Category: Financial Analysis

Funds from operations

Published on:
December 14, 2018
Last Update:

Because GAAP accounting requires an annual depreciation of real estate, while in reality real estate often appreciates in value, the intent behind FFO is to get us closer to the economic truth.

The funds from operations definition

Funds from operations are the net income without non-cash or non-operating expenses. To the net income we add (1) depreciation and amortization, (2) gains and losses from real estate sales, (3) gains or losses from change in control and (4) impairment write-downs of real estate.

Yet funds from operations do not include capital expenditures. Omitting this expense results in an inflated, optimistic measure of earnings. So the real estate industry often includes a second measure called adjusted funds from operations (AFFO). Visit for example how to calculate funds from operations.

Finding out what are the funds from operations will get us closer to the economic truth.

It is now often reported by management. In AFFO reporting, managements discusses the amount of cash spent on the maintenance of existing properties and on the development of new properties and acquisitions.

The adjusted funds from operations definition

To calculate the adjusted funds from operations, we use the funds from operations less capital expenditures and less any gains on sale. We then adjust for straight-lining of rent and any one-time loss or gain. We then add back amortization related to stock compensation and other deferred costs.

AFFO is a superior measure to the FFO because the maintenance of real estate, whether it is renovating the lobby or replacing the roof, is a real and frequent cost that affects cash flow. To see the wide difference between net earnings, funds from operations and adjusted funds from operations, I will use Plymount Industrial Reit most recent annual report.

For 2017 the company reported a net loss of $14 million. But if we add back depreciation of $14 million and remove the gain of $231 thousand from real estate sale, we get funds from operations of $260 thousand. To arrive at AFFO, we further deduct for the recurring capital expenditures, straight line rents and added back non-cash interest expense, acquisition costs and stock compensation. This results in AFFO of $818 thousand.


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So we arrived at three numbers that tell a different story. Returning to PLYM, the 5-year average net loss was $25 million. The 5-year average loss from funds from operations was $17 million and the 5-year average loss from adjusted funds from operations was $9 million. In 2017, all three numbers improved, and the company showed profit in AFFO. And it is the REIT investor’s job to determine whether the reported earnings are a sign of a better, promising future.

FFO of all listed U.S. equity REITs. Source: S&P Global Market Intelligence
FFO of all listed U.S. equity REITs. Source: S&P Global Market Intelligence

FFO and AFFO multiple

Like the popular price to earnings ratio, investors in REIT companies often estimate whether a stock is a bargain or expensive using multiplies such as price to FFO ratio or price to AFFO ratio. Observing these ratios over time provides a signal of how the stock market is valuing the company. And it also allows us to see the relative value across companies.

Judging by the price to FFO ratio, the stock market believes that Essex Property Trust is a superior to Mid-America Apartment Communities. For Essex, between 2013 and 2017, funds from operations were as low as $7.6 (in 2013) and as high as $11.191 (in 2017). And during this time, the average price to FFO ranged between 20 and 23 times.

Observing the price to funds from operations ratio over time signals the changes in how the market values the real estate company.

For Mid-America the price to FFO was as low as $4.34 and as high as $6.15. The 5-year average price to FFO was 15 times. For over five years, the stock market felt ESS was worth 33% more than MAA. Let us move from the particular case of Essex versus Mid-America to the general cas and ask what are some of the reasons that one REIT stock is priced higher than a different REIT stock.

There are three common reasons. The first reason is growth expectation. If REIT’s A portfolio of real estate is currently earning below-market rents, a case could be made that future earnings will grow. Another reason for a growth premium is that the portfolio of real estate is in areas in high demand. Consider apartment rents in San Francisco or Vancouver.

The second reason is risk associated with the real estate. If REIT's A portfolio of real estate consists of apartments, while REIT's B portfolio of real estate consists of single, anchor-tenant shopping malls, then investors demand a discount for the additional risk they take (the risk is that if one tenant leaves, the shopping center is effectively shut down.)  


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The third reason is risk associated with capital structure. If REIT A carries more debt than REIT B than investors will view REIT A to be riskier and will demand a discount to the net asset value. If REIT A has preferred stock holders who are paid a dividend prior to the common stock holders, then investors would demand a discount, too.    

The aggregate price to FFO multiple for equity REITs compared to p/e multiple on the S&P 500. Source: S&P Global Market Intelligence
The aggregate price to FFO multiple for equity REITs compared to p/e multiple on the S&P 500. Source: S&P Global Market Intelligence

Funds from operations weakness

Fund from operations are not a perfect earnings measure. They do not include the value of land for example. So, if a REIT has a substantial number of projects under development, which currently are not generating any income but are expected to generate income in the future, then the price to funds from operations ratio is artificially rich. Visit my analysis of Seritage Growth Properties to see an example.

Adjusted funds from operations bring us closer to the true earnings of a REIT. But since for most real estate projects, the capital expenditure varies significantly each year, it is practically impossible to compare between a single year's AFFO of Reit A to AFFO of Reit B.

And since many REIT companies do not report AFFO numbers- and since there is no standard calculation of the metric - for now at least, AFFO remains a subjective number.

Investing in bonds versus stocks

Published on:
November 24, 2018
Last Update:

The Golden Rule in financial planning is 60/40. If you saved $10,000 your financial adviser would tell you that $6,000 should be held in stocks. And that you should buy bonds with the remaining $4,000. The rationale is that stocks are known to be volatile and risky. While bonds are considered to be safe and sound and do not fluctuate in value as much. 

The Darwinian rule that only the fittest survive does not seem to apply in the world of bonds. You would think that over time, only the best - and safest - bonds would be available to purchase. But as a matter of fact, the types of bonds an investor can now buy nowadays are fulls of risks.

A few examples: there are bonds backed by the full faith and credit of the U.S. government; bonds backed by corporations, both domestic and international; bonds whose payments are tied to U.S. inflation, known an TIPS; bonds backed by the full faith and credit of foreign governments; bonds backed by promises of local municipalities; bonds backed by residential mortgages; And junk bonds, which are bonds that pay a higher yield due to a higher probability of default.

Great investors do buy bonds. Bill Gross, who co-founded Pacific Investment Management Corporation and ran their $270 billion Total Return Fund, is considered a legendary bond investor. 

In 1984, Warren Buffett bought large quantities of Washington Public Power Supply System bonds. He noted: “

Charlie and I judged the risks at the time we purchased the bonds, and at the prices Berkshire paid, which were much lower than present prices, to be considerably more than compensated for the prospects of profit."  

Bonds are not risk free

Yet holding bonds pose risks. First, at time of duress - think the Great Recession - it becomes difficult to sell bonds. This is known as liquidity risk. 

Second, while as a bond holder you are promised a certain rate of return, if interest rates increase, and similar bonds in terms of credit and risk offer a higher rate of return, the value of the bond you hold is reduced. This sensitivity of the bond's value to the interest rate environment is known as duration risk. 

Third, purchasing one bond, backed by just one corporation, will expose you to the financial health of the company. Read: if the operating performance of the corporation deteriorates, you may not get your payments as promised. This is known as concentration risk.  

Mr. Market solution to these three risks has been the advent of exchange traded funds (ETFs). In a conference I attended last week in Newport Beach, I learned that there are now over 380 bond ETFs; effectively, these are investment vehicles that buy bonds and pay you, the investor, a coupon payment. There are ETFs that track inflation, such as Schwab U.S. TIPS ETF (traded under SCHP) and municipal bond ETFs, such as SPDR Barclays Municipal Bond ETF (traded under TFI). The list goes on and on.

What can replace a bond ETF

But I never bought a bond ETF nor do I plan to own one. Nassim Taleb, the investment philosopher, once said that the greatest risk is the one we don’t understand. And I certainly cannot understand the value of the bonds owed by any of the varying ETFs.

Take, for example, PIMCO Total Return ETF, traded under the symbol BOND. The “sensible income-focused strategy paired with world-class resources” as described by Morningstar the ETF, owns U.S. Government bonds (25% of the fund), Mortgages (60%) of the fund and investment grade credit bonds. And if you had invested $10,000 in BOND in February 2012 it would now be worth $12,602, a pittance of return at 3.36%.

But even with an inferior yield for bond investing, for some investors buying bonds is important. Take banks or insurance companies, for example. These financial services entities are required by law to hold bonds and are discouraged from purchasing the stock of publicly traded companies. A second example would be a pension fund that expects to pay out, in 3 years, retirement benefits and would need to buy a bond that will expire in 3 years.

In the Intelligent Investor, Benjamin Graham devotes much space to historical patterns of financial markets. "To invest intelligently in securities on should be forearmed with an adequate knowledge of how the various types of bonds and stocks have actually behaved under varying conditons - some of which, at least, one is likely to meet again in one's own experience." 

And there is simply insufficient data to understand how bond ETFs behaved in different market cycles.


History shows that the return from holding bonds is less than the return from holding stocks. In Jeremey Siegel’s Stocks for the Long Run, he provides data that supports the prior statement. If you had invested $100 in 1802, you would have $704,997 in 2002. Compare that to the same investment in bonds and you end would have ended up with a pittance of $1,778 in bonds. 

The 200-year annualized return from stocks was 6.6%, and for bonds it was merely 3.6%. This is the magic of compounding interest.  

More important than choosing between stocks and bonds and the allocation between the two assets is that you follow Socrates’ advise to know thyself. Not very different from a scientist, a successful investor constantly asks: “Why? Why am I buying bonds, and will my rationale hold in good and in bad times?”

Caveat Emptor!

Published on:
October 28, 2018
Last Update:

Gordon Gekko could be easily identified. He combed his slick dark hair back; wore white
shiny suspenders; and certainly had an evil and malicious look. But to identify such sleazy characters in real life is not as simple.

I came across financial advisors, charged indicted and by the SEC, with crimes that ranged from insider trading to the creation of fraudulent financial statements, and some of them were the nicest looking people. 

 We need more than Hollywood characters to know which stock products or services to avoid.  BrokerCheck, by Finra is a website aimed to help you make informed choices about brokers and brokerage firms. But I doubt how many investors actually know of its existence and use it regularly to check on their financial advisors. 

The psychologist Jordan Peterson observed that most people take care of their dogs better than they take care of themselves; that most investors rarely investigate enough the custodians is an example of how little we take care of ourselves.

This meditation describes a few warning signals of bad financial advice.   

 Red Flag #1: Quick and Effective Cure-All

Just as there are no shortcuts to a happy life, there are no shortcuts to stock investing. To become successful at stock investing, you need to exhibit a stoic patience and to develop a long-term perspective. By definition, these qualities require time. 

And there is no single investing formula that will work in all economic cycles. What works when the markets are down will not necessarily be logical to follow when the markets are rising. How how you should invest in stocks in your twenties is not the same as how you should invest in your sixties. And if you are planning to sell your stock portfolio in three years or thirty years makes a big difference.  

 Red Flag # 2: A One-Size-Fits-All Formulas and Miraculous Breakthroughs

Except for the adage "Live within your owns," there are no axioms when it comes to stock investing. One investor may be comfortable in placing big bets on the direction of a foreign currency (imagine a George Soros) while another investor, who is just as skilled and smart, may be appalled by that investing strategy. Instead, that investor may focus solely on commodities such as gold (think James Grant).

 Not only is there no single formula for stock investing, logic dictates that if there was one, no rational person would share that information with you. When a business hires a consultant, he or she is expected to provide research. But it would be outlandish to think that the consultant is expected to explain to the business owner how to make a profit. 

Red Flag #3: Act Now!

"Necessity never made a good bargain,” said our founding father, Benjamin Franklin. And what was true over two centuries ago is relevant today. A wise investor compares among brokerage companies, assesses the possible outcome of a stock purchase and carefully analyzes the companies prior to investing in their stock. 

When a speaker for a commercial advertisement explicitly implores you to make a decision now, the speaker implicitly suggests that you should not think at all. And an omission of thought is one of the leading causes of accidents. The linguist Steven Pinker notes that "accidents are the fourth leading cause of death in the Unites States, after heart disease, cancer and respiratory diseases."  

 Red Flag #4: "Sophisticated" and Greek-Laden Language

Delta measures the degree to which a stock option is exposed to shifts in the price of the underlying asset. Gamma is the rate of change in an options delta per one point move in the underlying asset's price. And beta is a measure of a stock's volatility in relation to the market. And while these are interesting terms to explore if you pursue a doctoral thesis in finance, the prudent investor is better off to leave these terms to academia.

One of my pet peeves is the term "risk adjusted return," often found in a prospectus. What the authors of the prospectus mean to say is that they feel the expected return is adequate for the given amount of risk that they take. But an adequate return should be defined by the investor, not by the manager of a fund.

And so too should be the definition of risk. The American food author Michael Pollan suggested that we should not eat food that our grandmother would not recognize as food. His rule of thumb applies to stocking investing, too.  

Red Flag #5: A Claim of a Risk Free Investment

Marrying another person requires a leap of faith. Going through a medical procedure may have unwanted results. And when you invest in stocks, you may lose money. The term "risk free" is as real as the character Tyler Durden.

Instead of focusing on the sisyphean task of eliminating risk completely, what the investor should ask is what are the benefits compared to costs, and how the two weigh against each other. I argue that risk free investments are fairly tales. But the advisors who offer that schemes do exist in real life.


"Please let there be no strife between me and you, and between my herdsmen and your herdsmen," Said Abraham to Lot. "For we are kinsmen. Is not all the land before you? Please separate from me: if you go left, then I will go right, and if you go right, then I will go left."  

If you come across a financial advisor who claims any of the above mentioned red flags, my suggestion is to turn the other way and to follow Abraham's words.

Anticipating NAFTA

Published on:
October 20, 2018
Last Update:

That things are not always what they seem and that first appearance may deceive many was already understood by Plato over two millenniums ago. In this meditation I will describe what at a first glance appeared to be a bargain stock, was an ill-advised purchase upon a careful review. My purpose in writing this meditation is to demonstrate that financial numbers and the prices of stocks are the starting point, but not the final word in stock investing.  

Core Molding Technologies Inc., which trades on the New York stock exchange, appeared to be a bargain stock. Management had increased the number of outstanding shares by one percent compounded over the past decade. In 2008 there were 6.8 million common shares outstanding and today there are 7.7 million common shares outstanding. The average 10-year earnings per share was 93 cents - the stock traded at roughly 9 times the decade-long average earnings per share. The book value per share increased by three-fold during this time. And Benjamin Graham would be proud of my discovery, I thought.      

Its rags to riches story is remarkable. CMT sells a particular niche product called reinforced plastics. The top industries that use the product are transportation, construction and industrial. The company’s major customers include Navistar, Volvo, Paccar, Yamaha and Bombrader Recreation Production. As of the end of last year, these customers were responsible for over 90% of CMT's sales.  

What drove the stock price down

So here is a company with a reasonable product that traded hands at a cheap price. The company's common stock started at $20 in 2018 and had halved recently. The culprit was Mr Market's fear of how changes in the North American Agreement on Environment Cooperation (NAFTA) will affect the company.

NAFTA targets the relationship between America, Mexico and Canada, the same countries in which CMT predominately operates. In 2017 CMT revenue from Uncle Sam’s land was $103.5 million in the United States, $52.5 million from the land governed by Enrique Pena Nieto and $5.6 million in the land of Maple syrup. It also owns and leases manufacturing plants in all three countries.

As many of you know NAFTA is now being renegotiated. And while final details have yet to be published, it will be of little surprise to see red tape and additional costs in the auto industry (in which the majority of CMT’s customers operate.) And business logic dictates that if the customer of a company is suffering, then the company’s business will be hurt too. In short, the expected macroeconomic changes in policy penalized the stock price of CMT.    

But while the looming NAFTA uncertainty is not helping companies like CMT, the is more to the the decline in the stock price. I argue that CMT’s stock price to decline its purchase of Horizon Plastics International, which was announced in January of this year.

Using a combination of cash and debt, CMT paid $63 million for Horizon. "The purpose of the acquisition was to increase the company's process capabilities," explained management. "They will now include structural foam and structural web molding, expand the geographical footprint and diversify the company's customer base."

All nice and well, I thought. But at what premium? Instead of waiting to see whether the future value of companies that operate in Canada and Mexico will deteriorate given the new NAFTA agreement, CMT's management was eager to move forward and paid a premium for Horizon Plastics.

On an increase in goodwill and debt

In CMT’s10-Q filing as of year end 2017, the company recorded $2.9 million in goodwill and intangible accounts. Compare that to the second quarter of this year where it recorded a whopping $40.1 million in intangible assets. Yet what should truly scare current shareholders (yours truly is not included in that group) is the debt level.

Long term debt as of last year was only $3.75 million. Yet as of the second quarter of this year, long term debt was $39.4 million, a little over nine times as much. Evidently, management's appetite for debt affected the income statement. The interest expense this year was 8 times higher compared to the same period last year. In numbers: In June the interest expense was $1.07 million compared to $129 thousand a year ago. So operating income to interest expense deteriorated to 2.37 times, compared to 44.38 times a year ago.

In our rising interest rate environment, it is puzzling why management had added fuel to the fire by taking a variable debt obligation and not a fixed debt obligation. Since management had not addressed the matter in its recent earnings call, I will offer a few explanations for the variable versus fixed debt conundrum.

First, the bankers would not finance the acquisition of Horizon Plastic with fixed debt. Second, management does not consider this to be a rising interest rate environment. Third, the cost of variable debt payments was much cheaper than fixed debt payments. Fourth, management was just careless and does not see the variable-versus-fixed debt as a material issue. Fifth, and most likely in my opinion, management did not have other options.

All roads lead to Rome. And no matter the justification, current shareholders should be appalled by CMT’s management's past business decisions. To pay a premium for a company that operates in Canada and Mexico was wrong. To finance the acquisition using variable debt was wrong. And to reduce the cash balance to practically nil was wrong too.

Unfolding the truth

Published on:
October 12, 2018
Last Update:

One of the unsolved mysteries of stock analysis is how to learn about stocks in the first place. Some investors hear about stocks at cocktail parties ("Tesla is going to be 10x in 3 years") and rush to buy the stock. Other investors carefully read buy-side analyst reports. And some investors just follow a gut feeling (I know a portfolio manager who regularly visits a fortune teller.)

I argue that one of the best methods to understand a stock is by reading the risk Factors section of the 10-K report. This section of the annual report describes much more than risks - it provides a snapshot of the company and its industry. In short, the section details that keep management up at night. 

In this meditation, I will share what can be gleaned from the Risk Factors section of Orchids Paper Company, a company I invested in a few weeks ago. 

Debt and variable payments

On page 10 of the 2017 annual report, management wrote "We have significant indebtedness, which subjects us to restrictive covenants relating to the operation of our business." Management expected $22.9 million in total debt payments for 2018. And for a company that reports on an adjusted EBITDA of about $15 million, that is a hefty debt burden. A closer look at the income statement reveals that while in 2016, the interest expense was $1.7 million, debt services mushroomed by over twofold, to about $5 million in 2017.

The cost of debt in numbers: Orchid paid a weighted interest rate of 2.6% in 2016. But in 2017 it paid a weighted interest rate of 7.3%. And as of the second quarter of this year, the rate on its debt crept up to over 9%.

Why the rising cost of debt? Risk number 12 in the Risk Factors section explains: Orchids is paying its debt based on variable payments. That is, the debt service fluctuates according to the level of the interest rate environment, specifically, the 30-day LIBOR index, an interest rate index that is almost twice as high compared to a year ago. (The 30-day LIBOR is now 2.06%, compared to 1.23% twelve months ago.)  

Rising debt costs is an important issue for the common stock investor, and this section of the annual report immediately cuts to the chase.  

Customer concentration

"A substantial percentage of our net sales is attributable to three large customers," noted management, "any or all of which may decrease or cease purchases at any time." Listed as risk number 4 out of a list of 15 risks, the risk explains that between Dollar General, Wallmart and Family Dollar, about 67% of 2017 sales occurred.

To illustrate how sensitive capital markets are to this risk, I will remind current shareholders, yours truly is included in that camp, that Orchid's share price declined from about $4 to 80 cents a few weeks ago because management disclosed that a major customer would terminate its relationship with Orchid in 2019.

In Let my People Go Surfing, Yvon Chouinard boasted that Patagonia worked with one manufacturer in Japan. And because of the single concentration to one supplier, many of his peers regarded him to be mad. David Tran, founder of Sriracha, followed the same practice and relied on just one producer of hot peppers.

But what works for one-of-a-kind companies, such as Patagonia or Huy Fong Foods (the company behind the hot chili sauce), is inapplicable to the rest of us. Most businesses are better having an ample number of customers, a group of heterogenous suppliers and a host of manufacturing facilities in case one is out of commission. Orchid, selling a commodity product, cannot afford the customer concentration and the risk section, again, lets us quickly understand that.

Capital expenditures

To operate a paper mill requires constant work. And in Risk Factor number 7, management disclosed that "Our operations require substantial capital, and we may not have adequate capital resources to provide for all of our cash requirements." When I purchased the stock of TIS, I entirely ignored this risk factor. But you should not. Especially as we saw in prior paragraphs that most of the operating cash flow is expected to go to service the debt.

Between 2013 and 2017, the average capital expenditure was $48 million each year. If we want to go back even further, for the decade between 2008 and 2017, the average capital expenditure was $30 million. Compare that to the average EBITDA of $22 million for the past five years, or $20 million for the average EBITDA over the past decade. 

And capital expenditure is a real expense for Orchid. And more worrisome, given the amount of variable debt, Orchid's ability to continue to pay for the expense is questionable.

Cost of sales

I learned from Guy Spier how important it is to understand a company's cost structure. In The Education of Value Investor, he wrote, "It is critical to discern whether a business is overly exposed to parts of the value chain that it can't control." Returning to the business of running a paper miller, Orchid has two dominant costs of good items. The first item is energy cost and the second is solid bleached sulfate paper, also known as SBS paper.

The cost of both are rising. And rising costs are lethal when a company sells a commodity product as it is practically impossible to pass through the rising costs to the customer.  

Between the SEC definition and my use

According to the Securities and Exchange Commission (SEC), the risk factors section in the 10-K includes information about the most significant risks that apply to a company. My purpose in this meditation was to argue that the risk section is much more than that.  The risk factors section should be looked at as an index to story of the company.