Monday, July 16, 2012

Float and Earnings

A fantastic post.
It covers the concept and practical application of 'floats'; floats are a liability which will ordinarily be rather long-term and/ or permanent in nature, and hence can be termed as quasi-equity but with a very low cost. Floats can be created by very special companies. 

The post also talks about how one of WB's investments used money from a float to fund the acquisition of See's Candies. Interestingly, the business had pre-tax earnings of less than USD 5 million and the acquisition price was USD 25 million; back then, WB said that the price was quite high relative to his original value investing philosophy. But if one reads the biography, Snowball, one could see how wonderful a business See's Candies was; he saw that the company would need very little incremental capital to expand operations. 
Pre-Tax Earnings in 2007 were USD 82 million. One could say, "That's not much, because it means that the business was able to increase earnings at about 8.3% p.a."
1. That is quite a bit, for a country that has had relatively low inflation for many many years.
2. That calculation is not correct.
Point number 2 stems from the meaning of the term 'earnings'. Real earnings comprises of money that can be taken out from an investment or a business; hence comes the concept of free cash flow! See's has used only USD 32 million in expanding the business in all those years. On the other hand, cumulative pre-tax earnings have totalled USD 1.35 billion odd. 
When analyzing investments, the ability to generate free cash flow for the equity shareholders is often overlooked in favour of PAT or Cash flow from operations.

Another wonderful example cited in the article is of Amex. Do read the story.
1964 - 5% of Amex for USD 13 Mn (+/-) (Possibly around USD 35 per share)
1968 - 5% of Amex sold for USD 33 Mn (+/-) (Possibly below USD 180 per share - something weird here...)
Possibly, he sold a lot of the stock on the way up to keep a 40% of portfolio limit
2004 - 10% of Amex bought for USD 1.4 Bn or 5% for USD 700 Mn

Seems like a big opportunity cost loss? No.
Between 1968 and 2004, the cost of 5% of Amex increased at 8.85% odd compounded p.a. Of course, I am simplifying a complex calculation, but the gist is that there are times when crazy profits are available on the table, and one should not be foolish to wait for a higher pop in the face of a reasonable valuation. One could argue that WB should have sold out of KO or may be he did the right thing by cashing in on the Petrochina trade.

All in all, a fantastic post by Sanjay Bakshi.

An addendum to this post - this excerpt from WB's letter to partners from 1967:
"Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess - I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a "high-probability insight". This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side - the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions."

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