ROIC and growth are the two central drivers of value.


The numerator comes from the income statement. The denominator comes from the balance sheet.

NOPAT is net operating profit after taxes. It is often modeled as EBIT (1 – tax rate). While depreciation is a real cost, the amortization of intangibles is often added to adjust EBIT. Thus,

NOPAT = EBITA (1 - tax rate)

There is a fair amount of subjectivity in defining the denominator IC (invested capital).

It can be obtained from the asset or operating side of the balance sheet (recommended), or the right or financing side. I found this position paper from Credit-Suisse very useful. The authors present practical tips on how to think about IC, instead of getting caught up in some particular formula.  An illustrative example (CSCO) is used to animate some of these ideas.

Screenshot from 2017-05-08 08-56-19Essentially, IC should include all the “capital” (inputs that generate revenue over long time frames).

To the first approximation,

IC = total assets - non-interest bearing current liabilities

It definitely should include current assets, net PPE, and other operating assets. One can make several commonsense adjustments:

  1. If a company carries excess cash or marketable securities (over that required to run the business), then that should be excluded from IC. A recommended rule of thumb is cash equal to 2% – 5% of sales (ranging from mature to growth companies) are required in the running of the business. Any excess should be excluded from IC.
  2. If M&A is part of the company’s modus operandus, then one should not exclude goodwill, as it represents a true cost of doing business.
  3. Capitalize leases and R&D, since they have characteristics of debt and long-term assets, respectively.

Here are some other resources on ROIC that I found useful.

This paper by Damodaran, “Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications”, is quite readable, and presents some useful insights.

John Huber has some of the most well-articulated thoughts on ROIC. He has written several articles (compounding and high ROIC, and legacy versus reinvestment ROIC), which can be found on his website here.

This Bears-Stearns presentation on the role of ROIC in valuation has been floating around in a lot of different places.

Qualified Covered Calls

Early last year, I bought CFR around $53, valuing it at around $75. As it rose to $70, I wrote a $75 covered call expiring in 45 days. CFR promptly climbed to $80, and my call was ITM.

Since the stock had risen above my target price, I did not mind selling it.

However, I reckoned that if I could somehow hold on to the stock for couple more months, then I would avoid short-term capital gains tax on my profits. At that time, I naively thought that I would keep rolling over my $75 call, and only let it get exercised after I had owned it for 12 months.

It turns out that the rules governing deep in the money covered calls are somewhat complicated.

If you write a call sufficiently deep in the money, you are no longer considered an owner of the stock. This actually makes sense, since you have given away most of the pain, and the gain, associated with the stock’s gyrations that a true owner would feel.

The key phrase here is “qualified” or “unqualified” covered calls. If your covered call is qualified, then no problem.

If it is unqualified, the clock that determines the holding period for the stock stops. It resumes, once the call is closed or replaced by a qualified covered  call.

We need to know five numbers (two of which may not be needed, depending on the situation).

P = stock price at the end of the previous trading day
S = strike price of the covered call
d = number of days till expiry of the covered call
SP-1  = first strike below P 
SP-2  = second strike below P

For example, yesterday – May 5, 2017 – AAPL closed at $148.95. On the next working day (5/8/2017), suppose I consider writing covered calls expiring on May 19 (d = 12 days to expiry), at a strike price of S = $150. The two strike prices available below P are $148 and $149.

To determine if a covered call is qualified, I run the five numbers through the following flowchart.


Out of the money calls are always qualified. In the AAPL example above, the call is qualified because the call OTM.

If calls are ITM, they have to have sufficient duration (at least 30 days), and cannot be too deep in the money.

Update: Codan Ltd

Codan is a sub $500m Australian company, that I have written about in the past. It is a decent, if superficially rough business, with both net margins and ROE near 15%.

For FY 2016, its EPS was $0.12 (all numbers in AUD, unless otherwise stated). At 12-15x EPS, I had reckoned that CDA.AX shares were worth about $1.50. In July 2016, they were trading at $1.13.

Since then, shares have doubled and are trading at about $2.10. The narrative around the company’s core business has been improving steadily.

Debt has been paid off. This Feb 2017 presentation shows that FY2017 is off to a stellar first half. Here’s a picture:

Screenshot from 2017-04-28 22-05-50

The NPAT in 2016 was $21.1m. The NPAT for 1H 2017 was $22.2m. The latest guidance for FY2017 is $35m.

If Codan manages to hit that, the EPS for 2017 will $35m/177.2m ~ 19.7c. At 15x this (decent ROE, secular tailwinds, 3% dividend), the shares are probably worth $3 a piece. Thus, even after a near doubling, shares are probably undervalued by nearly 30%.

I continue to hold.



Why Value Investing?

Once you enter the wormhole of options, you enter a different galaxy of possibilities.

With stocks, you buy, sell, or hold the underlying security. With options, just learning the colorful terminology of the standard option strategies takes a while.

The more I learn about them, however, the more I understand why I find plain value investing appealing. Here is a partial list of reasons:


I find that my personality and lifestyle are aligned with the philosophy and practice of value investing. By this I mean a whole bunch of things.

I enjoy learning about companies. This curiosity increases my engagement with the world around me. I used to do this even before I had any interest in businesses or investing. Now, I simply use a different lens.

I like to think I have the right temperament. I may be deluding myself. But being disciplined, conservative, and contrarian comes somewhat easily to me. History provides some external validation for this claim; during both the recessions I have been through (2000 and 2008), I ploughed in nearly all my discretionary capital into the market. Over the last few years, as the market has embarked on its fast and furious ascent, I have been reluctantly liquidating my holdings, and increasing my cash position (now at >35%!).

I have a full-time job that I enjoy; I cannot devote more than an hour of time everyday monitoring positions, and plotting schemes. The low-frequency and low-maintenance aspect of value investing is aligned with my schedule and life-style.


I am happy with a compounding rate of 10-15%. I want a formula that lets me do that relatively consistently over the long-term. I want to be tethered to a core philosophy and process that will scale gracefully as the amount of capital being managed increases.

Is that asking for too much? 🙂 Many in options world might think, I am asking for too little!

It is clear that many option strategies occasionally yield extraordinary returns on investment, especially when you annualize them. If you buy a call option, and the price goes up by 10% in 10 days (a rather commonplace occurrence), your annualized return on that investment is over 3000%!

If I have $10,000, I would end up with a profit of $1,000. But the key question is, would I do it as the stakes got higher? Would I stick $10,000 into the same bet if it had, say a greater than 10% chance of expiring worthless (again a rather commonplace occurence).

Probably not.

And what if I had to manage an all-option $1M portfolio? I am not sure if I would die of hypertension, or go broke, first.

I know some skilled traders do it. I know I can’t. And I am not interested in the game.

One appealing feature of simply buying good companies at a bargain and holding them for a long time is that the process is completely scalable.

You can stick to the same process regardless of whether your portfolio size is $100,000 or $1 billion.

Structurally Advantaged

In economics and finance, if a good strategy becomes widely known, it generally stops working. Information has a way of getting arbitraged away. This is why I think the efficient market hypothesis is, by and large, a decent model, despite the bad name it gets in value investing circles.

Most liquid securities are “fairly” priced, most of the time. This is also why most individuals should just index.

However, there are behavioral reasons why value investing continues to work. It works because we are humans.

Because we are a big organic ball of greed and fear with a tiny microprocessor attached, masquerading as a rational animal.

When we look at things that make us go “yuck!”, the natural response is revulsion. When everything around us is crumbling, our instinct is to run for safety, not look for sweet bargains. When the party is going great, nobody wants to leave early.

Knowledge of these biases is not enough to overcome them. Knowledge is a necessary condition; it is not sufficient.

There are tax advantages to value investing over options investing, which generally tends to be short-term. Holding good to great companies for a long time, we can let compounding really do its number. Short-term taxes can be a big drag on returns. As portfolio size grows, this can lead to inconvenient and unexpected tax bills.

There are also institutional reasons why value investing is structurally advantaged. Most money managers are lucky if their performance is measured on an yearly basis (usually it is on even shorter timescales). They might have far more resources and intelligence than you and me, but they have constraints (like size, mandate, and time horizons) that we are unfettered by.

If you have a 20%/year idea that will take 5 years to fully play out, you can take that bet. The money manager probably can’t.

Time arbitrage and freedom from yearly comparisons with a index are two of the biggest structural advantages that we small value investors have over professional money mangers.


What Are My Options?

It is not a great time for bargains.

To avoid frustration, I have been keeping myself busy by taking a deeper dive into the world of options.

For quite some time now, I have used naked puts and calls and to get in and out of stocks. It lets me squeeze a few extra drops of value, and enforces a certain price discipline. This is similar to some people I know, who use GTC limit orders as a way to enter or exit a position, when it hits their target.

I’ve never tried hard to optimize for the premium (the few extra drops of value) in the past. But this will probably change in the future.

I have become more cognizant of time value and volatility.

I knew about these factors, but I never really cared for them much: my thinking was “I am not in the option trading business.” For example, I never really thought seriously about how far out, I wrote my options.

My commissions were quite steep ($7 + 0.75/contract), which made me reluctant to write a series of short duration options, instead of  a single longer duration one. [I subsequently renegotiated my commission structure, and also opened a new account with Interactive Brokers ($0 + $0.70/contract). I plan on doing most of my “option trading” in this account.]

While I have been reading and digesting a lot of information on options, and learning the wonderful ways in which complicated option strategies let you express nuanced expectations about stocks or markets, it did not take me long to realize that I don’t have the time, foresight, or stomach to become a trader.

My interest in options is primarily as an overlay on my core strategy of value investing. For kindred souls, the following resources might be useful:

  • Chapter 6 in Joel Greenblatt’s “You can be a stock market genius” on using LEAPS to synthetically create stub stocks. I haven’t used this strategy yet, but I might if the stock market corrects itself sharply, and I find something that I don’t mind applying leverage on.
  • Erik Kobayashi-Solomons “Intelligent Option Investor“. The book is interesting in that it summarizes many common option trading strategies, but uses the lens of a long-term value investor. Again LEAPS are the tool of choice, but this is contextualized with interesting diagrams, and a discussion of other strategies. I found the website associated with the book too intrusive, and haven’t explored it much.
  • While the two sources above focus on buying long dated ITM calls, the website “Great Option Trading Strategies” (if you can get beyond the cheesy name) offers interesting perspectives on writing short-dated naked puts and calls. It crystallized a lot of information in my mind.

I am trying to synthesize my own options strategies which combines the elements discussed in the sources above. This will no doubt involve some trial and error with real money, and I pray that the cost of this education won’t be to steep.

Updated Valuation Notes

Some updated valuations and notes on my three insurance holdings.

Berkshire Hathaway

Semper Augustus did another deep dive into Berkshire this year (among other things), and came up with a valuation band of $207-215 per B-share.

I have it pegged not too far away at $200/share.


Rational Walk shared his thoughts on Markel’s annual letter. While the share price had done really well in the recent past, it is still probably worth somewhere between $950-$1250/share.

The following table updates the “three separate units” methodology used in this blog post, where the underwriting, investment, and ventures units are analyzed separately. All dollar numbers are in millions.

Screenshot from 2017-04-05 15-09-04

Intrinsic value growing at a reasonable pace. While the growth in stock price has outpaced growth in intrinsic value over the last year, MKL is still probably fairly or slightly undervalued.

Fairfax Financial

Fairfax released its annual letter to a more skeptical audience. Insurance operations are doing great. The hedges are mostly off (the cash hoard is a more conservative hedge). As a consequence, BVPS dropped to $367/share. It currently trades around 1.3 times book (seems reasonable). It is hard to make a quantitative case for buying more, despite the fall in price, unless one shrugs off the recent past, and takes a longer forward looking view. Using updated numbers, I believe a fair “normalized” intrinsic value might be $530-$630/share.

While the hedges are gone, they have a huge cash hoard now, which can be deployed in case the market swoons.



One thing leads to the next. I started looking at Under Armour, stumbled into VF Corp, before landing on Hanesbrand (HBI).

All three stocks have been beaten up, and are trading near their 52-week lows. While S&P is up 15% and near its all time highs, VFC, HBI and UAA are down 20%, 30%, and 50% from a year ago, and are trading near 2-year lows.

Naturally, I had to take a look.

HBI was spun out of Sara Lee in 2006. It sells basic innerwear and activewear apparel in the Americas (US accounts for more than 3/4 of sales), Europe, Australia and Asia/Pacific. It owns many popular brands as listed in their 10-K.


Sales have grown from $4.5B to $6B  from 2007-2015, even as EBIT margins have improved from 7-8% to 10-13% over the period. The ROIC has been a respectable 12-13% since 2013. The EPS has increased steadily from $0.33 in 2007 to $1.40 in the past fiscal year.

Their secret sauce has three ingredients:

  1. Acquisition and Integration of Brands: Over the years they streamlined their manufacturing and distribution capability to the point where they could acquire brands, plug them into their manufacturing and distribution pipeline, and end up with EV/EBITDA ~ 5 in a couple of years. Measured against its historic appetite to gobble up new brands, the last two years have been outliers. HBI spent nearly $1.3B acquiring Pacific Brands ($800m), Champion Europe (€200m), and Knight Apparel ($200m). For a company with a $7.5B market cap, this is serious!
  2. Turbo-charged with Debt: How has it been able to finance these acquisitions? The total number shares has remained somewhat stable (385m). HBI has always employed a lot of debt; currently, debt accounts for 75% of capital. This leverage obviously juices the return on equity. It allows HBI to lower the cost of capital, and reduce taxes. Leverage might be okay,  if cash flows are dependable. Since HBI sells a staple rather than a fashion product, it is somewhat shielded from unpredictable swings. As of the last filing, debt was about 3.5 EBITDA, and interest payments ($200m/year) were amply covered by operating income ($775m).
  3. Low Tax Rate: Finally, HBI benefits from a low tax rate (single digits to teens). I don’t understand why this is so. On their IR site, they have a FAQ which addresses this question:

Q: Do you believe a high‐single digit to low double‐digit tax rate is sustainable?

A: Yes. Assuming no changes to various global tax laws, we believe a high‐single digit to low double‐digit tax rate is sustainable for many years to come. Our tax rate is the by‐product of our global business model. We do not use artificial tax management, such as inversions or earnings stripping. Our accounting and tax strategies are sound. In fact, we were recently audited by the IRS (see our third quarter 2015 Form 10Q) and the audit was closed with no adjustments.

I can’t pretend I understand this answer.


Let’s look at this in different ways.

Once the current acquisitions have been digested, a conservative estimate of normalized earnings is say $500m/year. FCF has hovered between $450m and $550m since 2012. The new acquisitions are expected to increase this historical number by about 10%. Using an 8% cost of capital, the  no-growth EPV estimate would give us something like $500/0.08 = ~$16/share.

However, this assumes no growth. Over the past 5 years, HBI has grown revenues, EBIT, and net income at a CAGR of 5%, 10%, and 15%, respectively. Let us see the effect of a small but non-zero growth rate (say, 3%). Now the EPV = $500/(8%-3%) ~ $26/share. This suggests a reasonably conservative range of $20-$25 for HBI. If it can grow faster than this, then the value may be much higher.

Let us look at this another way.

S&P estimates 2017 and 2018 EPS to be ~$1.90 and $2.30. Suppose HBI trades at 15x (approximately where it is trading now) at the end of 2018. This would imply a  15*2.30 = $34.50 stock price. If we buy the stock at current prices (~$20) and sell in two years, the CAGR return would be about 30%. Not too shabby.

The stock pays a nearly 3% dividend, which may be a suboptimal cash distribution strategy, but makes it easier for people like me to wait for the market to rerate the company. Furthermore, although HBI does buybacks, it seems price insensitive; thus, I prefer dividends over buybacks.


There are many obvious risks. Any disruption of the three secret sauce ingredients can jeopardize the investment. Taxes are low, and one might be able to argue that HBI is not paying its fair share in taxes. If one can make that argument persuasively enough to change current policy, HBI could be in trouble.

However, it won’t be in mortal danger because of increased taxes. It is the high debt load that has me worried on this count. Sure, currently it doesn’t seem like a problem, but if for some reason earnings start falling, then debt can present an existential threat. Cash flows may be predictable, but Fruit of the Loom (now a Berkshire subsidiary), which is a competitor, did go bankrupt.

Overall, I believe that HBI, like VFC, is modestly undervalued in the 20-25% range. It may be a decent buy, in this otherwise overvalued market. But one has to keep an eye out on the debt/EBITDA ratio and tax rates (and they may end up being correlated).