Category: Financial Analysis

Rocks, Pebbles, and Sand

Published on:
May 10, 2020
Reading Time: 4 Minutes.
Last Update:

The rocks, pebbles, and sand story asks us to reflect on what's essential in life. In the story, rocks represent our lives' core values such as relationships and moral standards. The sand represents distractions what Cal Newport describes as shallow work. Shallow work is the new show on Netflix or the mindless wandering in shopping malls. 

If you had a jar, the fable continues, and you fill it first with sand, you won't have room for the rocks. But if you prioritize by first putting the rocks in the jar, then you will have no difficulty in pouring sand afterwards. 


If you are looking for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.

Join the waitlist to learn more.


Financials life has priorities, too. While most of the content on Pen&Paper, at least as of May 2020, is about business analysis, where we look at a company's fundamentals and strive to understand whether to buy into its business model, stock investing is not a priority for most of us. 

What is a priority is to set financial goals and to plan a roadmap on how to achieve them. And the first step is getting rid of any credit card debt, funding an emergency fund, and paying off short term liabilities such as auto and school loans. 

Credit cards

First, get rid of credit card debt. It's tough to get ahead in life when you owe someone a 20% interest rate. Hardly any skilled investor, including those reputable investors that watch businesses every day of the week, compound their capital at that rate of return. 

There is a common rebuttal to the pay-off-your-credit-card debt argument, which is that having credit card debt builds your credit score. While payment history is important, it serves less than 1/3 of the total credit score. Also, there are no benefits to having several credits cards compared to just having one card [1].

In short, the proper way to use credit is to build a payment history. But (1) limit the liability to one credit company, and (2)  pay off the outstanding debt every single month. 

Emergency fund

The second priority is to set up an emergency fund. The purpose of the emergency fund is to allow you to keep your lifestyle as life happens[2].

Typically, your financial advisor will recommend that you set aside three to six months of reserves. If your household has one provider, then six months of reserves are recommended; if there is dual incomes in your home, then, perhaps, three months of reserves suffice. 

The Certified Financial Planner (CFP) board writes:

Saving is the process of putting cash aside in safe, liquid accounts, such as the emergency fund…Only after these reserves are established can you address secondary considerations for the balance of your clients have in savings - namely, keeping pace with inflation by investing.

Whether you set aside three or six months of reserves depends on how quickly you will be able to recover from the life event. It won't take long for a dentist to find employment. But it will take a long for a real estate broker to find work in a downturn. So the amount of reserves is subjective.  

 The emergency funds should be in cash or cash equivalents [3]. I  recommend that you exclude the emergency fund from your net worth. The funds are not to be used for vacation or any home upgrades. 

Pay off auto and school loans

After you paid off the credit card companies and set aside an emergency fund, your third priority is to pay off any short- to mid-term liabilities [4]. These liabilities include auto loans and education loans. 

While mortgage payments are tax-deductible, the interest payment on the school and auto loans is not deductible. There is no benefit of holding these loans - not from a tax perspective and not from a life perspective. 

From my experience, especially when markets rise, it is difficult to pay off current liabilities instead of placing the money in the stock market. I often hear that investors feel that, in effect, they have a low-interest loan where they can earn a higher return in the stock market. But when they need the money, they risk that markets could freeze. 

Save to meet  long term goals 

Equity markets, whether you buy individual stock or ETFs, serve to fund a portion of our long term goals. Those goals include retirement and income planning or buying a home. And then also, individual goals such as gifts to children. 

Again, returning to the CFP board, in their words:

Investing involves using money, or capital, to purchase an asset that offers the probability of generating an acceptable rate of return over time, providing the potential for earnings while assuming more volatility. True investments are backed by a margin of safety, often in the form of assets or owner earnings.


Businesses compete for our time, money, and attention. And it is up to set to prioritize our goals to offset these pressures. To meet our goals, we have to set a road map. And to establish a road map, we have to consider tradeoffs: how one decision compares to the other[5].

Think about that next time you see rocks on the beach.

FOOTNOTES: [1] My credit score is over 780, and I never had more than one credit card. [2] Life events include layoffs, divorce, and significant unplanned events. [3] Cash-equivalents are money market accounts or certificate of deposits. [4] Liabilities that are due within ten years. [5] Yes, a newer car would make the commute more pleasurable. But if you wish to own a home and decide on a 5-year plan how to save for the down payment, owning a new car won't get you there.

Reading and Thinking

Published on:
May 2, 2020
Reading time: 3 Minutes.
Last Update:

"There is a difference between solitude and loneliness," explains Mihaly Csikszentmihalyi in Flow. While both experiences result is the same, solitude is a desired state of mind while loneliness is not. In his words: 

"How one copes with solitude makes all the difference. If being alone is seen as a chance to accomplish goals that cannot be reached in the company of others, then instead of feeling lonely, a person will enjoy solitude and might be able to learn new skills in the process." 

He continues: 

"On the other hand, if solitude is seen as a condition to be avoided at all costs instead of as a challenge, the person will panic and resort to distractions that cannot lead to higher levels of complexity." 

This wordy prelude to the difference between solitude and loneliness is my way of introducing a day in my work life. The typical day consists of many hours where I sit, read, and think. And this is done from the quiet of my home office.

A day in the life of a value investor 

As a value investor, I spend most of the time reading. Usually, at 7:00 am, I sift through general business journals such as The Economist, Financial Times, and The Wall Street Journal.  I also subscribe to Barrons, Fortune, and Forbes magazine to keep up with financial news. And about once a week, I'll read about industry-specific publications such as American Banker

After reading a bit of financial news, I move to read reports by individual businesses from their public filings[1]. I find that when annual reports are written for investors, and not to please regulators, they reveal a great deal about an industry, business strategy, and competitive landscape [2].

When annual reports are written for investors, and not to please regulators, they reveal a great deal. 

Next on my reading list are books. My reading list is not structured. The reading list includes anything from autobiographies of CEOs, to marketing and business lessons. While in the early years, I only read books about business and finance, I moved to psychology, philosophy, and history.

General reading, unrelated to business or investing, I believe, makes a difference. I am not sure how to define that difference, but I know that reading about history and human psychology has many benefits and application to capital markets. Reading a broad range of topics also affects my wellbeing. Reading a wide range of topics gives a sense of perspective, reduces the urge to act, and promotes a kinder self.


Look for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.

Join the waitlist to learn more.


I also like to spend an hour or two a day on my portfolio holdings. I own 19 stocks in different industries (from computer hardware chip manufacturer as Micron to the graphite electrode manufacturer Graftech to pharmaceutical companies such as Teva.) So I try to learn something new every day about their business or their industry. 

So, about 4 to 5 hours of my day are used for reading. The remaining hours are for independent thinking[3]. While financial press compresses information and business insights into sound bytes, it takes a long time to understand a business truly.

For example, I heard a reputable investor this week describe his lengthy conversation with Indian regulators. He was attempting to decipher how will regulators behave if (or, rather, when) Indian rating agencies will falter. In short, it takes a long time to understand a business. 

 But it takes even longer time to understand the value of a business. Consider Coke-Cola, for example. The big picture is obvious: here's a company selling a product that consumers are buying. 

But why did Coca Cola survive where others have failed? How come competitors were unsuccessful in copying their business? The answer to these questions, perhaps, a topic for the future essay, requires deep thinking. To answer, we have to delve into branding, distribution, and biology [4].  


"A happy life must be to a great extent a quiet life, for it is only in an atmosphere of quiet that true joy can live," writes Bertrand Russell in The Conquest of Happiness

Because the typical lifestyle of a value investor is so different than that of a day trader, I thought it would be worthwhile to write about briefly. 

To write about a day in the life of a value investor was inspired by a Youtube video I saw last week. Titled A Day in the Life of Day Trader, the Youtuber mentioned the word "markets" 13 times. She explained her trading methods when the markets open. When markets are volatile. When markets close. And how she scans markets for opportunities.  

In a recent CNBC interview, Warren Buffett was asked how Todd Combs will manage a $13 billion portfolio, run Geico, oversee Haven, be on the board of JPMorgan[5]. "Portfolio management is not something you do every day," he explains. "Portfolio management is something you learn over decades." 

FOOTNOTES: [1] Such as 8-k, 10-k, 10-q, and proxy filings. [2] My goal is to read annual reports of the top five businesses in every industry. [3] Charlie Munger once said: "We both insist on a lot of time being available almost every day just to sit and think." [4] You can drink an endless amount of Coke. But you can only drink a glass or two of milk. [5] The interview is two hours long. Skip to 65:45 to see this section. 

Finding a Rope to Climb On

Published on:
April 25, 2020
Reading time: 4 Minutes.
Last Update:

COVID-19 impact on the first quarter of 2020 capital markets results was felt by all of us. And every profession slowly finds ways to respond and to adapt.  

In this essay, I write that treating your portfolio of stocks as a portfolio of businesses - and not a collection of ticker prices - may help you see things differently. 

A random walk on the Indices

Imagine an investor placed a $10,000 bet on a S&P 500 mutual fund on January 1. By the end of January, the value of bet would $9,984. The value would further drop to $9,144 by the end of February. The portfolio would drop to $8,000 by the end of the quarter [1]. In short, the investor's bet would be down 20% for the quarter.

The fall in market prices was felt across the indices. Nasdaq started 2020 at 9,151 points and ended the month of January at 9,190 points. By February, the index dropped to 8,667 points and ended the quarter at 7,459 points. A drop of 1,692 points or an 18% drop. One more example is the Dow Jones Industrial Average. The Dow started 2020 at 28,638 and ended the quarter at 21,227, down 7,411 points, about a 25% drop. 

Global markets were down, too. The MSCI World index dropped by 21% during the first quarter of 2020. And the MSCI Emerging Market dropped by 23.6%. (Try not to laugh next time you hear about the benefits of global diversification.) 

So it took just three months to bring back the five indices two to market levels seen over two years ago. Can we assume that's likely the time frame for the indices to return to the early 2020 levels? 

"No,"  nervous investors would say. They would further note that if we annualize the market loss over the past three months, the initial $10,000 bet in the SP&500 will be worth $4,096 by the end of 2021. 

Bearish investors would remind us that it can take a long time - much longer than two years - for indices to recover. They would recite that on December 31, 1964, the Dow was at 874 points. And that if we fast forward 17 years later, The Dow stood at 875 in exact on December 31 [2].   

COVID-19 effect on my portfolio

My portfolio of stocks was not immune to the vicissitudes of the market. Out of sheer luck, before the market fell, I didn't own any restaurants, cruise lines, hotels, retail, or restaurant businesses. I also didn't have any material positions in the gas and oil industry and airlines.

I did own three companies in the Gas and oil business (Gulfport Energy, Noble Energy, and CNX Energy). I also owned one Airline company (Hawaiian Airlines, which I wrote about in June 2019).  While the market value of the four positions more than halved, the overall effect was small. The four companies represent less than 7% of the portfolio. 


If you are looking for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.

Join the waitlist to learn more.


But the portfolio's value took a hit nonetheless. It dropped by 38% over the past quarter. So I opened Excel and fooled around with a few "what if" scenarios, hoping this exercise may alleviate my mood. 

The 'What If's

My highly-concentrated portfolio of common stocks consists of 19 companies. The first ten names are three-quarters of  the value. 

Let's imagine one conglomerate had owned the 19 companies. Let's name the conglomerate G.H. Here is what G.H. would report to shareholders for yearend 2019: 

G.H. 2019 revenue [3] was $5,847 million, with an operating income of $1,184, a reasonable 20% operating margin [4]. The pre-tax earnings were $416 million, and the after-tax earnings were $330 million, a 5% profit margin.

With a market valuation of $6,867 million as of yearend 2019, the market valued the 2019 earnings at 21 times. 

Ganel Holdings 2019 Income Statement
G.H 2019 Income Statement

If G.H profit margin stays at 5% over the next five years, then the annual return between 2019 and 2023 will be a loss of one percent. This gloomy result assumed a 10 times earnings valuation in 2023 [5].

Ganel Holdings 2019 Balance Sheet
G.H. 2019 Balance Sheet

If G.H net profit is 10% sometime over the next five years, then the 5-year annual return will be 10%. Again, the earnings multiple assumption is 10 times the earnings.

Let's increase the earnings multiple valuation assumption from 10 times to 15 times the earnings. At a gutsy 15 times, the 5-year annual return will be 8%, assuming a 5% profit margin and 24% assuming a profit margin of 10% [6].


"While we see ourselves as rationale machines, constantly weighing the cost and benefits of our decisions, current research says otherwise," I wrote in January 2019 in The Ten Commandments of Value Investing. "It is only a matter of time before something drastically bad will happen to us. And it is important to prepare for times when we will recite that these are times that try men's souls." 

Indeed, these are times that try men's souls.

[1] The S&P 500 lost 0.16%, 8.41%, and 12.51% during those months, respectively. [2] Read more in Tap Dancing to Work written by Carol Loomis. [3] Figures are weighted average to reflect the proportional positions in each company. [4] Driven upwards because of GrafTech's operating margin of 53%. [5] For reference, the S&P500 earnings multiple was 18 times at the end of 2019 and 13 times at the end of the first quarter of 2020. [6] According to Factset, the S&P 500 profit margin is about 10%.

Spring Cleaning

Published on:
April 11, 2020
Reading time: 3 Minutes.
Last Update:

There is no better time to reflect on portfolio holdings than today [1]. This week's essay is about the three questions you should ask as you spring clean.

The first question is whether the business will survive for the next few years. The second question is whether the company generates free cash flow. And how essential is the business is the third question. To illustrate the concepts, I will use examples from my portfolio. 

The 3- to 5-year survivability 

It is going to be challenging to refinance debt and to raise equity. And any business that relies on capital markets to fund its on-going business operations is going to face a large number of rejections. 

A friend of mine, a founder of a start-up company, told me she is now spending the bulk of her time in understanding  (1) how long can her business run until cash reserves are depleted, and (2) what can she do today to better prepare for that day. 

The same mindset is applicable to portfolio holdings. If you own a company that has a sizeable maturing debt over the next year or two, you should reflect on how likely will it be able to refinance the mortgage, at what terms, and how it will affect operations.

Here is a summary of what I learned about some of the stocks I bought in 2019: 

Graftech reports $1,812 million in long term debt. And on page 80 of the 2019 annual report, you can read that the debt facility will mature on February 12, 2025. In other words, Graftech has five years of breathing room. 

Teva Pharmaceutical reports on $24,562 million of long term debt. The company will have to pay down $5,263 million, an average of $1,023 million each year until 2025. But I don't foresee that an issue as the company has $1,975 million in cash on hand and $5,676 million in receivables.

Micron reports on long term debt of $4,541 million and holds $7,152 million in cash and $3,195 in receivables. And on page 58 of the 2019 annual report, we read that most of Micron's debt is due after 2025. 

Visit my essays on Graftech and Teva Pharmaceutical

Two companies that will face challenging times ahead are Seritage Growth and Gulfport Energy. Seritage Growth Properties reports on $1,598 million in fixed debt with Berkshire Hathaway Life Insurance as the lender. The loan matures July 31, 2023. Gulfport energy reports on $1,978 million in long term debt. Where $329 million in due 2023 and $603 million is due in 2024, and $529 million is due in 2025.

In the case of Gulport, current cash and receivables will not cover the pending debt obligations. So either Gulfport will sell assets (it reports on $10,595 million of oil and natural gas properties), or somehow it will manage to refinance the debt miraculously. 

Visit my essays on Seritage Growth and Gulfport Energy

Free cash flow 

Investors usually accept negative free cash flow when the business promises growth. But future growth always comes with a present cost: either the right side of the balance sheet increases or current shareholders will be diluted. 

Consider Ormat Tech (Ora on Nyse) as an example. The Israeli-based, geothermal company reported negative cash flows between 2015 and 2019 [2]. So, the company issued more debt and diluted shareholders. (Long term debt in 2015 was $856 million and increased to $1,035 in 2019. Common shares were 49 million in 2015 and went up to 51 million in 2019.) 

Yet positive, free cash flow is one of the most useful antidotes to keep a healthy balance sheet. Positive cash flow allows management to remain independent of capital market woes and fury and to grow the business without niceties to lenders. 

There are two ways to find free cash flow. The CFA Institute defines free cash flow [3] as net income plus non-cash charges plus interest minus capital expenditures minus working capital expenditures 

FCFF = NI + NCC + Int(1-T) -FCinv - WCinv  

Another approach is to use cash flows from operations. To find the free cash flow, you take the cash flow from operations, add back interest less capital expenditures. 

FCFF = CFO + Int(1-T) -FCinv

Consider Whirpool as an example. On page 37 of its 2019 annual report to shareholders, management reports on $1,230 in cash provided by operating activities less $532 in capital expenditures. It reports on $912 million in free cash flow

If management does not report on free cash flow, it is because there isn't any.  

Is the business essential? 

If you can't reasonably estimate today where the business will be in ten years, you shouldn't invest in it. The 10-year outlook is important because of two reasons, a pragmatic one and a psychological one. 

The pragmatic reason is that if you can't estimate the business outlook, you can't estimate the earnings. And if you can't estimate the earnings, how could you determine the value of the business? 

The second reason is psychological. When capital markets freeze, when investors are selling, and the quoted price of your stocks drops, understanding the future of the business will allow you to better weather the storm. A few examples will explain this statement. 

I bought Carriage Services in January 2019 for about $20. The stock went up to $28 by year-end 2019 and now trades at $15, a 46% drop from the peak, and a 25% discount from my cost basis. But instead of selling the position, I remind myself that the business outlook for Carriage, who is a funeral home company, is invariably the same. Just because markets are discounting the business does not mean the business fundamentals deteriorated. 

Another example is Teva Pharmaceutical. Two months ago, I explained Teva's tailwinds: 

"Other trends in global healthcare include an aging population, chronic diseases, and growing pressures from governments to provide affordable healthcare solutions." 

I don't believe the tailwinds changed. 

But I have made mistakes by overlooking the 10-year outlook criteria. For example, I bought Weight Watchers in March of last year. I didn't have the slightest idea then, and I don't know how the business will look like in a decade from today. This business falls in the "too complicated" bucket. 

Visit my essays on Carriage Services, Teva Pharmaceutical, Weight Watchers, and L Brands

Another mistake I made was buying L Brands in late 2018. In hindsight, there is no way to predict our clothing preferences in a decade (let alone next season.) Not only is it difficult to correctly predict what color will be fashionable next season. 

FOOTNOTES: [1] As we are ordered to stay home. [2] the 3-year average earnings per share were $2.23, and the 3-year average capital expenditures per share were $4.26. [3] Taken from understanding cash flow statements, chapter 25 level 1.

Caveat Emptor!

Published on:
February 26, 2020
Reading time: 3 Minutes.
Last Update:

Management will find reasons to keep the lights on. You just never hear of management declaring "we quit, let's just liquidate the company and return capital to shareholders".

One popular technique to keep capital is turnarounds. In turnarounds, management explains to shareholders that the changing business landscape requires a total, 180-degree change in the business mindset, which, in turn, requires a change in the company's strategy and long-term business plan.

The three promises

Turnarounds follow three basic promises: (1) cost reductions, (2) a change to the business’s fundamentals, and (3) long term growth. In cost reductions, management promises investors of improvement in operations. Usually this means reducing labor costs, selling unprofitable assets, and focusing on high return-on-invested capital projects.

In the second item, the promise to change, management tells investors that the company needs to evolve in order to grow in the future; old products are replaced with newer ones, and new products get a newer look.

The third promise rests on the long-term growth of the company. In turnarounds, management argues that consumer preferences had changed and the company must adapt its business model. Consider The Wall Street Journal for example. The print newspaper changed its revenue from collecting revenue from print to digital. According to Statistica, a data company, there are 1.6 million digital-only readers compared to 1.03 million print readers.  

The risks

Turnarounds usually involve a new chief executive officer who appoints a new executive team. From my business experience, it takes at least a year for individuals to trust and understand one another. And in corporate America, a year can be a very long time.

The second risk is that something is fundamentally wrong with the company. Turnarounds, no matter how profitable may be in the future, are the result of something gone wrong. For example, the industry margins dropped due to an unforeseen competitor (think Amazon and retail stores). Or, perhaps, something is wrong in the profitability of the business or in the product itself.

In a turnover situations, something is fundamentally wrong with the business.

The third risk revolves around capital markets, for it is harder for a company to raise equity or to issue debt while it is changing its operations. This point, that capital markets affect value, is best understood with a story.

A friend is suing his realtor. She promised him that the house he bought, which was on a land lease, had more than 30 years until the lease expired. But, in fact, there were 27 years left. Because of that 3-year difference, buyers are unable to obtain a 30-year mortgage, reducing the demand for homes in that community, and the value of his home.  In short, financing affects value.

What does this mean?

Because of the risks associated with turnaround situations, investors must look for Benjamin Graham-like criteria  before buying such stocks. So a margin of safety is a must; and investors should not pay more than 10 times the trailing earnings per share. Or more than 70% of the net asset value. And any investor in turnaround situation must also realize that a three to five year investment horizon is a must.

Buyers of turnaround stocks should demand a steep margin of safety.

(Given the risks and uncertainty in turnaround situations, I never allow more 20% of my portfolio in turnarounds.)

My portfolio of turnaround stocks

A few examples from my portfolio: Seritage growth company is replacing tenants. I estimated that Seritage is replacing leases with rent that are about  50% below market rents. Read more about Seritage here.

Another turnaround example is Signet Jewelry. Millennials are looking at the institute of marriage differently than their parents. And Signet is adapting: it is now selling carbon-based diamonds - a better option for the conscientious consumer.

In Teva's Common Stock is Only for The Contrary-Minded Investor, I write about Teva Pharmaceutical, another turnaround stock in my portfolio.

1 / 7