Margin of Safety

Bond Yields and Stocks

Bond yields are public information so stocks incorporate these into their share prices, when bond yields are low share prices are likely to be high

Depreciation and Amortization on FCF

Cash flow also results from excess of depreciation and amortization expenses over capex e.g. when a company buys a machine it is required by GAAP to expense that machine over its useful life (depreciation) which is a non cash expense that reduces net income but not cash, so depreciation contributes to cash but must eventually be used to fund capital expenditures that are necessary for new equipment so capex (use) is a direct offset to depreciation (source) Amortization of goodwill is also a non cash charge but is more of accounting fiction than anything else--> when company is purchased for more than book value then GAAP requires buyer to create an intangible balance sheet asset called goodwill to make up for the difference and then amortize over forty years, but amortization does not necessarily reflect a real decline in economic value so company may not need to spend this non cash expense to preserve the business like they would with depreciation so goodwill amortization increases FCF EBITDA ignores Capex when adding back depreciation, so unless you finance 100 percent of your capex then this understates what the business will have to do to grow and maintain and diversify etc. Make sure to look at both EBIT and EBITDA to see how much depreciation is contributing to cash flow, want a company to have more than enough money beyond depreciation expense to pay down interest etc. see pg 75 of Margin of Safety

Bond

Face value - principal value (Varies from price) Coupon- interest rate Maturity - length of bond repayment Yield - when a bonds price increases, yield decreases because the yield is essentially the annual coupon payment / price so as prices decrease yields increase Bond investors like to see low interest rates because dropping yields mean higher bond prices https://www.investopedia.com/terms/b/bond-yield.asp

Value investing overall stragety

Investing at a discount provides a margin of safety Need to look at where the real value of the business is coming from Intangible asset business dont really have margin of safeties because real value comes from intangible asset (dr pepper soda formula) Tangible asset businesses can be liquified worst case scenario Buy at a discount to value and sell when value is realized by price and by not investing to be invested Look at not only what is undervalued by why is it undervalued and sell when reason for investment ownership no longer applies Look for catalysts that may directly assist in the realization of underlying value Metric--> net cash per share relative to price per share

Value Investing

Investing at a discount to the underlying value of the asset, leaving a margin of safety for bad luck or analytical error

EBITDA Analysis

May lead to overvaluation of businesses Because interest expense is tax deductible, pretax income can be used to pay down debt; money that would have otherwise gone to pay taxes goes instead to lenders so highly leveraged companies thus have more available cash flow than the same business using less leverage EBIT is not necessarily all freely available cash, if interest expense consumes all of EBIT no income taxes are owed. But if interest expense is low, taxes consume an appreciable portion of EBIT. --> at height of junk bond boom companies could borrow an amount so great that all of EBIT was frequently required for paying interest After tax income plus that portion of EBIT going to pay interest is a company's true cash flow

Junk Bond Market

Milken created on the premise that below investment grade bonds not only had high yields but had low risk and high liquidity The idea of low risk was because risk averse investors shunned low grade bonds regardless of potential return so these bonds traded at depressed prices and low prices not high coupons were the driving force behind the attractive returns (spin off of the value investors mindset but it wasn't true)--> Fallen angles traded considerably below par so had less downside risk than newly issued junk bonds that traded near par so limited upside but unlike high grade bonds have very high downside potential For fallen angels trading below par, if credit quality improves or interest rates drop then there is room for appreciation but bonds at par are generally subject to call prior to maturity and thus have very limited upside Milken falsely claimed that default rate of small number of fallen angels would be same as newly issued junk bonds a decade later Default rates lagged because it takes time to default also they raised capital to offset defaults and issued paid in kind or zero coupon securities where no cash was paid until the end Concept of buying with other peoples money drove multiples up --> excessive prices were paid for businesses by buyers able to issue risky paper to investors who in turn stretched their own customary analytical standards to justify the prices paid

Institutional investor

Post WWII, retirement funds through businesses (pension funds) grew and alongside money managers saw an opportunity to manage this money, institutional investing went from 8% to 45% share of the overall stock market over 40 years Because they dominate the share of the market, institutional investors affect all investors Modest returns win because comp for money managers is based on fees associated with AUM so the last thing they want to do is lose clients so modest return > high return with great risk Selling is relatively difficult because many investments are illiquid and selling creates additional work as sale proceeds must be reinvested in a subsequent purchase so retaining current holdings is much easier and the SEC regards portfolio turnover unfavorably Do a lot of indexing, basically unconcerned with if market goes up or down , just riding the wave and collecting fees Constrained by always wanting to be fully invested

Security price fluctuations

Security prices move up and down for two basic reasons--> to reflect business realty or to reflect short term variations in supply and demand Biz Reality --> Company specific e.g. expanding business or hurricane causes losses then increase/decline in total market value equal to estimated gains or losses may appropriate or Macroeconomic e.g. broad based decline in interest rates, drop in corporate tax rates or a rise in the expected rate of economic growth could precipitate a general increase in security prices Supply and demand--> Short run supply and demand alone determine market prices, if there are many large sellers and few buyers than prices fall, sometimes beyond reason. Can result from year end tax selling, institutional stamped out of stock for disappointing earnings or unpleasant rumor, most day to day fluctuations result from supply and demand not fundamental developments

P/E Ratio

Some people like to buy low P/E ratio bc buying at a bargain (he equates to driving while only looking in rear view mirror) In reality, many P/E ratios are often depressed because the market price has already discounted the prospect of a sharp fall in earnings (P/E ratio may soon rise because earnings have declined)

Underwriting

Stock or bond underwriting for a corporate client generates high fees for an IB (2-8%), these are shared with stock brokers who sell the underwritten securities to clients, IPOS are capitalized at high multiples which is often overpriced because of financial engineering rather than raising capital to finance the business's internal growth --> deck is always stacked against the buyer The secondary market (after stock is owned and resold) commissions are much smaller

Stocks Bonds

Stocks - fraction of company Bonds - loans to the company

Wall Street

Three principal activities: Trading (earn commission from trading spread), Investment banking (arrange fro M&A, underwrite new securities, provided financial advice, and opine on the fairness of specific transactions), and merchant banking (commit own capital while acting as principal in investment banking transactions) Upfront fees and commissions based on what they do not how effectively they do it

Successful Investor

Value investor Without fear and greed

Net Asset Value (NAV)

Value per share of Mutual Fund or ETF NAV = (assets - liabilities) / number of outstanding shares In this context, assets include total market value of the fund's investments (priced using the closing price of all the assets on the day the NAV is calculated), cash and cash equivalents, receivables and accrued income. Liabilities equal total short-term and long-term liabilities, plus all accrued expenses, such as staff salaries, utilities and other operational expenses. Mutual funds and ETFs relate their market prices to NAV, but the market price includes fees such as sales loads or purchase fees. The price for selling a share is based on the per-share NAV but subtracts any fees charged at redemption, including deferred sales loads or redemption fees. Like stocks, the market value of mutual funds and ETFs also fluctuates based on supply and demand, but typically stays closely tied to NAV.

Business Value

fluctuates The credit cycle the periodic tightening and relaxation of the availability of credit affects this, buyers will pay higher multiples for businesses if they can secure cheap financing Inflation or deflation- If for 50 cents you buy a dollar of value in the for an asset like real estate or natural resources that increase in value with inflation, a 50 cent investment can realize a value appreciably greater than on dollar (however, if inflation becomes expected inflation then that will be reflected in the security prices which will be bid up or vice versa with deflation) Cannot determine when prices will rise or fall so all investments should be made conservatively giving weight to worst case liquidation value