5 Stocks Ben Graham Would Buy

by Geoff Gannon


In an earlier post, I said that the only stocks in the U.S. showing up on Ben Graham type screens right now are retailers.

Here are 5 of those retailers:

(All numbers are taken from GuruFocus)

What do I mean when I say a Ben Graham screen?

There are three ways to go with this. A “Ben Graham screen” could mean: A) a screen that uses a single, specific formula Graham developed (like a net-net screen), B) a screen that uses a checklist that Ben Graham laid out for investors in one of his books (like the criteria he lists for “Defensive Investors” in “The Intelligent Investor”), or C) a screen that tries to duplicate the approach Ben Graham used in his own Graham-Newman investment fund.

Here, I chose “D” which I would define as adhering to the “spirit” of Graham rather than the letter of any Grahamite law.

What do I consider the spirit of Ben Graham?

1.       Don’t pay too high a price relative to a stock’s earnings (eliminate high P/E stocks)

2.       Don’t pay too high a price relative to a stock’s assets (eliminate high P/B stocks)

3.       Don’t buy stocks with a weak financial position (eliminate low F-Score stocks)

4.       Don’t buy unproven businesses (eliminate stocks that either lost money or didn’t exist sometime within the last 15 years)

5.       And needless to say: don’t buy into frauds (eliminate U.S. listed stocks that operate in China)

If you apply those 5 filters to all U.S. listed stocks, you’re left with just 5 stocks:

 

These are all retailers. And, obviously investors are concerned that Amazon and others will put offline retailers out of business. Do I think Ben Graham – knowing internet retailers were coming for these stocks – would buy a basket of these 5 retailers today?

I do.

The Warren Buffett of the 2010s wouldn’t. But, the Ben Graham of the 1950s would.

The reason I’m so sure Graham would buy these 5 stocks if he were alive today is that they all share the same exact value proposition. The bear case is speculative (future oriented). The bull case is historical (past oriented).

Graham’s approach was always to bet on the basis of the past record you do know and against the future projections you don’t know.

The quote he opened Security Analysis with is from the Roman poet Horace:

“Many shall be restored that now are fallen; and many shall fall that are now in honor.”

These 5 stocks are all fallen angels. In almost all past years, they were valued more highly than they are today. They are the common stock equivalent of junk bonds.

 

Hibbett Sports (HIBB) – P/E 7, P/B 0.9, F-Score 6

Hibbett Sports runs small format sporting goods stores in mostly rural America. The best way I can sum this up is that if you drive through an American town where Wal-Mart is the main retail destination for just about anything, there will be a Hibbett Sports. However, if you drive through an American town where there’s a big format supermarket, or a Best Buy, or a Nebraska Furniture Mart or an Ikea anywhere in sight – you’re not going to find a Hibbett there. Instead, you’ll find something like a Dick’s Sporting Goods (DKS). The average Dick’s location is about 50,000 square feet. The average Hibbett location is about 5,000 square feet. Quan and I considered researching Hibbett Sports for the newsletter. Just based on his reading of various company filings, Quan had concerns about the Hibbett business model’s survival as sporting good retail shifted more online. After travelling more in towns where Hibbett is located, I pretty much eliminated this stock as something I’d ever consider buying. I could be completely wrong to do that. But, Hibbett serves a very weird purpose where it’s basically in towns that can’t support a sporting goods store with a wide selection. Online retail isn’t great at a lot of things (it’s often not cheaper than offline). But, the one thing online can always do better than offline is bring a wider selection of products to places that used to be offered only a narrow product line-up.

 

Bed Bath & Beyond (BBBY) – P/E 7, P/B 2.1, F-Score 6

Bed Bath & Beyond is a category killer in soft stuff for the home. Of the stocks that come up on this screen, Bed Bath & Beyond is clearly the best positioned competitively – at least offline. The company’s position is similar to something like Barnes & Noble (BKS), GameStop (GME), or Best Buy (BBY).  If anything in this company’s category survives in an offline form – it’ll have to be Bed Bath & Beyond. The most recent earnings release showed online sales growing 20% a year. Meanwhile, offline same store sales declined at a “mid-single digits” rate. I was surprised to see this stock show up on a Graham screen I created. That’s because I was surprised to see it has a P/E of 7. Even more amazing is the current market cap divided by the 15-year average net income is only 6. It’s very rare to find a stock trading for a single digit P/E relative to its average net income over the last 15 years. For perspective, Bed Bath & Beyond is 3 times larger today than it was 15 years ago. And yet the stock is only trading at 13 times what it earned back in 2002. This is definitely a Ben Graham stock.

 

Kohl’s (KSS) – P/E 12, P/B 1.5, F-Score 8

This company has a solid past record. However, as a department store, it faces the most competition from both the online front and the offline front of any of the stocks on this list.

 

Genesco (GCO) – P/E 8, P/B 0.9, F-Score 7

This company operates the Journeys, Lids, and Schuh stores. They mostly sell shoes, caps, and apparel to mallgoers in their teens and twenties. They also own the Johnston & Murphy shoe brand. Last year, almost three-quarters of earnings came from the Journeys part of the business. Journeys sells shoes to teenagers. It’s not a business I feel I could ever learn enough about to judge. So, I could never buy the stock. But, I imagine Ben Graham could as part of a basket.

 

Ingles Market (IMKTA) – P/E 10, P/B 1.0, F-Score 7

Ingles Market runs about 200 supermarkets (and owns over 150 of them) in North Carolina, South Carolina, Georgia, and Tennessee. Ingles is undoubtedly the most “Grahamian” stock on this list. The P/E is reasonable at 10. And the price-to-tangible book is very reasonable at 1 times book. It’s also clear from reading the company’s 10-K that book value understates market value, replacement cost, etc. So, this company is selling for less than its net assets.

Those assets include:

·         155 existing supermarkets

·         18 undeveloped sites suitable for a new supermarket

·         “numerous outparcels and other acreage adjacent to” its supermarkets and shopping centers

·         3 million square feet of leasable shopping center space not used by its own supermarkets

·         A 1.65 million square foot distribution center / headquarters

·         The 119 acres on which the distribution center / HQ is located

·         A 139,000 square foot warehouse

·         The 21 acres on which that warehouse is located

·         A 140,000 square foot milk production/distribution center along with truck fueling/cleaning site

·         The 20 acres on which those buildings are located

All that plus equipment and trucks is held at a depreciated cost of just under $1.25 billion on the company’s books.

The company also has 38 supermarkets under very long-term leases (like 30+ years if the company chooses to renew). I believe these are the result of a sale and leaseback transaction done sometime in the late 1980s or early 1990s. Long-term leases (although a balance sheet liability) are often the most valuable economic asset a good supermarket company has.

On the downside: Ingles also has a lot of debt. It’s about $850 million of debt versus just $200 million to $250 million of EBITDA (so, net debt is almost 4 times EBITDA). That’s a lot of debt for a supermarket operator to carry. But, $850 million of debt doesn’t sound excessive relative to the list of real estate assets I just gave you. Most of the debt ($700 million) is due in 2023 (so just over 5 years from now).

The most important fact here is that it appears that at least two-thirds of all the assets I mentioned were already owned by Ingles in 1992. That was 25 years ago. To adjust for inflation, anything put on the books in 1992 – and obviously, almost all of these assets listed here were put on the books before 1992 (that year is just the furthest I could go back using EDGAR) – would need to be adjusted up in value by about 70% to take 25+ years of inflation into account.

If you make this inflation adjustment to Ingles Market’s property, plant, and equipment line you’d be adding $28 a share in book value adjusted for inflation. That would make book value adjusted for inflation $52 a share versus a stock price of $24.50 a share right now. It seems very likely that Ingles has at least $2 in shareholder assets for every $1 of market price on the stock. In fact, the stock is probably trading for well under 50% of the fair market value of its net assets.

The company is family controlled through super-voting “B” shares. The 10-K says Ingles considers real estate operations to be an important part of their business. And, of course, if you adjust past return on equity to reflect what the property Ingles controls is probably really worth – earnings have always been very small relative to assets.

Ingles has never been a compounder. Over the last 30 years, the stock badly underperformed the overall market – and that was true even before it dropped 49% in price this year.

Ingles looks like your typical dead money stock. It’s definitely your typical Ben Graham bargain.

Ingles is the one stock on this list that stands out as being an asset play more than anything else.

Talk to Geoff about 5 Stocks Ben Graham Would Buy


Are You Buying Anything Now?

by Geoff Gannon


A blog reader emailed me this question:

“Are you buying anything now?”

No. I still haven't bought a stock this year.

I like Cheesecake Factory (CAKE) a lot. There's a write-up in the Focused Compounding member idea exchange about it. If I was to buy something right now, it would probably be CAKE. It's a good business facing a temporary problem. Over the last two years, "food away from home" (at restaurants) is up 5% in price while "food at home" (supermarkets) is down 1.6% in price. So, the relative cost of eating out versus eating in has changed 6.6% in the last 2 years in the U.S. As economic theory would say has to happen, value seeking households have done some substituting from eating out to eating in. This has caused a decline in same store sales. The Cheesecake Factory’s same store sales are down 1% this year. The stock is down 32%. I had researched the business previously. CAKE shares were probably about fairly valued at the start of this year ($60 then vs. $40 today). 

I would consider buying Omnicom (OMC) at about $65 a share. It's at $73 a share now.

And you know I like Howden Joinery and continue to follow that stock as a possible purchase as well.

Not that long ago, I dropped everything and looked intensely at AutoZone (AZO) when it plunged just under $500. It's at $570 now. I liked what I saw. At $500 a share, I think AutoZone would make sense as a "value" stock (really more of a cannibal that grows EPS through buybacks). But – for me at least – it’s the kind of stock you’d want to buy now and sell in 3 years or whenever its multiple expands again instead of holding forever.

I've looked at other companies recently, but have not bought any.

I looked at Howard Hughes (HHC) this past week. The company still owns a lot of valuable land in high-end master planned communities like Summerlin, Nevada (about 10 miles from the Vegas Strip) and is developing commercial real estate at the South Street Seaport in Manhattan and Ward Village (about 3 miles from Waikiki Beach in Honolulu). It has nice assets. It doesn't seem obviously overpriced (before I looked, I expected it would be). But, I can't prove it's cheap. I'm only able to come up with estimates for some of HHC's assets. Not all. I can't imagine ever being able to come up with a solid appraisal value for the whole company.

I plan to look at Green Brick Partners (GRBK) and LGI Homes (LGIH) this week. They build homes here in Texas and elsewhere.

The only U.S. stocks that show up on Ben Graham type screens right now are a lot of retailers and some homebuilders. There's literally nothing else here in the U.S. that's quantitatively cheap anymore.

Talk to Geoff about Whether He’s Buying Anything Now


Frost (CFR): Interest Rate Expense and Cyclically Adjusted Earnings

by Geoff Gannon


A reminder: 40% of my portfolio is in Frost. It’s the stock I like best.

Someone wrote me to ask about Frost’s interest expense:

“Hi Geoff,

I have not read your report on Frost…but right now I am looking at the latest balance sheet and (am) very  surprised…the average interest expense is…paltry…the cost of funding is 0.032%. That's extremely low, almost free. Am I right on this calculation? Or is it a mistake?”

My response goes into way more arithmetic than anyone wants to read. But, if you want the full picture of how I personally value Frost – read on…

First of all, a bit more than half of Frost’s deposits are in accounts that pay pretty close to 0% interest because they provide a lot of services and these customers are not hunting for yield. Frost pays "credits" to reduce the fees customers are charged for banking services. I think when we wrote our report it was about 1.5% combined interest and non-interest expense. Frost generally has the lowest non-interest expense of a bank I know of. They're always a little lower than Wells Fargo (WFC).

Anyway, I did the calculation for last year’s interest expense that you did using average interest bearing deposits and annual interest paid on those deposits (the information is in the 2016 10-K at EDGAR). They paid 0.03% on average in interest (3 basis points). Which is what you said. However, remember, the Fed Funds Rate started 2016 at 0.25% to 0.50%. So, the 2016 interest rate expense for any bank is very misleading. 

In the long-run, I expect Frost to pay 0.5 times what the Federal Reserve pays for the same amount of money. So, if we end this year at say a 1.5% Fed Funds Rate and then it just stayed there, I'd expect Frost's interest expense to rise to 0.75% eventually.

The formula:

FFR * 0.5 = Frost's interest expense is pretty accurate. 

That's only the cash interest rate though.

On some accounts, Frost also pays an "earnings credit rate" that customers use to offset fees for services the bank would otherwise charge for. So, back in 2016, Frost might have been paying 0.03% on an account in cash interest but then 0.25% in credits you can use to offset bank fees.

Of course, it’s the total expense that matters for a bank. You have to count both the interest expense and the net non-interest expense when calculating cost of funds. Frost pays maybe 1.4% of deposits in net non-interest expense and then you have the interest expense.

So, the bank’s total economic cost of funding would really be:

FFR * 0.5 + 1.4% = Frost’s total cost of funding.

So, if we end 2017 at a 1.5% Fed Funds rate and the rate stayed there, Frost should be getting their money at about 0.75% (interest expense) + 1.40% (net non-interest expense) = 2.15%.

If the Fed Funds Rate was a more “normal” 3% to 4%, then Frost’s total cost of funding would be 1.5% + 1.4% equals 2.9% to 2% + 1.4% equals 3.4%. So, at a 3-4% Fed Funds Rate, Frost’s total cost of funding would be like 3% to 3.5%. Frost would basically have the same cost of funding as the Fed.

The way interest rates drive Frost’s earnings is that:

·         Frost has a constant 1.4% net non-interest expense regardless of where rates are

·         The relationship between interest expense and Fed Funds Rate is multiplicative (0.5 times the Fed Funds Rate)

·         The relationship between yield on loans and securities and the Fed Funds Rate is additive (FFR plus 3.3%)

So, what Frost actually earns before loan loss provisions and taxes on each dollar of deposits works like this:

(FFR + 3.3%) – (0.5 times FFR + 1.4%).

So, if the Fed Funds Rate ends 2017 at 1.5%, you’d expect Frost’s pre-tax and pre-provision earnings per dollar of deposits to be:

4.8% (1.50% + 3.30%) – 2.15% (0.75% + 1.40%) = 2.65%.

And, if the Fed Funds Rate eventually hits a more “normal” 3% to 4%, you’d expect Frost’s pre-tax and pre-loan loss provision earnings per dollar of deposits to be:

6.80% (3.50% + 3.30%) – 3.15% (1.75% + 1.40%) = 3.65%

Based on past experience, they’ll charge-off about 0.50% of loans per year. So, let’s call after-provision earnings 3% and then you pay a third of that in taxes and so you’ve got earnings of 2% after taxes for every dollar of deposits you have.

In other words, in a 3% to 4% Fed Funds Rate world, Frost should report $1 of EPS for every $50 of deposits. Right now, they have $400 a share in deposits. So, if the Fed Funds Rate was 3% to 4% right now, they’d probably have $8 a share in EPS.

That’s what I mean when I say Frost is interest rate sensitive. EPS should be about $5.50 a share when the Fed Funds Rate is 1.5% and about $8 a share when the Fed Funds Rate is 3.5%.

Those numbers won’t be exactly right, because I overstated what the combination of loan losses and taxes will really be. But, the pre-tax and pre-provision formula I gave you is an excellent estimate for all interest rate environments.

If you want to go through all the details of how (my newsletter co-writer) Quan and I got these figures, you have to read the “Value” section of the notes in this PDF report on Frost. It starts on page N56 (that’s page 81 of the PDF).

Full Report on Frost (CFR)

I don’t recommend reading that though. I went into way more arithmetic here in this post than I think most people want to get hit with at once. The notes section is much more detailed in providing evidence for why the Fed Funds Rate based earnings model shown here should correctly predict (with some lag) what EPS for Frost will be in any future year as long as you know just 2 things:

·         Frost’s deposits per share

·         The Fed Funds Rate

We know Frost’s deposits per share are about $400 now. And I think I know that in the very long-run, the Fed Funds Rate has the same or better odds of being above 3% in any year as it does being below 3%. Most people disagree with me on that assumption. If you assume today’s Fed Funds Rate is normal, then you’d assume normalized EPS on Frost is now about $5.50 or so. If you assume a 3% to 4% Fed Funds Rate is normal (like I do), then you’d assume normalized EPS on Frost is now about $8 or so. Obviously, that means if most people believe the Fed Funds Rate is normal now, then most people are going to value Frost stock about 30% lower than I do.

Personally, I value Frost at about 0.40 times deposits. That’s about $160 a share. If you think a Fed Funds Rate of 1.5% is normal, you should value Frost at about 0.28 times deposits. That’s about $110 a share. The stock now trades at just under $90 a share. So, if you think a normal Fed Funds Rate is 1.5%, you shouldn’t buy the stock. It’s a terrible idea to pay $90 for something you think is only worth $110.

Talk to Geoff about Frost

 


Frost (CFR) in Barron's: Read My Interview about Frost and My Report on Frost

by Geoff Gannon


Some blog readers emailed me to say this week's Barron's did a piece on Frost (CFR). If you read that piece and are looking for more about the bank you can:

Read my interview with Punch Card Research about Frost

Read the report I did on Frost

Frost is my biggest position. It is around 40% of my portfolio. 

The stock's price is now a little under $90 a share. In a "normal" interest rate environment, I think it'd be worth $150 a share.

Of course, it could be a while before interest rates are normal.

Talk to Geoff about Frost (CFR)

 


Why Ad Agencies Should Always Buy Back Their Own Stock

by Geoff Gannon


(Excerpt from today's Focused Compounding article)

"My belief is that the market undervalues the ad agency business model. It doesn't understand the P/E premium over the market that an ad agency would need to trade at to equalize the likely future return of the ad agency with that of a "normal" business. Every year, an ad agency both grows organically (in line with growth in the ad budgets of its existing clients) and is able to payout 100% of its earnings. Normal businesses can't do both of these things at the same time. So, they can grow 5% a year, but they can only pay out say 50% of earnings. That means a normal business trading at a P/E of 15 would be priced to return 8.33%. Actual returns in the stock market have not been exactly 8.33%. But, they've been close and they've been close for the reason I just explained.

The typical stock grows 5% a year organically, it pays out half its earnings in dividends (or share buybacks), and it trades at a P/E of 15. Those conditions will - in the very, very long-run - give you a return of 8.3% a year.

A P/E of 15 is an earnings yield of 1/15 = 6.67%. Half of 6.67% is 3.33%. So, I am saying that to the extent stocks tend to trade at a P/E of 15 and retain 50% of earnings they will tend to have an annual payout (in either the form of dividends or reductions in shares outstanding) of 3.33% of their market price. When you add this "yield" to the growth rate, you get a return for the investor of 8.3%. In some periods, the Shiller P/E - or whatever normalized valuation measure you want to use - will expand and returns may reach 10% or 12% over a certain 15 years. But, in other times valuations may contract and there will be 15 year periods where returns are just 6% or even 4%. For a typical business: what's really underlying all this is about an 8% to 8.5% increase in intrinsic value (which is normally turned into about 5% sales growth and like 3% to 3.5% dividends and share buybacks).

Now, do the same math with an ad agency and you get a different number. Ad agencies retain no earnings as they grow 5% a year. So, if an ad agency stock trades at the same P/E ratio of 15 as a "normal" stock, it will have a 6.67% yield in terms of what it is going to use on dividends and buybacks. Add that to the growth rate and you get an 11.7% long-term expected return instead of an 8.3% long-term expected return. That's an inefficient pricing.

How would the market efficiently price ad agency stocks?

The market would need to put a P/E of 30 on ad agencies instead of a P/E of 15. Value investors don't like hearing this. But, it's true. If Company A can grow 5% a year and pay out 3.3% and Company B can grow 5% a year and pay out 3.3% - they're equalized in terms of future return expectations. Because ad agencies have a 100% earnings payout, they will only reach intrinsic value parity with the market when they trade at a P/E of 30 and the market trades at a P/E of 15. The earnings yield on an ad agency stock should be half the earnings yield on the overall market for it to be correctly valued.

In almost all years, ad agency stocks don't trade at double the P/E ratio of the market. And yet, in literally all years, they do have free cash flow that isn't needed to grow their business organically. Therefore, the best and simplest capital allocation policy for any publicly traded ad agency would be to pay no "regular" annual dividends and instead commit to "regular" share buybacks.

Historically, the stock that has come closest to this ideal capital allocation policy is Omnicom (OMC)."

Focused Compounding


Hold Cash: Wait till You Get Offered 65 Cents to the Dollar

by Geoff Gannon


(Excerpt from today's Focused Compounding article)

"...three stocks I like right now (are):

1.       Omnicom (now $72 a share)

2.       Howden Joinery (now 424 pence)

3.       And Cheesecake Factory (now $40 a share)

All are reasonably priced...Omnicom has a P/E of 15. Howden has a P/E of 15. And Cheesecake has a P/E of 14.

All of those sound wrong to me.

These are above average businesses with far above average predictability. They should have above average P/E ratios...

So, why aren’t I buying these stocks right now? Why keep 30% to 35% of my portfolio in cash when these 3 opportunities are available?

...I tend to buy stocks when a business I know I really like trades at about a 35% discount to my appraisal of its intrinsic value...these decisions are arbitrary in terms of the levels you set. If I plan to hold Omnicom stock for let’s say 5 years a difference of 10% in the initial purchase price level isn’t going to make more than a 2% difference in my annual rate of return...How much does that 2% a year really matter to you?

Most people I talk to would be more bothered by missing out on the opportunity to buy a business they like than they would be bothered by paying 10% more for the stock at the start. Most people I talk to about Omnicom say...if I like the stock that much...I should just buy it now.

But, that’s just not my approach.

I’m selective both on the quality of the business…and I’m selective on the price. I don’t like paying more than 65 cents to the intrinsic value dollar even when I like the business a lot."


Weight Watchers (WTW): Mistakes Made Over 4 Years of (Emotional) Volatility

by Geoff Gannon


(Read the full article)

"I lost a lot of money in Weight Watchers. Let’s look at why that was.

As I write this article, Weight Watchers (WTW) stock is at $44.30 a share.

I bought my shares at $37.68 a share in 2013 and sold them (in March of 2017) at $19.40. So, I realized a loss of 49%...

...What’s notable to me looking back at what I wrote then is how little any of the essential analysis changed. Emotions changed. Owning the stock for over 3 years, you might get worn down by the constant barrage of bad news. But, with few exceptions, we laid out what the grim future would be for Weight Watchers over the next couple years and that’s not that different from the grim future that actually materialized....

...In the report, I really laid out a five year thesis – as I pretty much always do – and yet I sold the stock after not much more than 3 years.

Why didn’t I wait another 2 years?

You get tired of sitting through all the volatility in both the business and the stock.

For me, there is also an added difficulty. I don’t just pick stocks for myself. I write about the stocks I pick.

And I get tired of answering emails about the stock. By the time I sold Weight Watchers it was not one of my biggest positions at all, and yet it accounted for probably more email questions from readers than all of my other stock picks combined...It is very unpleasant to write about a volatile stock, a controversial stock, a heavily shorted stock, etc...

...Would I have held my Weight Watchers stock till now if I hadn’t made my investment in the company public?

I don’t know.

But, I do know I’m more likely to sell a controversial stock because I have to write about what I own and talk to people about what I own.

The truth is that there isn’t really that much to say about Weight Watchers other than what I said in that 2013 report...there’s been big changes in my emotions and in the stock price and there’s been some changes with the business – most notably, Oprah’s investment – but if I was going to make a decision to buy, sell, or hold Weight Watchers today I would still base 90% of my decision on what I wrote in 2013."

(Read the full article)


Price / Original Appraisal Value of All Stocks I've Written Reports On

by Geoff Gannon


Focused Compounding

Free Report: Omnicom (OMC)

Here is the price to original appraisal value (what I pegged the intrinsic value of the stock at when I wrote the report sometime between 2013-2016) of all stocks I've written full reports on.

(CLICK IMAGE TO MAKE IT BIGGER)

Stocks in red are expensive. Stocks in yellow are close to fair value. Stocks in green are cheap.

Stocks shown in red are far too expensive to buy.

Stocks shown in yellow are too expensive to buy right now, but may be good businesses to research now so you can buy them the next time some news causes their share prices to collapse.

Stocks shown in green are cheap enough to buy now. However, that does not mean they are necessarily good enough or safe enough to buy. I wrote these reports between 2013 and 2016. So, some businesses may have changed for the worse in the years since I wrote the report.

Each report is 10,000 words or more in length. A subscription to Focused Compounding gives you immediate and unlimited access to reports on all the stocks listed here.

Membership is $60 a month.

Focused Compounding

Free Report: Omnicom (OMC)

 


The Market is Overpriced: These 3 Stocks Aren't

by Geoff Gannon


(Focused Compounding)

Most stocks are now overpriced.

Historically, a normal price for a stock has been about a P/E of 15.

And historically, stocks have outperformed other assets.

Therefore, it makes sense to buy above average businesses when their shares trade at a P/E of 15.

Right now, I see 3 above average businesses trading at about a P/E of 15:

  • Cheesecake Factory (CAKE)
  • Omnicom (OMC)
  • Howden Joinery

I’m not buying any of these stocks personally right now.

However, if you asked me right now whether or not I think you should buy a certain stock, I’d say “no” to 99% of the stocks you can name.

Those 3 belong to the 1% of stocks I’d say “yes” to.

I’ve never seen a time when it’s as difficult to find a good stock to buy without overpaying as what I see right now.

But, I don’t think that means you should be 100% in cash. I think it means you should be in stocks like:

  • Cheesecake Factory (at $41 as I write this)
  • Omnicom (at $73 as I write this)
  • And Howden Joinery (at 412 pence as I write this)

If the market as a whole is overpriced, it will fall. And when it does fall: it will take stocks like Cheesecake, Omnicom, and Howden with it.

In time, they will recover.

And you will be able to look back – 5 years or more down the road – and say that buying stocks like these at today’s “not overpriced” levels and holding them wasn’t a mistake.

You don’t need to get out of the market.

But, you do need to be more selective than ever now that the market is more expensive than ever.

(Focused Compounding)


My Investing Goal

by Geoff Gannon


Someone emailed me this question:

“For the past months I've dug into your posts on Gurufocus…in this article you write about Warren Buffett's early years:

‘Warren Buffett was thinking about compounding wealth. He was interested in getting rich.’ 

This sentence piqued my curiosity a little. What (are) your goals and objectives in the stock market? Is it getting rich, saving for retirement, or something not money related?”

I have zero interest in getting rich. Investing is a purely intellectual exercise for me. I love writing and I love investing. My only financial goal is to make enough money so I never have to do any work that isn't either writing or investing.

A lot of people email me asking if I'd ever be interested in managing money. 

The answer is no.

If I was interested in getting rich, the answer would be yes. The way to get rich in the stock market is to manage other people's money and manage it well. That's what Buffett did. 

For myself, I'd be really happy if I could:

  • Save some money every year
  • Put all the money I saved that year into just one new stock
  • Keep that stock for the rest of my life
  • Repeat annually till dead

I can do the likely compound math and see that would ensure an adequate result in my case. I'd like the intellectual challenge of picking one and only one stock a year and never being able to reverse that decision. But what I'd really love would be never being troubled by the constant irritation of active portfolio management. 

The only thing I like about investing is picking stocks. Nothing else about it appeals to me.

So, those bullet points are the routine I'd follow if I was just investing for myself and not having to write about it for anyone else.

Talk to Geoff about his Investing Goal


Did You Invest in Weight Watchers (WTW)? Call for Quotes/Comments: Weight Watchers Re-Visit

by Geoff Gannon


Talk to Geoff About Weight Watchers

I planned to do a quick re-visit of my own experience investing in Weight Watchers (WTW). However, since announcing my plan to do that, I’ve gotten a lot of emails from people telling me about their own experience either investing in that stock on their own or following me into it.

So, I’ve decided to do a post that includes those experiences. If you owned Weight Watchers stock – or even considered buying the stock but ultimately deiced to pass – at any time between 2013 and 2017, please send me an email detailing your experience.

Try to include:

1.       How did you first find out about the stock? (Was it my blog, my newsletter, someone else’s write-up online, a news report, your own experience trying to lose weight, Oprah’s investment, etc.)

2.       When did you buy the stock? (what date, at what price, etc. – to the best of your memory)

3.       What factors drove your buy decision?

4.       When did you sell the stock? (what date, at what price, etc. – to the best of your memory)

5.       What factors drove your sell decision?

6.       And most importantly: How did holding this stock make you FEEL? (what emotions did you cycle through and what influence did these emotions have on your decision to buy, hold, or sell?)

7.       Do you think you learned anything from this experience?

I will quote from the emails sent to me. I will edit only for clarity and brevity.

Please rest assured: I will anonymize all quotes. Your name will not appear anywhere in the post.

I’m in the midst of summer vacation. So, you have till the end of August to send in your personal history investing in Weight Watchers stock. I will post this at the start of September regardless of how much feedback I get. I don’t want to hold off any longer than that. So, if you want to submit – submit now.

If you invested in Weight Watchers, please do consider submitting your thoughts.

I think you’ll find the experience of summarizing your experience and sending it off to me to be cathartic.

Talk to Geoff about Weight Watchers


Get $200 for Your Stock Write-Up

by Geoff Gannon


Focused Compounding: Full Details

My members only website, Focused Compounding, is giving away $200 for this month’s best subscriber submitted stock write-up.

Focused Compounding’s co-founder, Andrew Kuhn, and I will make the winning idea available to everyone – subscriber and non-subscriber alike – at the start of September.

All the runner-up ideas will be viewable only by members.

So, if you’re a Focused Compounding member reading this, submit your stock write-up to the Focused Compounding Idea Exchange by the end of August for a chance to get $200 for your idea.

We’re looking for an idea that is:

1.       in depth

2.       well thought out

3.       analytically strong

4.       and actionable

In that order of importance.

Focused Compounding: Full Details


Weekly Stock Revisits Start Monday with Weight Watchers (WTW)

by Geoff Gannon


I'm going to be doing something new here. I don't normally discuss specific stocks much (mostly because I haven't bought a stock in about 2 years).

However, starting Monday, I will revisit each of the 27 stocks I picked from 2013-2016 for the newsletter I was then writing.

I'll start Monday with a blog post on Weight Watchers (WTW) since that was a stock I picked 3-4 years ago at $32 a share. It fell to $4 a share. And then closed today at $41 a share.

I'm not sure it's the most instructive case study. But, it's definitely the wildest ride to write about.

As I mentioned in an earlier post, I personally bought WTW shares at $37.68 and sold the shares at $19.40 for a realized loss of 49%.

To prepare you for my Weight Watchers re-visit here are two articles others wrote that were inspired in some way by my case for Weight Watchers:

Weight Watchers Provided A Valuable Lesson In Stock Watching (January 9th, 2017)

A Closer Look at Weight Watchers (WTW) (August 21st, 2013)

You can also read my own reasons for why I bought Weight Watchers:

What Led to the Weight Watchers (WTW) Purchase? (August 3rd, 2013)


The Two Things Every Stock Picker Needs to Learn: Independence and Arrogance

by Geoff Gannon


Check Out Geoff’s Members Only Site: Focused Compounding

I get a lot of emails from people asking how to become a better investor. They usually have very specific ideas about what would help them improve. For example, they think they need to get better at reading 10-Ks and that would fix their problem. Or they think they need to get better at deciding which stock to research in the first place. The truth is that most of the people I’ve talked with and tried to help improve as investors suffer from the same mental block.

They think there is a right way and a wrong way to analyze a stock. They have – whether they realize it or not, and I think usually they do not – a kind of moralistic view of how investing ought to be done. They believe that if you do what you’re supposed to do, work hard, etc. you will get a good outcome. Investing doesn’t work like that. Stock analysis doesn’t work like that. It really doesn’t matter whether you are a very hard working, diligent researcher of stocks or a lazy but brilliant one. There are no points for effort. Nor is there any degree of difficulty modifiers. Often, the best ideas are easy to come up with. They don’t take much time to research. They are 99% inspiration and 1% perspiration type ideas.

So, what do you need to be a good stock analyst? What is the key to hunting for and finding the right ideas to bet big on?

You need a different, better way of seeing the stock than most investors do. I’ve talked about the importance of “framing” an investment problem before. In my discussions with readers, I’ve realized they really underestimate the importance of this. Yes, I read the footnotes to financial statements, and I take notes on the 10-K, and I put together Excel spreadsheets. But there’s really nothing in any investment thesis that’s going to flip the correct answer of whether to buy a certain stock from a “no” to a “yes” or vice versa depending on whether the P/E is 14 or 18, the projected future growth rate is 4% or 6%, the Net Debt / EBITDA ratio is 1.5 or 2.5. If something as small as that can change your decision to invest – this stock probably isn’t worth your time.

The investment ideas really worth having are all “framing” problems. You have to find a stock where the way you frame the entire problem of analysis and appraisal is different from the way other people frame that same problem.

Let’s start with two examples from my own portfolio. Right now, I have 40% of my portfolio in Frost (CFR) and 25% of my portfolio BWX Technologies (BWXT). No other stock accounts for more than 6% of my portfolio. So, these are really the only two stocks that matter in my portfolio. In both cases, I framed the problem of appraising those stocks differently than most investors probably did.

Let’s start with the smaller position: BWX Technologies. I bought BWX Technologies when it was Babcock & Wilcox. That company had been separated from a larger public company – McDermott International – about 5 years before and Babcock itself was expected to break-up a second time into two units: BWX Technologies and B&W Enterprises. B&W Enterprises was a highly cyclical engineering company tied especially to maintenance on coal power plants in the U.S. and new build revenue on other types of power plants around the world that also used big steam boilers. That is what united the two parts of Babcock. Both BWX Technologies and B&W Enterprises had long experience engineering steam boilers for use in industrial power plants, power plants owned by electric utilities, and the onboard nuclear power plants that power U.S. Navy submarines and aircraft carriers. I was not interested in owning B&W Enterprises. I was interested in BWX Technologies. That company’s profits came from its work providing nuclear reactors and other critical components to 3 U.S. Navy projects: 1) aircraft carriers, 2) nuclear ballistic missile subs, and 3) attack subs. It also made some profits from other nuclear work for other parts of the U.S. government. For example, it down blended weapons grade uranium from the level of enrichment that the U.S. military used in its nuclear weapons program to a level that would allow civilian uses. And it also provided material to the U.S. nuclear weapons program. There were some other businesses like maintaining nuclear power plants in Canada (where nuclear reactors were built to a different design than the rest of the world). I thought nuclear was a mature technology with a limited number of companies that had experience in it, with certain national rivalries and security concerns that often kept foreign competition low, and – most importantly – I thought it was an area most companies weren’t interested in entering. In Warren Buffett’s terms: I thought BWX Technologies had a wide moat. In GuruFocus terms, I thought it was inherently a “5-star” type predictable company. None of this showed up in the headline financial data though. BWX Technologies had been part of a much larger company and then part of a combined company with a unit that did work on coal power plants. Also, there was a unit called mPower that was basically a skunkworks type project for an experimental modular nuclear reactor (a nuclear reactor so small you could deliver it by train anywhere there was a rail line and run it for years without needing to refuel).

Basically, the way I framed the problem was that I was looking at a crown jewel type business that should trade at 20 to 30 times earnings in normal times. And yet, when you tried to take the entire combined company – B&W Enterprises, mPower, and BWX Technologies – together and value it, you saw the market was putting a P/E of 10 to 20 times normal earnings on the stock.

There really were not big differences in any sort of math here between what I saw and what anyone else saw. I had perhaps slightly more aggressive targets for the unit that became BWX Technologies over the next 5 years than others might have (but I was basing that on BWXT’s announced backlog, the U.S. Navy’s announced long-term plan for its capital ship needs, etc.). There was nothing very math-y about any of my calculations. There were a couple key differences to how I saw the stock. One, was deciding that mPower had a value of zero – not a negative value as some investors might have put on it if they lumped in its EBIT loss each year with the EBIT profit of the established businesses and then slapped a multiple on the corporate EBIT as a whole. Two, was deciding that BWX Technologies was really as blue as a blue chip stock could get and should trade at a P/E of 25 or whatever companies like Coca-Cola, Colgate, etc. deserve – because its future seemed as certain and as profitable to me as those kinds of companies. And then the last part was that I decided to buy the stock right then – when it still consisted of mPower, B&W Enterprises, and BWX Technologies all together and hadn’t technically announced for sure that it was definitely going to split up on such and such a date. So, my way of framing the problem was to say that BWX Technologies was a wide moat, predictable company worth 25 times earnings and you could buy it now if you’d just put up with some waiting time and uncertainty about when mPower would be shut down and when the spin-off would take place. In retrospect, you could have done fine in BWX Technologies by making a different decision than me on that last one. You could have waited till BWX Technologies was trading cleanly on its own. You couldn’t – however – have made as much money if you waited a full year or so for BWX Technologies to report a full year on its own, give long-term EPS growth guidance, etc. So, to me, BWX Technologies is an investment that is all about how you “frame” the problem. I didn’t see anything other investors didn’t. I just saw the stock differently. I saw it as this blue chip unit hidden in a hodgepodge of 3 different business units that were muddying the reported results.

My bigger position is in Frost. This is an extreme example of kind of crunching the numbers exactly the same as other investors do – but just choosing to focus on different numbers. I think Frost is – in normal times – one of the most value creating banks in the country. Let me explain. Frost has some of the lowest “all-in” funding costs per dollar of deposits. Banks pay two types of costs for their deposits. They pay interest. And then they pay everything else – branch costs, the cost of providing you with a nice website, moving your money around at no extra cost, etc. However, banks also charge fees. Frost doesn’t charge much in fees. It charges very little relative to what it provides. But, for some – especially big – banks fees are a huge offset to services. So, the way I look at banks is simply to add up what I think normal interest expense is and normal NET non-interest expense (cost of services less revenue from fees) and then divide that number by the bank’s deposits. If you do this, you get an “all-in” cost of funding which might be 2%, 4%, 6%, etc. Right now, if it’s 6% – that bank’s not worth anything. Banks make loans which aren’t better investments than government bonds, mortgage backed bonds, corporate bonds, etc. So, the way I “frame” the problem of valuing a bank – money is a commodity. Loanable funds are the same as investable funds. I don’t care if you are a life insurer that is buying long-term corporate bonds, a bank that is making loans to small businesses, or a sovereign wealth fund that is buying U.S. Treasuries. The asset side of your balance sheet is basically the same. I’m not going to be interested in an investment because of what the financial firm owns. I’m only interested in what it “owes”. I am interested in an insurer for its float. I am interested in a bank for its deposits.

Many banks use some liabilities other than customer deposits. These tend to be expensive. Frost’s balance sheet is pretty close to fully funded by shareholder’s equity (a little bit) and customer checking and savings accounts (a big bit). I don’t want them to use a lot of shareholder’s equity – that’s “my” money that they’ve had to retain. What I want them to use is a lot of low-cost, stable deposits. That is their “float”. If Frost can invest in 4.5% bonds the same as everyone else but it can fund deposits at an “all-in” cost of 2.5%, then it can make a 2% pre-tax profit on this “float”. And then I think Frost is a bank with a higher than average retention rate. Although I can’t definitively prove it, there’s evidence that Frost’s retention rate is the equal of any other bank in the U.S. A bank with a higher retention rate will grow deposits faster than a bank with an industry average retention rate. And then Frost is in Texas. Texas will grow its economy – and its banking deposits – faster than the rest of the country. So, the way I “frame” Frost is that I see a bank with low cost float that is going to grow that float faster than other banks (including banks with much higher cost float). I may or may not be right about that. However, I’m definitely different in doing that. I value Frost purely on deposits per share and the growth rate in deposits per share. So, if Frost had $200 a share in deposits and was growing deposits at 6% a year, I’d use a multiplier (it’s always actually a fraction less than 1) to multiply the deposits per share by to get a valuation figure. So, I might say that Frost is – if growing deposits by 6% a year – worth somewhere between 0.25 and 0.35 times deposits.

I don’t care what the P/E is today. I don’t care what the price to tangible book value is. I also don’t care what the “efficiency ratio” is (this is costs as a percent of revenue) because I always think in terms of costs relative to deposits never costs relative to revenue. And I don’t think about net interest margin. Float will appear to be less valuable in low interest rate environments and will appear to be more valuable in high interest rate environments. However, bank customers rarely switch banks or pull their deposits – so a dollar you add to your “float” in a low interest rate environment will eventually be an extra dollar you have in the next high interest rate environment.

I bought Frost a couple years ago. Before buying it, I analyzed and appraised it. When I valued Frost this way, I got an appraisal that was something like 2-3 times the then current stock price. Frost was then trading at 0.16 times its deposits while I valued the stock at 0.37 times deposits.

This is what I mean by an investment not being about seeing something others don’t and instead being about seeing the entire stock analysis problem differently. If I had framed Frost as something to be valued on the basis of the current P/E, P/B, etc. I would have seen the P/B was high and the P/E was a fairly normal 14 or so. Frost was – at the time I bought it – about the most normal looking stock you could find in terms of P/E, dividend yield, and EPS growth rate. It looked like a boring and correctly valued stock.

I looked at it differently. I valued the stock for the low cost “float” provided by its deposits. I didn’t look at the reported EPS growth rate from 2008-2014. Instead, I looked at the deposit growth rate from 2008-2014. And I didn’t look at what that float would provide in interest income when the Fed Funds Rate was 0% (as it was when I started looking at Frost). Instead, I looked at the interest income Frost would take in when the Fed Funds Rate was 3%.

What I am outlining here may seem like a boring rehash of the investment cases for two stocks I already own and which you can no longer buy at anywhere near the prices I paid for my shares. But, the process I am laying out here is one of the most important parts of successful investing. There is an intellectual pillar to good investing and there is an emotional pillar to good investing. The intellectual pillar is seeing things differently than others see the stock. The emotional pillar is holding on to your shares while others continue to see the stock the way you think is wrong.

There isn’t much I can do to help anyone with the emotional pillar of good investing. But, the answer to mastering the intellectual pillar is easy. You need to be more arrogant and independent. You need to be independent minded enough to be willing to frame the problem of appraising a stock in a way that is completely different from the approach everyone else is taking. And then you need to be arrogant enough to recognize that sometimes – far less than half the time, but yes, sometimes – your view is so clearly correct and yet so clearly at odds with the standard valuation approach, that you need to act on it.

I know it’s scary to think that way. Suggesting that most value investors I’ve come across lack both the independence and the arrogance to carry out a good, contrarian analysis and pounce seems like dangerous advice. But that’s what stock picking is. If you want to use “standard” approaches with the Ben Graham stamp of approval or something like that – you can. I think that’s a great approach. But, it’s a basket approach. You don’t need to spend a lot of time “picking” specific stocks along the traditional value metrics of price-to-book, EV/EBITDA, etc. If all banks are cheap enough – buy a basket of 5 of them, don’t try to select one over another. But, if you want to invest a lot of time in picking one stock over another – the only sensible approach is to up your level of intellectual independence and arrogance to the levels you see in someone like Warren Buffett.

If you’re going to pick specific stocks, you have to trust your analytical abilities enough to allow you to create a model of a stock that differs from the standard model. Every stock pick is an act of arrogance. If you don’t think you’re capable of seeing a stock more clearly than the market – get out of the game.

In 99 cases out of 100, I’m not capable of seeing a stock more clearly than the market. But, when I do act – it’s usually because I have the intellectual independence and, yes, arrogance to believe I’m framing the investment problem more clearly than the market is.

Check Out Geoff’s Members Only Site: Focused Compounding


Focused Compounding Now Includes One-on-One Sessions with Geoff

by Geoff Gannon


Focused Compounding

A membership at Focused Compounding comes with an unlimited number of private one-on-one texting sessions (conducted via Skype) with Focused Compounding co-founder Geoff Gannon.

 

The only restrictions are:

  • Each session runs only from 9 a.m. to 11 a.m. (U.S. Central Time).
  • Sessions are only scheduled for Monday-Friday.
  • You can’t book a session for a day the calendar shows as “ALREADY BOOKED”.

 

During your session, you can discuss any investing topic with Geoff. You pick the topic. It can be a specific stock you are thinking of buying or selling. It can be a general investing question. It can be asking Geoff a laundry list of questions you’ve come up with.

Everything is on the table.

The agenda is yours to set for those two hours and the conversation can cover absolutely anything related to investing.

Membership also includes:

  • General investing articles by Geoff
  • Specific stock write-ups by Geoff
  • A variety of articles by Andrew Kuhn
  • An idea exchange where members post their own stock write-ups. Ideas on the board already include detailed write-ups on: Merkur Bank, Kroger, Protector Forsikring, Wells Fargo, and Under Armour.
  • And a collection of 27 past stock reports written by Geoff between 2013-2016.

A Focused Compounding membership is $60 a month.

Focused Compounding


Guesses About My Next Purchase

by Geoff Gannon


In an earlier post, I mentioned I MIGHT be buying a new 20% position this week. Here is what you guys guessed that position would be:

Blog readers emailed me guessing I would buy one of four stocks this week: Howden Joinery, Omnicom, Hunter Douglas, or MSC Industrial.

Blog readers emailed me guessing I would buy one of four stocks this week: Howden Joinery, Omnicom, Hunter Douglas, or MSC Industrial.

The stock I am considering is not among those four.

Richard Beddard's Share Sleuth portfolio, however, did buy Howden Joinery. Read the post explaining why here.


Focused Compounding: Member Stock-Writeups

by Geoff Gannon


Focused Compounding

Merkur Bank

“Merkur Bank (MBK) is a small regional bank located in Munich, Germany…MBK’s stock offers a good opportunity to partner with an owner-operator whose financial wealth is being tied to the bank’s future performance. This should provide outside investors with the comfort that Mr. Lingel will not take on any undue risks. MBK is a well-run bank that does business quite differently than most of its competitors; it focuses on a few attractive markets that it understands well and values long-term partnerships with its clients. At the current price, investors can expect a satisfactory return on their investment without paying for any potential growth in the coming years.”

 

Kroger

“Founded in 1883, Kroger is now one of the largest retailers in the world, with more than $115 billion in revenue in 2016, serving more than 8.5 million customers every day. As of January 28, 2017, Kroger operated, either directly or through its subsidiaries, 2,796 supermarkets under a variety of local banner names…it’s hard to get comfortable about Kroger’s ability to grow its EPS by 8% a year without more aggressive assumptions such as meaningful increase in leverage.”

 

Protector Forsikring

“Protector is quite a new player in the Scandinavian insurance market. The company was established in 2004, and listed on the Norwegian stock exchange in 2007... This is a far riskier investment than for example Progressive, Gjensidige or any other stable insurance operator. But at the same time, it is cheap relative to their historical performance and the potential growth rate it may achieve over the next 5 years. For a more diversified portfolio, this might be an interesting bet. However, for a very concentrated portfolio, this investment may be a pass.”

 

Wells Fargo

“In general, Wells Fargo makes money in two ways.  Firstly, it earns a spread on its interest-earning assets by borrowing at low rates and lending at higher ones.  Secondly, Wells Fargo collects fees for the products and services it offers (non-interest income).  Non-interest income only partially offsets the company’s non-interest expenses; thus, it is only accretive to earnings if it outpaces costs…I believe Wells Fargo securities represent a safe investment.  U.S. banks are very durable businesses with high customer / deposit retention.  Most American consumers and businesses use their bank accounts for transactions and are generally indifferent to interest payments on the money they use month-to-month.  Banks could change for the worse, but changing for the better is much more likely. Traffic to branches is declining, which should lead to branch closures and cost reductions.  Wells Fargo has a strong competitive advantage built on a strong branch network, huge base of low cost deposits, conservative lending practices, and an ability to increase non-interest income by cross-selling its products.”

 

Under Armour – One Member’s Take

“Athletic apparel manufacturers typically develop, market, and distribute their own branded apparel, footwear, and accessories for men, women, and youth.  Products are usually sold worldwide and worn by athletes, as well as by consumers of active lifestyles…the athletic apparel industry is an attractive industry for investors to shop in.  After a track record of impressive and consistent sales growth, Under Armour has stumbled in its last 2 quarters, causing a mass sell-off of its shares that have driven the price down by around 50% over the last year.  I believe that most of the causes of recent poor performance are either temporary or cyclical in nature; however, the brand’s dropping popularity with fickle teenagers could be problematic if it endures.  If the brand’s strength is intact and sustainable, Under Armour shares should perform well by offering returns ranging from 9% to 15% over the next decade or more if the brand endures, but if the brand fades, investors should expect a loss of 40% on their investment.”

 

Under Armour – Another Member’s Take

“Under Armour (UA) was founded in 1995 by Kevin Plank, then special teams captain of the football team from University of Maryland. Frustrated by the increase in weight traditional cotton T-shirts incur after heavy sweating, Plank set out to develop T-shirts using better materials…While UA is not a traditional value investment. Given the business quality and reasonable growth assumptions, buying its stock now may still get you market beating results if you buy and hold for 20 years. But if you want a wider margin of safety, you should closely monitor the stock price. Let’s say the stock price drops another 20% or so, it may still trade at a seemingly high P/E of 40x. Yet, that would be a good entry point already, with an expected return closer to 9% to 10% over the next 20 years.”

Focused Compounding
 

Talk to Geoff about Focused Compounding


I MIGHT Buy a New 20% Position This Week

by Geoff Gannon


It's very possible I will purchase a new 20% position this week (29% of my portfolio is in cash and 6% is in a stock I'd happily eliminate).

If I do buy the stock, I'll announce it on the paid site (Focused Compounding) first and then mention the stock's name here a week or two later.

Anyone who wants to guess what the stock is can email me at gannononinvesting@gmail.com

There are no prizes for a correct guess. But, it might be a fun exercise.


All Supermarket Moats are Local

by Geoff Gannon


Following Amazon’s acquisition of Whole Foods and the big drop in supermarket stocks – especially Kroger (KR) – I’ve decided to do a series of re-posts of my analysis of the U.S. supermarket industry.

Today’s re-post is a roughly 1,300 word excerpt from the Village Supermarket (VLGEA) stock report Quan and I wrote back in 2014. This section focuses on how the moat around a supermarket is always local.

Read the Full Report on Village Supermarket (VLGEA)

In the Grocery Industry: All Moats are Local

The market for groceries is local. Kroger’s superstores – about 61,000 square feet vs. 58,000 square feet at a Village run Shop-Rite – target customers in a 2 to 2.5 mile radius. An academic study of Wal-Mart’s impact on grocery stores, found the opening of a new Wal-Mart is only noticeable in the financial results of supermarkets located within 2 miles of the new Wal-Mart. This suggests that the opening of a supermarket even as close as 3 miles from an incumbent’s circle of convenience does not count as local market entry.

In the United States, there is one supermarket for every 8,772 people. This number has been fairly stable for the last 20 years. However, store churn is significant. Each year, around 1,656 new supermarkets are opened in the United States. Another 1,323 supermarkets are closed. This is 4.4% of the total store count. That suggests a lifespan per store of just under 23 years. In reality, the risk of store closure is highest at new stores or newly acquired stores. Mature locations with stable ownership rarely close. So, the churn is partially caused by companies seeking growth. Where barriers to new store growth are highest – like in Northern New Jersey – store closings tend to be lowest. Village’s CFO, Kevin Begley, described the obstacles to Village’s growth back in 2002: “…real estate in New Jersey is so costly and difficult to develop. New Jersey is not an easy area to enter. This situation also makes it challenging for us to find new sites. It’s been very difficult for us, and for our competitors, to find viable locations where there is enough land especially in northern Jersey and where towns will approve a new retail center. With the Garwood store…we signed a contract to develop that piece of property in 1992; it just opened last September (2001). So it can be a long time frame from when you identify a potentially excellent site and when you’re able to develop it. Finding viable sites is certainly a challenge that we face, as do our competitors.”

New Jersey is 13.68 times more densely populated than the United States generally (1,205 people per square mile vs. 88). It is about 12 times more densely populated than the median state. This means New Jersey should have about 12 times more supermarkets per square mile to have the same foot traffic per store. The lack of available space makes this impossible. As a result, the number of people visiting a New Jersey supermarket is greater than the number of people visiting supermarkets in other states. The greater population density in New Jersey has several important influences on store economics.

One, it encourages the building of bigger stores. This sounds counter intuitive. If there are a lot of people in a small space and land is difficult to develop, it would be logical to enter the market with a small format store. That is true. However, incumbent stores have big advantages over new entrants. Incumbents have leases in key locations. Their stores are highly profitable. As a result, store owners in New Jersey will favor expanding each existing store to the maximum possible square footage whenever renovation is a possibility. This is what most Shop-Rite members have done. Village does not operate especially large Shop-Rites. However, 58,000 square feet is huge by national supermarket standards. Whenever Village has renovated a store, it has tried to increase square footage. Village has sometimes relocated stores to larger footprints. And Village’s most recent new stores have been huge. For example, Village recently built a 77,000 square foot replacement store in Morris Plains. This store is almost as large as the Wegman’s superstores (80,000 to 140,000 square feet) that tend to be the biggest supermarkets in New Jersey.

Two, New Jersey supermarkets turn the product on their shelves faster. This changes product economics for the store and the experience for the customer. A Shop-Rite turns its inventory phenomenally fast relative to the grocery section of a Wal-Mart. As a result, stale inventory and lack of help – the two largest complaints from grocery shoppers at Wal-Mart – are unusual in New Jersey supermarkets. More customers per square foot means higher sales velocity. It is not possible to stack more inventory per square foot. It is only possible to restock inventory faster. High inventory turnover can increase customer satisfaction by increasing the freshness of the product without requiring the store to buy different merchandise than a competitor with stale product on its shelves. More importantly for the stores, gross margins can be lower at a high traffic location and yet gross returns can be higher. In fact, this is exactly what happens at Village. Village’s gross margins are 10% lower than Kroger’s (27% vs. 30%) while gross profit divided by net tangible assets is 2.32 times higher (290% vs. 125%). A New Jersey Shop-Rite generates much higher returns on capital than any other traditional supermarket around the country. Again, this encourages reinvestment in existing stores. This further raises the barrier to local entry. A new store would need to find an open location where it could put a 60,000 square foot location to rival the breadth of selection and the low prices of the incumbent supermarkets. In most of the country, land is more widely available and the incumbent supermarkets are only around 35,000 square feet. Nationally, the average supermarket does $318,170 a week in sales. In New Jersey, the average Shop-Rite does $1 million a week. The initial investment required to enter a local grocery market in New Jersey is higher because the industry standard is higher and the costs of developing anything are higher. It is important to remember that the barrier is not simply the roughly 100% more expensive real estate in New Jersey versus the country generally. Nor is the barrier simply the lack of available space in New Jersey. The final hurdle to clear is the simple fact that supermarkets in New Jersey have evolved into much larger, lower margin beasts than the competition elsewhere.

Large stores support wide selection, low prices, fresh inventory, and high customer service. A comparison of inventory turns (Cost of Goods Sold / Average Inventory) helps illustrate this point. Village’s inventory turns are 26, The Fresh Market 21, Whole Foods 21, Fairway 20, Kroger 12, Safeway 11, and Weis Markets 9. It is easy to imagine a division between two groups: the supermarkets focused on freshness and the supermarkets focused on low cost. However, Village – a low cost generalist – has higher inventory turns than the group of “fresh” supermarkets (The Fresh Market, Whole Foods, and Fairway). Village turns its inventory twice as fast as traditional supermarkets like Kroger and Safeway. Kroger is an especially good comparison because its store size is the same as Village’s and its business strategy (big stores, wide selection, low prices, and generalist) is virtually identical. The difference between inventory turns at Village and Kroger is that almost all of Villages’ stores are in New Jersey while none of Kroger’s stores are in New Jersey. As a result of this higher inventory turnover, Village can charge customers 3 cents less per dollar of sales than Kroger and have double the return on capital (33% vs. 17%). The moat around Village is its portfolio of big, established stores in New Jersey that would take a lot of time, money, and risk to duplicate. If Kroger controlled these locations it would have at least as good returns on capital as Village. But the only way Kroger will ever control key New Jersey locations is through the acquisition of a New Jersey supermarket chain. The time, cost, and risk of introducing a new banner – the Kroger name is unknown in New Jersey – makes entry by any means other than acquisition extremely unlikely. The moat around Village is entirely local and historical. It runs big, mature stores under the well-known Shop-Rite name. Most importantly, it runs them in the best locations in America for supermarkets.

Read the Full Report on Village Supermarket (VLGEA)