Financial Education

The following is an excerpt from Jesse Livermore’s “Reminiscensces of a Stock Operator,” which is available in our public domain library.

There I was on the morning of May ninth with nearly fifty thousand dollars in cash and no stocks. As I told you, I had been very bearish for some days, and here was my chance at last.

I knew what would happen — an awful break and then some wonderful bargains. There would be a quick recovery and big profits for those who had picked up the bargains. It didn’t take a Sherlock Holmes to figure this out. We were going to have an opportunity to catch them coming and going, not only for big money but for sure money.

Everything happened as I had foreseen. I was dead right and I lost every cent I had! I was wiped out by something that was
unusual. If the unusual never happened there would be no difference in people and then there wouldn’t be any fun in life. The game would become merely a matter of addition and subtraction. It would make of us a race of bookkeepers with plodding minds. It’s the guessing that develops a man’s brainpower. Just consider what you have to do to guess right. The market fairly boiled, as I had expected. The transactions were enormous and the fluctuations unprecedented in extent. I put in a lot of selling orders at the market. When I saw the opening prices I had a fit, the breaks were so awful. My brokers were on the job. They were as competent and conscientious as any; but by the time they executed my orders the stocks had broken twenty points more. The tape was way behind the market and reports were slow in coming in by reason of the awful rush of business. When I found out that the stocks I had ordered sold when the tape said the price was, say, 100 and they got mine off at 80, making a total decline of thirty or forty points from the previous night’s close, it seemed to me that I was putting out shorts at a level that made the stocks I sold the very bargains I had planned to buy. The market was not going to drop right through to China. So I decided instantly to cover my shorts and go long.

My brokers bought; not at the level that had made me turn, but at the prices prevailing in the Stock Exchange when their floor man got my orders. They paid an average of fifteen points more than I had figured on. A loss of thirty-five points in one day was more than anybody could stand. The ticker beat me by lagging so far behind the market. I was accustomed to regarding the tape as the best little friend I had because I bet according to what it told me. But this time the tape double-crossed me. The divergence between the printed and the actual prices undid me. It was the sublimation of my previous unsuccess, the selfsame thing that had beaten me before. It seems so obvious now that tape reading is not enough, irrespective of the brokers’ execution, that I wonder why I didn’t then see both my trouble and the remedy for it.

I did worse than not see it; I kept on trading, in and out, regardless of the execution.

Consider two companies, Arkansas Best and Landstar Systems, both of which are classified as trucking companies. According to Landstar’s 10K filing for the year ended December 30, 2006 (p. 5), “The carrier segment markets its services primarily through independent commission sales agents and utilizes Business Capacity Owner Independent Contractors and Truck Brokerage Carriers. Using a stylized example:

Operating leverage is computed by dividing the contribution margin (revenues less variable costs) by the operating income. In this case, operating leverage is 1.50 (300/200). So, a 10% increase in revenues should yield a 15% increase in operating income (10% * 1.5). As seen above, a 20% increase in sales yielded a 30% increase in operating income. Since our example had no interest expense, there is no financial leverage and the increase in taxes and net income was also 30%.

The company benefits from operating leverage as it grows since fixed costs do not increase and existing fixed costs are “spread” across higher revenues. As a percentage of revenues, the fixed costs shrink. Of course operating leverage will also work against the firm if revenues fall since fixed costs do not fall accordingly. In fact, in our stylized example, if revenue were to fall by 20%, operating income would fall by 30%.

Operating leverage also does not remain constant; it must be recomputed each period as the relationships among contribution margin, fixed costs, and operating income change. This can be seen from the Arkansas Best example, where adding capacity caused the “fixed” costs to rise at a higher rate than revenues in 2006. It can be difficult even for someone inside the firm to accurately measure fixed costs versus variable costs. Statistical techniques such as regression analysis can be useful for this purpose. A shortcut method of approximating operating leverage is to divide the change in operating income by the change in sales:

(Percentage Change in Operating Income)/(Percentage Change in Revenues)

For Arkansas Best, if we assume that the change between 2004 and 2005 represents a “normal” level of operating leverage (in reality a longer data series would be needed) we can approximate the operating leverage as 8.2%/6.0% = 1.37 or 137%. A 10% increase (decrease) in sales would result in a 13.7% increase (decrease) in operating profit.

It is unrealistic to expect fixed costs to remain constant indefinitely. As the company grows, fixed costs may need to be increased periodically in a stepwise manner. For example, headquarters administrative costs might be fixed for a company’s current level of production and for small increases in production. However, if production were doubled, some of these fixed costs might increase.

For Arkansas Best, it wasn’t an actual increase in sales but planning for anticipated future increases that hurt margins in 2006. If we calculate the operating leverage from 2005 to 2006 we get 6.2%/9.5% = 0.65. Operating leverage less than 1.0 implies that profitability declines when sales increase. This is clearly not normal. In future years, the company’s profit margin should improve as sales grow into the new fixed costs. At some time in the future, though, the company will again reach a level of activity where fixed costs must increase, and the profit margin would generally be expected to decline in that year.

Operating leverage can be measured if the breakdown of fixed cost and variable cost in a company’s operating structure is known. Operating leverage is normally based upon operating income to avoid muddying the signal with financial leverage or taxes.

Computing operating leverage would be easy if the proportion of fixed and variable costs could be known with certainty. Consider a stylized example:

Operating leverage is computed by dividing the contribution margin (revenues less variable costs) by the operating income. In this case, operating leverage is 1.50 (300/200). So, a 10% increase in revenues should yield a 15% increase in operating income (10% * 1.5). As seen above, a 20% increase in sales yielded a 30% increase in operating income. Since our example had no interest expense, there is no financial leverage and the increase in taxes and net income was also 30%.

The company benefits from operating leverage as it grows since fixed costs do not increase and existing fixed costs are “spread” across higher revenues. As a percentage of revenues, the fixed costs shrink. Of course operating leverage will also work against the firm if revenues fall since fixed costs do not fall accordingly. In fact, in our stylized example, if revenue were to fall by 20%, operating income would fall by 30%.

Operating leverage also does not remain constant; it must be recomputed each period as the relationships among contribution margin, fixed costs, and operating income change. Statistical techniques such as regression analysis can be useful for this purpose. A shortcut method of approximating operating leverage is to divide the change in operating income by the change in sales:

Percentage Change in Operating Income

Percentage Change in Revenues

Contribution margin is revenue less any variable costs such as sales commissions. Since variable costs rise and fall at the same rate as revenue, the more revenue earned the more the associated costs. All non-variable expenses will have to be paid from what is left, the contribution margin.

Fixed costs are expenses that stay relatively constant within a given level of sales. For example, the cost of renting a corporate headquarters is likely to be a constant amount (say, $100,000 per month) regardless of how much revenue the company generates.

Variable costs, as the name implies, vary with the amount of revenue. A good example is sales commissions. More commissions will be paid if the company generates $2 million in sales than if it generates $1 million.

The following is an excerpt from Jesse Livermore’s “Reminiscensces of a Stock Operator,” which is available in our public domain library.

Everybody was making money. The steel crowd came to town, a horde of millionaires with no more regard for money than drunken
sailors. The only game that satisfied them was the stock market. We had some of the biggest high rollers the Street ever saw:
John W. Gates, of `Bet-you-a-million’ fame, and his friends, like John A. Drake, Loyal Smith, and the rest; the Reid-Leeds-Moore crowd, who sold part of their Steel holdings and with the proceeds bought in the open market the actual majority of the stock of the great Rock Island system; and Schwab and Frick and Phipps and the Pittsburgh coterie; to say nothing of scores of men who were lost in the shuffle but would have been called great plungers at any other time. A fellow could buy and sell all the stock there was. Keene made a market for the U. S. Steel shares. A broker sold one hundred thousand shares in a few minutes. A wonderful time! And there were some wonderful winnings. And no taxes to pay on stock sales! And no day of reckoning in sight.

Of course, after a while, I heard a lot of calamity howling and the old stagers said everybody — except themselves — had gone crazy: But everybody except themselves was making money. I knew, of course, there must be a limit to the advances and an end to the crazy buying of A. O. T.– Any Old Thing and I got bearish. But every time I sold I lost money, and if it hadn’t been that I ran darn quick I’d have lost a heap more. I looked for a break, but I was playing safe — making money when I bought and chipping it out when I sold short so that I wasn’t profiting by the boom as much as you’d think when you consider how heavily I used to trade, even as a boy.

There was one stock that I wasn’t short of, and that was Northern Pacific. My tape reading came in handy. I thought most stocks had been bought to a standstill, but Little Nipper behaved as if it were going still higher. We know now that both the common and the preferred were being steadily absorbed by the Kuhn-Loeb-Harriman combination. Well, I was long a thousand shares of Northern Pacific common, and held it against the advice of everybody in the office. When it got to about 110 I had thirty points profit, and I grabbed it. It made my balance at my brokers’ nearly fifty thousand dollars, the greatest amount of money I had been able to accumulate up to that time. It wasn’t so bad for a chap who had lost every cent trading in that selfsame office a few months before.

If you remember, the Harriman crowd notified Morgan and Hill of their intention to be represented in the Burlington-Great Northern-Northern Pacific combination, and then the Morgan people at first instructed Keene to buy fifty thousand shares of N. P. to keep the control in their possession. I have heard that Keene told Robert Bacon to make the order one hundred and fifty thousand shares and the bankers did. At all events, Keene sent one of his brokers, Eddie Norton, into the N. P, crowd and he bought one hundred thousand shares of the stock. This was followed by another order, I think, of fifty thousand shares additional, and the famous corner followed. After the market closed on May 8, 1901, the whole world knew that a battle of financial giants was on. No two such combinations of capital had ever opposed each other in this country. Harriman against Morgan; an irresistible force meeting an immovable object.

Returns in a fixed income portfolio typically consist of two components.

The effect of the interest rate environment arises because fixed income security prices are inversely related to interest rates.

The active management effect arises from factors that affect the nonimal spreads relative to the yield curve. These include:

• Sector weightings
• Credit quality
• Differentials between individual securities

Managers can affect the overall return through either interest rate management or the sector/quality effect.

Interest rate management relates to how well the manager predicts changes in interest rates. It can be calculated by subtracting the aggregate return on the Treasury universe from the aggregate return of the portfolio after repricing the portfolio to the risk-free rate. Interest rate management effect can be further broken down into effects from duration, convexity, and yield curve shape changes.

The sector/quality effect is the manager’s ability to select the “right” issuing sector and quality group. It can be estimated by repricing each security in the portfolio to the average yield premium for its respective category, and comparing this gross return to the manager’s portfolio return.

Many analysts use a shortcut operating cash flow estimate: Earnings Before Interest, Taxes, Depreciation, and Amortization (or EBITDA). EBITDA estimates of pretax, pre-interest, operating cash flows, assuming no significant changes in the working capital accounts. In AT&T’s case, EBITDA is calculated as follows (in millions of dollars).

Note that this shortcut estimate of cash flows from operations is considerably higher than the actual cash flow from operations in all three years. Clearly the adjustments for working capital and other non-cash items are very significant, which illustrates a significant weakness of the EBITDA shortcut. Working capital investments require cash, and ignoring this could prevent an investor from recognizing financial distress. On the other hand, looking at EBITDA serves to illustrate the magnitude of any difference, and can help point the investor in the right direction for further analysis.

Normally, EBITDA should be refined by reversing any items that are unlikely to occur again in the future. The purpose of these analyses is not merely to understand the past but also to help predict future cash flows. Therefore, the analyst must consider the firm’s situation, as well as the specific analytical techniques being applied, to determine how best to use cash analysis measures to provide the most robust basis for future projections. When used appropriately, these cash analysis techniques can provide insight into how well the firm is managing its cash resources. Furthermore, the analyst can potentially gain important insights into the company’s reporting stance by studying the differences between the reported cash numbers and the accrual accounting numbers.

While free cash flow to the firm measures the cash flow available to all investors, free cash flow to equity is intended to measure what is left over (the residual) for equity holders. The basic calculation is:

Since this represents cash flow available only to equity holders, there is no need to add back interest expense. Instead, cash flow must be adjusted for net borrowing/repayment of debt. In the case of AT&T, FCFE would be:

For AT&T there is a substantial question mark regarding what should be done about their stock-based acquisition of BellSouth. While it did not represent a cash outflow, it was the equivalent of issuing shares to fund one. According to an 8K filed when the deal closed, “based on the closing price of $35.75 per share of AT&T Common Stock on the New York Stock Exchange on December 29, 2006, the last trading day before the closing of the Merger, the aggregate value of the consideration paid to former holders of BellSouth Common Shares in connection with the Merger was approximately $85.8 billion.” Consider what would happen if we treated the 2006 acquisition as having been made for cash, and the company had issued shares to raise that cash:

It’s quite a different picture. It is also a somewhat unfair picture, since the deal closed on December 29 and thus very little of BellSouth’s operating performance is included. Nonetheless, it serves to illustrate a possible adjustment that could be made in order to facilitate comparisons over time or between companies.

Some analysts use a shortcut approximation for free cash flow:

This shortcut is especially useful if net borrowing is expected to balance out over time, as it measures the ability of operating cash flow to cover capital investments. Under the shortcut method, AT&T had less cash flow in 2006 and more in 2005, and the cash flow trend worsened rather than improved. Which is the best method? It is often appropriate to examine several different approaches to get a full picture of the company’s financial condition.

There is no “Generally Accepted” definition of Free Cash Flow to the Firm. However, in basic form it is typically defined as:

Remember that under IAS a company has some flexibility in reporting interest paid. A free cash flow to the firm calculation should only add back the interest expense if it was deducted from operating cash flow. Further, since net income and operating cash flow are determined on an after-tax basis, but bondholders are paid on a pre-tax basis, the interest paid must be adjusted by the tax rate. Finally, companies must invest some amount in capital to replenish capacity that gets worn out. Therefore, the “free” cash flow is what remains after investments in fixed capital, such as property, plant, and equipment and other acquisitions.

Using AT&T’s 2006 numbers, we start with cash from operations of $15,615 million. Interest paid (from the cash flow statement) was $1,666 million, and the income statement shows a 32.4% tax rate for the year. Therefore the after-tax interest expense was $1,026 million.

AT&T spent $9,424 on capital expenditures and investments in affiliates, and generated $756 million by selling existing equipment. The company also received $368 million from an acquired company, which we do not count as free cash flow for two reasons: first, it is not a “normal” source of cash; and second, since we did not count the shares paid in the acquisition as a cash flow it would not be consistent to calculate cash received. In a way this was really a financing activity (receiving cash for shares issued is exactly the same as issuing shares to raise cash.) This results in free cash flow to the firm of (in millions of dollars):

There are many variations on this formula. We included investments in affiliates and dispositions of property, plant & equipment. We have excluded investments in securities and other investments, which are not required for ongoing operations. Some analysts prefer to only deduct capital expenditures (PP&E) and would exclude investments in affiliates, just as the non-cash (share-based) acquisition is ignored. Others might prefer to treat the acquisition as though it were made for cash, and treat the issued shares and acquired debt as financing cash flows. While we used the tax rate implied by the income statement, many investors would likely want to use a normalized tax rate. To some extent these questions can be answered on a case by case basis, depending on how frequently the acquisitions occur, and whether it is part of management’s growth strategy (acquisitions are really a substitution for capital expenditures in some ways.) Furthermore, given that the cash flow from operations includes cash provided by any acquisitions made, ignoring acquisitions would make a company that grew organically (through capital expenditures) appear to generate less free cash flow than a company that actually spent more by acquiring companies. Particularly when comparing companies that use approaches to acquisitions it is important to use consistent treatment for all investments that will generate cash from operations.

While cash flow from operations is positive in all three years, it was not sufficient to pay for the firm’s investments in affiliates in 2004. Not surprisingly, in 2004 AT&T drew down its cash balance significantly, and also raised cash by issuing more debt.