Value Investing Principle #4: Value Investors are Futurists

My interest is in the Future because I am going to spend the rest of my life there. - Charles Kettering

In a recent post on Value Traps, I promised that I would offer what is the #1 way to hone one's ability to recognize a 'value trap'. The answer's simple: Become a 'Futurist'.

Before I tell you what a Futurist is, allow me to briefly explain how I stumbled across Futurism.

In 2001, and from the furthest city in the world from Jerusalem – Sydney – I watched intently (and with great disapproval) at how the political and social situation in Israel was unfolding. I couldn't bear being a distant sideline observer, and wanted to become more involved in Israeli 'policy-shaping'. And so, in the first half of that year, I left Australia and abandoned the world of entrepreneurialism, venture capital and financial markets to begin a new career path.

Soon after arriving in Israel, I found myself working under Professor Yehezkel Dror, Israel Prize Recipient, and one of the country's foremost thinkers and policy-planners. With his guidance I co-wrote the "The External Mirrors of Israel: A Comparative study of Israel and it's Neighbors" which was presented at the 2001 Herzliya Conference.

Dror introduced me to a field which immediately appealed to my love of history and sense of curiosity: Futurist Studies or Futurism. As I immersed myself in the reading material, I quickly recognized the similarities and importance of this field to my former profession – and to Value Investing.

So what's a Futurist?

Imagine that we're all passengers on one of the ships on Columbus' fleet. The Futurist's role is to sit in the little 'lookout perch' (called a 'crow's nest) at the top of the ship's mast and to scan the horizon in search of possible danger such as hidden reefs, enemy ships, or changing weather patterns. In fact, anything that might affect the ship's course, mission or safety. He relays all relevant information to the ship's captain and crew, who take such information with the required seriousness, and they respond as needed.

OK – enough with the metaphor. Adopting a multidisciplinary perspective, Futurists examine various long term trends with the hope of identifying the threats and opportunities that face all of mankind in the future. Futurists study and seek patterns of 'change'. To see what I mean, take a look at what I believe is one of the most eye-opening videos on YouTube today:

Futurists pose the question: "how will our lives be different 25 (or more) years from now?" Areas of interest include:

- Demographics: How do the trends of living longer, getting married later and having fewer children affect society, the labor force, social welfare, taxes, etc.

- Religion: What's happening in the world's major religions?

- Education: How are learning habits changing?

- Health: What are the trends and developments regarding health, diseases, nutrition, obesity, medication and health care?

- Work Lives: How is our work lives changing? Are we working more or less than previous generations? How does this affect our family units, education and social values?

- Wealth: Which professions and industries are valued the most by modern society – and why?

- Recreation: What are the trends with regards to how much free time we enjoy and how we choose to spend it?

- Environment and Ecology: What are the environmental and ecological challenges that we have created for ourselves – and how can they be addressed?

- Science & Technology: What are the new frontiers? Space? DNA engineering? New forms of planetary and inter-planetary travel. New forms of communication and knowledge-sharing.

- World Conflicts: How have global conflicts changed in the past century?

Examining such issues, futurists most of all seek to identify 'disruptive trends' or 'ruptures' in history. These are changes so significant that Futurists predict they will have a major impact on our future lives.

Back to the metaphor: unlike a ship's captain or crew whom listens and acts according to what the ship's lookout sees, mankind and its leaders do not have the same inclination to heed futurist thought. Futurists are sometimes ignored and often ridiculed, as states, world leaders, industries, and multinational corporations continue to focus on individual short-term interests over collective long-term security.

Ironically, if a Futurist succeeds in his role as a 'policy shaper', then the leaders he works for will have found ways to navigate around the threats that he identified, and his predictions will never eventuate.

The interesting thing about 'futurist thinking' is that when a person is revealed to it, they are usually not surprised at its findings. This is because the trends discussed are happening before our very eyes, and happening ever so slowly that we fail to ask the important question: 'So What?' We usually know what's going on – but fail to recognize the long-term implications that they have on our lives. Perhaps this is because we are so focused with the short term day-to-day distractions that lie immediately before us that we rarely manage to lift our heads and set our eyes on the horizon? I don't know. What I do know however is that if we are unable to look to the distance, we should at least pay some attention to those that can.

So how does this bear any relevance to Value Investors?

Futurist thinking and Value Investing go hand in hand. Value Investors are by nature, long-term oriented, and seek to gain understanding on 'what's going on?' from the long perspective. Such an understanding allows Value Investors to identify what will be important markets and industries in the future and what industries are waning and should be avoided. (Take a look at my recent post on Gannett to see how recognizing the changing trends on how we consume news would have prevented you from erringly invested in a 'value trap'.)

When reading Berkshire Hathaway Annual reports and Letters to Shareholders one gets the distinct impression that Buffett is a Futurist at heart. His writings also bear the tone of a ship's lookout that is desperately trying to get the attention and warn the captain and crew below. Just take a look at these two recent examples:

America's Growing Trade Deficit is Selling the Nation Out from Under Us. Here's a Way to Fix the Problem - and We Need to Do It Now! - by Warren Buffett, Fortune Magazine, October 6, 2004

What Worries Warren - by Warren Buffett, Fortune Magazine, March 3, 2003

In the coming posts I intend to introduce some Futurist thought, although I doubt that any of it will be new to you. In these, I hope to answer the 'So What?' question by pointing to what I believe are the main long term drivers of the future and the Value Investing opportunities that we can patiently lie in ambush for.

Some Additional Futurist Resources

- The Futurists Top 10 Forecasts for 2008

- The World Futurist Society

- The Futurist Magazine

Recommended Futurist Reading:

(Tip: Hover your mouse over the title of the book for additional information on it).

Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics

Revolutionary Wealth: How it will be created and how it will change our lives

The Third Wave

Future Shock

Powershift: Knowledge, Wealth, and Power at the Edge of the 21st Century

Seeing What's Next: Using Theories of Innovation to Predict Industry Change

Medici Effect: What Elephants and Epidemics Can Teach Us About Innovation

The Next Great Bubble Boom: How to Profit from the Greatest Boom in History: 2006-2010

The Roaring 2000s: Building The Wealth And Lifestyle You Desire In The Greatest Boom In History
Guns, Germs, and Steel: The Fates of Human Societies

Collapse: How Societies Choose to Fail or Succeed

The Third Chimpanzee: The Evolution and Future of the Human Animal (P.S.)

The Art of the Long View: Planning for the Future in an Uncertain World

Inevitable Surprises: Thinking Ahead in a Time of Turbulence

What Value Investors Look for in Quarterly Earnings Reports

Well we're just about nearing the end of the reporting season for quarter 3, 2007, and I thought it might be an opportune time to briefly discuss quarterly earnings announcements - and what Value Investors generally look for.

True - Value Investors do not focus or judge companies on quarterly earnings performance, but rather assess a company on its performance during different parts of the long term business cycle. This however, does not mean that Value Investors do not pay attention to quarterly earnings reports.

Quarterly earnngs reports allows Value Investors to extract 2 qualitative dimensions about a company and the industry it operates in:

(i) Quality of Management - Is Management shareholder-oriented? Is it open, candid and honest in the manner it reports and answers questions?

(ii) Industry Changes - what's going on in the industry? Have any fundamental changes occurred?

I have always found Morningstar's research and website a great investing resource. (At the right price, Morningstar Inc (Ticker: MORN) would be definitely worth looking at). Anyway, I came across the following 3 minute video by Pat Dorsey, Director of Stock Analysis at Morningstar.

If you've got a few moments, have a look at the video below. If you like what Dorsey has to say, I highly recommend his The Five Rules for Successful Stock Investing - it's a great book for a Value Investor that is just starting out.

Below is a brief summary of the tips that Dorsey provides, as well as a few insights and recommended resources of my own.

Earnings News or Earnings Noise, July 2007

(1) Don't focus on the the quarterly earnings number - it is the least relevant. If there is only one thing you should take away from Dorsey's advice it is this:

(2) Ignore the Headlines - face the facts - it is only natural that companies will 'put their best foot forward' and report in a manner that optimizes how they look. Most public companies hire PR / IR consultants whose job it is to frame them in the best light. So the challenge before Value Investors is to cut through the PR jive and get through to the nitty gritty.

(3) Focus on Why, Not What - Revenues are dropping? Margins are eroding? Inventories are building up? You've got to be asking yourself 'Why?'. Why is this happening? Is this a new trend? Has something changed in the industry? The answers to the "Why' question are usually what alerts Value Investors to significant changes in the industry. (To see why this is high importance take a look at this).

(4) What Do You Want To Know - Before the earnings release, Dorsey recommends that investors should make a list of what they want to know from the earnings release. I totally agree. By taking this step, you move from being in 'passive mode' where the company information is 'dressed up' and 'fed to you', to 'active mode' - where you in control of what you seek. It is a good sign when a company is able to answer all your pre-prepared questions. It means that they are being upfront and candid with investors, telling it exactly as it is.

(5) Listen to the Conference Call - There is so much qualitative information that can be gleaned from company conference calls that the importance of this tip cannot be understated. These days, almost all public companies in the US allow investors to listen in on the conference call via the internet or via phone. The investor relations section of the company's website will tell you how to do this. Generally, these calls are divided into 2 parts: a pre-prepared statement (which is usually read out by the CEO / COO /CFO), and then a Q&A section where industry analysts ask questions. It is the second half of the call that I find of greatest value to me. These analysts typically know the industries they cover like the back of their hands. It's their bread and butter. Remember - they are most probably covering the company's competitors as well - so they should be able to recognize shifts in industry trends. So pay special attention analysts' questions - they may raise some important red flags. Equally important is how the company's management answers analysts' questions. Are their answers open and candid ('yeah - we really messed up' or 'we really don't know') or are they defensive and evasive?

The following tip may be too much for some investors, but I also like to re-read the earnings transcript for the previous quarter. If you make a habit of taking notes, then you just re-read those notes. You should take note as to what extent the company's management is optimistic and upbeat.You should also note any forecasts of growth - even if they are somewhat vague. (you'll get used to the lingo - single-digit, double-digit, low teens, high-teens). By doing this you can then compare what they said last quarter to what they are saying now - and immediately identify any changes. An Israeli company that I have been watching closely and which is releasing it's Q3 earnings report tomorrow may provide a prime example. Stay tuned.

A Great Resource for Quarterly Earnings Transcripts: Check out Seeking Alpha.

Israel: World MVP

I've been meaning to write a post on why value investors should take a serious look at Israeli companies, and why Warren Buffett made his first invesment outside of the US in Israel. But someone beat me to it.

Pat Boone, the legendary music artist penned the following column last week on WorldNetDaily. I couldn't have written it better myself.

Israel, World MVP
Posted: October 27, 20071:00 a.m. Eastern

As you read these words, I'm in Israel. My wife, sister, brother and his wife, two of our granddaughters, a host of friends and their friends … all 38 of us have literally walked into the pages of the Bible.

This is perhaps my 12th trip (I've lost count), but the impact, the emotional and spiritual shivers I always experience, have never lessened. It's one thing to read the whole Bible cover to cover, as I do every year, but actually to walk around on the very sites of the events described so accurately in that book is truly soul shaking.

We'll stand, physically, where David picked out the stone with which he felled the giant Goliath; we'll climb up the rocky ravine to the cave of Ein Gedi, where David hid from King Saul; we'll look out over the vast plain of Megiddo, where the cataclysmic battle of Armageddon will take place; we'll buy sodas at Jericho, still inhabited, though without the wall that used to surround it; we'll look up at Mount Nebo, from which Moses gazed at the Promised Land he'd never enter; we'll read aloud the Sermon on the Mount in the natural hillside amphitheater where Jesus first spoke those words; some of our group will be baptized in the Jordan River, close to the place where Jesus Himself was baptized by John the Baptist; we'll visit the hill called Golgotha, the "place of the skull" where He was crucified between two thieves – and we'll also spend time looking into the hole in the wall where His body was laid and celebrate the fact that it's empty, as it has been since the stone rolled away at dawn on the third day.

All these things, and hundreds more, actually happened in Israel, just as the Bible recounts. And one of the most amazing things is the seemingly impossible promise God made to Abraham, an unknown sheep-herding nomad from Ur of the Chaldeans, and repeated to Isaac and Jacob: "In your seed (through your descendents) all the nations of the earth will be blessed." How could this possibly be? But it has literally happened, and extravagantly!

I've written here before about the innumerable contributions Israelis have made to the world, in virtually every category – literature, chemistry, medicine, physics, economics, every science and technology, Internet and communication, and efforts for world peace. Twenty-one perceont of all Nobel Prize winners worldwide have been Jews! The list of achievements and astounding contributions is endless.

Every day, virtually every person in the civilized world benefits from these contributions, in areas relating to food, medicine, overall health, knowledge, security, great literature (including of course the Bible) and music – almost everything that we think of as "quality of life." It has long been established, and is obvious on its face, that in every nation motivated and influenced by Judeo/Christian principles, the population has prospered and the culture flourished. The reverse is also true: Societies and cultures that have rejected and even opposed those principles have lagged behind, even drastically suffered in all the same areas and quality of life.

And the pace has greatly quickened in the last several decades. Consider: Israel is the 100th-smallest country, with less than 1/1000th of the world's population – but its $100 billion economy is larger than all of its immediate neighbors combined. It also has the fourth-largest air force in the world (after the U.S., Russia and China), with over 250 F-16s and very powerful weapons – to defend itself against the announced and very serious threats of some of those same neighbors.

Out of its own necessity, but also to help all peaceful societies, Israel designed the airline industry's most impenetrable flight security. U.S. officials now look to Israel for advice and technology in handling airborne security threats. Fly anywhere safely lately? Thank Israel. (My family and I do that every day, sometimes every hour, here in Israel.)

Look further: Israel has the highest ratio of university degrees to its population in the world; she produces more scientific papers per capita than any other nation by a large margin – 109 per 1,000 people – as well as one of the highest per capita rates of patents filed. With more than 3,000 high-tech companies and startups, Israel has the highest concentration of high-tech companies in the world – apart from the Silicon Valley, USA.

How does this matter to you and me, and every other citizen in the world of the 21st century? The cell phone was developed in Israel by Israelis with Motorola, which has its largest development center in Israel. Most of Windows NT and XP operating systems were developed by Microsoft-Israel. The Pentium MMX chip technology was designed in Israel at Intel, and both the Pentium-4 microprocessor and the Centrino processor were entirely designed, developed, and produced in Israel. Voice-mail technology and AOL's Instant Messenger were developed by young Israelis.

Medical technologies, diagnostics, pharmaceuticals and treatments that offer healing in almost every area of disease and disability are just too many to list here. But let's note that when Stephen Hawking, generally considered to be the most brilliant thinker on the planet, visited Israel recently, he shared his deep musings with scientists, students and even the prime minister. But the world's most renowned victim of ALS, or Lou Gehrig's Disease, also learned something: Due to the Israeli ALS Association's advanced work in both embryonic and adult stem cell research, as well as its proven track record with neuro-degenerative diseases, the Israeli research community is well on its way to finding a treatment for this fatal disease affecting 30,000 Americans and tens of thousands worldwide!

Israel's Given-Imaging has developed the first ingestible video camera, so small it fits inside a pill; it's used to view the small intestine from the inside, to detect cancer and digestive disorders. And other Israeli researchers have developed a new device that directly helps the heart pump blood – an innovation with the potential to save lives among those with heart failure. There's also a revolutionary new acne treatment, the Clear Light device, that causes acne bacteria to self-destruct – without damaging surrounding skin or tissue.

An Israeli company was the first to develop and install a large-scale, fully functional solar electricity generating plant, in Southern California's Mojave Desert. What does that portend for an energy-guzzling, oil-stained world?

Truly, the accomplishments – too numerous and complex to list here – are staggering; I've only scratched the surface, and I've already noted the pace is accelerating exponentially. Israel is just getting started. Proportionately, no other country in the world can match her creativity and her massive contributions to the world's standard of living – not even the United States.

And I haven't even mentioned that the three largest religious faiths in the world are expecting the appearance soon of a Messiah – a Savior to all mankind, at least to those who will acknowledge and receive Him – in ultimate fulfillment of the incredible promise made to Abraham, "Through your seed will all the families of the earth be blessed."

In this game we play on earth, called life, though many players have contributed great things, the MVP – the Most Valuable Player – has been clearly revealed.

It is Israel.

Pat Boone, descendant of the legendary pioneer Daniel Boone, has been a top-selling recording artist, the star of his own hit TV series, a movie star, a Broadway headliner, and a best-selling author in a career that has spanned half a century. During the classic rock & roll era of the 1950s, he sold more records than any artist except Elvis Presley.

Is Gannett Co. (GCI) A Value Bargain or Value Trap?

In my last post I introduced the concept of 'Value Traps' - where the business looks like it is a 'bargain', but there is in fact a justified reason behind the market's discount.

There are some industries that experience significant upheaval and change as a result of a disruptive technology or change in consumer behavior. The erosion of economic fundamentals that occurs will impact a Value Investor's estimation of a business' intrinsic value.

An immediate example that comes to mind is the newspaper and print media industry. Let's see what Buffett has to say on the matter:

From the 1991 Berkshire Hathaway Letters to Shareholders:

"We have a significant investment in media - both through our direct ownership of Buffalo News and our shareholdings in The Washington Post Company and Capital Cities/ABC - and the intrinsic value of this investment has declined materially because of the secular transformation that the industry is experiencing."

And again in his 2006 Letter:

"And fundamentals are definitely eroding in the newspaper industry, a trend that has caused the profits of our Buffalo News to decline. The skid will almost certainly continue."

And for those who might believe that each newspaper's website will substitute for any lost revenue Buffett continues:

"True, we have the leading online news operation in Buffalo, and it will continue to attract more viewers and ads. However, the economic potential of a newspaper internet site – given the many alternative sources of information and entertainment that are free and only a click away – is at best a small fraction of that existing in the past for a print newspaper facing no competition."

And now for a real-life example: Gannett Co [Ticker: GCI]. Founded in 1906, Gannett's operations are primarily in the US and UK, and include 90 daily newspapers, 1,000 non-daily publications as well as 23 television stations that reach an estimated 20 million viewers in the US.

In order to establish an estimate of Gannett's Intrinsic Value, I will first need to obtain an estimate for free cash flow. Going to last year's Cash flow Statement. I take Net Income, add Depreciation and subtract Capital expenditure. Free Cash flow comes out to be around $1.24 billion.

Now comes the tricky part: estimating future earnings growth. I go to analyst consensus earnings - here. Scrolling down to the bottom of the page I see that analysts are expecting average annual earnings growth for the next 5 years of 4.35%.

I now plug both these figures into a simple DCF calculation, use a 10% discount rate, divide by the total number of shares outstanding and get an intrinsic value of about $64 per share - a 55% discount to current market price. On the face of things - this seems like a bargain, right?

What's wrong here? Going back to Yahoo's analysts consensus earnings estimates, I take a look at earnings growth for the last 5 years - an average of just under 2%. Many studies have shown that analysts tend to be optimistic in their assumptions - and here we see it in action. The last 5 years earnings growth was barely 2%, and analysts believe that in the next 5 it'll be double that? I doubt it.

What happens if I plug in 0% growth for the next 10 years into my DCF - in other words the industry remains stagnant and goes nowhere. I come up with an intrinsic value of $44 - still a 7% discount to today's price. In other words, contrary to analyst consensus, the market believes that the industry will experience continued erosion.

Gannett looks like a bargain, but a Value Investor who looks past the numbers, takes analyst estimates with a pinch of salt, and investigates what's happening in the industry may come to a completely different conclusion.

In my next post on Value Investing Principle #4, I will reveal what I believe is the best way to spot a 'Value Trap'.

Please read the Legal Disclaimer.

Disclosure: Author does not hold a position in GCI.

Avi Ifergan is the Managing Partner of Israel Value Funds (www.israelvalue.com) an Israel-based investment partnership that follows a disciplined and long term oriented Value Investing approach, with a primary focus on Israeli public companies. Avi is a former equity analyst, corporate advisor and serial entrepreneur. These days he spends his time teaching economics at a major Israeli university and seeking value investing opportunities. He very much appreciates your feedback at avi@israelvalue.com.

Value Investing Principle #3 (Part 3): Value Investors Love a Good Bargain

In the previous 2 posts on Value Investing Principles (here and here) I looked at the concepts of Margin of Safety, and Intrinsic Value. I explained that the calculation of the intrinsic value of a business is not an exact science but rather a rough estimate of value, hence the need for a margin of safety.

As promised in my previous post, in this post I am going to attempt to answer the last of the 5 questions that I posed:

Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?

In attempting to answer this question I will introduce a new Value Investing concept - 'The Value Trap' . I'll also explain why some investors tend to be fooled by Value Traps, and in a later post will provide some advice on the best way to recognize them.

Drawing on the metaphor I used in the first post, imagine you are shopping and you see packets of pasta at half price. Instinctively you may want to take advantage of the bargain and buy in bulk. Savvy shoppers will immediately ask 'where's the catch?' - and will attempt to identify something faulty with the good (perhaps the pasta is close to its expiry date or is of poor quality). If you've discovered a valid reason why a product is 'on special' or trading at a significant bargain to market prices, you have discovered a 'Value Trap'.

Simply put, I define a Value Trap as a company that appears to be undervalued and a Value Investing opportunity, but in fact does not possess any recognizable significant investment potential.

So, to answer the question I posed: In my humble opinion I believe that for the most part, when a business is valued cheaply, there is a good reason for it and I seek to identify it. Most of the time, the market is to a large extent correct. This is expected. Never in the history of mankind have investors had so much company and industry information available at no cost, and never have they been as savvy and educated.

There are instances, however, when the market has mispriced or undervalued a business with little justification. These include:

(i) When it focuses on the Short Term and ignores Long Term potential: I think this is a primary reason for pricing inaccuracies as analysts and investors with a short term investment horizon focus solely on quarterly earnings. Long Term Value Investors take advantage of such short-sightedness to pick up quality companies cheaply.

(ii) The Market Confuses Uncertainty with Risk - this is a underlying theme of Mohnish Pabrai's investment philosophy. You can read about it in detail here. Basically, investors tend to react in simialr fashion when there exists business uncertainty as when there exists business risk - they panic. Two recent examples come to mind: in 2005 Mercury Interactive's CEO and CEO were accused of fraud with regards to the backdating of options. The market responded with a significant sell-off and drop in market price. Mercury's business and clients had not changed. The only difference is that 2 of Mercury's former senior management would now be wearing orange overalls. Hewlett Packard was able to take advantage of the negative market sentiment and less than a year later to acquire the company for $4.5 biliion in cash. A similar story occured with M-Systems and an internallly-initiated options backdating enquiry which resulted in the market severaly overeacting. Nothing had changed in the business at all, but the end was the same as Mercury's. SanDisk took advantage of the negative market sentiment and low share price and acquired M-Systems for approximately $1.5 billion

(iii) When Investors Do Not Properly Understand The Business: Sometimes investors do not understand the fundamentals of a specific business, and when certain industries face negative sentiment, these businesses included and collectively punished. A current example is the sub-prime crisis. There may exist certain mortgage businesses or financial insitutions that have little exposure to low-quality loans, and yet they have suffered the same fate as the others in the industry.

Rear-View MIrror Investing: Why Investors Fail To Recognize Value Traps?

The main reason that investors fail to recognize Value Traps is what Buffett calls 'Rear View Mirror Investing' - making investment decisions based on past experience. (See the entire article here). Psychologically we all tend to place significant weight on our past experiences and extrapolate them into the future. This is one of our prime learning mechanisms. If we get food-poisoning from dining at a certain restaurant, we most likely won't return there again. And the converse with positive experiences. Unfortunately, this does not exactly work in the investing game, and is a major cause for failing to recognize a 'Value Trap'. As John Maynard Keynes suggests:

"It is dangerous to apply to the future inductive arguments based on past experience, unless one can distinghuish the broad reasons why past experience was what it was."

There are many examples of businesses that were once dominant players in their industry, and in fact still remain dominant, yet the fundamentals of the industry as a whole have changed.

In my next post, I will provide an example of a great business that looks absurdly cheap, but which, because of massive changes in the industry it is in, make it a 'Value Trap'.

Can you think of the industry that I am referring to? Or a business in such an industry?

Until next time: "May you possess the Wisdom to see what the market does not, and the Courage to act on it".

Value Investing Principle #3 (Part 2): Value Investors Love A Good Bargain

"The entrance strategy is actually more important than the exit strategy". – Eddie Lampert

"Plan before acting. Fight only when you know you can win." - Zhuge Liang

In the previous post on the Principles of Value Investing I introduced the concept of Margin of Safety and Intrinsic Value and answered the first of 5 questions that I posed:

(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?

(2) How Do I Calculate the Value of a Stock?

(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?

(4) How great a Margin of Safety do Value Investors generally demand?

(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?

In today's post I will attempt to answer questions 2 to 4.

Q2: How Do I Calculate the Value of a Stock?

The important point to understand here is that calculating the Intrinsic Value of a business or stock is not an exact science. It is an estimate or a range between prices.

A simple example: Let's assume you are interested in purchasing a felafel stand. How would you calculate what price is a fair price you should pay for the business? Hopefully, you would look at 2 factors:

(i) Cashflow: You would try to assess how much cash the business will generate (cash flow) every year after all your expenses have been paid.

(ii) Growth Expectations: You will try to assess the growth potential of the business.

Now let's assume you do some research and discover that similar falafel stands in the area generate in their first year of operation an annual cashflow of $50,000, after all expenses have been paid. And let's assume that you discover that a similar falafel stand increased it's annual cashflow by 10% every year.

Would you pay $50,000 for the stand? Probably – as this means that you would earn back your initial $50,000 in one year. How about $100,000? Yeah, maybe. $200,000? Um, let me think about it. So you now have an estimate – in your opinion it is worth somewhere between $50,000 to $200,000.

If the seller of the falafel stand wants $1 million for it, you would immediately recognize that only a fool would pay such a price – even if there are hundreds of other fools paying similar prices for similar businesses elsewhere. On the other hand, if someone, for some reason offered to sell it to you at $25,000 – you would take a serious look at this deal.

In calculating the intrinsic value of stock, Value Investors apply a method called "Discounted Cash Flow" or DCF. The 2 main assumptions are free cash flow and growth. As much has been written by individuals far more capable than me, I will not go into the actual calcualtion or methodology of DCF. Instead allow me to point you to:

(i) An excellent article from the Motley Fool.

(ii) Joe Ponzio's FWallStreet - Joe's blog is first class - extremely well written, a shining example of an individual bringing value to the market. Specifically look at the 4-part series on The Value of a Business that begins here. You can also download a very good DCF excel spreadsheet which Joee used on his analysis of JNJ here.

Q3: Why Not Pay the Fair Value? Why Must I seek a Margin of Safety?

"One of the hardest things to imagine is that you are not smarter than average" - Daniel Kahneman, New York Times "Why Both Bulls and Bears Can Act So Bird-Brained", March 30, 1997

You haven't been paying attention, have you? Calculating Intrinsic Value is not an exact science – it is estimation only that requires two assumptions – a forecast for annual cash flow in year 1 and an estimated growth rate. As these are only assumptions – they can be wrong (and often are). You need to leave some contingency in the event that your assumptions are wrong.

Warren Buffett refers to the field of construction and engineering where the Margin of Safety concept is applied daily:

"You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing." - The Superinvestors of Graham-and-Doddsville

In his 1974 Letter to Shareholders Buffett wrote:

"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."

This is why I have always said that Value Investors earn their money when they place a 'buy order' - not on the sell. The skill is in buying well.

And in his 1992 Letter to Shareholders he said it again:

“What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).....The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value...... If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”

Q4: How great a Margin of Safety do Value Investors generally demand?

"If you understand a business and if you can see its future perfectly, then you obviously need very little in the way of margin of safety...Conversely, the more vulnerable the business, the larger the margin of safety you require." - Warren Buffett

As the Buffett quote suggests, the Margin of Safety that you give yourself is a function of to what extent you feel confident about forecasting a businesses cashflows and growth. Value Investors typically demand a margin of safety (or discount) of at least 30% (and sometimes as high as 50%) to calculated intrinsic value.

It is also worth noting that the greater the Margin of Safety that you give yourself, the lower the risk in losing your initial investment. The Partners at Tweedy Browne, a well-known Value Investing fund manager explains:

"One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value. Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e. lower risk."

In Part 3 of Value Investing Principle #3, I will attempt to answer Question 5 and discuss what the industry refers to as 'Value Traps'.

"May you possess the Wisdom to see what the Market does not, and the Courage to act on it".

Warren Buffett Bursting with Pride at Israeli Acquisition

Warren Buffett is currently on a whirlwind tour of Asia. The impetus of the trip was an invitation by Iscar CEO, Eitan Wertheimer to Buffett, to officially open Iscar's first metalworking production plant in Dalian China.

In yesterday's exclusive interview with Ha'aretz's Guy Rolnick, Warren Buffett could not say enough great things about his purchase last year of Israeli metalworking company, Iscar.

Below are some of Buffett's thoughts:

"Iscar is a dream deal. It has surpassed all the expectations I had when buying the company, and my expectations had been very high."

"Since I met Eitan Wertheimer [Iscar's CEO], and acquired Iscar, the people at Berkshire Hathaway think I'm a lot smarter".

When Rolnick asked Buffett how Iscar has performed since he acquired it, Buffett responded:

"Next week I have a board meeting in Columbus, Ohio....Only three Berkshire Hathaway companies will be making presentations there: two insurance companies and Iscar.... And when the people from Iscar make their presentation.... the buttons are going to burst right off his shirt because [I'll] be so puffed with pride about that deal."

For those readers who are not up to speed with the Berkshire acquisition of Iscar, here's a quick summary.

• In early 2006, Buffett received aone and a half page letter from Eitan Wertheimer, Iscar's CEO, describing the Iscar business. Buffett stated that when he read the letter something jumped out at him, and he invited Eitan to Omaha.
• Soon after meeting Wertheimer, the details of Berkshire's acquisition of Iscar were agreed upon.. Buffett did not use an investment bank or corporate advisors on the acquisition. He didn't even visit the Iscar plants.
• Berkshire paid $4 billion for an 80% interest of the business. This was Buffett's first acquisition outside of the US.

Soon after the Iscar acquisition, Buffett paid his first visit to Israel. Below is a 7 minute interview from that trip. Apart from the first 25 seconds, the interview is in English.

In the interview, he explains why he does not perceive Israel as a greater security threat than either the US or the UK.

Some Excerpts:

" I can give you an absolute, unequivicol answer....it's very impressive when a country of 7 million or so people turns out a business like this.... I haven't seen anything like this in the US."

"We weren't measuring Iscar against any other Israeli company. We were measuring it against everything we see in the world".

"If you compared Israel in 2006 with Israel in 1948, it's very very impressive".

"Israel should not be a secret....it's remarkable place... particularly the talent.... talent's worth far more than money."

Value Investing Principle #3 (Part 1): Value Investors Love A Good Bargain (Margin of Safety)

"Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety."

– The Intelligent Investor, Chapter 20, Benjamin Graham

"Good warriors prevail when it is easy to prevail. "
- The Art of War, Sun Tzu

In this post, and in the following two after it, I will discuss the ideas behind what is probably the most central concept in the Value Investing discipline: the 'Margin of Safety'. Benjamin Graham, the 'Father of Value Investing' introduced it to the investing world in his book, The Intelligent Investor.

Simply explained, the Margin of Safety principle demands that investors only invest in businesses or stocks that trade at a significant discount to their calculated 'true value'. This 'true value' is also called the 'intrinsic value'. In other words, if you calculate a stock's intrinsic value to be $100, you should give yourself a 'margin of safety' and only pay, say $70 or less for it. Makes sense, right? This is no different to when you go shopping at the supermarket: Pasta, which normally sells for $2 a pack is now on special, and priced at $1. You wouldn't think twice (unless of course you're allergic to pasta or the expiry date is way passed today's). Savvy shoppers will take advantage when items are on sale, and buy in bulk.

All this sounds like common sense, but I bet you're dying to ask the following questions:

(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?

(2) How Do I Calculate the True (Intrinsic) Value of a Stock?

(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?

(4) How great a Margin of Safety do Value Investors generally demand?

(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?

In this post I'm going to answer only the first question. The others will be dealt with in the coming posts.

Q1. Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?

A1: Yes – all the time. Don't believe me? Open any newspaper, or financial website (Yahoo will do), pick any major public company and look at the 52-week high and 52-week low. Let's look at Teva (TEVA). The 52-week low was $30.70, pricing the entire business at around $23.39 billion. (To calculate the value of the entire business, mutliply the no. of shares that are outstanding by the share price). The 52-week high is $45.44, pricing the entire business at $34.62 billion. That's a huge spread – a little over $11 billion. How can this be? Which is the correct and fair price? Can a business change so significantly that it will have gained or lost $11 billion in value in the space of a year? The answer to all this is simply this: the market does not always behave rationally. Why not?

Two reasons that may explain this are:

(i) The market is sometimes driven by the emotions of greed and fear. For example, when an individual invests in a company without really researching it, because he heard from a neighbor that he made several thousand dollars from a stock that shot up 20%. That's not rational - it's insane. Imagine being told that the price of bread increased by 20% at a certain bakery. You wouldn't feel the sudden need to rush out and buy bread from that bakery. You'd look elsewhere for a better deal. Most people however, behave differently when it comes to the stock market. When hearing a stock or fund has increased by a huge amount, they feel that they are going to miss out on the profits and buy after the stock is has already increased in prive. That's greed talking. My neighbor, however, is smarter than that. If I tell him that I bought SanDisk at $37, and it drops to $36, he understands that he can get a better deal than what I got, and he calls his broker. Just like buying pasta on special at the supermarket. Right, Oren?

In Robert Hagstrom's, The Warren Buffett Way, (see also this post) he explains that the Value Investing methodology developed by Graham was based on the belief that the market is often wrong:

"Graham's conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market."

(ii) The market forgets that stocks are fractional bits of actual companies. Some individuals think of stocks as bits of paper that are traded back and forth. They rarely consider the business behind the stock - the products or services, the clients or employees. As Benjamin Graham wrote in Security Analysis in 1934:

"It is an almost unbelievable fact that Wall Street never asks: 'How much is the business selling for? Yet this should be the first question in considering a stock purchase."

"Why Both Bulls and Bears Can Act So Bird-Brained" - a New York Times article written a decade ago explores this in some depth. You can view it here.

So I think it's just about now where we learn the first Value Investing Mantra.

Repeat after me:

"The Price of a stock is not the same as the Value of a stock"

Most investors do not understand this principle, which explains why the market crowd is very often emotionally-driven, and does not behave rationally.

Value Investors focus on the Value of the business, not on the price of it.

As Warren Buffett famously declared: "Price is what you pay, value is what you get."

In the next posts I will continue our discussion on Margin of Safety and look at how intrinsic value is calculated, why you must seek a Margin of Safety, and how great a Margin of Safety is required. I will also briefly discuss 'Value Traps'.

Until next time - May you possess the Wisdom to See what the market does not, and the Courage to act on it.

VIDEO: Legg Mason's Robert Hagstrom on WealthTrack

Legg Mason fund manager, Robert Hagstrom was one of the interviewees on last Monday's edition of WealthTrack.

In my opinion, Hagstrom's greater contribution to the world is not as an asset allocator, but rather as a best-selling author. His books The Warren Buffett Way, The Warren Buffett Portfolio, and Latticework all raised the level of understanding and awareness with regards to Value Investing. In my opinion, all three are invaluable resources for becoming a more successful long-term investor.

In the last 5 minutes of the WealthTrack interview, the host provides a tight summary of Hagstrom's first book - which is about Warren Buffett's Value Investing Philosophy.

Below I provide some excerpts from Hagstrom's comments in the interview. As you will see from my thoughts (tagged IV in blue), I wasn't as impressed as I was from his books.

"It's true, the economy is weak, and it's true, there's a lot of negativity in the market, but these times are also the seeds of future excess returns. I think it's time to be cautious, a time to stay with quality, but I think if you look back at periods like this - these are the opportunistic periods that allow you to build a portfolio that's going to generate very high returns, much better than the market rate of returns".

IV: Why do some investors see what's happening in the market now as a terrible thing, while others are actually glad? The difference between these 2 camps is their 'investment horizons'. Short term oriented investors are having trouble dealing with the recent market weakness. Those investors that adopt a longer investment horizon view these periods as an opportunity to invest in great companies at bargain prices. Hagstrom's fund has an average holding perid of 3 to 4 years - so it is little wonder that he is concerned.

IV: In the interview Hagstrom indicated that his fund is now 100% fully invested in the market (i.e. it's cash holdings are minimal). I found this strange considering the fact that his previous comment suggested that this is the opportune time to look for great prices. If he thinks this is the case, why doesn't he keep some cash in reserve - like Fairholme's Berkowitz or First Eagle's Eveillard? Perhaps Legg Mason's team believe that the worst is already behind us? I don't know.

"We've taken the Warren Buffett Way, the Warren Buffett Process, and tried to apply it to the new economy".

IV: Hagstrom's top 5 holdings are Nokia, Yahoo, Amazon, Qualcomm and E-Bay. They make up a little over 30% of the fund. So he's definitely 'new economy'. I can see how he applies Buffett's principles of businesses with economic moats (you could argue that each is the dominant brand in its space), but what about predictability of future cashflows? You know there's going to be growth - but isn't that already factored into the high valuation multiple? How does one seek a 'Margin of Safety', the centerpiece to the 'Warren Buffett Process', when it is not easy to forecast future cashflows? This is why I wrote in my last analysis of SanDisk that Warren Buffett would not touch it.

When WealthTrack's host, Consuelo Mack, asked Hagstrom whether those stocks offer protection in a weak economy he replied:

"If we go into a recession, there's not much of anything that you can own that will do exceptionally well."

IV:Now I'm not sure about you, but I find this reply a little strange. How about company's that hold large positions of cash? Like Buffett's Berkshire Hathaway (BRK). That's what Sequoia, Fairholme and Eveillard have done - invested heavily in a business with strong cashflows and a strong cash position. When the market really craps out - you can count on Buffett to be pick out the treasure from the trash. How about Charlie Munger's favorite Costco (COST)? Costco will benefit in a recessionary environment as people seek ways to save money - and Costco is certainly one of the obvious places to do so. Another is GEICO - with a reputation as a cheap Insurance provider. Oh - that's right - it's owned by Berkshire.

If you can think of any other investment ideas whose business might benefit from a recessionary period - I'd love to hear them.

Signing off for today: "May you always possess the Wisdom to see what the market does not, and the Courage to act on it".

Shlomi Cohen: SanDisk's Steep Slide - Globes

Shlomi Cohen, one of Israel's veteran financial journalists wrote an excellent piece on SanDisk yesterday. I have followed Cohen's work since I have been in Israel, and he has proven to be very much in the know when it comes to the NAND flash memory industry.

In his column, he attempts to [and in my opinion, succeeds] pinpoint the reasons behind last Friday's market trashing of the stock.

You can view his piece here.

The Market’s Birthday Gift to Me: SanDisk Hammered 15%

I celebrated my 36th birthday yesterday, and received two wonderful gifts – one from my wife and one from the market.

There is a connection between both.

A GIFT FROM MY WIFE:

For the past 5 years I have used the same cell phone – Nokia’s 3100. A simple phone, sturdy with good battery life, it did the job: making and taking calls. I didn’t need or want anything fancier. 5 years ago it was the most advanced cellular handset. Today – a dinosaur.

My wife however, in her good wisdom, thought that it was time that I upgrade to something a little more advanced – Nokia’s N95. I am ashamed to admit that I have been behaving like a little child ever since receiving it. I am thrilled. This baby does just about everything but make percolated espresso coffee. It’s got two cameras – a primary 5-megapixel camera (higher resolution than my digital camera!) and a secondary camera for video calls. Not only can it take digital stills – but also records high quality video. It has GPS Navigation capabilities with regional and local maps, a very functional daily organizer and planner, an MP3 player, radio and a video center. It is able to read pdf, excel and word documents and of course there’s e-mail and internet capabilities, and connectivity via wireless and Bluetooth. And there’s a calendar and clock too! Seriously though, it’s a nice gadget, with more functionality than I’ll ever really need. It’s probably one of the top-of-the-line handsets on the market today, up there with Apple’s iPhone. Just like my previous phone, within 5 years it too will be obsolete. It is hard to imagine what technology will be available 5 years from now.

It soon dawned on me however, that to really take advantage of the N95 I am going to need memory – a lot of it. The more, the better. (You can’t ever have enough memory!). I’m going to carry everything on it – hundreds of tunes, photos of the girls, you name it. Anyway, a quick look on the web reveals that the highest capacity of microSDHC memory available for handsets is a whopping 8GB. The mind boggles when you think of this. My first PC, a 1984 Apple II+ had 64kb of memory. The computer on Apollo 11's Lunar Landing Module, the spacecraft that landed Neil Armstrong on the moon, had 74kb of memory. But I digress. The gargantuan 8GB microSDHC that I yearn for is manufactured by SanDisk (Ticker: SNDK), which brings me to my second birthday gift. The one that came in at end of market trading last Friday.

A GIFT FROM THE MARKET:

Last Thursday, SanDisk (SNDK) released its Q3 earnings report, and by end of Friday's trading the market had severely hammered the stock, which was down 15%. Since the beginning of October, the stock price has dropped by almost 24%. The questions that demand asking are: If SanDisk's Q3 press release showed significant growth, why has the stock price plummeted? Have there been any material changes in SanDisk's business in the last quarter? Is the market behaving rationally here?

What Does SanDisk Do?

"It is not an exaggeration to say that SanDisk receives a percentage of the revenue of virtually every flash device sold on the planet, and considering the explosion of digital content, represented by products like Apple's iPod and iPhone…[this] is a very attractive position [to be in]." – Alex Morozov, Morningstar

SanDisk is the global leader in NAND flash memory technology. What's NAND flash memory, I hear you ask? Let's just say you probably use NAND flash memory several times a day. It's everywhere - cell phones, video games, PDA's, digital cameras, camcorders, television set-top boxes (like TiVo) and USB drives. It has replaced hard drives in some high-end laptops and is even in some of the newer model cars. It benefits from multiple revenue streams which include:

1. Licensing Revenue: licensing royalties from its patents. This year is expected to earn approximately $450 million from royalties (approx. 10% of total revenue)


2. OEM Revenue: Selling NAND flash memory components to OEMs (such as handset manufacturers (approx. 30% of total revenue)


3. Retail Revenue: Retail products such as USB memory sticks, its line of Sansa media players, and its memory cards for digital cameras and cellular phones. (Approx. 60% of total revenue)

Is SanDisk a Dominant Player in the Markets it operates in?

The answer here is a resounding YES.

NAND Flash Memory Production

According to SEMI ('Fabfutures' and 'Fab Capacity Report') SanDisk is the world's largest producer of data storage memory chips. It manufactures, via a joint venture with Toshiba via its 'megafabs' located in Japan. Fab 4, which commenced operations this September, is said to be the size of five football fields, and the most advanced manufacturing plant of its kind in the world.

Retail - USB and Memory Cards

SanDisk is the dominant player in all markets it has entered. It has approximately 42% market share in North America; In Europe, it doubled its market share in the last 12 months to 28% and indicated that it is experiencing difficulties in meeting European demand; in Asia and Australia market share is 23%.

Retail - Media Players

According to recent data from the NPD Group, SanDisk is ranked a distant 2nd in the US MP3 player market, with approximately 10% of market share, compared to Apple's 73%. The good news however is that whenever Apple sells an iPhone or iPod, SanDisk indirectly earns revenue in the form of royalties from Samsung, who make the chips for Apple's products.

Does it possess an 'Economic Moat' (a durable competitive advantage)?

SanDisk's economic moat is its business model. Based on tight vertical integration, SanDisk's business model has allowed it to remain competitive and protect its margins during the tougher periods.

(1) License Royalties: SanDisk's intellectual property, which it strengthened with the M-Systems acquisition in 2006, is the foundation of the business. With more than 700 U.S. patents and more than 400 Foreign patents, it is the only company in the world that has the rights to manufacture and sell every major flash card format and USB flash drive. Revenues from license royalties account for approximately 10% of total revenue and will amount to around $450 million for 2007. The estimated 2-3% that competing manufacturers pay to SanDisk in licensing provides that much of a buffer to SanDisk's margins and allows it to remain competitive, and continue to be the lowest cost producer.

(2) Manufacturing Capabilities: The captive production from the SanDisk-Toshiba Fabs allow SanDisk to pay significantly lower prices for NAND flash components for its own products than its competitors. Again, this enhances SanDisk's competitive position.

(3) Technological Expertise: In the 2006 acquisition of M-Systems, SanDisk acquired superior Flash technology that has yet to be rolled out. Known as X4, it allows NAND flash manufacturers to produce twice as much memory on the same wafer, at half the cost. It is estimated that this will translate to a 30 percent cost reduction in producing a 1 gigabyte NAND flash wafer. During the recent conference call an answer to one of Craig Ellis' questions revealed that in 2008 the majority of products will still be 2-bit per cell, and not X3. This suggests that SanDisk has chosen to keep their 'big technological guns' - X3 and X4 "in reserve" and to roll them out when the business environment turns for the worst. You could come to the conclusion that the fact that SanDisk's management has not chosen to do so as yet means that they are not really 'feeling the heat' yet – and are confidently competing well.

(4) Retail Operations: With more than 210,000 global retail outlets, Sandisk enjoys a large distribution network, which sells its USB and flash memory cards for cell phones, media players, cameras and video games.

What are the Concerns?

(1) NAND Flash is a Commodity – its pricing is Volatile

SanDisk operates in an extremely price-competitive environment. NAND flash memory is a commodity, and is traded on an exchange, with daily pricing which can be viewed at http://www.dramexchange.com/. While SanDisk is vulnerable to this volatile market, it is less so than its competitors because of its low cost manufacturing capabilities.

(2) 2007 SanDisk's growth was not organic, but mostly a result of the M-Systems acquisition

The SanDisk Q3 press release announced: "Revenue Grows 38% Year-Over-Year", "Product revenue was $919 million in the third quarter, up 36% year-over-year and 28% sequentially" and "License and royalty revenue for the third quarter was $119 million, up 52% year-over-year and 11% sequentially". Impressive numbers, right? Well, not exactly.

As Avishai Ovadia correctly pointed out in his blog (Hebrew), you cannot compare revenue and earnings numbers for this quarter to the same quarter a year ago - it's comparing apples to oranges. This year's Q3 data includes the revenues and earnings from the M-Systems acquisition. Last year's Q3 data does not.

(3) SanDisk's Supply Cannot Meet Demand

I think this came through loud and clear in the last conference call. That demand is strong is clearly a good thing, but when that demand cannot be served, customers seek the product elsewhere – and market share is eroded. Which brings me to my next concern.

(4) Capital Intensive Requirements

In early September, SanDisk and Toshiba jointly opened their latest fabrication facility in Japan - Fab 4 – larger than 5 football fields. According to SanDisk's July 2006 8-K, the cost to SanDisk will be in the vicinity of $1.5 billion (through to the end of 2008). SanDisk have already commenced discussions with Toshiba on constructing a new facility – Fab 5, but as was learned from the conference call, capital expenditure requirements for this plant are not expected to hit the books before the second half of 2009.

(5) Samsung and Other Manufacturers May Aggressively Re-Negotiate Licensing Agreements

Samsung, the second largest producer of NAND flash memory components may grow tired of paying licensing royalties to SanDisk, and may aggressively re-negotiate these contracts in 2009. I am not able to provide a qualified opinion on this issue.

(6) Litigation Risks

Sandisk CEO, Eli Harari received a grand jury subpoena as the US Department of Justice is looking into possible anti-trust violations in the industry .Also, the company, along with 23 other companies, are also being sued in a consumer class action that alleges a conspiracy existed to fix flash memory prices.

(7) NAND flash may become superseded by a newer more superior technology

There is always a possibility that this may occur, but even if a more superior technology was developed, billions of dollars have already been invested in manufacturing plants, cell phone design, etc. and I doubt that the new technology will be embarced. I think the probability of this happening is low, and that NAND flash has become the standard for the mid to long term.

What's the Catalyst? What trends will benefit Sandisk's Business?

The catalyst here is forecast NAND flash growth. According to Gartner Dataquest, current global NAND Consumption is estimated at less than 3 trillion MB. By 2011 however, the entire NAND landscape will be completely unrecognizable with estimated consumption at – wait for it – 33.5 trillion MB. This is mind-blowing growth!

Do these estimates make sense? Consider the following:

• 3 years ago there wasn't a single handset that could use an external memory card.
• Up until this year, only 30% of mobile phones could use an external memory card.
• According to estimates by Sweden's Telefon AB L.M. Ericsson, almost two billion people [predominantly in India and China] are projected to start using mobile phones in the next five years.
• Sandisk's recent conference call revealed that the company shipped more mobile card units in Q3 than all of 2006.
• Apple's iPhone has set the standard with the minimum amount of memory required in the handset. It no longer sells the 4 GB model, only the 8GB one. Handset manufacturers that wish to compete are left with little choice but to do the same. All great news for SanDisk's business.

In short, the major growth driver will be the next generation of multi-functional cell phones. Just as I did with my new Nokia I95, users will realize the potential of these devices (high resolution cameras, mp3 players, GPD capabilities] and will demand significantly larger amounts of memory than we are using today.

Another secondary catalyst to watch for is the trend towards laptops with NAND flash memory drives (called Solid State Drives or SSD). These are more reliable than conventional hard drives with moving parts, and allows for a laptop that is significantly lighter. While some high-end models are already on the market, the costs are still too high to hit the mainstream. If prices come down further, SSD drives for laptops may become a secondary growth driver for Sandisk's business.

So What do the Numbers Say?

SanDisk's Balance Sheet is strong:

• Total Assets are more than 3 times total liabilities
• Benjamin Graham typically demanded that Long Term Debt should not exceed Working Capital (or Net Current Assets defined as Current Assets minus Current Liabilities). Sandisk's Balance Sheet meets this criteria.
• 23% of the current share price is cash or short-term securities ($2.31 billion or $9.73 per share).
• Earning in the past 5 years grew on average by 34%, and analysts' consensus has earnings growth in the next 5 years to be 22.75%
• Quality of Management metrics such as Return on Equity (ROE) and Return on Assets (ROA) are not high. Warren Buffett typically seeks businesses with an ROE that has been consistently greater than 12%. This suggests that the business is able to create value for its shareholders. Sandisk's ROE and ROE are under 5%. This is what you would expect from a business that must continuously plow back its earnings into building new manufacturing plants.

So what's the Business Worth?

According to Thomson / First Call, 12 analysts have coverage on Sandisk, and the target valuation ranges between $45 to $75, with a $65 median. Lazard Capital's Daniel Amir, who in my opinion has a good handle on the company values the business at around $63 a share. Citi's Craig Ellis has a target price of $65

If I performed a discounted cashflow solely on the royalty license revenues (which are in essense free cashflow) with the intial year being $450 million, 10% growth for years 1 to 5, and 3% growth for years 6 to 10, and a discount rate of 10%, I receive a valuation of $42 per share - or the current share price.

A complete valuation of the business, with estimated average 5-year growth of 19%, provides a valuation of around $58 per share. This is a 33% discount to the current share price.

So What do I think?

Why did the price drop 15% on Friday after Thursday's earnings call? I'd love to be able to put my hand on my heart, look you in the eye, and give you a good reason. But I can't. I've never really known how to properly explain the sudden movement of crowds. Expectations not met? Perhaps. Lower Q4 guidance? Who knows? Fortunately, I do not assess a business because of price action. Instead, I try to assess what the free cashflows are going to be in the years to come, and formulate a rough valuation on that basis. This is not an easy thing to do with SanDisk or with this industry.

Usually, I try to look at a 10 year history of a business before making an investment. When you analyze 10-year financials you get a feel how a business has been able to handle tough periods, whether it has been able to protect margins, or whether management has been able to create value for shareholders. Looking at Sandisk's 10-year financials is useless. The environment is changing too quickly. 3 years ago, a mobile market did not exist for mobile memory cards. Today it is Sandisk's leading product. This year there is barely a market for Solid State Drives - but that may quickly change.

This is not a business that Warren Buffett would invest in. He would place it on the 'too hard' pile as it is capital intensive, because of its changing nature, and because of its low Return on Equity.

I however, see value here. The NAND memory market is forecast to experience continued explosive growth and while it is true that the industry is highly competitive, SanDisk is extremely well-positioned to capitalize from this growth. It has demonstrated that it is able to enter new markets quickly, and because of its vertically integrated model is able to quickly establish a dominant position.

If I was to place my bets on one player in this industry, it would be SanDisk, and recent share price weakness presents an opportune entry point.

Please read the Legal Disclaimer.

Disclosure: Avi Ifergan has an interest in SNDK.

Avi Ifergan is the Managing Partner of Israel Value Funds (www.israelvalue.com) an Israel-based investment partnership that follows a disciplined and long term oriented Value Investing approach, with a primary focus on Israeli public companies. Avi is a former equity analyst, corporate advisor and serial entrepreneur. These days he spends his time teaching economics at a major Israeli university and seeking value investing opportunities. He very much appreciates your feedback at avi@israelvalue.com.