Monitor Metrics over Time
Monitor metrics over an extended period of time, rather than drawing conclusions from a single year. Construct a simple spreadsheet to calculate operating metrics on a quarterly or annual basis so you can better understand trends. Then identify the reasons for changes in these metrics period by period by reading the MD&A section found in the 10-Q or 10-K reports.
For example, in the 2009 10-K report for restaurant business Cheesecake Factory, management describes why comparable sales decreased 2.3 percent from the prior fiscal year 2008:
We realized effective menu price increases of approximately 1.2 percent and 0.8 percent in the first and third quarters of 2009, respectively. The decrease in comparable sales for fiscal 2009 was due to reduced traffic at our restaurants, which we believe was primarily driven by the macroeconomic factors affecting the restaurant industry in general.
Write down all of the reasons for the changes in a particular operating metric for at least a three- to five-year period. By studying the reasons behind the changes in the operating metrics, you will gain deeper insight into what factors have the greatest impact on the value of a business.
For example, if sales drop, identify why they are dropping, instead of focusing on how much they dropped. When you identify which factors have the most impact on a business, those are the operating metrics you want to track most closely. Suppose the changes in the cost of a particular raw material greatly affect costs, then you need to track a relevant metric for it, such as cost per ton.
Determine if Changes in Metrics Are Lasting or Temporary
Ultimately, you want to determine whether the changes in the metrics are lasting or temporary. For example, the most common reason for gains in same-store sales are increased customer traffic and higher pricing. If you discover a decrease in customer traffic, evaluate if this decrease is temporary or lasting. For example, extreme weather conditions generally cause a change in retail traffic. This is a temporary, rather than permanent, effect. In contrast, increased competition may be long lasting.
Comparing Metrics among Competitors
You need to determine the reason for the differences in metrics among competitors. When comparing operating metrics of one business to its competitors, make sure both businesses are using the same measurement and accounting standards. For example, when comparing same-store sales growth of two retailers, make sure the same time periods are used, such as 15 months versus 12 months.
If you are comparing two oil-exploration businesses, and they both use a metric such as finding costs per barrel of oil, make sure the accounting standards are the same. (Finding costs reflect the expenses of searching for new oil and gas reserves.) There are two very different methods for calculating finding costs under Generally Accepted Accounting Principles (GAAP). Check the footnotes of the 10-K to make sure the accounting methods used to calculate the metrics are comparable and adjust them if they are not.
23. What are the key risks the business faces?
Businesses face different types, frequencies, and levels of risk. As an investor, you need to evaluate how these risks may affect the business. The first place to start is the 10-K, in a section titled Risk Factors, where management discloses most of the known risks to the operations of the business. The risk factors section is broken up into two parts:
1. The first part highlights risks that relate to the business or industry.
2. The second part highlights risks that relate to the stock price.
The first set of risks is more useful because it outlines what can go wrong with the operations of the business, whereas the second set of risks tends to be standard legal language found in all 10-Ks: for example, “the stock price may fluctuate.”
Most investors read through this section fairly quickly and do not take the time to understand the potential risks of the business. However, it is important for you to spend some time in this section and investigate whether the business has encountered the risks listed in the past and what the consequences were. This will help you understand how much impact each risk may have.
You may also want to review the risks section in the 10-K of direct competitors and look for risks that the business may not have covered. Trade associations will often outline common risks, and many articles are written on how to reduce them. This will help you build a comprehensive collection of risks the business may encounter.
Write down the operational risks you find in the 10-K or other sources in a report; these operational risks might include:
Overcapacity
Commoditization
Deregulation
Increased power among suppliers
Shifts in technology
Changes in laws and regulations
Product obsolescence
Patent expirations
Development of new product lines where the business has limited expertise
The emergence of competitors
Brand erosion
Overreliance on too few customers
Limited geographic distribution
Research and development failure
Business-development failure
Merger or acquisition failure
A weak product pipeline
And others
Spend time carefully reviewing each of these risks. As you learn about the different risks a business may encounter, use this information to construct downside scenarios for your valuation of the business. This helps you better understand the threats to the value of the business. Identify those risks that have the greatest impact on the value of the business.
For example, if five customers make up 70 percent of the revenues of the business, and if one customer who represents 20 percent of sales were to leave, what impact would this have on the financials of the business? If you discover that losing the customer might send the business into bankruptcy because the business has a high debt load, then you might want to avoid investing in that business.
You will learn that the majority of the risks the business will encounter are outlined in the risk factors section of the 10-K and the reasons a business will fail are also disclosed. For example, those investors who carefully read the risks section in global financial-services firm Lehman Brothers’ 10-K avoided investing in the company’s stock because they saw that those risks were being magnified as the financial crisis began to unfold. Some investors even made money by selling the stock short. The short sellers saw events transpiring such as counterparties refusing to trade with Lehman, which increased their conviction that Lehman could fail. The reasons that Lehman failed are disclosed below, which were also disclosed in the 10-K:
1. The company’s capital position was severely weakened by excessive trading losses
2. Counterparties stopped dealing with Lehman as they remained defensive and shifted their activities to more stable competitors
3. Lehman’s reputation was in trouble
4. Short-term secured creditors did not have any reason to continue to renew their loans to Lehman
5. Lehman was unable to sell complex instruments because they were difficult to value
By carefully studying the risks section, you will be in a better position to evaluate the downside in any potential investment and learn more about the potential impact of risks on the earnings of the business.
As you read articles about the business, look for examples where the business or its competitors have encountered a particular risk before. Learn what happened and what the financial implications were.
For example, when my firm invested in bond ratings firm Moody’s at less than $20 per share, the stock price had just dropped from more than $30 per share because investors were worried about the many lawsuits that were being filed against Moody’s. Most of these lawsuits were from state attorney general offices and institutional investors who claimed that Moody’s caused them to lose money because they relied on their ratings to buy bonds. Many of these bonds that defaulted were rated AAA, which was Mood
y’s highest rating. There were many newspaper articles written about these lawsuits, and every time the newspapers announced that a new lawsuit had been filed, the stock price dropped.
However, my firm was not as concerned as other investors, because there were many past examples of similar lawsuits filed against Moody’s. In fact, some of the lawsuits even used the same legal language that was used in previous suits. In one such case, institutional investors unsuccessfully sued Moody’s to recover money they lost investing in the municipal debt of Orange County, at that time the largest municipal bankruptcy in U.S. history. We used this evidence of past legal precedent to support our investment thesis that the threat from the lawsuits filed against Moody’s was weaker than investors perceived.
When Evaluating Operational Risks, Adopt the Mentality of an Insurance Underwriter
When thinking through risks, adopt an insurance underwriter’s mentality instead of relying on subjective measures. If you allow subjective measures to permeate your thinking, then such factors as prevalence in the news might lead you to believe that a risk is greater than another. Most of us are afraid of risks that are new rather than those we’ve lived with for awhile.
For example, when terrorists attacked the World Trade Center on September 11, the relative newness of domestic terrorism decreased the prices of many stocks. Investors believed that there would be many more terrorist attacks and that this was a risk that most businesses now faced. Thankfully, there were not any other major acts of terrorism that resulted in lost lives or damaged properties. Just because an event has occurred and the media constantly discusses it does not mean that the actual risk is greater. Therefore, how much people discuss something is a bad indicator of actual risk. In fact, the more people talk about a risk, the more likely that risk will be mitigated.
In contrast to popular thinking about risk, insurance underwriters think in terms of frequency (i.e., how often in the past has the risk happened?) and severity (i.e., what is the financial cost?). Therefore, when you are identifying operational risks, you should identify whether they are low, medium, or high for frequency and severity.
One valuable source to help you identify the frequency and severity of potential risks is insurance manuals written for insurance underwriters, such as A.M. Best’s Underwriting Guide. The job of insurance underwriters is to identify all of the risks in a business so that they can properly price insurance coverage. This guide provides detailed descriptions and underwriter’s checklists of all the key risks involved in running nearly 580 commercial and industrial classifications—from advertising agencies to beverage distributors, clothing manufacturers, e-tailers, furniture stores, crushed-stone-mining companies, money-lending businesses, wireless phone carriers, and hundreds of other types of businesses. The list of risks is thorough, and the main risks a business encounters are highlighted.
How Do You Measure Risk?
Risk does not just include the probability that something may happen; in addition, you have to consider how severe the outcome might be. The more severe the outcome, the higher the risk. For example, the threat of bankruptcy is much more severe than the threat of having to pay a fine for violating a law.
It is very difficult to measure risk because you never know what will happen for sure ahead of time. More than one outcome can occur.
To help you understand the potential financial implications of a certain risk, look for past evidence. Use appropriate historical data, instead of making subjective estimates. Look to other businesses that have encountered a similar risk. For example, in Chapter 1, we looked at Heartland Payment Systems, the credit-card transactions company that had a security breach. A hacker was able to obtain the credit card information of several merchants, and Heartland was responsible for paying the cost of replacing these stolen credit cards. A similar case had settled recently involving retailers TJ Maxx and Marshalls, whose computer systems were also hacked. These retailers settled with the issuing banks to replace the stolen cards for about 70 cents per card. Using this information as a reference point, you could make a better estimate of the potential cost of settling. If you do not have data on what the impact will be, then you might think about reducing the size of the investment or selling it.
Let’s take a look at another example, in this case, why investment manager François Rochon did not invest in Canadian oil sands because he could not understand the potential financial implications of the risks involved.
Case Study: Investing in Canadian Oil Sands Deemed Too Risky
François Rochon, the founder of money manager Giverny Capital, outlined to his partners the risks of investing in businesses exploiting oil sands in Alberta, Canada, in his 2008 annual report. He explained why he felt these risks were too great for him because the business involved too many unknown variables:
It is clear that oil sands in Alberta represent a source of fabulous wealth. The reserves are astronomical, and everything seems to be in place for a profitable exploitation. But this exploitation is not as simple as conventional fuel. There are extremely high capital requirements and a complex procedure to transform the oil sands into oil. To produce a barrel of petroleum from oil sands requires two to four water barrels, and the waste must be stored somewhere. This disposal of wastewater could become a major environmental problem. At the end of 2007, the American government passed the Energy Independence and Security Act. It stipulates that federal agencies cannot initial fuel procurement contracts anymore that are more polluting than conventional sources of oil. Experts estimate that emissions related to oil sands are approximately 20 percent to 25 percent higher than conventional petroleum sources. This political element is added to the increase of royalties ordered by the government of Alberta last fall. The growth prospects of this region are impressive, but there are numerous possible unexpected circumstances (including huge reliance on the price of crude oil). We are monitoring the major players of this industry, but for now, we just remain curious spectators.
If Rochon had past examples of the potential financial impact from these environmental liabilities or other data to support the oil sands investment thesis as safe from risk, he might have some basis on which to act. With no data, he decided to stay on the sidelines.
As you consider the risks as presented in the 10-K or other sources, think like an insurance underwriter, making sure that you understand both the risk’s likelihood and potential financial cost. Learn more about these risks by reading articles and looking for examples where the business or competitors encountered a specific risk before. Attempt to understand the financial implications of these risks. Finally, base your evaluation on data and past examples, not noise. With limited or no data about a major potential risk, consider rejecting the investment.
24. How does inflation affect the business?
Inflation affects most businesses negatively. Most investors think about inflation as prices going up. It is not. It is the value of money going down. To evaluate the effect of inflation on your holdings or potential holdings, ask yourself if the business will be able to maintain its cash flows in real terms. In other words, in order to avoid inflation’s value-destroying effects, cash flows must increase at the same rate as inflation. Inflation’s biggest threat to the value of a business comes from the inability of a business to fully pass on cost increases to its customers without losing sales volume. If a business is unable to increase prices to offset the effects of inflation, then it will fail to maintain its cash flows in real terms. A business can offset the negative effects from inflation if it:
Can pass on price increases to its customers (pricing power)
Has the ability to reduce its costs
Has low capital-expenditure requirements and minimal levels of debt on its balance sheet
Let’s look at each of these factors in a bit more detail.
The Ability to Pass Along Price Increases
Price increases allow the business to offset the effects of inflation because the business can pass along t
he increase in costs. If the business can maintain sales volume, its cash flows will be maintained in real dollars.
The Ability to Reduce Costs
If a business can reduce its cost structure, it can offset the increased cost of labor and materials during an inflationary period. A business that has a high fixed-cost structure or one that needs to constantly reinvest capital in its assets (for example, a refinery) will have a difficult time decreasing costs to offset the negative effects of inflation. Those businesses with variable cost structures (for example, money-transfer business Western Union, where variable costs represent more than 75 percent of the business’s total costs) can more easily adjust their costs.
Low Capital-Expenditure Requirements
For businesses with large capital expenditures, inflation increases the cost of replacing existing assets. For example, businesses that are growing, such as a retailer, may suffer from inflationary effects because the cost to build new stores increases. On the other hand, businesses that have invested capital at a lower cost might benefit in an inflationary environment as the value of older assets increases. For example, an investor who built a building 10 years ago in a growing area benefits when new buildings in the area are constructed at a higher cost. This causes the value of the older building to rise as rental rates increase in the area.
Long-Term Debt Maturities
The common view is that businesses with a lot of debt benefit from inflationary periods as the value of the debt declines. This is true if the business does not have to refinance its debt in the near term, because inflation generally causes borrowing to become more expensive, not less expensive. Lenders, in fact, avoid making long-term contracts and are more demanding on covenants during inflationary periods. Businesses that have long-term debt maturities or limited debt on their balance sheets are therefore in a better position, as they can avoid both increased interest expenses and more restrictive loan covenants.
The Investment Checklist Page 14