Stocks have value for two reasons only: 1) their liquidation value (what their assets are worth after subtracting what they owe) and 2) because of the expectation of future earnings.

Regarding 1), it's uncommon for stocks to be valued purely based on their liquidation value since most companies are not meant to be liquidated, but rather to continue as going concerns.

Regarding 2), a stock's history of earnings has no bearing on its future value other than as a proxy for what it could earn in the future. But if the future prospects for a company are really dim, then no glorious history of past earnings can lift the stock much beyond liquidation value.

So what does all of this has to do with recency bias and one-time gains? Well, everything. First, businesses, like life, have their ups and downs. So the recent past might not be a good proxy for judging the future earning power of a company. Even though this is stating the obvious, Wall Street too often forgets this and assigns too much weight to recent events such as improved earnings, one-time gains, a rough patch, etc.

Think about it: The past is bounded, but the future is unbounded. So what a company did last quarter or what it will do next quarter should have close to zero effect on its value in perpetuity.

In summary, when appraising a company, make sure to adjust one-time gains (or charges) and look at earnings over a long period of time (at least 5 years, typically 10 or more) to smooth out recent effects. Averaging the returns after adjusting them can also help you gain a basis for projecting future earnings.

At the same time, make sure to discount recent events that may not have much long-term meaning such as launching new fad products, some types of planned changes in management (especially when a successor has been groomed for many years) and small divestitures or acquisitions of subsidiaries that are unlikely to have a material impact.

When recent changes appear meaningful, ask yourself whether or not they fundamentally change the characteristics of the business on a permanent basis. Is buying that piece of equipment or installing that computer system going to enable the business to earn more or keep more of what it earns permanently in the future? Does it change the nature of the business?


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Expenses are costs to the company and as such they are typically recorded as a charge against revenues or sometimes surplus. But in some cases, expenses are capitalized. That is, the costs incurred are not charged against revenue or surplus, but instead built into the balance sheet as assets.

Sounds backwards? But there are valid and legal reasons for this. Imagine that you build a factory, that costs $1M to build over two years. Some expenses incurred can be capitalized because the factory you built is now an asset that is worth something if sold in the market. That's what capitalize means -- to convert into capital.

The problem starts when one needs to decide how much of the total cost should be capitalized. If the factory when ready is worth in the market $2M, then an argument can be made that $2M is what should be capitalized when the factory is ready. But if out of your building cost of $1M, some $300,000 went into buying new equipment that was stolen during construction, then an informed buyer of your factory wouldn't need to repay you that much, since he could rebuild the factory himself for only $700,000. So an argument could be made that the asset is worth only $700,000.

Moreover, if this factory is used to build sprockets that can be sold for $15 each and it can build them for $5, at the rate of 10,000 per year, then one could use the $10 spread, times the volume built to value this factory as one would value a bond or a dividend-paying stock. For the sake of the exercise, with a 9% discount rate and depreciating the factory over a period of 20 years, the fair value of this factory would be $912,854. Such projections can be misleading and are not proper accounting methods, but it illustrates how widely one can value assets.

So, what's the fair value of this hypothetical factory? In my mind, I would treat the monthly expenses for the two years it takes to build it as just that, expenses. The income statements and the balance sheet should both reflect the costs incurred. After all, it's hard to value a partially-built factory and if bad times happen and the company needs to raise cash, it will find itself in a precarious position and unable to sell the factory for what it has paid thus far. After construction, I'd call an appraiser and have the market value of the factory be reflected on my balance sheet.

Of course, this is being very conservative and is very lumpy, especially at the end. Most companies don't do it this way, but instead capitalize some or all expenses as they are incurred.

But an investor should be on the look out for abuses. AOL, during the dot-com boom, once capitalized advertising expenses, as they argued that the money used would soon be reflected in the form of new customers and increased revenues. Another company capitalized its Christmas party, under the excuse that it would reap the benefits of increased morale.

In another post, I will discuss a likely undervalued company that has many capitalized assets that need some intricate adjusting.


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This article originally appeared on The DIV-Net on October 6th, 2009.

Recently, we talked about the need for investigating capitalized expenses. Now, let's illustrate that with a current example.

Formula Systems (FORTY) is a software and technology company engaged in software consulting services, developing software products and providing computer-based business solutions. Software development means paying software programmers to write code. The end product is the virtual concept of software.

As of the end of 2008, FORTY had a reported book value of $170M and has been trading in the last four months between $84M and $122M. At first glance, it seems like a bargain.

According to the company, FORTY capitalizes "development costs of software which is intended for sales that are incurred after the establishment of technological feasibility of the relevant product". They also start to amortize capitalized software development costs "when the product is available for general release to customers". Typical amortization period is 3-5 years.

Sounds reasonable. Until one thinks about the nature of software. Unlike a building or a factory, as in our previous example, software has a dynamic nature that is unpredictable -- a new one can quickly obsolete the old one, much faster than 3-5 years.

Also, software development costs vary widely. What one company paid to develop one can seem like fortunes to another, more efficient developer. It's unlikely that a software without a moat such as Windows or Google Search can fetch a lot of money if sold to an informed buyer, especially since new programming technology can also change the cost of building new applications.

Going back to its most recent annual report, FORTY had at the end of 2008, $46M of capitalized costs and other deferred charges listed as "Other Assets".

It also had $143M of goodwill from two acquisitions that are not amortized since 2002 but instead tested for impairment every year. Moreover, the value of these assets is calculated based on future cash flows expected in the future, like our sprocket factory example in Part I of this article. We concluded then as we conclude now, that this type of valuation can be very misleading, since the future is unknown.

So, what's FORTY worth without capitalized costs? Let's subtract all the capitalized costs and assume the software is worthless at liquidation: $170 - 46 = $124M. That's more inline with its current market value.

Now assume that we don't fully trust the company's estimate of the fair value of their goodwill. If we subtract $143M, the company is worth nothing. Of course, it must be worth something or they would have been out of business by now. But figuring out what portion of these $143M are inflated is an exercise I prefer not to engage in, especially because what's left after subtracting capitalized costs is already too small a margin for my taste.

For now, I'm passing on FORTY.

Disclosures: None.


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Quick question: which company is more fairly-valued? ARLP or NRP?

Note that I'm not saying they're fairly-valued, undervalued or overvalued. I'm asking which one, relative to each other, is more appropriately valued, even if not so on an absolute basis.

Natural Resource Partners (NRP) is a coal property lessor, currently trading for $21 for a total market cap of $1.5B with a P/E of 14 and a dividend yield of 10%.

Alliance Resource Partners (ARLP) is a producer and marketer of coal, currently trading for $37, for a total market cap of $1.4B, with a P/E of 12 and a dividend yield of 8%.

Both companies are limited partnerships, thus required to pay out substantially all of their cash flows in dividends every quarter.

Now, what's your answer?

Okay, I didn't give you enough information. Fair enough.

My point is that nothing you can fish out of Google Finance or ratios from Reuters or Morningstar will make answering this question any easier.

This is because exploration companies such as NRP and ARLP are a special category of business. Their fair value depends heavily two things: a) the price of coal and b) their proven reserves.

For this exercise, we can ignore the price of coal, since we're talking about relative value here. If the price of coal changes, it will change for both companies.

Now, proven reserves. That's the amount of coal in the ground that is available for mining. This is a determinant factor because even if one company can extract coal more cheaply than the other, due to it having better technology, cheaper labor or being closer to cheap transportation, this fact may still be irrelevant on the long run if one company will live three times as long as the other one.

Consider this: As of December 31, 2008, NRP owned or controlled approximately 2.1 billion tons of proven and probable coal reserves, while on the same date, ARLP had approximately 686.3 million tons of proven and probable coal reserves.

So, it looks like NRP is the one that may live three times longer and distribute more of their cash flows to shareholders over the long term.

While this simple analysis does not answer the question, it brings up an important point to consider when dealing with exploration companies: the value of their proven reserves.

The real answer requires a little bit more "digging" (pun intended), but not in the ground; rather in the balance sheet of the companies. In specific, how accurately are the proven reserves reflected in the balance sheet? Also very important is the companies' capitalization structures -- how much debt they have, since interest on debt gets serviced ahead of common shareholders.

I'll leave this as an exercise for the reader for now. But unlike high school books, I will answer this question eventually in a future post. Stay tuned.

Disclosures: None


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A friend recently asked me whether or not to sell some stock options from his employer and what to do with the proceeds. This is a tough question to answer because each one's situation is different. So I answered him first with a set of premises that I believe are universally true and are to be followed as general guidelines at all times. And then, I mentioned a few twists for taking advantage of the current situation as well as some precautions.


Investing Premises for the Defensive Investor

  1. Emergency Fund. Always have at least a six-month fund in cash or ultra-safe investment for eventual emergencies.
  2. Money needed in less than five years should not be in stocks.
  3. Extra money not needed within five years should always be at least 25% in stocks, typically more. A 50-50 allocation between stocks and bonds is a good, no-brainer choice.
  4. Inflation is the enemy. Be weary of anything that ties up money for a long time and has no chance of benefiting during inflationary times. Inflation is always around, sometimes to a larger degree than others.
  5. The taxman is the enemy too. All things equal, paying less taxes is always better. Avoid taxes as much as legally possible. Delaying taxes is often an option, especially if one can choose between taking a profit now or later. Typically, avoid taking taxable profits at the end of the year, since taxes will be due sooner than if you took the profits early in the year (say, selling in November gives you 6 months until tax collection time in April, while selling in January gives you a year and four months to enjoy the money -- exceptions abound, so consult your tax advisor for details).
  6. Avoid over-relying on your employer. If you depend on employment income for a living, loading up on your employer's stock significantly increases the amount of risk you take. Sell those stock options when it makes sense. If your spouse works there too, that's even more risk, you probably don't need to hold any employer stock at that point.

As they are, these are general guidelines to be observed at all times. What does that mean right now, in terms of actionable items and the current situation? Let's take a look at the current investing scenario.


Current Investing Situation

  1. Low interest rates. Money market and savings accounts yield next to nothing, so investors will lose money to inflation over time.
  2. Threat of higher inflation in the near future. With money printing and inflation officially at its lowest point in years, it's guaranteed that the only possible outcome in the future is higher inflation.
  3. Devaluing of the dollar. With the recent threat of collapse of american financial institutions, the rest of the world is scared of the dollar -- China is buying gold and Saudi Arabia is allegedly selling oil in Euros, not Dollars. Combined with fear of higher inflation, holding US Dollars doesn't seem like a good call right now.

Intersecting the current investing situation with the investing premises for defensive investors, what is my friend, a defensive investor, to do?


Current Action Items for the Defensive Investor

  1. Get an emergency fund in place. My friend should sell enough of his stock options and get that emergency fund in place. A good place to park it is in Vanguard's Prime Money Market Fund or a muni fund from his state if he's in a high tax bracket. In his case, the California Muni Market Fund will do it.
  2. Diversify away from the dollar and hedge against inflation. With the funds my friend will need in the next 5 years, he should put them in inflation-protected places. My favorites are TIPS funds such as Vanguard's Inflation-Protected Fund and a CD of a basket of strong currencies, such as Everbank's Commodity CD, which contains 25% of each Australian, Canadian, New Zealander and South African currencies. Another good choice is the Debt-Free CD which has among others the Swiss Franc and the Brazilian Real.
  3. Invest for the long-run. With the rest of the money he won't need in the next 5 years, I told my friend to invest at least 25% in stocks, but possibly even more. A good choice is to go 2/3 stocks and 1/3 bonds with the Wellington Fund. To be more aggressive, I'd allocate 70% to Wellington and the rest into a Total International Stock fund or equivalent.

Regarding his employer's options, I told him to lock-in most of his gains now to start the above plan right away and to keep only a small portion for future appreciation, since his options vest continuously and are replenished by his employer annually (there are more where these came from).

My advice for Entrepreneurial  Investors would only be slightly different, and it would also include to a large extent the same defensive investments outlined above. The difference between the two types of investors is the amount of time and interest they have to devote to their investments. As such, a defensive investor should refrain from picking stocks and engaging in short-term arbitrage transactions. And every investor, seasoned or not, had better stay away from market-timing folly and listening to financial commentary in general.

Disclosures: I own shares of some of the funds mentioned above: VGTSX, VCTXX, VIPSX and the Commodity CD. I did not receive any compensation for mentioning the names or products of any of the companies cited above.


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