Category: Financial Analysis

On the stubbornness of facts

Published on:
March 31, 2019
Last Update:

"Facts are stubborn things," said my favorite American founder, John Adams. "And whatever may be our wishes, our inclinations or the dictates of our passions, they cannot alter the state of facts and evidence." And so, I collected a few facts about Frontier Communication for this week's meditation.

 A few facts on Frontier are needed because Frontier’s stock is trading at 71% compared to a year ago. And as most analysts are rushing investors to cut their losses and sell Frontier position, I plan to do the opposite.  

The 2018 earnings estimate

After adjusting for non-cash expenses, I expect Frontier to report on a billion dollars of after-tax cash flow. The company’s average quarterly revenue was $2.1 billion in 2018, the average quarterly expense for interest was $400 million and the average capital expenditures were $320 million. 

If we remove non-cash charges, such as depreciation ($480 million each quarter) and goodwill expense ($400 million in the third quarter), we get a quarterly after-tax cash flow of $250 million. Multiplied by four quarters, we get the billion-dollar estimate.  It is a fact that these after-tax earnings, adjusted for non-cash items, are higher than the after-tax earnings when the stock was trading in the double digits.  

Another way to look at my estimate of Frontier's 2018 after-tax cash flow of a billion dollars is to say that the company profit margin is about 12% and that while the debt service coverage ratio is thin, it is adequate. The operating income to debt service ratio is slightly above two times. It is a fact that operating income for 2018 will be higher than $3.9 billion and that the interest expense will be $1.5 billion.

As of the third quarter of 2018 public filing, Frontier reported total assets of $24 billion. If we remove goodwill of $6.6 billion, we find tangible assets of $17.4 billion. And so, with a rate of return of capital of 5.75%, I cannot understand why there is an increased demand in investors who are shorting the company. 

Twelve months ago, the short interest, as reported by Nasdaq, was $2.9 million with average daily volume of $2.7 million. As of today, the short interest is $49.4 million. The stock price declined from $8 to $2, too.    

The 5-year operating performance and the 10-year earnings multiple valuation

While operating results slightly improved, Frontier's valuation is materially below what the stock was valued in the past. Between 2013 and 2017, revenue grew by 14% compounded annually. In 2013, revenue was $4.7 billion, and in 2017 revenue was $9.1 billion. Earnings before taxes (EBT) grew by 6% compounded annually. The 2013 EBT was $1.5 billion, and the 2017 EBT was $2.02 billion. It is true that the after-tax cash flow declined from $857 million in 2013 to $618 million in 2017, but to me, a drop of 30% in after-tax cash flow does not explain the gloomy outlook.  

If we expand our time horizon and look at the past decade we see that the stock traded as high as $194 (in 2008) and as low as $2 (current valuation). The earning multiple ranged from 6 to 12 the earnings. My estimate of a billion in after tax cash flow, alongside the reported outstanding shares of $103 million, translates a market valuation of less than one times the earnings multiple.    

The market's view

But the stock market’s focus is in future trends (for example, that employess are unhappy) and not in the historical record. "Quarterly revenues continue to decline at Frontier Communication," writes Wayne Nef of Value Line, an investing newsletter. "Both the consumer segment and the commercial business are under pressure. Management is optimistic that the revenue trend will turn in the fourth quarter due to new marketing programs and seasonality, but we are less sanguine."

In Seeking Alpha, the crowd-sourced financial website, you will read of a bearish outlook, too. Here are a few headlines I found: "Frontier Communications: Fundamentals Are Meaningless in a Bear Market" writes one author. "After A 60% Decline, Frontier Communications Offers Little Value," argues another. And picked by Seeking Alpha's editor as a favorite article is "Frontier Communications is uinvestable."

Ashraf Essa, who writes for The Motley Fool, is bearish, too. He warns us that "Frontier's business is on the decline, and the company had about $1 billion worth of long-term debt coming due within the next year." And that Frontier Communications shaky business fundamentals, coupled with its massive debt load, make it an extremely risk stock to own."    

Securities lending

Since I began to buy the common stock of Frontier in March of last year, I did not pay much attention to the company. In 2017 the stock price was in the two digits and it would surely climb again, I thought to myself. I did not plan to think about Frontier before it published its 2018 fiscal year-end results, which was reported on February 28, 2019 and which I have yet to read.  

But Jeff, a Charles Schwab representative, called this morning and asked whether I would be interested in lending the securities I owned. There is an increasing short demand, he said. He offered an interest rate of 10%, which is the equivalent of two Starbucks per today.

The math behind the two-Starbucks-per-day: Charles Schwab is borrowing from me 8,000 stocks at a rate of 10%. The stock is today worth $18,000 (I bought the stock for little over $40,000). This translates to an annual payment of $1,800, or daily payment of $5. The terms of the agreement between us are that Schwab may pay off the loan at any time and payments are made every month.

In 1774, Adams renounced tea drinking as unpatriotic and switched to coffee drinking according to a letter he wrote to his wife, Amelia. He would have been supportive with my securities lending practice, I am quite sure.

The state of ETFs

Published on:
February 16, 2019
Last Update:

"The principle on which this country was founded and by which it has always governed is that Americanism is a matter of the mind and heart; Americanism is not, and never was, a matter of race and ancestry," said former President Franklin D. Roosevelt. "A good American is one who is loyal to this country and to our creed of liberty and democracy."

The spirit behind exchange-traded funds (ETFs) investing is similar. What is required of the ETF investor is (1) to form an opinion and (2) to understand the investment. And if we agree on conditions (1) and (2) then it logically follows that the ETF investor can participate in many forms of investments, from foreign-domiciled stocks to small, U.S. capitalization stocks; from investing in ETFs that track the performance of widely known indices - such as the S&P 500 and Dow Jones - to ETFs that follow the performance of energy or commodity prices.

Exchange traded funds - the good kind      

If you believe that the U.S. population is ageing, the Vanguard Health Care ETF (VHT) is a simple strategy to follow. The ETF includes stocks of companies involved in providing medical and health care products, services and equipment. It includes 359 stocks with a median market capitalization of $81 billion. By buying shares in the Vanguard Health Care ETF you will be tracking the performance of companies such as Johnson and Johnson, Pfizer, Inc. and UnitedHealth Group Inc.

Are you determined that the world will consume more energy with time? Then you can buy Vanguard Energy ETF (VDE). For a minuscule expense of 10 basis points, the Energy ETF tracks the performance of companies involved in the exploration and production of energy products such as oil, natural gas and coal. The ETF includes 141 stocks with a median market capitalization of $50 billion. Some examples of energy companies include Exxon Mobil Corp., Chevron Corp. and Phillips 66.

Agnostic about macro-global trends but convinced that corporations are becoming more efficient and that people will be consuming more? Vanguard Consumer Discretionary ETF (VCR) tracks the performance of stocks of companies that manufacture products and provide services that consumers purchase on a discretionary basis. In this ETF you will find Amazon, Inc., Home Depot Inc., Nike Inc., Starbucks Corp. and even the controversial Tesla Inc.

You can buy any segment of the economy. There are ETFs that track financial companies such as JP Morgan and Bank of America, or utility companies such as Duke energy and Dominon energy, or consumer staples companies such as Proctor and Gamble and Coca Cola, industrial companies such as Boeing, 3M and Caterpillar, or technology companies such as Apple and Microsoft, telecom companies such as Verizon, ATT and Comcast, or material companies such as PowDuPont, Lind PLC and Ecologic and the real estate sector such as American Tower Corp., Simon Properties and Prologis.

Adequate rate of return usually follows a sound investment. If you had invested in any of the sectors, you would have done reasonably well. The financial sector 10-year rate of return was 15%; both the healthcare and the real estate sector was return was 15%; the technology sector rate was 20%. The worse performing sector over the past ten year was the energy sector, with a rate of return of 5%.

Exchange traded funds - the bad kind  

But any good idea can be turned into a bad one (see the Netflix documentary about Fyre Festival for a recent illustration). And just as exchange trade vehicles serve the value, prudent investor, they may develop into a co-dependent relationship with the speculator. Last week I came across a few ETFs that the value investor should avoid.  

The Global X Millennials Thematic ETF (MILN) is one example. This ETF aims to benefit from the spending power and preferences of the U.S. millennial generation (defined by those born in years ranging from 1980-2000.) The ETF invests in companies that millennials use, such as Snap Inc., Twitter Match and Zynga.

But the value investor acts upon principles, not trends. Nothing is mentioned in the ETF’s prospectus about fundamental value-oriented valuation concepts such as price to earnings, leverage, seasoned management or return on invested capital.

The Obesity ETF is another example of a good idea turned bad. This ETF that opened in June 2016 tracks the performance of the Solactive Obesity Index link and "provides investors with the opportunity to invest in companies that may benefit from the transformational forces changing our future." 

Simply put, the ETF tracks the stock of companies that claim to fight obesity. This list of companies includes Arena Pharmaceuticals (a company that develops a molecule drug), NxStage Medical Inc. (a company that develops systems for the treatment of end-stage rental disease), MannKind Corp (a company that aims to fight diabetes) and CyroLife (a distributor of cryogenically preserved human tissues for cardiac and vascular transplant applications).  

The third example is Ark Innovation ETF (ARKK). The ETF’s prospectus uses buzz words such as "disruptive innovation" and "next generation Internet." This passively managed ETF (with actively-traded fees of 0.75%) has about a billion dollars in assets under management. This ETF owns Grayscale Bitcoin Trust, Editas Medicine and Organovo Holdings.


ETF investing began almost thirty years ago with the goal of reducing active management fees. When I heard John Bogle speak at conference last year, I learned that he was surprised by the immense success of passive investing. He was also worried, mentioning that ETFs serve nowadays as a means to speculate, which is the exact opposite of his original intention.

This week's meditation on ETFs was inspired by one of the last interviews Bogle, of blessed memory, gave. This Bogle interview is a reminder for us all that products are not necessarily good or bad. It is how we use them.

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.