Black Swan Hunting

In my years as an investor and a professional in the financial services industry, I have not yet been able to find anyone who can accurately and consistently forecast future market events with any degree of accuracy. In my view, any and all forecasts are, at best, educated guesses. Many brokerage houses and investment banks have literally dozens of in-house economists that dedicate their careers to identifying changes in the economy before they happen, when in reality we have found that, no one truly knows what tomorrow will bring. In a survey of Wall St. economists taken one year ago, the "consensus" view was that the likelihood of recession was less that 40%. One problem with these forecasts is known as the "Black Swan Theory", popularized in a book by Nassim Nicholas Taleb, that recounts a 17th century scientific experiment as a metaphor for a deeper philosophical question about human behavior. In the book he argues that we place too much weight on the odds that past events will repeat, using statistics and the scientific method. Instead, the most impactful events are those that are rare and unpredictable. Aside from their obvious human tragedy, events occurring in the last decade such as the tech/telecom bust, 9/11, hurricanes of 2004, and the current credit crisis have been powerful examples of highly improbable events that have had a profound impact on history and our portfolios.

While I would agree with his conclusion, I would argue that there are 2 kinds of predictions that, when applied consistently, have some value to investors and should be considered in the investment process: One is opportunity-based, and the other is risk-based. Risk based forecasts are applied extensively in the asset allocation process. First and foremost, when constructing and maintaining portfolios I believe that by applying a consistent and disciplined strategy balancing growth, income, and alternative asset classes you can successfully reduce exposure to inflation, currency devaluation, credit risks, and declines in corporate and consumer spending. While we can add value by tilting these beta exposures in response to cyclical and fundamental changes, anchoring the portfolio from these risks increases the likelihood of long term success of the strategy. One tool used in determining these allocations is known as "Monte Carlo" analysis, in which a computer effectively recreates over 10,000 portfolio outcomes or "rolls of the dice" in order to effectively determine which weightings are most appropriate, Because a "black swan" can have such a large impact on our portfolios, and are so as hard to predict, we should continue to embrace diversification.

Probability assessments are typically based upon historical comparisons of prior markets with similar characteristics: The more variables that align, the higher the likelihood that a given scenario plays out in a similar fashion. While I admittedly did not anticipate the magnitude and depth of the current crisis, I have been, and continue to strategically position assets away from financial, consumer discretionary, and cyclical industries, in favor of increased weighting toward healthcare, staples, and utility stocks, which are generally a safe haven during periods of market duress. Many times these types of comparisons require going back in time, to make a thoughtful judgement about the future. A recent decision to sell a position in Schlumberger (SLB) was based on an analysis of the oil services industry and its sensitivity to economic events that happened in 1974 and 1981.

Another way to improve the likely outcome of the portfolio can be seen within the research process itself. As access to credit and free flowing spigot of the capital markets becomes sealed temporarily, I have rigorously approached each holding as "credit analyst" would, rather than simply an equity analyst. Reviewing debt covenants, credit facilities, and near-term spending needs for each company owned has become routine. I am highly confident that these actions have minimized risk, and recent additions to the portfolio like Alcon, Stryker, and Google, further improve quality of the portfolio with their pristine balance sheets and strong cash generating ability.
Probability assessments are not only used as a defensive mechanism, but also as tool used in search for opportunities within your investment universe. To illustrate this concept consider an investor with the following investment opportunities presented to him/her: Opportunity A) a $1mm investment that offers a 20% return, with an 80% likelihood of success. Opportunity B) a $1mm initial investment with a payoff of 50%, but only a 50% likelihood of success. At first glance, most people would pick opportunity A, because if its relative certainty, but a more informed investor would actually pick the second opportunity, because the probability weighted expected value is actually higher (250k vs. 160k). This type of analysis is used extensively when evaluating an E&P company with a portfolio of oil or gas reserves, with differing levels of profitability and probability of drilling project success.

When thinking about constructing your portfolio in a way that is aligned with your view of the world, it is important to have an investment paradigm or framework in place to guide decision making in a disciplined and consistent manner. Mohammed El-Erian, former manager of the Harvard Endowment, and currently a bond portfolio manager at Pimco, uses the analogy of a 6 lane highway, to illustrate how to benefit from our perceived systemic changes to the investment landscape. He believes that investors can benefit by identifying a handful of growth themes (lanes of highway) in a portfolio, that may take several years to materialize, but investor can shift vehicle to avoid traffic (risk exposures) but needs to stay within the highway barriers (investment process). Within the framework of an investment process, we can add value in a similar fashion.

In the near term I anticipate weak consumer and corporate spending environment, however, recently announced government stimulus programs around the world may offset some of this weakness. President Obama recently announced a $700B program designed much like the "New Deal" with huge investments in transportation, telecommunications, healthcare, and power grid infrastructure, are likely to benefit many of our holdings. Norfolk Southern should benefit from improvements to the nations rail network; companies like Cisco Systems, Citrix, and Google will benefit from the "networking" of America's schools and institutions, and names like ABB and ITT will surely benefit from increased spending on infrastructure and energy efficiency.
While none of us has a clear “crystal ball” to foretell the outcome of current economic situation, history tells us that it is likely to be longer and more complex than most people anticipate, and controlling risk needs to remain the top priority in your portfolio. That said, with risk comes opportunity. Many of the darkest, most uncertain times in our history, were times that presented the greatest opportunities for investors. We continue to strive to find those opportunities without taking unnecessary or excessive risk.

While the consensus thinking is that MLP’s may have difficulty accessing capital to fund future growth projects, I believe the valuation adequately discounts these risks, and in general, MLP’s are an attractive investment vehicle for the following reasons:

-Historically very low correlation to traditional equity and fixed income asset classes, and surprisingly low correlation to price of oil (co-variances of 10-30% to equity and fixed income) making them a great portfolio diversifier during times of uncertainty

-Attractive source of relatively stable income (yields ranging from 7-10%), particularly during periods of declining interest rates and volatile equity markets. With 10 year treasury yielding 3.9% nominally, and much less in real inflation adjusted terms, the value proposition of an 8% dividend is compelling

-Annuity like cash flows, similar to utility or infrastructure plays, due to inelasticity of demand provide dividend visibility. Whether the price of oil/gas falls, it still needs to be transported to the end user. A majority of an MLP’s cash flow is fee based on the volume of oil/gas that is distributed.

My analysis suggests that Oneok is one of the most well positioned MLP’s, trading at a reasonable valuation, and is therefore poised to outperform its peer group (Alerian MLP index is most comprehensive) over the next several years

On a relative basis, Oneok generates a greater % of its EBITDA through the storage and refining of natural gas, vs. other pure play pipeline/distribution business models. Just as Valero (a refinery company that we owned in 2006-2007) earns excess returns by running complex refining system capable of converting abundant & inexpensive heavy-sour crudes in to higher value grades of distillates and gasoline, Oneok benefits from similar dynamics as it converts domestically produced natural gas into LNG (liquid natural gas) used in many commercial applications, and increasing as an alternative to gasoline and diesel. The energy content ratio of 6X, is largely “out of whack”with the $6:$70 NYMEX (Nat. Gas) vs. WTI (Light Sweet Crude Oil) relationship. This increases the value proposition of the conversion & refining process, and leads to higher margins for Oneok (about 40% of cash flow) (40% pipeline, 40% refining, 20% storage). In simple terms, there is a wide price differential between raw inputs & prices paid by the consumer.

Well positioned infrastructure near high growth gas areas like the Barnett Shale, the Anadarko Basin, and Fayetteville Shale in Oklahoma. High levels of asset turnover(revenue growth/asset growth) are indicative of highly productive and improving asset base. Management has exercised capital discipline in acquiring these assets. One new area of investment has been the Woodford Shale, a resource we are very familiar with given our investment in Newfield Energy. As the chart below indicates, you can see the secular growth in production that these unconventional, mid-continental shales are experiencing.

The company has a relatively high ratio of unregulated “intra-state” pipelines, vs. “inter-state” pipelines, which are regulated by FERC who typically allows no more than a CPI-linked price increases, and generate regulated utility-like ROE’s of about 10-12%. Essentially this is a volume story, not a pricing story, but the prolific nature of the mid-continental shales (Barnett & Woodford) with their low decline rates and the application of more sophisticated technology like horizontal drilling techniques are increasing the daily output from these areas.

Most importantly, the company looks healthy than most of its peers from a financial perspective:

-Strong balance sheet – The company has industry leading interest coverage ratio, low debt/EBITDA, and has relatively minimal capital needs to fund near term growth

-Distribution coverage ratio – cash flow generation ability vs. expected dividend payouts. The company is believed to have one of the most secure dividends because of its strong cash flow coverage and consistent growth in payouts.

-Capital Spending budget analysis– We believe that OKS has lower risk of missing its growth targets over the next 2-3 years because the bulk of its capital investments have been made in 2007 & 2008, and on a relative basis, should be much less reliant on re-accessing the capital markets to fund its growth promises and maintain its dividend growth rate.

Investment Risks

We remain bullish on the MLP investment thesis presented last week but will continue to be vigilant of the following risks

1. potential conflicts between limited and general partners – to date, this has not been an issue, but voting control does lie in the more leveraged and less profitable GP structure

2. Access to capital markets & post 2009 capital budget needs – in late 1970’s there was a boom in MLP development, followed by a huge bust in the mid-1980’s as energy prices collapsed & access to credit became more difficult. While we have extensively reviewed the companies capital needs over the next 2-3 years, should the company need to greater than expected amounts of capital that it has communicated to investors, and credit conditions remain tight, this could hamper growth.

3. Regulation risk - any changes to their laissez-faire approach regulation during times of consumer and economic contraction. Does new democratic administration have any tax law changes that would jeopordize MLP’s tax status?

4. Natural disasters – While the company does have insurance for these types of events a major hurricane outage could put near term revenues at risk until pipelines are replaced

Given the volatility and poor returns in the market lately, investors should continue to look for new alternative sources of growth in their portfolios, and I believe that MLP’s offer investors a great opportunity at these prices

One exciting investment opportunity identified through a fundamental/earnings quality screen that I run periodically is ABB Ltd. ABB is a Swiss conglomerate that provides a wide range of products and services to the power and automation markets. A recent earnings warning from Siemens, another European conglomerate that competes in similar markets, dragged the stock down in sympathy, and now trades at an earnings multiple slightly less than its long term growth rate. I felt the problems at Siemens were company specific, and the market reaction of ABB was unwarranted, creating an opportunity for long term investors to own a great business at a reasonable price.

The investment thesis on ABB is relatively straightforward. ABB has smartly positioned itself as an “energy efficiency” solution provider. Its products & services can be found at every node of the energy value spectrum, resource production, transportation, por generation, por transmission & distribution, and even consumption. Here is a sampling of the types of solutions that ABB offers:

• motors that efficiently por deep-sea drilling rigs



• marine propulsion systems that transport the oil



• substations, circuit breakers, capacitors used in electricity generation



• high, medium, low voltage transformers used to transmit and distribute energy across



• power grid automation, robotics, and variable speed drives/motors that drastically reduce industrial consumption

ABB is well positioned competitively to maintain its leadership status in most of the markets it serves. An enormous installed base, economies of scale, and a core competency in efficiency solutions provides the company with an enviable competitive moat. It's industry leading R&D budget that has generated a voluminous portfolio of intellectual property and innovative new products has galvanized this edge over the competition. Lastly its global footprint positions ABB favorably to benefit from rapidly growing emerging markets. Only 15% of revenues are generated in the US, and almost 40% from fast growing emerging markets. Interestingly, its leading market share in Asia is likely remain firm, as customers in that part of the world place greater emphasis on business relationships, and are more likely to award new contracts to their existing network of suppliers, a Chinese social custom known as Guanxi.

New Infrastructure needs to be built to support electricity demand in emerging markets-
As a provider of infrastructure & energy efficiency, ABB finds itself in a “perfect storm” of end-market demand. Emerging market electricity demand is expected to grow from 8B kilowatts per hour to 16B kw/h over the next 20 years. As population and GDP grows in these parts of the world, new infrastructure will be required to provide the energy to fuel that growth.



Existing Infrastructure in developed markets needs to be replaced -
Wall St. as ll as the entire northeastern US remember the summer of 2005 por outage in that left more than 20% of the US population in the dark for nearly 24 hours. A huge capital investment cycle in the 1960’s and 1970’s follod by a long period of neglect has left the US por grid in brittle condition, and as the head of the EIA describes, “one or two heat waves” away from crisis. The average US transformer is over 40 years old, ll beyond the average life expectancy for that type of equipment.

Energy Efficiency – The low hanging fruit of the green movement. While less “sexy” than other green investment opportunities, efficiency improvements are the low hanging fruit of the energy problem. 65% of energy use and CO2 pollution can be attributed to motors and engines. ABB’s variable speed drives and motors can significantly lor energy consumption and pollutants, yet in the US are used marginally (only 5% penetration). For perspective, consider that the installed base of these drives/motors in Europe has reduced annual consumption of energy to a level equivalent to 32mm households (1/3 US households!) and reduced yearly CO2 tonnage by the amount that the entire country of Ireland emits on an annual basis. Throughout the energy value chain, ABB believes it can reduce waste by about 20%, generating low-risk, high return on investment opportunities that businesses and governments will find hard to walk away from.

Renewable Momentum – Remote energy sources (solar/wind) will require transmission
Renewables – Public & legislative momentum as ll economic parity with traditional coal, gas, & nuclear fired por plants, is stimulating demand for renewable energy sources around the globe. While wind and solar por have become a meaningful part of the European por grid, the US still only generates about 2% of its electricity needs from such sources. Because renewable por sources are often great distances from the population centers that they serve (think Arizona!), infrastructure such as high voltage transformers must be used to effectively distribute the energy. ABB is the #1 player in this type of equipment.

Catalysts & Low Expectations may drive upside surprise for investors
In addition to these growth drivers, ABB has a great balance sheet, which could be a catalyst for the stock. The company has paid off most of its debt and now boasts a net cash position of over $6B, which can be used as competitive ammunition, for strategic M&A, or simply can be returned to shareholders through dividend or share buybacks. Expectations are modest relative to recent results, and believe the 10% earnings growth that Wall St. is anticipating will be easily surpassed. A closer look at the company backlog reveals a visible stream of high margin revenue yet to be realized.

Fundamentals & Valuation very attractive – Price target of $43
Returns for the company have been strong. Margins have grown from 5% to almost 12%, and the company sees 18% margins down the road as internal goals are met. Return on invested capital is ll over 20% highlighting quality management and focus on creating shareholder value.

Valuation is reasonable. For a company growing earnings at a 20% rate over the long term, a P/E of 18 represents a fair value in our opinion. This is a 20% premium to the market, but would argue growth prospects and profitability deserve an even greater premium. I am also comforted by the free cash flow yield of just over 4%, and annual free cash flow generation of about $4B. Using relatively modest assumptions (about 10% long term growth) and a 8% discount rate, I arrived at an intrinsic value of about $43 for the shares.

In conclusion, I found it difficult to poke holes in this investment case. While the world adjusts to $130 oil, terrorism, and a rapidly growing population, ABB’s products and services address some very real problems. We may not be able to find more energy, and it may take several years to find alternatives, ABB offers solutions to get much more out of what have, today.

How Mother Nature Can Grow Your Portfolio

If a tree falls in the woods, does Wall Street hear it? Clearly not, judging by the wide discounts to intrinsic value being awarded to names in the Timber REIT sector. Based on my analysis of private market value, the three largest timber REITs, Plum Creek, Rayonier, and particularly Potlatch Corp. offer investors a wide margin of safety, relatively stable cash flows, and a healthy dividend yield.

Perhaps the most compelling argument for an investment in timber lies in the risk reduction benefits that timber can add to a growth focused portfolio. Backtesting 20 years of data from the NAREIT Timberland Index, in addition to a portfolio of US stocks, intl developed, emerging markets, and bonds reveals remarkably low correlation, while generating long term returns of almost 14%. The correlation with equities was less than 10%, providing "bond-like" diversification, with returns that would be expected from smallcap or emerging markets. As these risk/return characteristics continue to improve the opportunities along the
efficient frontier, the optimization models that institutional investors base their asset allocation on will continue to overweight this asset class. Many highly regarded asset allocation gurus, such as David Swensen, who manages the Yale endowment, have been long time proponents of adding real assets, such as timber, to a well diversified portfolio. That said, as of this past Decemeber, the average institutional portfolio only held about 1% of their assets in timber, a far lower allocation than the efficient frontier would suggest as optimal.

Within the Timber REIT sector, one of the more attractive companies is Potlatch Indstries. Potlatch owns about 1.7mm acres of timberland in Arkansas, Minnesota, and Idaho. The company is vertically integrated with higher margin businesses such as resources (timber harvesting) and real estate sales, offset by its lower margin, downstream businesses such as wood products (lumber), pulp/paperboard manufacturing, and consumer products (off-label tissues). This provides the company with numerous growth levers and allows
them to more effectively manage volatility in its business. For example if timber pricing is weak, the company may delay its harvesting activities, choosing instead to generate cash with its manufacturing operations and real estate sales. Importantly, there is minimal opportunity cost when the company delays its timber harvest as trees continue to grow biologically. On average, trees grow between 3-6% per year.

After recently filling the CFO post with Eric Cremers, who recently orchestrated the splitup of Albertsons, it is clear that the company is focused on creating value for shareholders. Based on my analysis, there is plenty of value that can be monetized. Using data from 30 of the largest private market transactions over the last 5 years, US timberlands have been sold at roughly $800 per acre. The most recent data, published by industry journal, Timber Mart South, indicates timberland transactions have been averaging $1400 per acre. Lets be conservative, and use the 5 year average. The company also has 225k acres of HBU land (or higher or better
use land) that the company conservatively believes can be sold at $2000 to $4000. After conferring with industry sources, and considering that competitors Plum Creek and Rayonier value their comparable HBU land at $4000 to $10000, using $2000 per acre as a base-case scenario should provide a margin a safety in the analysis. Assigning these values to the 1.5mm timberland acres and the 225k HBU acres, subtracting debt, and applying a trough 6x EBITDA multiple to the the manufacturing businesses implies a total enterprise value of about $56 per share for Potlatch. At its current $40 stock price, the risk reward is quite favorable. Furthermore, a dividend yield of 5% should offer investors a healthy stream of income as we
patiently await for catalyst to develop and the intrinsic value to be realized.

Adobe Corp: Riding the Wave of Web 2.0
Given the recent volatility in the market, I have slightly modified my screening process placing a slightly greater emphasis on strong topline growth, earnings consistency & clean balance sheets, the qualities of companies that tend to trade well during times of economic uncertainty. Obviously, I am not the only investor seeking a safe haven in this market, and the redirection of money flow into these stocks has driven their prices and P/E ratios up. Stocks like Proctor & Gamble and Microsoft are at their 52 week highs and trade at P/E multiples much higher than historical averages. Although my investment approach is rooted in value investing, I am willing to pay a premium for stability in this environment. After all, the great Warren Buffet has even been known to pay up for quality during times of turmoil, as evidenced by Berkshire's late 1980's purchases Coca Cola and Gillette.

My search has led me to Adobe Corp. Most everyone that owns a computer in the developed world has at one time or another used Adobe Acrobat(900mm installed base). Adobe utilizes a "reverse razor blade" strategy by distributing free copies of its reader product to PC manufacturers, and generating its profits on sales of its writers, or applications used to create communications in PDF. format. This creates enormous competitive moat for the company and allows it to generate strong returns on its invested capital.

Not only does the company have strong competitive position, but several growth catalysts are emerging that should increase the visibility of earnings growth and likelihood of upward revisions. From an industry perspective, the outlook is bright. Enterprise roll-outs of Vista (Microsoft) and insatiable consumer demand for notebooks is expected to support PC/Notebook shipment growth of over 11%-13% according to Gartner and IDC forecasts. Most of these machines will come pre-installed with Acrobat software. Furthermore, the popularity of web-communities such as myspace and youtube is resulting in exponential growth in the number of websites and the need for creative content solutions.


Internally, the company is intently focused on its recent launch of CS3 (Creative Suite 3), a suite of tools used by creative professionals and consumers that want to use computers to create their own websites, blogs, and share media with family and friends. With the recent acquisition on Macro-media, known for their popular flashplayer technology, the new product offers much greater video functionality for web-developers and should generate significantly higher per unit margins than previous rollouts. Since 2003 the average selling price of ADBE's product mix has grown from about $250 to $400. This trend should continue. Going back 20 years, I found a strong correlation between product launches and accelerating sales trends. Given that CS3 is anticipated to be the most successful launch ever for the company, revenues are poised to follow the historical pattern of post-launch growth. On its most recent conference call Adobe management pointed out that penetration rates among creative professionals are 40% higher than previous releases at this point in the product roll-out cycle (launch + 6 months), due to the products growing popularity and enhanced functionality.


Additionally, new product launches in mobile applications should gain traction in 2008. The number of of "flash enabled" devices sold per year has grown from about 50mm to 250mm in just the last 3 years. Interestingly, most of the developing world (and over 60% of the worlds population) will access the internet for the first time via a mobile device, so the enormous opportunity here is clear. There are indications that the company will launch a mobile product in 2008.

Lastly, the company is making significant strides within the enterprise marketplace through a recently announced partnership with SAP which should dramatically increase the Adobe value proposition within large organizations. Longer term, the company has been beta testing a new html-based architecture known as AIR that will make web content creation much more accessible to the masses. As the operating system continues to look more and more like a home-page, applications such as AIR will be at sweet spot of this technological evolution. At a recent conference management indicated that internally, they think AIR has the potential to do for internet content development what Acrobat did for document management. The company expects numerous product launches based on the AIR technology, as this next generation "razor blade" gains mass acceptance.

Fundamentals & Valuation
The company should earn about $1.85 next year, which means it trades at about 22x earnings at the current price of 42. They do have over $6B in cash & equivalents on the balance sheet, so adjusting for cash we are paying about 19X, not cheap, but not ridiculous either for a company that generates ROE's of 25% and is expected to grow at 16% over next several years. I also like to look at free cash flow, and as expected with any software company, Adobe is a cash machine. The company has well over $1B in cash flow earning power, which is healthy for a company with an net enterprise value of about $18B. Based on my DCF analysis, which assumes consensus growth rates, a discount factor of 10%, and a terminal multiple of 18X, the stock is intrinsically worth about $50 per share, a modest margin of safety.

This isnt a classic value stock, and any execution missteps with the new management team do pose a real risk to the thesis given the premium we are paying. I have met the new management team, and they have been well groomed internally, and largely seem to be thoughtful, shareholder friendly managers. Not a risk free story, but when the market gyrations have you reaching for the Pepto, a stock like Adobe, might let you sleep a little better.

Show me the money!!!

The myopic focus that Wall Street places on near-term earnings-per-share (“EPS”) and the resulting price appreciation awarded to companies that “beat” EPS estimates creates a misguided incentive for executives to “manage” reported earnings. Though accounting rules have been tightened, there are still many ways which companies can use aggressive accounting to “beat” EPS targets. Naturally, financial engineering has become an all-too prevalent and sophisticated exercise.

One infamous example of this involved appliance maker, Sunbeam Corporation, which after a string of poor results initiated a restructuring to repair its image with investors. As sales continued to falter, newly hired CEO “Chainsaw Al” Dunlap initiated a scheme to improve results by shipping barbecue grills and air-conditioners to retailers—in December!! With generous rebates and return allowances Sunbeam successfully padded near term sales but the returns from retailers led to ballooning inventory, hurting pricing and leading to disastrous results and the collapse of Sunbeam. This kind of “channel stuffing” is often a warning flag of declining corporate performance and a lower future stock price.

Because, historically, EPS has been the primary measure of a company's performance, accounting rules have evolved that attempt to more precisely match the timing of a firm's revenue and expenses. Earnings are composed of cash flows and accruals. Accrual accounting strives to recognize revenue when it is “earned” and allocate expenses when they are “incurred” regardless of the timing of the actual cash flows. The benefit of accrual accounting is that more appropriately smoothes the operating results of a business. However, because accruals are based on assumptions about the future, corporate managements may be tempted to tweak assumptions in a manner that make the company appear more attractive.

Here are a handful of situations that highlight the importance of monitoring the level and trend of accruals:

1. Manipulation of depreciation and other non-cash expenses
Accounting rules allow managers wide discretion to determine the allotment of “non-cash” costs such as estimating the useful life of an asset. Waste Management was recently penalized by the SEC for "juicing" its earnings by re-estimating the useful life of its garbage trucks, an action which had the effect of lowering its depreciation expense and reporting higher income.

2. Excessive capitalization of items which should be expensed
In 2002 AOL Time Warner was forced to take a charge of $54 billion as a result of the excessive purchase price of AOL and years of aggressive accounting policies that overstated the true economic value of the enterprise. AOL abused the accounting rules allowing certain expenses to be classified as assets and expensed over many years, rather than during the period when they were actually incurred. For example, as AOL was struggling during the late 1990s to show a profit, they extended the assumed useful life of the “starter kits” for dial-up internet service from two years to five years, dramatically lowering their current marketing expenses and increasing their reported income. AOL was grossly overestimating the useful life of these now-obsolete assets and, had they properly reported these expenses, the profits reported from 1997 through 2000 would in fact have been losses.

3. Inventory trends relative to sales
The collapse of Lucent and several of its telecom peers provides an example of where more careful monitoring of inventory trends may have protected investors from significant losses. While Lucent was keeping the Wall Street analysts pacified by consistently exceeding earnings expectations, investors overlooked that the company's inventories were growing at a dizzying pace. Increasing competition, product development missteps, and tempering demand was weighing heavily on Lucent’s cash flow. These factors together with the accelerating levels of accruals caused by the disproportionately higher inventory levels should have served as a warning regarding Lucent’s deteriorating business performance.

4. Accounts receivable (credit-based sales)
Lucent’s situation was exacerbated when the company loosened its credit standards and began offering very favorable financing terms to entice its customers to buy more equipment. The financing game stimulated some artificial demand by “borrowing” sales from future quarters and encouraging marginal customers and distributors to buy more products they otherwise likely wouldn't have purchased. While this stimulated near-term results, the higher-credit risk customers eventually defaulted on payment which contributed to the fall of Lucent’s stock.

While EPS (i.e. “accrual earnings”) is important, these four accounting situations highlight why we focus equal attention to a company’s ability to generate free cash flow (also know as "defensive earnings"). A recent study published by professors from the Universities of Michigan and Pennsylvania identify a phenomenon they call the “Accrual Anomaly”, where excess returns may be available to investors that buy companies with low levels of accruals. The results of their study are both robust and compelling as their model portfolio (long top 25%, short bottom 25%) beat its benchmark in 28 out of 30 years, and outperformed the market by almost 10% per year.

We view studies such as these as reaffirming of our practice of analyzing EPS quality and using earnings quality as a filter to our research process. In each investment we make, we closely evaluate levels of free cash flow trends in defensive earnings relative to accrual earnings, which we believe reduces the risk of earnings blow-ups amongst the names we own. This demand for strong earnings quality, in addition to seeking robust fundamental attributes of profitability, growth and valuation strengthen our portfolio holdings.

TJX, a high quality retailer in the bargain bin....


The recent credit card breach at TJMaxx has evoked loud criticism from all corners of the investment and political spectrum over the company's lax security measures. Some have gone as far as to equate the companies actions as those of the criminals themselves. In a recent Lightening Round on Cramers Mad Money, when asked his view of the stock, Jim declared that TJX is a "mismanaged" company. Perhaps had he given more than the 12 allotted seconds to deliberate each stock idea, he may have constructed a more thoughtful position.

While I am concerned that more stringent controls were not in place before the breach, I view TJX as more a victim than culprit in this situation. I love when short term issues like this give us the opportunity as long term investors to buy and hold great companies until the market lets them out of the penalty box. I must say, I have to respectfully disagree with Cramer’s conclusion however that TJX is a “mismanaged” company. Having done significant work on the drivers of outperformance in the retailing space, I have concluded that the winners are usually the companies that #1 can generate the highest return on shareholders capital & #2 can sustain strong “same store sales”

Because TJX employs a unique business model that emphasizes operating highly efficient stores and delivering value to the consumer and focuses less on developing fancy store layouts and concepts, they consistently earn higher return on invested capital than their peer group. TJX turns its inventory much faster than most peers, which creates value in three important ways. The faster inventory turnover enables TJMaxx to generate higher levels of cash flow as less working capital is needed to finance the inventory. Capital expenditures also tend to be lower as store concepts are lower priority, and stores do not need to be renovated every three years to remain "trendy", As the chart below illustrates, TJX has one of the highest levels of free cash flow earning power in the retailing sector, a financial metric which is typically associated with higher valuations and stock prices. Secondly, the brisk turnover model creates huge value proposition for its suppliers, providing the clothing manufacturers and department stores an additional channel of distribution and allows them to optimize their merchandising. Finally, the model lowers the financial risk profile for TJX as fashion risks are minimized.

It is difficult, in the long run, to make money on stocks that have high fashion risk, companies that can often be victim to consumers rapidly changing tastes, i.e. the Gap, Krispy Kreme, and Cramer’s favorites like Crocs and Under-Armor. Sure, some will succeed, but getting the merchandise strategy right is another uncontrollable variable in the mix.

TJX has much less risk because if it makes a fashion blunder, it has much shorter lead-times and can quickly adjust its merchandising. Other companies could have several quarters of earnings misses if it makes poor merchandising decisions as purchasing decisions are made several months in advance.

In terms of growth, TJX has strong unit growth potential in some of its newer concepts, but more importantly it grows its “same store sales” much more consistently than most retailers. The attached charts show how TJX has a very loyal customer base (we call them “treasure hunters”) and in fact in slowing periods TJX tends to attract marginal customers that trade down from higher-end retail.


These are signs of very solid management and I remain confident that over our longer frame investment time horizon, this thesis should materialize and we will see a solid return.