Investing Sabermetrics: A Formula for Financials and Holding Companies

"There's a way to do it better — find it." — Thomas Edison

Open any Berkshire Hathaway (BRK.A)(BRK.B) annual letter and the first thing you see will be a listing of the yearly gains in the book value per share of BRK.A from 1965 to the present year. At the bottom of the year-by-year synopsis lies the compounded annual growth rate (CAGR) of those gains in equity. Later in the article I will show the mathematical formula for calculating those compound gains.

Buffett believes that gains in book value per share are a better reflection of the growth in value of BRK.A as opposed to gains in the price per share of the company. Buffett uses book value as opposed to price per share since he feels that the market does not always assign a fair valuation to his company. He then compares changes in the equity of BRK.A to changes in the value of the S&P index while adding back in dividends.

This is Buffett's acid test for evaluating his efficiency in allocating capital at Berkshire Hathaway. After all, if the gains in the equity of his company were not significantly superior to gains in the S&P plus the dividends which they accrue, why would any sane individual choose to invest in BRK.A instead of an S&P index fund?

Rest assured that Buffett has passed the acid test with flying colors. Since 1965 Berkshire's book value has compounded at an annual rate of 19.8%, while the S&P with dividends included has compounded at an annual rate of only 9.2%. That means that Buffett has outperformed the S&P at a compounded rate of 10.6% since the inception of the current Berkshire Hathaway holding company in 1965. That translates into a gain in excess of 500,000% for the original stockholders. Alas, if only I had invested a double sawbuck of my grade school allowance in 1965.

All that said, today's article is not about singing the praises of "The Oracle." Rather, it is about introducing a better investing sabermetric in evaluating the efficiency of the management of a company. For reasons! which I discuss later, today's analysis is best suited for evaluating financial stocks and holding companies.

The thesis of today's article is that investors should focus on businesses which have a 10-year annual compounded growth rate of book value per share in excess of 15 percent. Further, investors should only purchase these companies when they are trading at a 25 percent discount to their 10-year cyclically- adjusted price to book value ratio.

The idea is simple: Buy stocks with high quality management when they are inexpensive in relative terms.

Incidentally, GuruFocus has all the information you need to access this information — and you thought you knew everything about GuruFocus. More on that later.

Book Value as the Key Metric for Financial Stocks and Holding Companies

Traditional earnings multiples do not supply investors with relevant evaluation tools in the case of many financial stocks or holding companies. When looking at holding companies the reason is clear. Take the example of BRK.A: The only earnings which are derived from their extensive investment portfolio are the dividends or interest payments they receive from the various securities.

The reason is not so clear to investors when evaluating financial companies; however, asset-based evaluation metrics are generally superior to earning-based metrics in evaluating such companies for the following reason:

Many financial companies have extensive investment portfolios which only record earnings gains on dividends, interest payments or capital gains if a security is sold. Therefore, the value of the these investment portfolios, particularly the unleveraged portions of the investments, is not reflected by the earnings power of the business. For my purposes, the unleveraged portion is defined as total invested assets less the float (prepaid premiums and other money held in investment accounts that does not belong to the company).

Allow me to illustrate the point since I am sure th! at many r! eaders are confused by the previous paragraph. Let's compare two mythical insurance companies. Assume that both companies have earned $1 in investment earnings for the last five years. Suppose Company A has $50 million in equity on their balance sheet whereas Company B has equity of $100 million.

Let's further assume that both companies possess equal float which is invested in government agencies and treasuries which supply exactly the same interest yield for the two stocks. However, Company B is also an unleveraged equity portfolio which is valued at $50 million. For the sake of simplicity, say it contains stocks that pay no dividends. Company A has no unleveraged capital to utilize for investment purposes; it merely invests the amount of its float in fixed-income investments.

According to an earnings-based metric such as a price to earnings ratio, the companies are equivalent in value in terms of investment earnings (of course their operating earnings are a different matter). However, what if Company B decides to sell its equity holdings tomorrow and distribute the after-tax proceeds to its shareholders in the form of a special dividend? In such cases, the intrinsic value of Company B is much better reflected by its price to book ratio rather than its price to earnings ratio.

To reiterate, price to book ratios offer a better measurement of the value of a company's investment holdings, particularly the unleveraged portion of a financial company's investments. Thus, investors are generally better served by estimating a financial company's intrinsic value by using asset-based metrics rather than earnings-based metrics.

Gains in Equity per Share as the Key Metric in Financial Stocks and Holding Companies

I will now return to our previous discussion involving Company B and its unleveraged equity portfolio. As we discussed earlier, Company B is definitely cheaper than Company A in terms of its price to book ratio. But is it necessarily a better investment merely because! it is ch! eaper? The answer lies in evaluating the long-term CAGR of the book value per share of Company B vs. Company A.

Let's journey back ten years and examine the two companies. Ten years ago, Company A had $20 million in equity and Company B had had $40 million, so both companies have grown their equity by 150 percent. Therefore, are they roughly equivalent? Hardly. Further examination reveals that Company B had $40 million shares outstanding ten years ago. Now they have 100 million shares outstanding. The extra shares were created by a secondary offering and stock options which were granted to management.

On the other hand, Company A still has the same amount of shares outstanding as they did ten years ago — 20 million. So the book value per share of Company A has increased from $1 per share to $2.50 per share in the past ten years. For Company B, the book value per share has remained at a $1 per share, although their equity has risen 150 percent. Furthermore, the equity portfolio still has the same market value as it did ten years prior. Additionally, the combined ratio for Company B is inferior to that of Company A, indicating the company writes inferior business. All these factors have played a part in the divergence of the growth of equity per share between the two companies.

In this illustration, the management of Company A has clearly performed in a superior manner when compared to the management of Company B. Their superiority is reflected in the equity growth per share in the business. It would seem that the discount to book that the market is offering on Company B is really no bargain after all.

Gains in equity per share reflect the effectiveness of management decisions in terms of capital allocation as well as revealing the operating efficiencies of a business. For instance, if stock options are issued and exercised they show up in the figure. The same is true for all stock buy-backs and secondary offerings as well as increases or decreases in the retained earnings ! of a comp! any.

So long as the management exercises veracity in their accounting practices, evaluating the CAGR of equity per share is an excellent measurement of business efficiency and the effectiveness of management.

Calculating CAGR

As promised earlier, I will now unveil the mathematical formula used to calculate the compound annual growth rate (CAGR). The following example calculates the CAGR of the S&P 500 from 1986 through 2005, brought to you courtesy of allfinancialmatters.com.

CAGR = [(Ending Value ÷ Beginning Value)1/n] – 1

Where "n" is the number of time periods (20 years for this example)

Substituting the numbers from the example, the equation looks like this:

CAGR = [($95,421.19 ÷ $10,000)1/20] – 1

CAGR = [9.542119.05] – 1

CAGR = 1.119392 – 1

CAGR = .119392 or 11.94%

[ Enlarge Image ]

Finding CAGR of Book Value and Tangible Book Value per Share on GuruFocus

GuruFocus provides CAGR per share in its 10-year financial section. Just go to the 10-year financials section and click on book value per share and you will be transported to a page that shows the following information:

Everest Re Ltd Annual Data

	Dec02	Dec03	Dec04	Dec05	Dec06	Dec07	Dec08	Dec09	Dec10	Dec11
Total Equity	2,368.6	3,164.9	3,712.5	4,139.7	5,107.7	5,684.8	4,960.4	6,101.7	6,283.5	6,071.4
Preferred Stock	--	--	--	--	--	--	--	--	--	--
Total Shares Outstanding	50.9	55.7	56.1	61.9	65.0	62.9	61.4	60.4	55.0	53.7
Book Value per Share	46.5	56.9	66.2	66.9	78.6	90.4	80.8	101.1	114.3	113.0

The yearly price to book value range for a stock can also be accessed in the 10-year financials section. The price of the stock appears directly under Book Value Per Share listed as Month End Stock Price. One can easily calculate the average price to 10-year book ratio of a stock by performing the simple mathematics.

A Formula for Success in Purchasing Financials and Holding Companies

Our goal is to purchase outstanding companies at discounted prices based on their 10-year CAGR of book value per share and their 10-year average price to book multiple. It is imperative that we add back dividends into the formula since they represent equity which was distributed to shareholders.

We are looking for financial stocks or holding companies which have grown the highest CAGR of BV per share, including dividends, trading at a minimum of a 25% discount to their 10-year average price to book multiple.

Thus our revised formula for CAGR of BV now reads as follows:

CAGR of BV per share = [(Ending Value + dividends ÷ Beginning Value)1/n] – 1

Where

CAGR of BV per share is > 15%

And

The stock price is< .75 its 10-year average price to book ratio

If investors prefer to eliminate intangibles from the equation they should feel free to do so. I have decided to include goodwill and other intangible assets in my price to book ratios due to accounting changes enacted in 2002.

Goodwill is now impaired rather than amortized; therefore, theoretically, it will disappear from the balance sheet if it contains no real economic value. That said, I ! fully und! erstand the subjective nature of goodwill impairments. Fortunately, many financial stocks show little in the way of goodwill and other intangible assets on their balance sheets, unless they engage in serial acquisitions. In the case of holding companies that is another story.

RE a Perfect Example of Value Uncovered by the Formula

Last August, I purchased Everest Re (RE) when it fell within the value parameters outlined in today's article. I wrote an article about the stock titled: Everest Re: Low Risk High Reward http://www.gurufocus.com/news/143388/everest-re-low-risk-high-reward

At that time RE had generated 10-year CAGR of BV per share with dividends included was 26.8%. The stock qualified under the investing sabermetric since it was trading at approximately .7x its book value in August with a 10-year average price to book value of 1.115; therefore it was trading at approximately 63% of its mean price to book ratio.

Currently RE has reached a 52-week high and is trading at about .89x book value. It would qualify as a buy under the investing sabermetric if the price the price dropped below $89 per share using the latest financials to determine its current book value per share.

Summary

1) Warren Buffett uses CAGR of book value to track the progress of Berkshire Hathaway and his management efficiency.

2) A similar method which tracks CAGR of book value plus dividends can be use to identify high quality financial stocks and holding companies.

3) It is imperative that investors purchase these high quality companies at favorable prices; I suggest buying the companies at less than 75% of their ten-year average price to book ratio.

4) The formula is as follows:

CAGR of BV per share = [(Ending Value + dividends ÷ Beginning Value)1/n] – 1

Where

CAGR of BV per share is > 15%

And

The stock price is < .75 its 10-year average price to book ratio

5) The formula is best suited in evaluating financial stocks! and hold! ing companies.

Absent Higher Rates, Comerica Has Probably Gone Far Enough

Comerica (NYSE:CMA) is a curious bank in multiple respects. Although it has a sizable commercial loan book, the net interest margin isn't all that impressive. On the other hand, this looks like one of the most asset-sensitive of the larger banks, and income could accelerate relatively quickly if rates head meaningfully higher. All things considered, while I think Comerica's market position in Texas and California is worth more than average, I think the shares don't offer all that much promise unless you have a firm belief that the company can generate significantly better long-term returns on equity than the sell-side presently expects.

Another Familiar Pattern In Second Quarter Earnings
Add Comerica to the list of banks reporting okay net interest income and beating quarterly estimates on the basis of fee income and lower credit costs. Commerce Bancshares (Nasdaq:CBSH) actually reported the opposite, but other banks like Bank of the Ozarks (Nasdaq:OZRK), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) have been following this basic pattern for the second quarter.

SEE: Citigroup Continues The Theme Of Decent Big Bank Earnings

Operating revenue declined 2% from the year-ago level, but rose about 1% sequentially. Net interest income declined slightly on a sequential basis as the net interest margin ticked lower (down 5bp) on lower purchase accretion. Again, that slim sequential decline was consistent with Wells Fargo and Citigroup's experiences. Fee income rose 5% sequentially and expenses were flat, leading to a 4% sequential improvement in adjusted pre-provision earnings.

Growth Is Still Lacking
Comerica saw just 1% sequential loan growth, better than Wells Fargo and Citigroup, but weaker than Commerce (which also focuses on commercial lending and is looking to grow its loan book in Texas). Commercial lending was up about 2% over all, though commercial real estate lending was softer. Deposits declined 2% (on an end-of-period basis), marking the second straight sequential decline. With Comercia's capital position on the weaker side of "okay" (at least relative to peers), I'm starting to wonder if this softness in deposits will constrain lending capacity at some point or force the company to turn to more expensive wholesale/borrowed sources of funds.

Quality Improving, But Capital May Be A Little Thin
Comerica reported some solid improvements in multiple credit metrics. Non-performing loans declined 38% from the year-ago level and 9% from the first quarter, and the non-performing asset ratio declined again (from 1.78%/1.18% in the prior year/quarter to 1.05%) - far below the level of Citi and Wells, but more than double the rate of Commerce. The net charge-off ratio dropped again (from 0.42%/0.22% to 0.15%) and is very low.

The reserves are interesting, though. While the decline in non-performing loans has lifted the reserve/NPL percentage to almost 137% (from 93% a year ago), the reserves-to-loans ratio of 1.35% looks a little thin to me, particularly as the the Tier 1 common ratio of 10.4% isn't exactly a peer-leading number. That said, Comerica did fine in the Fed's stress test earlier this year and has the all-clear to return capital to shareholders, which is a meaningful detail in a growth-poor banking industry.

SEE: Foreclosure Activity Tumbles In 1H

The Bottom Line
With close to 10% of Comerica's loan book going to car dealers, Comerica should be taking advantage of a pretty healthy car market in the U.S. Likewise, the company's position in the energy sector ought to be a positive assuming the North American energy market has indeed seen its trough. And as I mentioned earlier, this is a lender with above-average leverage to higher rates, as about 80% of the portfolio is variable rate (with about 70% indexed to 30-day LIBOR).

There aren't too many cheap bank stocks left, though, and Comerica isn't one of them. A 10% estimate for long-term ROE suggests a fair value today in the low-to-mid $30s, and you have to go up to about 13% to get a target ahead of today's price. While Comerica's geographically concentrated business may give it an above-average chance of returning to the higher ROEs of yesteryear, I still think that's a pretty bold assumption to use today. On the other hand, the company's return on tangible assets suggests a fair price/tangible book value multiple of around 1.4x, which implies a fair value of about $47. So not unlike Citi, there seems to be a dichotomy in how the market is viewing/valuing the long-term prospects for some of these banks.

While I think Comerica is a relatively good way to play higher rates, I think at least some of that expectation is already built into the stock price today. With mediocre loan growth and still above-average expenses, I'll continue to be on the sidelines with this stock.

Wells Fargo's Uncanny Knack for Sensing Trouble

The news that Wells Fargo (NYSE: WFC  ) is exiting the mortgage joint venture arena is grabbing headlines, but it shouldn't surprise anyone. The decision comes on the heels of new regulations, stemming from Dodd-Frank, which will negatively affect this type of business. Rather than fighting against the tide, Wells has decided to end its joint ventures with its eight partners.

Wells obviously saw this day coming. A bank representative, Franklin Codel, told Bloomberg that Wells once participated in over 100 of these joint ventures, so it's clear that things have been winding down for some time. According to Codel, it will take from 12 to 18 months to unwind the current eight partnerships.

Keeping an eye on legal issues
This move by Wells is not unusual. Time and again, the fourth-largest U.S. bank has read the writing on the wall, making changes as needed to limit future legal and regulatory problems.

The bank's foresight hasn't kept it completely out of trouble, though. Along with fellows Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and JPMorgan Chase (NYSE: JPM  ) , Wells signed off on the National Mortgage Settlement, pledging to rectify its foreclosure practices.

Considering how dominant Wells has been in the mortgage market over the past few years, it's understandable they would experience at least some mortgage-related problems. Imagine how much additional legal expense it would currently be incurring, however, had it not -- in another prescient move -- begun to back away from subprime lending back in 2004. 

Similarly, Wells Fargo ceased wholesale mortgage lending a little over one year ago, just as it announced its settlement with the U.S. Department of Justice regarding alleged discrimination tied to a sampling of its mortgage loans written between 2004 and 2009. Though Wells noted the termination of its wholesale channel was separate from the settlement, it stated that shutting down that business would give the bank more direct control over its mortgage lending practices. Earlier, both Bank of America and Citigroup had also exited this type of lending.

The effect on lending should be minimal
Since Codel notes that joint ventures made up only 3% of new loans in the second quarter, this move shouldn't affect the bank's lending pipeline in any appreciable way. As for the partnerships, at least one is planning to continue on, without Wells by its side.

HomeServices Lending LLC announced that it will become a wholly owned subsidiary of HomeServices of America, an affiliate of Berkshire Hathaway  (NYSE: BRK-A  ) (NYSE: BRK-B  ) . HomeServices Lending is the biggest of the remaining joint ventures, accounting for $3.5 billion to $4 billion of loan production each year. According to the announcement, the new entity may continue to have dealings with Wells Fargo in the future.

Considering the fondness Warren Buffett has for Wells Fargo, a future relationship is quite possible. Undoubtedly, the bank's ability to predict and react to future threats is part of the reason Buffett invests so heavily in Wells. This farsightedness surely played a part in the bank's recent ascension to the rank of the world's largest bank, as Wells' market capitalization surpassed six-year champ Industrial & Commerical Bank of China. Hindsight can impart valuable lessons, but it is foresight that will put you at the top of the heap.

The price of becoming the world's greatest investor is that Warren Buffett can no longer make many of types of investments that made him rich in the first place. Find out about one such opportunity in "The Stock Buffett Wishes He Could Buy." The free report details a sector of the economy Buffett's heavily invested in right now and exactly why he can't buy one attractive company in that sector. Click here to keep reading. 

When Apple Reports Earnings, Take It With a Grain of Salt

Apple (NASDAQ: AAPL  ) is getting ready to report earnings next week, and for the second straight quarter, it is expected to report a significant year-over-year decline in earnings. This time around, analysts aren't even sure it can keep revenue growth going.

As soon as the company announces earnings, you can be sure that a bevy of analysts, pundits, and investors will start weighing in with their opinions on whether you should buy or sell Apple stock. What they might forget to tell you is that the quarter's earnings need to be taken with a grain of salt -- they are not very comparable to the prior year period. Moreover, even Apple's forecast for next quarter won't mean much without further context. In other words, whatever you hear, you should be careful not to overreact.

An unusual comparison
Apple went through a historic product launch cycle last fall, as it introduced the iPhone 5, refreshed the full-size iPad, brought the iPad Mini to market, and redesigned its iPod and iMac lineups. These launches led to Apple's first-ever $50 billion quarter, but it also created a gap for much of 2013; Apple still has not launched a new iPad or iPhone this year.

By contrast, Apple released the third generation iPad (the first with a Retina display) in mid-March of 2012. Most of the early sales rush fell into the June quarter, when Apple sold 17 million iPads at an average selling price of $538. With no new iPad this year (and new designs expected in the fall), some analysts expect Apple to sell a similar number of iPads in the recently ended quarter, but with a much lower ASP due to the iPad Mini's popularity.

The iPad Mini has boosted iPad sales, but dampened margins. Image source: Apple.

In other words, the change in the iPad release schedule probably had a significant negative impact on revenue and earnings last quarter. However, the next iPad launch could provide a big boost in the holiday quarter, as long as Apple is able to meet demand.

There were similar "non-comparable" factors affecting iPhone sales last quarter. First, Apple ended the March quarter of 2012 with 8.6 million iPhones in channel inventory, whereas it had 11.6 million iPhones in the channel at the end of March this year. With slightly higher iPhone inventory coming into the June quarter this year, Apple probably built correspondingly fewer devices.

Additionally, Apple added China Telecom as a carrier partner in March, 2012. While the big prize in China is China Mobile, with over 700 million subscribers, China Telecom was still a significant win, with approximately 129 million subscribers as of 2012. Just as last year's March iPad release had its biggest effect in the June quarter, the iPhone launch on China Telecom last March probably provided a one-time boost that carried over to the June quarter.

Beware the outlook
Thus, a variety of issues make it difficult to compare the just-ended quarter with the same quarter of 2012. What about the upcoming quarter? Unfortunately, Apple's guidance for Q4 of FY13 will not reveal much about business trends without additional context that probably will not be provided.

The problem is that Apple is expected to launch a bevy of new products this fall, just as it did last year. However, investors do not know the exact launch schedule yet, and this will have a major impact on next quarter's revenue, margins, and earnings. Apple sold 5 million units of the iPhone 5 in its first weekend on sale, which alone would have contributed more than $1 billion of profit.

In other words, until investors know the exact product launch schedule assumed in Apple's guidance, it will be impossible to interpret the numbers. A two- or three-week difference in the product launch time frames would have little effect on Apple's long-term value -- which is what ultimately matters -- but could conceivably shift $2-$3 in EPS between the September quarter and the December quarter.

Just breathe
Investors should recognize that Apple's upcoming earnings release is far less important to the company's future than the success of the new "hardware, software, and services" slated for release in the fall and 2014 (according to Tim Cook's comments on last quarter's earnings call).

It's natural to pounce on every nugget of information available to decide whether to buy, sell, or hold a stock.  However, in Apple's case, this short-term focus could cause you to miss the bigger picture. As I recently pointed out, while Apple's earnings have taken a step backward in 2013, revenue is still growing and the company's margins are likely to stabilize going forward, leading to a rebound in profitability next year. Investors should keep their eyes on Apple's long-term value and avoid making a rash decision to buy or sell based on next week's earnings report alone.

Apple's not for you? Another way to profit in mobile
Want to get in on the smartphone phenomenon? Truth be told, one company sits at the crossroads of smartphone technology as we know it. It's not your typical household name, either. In fact, you've probably never even heard of it! But it stands to reap massive profits NO MATTER WHO ultimately wins the smartphone war. To find out what it is, click here to access The Motley Fool's latest report: "One Stock You Must Buy Before the iPhone-Android War Escalates Any Further..."

Dana Expands Buyback Program to $1 Billion

Auto parts supplier Dana Holding (NYSE: DAN  ) announced today it is expanding its share repurchase program to $1 billion, representing a $900 million increase over the $100 million bought back under the previous authorization. Shares will be bought back over the next two years.

Dana Holding President and CEO Roger J. Wood said: "This expanded program reflects confidence in the long-term prospects of our business and our commitment to delivering value to all of our shareholder. We continue to review our capital structure with the goal of best utilizing our strong balance sheet to maximize shareholder value." As of this writing, Dana shares are trading at $19.40.

The auto parts supplier anticipates having sufficient liquidity to support this initiative after refinancing its current U.S. revolving credit facility and establishing a new five-year, $500 million revolving credit facility. While the stock repurchase is subject to prevailing market conditions, Dana says it will continue to evaluate further credit market opportunities.

Headquartered in Maumee, Ohio, Dana Holding is a supplier of driveline, sealing, and thermal-management technologies that improve the efficiency and performance of passenger, commercial, and off-highway vehicles with both conventional and alternative-energy powertrains. It had revenues of $6.9 billion for the 12-month period ending March 31.

link