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Written By JAMES ESLER

Just a quick word for you while you get through your Tuesday.

 
This week is essentially the final week of the 2nd quarter (fiscal) earnings season. The results of the season have been spectacular, to say the least leading to both good news and bad news. 
 
Good news first – all major indices have increased ffrom beginning of July to today (August 14). While the indices finished up, there was an incredible amount of political background noise threatening gains (USA vs. everyone else). The noise produced volatility, but again, earnings stole the thunder.
 
Bad news – there will be no earnings to hide behind in coming months. I expect POTUS to intensify trade wars, but your guess is as good as mine (I have no chance of being correct when it comes to politics). Whatever the result, there will likely be a large amount of volatility. As Harry Truman once said – If you can’t take the heat, get out of the kitchen. Next week we walk into the kitchen. There is no chance of our firm knowing the effects of USA vs. everyone else, so we are staying invested for the long term.
 
We are positioning the portfolio more in favor of value companies at this time – lots of tangible book value. We believe our ideas will stay buoyant in a down market and rise with a lifting tide. We also like companies with net liability exposure in the face of rising rates, but again the companies must meet certain strength tests.
 
As an aside, many of my colleagues have asked that I detail what gives a company intrinsic value. There are many ways to conceptualize intrinsic value, however I feel the best way is via the equity method of accounting for M&A. When a parent company (ie investment firm) buys into a subsidiary (ie common stock), the balance sheet records ‘investment in associate’ line item. This line item is a combination of tangible book value and goodwill. Therefore, when you buy one share in a company, you are buying the tangibel BV per share and any excess is goodwill. The goodwill is reduced over time in exchange for tangible book ultimately by the addition of earnings. Dividends are considered a return on capital and will reduce the amount of goodwill just the same. The price to earnings ratio is therefore a key figure since it gives you an idea of how long it will take for your investment to turn positive. Once goodwill is fully reduced, the earnings you receive support your own bottom line. Ideally, the company will trade for less than the price of the tangible book value and still have good earnings potential. This leads to the term, “undervalued”. Where there is goodwill, there is [absolute] “overvalue”. 
If a company sells for below book value, investors expect it to lose business and impair many of its assets. If an investor believes the company will be profitable consistently and long term, the company below book value is trading below its natural price.
 
The big question, then, is how reliable are the earnings? What offerings do the competitors that could ruin earnings? Is management deploying capital incorrectly (through poor M&A, overcompensated executives, etc) and getting in the way? If there is risk of profit deterioration, what is the maximum amount of such deterioration? Enough on that.
 
This morning I received word that I passed the rigorous CFA Level 2 examination. I attribute this to the man upstairs and lady luck… Game theory tells that in the presence of intense competition, luck is the primary way you get the edge. Let’s hope the hot hand continues.
 
The results affect clients in two ways. First, and most importantly, I will be studying nights and weekends from February 1, 2019 until May 15, 2019. I anticipate taking off significant time from the normal work week from May 15th until the Level 3 exam date Saturday, June 15, 2019. Ultimately, I can virtually guarantee that this time spent will have the largest ROI for all current and prospective clients. I encourage you to look at articles about the CFA is and why it’s important. 
 
Secondly, I have joined the CFA society (San Diego chapter). I expect this to be overall accretive to our firm due to new ideas, perspectives, and marketing potential. I do not plan to sacrifice any time from normal working hours – this will be completely extracurricular (read: no conflicts of interest).

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