Great returns so far - but so what?

Thanks to justadrone from the yahoo MFI group, I just calculated my annualized internal rate of return. I'm still trying to figure out exactly what an IRR is. It seems to not only give the growth rate, but also to take into account the effect of cash flows - and this is the part that I'm still working on understanding. In any case, I think that the annualized IRR for my total portfolio is pretty awesome - it's just over 50%. After nearly five months, this may be long enough to start to be meaningful. On the other hand, the market has been going up like crazy since about July or so, meaning that I'm going to try not to consider this kind of return rate anything near 'normal'.

Even if I calculate my return using a method that I understand better - calculate the percent increase, divide by the number of months invested, multiply by twelve months of the year - I still get well over 30% annualized returns.

Let's see if I can keep up something even close.

I've just been reading Fooled by Randomness - so this leads me to believe that beating the market by a few percentage points is attributable to nothing other than luck. I think that occassionally reading that book, and anything else by Taleb, will be a good way to try to stay skeptical of any success.

UEPS in the Mayo Clinic

Continuing with the analysis of UEPS as recommended by Christopher Browne in The Little Book of Value Investing, now is the part that I suppose is more art and less science, at least as compared to income and balance sheet analysis.

1. Can the company raise prices?
The answer is no. The product is for people without access to banks, or people for whom bank fees are prohibitive. These are not people who can afford to pay more. The UEPS model requires more people to be part of their network, not to charge their network high fees. Having said that, though, they are positioned to find new applications for their smartcard products - both geographically (old applications in new countries) and systematically (new applications in established countries).

2. Can the company sell more?
Definitely. Their technology has been broadly adopted in South Africa, they currently operate in Namibia, Botswana and Nigeria, and are exploring opportunities in nearby African countries, as well as a number of South American and South Asian countries. Third parties are operating their technology in Malawi, Mozambique, Zimbabwe, Ghana, Rwanda, Burundi and Latvia. I would prefer that they were operating their own technology - to me this means that perhaps they couldn't keep make the most of their technology, and so resorted to licensing it out. But it's a start. In addition, they mainly operate by distribution of social welfare and payroll distribution; but they've identified additional mechanisms for adoption, including medical welfare distribution.

3. Can they increase profits on existing sales?
Not sure. Probably not, at least not any time soon. They need to expand as much as possible. Once much better established, they could probably spend less on network expansion, increasing the number of point of sales card readers, possibly once better established they can rely on government contracts to a greater extent than they do now. But for now, they need to reinvest the money they make into expansion. Revenue has gone up, but cost of goods sold has remained constant for 2005 and 2006.

4. Can the company control expenses? What is the outlook for SG&A?
SG&A went up $6M in 2005, and $3M in 2006. I showed earlier that SG&A is declining as a percentage of gross revenue, and this seems to indicate that the company is indeed controlling expenses.

5. If the company raises sales, how much goes to the bottom line?
Comparing 2006 and 2005 as an example, revenues went up a ton, cost of goods sold was constant, SG&A went up just a bit. This seems to be asking about the net profit margin, and I showed that this is increasing yearly. So historically, they've been successful with this - the question is whether they'll continue to do so, but there's no reason to think that they will not.

6. Can the company be as profitable as it used to be, or at least as profitable as its competitors?
The company is increasing profitability year-over-year. I'll compare it to competitors shortly.

7. Does the company have one-time expenses that won't need to be paid in the future?

They acquired Prism in 2006, but after the end of the fiscal year. Next year will have a $95.2M charge that is one-time. There was a similar charge in 2004, for reorganization involved in the acquisition of Aplitec.

8. Does the company have unprofitable ops they can shed?

I don't see any.

9. Is the company comfortable with Wall Street earnings estimates?

They don't seem to discuss earnings estimates in the annual report. According to Yahoo! Finance, they seem to have come in within pennies of analyst earnings estimates in recent quarters.

10. How will the company grow in the next five years? How?

I've pretty much covered this one. It looks as though they have some pretty good prospects for growth.

11. What will the company do with excess cash?

Seems as though it will be reinvested in the company for continued growth.

12. What does the company expect its competitors to do?

They don't seem to discuss this much. They do discuss the risks of competitors, including retail banks as well as other companies that are direct competitors, but not much of what they think their strategy will be. Basically, the risks are that users will prefer special bank accounts that offer reduced charges, or that they will prefer their competitors.

13. How does the company compare financially to competitors?

I'll get into this shortly.

14. What would the company be worth if it were sold?

Hm. Interesting question. It seems that each industry has some 'typical' multiple of cash flow that is how it is valued for buyout. I'm not sure how to figure this out, but I'll play around with some numbers and come back to this.

15. Does the company plan to buy back stock?

I don't see plans to do so, but the company did buy back nearly 150,000 shares at $26.75, more than the price it's trading at now. However, this seems to have been somehow tied to purchases made by employees, maybe in a company stock puchase plan.

16. Are insiders buying?

One director bought a ton in June; A number of officers exercised options in June and one more did as well in September, all without selling their options immediately. Perhaps the options were going to expire; but I've read somewhere that exercising the options but not selling may be a sign that they are very bullish - that it somehow minimizes the tax implication for the potential gain.

Back to the financial experiment...

I had wondered in a previous post about why larger cap MFI companies tended to have higher Piotroski F-scores. I realized recently that I had failed to consider an important explanation. Chances were good that they didn't grow to be a large cap without being a fairly good company, especially considering that these large cap companies had high return on invested capital. In other words, the fact of being both a large cap and a MFI company should both correlate well with scoring highly on the Piotroski scale.

Part II

From the balance sheet to the income statement, it’s time for part II of the physical exam of UEPS.

Step 1: Revenue is listed for 2004 through 2006, and increased each year. 11.2% in 2006, and 34.5% in 2005. It is not particularly encouraging that revenue growth declined. Have they made the largest gains in market penetration (really, creation, given what they do)? This is probably why they are looking to diversify into new countries.

Step 2: The cost of goods sold increased by ~20% in 2005, but remained unchanged in 2006. As they grow as a company, does this indicate that they are streamlining production? Have they found cheaper labor or materials or products? It is perhaps a network effect: once the network is in place, there are perhaps only smaller charges to maintain it.

Step 3: Gross profit is revenue minus the cost of goods sold. 2006 - $146M; 2005 - $126M; 2004 - $92M. So, gross profit is increasing yearly. Browne says that he likes for this number to be stable, but clearly it isn’t. I suspect that is typically for a more mature company, but who knows?

Step 4: Determine operating profit by subtracting SG&A from gross profit. 2006 - $97M; 2005 - $80M; 2004 - $52M. As a % of gross revenue: 2006 – 32%; 2005 – 37%; 2004 – 43%. So with this number coming down percentagewise, this is probably a good thing. Browne says that this is the earnings before interest and taxes, EBIT, that is so important for the MFI, actually, and, Browne continues, this is the number that is used to value the company, including people looking to acquire it. The UEPS income statement includes depreciation and amortization in calculating the operating profit, as well as reorganization charges in 2004 and costs associated with the IPO and continued Nasdaq listing. The Nasdaq charge is probably more or less recurring, but it seems to me that the IPO cost and the reorganization charges should probably be ignored for calculating EBIT. And when depreciation and amortization are included, it becomes EBITDA. I’ve heard elsewhere that EBIT is more important than EBITDA.

Step 5: Calculate EPS. It took a little searching in the annual report to find a clear statement of the number of shares outstanding, but finally, the “Total weighted average number of outstanding shares used to calculate earnings per share – diluted” is 57.3M. So, using EBIT as earnings, EPS is 97 / 57.3 = $1.69. Using nondiluted shares EPS = $1.72, not a big difference at all. And looking at the other 2 years: 2005 – dil, $1.43, nondil, $1.46; 2004 – dil, $1.50, nondil, $1.56. A large number of shares were issued in 2005, increasing the number of shares 60%. So that explains the drop in EPS in 2005, but now in 2006, the EPS has more than made up for the dilution of ownership.

Step 6: Calculate the ROC: Divide the earnings of any year by the beginning year’s capital (ie, the end of the previous year), which is the shareholder’s equity and total liabilities. In this case, then the EBIT for 2006 is $97M, while the capital is $182M. ROC is 53%. ROC is of course one of the two measures for identifying MFI stocks, and this is a pretty high number for ROC. I’m encouraged that I came up with a number that seems appropriate for a MFI stock.

Step 7: The net profit margin is the earnings divided by the total revenues, presumably using EBIT as earnings. 2006 – 49%; 2005 – 45%; 2004 – 40%. So profit margins are increasing, which means that reinvesting cash in the company is leveraging sales.

Coming up is taking the stock to the mayo clinic. This one has more to do with everything the company has to say about their business, and less to do with the balance sheet and the income statement. This part is harder, and I’ll wait a little for it.

One last thing: I bought UEPS at $24.64. With EPS of $1.69, this gives an earnings yield of 7%. This sounds low for a MFI stock. When I get back the Little Book That Beats the Market, I’ll have to double check how EY is calculated for MFI.

But overall – that wasn’t so hard. Really.

You've taken your first step into a larger world - Obi-Wan Kenobi

I just read the Little Book of Value Investing by Christopher Browne. One of the original value investors, along with his partners at Tweedy, Browne, he worked with Benjamin Graham and Warren Buffett in their early years. I read the paper by Tweedy, Browne called, “What has worked in investing.” It’s pretty much the same sort of thing but with more hard data and fewer anecdotes. All in all, yes, I’m convinced.

The most directly useful part of the book are three chapters that discuss how to value a company. Coincidentally, the same day that I finished the book, I received in the mail the year-end report for Net 1 UEPS, one of the stocks that I own in my MFI portfolio. I decided to evaluate UEPS using the steps outlined by Browne (he doesn’t actually list them as ‘steps’ – these are my arbitrary divisions of his commentary). Here goes.

Step 1: Current assets and current liabilities. The current assets are ~$240M, and the current liabilities are ~$40M, so the current ratio is 6. Browne says at least 2:1 – UEPS is doing well. The working capital is ~$200M; Browne says the more the better. The quick ratio is the (current assets – inventory) / current liabilities. Inventory is only ~$2M, so the quick ratio is only marginally different from the current ratio.

The 2005 current ratio was roughly 5, and the working capital was ~$115M. So 2006 seems an improvement over 2005.

Step 2: Long term assets and liabilities. Total LT assets are ~$29M; Browne says to subtract out intangibles and goodwill, so he would consider LT assets as ~$11M. The only long-term debt listed is deferred income taxes, at ~$18M. How does this compare to last year? In 2005, LT assets were ~$30M, or ~$9M excluding intangibles and goodwill. LT liabilities were ~$10M in 2005. So, LT assets (excluding intangibles) went up ~20%, while LT liabilities increased 80%. However, the long-term liabilities are small compared to cash on hand, never mind short-term assets. This seems healthy.

Step 3: Book value. Subtract all that the company owns from all that it owes: $209M. Browne suggests subtracting intangibles here as well, so the book value is $189M. The debt to equity ratio is ~0.3. This means that the company is funded primarily through investment. In 2005, this value was ~0.4, so this also seems to be improving. Browne says that even if this number is greater than 1 it’s not the end of the world, so the small improvement in debt to equity ratio seems not particularly important. What is important, I think, is that the value is significantly less than 1.

I’m going to skip step 5 for now: comparing the book value of UEPS to its competitors. This brings me to the end of the first chapter about evaluating a company, and it seems that the balance sheet shows that UEPS has a solid foundation.