The article states that the occupiers’ chief complaint is “that business is falling short of its social responsibility.”  To summarize the current drumbeat (pun intended), capitalism no longer works.

So, is capitalism dead and Mr. Friedman just an interesting guy from a previous generation?  Only if you believe that principles become outdated!

In his hugely successful book The 7 Habits of Highly Effective People, Stephen Covey describes principles as “natural laws in the human dimension that are just as real, just as unchanging and unarguably ‘there’ as laws such as gravity are in the physical dimension.”  He goes on to say that “principles are deep fundamental truths that have universal application.”  Thus, if you can change them, then they weren’t principles to begin with.  If they are principles, then they have been proven useful in many applications.  For example, every major world religion has its own version of the Golden Rule.

Schultz’s reference to Milton Friedman expresses one of the principles outlined in Adam Smith’s magnum opus, The Wealth of Nations.  Basically, Mr. Friedman was saying that, if corporations indulge in supporting social causes, it will lead to inefficient markets.  For an example of this, we need look no further than the recent mortgage market meltdown.

The capitalism that made the U.S. economy the envy of the world is based on The Wealth of Nations, which was written in 1776.  It is certainly old, but the principles described in its pages were not invented by Adam Smith; he simply codified them so that others could understand.  It is interesting that Smith doesn’t use the term capitalism in his book.  He talks about a “system of natural liberty.”  In the past 235 years, many have understood this system and, if they followed it, they were rewarded with usefulness.

I realize that it is difficult to understand the everlasting nature of a principle.  Principles don’t lend themselves well to sound bites suitable for newspaper articles.  Typically, the importance of a principle is better understood through examples.  Here are a few that I believe will sound familiar: “We hold these truths to be self-evident”; “I have a dream”; “Slow and steady wins the race;” and, in my industry, “Don’t put all of your eggs in one basket”—a.k.a. diversification.

Can you imagine any of these principles being described as “old-school”?  Go ahead and try to argue against any one of them.  You will feel silly within a couple of sentences.

Now argue against free-market capitalism, but try it without the ad hominem attacks or the marketing spin.  First, you would have to overcome another statement typically attributed to Milton Friedman.  I will respectfully paraphrase his statement as follows: Throughout history, the only time a large percentage of a population has been lifted up economically, it has been under a form of free-market capitalism.  Thus, begin your argument against capitalism by citing a historical case in which a socialist, Marxist, progressive system has economically lifted up a middle class.  Just one example.

You see, stating that capitalism is not perfect or fair or socially responsible is an ad hominem attack.  It is a rant against capitalism without addressing the real question.  What has proven more useful than capitalism?

Above, I used one of Aesop’s fables, “The Tortoise and the Hare,” as an example of the timelessness of a principle.  Before destroying capitalism, I suggest the Occupy Wall Street group—and their sympathizers—review another 2,500-year-old fable by the blind Greek slave, “The Goose That Laid the Golden Eggs.”

Why did BofA’s stock price go up?  People say the stock jumped because the Oracle of Omaha has put his stamp of approval on the company and its management.  Really?  If I am correct and Mr. Buffett got a favorable deal, then BofA effectively did the deal to get Mr. Buffett as their new pitchman.  Remember, BofA had already said they had enough capital to weather this storm. 

Warren Buffett’s company, Berkshire Hathaway, purchased “cumulative perpetual” preferred stock from BofA and also received warrants to buy their common stock at $7.14 a share.  “Cumulative perpetual” being the key words, showing this was a fixed-income investment.  Cumulative preferred stock does not qualify as Tier 1 common capital, the important regulatory capital gauge.  In the simplest of terms that says that this deal goes on BofA’s balance sheet as debt, not equity.  Hence my statement above that Mr. Buffett made a fixed-income investment.

So why did Mr. Buffett do the deal?  It’s an interesting question, considering that unlike the Goldman Sachs and GE deals during the 2008 meltdown, this time Mr. Buffett called BofA.

My guess is Mr. Buffett has learned that when he does one of these deals the bipolar Mr. Market drives the stock price up in a knee-jerk reaction.  So he effectively got paid $3 billion for buying $5 billion of preferred stock; $3 billion being the lowest estimated value of the warrants I have found.

In the investment world, it’s nice to be Warren Buffett!  But please do not confuse buying “BAC” in your personal account with the deal struck between Mr. Buffett and BofA.

Mr. Buffett’s Secretary

Warren Buffett can only hope his secretary does not read the Wall Street Journal.  Their editorial yesterday morning, “Buffett’s Latest Tax Break,” points out that his fixed-income investment in BofA will have an effective tax rate of only 10.5%, which is even farther below what his secretary paid.  The editorial stated the reason for that low rate is because “corporations can exclude from taxation 70% of the dividends they receive from an investment in another corporation.”  The editors did point out that Mr. Buffett’s tax break is justified because dividends are normally double taxed, but would be triple taxed if they go from corporation to corporation to an individual.

But I’m sure his secretary will understand that his own editorial in The New York Times on August 14th was only addressing the difference in their personal effective tax rates.  She is obviously free to start her own corporation to take advantage of the different tax rates on different types of income. 

Oh wait, Mr. Buffett forgot to mention in his editorial that there are logical reasons for different tax rates on different types of income built into the tax code.  Or, maybe he believes logic only applies to corporate taxes and not individual taxes?

No, he must understand the same logic applies to personal and corporate rates.  If he didn’t he would have also demanded we stop “coddling” the retired people whose effective tax rate is even lower than his secretary’s because they are living off of the income they received from tax-free municipal bonds.

Come on, do you really believe the Oracle of Omaha doesn’t know the logical reasons for the different tax rates on his different types of income that result in his low personal effective rate of 17.4%?  It must have slipped his mind when he quickly penned his two-and-a-half-page editorial comment.

After all, Warren Buffett learned about logic from the same guy he learned about Mr. Market.

Value investing is based on Benjamin Graham’s work on the principles of investing and investor behavior.  I hope that that this posting will help you understand how Gracor applies those principles.

Value Investing vs. Bargain Hunting

It has become fashionable for professional value investors to say that their style is to buy great businesses for 60 cents on the dollar.  Really?  Granted, this is a marketing statement and not a white paper on the subject, but I believe it is important for you to understand what is missing from this statement.

The missing part is why you are able to buy at such a significant discount?  Remember, it is not true that the market randomly coughs up a dollar bill for 60 cents.  To get a significant discount, something negative, and typically unforeseen, must occur to scare the market into overreacting.

Before buying such a bargain—even before in-depth valuation analysis—value investors should do the following two things.  First, they must understand the nature of the negative event.  Second, regardless of the nastiness of the event, they must ensure that the company has the financial and managerial resources to make it through.

What good is the most elegant spreadsheet on the company’s future valuation if it doesn’t recover?  As Benjamin Graham put it in his book, The Intelligent Investor, it is not as important for the buyer to be enthusiastic over the company’s long-run prospects as it is for him or her to be “reasonably confident that the enterprise will get along.”

Telefonica vs. Spain

Telefonica’s negative event was the European debt crisis, with Greece being the spark that led to concerns about other European countries, such as Portugal, Ireland, and Spain (hence the rather pejorative acronym, P.I.G.S.)—and, more recently, Italy and France.

To provide a little perspective, since the beginning of this debt crisis the Spanish market has dropped 25%, underperforming the S&P 500 by 37%.  Telefonica is Spain’s largest company according to market value, so it has a 20% weighting in Spain’s IBEX-35 stock market index.  Thus, it is no surprise that Telefonica’s performance has matched the terrible performance of the Spanish market during the debt crisis.

But what if I told you that Telefonica was only one-third Spanish?  If this is true, then perhaps a valid initial hypothesis would be that a matching -37% relative performance is an overreaction by the market.  Remember, it is not a bargain if the market corrected properly; it is only a value stock if there has been an overreaction.

Hypothesis Support

As of the end of 2010, approximately two-thirds of Telefonica’s revenues and operating profit came from outside of Spain.  Admit it: doesn’t that surprise you?

Telefonica is well known for its presence in Latin America, which accounts for approximately 42% of the company’s revenues and 53% of its operating profit.  In Latin America, it has leading positions in Brazil, Argentina, Chile, and Peru.  It also has operations in Colombia, Ecuador, El Salvador, Guatemala, Mexico, Nicaragua, and a few others.

Not as well known is the company’s presence in Europe (not including Spain), which accounts for approximately 25% of its revenue and 14% of its operating profits.  It has good footprints in the U.K., Germany, Ireland, and the Czech Republic.

This is the data that led me to my hypothesis.

“Get Along” Analysis (Liquidity and Rollover Risks)

To determine whether a big company in an important industry can make it through a negative event, you need to look at the company’s financial statements through the lens of a credit analysis.  The point of this exercise is to determine whether Telefonica, in light of the current negative event, still has the financial flexibility to absorb another unforeseen negative event.

Please, this has nothing to do with the current brouhaha regarding the rating agencies and the U.S. downgrade.  This is just nerdy debt and liquidity analysis.  I will try to keep it pithy.

My analysis shows that Telefonica’s liquidity (cash and cash equivalents) is sufficient to cover debt maturities, capital expenditures, and dividends for at least the rest of this year and probably well into next year.  Additionally, it has double that amount in unused committed credit lines, which are not subject to material adverse changes or financial covenants.  And yes, that is all net of its acquisition of PT’s stake in Vivo last year.

Telefonica’s rollover risk appears low, considering how debt maturities were dealt with during 2010.  Telefonica did a number of transactions in capital markets to cover debt maturities through 2011, so the remaining debt maturities through 2012 are clearly covered through expected cash flow generation even if the capital markets seize up.

After this analysis, I am comfortable saying that even if the European debt crisis worsens, Telefonica has the capacity to deal with the rising costs.

Obviously, none of this matters much if management makes a dumb acquisition.  In 2006, they did have trouble with a debt-financed acquisition, but the recovery has gone well and management’s current statements don’t lead me to believe that they will make this mistake again anytime soon.

Valuation via Benjamin Graham’s Two-Part Appraisal Process

• First part of the two-part appraisal process

The first part of the appraisal is what Graham calls “past performance value,” which means mechanically basing the valuation on the company’s past record and assuming that relative growth for the intermediate past will continue in the future.  Is it no trickier than applying a P/E to earnings?  Not exactly.

First, historical accounting information must be scrubbed (my word).  Or, as an old green-shade accountant would tell you, the devil is in the footnotes.  Database subscriptions today make it easy to download decades of financial statements, but they might not tell you when a company switched over to IAS GAAP, the short-term effect of exceptional charges, new management’s kitchen-sink quarter, or one country’s legacy thinking about goodwill and its effect on ROE.

To oversimplify this scrubbing process, an experienced eye needs to review the financial history for odd-looking data.  Sometimes you find shenanigans, but most of the time it’s Modifying Conventions within the accounting.  Either way, the nails that stick out need to be hammered down.

Next, I will discuss the more mechanical application of a P/E to earnings.

For the P/E, I looked at the data available for the 20 years before the 2008 global meltdown.  Telefonica was trading in a P/E range from a low of 10 to a high of 22 (excluding the nutty Tech Bubble period).  Since the meltdown, it has broken below that floor and traded between 8 and 9 times earnings three times.  For this central value exercise, I decided on a P/E of 15-16.

For the company’s earnings, I averaged the EPS for the past four years and got $2.50.  Remembering this is the mechanical part, but more on this $2.50 later.

Applying a 15 P/E to that EPS, I got a value of $37.50, and $40.00 with the 16 P/E.  Lo and behold, the $37.50 valuation is right in the middle of a long-term chart of the stock’s trading range (I like congruency).  Interestingly, the highest price Gracor paid for Telefonica was $21.36, a 43% discount on the $37.50 valuation. 

• Second part of the two-part appraisal process

The second part of the appraisal is where knowledge and experience are applied to decide whether modifications should be made to the above valuation due to new conditions that are expected in the future.  Right away, I focused on growth, margins, and—the biggie for Telefonica—technology risk.

In order to get right to the technology risk, let me just say that the first two factors are standard congruency checks.  Is the growth congruent with the P/E multiples?  Are the margins congruent with the EPS used?  If the margins are on the high side, then the earnings need to be normalized.  Have the growth and margins affected each other in an unsustainable way that needs to be normalized?

There is a specific issue in the equity account of Telefonica that I have worked with for at least a decade.  It has to do with Spanish managers’ (CEOs, CFOs, etc.) long-held desire to be conservative regarding goodwill on their balance sheets.  At this time, I don’t believe this has a material impact on the valuation.

• Technology risk

Technology risk is the biggie for all telecom companies, and Telefonica is no different.  This risk can be defined as the differences between legacy depreciation charges imbedded in the financial statements and the reality of future capital expenditures (capex).  It is certainly not a new risk, but it is the biggie and has been for at least a decade.

A simple example that’s closer to home is Verizon’s decision to lay fiber to every home (FIOS).  If cheaper wireless broadband technology develops during Verizon’s depreciation time frame, then Verizon will have wasted a lot of capex.

There are two factors critical to the assumptions regarding technology risk: next generation fixed networks and broadband-enhanced mobile.  In terms of fixed networks, around the world, copper is still king.  The move toward fiber will be necessary to remain competitive, and fiber is capital-intensive.  In terms of mobile, it’s all about fourth generation wireless standards, or 4G (also known as LTE, long-term evolution).

Moody’s has done good work on this “capex” issue for the telecommunications service providers.  Its findings show that growth pushed by smartphones, etc., will increase the capex/revenue ratio up from the current average of 15% to 18% in the next three to five years.  Remember, the profitability of that investment is the second issue; the first issue is who has the capital to invest.  Moody’s also stated that it found that a majority of the companies in this industry have little room in their rating categories for debt-financed capex growth.

Telefonica is different.  It not only has the financial capacity for the upcoming increase, it has also been able to achieve better growth than its peers with below average spending.  Its capex/revenue has been approximately 1% below the industry average.

Stop!

A fundamental principle of Benjamin Graham’s work on value investing is that no one can predict the future, but we can protect against it.  Predicting the efficacy of the future capex/revenue spending of an industry exposed to this much technology is folly.  There is a much greater chance of falling victim to a self-deceptive overconfidence bias than there is that we will get usefully precise numbers!

• Protection against the future in this valuation

First, the above “get along” analysis tells us that the company has the financial flexibility to compete against its rivals if more capital investing is necessary.  Second, I have used a conservative average EPS for the last four years: $2.50.  Considering both the company’s growth in revenues per share during that period and its recent acquisitions, I could build a pro forma case for a bigger number.  The important point is not to get excited and pay up for prospects and promises of the future.  Third, the P/E of 15-16 that was used is a long-term average P/E for the market in general.  Considering the growth prospects for the industry and the majority of Telefonica’s markets, it could be argued that this is a conservative P/E.

Finally, and most importantly, the protection against the future lies in the size of margin of safety.  To put it differently, buying a dollar bill for 60 cents is a huge margin of safety for a company of this size and scale that is in an important and growing industry, has a good operating track record, and possesses its current financial strength and liquidity.

Conclusion

Benjamin Graham never said that one should only buy with a 40% margin of safety (60 cents on the dollar).  Rather, this was a metaphor used by Warren Buffett in his 1984 speech, “The Superinvestors of Graham-and-Doddsville.”

The closest Benjamin Graham came to this was when he spoke about buying secondary companies with an “indicated value of at least 50% more than the price.”  Mathematically turned on its head, this would be a 33% margin of safety or 67 cents on the dollar.

Telefonica is no secondary company, and we still bought it at a price better than the metaphorically-mixed-up “60 cents on the dollar.”

Truthfully, I don’t believe Benjamin Graham would demand that big a margin of safety for Telefonica.  But Mr. Market was offering, so I took it.

Postscript Warning on Dividend Yield

Telefonica’s dividend yield is eye-popping and misleading.  At the very least, Spain’s 19% foreign withholding tax cuts it down substantially.  That tax is withheld at the source and, from what I have read, it is very tricky to recover.  Please consult with a tax adviser!  Additionally, the dividend yield to you will be affected by the euro/dollar exchange rate.

Benjamin Graham on Market Volatility

Wild market volatility in the last couple of weeks has noticeably enhanced investor emotions.  So I thought it timely to review Benjamin Graham’s view on market volatility, especially as it pertains to “true” investors.  Remembering that, from Graham’s point of view, a “true” investor is one who is prepared not just financially, but emotionally, so that they can not be “stampeded” out of their allocations.

First of all, no one wants to see their investments drop 15 to 20% in a short period.  Certainly, I don’t enjoy my personal net worth dropping that fast.  But those are emotional statements and, although we can not stop ourselves from having emotional reactions, it is critical that we don’t let those emotions drive our investment process.

Second, from the bloodless perspective of logic, this kind of volatility is our friend!  If we are prepared financially for market gyrations, meaning our time horizon is that of a business owner and not a Wall Streeter, then these are opportunities to snatch up companies we want to own over the next five to seven years at significant discounts.  However, it doesn’t mean we always will buy – but it is to our advantage to have these opportunities.

Just yesterday, I saw a headline in SmartMoney.com that read “Why the Stock Market Has Turned Bipolar.”  Sorry, the truth is the market has always been bipolar and it is sound thinking to assume it always will be.

This manic-depressive disorder is precisely what Benjamin Graham was talking about in his famous Mr. Market parable.  Knowing that Mr. Market is bipolar encourages you to do business with him only when it suits your needs.  Summarizing the principle at the end of his parable, Graham said, “At other times he [the investor] will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”  The last part is what I do for you.

So, when the talking heads in the media use their inflammatory language and your gut starts screaming at you, remember your plan and process.  If I were allowed to channel Graham for a moment, I believe he would tell you today that Mr. Market is to be pitied and not followed.

For more on Benjamin Graham’s Mr. Market parable and what it means to be a true investor, see chapter 8 in The Intelligent Investor 1973.  I promise you it’s a good read even if you haven’t read anything else by Graham (for you purists, that would be chapter II in the 1949 version). 

Are We Evil for Owning Oil Companies?

Wow, I didn’t know I was evil for buying Exxon and BP for Gracor portfolios.  But after watching the Senate hearing with the big 5 oil companies, I came away feeling, at a minimum, “greedy.”  However, Benjamin Graham teaches us that true investing is not about feelings, so I took a look at the details of the accusations.

The accusations appear to be centered around “tax breaks,” “loopholes,” and “subsidies.”  The implications appear to be that the oil companies get something special that no one else gets or that they got these benefits by less than fair dealings.  Unfortunately, the accusers are not forthcoming with specifics.

Having studied this industry since the mid 1980s I was fairly sure that oil companies didn’t enjoy any enriching government mandates – certainly none that rise above the materiality threshold.  Also, the most recent information I have read indicates that the industry pays an effective tax rate of 48.4% versus 28.1% for all other S&P industries.

If the government really wanted to ease our burden at the pumps, my alternative target would be to correct the Federal Reserve’s weak dollar policy, which has sent prices for commodities prices like oil soaring.

But the point of this exercise is to ensure we are not being evil, so I will focus on the accusations.  I hope this can be a resource to you while the political show continues.

Tax breaks

Here at least the accusers mentioned some specifics like depletion allowance, intangible drilling costs, the Energy Policy Act of 2005, and the Manufacturing tax credit.  The first two are routine accounting issues!  The second two are congressional acts.  Let’s look briefly at each.

Depletion is a term used in accounting by which costs of natural resources (a wasting asset) are allocated to match them with the revenues they generate.  Depletion expenses are also a big factor in the mining and timber industries.  This expense falls under the matching principle of accounting and is very similar to the deprecation expense for other assets.  Expenses are deducted from revenues to determine profit, which in our tax system is what is taxed.  Technically, depletion has been in the our tax code since 1926, and the matching principle is one of the corner stone principles of accounting dating back to the days of Pacioli (Summa… published 1494).  Therefore, my decision is that the use of depletion expenses are legitimate tax expenses and NOT evil.

Intangible drilling costs are a confusing because the word “intangible” is not used properly.  These are costs for developing a well before actually operating it.  Included costs are labor, survey work, supplies, taxes, power, and equipment rentals, all of which are quite real, but they are classified as intangible because they have no salvage value.  Accounting for these costs is governed primarily by the timeless accounting principle of asset/liability measurement, and again, are handled in the same way plant assets are.

The tax code, however, does allow the exercise of some judgment in deciding if the costs should be immediately expensed or capitalized and matched with revenues over time.  The accusers could probably argue against the expensing method, but it should be noted that these are deductions have been in the tax code since 1913.  My verdict is they are defiantly not evil deductions, although some debate on fine tuning the ability to use judgment might be possible.

P.S.– before anyone jumps on the word “judgment,” let me state that judgment is part of the modifying conventions in The accounting theory model – and has been forever.  Between theory and practice, people must make judgment calls (accountants and management).  Modifying conventions help resolve these questions.

Energy Policy Act of 2005. I used my super-secret-Wall-Street connections (Wikipedia) to read the actual law signed by President Bush.  Not really fun reading, but it only took me five minutes to determine that at least 81% of all the “tax reductions” went to competitors of the oil companies: advanced nuclear reactors, wind, wave, tidal power, geothermal, clean coal, alternative motor vehicles, bio-fuels, and government agencies for renewable energy projects.  The rest went to the oil companies for some sort of ethanol blending.

This was anything but a partisan, this act of Congress!  The final vote was 64% in favor in the House and 74% in the Senate.  Perhaps most importantly to my worry about being evil is the fact that the then-senator from Illinois, Barrack Obama, voted for the act.  My verdict?  For no other reasons than those in this last paragraph, I find the accusations hurled at the oil companies relating to the Energy Policy Act of 2005 silly!  It’s certainly not clear that what the oil companies got from this act was material, and if Congress wants to take away what they gave, so be it.  But accusations of greed and evil?

Manufacturing tax credit.  This is the silliest of the accusations against the oil companies.  This came from Congress in 2004 as a way of improving the economy.  The definition of manufacturer is so broad that even Starbucks qualifies.  It basically covers any firm with investments in physical capital.  This is clearly not a special privilege for just for oil companies but it is stupid and should be reformed.

Loopholes

These accusations are primarily concerned with American companies that have foreign subsidiaries that relocate operations (jobs) overseas – not exclusively an oil company issue!  The current accusations specifically target the tax code that allows companies to only pay the difference between the U.S. tax rate and the foreign rate WHEN they bring profits back to the U.S.  In other words, the company receives a tax deferral until the money comes back to the U.S., which is similar in nature to an IRA deferral of taxes until money is used for retirement.  It is certainly not a “tax break” or “subsidy.”  Once we expand properly to a global perspective, I believe you will see that the “loophole” accusation will sound too pejorative.

This is not the first time this repatriation-of-earnings issue has come up.  In fact, it is rather obvious that for a long time now the U.S. tax code has been punitive compared to other developed countries.  In most other developed countries, including Germany, Japan, the U.K., France, Spain, Italy, Russia, Australia and Canada, companies can repatriate earnings at a tax rate of 2% or less.  Considering that the U.S. rate is 35% and the average for OECD countries is 19.5%, paying the difference of 15.5% is a true penalty for bringing profits back home (data from the Cato Institute).

As other nations have cut their rates, the incentives for capital to leave the U.S. have become stronger.  Call me simpleminded but why not reduce the penalty to 4% and create what the Wall Street Journal editors called “a privately funded stimulus of up to a trillion dollars”?  Not to mention a quick $40 billion pop for the federal government’s coffers.  Personally I don’t see tax rate competition between countries as a good versus evil argument!

Subsidies?

Monetary assistance granted by a government to an enterprise?  Other than the bit they got in the above-referenced Act of 2005, I don’t know what “subsidies” they get.  At any rate, they receive none that cross the materiality threshold or cause the oil companies to be “hugely profitable” or “profoundly out of touch.”  Verdict: this is a non-sequitor – or at the very least – a poor choice of words by the accusers.