Outstanding Work

MagicDiligence — Sun, 20 Apr 2008 20:38:32 -0400

Great job as always, Mike.

Steve

=========================
Adding fundamental analysis to a winning
value stock strategy.

www.magicdiligence.com

This is an excellent posts -

five_whys — Thu, 13 Mar 2008 23:46:44 -0400

This is an excellent posts - almost a reminder of that a step wise disciplined approach to investment analysis is humanly possible!

I have two points to make:

1. The yield shows up as <3% right now on Morningstar as well as Yahoo Finance. Since the today's price about lowest in 2008, I cant grasp the difference between what Mark said (6%+) on Feb 4th v/s <3% today (March 13th)

2. As Mohnish Pabrai says, can we try to differentiate between risk and uncertainty.
Near term uncertainty about earnings is pretty clear on this stock due to credit crunch environment. Question is - if there is a real risk of losing earnings power or mere uncertainty as to when the earnings power well be restored for MHP.

Any opinion?

five_whys
Choose the Best Tools for Investment

reverse DCF

Jeff Liang — Sat, 09 Feb 2008 17:46:34 -0500

As Charlie Munger famously says, "Invert, always invert".

Another approach I would suggest is to invert the current stock price. At $40, the price assumes a 10-year annualized growth rate of 4.0% at a cost of capital of 10.5% and long-term growth rate of 1.0%. I would then ask myself how likely this scenario will occur, given that Moody's recently reported an earnings contraction (-54% in Q4'07 versus Q4'06) and that the SEC is looking very closely at the rating agencies (possibly imposing regulations).

I think that S&P is an excellent franchise and will be around in 10 years. However, I think that there is certainly risk that MHP's earnings will contract, which would affect a model that consists only of positive earnings growth.

I agree. Mike has done a

George — Mon, 04 Feb 2008 13:51:20 -0500

I agree. Mike has done a great job on this research. I hope his high school teacher gave him a great grade for this paper. It simply amazes me that Mike is still in high school and can produce such top notch analysis like this McGraw-Hill report. I look forward to reading future reports by Mike.

nice

alexg — Mon, 04 Feb 2008 12:07:15 -0500

one of the better write ups I have seen on VIN. Great Job!

http://www.contrarianvalueinvesting.com/

McGraw-Hill Research

Teenvestor — Sun, 03 Feb 2008 23:28:41 -0500

In his 2006 book, The Little Book That Beats The Market, Hedge Fund Manager extraordinaire (You Can Be a Stock Market Genius, 271) Joel Greenblatt writes about a strategy that has produced 30.8% annual returns over the past 17 years, as opposed to only 12.3% returns from the general market (Little Book, 52).

Over that time period $1,000 would have turned into $109,258.36 if invested in his ‘Magic Formula’ and the general market would have produced just $7,185.48 (Moneychimp, Compound Interest Calculator); not too shabby but over $102,000 less.

Sounds too good to be true, but the strategy is based purely on logic. Greenblatt suggests that by combining a good company (high Return on Capital) with a low price (high Earnings Yield) (Little Book, 138) a great investment will result.

In simple terms Return on Capital is the amount of net income a company makes in a given time period with its invested assets (capital) and Earnings Yield is the percent of the Market Value of a business earnings currently represent. Companies that can earn a lot of money on their assets are generally considered good and companies whose earnings represent a large portion (>6%, or the current coupon from T-Bill) of their price are considered ‘cheap’ (Little Book, Chapters 3-5)

McGraw-Hill, a textbook maker and information services provider (Annual Report, 22), represents a potential investment based on the Magic Formula.

According to Google Finance it currently trades at a 7% earnings yield, with a Return on Capital in excess of 30% (Google Finance, MHP).

According to the Magic Formula one would stop there and just buy this stock (Little Book, 134). This is called mechanical investing, because it is, “Buying and selling stocks based on predetermined criteria” (Investopedia, Mechanical Investing).

According to Author Rich Rockwood superior returns can be earned by, “Finding quality businesses with sustainable competitive advantages selling at advantageous prices” (The Focus Investor, 14).

The Magic Formula says McGraw-Hill has a quality business and may be selling at an advantageous price, but says nothing of its competitive advantages. Morningstar Director of Stock Analysis Pat Dorsey suggests one can analyze competitive advantages by:

1. Evaluating the Firm’s historical profitability

2. Assessing the source of the firm’s profits

3. Estimating how long a firm will hold off competitors, and

4. Analyzing the firm’s competitive structure (The Five Rules for Successful Stock Investing, 22).

In this research paper McGraw-Hill will be examined to learn about its business, to find if it does hold a competitive advantage, if its managers are capable of running the company and if it does in fact trade for a cheap price.

Business

In its annual report McGraw-Hill describes its business:

The McGraw-Hill Companies, Inc. (The Registrant or the Company), incorporated in December 1925, is a leading global information services provider serving the financial services, education and business information markets with a wide range of information products and services. Additional markets include energy, construction, aerospace and defense, and marketing information services. The Company serves its customers through a broad range of distribution channels, including printed books, magazines and newsletters, online via Internet Websites and digital platforms, through wireless and traditional on-air broadcasting, and through a variety of conferences and trade shows. (McGraw-Hill Form 10k, Business)

McGraw-Hill’s two founders, James H. McGraw and John A. Hill both started publishing companies, both named after its respective founder, before they formed an alliance in 1909 (McGraw-Hill History, The Foundation) .

The company expanded and prospered thorough the twenties, acquiring numerous companies. In the ‘30’s and 40’s the company bought into different industries including aviation, health and atomic energy (McGraw-Hill History, Development).

Into the 60’s the company started to diversify, acquiring Standard & Poors in 1966 and helping form CUSIP in ’68. The company also acquired TV stations in San Diego, Indianapolis and Denver in 1972 (McGraw-Hill History, Expansion).

In 1989 the company formed Primis Custom Publishing which allowed professors to design their own text books. This company grew to 18.5% market share and was the market leader. The company continued to innovate online and its growth exploded in all areas other than Information & Media (McGraw-Hill History, The Information Age).

In a November, 2004 article Whitney Tilson wrote what he thought would make a perfect business. Tilson said, “To determine how good a company is, it helps to think about what the perfect business looks like” (The Motley Fool, The Perfect Business).

Among his criterion were high profitability, high returns on capital and good competitive advantages (The Motley Fool, The Perfect Business).

Good companies are those who provide a product whose price can be jacked-up. When companies do this more revenue falls to the bottom line and the margins are higher than the competition (The Motley Fool, The Perfect Business). According the Quicken, “MHP's net profit margins have been consistently above the Publishing - Books industry's average” (One Click Scorecard, Warren Buffett Way).

Next, high returns on capital: if a company with high margins has a low return on capital it is not an attractive business because it requires massive amount of investment to produce its earning (The Motley Fool, The Perfect Business). McGraw-Hill’s return on capital was established earlier at 30%.

Pat Dorsey’s method will be used to find if the company has a competitive advantage.

1. To evaluate profitability Dorsey suggests finding if the firm produces free cash flow, if it has healthy profit margins and if it produces good Return on Equity and Assets. Free Cash Flow has been consistently over $900 million (Morningstar, 10year Cash Flow). The company has a profit margin of 16% (Morningstar, 10year Income Statement). Finally, returns on equity and assets have averaged 33% and 13% respectively over the past five years (Morningstar, 10year financials).

2. Next, one should analyze the source of the firm’s excess profitability (Morningstar 5 Rules, 25). A company can keep competitors at bay with multiple different strategies. Two of McGraw-Hill’s biggest divisions, S&P and its Textbook Publishing division hold dominant market share (Investor Fact Kit, Segments). Moody’s is the only competitor of S&P’s size in the debt rating business and they have an oligopoly, Rich Rockwood said, “Competition doesn't seem as destructive in this industry as say in the retail industry” (Focus Investor, Moody’s). According to Morningstar, “McGraw-Hill, Pearson, and Reed Elsevier dominate [the US elementary-high school publishing market]” (Morningstar, MHP).

3. The next step is the most imprecise, and, “No rule of thumb exists” (Five Rules, 34). Dorsey advises one decide whether the firm’s moat – another word for competitive advantage (Five Rules, 22). Rich Rockwood’s article was written in August of 2000 and no competitors have approached Moody’s or S&P since then so it’s safe to assume the moat there is wide. The same applies for the education business which took control in the early 90’s.

4. The final objective is to analyze the company’s industry, Dorsey advises one have a firm grasp of the competitive structure (Five Rules, 36). McGraw-Hill’s place in its industry was analyzed in the previous test.

Using Pat Dorsey’s method it would be logical to say McGraw-Hill holds a competitive advantage, and using Tilson’s method the same could be said in analyzing its business.

Management

Author and Hedge Fund Manager Robert Hagstrom wrote in The Essential Buffett that billionaire investor Warren Buffet bases his judgments on management on three basic tests. Buffett asks if management is rational, candid and if it resists the ‘institutional imperative’ – if the management just works to please Wall St. in the short-term (The Essential Buffett, 84).

Hagstrom wrote that Buffett first looks to see if management is rational in its investment of capital. To find this one must check it Return on Capital (The Essential Buffett, 85) and look to see if the company has increased at least a dollar in market value for each dollar it re-invested in its business (The Essential Buffett, 100).

According to Quicken’s One-Click Scorecard McGraw-Hill has created $2.96 in market value for each $1 it re-invested in the business (One-Click Scorecard, Warren Buffett Way).

The next test, candor, is to check if management is candid with shareholders and isn’t hiding anything. The book suggests an example of Berkshire Hathaway which separately reports the earnings of each of its different companies (The Essential Buffett, 89). McGraw-Hill’s investor relations website is very helpful including the company’s history and offering an Investor Fact Book which breaks down the company’s Revenue and earnings by segment and also includes market share for the different segments (McGraw-Hill.com, Investor Relations).

Finally, the Institutional Imperative, in a June 2005 interview with Value Investor Insight Hedge Fund Manager and former Morningstar analyst Mark Sellers presented a list of different things to look for when evaluating management. These points show when Management doesn’t resist the Institutional Imperative. Among them are:

· The company grants more than 2.5% of shares in options each year

· Quarterly Earnings Releases show a quarterly mentality and are aimed to please Wall St.

· Executive pay is far higher than that of similar companies

· Material Related-Party transactions

· More than 10 members of the Board of Directors, and some with no business background

· Splitting the stock repeatedly below $40 a share

· Is audited by a no-name firm

· ‘One-Time’ or recurring charges taken each quarter (Value Investor Insight, June 2005)

The Following are McGraw-Hill’s statistics:

· In the past nine years McGraw-Hill’s shares have fallen 9.6% (Morningstar, 10 yr. Income Statement)

· The headline for McGraw-Hill’s most recent quarterly release was, ‘The McGraw-Hill Companies Reports Third Quarter EPS of $1.34, a 26.4% Increase’ (Investors, News Releases).

· CEO Harold W. McGraw made just over $3.1 million last year, compared to $1.3 million earned by the CEO of Publisher Wiley John & Sons which is one-seventh of McGraw-Hill’s size and has far less subsidiaries (Reuters, Officers & Directors Detail).

· The only related party transaction in the most recent McGraw-Hill annual report is that the company bought back shares from the account of recently deceased William H. McGraw (10k, Part II Item 5).

· The McGraw-Hill board of directors includes 13 members, but all of them work for the company, teach at a university, have a high position in another company or work for a separate investment firm (Investor Relations, Corporate Governance: Board of Directors).

· In the past eleven years McGraw-Hill has split its stock three times, only once was it below $50 per share (Google Finance, MHP).

· Ernst & Young LLP audited McGraw-Hill’s most recent annual report (10k, Item 9b). According to its website Ernst & Young earned $21.1 billion last year (Ernst & Young, About Us).

· McGraw-Hill has taken no one-time charges in the past four quarters (Yahoo Finance, Income Statement).

In an interview Hedge Fund manager Matthew Richey said,

“I think management's incentives are a key predictor of future behavior, and there's no better way to align management and shareholders' interests than by having management own a meaningful amount of stock. It doesn't necessarily have to be a certain percentage of the company (say, greater than 10%) but it does need to be a significant portion of top management's net worth” (Interview, Matthew Richey).

CEO Harold McGraw owns over $75 million worth of stock in the company, though his net-worth in unsure to the author; $75 million is a sufficient amount of money to compel him to have his interests aligned with shareholders (Major Holders, MHP).

Valuation

Hedge Fund Manager Mohnish Pabrai has written about two valuation methods he has used. In a 2001 article he wrote about ‘Intrinsic Value’ (Mosaic, 114) and in a 2007 interview said, “If there is growth, depending on how much and how consistent, I’d be willing to value [the company] at 12-15x [cash flow] plus excess capital” (GuruFocus.com, 10 Questions to Mohnish Pabrai).

His second and more recent method is quicker and more efficient than the first. According to hedge fund analyst Joe Koster, Excess Capital = Book Value – Fixed Assets – Goodwill – Working Capital Needed for Operations (2% of Sales) (Interview, Joe Koster). Using this formula McGraw-Hill has -$1,559,920 in excess capital (10k, Item 8) and $1,419,100 in cash flow (10k, Item 8) this gives a value per share of $55.10.

In his book Pabrai explained intrinsic value: “Any business is worth the sum of free cash flow it will generate from now to eternity, discounted to present value using a reasonable risk-free interest rate” (Mosaic, 115).

In the Intrinsic Value calculation growth of 10% is predicted for the first five years, which is inline with analyst estimates (Analyst Estimates, MHP), the growth is then predicted to slow to eight percent for the next two years, then to five percent for the final three. In the article Pabrai used 10% as a discount rate for Microsoft (Mosaic, 115); this number is also used for McGraw-Hill. In line with the past nine years, negative one percent growth is assumed for the share count (Morningstar, 10 yr. Income Statement). The value according to this model is $72.82.

Another valuation method, created by analyst Hewitt Heiserman, is called the ‘Croesus Test’ the test, “Tells us the earnings growth rate needed to support our minimum required rate of return” (It’s Earnings That Count, 173). In the method one uses his desired rate of return along with a predicted earnings multiple and the company’s dividend yield to find what earnings growth rate is required to earn the desired rate of return (It’s Earnings That Count, 171).

With this method I tested four different possible situations:

· First, a 36% Compound Annual Growth Rate for two years and an estimated ending P/E of 15x was used. According to the model earnings would need to grow 9.4% to achieve this, which is below the assumptions used previously.

· The next test looked for 18% annual returns for five years with an ending P/E of 16x. For the next five years earnings would need to grow 5% per year which is well below the earlier assumptions.

· A long-term view was taken next with 15% annual returns over ten years required and an ending P/E of 15x applied. The model says 7.74% growth is needed, while below the estimates it is cutting it pretty close.

· Finally, the model was reversed to find what the multiple would need be for the stock to increase 25% in one year with negligible earnings growth. According to the model the multiple would need to increase form the current 10.2x to 12.4x to produce a 25% return.

The final step in the valuation process is to find if the stock has a margin of safety. In The Intelligent Investor Benjamin Graham wrote, “Confronted with the challenge to distill sound investing into three words, we venture the motto: MARGIN OF SAFETY” (The Intelligent Investor, 512). Rich Rockwood wrote, “Focus investors invest in companies only at a price below the company’s true worth… this provides a cushion or Margin of Safety in case the company’s price declines” (The Focus Investor, 15).

McGraw-Hill’s current price provides a 42% Margin of Safety using Pabrai’s Intrinsic Value method, and the Croesus test provided earnings growth rates which were all below the growth predictions.

Different investors look for different margins of safety, Pabrai wants 40-50% (Mosaic, 118), but Pat Dorsey said, “Because all stocks aren’t created equal, not all margins of safety [required] should be the same” (Five Rules, 152). Dorsey than said that Morningstar usually requires a 30-40% margin of safety before buying a stock. Using these two methods McGraw-Hill looks like it is currently trading low enough to provide a significant margin of safety.

Conclusion

This report set out to find whether McGraw-Hill had sustainable competitive advantages, capable management and if it was trading for a cheap price. According to the analysis there are no red flags when analyzing its management it has a wide moat and is currently trading for a cheap price.

Works Cited

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Greenblatt, Joel. Magic Formula Investing. 1st. USA: Wiley, 2005.

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Dorsey, Pat. The Five Rules of Successful Stock Investing. 1st. USA: Wiley, 2004.

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Sellers, Mark. "Moat Control." Value Investor Insight 5(2005): 10-18.

"Officers & Directors Detail." Reuters. 10 Jan 2008 <http://stocks.us.reuters.com/stocks/OfficersDirectorsDetails.asp?rpc=66&symbol=MHP&officerID=29388>.

"About Us." Ernst & Young. 10 Jan 2008 <http://www.ey.com/global/content.nsf/International/About_EY>.

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Pabrai, Mohnish. Mosaic. 2nd. Grammer Buff, 2004.

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