Blog being terminated

For personal reasons I will no longer be posting to this blog.

Is the Company Strong? (Part 2)

     In Part 1 of this series, I discussed my first criteria in determining whether a company meets my “safety of principal” objective. I noted that such a company must meet my definition of "strong", and analyzed Pfizer (PFE) to determine whether it generates substantial free cash flow (fcf). After explaining why I believe it does, I ended the discussion by noting I would discuss "my analysis of the consistency of PFE's free cash flow in my next post." This is it.
    Applying my definition of fcf, here is the relevant info for determining its consistency:
Year     fcf/sh    3 yr moving avg fcf
2000    0.62      n/a
2001    1.14      n/a
2002    1.30     1.02
2003    1.30     1.24
2004    1.83     1.47
2005    1.65     1.59
2006    2.07     1.85
2007    1.63     1.78
2008    2.42     2.04
[2009   2.12     2.05]
From this I saw a few important things. First, during the time period covered (8 yrs) the company had positive fcf every year. Second, that even though it experienced two years (2005, 2007) in which the fcf/sh declined from the previous year, its fcf over a 3 year moving avg did not decline, except in 2007. Third, in 2008 (its most recent year at the time I decided to buy -- Dec, 2009) fcf/sh was the highest in its history. All of these facts reveal the company's fcf to be consistent, and with only one exception (2007) it has had a consistently growing 3 yr moving avg fcf/sh. This led me to conclude that PFE's fcf/sh was consistent.
     [It is interesting to note that in 2009 (PFE acquired Wyeth in Oct 2009) fcf/sh declined to 2.12; but, (1) that was still the 2nd highest in its history, and (2) it exceeded the 3 yr moving avg for fcf/sh. Of course, that was information I didn't have at the time I made my decision.]
    My third post in the "Is the company strong?" series will discuss why I concluded PFE met my second criteria --  a solid balance sheet.

PFE Report (03/21/2010)

     I currently hold 475 shs of Pfizer (PFE). This holding is a foundation of my options investment portfolio. 75 of the shares are being held for the purpose of participating in any significant appreciation of the stock price over time. The bulk of the postion (the remaining 400 shares) are used as underlying for covered calls or for use in writing cash secured puts.
    I initiated my position on 10/19/09, selling two csp. The share price of PFE has been declining since it reached its 52 week high of 20.36 on 1/20/10. I have paid an average of $18.04/sh (no adjustment for premiums/dividends rec'd), 11.39% below the high. After factoring in premiums/dividends, my break-even price is 17.36 (14.73% below the high). Here is my position history, followed by some comparitive returns:

10/21/09 STO 2 PFE Nov09 17.0p @ 0.2325 net
11/19/09 Bought 75 PFE @ 18.14 net = $1360.50
11/21/09 Nov09 puts EXPIRED
11/24/09 STO 2 PFE Dec 09 18.0p @ 0.2425 net
12/19/09 Dec09 puts EXPIRED
12/21/09 STO 2 PFE Feb10 18.0p @ 0.4925 net
2/3/10 x-div = $13.50
2/8/10 Bought 200 PFE @ 18.04 net = $3608.00
2/8/10 STO 2 PFE Mar10 18.0c @ 0.6625 net
2/20/10 Feb10 puts ASSIGNED
2/20/10 200 PFE accepted @ 18.05 net = $3610.00
3/20/10 Mar10 calls EXPIRED

RESULTS THRU 3/20/10
Total cap invested = $8578.50
Net options income = $305.92 [+14.40% AROIC; Goal is +7.5%]
Net div. earned = 13.50 [+0.63% AROIC; Goal is +2.5%]
Total net income = $319.42 [+15.03% AROIC; Goal is +10.0%]
Unrealized cap gain = (507.25) [-23.87% AROIC; Goal is +5.0%]
Total net = ($187.83) [-8.83% AROIC; Goal is +15.0%]

COMPARATIVE RETURNS SINCE INCEPTION
MY PFE position: -8.83%/yr
Buy and Hold w/o options: -23.23%/yr
SPY Index: +14.44%/yr

     As can be seen, based on market value as of the close on 3/19/10, the value of my position is significantly above a straight buy-and-hold position, while significantly below the return of the SPY index over the same holding period.

Is the Company Strong?

Is the Company Strong? (Part I)

     As set forth in my First Things First (no3), my first criteria in determining whether a company meets my “safety of principal” objective is whether it is strong, that is whether it (1) consistently generates substantial free cash flow, (2) has a solid balance sheet, and (3) is growing (even if slowly). I now want to share how I approached the first of these issues in looking at Pfizer (PFE).
     Substantial Free Cash Flow. The first “down and dirty” I looked at was the “cash yield” Pfizer was offering at the time (Oct 2009). I determined that by using the following formula:

free cash flow/market capitalization

This approach treats the stock in a manner similar to a bond. A bond’s current yield is determined by dividing its coupon (the interest payment) by its face value. Thus, a bond selling at $1,000 with a coupon payment of $100/yr, is yielding 10%.

     First, here is how I calculate free cash flow:

cash from operations - 3-yr avg of capital expenditures = free cash flow

Applying the formula to Pfizer for the year 2008 (the then most current year available), here is what I got:

$18.238bn-$1.877bn = $16.361bn in free cash flow. With 6.76bn shares outstanding, each share of stock was generating $2.42 in free cash flow to its owner.

     I sold my first csp on PFE on 10/21/2009. It was the Nov09 17.0 strike. Since free cash flow is the money belonging to the shareholders after all expenses have been paid, I reasoned that if PFE were a bond, my current cash yield would be 14.23%/yr (2.42/17.00). Pretty impressive when the 10-yr Treasury is yielding 3.7%, and cash in the bank is yielding nothing!

    Another way to look at the situation is to answer this question: “What would be the market value of a bond if its 3.7% yield equalled $2.42 interest/year? The answer: $65.40 ($2.42/3.7%). So, if put to me, I would be paying $17.00 for a “bond” worth $65.40 based on its current yield. But, as we know from my post, I am looking to earn 7.5%/annum from dividends and capital appreciation (both of which are ultimately determined by free cash flow). Using 7.5% as my minimal acceptable yield, then the PFE bond yielding $2.42 is worth $32.26 (2.42/7.5%). Thus, I was able to conclude that the current yield on PFE justified paying a price of $32.26, yet I would only need to pay $17.00 if the stock was put to me.

     Clearly PFE met my first test of “generates substantial free cash flow,” therefore, further analysis was justified. I will discuss my analysis of the consistency of PFE's free cash flow in my next post.

First Things First (no. 3): My Goal and Objectives

My goal is to establish what Benjamin Graham termed a successful “investment operation.” He identified two objectives necessary to such an operation: (1) safety of principal; and (2) an adequate return.

1. Safety of Principal. How do I intend to accomplish this objective in a market atmosphere, where one’s invested principal is always at risk? I will seek to buy only the stocks of strong companies at prices no greater than their fair price.
     A. Strong Companies: those that consistently generate substantial free cash flow which is growing on a per share basis, and have solid balance sheets.
     B. Fair Price: companies selling at or below the discounted value of their expected future cash flows. (This is called the “discounted cash flow” or “DCF” model.)

2. Adequate Return – what it means and how I intend to attain it.
     A. Meaning: a return that will double my portfolio net worth every five years, assuming no further contributions to net invested capital. This requires an annualized compounded rate return of 14.87% – call it 15.00% per annum.
     B. Attainability: Is such a return reasonably obtainable given the safety of principal objective? History suggests that it is – if I employ three sources of returns: (1) dividends; (2) capital gains; and (3) premiums from covered call/cash secured put options.
     If stocks I select provide (1) a dividend yield of at least 2.5% per year, (2) provide an average captial gain of 5% per year, and (3) have call/put options available that generate premiums of 7.5% per year, then the objective will be attained (2.5+5.0+7.5=15.0). All of those benchmarks are well within historical experience.
     Finally, there have been other investors who have consistently generated returns well in excess of 15% per annum over multiple year time periods. These include Walter J. Schloss (+21.3%); Tweedy, Browne, Inc. (+20.0%); Warren Buffett (+29.5%); Sequoia Fund (+18.2%); Charlie Munger (+19.8%); Pacific Partners (+32.9%); and Peter Lynch (Fidelity Magellan Fund)(+29.0%). Yes, I know they are/were extraordinary men with incredible ability/luck; but, the mere fact that they exceeded my 15%/annum objective demonstrates it is attainable.
 
This goal, and the objectives necessary to its accomplishment, will be both the guide for my actions and the measure of my success; which will be posted here for all to see.

First Things First No. 2: Patience

After discipline, the second element of First Things is Patience.

I doubt there is a single episode of any business program on television that doesn't have at least one guru advising the members of its audience to do something NOW .... buy this NOW or .... sell that NOW .... or at a minimum get into the market NOW! It appears that had there been three stone tablets handed to Moses on Mt. Sinai, the Eleventh Commandment would have read "Thou shall not miss the next market move!" I don't doubt that in the Fall of 2007, when the Dow was at its highest, many a broker was on the phone to his clients asserting that the Dow was heading to 20,000 and if the client didn't act "NOW" he/she was going to miss the greatest buying opportunity of their lifetimes. How did that work out?

If you are fortunate enough to have any money available to invest, you must have the patience to sit on it until (1) you have developed your investment plan, and (2) opportunities present themselves that are consistent with your plan. Yes, it is extremely difficult to resist the urge to sit in front of the computer the first thing in the morning, gulp your coffee, and begin clicking that mouse on the buy/sell button. But you simply must not act rashly or prematurely, for therein lies the road to ruin.

Not only must you be patient, waiting for that first opportunity to present itself; you must also have the patience to wait for the next one -- which may not come for some time. Investing is not the place for eagerness, it is a place for calm analysis and judicious decision-making. A big part of successful investing is avoiding unforced errors, mistakes resulting simply because we were unable to control our emotional need to act.

Warren Buffett declared that Benjamin Graham's extraordinary book The Intelligent Investor, is "by far the best book on investing ever written." In it Graham wrote: "... the investor's chief problem -- and even his worst enemy -- is likely to be himself." (2006 revised edn., p. 8.) In his "Commentary on the Introduction" appearing in that same edition, Jason Zweig asked "What exactly does Graham mean by an 'intelligent' investor?" Zweig then notes that the kind of intelligence Graham was referring to "has nothing to do with IQ or SAT scores. It simply means being patient, disciplined, and eager to learn; you must also be able to harness your emotions and think for yourself." (ibid, p.13. -- my emphasis.)

First Things First No.1: Discipline

Based on my more than five decades of life I have concluded that the most important attribute to success in any human endeavor is discipline. It seems to me that history demonstrates that whatever serious activity humans pursue, their chances of success are greatly reduced -- and often destroyed -- by a lack of discipline; and since investing is a serious human activity, it is no different.

Many a wonderful plan has been considered a failure when, in truth, the plan was fine; but, those responsible for implementing it weren't disciplined enough to see it through. The lack of discipline makes us easier prey to outside forces that seek to influence us, that tempt us to deviate from our plan. And once pulled away, we are left to stumble about, dispersing our time, focus, and energy to such a degree that we cannot progress towards success.

In the world of investing we see this all of the time. We are constantly confronted by experts and gurus who claim to have the key to making investors rich. Sometimes their motives are pecuniary; they are hoping to sell us something (their plan perhaps?). Other times their motives are much more benign; they honestly believe our plan is badly flawed and hope to save us from ourselves.

Successful investing presents many challenges and temptations, especially during times of uncertainty. During those times we all tend to be more susceptible to our emotions, and the blandishments of those who believe our plan is "too risky", "not risky enough," "too rigid," "too flexible," etc. The most formidable armor we can wear to protect us in the investment battles to come is the discipline to stay focused on our plan and its implementation.