(To have your question answered on the blog, email Geoff.)
Someone who reads the blog emailed me this question:
“Buffett has Munger, and you have Quan. It seems like in this industry, a collaboration of minds can be a potent formula for long-term success if approached correctly. That said, how would you recommend investors/ aspiring portfolio managers to find a suitable partner who not only is able to shine light on your blind spots, but who can also be of one mind and culture?”
It's a huge help to have someone to talk stocks with. But, I’m not sure it’s a help in quite the way people think it is. I think people believe that Buffett is less likely to make a big mistake if he has Munger to talk to, that I’m less likely to make a big mistake if I have Quan to talk to, and so on. I’m not sure that’s true. I know from my experience working with Quan that our thinking was more similar than subscribers thought. For example, one question I got a lot was who picked which stock. And that’s a hard question for me to answer. Some of that might be the exact process we used. I can describe that process a bit here.
When I was writing the newsletter with Quan, we had a stock discussion via instant messaging on Skype. We did this every week. The session lasted anywhere from maybe 2 hours at the very shortest to maybe 8 hours at the very longest. A normal session was 4-5 hours. So, we were talking for let’s say 4 hours a week about stocks. We weren’t talking about stocks we had already decided on. Instead we were just throwing out ideas for stocks we could put on a “watch list” of sorts. We called it our candidates pipeline. It was really a top ten list. So, instead of saying “yes” or “no” to a stock – what we did is rank that stock. We always had the stock Quan was currently writing notes on, the stock I was currently writing an issue on, and then 10 other stocks. In almost every case, once I started writing an issue – that issue did end up going to print. In most (but not all) cases, whenever Quan started writing notes on a stock – that stock eventually became an issue. But, there were probably 3 to 5 times that he started writing notes on a stock and yet we didn’t publish an issue on that stock. This was rare. Most stocks we thought about but eliminated were eliminated in the “top ten” stage.
So, we’d have a list of ten stocks that we weren’t yet doing but that we planned – if nothing better came along – to work on next. Let’s make up a list here. Let’s pretend #1 is Howden Joinery, #2 is UMB Financial, #3 is Cheesecake Factory (CAKE), #4 is Kroger (KR), #5 is Transcat (TRNS), and #6 is ATN International (ATNI). It would go on like this for 10 stocks. A lot of times there were stocks on there that we didn’t really love – but we had this rule that we had to always keep 10 stocks on the board. This kept us from ever saying an idea just wasn’t good enough. We were trying to do an issue a month – so the answer was that if it’s better than every other idea we have right now, it should be the next issue. This way of working – by making our next best idea the hurdle – was very helpful. Each week, as we’d talk, we’d move stocks up or down. So, maybe I would say that I had been reading about Cheesecake (since it’s number 3 on our hypothetical list) and I decided that its future growth prospects in terms of the number of sites it could open is just not high enough to justify its P/E. It might be fairly valued. But, it’s unlikely to be undervalued. So, I wanted to move it down the list. Well, instead of just moving it down the list – I had to say where I wanted to move it and what I wanted to move up in its place. In other words, I’d have to explain to Quan why I thought Cheesecake was a less attractive stock than Kroger, Transcat, and ATN International. Otherwise, the stock would stay where it was.
I’m sure that if each of us had done separate newsletters, we would have ended up with a different set of stocks than Singular Diligence covered. But, it’s not like Quan and I disagreed much on which stocks to do. I think we tended to be furthest apart in the earliest stages of considering stocks. Early on, we weren’t going to do any financial stocks. But, independently, Quan and I had kept looking at Progressive (PGR). This was an obvious choice for the newsletter. GEICO and Progressive are similar. Over the years, they’ve become even more similar. Progressive has a very long history of excellent stock returns (something we always looked at). Some value investors own it. I think it had been consistently buying back stock and it may even have been within spitting distance of a 5-year low when Quan and I first talked about the stock. Things like a continuously declining share count (“cannibals” as Munger calls them) and a 5-year low (we don’t look at 52-week lows – but we are interested in when a company seems to have gotten better while its share price has gone nowhere) would have attracted us to the stock. So, either I brought Progressive up to Quan or Quan brought Progressive up to me. And the other one said he’d already looked at the stock. And neither of us was sure at first whether we’d do it. It’s not that we didn’t like Progressive. We just weren’t sure we ever wanted to do an insurer. We had done HomeServe (a U.K. stock). But, the actual insurance aspect of HomeServe – the risks it takes – is extremely minor when compared to something like Progressive. Progressive is a true financial stock. It is taking tremendous underwriting risk. In fact, you won’t find many insurers that write more in premiums (and expect to cover more in losses) relative to their shareholder’s equity than Progressive. If Progressive suddenly had a combined ratio of 110 for 2-3 years in a row – the company would be insolvent. On the other hand, if Progressive had low equity levels and then had 2-3 years of its usual – very good – underwriting profit, it could quickly re-build an insufficient capital level to an overcapitalized position. Progressive takes very little investment risk. But, it takes huge underwriting risk. Premiums are very high relative to equity. It can – if it misprices its policies – wipe out a good chunk of its shareholder’s equity in a single year.
So, Quan and I thought about Progressive a lot. Did we really want to break the seal on financial stocks? Once we did Progressive, other financial ideas might start appearing on our top 10 list. I mean, if we can do Progressive – why not Wells Fargo?
And that’s exactly what happened. We saw how much Progressive was hurting because of low interest rates. I described it as “flying on one engine” because Progressive usually made profits on both investments and underwriting. But, the stock’s current P/E only reflected the underwriting profit. It had way more float than it had ten years ago – yet it wasn’t earning more investment profit than it had 10 years ago. If that was true of Progressive – it was probably true of some banks too. There had to be banks that had twice as much in deposits today as they did before the financial crisis – and yet they weren’t earning a penny more in income than they had before the crisis. The stock I’m describing here is Frost (CFR). I had mentioned it to Quan several times. But, we weren’t doing financial stocks. It’s just not something we ever planned to do. And so, whenever I mentioned Frost – Quan wouldn’t say there was anything wrong with Frost. He just said we weren’t doing financials. But then we had done Progressive. So, now we were doing financials. So, it was time to look at banks.
Warren Buffett has said something like – I’m paraphrasing here: the best investments are the ones where the numbers almost tell you not to invest, because then you are so sure of the underlying business.
I don’t think he is talking about numbers specifically when he says that. I don’t think that statement is an argument against value investing. It’s an argument against prejudice. So, Warren Buffett is – at heart – a value investor. He is going to make the mistake of passing on a great business because it trades at too high a P/E ratio more often than he’s going to make the mistake of buying a great business at too high a price. Well, we each have our own biases. I certainly have that same value bias that Buffett has. I have missed out on some stocks I should have bought because they were trading at an above average P/E ratio, EV/EBITDA ratio, etc. They looked expensive by all the usual metrics. I also have a bias against financials stocks. So does Quan. So, it took a lot for us to move in that direction. We didn’t do it for just any insurance company – we did it for Progressive. And then when we moved into banks, we didn’t just pick any bank – we picked Frost (CFR). Progressive is a much better business than almost any other insurer. Frost is a much better business than almost any other bank.
It's interesting to talk about how we moved into doing banks at all. It took a lot of time. What happened was Quan had to do some research into the industry. He needed to gather information on a lot of banks and create some Excel sheets we couldn’t find ready made elsewhere. There were two reasons for this. One, we needed long-term data on the industry to prove that something like the 2008 financial crisis wasn’t more common than we thought. And, two, we needed many banks to draw from for potential picks. It was especially hard to come up with good banks. We thought we’d find a ton of them. If we’d been looking for banks that were cheap enough – value stocks – we might have found plenty. There are thousands of banks in the U.S. But, they aren’t equally attractive. Small banks don’t have the economies of scale of big banks. They tend to have higher expenses as a percent of their total earning assets. They also don’t have equally attractive deposit bases. I know the three banks I was most interested in from the start were: Frost (CFR), Bank of Hawaii (BOH), and Wells Fargo (WFC) because I was most comfortable with their deposit bases. We never did an issue on Wells. Quan looked at it for a very long time. I can’t think of another time where we talked so much about a stock we didn’t do. But, we did do issues on Frost and Bank of Hawaii.
We also did issues on Prosperity, BOK Financial, and Commerce (CBSH). We found those stocks as peers. Frost’s most natural peer in Texas is Prosperity. It’s the second largest bank in Texas. And then Frost’s closest peer in energy lending is BOK Financial. Commerce would have shown up as a peer of BOK Financial. And we were going to do an issue on UMB Financial. UMB is controlled by different descendants (I guess they’re cousins) of the founder of Commerce. So, members of the “Kemper” family control both Commerce and UMB. However, the lines of succession split off almost a century ago, so these people are not closely related even though the banks share the same founder and are both controlled by Kempers.
So, what can this tell you about working with an investing partner? Quan and I both had a bias against financial stocks. It may have taken us even longer than it would have if we were investing on our own to branch out into these stocks. Would I have written about Frost sooner if Quan hadn’t been so reluctant to do banks? Maybe. But, I certainly wouldn’t have done issues on Prosperity, BOK Financial, and Commerce without Quan. Those were much more his picks than mine. Without Quan, I might have eventually done issues on both Frost and Bank of Hawaii. I don’t know about Wells Fargo. Wells is a tricky idea to discuss. Quan and I both like the stock a lot. We thought – even at the time we were looking at the stock – that it was one of the cheapest banks we’d looked at on a normalized basis. And yet we didn’t do it. Quan was more insistent than me that we not do it. But, I’m not sure I’d do Wells if I’d been writing the newsletter on my own. I know I would have written about Frost first, Bank of Hawaii second, and Wells – if I ever decided to write about Wells – third. I was more comfortable with both Frost and BOH than Wells. Quan was more comfortable with all the banks we did than with Wells.
There are sometimes slight differences between Quan’s preferences and mine. For example, I told some subscribers who asked about it that Quan probably likes Prosperity (PB) a bit more than I do and I probably like Bank of Hawaii (BOH) a bit more than Quan does. But I like Prosperity fine. And Quan likes BOH fine. Maybe this reflects a difference that Quan is a little more comfortable with a long-term strategy of serial acquisitions and I’m a little more comfortable with a long-term strategy of continual stock buybacks. Prosperity is unusual in how many acquisitions it does. BOH is unusual in how much stock it buys back.
There’s a chance I would’ve done Wells if Quan wasn’t co-writing the newsletter. There’s a chance I would’ve done ATN International (ATNI) if Quan wasn’t co-writing the newsletter. I think ATNI is more likely than Wells. But, in most cases where we eliminated a stock – it was unanimous.
I’ll give just two examples. Two stocks we liked a lot – and thought were “good” bets in some sense – but eliminated from consideration were Western Union (WU) and Wells Fargo (WFC). However, we were pretty much in agreement that Wells was too difficult to understand and that we didn’t like the management at Western Union. If one person had each of these “hunches” alone – would they have ignored it? Maybe. So, maybe analyzing stocks in pairs helps build your confidence more than it helps you avoid your blind spots.
(To have your question answered on the blog, email Geoff.)
Someone who reads the blog emailed me this question:
“GuruFocus provides data on predictability of a business. Do you like this metric? Do you use this metric in your analysis? It seems to me that the more predictable a company’s historic earnings, the easier it should be to calculate the intrinsic value of the company. Do you agree with this assessment?
The problem with this for value investors is predictable businesses tend to not get nearly as mispriced (at least highly followed large cap stocks).”
I do use predictability in a general sense. I don’t want to talk about GuruFocus’s measure of predictability specifically – because GuruFocus publishes some of the stuff I write. So, I’m biased. If I say something good about a GuruFocus feature – you won’t believe me. And I wouldn’t want to say something bad because they’re kind enough to publish my writing. I’ll just say that “predictability” is a good measure to look at. And that is what the GuruFocus predictability rank is trying to do. So, it’s trying to do a good thing. And you’re not going to come to any harm by looking at it. And you might get something positive out of looking at GuruFocus’s predictability score for a company. So, yes, I like the metric of predictability.
Now, what do I use personally? I enter a company’s financial data into Excel myself. I’ll look at the data at places like GuruFocus. But, I want to go to the historical 10-Ks and pull the numbers out myself and adjust them as I see fit. This is to get comfortable with the numbers. There’s a difference between when you are relying on something a computer has done and when you are doing the data entry yourself. So, I set up an Excel sheet with 15 years or 20 years or 30 years of financial data. I prefer 30 years where 30 years of data exists. I also like to read the very oldest and very newest annual report from the company. Sometimes I read other specific past annual reports (like the 2008 financial crisis year) that were unusual for the company, the industry, or the country it operates in.
One thing I have Excel calculate is the variation in EBIT margin. So, if you have say 30 years of financial data for EBIT, and the EBIT margin is positive in every single year – you’ll be able to calculate both the standard deviation and the (arithmetic) mean in the series. Excel can give you other types of averages too. It does geometric and harmonic means which investors use rarely. But something like the harmonic mean is actually a useful measure for the very long-term return on capital, because as a rule – a company’s compounding in its intrinsic value will not be less than the long-term harmonic mean of its return on capital. It could – especially if it’s in a very cyclical industry – be much lower than the arithmetic mean. I bring this up because it’s sort of related to “predictability”. Investors don’t pay much attention – except to “recency” – to the order a company’s results come in. But, the order of results is important for things like compounding. It’s not important if the variation in ROC is close to the mean. Let’s say I’m looking at ROC and I have a 30-year series of ROC figures with – Minimum: 10%, Maximum: 20%, Median: 15%, Mean: 15%, Standard Deviation: 5%. That’s a very predictable company. The median and mean are the same. We can scale the standard deviation to the mean (5% / 15% = 0.33). Variation of 0.33 in ROC is low. Not many companies have such low variation in ROC.
I use the same calculations I just showed you for the company’s ROC history and apply it to the company’s EBIT margin history. I like to look at both return on sales (EBIT/Sales) and return on capital (EBIT/Net Tangible Assets). When you are buying into a company – you must remember that earnings aren’t actually that stable. As a rule, things like assets and sales are going to vary less than earnings. That’s as a rule. It’s not totally true. There are cases where a company has several good business units and one money-losing or breakeven business it’s just running as a legacy. In that case, it could dispose of a lot of assets and eliminate a lot of sales and yet not make much of a dent in earnings. But, if we’re talking about the core business – the good business – a change in assets or sales from year to year is going to be smaller than a change in earnings.
Let’s talk about the danger of using the two ratios value investors mention most: P/E and P/B. Earnings are volatile. So, P/E isn’t a good measure. And then P/B is a net number. Book value – or tangible book value (you should always be using tangible numbers for equity and assets) – is net of the liability situation. So, it’s a heavily leveraged number. When a company has low liabilities, P/B could be a pretty stable and solid indicator because it’s basically like Price/Tangible Assets. But, in cases where the company has an “iceberg” type balance sheet where it has $100 a share in assets and $90 a share in liabilities and a stock price of $8 a share – yes, it’s selling for a price-to-book ratio of 0.8. But, an 11% decrease in assets would wipe out all of the company’s equity. You see the problem. If we look at things like sales and assets – those are much more stable.
I also do something else people think is really weird. I look at gross profit. Gross profitability is an important number for me. When I say gross profitability, I mean Gross Profits / Tangible Assets. So, it’s possible a supermarket – which tends to have a ton of operating leverage, it’s a high unit volume business – could have a 120% gross return on assets (Gross Profit/Total Assets = 1.2) and yet it only has a 20% pre-tax net return on assets (EBIT/Total Assets = 0.2). That can actually happen with a supermarket. So, why does gross profit matter? It has to do with things like scale, business organization, who is running the company at the top, how much are they getting paid. Things like that. For example, Village Supermarket (VLGEA) is a relatively small (by number of stores) Shop-Rite operator in New Jersey. It is run by members of the family that control the company’s stock. They are well compensated. It’s possible that there are years where the company makes say $30 million in EBIT and yet pays $5 million to top executives of a company with only about 30 stores. Now, if another New Jersey Shop-Rite operator (Wakefern co-op member) acquires Village, it’s not going to pay management $5 million a year to run 30 supermarkets. I’m not sure it’s even going to pay a combined $1 million to however many people you have running a 30-store operation. An acquirer already has general counsel, a CFO, a CEO, a COO, a board, etc. So, there’s $5 million right there that can be severely trimmed. And I don’t know how lean Village runs its head office, its IT, etc. I can better judge the stores. So, collecting data on the store level – and the gross profit level – is more useful. I’m not sure that high gross profitability is ever a “green flag”. But low gross profitability absolutely is a “red flag”. Companies talk about synergies all the time. They talk about plans to turn a business around and improve margins and so on. Sometimes these plans are realistic – sometimes they aren’t. But, I’ll tell you right now – they’re a lot more realistic if they plan to increase operating profit relative to gross profit. They are a lot less realistic if they think they are going to raise gross profit as a percent of total assets or total sales. If you have 10 firms in an industry with a combined $10 billion of assets and $2 billion of gross profit – that’s a bad industry. And it’s likely to be a bad industry even if you consolidate down to just 8 firms, 6 firms, or even 4 firms. The economics of that business have something severely wrong with them. The ratio of just 20 cents of gross profit for every 1 dollar of assets in service is simply unacceptable.
What does this have to do with predictability? It’s easy to predict an industry like that will have long-term problems it can’t fix. On the flip side, if you have a company with good gross profitability year after year for decades and yet net profitability is only now looking good – that’s something you might want to buy. The reason for this is that when we’re talking about predictability – we’re talking about persistency. How durable are sales, assets, gross profits, net income, book value, etc. Things like sales per share, assets per share, and gross profits per share are more persistent and more predictable from year to year. Now, some investors are going to say: so what? As an investor, you make money from free cash flow. Free cash flow is usually somewhat approximated by net income (it can be a very approximate relationship) and so the P/E ratio is telling you what kind of dividends and share buybacks a company can give you. That’s why a P/E ratio can tell you what kind of returns to expect in the future. I’d agree with that line of logic if you applied it to an entire nationwide market. If we’re talking the S&P 500. Then yes. First of all, the P/E ratio still doesn’t matter. But a normalized P/E – like the Shiller P/E does matter. But that’s because we know the quality of the S&P 500. It doesn’t get better or worse. It’s too generic a mix of businesses to be worth buying on anything but price.
A company can be worth buying for its predictability though. Some industries have more persistent profits than others. When I was writing my newsletter, Quan (my co-writer) and I gave every single stock we looked at an industry category code. So, we’d code an ad agency like Omnicom as “business services” and a fast food joint like Greggs as “restaurant” and a helicopter hoist maker like Breeze-Eastern as “capital goods”. You can find research on the relative persistency of profits in industries like business services, restaurants, and capital goods. Generally speaking, the lower your customer retention, the lower the purchase frequency, and the further you are from the end consumer – the worse the persistency of your profitability is. Now, this isn’t always true. Market structure matters too. Breeze-Eastern was a duopolist with a 50% or higher share of search and rescue helicopter hoists. It was serving an oligopoly (about 5-6 helicopter makers). As a rule, a duopoly that serves an oligopoly is going to have highly persistent profits compared to some other market structures. For example, the beverage can manufacturing business has persistent profits. In a given market, you generally have like 3 companies: Crown (CCK), Ball (BLL), and someone else serving a small number of customers (Coke, Pepsi, Coors, etc.). There’s probably a huge market for smaller plants serving smaller customers. But the biggest customers need someone who can do huge volumes at one plant. So, you have only a small number of customers who need huge volumes at a single plant and only a small number of competitors who are willing to produce huge volumes at a single plant for a single customer. So, you have persistency in that kind of business. I think BWX Technologies (BWXT) should have persistent profits. It’s the monopoly provider of all but one (Curtis-Wright makes the one) nuclear components for reactors in U.S. Navy submarines and aircraft carriers. It also has a monopoly position in uranium down blending and some other stuff related to the U.S. nuclear weapon program. I think it’s persistent because I don’t think the U.S. Navy will – within the next few decades at least – want to stop producing nuclear powered submarines or aircraft carriers and I don’t think they can possibly choose any other provider besides Babcock for what they need. So, Babcock has a monopoly position.
The best kind of persistence comes from high customer retention. I like the ad agency business, the auto insurance business (although I’m convinced driverless cars will obsolete this business over the next few decades), and banks because the customer retention rates for an ad agency can be 95%, for a bank they can be 90%, and for an insurer they can be 80%. If ad agencies, banks, and insurers didn’t retain the same clients – if they had to market aggressively to win new business, I’d have no interest in them. The lack of price competition to retain customers is what attracts me to this business. Now, there is very intense price competition in insurance – especially to win a new customer. In fact, auto insurers lose money on new customers at first because they spend so much on marketing. Once they have a customer though, retention rates are high. There are people who have been renewing with the same insurer for 25-50 years. Ad agencies are even better. There are tons of big brands that have been with the same creative agency for more than 25-50 years. A couple have been with the same agency for 100 years.
So, yes. I do look for predictable companies. I look at long-term variation (standard deviation / mean) in return on capital and EBIT margin. GuruFocus also has predictability rankings. You can use those too. Think a lot about how persistent profits tend to be in each kind of industry. Know that EBIT margins at a restaurant are a lot more predictable than EBIT margins at a capital goods company. And remember that things like assets and sales are more persistent than earnings. Gross profit is also more persistent than net profit. So, start by looking at long-term trends in sales, assets, and gross profit. For example, has asset growth been consistent? Or has it been accelerating in recent years? Try not to buy into a company that is growing its assets more rapidly than everything else. High asset growth right now is usually a bad sign for ROA in future years. Growing profits faster than assets in recent years is usually a better sign.
I’d focus on persistence on measures like ROC and margins rather than growth itself. Consistent growth is good. But, a 7% annual growth rate that is consistent and accompanied by a high ROE is all you need. You don’t need 12% annual growth. What you need is consistent growth accompanied by a high ROE.
(To have your question answered on the blog, email Geoff.)
Someone who reads the blog emailed me this question:
“If one was a widely-read value investor but only had 5-10hrs per week to spend on investing (due to employment / family constraints) and one had less than $1m, would you recommend a classic Graham net-net portfolio as the surest and best way to make market beating returns? If no, what other strategy (apart from indexing) would you recommend under these time constraints?"
I’m going to rephrase this question as “If one only had an hour a day to spend on investing”. You said 5 to 10 hours. I’m going to ask you to spend 5-7 hours a week on investing. But it must be an hour a day – every day – instead of five hours all at once. There’s a reason for this. I want you 100% focused when you are working on investing. You don’t have to spend a lot of time on investing. But you do need to be focused when you are doing it. Most people who invest are never fully focused for even an hour on a narrowly defined task. So, that is what I need from you. An hour a day of total focus. If you can’t do it every day – then don’t do it at all on weekends. Just spend an hour a day on Monday through Friday. But never skip a day. Okay. Let’s say you’re willing to make that commitment. Then what?
The approach for you to use is not a net-net approach. It’s a focused approach. A concentrated approach. You don’t have a lot of time. So, you need to spend that time focused on what matters most. Stock selection is what matters most. So, first I want you to give up the idea of selling stocks. Don’t worry about it. You’re only going to sell one stock to buy another stock. You’re not going to sell a stock because it is now too expensive, the situation has played out, etc. Okay. So, we’ve cut out about half the time investors spend thinking about stocks. You can now devote all the time you would have spent thinking about selling the stock you already own and instead double the time you will spend thinking of the next stock to buy. I also want to eliminate the idea of portfolio management – asset allocation, diversification, etc. – from your schedule. So, I’m going to ask you to commit to identically sized positions. By this I mean the positions will be the same size when you buy them. So, if you are comfortable being as concentrated as I am – then you’ll want to set 20% as your position size. You’ll own just 5 stocks. If you want to be more diversified – you can settle on owning 10 stocks at a time. That’s fine. But I don’t want you to have some 5% positions and some 20% positions. If you are going to own 10 stocks at a time – make every position a 10% position. If you want to be really, really diversified – you can own 20 stocks at one time. In that case, every time you buy a stock – you put 5% of your portfolio into the stock. There’s no point owning more than 20 stocks. It doesn’t do much to diversify any risks. And it does distract you from what matters most – deciding which stock to buy next. So, start out by making that decision now. Do you want to own 5 stocks, 10 stocks, or 20 stocks? Do you want to put 20% into each stock, 10% into each stock, or 5% into each stock? Make that decision now. And then that rule is set in stone for you. Never vary how much you put into a specific stock. This will keep you from being distracted by concerns about how much you like a stock – how much you “should” allocate to it. The answer is that you should allocate the same amount as you always do to every stock you like. Now, you can focus 100% on finding stocks to buy.
The next thing you need to do – if you only have an hour a day to spend on investing – is to commit to holding stocks for as long as possible. This is critical. I was talking to someone recently who considers himself a buy and hold investor. And yet he found that over the last year – when he was pretty happy with his portfolio – he still had portfolio turnover of about 30%. That means, on average, he was holding stocks for only about 3 years. And he probably had years – years where in January he liked the stocks in his portfolio less – where his turnover was more than 30%. Let’s think about the difference between owning stocks for an average of 2 years – as even many value investors do – and owning stocks for an average of 5 years. I want you to try to get closer to the 5-year holding period. Why?
The three choices I gave for diversification were a portfolio of 5 evenly weighted positions, 10 evenly weighted positions, or 20 evenly weighted positions. The ideal situation in terms of focused attention is a 5-stock portfolio and a 5-year holding period. That’s because this is a low maintenance portfolio. The “maintenance” level of idea replenishment is just one great idea per year. You have an hour a day to spend on investing. If you spend that every day – including weekends – that means you have 365 hours to spend picking just one stock. Coming up with one good idea for every 365 hours you spend looking for one sounds easy, right? Even if you don’t work on investing on the weekends – it’ll still be 260 hours of thought to come up with just one idea. Now, what if you own 10 stocks and hold them each for 5 years? Then your idea replenishment rate has to be 10 stocks / 5 years = 2 stocks a year. If you’re only spending 260 hours a year on investing – we’re down to 130 hours spent coming up with one idea. At 20 stocks / 5 year holding period it’s 4 stocks a year. And that’s only 65 hours of thinking per idea. Think of the worst-case scenario here: a portfolio of 20 stocks that you only hold on average for 2 years. Some investors do invest that way. How can they? You’re still committing to just 260 hours of focused thought on investing. But now your replenishment rate is 20 stocks divided by a 2-hour holding period equals 10 stocks. You’d need 10 new stock ideas this year. You only have 260 hours to spend thinking about investing this year. So, you’d have to come up with one great idea every 26 hours. That’s less than a work week (40 hours) of thought to come up with a great stock idea. Who can do that? You’re going to end up relying on other people’s judgment. Because you aren’t going to have enough time to form an opinion of your own.
Let’s go back to the ideal. You spend an hour a day – including weekend. You only hold 5 stocks. And you hold each of them for 5 years on average. That’s 365 hours of thinking for just one great idea. This is what I want every value investor to reach for. Come as close to spending one focused hour a day on investing as you can. Come as close to keeping stocks for 5 years as you can. And come as close to owning just 5 stocks as you can. Most investors will fall short of each of these 3 goals. But these should be the goals you’re reaching for.
So, what kind of stocks should you spend this 365 hours a year looking for? And where can you find these ideas? You want great businesses that are having temporary problems. You want a list of companies you might one day own. Where can you come up with such a list? GuruFocus has a Buffett-Munger newsletter, it has a Buffett-Munger screen, and it shows 15 years of financial data for stocks. Look for the predictable ones. You can use ratings on this. But, look yourself at predictability as you would judge it – not just as a computer program would. Do you see a dependable history of EPS stability, EPS growth, margins, returns on capital, etc. I look at operating margin (EBIT) margin volatility. That’s always my favorite measure. In my experience, most companies – by which, I mean most managers who run the day-to-day business of each unit, location, etc. – don’t want to do less physical volume this year than last year and they don’t want to have a thinner profit margin. They like doing a little more physical volume – unit volume – than last year and they like making a little more profit per dollar of sales than they did last year. They are frightened by the idea of falling volume and falling margins. So, the competitive pressure in a lot of industries is toward protecting volume and protecting margin. When volume declines – a company may try to lower prices, increase marketing, etc. When margins decline – a company may try to cut overhead, look for synergies, cheapen the product, etc. We often don’t have good unit volume data. In fact, most public companies are too diversified across too many different product lines to have consistent reporting on unit sales and pricing per unit. Some commodity type businesses do have data on this. A miner, a steelmaker, an airline, a hotel, etc. has good data on this. But all companies have data on EBIT margin variation. So, that’s what I look at. EBIT margin is just pre-tax operating profit divided by sales. The level of the EBIT isn’t what’s important to me. In a business like software you could have an EBIT margin of 30%. In a business like groceries you could have an EBIT margin of 3%. What matters to me is how likely it is that the 30% margin for the software company is going to stay in the 20% to 40% (plus or minus one third of the average), and how likely the margin of the supermarket is to stay in the 2% to 4% range (plus or minus one third of the average). That’s really the same thing. So, stability in the EBIT margin has to be defined as variation scaled to the mean. For a company that has been profitable in each of the last 15 years – you could use 15-year average Standard Deviation / Mean. That’s a number I track in Excel. I prefer industries where EBIT margin variation (defined as the Standard Deviation in the 15-year EBIT margin divided by the 15-year mean EBIT margin) is low. And I like those companies in an industry who have the lowest EBIT margin variation. These are usually the least marginal players. They are leaders in their market niche. The weakest companies in an industry – especially those that compete primarily on price – often have wobbly EBIT margins compared to the leaders. It’s not a perfect measure. Scale can be a problem. Some companies have wobbly EBIT margins simply because they aren’t big enough to enjoy economies of scale. These companies may not be good investments yet – but they are good takeover targets for the bigger companies in the same industry. So, this isn’t a perfect measure. But some measure of predictability – whether it’s EBIT margin variation, or GuruFocus’s predictability measure, or your own eyeballing of the 15-year history, is a good place to start your search for ideas.
You can read blogs and articles. I recommend the GuruFocus articles written by “The Science of Hitting”:
And the blog “Base Hit Investing”:
There are also idea boards like “Value Investor’s Club”:
I don’t recommend Value Investors Club the same way I do the blogs and articles I mentioned above. A lot of that board is short-term oriented, interested in shorting, etc. And the quality of the ideas is very hit or miss. So, I’m not suggesting VIC on the basis of idea quality. Just quantity. It has a ton of different stocks that have been posted there over the years and those stock ideas come with plain English descriptions of the business and its possible competitive advantages. So, it’s a good place to peruse.
One caveat: if you’re going to read articles and blogs – don’t read them willy nilly. Block out your article and blog reading times. So, don’t read one article of mine at a time or one “The Science of Hitting” article or “Base Hit Investing” blog post. Instead, identify the articles you are interested in as you find them. But then print them out and put them aside till the end of the week. I want you to spend a full hour of total focus reading the blog posts, articles, etc. you thought you’d be interested in. Don’t just dip in for 15 minutes at a time reading blog posts, articles, newspapers, etc. as you come across them during the week. Put them away in a folder till you are ready to focus on them.
This is what I do. I have baskets that I fill with reading material during the week. Then I tell my Amazon Echo to set a timer for one hour and I read as much of the material as I can get through. I put the rest aside till later and do this again. I read with a pen in my hand and mark up the articles, posts, etc. I read with questions of my own. This ensures I’m 100% focused and 100% engaged with the material. Most people who read an article or blog post are neither fully focused on it nor fully engaged with it. They just read it passively for 10 or 15 minutes and then move on to the next unrelated task. They may have just been checking their email a minute before and will be checking their phone a minute after. Don’t do this. Create a “batch” of reading material you’re interested in. Set a timer for one hour. And then do nothing but read that material for that hour. An hour a day is plenty to spend on investing. But you have to spend it 100% focused.
For more information on how to do this kind of focused work you can read the book “Deep Work: Rules for Focused Success in a Distracted World” by Cal Newport. I’m recommending the subject. I’m not really recommending the book as a book. It’s not a great book. But it’s a great subject. And I’m sure you’ll get something out of reading the book if you haven’t already.
So, my five suggestions for someone who only has an hour a day to spend on investing are: 1) Read “Deep Work: Rules for Focused Success in a Distracted World” 2) Spend all your investing time focused entirely on selecting which stocks to buy 3) Read articles from authors like “The Science of Hitting” and blogs like “Base Hit Investing” – but only in hour long focused batches of reading material 4) Use tools like GuruFocus’s predictability ratings and 15-years of financial data to find the most predictable businesses and 5) Buy great businesses that are going through temporary problems.
(To have your question answered on the blog, email Geoff.)
Someone who reads the blog emailed me this question:
“Is value investing broken?
To clarify: with worldwide debt at 200+ trillion and incomes stagnating or falling who exactly is going to go out and buy new products (whether from Luxottica, Movado, Swatch etc.) when they have record debt levels and are getting by at $10/hr? I realize that is a limited example but in many industries there is massive change going on that will, temporarily at least, push down income levels (driverless cars and trucks, robotic everything etc.) and people will therefore be spending less. Does value investing still work in this environment? Do you bother investing at all?
Apologies for the gloomy tone of this email but I don't see a good place currently to invest and am frustrated by my inability to figure it out. Please help!“
No. Value investing is not dead. There’s a tendency for people – people of any time – to see the time they live in as unique, dangerous, different, unlike any other age. In some ways, they are always right. Some things really are different this time from all other times. But, mostly, they’re wrong. And what they are wrong about is reading a golden age of stability into the past. I was talking with a value investor once and this value investor said that sure Ben Graham’s ideas worked in Ben Graham’s times. But Ben Graham invested in simpler times.
Here are the times Ben Graham invested in: the 1910s through the 1950s. He invested during Two World Wars, the start of the Cold War, the atomic bombings of Nagasaki and Hiroshima by the U.S. and then the testing of nuclear weapons by other countries, The Great Depression, a big explosion (reportedly a terrorist bombing) on Wall Street, and the longest shut down of trading in Wall Street history that I can remember at least (right as World War One started). People talk about political risk today. Political risk in Ben Graham’s time meant Marxists and Fascists. Investors saw hyperinflation in Germany after the war and then they saw deflation after the 1929 crash. These were not simple times. If you go back and read the newspapers from the time – you can see how not simple they were.
Now, yes, they were different from today in some ways. Much of the period investors and economists in the U.S. study were more regulated than today. So, you either had the Gold Standard or Bretton Woods. You had much greater belief in planned and insular economies in a lot of countries. With the benefit of hindsight – and seeing the entire sweep of history – many of these decades seem simple to us. They rarely were. Try to find a decade without too much inflation, too much deflation, too much war, the mania of some bubble, or the bursting of that bubble. At any point in that past, people could have believed value investing was dead. And yet, buy and hold investors – business owners and the like – have been compounding fortunes in the U.S. from the 1800s through today. If there are companies that can make founders and their families billionaires – there are companies that can make shareholders very rich if they buy and hold.
It’s hard for me to address the specific issues you mention in your email, because I don’t think that’s the problem here. The problem is that you are looking at the entire investment landscape as a depressive would look at their own life. You are fixating on some negative things – some real headwinds – that are likely to be a drag on the performance of some investments for many years to come. Sure, those things exist. But, both good and bad things exist in all sorts of years. In 1946, an investor could have lamented the low yield on bonds, the inevitable depression that would come from demobilization (many people at the time believed there would be such a return to Depression as soon as the war was over) and then either another World War or a nuclear exchange. With hindsight, we can see that 70 years later, there never was another World War nor did anyone else use nuclear weapons. But, that would have been a hard sell in 1946. Try convincing people who had been through two World Wars in 30 years and now saw the invention of a weapon of mass destruction that there would be no war on that scale again in their countries and there would be no nuclear exchange.
Your question was not about geopolitics. And some value investors get tired of Warren Buffett often repeating that he first invested in 1942 when the U.S. was losing the war against Japan. But, it is worth remembering these things. Because to the people who were caught up in them at the time – the outcome was not clear. We may believe The Great Depression was some sort of one-off event and that while World War Two may have provided a great deal of stimulation to the economy that did not mean that the second it ended, the peacetime economy would again return to that Depression. But, people at the time did believe that. They were unsure. Just as we are unsure.
As far as things like mechanization – I understand your concern. And I don’t deny that over time you will see the substitution of capital for labor. But, that has already happened in the past. My grandparents all worked in jobs that are now done by machines. They either did factory work that is completely automated now or they did office work that is now performed by managers using computers instead of secretaries. There are still workers in those factories. But the tasks they themselves performed are not done by humans any more. There are still workers in those offices. But there are not secretarial pools typing up all the inter-office communications that is now done entirely by email. So, those jobs don’t exist. That’s not at all unusual.
And deflationary pressure from investment in capital like driverless cars is not unusual either. Driverless trucks aren’t really that different from railroads. Very little labor is involved in running railroads now. If you look at things like railroads and farms in the U.S. and how many people used to be involved in doing work at those sites and how much greater output there is now with far fewer people – you’ll see that these are not new trends.
Deflation is probably the natural state of an economy. Even if you look at economies like the U.S., you don’t have much in the way of inflation between about the end of the Revolutionary War and the start of the Second World War. The inflation you have is largely over the last 75 years. Now, obviously, the economy grew tremendously quickly before all of that inflation.
Debt problems are not new either. In the ancient world – the Roman Republic and Athenian Democracy – the most common call for reform was debt relief. There were occasional monetary crises and these were often discussed in terms of heavy debt loads that couldn’t be serviced. There was a push even in Ancient Athens to get farmers to stop investing in growing food crops and instead focus on a cash crop (olive oil) that the city could export. Olive trees take time to mature. So, they require an upfront commitment of capital with no immediate payback. Farmers didn’t want to do this. And it was only those who had ample capital – probably from trade – who were eager to make the investment. It is not an unusual problem to see those with heavy debt loads unable to make the necessary investments in capital and falling behind in society. Back in ancient Rome and Athens this was investment in large scale farms. It was investment in slaves, and implements, and land improvement, and focus on cash crops instead of food crops. Doing those things took savings. Today, it can be the cost of tuition. Education is critical to future earnings. So, a parent in the U.S. may feel they have to buy a home – taking out a huge mortgage to do so – to raise their kids in the right town with the right schools. And those kids may – when they reach college age – feel they need to take out student loans and pursue graduate degrees and so on. Most people don’t have the savings to do this. So, they borrow. They have to borrow to invest in their own human capital. People who have only their labor – and no saved up “human capital” in the form of education and specialized skills – fall behind relative to others. That’s the kind of story you are telling me now. It’s a sad story. But, it’s not a new story. Likewise, cyclical debt problems aren’t new. They aren’t new for households, for businesses, or for governments. Historically, governments defaulted all the time. The conclusions in the book “This Time Is Different” might not be right. But the list of defaults they have for governments going back centuries isn’t wrong. Those governments really did default. And some of these government defaults happened during periods we now consider “normal” and “stable” and “simple” compared to today.
There are a lot of changes happening in the economy right now. There are a lot of risks. I just wrote a post about the possibility of negative interest rates. Now, in the 1970s and 1980s, what would an investor say about such a post? They’d think I was crazy to even write such a post. And they wouldn’t necessarily think that sounded like such a bad place. A place without inflation? The concern back then was that inflation would destroy an investor’s returns even if he picked the right stock. And you know what – they were right.
As a buy and hold investor, the risks posed by depression, deflation, and negative interest rates aren’t as bad as the risk posed by persistently high inflation. It’s easy to forget that now. You look back at Berkshire Hathaway’s results through the 1970s and you think they look pretty good. But, as Warren Buffett wrote in one of his letter to shareholders – the truth is that an investor could have done about as well simply by investing in a barrel of crude oil or an ounce of gold instead of Berkshire Hathaway stock. That’s not because Buffett wasn’t making great decisions. Buffett’s own record has gotten progressively worse each decade in terms of the value his decisions have added. His best decade as an investor was the 1950s, his best decade at Berkshire was the 1960s, then the 1970s and so on. But, during the 1970s and into the 1980s – it was very hard for an investor buying and holding high quality businesses to outperform assets like land, gold, and oil. Low amounts of inflation might be good for some businesses. For example, Grainger (GWW) has said that it benefits from inflation because its own business is deflationary. So, it can take costs out of its own distribution centers before it passes those savings on to customers. There is a time lag. And that lag can benefit the company by as much as 2% a year. Customers will eventually see the benefit of the company’s cost savings. But, the company will see them first and then only update catalog prices later. But, most businesses can really only insulate you from inflation. They can’t benefit from it. So, I’m not even sure that too much debt is a worse problem for investors to have than too much inflation. If you look at the real return on equity (nominal ROE less inflation) at companies, it has obviously been good recently. It was terrible at times in the 1970s and 1980s. There were large U.S. companies that weren’t creating any real – inflation adjusted – value for shareholders. You could buy the Dow near book value and it would just manage to preserve your real purchasing power – not help grow your actual wealth.
The problem here is not with the world economy. It’s with your framing of your situation. Even if there was a problem with the world economy – and there is always some problem – you need to frame your behavior in terms of your own problems and your own opportunities. What can you do today to make your situation better? It’s not enough to have an opinion about what is or what isn’t true about the world. You need to have an opinion that’s useful to you as an investor. You need an idea about how you can get to work doing something to improve your own situation.
(To have your question answered on the blog, email Geoff.)
Someone who reads the blog emailed me this question:
“What's your general thoughts on negative interest rates? Do you just take that out of your consideration for US banks?
I have read about some interesting analysis from smart people that outlines their reasoning for a much lower interest rates going forward than the past, say, 50 years. Most include points like less capital needed ahead because of the lower capital of new tech companies and more savings from around the world with people living longer.
Do you have any thoughts here?”
Yes. I do just take negative interest rates out of consideration when analyzing U.S. banks. I wrote reports on Prosperity (PB), Frost (CFR), Bank of Hawaii (BOH), Commerce (CBSH), and BOK Financial (BOKF). I can’t remember discussing negative interest rates in any of those reports. And they weren’t brief reports. I did discuss a lot of scenarios – like interest rates staying lower longer than I expected. But negative interest rates weren’t discussed.
I think talk of negative interest rates is the result of years and years of low interest rates. People talk a lot about the long-term average price of a barrel of oil, a house, etc. in the early stages of a bubble. Later, when prices have been out of whack for years and years they stop listening to the people who say you’re going to see mean reversion. Instead, they believe the now is normal. When the now is new – people know it’s abnormal. But once the now – in this case, rates near zero – goes on long enough, the recent past erodes their memory of the distant (like 70 years ago) past.
It’s natural for people to project the recent past into the future. Rates are low now. But they were low just after World War Two as well. Look at long-term corporate bond rates in 1946. They were low. Very short-term government bond yields (and the Fed Funds Rate) have been lower in the past few years than at just about any time in the past. But, I’m not sure the things that would matter more to an investor – things like the long-term corporate bond yield – are lower now than they were 70 years ago. And, of course, in between you had some very high yields. A long time ago, I wrote a series of posts about normalized P/E ratios. These are like the Shiller P/E ratio. I looked at normalization over periods longer than the 10 years he focused on. But, I don’t think the result is that different whether you are using a 10-year average, 15-year average, or 30-year average of past earnings. What I found is that the stock market – in normalized P/E terms – tended to get more expensive for about 17 years and then tended to get cheaper for about 17 years. For example, the market (I used the Dow) reached a peak normalized P/E ratio in 1965, it hit the bottom in terms of normalized P/E in 1982, and then it peaked again in 1999. If we went further back in time, the pattern wouldn’t be that different. You have 1929 (peak), 1942 (valley), 1965 (peak), 1982 (valley), 1999 (peak). Buying near the peaks and holding wasn’t such a good strategy. Buying near the valleys and holding was a very strategy. But, the problem is – of course – that we are talking about 13 years between 1929 and 1942 in which the market tended to have a contracting normalized P/E multiple. Then you had 23 years from 1942 to 1965 where the multiple tended to expand in normalized terms. Then 17 years of contraction. And then 17 years of expansion. So, we have “cycles” that are 13-23 years in terms of just one side of the cycle. It would take 26-46 years to have a complete cycle of extraordinarily low normalized P/E and extraordinarily high P/E. Many investors will only live through one or two years like 1929, 1965, and 1999. Likewise, many investors will also only live through one or two years as cheap as 1942 and 1982. A trend that continues for a decade or more is hard for people not to get caught up in. People got caught up in the dot com bubble and that was just the tail end of a rise in stock prices from 1982 to 1999. People got caught up in the housing boom – that was like half a decade. The recent oil boom lasted maybe 10 years. Interest rate cycles are at least as long. So, while I am sure there are good arguments for why interest rates might be negative for a long time – there were also arguments made for stocks in 1999, houses in 2006, and oil a few years ago.
I think there are plenty of arguments against negative interest rates being normal. For one thing, in the U.S. the rate of population growth is fine because of immigration. So, you have a very stable population pyramid. Now, that’s not true in some other countries. China is going to have a contracting pool of workers. I think it would make more sense if someone was arguing that China’s long-term future included very low interest rates than arguing that the U.S.’s future included very low interest rates. The U.S. has relatively high returns on assets. So, if a company gets paid nothing to put money in the bank – it should expand or if the incremental ROA is terrible because there’s nothing to do, it should buy back its stock. Eventually, the prices of stocks, buildings, etc. would be pushed too high and this wouldn’t be a way to use cash. But, it would take longer than it did for a similar situation to develop in Japan during that country’s growth phase or in China today. Companies in those countries have lower returns on assets. It is easier to imagine a situation where households and companies are leaving money idle if their alternative is a low return on asset investment. Countries like Japan and China have long histories of lower returns on assets than the U.S. You’d need the ROA in the U.S. to decline closer to wherever you expect interest rates to stay. Otherwise, it would be too obvious an action to borrow and do anything with the money.
You mention things like more savings around the world. I agree with that. In Asia, you have high percentages of workers relative to the total population. That leads to higher savings. So, the total amount of savings is going to depend in part on the ratio of workers to dependents. If a country like China, Taiwan, or South Korea has a lot of workers relative to its total population today – a dependency ratio of less than 1 to 1 – then it is going to have more savings now and less savings in the future. But this is a temporary – cyclical – phenomenon. It’s like borrowing money now to make investments. You can increase leverage today. But that will cause you to decrease leverage in the future. So, you are growing faster than your sustainable rate of growth now and then you will have to grow slower than your sustainable rate of growth in the future. Returning to the concept of ROA – if a company grows its business faster than its ROA, that company is pursuing an unsustainable rate of growth. That doesn’t mean it can’t grow in the future. But, it does mean it has to grow slower in the future relative to its ROA – because it can’t keep growing debt faster than it grows assets. I see that as a potential problem in places like China – because they have a lot of firms growing faster than their ROA. I don’t see that as a potential problem in the U.S. In the United States, companies fund themselves primarily from retained earnings. They do this even though their return on assets is often higher than what the cost of debt would be. For example, a company might be able to earn a 6% after-tax ROA (9% pre-tax) and yet borrow at 6% pre-tax (4% after-tax). Retained earnings are not the theoretically best way to fund the company. It would seem to make sense to borrow at 6% and benefit from the tax savings. U.S. companies don’t do this much. And I think it’s because that is not the analysis most companies do. They simply look at everything they want to do and if they can fund it out of retained earnings – they do. Some companies are different. John Malone is going to run a company he controls more rationally than that. He’s going to use as much debt as possible if using debt is cheaper than using retained earnings.
I don’t have any problem with the idea of very low long-term interest rates. But, I do have a problem with assuming they would happen even in situations where you had not already made some pretty severe mis-investments as an economy. I have trouble reconciling high returns on assets and low interest rates. So, if the firms in an economy are already earning low ROAs and then they start borrowing a lot and investing that borrowed money in low ROA activities – yes, I can see how you would end up in a situation where rates are close to zero for a very long time. I don’t see how that would happen unless you invest in low ROA activities though.
Now, interest rates – at least the short-term ones that matter a great deal to banks – are set by institutions like the Federal Reserve. And they may have goals like full employment that encourage them to set rates lower than would make the most sense in terms of driving good long-term investment decisions. For example, they might see a pool of unemployed workers. And they might know land prices are high. But, they know that if really low rates will stimulate homebuilding activity the stimulation such homebuilding will give the labor market right now is big. And so encouraging the building of a home that will turn out to cost more now than it will be worth in the future isn’t a concern for them. I’m not saying some people might not want negative interest rates at time certain cyclically difficult point in time. But, keeping them there long enough to change the investment thesis on a bank, insurer, etc. – is a taller order.
Let’s look at why. First, we have to consider that all banks, insurers, etc. have a P/E ratio. And that if interest rates are low that will tend to both decrease what they could earn on their investments – so their ‘E’ – but it will also tend to increase the P/E multiple that investors award all stocks. This includes the P/E multiple of banks, insurers, etc. Let’s say Progressive usually makes 5% on its investments. Interest rates fall so Progressive is now making 2.5% on its investments. But, if the normal earnings yield Progressive had traded at was 5% (a P/E of 20) and it now drops to 2.5% (a P/E of 40) you would have offset the difference in terms of the investor’s return in the stock. If investors expect less return from all their assets – that means banks, insurers, etc. make less on their loans, bonds, etc. But it also means stock investors are willing to make less. So, you can sell the stock for more. Now, Progressive would be hurt by this situation. But Progressive makes some of its money from underwriting and some of its money from investing. Banks also make income from fees, etc. If they aren’t making money lending out checking deposits – they can charge ATM fees, monthly fees, etc. on those accounts so they don’t lose money in a zero-interest environment. They can also buy long-term bonds.
Banks can also make longer-term commitments. This is the risk I am most worried about. And I did talk about it a little in the Bank of Hawaii report and a lot in the Frost report. These banks don’t just make loans. They invest about half their balance sheet in securities. When short-term rates are low, these banks tend to invest in longer and longer term securities. Instead of buying a 5-year bond they buy a 10-year bond. This exposes them to interest rate risk. If interest rates rise, the market value of the securities on their balance sheet will fall. They know this. They talk about this. And, honestly, for banks like BOH and CFR that benefit so much from higher short-term interest rates – it’s mostly just an initial offset. They will immediately write-off a lot of value. But then their cash earnings will start rising. It won’t threaten their solvency.
So, no. I’m not worried about negative interest rates. But, I am worried that short-term interest rates have been so low for so long that banks and insurers have been reaching further and further out in terms of the length of the commitments they are making. I’d rather they didn’t do this. I’d rather Frost kept more money at the Fed earning nothing and less money buying longer term bonds. Doing that would weigh down today’s EPS. And it probably wouldn’t turn out better for them in the long-run than buying overpriced bonds now. But, I think it’s a bad idea to ever buy an asset you know is overpriced. And these banks know the bonds they are buying are overpriced. They just don’t want to keep billions of dollars idle at the Fed for years.
Banks like BOH and Frost are interest rate sensitive. So, there’s a huge offset built into their business model that will mitigate the losses their securities portfolios will have. That’s not true for insurers. A lot of insurers have bond portfolios that are too expensive and too long-term. So, I’d suggest avoiding most insurers till interest rates are much higher again. Sure, I’m worried that it might take a lot longer for the Fed to raise rates than I’d expect. But I’m not worried that rates will be sustainably negative at any point in the U.S.
(To have your question answered on the blog, email Geoff.)
Someone who reads my blog emailed me this question:
“Imagine you're giving advice to a young person (early twenties) who just got their first job and has a 401k match program or has decided to set aside part of their paycheck each month for a tax advantaged investment account. They want to learn enough about investing to not get into trouble while managing their account, but they don't want to turn this into a hobby or a part time job.
Is there one book or resource they should study to learn how to select suitable investments and manage them within a portfolio over time that you'd recommend? Imagine they'll never read or think about the subject again, this is your one shot to set them on a good path. What do you recommend for the everyman investor?”
That’s a good question. And a tough one to answer. I can quickly come up with a list of books I’d recommend as a group. Everyone should read Peter Lynch’s “One Up on Wall Street” and “Beating the Street”. Joel Greenblatt’s “You Can Be a Stock Market Genius” and “The Little Book that Beats the Market”. Ben Graham’s “The Intelligent Investor” (the 1949 edition is best). And then Phil Fisher’s “Common Stocks and Uncommon Profits”. Just writing this I’d say that maybe the number one book I’d recommend – if I was only recommending one – is Phil Fisher’s “Conservative Investors Sleep Well.” Now, technically, “Conservative Investors Sleep Well” is included in “Common Stocks and Uncommon Profits”. It was originally published as a separate book. So, if you’re willing to count it as a separate book – even though it’s only available as a really old, used book in that form – I might say “Conservative Investors Sleep Well” is the one book I’d recommend.
Why wouldn’t I make the Lynch books, the Greenblatt books, or the Graham book the one and only book to read? A few of them are too specialized. I’m a big Ben Graham fan. But, Ben Graham is not a good choice for someone who doesn’t want to spend a lot of time picking stocks. His approach takes a lot of time to implement. And it can be dangerous if done wrong. Greenblatt’s best book is “You Can Be a Stock Market Genius”. I think that’s the single best book on investing. But, it’s not the one I’d recommend for someone who isn’t going to focus on investing all the time. His other book “The Little Book That Beats the Market” is the easier one to implement. But, it’s not that different from indexing. That is what Warren Buffett would recommend – the John Bogle approach. If an investor isn’t willing to put in the time to research stocks in depth, he should just buy the S&P 500. I don’t know if I agree with that. There is another way you could make things work I think.
Let’s say you only picked one stock a year. And let’s say you never sold stocks. So, there was no question of Graham’s “group operations” like net-nets and there would be no question of Peter Lynch’s higher turnover approach. Greenblatt’s best book focuses a lot on spin-offs and such. It’s a high turnover approach. And his other book (the Magic Formula one) suggests flipping the stocks each year. You obviously don’t have to do that. But, I’d suggest that an investor who doesn’t want to think too much – or doesn’t want to think too long at least – should follow the Phil Fisher approach as much as possible.
So, if we’re committed to the idea that an investor who doesn’t want to spend a lot of time tending his portfolio should focus on Phil Fisher’s writings – we’re left with a choice between “Common Stocks and Uncommon Profits” and “Conservative Investors Sleep Well”. Like I said before, you can buy these two together in one book now. So, if we’re counting them as one book – that’s the book I’d recommend.
This means I’m suggesting a growth investor approach instead of a value investor approach. My second choice wouldn’t be a value investor either. I’d say the single best investing book to read if you’re only going to read one is Phil Fisher’s “Common Stocks and Uncommon Profits” and the second-best choice is Peter Lynch’s “One Up on Wall Street”. These books are the most approachable for the new investor. Ben Graham’s 1949 Intelligent Investor would probably be my third choice. So, there you have a Fisher, a Lynch, and a Graham to choose from. Fisher is the ultimate buy and hold growth investor. Graham is the ultimate value investor. And Lynch is somewhere in between. If this new investor had any idea temperamentally which author he lined up with most, he could read that guy’s book. But, if I had to recommend just one I’d recommend the Fisher.
Why? Phil Fisher was a buy and hold investor. And I don’t see any way to invest successfully without putting in a lot of time unless you’re a true buy and hold investor. So, if someone said they don’t want to make investing a profession or a hobby – but they do want to put money away for the rest of their life in stocks they themselves choose, then that person must commit to buy and hold. There’s no other way for this to work.
Committing to a buy and hold approach solves a lot of problems. The average investor probably spends half their time worrying what they should sell and when they should sell it. If you simply commit to the idea that you will literally never sell – then you can double the amount of time you spend thinking about which stock to pick in the first place. Ben Graham’s approach would work fine in a buy and hold sort of way. You can buy low price-to-book stocks and the like and hold them for 5 years without any problem. But it’s a group approach. Graham wanted the “defensive” investor to have something like 20 stocks in his portfolio. Even for the individual investor, his idea of diversification was 10 to 30 stocks – never a handful like Fisher was willing to focus on. So, I don’t think you can go with the Graham approach unless you are willing to put in the time. If you aren’t willing to put in the time – your two choices are Bogle (indexing) or Fisher (buy and hold forever).
The next thing I’d recommend to someone who wanted to pick his own stocks but didn’t want to spend much time picking those stocks is to only buy one stock a year. I think that would – when combined with the commandment to never sell – be a big help. Why?
How selective you can be in your stock picking is the result of how many decisions you make and how much time you have. The less time you have – the fewer decisions you should make. Now, the Fisher approach solves part of the problem for us. Fisher was a buy and hold investor. He felt that if you picked the right stock to start with the right time to sell that stock was never. I agree. Not for all investors. But for an investor who doesn’t want to make this his profession or his hobby. For that investor, you never want to waste a second thinking about selling. So, you buy and literally hold forever. That cuts the amount of decisions you have to make in half. But, unless you also make a decision about how often you are going to buy a stock – you’ll have a problem. There will still be the problem of portfolio allocation. What if you have 5 good ideas one year? Should you put 20% of your savings for that year in each? Or should you focus on the best idea to the tune of 50% of that year’s savings? There’s an easier answer. Always put everything you add to your 401k in a given year into just one stock. For a trader, this would lead to a lack of diversification. But for a true buy and hold forever investor – the level of diversification will be big. You mentioned an early 20s investor. Let’s take a 25-year-old. He picks one stock a year and puts all he adds to his savings into just one stock. By the time he’s 40 years old he owns 15 different stocks. Now, some of these stocks could go bankrupt. Some could be sold out for cash. So, maybe the number isn’t 15. But even if one company takes over another in an all-stock deal – he’ll just keep his shares in the new, merged company. Likewise, if there’s a spin-off, he’ll keep his shares in that too. Because, remember, he’ll never sell. So, he will end up more diversified than Phil Fisher was. Because Phil Fisher didn’t keep close to equal amounts in 15 different stocks.
The other benefit to needing to pick only one stock a year is that this investor – who doesn’t want to spend too much thinking on his own, remember – can do a lot of copycatting. The press covers what Warren Buffett bought this year. It covers spin-offs and scandals and IPOs and mergers and so on. So, there will often be a stock in the news that could catch this investor’s interest without a lot of him having to do background searching. For example, let’s say this investor eats at Chipotle (CMG). Well, Chipotle is having a hard time. I don’t have an opinion about the stock. But, this investor certainly could see the stock mentioned in the news. He could focus on that stock because he eats there. And it might be the one he decides to buy and hold forever. Or, he could read in the news about a possible merger. For example, you have the whole Viacom drama with Sumner Redstone and whether it will merge with CBS. If this investor is in his early 20s right now, he’d have grown up with MTV and Nickelodeon. He’d have seen plenty of Comedy Central. He might have a view on Viacom. Or, he might be reading about Brexit online somewhere. And it is just this political drama on another continent. But, then, he reads something about how much the Pound has dropped or how much some of the stocks over there have gone down. And so he focuses – for this year, and this year only – on U.K. stocks. He only has to find one. He knows that going in. Looking through the carnage like that is more of a Peter Lynch approach than a Phil Fisher approach. In fact, what it’s like is Peter Cundill. There’s a good book that draws from Cundill’s journals. It’s called “There’s Always Something to Do”. I didn’t list the top 5 books I might recommend to the kind of investor you talked about – but I think that Cundill book would make the list. It’s a good book for telling you about the psychology of investing. The psychology of holding especially.
The most important thing this investor will need to learn from these books is the need to hold when others are selling. Not just the need to be contrarian. But the need to hold during those times when others would sell. So, maybe “There’s Always Something to Do” would be a good choice. Those would be my top 4 I think. Number 4: “There’s Always Something to Do”, Number 3: “The Intelligent Investor (1949)”, Number 2: “One Up on Wall Street”, and Number 1: “Conservative Investors Sleep Well”. If I’m allowed to cheat – because it is now packaged as one book – I’d choose Phil Fisher’s “Common Stocks and Uncommon Profits and Other Writings” as the one book for this new investor to read. My one recommendation though would be that while it’s enough to read this book and only this book – it’s not enough to read it only once. If this investor would commit to re-reading “Common Stocks and Uncommon Profits and Other Writings” every year, buying only one stock a year, and never selling – I think he could do okay. That’s not much of a commitment. Re-read (the same) one book a year and buy one stock a year. But I don’t know many people who would actually stick to it.
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(This post is a reprint of one of the nine sections that make up last month's Singular Diligence issue on MSC Industrial Direct.)
MSC Industrial Direct is an MRO (maintenance, repair, and overhaul) distributor focused on the metalworking industry. The company’s initials originally stood for Manhattan Supply Company. This is a company MSC’s predecessor acquired many years ago. MSC can trace its roots to Sidney Jacobson’s Sid Tool Company. Sid Tool was founded in 1941 in Manhattan. Sid Tool’s store sold cutting tools and accessories to New York City machine shops. The company moved to Long Island in the 50s. Business grew rapidly after World War Two. But Sid Tool soon became dependent on two key customers. Grumman Corporation and Republic Aircraft made up 90% of Sid Tool’s sales. To diversify its sales, Sid Jacobson started a catalog business. The catalog offered discount prices on imported cutting tools. Since it was a catalog instead of a store, the book was able to offer a wider range of products. Sid Tool’s catalog was launched in 1961. By 1964, it had over 150 pages. Today, MSC’s catalog – known as the “Big Book” has over 4,000 pages.
Within a few years, Sid Tool’s catalog sales were greater than the sales it had been making to those two key customers. Sid Tool was selling products it found at trade shows. Jacobson would visit trade shows and make up lists of the products he wanted to sell. Or manufacturers who saw Sid Tool’s catalog would contact him and ask to be put in the catalog. This allowed the catalog to have a wide range of products. But, it created a problem in the late 1960s. An imported item was out of stock. Sid Tool didn’t have the product on hand – though it was in the catalog – and was told it would take 6 months to fill the order. Jacobson wanted to make sure this would never happen again. So, in 1969, he installed a computerized inventory control system. MSC has been quick to adopt technology to manage inventory and fill orders quickly and accurately ever since.
In 1970, Sid Tool acquired Manhattan Supply Company. This is where the MSC name comes from. MSC opened its first distribution center in 1978. In the 1970s, Sidney Jacobson’s son, Mitchell Jacobson, joined the company and soon took over day-to-day management. Mitchell Jacobson was very young when he took over the company. So, he is actually still with MSC today. He serves as the company’s Chairman. Members of the extended Jacobson family control much of the economic interest – and a majority of the voting power – of MSC to this day.
Under Mitchell Jacobson, MSC started a geographic expansion. It went from 3 branches in the mid-1980s to 26 branches in 1990. That same year, MSC opened a second distribution center in Atlanta. This gave the New York based company better geographic coverage. The company also made same day shipping a priority. By 1991, MSC was shipping 98% of orders the same day it received them. This was several years before e-commerce became a reality in the U.S. So, same day shipping under almost all circumstances was not yet common. MSC’s management decided same day shipping helped differentiate the company from its competition. So, it pressed this advantage. For orders placed by 4:30 p.m., MSC said it would either ship the order that day or it would send the customer a check for $50. In the first 3 years of the program, MSC had a 99.99% same day shipping rate.
MSC went public in 1996. Revenue was $305 million at that time. We know what MSC’s sales were in the mid-1970s. So, we know that MSC had achieved a 20% annual sales growth rate from 1976 through 1996. It was a growth company. But, it was determined to invest in additional infrastructure. From 1996 through 2004, MSC opened 3 new distribution centers, added 60 branches, and increased its catalog by 400,000 stock keeping units. In the 20 years since its 1996 IPO, MSC has grown sales by 12.6% a year and earnings per share by 13.3%. The stock price has compounded at 11% a year while the company stuck to a 30% to 50% dividend payout rate throughout those two decades.
There are two ways to look at MSC today. The first is to see it as one of the big MROs like Grainger and Fastenal. By this measure, MSC has 2% of the North American MRO market. It has 1.1 million stock keeping units available online. And it actually stocks 880,000 of these items. Orders placed by 8 p.m. have a 99% chance of being shipped that same day. If you think of MSC as just another broad line MRO distributor like Grainger and Fastenal – it appears more centralized. MSC ships almost everything out of just 5 distribution centers. The company still has 100 branches. But, these branches should not be thought of as stores like the small ones Fastenal operates or the large ones Grainger runs. MSC’s 100 branches are really just sales offices. They carry very little inventory.
So where is the inventory? It’s in MSC’s 5 distribution centers. And it’s in vending machines. MSC is mostly an e-commerce company. MSC has sales of $3 billion. About 57% of those sales come from electronic sources. Metalworking revenue is 50% of all sales. So, actually, MSC is almost 30% a pure online metalworking supply company. It can be thought of as about half online and half offline and it can be thought of as about half metalworking and half non-metalworking. MSC’s relative market share within metalworking supplies is big. The company has 10% market share in metalworking. This is several times the size of its nearest competitor.
The Jacobson family has 82% of MSC’s voting power and 49% of its economic interest. We’ve included shares owned by the Chairman (Mitchell Jacobson), a Jacobson family trust, shares held by Mitchell’s sister, and shares held by his niece and nephew. Calculated this way, the Jacobson family controls MSC. It is a family controlled company despite being public for 20 years now.
MSC has $3 billion in sales. It just completed a major expansion of its infrastructure which included a second headquarters and a fifth distribution center. The company will not be running “at capacity” till it hits $4 billion in sales. The EBIT margin is 13% now. But, Quan estimates the EBIT margin will peak in the 16% to 18% range when MSC once again operates at capacity. This is an important point to keep in mind throughout the issue. MSC might look like it is trading at a P/E of 19. But, over the next 5 years, MSC can increase sales, increase margin, and pay out free cash flow without additional investment in infrastructure. So, 2016 earnings are very low compared to what we expect 2021 earnings to be. When a buy and hold investor looks at a stock, it isn’t this year’s earnings they should price the stock off of. It’s earnings five years down the road. MSC is not cheap compared to what it is earning if you buy it today. But, today’s stock price is cheap compared to what MSC will be earning when you sell it in 2021.
(This post is a reprint of one of the nine sections that make up the recently released Singular Diligence issue on Commerce Bancshares.)
Commerce has been controlled by the same family – the Kemper family – for over 100 years. In the 113 years since the Panic of 1903, Commerce has survived several financial crises. In 2008, it did not accept TARP money from the U.S. government. Commerce’s net charge off rate peaked at just 1.31% in 2009. Even in that crisis year, loan losses at Commerce were quite low (well less than half a percentage point) in all areas except credit cards, real estate construction, and consumer credit. These 3 areas are high risk loan categories. Right now, about 13% of Commerce’s total loans are in areas Quan and I consider high risk. Credit cards are 7% of total loans, real estate construction (and land) is 4% of total loans, and boat and recreational vehicle loans are 2% of total loans. So, 13% of Commerce’s loans are in areas that would be severely stressed by a financial crisis like the one seen in 2008. The next financial crisis probably won’t look like the last one though. They never do. So, it doesn’t make sense to focus too much on loans that go bad with the housing market and household finances. Just know that about 87% of Commerce’s total loan portfolio is in fairly safe and traditional types of lending. None of these types of loans had charge-off rates above 0.41% in 2009. Those are very low charge-off rates. So, any risk to the durability of Commerce comes from the other 13% of loans that are in credit cards, real estate construction, and marine and RV lending.
Overall, Commerce makes all types of loans. Consumer and mortgage loans are 41% of total loans. Real estate is 47% of total loans. Real estate is diversified among: business real estate (20% of total loans), personal real estate (16%), home equity (7%), and construction (4%). There are many ways to break down a bank’s loan portfolio. In Commerce’s case we can look at some big and fairly traditional forms of lending and see what they add up to. Business loans (non-real estate – so commercial loans) are 35% of all loans. Business mortgages are 20%. Personal mortgages are 16%. So, right there, you have 71% of loans from those 3 categories. These loans are very typical of what banks we’ve talked about before make. Then, we get down to some categories of loans that Commerce makes which are less important at other banks – or even non-existent. We have 8.5% car and motorcycle loans, plus 1.3% RV loans, plus 0.4% boat loans equals 10.2% vehicle loans of some kind. We have 7% credit card loans. And we have 6.6% home equity loans. Home equity loans are fairly common at other banks. Auto loans and credit card loans are often a lot smaller at the banks we’ve talked about then at Commerce though.
Commerce’s charge-off rate tends to be much lower than the industry. This isn’t just overall. It’s also within each category. Commerce did have higher charge-offs in 2009 than Frost. A lot higher, in fact. But, this was due to Commerce making types of loans that Frost does not. So, in 2009, Commerce peaked at a 1.31% charge off rate. Frost peaked at 0.58%. As you know from reading our bank issues – Frost and BOK Financial and Prosperity all had very low charge-offs right through the crisis. Commerce did not have an extraordinarily low charge-off rate. But, the crisis was a much tougher test of the types of loans Commerce makes than it was at Frost. Frost makes a lot of business loans in Texas. Businesses in Texas just weren’t very stressed by the crisis. Real estate in parts of the country was stressed. Households around the country were stressed. But, businesses in Texas were stressed much less by the 2008 financial crisis than by the early 1990s recession or the early 1980s oil bust. So, 2008 was not the toughest moment for Frost’s borrowers. It was certainly the toughest moment in 30 or more years for some of the consumer type loans that Commerce makes.
For example, Commerce made construction loans. These are very risky in a housing bubble. In 2008, 2009, 2010, and 2011 Commerce charged off 0.89%, 4.61%, 2.69% and 1.66% of its construction loans. That sounds high. But, now, let’s do a comparison of Commerce versus the industry in that loan category. In 2008, Commerce charged off 0.89% of its construction loans versus 2.63% for the industry. In 2009, it was 4.61% vs. 5.40%. In 2010, it was 2.69% versus 5.45%. And in 2011, it was 1.66% versus 3.33%. In 2012, 2013, and 2014 – Commerce then had a negative charge-off rate (it actually recovered on some written off loans) while the industry as a whole never did. For the entire period of 2008 through 2014, Commerce wrote off far less of its construction loans than the industry did.
Over the last 24 years, Commerce has only charged off an average of 0.63% a year of its consumer loans (these are passenger vehicles, boats, and recreational vehicles – probably they are mostly cars). In each year from 2008 through 2014, Commerce charged off less than the industry did within the category. It’s also worth mentioning that the composition of this category is now different. In 2009, boat and recreational vehicle loans were 50% of all consumer loans at Commerce. Today, boat and RV combined are just 12% of all consumer loans at Commerce. So, Commerce is making far more car loans in this category relative to boat and RV loans.
Charge-offs in credit card lending are always high. Over the last 24 years, Commerce has averaged a charge-off rate of 3.5% a year in this category. Commerce’s charge-offs peaked in 2009 at 6.77% of all its credit card loans. The industry peaked in 2010 at 10.08% of all of its credit card loans. Again, Commerce’s charge-off rate in this category was lower than the industry’s charge-off rate in every single year from 2008 through 2012.
I focused on these riskier categories even though they are not Commerce’s biggest categories – because they are the only categories where charge-offs have ever been high enough to cause any concern. Commerce’s biggest loan categories are actually real estate loans. Missouri and Kansas didn’t have a housing bubble. So, Commerce’s record in these areas is pristine. Net charge-offs in business loans averaged 0.07% a year. They peaked at 0.70% in 1991. Charge-offs were a lot lower in the 2008 crisis than in the early 1990s recession. The same pattern is true for residential real estate loans. The very worst charge-off rate for residential real estate was just 0.19%. The industry average was 9 times higher at 1.72% in 2009. Commerce probably had low losses because Missouri and Kansas didn’t have a real estate bubble, Commerce generally originated the loans on its books (it didn’t acquire them), it never made subprime loans, and it generally required at least a 20% down payment. To illustrate, in the year 2006 (a bubble year in the U.S.), 87% of all Commerce’s residential real estate loans had a loan-to-value ratio of 80% or less. And 98% of loans required principal payments be made – not just interest payments.
Commerce’s commercial and industrial loans actually have even lower charge-off rates than Frost’s C&I loans. So, by category, Commerce is a more conservative lender than Frost. To be fair to Frost, that bank specializes in commercial lending and avoids things like credit card and home mortgage loans entirely.
Commerce – like Frost – also has a lot of cultural continuity. If the bank didn’t make risky loans in a category in the past – it’s very unlikely to start making risky loans in that category, because the same people are making the loans. Commerce has been run by the same family for over 110 years. It is the slowest growing bank among those we’ve profiled. It is in the slowest growing region. And it isn’t a serial acquirer. BOK Financial, Frost, and Prosperity all grow faster and either make acquisitions or have to hire new employees more frequently than Commerce. In 2013, the company’s CFO said: “Somebody that’s been with us for 10 years is a short-timer. We still look at them kind of as a newbie and that’s just sort of the culture at Commerce.” Commerce made it safely through the 2008 financial crisis without accepting TARP money. There is no reason to believe another 2008 type crisis is imminent. When another crisis like 2008 does happen though, Commerce should be in the same position to survive it. Commerce’s durability should be equal to or greater than the durability at BOK Financial, Frost, and Prosperity. Cultural continuity is probably even higher at Commerce than at those banks. And the bank doesn’t grow as quickly as those banks do. So, the pace of change in risk taking is probably slower at Commerce than at those banks. It’s a durable bank.
(This post is a reprint of one of the nine sections that make up the Singular Diligence issue on Grainger.)
Grainger distributes the products needed to keep a large business running smoothly. It sells light bulbs, motors, gloves, screwdrivers, mops, buckets, brooms, and literally thousands of other products. About 70% of the orders customers place with Grainger are unplanned purchases. By unplanned we mean things like the filter in an air condition system, the up / down button on an elevator’s control panel, the motor for a restaurant kitchen’s exhaust fan. The customer knows these things break eventually. But, they don’t know when they will break. These aren’t cap-ex purchases made when the place first opens. And they aren’t frequent, predictable purchases. Things like light bulbs, safety gloves, and fasteners – a key part of Fastenal’s business – are bought more frequently in greater quantities as part of planned orders. Grainger sells to both large customers and small customers. And customer orders are sometimes planned and more frequent, sometimes unplanned and less frequent. But, the biggest part of Grainger’s business is unplanned purchases made by large business customers who have a contract with the company. Almost all of the company’s profit comes from the U.S. So, when you think about what Grainger does – think unplanned purchases by big U.S. businesses.
Grainger was founded by William W. Grainger (hence the W.W. in the company’s name) in 1927 in Chicago. The company is still headquartered in Illinois. It started as a wholesale electric motor distributor. At the time, manufacturers were switching their assembly lines from a central DC driven line to separate work stations each with their own AC motor. Grainger focused its business on customers with high volume electric motor needs. It was a catalog retailer. The original “Motorbook” catalog was just 8 pages. Today, Grainger’s “Red Book” catalog is over 4,000 pages. It features more than 1.4 million stock keeping units. Grainger started opening branches in the 1930s. From Chicago, it expanded into Philadelphia, Atlanta, Dallas, and San Francisco. By 1937, it had 16 branches. In 1953, Grainger started a regional warehousing system. The company added distribution centers to both replenish stock at the branch level and to fill very large customer orders. The company eventually added distribution centers in Atlanta, Oakland, Fort Worth, Memphis, and New Jersey. As alternating current became standard throughout the U.S., Grainger focused on doing more than just selling motors to American manufacturers. It sought out smaller scale manufacturing customers, service businesses, and other parts of the economy. Today, Grainger’s customer list is very diversified. It is much less dependent on the manufacturing sector than publicly traded peers like MSC Industrial and Fastenal. Grainger basically sells to any U.S. business customer who makes a lot of small orders. So, high frequency combined with low volume per order. Grainger is best at dealing with big customers. The company’s competitive position is strongest where the customer has a contract with Grainger and is served by a specific account representative. These customers make purchases at their different sites across the country under the same overarching agreement that provides steep discounts to the list price shown in Grainger’s catalog.
Grainger went public in 1967. At the time, sales were $80 million. Those sales have since compounded at 10% a year over the last 39 years. Grainger has changed its logistical footprint several different times. It eliminated its regional distribution centers by the mid-1970s. But, it brought them back in a different – heavily automated form – starting with a distribution center in Kansas City in 1983. Grainger rapidly increased its branch system during the late 1980s. It was opening about one branch a week by the end of that decade. In 1995, the last Grainger family CEO – David Grainger – retired. In that same year, the company launched its first website. Online became a huge part of Grainger’s business. Today, Grainger is the 13th biggest online retailer in the U.S. It is one of UPS’s top 10 customers. And it gets 40% of all U.S. revenue through the internet.
Over time, Grainger also expanded a little internationally. It acquired a Canadian company in 1996. And it entered a few different countries – like Mexico, Japan, Brazil, and China – in recent years. Some of these attempts succeeded. Others failed. The U.S. business provides most of the company’s profits. The Canadian business is big and successful. The Mexican business is small but profitable. Brazil and China were failures. However, Grainger is still in China. But, we don’t expect them to invest any further there. Japan was a huge, huge, huge success. We’ll talk more about Grainger’s model in Japan and how it brought that over to the U.S. later. For now, we’ll just let you know that Grainger is the majority (53%) owner of a publicly traded Japanese company called MonotaRO. The stock – which is a wildly expensive, Japanese growth stock – has a market cap of $2.4 billion (that’s U.S. dollars). That gives Grainger’s stake a $1.3 billion value at market. I’m not sure that’s the correct value. The P/E on the stock is astronomical. But, so is the growth rate.
The reason for Grainger’s success in the U.S. is supplier consolidation. Big customers want to consolidate purchases across their various sites. In high GDP per capita countries – places where labor cost per hour worked is expensive – there is a lot of interest in reducing complexity. For example, Grainger’s business in China was unsuccessful in part because in China employers will just send an employee out to a big open market to browse through various parts for the one replacement part the company needs. This kind of set up is not reasonable in countries where an employee’s time is more valuable. Customers in the U.S. like using one supplier for more and more of their maintenance supply needs. They like that Grainger can install vending machines, provide inventory management by re-stocking inventory, and give a discount below the list price on a wide variety of the products the company might need to buy however infrequently.
The most important thing to understand about Grainger is the nature of the orders customers are placing with the company. The orders can be fairly random looking – almost every business needs a mop, a screwdriver, a small motor, a light bulb, etc. sometime even if it’s far from the core of what they do. The average order size is small. However, it needs to be filled fairly rapidly. Customers are often satisfied with next day shipping on most items. They’re unlikely to be satisfied with next week shipping. This means Grainger has to keep a lot of inventory on hand. They also have to offer credit terms to customers. Business customers are used to buying on credit. They don’t want to have to pay their bills any faster than 30 days. So, Grainger has a lot of inventory and a lot of receivables. It has low turns. But, it has high margins. This surprises some people. Investors and analysts see 40% gross margins and wonder how that can be. Can a middleman really mark-up basic, boring products like we’ve talked about here – mops, buttons, motors, light bulbs, etc. – by 50% to 70% over the price they paid for that product? The answer is yes. But, it’s yes because of issues of quantity and timing. Grainger is willing to go to a maker of let’s say mops and order a thousand of them. It’s willing to hold those mops. And it’s willing to pay the mop maker before it collects payment from the eventual mop user. Grainger’s customer can buy one mop – just one mop – as part of an order with completely unrelated products. And that customer can buy on credit. They don’t need to buy more mops than they need. They don’t need to keep spares around. And they can get better credit terms – a longer time to pay – and a lower price than you could get from sending an employee to Wal-Mart looking for just one mop. This is why the gross margin is so high. The end user of the mop has no interest in dealing with the maker of the mop on terms the two would find acceptable. In some cases, a customer is buying a product they’ve never bought before. Using the example of a motor in an HVAC system. The plant manager or store manager or branch manager of some customer of Grainger’s may never have bought an HVAC motor before in his life nor may he ever have to again. He knows he needs a motor. But, he doesn’t know much about pricing, availability, etc. Having a main supplier of most replacement needs gives him a place to turn to for a consistently decent price, delivery time, and credit terms – even for products he knows little about. This is Grainger’s strength. It’s facility maintenance. Grainger isn’t as strong as MSC Industrial and Fastenal when it comes to the manufacturing floor. Those companies are better at selling cutting tools and fasteners and lots of related products to customers who have consistently high needs for some specialty products.
Like I said, Grainger is the most diversified company in its industry. The client list is extremely diversified. Manufacturing (18% heavy, 11% light) is just 30% of revenue. Commercial customers are 14%. Government is 13%. Contractors are 11%. Sellers – wholesale, retail, and resellers combined – are 10%. Transportation is 6%. And natural resources is 5%. It’s not quite as diversified as U.S. GDP. For example, manufacturing at nearly 30% of Grainger’s sales is clearly over-represented relative to the U.S. economy. But, it’s pretty close.
The products Grainger sells are so extraordinarily varied that I’ve had trouble talking to you about them so far. I’m sure that will continue to be the case. Grainger sells everything a business facility needs to keep running smoothly. Product categories include: Safety and security (18%), material handling (12%), metalworking (12%), cleaning and maintenance (9%), plumbing and test equipment (8%), hand tools (7%), electrical (6%), HVAC (6%), lighting (5%), fluid power (3%), power tools (3%), motors (2%), and power transmission (2%). So, concentrations in any one area are very low. For example, metalworking is a big, specialty category – but it’s still only 9% of the company’s total sales. A 10% drop in metal working sales would be less than a 1% hit to overall revenue.
Grainger has 1.4 million stock keeping units. About 500,000 SKUs are kept in inventory. Most orders ship same-day or next day. Grainger keeps products in inventory at 19 distribution centers and 350 branches across the country. Branches average 22,000 square feet.
Grainger divides customers into large customers, medium customers, and small customers. Quan and I think the real distinction is between customers covered by a specific Grainger sales representative (and attached to a corporate contract) and customers covered by a territory sales representative. Our best guess is that Grainger gets 85% or more of all revenue from customers covered by a specific sales rep under an attached account. Grainger says it has 14% market share in large customers. Large customers are customers with over 100 employees per location that buy over $100,000 worth of facility maintenance supplies each year. Grainger is very weak in small customers. These customers have fewer than 20 employees per site and buy facility maintenance supplies just once or twice a month. Almost all of Grainger’s growth has come from increasing sales to its biggest customers. Since 2009, sales to large customers have grown 8.6% a year. This is much, much faster than nominal GDP growth. Grainger has been increasing its share of wallet among these customers.
The company now has something called Zoro in the U.S. This company is modeled after Grainger’s joint venture in Japan. The Japanese joint venture – MonotaRO – was wildly successful in terms of revenue growth. So far, Zoro has been a fast grower too. The online only distributor had sales of $80 million in 2013, $180 million in 2014, and $300 million in 2015. Grainger hopes to copy Zoro’s success in both the U.K. and Germany. So, Grainger has several business units following this model. There is MonotaRO in Japan – which now has over $500 million in sales. There is Zoro in the U.S. – which now has $300 million in sales. And then Grainger hopes to use its U.K. acquisition to build a U.K. online only business. There is also Zoro Germany. So, one day, Grainger could have a meaningful online business in the U.S., Japan, the U.K., and Germany. These businesses compete directly with Amazon Supply. The rest of Grainger really doesn’t. Grainger sales reps always say that their largest competitors are other local or regional MRO companies. They say they rarely find themselves competing directly with Fastenal, MSC Industrial, or Amazon Supply – despite those being the competitors investors and analysts ask most about. Quan and I found in talking to people at the publicly traded MROs, that they are quite knowledgeable about each other’s business models, but actually don’t believe they compete very directly with each other or even do business in the same way. They all have different theories on which model is best. Part of the explanation for this can be that they each have different customer populations. Grainger’s success has really been on the least frequently purchased items by the biggest American companies. When it comes to frequently purchased items, smaller customers, or foreign countries – they’ve had a very mixed record. But, when it comes to large businesses, they are actually even more successful than the past record makes them seem. Sales growth looks mild in recent years due to the huge decline in sales to Grainger’s smallest customers. As we said, Grainger actually grew 10% a year since going public 40 years ago. And, it has grown sales to large businesses by more than 8% a year since the financial crisis. Earnings grow even faster than sales. So, Grainger is definitely a growth stock. In fact, it’s a growth at a reasonable price stock. As I write this, Grainger stock sells for about 10 times EBIT. That’s a great price for a growth stock.
(This post is a reprint of one of the nine sections that make up the Singular Diligence issue on Omnicom)
Moat is sometimes considered synonymous with “barrier to entry”. Economists like to talk about barriers to entry. Warren Buffett likes to talk about moat. When it comes to investing, “moat” is what matters. Barriers to entry may not matter. Thinking in terms of barriers to entry can frame the question the wrong way.
If you’re thinking about buying shares of Omnicom and holding those shares of stock forever – what matters? Do barriers to entry matter? Does it matter if it’s easy to create one new ad agency or a hundred new ad agencies? No. What matters is the damage any advertising company – whether it’s WPP, Publicis, or a firm that hasn’t been founded yet – can do to Omnicom’s business. How much damage can a new entrant do to Omnicom’s intrinsic value? How much damage can Publicis or WPP do to Omnicom? The answer is almost none. In that sense, the barriers to entry in the advertising industry are low but the moat around each agency is wide. How can that be?
First of all, the historical record is clear that among the global advertising giants we are talking about a stable oligopoly. The best measure of competitive position in the industry is to use relative market share. We simply take media billings – this is not the same as reported revenue – from each of the biggest ad companies and compare them to each other. If one company grows billings faster or slower than the other two – its competitive position has changed in relative terms. Between 2004 and 2014, Omnicom’s position relative to WPP and Publicis didn’t change. Nor did WPP’s relative to Publicis and Omnicom. Nor did Publicis’s position relative to WPP and Omnicom. Not only did they keep the same market share order 1) WPP, 2) Publicis, 3) Omnicom – which is rarer than you’d think over a 10-year span in many industries – they also had remarkably stable size relationships. In 2005, WPP had 45% of the trio’s total billings. In 2010, WPP had 45% of the trio’s combined billings. And in 2014, WPP had 44% of the trio’s combined billings. Likewise, Omnicom had 23% of the trio’s billings in 2005, 22% in 2010, and 23% in 2014. No other industries show as stable relative market shares among the 3 industry leaders as does advertising. Why is this?
Clients almost never leave their ad agency. Customer retention is remarkably close to 100%. New business wins are unimportant to success in any one year at a giant advertising company. The primary relationship for an advertising company is the relationship between a client and its creative agency. The world’s largest advertisers stay with the same advertising holding companies for decades. As part of our research into Omnicom, Quan looked at 97 relationships between marketers and their creative agencies.
I promise you the length of time each marketer has stayed with the same creative agency will surprise you. Let’s look at some of the examples. Wrigley – now a part of Wrigley Mars – used Saatchi & Saatchi as its creative agency from 1954 till 1995. Wrigley left Saatchi because of squabbling within the Saatchi family itself. After leaving Saatchi, Wrigley has been with Omnicom from 1995 through 2015. So, 40 years with Saatchi and then 20 with Omnicom.
Procter & Gamble has historically used Saatchi and Grey. P&G’s relationship with Saatchi dates back to 1921. Its relationship with Grey started in 1956. P&G’s relationship with Grey was costly to Omnicom, because P&G acquired Gillette in 2005. Gillette had been a client of one of Omnicom’s agencies for about 70 years. But, since P&G prefers working with Saatchi and Grey – it moved the Gillette account to Grey in 2013. This is how many big clients are lost. The client merges with a company that is served by a competing agency. Unilever has been an even more loyal client than P&G. Unilever prefers working with J. Walter Thompson and Lowe. It has been with J. Walter Thompson since 1902. So, that relationship is now 114 years old. It’s not the oldest relationship for Unilever. The company started working with Lowe in 1899. So, that relationship is 117 years old. Another example in household products brands is Clorox. Clorox has been with Omnicom’s DDB since 1996. Its prior relationship lasted 75 years. So, Clorox chose an agency in 1921. Then, it switched creative agencies in 1996. So, two moves in close to a hundred years.
Some industries have very high client retention. It seems financial services firms mostly leave agencies due to consolidation. So, one bank buys another and they switch to the bigger bank’s creative agency. Otherwise, the relationships are almost all long ones. State Farm has been with Omnicom’s DDB from 1930 till today. Between 2010 and 2011, State Farm shifted some of its business – especially the car insurance brand – to a different creative agency, but it moved all of that work back to DDB the following year. Allstate has been with Leo Burnett since 1957. Geico has been with the Martin Agency since 1994. All of GEICO’s campaigns you remember were created by The Martin Agency. American Express has been with Ogilvy since 1962. Visa is an interesting example of “moat”. Visa has been an Omnicom client from 1985 through today. However, Visa dropped BBDO in 2005. Omnicom asked Visa to limit its search for a new agency to among Omnicom owned agencies only. Visa agreed. And so the firm selected from pitches made by DDB, TBWA, etc. It didn’t consider moving to an agency owned by WPP or Interpublic or anyone else. In 2005, Visa switched from Omnicom owned BBDO to Omnicom owned TBWA. However, it moved back to BBDO in 2012. So, Omnicom retained Visa as a client despite one of Omnicom’s agencies being fired two different times in that period. Wells Fargo has been an Omnicom client since 1996. Discover Card was an Omnicom client from 1987 to 2006. Then, Discover moved from Omnicom to The Martin Agency. By 2006, The Martin Agency would’ve already been well known for the amazing work it had been doing for GEICO throughout the 1990s and early 2000s.
I don’t want to bore you with almost a hundred different examples of how long one client stays with one creative agency. But, I do think this is the most important fact in this entire issue. So, I encourage you to flip to the “Notes” section of the issue and read the list of relationships and their start dates that Quan prepared for industries ranging from carmakers to transportation companies to electronics brands.
Consolidation is the leading cause of losing a once loyal client. The other reason clients leave is because they are fickle. The same brand keeps switching creative agencies. This is common among troubled brands. A good example is Heineken in the U.S. Heineken is an imported beer that basically has the same positioning as “better beer” brands like Samuel Adams. Heineken originally competed with the big, boring domestic brands like Bud. Over the last 20 years, it’s had to compete with U.S. based craft beers and other imports. In the last 10 years, the brand has been in constant turmoil. From 2005 through 2011, Heineken had 4 different CEOs and 4 different chief marketing officers. Its creative agency from 2003 to 2007 was Publicis, then Wieden & Kennedy for 2008-2009, then Euro RSCG from 2009-2010, then back to Wieden & Kennedy for 2010-2015, and then in 2015 Heineken left Wieden and returned to Publicis. You can see this is not a problem with a particular creative agency. It’s a problem with the Heineken brand.
The other reason clients switch is because they belong to an industry with a lot of cyclicality to brand perception. Restaurants and retailers are the most fickle client group. Still, “fickle” is a relative term. Client retention is still very high compared to other industries. Wal-Mart has used 3 agencies over the last 30 years. Darden (Olive Garden) has been with Grey since 1984. McDonalds has used Leo Burnett and DDB since the 1970s.
There is no customer retention figure generally available for Omnicom or for the industry. But, you can easily estimate the retention rate is above 90% based on the nearly 100 relationships we looked at. You can peruse many of these relationships in the notes. From time to time, articles give client retention figures for a single agency. For example, in 2001 and 2002 and 2003 it was reported that DDB retained 98% or 99% of clients. In 2014, it was reported Grey had a 95% retention rate. An industry wide customer retention rate of 90% would be conservative for key accounts. A figure like 95% may be more realistic.
The most important fact to consider is that agencies don’t try to take business from each other. They try to take business once it is “in review”. In 2006, Omnicom’s CEO said: “We’re invited to new business pitches…we can’t create them…Fortune 100 companies, typically take their time and go through a lot of deliberations before they actually…put an account or an assignment into review.”
In 2007, Omnicom’s CEO (John Wren) again said: “…what goes into review is driven by clients…we can’t cause somebody to put their account in review.”
In other words, the only time one agency takes a Fortune 100 type client from another agency is when the client decides first to put the account in review. First, the client says they may fire the agency and then other agencies pitch for the business. When agencies do pitch for an account in review, they don’t usually compete on price. Traditionally, creative agencies took a 12% commission on billings. Media agencies took a 3% commission on billings. Now, the work tends to be fee based. But, it doesn’t matter. It’s clearly been structured the same way to keep price competition from happening. Omnicom has a very consistent EBIT margin from the 1990s through today. It has a quarter century record of extreme consistency in pricing versus its expenses. It’s basically a cost plus business. We can see with WPP – who reports billings while Omnicom doesn’t – that sales were between 20% and 22% of billings over the last 20 years. Again, it’s a consistent number and it’s not lower than the traditional commission structure the industry used. So, there is no evidence of agencies competing for business by trying to offer lower fees and commissions. The moat around each ad agency is wide because: 1) Customer retention is nearly perfect 2) Pricing is very consistent and 3) The relative market share of the oligopolists in this industry is also very consistent. Without changes in prices or relative market share – a business is basically the same from year-to-year. So, ad agencies mostly report earnings growth and declines based purely on the increases and decreases in ad spending by their existing clients. In fact, what you see in the year-to-year results of an advertising company is basically just that. It’s mostly just a record of what the existing client roster did in terms of their ad spending compared to last year. So, the industry is incredibly stable over full cycles. It is cyclical to the extent that ad spending is cyclical and follows the macro economy.
(This post is a reprint of one of the nine sections that make up the Singular Diligence issue on Prosperity Bancshares)
An investor interested in Texas banks should simply buy both Prosperity and Frost. These two biggest Texas based banks are among the best banks in the U.S. They each have their risks. Frost makes energy loans. And Prosperity does not have especially high capital levels. But, these risks should be small because of the conservative attitudes toward lending and acquisitions at each bank. Frost doesn’t make big, transformative acquisitions. And Prosperity is a serial acquirer that has never had high loan losses despite acquiring many different Texas banks.
We can certainly compare Prosperity and Frost. But, my advice and Quan’s advice would be not to buy Prosperity without also buying Frost and not to buy Frost without also buying Prosperity. Unless you have a very, very concentrated portfolio – there is little reason to focus on buying only one bank and not the other.
Prosperity is less interest rate sensitive than Frost. And Prosperity doesn’t make energy loans. So, if your two big concerns are that oil prices will stay low for many, many years to come and the Federal Reserve will keep interest rates at or below zero for many, many years to come – it makes sense to buy Prosperity instead of Frost. I understand some investors may have a feeling about where oil prices or interest rates are headed in the next few years. And they may want to bet on that feeling. But, oil below $30 a barrel is cheap long-term. And a Fed Funds Rate under 1% is low in normal times. So, it doesn’t make much sense to bet against either an increase in oil prices or an increase in the Fed Funds Rate. Buying both Prosperity and Frost can diversify whatever risks Frost has in terms of energy loans and low interest rates. But, I can’t suggest picking Prosperity over Frost. Because, actually, it’s reasonable for rates to rise over the next 5 years and for Frost to benefit far more from that than Prosperity. As for energy loans, the truth is that while Frost might have to write-off a lot of energy loans if oil stays below $30 for years – those losses would not bring Frost’s tangible equity levels lower than Prosperity’s. In other words, Frost can charge-off a lot of its energy loan portfolio and still have higher tangible equity to total assets after doing so than Prosperity does now. So, it’s not logical to prefer a bank with lower tangible equity levels over a bank with higher tangible equity levels just because the bank with higher tangible equity might charge-off loans that would still leave it more highly capitalized than the bank that doesn’t charge-off any loans. So, again, I see no reason to prefer Prosperity over Frost because of energy loans. Low oil prices will cause bad headlines at Frost and not at Prosperity. But, bad headlines don’t necessarily make for a bad stock.
What about interest rates? This one is speculative. But, it’s also a meaningful difference between Prosperity and Frost. If you really did know what the Fed Funds Rate would be at various points in the future – you could discriminate between Prosperity and Frost on that basis. For example, Quan and I estimate that based on today’s interest rates, Prosperity is more than 10% cheaper than Frost. However, based on a 3% Fed Funds rate – which we consider normal – Prosperity would actually be about 20% more expensive than Frost. So, is Prosperity cheaper than Frost or more expensive? In my opinion, Prosperity is more expensive than Frost. I always look at normal earnings. If you’re analyzing an oil company while oil is $27 a barrel and you expect oil to be $55 a barrel in 2021, then you would estimate 2021 earnings based on $55 a barrel. And if you’re a long-term investor, it doesn’t matter what earnings are in 2016 when you buy the stock. It matters what earnings will be in 2021 when you sell the stock. I think the same rule applies to interest rates – except only more so. Central banks have implemented negative interest rates in other parts of the world. It’s technically possible the Fed could do that in the U.S. But, is it important to consider? There are real problems with having interest rates very close to zero and even bigger problems when interest rates are below zero. It’s not reasonable to believe that a negative 3% Fed Funds Rate in 2021 is as likely as a positive 3% Fed Funds Rate in 2021. And yet we know that Frost will benefit more from higher rates than Prosperity. So, with interest rates as close to zero as they are – we would expect higher rates to be a more likely event in 5 years’ time than lower rates. This is speculative. But, it’s not speculative in quite the same way as looking at $38 a barrel oil today and wondering whether oil is more likely to be at $76 a barrel in 2021 or $19 a barrel in 2021. Long-term costs would suggest $76 a barrel might be a little more likely than $19 a barrel. But, $19 a barrel is not an unreasonable price for oil in quite the same way that a negative yield on money is an unreasonable price for a loan. Oil at $19 a barrel in 2021 would not be as odd an occurrence as a meaningfully negative Fed Funds rate in 2021. So, Prosperity is cheaper than Frost now because interest rates are abnormally low now. But, Frost is cheaper under any reasonable “normal” interest rate scenario. That’s why I consider Frost the cheaper stock. You shouldn’t price a stock based on what it’s earning in an abnormal present. You should price it against what it will earn in a normal future.
Prosperity might have more upside. Quan believes Prosperity’s organic growth has a 20% or better after-tax return on equity. He also thinks any acquisitions Prosperity does should have a 13% or better after-tax return on equity. The stock has a 2.5% dividend yield. So, the only part of the future return equation that could be sub-standard is the reinvestment of that dividend. Prosperity may be able to earn between 13% and 20% on the earnings it retains. It’s unlikely you can earn that much on the dividends it pays you. But, as long as the dividend payout ratio is low, it’s unlikely your total return will be pulled below 10% a year.
Prosperity has a P/E around 11 today. Historically, it has traded at between 13 and 20 times earnings. So, the stock is cheap relative to its own past. It’s not clear why this is. Prosperity is a Texas bank. Some investors may worry that Texas real estate will perform poorly in an oil bust. They may worry about Prosperity’s real estate loans in areas like Houston where energy companies are large employers and large office tenants. Energy loans are only 5.5% of Prosperity’s loan portfolio. That’s 2.7% of earning assets. Losses on those loans can’t meaningfully increase risk at all for shareholders. To put this in perspective, if every energy loan Prosperity made defaulted and Prosperity recovered zero cents on the dollar in all these defaults – Prosperity could cover all of the losses out of roughly one year’s earnings. Investors may also dislike all regional banks because of interest rate sensitivity. But, Prosperity is fine with low rates. The Fed Funds rate declined from over 5% to less than 0.25% from 2007 to 2014. During that time, Prosperity grew earnings per share by 12% a year. At worst, the risk that investors are worried about for the next 7 years is that the Fed Funds Rate is fairly flat near zero – not that it declines by five full percentage points. So, Prosperity was a growth stock over the last 7 years when rates were falling rapidly. No one expects rapidly falling interest rates. So, the next 7 years should present Prosperity with interest rates that are easier to cope with than the last 7 years. Right now, Prosperity’s net interest margin is in line with the bank’s long-term historical average net interest margin. Honestly, Prosperity’s net interest margin doesn’t vary much with the Fed Funds rate. So, concerns about the Fed not raising rates as fast or at all as expected are an argument against buying Frost right now. They aren’t an argument against buying Prosperity. It’s also worth mentioning that we are really only debating the upside here. Even if interest rates don’t rise, Frost is a cheap stock that will deliver good returns. It just won’t deliver great returns quickly if rates stay near zero. Prosperity’s upside is pretty similar regardless of what happens with interest rates.
So, if you are concerned about energy loans and believe the Fed will not raise rates – you might prefer Prosperity over Frost. Quan and I aren’t that worried about energy loans. And we expect the Fed Funds rate to be a lot higher in 5 years than it is today. So, if you’re a long-term buy and hold investor, we suggest putting equal amounts of your money into the two biggest Texas based banks: Frost and Prosperity
Over the last two years, Quan and I failed to find as many good, small stocks for the newsletter as we should have. We did Breeze-Eastern which was small. We also picked Ark (ARKR), Tandy Leather (TLF), and Village Supermarket (VLGEA). All of those are under $500 million in market cap. America’s Car-Mart (CRMT) is also on the small side. But, it’s a financial stock.
If your biggest problem with sifting through small stocks is getting rid of the low quality and high risk stocks in the group – there’s an easy screen for this.
Just look for stocks that:
Have been public a long time
Have a long history of profitability
Have an adequate Z-Score
Have an adequate F-Score
This won’t leave you with a list of good stocks. But, it will remove the junk. This is a value investing blog. So, we’ll insist on an enterprise value no higher than 10 times EBIT (ideally, it would be 10 times peak EBIT – but that’s harder to screen for).
If we apply these 5 criteria – 1) didn’t go public recently, 2) decent history of past profits, 3) decent Z-Score, 4) decent F-Score, 5) decent EV/EBIT – we are left with 26 U.S. stocks with a market cap under $500 million:
Armanino Foods of Distinction (AMNF)
Espey Manufacturing (ESP)
Educational Development (EDUC)
Shoe Carnival (SCVL)
Air T (AIRT)
Comtech Telecommunications (CMTL)
Miller Industries (MLR)
ADDvantage Technologies (AEY)
Collectors Universe (CLCT)
Houston Wire (HWCC)
Wayside Technology (WSTG)
Lakeland Industries (LAKE)
Taylor Devices (TAYD)
Core Molding (CMT)
Natural Gas Services (NGS)
Universal Truckload (UACL)
Acme United (ACU)
Preformed Line (PLPC)
This list excludes stocks I’ve already picked. Tandy, Village, and Ark would be on the list if that wasn’t the case.
Sorting through that list then becomes a matter of personal preferences and biases. For example, I’d be less likely to research Zumiez – which is a specialty retailer (it’s basically a mall based chain of stores selling skateboarding related clothes, etc. aimed at teens) because Quan and I rarely consider investing in retailers. I might be more likely to look at Collectors Universe and Miller Industries because they have big market share in their niches (collectibles grading and tow trucks respectively).
Quan and I did an issue on Breeze-Eastern last year. The stock has since been acquired by TransDigm (TDG). When we did the issue Breeze-Eastern was priced at $11.38 a share. We appraised the stock at $15.02 a share. TransDigm would later pay $19.61 a share for all of Breeze-Eastern.
What lesson can we learn from our Breeze-Eastern experience?
Here’s what we said about Breeze-Eastern’s stock price at the end of our issue:
“Breeze should – based on the merits of the business alone – trade for between 10 and 15 times EBIT. It is unlikely the stock market will ever put such a high value on Breeze…It is a small company. And 3 long-term shareholders own 70% of the stock. That doesn’t leave a lot of shares for everyone else to trade…Some investors may not like that kind of illiquidity…Breeze is not a fast growing company. And it’s not in an exciting industry. So, it is unlikely to get attention based on anything but its numbers. This might cause investors to underappreciate the qualitative aspects of the company…It is possible that the investment funds that hold most of Breeze’s stock will not hold it for the long-term. They may want to sell the company.”
Last year, Value and Opportunity did a blog post called “Cheap for a Reason”:
“Every ‘cheap’ stock you will find has problems. Some of those problems might be individual (bad management, too much debt etc.), some of those problems might be more sector specific (oil&gas, emerging markets exposure) or a combination of both.
The most important thing is to be really aware what the real problem is. If you don’t find the problem, then the chance is very high that you are missing something.”
So, why was Breeze-Eastern cheap?
Quan and I thought it was that the company had been spending on developing new projects in the recent past that wouldn’t pay off till the future:
“Between 2007 and 2011, Breeze-Eastern’s EBIT margin was depressed by 5 full percentage points as a result of development spending on projects like the Airbus A400M…Breeze-Eastern’s gross margin and operating margin will be higher in the future than they were in the last 10 years.”
The merger document for the acquisition includes a projection by the company’s management to its financial advisors that suggests the reason TransDigm – or any other 100% buyer – would pay more for Breeze than the stock market had often valued the company at was because:
Breeze will have lower costs as it spends less on development projects
AND Breeze will have higher sales as a result of the development projects it spent on in the recent past
The projections show EBIT going from $12.9 million in 2015 to $29.3 million in 2021. This is a 15% annual earnings growth rate. The projected growth is largely due to management’s belief that revenue from platforms under development will go from $0 in 2016 to $28 million in 2021.
This would seem to suggest that we were right about two things:
The stock’s illiquidity made its shares more attractive to a 100% buyer than to individual investors buying just a small, tradeable piece of the company
Breeze was cheap today versus its likely future value, because the company’s reported results included present day expenses as incurred but did not include the expected long-term payoff from supplying new helicopter and airplane projects that won’t be launched for several years
So, maybe the two lessons we should learn from the Breeze takeover being done at a much higher price than the stock traded at or than we valued the company at are:
Always value a stock based on what a control buyer would pay for it as a permanent, illiquid investment – never value a stock based on what traders will pay for small, tradeable pieces of the business (Ben Graham’s Mr. Market rule)
Look for businesses that have to report bad results today even though you know they will report better results in the future
Quan and I weren’t sure if Breeze would have higher revenue from these projects one day. The acquirer here is counting on future projections for revenue. However, we were sure that Breeze would spend less in the future than it did in the past. That was a sure thing.
There is one problem with this analysis of the learning experience we got from Breeze. Mr. Market actually did re-value the company upwards before the acquisition – not after. Breeze went from like $12 a share in the summer of 2015 to $20 a share in the fall of 2015. You didn’t have to hold the stock through the acquisition to make money. We were wrong that Mr. Market would never pay up for such a boring, obscure, and illiquid little stock.
It’s worth mentioning here that Breeze’s enterprise value had been $160 million in 2009. We even mentioned in the issue we wrote that Breeze fell in EV from $160 million in 2009 to $95 million in 2015. Yet, we didn’t speculate that Mr. Market would once again assign Breeze a $160 million enterprise value. It seemed more reasonable to us that someone would buy the whole company. So, again we proved we are really bad at guessing what Mr. Market will do. And maybe it is better to assume we know nothing about how a stock will be valued by anyone other than a control buyer.
Also, we were clearly too conservative in our appraisal of Breeze. At about 7 times what we considered normal EBIT to be, it was a cheap stock when we picked it. And we probably presented it as too much of a value investment and not enough of a quality investment. I think we were biased against Breeze – we ticked off its extraordinary virtues in the text of our issue but still slapped an utterly ordinary EBIT multiple of 10 on the company – due to its small size as a stock and its low growth in recent years. We may have pigeonholed it as “microcap” value. In fact, we knew that based on signs like market structure, relative market share, and the bargaining power Breeze had when dealing with spare parts buyers that its “market power” was among the strongest of any company we’ve covered. Probably John Wiley and Tandy Leather are as strong. Hunter Douglas also has an excellent competitive position.
Since Breeze is a small company in a very small industry, we didn’t have precise data to give on market share the way we often do. All we could say was that Breeze had “a greater than 50% global market share” in a “true duopoly” and that “the only reason customers ever seem to switch from Breeze-Eastern to UTC or vice versa is when they get annoyed that a critical spare part is taking too long to arrive.”
This last sentence is probably the most important sentence in our issue. We rarely come across companies to analyze where the customers tell us flat out that they just aren’t going to switch providers. The two clearest examples of this are Breeze and John Wiley.
Finally, Breeze is a classic example of a “Hidden Champion”. We’ve only done a few truly dominant companies for the newsletter. Tandy and Hunter Douglas are probably the closest to Breeze in terms of market leadership. They’re also similar in that they have no real peers. We try to present “comparable” peers in each issue. We said flat out in the issue that “Breeze has no good peers.” The same thing is true of Tandy and Hunter Douglas.
There’s a lesson in here. Look for companies with no publicly traded peers. Analysts cover entire industry groups. And investors like to pick from the top down too. If you started from the top down would you ever get to the “helicopter rescue hoist industry”? Where does that fit in a portfolio? What about leathercrafting? Most people don’t even know that’s a real hobby. Or shades and blinds? Is that housing related?
For me, the biggest lessons from Breeze-Eastern are both about timing.
We can time normal earnings. For example, we could see Breeze was under earning now. This isn’t hard. We know Hunter Douglas will make more in the future than it did in the recent past (since U.S. housing was lower than normal). We know Frost will make more in the future than it did in the past (since interest rates are lower than normal). Often, you don’t know “when” this “normal future” is. But, it’s not hard to notice when the present is abnormal in some way.
We can’t time the stock market. Quan and I never would have predicted that Breeze-Eastern’s stock would rise on its own – without a buyout offer – to anything like the level it did. And we never would have expected it’d do it so fast.
I think it’s a lot easier to figure out what an acquirer will eventually pay for a company than what the stock market will eventually pay for a stock.
So, how do we combine the ideas of finding companies that are under earning today compared to a normal future year with the idea of ignoring Mr. Market entirely and simply valuing a stock based on what an acquirer would pay for the entire company?
I guess we could distill that down to a simple investment recipe:
Step One: Fast forward 5 years.
Step Two: How much would an acquirer pay for this company (in 2021 not 2016)?
Last Step: Work backwards to decide how much you should pay for one share of the stock today assuming the whole company is bought 5 years from today.
Quan and I have picked 19 stocks over the last couple years. One of those stocks, Babcock & Wilcox, split into two different stocks. So, there are 20 stocks that had our blessing. Six of these are not good choices for you to look at. Two have been acquired so you can't buy them (LifeTime Fitness and Breeze-Eastern). Two were stocks we shouldn't have picked in the first place (Town Sports and Weight Watchers). And two are now too expensive to be worth your time (BWX Technologies and HomeServe).
Here is the full list including the six stocks that I'd disqualify.
Once you disqualify those 6 stocks, you're left with 14 stocks that are still worth looking at today:
Babcock & Wilcox Enterprises
Sells old cars on credit to deep subprime customers mostly in the U.S. deep South.
Runs big single location restaurants (not chains) in high visibility venues (casinos, museums, train stations, parks, etc.).
Babcock & Wilcox Enterprises
Builds and maintains big steam boilers for thermal power (coal, incinerator, etc.) plants.
A Tulsa, Oklahoma based commercial bank that does a lot of energy lending.
Makes Stressless brand recliners.
Sells watches under the Fossil and Skagen brands it owns and the many fashion brands (Michael Kors, Armani, etc.) it licenses the rights to.
A San Antonio, Texas based commercial bank that also does a lot of energy lending.
Makes the Hunter Douglas and Luxaflex brands of shades and blinds.
Sells academic journal subscriptions to university libraries.
Sells watches under the Movado brand it owns and the many fashion brands (Coach, Tommy Hilfiger, etc.) it licenses the rights to.
Writes car insurance coverage for American drivers who go to the company’s website or get their policy through an agent.
Sells watches under the many brands (Omega, Longines, Tissot, Swatch, etc.) the company owns.
Runs a chain of leather goods stores that serves both retail and wholesale customers.
Runs a couple dozen big Shop-Rite supermarkets (they average 60,00 square feet of selling space) in New Jersey.
I spend about 10-15% of my time crunching data. That sounds tedious but I actually enjoy this task. It forces me to pay attention to details, checking any irregularity I see in the numbers and trying to tell a story out of the numbers. My recent work on Commerce Bancshares (CBSH) led me to ponder the relationship between ROIC and long-term return.
Over the last 25 years, Commerce Bancshares averaged about a 13-14% after-tax ROE, and grew deposits by about 5.6% annually. Over the period, share count declined by about 1.9% annually, and dividend yield was about 2-2.5%. Assuming no change in multiple, a shareholder who bought and held Commerce throughout the period would receive a total return of about 9.5-10%, which is lower than its ROE. Why is that?
Chuck Akre once talked about this topic:
“Mr. Akre: What I’ve concluded is that a good investment is an investment in a company who can grow the real economic value per unit. I looked at (what) the average return on all classes of assets are and then I (discovered) that over 75-100 years that the average return on common stock is around 10%. Of course this is not the case for the past decade but over the past 75-100 years, 10% has been the average return of common stocks. But why is that?
Audience A: Reinvestment of earnings.
Audience B: GDP plus inflation.
Audience C: Growing population.
Audience D: GDP plus inflation plus dividend yield.
Audience E: Wealth creation.
Audience F: Continuity of business.
Akre: …what I concluded many years ago, which I still believe today, is that it correlates to the real return on owner’s capital. The average return on businesses has been around low double digits or high single digits. This is why common stocks have been returning around 10% because it relates to the return on owner’s capital. My conclusion is that (the) return on common stocks will be close to the ROE of the business, absent any distributions and given a constant valuation. Let’s work through an example. Say a company’s stock is selling at $10 per share, book value is $5 per share, ROE is 20%, which means earnings will be a dollar and P/E is 10 and P/B of 2. If we add the $1 earning to book value, the new book value per share is $6, keeping the valuation constant and assuming no distributions, with 20% ROE, new earnings are $1.2 per share, stock at $12, up 20% from $10, which is consistent with the 20% ROE. This calculation is simple and not perfect, but it has been helpful in terms of thinking about returns on investment. So we spend our time trying to identify businesses which have above average returns on owner’s capital.”
The restriction in Akre’s explanation is “absent any distributions.” In general, there are two sides of total return: the management side, and the investor side. Management can affect total return through ROIC, reinvestment, and acquisitions. Investors can affect total return through the price they pay and the return they can achieve on cash distributions.
The Problem of Free Cash Flow
Reinvestment into the business usually has the highest return (this post discusses only high quality businesses that have high ROIC). Problems arise when there’s free cash flow. Management must choose either to return cash to shareholders or to invest the cash themselves. Both options tend to have lower return than ROIC.
Cash distributions don’t seem to give investors a great return. Stocks often trade above 10x earnings so distributions give lower than 10% yield. In my example, Commerce Bancshares wasn’t able to reinvest all of its earnings. It retained about 40% of earnings to support 5.6% growth and returned 60% of earnings in the form of dividends and share buyback. The stock usually trades at about a 15x P/E, which is equivalent to a 6.67% yield. The retained earnings had good return, but the cash distributions had low underlying yield. The average return was just about 10%.
Unfortunately, many times returning cash to shareholders is the best choice. Hoarding cash without a true plan on using it destroys value. Expanding into an unrelated business for the sake of fully reinvesting doesn’t make sense. Similarly, acquisitions often don’t create a good return.
The problem with acquisitions is that they’re usually made at a premium so the underlying yield is likely lower than the yield that would result from share buybacks. The lower underlying yield can be offset by either sales growth or cost synergies. Studies show that assumptions about cost synergies are quite reliable while sales growth usually fails to justify the acquisition premium. To illustrate this point, let’s take a look at 3 of the biggest marketing services providers: WPP, Omnicom, and Publicis.
Omnicom is a cautious acquirer. It spends less and makes smaller acquisitions than peers. Its average acquisition size is about $25 million. Over the last 10 years, Omnicom spent only 16% of its cash flow in acquisitions while WPP and Publicis spent about 44% of their cash flow in acquisitions. Publicis is a stupid acquirer. It makes big acquisitions and usually pays 14-17x EBITDA. WPP is a smart acquirer. Like Omnicom, it prefers small acquisitions. When it did make big acquisitions, it paid a low P/S and took advantage of cost synergies. For example, it paid $1.75 billion or a 1.2x P/S ratio for Grey Global in 2005. That was a fair price as WPP was able to integrate Grey and achieve WPP’s normal EBIT margin of about 14%.
To compare value creation of these companies over the last 15 years, I looked at return on retained earnings, a measure of how much intrinsic value per share growth created by each percent of retained earnings. As these advertising companies have stable margins, sales per share is a good measure of intrinsic value. Retained earnings in this case is cash used for acquisitions and share buyback, but not for dividends.
As expected, Publicis created the least value:
It’s interesting that the smart acquirer WPP didn’t create more value than Omnicom. That’s understandable because acquisitions aren’t always available at good prices. So, it’s very difficult for management to generate a great return on free cash flow. Therefore, the value of a high-ROIC business is limited by the capacity to reinvest organically. Free cash flow tends to drag down total return to low double-digit or single-digit return.
The Investor Side of Total Return
It’s very difficult to make a high-teen return by simply relying on management. The capacity to reinvest will dissipate over time and free cash flow will drag total return down to single digit. However, there are two ways investors can improve total return.
First, investors can shrewdly invest cash distributions. When looking at capital allocation, I usually calculate the weighted average return. For example, if a company invests 1/3 of earnings in organic growth with 20% ROIC and 1/3 in acquisitions with 7% return on investment, and returns 1/3 to shareholders, how much is the total return? It depends on how well shareholders reinvest the money. If we shareholders can reinvest our dividends for a 15% return, the weighted average return is 20% * 1/3 + 7% * 1/3 + 15% * 1/3 = 14%. This number approximates the rate at which we and the management “together” can grow earnings (actually if payout rate is high, combined earnings growth will over time converge to our investment return on cash distributions.)
Second, an investor can buy stocks at a low multiple. The benefit of buying at a low multiple is twofold. It can help improve yield of earnings on the initial purchase price. It also creates chance of capital gains from selling at a higher multiple in the future.
Warren Buffett managed to make 20% annual return for decades because he was able to buy great businesses at great prices and then profitably reinvest cash flow of these businesses.
Small investors can mimic Buffett’s strategy as long as the stock they buy distributes all excess cash. They can reinvest dividends for a great return. In the case of share buybacks, they can take and reinvest the cash distribution by selling their shares proportionately to their ownership. That’s how Artal Group monetizes Weight Watchers (WTW).
Share Repurchase at Whatever Price
This discussion leads us to the topic of share repurchases. I think many investors overestimate the importance of share buyback timing. It’s nice if management buys back shares at 10x P/E instead of 20x P/E. But what if share prices are high for several years? Would investors want management to wait for years – effectively hoarding cash – to buy back stock at a low price?
Good share buyback timing can help build a good record of EPS growth but EPS growth doesn’t tell everything about value creation. It’s just one side of total return. What investors do with cash distributions is as important. So, I think management should focus more on running and making wise investments in the business and care less about how to return excess cash. I would prefer them to repurchase shares at whatever price.
By doing so, management effectively shares with investors some of the responsibilities to maximize total return. Share buyback gives investors more options. Investors must automatically pay tax on dividends but they can delay paying tax by not selling any shares at all. If they want to get some dividends, they can sell some shares and pay tax only on the capital gain from selling these shares instead of on the whole amount of dividends. Or they can simply sell all their shares and put all the proceeds into better investments if they think the stock is expensive.
I do not believe in buying a good business at a fair price. If the management does the right things, holding a good business at a fair price can give us 10% long-term return. But great investment returns require a good job of capital allocation on the investor’s part: buying at good prices and reinvesting cash distributions wisely.
Moat is really about protecting a company’s profit as Warren Buffett said:
“You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley’s. I can’t do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it. Those are good businesses.”
A business may make less profit because of lower sales, lower margin, or both. So, there are two sides of moat: the sales side and the margin side. The sales side can be broken down into customer retention and customer acquisition.
There are many factors that lead to high retention, including customer behavior, price insensitivity, switching cost, etc.
Customer behavior is subtle. Sometimes customers just don’t think about switching. I used to wonder how small banks can compete with big banks. I realized that a bank’s moat doesn’t come from low funding cost or low operating cost but actually from customer habit. Customers rarely change their primary banking account. So, a small bank may have a low ROE because of its high costs but it can still have stable local market share. Despite their big scale to sell many financial products, big banks can’t steal business from small banks very easily.
Similarly, car owners rarely shop for a new insurer unless there's a bad experience, there's a major event in their life (move or marriage) or there's a spike in the price of their premiums. In fact, insurers like State Farm and Allstate have greater retention rate than Progressive and Geico because they sell bundled products. So, even though Progressive and Geico have a huge cost advantage, they have only low double digit market share after decades of gaining market share. There are simply not many people shopping for new car insurance policies each year.
Price insensitivity helps retain customers in the face of price competition. Customers may pay little attention to price when it’s a tiny part of their total spending. Switching from Coca Cola to a private label cola simply doesn’t save much.
Even better, some customers are willing to pay more for convenience, tailored solutions, product quality, or customer services. I find it interesting that Frost often pays less than one-tenth of the Federal Funds Rate for its interest-checking deposits. For example, Frost paid only 0.47% on its interest-checking deposits in 2007 while many other banks paid about 1.50%. I’m not sure why but perhaps Frost’s customer service is so good that customers simply don’t care about getting interest income on their deposits.
Strong customer acquisition can be achieved through distribution, mindshare, product superiority, or price.
The best example of distribution power is perhaps big food companies. By owning key brands, they have the power to convince retailers to carry new brands. Similarly, journal publishers like John Wiley have distribution power by selling bundles of journals to university libraries.
Mindshare also benefits customer acquisition. Mindshare can be created by advertising, word of mouth or simply positive experience. If a customer decides to buy car insurance directly, he’ll pick either Geico or Progressive. Price comparison is actually much less common in the direct channel than in the agency channel. Direct customers know they’ll get a good price from Geico or Progressive.
Mindshare is particularly strong when a purchase is infrequent. The classic example is See’s Candies. People shop on only one or two occasions a year so there’s no incentive to look for other brands. To a lesser extent, some furniture brands in the U.S. spend a lot in advertising so that people think of Tempur-Pedic when they want to buy a memory foam mattress, think of Select Comfort when they want to buy an air-adjustable mattress, or think of La-Z-Boy when they want to buy a recliner.
Product superiority usually results from investment in R&D or service. It is strongest when there’s a network effect, which makes a popular product more valuable to customers. People join Facebook because many of their friends are there. People go to Amazon or eBay because that’s where they can find the most sellers and thus the best price.
Finally, low price is always a powerful customer acquisition tool.
Margin can be protected by maintaining the gap between price and costs. To analyze the margin side of moat, the key questions are:
1. Does the company have lower costs than competitors?
2. Does the company have higher asset turnover than competitors?
3. Does the company have higher customer willingness to pay than competitors?
4. Is the power of suppliers and buyers low?
Low cost, high asset turnover, and high customer’s willingness to pay provide a cushion against price competition in the industry. Low power of buyers and suppliers keeps profits from leaking out of the industry. Increasing concentration of buyers or suppliers is a big threat to future profits. Better organized buyers or suppliers may demand better pricing or they threaten to sell or source directly.
To evaluate moat, we should look at 3 things:
1. Barrier to entry
2. Potential damage of new entrants
3. Rivalry among existing firms
Barrier to Entry
In this step, we should try to detect all advantages of a company in customer retention, customer acquisition, and margin protection. Barrier to entry is high when several factors are required at once so that entrants need not only money but also time to compete well.
Let’s look at Hunter Douglas.
Customer retention isn’t very important for Hunter Douglas because purchases are infrequent. That said, Hunter Douglas’s customers are highly satisfied. Hunter Douglas’s focus on product innovation and services raise a customer’s willingness to pay. Customers rarely downgrade to a lower quality product unless they move to a rental home.
Hunter Douglas’s greatest strength is in customer acquisition, specifically distribution. Independent dealers choose Hunter Douglas because the product quality is higher and they can sell the brand more easily. In fact, it’s usually the brand that draws traffic to dealers rather than dealers getting the traffic themselves. Hunter Douglas advertises more than anyone else in the window coverings industry. It also enjoys great word of mouth.
Hunter Douglas’s margin is sustainable. Thanks to its huge relative market share, Hunter Douglas benefits from economies of scale in advertising, in R&D, and in fixed investments in its integrated and highly automated manufacturing facilities. Customer’s willingness to pay is higher than competitors because of product quality, advertising, and dealer service. Finally, the power of suppliers and buyers is low. Hunter Douglas is an integrated manufacturer so its inputs are mostly commodities. Dealers have little power because they’re individual mom-and-pop operations.
A competitor needs brand recognition and low cost to recruit dealers. But it needs wide distribution to have low cost and to justify advertising investment. So, this is a chicken and egg problem. The best chance to compete with Hunter Douglas is through the online channel or through the big box channel. The only weakness in Hunter Douglas's moat is the possibility of a market share shift between channels.
It’s worth noting that customer power is very strong in the big box channel, which Hunter Douglas avoids. Home Depot or Lowe’s usually demand a low price. Hunter Douglas’s competitors sell through big boxes and make little profit to reinvest in marketing or product innovation. And they tend to cut product quality to meet the low-price demand from big boxes. So, end-customers can be segmented by channels.
A weak example is Weight Watcher (WTW).
WTW’s customer retention is weak because its members come and go. People don’t take responsibility for their failure so they’re always eager to try new weight loss programs.
WTW’s customer acquisition is a bit better. It has no distribution advantage because fads can pick up easily in health and fitness. However, it has strong mindshare. Many people know what it is and know its effectiveness. In fact, its members re-enroll in the program on average three more times during their lives. All WTW needs to do is to give people a reason to join right now instead of putting off joining indefinitely.
WTW’s margin is great. Customer willingness to pay is high thanks to the social value of weight loss. The power of suppliers and customers is low. So, it’ll make a lot of profits as long as it gets enough customers.
So, WTW doesn’t have moat but it has some strength in customer acquisition. Its former customer base, about 20 million in the U.S., grows over time. The overweight population grows over time. So, it just needs the right program news and the right marketing buzz. In the past, Weight Watchers has always made record profits after each cycle.
Potential Damage from New Entrants
Sometimes a business can be good despite a low barrier to entry. I think WTW is a good example. So, it’s useful to make some attempts to judge the potential damage of new entrants.
The best tool in this step is to look at history. I unfortunately underestimated WTW’s risk in the recent cycle. The problem is that I only had WTW’s financial data back to 2001. I would have been more cautious if I had financial data back to 1990 to see how WTW performed in its previous crisis in early 1990s. Without financial data, we only know that WTW has always been able to reinvent its program during each crisis.
I think there’s some similarity between WTW and restaurant chains. The market is huge. Each chain has a different concept and few have a big market share. But barrier to entry is low and customers are willing to try new restaurants.
New entrants actually don’t do as much damage to existing chains as people think. There are not many new successful stories like Chipotle (CMG). And it took Chipotle 20 years to seize just a 2% market share. A rate of two percent is less than the restaurant industry grows in a single year.
Moreover, new restaurants don’t always open in a brand new location. Often, they open in or near a location another restaurant concept had occupied before. So, the total supply of fast food restaurants doesn’t necessarily increase more than population growth despite the industry’s low barrier to entry.
So, the biggest competition in fast food chains is actually among existing chains.
Recently, Value and Opportunity argued that Fossil has no moat because “…wholesale distribution network seems to be quite open for newcomers like Daniel Wellington.” It’s true that department stores always have store space to test new suppliers. Retailers care about gross profit per square foot so they often switch suppliers in that area of their stores. Sometimes a new entrant may succeed.
But how much will the success of a new watch brand actually hurt Fossil?
Customer’s willingness to pay is high in this category so it won’t hurt margin. It may hurt volume, thus reducing gross profit per square foot of Fossil’s licensed watches. But cannibalization might not be as high as most people expect. Revenue of Michael Kors watches went from $100 million to $900 million in 5 years but it didn’t hurt Fossil’s other brands. And Fossil’s other brands didn’t benefit from the recent fall in Michael Kors either. Perhaps not many people wear watches today so Michael Kors helped bring more consumers to the category. Or it simply induced people to buy more often.
Also, can Daniel Wellington build on its early success and keep its brand relevant? It’s a big challenge for any newly successful entrant.
So, I think it’s safe to bet that a (growing) diversified portfolio of strong licensed brands can help Fossil gain market share over time.
Rivalry Among Existing Firms
This step is similar to the Barrier to Entry step. However, we compare a company’s strengths in customer retention, customer acquisition, and margin with its competitors. We want to see some durable competitive advantages that allow a firm to gain market share over time. And we want to make sure that the moat is widened over time.
In our bank example, every American bank has a pretty good retention rate. However, some regional banks such as Commerce Bancshares (CBSH) and BOK Financial (BOKF) have the scale to sell other products like wealth management or payment systems service. Selling more products to a customer creates a closer relationship and improves retention. More products also mean more touch points to acquire new customers. Finally, more products result in more fee income, reducing net operating cost and creating a cost advantage. A cost advantage may allow for more reinvestment in products and services. So, these banks will possibly gain market share from tiny local competitors over time.
There’s nothing innovative in this this framework. But I think it can help us connect different competitive advantages and see a clearer picture of moat. It’s a simple way to think about moat. But the most important question is always the one Warren Buffett asks:
“I say to myself, give me a billion dollars and how much can I hurt the guy?”
Geoff said in the last post that: “simply learning to love illiquidity, boredom, and a lack of headlines in your portfolio might be enough to improve your returns.” The key word is boredom. I think 3 main reasons for a stock to be boring are low growth, lack of catalyst, and a so-so price. A stock with these characteristics is not attractive to growth investors, value investors, and momentum investors. But sometimes these characteristics hide qualities that can generate great long-term returns.
Quality of Growth
I once made a bold statement that Frost promises the best growth investors can find. I think that Frost can have 7-8% growth for the next 20-30 years and I don’t normally find a stock with such high growth potential. My friend was surprised at my claim and he said “you can’t say that because 20% growth is a certainty for companies like Valeant!” What he said represents the attitude towards growth of most people. To them, a single-digit growth isn’t stellar. To me, 7-8% growth is a treasure. That doesn’t mean I’m less demanding. I’m just focused more on quality of growth.
Low growth can be valuable if ROIC is high. Let’s compare Bristow, Frost, and Omnicom.
Over the last 10 years, Bristow’s revenue almost tripled from $674 million in 2004 to $1,859 million in 2014, which translates into an 11% annual growth rate. Annual sales growth was always higher than 10% except for the “bad” years between 2009 and 2011. The problem is that pre-tax ROIC is just about 9%. So, Bristow had to use debt and equity to finance growth. Over the period, net debt increased by $650 million. Share count increased by more than 50% from 23 million to 36 million mostly as a result of the issuance of $223 million in convertible preferred stock in 2007.
Frost is a better business. Frost grew deposits from $7,767 million in 2004 to $22,053 million in 2014. That means intrinsic value has compounded annually by 11% over the last 10 years. Unlike Bristow, Frost can make 18-20% ROE. So, Frost was able to return 40% of total earnings over the last 10 years.
Omnicom is even better. Omnicom grew sales by 5% over the last 10 year while returning 110% of earnings to shareholders. Omnicom doesn’t need to retain earnings to grow. It actually received about $1 billion from the decrease in its negative working capital over the period.
Omnicom’s 5% growth can be as valuable as Frost’s 8% growth. If we pay 20 times after-tax earnings for both stocks, we can get similar returns. Omnicom can give us 5% growth and 5% yield, adding up to 10% total return. Frost can grow 8% while paying out 50% of earnings. So, it can give us 8% growth and 2.5% yield, adding up to 10.5% total return. A similar calculation shows that we can get 11.67% total return from Omnicom and 11.34% return from Frost if we pay 15 times after-tax earnings for both stocks.
So, growth can be more valuable than numbers suggest. Adjusted for quality, Omnicom’s 5% growth is equivalent to Frost’s 8% growth, and is much superior to Bristow’s 11% growth.
Consistency also contributes to quality of growth. Geometric means are always smaller or equal to arithmetic means. Therefore, low-growth years tend to pull compounding growth more than high-growth years. In other words, of two firms with the same average (arithmetic mean) growth, the one with more consistent growth has the higher compound annual growth rate.
To illustrate this point, let’s look at Frost’s deposit growth over the last 10 year and Select Comfort’s sales growth from 2002 to 2012:
Frost’s annual growth: 13% 11% 3% 18% 13% 8% 14% 11% 14%
Select Comfort’s annual growth: 37% 22% 24% 17% -1% -24% -11% 11% 23% 26%
Over the 10-year periods, Frost’s average growth was 11.8%, and compounding growth was 11.0%. Select Comfort’s average growth was 12.3% and compounding growth was 10.8%. Select Comfort’s growth looks fancy. It was higher than 20% except for recession years. But Select Comfort’s average compounding growth was actually lower than Frost.
A serial acquirer like Valeant may have a great platform to create value from acquisitions. But we never know when the party will end. At some point, smaller acquisitions can no longer move the needle. Bigger acquisitions can be more expensive. The company may become too big for adequate management. So, Valeant’s growth is repeatable but not predictable.
I prefer companies with consistent growth drivers. Some drivers are company-specific and some are external.
Store expansion is a reliable internal growth driver. If a company is disciplined in picking new locations that fit its model, and if it successfully replicates its competitive advantage, performance will be consistent. Growth is predictable. We can pick a conservative number of stores the company can open, and pick a conservative number of years for it to fill in the opportunities. For example, America’s Car-Mart (CRMT) will keep opening stores in small town with populations from 20,000 to 50,000 in South-Central states. It has huge competitive advantages over mom-and-pop operators in these areas. Car-Mart now has 141 locations. It may double store count in 10 years. So store openings can lead to 7.2% growth. With 3-5% same-store sales growth, it can have double-digit growth for the next 10 years.
The driver I’m most comfortable with is market share gain. Some companies have durable weapons to consistently gain market share. For example, Progressive (PGR) and Geico have low-cost advantage to gain market share almost every year. Industry growth is usually predictable so betting on market share gainers allows me to sleep well at night.
Industry tailwinds can make market share gainers more attractive. For example, banking is a better business than car insurance. Total deposits tend to follow GDP growth while car insurance policies face deflationary pressure as technology reduces accident frequency. Texas GDP grows about 1% faster than the U.S. GDP so banks in Texas have 1% higher growth than the average U.S. bank. Frost is a great franchise in Texas. It’ll keep growing its relationships with small businesses. It’ll keep attracting consumers for being a Texas bank and for great customer service. So, it’s safe to expect 7-8% annual growth far into the future.
Omnicom also benefits from changes in the industry. Marketing budget is stable as a percentage of sales at most companies. So, total marketing spending tends to follow GDP growth. However, marketing is becoming more and more fragmented due to the rise of new channels like online, mobile, social media, etc. Marketing spending will shift from traditional media to new mediums. That means more and more work for agencies. Omnicom has done a great job at building new capabilities or making small acquisitions to serve client needs. Another trend is that marketers want to deal with fewer vendors, leading to account consolidation. These two trends allow Omnicom to capture more % of clients’ spending over time. So, Omnicom’s organic growth is about 1% or 2% higher than GDP.
Margin expansion can make growth better than it looks. Margin expansion usually happen when gross margin is high, price competition is low, and fixed cost is significant. Watches are a good example. A watch isn’t a timepiece. It’s a fashion piece or a jewelry piece. Watch brands don’t really compete on price. People have a price range for their watches and they choose the brand and style they like most within that range. So, even cheap Chinese made watches that Fossil (FOSL) sells have 50-60% gross margin. Fixed costs of designing, distributing and advertising watches for a brand are quite significant. So, bigger brands have higher margin. Fossil’s 16% EBIT margin is higher than Movado’s 12% because Fossil has higher revenue per brand.
Within Fossil, Michael Kors possibly makes 30% EBIT margin. Revenue from Michael Kors watches was over $900 million last year. But Michael Kors can be a fad. It can rise and fall, and has a big impact on Fossil’s EBIT margin.
Margin expansion is better when combined with consistent growth. It causes EBIT to grow faster than sales. So, mid-single digit sales growth may mean high single-digit earnings growth. Of the candidates I’m looking at, Grainger (GWW) is potentially a company with both margin expansion and consistent growth. If that’s true, it can have low double-digit earnings growth for many years and deserves a high multiple.
So, investors should be skeptical of high growth, and be positive about low growth. High growth can be a problem if it’s unpredictable and leads to high expectations and thus a high multiple. Low, boring growth can be a treasure if it’s consistent and supported by high ROIC and margin expansion.
Lack of Catalyst
A lack of catalyst can cause even value investors to neglect a stock. Two of the least controversial stocks we’ve analyzed are Progressive and Frost. Most people agree on their moat and quality, and most don’t think the stocks are cheap. Geoff and I didn’t realize how cheap they were until looking deeply at them. Higher interest rates can be a catalyst but most responses I get from people are “interest rates may stay low for a while” or “how quickly earnings will increase?” What’s interesting is that no guru owns these stocks while many own Wells Fargo. According to Morningstar, most concentrated shareholders are ETFs or institutions that put a small % of total portfolio into Frost. So, it’s possible that most professional investors just look casually at the stock.
I’m not sure how important catalysts are. It’s easy to imagine catalysts and get excited. People tend to overestimate the chance of catalysts happening and underestimate the chance of unexpected events. In my short experience, I’ve seen stocks we’ve picked like Ark Restaurants (ARKR), PetSmart, and Lifetime Fitness get acquired or buyout offers. Such events happened more often than I expected.
I don’t think there’s any problem with the lack of a catalyst. Time is such a good friend that good businesses don’t need a catalyst. We’ll do fine as long as we buy businesses that can compound intrinsic value.
That said, I do see catalysts work in some special situations. Sometimes catalysts are playing out but the market is so inefficient that the stock price doesn’t reflect the ongoing developments. That’s true for the two best performing stocks we picked this year: Babcock & Wilcox and Breeze-Eastern (BZC). Babcock returned about 30%. Breeze-Eastern returned about 22% since our issue on the stock was published, and about 40% since when I began analyzing the stock in May.
Babcock is a spin-off. I’m really surprised because value investors follow spin-offs closely. I started analyzing the stock in October 2014. There were several presentations about the spin-off and I was worried that the price would move a lot before we published the issue. Yet, it stayed flat for months. And then it worked out exactly as Joel Greenblatt taught us about spin-offs: the good Babcock (BWXT) is expensive at 13.4x EV/EBIT, and the bad Babcock (BW) is cheap at 5.4x EV/EBIT.
Breeze-Eastern was lucky timing. I analyzed the stock when it was finishing some long-term projects. So, R&D expense was going down and revenue was ramping up. Years of under-earnings were coming to an end. Anyone could expect Breeze to make more profit. But few people acted until it released quarterly earnings.
It’s worth noting that some investors (who are now among the company’s biggest shareholders) bought Breeze-Eastern on the same thesis in 2011. But they had to wait until 2015. So, I was lucky to analyze Breeze-Eastern in 2015 when I saw that R&D had been declining.
Right now I think Ekornes is another special situation. Ekornes keeps most production in Norway. A lot of cost is in Norwegian Krone (NOK). But Ekornes gets 95% of revenue outside of Norway. So, most of revenue is in U.S. dollars, Euros, or other currencies. For years, Ekornes was badly impacted by the overvalued NOK. But the recent crash in oil price caused NOK to decline against U.S. dollars and Euros. On the surface, currency is a risk. American investors buying Ekornes today may sell Ekornes and convert into fewer $ if NOK weakens. But weaker NOK is actually a boon for Ekornes because revenue in $ or € will be converted into much more NOK while costs in NOK won’t change. As a result, margin can expand by a huge amount, and the NOK-based stock price appreciation will far outweigh NOK valuation.
Value investors can have different styles but they all buy stocks on the same principle: they minimize downside.
Buy-and-hold investors seek safety in business quality. They ask themselves if they buy a stock at current market price and hold forever, what is the very conservative expected return they can get? If the expected return is adequate – say 10% - the stock is very safe.
How can they make more than 10%?
They can get more than 10% return as long as they buy a good business at a lower than average price. Sometimes they’re luckily to buy a good stock very cheaply. For example, paying 10 times unlevered P/E for a business that can grow 5% while paying out all earnings can result in 15% total return. More realistically, they can only buy at 12-15x unlevered P/E. That’s still good because the stock – if it’s truly a good business – will soon trade at the normal 18-20x P/E. Even if it takes 3 years for the multiple to expand from 15x to 18x, the expansion still generates 6.3% annual return. Adding 5% annual growth and 6% cash return results in over 17% annual return.
So, just like growth, price can be better than it looks if we consider quality.
One great lesson I learnt from Geoff is to keep expectation low. He says if he does everything right, he might be able to get 10% a year long-term.
I do think that keeping expectation low is the key to learning to love boredom. 10% sounds low to most investors. Investors like things that can double in 2 or 3 years. In pursuit of high return, they embrace dirt-cheap price or fancy growth. My view is that there’s no certain 20% return. Big upside comes with high risk. There are a few certain 15% returns. And there are some certain 10% returns. So, I stay with such certain boredom. If I’m lucky I can get 15-20% return in my career. But without luck, I can still make 10%. I’m really comfortable with luck-independent 10% return.