The Doppler Value Portfolio

The Doppler Value Model Portfolio is my simulated portfolio. The rules are as follows:
1. The initial portfolio consists of $100,000 in cash and begins on May 8th, 2008.
2. In the interest of simplicity, the model portfolio is NOT subject to taxes, much like an IRA account. An identical taxable account will fare worse, but the low turnover will minimize the difference between the after-tax and pre-tax performance when compared to investment strategies that involve higher turnover.
3. Sales and purchases of stocks will take place at the close of trading at least one COMPLETE calendar day after I announce the transaction. So if I announce a trade on a Tuesday, the trade takes place at the closing price on Wednesday. If I announce a trade on a Friday or over the weekend, the trade takes place at the closing price the following Monday. If I announce a trade on a holiday, the trade takes place at the closing price the next day that the market is open.
4. The commission for all stock trades will be 4 cents per share or $40, whichever is greater. I know that there are many brokerage firms with cheaper commissions, but I’m making some conservative assumptions to balance out my aggressive consumptions elsewhere in these rules.
5. The cash balance is invested in the Doppler Value Treasury Money Market Fund, a hypothetical money market fund that invests exclusively in US Treasury Bills. It is assumed that half of the portfolio consists of 1-month Treasury Bills purchased the previous month and the other half of the portfolio consists of 3-month Treasury Bills purchased two months before that. The Doppler Value Money Market Fund yield for the current month will be the average of these yields minus a .3% expense ratio. Since 1-month Treasury Bills in April 2008 averaged 1.072% and 3-month Treasury Bills in February 2008 averaged 2.174%, the yield for May 2008 is 1.323%. On average, the fictional Doppler Value Treasury Money Market Fund will yield roughly the same as the real Vanguard Treasury Money Market Fund. However, these two yields may be substantially different at times if interest rates are rising or falling, especially if the Vanguard fund has a longer or shorter average maturity.
6. Interest accrues daily but is credited monthly. Accrued but uncredited interest does NOT earn interest.
7. Purchases of CDs will take place at the end of the day 1 week following my announcement.
8. Cash dividends are NOT reinvested but added to the cash balance.

Introducing the Doppler Value Investing Blog

Doppler Value Investing is a blog dedicated to value investing in the quantitative tradition of Benjamin Graham and David Dodd but also in the qualitative tradition of Warren Buffett and Charlie Munger. Just as Doppler radar is an improvement over the older conventional radar systems in observing thunderstorms and detecting tornadoes, Doppler Value Investing (with free cash flow and net liquidity) is an improvement over conventional value investing (with earnings, book value, and dividends).

Conventional radar systems can only show precipitation intensity while Doppler radar systems can show precipitation intensity AND the velocity of precipitation towards or away from the radar. Before Doppler radar was available, the tornado warning system was much less reliable. Most of the time, tornado warnings were not issued until one was spotted on the ground. This was especially problematic if the tornado took place at night or was surrounded by rain. The only sign of a tornado on radar was a hook-shaped echo, the result of precipitation-bearing clouds rotating around the center of the thunderstorm’s wind circulation. Usually, the hook echo did not appear until after the tornado was on the ground, because it takes several minutes for the vortex to blow the precipitation-bearing clouds around.

Because Doppler radar systems can show the velocity of precipitation towards or away from the radar, they can detect tornadic circulations much sooner and usually before the tornadic winds reach the ground. The tornado vortex signature consists of two adjacent pixels, one showing a very high velocity towards the radar and one showing a very high velocity away from the radar. This tornado vortex signature will usually appear several minutes before the tornado touches the ground and thus provides valuable lead time to get the warnings out so people can take shelter.

Just as conventional radar is a crude tool for detecting tornadoes, conventional value investing (with appraisals based on earnings, book value, or dividends) is a crude way to find bargain stocks, especially at a time when computers and online databases make it easy for anyone to find the low multiple stocks. Conventional value investing does not distinguish between conservative vs. aggressive accounting practices, liquid vs. illiquid assets, capital-intensive vs. non-capital-intensive businesses, leveraged vs. nonleveraged, or franchise businesses vs. commodity businesses. Some industries also tend to have higher multiples than others over time. Because the managements in industries with poor economic characteristics have the greatest incentive to demand the most aggressive accounting practices, conventional value investing can lead you to fake bargains – stocks of companies with earnings and assets of questionable quality.

Doppler value investing, which is based on free cash flow and net liquidity, takes into account the basic things that conventional value investing overlooks. The plant/property/equipment at cost (PPE) is used as the base of capital instead of equity or total assets. Free cash flow is used as a substitute for earnings. Net liquidity (liquid assets minus all liabilities) is used to take into account how leveraged or unleveraged a company is. Good businesses generate a substantial amount of free cash flow for a given amount of PPE while poor businesses generate very little free cash flow for a given amount of PPE or even negative free cash flow. Companies with conservative accounting have a more free cash flow than earnings while companies with aggressive accounting have substantially less free cash flow than earnings. Dying companies that use aggressive accounting practices to look good do not look attractive with Doppler Value Investing, because their liquid assets are dwarfed by the total liabilities even as illiquid assets are appraised generously on the balance sheet. Thus, using Doppler Value Investing will help you to steer towards the next See’s Candy and away from the Yugo stocks.