Svolder A: The Big Short

A Case Study of Unintelligent Speculation

Svolder’s A-share (ticker: SVOL A) today closed at SEK 243.50, down from an intra-day high of SEK 275.00. During the last twelve months the A-share reached a low of SEK 112.50 and a high of SEK 275 (Source: Avanza).


Svolder is a Swedish investment company founded in 1993 and listed on the Nasdaq OMX Nordic exchange. Svolder invests in small and mid cap listed entities. Click image below for a brief history in Swedish of Svolder (Source: Svolder).


Net Asset Value per Share as of May 31, 2016

The equites portfolio as of May 31, 2016 is shown below. As of this date, the market value of the equities portfolio amounted to SEK 1,644.1 billion. Adjusting for net debt/net receivable results in a total net worth of SEK 1,859.6 billion, equal to a net asset value (NAV) of SEK 144.60 per share (Source: Svolder).

Svolder’s equities portfolio as reported in the most recent quarterly report per May 31, 2016 was made up of the following equities (Source: Svolder).


Net Asset Value per Share as of August 12, 2016

Per August 12, 2016, Svolder reported a NAV of SEK 162 per share (Source: Svolder). The current share of SEK 243.50 is about 150.3% of NAV. At SEK 275 it’s 169.8%. A reasonable expectation would be that the share price would stay close to NAV.

One may wonder why on earth someone would be willing to pay a lot more than NAV for the A-share for a collection of marketable common stocks that Svolder currently owns? Sure, you get 10 votes for each A-share compared to 1 vote per B-share. But that looks like a very optimistic view in regards to the value of the votes connected to each A-share.


Shares Outstanding

Svolder’s shares outstanding disclosed in the 2015 annual report per December 31, 2015 was 12,800,000, consisting of 622,836 A-shares (10 votes per share) and 12,177,164 B-shares. Below an excerpt from the 2015 annual report (in Swedish).


Final Words

To wrap this up. Right now the Svolder A-share is trading at a price-level that is not supported by underlying value. I’m on the sidelines here, but when I saw this case earlier today I was just fascinated of what I was just looking at. One last question: How long will it take for the A-share to trade in line with underlying NAV? Guess we’ll have to wait and see.

For some final words, here’s an excerpt from The Intelligent Investor.

Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

Disclosure: I have no position in the stock mentioned, and no plans to initiate any position within the next 24 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion, and should not be considered investment advice. Always do your own due diligence and contact a financial professional before executing any trades or investments.

The Buffett/Munger Investment Checklist

“When investing, we view ourselves as business analysts—not as market analysts, not as macroeconomic analysts, and not even as security analysts.”

—Warren Buffett, Letter to Shareholders, 1987

The Buffett/Munger Investment Checklist: A Framework for Business Analysis and Valuation

How to go about when performing a business analysis, and what to look for in doing so, is nothing but the holy grail of investing. A business analysis could be carried out in a number of different ways. You just have to make sure that you have a way that works for you, a process for analyzing and evaluating businesses that is continually updated along the way as you learn about new facts and circumstances.

When building your own framework for business analysis, you should always remember to keep things simple, since it most likely will tend to get hard enough anyway in the end. Also, you don’t have to come up with your own stuff, you are perfectly free to use everything there is from great men that’s come before, as Charlie Munger noted when he said: 

I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.

To set the scene to sort of create an investing map to follow it’s worth considering what Warren Buffett once wrote:

In our view, though, investment students need only two well-taught courses—How to Value a Business, and How to Think About Market Prices.

To be able to value a business, you have to understand the business. And to be able to say that you understand a business you would likely want to know about its products/services and revenue sources, operating leverage, financial leverage, competitive position, industry characteristics, etc. These questions all belong to the first section of the Buffett/Munger Investment Checklist, i.e., understanding the business.

When you understand a business and its management, and have evaluated the long-term prospects as favorable, the next step is to value the business, i.e., come up with an estimate of intrinsic business value that is to be compared to the current market price of the business. If you manage to, and have the luck, to check each of the four main parts of the checklist, you most likely have an investment worth making.

In his 1977 letter to shareholders Warren Buffett explained his and Charlie’s process for analyzing and evaluating businesses.

We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term.  In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.

So, already back in 1977 Warren Buffett laid out the checklist that he and Charlie go through when evaluating a business. This will serve as a good starting foundation for anyone who wants to build their own investment checklist. Each checklist point could then be expanded to included a number of supporting sub-questions needed for coming up with a conclusion about the “main” checklist question being evaluated.

From the above quote and discussion, keep in mind the foundations of our Buffett/Munger Investment Checklist:

  1. Understand the business
  2. Favorable long-term prospects
  3. Operated by honest and competent management
  4. Very attractive price

To make it easier to remember the top four checklist points, memorize the acronym “UFOV.” That’s easy to remember, right? It’s just “UFO” plus a “V.”

As always, when talking about the subject of checklists, make sure to use them in an appropriate wat and also remember Warren Buffett’s words that “A checklist is no substitute for thinking.”


“Take a simple idea and take it seriously.”

—Charlie Munger

Peter Thiel on the Characteristics of Monopoly

”The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

—Warren Buffett

”ESCAPING COMPETITION will give you a monopoly, but even a monopoly is only a great business if it can endure in the future.”

—Peter Thiel, Zero to One

Are you buying an asset or a franchise?

Let’s start with some thinking about investing, what you buy, and why you buy it.

In the end, for any single investment you’ll make, it’s all about the risk and inflation adjusted after tax return on invested capital net of any expenses. When you invest you are giving up money that could have been used to buy goods or services today, with the aim of (hopefully) receiving more in the (unknown) future.

One critical questions to consider and answer for each business you invest in is: “Are you buying an asset or a franchise?”

In his 1991 letter to shareholders Warren Buffett provided a definition of a franchise:

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage. 

In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management. 

(Source: Warren Buffett, Shareholder Letter, 1991)

What Buffett calls “a business,” is what I earlier named an “asset.” In theory, what Buffett calls “a business” is a business that does not have a sustainable competitive advantage, i.e., no moat, and thus is not able to earn any economic profits, i.e., a return on invested capital (ROIC) above its cost of capital (COC). The invested capital (assets) in a business like this does not generate any excess value since ROIC equals COC, and the business is only worth the value of its assets.

In contrast, a franchise is a business that earns a ROIC above its COC, and in a situation like this the earning power of the business will result in a intrinsic value exceeding the value of the assets. For this to be sustainable, and for you to go on and base your valuation from the future earning power of the business, there must be some characteristics of the business that makes it possible to defend these excess profits from any competitors that will try to take these profits away. A wide moat (sustainable competitive advantage) will make sure this does not happen—then the next question to consider is the durability of the moat, i.e., how long the business will be able to defend its excess profits. If there is no moat, incumbents have no advantage over entrants and all excess profits will be competed away—maybe not in the short term, but it will happen over the long haul.

A stock selection framework when trying to answer this question—see image below—was originally published in The Manual of Ideas: The Proven Framework for Finding the Best Value Investment, written by John Mihaljevic.

Depending on your answer to the question (asset or franchise), there are two different ways when approaching your analysis: (1) asset value analysis or (2) earning power analysis. When looking at a franchise, that is, a business enjoying a sustainable competitive advantage (or a moat with lots of piranhas in it) the analysis will focus on the earning power of the business.

In the beginning of the book Mihaljevic describes the stock selection framework as follows.

Figure 1.2o outlines an approach that may be able to handle, at least in principle, the vast array of equity investment opportunities available in the public markets. Although the following framework may not be practicable for most small investors, it does illustrate how we may think about security selection if we adopt the mindset of chief capital allocator.

The stock selection framework begins by asking whether the net assets are available for purchase for less than replacement cost. If this is not the case, we exclude the company from consideration because it might be cheaper to re-create the equity in the private market. If the equity is available for less than replacement cost, then we consider whether it is so cheap that liquidation would yield an incremental return. If this is the case, we may consider liquidating the equity. In the vast majority of cases, an equity will trade far above liquidation value, in which case we turn our attention to earning power.

Once we focus on the earning power of a going concern, the key consideration becomes whether the business will throw off sufficient income to allow us to earn a satisfactory return on investment. Many related considerations enter the picture here, including the relationship between net income and free cash fl ow, the ability of the business to reinvest capital at attractive rates of return, and the nature of management ’s capital allocation policies.


From Zero to One, or Asset to Franchise

Zero to One, written by Peter Thiel, is a book about ”how to build companies that create new things.” The book is based on a course that Thiel held about startups at Stanford in 2012, and ”the primary goal in teaching the class was to help [his] students see beyond the tracks laid down by academic specialties to the broader future that is theirs to create.”

As always, there is no one formula to find. Instead, there are principles.

”The paradox of teaching entrepreneurship is that such a formula necessarily cannot exist; because every innovation is new and unique, no authority can prescribe in concrete terms how to be innovative. Indeed, the single most powerful pattern I have noticed is that successful people find value in unexpected places, and they do this by thinking about business from first principles instead of formulas.”

Zero to One is about a few things to consider in building a business from the start. Although the book focuses on venture capital and startups, it’s worth reading for everyone interested in business analysis and investing. Why? It discusses the difference between a great business, a business with a sustainable competitive advantage (or “monopoly”), and and businesses that doesn’t enjoy any competitive advantage at all and is bound for a hard struggle for any profits available in a highly competitive market (in theory, the cost of capital since economic profits are competed away).

The value of a business today comes from the cash inflows and outflows that can be expected to occur during the remaining life of the asset discounted at an appropriate interest rate. So, when thinking about the value of any business, future cash flows is highly critical, and at the same time highly uncertain.

One section in the book is called Monopoly Characteristics and devoted to a discussion of what characteristics (i.e., competitive advantages) to look for in a business. Thiel starts by asking a central question:

”What does a company with large cash flows far into the future look like? Every monopoly is unique, but they usually share some combination of the following characteristics: proprietary technology, network effects, economies of scale, and branding.”

Further Thiel notes that:

”This isn’t a list of boxes to check as you build your business—there’s no shortcut to monopoly. However, analyzing your business according to these characteristics can help you think about how to make it durable.”

Characteristics of Monopoly to Look For

Thiel asks and discusses a critical question when it comes to businesses and investing: “What does a company with large cash flows far into the future look like?” This is pretty close to the one-million dollar question. But Thiel also provides a discussion of the different characteristics to look for in our analysis of different businesses. According to Thiel “[e]very monopoly is unique, but they usually share some combination of the following characteristics: proprietary technology, network effects, economies of scale, and branding.”

Below each one of the different characteristics is summarized with all of the quotes below taken from the book.

Monopoly Characteristic Nr. 1: Proprietary Technology

Definition: “Proprietary technology is the most substantive advantage a company can have because it makes your product difficult or impossible to replicate.”

Two different ways: (1) invent something completely new, or (2) radically improve an existing solution.

  • Invent something completely new: “Google’s search algorithms, for example, return results better than anyone else’s. Proprietary technologies for extremely short page load times and highly accurate query autocompletion add to the core search product’s robustness and defensibility. It would be very hard for anyone to do to Google what Google did to all the other search engine companies in the early 2000s.”
  • Radically improve on an existing solution: “Or you can radically improve an existing solution: once you’re 10x better, you escape competition. PayPal, for instance, made buying and selling on eBay at least 10 times better. Instead of mailing a check that would take 7 to 10 days to arrive, PayPal let buyers pay as soon as an auction ended. Sellers received their proceeds right away, and unlike with a check, they knew the funds were good. Amazon made its first 10x improvement in a particularly visible way: they offered at least 10 times as many books as any other bookstore. When it launched in 1995, Amazon could claim to be “Earth’s largest bookstore” because, unlike a retail bookstore that might stock 100,000 books, Amazon didn’t need to physically store any inventory—it simply requested the title from its supplier whenever a customer made an order. This quantum improvement was so effective that a very unhappy Barnes & Noble filed a lawsuit three days before Amazon’s IPO, claiming that Amazon was unfairly calling itself a “bookstore” when really it was a “book broker.”You can also make a 10x improvement through superior integrated design. Before 2010, tablet computing was so poor that for all practical purposes the market didn’t even exist. “Microsoft Windows XP Tablet PC Edition” products first shipped in 2002, and Nokia released its own “Internet Tablet” in 2005, but they were a pain to use. Then Apple released the iPad. Design improvements are hard to measure, but it seems clear that Apple improved on anything that had come before by at least an order of magnitude: tablets went from unusable to useful.”

Examples: Google, PayPal, and Amazon.

Rule of thumb: Must be “at least 10 times better than its closest substitute in some important dimension to lead to a real monopolistic advantage.”

Monopoly Characteristic Nr. 2: Network Effects

Definition: ”Network effects make a product more useful as more people use it.”

Examples: “For example, if all your friends are on Facebook, it makes sense for you to join Facebook, too. Unilaterally choosing a different social network would only make you an eccentric.”

Rule of thumb: “Network effects can be powerful, but you’ll never reap them unless your product is valuable to its very first users when the network is necessarily small. … Paradoxically, then, network effects businesses must start with especially small markets. Facebook started with just Harvard students—Mark Zuckerberg’s first product was designed to get all his classmates signed up, not to attract all people of Earth. This is why successful network businesses rarely get started by MBA types: the initial markets are so small that they often don’t even appear to be business opportunities at all.”

Monopoly Characteristic Nr. 3: Economies of Scale

Definition: ”A monopoly business gets stronger as it gets bigger: the fixed costs of creating a product (engineering, management, office space) can be spread out over ever greater quantities of sales. Software startups can enjoy especially dramatic economies of scale because the marginal cost of producing another copy of the product is close to zero.”

Rule of thumb: ”Many businesses gain only limited advantages as they grow to large scale. Service businesses especially are difficult to make monopolies. If you own a yoga studio, for example, you’ll only be able to serve a certain number of customers. You can hire more instructors and expand to more locations, but your margins will remain fairly low and you’ll never reach a point where a core group of talented people can provide something of value to millions of separate clients, as software engineers are able to do.”

Examples: ”A good startup should have the potential for great scale built into its first design. Twitter already has more than 250 million users today. It doesn’t need to add too many customized features in order to acquire more, and there’s no inherent reason why it should ever stop growing.”

Monopoly Characteristic Nr. 4: Branding

Definition: ”A company has a monopoly on its own brand by definition, so creating a strong brand is a powerful way to claim a monopoly.”

Rule of thumb: ”Beginning with brand rather than substance is dangerous.”

Examples: ”Today’s strongest tech brand is Apple: the attractive looks and carefully chosen materials of products like the iPhone and MacBook, the Apple Stores’ sleek minimalist design and close control over the consumer experience, the omnipresent advertising campaigns, the price positioning as a maker of premium goods, and the lingering nimbus of Steve Jobs’s personal charisma all contribute to a perception that Apple offers products so good as to constitute a category of their own.”

Competitive Advantages Framework

I have written about the subject of competitive advantages earlier, and put together the “Competitive Advantages Framework” as a way to keep the most important parts in one and the same place. As we noted earlier, there is no single formula, instead there are principles to guide us in our analysis and understanding.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Fortnox: Visma’s Cash Offer Re-Engineered

Fortnox: A High Growth Small-Cap with High Profitability

Fortnox is, according to themselves, the leading provider of Internet-based applications for businesses, associations and accounting and auditing firms (a big part being their offering of accounting software). The business concept is to offer a wide range of Internet-based applications that are easy to learn and use, yet is powerful and feature-rich enough to meet most needs and wishes. Fortnox has been growing at a fast pace back since it was founded in the early 2000s.


Below a page from the 2015 Fortnox annual report with my own notes (I now see that I made a mistake when I wrote 2016 which is incorrect, should be 2015 and nothing else).

Cash Offer from Visma

On March 14, 2016, Visma made a cash offer to acquire Fortnox for a total purchase price of SEK 1,406 billion, or SEK 24 per share. To read the press release, click here.

In its quaterly report for Januari-March 2016 Fortnox disclosed a non-recurring item of approximately MSEK 1 for consultations, a so-called fairness opinion, in connection with the Visma bid mentioned above. The Fortnox Board of Directors have evaluated Visma’s bid by themselves, and from taking in a fairness opinion, decided to favour Visma’s bid.

Visma’s current bid puts a total value of MSEK 1,406 for the shares outstanding, or SEK 24 per share. On the same day as the bid was made public the share price rose from SEK 18.2 to SEK 23.9, an increase of +32%. With the value of equity at MSEK 1,406, almost no debt (only MSEK 0.5) and cash of MSEK 46 at year-end 2015 (compared to MSEK 52 per March 30, 2016) Fortnox has an enterprise value of about MSEK 1,360.

Re-Engineering Visma’s Cash Offer

Reverse engineering a certain valuation makes it possible to back out what growth is implied in it, as noted by James Montier:

So, if one can’t use DCF how should one think about valuation? Well, one solution that I have long favoured is the use of reverse engineered DCFs. Instead of trying to estimate the growth ten years into the future, this method takes the current share price and backs out what is currently implied. The resulting implied growth estimate can then be assessed either by an analyst or by comparing the estimate with an empirical distribution of the growth rates that have been achieved over time, such as the one shown below. This allows one to assess how likely or otherwise the implied growth rate actually is.

Let’s see what implied growth assumptions we get if we reverse engineer Visma’s cash offer per share of SEK 24, equal to a total purchase price of MSEK 1,406.

I have put together three different scenarios, all starting with earnings per share (EPS) of SEK 0.43 (calculated by assuming 25% growth in revenues in FY2016 and an operating margin of 20% with a 22% corporate tax rate). A discount rate of 10% is used in all the scenarios.

  • Scenario 1. Forecast period of 5 years with a compounded annual growth rate (CAGR) of 25%.
  • Scenario 2. Forecast period of 10 years with a compounded annual growth rate (CAGR) of 15%.
  • Scenario 3. Forecast period of 3 years with a compounded annual growth rate (CAGR) of 35%.

Scenario nr. 1 requires, except for the assumed 25% CAGR during 2016-2020, a terminal growth rate beyond 2020 of 6.76% to end up with an intrinsic value per share of SEK 24, equal to the cash offer from Visma. The numbers and the calculation of the reverse engineered scenario nr. 1 valuation is shown in the table below.


Scenario nr. 2 requires, except for the assumed 15% CAGR during 2016-2025, a terminal growth rate beyond 2025 of 6.76% to end up with an intrinsic value per share of SEK 24, equal to the cash offer from Visma. The numbers and the calculation of the reverse engineered scenario nr. 2 valuation is shown in the table below.


Scenario nr. 3 requires, except for the assumed 35% CAGR during 2016-2018, a terminal growth rate beyond 2018 of 7.20% to end up with an intrinsic value per share of SEK 24, equal to the cash offer from Visma. The numbers and the calculation of the reverse engineered scenario nr. 2 valuation is shown in the table below.Fortnox_V_s3

Discount Rates and Terminal Growth Rates

By altering the discount rate used we can solve for what terminal growth rate needed to get an intrinsic value per share of SEK 24.

See table to the right where different growth rates are shown for each of the three scenarios depending on what discount rate is applied, ranging from 8.0% to 15.0%. Depending on the discount rate used the growth rate range between 4.1% to 13.1%. What should be considered a reasonable discount rate as well as growth rate is up to each individual investor to decide.


The Trade-Off and Where to Go From Here…

I have not, and I do not, own any shares in Fortnox. Clearly, I was too late to the party and didn’t find this gem before Visma made its bid public. Without doing a lot more digging into this case it looks like Visma’s cash offer per share is reasonable. Of course Fortnox could go on and grow even faster. As always, the future is uncertain, but selling and taking the cash received to look elsewhere for new investment cases may be the thing to do. By reverse engineering the SEK 24 per share cash offer from Visma we are at least able to see what kind assumptions give this value.

Before making any further decisions about what to do, one would have to take a look at what levels of revenues that each EPS is derived from and analyze them to come up with an answer to whether they could be deemed reasonable or not. A quick look at revenues from the three different scenarios is shown in the table below. Scenario nr. 2 gives MSEK 395.8 in revenues in 2020, CAGR of 25%. This growth looks to be in line with the underlying growth in the industry (see link to analysis, in Swedish though, that I found that is referring to Statistics Sweden).

Before making any decisions one would likely want to have a closer look at revenues, both for Fortnox but also for the whole industry, to decide what levels could be deemed reasonable.


See tables below for some historical Fortnox key ratios.



Disclosure: I have no position in the stock mentioned, and no plans to initiate any position within the next 24 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion, and should not be considered investment advice. Always do your own due diligence and contact a financial professional before executing any trades or investments.

Henry Singleton, Teledyne, and Free Cash Flow

“Henry Singleton has the best operating and capital deployment record in American business … if one took the 100 top business school graduates and made a composite of their triumphs, their record would not be as good as Singleton’s.” 

—Warren Buffett, 1980

Teledyne: Henry Singleton’s Cash Flow Machine

This post is about earnings, cash flow and the search for the value created in a business during its lifetime. How should an investor measure the value being created in a business? Should the focus be on earnings, earning power, free cash flow, or maybe something else? Or is earning power a measure derived from both considering the earnings and free cash flows generated?

Excerpt below from chapter two—An Unconventional Conglomerateur: Henry Singleton and Teledyne—of The Outsiders (emphasis added).

Once the acquisition engine had slowed in 1969, Roberts and Singleton turned their attention to the company’s existing operations. In another departure from conventional wisdom, Singleton eschewed reported earnings, the key metric on Wall Street at the time, running his company instead to optimize free cash flow. He and his CFO, Jerry Jerome, devised a unique metric that they termed the Teledyne return, which by averaging cash flow and net income for each business unit, emphasized cash generation and became the basis for bonus compensation for all business unit general managers. As he once told Financial World magazine, “If anyone wants to follow Teledyne, they should get used to the fact that our quarterly earnings will jiggle. Our accounting is set to maximize cash flow, not reported earnings.” Not a quote you’re likely to hear from the typical Wall Street–focused Fortune 500 CEO today.


Is Negative Free Cash Flow the Same as Zero Value Creation?

In the fourth edition of Financial Statement Analysis and Security Valuation the author Stephen H. Penman discusses the topic of free cash flow and concludes in the second paragraph that free cash flow is not a measure of value added. Then what is a measure of value added? The search goes on, but it sometimes feels like “The more you know, the more you know you don’t know.”

But, for what it’s worth, let’s see what Penman has to say about free cash flow and his take on free cash flow when it comes to valuing a business (emphasis added).

Free Cash Flow and Value Added

Why does DCF valuation not work in some cases? The short answer is that free cash flow does not measure value added from operations over a period. Cash flow from operations is value flowing into the firm from selling products but it is reduced by cash investment. If a firm invests more cash in operations than it takes in from operations, its free cash flow is negative. And even if investment is zero NPV or adds value, free cash flow is reduced, and so is its present value. Investment is treated as a “bad” rather than a “good.” Of course, the return to investments will come later in cash flow from operations, but the more investing the firm does for a longer period in the future, the longer the forecasting horizon has to be to capture these cash inflows. GE has continually found new investment opportunities so its investment has been greater than its cash inflow. Many growth firms—that generate a lot of value—have negative free cash flows. The exercises and cases at the end of the chapter give examples of two other very successful firms—Wal-Mart and Home Depot—with negative free cash flows.


Free cash flow is not really a concept about adding value in operations. It confuses investments (and the value they create) with the payoffs from investments, so it is partly an investment or a liquidation concept. A firm decreases its free cash flow by investing and increases it by liquidating or reducing its investments. But a firm is worth more if it invests profitably, not less. If an analyst forecasts low or negative free cash flow for the next few years, would we take this as a lack of success in operations? GE’s positive free cash flow in 2003 might have been seen as bad news because it resulted mostly from a decrease in investment. Indeed, Coke’s increasing cash flows in 2003 and 2004 in Exhibit 4.1 result partly from a decrease in investment. Decreasing investment means lower future cash flows, calling into question the 5% growth used in Coke’s continuing value calculation.

Free cash flow would be a measure of value from operations if cash receipts were matched in the same period with the cash investments that generated them. Then we would have value received less value surrendered to gain it. But in DCF analysis, cash receipts from investments are recognized in periods after the investment is made, and this can force us to forecast over long horizons to capture value. DCF analysis violates the matching principle (see Box 2.4 in Chapter 2).


A solution to the GE problem is to have a very long forecast horizon. But this offends the first criterion of practical analysis that we established in Chapter 3. See Box 4.3.

Another practical problem is that free cash flows are not what professionals forecast. Analysts usually forecast earnings, not free cash flow, probably because earnings, not free cash flow, are a measure of success in operations. To convert an analyst’s forecast to a valuation using DCF analysis, we have to convert the earnings forecast to a free cash forecast. This can be done but not without further analysis. Box 4.4 summarizes the advantages and disadvantages of DCF analysis.


Additional Reading: Henry Singleton Case Studies

Longleaf Partners: Valuation Principles

“You do eliminate a lot of interference by being in Memphis as opposed to Manhattan.” —Mason Hawkins

This post contains a discussion of the valuation principles followed by Longleaf Partners. In it Mason Hawkins and his colleague Stanley Cates discuss the valuation approach underlying Longleaf Partners daily work in valuing businesses.

Letter To Our Shareholders

The first quarter of 2015 saw a continuation of the themes from the second half of 2014. Almost all of our individual businesses delivered solid operating performance, and our management partners pursued productive ways to build long-term per share values. This activity produced strong excess returns in Longleaf Partners Small-Cap Fund,“which helped the Longleaf fund earn the No. 1 ranking among small-cap U.S. equities funds.” (1) By contrast, the Partners, International, and Global Funds’ relative performance remained challenged as solid company results could not overcome three ongoing broad headwinds: the fall in energy prices, the U.S. dollar strength, and the Chinese government’s pressure on Macau gaming. While these challenges affected only a handful of our holdings, they were large enough to offset the good results at the vast majority of our companies.

The steady upward climb of the S&P 500 has intensified the debate over active versus passive investment approaches, and given this, we want to detail the reasons we are confident that our portfolios can outperform relevant benchmark indices and deliver on our absolute goal of inflation plus 10% over the long term. Our current underperformance is the exception. The three Longleaf Funds with a greater than 5-year track record have since inception returns well above their benchmarks.

Our history aside, future performance is all that matters to our shareholders and to us as the largest collective shareholder in the Longleaf Funds. Normally, we discuss future performance in terms of our price-to-value ratio (P/V), an indicator of our absolute return opportunity. Today, the P/V is above our long-term average, which is not surprising given the bull market run. A more objective and simple comparison to address the current focus on relative returns versus the indices is price-to-free cash flow (P/ FCF), which measures the multiple being paid for the cash earnings coupon that businesses will generate over the next twelve months. The free cash flow coupon is a better reflection of cash profits than are stated earnings. That P/FCF multiple translates into FCF yield (the inversion of P/FCF), which is the FCF return that an investor will earn over the next year if the stock prices remain the same, assuming the 12-month FCF estimates are accurate. That yield can be enhanced if the FCF coupons grow. We can distill our investments’ and the indices’ future return prospects down to the following objective formula:

Going-in free cash flow yield


Organic growth our companies can generate without spending that cash yield


Any excess returns our managements generate from reinvesting those cash coupons.


Expected cash return for shareholders

We believe comparing the FCF yield and prospective coupon growth in the Longleaf portfolios to those in the relevant indices indicates how well our current holdings are positioned and why we are confident in our ability to deliver long-term outperformance with low risk of permanent capital loss.

Going-in free cash flow yield:

FCF yield is the primary source of expected cash return. Today we are paying, on average, 11X forward free cash flow (P/FCF) for the Funds’ common stocks. If none of our companies grew, and they simply earned cost-of-capital-type returns on what they reinvested, we would expect a 9% return from the FCF earnings yield (the reciprocal of 11X). Admittedly, this number is based on our next 12-month cash earnings estimates, which may be no better than Wall Street’s estimates for any given company. In aggregate, however, our estimates for the whole portfolio generally even out any single- company misses and prove to be conservative.

Organic growth our companies can generate without spending that cash yield:

In addition to our estimated 9% FCF yield, the quality of our businesses and operating skill of our management partners will largely determine organic earnings growth. Beyond FCF coupons, returns will be powered by owning high quality businesses that can grow revenues and margins without substantial spending. We mostly own companies we believe are competitively superior like Aon, adidas, and Vail Resorts, where pricing power and other advantages enable organic growth that requires virtually no capital. Additionally, margin improvements can further boost organic earnings growth. We own companies like FedEx and Philips, where margins are nowhere near peak, and where the predominant sell-side descriptor is “self-help” – meaning they can raise margins even without an economic or revenue tailwind. Oil and gas companies, which are hurting performance right now, are the noted exception to our FCF profiles, but in the face of depressed energy prices, our partners are finding other ways to build value.

Any excess returns our managements generate from reinvesting those cash coupons:

Wise capital allocation by our management partners can create additional return beyond the sum of our FCF yield and earnings growth from organic revenue and margin gains. We own companies like Level 3 and Lafarge that are using capital to grow revenues with huge IRR (internal rate of return) expectations on the amount they invest above depreciation and amortization. Melco opening a new Macau casino, Chesapeake picking among millions of acres and thousands of possible well sites in an effort to drill the most profitable projects, and Scripps buying stock back far below private market value are representative of the high IRR projects our management partners are undertaking to grow value per share and thereby increase our ultimate returns.

If the three listed FCF return components perform as we expect, we should achieve our absolute return goal of inflation plus 10%. The yield is based on a constant stock price, but ultimately Longleaf’s performance should also benefit from the gap between stock prices and intrinsic values closing. Contrasting our companies’ metrics with those of the indices highlights the strength of our relative position. Our P/Vs range between 70-80%, while we believe the indices trade close to or above full value. The S&P 500, MSCI EAFE, and MSCI World indices sell for 21-22X next year’s estimated FCF, and the Russell 2000 is at 30X. This translates to a 4.7% yield (the reciprocal of 21-22X) for the first three and a 3.3% yield for the Russell 2000.(2) Earnings growth is limited with margins of the S&P and MSCI World indices near peak levels. Even if margins can stay at these highs, earnings growth is confined to organic revenue growth in a universe where most economies expect low single-digit growth. Conversely, if margins regress to the mean, the outlook for earnings growth is poor. Nor is capital allocation likely to generate growth, because the collective group of CEOs at index companies is not earning excess reinvestment returns. The most telling example is the recent manic stock repurchasing within the S&P 500. Ironically, we are huge supporters of share buybacks when a stock trades at a big discount to intrinsic worth; it de-risks capital allocation while boosting our value per share. But most companies tend to do just the opposite. When stocks had a fire sale in 2009, S&P companies repurchased $138 billion, but as the index was approaching historic highs in 2014 with many stocks trading above intrinsic values, these companies bought back $553 billion, close to their entire FCF coupon after dividend payments.

This behavior is boosting stock prices for now (and indirectly feeding the index’s outperformance of active managers), but will likely end badly, as all overpriced share repurchases ultimately do.

After the dramatic declines in the global financial crisis (GFC), the Funds’ absolute returns over most periods at the end of 2008 fell below our inflation plus 10% goal. We told our partners that because our P/Vs were below 50% and our P/FCF multiple was 7X, yielding 14%, we anticipated stronger compounding than normal. Over the six years since then, the Partners and Small-Cap Funds have made substantial money for shareholders as our absolute returns have far exceeded inflation plus 10% and we have outperformed the relevant benchmarks. Today, we face a similar end point challenge in the Partners, International, and Global Funds, but it is our relative returns that have underperformed. While we are committed to our absolute goal, given FCF yields, P/V levels and a slim on-deck list, we anticipate lower absolute returns than we did at the end of 2008. We feel as strongly now about our ability to outperform the indices over the next five years as we felt about our absolute opportunity after the GFC. Our portfolios sell on average for 11X FCF, slightly higher than our normal 9-10X, but very attractive against broader markets at 21-22X versus their historic 17-18X (and an even higher multiple in the Russell 2000). Said differently, we own portfolios with 9% FCF yields where we believe the cash coupons will grow versus the markets’ 4.7% FCF yields where the coupons will likely decline in the next few years.

While the payoff pattern may be unpredictable, the transaction activity that helped produce our substantial Small-Cap Fund returns in the past few years is occurring in companies across all of our portfolios. Exceptionally positive corporate activity is generating value growth in U.S. holdings such as Chesapeake, CONSOL Energy, and Murphy Oil. Likewise, our non-U.S. partners at Philips, Vivendi, Exor, CK Hutchison, and Lafarge are involved in transactions that have gone partially unrecognized in their stock prices thus far. In addition to owning quality businesses with relatively high FCF yields, we have partners making superior capital allocation decisions that we believe will further drive excess returns.

Southeastern has followed the same proven investment disciplines under the same leadership for four decades. While our concentrated, valuation- based approach has not outperformed the indices all the time, it has delivered strong relative results most of our history. Ultimately, our partners have been rewarded for owning strong businesses run by good management teams when the discounts between prices and values have closed. The payoffs tend to occur in periodic bursts that do not necessarily correspond with the broader markets. As the largest owners of the Longleaf Funds, we believe our portfolios are positioned to experience a burst of outperformance because they reflect a:

• Time-tested investment discipline rooted in the principles of investors such as Keynes, Graham, Templeton, and Buffett and implemented by a singularly focused, aligned manager,

• Set of criteria that has produced a track record of high rates of outperformance over multiple periods throughout our 40 year history,

• Strong position against benchmarks near historic high levels after a long-winded bull run in what arguably has become a “passive bubble,” and

• Carefully selected set of competitively advantaged businesses that are generating solid operating results with capable, motivated managements driving above average value growth and in many cases, creating catalysts for value recognition. We are grateful for our supportive, long-term partners who share our conviction. If you missed our shareholder webcast on Wednesday, May 6, a replay is available on our website.


/s/ O. Mason Hawkins

O. Mason Hawkins, CFA Chairman & Chief Executive Officer Southeastern Asset Management, Inc.

/s/ G. Staley Cates

G. Staley Cates, CFA President & Chief Investment Officer Southeastern Asset Management, Inc.

May 14, 2015

(1) Bloomberg Markets April 2015, “Staying Active.” Returns through 12/31/14

(2) Factset

(Source: Letter to Our Shareholders, Q1, 2015 – see link below)

The Cautionary Statement in the quarterly report contains a few definitions that can be useful to know.


EBITDA is a company’s earnings before interest, taxes, depreciation and amortization.

EV/EBITDA is a ratio comparing a company’s enterprise value and its earnings before interest, taxes, depreciation and amortization.

Free Cash Flow (FCF) is a measure of a company’s ability to generate the cash flow necessary to maintain operations. Generally, it is calculated as operating cash flow minus capital expenditures.

Free Cash Flow Yield (FCF Yield) equals a company’s free cash flow per share divided by the current market price per share.

The Global Financial Crisis (GFC) is a reference to the financial crisis of 2007-2008.

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows from an investment equal zero.

A master limited partnership (MLP) is, generally, a limited partnership that is publicly traded on a securities exchange.

Organic growth is the growth rate a company can achieve by increasing output and enhancing sales, as opposed to growth via mergers and acquisitions.

P/V (“price to value”) is a calculation that compares the prices of the stocks in a portfolio to Southeastern’s appraisal of their intrinsic values. The ratio represents a single data point about a Fund and should not be construed as something more. P/V does not guarantee future results, and we caution investors not to give this calculation undue weight.

Further Reading

Southeastern Asset Management, Inc. 

Letters to Shareholders – All Years Consolidated(1997Q4 to Present)

Longleaf Partners Funds Quarterly Report, Q1 2015

Berkshire Hathaway Value Update, Year-End 2014

“As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). In our 2010 annual report, however, we laid out the three elements – one of them qualitative – that we believe are the keys to a sensible estimate of Berkshire’s intrinsic value. That discussion is reproduced in full on pages 123-124.

Here is an update of the two quantitative factors: In 2014 our per-share investments increased 8.4% to $140,123, and our earnings from businesses other than insurance and investments increased 19% to $10,847 per share.”

—Berkshire Hathaway, Annual Report 2014, p. 7

Intrinsic Business Value Update

Last weekend I read the 2014 annual report from Berkshire Hathaway. As usual I enjoyed it, and even more so this year due to the extra writings from both Warren and Charlie.

Buffett himself summed up Berkshire’s 2014 in a good way in the beginning of the shareholder letter, when he said that “It was a good year for Berkshire on all major fronts, except one.” The exception was attributable to BNSF that according to Buffett “…disappointed many of its customers. These shippers depend on us, and service failures can badly hurt their businesses.”

The table below shows some key financial data for the prior ten-year period, including an estimate of intrinsic business value (by using the so-called “two-bucket approach”).

By using this two-bucket approach and applying a pre-tax earnings per share multiple of 10 times, results in a intrinsic business value per A share of $248,593 (or $166 per B share) at the end of 2014, and increase of 12.8% year-over-year. Book value per share increased 8.3%, from $134,973 to $146,186. The biggest change was in the price per share, increasing 27.0% year-over-year, from $177,900 to $226,000.


The 10-year average intrinsic business value (IBV) to book value (BV) was 1.65. Price to book value and price to intrinsic business value averaged 1.38 and 0.84 respectively.


At the moment (March 6, 2015) the A share is trading at $218,986 (or $146 per B share), giving a margin of safety of 12%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.