Double Quote of the Week

Sorry, I don't have any going private transactions, but there will be a double quote of the week -- I've been gone and need to make up time :-)

"The efficient market hypothesis is the most remarkable error in the history of Economic theory"

- US Treasury Secretary Lawrence Summers responding to the 1987 market crash

"If you don't know where you are going, you will wind up somewhere else."

-Yogi Berra

-Mike

Double Quote of the Week

Sorry, I don't have any going private transactions, but there will be a double quote of the week -- I've been gone and need to make up time :-)

"The efficient market hypothesis is the most remarkable error in the history of Economic theory"

- US Treasury Secretary Lawrence Summers responding to the 1987 market crash

"If you don't know where you are going, you will wind up somewhere else."

-Yogi Berra

-Mike

The Attractiveness of 22 Wide-Moat Companies

I just got back from my grandparents house in Florida and decided to do a little experiment right away.

I will combine two things, a Morningstar report I got with 20 super wide-moat companies and Quicken's inverse DCF (they show what earnings growth, over the next ten years, is needed to justify the current Market Cap.)

I also added Oil Dri, which according to my dad has become a verb in factories (He's a Vice President at LFB), and Paychex, who's high switching costs eliminate customer churn.

I typed all the info into excel and then used the sort tool to put the lowest needed growth at the top. It took me about five minutes for me to do all of this, so if you have any other groups of companies, and don't have access to quicken's stock evaluator just send me an e-mail (teenvestor at gmail dot com) and I'll post the group's numbers.
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Company Growth Needed
Progressive 7.80%
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Berkshire Hathaway 8.60%
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McCormick 9.40%
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SLM 10.70% high debt
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Wal-Mart 11.10%
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Anheuser-Busch 11.30%
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Microsoft 11.70%
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Procter & Gamble 11.70%
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Dell 12.10%
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Sysco 12.10%
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Citigroup 12.30%
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American Express 13.70%
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UPS 13.90%
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Oil Dri 13.90%
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PepsiCo 14.10%
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Wm. Wrigley 14.10%
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Adobe 17.20%
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Autodesk 17.40%
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Paychex 18.40%
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Moody's 19.10%
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Medtronic 19.30%
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eBay 27%


Here's some of what Morningstar has to say about Progressive and McCormick.
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Progressive- Progressive's underwriting insights, speed, and smooth service are making its auto insurance more than just a commodity and simultaneously compounding the firm's already-wide moat.
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McCormick- Strong brands, contracts, product breadth, and an integrated global supply chain earn McCormick a wide-moat rating.
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Too bad I still need to learn how to analyze insurance companies :-)
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-Mike

American Eagle, like Warren Buffet

I recently finished reading How to Pick Stocks Like Warren Buffett: Profiting from the Bargain Hunting Strategies of the World's Greatest Value Investor.

The third part of the book is about analyzing comapnies like Buffet, here I will analyze a company that currently interests me, American Eagle.

Valuation

The first chapter is about valuation, mainly Discounted Cash Flows. I'll use 12% as my first five years growth, 8% for the next five years, and 3.5% terminal growth. $366 million will be my cash flow munber.

> Five Years 8%

Terminal 3.5%

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Discount Rate 11%

Year Cash Flow Discount Cash

1 $409.92 1.11 $369.30
2 $459.11 1.23 $372.62
3 $514.20 1.37 $375.98

4 $575.91 1.52 $379.37
5 $645.02 1.69 $382.79
6 $696.62 1.87 $372.44
7 $752.35 2.08 $362.37
8 $812.54 2.30 $352.58
9 $877.54 2.56 $343.05
10 $947.74 2.84 $333.78

First Ten Years $3,644.29

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Add Terminal Value $4,606.16
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Intrinsic Value (Per Share) $54

This model gives a value of $54; more than twice the current value. But the DCF is not all powerful, and sometimes ignoring is better than relying.

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Book Value

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Mr. Vick says book value is Buffet's favorite yardstick for growth. Here's American Eagles ten year book value growth numbers:

Year Book Value Growth Earnings Growth

1996$71.10--
1997$90.8027.71%230.51%
1998$151.2066.52%177.44%
1999$264.5074.93%67.65%
2000$367.7039.02%3.42%
2001$502.1036.55%12.47%
2002$577.5015.02%-15.92%
2003$643.7011.46%-32.36%
2004$963.5049.68%255.50%
2005$1,136.3017.93%27.47%

Average37.65%80.69%

American Eagle's book value growth is extraordinary. The growth was consistent, as compared to earnings growth which was powered by four main years. However there are bad ways a company can grow book value, I will examine those now.

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Issuing Shares

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Companies can easily grow book value by issuing more shares. While this grows cash, it also dilutes the value of shares. American Eagle has 15% share growth during the past ten years, compared to book value which has grown a total of 1,498%; share dilution is not a problem.

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Acquiring other Companies

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I also don't believe AEOS has been acquiring other companies to fuel growth.

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Letting Profits Sit Gathering Interest

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American Eagle has been sufficiently investing cash back into the business. Quicken estimates American Eagle has created $4.98 in market value for every dollar of retained earnings over the past five years.

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Return on Capital

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Return on capital shows the life-blood of a business. I will use Net Income / (Average Equity) + LT Debt. I will use a method described in the book to see what earnings growth is needed to sustain its current ROE.

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American Eagle's current ROE is 20%.

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Assuming Equity will grow about 21% a year American Eagle will have to grow earnings 14% a year to sustain a 21% ROC. The industry's current ROC is 15%, American Eagle is above this, but it could do better, and may have a hard time in the future maintaining a good ROC.

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Hurdle Rate

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The book says Buffet looks for a ten year hurdle rate of 15% CAGR before investing. I'll go a little further and look for 20% CAGR over 5 years.

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Over the last ten years American Eagle has had an average P/E of 19.6x, I will use this to project the future price for my hurdle rate calcualtions. I'll also assume a twelve percent earnings growth rate, and a 15% dividend payout.

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Expected 2010 price $ 54.59
>> Dividend $ 1.69
Total Dollar Amount $ 56.28
Expected 5y Return 168%
CAGR 21.79%

American Eagle passes the hurdle rate test, if it can grow earnings at a twelve percent rate for the next five years, and then trades at a P/E of ~19.6 the compound annual return should be about 22% per year - not too shabby.

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Putting Growth in Context

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Even Buffet admits estimating growth for a company, outside short periods, is not exactly a walk in the park.

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Vick suggests using Quicken's stock evaluator to judge the earnings growth necesary to justify the current stock price - inversing the DCF.

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Using a 15% discount rate the stock evaluator says American Eagle must grow its earnings only 2.3% to justify its current stock price.

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Comparing Stocks to Bonds

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Buffet won't buy stocks unless its earnings yield (e/p) is greater than an average bond yield.

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Using Morningstar's yield comparison I see American Eagle's earnings yield is almost double that of a 30-year T-Bill.

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Part 2

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This is only a partial analysis, in the next post(s) I'll go through American Eagle's past financials statments and its business model.

-Mike

Six Categories

Before I started this blog, I posted very frequently on the Motley Fool Boards.

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I'll re-post this about Peter Lynch's six categories.
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The Six Categories
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While surfing the Foolish Discussion boards I came across a post written by TMFJordan about his reading list. I am in high school and most of my classes are either Honors or AP, so my first thought after reading the post was: Oh great more homework, but after closer examination of the list found some “Hidden gems” and ended up spending close to $75 on amazon.com.

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The first book on this list was One Up On Wall Street by Peter Lynch. Seeing it on his list inspired me to re-read the book.

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Upon reaching the part of the book labeled “The Six Categories”, I decided to put it to the test and try to find at least one good company in each category.

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I will detail the category, and go further adding at least one characteristic -- in an effort to start filtering out the companies who will not have as good returns.

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Slow Growers

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These companies, are usually large -- over 50 billion market cap -- and aging. They have not always been slow growers, they started out as fast growers, then their industry either stopped growing as fast as a whole, or they just got to big.

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The charts of these companies, as Peter Lynch said, usually look like a map of Delaware – not much volatility.

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Lynch wrote that these companies grow less than ten percent a year, and also have good dividends, so our criteria for good slow growers-

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1. Growth of less than ten percent per annum over the past three years

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2. A meaningful dividend; dividend yield over 2%

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General Electric (NYSE:GE)

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With a market cap of over 375 Billion, General Electric is the biggest company in the world – it can't grow any faster without taking over the world.

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General Electric average earnings growth over the past three years is just over 4.5%. And its dividend yield is 2.48%.

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Stalwarts

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These companies -- which don't grow as fast as their small cap counterparts ; or as slow as their extremely large cap slow growers – typically grow anywhere between 10 and 15% per annum.

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Because their products are not ones that people would stop buying during a down period stalwarts offer great protection during a recession.

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To find worthwhile stalwarts we'll look for:

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1. Average growth in the last three years between 10 and 17% per annum.

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2. A repeat-purchase product that people wouldn't think twice about buying during a recession.

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Nokia (NYSE:NOK) – Nokia is -- in my opinion -- the perfect stalwart. Its average earnings growth in the past three years is 13.5%, perfect stalwart growth. I would be surprised if people stopped talking on the phone so Nokia is good recession-protection. To top it off Nokia's stock price has been depressed enough that it should present a good return for a stalwart stock -- Peter Lynch wrote that timing your buying is the most important part of stalwart investing, adding that if anyone ever tells you that they doubled their money in a stalwart stock your first question should be – how long have you owned it.

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Fast Growers

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Everyone's favorite group, is what ten-baggers are made of. These are the stocks that the Gardner brothers look for in their respective newsletters.

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Charts of these stocks look like a rocket launch. Lynch wrote fast growers have at least 20 – 25% growth and are usually growing faster than the other companies in its industry -- He loved stocks in a dead industry that could pull off fast growth.

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We'll look for companies that display-

1. Earnings growth of at least 20% per annum.

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2. Growing faster than the rest of the companies in its industry

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Lynch also wrote he only considered fast growers with solid balance sheets, so-3. A Flow ratio under 1.25.

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The last Lynchian criteria for fast growers -- Lynch wrote fast growers are typically small cap stocks, 4. Market cap must be under 3 billion.

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Blue Nile (NASDAQ:NILE) – Blue Nile has a market cap well under 3 billion, at 460 million. Blue Nile is an online retailer of jewelry. Blue Nile is truly a fast grower, as it grew its earnings from $2 million to $27 million in one year, and increase of 1350%. Two of Blue Nile's competitors – Tiffany & Co and Zale Corp. – have earnings growth of 15% and Zale had negative earnings last year. Blue Nile has an excellent Flow Ratio of .94.

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Cyclicals

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Cyclicals are companies that grow their sales and earnings in predictable cycles. They follow the market in a way. Cyclicals are companies -- such as Ford or American Airlines -- that have products that people buy a lot during good market rising times, but not during recessions when people are trying to save their money. The chart of Cyclicals looks like the polygraph of a liar.

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For Cyclicals we look for –

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1. Companies that grow their earnings and revenues in predictable cycles.

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2. They are towards the bottom of a cycle; like stalwarts -- but worse -- if you buy a cyclical at the wrong time you can lose your money in a very short time.

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Applied Materials (NASDAQ:AMAT) - I mentioned above, industries such as airlines and automobiles; I did not mention, however, semiconductors. Applied Materials is a leading producer of Chip equipment. Intel proved in 2003 semiconductors move in predictable cycles. If you look at this chart, you'll see Applied Materials already closed out the down cycle and is rising.

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Turnarounds

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Peter Lynch said turnarounds are not slow growers they are no growers.

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These companies went through bankruptcy or a really bad lawsuit. Usually they have new management coming out of bankruptcy. K-Mart is the most recent big turnaround-gainer.

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1. First we look for a company that has already proved it can keep rising.

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2. Then we'll use turnaround specialist John Neff's proven ratio – P/E / growth rate + dividend yield, we like this to be under 1.25.

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Alderwoods (NASDAQ:AWGI) – Alderwoods is a leading provider of funeral services - another Lynchian principal, it does something people don't like -- in 2002 it went into bankruptcy. Since then it's gone from as low as $3 per share to its current $11 per share.

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Because only one analyst follows Alderwoods they do not have analyst expectations for the next five years, however analyst expectations for the next year -- which I believe are probably exaggerated -- predict them growing 420%, which puts their PE/G+DY way under 1.25.

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Asset Plays

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Asset plays are companies, which have assets that Wall Street has overlooked or just doesn't care about. This asset could be anything from real estate, to TV networks, to gravel pits. We like

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1. Companies that have some kind of asset that Wall Street has either overlooked or doesn't know or care about.

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2. The company has a Book value per share / share price under 3.

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International Paper (NYSE:IP) – International Paper is America's biggest private landowner. Most of this is valuable forestland -- which they can sell for a lot more than they bought it for -- that the company uses to make the paper and corrugated boxes that it sells. International Paper has $16 in book value per share divide their current share price of $41 by that and you get 2.6, under the cutoff.

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Put your portfolio to the test

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What are the stocks in your portfolio? Do you have more small cap fast growers or do you prefer bigger stalwarts. What do you tend to invest in?

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-Mike

Templeton's 15 rules

I got Lessons from the Legends of Wall Street from the library yesterday. The fifth chapter is on John Templeton, chapter 26 is on his 15 common sense rules.

          1.Be aware of the real return.
          2.Invest, don't speculate
          3.Be flexible
          4.Buy Low: The contrarian Approach
          5.Buy Quality
          6.Practice Value Investing
          7.Diverisify (I don't agree with this one)
          8.Do your home work
          9.Monitor your Investments
         10.Don't Panic
         11.Deal with mistakes effectively
         12.Prayer helps
         13.Be humble
         14.There's no free lunch
         15.Have a positive attitude towards investing

-Mike

New Quote & Going Private Transaction

"It's a real tragedy when you buy stock of a comapny that's overpriced, the company is a big sucess, but you still don't make any money."

-Peter Lynch

Tendercare International (TCAR.IB)
SC 13E3

Tender Price:                         $.23
Current Price:                        $.23
Gain:                                   0%
Broker shares OK
Cash                                  $75k
Cash Flow                            -$54k
Market Cap                           1.72M

This one doesn't look very safe, and 0% return, but a few days ago it traded at $.16, so watch it maybe you can get it for a good return.

-Mike

Quote of the Week & a Potential Going Private Transaction

Just in case you haven't noticed I've been putting quotes of the week on the sidebar, this week's quote is:

"Buy early in the growth cycle, before institutional interest in an issue begins to build, and keep close tabs on earnings quality."

-T. Rowe Price

The first two quotes are below on the sidebar.

Collins Industries (COLL.PK)
SC 13-E3
Limit - 300
Tender Price - $7.70
Current Price - $6.15
Broker Held Shares OK
Cash + ST Investments - $163,000
Cash Flow - $3,544,000
Market Cap - $37,830,000

-Mike

New Book

Yesterday I got a few new books in the mail, one of them being:

-How to Pick Stocks Like Warren Buffett: Profiting from the Bargain Hunting Strategies of the World's Greatest Value Investor

The book is divided into Five sections (and the appendix):

• Part 1 - Becoming a Billionaire about how Buffet went from $100 to $30,000,000
• Part 2 - Developing a Mathamatical Mind about compounding interest, buying low and buying fat pitches
• Part 3 - Analyzing Companies like Buffet Valuation, assessing moats, ROE and comparing stocks to bonds
• Part 4 - Avoiding Losses Avoiding losses and using arbitrage
• Part 5- Chicken Soup for the Investor Buffet on Forming good habits

There are also appendixes about Mr. Market and your competitive advantage over Buffet.

I'm happy about recieving this book, and will try to write more about it in the next few days, I'd reccomend it, also.

-Mike

I was mentioned

In an article on TMF, from about a week ago, I was mentioned:

The best of the bunch
The best-performing pick to date was invertirmenor's pick of Google (Nasdaq: GOOG), which has returned 46%. As everyone knows, Google is the leader in the search market and boasts a ridiculously high growth rate. Its strategy of allowing advertisers to bid for ad space on keywords has allowed the company to monetize its position as the most popular search engine on the Internet.

Google's financials are amazing. It has no debt, impressive margins, and strong return on capital. Growth seems almost certain, with the only questions being "How fast?" and "How long?" Google's valuation is the only problem that invertirmenor sees. He notes that 18 times sales and 123 times free cash flow is more than a bit pricey.


-Mike