares
    • Surplus items includes reserves, which could be for contingencies, plant improvements, etc.
    • Preferred stock must be subtracted from assets available to common shareholders. Usually it is acceptable use the balance sheet value, but one must check that it is accurate. It is perhaps easiest and best to value them at par or market, whichever is higher. (pg 551).
  • Current asset value and cash asset values are also calculated with appropriate reserves added to them. Inventory values are naturally increased by inventory reserves. (pg 554).
  • The significance of book value is approximately that of showing the “true value” of shares. But this is an issue because the costing methods of the book value assets are often inaccurate relative to their actual value, and therefore it is difficult to rely on the figure. There do exist extreme examples where book value has absolute relevance, when there are massive discrepancies between price per share and book value per share. Graham offers the situation of Pepperell Manufacturing, which had a book value of $176/share, and a price of $18/share. Even if a substantial amount of the book value did not reflect actual asset values, there was such a large margin of safety available that it hardly mattered. (pg 556).
  • Intangibles, despite Graham’s treatment of them for book value, are “every whit as real from a dollars-and-cents standpoint as are buildings and machinery” in his opinion. They may even act as a form of leverage, where a company is able to earn greater returns on capital with less capital employed because of the intangibles. (pg 558).

Chapter Thoughts and Analysis

  • The final point in the summary is quite interesting understanding Graham’s portrayal by popular media as being an investor focused on book value and tangible assets. In actuality, he did believe in the value of intangibles. I think his position is that of being extremely skeptical of intangibles, particularly in the depressionary environment he experienced in the 1930’s. But indeed, his concept of intangibles acting as leverage for higher earnings was remarkable for his day, and became the strategy one of his disciples, Buffet, based a good chunk of his investing strategy on.

Security Analysis Series: Introduction to Part VI

“Deconstructing the Balance Sheet” by Bruce Greenwald

Chapter Summary

  • The main value in Security Analysis comes from two concepts. First, the distinction between investment and speculation, investment demanding a “thorough analysis” and “safety of principal and a satisfactory return”. The second from a focus on the “intrinsic value” of a security, namely the discounted present value of the future cash flows. (pg 535).
  • Intrinsic value does not, and usually cannot, exist as a precise figure, but rather a range of value. It only needs to be valuable relative to market price, with a further divide between value and price bringing about a larger margin of safety. (pg 536).
  • P/E dominates modern discussion on valuation. Balance sheets are largely ignored by the popular investing community. (pg 537).
  • “Earnings on assets that are well in excess of a company’s cost of capital will be sustainable only under special circumstances.” Therefore, earnings must be supported by appropriate asset values; unsupported earnings tend to be temporary. (pg 538).
  • It also remains true that a balance sheet has less room for manipulation by management and accounting teams as compared to the income statement. (pg 539).
  • While Graham and Dodd hunted for bargain purchases that could be offered a large margin of safety by the supporting liquidation value of assets, they also understood management’s ability to dissipate the value of assets by continuing unprofitable operations. (pg 540).
    • “Net nets”, or a company selling at a price below liquidation value, is extremely rare today. (pg 541).
  • Replacement value of assets can be found far more easily than in Graham’s day considering the use of the internet, or contacting industry experts. (pg 542).
  • One must also consider the reasons that earning power exceeds asset values. For example, does the company hold irreplaceable “moats” to their business, protecting them from competition? How sustainable are these protections? (pg 544).
  • WorldCom serves as an excellent example of asset values that did not justify earnings. Over 85% of book value was made up of goodwill and other intangibles in 1997. Many expenses were being capitalized that were illogical. By 2001, the company was insolvent. (pg 546).

Chapter Thoughts and Analysis

  • While many true “net nets” with low risk can be found, the concept is still very applicable to modern investing. Understanding the current asset values and their liquidity can act as a floor to downside risk. If a company has cash assets/equivalents per share that make up, say 80% of price per share, an investor can take a position that is 80% protected by that cash asset.
  • I am unsure if the discussion on “moats” or protections from competition have an appropriate place in resource investing. It feels as though extractive companies are fairly removed from direct competitors, unlike companies in the consumer goods industries (Pepsi vs Coke, for example). What competitive protections can exist for two different gold miners that allow them to earn excess rents? The first thought that comes to mind is a limited tax burden/tax protections, but in theory, these should already be incorporated into cash flow calculations. Perhaps there is something to be said about having competitive advantage by having institutional partners that are ready and able to provide financing, cheapening cost of capital. But is this truly a lasting competitive advantage that will provide earnings in excess of asset values? I don’t think so. So overall, I would say competition in the resource industry is straightforward, with no monopolistic protections available to certain players.

Road to 2000: An Introduction

Hi all,

I have decided to begin blogging about one of my past-times, which is chess. I think it is going to be an interesting exercise for my perseverance to see how quickly I am capable of accomplishing a goal by applying myself and studying the game more intensely. Extra-curricular effort and study is something I have struggled with enormously in my past. And while I believe this is no longer the case, this will be an excellent test of that belief.

My stated goal will be a 2000 classical rating on lichess.org.

I believe this will be very difficult and perhaps take upwards of a year to do given that my knowledge of chess is rudimentary. I have done no studying of the game outside of tactics (which I have done a significant amount of), so my positional game is extremely lacking.

Anyhow, I hope everyone enjoys this as much as I will!

Security Analysis Series: Chapter 41 Summary

“Low-Priced Common Stocks. Analysis of the Source of Income”

Chapter Summary

  • Speculatively capitalized common stocks generally are found in the “low-priced” category. Graham defines this as sub-$20 companies. (pg 520).
  • As he discussed in the previous chapter, low-priced common stocks “can advance so much more than they can decline.” It is far simpler for a stock to advance from 10 to 40 than 100 to 400. Graham backs this anecdote with a study from the University of Chicago, which puts forth that in a bull-market, low-price stocks gain on average more than high-priced stocks, and do not cede their gains as much in following recessions. (pg 521).
  • Graham argues that many losses are made in the low-price range of stocks due to the fact that many of these low-price stocks are not genuine, but “pseudo-low”. A genuine low price shows value is in relation to assets/earnings etc. A “pseudo-low” refers to heavily diluted companies that do not trade in relation to their true value. (pg 522).
  • A speculative, or leveraged position “may arise from any cause that reduces the percentage of gross available for the common to a subnormal figure”. This effectively can include high operating costs and other fixed charges. Graham provides the example of two theoretical copper producers, one a high-cost, high-volume producer, the other a low-cost, low-volume. At lower copper prices the low cost producer trades at a higher price; but when the copper price advances, the higher cost producer, due to volume, sees a greater rise in share price. Thus, when prices of a product are likely to rise, it is the high-cost producer that should be more attractive to an analyst. (pg 526).
  • Rather than applying blanket financial multipliers (such as P/E) to companies in an entire industry, Graham suggests analyzing the specific assets of companies in order to determine if these multipliers are appropriate. Certain sources of earnings are more stable that others. An example might be bond income as compared to rental income. (pg 528).
    • These sources of income can be detected and analyzed by examining information from the balance sheet. (pg 532).

Chapter Thoughts and Analysis

  • Graham’s conclusion that an intelligent investor ought to be targeting high-cost, high-volume producers in light of an momentary price increase makes this book more than worth its weight in gold. In the mining industry, for example, there is so much focus on reducing cost per unit, when in reality it is the company with higher costs and more volume potential that offer the true value in price up-swings.
  • The assertion that low-price stocks tend to advance further than high-priced seems a bit arbitrary, and citing a single study from 1936 certainly doesn’t confirm this as truth. More research ought to be done, as theoretically speaking, there should be no true difference. There could also be a number of different reasons for this; perhaps it is the case that low-priced companies advance more because they tend to be more speculative in their capital structure.

Security Analysis Series: Chapter 40 Summary

“Capitalization Structure”

Chapter Summary

  • Graham presents a paradox in this chapter: namely that companies with the same earning power can have different values due to capitalization structure. This is due to the concept of leverage. Leverage refers to the sensitivity of earnings per share to change. Given two companies that have an identical change in earnings, where one sees a greater % change in EPS, that company can be said to be more “levered” than the other. (pg 508).
    • Leverage operates both ways; a decrease or an increase in earnings will affect the more levered company’s EPS. (pg 508).
  • The optimum capital structure according to Graham:
    • “…includes senior securities to the extent that they may safely be issued and bought for investment.” (pg 509).
      • What Graham means by this is that his standard of “investment basis” selection applied to the debt in the capitalization structure of a company. A company should be as levered as possible, but only to the maximum level where the issued debt is an investment, rather than speculation, IE it is well covered by assets, the interest payments are sustainable in regards to earnings, etc. (pg 509).
      • It is also important to note that a higher % coupon rate can lead to rejection by an investor due to poor interest coverage. However Graham points out that it is rediculous to accept one bond at 4% because it has 2x coverage, and reject another 6% bond because it has slightly less than 2x coverage. It is clear that rejecting a bond because it pays a higher rate is fallacious. Graham advises that “the minimum margin of safety behind bond issues must be set high enough” to avoid the appearance of safety achieved by a lower rate.  (pg 511).
  • Highly levered companies may not be bought on an absolute investment basis, but rather on an investment basis with a degree of “speculative advantage” attached. These companies sell at high prices relative to their value in booms, but in depressions, there is a large degree of undervaluation. These issues bought on a depression basis “can advance much further than they can decline”. (pg 513).
  • There exists other ways a company’s leverage can be influenced apart from capital structure. Fixed expenses eat up a greater % of earnings when earnings are low, depressing EPS; however, when earnings are high, these expenses make up a fraction of a % compared to the low earnings periods. Thus, high amounts of fixed charges such as depreciation can act as leverage for a company. (pg 515).
  • A speculatively capitalized company offers shareholders the possibility of benefiting at the expense of the debt holders. “The common stockholder is operating with a little of his own money and with a great deal of the senior security holder’s money”. (pg 517).
  • Due to the fact that this benefit only exists when the share price is advancing, Graham suggests only buying highly levered issues when “they are selling at abnormally low levels due to temporarily unfavorable conditions”. (pg 518).
    • The difficulty in this is being able to detect these temporary conditions and low prices, as well as waiting for the conditions to be solved. (pg 518).

Chapter Thoughts and Analysis

  • This chapter is perhaps my favourite in the entire book. Graham’s communication of leverage as an influence on earning power, and the speculative advantages when buying levered companies on a depression basis, really gave a profound clarity to these concepts.
  • The idea of fixed charges acting as leverage is a concept I hadn’t heard of anywhere before. As he will put forth in the following chapter, this has many applications. Highly capital intensive industries with large fixed charges/outlays (the extractive industries obviously come to mind) will be able to accomplish absolutely explosive growth in an uptrend.
  • As Graham pointed out, it seems to be that the main issues with an investment strategy based (partially, as one still must due proper due diligence to find investment grade companies) around depressed industries is opportunity cost. Sure the price may kick at some time in the future, but what investments are we possibly missing out on in the near future? And given the time value of money, will the growth a speculatively levered company enjoys five years down the road outweigh its near-term alternatives?