Posts Tagged ‘Value Investing’

The Compelling Case for Bank of America

Bank of America is probably one of the most hated and reviled corporations in America right now. They are the poster boy for just about everything that’s wrong with the American financial system – from corporate greed, TBTF banks, excessive compensation etc. However, with all the emotions involved, it is important for us to take a step back and examine whether the relentless pressure on BAC is truly deserved.

Market Capitalization of BAC – Has it really lost 2/3 of its value in a year?

Here’s a disclaimer, if you’re going to consider in BAC, you should at least have a basic understanding of how the banking system works, and how banks in general generate their revenue. Furthermore, it’s important to at least have a grasp of the underlying failures of the financial system that eventually led to the subprime crisis, and an understanding of the credit cycle.

I will be attaching some links at the end of my post to provide further reading if you’re interested.

Brief Summary of BAC:
BAC 2010 Operating Results:
Net Income: -$2.238 billion
EPS: -$0.37
Book Value Per Share: $21.62
Return on Assets: -0.16%
Current Valuation:
P/B: 0.3
Industry Average: 0.7
BAC 5 Year Average: 1.0

 The central thesis for investing can be summarized:

“…Its earnings power has been disguised by the intense provisioning for loan losses. But when the provisioning gets back to a normal level, you’ll start to see that incredible earnings power come down to the bottom line. And it’s as simple as that.”

Bruce R. Berkowitz, November 25, 1992

Interestingly enough, Bruce Berkowitz and Warren Buffett made a similar investment in Wells Fargos during 1992 when the housing bubble in California bursts, leading to similar write downs by Wells.

Here’s a simple overview of what Bruce Berkowtiz is driving at:

Despite the massive write downs on their real estate assets, Bank of America is an immensely profitable company with significant earning power. Almost every American institution or citizen does some form of business with BAC and it’s an integral part of the financial institution. Charge offs have been steadily declining since late 2009, and once BAC clears through its legacy loans, the underlying profitable businesses of BAC will be realised.

Bank of America now is vastly different from the Bank of America in 2008. The CEOs have changed and the company has gone from its “merger” mentality to one of consolidation and restructuring. They are making massive charge offs on their non-performing loans and assets. They are also selling off assets and shoring up capital.

Loans made in recent years are much stricter than they were before. One of the reason (though not the only) why people find it difficult to get loans these days is because the criteria for  making a loan has gone from incredibly easy to being infinitely hard. However, these means that the overall quality of loans that BAC has been making has drastically improved.

Now, BAC still has legacy loans made by Countrywide, one of the most notorious subprime lenders. However, it’s important to note that all loans have “half-lives” and BAC is slowly burning through these legacy loans.

Under normal circumstances, it’s not unreasonable to expect BAC to earn a 1% return on asset, or 10% return on equity which works out to be roughly around $2 per share. Contrast this to its current $6 a share price. Furthermore, BAC is selling at a 40% discount to its tangible book value (excluding goodwill and intangible assets), which works out to be about $15. Under normal operating conditions, it’s not unreasonable to expect BAC to sell for at least tangible book value, giving us a base price of around $15.

Even so, there are many challenges that are involved in investing in financial institutions:

a) We still do not fully understand or trust the numbers
b) Financial regulatory reform may reduce earning power
c) New Basel rules may require more capital and reduce profits
d) There may be a double dip recession
e) The unemployment rate may go higher and create more defaults
f) Commercial real estate prices may fall dramatically
g) Banks are still not marking loans in their books properly
h) Residential real estate prices may fall further
i) States and municipalities are in bad shape
– Francis Chou Semi Annual Report 2010

It’s important to note that investing in BAC requires a long term horizon of at least 3 – 5 years as there remains many unresolved issues.

Concluding thoughts:

Many people are familiar with Graham’s view on investing, and the strict definition that he placed upon it. However, he went into great lengths to disabuse the notion that all speculation was inherently bad. There is after all intelligent speculation just as there is intelligent investing. Situations which involve unintelligent speculation include:

  • speculating when you think you are investing
  • speculating seriously when you lack proper knowledge and skill for it
  • risking more money in speculation than you can afford to lose

Any investment in Bank of America involves a leap of faith that most at the very least, makes it speculative. However, I believe that as at least for the next few years, the quality of earnings on banks will improve, and that management will be far more risk adverse considering the fragile state of the economy.

Notes on how I structured my investment in Bank on America:

Small percentage of portfolio – currently 2.5 – 3%, potential to move up to 5% if the price is attractive
Current price: $6
Estimated intrinsic value: $15 – $30 (1x – 2x tangible book value)
Holding period – 5 – 8 years

I have a certain aversion when investing in financial institutions as they are inherently more complex than the average company. If there is one thing that I learnt from the subprime crisis, it is simply impossible (and foolish) to be absolutely sure whether a financial institution can whether the storm. Obviously, due diligence is done as humanely possible beforehand and the basic leverage ratios/long term debt holdings are examined.

As a result, I decided to purchase a protective put option. Let me illustrate it with the following example (date taken from the close on 21/11/2011).

BAC: $5.49
BAC Put Option, $4 Strike Expiring Jan 2013: $0.87
Total cost (100 shares): $6.36 * 100 = $636

A put option gives you the right to sell 100 shares of BAC at $4 before the strike date in January 2013. Think of it as an insurance policy that you pay for in the event that BAC collapses. The price that you pay represents the premium that someone would need in order for him to take that risk.

There are 3 main scenarios that might happen:

BAC hits the bottom range of our expected price – $15
Our profit per share is
$15 – $5.49 – $0.87 (price paid for the put option) = $8.64, representing a return of 135%
BAC hits the top range of our expected price – $30,
Our profit per share is
$30 – $5.49 – $0.87 (price paid for the put option) = $23.64, representing a return of 371%
BAC goes bankrupt and the common stock becomes worthless,
Exercise PUT option, sell shares for $4 per share.
Our loss per share is
$6.36 – $4 = $2.36, representing a loss of 37%

In this way, I structured my investment such that the risk reward ratio is heavily skewed towards my favour. Most of my capital is substantially protected in the event that BAC gets wiped out. However, in the event that BAC returns to its normalized operating profit, and earns a reasonable rate of return, I stand to earn a significant return on my investment.


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A few people commented to me that the market looks “volatile” & “dangerous” in the next few months and that we should wait and see before things get better.

Well, I understand how it might seem. The unrest in the Middle East, Libya, the Tsunami in Japan, the end of QE2 etc. The list goes on and on.

However, I would like to point out three problems with trying to predict the future.

Firstly, why didn’t you tell me this 3 months ago? Secondly, considering that you couldn’t predict the market 3 months ago, why would you be right this time round? And finally why on earth would the market be better 3 months later?

No matter what the media/newspaper/friends/books have you believe, very few people actually are able to predict the future with any degree of certainty that is useful to you or me. I would be extremely suspicious of anyone claiming to be able to do so in any capacity.

And the truth is, predicting the future is not a prerequisite of successful investing.

If your going to invest for the long term, through out the traditional definition of risk. Risk is not measured by beta, standard deviation etc.

Risk is the permanent loss of capital. 

My advice?

Take a moment to look through your analysis again if need be. Run through the calculations to make sure they make sense. Than, once your done, close your books and turn off the TV.

As Warren Buffett once said  –

Wall Street makes it money on activity. You make your money on inactivity.

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I just updated my main webpage to include a financial report of Johnson & Johnson so do check it out.

Johnson & Johnson Report

Also, its come to my attention that I didn’t update the Lubrizol Corporation link properly on the right hand side of the page. I have since corrected it.

Before investing in pharmaceutical companies, its important to know the pros and cons of the industry.

Big pharmaceutical companies typically have wide moats and attractive financial strength. Most of the global pharmaceutical  companies post Returns on Invested Capital of > 20%. They also have little debt on their balance sheets and plenty of free cash flow generation.

However, developing drugs is extremely costly and time consuming. Clinical testing phases of drugs can take upwards of a decade. Whats worst is that these expenses does not guarantee the success of a drug. A company can pump in a considerable amount of money into research with no guarantee of return.

Once a drug is developed and approved by the FDA, they normally enjoy patent protection. This typically lasts about 8 – 10 years.

Armed with this knowledge, one should look for the following traits in pharmaceutical companies:

  • Companies which have a diverse range of drugs, and that have considerable patent time left.
  • Companies that are actively developing new drugs to refill their pipeline.

Due to their strong financial positions, many pharmaceutical companies are choosing to acquire smaller companies to replenish their pipeline. This really illustrates why free cash flow and low debt levels are so important. Companies that are highly leveraged and generate little free cash flow would be unable to fund such acquisition’s easily.


I am bullish on healthcare companies in the long run. As we face an aging population in developed nations around the world. Furthermore, as developing countries improve their standards of living, there will also be a corresponding increase in demand for better healthcare.

However, it’s important (to me anyway) not to get too carried away with macro trends. Always ensure that the companies you invest in are trade at a reasonable valuation no matter how rosy the outlook maybe.

The author is long JNJ.


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The entire idea of valuing companies using a discounted cash flow method is based on the premise that the value of a company is the value of its future cash flows, discounted by an appropriate rate to the present.

Now, DCF models provide a very elegant solution to the valuation problem. Simply plug in your implied growth rate, your starting cash flow and tadah! You have the intrinsic value of a company.

However, what most people do not realise is that DCF faces several challenges that can potentially overvalue or undervalue a company.

The first challenge is that DCF is extremely imprecise. Put in garbage and you get garbage valuation. Its notoriously hard to predict whats going to happen the next year, much less 20 years into the future. I would be very suspicious of anyone claiming to be able to do so!

Secondly, if you look at a discounted cash flow model, it only shows results getting better year after year (entirely ridiculous!). There is never a down year. Furthermore, high growth rates are impossilbe to maintain over time due to the law of big numbers. For example, its a mathemtical impossilibty that Apple can keep growing at its current growth rate in the long run so it would be suicidal to use a DCF model here.

Finally, there is the problem of choosing an appropriate discount rate. Academics have debated it to the death and still no firm consensus has been ironed out. I have even seen people deriving a discount rate from beta (which I consider to be a ridiculous concept..) which makes no sense whatsoever to me.

That being said, I still feel that Discounted Cash Flows are still the best method in many situations to evaluate companies. It’s really a situation whereby there are a lack of better tools avaliable to do the job. In other to deal with the flaws of the DCF Model, I normally try to do the following:

1) DCF Valuation should be the last step of your entire evaluation process.
2) Look for a company with relatively stable free cash flow throughout a long number of years.
3) Be extremely conservative in your growth rates. If it looks to good to be true, it probably is. As a rule of thumb, companies that post growth rates exceeding 15% rarely meet expecations.
4) Look at the relative valuations like P/E to see if your valuation makes any sense.

The above discussion highlights why Margin of Safety is the most important aspect of investing. Valuation is really more art than science. Benjamin Graham once valued a company to be worth between $15 – 40 – reflecting how imprecise he knew it to be.

Always demand a Margin of Safety no matter what kind of valuation tool you use.


In the end, DCF is only one of the methods to go about valuing a company. My advise would be to look at different valuation methods to see where yours stands before making an investment decision.


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There’s an active discussion regarding VICOM at one of the local investing forums – Value Buddies.

Let’s go through the qualitative aspects of the company first.

I think VICOM has a narrow economic moat at the very least for its vehicle testing services.

The good thing about their business is that their profits are recurring. You have to get your car certified with them at some point in your lives.

Lets look at the fundamentals of the company.

Revenue & Earnings

VICOM has been growing its bottom line really well over the past few years.

Its average annual growth rate is an astonishing 18.2%.

Financial Leverage

The great thing about VICOM is that its a very cash rich company. It has no debt on its balance sheets – a very big plus for me.

Returns on Equity

Returns on Capital are nearly identical to Returns on Equity as there are no borrowings.

Average ROE is 18.3% which is great.

Free Cash Flow Per Share

Free cash flow has also been growing at a reasonable rate – about 10% per annum since 2004.

It’s important to note that Free Cash Flow growth is sometimes slower – especially when a company is expanding it’s operations.


VICOM was a real surprise find for me. High returns on capital, good growth rate, and a reasonable price all add up well.

VICOM in my opinion, wont be surprising anyone with high growth rates or sudden surges in profits anytime soon. However, if your a long term investor, VICOM will probably do quite well for you over time.

Disclaimer – The author has no position in VICOM at the time of writing.



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