The effect of business education in Spain

When I look at the business landscape in Spain, I find lot of similarities with the United States during the 1950s and 1960s. Nowadays; the Instituto Nacional de Estadistica reports that 3 million enterprises are registered in Spain, of which, 97% are small/mid-size businesses (PYMES) and 72% are family owned. If we take into consideration that only 30 million habitants are in working age (between 18 and 65 years old), we are saying that roughly 1 in 10 people is a business owner in Spain. There is not specific data for Madrid but I can assure you that this percentage is greater in rural areas where families found small ventures and by contrary, the percentage is smaller in cities where big corporations do most of their hiring and competition is greater among smaller businesses. It is therefore surprising that in a country with such a big entrepreneurial mindset, we are only recently realizing the value of an executive education. Exactly, how important is it?

As early as the 1960s, David Landes among others at Harvard University realized a study pointing out how professional management was a key factor in the rise of U.S. economy compared to that in France and the UK and how business schools had worked to identify the source of success and had trained these managers accordingly. In “Common stocks and uncommon profits” by Philip Fisher, the author writes about how U.S. businesses couldn’t be valued by financial statements any longer and that proper management accounts for a big part of the decision process when choosing an investment. In fact, Fisher’s work, considered the father of growth investing, managed to influence Warren Buffett’s investment decisions by explaining how business education and the importance of research (I+D) had changed the corporate landscape.

In Spain we live a unique situation. Big corporations, long having to compete at a larger scale, have realized the importance of a business education. They cover expenses for Executive MBAs, Masters in Marketing, Strategy, Management and so on. On the other end, we live in a country where 72% of the ventures are family owned who regards the corporation as a personal possession where interests of outside stockholders are largely ignored, and therefore, no consideration is given to the problem of management continuity or corporate education. This is changing, as the world becomes smaller thanks to globalization and competition increases accordingly, small businesses are failing and management is looking for ways to keep up with today’s big corporations never-ending search for improvement, even going outside its own organization to consult and/or hire new talents.

This new talent is mostly coming out of business schools, where they are trained in finance, corporate management, ethics, decision making, marketing, and the value of research as a tool to grow profits and compete in a global marketplace. The changes coming to the business landscape in Spain are immense, ending an age of autocratic domination to begin an era where management engages stockholders and promotes continuous research. Executive education could plant the seeds to finally allow Spain to increase its spending in research and development (I+D), possibly leading to the biggest increase in profits, productivity and entrepreneurial activity in recent history. After all, it did happen in the U.S.

A new paradigm… for those who don’t study history

During the current crisis, I often read or hear people talking about how we are in a “new era”, living a “paradigm shift” or “the end of wall street as we know it”. People have short memory span and although never exactly the same, history does rhyme, or as the saying goes, the more things change, the more they remain the same.

Please, play with me this little game. Let’s see whether you are able to identify the time of this happenings and whether you find similarities with anything in the past:

“As the long bull market was reaching its final peak in XXXX another mistake ocurred. To understand what happened it is necessary to recreate the psychological fever which gripped most investors in technological and scientific stocks at that time. Shares of these companies, particularly many of the smaller ones, had enjoyed advances far greater than the market as a whole. During XXXX and XXXX only one’s imagination seemed to cap the dreams of imminent success for many of these companies. Some of these situations did have genuine potential, of course. Discrimination was at a low ebb. For example, any company serving the computer industry in any way promised a future, many believed, that was almost limitless. This contagion spread into instrument and other scientific companies as well.”

Can anyone approximate the year?

What about this one?

“Incompetent, dishonest, and fraudulent behavior by corporate executives, boards of directors, auditors, investment bankers, security analysts, and other market participants. They exaggerated revenues, embellished earnings, and concealed debt, all to make the company’s financial performance look better than it was. The payoffs for the executives were higher share prices that allowed them to turn their stock options into gold. For the auditors and financial firms doing business with these companies, the payoffs were lucrative consulting contracts and underwriting fees. The exposure of the chicanery left large parts of the investing public without faith in the honesty and fairness of financial markets and with less inclination to participate in the future. The guardians failed to do their jobs. The bubble market made many forget about the riskiness of the stock market, and the collapse of the bubble made many exaggerate it, helping to delay recovery.”

Game on.

The Snowball: an ethical masterpiece

I’ve just finished: The Snowball, Warren Buffett and the Business of Life, by Alice Schroeder.

It should be required reading for every MBA student and entrepreneur. It’s an ethical masterpiece.

Hopefully Mr. Buffett allows for a continuation narrating the current and coming years.

I bought the book at Amazon and shipping to Spain was surprisingly cheap.

Eaton Corp: My first public stock analysis

This is my first public stock analysis. You are more than welcome to correct me on my calculations and assumptions.

Eaton Corp. (ETN)
History:
I first came across Eaton upon reading Berkshire’s new purchases in the last quarter of 2008. At first glance it seemed a great company and BRK bought it in the $45 – $50 range. ETN is currently trading at $37. I decided to see if this is bargain opportunity.
Company summary:
Eaton Corporation designs, manufactures, markets, and services electrical systems and components worldwide. It offers electrical products for power quality, distribution, and control; fluid power systems and services for industrial, mobile, and aircraft equipment; intelligent truck drivetrain systems for safety and fuel economy; and automotive engine air management systems, powertrain solutions, and specialty controls for performance, fuel economy, and safety. For more info about the company and its cool products check: ool products check: http://www.eaton.com and http://finance.yahoo.com/q/pr?s=ETN
1) Does the company have an identifiable consumer monopoly or brand-name product?
70% of Eaton’s revenue comes from hydraulics and electrical products. 30% from automotive and truck segment (it is the world’s leading manufacturer in this segment). Eaton’s used to focus in the automotive/truck business and it was very dependent on it but the past few years diversification into a more profitable hydraulic/electrical manufacturing business has provided them with a wider diversification against economic downturns and cyclical businesses. Although it does not have an exclusive monopoly, any competitor will encounter significant headwinds to create the factories and equipment and acquire the contracts required to provide similar products and services.
2) Do you understand how it works?
Want to buy a golf club? Eaton is the world’s largest producer of golf club grips. Need breaks for your truck, factory equipment or a huge boat? Eaton’s Airflex technology is there. Eaton designs, manufactures, stress-tests, installs, maintains and finally trains your staff on location. From Oil & Gas excavations, to army/navy, grinding, paper, metal working and mining. These guys are everywhere! Most importantly, once a product is installed, the customer doesn’t go shopping around for new updates. After all, you can’t change the hydraulics of a dam every week. Customers do keep signing maintenance contracts and buying new pieces for broken machinery. Eaton’s strategy since Sandy Cutler took charge in 2000 has been to utilize the revenue from its truck and auto business to fund investment in more profitable ventures. It has paid out handsomely and they continue to follow the same strategy.
3) Is the company conservatively financed?
Year 2008 in millions:
Long-term debt:		$2,921
Other LT liabilities:		$2,565
Earnings:		$1,253
It can pay off its debt in: 4.38 Years
4) Are the earnings of the company strong and do they show an upward trend?
Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 EPS $2.97 $3.26 $1.65 $2.19 $2.67 $4.22 $5.38 $6.39 $6.76 $6.65 Growth: 9% annual rate from 1999 to 2008 Growth: 22% annual rate from 2001 to 2008
Earnings were affected by the crisis in 2001 but we can see that Sandy Cutler did an excellent job after he took office. Eaton grew earnings at a 22% annual rate.
5) Does the company allocate capital only to businesses within its realm of experience?
Yes.
6) Has the company been buying back stock?
Yes and no. They bought in 2005 and sold in 2008. I’m looking for the filings but it seems they bought in 2005 at around $65 and sold in 2008 at about $95 which would be all good. In any case, this is not a major point in favor or against Eaton but with Berkshire on the board, things can improve considerably.
7) Does management’s investment of retained earnings appear to have increased shareholder’s value?
Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 EPS $2.97 $3.26 $1.65 $2.19 $2.67 $4.22 $5.38 $6.39 $6.76 $6.65 Dividends $0.88 $0.88 $0.88 $0.88 $0.92 $1.08 $1.24 $1.48 $1.72 $2.00 Dividends growth: 9.55% Earnings from 1999 to 2008: $42.14 Earnings Growth: $3.68 Dividends paid: $11.96 Retained earnings: $30.18
Earnings grew from $2.97 to $6.65 ($3.68 growth) thanks to $30.18 in retained earnings.
This translates to:	12.19%
A 12.19% annual rate of return. Pretty good but not fantastic.
If we look at the performance after the 2001 crisis:
Earnings from 2001 to 2008: $35.91 Earnings Growth: $5.00 Dividends paid: $10.20 Retained earnings: $25.71
Earnings grew from $1.65 to $6.65 ($5.00 growth) thanks to $25.71 in retained earnings. This translates to: 19.45% annual rate of return. Good. Either way, it’s a good number during and after the crisis.
Is the company’s return on equity above average?
Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 ROE 16.70% 15.90% 9.40% 13.70% 12.90% 18.40% 21.90% 23.80% 19.70% 16.50% Eaton’s Average: 16.89% ROE USA Average: 12%
Most importantly. Eaton has consistently earned above average ROE.
9) Does the company show a consistently high return on total capital?
Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 ROTC 11.10% 9.50% 6.20% 8.80% 9.30% 13.10% 15.50% 17.40% 14% 12.50% Eaton’s Average: 11.74% USA Average: 12%
This is pretty close to American corporations’ average. Nothing to be excited about but nothing horrible either.
10) Is the company free to adjust prices to inflation?
It’s more dependent on manufacturing costs but they do raise contract prices on inflation.
11) Are large capital expenditures required to constantly update the company’s plant, equipment and products?
No. Once a product line is built, it stays the same. In the case of custom built products, they are financed by the customer.
12) How does it rank in Earnings Yield and Return in Capital? (Joel Greenblatt’s Magic Formula)
Playing around with Value Line and Excel, I found that ETN ranked 184 out of 1822 when using 2008 data. If I use the estimated 2009 information, it ranks 148 out of 1822. While not in the top 30, it’s definitely above average.
Conclusion: I don’t see anything clearly negative so far. I would be happier with a higher ROTC but it’s not a deal breaker either.

Eaton Corp: Price Analysis
1) Compare Eaton to a 10yr government bond:
In 2008:				Estimated 2009:
Eaton’s Earnings:	$6.65			$4.18
10yr Bond:	2.81%			2.81%
Eaton’s relative value:	$236.65			$148.75
This means that if you paid $236.65 (or $148 if you use the estimate) a share for Eaton, you’d be getting the same return than a 10 year gov bond.
At today’s price:	$37
Earnings:	$6.65
Return %:	17.97%
17.97% return on your investment if earnings don’t fall, which of course, high chances they will this year.
A look at the earnings growth for the past 9 years: 9% for the low range (22% for the high range)
Means that if you bought Eaton today at $37, you’ll be getting the equivalent of a bond paying a 17.97% yield that increases the coupon payments at 9% annually.
Since earnings will most likely fall due to the crisis, the current earnings estimate for 2009 is $4.18. Doing the same calculation:
Return %:	11.30%		on your investment if you bought it today at $37
and expect it to grow at 9% annually.
2) Eaton as an equity/bond
Equity value per share:			$35.42	book value
If Eaton can maintain its average annual return on equity of 16.89% over the next 10 years and continues to retain a historical 71% of that return, then the per share equity value should grow at:
Retained earnings:			71%
ROE:			16.89%
Growth rate of per share equity:		11.99%
In year 2019:	$109.94 Equity per share value
Growing at 16.89% earnings per share should then be:						$18.57
and if it’s trading at its low P/E of 10, it should be trading at:						$185.70
but if it’s trading at its high P/E of 18 it should be trading at:						$334.25
Projected earnings:
Dividends are growing at 9.55%
Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 EPS at 9% $4.18 $4.56 $4.97 $5.41 $5.90 $6.43 $7.01 $7.64 $8.33 $9.08 $9.90 EPS at 22% $4.18 $5.10 $6.22 $7.59 $9.26 $11.30 $13.78 $16.81 $20.51 $25.03 $30.53 Dividend $2 $2.19 $2.40 $2.63 $2.88 $3.16 $3.46 $3.79 $4.15 $4.55 $4.98
Total dividends paid:	$36
If in 2009 it’s trading at its low P/E of 10, it should be trading at:						$98.96
but if it’s trading at its high P/E of 18 it should be trading at:						$549.60
Therefore Eaton should be trading between $98 and $549 in 2019 and paid out $36 in dividends. If you bought shares today at $37:
Lower end return:	14%		annual return
High end return:	32%		annual return
You are beating the market. Still, I think it's better to use a EPS growth rate of 16% (value line suggest 17%) In that case:
Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 EPS at 16% $4.18 $4.85 $5.62 $6.52 $7.57 $8.78 $10.18 $11.81 $13.70 $15.90 $18.44 Dividend $2 $2.19 $2.40 $2.63 $2.88 $3.16 $3.46 $3.79 $4.15 $4.55 $4.98
If in 2009 it’s trading at its low P/E of 10, it should be trading at:					$184.40
but if it’s trading at its high P/E of 18 it should be trading at:					$331.92
Therefore Eaton should be trading between $184 and $331 in 2019 and paid out $36 in dividends. If you bought shares today at $37:
Lower end return:	20%		annual return
High end return:	26%		annual return
Also to add margin of safety, a suggestion is to consider a doomsday scenario where last years earnings are cut in half. Instead of assuming a EPS of $4.18 for 2009 as is the current consensus, I take half of the EPS in 2008: $3.32 and then set earnings growth flat until 2012: In that case:
Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 EPS at 16% $3.32 $3.32 $3.32 $3.85 $4.47 $5.18 $6.01 $6.97 $8.09 $9.38 $10.88 Dividend $2 $2.19 $2.40 $2.63 $2.88 $3.16 $3.46 $3.79 $4.15 $4.55 $4.98
If in 2009 it’s trading at its low P/E of 10, it should be trading at:					$108.84
but if it’s trading at its high P/E of 18 it should be trading at:					$195.92
Therefore Eaton should be trading between $108.84 and $195.92 in 2019 and paid out $36 in dividends. If you bought shares today at $37:
Lower end return:	15%		annual return
High end return:	20%		annual return
A great investment any way you look at it at the current price as long as it can keep up its growth prospect as well as it has done during the past 10 years.

Oh Berkshire

I’ve been courting Miss Hathaway for three years. We were introduced by a common friend and I developed an instant crush. I’m not sure her father would approve, but every few months I manage to get the guts to arrive with flowers to her door.

She has hardly noticed me. The always beautiful and refined Berkshire moves in higher circles surrounded by majesty, hedge fund managers and famous CEOs. She is in the A list of every major club. I watch her flirt with Mr. Cola and go out with Miss Eaton and Miss Ir to chic restaurants. Jealousy is killing me. Her status hasn’t deterred me from trying to impress her. I’ve saved money, I’ve let her known about my business education plans and I’ve even written a letter to her father complimenting his work raising her. All I managed to achieve was to take her out for dinner where she gave me a few B-kisses before dropping her back at home. It was a very expensive night with little results.

But times are changing. Her latest flings are provoking envy among her friends. They say she is uptight, that she is expending money unwisely and confident in her status-quo as the most desired lady in town. Some of her closest friends are turning their back on her. They are just jealous of her success. All the while I’m here waiting for her to notice me, enjoying Eaton’s company in private. But my heart belongs to you Berkshire. I hope one day you look down and bring me up to your A list.

Oh Berkshire, when will you notice me?

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Berkshire Hathaway lives in Omaha with her adoptive parents Warren Buffett and Charlie Munger. She’s currently offering her services at $80,000

Principle Investing – Introductory Post

“Our method is very simple. We just try to buy businesses with good-to-superb underlying economics run by honest and able people and buy them at sensible prices. That’s all I’m trying to do.”¹ – Warren E. Buffett

Since this is the first entry of the blog, I feel compelled to introduce myself and talk a bit about the purpose.

My name is Joaquin Grech Gomendio.² I was born in Madrid, Spain, the same day that Viking 1 landed on Mars.³ I’m oddly proud of my birth date. During my childhood, I seem to have developed a talent for problem-solving and somehow that drove me to write computer programs at a very early age. In 2003, I graduated from New York University with a double major in Computer Science and Latin American Studies. I had never studied finance.

In 2005, committed to a serious relationship, I realized I needed savings to plan for the future. The financial industry is where the money was; therefore I joined a Wall Street firm to help develop its fixed-income & derivatives software.⁴ I had always found conversations about finance as appealing as going shoe shopping,⁵ but I was quickly drawn in by the challenge. I realized that most fixed-income instruments were out of my reach and I started focusing in equities (stocks) during my free time. It wasn’t long before I became infatuated with value investing and began torturing my colleagues with long financial ramblings.

While reading investing material, I found a common pattern among great investors. They all had a set of rules or principles that they adhered to without letting emotions take over. That’s how the title of this blog came to be. In addition; there is nothing better than writing to clarify and organize your thoughts. The purpose of this blog is for me to better exteriorize my passion for finance while trying to keep it entertaining. I’ll try to avoid bombastic or technical language, first and most obviously, because I lack vocabulary and second, because I would bore everyone to death without adding any substance.

One thing that I loved about investing is that it’s simple. Not easy, but simple. Anyone regardless of his or her background can do it. We tend to reward complexity even if it lacks usefulness, but in investing the simplest solution is often the best solution. You just need to remember that you are trying to buy $1 for less, or putting it another way, selling 50 cents for a dollar. It does happen quite often in the stock market.

I am by no means a financial expert. I just enjoy investing and sharing my thoughts. I tend to avoid giving advices at this stage of my financial knowledge but I do always give one:

Avoid learning from your mistakes; learn from other people’s mistakes. Most people don’t learn from history; try not to be one of them. Read Benjamin Graham, Warren Buffett, Philip Fisher, Peter Lynch, Bruce Greenwald, Joel Greenblatt, Jeremy Siegel, Jim Jubak⁶ and any other known fundamental investor. Read their biographies, find out about their investing partners, and study their investing principles. Study the people that inspired them. There are a lot of great investors alive, even if they can’t be your personal mentor you can interact with them at conferences, meetings or by email.

On a final note, I’m a fundamental investor.⁷ I believe technical analysis⁸ (predictions made based on price/volume/charts) is equivalent to predicting a woman’s intelligence by the way she looks: you may be right but you wouldn’t bet your house on it.

And with this…

I declare inaugurated Principle Investing.

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1. “A Tribute to Ben Graham” [speech] December 6, 1994 at the New York Society of Financial Analysts.
2. In Spain we inherit one family name from each parent.
3. Viking 1 landed on Mars exactly seven years after Neil Armstrong set foot on the Moon.
4. Wikipedia description: Fixed-income and derivatives.
5. Explanation about the shoe shopping fact.
6. Benjamin Graham, Warren Buffett, Philip Fisher, Peter Lynch, Joel Greenblatt, Jeremy Siegel, Bruce Greenwald and Jim Jubak
7. Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets.
8. Technical analysis is a security analysis technique that claims the ability to forecast the future direction of prices through the study of past market data, primarily price and volume.