Book: Security Analysis and Business Valuation on Wall Street
Author: Jeffery Hooke
Key Takeaway: This is a great book for an overview of security analysis, though for a somewhat seasoned analyst, this book is primarily valuable for the section where it talks about valuation of certain specific industries. Case in point, I read this book first in fall of 2010, and thought this was an indispensable guide. Reading it again in 2015, I found the last section to be most useful. As a value investor, I think this book (and many others like it) do a teeny bit of disservice when they don’t emphasize the limits of the methods enough, but then again, perhaps several people know of it already. Having said that, I think this is a must-read.
Industry Analysis: Very useful to think (1) where the industry is in its life-cycle, and (2) how the industry reacts to the economy’s business cycle. Also key to understand how the major technological, social, government and demographic trends are impacting the industry. In industry reviews, people spend most of their time studying the demand trends and assume that supply will take care of itself–this can sometimes ignore certain bottlenecks and deterioration in quality.
- Business Description
- Corporate Strategy
- Life Cycle
- Financial Summary
Products and Markets
- Product Line and New Products
- Market for the Products
- Marketing Strategy and Customer Support
- Significant Customers
Production and Distribution
- Manufacturing Process and Costs
- Suppliers and Raw Materials
- Competitive Environment
- Comparative Analysis of Competition
Upon studying these, we need to figure out what the company’s sustainable competitive advantage is–(a)low cost, (b) differentiation, or (c) focus in a niche area. It is perhaps also useful to think of the company’s products in the famous BCG growth-share matrix.
Value = Market Value of Reserves + Value of Other Assets – Liabilities + Intangible Value of Management’s Ability to Replenish Reserves
Natural resource firm has its reserves evaluated by an independent engineering firm each year. This report provides –
- Proved Reserves: Includes developed (can be recovered using existing wells) + undeveloped (an estimate). PV and PV-10 (includes effect of certain income taxes) are derived from this.
- Reserve Production Ratio: Proved Reserves / Annual Production. Doesn’t account for the fact whether the reserve can be extracted economically.
- Underdeveloped acerage and cost per acre: Valued at historical cost, unless otherwise stated
- Average prices received
- Lifting costs per barrel (oil cos): cash operating cost to extract (separate from G&A and non-cash charges). Often times, it is analyzed on a rolling 3 year basis.
- Reserve Replacement Ratio: New reserves / annual production
- Finding costs: finding costs + lifting costs + G&A is the ongoing cash cost
Need to figure out whether the company capitalizes all wells or only the successful efforts. If the capitalized asset gets impaired, they’re written down. Note that the accounting rules do not allow upward revision, though. Most E&P companies pay very little federal income tax because the tax rules allow for more aggressive depreciation of investment and as long as the company keeps exploring, it can keep charging them as a tax-deduction–until the production falls off.
Companies are typically not valued as having a static production curve, and rather it is assumed that the company keeps finding reserves in excess of annual production. Based on the forecasted production and ASPs, the financial forecasts are made for 5-10 years. At the end of the estimate period, often a terminal value is assigned as 5-6x cash flow.
Financial Industry Stocks:
This section of the book talks about banks in particular. I have a strong personal bias against investing in banks because a 2.5% loss on assets can lead to a 25% loss on equity, assuming 10x leverage. This combined with the opacity of banks, makes it impossible to understand a bank unless you have a good understanding of its risk culture. In this section the book highlights these issues but does not give enough direction on how to rectify these issues and hence I didn’t this section was worth summarizing.
Banks are in what can be called a “spread business”; insurance companies are not like that. They’re solely in what I call “risk assessment” business. Insurance companies make profit after paying for expected insurance losses (claims), underwriting costs (claim processing and operations), and marketing costs (we ignore investment income and unexpected losses). The most important insurance ratio is the combined ratio, which is a measure of profitability of the core insurance business (excluding the returns from its investment income/losses). The industry is highly cyclical, as anyone who has read Berkshire Hathaway annual Chairman letters knows. In the U.S. an independent actuarial firm goes through the books (in addition to the company’s auditor) and files it with the state, and people can visit the state insurance companies to look at these (certain reserve information is included in Schedule P). These filings with the state regulators are made annually.
Life insurance companies have more accurate predictions of losses (vs. P&C) as the policies have a fixed payment and mortality schedule changes little. Until the ’80s, life insurance industry was dependent on the whole-life policy, where the customer built up cash $s (thru his/her premiums) tax-deferred. Due to competition from money-market and mutual funds, more and more customers switched to term-life policy vs. whole-life, leading the insurance companies to add “spread lending” (called annuity) and “money management” functions to their businesses.