
Talking Stocks  - prakash
http://www.blogmaverick.com/2008/09/08/talking-stocks-and-money/
======
smanek
_I had read A Random Walk Down Wall Street in college. I truly thought that
the markets were efficient, that any available knowledge about a company was
already reflected in its stock price. Yet I saw Raleigh using the information
I gave him to make money for his clients._

Heh, that's exactly what I'm experiencing now. I've always bought the
efficient markets hypothesis (i.e., that current prices already factor in all
available information). But, I've been meeting analysts who are supposedly
experts in their respective fields, and I've come to a simple conclusion: they
can't interpret the information they're given.

They are the kind of people who consider valuation by a constant multiple of
eyeballs to be legitimate. They are the pointy-haired-bosses of the world, who
read a few trade rags and think they are experts.

In one light, it's all rather depressing. In another, it seems like a great
opportunity ;-)

~~~
ntoshev
In order to exploit the "inefficient market hypothesis", you need to know what
information is reflected in stock price and what is not. This means you need
to know the market, not just the stock.

~~~
byrneseyeview
I'm not sure that's true. e.g. if you have a company that has real estate
worth $10/share, and a business that's worth $10/share, and the stock trades
at $15, you don't really need to know whether the market underestimates the
real estate, underestimates the business, or some combination of the two.

I guess for certain kinds of dirty hedges (e.g. trading the crack spread and
trading oil refinery stocks) you might need to know that.

~~~
ntoshev
You don't have complete information, so the market may know something about
the stock that you don't. Even if you're right, the market can stay irrational
longer than you can stay solvent. So you do need to know the market.

~~~
byrneseyeview
That's true. And I may know something about the stock that the market doesn't.
It's pretty impractical to make your decisions by finding out that everyone
else is wrong, rather than by ensuring that you're right (or as right as you
can be). It doesn't scale, either -- AT&T used to have over a million
shareholders, and interviewing every one of them about whether Ma Bell was
going to raise their dividend next quarter sounds like a real chore.

 _Even if you're right, the market can stay irrational longer than you can
stay solvent._

If you're leveraged, yes. If you aren't leveraged, you're going to be solvent
forever. And anyway, arguing about the timing obscures the real decision -- I
wouldn't discourage someone from pursuing a career because I didn't know
whether or not every employer would recognize their talent after the first
interview.

------
fallentimes
I agree with most of what he writes, other than his dividends vs share
buybacks commentary. I'm glad he published the descending comments though. A
few quick thoughts:

1\. Dividends are taxed, share buybacks are not. This is why in cases where a
mature Company is sitting on a large pile of cash with little to no long term
debt, share buybacks provide more value by avoiding the tax man.

2\. If the management team truly believes the company is undervalued, buying
shares back makes a lot of sense, especially for mature companies. However, if
the buy back leads to incentive bonuses for the management team I'm 100%
against it. Also, it's a lot more telling when a Company does this during a
recession than a boom.

3\. As alluded to in the comments, corporate earnings are relatively worthless
without a cash flow statement for the same time period.

~~~
bokonist
A stock buyback only increases the fundamental value of the company if it
results in an increase in dividends per share. A company that buys back stock
instead of paying dividends, and also has no intention of ever paying
dividends, would only be valuable in the way a baseball card is valuable.

~~~
fallentimes
Right, which is why I said "mature company" (who is hopefully, by then,
issueing dividends :-D). At the same time, if a company issues dividends it
can't afford to pay (cough Citi cough) this can be devastating to a Company's
prospects.

At it's core, the whole reason stocks are worth anything to begin with is the
anticipation of future dividends (DCF).

------
viae
I've been reading about stock trading over the last couple months, as time
allows, thanks to Metlife managing my 403b to a phenomenal 1% growth over 5
years. Hands down the best book I've read so far is, Fire Your Stock Analyst:
Analyzing Stocks On Your Own (Definitive Guides (Financial Times/Prentice
Hall).*

All other books I've seen are "get rich quick." FYSA is the only one that has
told me what the terms mean, how to calculate the "fundamentals", and
where/how to research a company. It also gives examples of value and growth
strategies. It doesn't, ever, tell you what you need to do to get rich, but
rather, what you need to do to make informed decisions.

Mix in "common sense" and your own opinions and your off!

* Yes, I've read (most of) a Kramer book, too. Avoid at all costs. The only useful advice: buy and research (not buy and hold), it is possible to make money in down markets too, and sometimes its better to be in cash instead of stocks while you find your next position. The other 350 pages is about how EASY it is too make MAAAAD MOOOONNEY. Don't you want MAAAAD MOOOONNNNETY??!?11

------
comatose_kid
The points he makes at the end of his "My Investment advice for 2006" are
dead-on, especially points 2 and 3. Investing well in the market requires a
_lot_ of time - saving money doesn't, and investing in yourself (side projects
for example) probably has the greatest potential for wealth generation.

------
chwolfe
"What about fundamentals? Fundamentals is a word invented by sellers to find
buyers."

~~~
fallentimes
I used to work in the finance & investing industry before doing a startup. The
slimy, misleading marketing proliferating itself everywhere is absolutely
ridiculous. They're even pretentious enough to call their fees and back loaded
funds "products".

If you've ever seen the movie _Boiler Room_ , my second finance job was
similar. My third finance job had similarities to _Barbarians at the Gate_ (on
a much lower scale) and the classic tulip bulb story:
<http://en.wikipedia.org/wiki/Tulip_mania>

Strange world is the finance.

------
mikesabat
This is a very well reasoned argument although it is rather depressing. I'm
actively evaluating a few stocks to invest my meager savings. Mark Cuban has
made me think one thing... bonds.

------
ojbyrne
I personally couldn't entrust my wealth to someone named "Raleigh Rails." But
then I don't actually have any wealth.

------
furiouslol
The secret to building a sustainable growing investment portfolio: DCF

~~~
tocomment1
Explain

~~~
furiouslol
Discounted Cashflow Model is one of the most robust way to value a company
(whether public or private). Unlike other models like the dividend model,
price/earnings model, a DCF model is flexible enough to value almost all type
of businesses (early stage, high-growth, maturing).

And its fundamental concept is so simple: You just need to make really good
guesses of the future cashflows and discount it back to the present and what
you get is the intrinsic value.

Assuming this public company is valued at $1 billion but based on your inside
knowledge of the company's projected cashflows, you derive an intrinsic
present value of $5 billion - it's a screaming buy.

Later, as time goes by and the company meets your previous cashflow
projections, the market will adjust their valuation to your initial
calculation and voila, you're in the money.

Other models like P/E and dividend don't work well. Earnings and dividends can
be manipulated SO EASILY. Imagine some dying company borrowing lots of cash in
order to increase their dividend. Based on the dividend model, its valuation
increases.

So the only thing you can back your life on is the cashflow. You can't just
manufacture cash.

DCF can help you explain several phenomenons. Eg. why doesn't Salesforce crash
despite its high P/E? Because the bulk of Salesforce customers pay upfront. So
there's a lot of cash coming in and that cash has value.

So here's a fun exercise for you to do today: Project Facebook's cashflow for
the next 10 years and discount it back to the present and compare it with
Microsoft's $15 billion valuation. Then you can tell people whether Microsoft
overpayed.

Happy DCFing!

~~~
byrneseyeview
_So the only thing you can back your life on is the cashflow. You can't just
manufacture cash._

Yes, you can. Read up on Enron's repo agreements. They raised cash by selling
assets near the end of the quarter, and promising to buy them back at the
start of the quarter -- it was underhanded, but it still showed up as
operating cash flow. They did this for t-bills, Nigerian barges, and
everything in between. Cash flow quality is higher than earnings quality, but
it is by no means perfect.

~~~
furiouslol
The DCF model adjusts to this situation perfectly.

 _They raised cash by selling assets near the end of the quarter, and
promising to buy them back at the start of the quarter_

So there is an initial cash inflow at the end of the quarter and a cash
outflow at the start of the next quarter. Just add that in your DCF analysis.

When I say you can't just manufacture cash, I'm talking about free money with
no strings attached. In your Enron example, there is a string attached - they
have to buy it back in the future, so there is a projected cash outflow in the
future. No company can manipulate the books to inject $100 million from the
thin air. That $100 million has to come from somewhere - from debt, equity
investment, asset sales etc.

Earnings is so unreliable. Eg. this company is projected to earn $1 million
with annual growth of 10% from Year 1 to Year 10. But they have a major debt
($100 billion) that is due on Year 11. A DCF model would value this company
correctly as bankrupt while an earnings model would not be able to value this
company correctly.

~~~
byrneseyeview
_So there is an initial cash inflow at the end of the quarter and a cash
outflow at the start of the next quarter. Just add that in your DCF analysis._

But you don't see it! All they have to do -- all they did -- was repo a little
more at the end of the next quarter. RJR did this with cigarettes a while
back: they offered discounts and 100% refunds to customers who bought just
before the end of the quarter, and they ended up with extra cash for their
10-Q even though these actions hurt the business.

A few other scenarios a cash flow analysis misleads you on:

* Gradual liquidation: if a company sells off its inventory and equipment over time, it can show positive, growing cash flow (and a rapidly growing cash flow as a proportion of capital!) even though the business is falling apart.

* A company with a few long-lived assets, like an airline with just a couple planes, will show low earnings and high cash flow when it's not replacing a plane. This is one of those situations in which high cash flow is deceptive and earnings are not.

 _this company is projected to earn $1 million with annual growth of 10% from
Year 1 to Year 10. But they have a major debt ($100 billion) that is due on
Year 11_

If the debt is normal debt, that shows up on the balance sheet, and the
interest payments. If it's a zero-coupon bond, it shows up in the income
statement but not the cash flow statement (although the tax effect shows up in
both).

The point of earnings is to show what kind of value has been added to the
business over time. We might call this Platonic version Earnings. Cash flow is
a better way to approximate Earnings when companies are manipulating their
earnings, but not when they're manipulating both. In the long run, given a
perfect accounting system, DCF will equal Tangible Book + Discounted Earnings.
Since accounting is imperfect, and a business can be manipulated to appear
better than it really is _by any measure that people actually use to value
companies_ , picking just one kind of valuation is folly. I use free cash
flow, but I use it judiciously -- I try to make it _as much like Earnings as
possible_.

~~~
furiouslol
_they offered discounts and 100% refunds to customers who bought just before
the end of the quarter, and they ended up with extra cash for their 10-Q even
though these actions hurt the business._

DCF deals with this. They get upfront cash but since these actions hurt the
business, it hurts cashflow in the future. So it's not like as if they got off
scot-free with this strategy. Like I said, DCF requires that you have really
good estimates about future cashflows. If you say _But you don't see it!_ ,
then you are not making good estimates.

Note: My point is not that DCF will give you a 99.99% accurate valuation. No
model will since all models depends on the accuracy of the inputs. My point is
that given the amount of knowledge you have about a particular company, the
DCF model provides the best framework to reaching a fair valuation.

 _A company with a few long-lived assets, like an airline with just a couple
planes, will show low earnings and high cash flow when it's not replacing a
plane. This is one of those situations in which high cash flow is deceptive
and earnings are not._

It is not deceptive. If the company does that, you just assume their future
cashflow from operations will decline from the aging planes.

While other valuation models are useful in supporting your initial valuation
calculations, DCF is the fundamental block.

