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Profiting From Cumulative Owners Earnings: AAR, Microsoft
5 comments | December 23, 2010 | includes: AIR, MSFT
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Today we are investigating a new concept that I have developed called “Cumulative Owners Earnings (COE).” Before I get into the details of how it works, I must first explain what Owners Earnings (OE) are. Further, I believe that both COE and OE are extremely powerful tools for analyzing companies on Main Street. From there, the data can be compared to the price offered per share on Wall Street by “Mr. Market” to see if a positive investment opportunity develops.
Owner’s Earnings is a concept that I learned from studying Warren Buffett. And rather than having me explain I will allow the great one to do so;
In his 1986 letter to Berkshire Hathaway (BRK.A) shareholders, Buffett defines “owners earnings” as:
(a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) since must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”
In a nutshell, A+B = Net Income + Depreciation – C or Capital Spending = Owner’s Earnings. (All of those component numbers are usually readily available through Value Line and other sources.)
So to break it down even further, Cash Flow Per Share – Capital Spending Per Share = Owners Earnings.
Mr. Buffett also likes to judge his own company’s performance based on growth in Book Value (Assets-Liabilities) and every year he updates how much Berkshire Hathaway’s book value grew from the previous year. Book Value is an indicator that is measured over a long period and is a measure of value, as it measures the cumulative assets that are left over when all liabilities are removed and it gets updated cumulatively over time. The problem with book value though is that one can really never know what the assets of a firm are really worth and as was shown in the financial crisis of 2008, the assets of many banks were fictional, so it can be hit or miss depending on the company.
Another way to judge a company is by its earnings per share, but then again this is more of a short term barometer and very unstable. From earnings per share you can also develop Cash Flow (Net Income + Depreciation) but then again companies with huge cash flow don’t necessarily equal good investments, as was shown by General Motors (GM) over the last decade.
The best indicator that I have found that allows an analyst to be able to get to the bare bones of what a company is really up to, is to analyze its free cash flow per share and how it relates to its price on Wall Street. By doing so you can see how much a company is spending in capital expenditures to grow or even maintain its current numbers. The ideal companies are those that are able to grow their operations with minimal capital expenditures. Basically companies like Apple (AAPL) grow their owners earnings at scorching growth rates because they only require minimal investment to increase their earnings, by utilizing things like “Economies of Scale” (the bigger you are the more you can buy in bulk and the cheaper your costs are per unit). Companies that are able to produce monster free cash flow growth numbers usually do very well. But a big mistake can occur when most of the darlings of Wall Street are judged on a year to year basis instead of looking at the big picture by introducing history into the mix.
In developing COE I have attempted to introduce a new way to analyze whether a company has shown consistency over time, because I am not just a Quantitative Analyst (Benjamin Graham) but also a Qualitative Analyst (Phillip Fisher) and one of the hallmarks of Mr. Fisher’s analysis of companies was that they needed to establish a firm pattern of consistency and thus minimize surprises. To read more on Mr. Fisher you can go here.
So what is COE and how does it work? Basically what I have done is add up all the yearly reported owners earnings for a company and then totaled them. This is not easy to do as you need to go back to the historical records of a company and get the numbers. But since this data is not readily available, those who can get their hands on it, have the advantage. What I hope to do over the coming years (here on my blog) is analyze a company and publish my research to allow the small investor to do what I do, by giving them access to my original research.
To give you an example of what I mean here are 40 years of Owners Earnings for AAR Corp. (AIR):
[click images to enlarge]
As you can see from the data, AAR Corporation has been a very profitable company on Main Street for over 40 years and has never reported negative OE in any of those years. And if you total its 40 years of OE you get $23.82 cents a share as its COE. What does this $23.82 mean?
Basically the company over the last 40 years has generated $23.82 in OE per share and in 2009 generated $2.41 in OE per share. So with those two results we have two data points to base our analysis on instead of just analyzing AAR relative to its 2009 Price to Owners Earnings or Price to Free Cash Flow alone. I bought the stock for my clients on July 23, 2010 when it was selling for $16.54 a share because as you can see it was selling at that price for 6.86 times its OE and less than 1 times its COE. It is extremely difficult to find stocks that trade for less than their COE and at the same time have a Price to OE of less than 7, but when you find them and then notice that they have a very consistent track record, the odds are definitely in your favor.
The secret to all this is to have a strong price to OE with a strong price to COE. If you can locate such stocks, the odds are in your favor. Since July 23rd AAR has gone up and I have been able to make my clients a 68.56% gain on it. I am not saying that anyone using my theory on COE will have similar results and its current price of $27.88 it is still not overvalued, but is selling for more than its COE.
Nevertheless I feel that I have discovered something important here, because if you look at the standard boilerplate quantitative numbers that most analysts follow, nothing inspiring springs up about AAR that would explain such a large rise in its share price.
For example its return on equity is only 6.55% and it has a profit margin of just 3.38%, which is hardly inspiring. It also has debt of $11.68 a share, which is also considered bad because at the time I bought it its debt was equal to 70% of its market capitalization. Therefore when you have eliminated the impossible, whatever remains, no matter how improbable, must be the truth!
The truth obviously has to do with COE and OE. The reason I say this is that most investors invest in stocks with little or no research involved and fly by the seat of their pants when they make investing decisions. Therefore the cumulative effect of all these actions (fractal geometry) creates opportunities for those who actually know the true value of a company.
It is clear from the chart of AAR below, that COE is quite a powerful tool to use when you can also match it with a low current year Price to Owners Earnings as well.
Another example of my theories in real time testing can also be found in my analysis of Microsoft (MSFT).
In that analysis you will notice that the COE for Microsoft was $14.51 but the reason I bought it for my clients, can be seen from this section of the article;
Since Microsoft closed the books already for 2010 (their annual year ends June 30th) we can therefore look at their latest Value Line page and we get an owner’s earnings of $2.24 for 2010 and an estimate of $2.50 for 2011. Thus we have Microsoft earning $4.74 a share for those two combined years and if we add that to our $14.51 we get $19.25 in owner’s earnings from 1982 to 2011. Multiply that number by the 8.5 billion estimated year 2011 shares outstanding and we get a total owner’s earnings generation of $163.63 Billion in the last 29 years. You will also notice that the combined 2010 and 2011 estimate is equal to 32.67% of the previous 27 year owner’s earnings generation. So with Microsoft you have a stock that is trading at $25.10, or at 10 times its 2011 owner’s earnings estimate with a market capitalization of $213 billion. The company has generated $163.63 billion in owner’s earnings and is selling for $213 billion.
So as you can see anyone buying Microsoft, after reading my blog post, would have seen it go from $25.10, to its current price of $28.25 and would have achieved a 12.55% gain since October 19, 2010. The closer you get to 1 times a company’s COE, the better the odds are for making larger gains and if you are lucky enough to find stocks selling at a deep discount to their COE then you have a greater chance for truly superior results.
One of the drawbacks to this system is that you have to usually swim against the tide as most analysts using antiquated models may find nothing interesting in your stock picks. Also current high fliers like Netflix (NFLX) and Google (GOOG) can not be analyzed using COE as one usually needs 20 years of OE data to make an accurate judgment call. So with companies like that we need to analyze them more from a qualitative point of view, which can be identified in Philip Fishers “15 Points”.
Always remember when analyzing a company using this methodology, to make sure that you have a very low current year Price to OE, to go along with the COE. If a company is not doing well in the present then the past track record of COE will not help you. Eastman Kodak (EK) is a perfect example of this as its COE from 1973-2009 is $71.35, but unfortunately it only had OE per share for 2009 of just $0.15 and at $5.17 a share it trades at 35 times its price to OE, which is bad. So the system only works if you get excellent numbers for current OE and Historical COE. Otherwise you have a value trap. If just the opposite occurs where you have a great current OE and a terrible COE you have a potential growth trap on your hands. The farther away that you are of having the current OE and historical COE lining up the greater your risk is. So if nothing else this system could also be a great way to measure risk.
As I have mentioned above, I will start a long process of analyzing a vast multitude of companies here and show how my system works in real time.
Disclosure: Long MSFT, AIR, AAPL, GOOG, No Position in NFLX, EK
This article is tagged with: Long & Short Ideas, Long Ideas, United States
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Comments (5)
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Old TraderComments (5042)
Peter,
Can I assume that you've developed this relatively recently? I'll be curious to see how the results of your application work out. 23 Dec 2010, 08:36 PM1
junaidfarooq@hotmail.comComments (3)
Hi Peter,
Wouldn't COE for a dividend paying stock would always be overstated. Comparing Market Cap to COE without adjusting for dividends paid in all those years would render the exercise pointless.
Regards
Junaid 27 Dec 2010, 03:26 AM0
BarrytechComments (40)
I cannot understand how you can consistently use COE in any ratio when you don't first specify how many years you must go back in time. Clearly, a company with 50 years of COE will outshine another company with 'only' 20 years, all else being equal.
For instance, comparing the COE with the current share price as you have done doesn't sound logical to me, especially when the number of years is variable. 24 Jan, 05:17 PM0
Mcase003Comments (2)
This is some of the research I have been waiting for. Very insightful, and well thought out process. I am a huge follower of Phillip Fisher, and am going to do my own due diligence on your process and overlap that with some metrics I use. I am a recent college graduate and just started with a research firm, but would love to be a part of the Mycroft team. Sounds like groundbreaking material, thanks again for sharing. 2 Feb, 10:31 AM0
ERIKWJComments (9)
I have truly enjoyed reading all of your post and want to thank you for taking the time to make your thoughts and findings public. Your COE model is particularly intriguing and I was hoping I might be able to ask you a few questions on the subject. I have noticed that others have already posted you in regards to the fact that an older company will naturally have a higher COE than a relatively younger company even if the companies are otherwise identical in all respects. I found this facet of your COE model perplexing at first, as it would seemingly overvalue an older company while undervaluing a relatively younger company. But, after a moment I then found myself asking the question is 15 or 20 years of positive OE a more reliable indicator of future OE, than say 3 or 5 year record of positive OE? If it is, and I believe this to be the case, the COE model is a real valuable tool for security analysts. With the idea supporting this concept of a longer track record of positive OE being a superior indicator for future OE I decided to make a list of narrative reasons why it may be true. (Just a shoot from the hip mental exercise.)
1.) A strong corporate culture dedicated to OE is difficult and time consuming to build but is relatively easy to maintain. Thus a higher COE for an older company is justified, as the corporate culture of respect for OE is firmly in place, while the younger company’s is not.
2.) Shareholder fraud takes time to become visible, and is more likely to occur among young companies than established companies. Therefor the longer a company exists the more likely it is that shareholder fraud is not occurring. Furthermore, the longer a company exists the less likely it is to begin engaging in shareholder fraud. Again justifying a higher COE for the older company. (have some doubts if I believe this one)
3.) While it is impossible to predict future business conditions, similarities between the future and the past will no doubt exist. Therefor an older company should have more experience in dealing with differing business conditions than a younger company. Once again justifying a higher COE.
4.) Business is a social dynamic that transcends the bottom line. A company that has existed and performed well for two or more decades has built relationships with customers and within the industry that will aid it in ways which are significant yet difficult to quantify. The longer you’ve been around and doing well, the stronger those ties ought to be. Therefor the COE helps to quantify that nebulous value that comes with age.
5.) A long track record of positive earnings can be an important component of receiving credit and getting it at the optimal rate. When it comes time to go to the bank, a company with a five year record will no doubt be at a disadvantage when compared to a company with identical numbers but a 20 year track record. Thus giving a higher COE to an older company with proper justification.
Well, these are some of my thoughts shooting from the hip. I am sure some great arguments could be made that negate what I just wrote or at least severely mitigate it, but I would be interested to get your thoughts on the whole process. Is the idea of the COE model that a long track record of positive OE is a superior to a short track record of positive OE, as an indicator for possible future OE? If so why? and How do you use this information in your analysis? I see that you use it in conjunction with SIA but i'm not sure how you fit them together...is it a prerequisite, or weighted against other criteria in some way? Anyways, thanks again for time and openness. It is greatly appreciated. 20 Apr, 06:19 AM1
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