NIB P&L continued

We saw in my last post that the bottom line is not always the bottom line - by removing just a few no-recurrent items what on the surface looks like a good result can, in reality, be a poor results.

So, after removing costs associated with listing on the ASX, setting up the NIB Foundation and net results from investing, the indicated earning power (IEP) for nib in FY2008 was $36.4m and dropped to $25.6m in FY2009.  I have performed the same exercise on the FY2010 results and again the (NPAT) falls by one-third, down to $17.1m.

So things are not looking so good for nib, but having three years worth of data makes the trends clearer.  In terms of their basic business - selling insurance policies and paying claims - the results are all good. The "underwriting result" has increased from $60.5m in FY2008 to $63.5m in FY2009 to $72.0m in FY2010.  So why is the underwriting result going one way and the IEP going the other way?  There are two aspects to this:

1. tax, and
2. investment result

Tax

In my last post, I did not adjust for tax in my assessment of IEP.  I did this on the basis that tax is an expense that reduces returns to shareholders.  However, looking at it again, the IEP result is being obscured by the fact that the loss due to non-recuring costs FY2008 has provided a tax benefit, the FY2009 tax paid is more typical of a standard year, and the FY2010 tax paid is higher due to the profit made on investments.  So, if I apply the company tax rate of 30% to the before-tax-IEP, I end up with new results as follows:

• FY2008 - $21.7M
• FY2009 - $23.4M and
• FY2010 - $29.8m

In short, a little knowledge is a dangerous thing.


Investment Result

Looking at the P&L, I'm going to use the term "Investment Result" to refer to the sum "Investment Income" minus "Investment Expenses".  I originally excluded Investment Result from my calculation of IEP for the years FY2008 and FY2009 because it represented such a small part of the results.  Obtaining the FY2010 results however, highlights the importance of examining as many years of results as you can when assessing a potential investment.  Here are the Investment Performance results for the last three years:

• FY2008 - $7.5m
• FY2009 - ($1.8m) loss
• FY2010 - $44.5m 

Suddenly, in 2010 the investment result is as important as the underwriting result. You would think that this would make the investment result an important topic of the shareholder review, however, in both the FY2009 and FY2010 shareholder reviews there is only a couple of paragraphs which merely set out a few facts.  Disappointingly, as we have no basis for estimating the investment result for future years, we have no way of assessing a IEP for this side of the business.

This is getting tricky now

I've started reading "Chapter 31: Analysis of the Income Account" of Graham & Dodd's Security Analysis, or rather, I started reading it again.  The date on my last post informs me that it has been six months between drinks (I can't believe its been six months) and I'm not sure how many times I've started Chapter 31. 

As I've discovered with other chapters, Graham & Dodd's relaxed style of writing makes reading the book deceptively easy.  Its when you try to apply the concepts for yourself that you discover how much information the book imparts.  To overcome this, I've decided to "divide and conquer", as they say in the IT world and tackle this chapter over several posts (hopefully in intervals shorter than six months, or I will have died of old age before finishing the book).

The "Income Account", or "Income Statement" or "Profit and Loss" or (as I prefer) "the P&L" is perhaps the most important of the three financial statements provided in a company's annual report.  This is because it is generally accepted that a share's worth is the discounted value of future dividends and the P&L contains the most relevant information to determine this. (Refer to the last couple of paragraphs of my post "What is a share?" for an explanation of discounting.)

One of the questions to be asked when examining a P&L is "What are the true earnings for the period studied?".  In a simple world, one would be able to look at the bottom line of a P&L and if it showed a profit of $23.8m, we could say that the true earnings for the period studied were $23.8m.  Unfortunately, we live in a very complex world with very complex accounting standards developed to deal with very complex things that people do with money, hence, we need to do a bit more work that this.

There are three elements of a P&L that "require critical interpretation and adjustment":

1. Nonrecurrent items (ie things that are one-off's and won't happen again)
2. Operations of subsidiaries or affiliates - particularly tricky as you may not be given any details about them other than their profit or loss
3. Reserves

Non-Recurrent Items

Graham and Dodd list nine types of non-recurrent items and point out that they need to be taken out to determine the "ordinary operating results". By doing this, we can get a better idea of the "indicated earning power", which is what you would expect the company to earn each year if business conditions remained the same.

To apply this concept I am going to examine NIB Health Fund's financial result for the year ending 30 June 2009 [specifically the pdf file titled Appendix_4E_Preliminary_Final_Report_30_June_2009.pdf, which I downloaded from NIB's website]. For the time being I'm going to only look at the Consolidated results and ignore the Parent Entity results. I have chosen NIB because I have had a health insurance policy with them for several years and, as a result, when they listed on the ASX they gave me some shares.

NIB's Income Statement is on page 41 of the annual report. NIB's profit for the previous year FY2008 was only $404,000, but increased to $23.8m for FY2009. Coincidentally, a large part of the difference is due to non-recurrent items and so proves a useful example when considering this chapter.
In looking for non-recurrent items the first thing I do is run down the list of figures and compare last year and this year.  Any items which differ significantly are likely due to non-recurrent items.

The most obvious thing that first stands out are the two items:

• Other underwriting expenses - demutualisation and listing costs: which was $10.8m in 2008 and $0 in 2009; and
• Other expenses - demutualisation and listing costs: which was $7.6m in 2008 and $0 in 2009.

These costs resulted from the demutualisation of NIB Health Fund and its listing on the Australia Securities Exchange in November 2007.  Obviously, this is an event that will likely only happen once in a company's existence, so we should exclude them entirely as they only serve to obscure NIB's "indicated earning power".  In doing so, the profit for FY2008 lifts from $404k to $18.9m.

The third expense that occurs in FY2008 and disappears in FY2009 is a $25m payment to the NIB Foundation. There is no discussion of the Foundation in the FY2009 financial statements, however, the media releases on the NIB Foundation website state that this donation established the Foundation using funds raised for the purpose as part of the ASX listing. The NIB Foundation aims to distribute $2m in grants each year, so presumably they are using the $25m as capital to raise the $2m each year. There is no mention made regarding whether NIB will provide ongoing monetary support to the Foundation, so I’m going to assume that we can exclude it for the purposes of determining NIB's "indicated earning power". As a result, the FY2008 profit lifts to $43.9m and suddenly what on the surface seemed an extraordinary improvement in performance from FY2008 to FY2009 is looking like a dramatic decline.


The next items to look at are Investment Income and Investment Expenses. If we add these two items together they represented on 1% of costs in FY2008 and 0.2% of costs in FY2009, so the temptation is to just ignore them all together. But as this is a learning exercise, we are going to delve in and see what we can find out about them. This will involve reading the dreaded Note 1. Every set of financial statements has a Note 1 - Summary of Significant Accounting Policies. Note 1's set out how the financial statements are put together. Note 1's always consist of several pages of single spaced type in a small font that contains a lot of accounting jargon. This is why I have never before read a Note 1, but I suppose there is a first time for everything.

So, on the third page of NIB's 14-page Note 1, we learn:

• changes in the value of financial assets are put on the profit and loss statement.
• dividends from subsidiaries are put on the profit and loss when the right to receive the dividend has been established - so even though they might not yet have recieved the cash, NIB will report the income as earned on the P&L.
• rent from building they own and lease out is put on the P&L for the period when it should have been received.

All these items are annoyances when it comes to determining a company's "indicated earning power".

Firstly, an increase in value of some shares you own (financial assets), doesn't put money in your pocket - at least, until the time you sell them, when the value would have changed again. So on the one hand, this should be excluded from assessment of indicated earning power (I'm going to go ahead and start calling this "IEP") on the other hand, over the long term, this will come into play.

Secondly, we do not have the financial statements of the subsidiaries so we have no way of assessing their IEP's and therefore no way of assessing likely future dividends and their contribution to NIB's IEP.

Thirdly, we have no details on the rental properties so cannot assess whether the rent is representative of a typical year or whether, for example, a significant tenant is about to vacate and leave 60% of the buildings empty for an indefinite period.

Fourthly, there is no breakdown of the investment income and given it has gone from a positive $8.8m in one year to a negative $1.2m the next, it could do anything in the third year. It may well be that when we examine the balance sheet we will get a better handle on this, but in the mean time, I'm going to fall back on my earlier comment and say that this is such a small part of NIB's IEP and exclude it.

With all these non-recurrent items excluded FY2008 profit becomes $36.4m and FY2009 profit becomes $25.6m and what looked like a good year has turned into a bad year with a 30% drop in profit from FY2008 to FY2009.

For the next post I will read through NIB's annual report and see what they have to say about their results. I will also run this exercise on the FY2010 results and see how the next year has been.

Dividends are good

The next section of chapter 29 examines the practice of retaining profits to build up the business.  The issue here is that if you owned the business you could take 100% of the profit because the profit is what is left over after everyone else has been paid.  However, most companies will retain part of the profit on the basis that it will enable management to build up the business and maintain the dividend rate in future.

I briefly discussed dividends when establishing my stock screening criteria (See "Selecting Stocks - Take Two" from January 2009).  Based on the premise that the value of the unpaid amount is added to the company value (because a share is a portion of the company), I said I preferred companies that don’t pay dividends because individuals receive a 50% deduction on tax due on capital gains (ie the change in the share price) and it is paid only when you sell (if you are not classified as a day trader by the ATO and hold the shares for over a year) but pay full tax on income (ie the dividend) and pay it annually.  (At least that is my understanding, tax law is always changing and I could simply have it wrong).  Also, there are no brokerage charges associated with reinvesting your dividends if they are just retained by the company (although this is not an issue if the company offers a dividend reinvestment plan).

Graham and Dodd question the practice of retaining earnings (ie withholding dividends) on the basis that:

1. if two companies are similar in all respects except the size of the dividend paid, the one with the higher dividend will have the higher share price.
2. withholding profits lowers the return.
3. it rarely succeeds in maintaining the dividend rate in terms of $ per share.
4. any increase in share price generated by withholding dividends will not necessarily compensate the shareholders for the dividends withheld – particularly if you take into account the interest that would have otherwise been earned on the funds.  I had a go at trying to test this using the data I’ve complied for the NAB, but given the volatility of the share market, seven years is too short a period.
5. they believe a study would show that the earning power of a corporation does not expand in proportion with the dividends withheld, although they are assuming the company is retaining the majority of the earnings, say 70% to 90%.
6. individuals in charge of companies have a vested interest in withholding dividends – they will want to retain the cash in the company where they have control over it and they will want to increase the size of the company for self aggrandizement and to generate a higher salary.  They may also withhold dividends to depress the share price so they can purchase more shares or to minimise their tax bill.

In relation to point 3, I have replicated an exercise Graham and Dodd performed on United States Steel, in my case using figures for National Australia Bank over the period 2003 to 2008:

Sum of earnings per share for the period:    $14.455

Dividends paid to shareholders                   $10.380

Dividends withheld:                                  $  4.075

In 2009, after earnings fell to $1.975 per share from $2.373 per share the year before, NAB reduced its dividend to $1.46 per share from $1.94 per share the year before.  With over $4 per share “saved up” in the previous six years (and more if I went back further), there seems little justification for reducing the dividend. I scanned through the annual report to find any discussion on how NAB determines the amount of the dividend and found nothing.

Graham and Dodd’s conclusions are:

• Any dividend not paid out loses value for the investor.
• The major proportion of earnings should be distributed and any earnings withheld should be justified by management.
• You should look for both an adequate return and an adequate dividend when investing.

Diversion: A Wordle

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And the winner is ... dividends!

In Chapter 29 of Security Analysis, Graham and Dodd make the comment “Until recent years the dividend return was the overshadowing factor in common-stock investment”. (These words come from the 1940 edition of the book.)

To illustrate this they present two tables, one for American Sugar Refining Company (ASR) and one for Atchison Topeka and Santa Fe Railway Company (ATSR). Each table shows for a number of years, the price range of the stock, the earnings per share and the dividends per share.

ASR had quite volatile earnings, for example going from $18.92 per share in 1911 to $5.31 per share in 1912, but maintained a constant dividend of $7 per share over the period of the table (1907 – 1913). According to Graham and Dodd, the volatility of its share price was low, suggesting that it was the dividends driving the price rather than earnings.

The table for ATSR covers the years 1916 to 1925. The dividend paid was $6 per share each year except for the last when it rose to $7 per share. Earnings per share, while exhibiting some volatility, had a general upward trend. The price range again was relatively steady and level, but jumped in the final year when dividends were raised. So again, dividends seem to be driving the price.

I decided to undertake a similar exercise on a current ASX listed company. I chose National Australia Bank Limited (NAB) because I thought a long established bank would have steady dividends but volatile earnings and because, due to accidents of history, I own some (a very little some) NAB shares.

Instead of replicating the tables, I created two graphs: one plotting earnings per share against closing price on the day the full year results were announced and one plotting dividends per share for the year against closing price on the day the full year results were announced.

Here’s the graph of earnings against closing price for the years 2003 to 2007 inclusive. Closing prices were taken from Yahoo’s finance site, which only goes back to 2003. The R-square figure of 0.163 is a measure of how well the movement of earnings per share affects the closing price. A R-squared of 1 would mean that a change in the earnings per share would result in the exact same change in the closing price. A R-squared of 0 would mean that a change in the earnings per share would result in absolutely no change in the closing price. A R-squared of 0.163 is very low suggesting earnings per share has little influence on price.





What I see when I look at the graph is a squiggle – it folds back on itself. In this case I think the R-squared is meaningless and earnings do not directly affect the share price.

In contrast, when I look at the graph of closing price against dividends per share for the same period, things are a bit clearer. Each rise in dividends paid has lead to a rise in the share price. The R-squared of 0.664 suggests a reasonable correlation. So although there are not many data points here and no doubt a statistician would draw no conclusions from this, it would appear dividends directly affect share prices and earnings do not.




The impact of dividends could also be seen in the market reaction to Qantas’s decision to cut its interim dividend for the FY2010 half year despite the profit result being in line with company guidance. Its share price fell 8% in one day.

You may be wondering why I only took the graphs out to 2007. It’s because 2008 is when the global financial crisis hit and things went awry. When I extend the graphs out to 2009, it all goes horribly wrong.





Now both graphs are squiggles. So from this I conclude when it all goes wrong, it all goes wrong and hopefully when it happens again, I will have already switched my portfolio into cash.

What is a share?

Typically the answer to the question "what is a share?" runs along the lines of "a share is part ownership in a company". This definition is almost entirely unhelpful because it does not explain what ownership means.

If you own an ipod you can download music to it, you can listen to it, you can put a cover on it, you can stick it in a blender and turn it into dust like in that YouTube video, but you can do none of these things to a share.

The best definition of ownership that I have come across is that ownership is a bundle of rights. The rights associated with a share are quite limited. From what I can tell these are the rights available to shareholders:

- you can sell your shares
- you are entitled to dividends in proportion to the number of shares you own, that is, the cents per share paid as dividends will be the same for your shares as for everybody elses (unless there are different classes of shares with different rights, in which case, all shares in a class will receive the same dividends)
- you have the right to attend and vote at the annual general meeting (which, if you work full-time, you will be unlikely to be able to attend)

This does not look like ownership of a company to me. This looks like ownership of a financial instrument and the point of a financial instrument is to move money around from where it is not needed to where it is needed so that everyone benefits.

Why is this important?

It is important because it has a bearing on how you value a company and if you don't value a company you can't tell whether you are paying too much for the shares or not.

If you take the view that a share is part ownership of a company then you would value the company by forecasting its earnings, discounting them to present value (see note below) and dividing by the number of shares. If you take the view that a share gives you the right to receive dividends, you would deduct the proportion of earnings that will be retained by the company from the earnings to determine the dividends then discount the dividends to present value. This adds an extra element of risk, which means you would use a higher discount rate, which would give a lower value.

Why am I thinking about this now?

I am thinking about this now because Graham and Dodd point out the existence of the conflict between ownership of a financial instrument vs part ownership of a company in Chapter 29 of Security Analysis. They only mention it in passing before going on to look at dividends in detail, but I needed to get my thoughts straight.


A note on discounting

Discounting can be thought of as the opposite of earning interest. If you have $1,000 and you put it in a term deposit at 5% interest, in a year's time it will be worth $1,050. So the present value is $1,000 and the future value is $1,050. If you were saving for something that costs $1,050 and you wanted to buy it in a years time, you would 'discount' the $1,050 by 5% to find out how much you had to put in the term deposit now to have $1,050 in a years time.

In the case of a bank account, it is fairly straight forward because you know the interest rate. In the case of shares you have to work out for yourself what dividends you think you will recieve in future and what level of return you want to compensate you for investing in the shares and taking the risk of not recieving those dividends either at that level or at all. This amount should be higher than what you can recieve by putting money in the bank because you can be fairly confident that you will be paid the interest by the bank and be able to get your principal back.

Starting Over

State of Play: Way back in August, when I wrote my last post, I was looking at Nomad Building Solution as a potential investment. Or more correctly, I was concluding that they were not a potential investment due to their lack of transparancy on an issue that was never fully explained.

My position on this might seem a bit over the top to some people, but it is based on my training as a banker. The first question a banker is supposed to ask themselves before considering anyone for a loan is "does this borrower have integrity?". Nomad's lack of info about the issue, plus their trumpeting of double-digit revenue growth and leaving the fact this was due to the aquisition of two businesses for inclusion in the fine print, leads me to question their integrity. Banks take mortgages and charges so they can force repayment of loans, share investors are at the mercy of the market when it comes to getting their money back. This is why I'm passing over Nomad.

I also said, in my last post, that I would look at their next set of results, just out of interest to see where the story went. However, my laptop has been stolen with all my blogs and workings, so I'm not going to go back and recreate excel files just for the sake of curisoity. I did take a look at how their share prices has moved over the last year however. They reached a high of $1.23 per share on 9 Sep 2009 and closed at 26c on 3 Feb 2010. My guess is they rode the market up but reality hit them in the end.

Nomad originally came to my attention as a result of judging every listed company against a set of critera. I developed the criteria after reading a couple of books on investing (see previous posts). This was done in January 2010. You will note that a year has passed since then. [You may also note that my postings in this blog can best be described as intermittant. My only defence is that I have had a baby in November and being pregnant and then looking after a new born are not condusive to blogging or investing.]

Anyway, to recap what has happened since my last post in August 2009, I re-ran the criteria on the 30 June 2009 financial statements. Only one company made it to the shortlist - ALE (they own pubs which they rent out to others to operate). Unfortunately, about that time I attended a conflicts of interest course at work and learned that I am not allowed to trade any shares in my industry sector (property) regardless of whether they are clients or not. So, ALE are disqualified.

At that point I decided its was time for a new approach, which means a new book. The Snowball, the biography of Warren Buffet, details how he read Graham & Dodd's book Security Ananlysis, then went to Columbia University to study with them and later joined Graham's investment firm. Has ever a book come so highly recommended on any topic?

So I headed to Readers Feast in Melbourne, which always has a good selection of books on finance and investment and indeed found a copy of Security Analysis (6th edition). My first impression is that it is a very big book at 2.5 inches thick with an accompanying CD containing additional chapters and appendices. It covers both bonds and shares, so fortunately I don't have to read the whole thing (but being a Virgo I probably will).

Anyway, back to the content. The issue I am currently grappling with (which I admit might not appear entirely obvious) is how do I select companies to invest in? The short answer to this is provided in Chapter 28 - Newer Cannons of Common Stock Investment.

I have to admit, that I did not find this chapter an entirely easy read, but this is what I believe it is saying:

• there are four approaches to share investing
• first approach - create a portfolio of "carefully selected, diversified group of common stock purchased at reasonable prices". This approach is discounted on the basis that investors cannot count on a general market wide increase in earnings or profit. I would have thought this would be taken care of by the careful selection, but maybe they are just saying there's no guarantee the market will go up.
• second approach - select growth stocks. This approach is discounted on the basis that by the time you can be certain a stock is a growth stock it may have matured and will not grow further or, even if it is a growth stock the price will contain a premium taking this into account.
• third approach - exploit market swings through buying when the market is low and selling whent he market is high. This approach is discounted on the basis that it is too difficult to pick the market turning points.
• fourth approach - buy undervalued shares. Graham and Dodd contend that although it is rare for a good stock to sell at a low price, it is common to find stock that have average prospects for the future and appear cheap on quantitative measures. This is because most investors focus on companies with unusually good prospects. "Because of this emphasis on the growth factor, quite a number of enterprises that are long established, well financed, important in their industries and presumable destined to stay in business make profits indefinitely in the future, but have no speculative or growth appeal, tend to be discriminated against by the stock market - especially in years of subnormal profits - and to sell for considerably less than the business would be worth to a private owner."

This fourth approach is the margin of safety principal and is considered the best by Graham and Dodd. Unfortunately, it appears I cannot just set a few criteria and bingo - there's a portfolio. It appears I must do a fair bit of analysis to form a view on the value and discover whether a certain share is trading at a discount to value. So from this point I think all I can do is plow on with the book and see where it takes me.