vinod1

Another alternative is that there are lots of off-balance sheet assets that are not being reflected on the books. I did try to size the off-balance sheet items but not really able to find anything that would be much higher for Citi than BOA. But then I have never been able to get my head completely around the off-balance sheet stuff of the big four banks. Vinod

Here is my notes on Ben Graham's comments on Dividend Policy and how investors should approach dividends. Vinod • The dividend rate is a simple fact and requires no analysis, but its exact significance is exceedingly difficult to appraise. From one point of view the dividend rate is all important, but from another and equally valid standpoint it must be considered an accidental and minor factor. • In the years until 1925, the price paid for a common stock would be determined chiefly by the amount of dividend. A common stock investor sought to place himself as nearly as possible in the position of an investor in a bond or a preferred stock. He aimed primarily at a steady income return, which in general would be both somewhat larger and somewhat less certain than that provided by good senior securities. Even if one company had steady earnings and another company had irregular earnings, this had little impact on the price paid which is dominated by the dividend rate. • Graham questions the established principle of corporate management which subordinates the current dividend to the future welfare of the company and its shareholders. It is considered proper managerial policy to withhold current earnings from stockholders to either strengthen the financial position or to increase productive capacity. The typical shareholder would most certainly prefer to have his dividend today and let tomorrow take care of itself. • Graham questions the assumptions of the dividend policy 1. It is advantageous to the shareholders to leave a substantial part of annual earnings in the business.  If a business pays out only a small part of the earnings in dividends, the value of the stock should increase over a period of years, but it is by no means certain that this increase will compensate the stockholders for the dividends withheld from them, particularly if interest on these amounts is compounded.  An inductive study would undoubtedly show that the earning power of corporations does not in general expand proportionately with increases in accumulated surplus (retained earnings). 2. It is desirable to maintain steady dividend rate in the face of fluctuations in profits.  Stability is usually accomplished by paying out a small part of the average earnings. The question that arises is if the shareholders might not prefer a much larger aggregate dividend, even with some irregularity. The main objection to the above is that stockholders receive both currently and ultimately too low a return in relation to the earnings of their property and that the saving up of profits for a rainy day often fails to safeguard even the moderate dividend rate when the rainy day actually arrives. Gives the example of US Steel that earned a profit of $2.344 billion over the period 1901-1930 and retained $1.25 billon of it. Yet, a small loss over a 1.5 year period in 1931 was sufficient to outweigh the beneficial influence of 30 years of practically continuous reinvestment of profits. Assuming that the reported earnings were actually available for distribution, then stockholders in general would certainly fare better in dollars and cents if they drew out practically all of these earnings in dividends. • Graham questions the accepted notion that the determination of dividend polices is entirely a managerial function, in the same way as the general running of the business. This is because the board of directors consists largely of executive officers and their friends. The officers want to retain as much earnings as possible to simplify their financial problems, expand business for personal aggrandizement to secure higher salaries. • Graham suggests European companies policy of paying out practically all earnings and any capital for expansion purposes be provided by sale of additional stock. • Experience would confirm the established verdict of the stock market that a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus (retained earnings). • Graham suggests that if an investor makes a small concession in dividend yield below the standard, he is entitled to demand a more than corresponding increase in earning power above standard. So if a stock is paying 5% div yield and 7% earnings yield and another company paying 4.4% yield, then the investor should demand an earnings of yield of perhaps 8% to compensate. • The dividend rate is seen to be important apart from earnings, not only because the investor naturally wants cash income from his capital but also because the earnings that are not paid out in dividends have a tendency to lose part of their effective value for the stockholder. • The principle for dividends should be for the management to retain or reinvest earnings only with the specific approval of the stockholders. Such “earnings” as must be retained to protect the company’s position are not true earnings at all. They should not be reported as profits but should be deducted in the income statement as necessary reserves, with an adequate explanation thereof. A compulsory surplus is an imaginary surplus. • Summary  In some cases stockholder derive positive benefits from an ultraconservative dividend policy i.e. through much larger eventual earnings and dividends. In such instances the market’s judgment proves to be wrong in penalizing the shares because of their small dividend.  Far more frequently, however, the stockholders derive much greater benefits from dividend payments than from additions to surplus. This happens because either (a) the reinvested profits fail to add proportionately to the earning power or (b) they are not true profits at all but reserves that had to be retained merely to protect the business. In this majority of the cases the market’s disposition to emphasize the dividend and to ignore the additions to surplus turns out to be sound. A company earning $10 and paying $7 in dividends should increase the value of stock over a period of years. This may be true but at the same time the rate of increase in value may be substantially less than $3 per annum compounded.  The confusion of though arises from the fact that the stockholders votes in accordance with the first premise and invests on the basis of the second.

Good job on Citi! Yes, you do get $1 if you assume a 1.5% ROA on the $1850 billion in current asset base. But, Citi excluding Citi Holdings has only about $1300 billion in assets. The $500 billion odd in assets in Citi holdings I assume are going to be in runoff. So would require more than 2% ROA to generate $1 EPS. To put this in perspective, it require earnings of more than $30 billion a year or 50% more than either WFC or BOA. Also the Book Value has held up because they were able to raise $90 billion in equity sales mostly at greater than book value so BV per share has been helped by this. Also the $300 billion in bad debt that it was able to hand off to Govt has also helped in this regard. Vinod

As much as I try to come up with a "normalized earnings" for citi, I am never able to get much above $0.8 EPS which is based on a very simplistic 1.2% ROA which I think is about average for Citi even after excluding the 2008-2010 period. Given that Citi is shrinking its BS I cannot see how Citi can earn $1 with nearly 30 billion in shares outstanding. Given that it is a near certanity that it would go through a near death experience once again over the next 10 years (having gone through this about once a decade for the last 4 decades and having participated in every significant scandal involving the financial industry of the last 20 years), I am just not able to see the value here. Obviously Bruce is on to something but along with AIG, I have not been able to understand the value he sees in Citi. Vinod

You got great feedback from others. My 2 cents 1. I strongly recommend reading Security Analysis. You would find it astonishingly relevant to the current environment. However, it is not a book that teaches you how to value stocks. The most surprising thing I found after a very detailed study of Security Analysis is that Graham does not think it is necessary to actually value a business. "Instead Graham focused on how to ensure that what you are buying is very cheap, which means you don't know the value is, but you do know that the value is much higher than the price that you are paying. And then you diversify. So, when you follow that approach, for example, you don't have to do management interviews, you don't have to really worry about the industry prospects. Graham said that you don't need to value the business. It's too hard to value a business. Anyway, it is not the job of an investor to value a business, that's the job of a business valuer which is very different from the job of an investor. The job of an investor, he felt, was to make sure that there is a big margin between the value that you are receiving and the price that you are paying." (Quoted from Sanjay Bakshi). If you read this book go with one of the first four editions, the other editions had much less Graham. My notes to the book are at http://vinodp.com/documents/investing/security_analysis_index.html 2. The best practical book on valuation I found is "Value Investing" by Greenwald. This is a definite must read for developing the right method of thinking about valuation. Vinod

Came across a good site for Oil and Gas stocks and thought it might be of interest to those who are following this industry. http://www.mcdep.com/index.htm Think it could be of some use as a screening tool for further analysis of each company. Vinod

A little info you may or may not find useful: I think it might have to do with fund withdrawals for Yacktman. Assets dropped from $1.1 billion to $0.3 billion during 1998-99 period. The withdrawals might be because he loaded up on deep value stocks like Philip Mliorris and also started under performing for whatever reason early in the bubble period than the other value investors. The under performance is concentrated tightly in the three year period between 1997-1999 - a badge of honor. I was told in an online message board discussion from a person who I respect enormously but do not have data that Fairholme has underperformed in its managed accounts in the mid 1990's. Since the fund did not start in this period we do not have public record. Vinod

Good catch. I looked at S&P 500 and Small Cap indices and they are up roughly 29% and 42% over this period. So the 7 year forecast change for these two tally out quite well over this period with the market moves. Quality on the other hand seems to have moved from a 6.1% annual premium over S&P 500 to a 3.5% premium while providing nearly identical returns over this period. Very strange. Vinod

Taking a very quick look it underperformed from its inception till late 1999. Most of the out performance came from 2002-2007 period. Maybe the manager improved his skill. To really assess his performance, reading up his letters to see how he thinks might give you a better indication of his performance. You might find more feedback on the Morningstar board about this fund. Vinod

I am "Inevitables" at 80 cents kind of guy. Vast majority of my portfolio - heck pretty much all - is invested in such businesses. However, I made a first foray into BAC this week. I am afraid that a great calamity is about to fall on US Banking system given my investment :) Vinod

Vinod - do you mean "were being valued"? As far as I can tell, the three companies you mentioned all have low-mid teens PEs. Unless I'm missing something... -M I was not clear. I took the orginal poster to mean, "why are banks currently an investment candidate if healthcare was deadmoney the last 8 years. Can banks suffer something similar?" I am referring to valuations about 8 years back in healthcare. They are priced to perfection at that time so it is not surprising that they did not provide good returns. Right now the valuations of Banks is vastly different compared to the situation with healthcare in 2002. Banks have their share of risks, but valuations are such that, on a risk adjusted basis (fully incorporating say a complete wipeout probability of say 10%), they are starting to look attractive. Vinod

Not really. JNJ forward earnings yield = 7.7% PFE = 13% MRK = 10% You cannot just break down a case for investing in a bank because of its P/E ratio, it's far too simplistic. That's the kind of mentality that got people killed when they were investing in seemingly cheap banks on backwards looking metrics during the financial crisis. I am talking about valuations of healthcare back in early 2000-2002 time frame (8 years back). I do not disagree with you, just pointing out that while 8 years is a long time period, for healthcare stocks the past 8 year period started with very high valuations as opposed to Banks at the current time. Vinod

The main difference is valuation. JNJ, PFE, MRK, etc are all being valued at PE ratios in the mid 30's. At an earnings yield of less than 3%, poor returns are baked in at those prices. Even using conservative normalized earnings, some of the bank stocks are at PE of about 6. At an earnings yield of greater than 15%, unless you run into some really severe economic/company specific issues you should have a satisfactory return. Vinod

The main point is that before you read any value investing books like Security Analysis, etc you need to get a good understanding of accounting. A good place to start is "The accounting Game" by mullis. Vinod

My background is in engineering and did not have any economic/finance background. Reading Intelligent Investor and other value investing books, it felt like sitting in the cockpit of a space shuttle - you get exited and want to do something but did not have a real clue. I completed my CFA which provided a good background - accounting, economics, statistics, financial analysis (at least how not to do it or way it is performed by analysts). I did feel it is a waste of time relative to the time spent. If you can look at the curriculum it provides a roadmap of what things you might need to learn and in what order. It however misses completely on how to actually go about investing in the markets. I found that I learned most from Graham's Security Analysis, the practical aspects of it. Then started reading and analyzing Annual Reports/10-K's, etc. The first 200 annual reports did not make much sense, but I kept reading anyway. Then after getting a good feel for the various industries and companies from reading the annual reports, I then selected a few industries and a few companies in each. Then spent a couple of years drilling down into the industries and companies. So I would really dig deep into 2-4 companies in a specific industry. 20-30 years of annual reports if available and try to also look at data of the past 30-40 years to see how they have evolved. Now I am comfortable with valuing companies that are within these specific industries. So if I have to look at a new company within the industry it takes relatively less time to get upto speed. Vinod

damianolive, Outstanding effort. Thanks for sharing. Vinod

Bronco Sorry. I agree completely with you w.r.t the examples. What I was commenting on is your statement "is it double counting if in today's terms I have both the assets and the NPV of future earnings." I made the assumption that the future earnings are being produced by the same assets. In your examples that is not the case. The investor referred to in the article seem to be adding up both the asset and furture earnings from the same asset. Vinod

Yes. It is double counting. Take another example, if you have a $1000 in your bank account that is paying 5% interest. Do you capitalize the interest and add back to your principle to get the total value? Vinod

After reading the full report, I stand corrected: Says Rees, “ I generally assign an estimated fair value on a company based on the value of net tangible assets plus a ten multiple on estimated forward run rate earnings. ” This is nuts!

It is double counting no doubt but I think we might be missing the context in which he is adding up the asset value and earning power value. Look at the example, Here ’ s a basic explanation of how Rees determines value. Say Rees fi nds a company with low debt and fi gures out that its tangible asset value is $ 5 per share. If his estimate for forward earnings per share was $0.10 he might apply a price - earnings multiple of 10 to that. That would amount to $ 1 of future earnings value, so Chris would simply add the two to get a $ 6 estimated fair value for the stock. He would then seek to purchase it at a 50 percent discount to that value, or $ 3. If the stock price was too high, he would simply move on to the next candidate. The earnings are 2% on the business tangible value. So he is estimating what the tangible value would be like a few years out and seeking to purchase at a discount to its eventual tangible value. If you think of it it is no different than removing any expected losses from the tangible value to arrive at an expected tangible value a little further out in the future. It would have made more sense if he is projecting the asset value say over 2-3 years rather than projecting out for 10 years (which is more like capitalizing earnings). Vinod

For every dollar that you are putting into either WFC common or WFC warrants, the equation seemed to be 1. If WFC trades below $54 around the expiry of options in 2018 - WFC common has the higher expected return 2. If WFC trades above $54 around the expiry of options in 2018 - WFC warrants has the higher expected return The downside seems to favor WFC common as long as WFC trades above $0. So if you are expecting a price of about $54 in 2018 I would think common is the better option. If you have higher expectations on WFC price then the warrants are the way to go. Vinod

At the end of the day 0% rates are like shuffling money from the left hand pocket to the right had pocket as each $ saved by a borrower is offset by an equivalent $ that is not earned by a saver. So it is a form of redistribution. The only benefit seems to be to induce some sort of bubble and pray that it fuels economic growth (at least in the short term) and hope that the bubble pops out when the economy is in a much better shape to handle the aftermath. Vinod

COC, What an outstanding first post! I have a word document of comments on this board that I want to re-read and your first post went right into it. I hope to have the pleasure of reading more of your comments. Thank you! Vinod

I think that is an extremely good point that often seems to get ignored. For all his talk about getting 50% returns, if you look at what Buffett has actually achieved, it had been about 25%-30% in his partnership days. This I would take it as the upper limit of realistic performance that can be achieved by a super investor. Mere mortals should not be too dis-satisfied with something lower. Vinod

Agree completely. I think many people on this board can and would outperform the market by a significant margin. My point is regarding only mutual funds and that for the average person (not the value investing fanatics of this board :-) ) index funds are the more reasonable choice. Vinod