Author: Finance Dude

As promised from the previous article, here is one real life example of applying our short discussion to real life scenarios:

Pepsi Cola Philippines Inc. (Ticker Symbol: PIP)

Listed on February 1, 2008 on the Philippine Stock Exchange, Pepsi Cola is a company most people are familiar with.  It listed with an IPO (Initial Public Offering) price of P3.50.  The Summarized Balance Sheet as of June 30, 2007 is as follows (figures are rounded off for simplicity):

Total Current Assets P2.3Billion
Total Non Current Assets     4.5Billion
TOTAL ASSETS P6.8Billion

Total Current Liabilities           P3.2Billion
Total NonCurrent Liabilities   0.3Billion
TOTAL LIABILITIES   3.5Billion

Capital Stock P0.5Billion
Additional Paid in Capital   0.05Billion
Retained Earnings   2.75Billion
TOTAL STOCKHOLDERS’ EQUITY (Net Worth) P3.3Billion
Cash from the IPO    4.0Billion
TOTAL NET BOOK VALUE or Stockholders’ Equity After IPO P7.3Billion

Market Capitalization After IPO (P3.50 x 3.68Billion shares) P12.9B

Market Capitalization Formula=Price per share x Outstanding Shares
During the IPO: the Market Capitalization is larger than the Net Book Value It is selling about 1.8 times its recorded value on its balance sheet, as calculated below:

Price to Book: (12.9B/7.3B= 1.8x)

Price to Book Formula=Market Capitalization Divide by Net Book Value

Let’s look at the 2007 Net Income

NET INCOME (for one year ending June 30, 2007) P1Billion

Let’s compute for (trailing) P/E

P/E: P12.9B / P1B = 12.9x

P/E : stock price per share divided by earnings per share (or market cap divided by total net income)

This means that if we buy at the IPO price of P3.50 per share and we expect to have the same 2007 Net Income in the future years, we’ll recoup our investment in about 13 years. Or put in another way, this could give us a return of about 8% per year (1 divided by 13).  This assumes that earnings do not grow or do not decrease per year.

Let’s now look at the dividends:
According to its IPO prospectus, it will have a dividend policy of paying off 50% of its net income as dividends.  So in this case, if it makes 8% a year, it will pay about 4% a year in dividends. You could get 4% return on your investments. This is better than time deposits but less than most long term government bonds.

(An IPO prospectus or red herring tells the public the important information about the company to enable the public to decide whether the IPO is a good one. Of course, I rarely know of investors who read it beginning to end before subscribing. Reading it should give you an advantage.)

Based on the IPO price, it’s an average investment but not an excellent one.

On the day of the IPO, it opened at P3.30 and went as low as P2.90. It traded above P2 until September 2008.  Then the sub-prime crisis came. Most investors panicked, selling irrationally the stocks they had bought just a few months ago. Starting October 2008 the price fell below P2, it even went below P0.70 and traded below P1  from late October 2008 to late April 2009. (Honestly, I didn’t think people would less likely to drink Pepsi products just because there’s a credit crunch going on.)

Although the prices went crazy, the business did not. Let’s look at the Financial Statements for the Fiscal year ending June 30, 2008. (A business year that ends on December 31 is called a Calendar Year when it ends any other month its called Fiscal Year)

Pepsi-Cola Products Philippines Inc.
Balance Sheet
June 30, 2008

Total Current Assets P2.5Billion
Total Non Current Assets     5.5Billion
TOTAL ASSETS P8Billion

Total Current Liabilities           P2.3Billion
Total Non-Current Liabilities   0.40Billion
TOTAL LIABILITIES   2.7Billion

Capital Stock P0.5Billion
Additional Paid in Capital   1.2Billion
Retained Earnings   3.5Billion
TOTAL STOCKHOLDERS’ EQUITY (Net Worth) P5.3Billion

Market Capitalization at P1 (P1 x 3.68Billion shares) P3.68Billion
Price to Book (3.68B / 5.3B = 0.69x)
LOOKING AT THE NET ASSETS:
The company is selling P0.69 for every P1 you’ll get using recorded book values. Based on the book value you’ll get about 30% discount.
We can also observe that the company has basically no long term debt. Long term Debt to Total Assets is just about 5% (0.40B / 8B). Long-term debt to equity is just about 7.5% (0.4B / 5.38B)

NET INCOME (for one year ending June 30, 2008) P0.76Billion
P/E Ratio (3.68B/0.76B = 4.84x )
LOOKING AT THE RETURN ON YOUR INVESTMENT:
Although the Net Income went down, and assuming it stays low, you still get a good deal.  Here’s why: It would take less than 5 years (about 4.84 years) to recoup your capital if you invest at current prices (in this case P1) and faster if earnings grow. Now based on the IPO prospectus the reason for the IPO was to pay off the company debt and to expand. A company would not normally expand if there would be no room for more demand that is foreseen.

Dividends: The company has a policy of distributing half of the income as dividends.  This means you could get a dividend return of about 10% a year assuming stock prices don’t go up soon.  You would be paid about P0.10 on your P1 while you wait for price to go back up to its right value.

Risks:
The risks are:

• Since it’s a bottling company, it could have increased manufacturing costs that cannot be passed on to buyers immediately.
• Its license may be revoked. (This is unlikely since Quaker Global owns almost 30% of its shares)
• Poor management. (President owns about 20million shares and no changes in management is seen in the immediate term which means we could expect a similar performance from previous years. Net income should be about P600million to P1billion in the next few years)
• People stop drinking Pepsi Products (Although this could have big impact over the long term, in the next few years, consumers will typically have a similar consumption habits for the past years.)

What happened:
Starting May of 2009, it traded above P1 and never looked back. On October of 2009 it went as high as P2.50. If you have bought the stock below or near P1 and held it, you could have made at least 100-160% of your investment in less than a year.

I know you might think it can’t be done. But you can do it too. With a little analysis and a commonsense approach, it’s doable. As a matter of inspiration, I did it and so can you!

P.S. Why I chose it: I understood the business. I understood the financial statements. I know the risks and the rewards. The sell-off was not due to the problems of the company but mainly systemic in nature. (Systemic means all stocks in the exchange are simply being sold. People just want to get out.) Of course, I could have picked other stocks which are cheaper and has more growth and better prospects. Although, I did pick some others I chose it for the abovementioned reasons.

Disclosure: I currently do not own stocks mentioned above anymore. This is not an advertisement of the product or the stock. )

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About the contributor:
Finance Dude
The writer is a financial planner, investor, speaker and a self confessed cheapaholic. (Cheapaholic- a term he invented to mean someone who is addicted to being very cheap).  Send in your questions.  He will try to answer any questions you might have, preferably on finance and money matters.  Although he does not object to questions on love and relationships, he never had one and due to his extreme cheapness, will probably never have one (In case you’ll send it mistakenly, he promised to forward it to HeaRty).

Disclaimer: Advice posted in this portion is merely opinions and views of the writer.  It does not constitute formal advice.  The writer will not be responsible for any of your gains or losses. If symptoms persist, contact your trusted financial planner.

Why of all the topics of investing should we tackle first this thing called Risk Management?  Well, to start I’d like to quote two men.  The first from one of the top three richest man and another is one who was successful during the recent economic turmoil.

Rule Number 1: “Never lose money.  Rule Number 2: “Never forget rule Number 1.” –Warren Buffett

This is interesting.  One of the richest investors does not look at how much he will make at first.  But he wants to make sure of not losing first.

Another famous billionaire investor, who had made a good amount of money for his clients when most was losing money during the crisis, has this to say:
“I really picked up my investment philosophy from Marty and his father, Joseph Gruss.  He had two sayings that guided me going forward.

The first was: Watch the downside, the upside will take care of itself.  That’s been a very important guiding philosophy for me.  Our goal is to preserve principal, not to lose money.” —John Paulson

In investing before anything else, always look at the risks and downside first.  Focus on
Return OF capital first before even asking for return on capital.  Ask the following questions:

• What are the risks?
• How likely are the risks happening?
• How can you protect yourself from the risks?

You can even classify risks in different classes.
Put another way, before flying high; make sure your landing gears works!

You may disagree and say, isn’t it that low risk means low return and high risk, high return? Well generally that is what common sense taught in business schools.  But low risks and high returns scenarios do happen from time to time.  Examples abound as during the recent recession, stock prices fell down when the value of the business didn’t.  Some companies sold for less than the net cash on their balance sheet.  What does this mean?  Let’s say you’re friend has a restaurant called Good Food Restaurant with the following assets and liabilities:

Cash P100,000
Receivables 10,000
Kitchen Utensils 50,000
Furniture 40,000

Total Assets P200,000
Liabilities 10,000
Net Worth P190,000

He is selling the business (including the cash) for P60, 000.  Would you buy it?

Again let’s see our rule number one. Will we lose money here? Maybe there’s a catch. So we ask around, we look at the financial statements, we check out for any lawsuits or problems.  We don’t see any.  I think we just had ourselves a good deal.  You pay P60, 000 and you get at least P90, 000 in cash. (P100,000 of cash less the liabilities of P10,000).  We will make at least P30,000.  You might tell me this doesn’t really happen.  An individual might not do it.  But it happened when supply outnumbered demand in the recent economic turmoil.  In following series, I’ll show you a real example of something similar.

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About the contributor:
Finance Dude
The writer is a financial planner, investor, speaker and a self confessed cheapaholic. (Cheapaholic- a term he invented to mean someone who is addicted to being very cheap).  Send in your questions.  He will try to answer any questions you might have, preferably on finance and money matters.  Although he does not object to questions on love and relationships, he never had one and due to his extreme cheapness, will probably never have one (In case you’ll send it mistakenly, he promised to forward it to HeaRty).

Disclaimer: Advice posted in this portion is merely opinions and views of the writer.  It does not constitute formal advice.  The writer will not be responsible for any of your gains or losses. If symptoms persist, contact your trusted financial planner.

When Investing
(The start of a series of articles when investing)

Before investing….

Know these….

• P/E or (ROI in years)
• ROE in %
• Net worth
• Assets
• Liabilities
• Risks Involved
• Industry
• Company
• Worse case scenarios and how will you handle them
• Effect on you
• Other things not listed.

Simple? Yes!
Easy? No!

Goodluck!

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About the contributor:
Finance Dude
The writer is a financial planner, investor, speaker and a self confessed cheapaholic. (Cheapaholic- a term he invented to mean someone who is addicted to being very cheap).  Send in your questions.  He will try to answer any questions you might have, preferably on finance and money matters.  Although he does not object to questions on love and relationships, he never had one and due to his extreme cheapness, will probably never have one (In case you’ll send it mistakenly, he promised to forward it to HeaRty).

Disclaimer: Advice posted in this portion is merely opinions and views of the writer.  It does not constitute formal advice.  The writer will not be responsible for any of your gains or losses. If symptoms persist, contact your trusted financial planner.

In 1626, Peter Minuit was said to have bought the Manhattan Island from the local Indian inhabitants for a load of cloth, beads, hatchets, and other odds and ends then worth 60 Dutch guilders equating to around $24.  If that amount was invested instead at 8% return annually and left to compound (grow) how much would it be now (2010)?

• What if only half of the income (4%) was invested and the other half spent every year?
• What if all the 8% return was spent every year while leaving only $24 principal intact ?

Answers:
$164 trillion, $83 million, $24.
(You may email Ms. HeaRty for the formula)

Above you can see the effects of compounding; it’s basically return on return, interest on interest. It is the way creatures multiply so fast and wealth increases over time.

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About the contributor:
Finance Dude
The writer is a financial planner, investor, speaker and a self confessed cheapaholic. (Cheapaholic- a term he invented to mean someone who is addicted to being very cheap).  Send in your questions.  He will try to answer any questions you might have, preferably on finance and money matters.  Although he does not object to questions on love and relationships, he never had one and due to his extreme cheapness, will probably never have one (In case you’ll send it mistakenly, he promised to forward it to HeaRty).

Disclaimer: Advice posted in this portion is merely opinions and views of the writer.  It does not constitute formal advice.  The writer will not be responsible for any of your gains or losses. If symptoms persist, contact your trusted financial planner.

Mr. Munger graduated law in Harvard and is in the Forbes 400 billionaire list. He is also the partner and longtime friend of Warren Buffett. He is second largest shareholder of Berkshire Hathaway.

These are his answers to the brain twisters last week:

1. This question was answered by Munger’s physicist son. “It can’t be anything requiring a lot of hand-eye coordination. Nobody 85 years of age is going to win a national billiards tournament, much less a national tennis tournament. It just can’t be. Then he figured it couldn’t be chess, which this physicist plays very well, because it’s too hard. The complexity of the system, the stamina required are too great. But that led into checkers. And he thought, “Ah ha! There’s a game where vast experience might guide you to be the best even though you’re 85 years of age.”

2. This was his answer: “Is this a low-priced store or a high-priced store? It’s not going to have a runaway success in a strange city as a high-priced store. That would take time. Number two, if it’s moving $500 million worth of furniture through it, it’s one hell of a big store,furniture being as bulky as it is. And what does a big store do? It provides a big selection. So what could this possibly be except a low-priced store with a big selection? But, you may wonder, why wasn’t it done before, preventing its being done first now? Again, the answer just pops into your head: it costs a fortune to open a store this big. So, nobody’s done it before. So, you quickly know the answer. With a few basic concepts, these microeconomic problems that seem hard can be solved much as you put a hot knife through butter. I like such easy ways of thought that are very remunerative. And I suggest that you people should also learn to do microeconomics better.”

3. “What’s different about that machine is people have used modern electronics to give a higher ratio of near misses. That machine is going bar, bar, lemon. Bar, bar, grapefruit, way more often than normal machines, and that will cause heavier play. How do you get an answer like that? Easy. Obviously, there’s a psychological cause: That machine is doing something to trigger some basic psychological response. If you know the psychological factors, if you’ve got them on a checklist in your head, you just run down the factors, and, boom!, you get to one that must explain this occurrence. There isn’t any other way to do it effectively. These answers are not going to come to people who don’t learn these mental tricks. If you want to go through life like a one legged man in an ass-kicking contest, why be my guest. But if you want to succeed, like a strong man with two legs, you have to pick up these tricks, including doing economics while knowing psychology.”-C.M.

4. This was the answer given by Mr. Munger:

“Is there some wave that Schwab could have caught? The minute you ask the question, the answer pops in. The Japanese had a zero position in tires and they got big. So this guy must have ridden that wave some in the early times. Then the slow following success has to have some other causes. And what probably happened here, obviously, is this guy did one hell of a lot of things right. And among the things that he must have done right is he must have harnessed what Mankiw calls the superpower of incentives. He must have a very clever incentive structure driving his people. And a clever personnel selection system, etc. And he must be pretty good at advertising. Which he is. He’s an artist. So, he had to get a wave in Japanese tire invasion, the Japanese being as successful as they were. And then a talented fanatic had to get a hell of a lot of things right, and keep them right with clever systems. Again, not that hard of an answer. But what else would be a likely cause of the peculiar success?…

“Extreme success is likely to be caused by some combination of the following factors:

• Extreme maximization or minimization of one or two variables. Example, Costco or our furniture and appliance store.
• Adding success factors so that a bigger combination drives success, often in non-linear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result. And of course I’ve been searching for lollapalooza results all my life, so I’m very interested in models that explain their occurrence.
• An extreme of good performance over many factors. Example, Toyota or Les Schwab.
• Catching and riding some sort of big wave. Example, Oracle.

Generally I recommend and use in problem solving cut-to-the quick algorithms, and I find you have to use them both forward and backward.” —C. Munger

5. Someone thought that they were paying the night shift by the hour, and that
maybe if they paid them by the shift, the system would work better. It worked!

6. When Mr.Wilson got there, he found out that the commission arrangement with the salesmen gave a tremendous incentive to the inferior machine. (power of incentives)

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About the contributor:
Finance Dude
The writer is a financial planner, investor, speaker and a self confessed cheapaholic. (Cheapaholic- a term he invented to mean someone who is addicted to being very cheap).  Send in your questions.  He will try to answer any questions you might have, preferably on finance and money matters.  Although he does not object to questions on love and relationships, he never had one and due to his extreme cheapness, will probably never have one (In case you’ll send it mistakenly, he promised to forward it to HeaRty).

Disclaimer: Advice posted in this portion is merely opinions and views of the writer.  It does not constitute formal advice.  The writer will not be responsible for any of your gains or losses. If symptoms persist, contact your trusted financial planner.