Analysis Selection of Equity Bonds Notes

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The Analysis & Selection of Equity BondsBy Theodor Tonca

Stocks 2011 Forum, Oct. 31, 2011

Notes

Slide 1: Introduction

How many people have heard of or know what an equity bond is?For those that do, my job is party done, for those that dont you may be a bit confused right now.

Slide 2: What is an Equity Bond?

An equity bond is not a guaranteed bond which promises a certain payment above your originalinvestment. In fact, it is not a bond at all.

An equity bond is simply a great business, the common stock of a great business is in effect an equitybond because while its returns are predictable (like a bond) the potential profits have no cap (like anequity)In our talk today, i am going to go over some specific attributes which every great business (equity bond)possesses and how these differ from the average business (common stock)Slide 3: Great Business: Equity Bond

* Simple Business - This is arbitrary depending upon one's own specialized knowledge and circle ofcompetence.

* Predictable - Very, very few businesses possess this trait.* Great underlying economics - Both from an individual business and industry standpoint.* Durable Competitive Advantage - every business wants it, few actually possess it.* Stable Earnings - See point # 2.* Free Cash Flow - The real measure of profitability.As we shall see, when all this factors come together (they are all interconnected) we have the makings of

a great business.Slide 4: Average Business: Common Stock

* Difficult to Understand Business - One simple rule that can be applied is: If a business cannot explainwhat it does and how it makes money in one paragraph or less, look elsewhere.* Poor Underlying Economics - Both from a business and industry standpoint.


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* No Competitive Advantage - The majority of businesses possess no advantage over others in theirrespective industry.* Fluctuating Earnings - A direct symptom of point # 3.* No FCF - Meaning the majority of the earnings (if there are any) must be re-invested back into the

business simply to maintain current operations.Slide 5: Equity Bonds V. Common Stocks

Here we can see the difference, like day and night between a great business and an average or mediocreone.Slide 6: Case Study: The Simple & Predictable

* Easily understandable - This will largely depend upon your own specialized knowledge and circle ofcompetence, but some businesses are just easier than others.

* Not subject to obsolescence - If our product, service and thereby business is eroding or likely to be dis-placed quite easily then we are not going to get very far.* No, I am not talking about my ex girlfriend in this instance. I am talking about the kind of company weshould all be looking for. If it is low priced, has no institutional ownership, no analysts follow it and it hasa very boring business, i want to know about it!* Straight forward capital structure A little bit of debt may actually be beneficial (insofar as it can besafely issued and bought for investment) but lots of outstanding shares, warrants, options and preferredsand other security instruments is a big no-no.* Conservative The kind of company that simply puts its head down and goes about its business,

without any promotion, flash or brow-beating.Slide 7: Example: The Simple & Predictable

Which is easier to understand and whose business is more predictable?* Sysco: Distributor and marketer of food service products. Or

* Cisco Systems: Designs and sells electronics, voice and communications systems.

Slide 8: Example: Not Subject to Obsolescene

Which is more likely to become obsolete?

* Wrigley: I don't think the internet or any technological development is going to change the way people

chew gum. Or

* Yahoo: How many people today still use the web directory which Yahoo started in 1994 as David &


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Jerry's Guide To The World Wide Web?

Slide 9: Example: Straightforward Capital Structure

If you had to inherit one of the two companies mentioned, which capital structure would you rather takeover?

As you may be able to guess, both are bank holding companies. One is a large money center bank, the

other is a small community bank (I will let you conclude which is which) If you were to delve into each

of these bank's financial statements, two things would become obvious:

* Preferred stock is a very expensive way to raise capital, businesses usually only take on preferred stock

obligations when other avenues of raising capital are closed to it.

* The vast divergence in the amounts of debt outstanding is not the key issue, if one were to look at the

balance sheet of each you would discover that Company B has over twice the amount of cash of its

outstanding debt, while Company A has less than $17 Bil. in cash, implying a very levered business.

Slide 10: Example: Conservative

* Un-promotional One local mining company released by my count, a total of 42 press releases in thepast 12 months (avg. of 3.5 per month) by comparison a holding of ours released a total of 5 in the past

year.

Point is, if a company is busy focusing on its external perception, then it will have less time to spend on

shaping its internal culture, which is much more important.

* Dual-listing Completely unnecessary

* PR & IR Staff If a business is overly focused on what its stock price is doing, chances are that it is

not focusing enough on its operations.

* Minimal Excess If a management loves executive perks more than they love the business, watch out!

Slide 11: Case Study: Great Underlying Economics

* Stable & Steady Stable business, steady operations with appreciating earnings over the past 5-10


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years.

* High Operating & Gross Margins - The trademark of a great business. A great business doesn't spend a

lot of money to earn a little, it spends a little and earns a lot.

* High Return on Shareholder's Equity A great business will allocate capital accordingly to where it canearn the highest return for its owners.

* Low Debt/Equity Ratio - A great business earns plenty of cash, therefore it does not need to borrow

much money.

* Negative Share Growth What this means is that the business is actually buying back shares rather than

issuing them. Over the long term the total shares outstanding of a great business will steadily decrease.

Slide 12: Case Study: Durable Competitive Advantage

* Consistency A business that produces a consistent product or service that never has to change will

produce consistent profits.

* High Return on Capital - Simply stated, return on capital is really the return that the company generatesfrom the amount of capital employed within the business.

* Goodwill & Intangibles Almost every great business has a brand that is more valuable than its

quantitative book value.

* Management It's importance cannot be overemphasized. Here we are looking for energy, intelligence

and integrity (last point being the most crucial)

* Reasonable Price "It's far better to buy a wonderful company at a fair price than a fair company at a

wonderful price." - Warren Buffett

Meaning, price is what you pay, value is what you get. At a small price you have a large margin of safety,

at a slightly higher price you have a smaller margin of safety, at some still higher price there is no margin

of safety and you have overpaid for the business.

Slide 13: Case Study: Stable, Increasing Earnings


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The key issue here is not the particular earnings, but the divergence in earnings.

* Great Business: The total divergence in earnings for our great business example for the past 5 years has

been approx. $6.8 Mil.

* Average Business: Meanwhile our average business had a divergence of about $73 Mil. From losing

$18 Mil. in 2006 to making a profit of approx. $55 Mil. in fiscal 2010.

This tells us that our average business is subject to economic cycles and does not have a leading position

the particular market which it serves.

Slide 14: Case Study: Free Cash Flow

Calculated as Operating Cash Flow - Capital Expenditures

The free cash flow figures are representative of the same two businesses whose earnings we last displayed

as we can see the FCF figures for our great business exmaple diverge only slightly from the earnings

figures (Earnings of $5 Mil in 2005 produced FCF of $4.5 Mil) (2006 earnings of $5.9 Mil. with FCF of

approx. $5.5)

While our average businesses figures diverge wildly, an accrual based earnings loss of $18 Mil. in 2005

with overall free cash flow of $61 Mil. and again the next year with an earnings loss of $71 Mil. yeat FCF

generated was approx. $2 Mil.

Wide devergences such as this between earnings and cash flow indicates possible accounting gimmicks

and therefore a less than honest management.

Slide 15: Conclusion

If you focus on purchasing minority stakes in great, intrinsically undervalued businesses you have a great

chance of earning an adequate return on capital, while taking on less risk than the market as a whole.

If average or mediocre businesses are more your thing then expect your return on capital to fluctuate

wildly (like their operations) while taking on substantially more risk than the market.


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Analysis Selection of Equity Bonds Notes