Maintenance CapEx

Companies make money by selling stuff they make. To make stuff, they need to invest capital.

This invested capital (IC) often takes the form of PPE for traditional widget manufacturers. From a business standpoint, one can take a broader view of IC, and recategorize any expenditure that is borne in a particular period, but “pays off” over longer time periods as capital. Thus, R&D or subscriber acquisition costs (in sticky businesses) may be thought of as CapEx.

This might involve reinterpreting the CapEx that appears on the cash flow statement.

CapEx (CX from now on) has two components: maintenance capex (MCX), which a business has to reinvest just in order to stay in place, and growth capex (GCX), which is the part of CX that increases sales.

CX = MCX + GCX

MCX is a “cost”. GCX is an investment.

If you own a rental business for example, replacing a broken heater is MCX.

Buying a new rental property is GCX.

Warren Buffet’s owner’s earnings (OE) or Greenwald’s adjusted earnings try to account for this “cost” of doing business.

OE = NOPAT - MCX

Calculation

Calculating MCX is both art and science. It is not a number that is directly broken out in financial statements. However, we can develop some intuition on how to think about it broadly, and estimate it.

For a mature company with stable sales (no growth or decline), there is no GCX. Thus, all CX is MCX. For such stable businesses, MCX is approximately equal to the depreciation.

MCX = depreciation

Another popular method uses the following algorithm:

  • estimate the sales to capital ratio, SCR
  • compute the change in sales dS = S(t) – S(t-1)
  • GCX = dS/SCR
  • MCX = CX – GCX

Additional Notes

  • average SCR over several years; compare with industry averages
  • some CX may not produce sales growth immediately (ex. building a new theme park). This may involve projection, if the past doesn’t rhyme with the present.
  • if stable or meaningful SCRs cannot be extracted, then be wary of the number you produce.

References

  1. CS Investing: Calculating Capex
  2. Old School Value
  3. Seeking Wisdom
  4. Gurufocus
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Cash Secured Puts: An Algorithm

Here’s a rough flowchart of my current CSP strategy.

Ideas - 31

I am still actively tweaking my process; so the following only represents a snapshot of my current thinking.

Search

The first step is to search a good candidate. Usually, I have about 20-30 stocks on my radar. These are stocks I am interested in owning. Some of these are companies I already own, but want to own more of.

In any case, I have a reasonable guess of the intrinsic value, IV, for this set of companies. Some of them may be trading below IV (price p < IV). If they trade at a sufficient discount, I will consider buying them outright. Usually, I like to buy stocks for at least a 20-25% discount to IV. This represents my margin of safety (MOS).

But what do I do, if the discount is not large enough? Say,

IV - MOS < p < IV.

I use this condition as an initial filter.

At any given time, depending on the overall market, 3-5 stocks may pass this filter. Two stocks, I am looking at, that pass this filter currently are MSM (IV ~ $85-90), and WFC (IV ~ $55-60). If MSM or WFC traded around $60-65 or $40-$45, respectively, I’d buy the stocks outright.

The second important filter is liquidity. When I am buying stocks, I usually don’t care about liquidity, because my holding periods are usually long. I don’t trade positions frequently. This freedom allows me to buy small-cap and foreign stocks.

With the CSP strategy, however, I need a fair bit of liquidity, since (option) holding periods (more on this later) are usually of the order of one month, and bid-ask spreads on illiquid names can be brutal.

This restricts the universe to somewhat large cap names, say market cap greater than $5B. This number is a guide, not a strict threshold. I like to see open interest for upcoming ATM options to be greater than a few hundred. Usually, both these facts are correlated.

WFC has a market cap over $250B. MSM is much smaller, ~$4B. The open interest for the $50 WFC put expiring on Oct 20 is about 5000. The comparable number for MSM is about 10. So WFC passes the second filter; MSM doesn’t.

The third filter is stock price. I like the stock price to be around $50 or below. This seems quite arbitrary, but is a self-imposed constraint because of position sizing and tactical considerations.

Right now, I like to restrict new positions that I ease into using CSPs to a maximum of 5% of my portfolio. At my current portfolio size, this means a total outlay of between $20-25K. Unlike many options traders, my goal – my ideal outcome – is to buy with a sufficient margin of safety. CSPs are a way to reduce the effective buy price below that level.

The main reason for the $50 stock price filter is that I might embark on long CSP campaigns. Sometimes, this means committing additional capital to the position if it moves deeper in the money.

I like to have 4 slugs in my revolver ($20K outlay/4 options ~ $5K/100 shares ~ $50 price threshold). This gives me added flexibility to adapt, adjust, and exploit volatility.

The final filter is price of the option. I target a minimum return of 20% IRR. If I commit a certain amount of cash to a new CSP, I seek annualized returns on that capital of 20% or more. I will discuss this filter in more detail in a separate post, because there is a fair amount of nuance.

If a stock has fallen in the recent past, its implied volatility is often high (say >30%). These are ideal candidates to chase, since the fall in stock price may have brought them close to value territory, making the pursuit all the more fruitful.

To recap, I search for the following characteristics:

  • attractive stock, but not cheap enough,  0.75 * IV < p < IV
  • liquid options market (generally large cap >$5B)
  • p <= $50, approximately
  • initial hurdle IRR > 20% (high implied volatility helpful – but check upcoming events)

Start Campaign

Okay, once we’ve figured out we want to pursue this strategy on an attractive candidate, we write or sell ATM puts on 1/4 or 1/2 of the intended position, with a duration of about a month. Why?

We sell at ATM options, because they have the thickest time value premiums. Ideally, we want to maximize these as we are going in. Later, we may be have to be content with ITM puts, which are less juicy, but we aim high to begin with!

How to size the initial position? This depends on how large the margin of safety is at the current price. If it is reasonably large, then I’d go with half. If it is not large enough, then I go with a quarter. This usually ties up $5-10K in the first round.

Finally, I usually try to sell options about one month out. You can get higher IRRs by using weekly options if they are available. This involves more frequent trading (potentially higher commissions), and careful upkeep. A frequency of one month is short enough to capture a fair chunk of the fastest decay in time value, and long enough to suit my temperament and schedule.

To summarize, we start a CSP campaign by,

  • writing ATM or slightly OTM puts,
  • on 1/4 – 1/2 the intended final position (depending on MOS),
  • with a duration of about a month.

Then we collect the premium and wait.

Quick Validation

Several things can happen. One outcome is that the underlying stock shoots up, and moves far away from the strike price of the puts we wrote. If that happens, it may be worthwhile to close the position prematurely. Suppose,

G = initial premium collected = maximum gain
T = initial duration of the put (in days)
t = current time to expiry 
g = gain on the position at current time (g < G)

Currently, I use a rough rule of thumb.

If the gain on the position exceeds 75% of the maximum possible gain, within the first half of the intended holding period, then I close position. Mathematically, this condition can be expressed as.

t < T/2 and g >= 0.75 G

The reason for not continuing to hold on to the position is that it frees up capital.

Thus, if the stock spikes, and then falls down again, you may be able to exploit the volatility by collecting twice on the same stock. In reality, things can work out even better. When the price of the security rises, its implied volatility falls. That, and the moneyness of the position make it cheap to buy it back. If the stock falls back, generally implied volatility increases, and you can juice out more time value from an ATM option.

Expiration

At expiry, you encounter one of three possibilities. Let’s dispose of the easy ones first.

If the stock prices exceeds the strike (p > S), you let the position expire. Depending on the price, you may consider reestablishing a new position at a later time.

If the stock prices hovers around the strike (p ~ S), or slightly below, you can roll out the position. This means you close the current put, and write a new put one month out. This lets you collect additional premium, or lower the effective buy price.

If the stock price has gone substantially below the original strike, things get interesting. This is where experience may be invaluable. I haven’t been doing CSPs systematically for long, but think that I have already gotten better at a few things.

In any case, you have several options; you could,

  1. take delivery – if you have reduced your effective buy price to a point where it is sufficiently below the intrinsic value, then it might be a good idea to take possession. Remember the overarching goal of the strategy is to buy good companies at a cheap price.
  2. roll out  – If you aren’t still happy with the effective buy price and have no new capital to commit, you can roll out the position. Note that the premium for ITM or deep ITM options may not be terribly attractive. Increasing the duration beyond one month might help add a little meat on the bone, but it will hurt your overall IRR. That said, it is a fine default strategy.
  3.  add position: if you have dry powder left (this is why I like four slugs in my revolver), you have more flexibility. There are multiple flavors, you could (i) keep the strike the same, (ii) lower it, or (iii) lower it and add extra duration. The first option (keep strike same) usually gives you the fattest premiums – it works best, when you think the stock has gotten really cheap and you want to lock in this cheapness. You fully expect the stock to rebound before the next expiry. The second or third options (lower strike/add duration) are worth considering, when you think the stock is headed even lower. You may take an IRR hit extending your position this way, but you are playing the long game. This way you reduce your effective buy price, and set yourself up to write future options that are less ITM (and collect fatter time premiums).
  4. use a wheel strategy: this involves some combination of the alternatives laid out above, and requires additional dry powder. You take delivery of the ITM options, write slightly OTM covered calls on these options, and use your dry powder to simultaneously write ATM or slighly OTM puts.

In future posts, I will highlight specific examples using this template.

Capitalizing R&D

Industrial companies reinvest in plant, property, and equipment to grow revenues. Technology companies grow by investing in research and development. However, on an income statement, these R&D investments are treated as an operating expense (instead of a capital investment).

One can reorganize financial statements of such companies by capitalizing R&D expenditures. You can check out this video, and this spreadsheet (look for R&DConv.xls) from Aswath Damodaran to understand the logic and mechanics of this reclassification.

The R&D asset you create goes to the asset side of the balance sheet.

Since assets = equity + liabilities, this increase in assets leads to an increase in the book value of equity, and hence the invested capital.

Similarly, we adjust the operating earnings by adding back the R&D expense and subtracting the depreciation of this asset in the current year.

When we capitalize R&D, we get a more authentic view of the earnings, reinvestment, and returns on capital. This alters the fundamental inputs that go into a discounted cash flow valuation, including earnings, growth and reinvestment rates (sales to capital ratio), and operating margins.

Process

To begin the process of capitalizing, we need the following inputs

  • An amortization period, N years, over which R&D is expected to deliver results (software ~ 2 years, hardware ~ 3-5 years, pharma ~ 10 years; Damodaran’s spreadsheet has some numbers for guidance)
  • Collect R&D expenses for the prior N (or N+1) years from the income statement. You can get these from company filings or a data service like Morningstar.
  • Create a table (see spreadsheet) to determine (i) the net value of the R&D asset on the balance sheet, and (ii) the current year amortization number.
  • Recompute operating earnings, net income, invested capital, and reinvestment rate.
  • Use these numbers to inform inputs in the DCF analysis

Example

I took Damodaran’s spreadsheet, and modified it slightly to account for partial year data. I did this to understand the spreadsheet better; not necessarily because I think such an adjustment is important. Of course, it uses the latest numbers, so it has that thing going for it.

For prior years, I assumed that R&D expenditures were distributed evenly throughout the year. Thus, if $100M were spent over an year, I assume $25M were spent each quarter. This spares me the burden of having to deal with quarterly filings.

I used this modified spreadsheet to analyze CSCO after two quarters of fiscal 2017.

1

Cells in yellow are inputs, while those in green are computed. This yields the following calculation for the value of the R&D asset and the amortization.

2

It also yields some summary statistics. In CSCO’s case, capitalizing R&D did not have a big effect on (i) operating income/margin and (ii) net income/margin. It had a modest effect on the reinvestment rate, which increased. The amount of capex, invested capital, and depreciation increased dramatically, while the return on capital went down modestly.

Valuing Financial Services Companies

Financial services companies are not quite amenable to a discounted cash flow analysis, because there is no wall separating operating and financial assets.

In such cases, it is difficult to figure out an ROIC, because “IC” in this context is a nebulous concept. This problem pops up in one form or another, when one attempts to do a firm level valuation (debt + equity). For example the sales/capital ratio which is handy in modeling reinvestment for growth is not particularly meaningful.

One way out of this quandary is to focus on equity (from Damodaran), and use a (potential) dividend discount model based on the Gordon growth model.

Let us define the relevant terms.

BV = book value of equity
ROE = return on equity
COE = cost of equity
nNI = normalized net income for next year = ROE * BV
g = stable earnings growth into perpetuity

The amount of free cash is determined by the g and ROE. This free cash can be distributed as a potential dividend. The payout ratio of this “free cash dividend” is

p = dividend payout ratio = (1 - g/ROE)

As a reality check, it is useful to compare the historical payout ratio to this value of “p”. One might have to account for all forms of cash return including dividends and buybacks while doing this.

Thus, the value of the equity is:

Equity IV = nNI * p/(COE - g)

Of course, if it makes sense, then the future can be split into explicit stages in which variables vary with time before settling into their terminal values.

On ROIC

ROIC and growth are the two central drivers of value.

ROIC = NOPAT/IC

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.

qualifiedCC

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.

Averaging Down

In 2011, Radioshack was trading at a single digit P/E. It was participating in the “mobile” wave, and sported a superficially healthy ROE. I bought the stock at $15. As the stock price declined, I took a second bite at $6. I thought the market was overestimating the odds that RSH would be zero. Saj Karsan, a blogger who I respect, seemed to think so.

Not long after, I unloaded the entire position at prices between $3-$4. I lost about 2/3 of the originally invested capital.

In 2012, I bought Prosafe SE (PRSEY) at $7.50. Its historical stability, and high dividend seemed attractive. Adib Motiwala, a money manager I followed, had endorsed it. As oil prices declined, I took another bite at ~$4.50. By the time, I realized that oil prices might not snap back right away, and sold my position, I had taken another haircut worth 2/3 of the capital deployed in the position.

Finally, Weight Watchers. I bought it over 2013-2014 at an average price of around $24. It had fallen nearly 70% from a high of $80 in 2012. I did not know much about WTW, before Geoff Gannon who writes a superb blog, mentioned it. He and Quan put out a compelling writeup, explaining their case. In 2015, WTW slipped below $4/share – an 85% loss on my buy price. Since then it shot up to $26 (where somebody smarter would have sold), and retreated back to $12. I am currently sitting on an unrealized loss of  ~50%.

I thought about these three investment mistakes, as I read John Hempton of Bronte Capital share his thoughts on averaging down a stock. There are useful lessons to distill from his post, and my painful experiences.

In all three cases (RSH, PRSEY and WTW), leverage was a serious issue. Leverage can make a stock go to zero, if the underlying business falters, even temporarily.

Lesson #1: Don’t buy a levered business in decline

In all three cases, the endorsement of someone I admired made me more reckless than I would otherwise have been. No, I don’t blame these people for being wrong; on the contrary, I am thankful that they share their good and bad ideas so freely.

Lesson #2: Ask “am I buying this primarily because someone I admire likes it?”

In the case of RSH and WTW, pressure due to new technology (Amazon and MyFitnessPal, respectively) was a contributing factor.

Lesson #3: Don’t buy businesses that can be rendered obsolete by technology.

Many/most businesses are susceptible to technological obsolescence, even if we can’t see it at the time. For some, we can can see – in relatively high-resolution – how its core will be disrupted in a short period of time. Those are the bets to be cautious about.