So far in this series we have looked at a number of investment issues. However, none of the letters discussed company-specific issues. From now on we will concentrate on a specific company and whether it is suitable for investment. When choosing a company in which to invest your hard-earned cash, you are well advised to be as thoughtful as when you are considering a marriage proposal. Marriage and equity investments - now there?s an interesting comparison. Here are some thoughts on that comparison.

It was George Bernard Shaw who wrote, ?Marriage is popular because it combines the maximum of temptation with the maximum of opportunity?. I think equity investment becomes overly popular at least once a decade because it combines the maximum of greed with the maximum of easy money. This is both a potent and deadly combination.

Unfortunately, most people experience equity markets as they do marriage. It is either a long and happy relationship or one with a brief euphoric high and a sudden, sickening low. In this context the markets can be compared to St Aldegonde, of whom Benjamin Disreali wrote, ?St Aldegonde had a taste for marriages and public executions.?

Enron, WorldCom, Global Crossing and the like reminded us that the dressing up of earnings is alive and well in corporate America, as well as in the rest of the world. If only companies spent as much time and energy in actually producing income as they did in manufacturing earnings! Come to think of it, we lost an enormous amount of exceptionally creative people when Enron went under ? they ?created? earnings in incredibly novel and ingenious ways. Perhaps they should go into advertising. Jonathan Swift found that similar dressing up happened in marriage and explained it like this, ?The reason why so few marriages are happy is because young ladies spend their time in making nets, not in making cages?.

Still in the context of Enron and, particularly, corporate excesses:

'Judges (CEO?s), as a class, display, in the matter of arranging alimony, that reckless generosity that is found only in men who are giving away somebody else?s cash.' -P.G Wodehouse

This week a friend of was interested in purchasing a particular stock because the analysts said blah, blah, blah ? and the technical indicators said blah, blah, blah. He felt the market was going to be going up the next day because blah, blah, blah. He wanted my advice and asked that I should please get back to him that evening, because he wished to get up early the next day to put in an order for the stock. I told him to forget about the stock and about investing in the market altogether. His behaviour indicated to me that he was bound to lose a lot of money in the markets. Not only that, but he was also going to waste a lot of energy in doing so and, by the looks of it, miss out on many hours of precious sleep. Sam Weller, in Dickens? Pickwick Papers, said to Samivel, ?Wen you?re a married man, Samivel, you?ll understand a good many things as you don?t understand now; but vether it?s worth while going through so much to learn so little, as the charity boy said ven he got to the end of the alphabet, is a matter o? taste.? Losses don?t taste too good man! My advice to my aspirant investor friend was the same as Punch?s back in 1845, ?Advice to persons about to marry - don?t!? Or maybe my advice to the guy above should?ve been what Iris Murdoch said, ?Investing (he actually said writing) is like getting married. One should never commit oneself until one is amazed at one?s luck? So, despite all the above advice to the contrary, we are still going to enter into corporate marriage, right? Right. As long as we understand that we will have to tread very carefully.

Remember, one only looks at companies that are available at a rational price because even the best company is a bad investment at the wrong price. The first thing I look at when considering a particular company is the return on equity. Investors (in their capacity as shareholders) give money to a company with which the company can do business and, hopefully, earn an acceptable return on. It is no different from putting your money in a savings account or buying a bond. In all investment you give someone your money and they need to return it to you in a series of cash flows (capital and interest). You can buy a bond, shares in a company or deposit money in a savings account and earn coupon interest, annual net income (dividends) or monthly interest payments, respectively.

With a bond or a savings account the yield is clear and this is what the markets concentrate on. However, in the case of equities current wisdom dictates that the market concentrates on earnings per share. In the terminology of a savings account, they only look at the coupon or interest payments, and not at the underlying capital amount. It equates to somebody who tells me I must invest with him or her because they made a million bucks last year. So what! Give me a hundred million - I?ll blow a couple of million, leave the rest in the bank and still make a million. The point is that earnings only mean something to me if I know how much cash (capital) you had to employ to make that million.

So, the first thing in judging the quality of a company is an examination of the whole picture, in order to determine the quality of its earnings. I look at the return on equity (ROE). As an investor I want to know what the company did in previous year(s) with the money I gave it. Was it at least able to cover its cost of capital? If a company has a good track record of earning an above average return on its capital/ equity then the odds are good that it will also be able to do so for me in future. Promises count for very little in this business. Show me your track record. This rule alone should have kept you away from the dot.bombs because they never had any returns to speak of.

When we look at return on equity we obviously have a numerator and denominator. For the denominator (equity) one has to make a couple of adjustments. Firstly, the marketable securities (i.e. equity holdings) have to be marked to cost. The fluctuation in value of the stock on equity markets will distort the true picture. The change in values cannot be ignored, but by keeping the values consistent you will get a better picture of return on equity. Historical goodwill is another thing you have to look out for. Previously companies were allowed to write off accounting goodwill against shareholders equity. If I didn?t go looking for this in the footnotes I would surely miss it. There are many companies that have written off substantial amounts, which have to be counted back. You will be surprised how many companies out there have return on equity figures of 30% and more, but once you count back the goodwill they drop to 15% or even less.

When it comes to the numerator (return) you want to use operating earnings, because you are interested in the operating performance of the company. Taxes and the amount of leverage (interest payments) will distort the true picture if you use net income as your nominator. Obviously, you cannot ignore the net income figure, but it is the operating performance we are interested in for the purpose of determining ROE. If I am satisfied with the operating return on equity I then look at the amount of leverage and the role that taxes play. Taxes are usually a non-issue because most companies are taxed at the same rate. Leverage beefs up return on equity, especially in low interest rate environments, such as we are currently experiencing in the US. Simply put, I don?t like leverage. Life is much less complicated without debt. This holds true in the case of personal finances, as well as in the finances of the companies. Stay debt free!

I prefer a return on equity of 20% and higher, but I will go as low as 15%. Anything above 10% can pass because this is approximately the cost of capital. However, I am only interested in above average companies - and so should you be!

Whatever you are up to, I hope it is profitable and ethical.

Mr. B

mail_mrb@yahoo.com

Posted: 2002/10/28 08:57 View Archive