Bonal (BONL): An Extremely Tiny, Extremely Illiquid Stock that Earns a Lot But Doesn’t Grow at All

by Geoff Gannon


Bonal isn’t worth my time. It might be worth your time. It depends on the size of your brokerage account and the extent of your patience.

So, why isn’t Bonal worth my time?

I manage accounts that invest in “overlooked” stocks. Bonal is certainly an overlooked stock. It has a market cap under $3 million and a float under $1 million (insiders own the rest of the company). It often trades no shares in a given day. When it does trade, the amounts bought and sold are sometimes in the hundreds of dollars – not the thousands of dollars – for the entire day. It’s also a “dark” stock. It doesn’t file with the SEC. However, it does provide annual reports for the years 2014 through 2018 on the investor relations page of its website. In the past, the stock has also been written up by value investing blogs. Most notable is the write-up by OTC Adventures (the author of that blog runs Alluvial Capital – sort of another “overlooked stock” fund). That post was written back in 2013. So, it includes financial data from 2008-2013. I strongly suggest you read OTC Adventure’s post on Bonal:

Bonal International: Boring Products and Amazing Margins – BONL

The company has also gotten some coverage in a local newspaper. For example, I’ve read articles discussing Bonal’s attempt to sell itself at a below market price. Shareholders rejected this. So, the stock isn’t a complete enigma. You have write-ups like OTC Adventures, you have some old press coverage, and you have annual reports (complete with letters to shareholders) on the company’s investor relations page. At the right price, it’s definitely an analyze-able and presumably invest-able stock.

But, not for me. Because I run managed accounts focused on overlooked stocks, I try never to eliminate a stock simply because it’s very, very small or trades almost no shares on most days. Even stocks that appear to have zero volume are sometimes investable. In my personal experience, I can point to cases where I bought up to 10,000 shares of a stock in a single trade that had a history of trading less than 500 shares on average. And that’s not a one-off fluke. It’s happened to me more than once. So, if the shares are out there – your best bet is to bid for the stock you like best regardless of what the past volume of that stock has been. Often, it may be easier to get into – and even out of a stock – in a few big trades than it appears on the surface. This is due in part to people trading much smaller amounts of the stock than you – and a few other bigger, or simply more concentrated investors – will want.

However, in the case of Bonal – there simply aren’t enough shares held by non-insiders to make it worth my while. The accounts I manage are not big. But, the investment strategy I practice is not one where you go out looking for 1% positions. It’s the kind of strategy where you always want to put 10% or more of the portfolio into any stock you buy. Sometimes, because of illiquidity – or the price moving up on you – the position size you end up with might be far short of 10%. But, to start bidding for something – you have to believe it’s possible to put 10% into this stock. Here, because of the extraordinarily small float, it’s just not possible. Even if everyone but the controlling family was willing to sell me shares – this would still end up being a smaller position than I want.

So, for me Bonal is a pass. But, those are trading concerns that some readers won’t have. Since I did look at the stock – I’m going to go ahead and write it up here without worrying about the fact that it’s “un-investable” for the accounts I manage. It might not be un-investable for your personal account. Maybe because your account is smaller. But, also maybe because you like to be much more diversified than I do. If you don’t mind single-digit percentage position sizes – maybe, Bonal is investable for you.

What jumped out to me about Bonal?

This graph…

From 2008-2018, Bonal’s gross margin was higher than 70% in every single year. Most public companies - and almost all public manufacturing companies - never have a single year with a gross margin over 70%.

Two things. One, the company’s size and the fact it was often profitable. This is unusual. There are very, very few companies with sales of just a couple million dollars that manage to eke out a profit. Yes, there are some private companies – often, more like sole proprietor type businesses – that are consistently profitable on such a small level of sales. But, it’s extremely unusual to find a public company turning a profit at such low sales levels. This has important implications. It means the company must have strong product-level economics – gross profitability has to be amazing here – to allow anything to exceed the SG&A line.  It also means that if the company can ever increase its sales by a few million dollars – the bottom line, the dividends paid, etc. are likely to absolutely explode.

Let’s talk “economies of scale”. The economies of scale gained by going from $2 million of sales to $10 million of sales are greater than the economies of scale gained by going from $2 billion of sales to $10 billion of sales. Investors underestimate this. We’re all used to using ratios, percentages, etc. to analyze the stocks we look at. This puts them on equal footing. It makes it appear that a group of 100 different wineries making 1,000 different wines has as good a chance of improving its operating margins as a company making 1 type of wine at a single vineyard. That’s wrong. The single vineyard has a much, much greater chance of expanding operating margins on even small increases in sales, because true fixed costs are a much greater percentage of the company’s current cost base and what I’ll call “semi-fixed costs” are also big. Semi-fixed costs are things that if the company quadrupled in size would be considered a “variable” cost because you would have to scale them up at the same rate. But, there is no scaling up of the cost – or very little scaling up of the cost – at small incremental sales gains till you hit a certain level of utilization. Basically, you might have a vineyard that could do $5 million in sales, but it is now doing just $2 million in sales. This doesn’t mean you need to more than double assets to get to $5 million in sales. It means you are operating inefficiently at 40% utilization of your current capacity. This is very, very common for very, very tiny companies. Everything about them from the premises they rent, to the sales team that markets their product, to the CEO’s time may be underutilized. The further down the income statement you go – the truer this is. Every company – even a “dark” company – has some “corporate costs” that eat up a lot of profit. It needs a CEO, it needs a board, and it needs an auditor. And every company – no matter how small – needs a location to use. Often, the location being used can handle more volume than a couple million in sales, production, etc. So, the administration of a very small public company and certain other general costs – as well as some costs that might end up in the “gross costs” line – have a ton of operating leverage built into them. Often, if sales go from $2.5 million to $1.25 million – the company goes from solidly profitable to being on the verge of bankruptcy. While a sales increase from $2.5 million to $5 million would make earnings explode.

Is that the case here with Bonal?

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Why Book Value Doesn't Matter, How to Find Cheaper Peers of Expensive U.S. Stocks, and How to Form a Fast Opinion about a New Stock

by Geoff Gannon


Listen to the Audio: Episode #81 of the Focused Compounding Podcast

Geoff:                   Hey, this is Geoff Gannon, and you're listening to the Focused Compounding podcast. This is the podcast where Andrew and I talk general investing concepts. If you want to know more about specific stocks I like, go to focusedcompounding.com where you can read stock ideas written up by me and other members. Membership costs $60 a month, but if you use the promo code PODCAST, it'll be $50 a month for you. Andrew and I also manage accounts for investors, to learn more about our managed accounts, email Andrew at info@focusedcompounding.com, or text or call Andrew at 469-207-5844, that's 469-207-5844. And now here's Andrew with your regularly scheduled podcast.

Andrew:              All right, we are back. How is everybody doing? Hope you are doing well. My name is Andrew Kuhn, Focused Compounding Podcast. Mr. Geoff Gannon, how's it going over there?

Geoff:                   It's going very well Andrew, how's it going with you?

Andrew:              It is going great. Hope it's going great for everybody else. I want to thank everybody for tuning in, and if you've given us a rating and review, that makes us happy and we definitely thank you for that. If you want to give us a rating review, feel free to go to the podcast app on your ... where you're listening to this, I mean we're on iTunes and the Podbean, and give us a rating and review. That definitely helps spread the word, and Geoff and I would be greatly appreciative of that.

Andrew:              So today we're going to be talking about ... So we always talk about, if they want to join your memo list to go to the website and type in their email. And if you're a member you get a premium memo, which is obviously a paid memo, which-

Geoff:                   Right a watch list.

Andrew:              Yeah, a watch list that you update every single week of stocks that you're currently researching, and you start a batting order from there. But there's a free part of the site where you do an investing topic and I think it'd be a good idea to sort of just chat about it, use an episode, because maybe not a lot of people know about it. There's a lot more people listen to our podcast than are subscribed to the email list, so that could be a good way-

Geoff:                   And it's free.

Andrew:              And it's for free, yeah.

Geoff:                   So, and we know a lot of people aren't going to sign up for a paid thing, but you can get this free thing, that you listen to a free podcast, you can get a free email each week, a written thing. It's one page.

Andrew:              Yeah it's always one page. So, a couple of weeks ago, and we'll go over a couple of different ones, and maybe we could just chat about them, a couple of weeks ago, you sent out a memo, what are super investors good for?

Geoff:                   Right. And I think we got a question from that on Twitter that we also talked about in our episode too.

Andrew:              Yeah, like cloning it-

Geoff:                   Because of that memo. Yeah.

Andrew:              Yeah, because cloning investors and what not. So, what are super investors good for?

Geoff:                   I think they're good for getting ideas from them. And so when we're talking about super investors, we're talking about things like Guru Focus and places like that where you can go and see all the stocks that they own, their portfolios. And I get a lot of questions about things from people's portfolios, from their 13Fs and things like that. I get a lot of emails saying, "Well, look at this in their holdings, what do you think about this," stuff like that. And I think we talked a little bit about how maybe the biggest position that they have isn't the best, because that might be the one that's gone up the most in value. So often the thing that they bought the most of when they bought is good, and more like looking at it at the price that they bought at, and seeing if you can buy it at a similar price to what they originally bought. Not that you can follow them in at a later higher price, obviously.

Geoff:                   So they're good for getting ideas for stocks. I also think they're good for getting ideas for industries. Sometimes picking a peer of a stock that they pick, as long as it's a smaller one because they tend to be bigger investors, and want to buy bigger stocks than you might be able to. But if you suddenly see that they're buying railroads, and that Buffett is buying railroads, and that he loves railroads, or airlines when he did that, that can tip you off on those are things that you should really study up on. There's something about it there.

Andrew:              Yeah, and Guy Spier and actually Mohnish Pabrai, I think they both kind of do that whenever they find a big company someone is interested in, they'll look overseas to see if they can find a pretty comparable company, because there may be cheaper than for example United States, or if it's a smaller company maybe more mispriced than a bigger company, but they just take like a good comparable to it. But that's just a good starting place.

Geoff:                   Yeah, I'll do that right now and say that Buffett did a private deal to buy Van Tuyl an auto dealership company in the U.S. We had a write up on the website about car dealerships in the U.K., and I talked about one of them in the U.K., but I think that would be a great example. If you're listening to this and you saw that Buffett bought car dealerships and you're looking at them in the U.S., there are actually a lot of them that are cheaper in the U.K., and it would be a good idea to at least compare them. There might be reasons why you like them better in the U.S., but you're going to pay more to buy them in the U.S., so definitely look in the U.K.

Andrew:              Have you ever bought a stock because a guru or super investor has purchased a stock?

Geoff:                   That's a very good question.

Andrew:              Like what if you see okay that they own it at 50 and now it's like 40 or 30? Because you just talked about maybe the biggest stock has gone up the most, but what about in other situations where it's not like that? Like do you think it's a good way to filter and look for ideas?

Geoff:                   Yes. I have looked for ideas. I can immediately think of some ideas I took. I put an idea that they had right onto a watch list that I was looking at. So Buffett personally bought, and eventually his company would give a loan to Seritage, but he personally bought Seritage and when he did I looked at it. So Seritage was a spinoff from Sears.

Andrew:              Because you don't really hear about him purchasing in his personal account too much at all.

Geoff:                   Right, but he did. He's bought REITs and things like that in his personal account. He bought J.P. Morgan in his personal account long before he bought it for Berkshire which is many years later. So it's usually something that he thinks doesn't conflict with other stuff, and mostly I noticed that he'd done it years and years ago with REITs. He seemed to be buying REITs, and Seritage fits into that sort of category. So that was one that I saw.

Geoff:                   There was one with Allen Mecham where he'd bought a business that I looked at that business, but then I also looked harder and actually wrote up some companies in the same industry, but not that business.

Andrew:              What company was that?

Geoff:                   It was DNOW, is the ticker.

Andrew:              A spin off

Geoff:                   Yeah, so it's distribution. It's a spin off.

Andrew:              An oil company?

Geoff:                   Yeah.

Andrew:              Cool. And then so like for example getting back to it, if the stock is lower do you think that's a good place for people to-

Geoff:                   Yeah.

Andrew:              I mean Mohnish Pabrai always talks about that, how he's like a one man shop, but he utilizes all these filing that of these hedge funds that have a team of analysts and he just kind of sifts through them.

Geoff:                   Yeah, and that's a great way of doing it.

Andrew:              Do you think though, I mean in the question Q&A podcast that we did though how sometimes confirmation buys can become a thing. You kind of have to obviously probably guard against that.

Geoff:                   Yeah, I mean I think I have that issue. I'm going to have it less than most people I talk to. A lot of people seem to be really interested in it, and if it goes badly or something they sort of blame the investor who they found the idea from, you know?

Andrew:              Yeah, sure.

Geoff:                   I don't I guess put a lot of faith in other investors that way. Even if something like ... Just because Buffett was selling some stock doesn't mean that I wouldn't consider buying that stock.

Andrew:              And you've got to remember too sometimes people sell stuff because just portfolio constraints, or like redemptions. Or it could be nothing to do with the actual business, or because they may not disregard that business, or not like it, but they just found something else that they kind of like more.

Geoff:                   And there are things that, I can think of things that Buffett bought, liked, held for a while, sold, and they did fine since he sold them. I'm thinking right away of General Dynamics in the 1990s, he made money on and stuff, but if he'd held it through today he would have done well. He would have done well if he'd of held onto Disney and not gotten rid of his Disney stock when Capital Cities and Disney merged and things like that. Or the Disney stock-

Andrew:              Or if you follow him with IBM, the other way around right?

Geoff:                   Yeah, but I think it's always an interesting thing, especially someone like Buffett is a really good example, but there are others who don't own a huge number of stocks and so they focus particularly on one industry or something like that at a moment, and that can really tip you off to it. But also, you can get ideas from bloggers and things like that. I've probably got as many ideas from bloggers as I had from super investors. I had read some people talking about Japan before I invested in net-nets in Japan. And in some cases I think some people wrote about it and stuff and I ended up putting more of my money into it than they ever did, but they gave me the idea for it basically of that country at that time, to really look into and some sort of hints of what was available.

Andrew:              And if you do become a member there is a list of past memos on the website.

Geoff:                   Of past memos, yeah.

Andrew:              So if you do want to read those, and like I said, it's just one page. You know a lot of people like, I tweet it out every single week, and if you do sign up for free, it'll be in your email box.

Andrew:              So the next one you talked about is value matters, but book value doesn't

Geoff:                   Yeah, that's true.

Andrew:              And this was before or after we talked about Warren Buffett's shareholder letter, which is I'm sure where this idea came from for this memo.

Geoff:                   Yeah, probably yeah.

Andrew:              So thoughts on it? Value matters, but book value doesn't.

Geoff:                   Yeah, this is one that I've talked ... like I consider myself a value investor in a lot of things we talk about here are value investing related, but a lot of times when academics talk about value investing they're talking about price to book. That's actually how a lot of indexes and things like that are formed of like of in style boxes and things like that, that you see for judging what a fund is, like if it's a value fund or something, is in part based on high the price to book is of the things that they own. Now it so happens that somethings that we own in the managed accounts have low price to book, but many don't, and some of the one that don't have low price to book I actually think are very cheap versus their appraisal value. And so I gave some examples in there.

Geoff:                   I gave an example of land that has been on the books for 100 years. Well you can buy it at a 50% discount to what it's worth, and yet still be paying three, four times book value. So is it not a value stock because it's three or four times book value? Or is it a value stock because it's half the price people are buying the acres next to it for? So value means paying less than what it's actually worth, then your appraisal of it, whereas book value is an accounting thing, which sometimes gives you an idea of what it's worth, but sometimes has nothing to do with that.

Andrew:              I mean back in the day it was probably more prevalent because of the types of companies that were around, right?

Geoff:                   Yeah. And it is still a very good way of valuing things like cash, current assets like receivables, things like that. Anything that was put into the business very recently. So if something goes public, raises a bunch of cash and puts it on the balance sheet, well the book value's going to be 100% accurate in that case, but it's going to become less accurate as they buy land to build a factory on it, or then they start producing things on it, and then 10 years later well a lot times that won't be worth what it says in the books. I can think of cases where companies that shut down a factory had to pay to have equipment moved away. They didn't get paid for it, because it was so not valuable at that time. Whereas in other cases you can have inventory and things that are worth quite a lot. There are cases of companies involved in like certain precious metals and things like that, but also diamonds, diamond inventory. I can think of things where there was steel inventory where it was probably worth actually more than the company was carrying on the books for it. Whereas most companies the inventory's worth quite a lot less if they can't sell it in their normal sort of way of doing it.

Andrew:              Why do you think Buffett spent so much time talking about that in his letter?

Geoff:                   Well because he's going to buy back stock I think. And because I think that-

Andrew:              It's not as important as-

Geoff:                   He's going to buy it back above book value.

Andrew:              Okay.

Geoff:                   So I think that's the biggest reason. So if you buy back ... There's actually, I talked about with someone, there's a pretty good article about all the companies that exist today that have negative book value. And I've actually invested in companies with negative book value, which would seem to be the ultimate not a value stock, but I for instance had a pretty big part of my portfolio in a company IMS Health, the public company IMS Health today is a little bit different than this one, but this one was back in very early 2009, and it had negative book value at that time, and that's because it produced a lot of free cash flow which it used to buy back its own stock. And it had borrowed some money and it used that money to buy back stock, but it used to buy back stock way above book value. And so, when you do that you reduce your book value as you buy back. If you pay above book value and you buy back stock then you'll reduce your book value over time, and if you do the reverse and you buy it back under book value it'll grow.

Geoff:                   But it was a very good company and it probably had a free cash flow yield over 10% and it grew a little bit each year as basically just a data base of information and things like that. And it would be a bargain at probably twice the price they paid, it would be worth in terms of like if you were adjusting the fair value of the company. They were buying back the stock at about half of what it was really worth in terms of its cash flows and things like that. And yet, they were causing the company to have negative book value when that happens.

Geoff:                   I think Buffett when he bought into Gillette, Gillette momentarily had negative book value. It took on some debt and ended up with negative book value. But you know Gillette isn't based on the factories that it has and things like that. It's based on the brand name and things like that which have no presence on the books.

Andrew:              Yeah, which is kind of a lot like the companies we see today. I mean they are just not-

Geoff:                   Yeah, if they’re built internally. Yeah, so if you have something like Apple which grew all of this brand and technology and stuff internally, yes. Now if someone goes and buys another company then they put on the books all these intangibles and that's different. But yeah, anything that's created brand names yourself through your advertising you've already expensed that. You expense that advertising each and every year.

Andrew:              Sure. Cool. Next one. Expanding your circle of confidence into other countries, and this is one I think is interesting because on the watch list that you send out, you do have a spot for I think overseas don't you? Overseas companies?

Geoff:                   Yeah, there's three parts. There's domestic, there's foreign companies, and then there's companies I'm going to revisit that I've already mentioned before.

Andrew:              Are you making a market call when you're going to other countries?

Geoff:                   Yeah, so no, I mean I'm looking at other countries, but in part that is true that it means I'm having trouble finding things in the U.S. I've said before in the letter to clients, that in the managed accounts, that ideally I would love to be 50% U.S., 50% the rest of the world. That's still a pretty big focus in the U.S. It's half of the portfolio. The U.S. isn't half of the world's economy. But I know more about things in the U.S. and stuff like that. But, it's something that I have not gotten anywhere near to, and would like to get closer to having 50% in other countries.

Geoff:                   I think the thing is, especially right now, but this has been happening a lot during the time that I've been investing, stocks in the U.S. have been more expensive than stocks in some other countries, and so there's the opportunity to look in other countries and to maybe find comparable merchandise at a lower price. You know, and that's what you're always trying to do. You're always trying to find the one peer in an industry or something that looks cheaper than all the others. So yeah, I know that recently I mentioned an elevator company in Japan is on that watch list, and it's much cheaper than elevator companies in other parts of the world. There's car dealers in the U.K. on that list, and they're much cheaper than car dealers in the U.S., and those are just generally industries that are pretty good. I think it's not a bad asset to own stock in an elevator company for the long term. It's not a bad asset to own stock in a car dealer for the long term. It's not like these are steel companies or something. It's not that I'm picking particular industries for the short term. These are assets that will be desirable for the long term.

Geoff:                   We just had a write up on the website about a company involved in public relations, which is basically related to advertising type of stuff, same sort of industry, in Japan and that kind of firm in the U.S. can sometimes be a lot more expensive, a public relations company in the U.S. So it's just historically those have been good industries. If you look the returns you get in things like advertising, marketing type companies, car dealers, elevator companies, all those things tend to have good returns as industries in all sorts of different countries. And so if you're finding them really expensive in your home country, why not look at other countries to see if there might be a cheaper example there.

Andrew:              What type of companies does Buffett own in other countries?

Geoff:                   Well one of the big ones is ISCAR, which makes like sort of cutting tools, things like that. So yeah-

Andrew:              He's predominantly in the United States though.

Geoff:                   Yeah.

Andrew:              For sure.

Geoff:                   He has at times owned some stock in other parts of the world. Let's see they owned ... They had an investment in POSCO at one time, which is a South Korean steel company. That was an unusual investment for them. Diageo. When he had bought it at least its biggest brand would have been an Irish beer. So there are some investments that he's made in other parts of the world, not very big. I'm excluding insurers, he's made some pretty big investments in insurers that are pretty global, but yeah.

Andrew:              What country is it that he said he bought an accounting book for that country?

Geoff:                   Korea.

Andrew:              It was Korea. Okay, that's who I thought it was.

Geoff:                   Yeah, he bought like 20 Korean companies.

Andrew:              That was just more of a like a-

Geoff:                   Like net-net type things. And he pointed them out, like he bought-

Andrew:              Reminds me of Japan, the net-nets.

Geoff:                   Yeah, they were very cheap in Korean. It was after the Asian crisis there that they had, the financial crisis, so.

Andrew:              He did this in his personal account?

Geoff:                   Yeah.

Andrew:              He said it brought him back to the early days.

Geoff:                   Yeah, and he looked at some things and he had some concerns that he didn't understand. If he didn't understand the accounting or wouldn't know if they were frauds or things like that so he wanted to diversify over like I think he said 20 or something things. Yeah, but some of the examples he gave were things selling at like one times earnings and stuff. Korean as a country tends to be pretty cheap compared to some of the others. So yeah, that's a good example. Japan, I think everyone should look at Japan. I think that the small companies there and those sorts of things, and we'll have posts I think each month now we're going to have a, in fact I know, each month now we're going to have a Japanese stock right now.

Andrew:              Is that for free?

Geoff:                   Yeah. That will be available for free. Well if you're on the memo list you'll see it. So we should point that out. If you're on the memo list, what happens if we send you the memo and at the top of the memo I put a link to whatever content you have access to that week so that people know there's new stuff to read, because otherwise, you wouldn't know. And I forget if it was last week or the week before when you were hearing this was about a Japanese stock and it was the first of what we'll have monthly up there. Which is something I've wanted to add to the site for a while. To have more coverage of those sorts of things and I think Japan is a good example there. But, it was a high quality company. I'd like to add more of those sorts of things because it does seem like people writing about Japan only write about like net-nets. You know that seems to be the thing, yeah.

Andrew:              Okay, next one. How to prejudge a stock?

Geoff:                   Okay, so that is a question I get a lot from people is like, "Do you really just sit down and read all about, like read the entire 10K without having any sort of knowing where the price is and knowing the sort of past financials and things like that?" The biggest things about prejudging a stock would be the industry. So know what industry it's in and if you've looked at things like it before. That's the most helpful thing. It's really hard to analyze a stock that has no connection to any stocks that you've researched in the past. So like when we were just talking about the countries' thing, it's really good to analyze and elevator company in Japan if you've analyzed one that's European or U.S. in the past. Or car dealers in the U.S., that makes them so easy to analyze them in the U.K. So those are really easy that way. And that's what I do a lot of.

Geoff:                   I mean I wrote about a company, and will write more about a company, Frontdoor, which was a spinoff in the last year, and a lot of that is because I had research a company called HomeServe which is U.K. based company, and so that's a big part of it is knowing the stocks that you've looked at in the past to be able to get some guess about the quality of the business, how the business works. I've talked a lot about like sort of Michael Porter approach to competition and things like that, about breaking down the competitive factors about relationships and bargaining power with customers and with employees and things like that. Actually that's a good example that recently is Buffett talking about how Kraft is not worth what it was before because them having less bargaining power with companies like Costco and Walmart. And that's a really good example of understanding those sorts of bargaining power. Usually you can make some guesses about bargaining power stuff right away just by knowing a little bit about the product and about the industry that it's in. So those are things that I used right away to do that.

Andrew:              And so when people reach out to you what do they sort of ask about other than, do you really spend so much time on it? Do they just say like, "How do you sift through it so quickly to move on to the next stock, or are you trying to disqualify it? Or what do you think?"

Geoff:                   Yeah, I think they're surprised by how much I just sit down and read the whole thing about the company. But, once I've made the decision to study this particular company, that is true. I just read the investor presentation, and the annual report, and for a lot of the stocks-

Andrew:              You can learn a lot about a business from their investor presentation. I would say it's a good place to start.

Geoff:                   Yeah, and for a lot of the stocks we're looking at which are for the manager accounts, we do overlooked stocks, a lot of times that is just reading an SEC filing or in some cases a dark company so they don't even have an SEC filing, but less likely to be investor presentations or things like that. But even then, you can find investor presentation in the same industry often.

Andrew:              Yeah, so that's a good place to start.

Geoff:                   I always say that to people that they should ... One thing people don't do, is like study three or four of the same kinds of companies at the exact same time which is really useful to do. So don't just try to figure out like you've never looked at a car dealer before, but you're going to try to value this one. Get a list of the five biggest public car dealers in the U.S.-

Andrew:              And compare them man. You learn so much from doing that too.

Geoff:                   Compare and contrast, that's really the key, yeah.

Andrew:              And even if you, talk about judging, if you just learn and you move on well you just learned so much about it which is only going to help you in the future.

Geoff:                   Yeah, so I think people try to too much to say one stock in isolation, instead of looking at the industry.

Andrew:              And you can very quickly, I mean from my experience, if you read about three or four of the competitors, you can tell which one's the best in my opinion.

Geoff:                   And you can see the differences in their strategy when they talk about that.

Andrew:              And then there's also things, you could take it forward, like for me it helps to propose questions like, "Why are these others companies spending so much on marketing, but this other company is not?" In relation to their revenue. Right? I mean cars.com that kind of

Geoff:                   Cars.com is a great example of that where we were like, "look at how much these other companies are spending on their marketing compared to their revenue and stuff," and that was a point of concern there is how much they would spend, and whether there was increased competition.

Andrew:              Cool. So if you do want to get access to all these, Geoff does send it out. Go to focusedcompounding.com and on the home page you will see a place to enter in your email and that will put you on our email list. We don't send you anything else other than a free memo, and you'll have that in your inbox every single week. It's just one page long like we talked about, and it's just always on an investing topic, and a lot of people really like it. So it's well received.

Geoff:                   Yeah, and that's free. You don't create user names, you don't do anything, you just give us your email.

Andrew:              And if you do want the premium memo, that comes if you're a premium member-

Geoff:                   Right, and that's when you create a user name and password, you get access to the whole site, the whole thing.

Andrew:              So if you do want to get access to those two reports, go to focusedcompounding.com, you can either enter in your email or if you become a member you get both.

Geoff:                   And if you become a member use the podcast promo code which I think we mention all the time on this podcast, but it's PODCAST and that'll save you $10 a month.

Andrew:              That will save you $10 per month. I want to thank everybody so much for tuning in with us. Have a great week. Make it a good one.

Geoff:                   Hey, this is Geoff Gannon and that was the Focused Compounding podcast. The podcast where Andrew and I talk general investing concepts. If you want to know more about specific stocks I like go to focusedcompounding.com where you can read stock ideas written up by me and other members. Membership costs $60 per month, but if you use the promo PODCAST it will be $50 a month for you. Andrew I also manage accounts for investors. To learn more about our managed accounts email Andrew at info@focusedcompounding.com or text or call Andrew at 469-207-5844, that's 469-207-5844. Thanks for listening.

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How to: Avoid Confirmation Bias, Do Some Serious Sleuthing about a Stock, and Dissect the Wording in a 10-K

by Geoff Gannon


Listen to the Audio: Episode #80 of the Focused Compounding Podcast

Geoff:                   Hey, this is Geoff Gannon and you're listening to the Focused Compounding Podcast. This is the podcast where Andrew and I talk general investing concepts. If you want to know more about specific stocks I like, go to Focusedcompounding.com where you can read stock ides written up by me and other members. Membership costs 60 dollars a month, but if you use the promo code 'podcast,' it will be 50 dollars a month for you. Andrew and I also manage accounts for investors. To learn more about our managed accounts, email Andrew at Info@focusedcompounding.com, or text or call Andrew at 469-207-5844. That's 469-207-5844. Now, here's Andrew with your regularly scheduled podcast.

Andrew:              We are back. How is everybody doing out there today? Hope you are doing well. My name is Andrew Kuhn, Focused Compounding Podcast. Mr. Geoff Gannon, how is it going over there?

Geoff:                   It's going great Andrew. How is it going with you?

Andrew:              It is going great. We hope it's going great for everybody else. Real quickly, I just wanted to say, "Thank you," to everybody that has been listening and helping us out by giving us a rating and review on the iTunes podcast app. That helps us out a lot and it's really helped put us on the map. I think we've talked about it many times, how the algorithm works with iTunes.

Andrew:              If you do want to help us out and you do like the work we're doing here and you want to support us, feel free to go to your iTunes podcast app and give us a rating and review. We hope that's five stars. It helps us get the word out and we spend a lot of time for these podcasts, so that would be great for us. Today, we're going to be going ... People just keep sending in a lot of questions.

Geoff:                   Right.

Andrew:              They like these question and answer, I guess, Q&A's that we've been doing. I think it's good also because we can just see what's really on people's minds. We just get to answer them live on the show. If you do want to have a question answered on the show, feel free to DM me. I usually compile them in a list and then when we have a Q&A session, I'll just pull them up.

Geoff:                   That's @focusedcompound?

Andrew:              Yeah. That's @focusedcompound. If you do want to reach out to me via email for anything, info@focusedcompounding.com and Geoff's is Gannononinvesting@gmail.com. Alrighty, first question. What steps do you take to mitigate biases like confirmation bias/overconfidence in your research process and when making investment decisions? Good question.

Geoff:                   Yeah, that is a good question. It's a tough one. I guess confirmation bias is the one we could talk about the most, which is once I've formed an opinion about some stock, presumably a biased stock I like, so something like the safety of the stock. If I think it's safe or something like that. Do I find things that reinforce that view and ignore things that don't reinforce it? That's probably one of the most difficult things. One of it is talking with other people. Often, people want to talk with you for two reasons.

Geoff:                   One, they really are interested in the stock sometimes, but two, they're really perplexed by why you would pick some stock or something. They'll talk to you a lot about the negative things that they have seen and the risks that they see. Even if they want to buy the stock, they're usually talking to you about the risks that they see. The upside is pretty obvious that way. I would say a lot of it does come from that, from people talking to me about some idea that they're aware that I'm interested or that I write about.

Geoff:                   Often, I don't necessarily own it first and I do usually look at stocks for a pretty long time before buying them. There's that kind of awareness of it. I've certainly read lots of things from different people and try to read the negative things that they have to say about it too.

Andrew:              I was going to say, wouldn’t you say, also it's like understanding why the shorts are shorting.

Geoff:                   Right.

Andrew:              Their thesis and their thought process.

Geoff:                   Absolutely, yeah. We have some things, some stocks I talked about before are, I guess, a bit more controversial that way, as seen as risky. A lot of them aren't and those can be harder, the ones where they're ... We focus on over-looked stocks in the managed accounts and some of them are literally just that. They're over-looked and most people that I talk to don't have anything negative to say about the business or that it's risky. They just might think that it's not especially cheap or that it is very small. They just haven't heard of it. It's not the most exciting thing. Those are the hardest.

Andrew:              What would you think about for KEWL or NACCO, where there's probably not a lot of people that write about it, right?

Geoff:                   Right. Right.

Andrew:              There's not a lot of people that know about the stock and there's probably not a lot of people that actually short the stock. I've never seen a short report on any of those companies.

Geoff:                   Right, that's true. Yeah. NACCO is a good one though because there are a lot of people who are short something related to coal. I did read a lot about it, just so people know. There is a company, Westmoreland Coal, which as we're recording this, I think may have, as we're recording it, just emerged from bankruptcy or at least when you're hearing this, they will have emerged from bankruptcy. They briefly were in bankruptcy. Some of their business is similar to what NACCO does. That's a good one.

Geoff:                   I did read a lot about that company's bankruptcy and why it happened and things like that. Comparing it a lot to NACCO and what could go wrong with them. Still, there is the risk of confirmation bias there because they had a lot of obligations that NACCO doesn't. It's very easy ... Doing that, it can be very easy to fool yourself then because you're like, "Well, their situation at NACCO isn't as bad as it was at Westmoreland a year or two or three ago.

Andrew:              Sure.

Geoff:                   That doesn't really prove that it's worth buying it. I think at one point, because it had this risk of bankruptcy, it probably traded at some incredibly low price and people were excited by it. I did read a lot of the ... I found going back, as many of the positive write-ups of Westmoreland as I could to see what people got wrong and stuff. Actually, I find that to be better than reading the short thesis a lot of times, is to find something that has performed badly and read the good things that people wrote about it. I actually did that with KEWL from about 10 years ago. I could find a couple things where people were very positive on it about 10 years ago. The stock didn't perform well for 10 years. It was very flat.

Andrew:              Sure.

Geoff:                   It was interesting to read and see, well what did they see 10 years ago? Are they the same things I'm seeing in it today? That sort of thing. Sometimes that's better is that when you know the outcome using the internet now, because all those things are permanent, you can look back and see what the people got wrong in terms of the long cases.

Andrew:              What about what they got right as well? Where you can go back on VIC or wherever and see past reports that they wrote about the stock.

Geoff:                   Yeah, yeah. You can see all those things and that's very good that way. The most useful information I get I would say for reading reports and things are not about stocks today, but sometimes they're even about a stock today, the information is useful, but they're writing about it from five years ago or something. A lot of times it's very helpful for learning about the management and things like that

Geoff:                   We use the internet very heavily. When we have an idea about something like a stock that ... Yeah, I did a good amount of research on timberland stuff and why people are positive on it or negative for a long period of time. For something like coal, it's true that there is not much. There were some from value investors. I found probably ... I probably read five or six pretty extensive write-ups on it in some form.

Andrew:              On KEWL?

Geoff:                   Yes.

Andrew:              Yeah.

Geoff:                   Including one thing written up by, now a member of the board. Actually, there is actually a member of the board now. He got on the board as part of the dissident slate of investors ... The hedge fund was about 25% owner or something of it. They won a vote and one of the people they got on the board happened to have written a book about value investing. There is an example he gives in the book, which does not say that it is KEWL. That it's KEWL, that stock, but you can tell from how he's describing it, that it was. You can get this old case and it's from before he was on the board and stuff, so it does give you some example. It's presented like a hypothetical case, but if you actually read it, you can tell.

Andrew:              Yeah. You can tell they're talking about a real life situation. Absolutely.

Geoff:                   A real life situation. Yeah, yeah, absolutely. There are even things like that that you can find. Yeah.

Andrew:              Interesting. Okay, cool. I think also just being aware of it is a huge step as well.

Geoff:                   Yeah.

Andrew:              Like being aware of the potential confirmation bias and how you could be subjected to it is huge as well.

Geoff:                   Yeah. A lot of times, being aware of your own past mistakes and your own biases. You personally even more so than what you read in Behavioral Finance or stuff like that. I think a lot of times, people are aware of those things. They like to read about things about thinking fast and slow or whatever, those sorts of things. The truth is, as the people who wrote those sorts of books will tell you, they know all those things. They've studied them and it hasn't really helped them to not have those biases.

Andrew:              Yeah.

Geoff:                   They still have those ways of things. Often it's useful to think about your own biases. Like, I'm very aware of the ways in which I do make certain ... I tend to make the same mistakes over and over again, but also in some things that a lot of people might make mistakes, but I tend not to.

Geoff:                   For instance, I would tend ... I'd be much less likely to pay too much for a stock than most people would, for a popular stock, but on the other hand, something I saw as a good business, safe, cheap enough, whatever, I might misjudge the durability of that business or something like that if there was a lot of debt or something like that. That's something I've been very aware of is the downside risks from leveraged things. That's because of past cases whether it's Weight Watchers or Barnes & Noble. They didn't go well.

Andrew:              I was going to say, does Weight Watchers come to mind?

Geoff:                   Yeah. Those are two that come to mind.

Andrew:              Yeah, because I know those are two that come to mind.

Geoff:                   Yeah. Those two stocks. Weight Watchers and Barnes & Nobles are good examples of the kinds of mistakes that are made in the past.

Andrew:              If you're interested in cognitive biases, read Poor Charlie’s Almanack. That will help you out.

Geoff:                   Yeah. That's good.

Andrew:              You know what's interesting? You were talking about thinking slow and fast and I'm pretty sure the author of that book, I think I read an interview once that he actually hated the book. Like, he couldn't stand it. He did not like the book. He didn't think it was good quality. He didn't think people would like it or benefit from it. It's been such a popular book.

Geoff:                   Yeah, yeah. That would make sense. Yeah.

Andrew:              It's funny. Alrighty, next question. What do you think about the recent Fed actions? Just kidding. This guy really asked that, but he was kidding.

Geoff:                   He did ask that?

Andrew:              He was kidding around because they didn't raise interest rates today. Okay, but then he goes on, "Tell us more about your sleuthing techniques."

Geoff:                   Sleuthing. Yeah.

Andrew:              "Just Google Maps?"

Geoff:                   No, there is more than Google Maps. I guess I just mentioned one. There was a hypothetical example in a book, which wasn't really hypothetical.

Andrew:              A very long time ago, we put out a checklist that was like a roadmap for how to find the steps that we go through with the investing process.

Geoff:                   A lot of people ask for those sorts of things. Yeah, I guess we could go over some of them, the most basic things. The most basic things are find the names of all the people involved. Whenever you find any sort of name of someone. There is always a proxy statement, which can be filed a couple different ways with the SEC, but it's usually filed as some sort of ... It will be listed as a 14 in some form. It will be like DEF 14 and then there will be a letter at the end of that.

Geoff:                   That will give you information on the proxy stuff. It can also appear in the 10K. It will give you information on who owns how much of the stock and they'll have things like a name and address for those people, which will be like an office address or something, but by Googling those names and things like that, anyone connected to the company, you can start to see if there are family connections, if there are business connections, and look into the history.

Geoff:                   Like, okay, if you find out that this person owns a business, which is in the same sort of ... Say an aerospace related business or something and they're a 5% owner of the stock and the stock does something related to aerospace. Okay, well is this a business relationship that they invested in years ago? Can you find out why? Usually you can if you Google around and stuff enough, there will some sort of mention of it. People's names are great. Specific locations of things are great. I've said before, I do pay attention to where a company is headquartered, where it says its offices are, a lot of things like that and the history.

Andrew:              Just to get a general idea of where they operate and stuff?

Geoff:                   Yeah, and trying to figure out more about the history because so often there will be a local paper that will cover it more or something like that.

Andrew:              That comes from just Googling around.

Geoff:                   Yeah. You can find things from many years ago about whether there was ever an attempt to merge with this company that failed or this thing happened or whatever. I can think of one case where I was able to find out information about a company's ... We knew a company owned a building, that it didn't need to use most of it, and it was in Manhattan.

Geoff:                   I was able by putting in that address and doing a lot of Googling, to find out that there was someone who had, for a long time, been interested in buying up an entire corner in the city and needed three different buildings to do it or something. This building was a lot shorter than the others. They needed to do it for whatever building plans they had in mind. Now, I didn't know if that would eventually go through or not, but it was a multi-hundred million dollar idea that this person had to redevelop this whole thing. You could just find that originally by starting by looking for the address and stuff like that.

Andrew:              Sure, yeah.

Geoff:                   You always look at what the properties are and things like that as a value investor. It's probably easier with those things. As we've said, we go to county records for land and appraisal of them and things like that. We can always find tax appraisals of things.

Andrew:              You were talking about the proxy, the people involved. That's what Buffett did back in his early days. He wanted to see, think, like how did people think and what sort of ticked them or what got them going or whatever? Was it money? Was it whatever?

Geoff:                   Yeah. A lot of times, it will have mention of each of the customers and things. For instance, NACCO. NACCO has very few customers. I have a list of all their customers and have looked up all the information on all their customers, so I know who they sell to. That's easy because they have specific mines associated with specific customers, but there are some other companies that have relatively few customers and will just say it.

Geoff:                   A lot of times, with very small companies, for whatever reason, I don't know if they don't have the lawyers that are careful about, like you don't really have to put this in here, but they will just sometimes be just more open about the list. Like, five of their biggest customers or something. Sometimes when you have a very big company, I've noticed I know who the customers they're describing are. They'll say some big customer that uses our jets or their wide body aircraft or something.

Geoff:                   We know who they mean, but they won't even say what the company's name is. Things like that. For some small companies, they'll come right out and say it and list five or 10 companies. I've seen many 10K's where they say, "We compete with companies such as ... " and list five of them. It could be almost all their competitors, where it gives you a really good idea of looking those up.

Andrew:              I remember when we were doing research on Hostess brands. I think we were trying to figure out which product of theirs sold the most or something like that.

Geoff:                   Okay, yeah.

Andrew:              I can't remember. I don't think it actually broke it down, but when they were talking about what they do sell, like their brands or whatever, you could tell it was going from biggest to smallest in that little table.

Geoff:                   Right. Yeah.

Andrew:              They weren't actually coming out and saying it or using percentages or anything like that.

Geoff:                   That's a great example. You can often find things that way with the order in which they say things.

Andrew:              Yeah.

Geoff:                   You realize it's the same. Sometimes people do ... I don't want to over-say how important it is because some people get almost paranoid about seeing things about what happens here, but you can compare by looking for the exact same lines in different filings each year, whether they've changed things. I've mentioned that before. I know that I had mentioned before and people asked about it, a while ago, I had said that I thought NACCO would have better royalty stuff than in the past because they had for a long time said, "We expect royalties to decline," and didn't give any reason why they thought it was. When asked about it, they said, "Well, we just don't know what it will be, so whenever it's high, we say we expect them to decline or whatever."

Andrew:              Yes.

Geoff:                   Finally then, they eventually this past year, gave guidance where they said, "We expect it to substantially increase." That wasn't so much of a surprise to me because they had changed the language that they had been using a quarter or two before then. It's a sign when they finally took out something that they had had in for a really long time that way. I've talked about that before with things that, you get used to certain, very standard ways of companies talking about things. Like, our industry is highly competitive. It's something that almost all 10K's put into them.

Andrew:              Yeah, sure.

Geoff:                   When a company doesn't say that, it's a big clue. I was looking at one company recently and when they described what its products were and stuff, I wasn't really that into it, but I realized in something it said, I was like, "It's saying something that makes me think this is very not competitive." Then I was able to find something else where they said, "We're only aware of one other company that this technology has been licensed to."

Andrew:              Yeah.

Geoff:                   From that, I was able to figure out that only two companies make this stuff. The tip off to that was the way in which they very much were not using the regular language for saying how competitive the industry was.

Andrew:              Yeah, sure.

Geoff:                   They were saying what the risks were in the industry. What they weren't saying is competition basically.

Andrew:              Yeah. That obviously stood out to you.

Geoff:                   Then you go hunt down thinking, "Oh." You write down, maybe competition is really low in this industry and then you look it up. It's just like, I say that to people all the time that it's like, you have to write down a guess based on okay, well this might be the situation here. Like, there is something unusual here. You take it as a lead.

Geoff:                   When you see, oh, this is ... Normally, when you see something about land or something, it's very easy to see, oh okay, well this was land that they bought in the last 10 years in Iowa or some place. It's probably not that different from what it is today. If they say something like, "This land was acquired 100 years ago," or something in the information, then that becomes a thing that you become obsessed with figuring that out because that's such an unusual item in there.

Andrew:              Sure.

Geoff:                   That's how you do the sleuthing. Yeah.

Andrew:              That's interesting. That was a great answer. What changes have you made recently to your investing style?

Geoff:                   Hmm.

Andrew:              You start reading 10K's on the computer instead of printing it out?

Geoff:                   No. I still read 10K's through print outs. I don't know if I've made that many that recently. I could say over time, there have been some changes I guess. Well, actually that's not true. Somewhat recently, there have been some changes and I guess I became more interested in some things that were cheap on an asset basis.

Geoff:                   Last year for instance, in the managed accounts, we had over a third or something of them, of the portfolio, in things that were in some way related to land values of some kind. I'd say that was very unusual for me. That's not something I'm usually interested in. I wouldn't say that's a change in my investment philosophy or something as much as just a reaction to prices for things in that stock prices perhaps are rising a lot faster than land prices.

Geoff:                   You know what I mean? It was becoming harder and harder to buy earnings at a cheap enough price and so it became attractive to buy assets. I've done that before where I bought things in Japan or something. Part of that wasn't just that I was excited about something in Japan, but also that it was getting difficult to find things in the US.

Andrew:              Have you always thought about ... Because when you're managing other people's money, it may be different than managing your own. Maybe, maybe not. Have you always thought about stock working geometrically over time? Where you know over time, the business is going to do okay? Did you always think about it in those terms?

Geoff:                   Yeah. That's true. That's always been the same. Where I was always thinking about it long-term that way. Certainly the things that we own now are less leveraged than some things that I owned a few years ago.

Andrew:              Purposely?

Geoff:                   Yeah, purposely. Again, maybe that's an earnings thing though, a price thing, whereas we're able to buy some things. We'll find some things that have the sort of same P ratio that a lot of stocks have, but maybe the ones that have no debt or a little more cash. Maybe I feel like the market might be undervaluing safety right now I guess. That's part of it is, I don't know if it's like that my philosophy has changed necessarily in the last few years, but it's always changing in response to what you're getting thrown.

Andrew:              Like the market changing.

Geoff:                   Changes in the market.

Andrew:              Which just comes on your radar because it's cheap.

Geoff:                   Yeah. Right. Because like ...

Geoff:                   Yeah. I have not owned tech things and stuff, but actually in the very early 2000's, I did own some tech things. That was because you had the bubble that burst in 2007, so you had some become actual value investments in terms of assets and things in the early 2000's. That can happen where it's a response to what the market is giving you that way. I think that things that are like very consistent, earning high quality businesses, I like them as much now as I did years ago.

Andrew:              Sure.

Geoff:                   But the market prices are that much higher now I feel than it used to. People talk about Buffett's approach to things and what he has owned and stuff. Part of the reason why he bought Coke now almost 30 years ago, is just that that kind of business was cheaper. Things like Coke and Gillette weren't valued as high as maybe they should have been and now they're valued at least as high.

Andrew:              Sure.

Geoff:                   He said that he overpaid for Kraft and I think that's true. A lot of those food companies were over-valued. Yeah. I have changed a little bit in terms of certain things of avoiding some kinds of risks I would say, but other than that, I think that although I have changed in the last few years, it's mostly in response to what things are expensive in the market, which I would say is ...

Andrew:              Just being thrown at you really.

Geoff:                   ... Earnings growth.

Andrew:              Yeah.

Geoff:                   Yeah. Companies that paid, if they didn't have good earnings growth each year, those have become so expensive, so I probably bought less of them and more of other things lately.

Andrew:              Cool. How would you think about the value of Lyft, Airbnb, and other similar companies? I'm guessing this is because Lyft just came out saying that they lost 900 million dollars last year or something like that. Maybe that's just top of mind.

Geoff:                   That's a very hard question to answer and you might be able to answer it better. I don't know. I have a somewhat different opinion on ...

Andrew:              I think Airbnb is probably a better company than both Uber and Lyft.

Geoff:                   Yeah, yeah.

Andrew:              Why? It's because A, you think about Google and all these other people who are like in the self-driving car, I guess, if race you could say, right? Airbnb, they just set up the platforms, less capital intensive, and more scalable I would say for sure.

Geoff:                   Yeah.

Andrew:              It will be interesting to see what happens because Lyft is going to go public and Uber brought in that new CEO from, is it Expedia or something? Now I can't remember where. Do you remember where?

Geoff:                   No.

Andrew:              I can't remember where. I want to say it's Expedia, but maybe I'm wrong.

Geoff:                   Okay.

Andrew:              Part of his goal was to actually bring the company public as well. That's obviously going to happen. Yeah. I would say Airbnb is probably a safer, better company than both of those companies.

Geoff:                   Yeah. That would probably be true in terms of the industry.

Andrew:              Probably profitable. I've actually listened to interviews where Brian Chesky, I think that's his last name, he's talked about Airbnb and how they're a profitable company. I think it's a good business. Yeah.

Geoff:                   Yeah. It's not an industry I know a lot about or something. I have done some research and an analysis of Booking Holdings and stuff like that, which are related to those sorts of things. In terms of, for example, I guess things like Lyft and Uber, those are somewhat unproven in terms of the industry. It's an industry that I wonder how much of the returns will go to them.

Geoff:                   When you talk about Airbnb, it's just in terms of the way that that kind ... The product economics work. You would expect them to capture a huge amount of the value. One thing I wonder is if the system that Lyft and Uber have really means that they will get a lot of the value and not that it will go ... I think primarily honestly, it goes to the consumer and secondarily, I think it goes to the drivers. I've actually talked a bit with someone who drove and made a fair income from it.

Andrew:              How much?

Geoff:                   How much?

Andrew:              Yeah. I don't even know what the average Uber driver makes or Lyft driver. I'm sure they'll have to talk about it. I have no idea.

Geoff:                   Yeah. Well, a big part of it was getting the car from Lyft. It was the ability to have the car.

Andrew:              Yeah.

Geoff:                   Yeah. When they changed some rules on that and stuff, he stopped driving for them. It is one that ... I don't know. I think I know enough about the industry that Airbnb is in that I would be more comfortable saying that the winner in that industry will have a lot more go to that platform. I really don't know in the case of Uber and Lyft, if so much of the returns will go to them, will go to other people. In some ways, that's probably more disruptive to society and stuff. Maybe it's good for society. Maybe it's good that way. It changes the world and everything, but I don't know that makes them incredibly rich.

Andrew:              Interesting.

Geoff:                   Yeah.

Andrew:              Interesting. Well, that was 25 minutes. Let's see if we can get one more question in here.

Geoff:                   Okay.

Andrew:              Here we go. What are some outstanding positive and negative examples of public firms that are focusing or neglecting to focus on creating long-term shareholder value by refraining from often value destroying behavior, like risky acquisitions, short-term earnings targets, et cetera.

Geoff:                   For really big companies, I guess we could say probably I would say Amazon, Apple. I would also say Costco. Each of those I can think of as doing things that, well, one, refraining from a lot of acquisitions that they could have done. Amazon has done some pretty big acquisitions.

Andrew:              You don't ever hear about Costco doing anything like that.

Geoff:                   No.

Andrew:              Yeah. They just stick to their business and go.

Geoff:                   When Costco opens new warehouses, it would take quite a long time for it to be earning as much in terms of their as already opened warehouses. In terms of return on equity and stuff, it depresses it as they make those investments. I would say that those are just three that come off the top of my head. Certainly, Apple has refrained from making acquisitions in a very big way.

Andrew:              Yeah.

Geoff:                   Compared to what other companies in their ... Certainly, they've been encouraged to do that I would say at lots of different times.

Andrew:              A lot of people want them to buy Tesla.

Geoff:                   Yeah. There you go. Tesla is something I can't evaluate in terms of ...

Andrew:              Yeah. I was going to say, what about ...

Geoff:                   They invest a lot. Yeah, they certainly invest a lot.

Andrew:              What about those antics. Yeah. We need to have Peter Rabover to come back on and talk about Tesla.

Geoff:                   Yeah. In terms of things that are value destroying things, I do think there is too much focus on short-term earnings guidance and things like that. I don't even really like the idea of guiding for a year ahead for a lot of things. For some things, it's okay. Like, we talked about NACCO. NACCO is not in a competitive business.

Geoff:                   Their customers are giving them a lot of ideas about what the plant will produce and stuff. It's okay if they do that. It never bothered me. BWX Technologies talks about what carriers and subs and stuff they expect to work on and produce for them. For an engineering company, it doesn't bother me in the same way. For the ones that are telling you, "We expect to win this much new business," that's what I worry about. We expect to sell this much new stuff to new customers. It's the sales part of it that bothers me.

Andrew:              Sure. Facts.

Geoff:                   Not, "Here is our backlog we expect to deliver." Yeah.

Andrew:              It's funny. Remember, wasn't it last year that Warren and Jamie Dimon went on TV trying to campaign against it?

Geoff:                   Yeah.

Andrew:              I remember Jamie Dimon was like, "Yeah. If you're trying to beat next quarter's estimates, just turn the jet off for a day," or something like that.

Geoff:                   Right, yeah, yeah.

Andrew:              Because then you'd be getting on that game.

Geoff:                   Yeah, yeah. Especially getting an earnings line that way. Where the company says, "Oh. We just missed a little on revenue, but we made on earnings or whatever." That is what he's talking about. That is the kind of thing you could do. Yeah.

Andrew:              Just financial engineer it a little bit.

Geoff:                   Yeah. There are some particular ones where they want to hit a certain percentage of it in terms of ... Often it's digital or something is the big thing now. It's something like that. That kind of stuff just does worry me. When it's almost like we want to move people to something that sounds more high tech or of a more new thing. You always get that. Sometimes it's good, but I did write up of Resideo Technologies and I think it's good over time if they move to doing more stuff on a subscription basis and more connected things. They can do that.

Geoff:                   I don't really like when I feel like sometimes a company like that is trying to present to investors, "Oh. We're not an old technology company. We're not this old thing that is just your thermostats and your things that all of this is ... None of this is connecting stuff. We're an internet of things or whatever. When they say, "We want to hit a certain number next quarter, next year, a certain percentage of our stuff will be this connected stuff or whatever," do the customers really want the connected stuff right now? I don't know. Do the contractors want to sell, put that into places? I don't know.

Andrew:              Yeah, yeah. That's pretty interesting. Why do you think they do that? Because they want the market to think differently about them?

Geoff:                   Yeah.

Andrew:              Is it like the Enron thing, how they never want to be known as a trading company because the multiples are different?

Geoff:                   Yeah. No, I do. I think that some of them do presentations to investors and things and realize that investors are like, that's old-school of whatever things that you're doing. Sometimes it makes sense and sometimes it doesn't because there is ... Because think about Disney or whatever. Years and years ago, I'm sure people were saying to them, "Oh. You have to get into all this new media thing or whatever."

Geoff:                   Then they come out. They have Marvel. Then they put out Marvel movies. They're like, "Oh no, that's okay." Now that those make a billion dollars, you can do this stuff that is basically the same stuff you were doing. The same sort of blockbuster movies you were doing 20 years ago or whatever. It works out fine. A lot of times, it's best not to just listen to the analysts that way. To listen to the market because the market is often focused on comparing you to what's the new hot area in these few years.

Andrew:              Sure. Interesting. Cool. Well, I think that's a good place to stop this week. I want to thank everybody for sending in questions. Of course, again like I did say, if you want to have a question answered of us, please just go ahead and email either Geoff at Gannononinvesting@gmail.com. You can email me at info@Focusedcompounding.com or just send me a DM or Tweet at me @focusedcompound on Twitter.

Andrew:              We compile all of them together and then we'll definitely chat about them on the show. If you do want to get access to Geoff's weekly memo that he sends out for free, there is a premium one for members and then there is a free one as well. Go to Focusedcompounding.com, enter in your email, and then you'll receive that in your inbox every single week.

Geoff:                   Yep.

Andrew:              Anything else to add?

Geoff:                   You could rate and review the show on the podcast app.

Andrew:              If you want to make Geoff happy, rate and review the show.

Geoff:                   Okay.

Andrew:              Give a comment. We're just trying to make Geoff happy.

Geoff:                   All right.

Andrew:              Thanks so much everybody for tuning in. We'll see you in the next one.

Geoff:                   Hey, this is Geoff Gannon and that was the Focused Compounding Podcast. The podcast where Andrew and I talk general investing concepts. If you want to know more about specific stocks I like, go to Focusedcompounding.com where you can read stock ideas written by me and other members. Membership costs 60 dollars a month, but if you use the promo code 'podcast,' it will be 50 dollars a month for you. Andrew and I also manage account for investors. To learn more about our managed accounts, email Andrew at info@focusedcompounding.com or text or call Andrew at 469-207-5844. That's 469-207-5844. Thanks for listening.

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A Value Investor’s Total Return Always = “Trade” Return + “Hold” Return

by Geoff Gannon


Someone emailed me about NACCO (NC). This is a stock held in accounts I manage. The email came up with an expected return calculation that didn’t include any change in the stock’s P/E multiple. NACCO trades at a P/E less than 8. So, I responded to the email by talking about how big a difference your total return expectation – as a value investor – can be in a stock depending on whether you assume a low P/E multiple will eventually expand into a normal P/E multiple, or whether you just assume your return in a stock will be what you get  from holding it forever.

 

As a value investor buying a stock – it is easiest to think in two terms: 1) The stock's "hold" return and 2) The stock's "trade" return. The reality is that while the general public investing in an index fund and holding it just gets the "hold" return less fees paid on those index funds, to advisors, etc. A stock picking value investor gets a different return. It might be better. It might be worse. But, a significant portion of a value investor's lifetime investment returns tends to come from the "trade" aspect of stocks rather than the hold aspect.

 

Let me give you an example. Say NACCO earns $5 a share today and grows earnings by 3% a year for the next 5 years. At the end of 5 years, you sell the stock. Well, the stock's earnings will be $5.80 a share in 2024. But, the question here is what will you sell the stock for in 2024.

 

Let's say future prospects for the stock look particularly gloomy in 2024, and investors value it at just 5 times earnings. That would be $5.80 * 5 = $29/share. You would lose money on the 5-year trade since the stock is now at $38 (when we're saying you hypothetically buy it). I put aside the issue of stock buybacks, dividends, etc. In reality, it's possible you could recoup as much as like $25 over those 5 years through some combination of those things. So, yes, it's still possible you might come out ahead in my scenario. But, I'm separating out "stock buybacks, dividends, growth, acquisitions, etc." and labeling that your "hold return". So, in this scenario - you might make $25 by holding the stock, but you'd lose $9 by "trading" it. This would net out to a return of like $16 made over 5-years on a $38 investment. You might make a little more than 7% a year under this scenario, despite the fact that you should be making about 13% a year ($5/$38 = 13%) each year just from holding the stock. Now, yes, this can be avoided if you hold the stock FOREVER. If customers do not go out of business, close coal mines, etc. - then, you could keep holding the stock in year 6 and beyond. The longer you hold a stock, the more important the "hold" return (which generally can be estimated as FCF Yield plus FCF growth) matters. When Warren Buffett holds stocks like Coke, American Express, etc. for 30 years - it becomes relatively unimportant what the initial price he paid was or what price the stock now trades at. What matters most is how much FCF it produces in those 30 years and how much that FCF is growing over time. But, this is unusual. While many founders, owners of private businesses, and even a few Warren Buffett type investors do hold a couple businesses for 30 years and get rich or poor without much regard to the price at which the business can be sold to others - you probably won't.

 

Odds are that if you do buy NACCO today, you will find a better stock to buy in the future. Many people consider me a longer-term oriented value investor. And yet, I have to say that stocks I've owned without the intention of selling quickly still end up existing my portfolio within about 3-7 years. This is probably similar to something like an LBO. Although they may do work looking at what they can extract from the business - they know that they are likely to sell out to another buyer or take the company public again within about 3-7 years.

 

This is potentially the way in which having a publicly quoted price for a stock you own is an advantage. If you bought NC and held it forever, you might make 13% a year if everything went right. But, you'd be taking the risks of things going wrong. And so, you have like a 13% return and whatever risk is associated with that return as your investment. If NC was a private business you were investing in that you knew the family would never sell - you could analyze the deal completely on those terms. Basically, what is FCF yield? And how much - in nominal terms - do I expect that FCF to grow each year? Then, imagine I hold forever. That's the "hold return calculation".

 

The combination of a sufficiently high hold return and a high willingness on your part to hold a stock forever if you never get offered a good price to sell at is the best defense in investing. This is what makes your investment safe. Investments are not safe whenever you - as the investor - are unwilling to hold the stock for a long time. That's because even a good, safe business could drop 50% in quoted price (though not in intrinsic value) next year. In fact, even the safest and best business will probably do that once every 20 years or so. If you are purely a "trader" and not a "holder" through insufficient offers for the stock you own - then, you'd risk selling when price is well below intrinsic value. So, being willing to hold a stock long-term - and never selling into bad offers for your business - are the key to not getting as bad returns in the stock market as many individual investors get. In theory, these investors should make the 8% or 9% or 10% that the market does while they are in it less whatever fees they are paying. For example, over the last 15 years, they should have compounded their money at 8%+. In reality, many do not because they sell at bad times. So, holding a good business and ignoring low offers for your stock is key in protecting you from underperformance.

 

But, many stock picking value investors want to outperform the market - not just match it. How do you do that? Warren Buffett has had periods where he can do it simply by finding businesses that have a higher hold return than the stock market. This can work. If you bought Microsoft or Wal-Mart or Southwest Airlines or something at the right time and held for 30 years - you would have more money at the end of your investment in those stocks than you would have had you put that money in an index. This is the Phil Fisher approach.

 

It's not the Ben Graham approach. The Ben Graham approach is to buy a stock selling at a discount to what it is worth and then - within a few years - sell that stock for closer to what it is worth. Graham often bought "net-nets" at 2/3rds of their net current asset value. If the stock simply did not burn up any cash, receivables, etc. in its operations - it basically operated at breakeven on a cash basis - and the stock eventually traded at 1 times NCAV, then Graham could make about 15% a year over a 3-year holding period. His "hold" return would be zero percent a year (the stock would pay no dividends, make no buybacks, and it wouldn't grow). But, he would buy at 65 cents on the dollar today and sell at a full dollar on the dollar in 3 years. The compounding of 65 cents into 1 dollar over a 3-year period is a 15% return. That's a pure "trade" return. Graham didn't intend to hold the business forever. He didn't pick the business because he liked the business. He simply bought the business today at what he though was an irrationally low price to be able to sell it at a more reasonable price. The quicker that reasonable price came, the higher the annualized return would be. This is because the value gap Graham was exploiting can only close once. The stock isn't returning anything to people who just hold the stock. But, the market is going from valuing net assets at 2/3rd to valuing them 1 for 1. That 35 cent value gap is the same whether it happens in one year (a 50%+ return for Graham), 3 years (a 15% return for Graham), 5 years (a 9% return for Graham), 10 years (a 4% return for Graham) or 15 years (a 3% return for Graham). Obviously, there are risks NCAV could shrink. But, there is also the possibility it could grow, the company could generate some "hold" return on top of the trade return, etc. And, assuming the stock took 3-15 years to reach the price/asset value Graham assumed was acceptable, then his "trading" the stock would add anywhere from 3% to 15% a year to whatever return he got in the stock. In practice, this makes a huge difference. Many investors buying businesses they knew were better than what Graham bought wouldn't outperform Graham - because, the businesses they were buying weren't better ENOUGH than the bad businesses Graham owned. A good business would need to outperform a bad business by 3% to 15% a year just to outperform a value portfolio bought at 2/3 of "intrinsic value" and held for 3-15 years. That's really tough for good businesses to do. It's really hard to get a hold return in a stock that is so high it can make up for that kind of annual trade return boost. Consider that most stocks historically don't have better than about an 8% hold return (if you held the market forever, you'd rarely compound at much better than 8% a year). If Graham could get 3% to 15% more per year by trading stocks (basically, "buying low and selling high") and these stocks had any sort of hold return on top of that - even a bad one - he could easily match or beat those people who were just holding stocks. In reality, even mediocre businesses often generate some hold return. It's not unusual for a stock people tell you is a terrible business to actually grow 2% a year and pay a 2% dividend over the last 15 years. Well, that's a 4% hold return. If you can just eke out a 5% or better annual "trade" return in such a terrible business - you can actually beat people who just hold the S&P 500. As an illustration: imagine you buy a business at 2/3 of book value and it grows book value by 2% a year while paying you a 2% dividend yield. You hold it for 10 years. At the end of those 10 years you sell it for 100% of book value (instead of the 2/3rds at which you bought it). What's your annual return? It would likely be 2% (BV growth) + 2% dividend yield + 4.4% "trade return" (the multiple going from 0.65x BV to 1x BV) equals 8.4% annual return. Even that subpar business could match the market over a 10-year holding period simply because you bought it at 2/3rds of some price/value ratio and it eventually trade at 100% of that price/value ratio. Basically, by buying a worse businesses at a lower price than others pay for good businesses you could offset the lack of quality in the business even over a long holding period like 10 years. If you got lucky and the market revalued the stock in 5 or 3 or 2 years instead of 10 years - you'd outperform the market by quite a bit in this bad business.

 

So, the reality for a value investor is that quite a lot of your return comes from the "trade" aspect of holding a stock instead of just the "hold" aspect. Let's take another look at NACCO and this time assume the reverse happens. In 5 years, investor sentiment shifts on this stock such that it's seen as a "normal" stock in terms of safety, quality, future prospects, etc. Is that impossible? This is, after all, a coal stock. I don't think it's impossible for investor sentiment to shift like that. Coal stocks will always be something avoided due to the risk that coal power plants shut down and we get less and less power from coal. However, NACCO's economics are frankly much better than normal businesses. The company earns higher returns on tangible equity than other businesses do. As you pointed out, "recurring" revenue of some kind makes up the majority of sales. These are under long-term contracts. The contracts are cost-plus and not tied to commodity prices, competitive factors, etc. So, that means "recurring revenues" become "recurring profits". These profits are earned entirely in cash. And the formula used to calculate costs rises with inflation. So, these are inflation protected, recurring profits. They are "real, recurring cash profits". Although coal may be a risky source for profits in the future - a dollar of real, recurring cash profits should be valued a lot higher than a dollar of profits earned this year under normal competitive pressures from a mix of new and old customers. So, it's not impossible that sometime in the next 5 years NACCO's stock price will spike in such a way that the stock can be sold at 15 times earnings. That's basically in line where with a normal stock has sold at times in the past. Assume again the stock grows earnings by 3% a year for the next 5 years. You get $5.80 a share in 2024 earnings. But, the market now prices that at 15 times earnings. That's $5.80 * 15 = $87 a share. Again, hypothetically, you buy the stock at $38 today. You sell at $87 in 2024. How much do you make?

 

Your "trade" return is 18% a year.

 

Your actual return in the stock would be some combination of the trade return and the hold return. Here, over a 5-year holding period, the combination of the two returns taken together something in the 15% - 30% a year range. But, it's risky. Both the trade return and hold return are tied to the same thing - the durability of the free cash flow. This is tied to how long customer power plants will keep operating. If they all continue to operate at the same levels for 5 or more years, it's possible you might see returns like that in the stock. After a long time of a stock producing good earnings, doing buybacks, etc. - it's common for investor sentiment to shift in a way that rewards each dollar of profits with a higher multiple.

 

So, you can analyze the stock as if today's multiple of 7.5 or whatever expands to 15 at some point.

 

Or, you can analyze the stock as if you just buy it today at 7.5x FCF or whatever and hold it forever.

 

Or...

 

You can analyze it on some combination of the two.

 

In reality, I've found the return you get is some combination of the two. But, remember - a specific stock comes with specific risks. If the stock you are analyzing fails to meet your growth expectations, FCF actually declines while you own it, etc. you get a double downward adjustment to your total return expectations. Your "hold" return drops because the company buys back less stock, pays less dividends, etc. And you get a lower multiple on the ending earnings of your stock - in 5 years, or whenever you might sell it - because investor sentiment has now turned even more negative.

 

But, what I've laid out above is the correct way to estimate your returns in a value investment. Over time, I've made a lot more money from multiple expansion than I would have initially expected. So, my own investment returns would be underestimated if I assumed that the stocks I owned generated just a "hold" return and wouldn't be sold at a higher price. If I don't make a mistake in judging the business - I tend to be able to sell the stock at a higher multiple sometime down the road. And this multiple expansion tends to provide much of my returns in a stock.

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NACCO (NC): How to Find Peers for Companies That Have Different Business Models from Other Stocks in the Same Industry

by Geoff Gannon


Those who read this blog regularly know that accounts I manage own shares of NACCO (NC). For details on why I like the stock and why I think it’s not the right stock for most investors to hold – listen to:

Focused Compounding Podcast Episode #21 NACCO Industries (NC)

The company put out its annual letter to shareholders this past week.

This blog post is not going to be about NACCO specifically, but about a more general situation. Most coal miners have a different business model than NACCO. The CEO does a good job of explaining the company’s “management fee” (as he calls it) type business in that letter to shareholders.

This presents a problem for investors trying to analyze the stock. On the one hand, it is a coal miner. Its future is tied to the power plants it serves continuing to burn coal as fuel. Therefore, it is perfectly correct to think of the risk at NACCO as being the risk of a long-term decline in the use of coal for power generation in the U.S. This is the same risk other coal mining stocks face.

However, the company’s business model is different from other coal miners. The economics of what it does – in all but one case – are very different from owning a coal mine outright.

So, how – in a case like NACCO – can you come up with a “peer group” to compare the stock to?

That’s the question a podcast listener emailed me recently:

“…a question about finding company peers: I googled this and see that a lot of the other top coal companies in the US industry have gone bankrupt in the last few years - I guess because they are exposed to the coal price, (unlike NACCO which makes a cost-plus profit per ton for unconsolidated mines, as you pointed out) and were over-leveraged. I found these looking further afield:

 - Stanmore Coal Ltd (Australia)

 - New Hope Corp Ltd (Australia)

 - Alliance Resource Partners Ltd (US)

 - Whitehaven Coal Ltd (Australia)

Would you consider these companies to be a reasonable basis for comparison? I thought that since the other US ones went bankrupt, e.g. Peabody, etc., I would not be able to calculate long term returns for them, and their post-bankruptcy period was too brief to give meaningful figures, since you mention a minimum three year average for financial figures.”

You're absolutely right that several U.S. coal companies have gone bankrupt recently. This has even happened to a "mine-mouth" coal company like Westmoreland Coal:

http://westmoreland.com/restructuring/

You can see how they presented their mine mouth operations as a plus to investors in their most recent investor presentation:

https://westmoreland.com/wp-content/uploads/2017/06/Westmoreland-Coal-Company-Investor-Presentation-June-2017-FINAL.pdf

Here is a discussion of Westmoreland's bankruptcy from an environmental group:

https://www.sierraclub.org/articles/2018/12/westmoreland-bankruptcy-spells-trouble-for-coal-industry

You can read Westmoreland's last 10-K.

But, this description shows the similarities with NACCO's business:

https://www.sec.gov/Archives/edgar/data/106455/000010645518000028/wlb201710-k.htm

"Each of our mining segments focuses on coal markets where we take advantage of customer proximity and strategically located rail transportation. We sell substantially all of the coal that we produce to power generation facilities. The close proximity of our mines and coal reserves to our customers reduces transportation costs and, we believe, provides us with a significant competitive advantage with respect to retention of those customers. Most of our mines are in very close proximity to the customer’s property, with economical delivery methods that include, in several cases, conveyor belt delivery systems linked to the customer’s facilities. We typically enter into long-term, cost-protected supply contracts with our customers that range from one year up to fifteen years. Our current coal sales contracts have a weighted average remaining term of approximately six years."

I underlined the points that are the same as at NACCO. There are differences. NACCO’s customers – not NACCO – put up all the financing for mines (this is why NACCO can’t consolidate the mines for accounting despite having a 100% interest in the earnings of the mines). Another difference would be the length of the contracts. Westmoreland’s longest contract is probably about as long as NACCO’s shortest contract.

As far as the long-term returns in coal, I don't have recent data - but, I have enough very long-term data to know stock returns in coal miners are abysmal. I have seen data for the return in coal stocks generally since about 1900 - and believe they are among the very worst of all industries. I think I may have mentioned in one podcast that over the last century or so, tobacco would have been among the best industry for stock returns and coal would have been among the worst.

I would consider those bankrupt - or recently re-emerged from bankruptcy coal companies to be comparable peers for NACCO. That is, I would definitely use them in a report. Not because it is necessarily accurate to say they are exactly like NACCO - but, because it's my practice to find the 5 closest peers I can find even when there really are no peers. For example, what is Amazon's peer? What is Costco's peer? We know that there is no company with the EXACT same model. But, we can come up with the 5 public companies that are MOST comparable - even when none are comparable. We then take the minimum, maximum, median, mean, etc. figures and compare the 5 stocks AS A GROUP to the one we are analyzing.

So, it's still useful to know whether the market is pricing NACCO above or below - in terms of EV/EBITDA, P/B, etc. - any coal companies that have recently emerged from bankruptcy.

In some cases, where there are no publicly traded companies it may still be possible to find private transactions or outright mergers etc. from previous years. In the case of coal, I think it's very difficult to find peers right now. So, maybe this isn't the best example for how to go about researching a stock normally. But, you're going to find situations like this. There will be times when there just aren't a lot peers. But, I would always say that you should list 5 companies that are the closest you can find.

Maybe you can use met coal companies as well as steam coal (like NACCO), maybe you can use coal companies from other countries (like Australia or the U.K.), maybe you can use a company like Hargreaves Services (in the U.K.) because it is coal related even though it doesn't do the same thing. Maybe you can use customers of coal companies (power companies that burn a lot of coal at the plants they own). Or companies that supply the coal mining industry (mining equipment, etc.). None of these are perfect comparables at all. But, they might show you a pattern. Maybe NACCO is a lot more expensive that most other coal related stocks, maybe it is cheaper, or maybe all coal related stocks are cheap. Sometimes you find a pattern - for example, where car dealers in the U.K. are all stocks that trade a lot cheaper than car dealers in the U.S. Why is this? It's something to think about and discuss in any report on car dealer stocks.

Finding comparables can also help you in one other way. You may uncover a business you like better than NACCO, think is safer than NACCO, or is cheaper than NACCO just because you spent the time to turn over 5 more rocks to see what is under them. A lot of people latch on to the first idea they hear about. You may have heard of NACCO because I bought it. That's fine. But, you don't want to have blinders on and not take the time to look for some idea I haven't discussed. So, I'm always in favor of finding the 5 closest "peers" even when, truthfully, you believe there really are no peers. It's still a useful exercise.

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How Long-Term Growth Expectations Determine the P/E Ratio You’ll Be Able to Sell a Stock At

by Geoff Gannon


Someone emailed me this question:

“When you combine a 3 or 5 year time frame with FCF yield analysis, does it actually make sense to include a growth factor that only reflects reality for that time period? Or does doing so inflate the multiple the company deserves to trade at, given that the sustainable growth profile is likely lower than the short term profile?”

Growth is a factor in the multiple the company eventually trades at. A not especially good business, that doesn't grow in real terms, etc. would have an end-point P/E assumption in more like the 10-15 P/E range.

A good business, that does grow a little in real terms would have more like an end-point P/E assumption in the 15-25 P/E range.

You would also incorporate growth into the analysis during the period you are analysis. So, you'd project forward EPS growth for the years during which you are analyzing (like 3, 5, etc.).

Yes, it does matter.

For example, NACCO has inflation adjusted price agreements. So, if inflation is 3% a year, you'd need to add an additional 3% a year to the figures you are looking at both in terms of the dividends, buybacks, etc. they might do and the final EPS level (at the end of 5 years or whatever).

So, imagine NC's FCF was $5 a share.

Over a 5 year time period, you'd assume $5 * 1.03^5 = $5.80/FCF in 2024. It does matter. Because, say you were using even just a 10x P/E at the end of that period. Well, an additional 80 cents of earnings adds and additional $8 to the end stock price you expect to sell at after 5 years.

To put it another way, even the difference between a company that does increase EPS with inflation and that doesn't increase EPS with inflation is something like an annual return difference of 3% (or 2%, or whatever inflation might be). This makes a big difference in whether you outperform or not over time.

So, it does matter. And over longer time periods, it matters more. By the time you're looking at like 15-year holding periods, it makes a huge difference whether you are assuming a company will manage to increase prices at least as fast or inflation - or won't.

The sustainable growth rate is really what you use to determine the expected P/E you sell at in the final year of your analysis.

It's worth mentioning something though. It's often as important - sometimes more important - what the return on capital of the business is than the growth rate.

One way to think of ROC is that it's the price of growth. So, a company that increases its growth rate at higher levels of return on capital matters a lot more than a company that grows with a low return on capital.

To put it simply: Growth - no matter how fast - really doesn't add value if the ROE is low. And a high ROE - no matter how high - really doesn't add value if the company has literally no growth.

It's only the combination of a high ROE (that is, low retained earnings each year) with growth that matters.

Take something like Kraft (which Buffett says he overpaid for). The ROE there is very high. If it grew in line with overall GDP - it might be worth a P/E of 25x at the end of your analysis period. So, you could say it's worth 25x P/E when you sell it if you expect it to always grow at least as fast as nominal GDP (which might be 4%, 5%, 6%, etc.). But, if you really think it'll grow at 0% - then, that makes a huge difference in the ending P/E ratio. If the growth rate was LITERALLY going to be 0% NOMINAL forever - the P/E ratio would need to be like 10x.

The reason for this is obviously that the FCF of the company plus the growth rate has to be in line with returns on the S&P 500. If, historically, stocks returned 10% a year - then, a business that will literally never grow (so, the equivalent of just a bond that pays out all earnings each year) would need to be very cheap to keep pace with the S&P 500. You'd need to buy it at like a 10x P/E just to match the market.

On the other hand, something that grows at least as fast as nominal GDP - let's say 6% indefinitely - is probably worth no less than 25x FCF. For some very capital light businesses, FCF basically is EPS. For example, ad agencies. So, if you believed an ad agency would grow at the rate of nominal GDP forever - then, you should assume that when you sell it the P/E you sell at shouldn't be lower than 25x.

I know that sounds exceedingly high. But, if you check the historical record from like the 1970s through the first decade of the 2000s - you can see it's not wrong. You wouldn't be worse off paying 25x EPS for an ad agency than you would be in the S&P 500. Now, however, the industry hasn't - these last 10 years or so - grown nearly as fast as the economy.

I just use ad agencies as a good example from the past. More recent examples would be software companies like Microsoft's Office and Windows business and then businesses like Facebook and Google. If you believed they would keep their competitive position - then, your analysis could include an end point where you sell in 3, 5, 10, or even 15 years at 25x EPS. This isn't wrong if you're right about the company's competitive position. In theory, a search engine / video site etc. that's dominant won't grow at less than nominal GDP in 2035.

There are plenty of companies that can't grow like that. For example, a supermarket - even a totally dominant one locally - would normally grow at the rate of just inflation plus population growth (over time, people spend less and less of their monthly income at supermarkets and more on entertainment, services, etc. as they get richer). Groceries are a basic necessity that don't keep pace with even the overall economy.

So, assume inflation is like 2-3% and population growth is 0-1% in an area. Then, your growth rate for EXISTING supermarkets can only be like 2% to 4% a year in EPS growth. As a result, the P/E of the stock must eventually be low (once it runs out of new stores to open) and the company must eventually pay out a lot of earnings in dividends, buy back stock, etc.

For chains of stores, restaurants, etc. it's often good to use the "saturation" point.

So, a company might have 100 stores today and say it will increase store count by 5% a year indefinitely. But, it also says it will "reach saturation" around 200 stores in the country. You can figure out by working backwards from how long it would take for 100 to grow to 200 at a rate of 5% annual growth that the best way to analyze this is to use a 15-year growth phase that ends with a not especially high P/E at the end.

This makes sense. In theory, chains of stores, restaurants, etc. could justify very high P/E ratios for now. But, at the end of their growth phase they really shouldn't have P/E ratios higher than like a "normal" 15x P/E or so. A chain with a 50x P/E might not be overvalued if it has another 20 years of fast growth ahead of it in store count. But, once it reaches saturation and stops opening many new stores - then, that P/E needs to contract to a more typical 15x P/E.

This is not true for very asset light companies that can raise prices. Things like Buffett's See's Candies actually can always justify a P/E of 25x.

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Revisiting the Stock Reports at Focused Compounding: Ark Restaurants (ARKR), BWX Technologies (BWXT), and Bank of Hawaii (BOH)

by Geoff Gannon


When someone joins Focused Compounding – use the promo code “BLOG” to save $10 a month – they get immediate access to the Singular Diligence archives. These are found in the “Stocks A-Z” section of Focused Compounding where we alphabetically list every stock write-up on the site. While there are plenty of write-ups on the site not written by me – and plenty of write-ups I’ve done for Focused Compounding that aren’t as long as the Singular Diligence reports – there are enough stock ideas in the Singular Diligence archives that I thought I’d spend a whole blog post just quickly re-visiting every report in there.

Each report is over 10,000 words.

There’s a bunch of past financial data at the front of each report.

And then there’s an “appraisal price” at the back of each report.

Some reports also include a “notes” section which includes quotes, data, and sources I used in writing the report but were too detailed to include in the report itself.

So, here are the stocks we have full reports on at Focused Compounding. Since we order them alphabetically on the site, I’ll order them alphabetically here too.

To keep these posts short enough – I’m just going to do revisit 3 stocks per day.

Come back tomorrow for another 3 stocks.

 

Ark Restaurants (ARKR)

Written up at: $22.20 a share

Now trades at: $23.13 a share

How I originally described it: “Ark Restaurants operates mostly very large restaurants in mostly landmark locations.”

A lot has changed at Ark Restaurants since I wrote it up. The company is a partner in the Meadowlands racetrack (a quarter horse race track in Northern New Jersey) and would have nearly exclusive rights to any food and beverage at a planned casino there. I say “nearly”, because another partner in the racetrack is Hard Rock and Hard Rock has the rights to put in a Hard Rock restaurant there. This is the “lottery ticket” portion of Ark I wrote about in the report. Allowing casino gambling outside of Atlantic City (where it’s long been legal) was put on the ballot in New Jersey. The measure failed. Sports betting became legal. Ark’s interest in the Meadowlands racetrack remains a “lottery ticket”. The company owns about 10% of the equity in that project – though this might be watered down by future dilutions if any project really did materialize. Casino gambling can be put back on the ballot in New Jersey again (just not immediately). I have no idea if it’d ever pass. The value in 10% ownership plus the food and drink concession would be huge for such a small company. But, a Meadowlands casino project remains 100% a lottery ticket – and not something any investor should count on. The company has also shifted its strategy by buying more restaurants outright. Previously, it had only long-term leases. The balance sheet of the company now looks different because it takes debt directly on to the balance sheet and also takes the land on to the balance sheet. Some of the locations the company has bought are pretty valuable. Overall, the stock continues to plod along as generally a pretty safe dividend paying stock with extremely limited growth prospects. I recommend researching this stock if you don’t know it, because there are very few public companies out there that operate non-chain restaurants. It’s an interesting business model to study. Though – as you can see in the stock’s long-term compounding record for the last 25 years or so – it’s not been an especially lucrative one.

What I originally concluded: “it is appropriate to value Ark as a high dividend yield stock. The company should be capable of paying $2 a share in dividends in the future. In normal times, a 6% dividend yield is considered high. That would value Ark at $33 a share.

That certainly hasn’t happened yet. Ark only pays a $1 dividend and only trades for $23 a share. This gives it a dividend yield of 4.3%.  Since I wrote that report, Atlantic City has certainly gotten worse. Some things have changed at the company – like the referendum failing and sports betting becoming legal – but, overall I’d say the stock is both similarly priced and similarly attractive now as when I wrote the report. For the most part, you can read that report and then read the most recent earnings call transcript, 10-K, etc. update some figures and come to your own conclusion about Ark. There hasn’t been a ton of change in either the stock price or business value here. This is still a stock idea it’s fine to research today.

 

Babcock & Wilcox – Now BWX Technologies (BWXT) and B&W Enterprises (BW)

How I originally described it: “The single most important line of business for Babcock…is providing critical nuclear components for nuclear powered military ships…Babcock is completely dependent on the U.S. Navy as its sole customer in this business…(and) the U.S. Navy is completely dependent on Babcock as its sole supplier.”

This is a rare case where I actually bought the stock I wrote about. There’s no reason to do the “written up at” and “now trading at” for this one. The BWXT half surged in value. The BW half plunged to almost nothing. I sold my BW shares and kept my BWXT shares. I also wrote up the BW – “bad Babcock” – half for Focused Compounding. In that write-up, I said I was not interested in the stock at all because it was far too risky. That turned out to be a good choice because the stock fell a lot further.

Should you read this report? To learn about the BWXT side, sure. BWX Technologies does a few things. The most important thing it does is build all of the U.S. Navy’s nuclear reactors for submarines and aircraft carriers. BWXT has long had a monopoly on that. And it has a monopoly, or oligopoly – as part of various consortiums bidding for government work – on just about everything else related to the U.S. government’s use of nuclear power and nuclear weapons. For example, BWXT does all the down blending of U.S. weapons grade uranium into uranium that can be used for other purposes. Since I wrote about the stock, two things have happened. One, BWX Technologies acquired a medical isotopes business called “Nordion”. Here’s a quote from the press release announcing the deal:

“Nordion’s medical radioisotopes business is a leading global manufacturer and supplier of critical medical isotopes and radiopharmaceuticals for research, diagnostic and therapeutic uses. Its customers include radiopharmaceutical companies, hospitals and radiopharmacies.”

And then the other thing that happened is BWXT was awarded a (very small) NASA contract to do work on nuclear propulsion for manned spaceflight (such as a future mission to Mars). You can find information about BWXT’s work on a mission to Mars here:

“BWX Technologies, Inc. (BWXT) is working with NASA in support of the agency’s Nuclear Thermal Propulsion (NTP) Project. BWXT is responsible for initiating conceptual designs of an NTP reactor in hopes of powering a future manned mission to Mars.

NTP possesses numerous advantages over traditional chemical propulsion systems. With NTP technology’s high-energy density and resulting spacecraft thrust, NASA is projecting up to a 50 percent reduction in interplanetary travel times compared to chemical rockets, significantly increasing the crew's safety by reducing exposure to cosmic radiation.

For this latest interplanetary endeavor, BWXT is drawing upon its extensive space nuclear reactor experience. While previous projects utilized high-enriched uranium, the current NTP Project relies on low-enriched uranium.”

So, how much has Babcock & Wilcox changed since I wrote the report?

Well, a huge amount overall. That’s because the company split off into two parts after I wrote that report. The BW part pursued new (non-coal) projects like waste-to-energy in a big way. It had disastrous losses on those engineering projects which may eventually bankrupt the company. Meanwhile, the market quickly valued BWXT – the Navy nuclear reactor business – like some sort of ultra-predictable high ROE, high growth blue-chip type company. BWXT is now pretty expensive. But, I would recommend reading the report to learn about BWXT – because, I believe it has the widest moat of any business I’ve ever seen. I would not recommend paying any attention to the power / coal – BW – part of the business. As soon as it was spun-off, it embraced a really risky strategy of straying from its circle of competence (which is an ultra-risky move for an engineering company) and is not a safe enough stock for investors to even consider right now.

What I originally concluded: “Once the nuclear operations unit is split from the power generation business, it will suddenly be seen as one of the most predictable stocks around.”

That happened. BWXT is still the widest moat business I know. Everyone reading this should learn about the company. You should read the 10-K, the investor presentations, etc. But, should you buy the stock today? It’s not cheap. But, it might be cheap one day in the future. Research it now. Remember it for later.

 

Bank of Hawaii (BOH)

Written up at: $73.99

Now Trades at: $75.57

How I originally described it: “Bank of Hawaii is the second largest bank in the island state of Hawaii...From 1994 through 2015, Bank of Hawaii’s deposit share in that state ranged from 27% to 32% ….Hawaii’s banking industry is much more consolidated than the banking industry in other U.S. states.”

Finally, an immediately “actionable idea”. You can buy this stock today if you want. Bank of Hawaii is one of my favorite bank stocks in the sense that it has one of the two best deposit bases – outside of the giant U.S. banks like Wells Fargo (WFC) – I’ve ever seen. The two regional (really one-state) banks I recommend every investor should learn about are Frost (CFR) in Texas and Bank of Hawaii in Hawaii. These banks always have cheap, sticky, and stable deposits. They have really, really low costs of funding. Part of this is because they have really, really high deposits per branch (so, expenses relative to deposits can be low) and the other part is that they have a lot of deposits – from business customers who are also often borrowers from the bank – who aren’t paid much in interest to keep money at the bank. The interesting thing about BOH and Frost is that things on the deposit side change very, very little over time. But, the stocks bounce all over the place because of the asset / yield side (loan demand, interest rates, etc.). Bank of Hawaii is much more growth constrained by its state than Frost is. So, I like Frost’s odds of compounding intrinsic value per share at a nice rate over a decade or something better than BOH.

But, BOH has a weapon that Frost doesn’t use. BOH buys back its own stock. So, if BOH stock gets cheap and stays cheap for a while when bank stocks are out of favor, you – as a new BOH investor – can get a double boost from the stock coming back into favor and EPS growth coming from cheap share buybacks. Bank of Hawaii stock is down 15% this year. Now is a great time to look at banks – they can be BOH, Frost, or some of the others I’ll write about in the week ahead – because stocks in general are down for economic reasons that aren’t bad for banks. Higher interest rates and higher inflation and things like that are truly bad for some U.S. companies. They’re not bad for banks that have a lot of deposits they pay very, very little on and yet haven’t been able to put to good use on the asset side. I don’t spend a lot of time thinking about big stocks like BOH and Frost. But, if I was looking for big stocks to buy – this month, I’d be looking at U.S. banks. And BOH would be very close to the top for me. This is never a very exciting looking bank stock in terms of upside. But, this is the kind of bank stock I think you should own if you can get in at a decent price. As I write this, the dividend yield on BOH and the 30-year Treasury yield are both about 3.3%. When that happens, you should seriously consider BOH. The coupon on that 30-year is never going to go up no matter what happens with inflation. The cash available to pay out as dividends will go up a little in most years at BOH. And the number of shares outstanding will go down every year. So, that dividend per share is going to grow. You’re getting a 3.3% dividend yield that’ll grow over time. This is a stock where you can go out and read the 10-K, investor presentation, etc. (or my report on the company at Focused Compounding) right now. Put this one on the watch list. I makes little sense for a stock like this to be dragged down in any of the recent market wide volatility we’ve seen. So, down days for the market are good days to look at buying BOH for the long-term.

What I originally concluded: “It’s possible to come up with a scenario where BOH stock returns as little as 7% a year over the next 5 years. It’s also possible to come up with a scenario where BOH stock returns as much as 14% a year over the next 5 years.”

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How Much is Too Much to Pay for a Great Business?

by Geoff Gannon


(FULL ARTICLE AT FOCUSED COMPOUNDING)

 

A Focused Compounding member sent me this email:

 

“I've just become a FC member and I've been listening to the very interesting podcasts from day one. Really enjoying them. Those have convinced me to purchase a membership of 1 year (for now).

 

I have a question that has been spinning my head for a while now.

 

Everybody is looking for this gem of a company with a sustainable competitive advantage and consequently… a high sustainable ROIC or ROIIC.

 

But when you invest in a company at 2 times invested capital doesn't that hurt your compounding effect big time in the long term (ROIC of 20% becomes 10%?)? Or am I pursuing the wrong train of thought here?”

 

Yes, it does hurt your compounding. But, paying more than you normally would – in terms of price-to-book – for a great business may not hurt your long-term compounding quite as much as you think. However, there’s a tendency for investors to focus more on how high the company’s return on capital, growth rate, etc. is right now instead of how long those high rates of return on capital, of sales and EPS growth, etc. can last. What matters a lot – as I’ll show using numbers in a minute – is how long you own a stock and how long it keeps up its above average compounding.

 

Think of it this way. If you buy the stock market as a whole, it tends to return about 10% a year. A great business might be able to compound at 20% a year. So, how much more can you pay for a great business than you would pay for the S&P 500? It might seem the simple answer is that you can pay twice as much for a great business. However, that’s only true if you’re planning to sell the stock in a year. That’s because 20% / 2 = 10%. So, paying 2 times book value gets you the same return right out of the gate in a great business as what you’d have in the S&P 500.

 

When value investors like Warren Buffett, Charlie Munger, and Phi Fisher talk about how it’s fine to pay up for great, durable businesses – they mean if you intend to be a long-term shareholder and if the company continues to compound at high rates far into the future. This makes all the difference in what kind of price-to-book value you can afford to pay.

 

To figure out how much more you can pay for a great business and still beat the market, you can actually just sit down and work out the math.

 

Here's what matters...

 

* Price / Asset (equity, invested capital, etc.)

 

* Amount of earnings reinvested in the business

 

* Return on that reinvestment

 

Over shorter holding periods in stocks reinvesting less of their earnings each year – the price you pay matters more.

 

Over longer holding periods where the stock is reinvesting almost all of their earnings each year – the return on reinvestment matters more.

 

A company's maximum growth rate tends to be set by its return on capital. Of course, they could issue stocks, borrow money, etc. for a time. But, in the long-run the only way a company can really have high EPS growth is by having a high enough return on capital. Otherwise, it wouldn't produce enough earnings to grow by that much each year. The easiest way for a company to compound at a high rate for a long time is simply to produce enough cash to fund its own high growth rate.

 

Okay. So, a company with a high rate of return and a lot of opportunity to grow is the kind of business you can afford to pay a higher multiple of book value for. From now on, let’s talk in terms of rate of compounding instead of just return on capital.

 

So, let’s pretend we’ve found a company with a high compounding rate. Now, we want to figure out what multiple of book value we can afford to pay for this company.

 

Say a stock compounds book value by 20% per year for 20 years (this is equivalent to having a 20% after-tax return on capital and always reinvesting 100% of the earnings back into the business). And let’s say you hold this stock for 20 years.

 

How much does it matter how much you paid?

 

If you pay 1x book value you make 20% a year for 20 years.

 

If you pay 2x book value you make 16% a year for 20 years.

 

If you pay 3x book value you make 14% a year for 20 years.

 

If you pay 4x book value you make 12% a year for 20 years.

 

If you pay 5x book value you make 11% a year for 20 years.

 

If you pay 6x book value you make 10% a year for 20 years.

 

This is what you make for holding a stock for 20 years – not what you make for “flipping” the stock by buying at a lower price-to-book today than it will trade at in the future. In other words, I assumed the same exit price – in terms of price-to-book – for all of those 6 scenarios (you always sell at one times book value).

 

So, thinking purely as a long-term shareholder, if you pay a bargain price (1x book value) for a great company with a really long period of growth ahead of it – you can make much, much more than the stock market overall.

 

But, even if you pay 6 times more for that great business with a really long period of growth ahead of it – you can still do about as well as the stock market overall.

 

So, truly long-term growth investors aren't wrong. If you find Southwest Airlines or Wal-Mart in the 1970s or Amazon in the 1990s or 2000s it will pay off – if you hold the stock long enough.

 

A really simple way to think of it is this:

 

The SHORTER your holding period in a stock, the more important the PRICE YOU BUY AT (P/E, P/B, etc.) and the PRICE YOU SELL AT (P/E, P/B, etc.)

 

The LONGER your holding period in a stock, the more important the RETURN ON CAPITAL / GROWTH RATE of the company you've invested in.

 

Basically, value investing works AND growth investing works. Buying and selling value stocks –  paying a lower P/E, P/B etc. and then selling at a higher P/E, P/B, etc. works. 

 

And HOLDING good, growing businesses also works. 

 

One of the best ways to think about this is to remember this formula.

 

Your "hold" return in a stock is:

 

Free Cash Flow Yield (that’s Free Cash Flow / Market Cap) + Growth = “Hold Return”

 

So, if you buy a stock that pays you out a 4% dividend and is growing at 6% a year – then, you can make 10% a year for as long as you own the stock without having to sell at a higher P/E, P/B, etc. than you bought at.

 

But, then you have the "trade" return in the stock.

 

So, let's say you buy a stock – like a net-net – that doesn't grow. Say the stock trades at 0.6 times NCAV. You'd make 19% over a 3-year holding period even if the stock didn't grow. You'd make 11% a year if you had to hold the stock for 5 years. So, because the “trade return” on a net-net is so higher (greater than 10% a year over more than 5 years, if you buy in at a greater than 40% discount), you can afford to hold a non-growing net-net for a long time and still match the market or even beat it.

 

However, good investments usually combine both aspects. A decent hold return or a decent trade return combined with a really good form of the other kind of return.

 

In other words, great investments are often “growth businesses” bought at “value stock” prices and then sold at “growth stock” prices.

 

For example, let's say I buy a stock with a 15% free cash flow yield and 3% growth. I make 18% a year while I hold it. But, then, say the stock doubles its FCF multiple (so the FCF yield drops to 7.5%) by the time I sell it in 5 years.

 

In that case, you'd make a return of greater than 30% a year (you have a double-digit return from a good free cash flow yield and a double digit return from buying at a really low Price/FCF multiple and selling at a "normal" one within 5 years).

 

That’s obviously a great situation. Many good long-term investments don’t look that good on the face of them. But, they do combine positive contributions from both the “hold return” and the “trade return”.

 

Let’s look at what can go wrong if you pay too much for a stock.

 

We said you could pay 6 times book value for a stock that compounds book value at 20% a year. You’d do okay. Not great. But, okay. You’d match the market. But, what if it turns out the stock only compounds at 10% a year for 20 years? In that case, you’d only make about 1% a year. So, the extra 10% a year in compounding – between 20 years of compounding at 20% a year and 20 years of compounding at 10% a year – is the difference between having a long-term stock performance that matches the market versus one that is a very bad outcome (a stock that does nothing for two full decades).

 

Now, growth investors may argue I’ve been unfair here. If a business is a really great compounder and it stays a really great compounder – it should trade at a higher multiple of book value even when you sell it. This would make a big difference in your long-term return.

 

For example, let’s say you have a stock that you pay 6 times book value for today. It compounds book value per share at 20% a year for the next 20 years. And then, at the end of those 20 years, it still trades at 20 times book value. In that case, you would – of course – make a 20% annual return.

 

This is the argument that investors often make when projecting out their own long-term returns in a great, growing business. They assume the stock will grow at more like 20% a year rather than the market’s normal return of 10% a year – plus they assume that, because the stock keeps growing at an above average rate, it’ll keep having an above-average price-to-book ratio.

 

There’s a logical problem with this argument. The argument isn’t wrong. It’s right. But, it leaves you with no margin of safety. You think you’re going to make 20% a year for 20 years, because you are paying 6 times book value for a stock that will compound its value at 20% a year and then will still trade at 6 times book value.

 

But, what happens if the stock grows at 10% a year instead of 20% a year?

 

Well, your two defenses here – the two reasons you think you’re going to get a good return in this stock – are that you expect an above-average growth rate and then you expect to exit the stock at an above-average price-to-book ratio because the stock will still have an above-average growth rate. Really, you are projecting both the growth rate that happens while you own the stock and the price at which you exit the stock based on a single projected data point: how fast this stock will grow.

 

All you’re doing is going all in with a bet on the stock’s future growth rate.

 

I talked about the “hold return” you can get in a stock (because it’s a great, growing business) while you own it and the “trade return” you can get when you sell a stock (because you sell it for more than you bought it for).

 

Well, if you assume both a high growth rate in a stock while you own it and a high price-to-book ratio when you sell it (because, it’ll still be a growth stock) – then, you’re really only making one bet. You’re betting the stock will still be growing at an above average rate far into the future. That is sometimes a difficult bet to make. And, if you’re wrong, there’s no protection on the downside. But, if you’re right – then, paying a price-to-book ratio of anywhere up to 6 times book value can make sense – if you’re buying the right business. Overall, though, it’s the durability of this growth that matters more than you’d think. Buying a stock that will compound at 30% a year for the next 4 years is nowhere near as good a deal as buying a stock that will compound at 15% a year for the next 40 years.

 

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How Big Can Amazon Get?

by Geoff Gannon


(FULL ARTICLE AT FOCUSED COMPOUNDING)

Someone emailed me this question:

I’ve been looking at Amazon for a little short of a year and because the equity doesn't provide a good price to value ratio and margin of safety, in my view, I’ve held back from investing so far. 

 

There’s a little brainteaser which involves asking people how much sales, as a percentage of total sales, are done online. The numbers people answered were surprisingly high. Right now they make up 10% of total sales in the U.S. and I’m positive that number won’t stop there.

 

Assuming internet sales grow at 8% for the next 10 years (16% right now) one-fifth of sales will be online (also assuming 4% historical growth rate on U.S. retail sales). It would be a $1.8tn industry, x4 the size of today. Is an 8% growth rate overly optimistic given that as the base grows, percentage growth usually slows? Not looking for exact numbers, just rough measures.

 

Amazon has 50% market-share and I would assume that isn’t sustainable and the market’s perception of a winner-takes-all is exaggerated, many businesses could co-exist. I don’t think this is a Facebook/Google “aggregator” situation in which the viability of a new company competing with them decreases as they get more users and advertisers. The viability surely decreases to some extent but not to the extent that it does for the other two advertising companies, the retail industry is also much bigger.  

 

All in all, bigger but perhaps fewer companies will co-exist in the online space, and when it comes to smaller online commerce firms, they'll perhaps cater more to niches as a European pet food company is doing. However, even a 20% market-share comes out to a huge revenue number when we extrapolate what the internet sales number might be in the future. 

 

Very successful U.S. retailers like Walmart have ~6% market share of total retail sales, that’s significantly higher for specific categories. In terms of online though I would apply a higher than average market share for Amazon because the supply chain is significantly harder to build and optimize (e.g. more nodes) and therefore in my view this increases barriers to entry. My second question is: Do you think this is a fair assumption?

 

Anything I say in this post is not a suggestion to buy Amazon as a stock today. This is because of the price. We’ll get to that at the end of my article. For now, let’s just say that Amazon stock is priced high enough that unless it grows faster than a conservative estimate of how fast internet retail would grow, or it expands into other things (which, of course, it already has), or it pays out dividends, buys back stock, makes good acquisitions, etc. on top of the industry’s growth – your return in the stock could be just so-so. In other words, Amazon keeping its current position in a fast growing online retail industry isn’t going to be enough to get you great returns in the stock. This is because of the starting price of your investment.

 

So, that part of my answer is pessimistic.

 

On the other hand, I think in the very long-term you've underestimated Amazon's likely size. There are several reasons for this. 

 

One, I don't think judging sales nationally by category makes much sense. For example, yes, Wal-Mart may have a certain share of Sporting Goods nationwide or something. But, in reality, Wal-Mart has little presence in certain categories - for example, groceries - in some parts of the country (Northern New Jersey, Southern California, etc.) and yet has a very high share of almost all categories in places like rural Oklahoma. Supermarkets are very, very regional in the U.S. And so national market share is misleading. For example, the financial press often talks about Wal-Mart and Kroger as if they have the strongest position in groceries. In reality, companies like Publix (Florida) and HEB (Texas) probably have the strongest competitive position because they have very high market share in specific states and essentially zero presence anywhere else. In an upcoming podcast (it’ll air next Wednesday), a portfolio manager talked to me and Andrew about why he likes Village Supermarket (VLGEA). Village is a member of the Shop-Rite co-cop (called Wakefern) that has high market share in New Jersey but less presence in surrounding states and no presence in other regions of the country. However, within Village’s home state of New Jersey the Shop-Rite branded co-op has higher market share than Wal-Mart. At least as of a couple years ago, I know there were 4-5 more Shop-Rite stores in New Jersey than there were Wal-Marts that carried fresh food. Kroger has no presence in the state. And the new competition that worries New Jersey supermarket operators the most is from Wegman’s entering the state not from a national chain like Wal-Mart or Whole Foods. Wegman’s started as a New York state supermarket and expanded into adjacent states over time. It is basically in “Mid-Atlantic” states only.

This is a good indication of how misleading market share data can be. Kroger is one of the biggest supermarket companies in the country. New Jersey is the 11th most populous state in the United States, and yet Kroger has 0% market share. Wal-Mart is a leader nationally in food retail. Its market share in New Jersey is not big. There are several regional chains that all sell a lot more food in the state than Wal-Mart does. This, of course, means that Kroger and Wal-Mart have much, much higher market share in food retail in those local markets where they are the #1 or #2 chain. There are good reasons why brick-and-mortar retail breaks down so regionally. There are less good reasons why online retail would break down that way. And while Kroger and Wal-Mart are also-rans in plenty of places around the U.S. in plenty of product categories – there are quite a few cities, counties, and even states where the two chains wouldn’t have a #1 or #2 market share rank – Amazon is a leader in online retail everywhere. It’s not like Amazon is well behind other online retailers in certain states. So, the analog you should use for Amazon’s potential market share is more like Wal-Mart’s market share in general retail in the most rural counties in the U.S., or the market share in groceries of HEB in Texas, Publix in Florida, etc.

 

How big is that market share?

 

It depends on how narrowly you define the regions and the markets. If you define Publix’s market as “traditional” grocery sales (this excludes things like deep discounters) you would get a market share of 55% for the company. That 55% is over its entire trading area. It has greater than 60% market share in some local markets. But, let’s say it’s possible for a company to have 50% market share in something like groceries.

 

HEB operates throughout Texas. But, because Texas consists in large part of 4 metro-areas that don’t really interact that much economically – Houston, Dallas, Austin, and San Antonio are all far enough apart that they are different “regions” of the same state – a retailers market share (like a bank’s market share) will vary tremendously by which metro area you are measuring. HEB’s home market is “South Texas” this includes the Austin and San Antonio markets and goes as far North as Waco (but not Dallas). HEB has 60% market share in South Texas. Wal-Mart is second in South Texas with 27%. No other seller of groceries has a meaningful share of the market in South Texas. So, you have two companies with over 85% of the market and then you have the other 15% of the market in the hands of competitors with 2% or less market share. The best market share data I have for South Texas groceries is…HEB 60%, Wal-Mart 27%, Safeway 2%. Now, companies like Whole Foods operate profitable stores in the area. They just operate a small number of stores that have bigger market share in a very local area. Across the whole region they add up to a low market share.

 

But, this again points to the possibility that you are overestimating the likely fragmentation of online retail. Retail in the U.S. is often fragmented because competitors with the most successful models started in different parts of a state, country, etc. and then slowly grew to the point where they came into contact and competition with each other. For example, HEB started in South Texas and Wal-Mart started in Arkansas. HEB tried to expand into Central Texas early in its history and had problems and focused on South Texas and eventually Northern Mexico as well.

 

What I’m saying is that if competition in online retail is largely a local matter – you’ll get very fragmented market share nationally like you do with retailers in the U.S. But, if online retail makes all of the U.S. market more like a single local market in offline retail – then, it’s entirely possible to have market share breakdowns like: #1) 50% market share, #2) 25% market share, #3) 12% market share, #4) 6% market share…everybody else: 7% market share. And that’s very possible. It may be that the leader in online retail has 50% of U.S. online sales and the top 4 together have 90%. I can think of lots of mature local retail markets where the leader having 50% and the top 4 having 90% is not uncommon. So, it may be that when online retail is fully mature Amazon has 50% market share in the “everything store” category.

 

What we’re talking about here is scale. And a lot of these lists potentially mis-measure the scale that matters. For example, does having 30% market share in one town instead of 10% market share in one town really mean the same thing as going from 5% to 15% market share nationally. When buying Heinz ketchup or Budweiser beer or Kingsford charcoal it might. But, when advertising it certainly doesn’t. You can target ads locally. The fact that some people in New Jersey have heard of Kroger doesn’t help Kroger sell to people in New Jersey. So, concentration at a very local level is useful. Having good density in a state overall – moving a lot of volume of stuff that needs to go through warehouses and trucks and such – also helps. That’s one reason why you have things like the Wakefern co-op and why supermarkets always try to cluster themselves enough. In fact, the reason why some otherwise good concepts have run into trouble is often due to the failure to put enough stores close enough together in the same state. If you don’t do that, you need to rely on someone else to warehouse and move all your stuff.

 

Amazon isn’t at a disadvantage to anyone in delivering this to your front door. So, they have already reached the scale needed to have the ability to move stuff to you quickly and cheaply. Now, they don’t really have the last mile thing down yet. And there are certainly categories where it’s lower cost to buy in-store than online and shipped to your door. Amazon is unlikely to make as much money as PetSmart on dog food if Amazon is shipping it to Prime members and PetSmart is selling it in its stores. But, I can’t think of many categories – I can think of a few, and most are kind of unusual like very high value to weight or very low value to weight – where someone else has an advantage over Amazon in cheaply and quickly getting an item to your door (rather than to a store for pickup).

 

So, we have to think of scale more specifically. What specific kind of concentration are we talking about? And how does it benefit the company?

 

When thinking about market share, scale, etc. it helps to breakdown what kind of concentration you are thinking about. Where does this company have bargaining power? What is the actual corporate function that provides it with profit? Is it having a big share of each customer's wallet, a big share of all purchases in a certain product category, or a big share of sales in a certain region? Wal-Mart is big nationally. But, there are plenty of towns where Wal-Mart is a total non-factor. There aren't places where Amazon is a non-factor. 

 

What business is Amazon most similar to?

 

Definitely not Wal-Mart. Amazon's model is much, much closer to Costco's model. How does Costco's model differ from Wal-Mart's model?

 

Costco does not try to be a leading general retailer in specific towns, counties, states, the nation as a whole, etc. What Costco does is focus on getting a very big share of each customer's wallet. Costco also focuses on achieving low costs for the items it does sell by concentrating its buying power on specific products and therefore being one of the biggest volume purchasers of say "Original" flavor Eggo waffles. It sells these waffles in bulk, offers them in one flavor (Wal-Mart might offer five different flavors of that same product) and thereby gets its customer the lowest price. 

 

There's two functions that Costco performs where it might be creating value, gaining a competitive advantage, etc. One is supply side. Costco may get lower costs for the limited selection it offers. In some things it does. In others, it doesn't. The toughest category for Costco to compete in is in fresh food. I shop at Costco and at other supermarkets in the area. The very large format supermarkets built by companies like HEB (here in Texas) can certainly match or beat Costco, Wal-Mart, and Amazon (online and via Whole Foods stores) when it comes to quality, selection, and price for certain fresh items. But, what can Costco do that HEB can't? It can have greater product breadth (offering lots of non-food items) and it can make far, far, far more profit per customer.

 

Let's look at that metric.

 

So, a big mistake that investors make when looking at things like retailers, restaurants, movie theaters, etc. is that they think about the product being sold and never about the customer. Often, investors don't know what the customer economics are for a supermarket, Costco, Amazon, etc.

 

This is dumb.

 

It's like knowing what the net interest margin is for a bank, but not thinking about how likely a customer is to keep their deposits with the bank long-term, add to it each year, make use of all sorts of different financial services, etc. Companies know a lot about customer economics and think a lot about customer economics. Investors don't.

 

Amazon's big, big, big advantage - this is the key to its long-term future - is the company's customer economics. It's completely different than offline retailers. But, first let's give an example of how customer economics might work. 

 

Investors think about supermarkets in terms of total sales and prices in store as if people are checking the price of bananas at Wal-Mart and Kroger and deciding to buy most of their shopping list this week at Kroger but then going across the street to Wal-Mart to buy the super cheap bananas they're being offered this week. That's not how actual shopping works.

 

Supermarket customers in the U.S. might do something like this:

 

- Spend $50 per shopping trip

- Make 2 shopping trips to their primary supermarket each week

 

And supermarket product economics might work like this

 

- 25% gross margin

 

And customer economics might work like this

 

- 75% annual retention rate

 

These are estimates. There are stores where gross margin might be 35%, there are stores (who sell fuel, etc.) where gross margin might be 20%. There are times when customer retention rate might be 50% and other where it might be 75%.

 

But, this is a pretty good estimate. Now, when we think about a retailer we can think in terms of the lifetime value of a customer rather than the annual results of a store. This is a much more sensible approach. After all, when you are buying into a retail stock - you are getting millions of existing customers with your stock purchase. This is totally different than buying 200 supermarkets around the country that are opening their doors for the first time this week. There's no customer base there yet. But, if the stores are run right, in about 5 years they'll be much more valuable because they will have built up a loyal customer base. It's this loyal customer base that creates much of the value in any retail stock you're buying into as an investor.

 

So, $50 a visit times 2 visits equals $100 times 52 weeks equals $5,200 in annual revenue. Let's round that down to $5,000 a year. So, a loyal supermarket customer might be a household spending $5,000 a year at the local supermarket of choice. The gross profit from that household will be 25% of $5,000. That's $1,250 a year. Note that there are 12 months in a year. So, even if we round this down to $1,200 – a loyal supermarket customer is actually equivalent to a subscription business where the subscriber pays $100 a month.

 

Imagine that Netflix charged $100 a month for its service. That's the kind of economics you get with a loyal supermarket customer. Note this is only true up to the point where the store becomes crowded. It's not unusual for a company with 25% gross margins to have 21% to 23% SG&A costs. This leaves operating margins in the 2% to 4% range. And it may make the economics of supermarket customers very different than the economics of a Netflix subscriber. SG&A costs at a store can be high. And there are certain unavoidable costs that work like overhead cost absorption.

 

Basically, a low volume store ends up having a greater labor cost component in everything from cashiers to stockers per order because they need a certain base level of service regardless of volume. For reasons I discussed in my Singular Diligence write-up of Village Supermarket (VLGEA) – you can read that report and two dozen other reports like it by becoming a Focused Compounding member – a bigger store with higher inventory turns and simply greater "busyness" has all sorts of wonderful things going for it on cost, quality, etc. It's an example of a "flywheel" type business. Basically, a supermarket location that is getting more and more crowded has store economics that are spiraling upwards. It can lower total costs, increase freshness of the product, increase the store size through additions to the store. It can - over the years - lower prices, increase quality, and increase selection. Meanwhile, a supermarket location that is getting less and less crowded is in a downward death spiral. It's not just that costs can get higher. The supermarket may end up with slower moving inventory, need to cut back on employee hours, it'll start skimping on investment in the store - it won't just became economically an inferior site for the owner. It'll become less appealing to shoppers too. So, in brick and mortar retail things like return on capital for a supermarket are highly tied to store economics. You'd be surprised at how much better the economics of small, established supermarkets in great locations are versus the biggest chains in the nation. It is not true that Wal-Mart and Kroger have the best economics in the supermarket industry. There are smaller operators with better economics and there always have been. So, nationwide scale is not what drives the best returns on capital in the supermarket business. Maybe it's customer economics. Let's return to that now.

 

So, we said a household that's a loyal shopper at a supermarket might bring in $5,000 in revenue per year and $1,200 in gross profit. This is equivalent to $100 a month in gross profit. But, it might be as low as $8 to $16 per month per loyal customer in EBIT (this is 2% to 4% of the roughly $400 in sales per household per month). In the U.S., there are often both state and federal income taxes. For brick and mortar retailers - the tax code is pretty tough. Companies like Google aggressively avoid taxes. This isn't possible with a chain of supermarkets. You have to pay taxes to both the U.S. government and to the state governments where you have stores. The result is probably like a 25% tax rate. So, $100 in gross profits becomes like $8 to $16 in pre-tax income which becomes $6 to $12 per customer per month in after-tax profit. In reality, a MARGINAL customer can add much, much, MUCH more value to a supermarket than $6 to $12 a month after-tax. Most supermarkets are nowhere near 100% full. And they will operate below breakeven if they are pretty empty. Also, new supermarket locations will lose money at first. They might have negative cash flow for a year or two and not payback the original investment till 3-5 years down the road (and this is in the case of a successful supermarket opening).

 

But, let's pretend that the economics of a supermarket are this simple…

 

Each loyal customer adds:

 

$400 a month in revenue

$100 a month in gross profit

$16 a month in EBIT

AND
$12 a month in after-tax profit / free cash flow / "owner earnings"

 

Basically, shareholders get:

 

Size of Customer Base * $12 = Monthly Free Cash Flow

 

Or in annual terms:

 

Size of Customer Base * $144 ($12 * 12 months = $144/year) = Annual Free Cash Flow 

 

So, we'd assume that a company will make about $150 a year per customer. A company with 10 million customers should make about $1.5 billion a year after-tax (going forward, the tax cut wasn't in effect last year so all U.S. supermarkets paid much higher taxes last year than they will this year). 

 

So, if a supermarket chain has a loyal base of 10 million shopping households (about 8% market share; 10 million customers / 126 million households in the U.S. equals 0.08) it should make something like $1.5 billion a year in "owner earnings" free cash flow, etc. In reality, this would be hard to check because these companies tend to use debt. And some own stores and use debt while others lease stores (instead of using debt). But, we can try to check these numbers roughly against a supermarket that has around 8% market share in the U.S. The closest company to having 8% market share of U.S. groceries is Kroger. It probably has like 7% market share or so.

 

So, let's check Kroger's numbers against our estimates. This is what a company with 10 million customers (8% market share) should theoretically look like based on our per customer model:

 

Revenue: $50 billion

Gross Profit: $12.5 billion

EBIT: $1.9 billion

After-Tax Earnings: $1.4 billion

 

What does Kroger really have?

 

Revenue: $100 billion (supermarket sales only - excludes fuel)

Gross Profit: $27 billion (does NOT exclude fuel)

EBIT: $2 billion

After-Tax Earnings: No meaningful figure (but, if taxed at 25% it would have been $1.5 billion).

 

In other words, our per customer economics and Kroger’s actual after-tax earnings for this year match up. Items further up the income statement don’t.

 

So, if Kroger had 10 million customers last year each customer would contribute

 

Revenue per customer: $10,000

Gross profit per customer: $1,250

EBIT per customer: $190

Earnings per customer: $150 

 

I've found estimates that an average family of 2 (which is almost certainly smaller than the median household size shopping at Kroger, because the median household size in the U.S. is about 2.6 people and I’d assume supermarket customers are on average bigger households than overall U.S. households because single people are the least likely to shop at a supermarket) spends around $5,000 a year on groceries. However, supermarkets - like Kroger - often get 1 to 2 times more revenue from "non-grocery" items than from grocery items. So, if a household spends $5,000 on groceries it may actually spend $10,000 a year at its favorite supermarket. So, again, our per customer model is within the realm of possibility. We might be off by 20% either way. We’re not off by 100%.

 

Okay. Let's just use after-tax earnings of $150 per customer as our estimate. How much is a present day customer worth to a supermarket?

 

Let’s look at what an “owner earnings” stream would look like for a supermarket. What is one household using this supermarket as its primary shopping destination worth to the owners of the supermarket?

 

This is how much the owners would make from that customer each year.

 

At a 50% retention rate

 

Year 0: $150

Year 1: $75

Year 2: $38

Year 3: $19

Year 4: $9

Year 5: $5

 

At a 75% retention rate

 

Year 0: $150

Year 1: $113

Year 2: $84

Year 3: $63

Year 4: $47

Year 5: $36

 

Now, your question was about Amazon. And I want to move the discussion a little closer to Amazon - and further away from supermarkets. But first we need to discuss stock market value. How much value in the stock market does a company have per customer?

 

A company like Kroger - so, a fairly normal U.S. public company – where the market is kind of indifferent to its future prospects will likely be valued at about 15 times after-tax profit / free cash flow etc.

 

So, the market value per present day customer this implies is:

 

Year 0: $150 * 15 multiple = $2,250

 

That may seem like a very strange way of looking at it. But, I want to stress just how highly the market values a supermarket customer. Basically, the "market value" of a supermarket customer is greater than $2,000. That may not be how supermarket shareholders are thinking. Cable investors often think in terms of EV/Subscriber. Supermarket investors may not. But, they’re basically paying more than $2,000 per household shopping at that supermarket when they buy into that stock.

 

Now, an interesting question to ask is what SHOULD determine the market value per customer. Not what does. But, what should? In other words, if we had to do a really, really long-term discounted cash flow calculation – what variables would matter most?

 

If two companies both have 10 million customers which company should be valued higher and why?

 

Two variables matter

 

One: Annual profit per customer

Two: Retention rate 

 

Basically, we're talking about a DCF here. If Company A and Company B both have 10 million customers and both make $150 per customer the company that should have a higher earnings multiple (P/E or P/FCF) should be the one with the higher retention rate.

 

And now we can talk Costco. 

 

Do you want to guess what Costco's retention rate is?

 

Costco's 10-K says:

 

"Our member renewal rate was 90% in the U.S. and Canada and 87% on a worldwide basis in 2017. The majority of members renew within six months following their renewal date. Therefore, our renewal rate is a trailing calculation that captures renewals during the period seven to eighteen months prior to the reporting date."

 

What this means is that if we assume a 90% renewal rate that will be an over-estimate of Costco's true retention rate. Their attrition rate is really greater than 10% a year. But, I'll simplify by assuming it's 10% a year. Now, let's look at what a company with the same exact customer economics I laid out before for supermarkets would look like if it had a customer retention rate like Costco's (90%).

 

Year 0: $150

Year 1: $135

Year 2: $122

Year 3: $109

Year 4: $98

Year 5: $89

 

Costco's earnings stream per customer looks very, very different from our theoretical supermarket example. In fact, a present day Costco customer is likely to be continuing to provide the same amount of FCF to Costco 13 years from now as a customer is likely to be providing a supermarket with a 75% retention rate in just 5 years. It's a totally different business.

 

Costco's customers are more loyal than your average supermarket customers. Therefore, Costco should be worth much, much more PER CUSTOMER than other stocks.

 

TO READ THE SECOND HALF OF THIS ARTICLE, BECOME A FOCUSED COMPOUNDING MEMBER: Use the promo code “BLOG” to take $10 a month off your membership.

 

To learn about our managed accounts, email Andrew at info@focusedcompounding.com or call or text him at 469-207-5844.


The Importance of Talking to Yourself

by Geoff Gannon


In the most recent podcast, I talked about how useful it can be to just talk a stock idea through whether that is with someone a lot smarter than you, a peer of about equal investing skill, or anyone else for that matter.

I talk a lot with people on Skype about stock ideas they choose.

And they often tell me how helpful I was in coming up with some insight – some way of thinking about their stock idea – that they themselves hadn’t seen. It’s a nice compliment. But, it’s entirely undeserved. People often think that ideas they themselves had during a discussion must have been someone else’s ideas because they hadn’t had that insight back when they were analyzing the stock quietly on their own.  Since they thought of this bright idea when they were in the middle of talking a stock through with someone else, that someone else must be the one who prompted the bright idea.

It doesn’t work that way.

The truth is that it’s not the someone else that matters. It’s just talking the idea through that matters. If you weren’t too self-conscious to do it – you could talk to a cubicle wall, that troll doll on your desk, or a bathroom mirror. They’re all good investing partners because they all listen.

If you could go into a quiet room, set a timer for one hour, and then start talking through your stock idea out loud till that timer dinged – you’d have a lot clearer idea of what you think about a stock and why than you get from the way you are probably doing it now.

Obviously, you’re not going to do that. Nothing I can say is going to convince you to talk to yourself out loud for an hour.

But, there are cheats. There are ways to trick yourself into doing functionally the same thing without embarrassment.

What are they?

One, you can write a blog. I write a blog. I get to talk to a lot of great people about interesting stock ideas. But, I also get to put down whatever ideas I have in writing. On this blog, I really only discuss general investing concepts now. My specific stock writing is done at Focused Compounding. Over there: from time to time, I’ve done what I call an “initial interest post” where I will write about some stock and at the end say my interest level is 10% in this stock idea, 90% in that stock idea, etc.

I’d be looking at these stocks anyway. Writing them up like that is a way of recording my own pipeline of ideas. Some subscribers have told me they like those write-ups better than true stock picks. They like reading about all the stocks I don’t like right off the bat and why I don’t like them. So, maybe it is useful to others. But, the reason those articles are formatted like that is because I’m constantly looking at stocks and deciding whether or not to follow up on that idea. What I’m doing in those write-ups is very similar to what I’d do on my own. So, writing about a new stock I’ve come across is a way of talking to myself in print. Typing up an idea doesn’t make you look as crazy as talking through an idea out loud. And it has the same benefits. It clarifies your thinking on the subject.

The podcast episodes we’ve done on specific stocks – NIC (EGOV), Frost (CFR), Cheesecake Factory (CAKE), Omnicom (OMC), NACCO (NC), and Tandy (TLF) – are all examples of me talking to myself about a stock by talking to Andrew about a stock. We recorded the discussion and shared it with listeners. But, I’d say that in 5 of those 6 cases, the reason for picking that specific stock at that specific moment in time was a selfish one. I was thinking about NIC or Frost or Cheesecake or Omnicom at that time and doing a podcast on the stock helped me work through my most up to date thoughts on the company.

I’d say NACCO was an exception. It’s a stock I had owned and written about behind a paywall a while back and we always thought it was something we should share with podcast listeners. We just didn’t think the stock was cheap enough (that is, as cheap as I had bought it for) till it dropped a bit right before that podcast. In that one case, I’d say the catalyst for the podcast wasn’t a selfish one. I wasn’t thinking that stock through myself when we recorded that podcast. I already owned it and I knew I wasn’t going to buy any more shares or sell any shares for many months to come.

So, that’s number two. One, you can write a blog. Two, you can record a podcast. What’s three? You can meet in person. Andrew and I do this every week. We each research a stock on our own. Then, we meet in person and discuss it. We usually talk about one stock for about 3 hours. Sometimes, after that talk – we go back to do our own follow up analysis. Usually it’s tracking down numbers and answering questions we hadn’t addressed the first time around that were then suggested to us by the other person. But, very often, we don’t even do that. We simply do our own solo analysis. And then we meet and talk together about a stock for 3 hours. We compare notes. We ask questions. We each state our case. And we come away from it not just clearer on what the other person thinks but clearer on what we think.

The fourth thing you can do is talk to someone not in person. Use the internet. There are other value investors out there. Most people don’t have people in their life who care as much about the stocks they care about as much as they do. It’s unrealistic to expect you can sit down once a week for three hours and just talk stocks with some local friend. But, it’s not unrealistic when you expand that search from offline friend to online friend. For any stock out there, you should be able to find someone who is as interested in the idea as you are.

What are the rules for talking an idea through?

Be yourself. Talk like yourself. Don’t apologize for having different opinions. And don’t feel you have to defend your opinions. Just state your analysis as fact. If someone disagrees with your analysis – they’ll do exactly that. They’ll disagree with your analysis instead of with you personally. The other things – and this is especially important when meeting with someone who you often agree with – is to remember there’s no such thing as veto power. You are investing your own money. You don’t need to win anyone over to your way of thinking.

I talk with a lot of investors on Skype. I’ve heard a lot of solid ideas. I’m not sure I’ve ever said: “oh, that’s such a good idea I think I should invest in it myself right now”. On some level, that means I “disagreed” with that person’s favorite stock idea. I didn’t think it was a good enough idea for me to drop everything and buy it. Yet they probably did come in thinking exactly that. Does that mean they failed to win me over?

That’s not the point. You’re not trying to win anyone over or impress anyone. You’re trying to think out loud for your own benefit. Don’t think of your stock talk sessions as an arena for arguments. What they are instead is just a place and time for guided thinking.

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Focused Compounding Podcast: All 6 Specific Stock Episodes

by Geoff Gannon


Lately, we haven’t done as many specific stock podcast episodes as I’d like. But, we do have some past ones. I think these are the most useful episodes for people to listen to. In order from oldest to newest they are:

Episode #2: NIC (EGOV)

Episode #5: Frost (CFR)

Episode #7: Cheesecake Factory (CAKE)

Episode #14: Omnicom (OMC)

Episode #21: NACCO (NC)

Episode #22: Tandy (TLF)

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Ekornes (Stressless) to be Acquired for 139 NOK - Here is My Report on the Stock

by Geoff Gannon


Focused Compounding members get access to a "Stocks A-Z" section of the website. This includes about two dozen stock reports I did for Singular Diligence between 2013 and 2016. Recently, Ekornes (the Norwegian maker of Stressless brand furniture) announced that its board had agreed to be taken over for 139 NOK a share in cash.

Last I saw, the stock was trading close to that level. So, this is no longer what I would call an "actionable" stock idea. For that reason, I thought I'd share the Ekornes report on this blog as keeping the report exclusive can't benefit paying members anymore.

So, here's my stock report on Ekornes. It's a good example of what the couple dozen other reports on Focused Compounding look like.

Ekornes Stock Report (PDF)

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You’re Now Getting 3 Podcasts a Week: Mondays, Wednesdays, and Fridays – Here’s an Off-Topic One

by Geoff Gannon


New podcast episodes will now come out 3 times a week: Mondays, Wednesday, and Fridays. For our first podcast on this 3-episodes a week schedule, Andrew and I decided to do an off-topic podcast episode…

Episode #33: Getting to Know Andrew and Geoff

By the way, some people have asked how you can get access to old episodes. iTunes only shows the most recent episodes. You can find them at the podcast’s Podbean page.

As for this Monday’s episode (which is already up now), you’ll get to learn more about me and Andrew than in a normal podcast. I like to keep the podcasts short (the unattainable goal seems to be the 15-minute mark). So, we never talk about ourselves. People know me pretty well. But, most don’t know Andrew. So, you’ll come away from this podcast with a better idea of who that other guy is.

Episode #33: Getting to Know Andrew and Geoff

Don’t worry.

We’re not planning to make a habit of these off-topic podcasts.

But, we didn’t tell people they could Tweet us any questions – no restrictions as to subject matter. So, we will do one and only one podcast where we rapid fire answer every question we get. Andrew and I will probably record again this Friday. So, if you do have a question you want answered tweet it to @GeoffGannon and @FocusedCompound.

This one time: you can ask absolutely anything.

We will answer it.

 

Ask Us Anything

@GeoffGannon

@FocusedCompound

 

Episode #33: Getting to Know Andrew and Geoff

 


Sunday Morning Memo

by Geoff Gannon


Sign up for Geoff’s Sunday Morning Memo

I write a weekly memo now. It goes out as a PDF sent via email. It’s about one page. And I discuss one general investing topic in it. In theory, I don’t discuss specific stock ideas in the memo. In practice, I sometimes cite a recent example (often a stock written up at Focused Compounding). It’s free to get the memo. You just enter your email address. And then the only thing we do with that email address is send you one email sometime every Sunday.

The memos so far have been:

5/13/2018: “Goodness vs. Soundness”

5/06/2018: “The Urgent and the Important”

4/29/2018: “The Second Side of Focus”

4/22/2018: “Patience as a Process”

4/15/2018: “Fear, Greed, and Boredom” 

4/08/2018: “An Illiquid Lunch”

4/01/2018: “Killing Your Horse” 

3/25/2018: “Choose to Choose”

The past memos are archived at Focused Compounding.

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Overlooked Stocks

by Geoff Gannon


In our most recent podcast episode, Andrew and I talked about “overlooked” stocks. I said overlooked stocks were basically synonymous with “oddball” stocks. You can read the Oddball Stocks blog here. I recommend going through every past post there and writing down the names of the stocks covered. It will give you a good list of stocks you might want to research and probably had never heard of before.

The truth, though, is that Oddball Stocks really only covers half of the universe I’d call overlooked stocks. The other half is “special situations”. The best blog to read for special situations is Clark Street Value.

Andrew and I also did a podcast episode about our favorite investing books. I mentioned in that episode – as I often have before – that Joel Greenblatt’s “You Can Be a Stock Market Genius” is my favorite investing book.

If you’re interested in overlooked stocks, I recommend reading both those blogs and that book.

Once you start thinking in terms of overlooked stocks – some otherwise odd stocks choices make sense. Among long-term readers and on-again-off-again readers of this blog: I get a lot of emails from two different types of value investors. One type is the Ben Graham / deep value / quantitative value investor. They remember me as someone who would buy a basket of Japanese net-nets, an OTC insurer trading below book value like Bancinsurance, and U.S. net-nets like George Risk (RSKIA). They ask me why my style changed such that I now invest in things like BWX Technologies (BWXT) that are so expensive and so clearly not value stocks. The other kind of value investor is the Warren Buffett / wide moat / qualitative value investor. They remember me as someone who would buy stocks like IMS Health (back in its previous incarnation as a public company). They ask me why my style changed such that I now invest in things like NACCO (NC) that is in a dying industry like coal.

The truth is that I tend to find the most success fishing in two ponds of stocks. One pond of stocks is what I’d call “overlooked”. These stocks are cheap because they are neglected. I should point out here that I don’t mean that all OTC stocks, illiquid stocks, stocks that don’t file with the SEC, stocks emerging from bankruptcy, spin-offs, the remaining company after a spin-off, etc. are in some sense either cheap or even necessarily neglected. Plenty of these stocks get plenty of attention. However, the argument that Keweenaw Land Association (KEWL) might be more likely to be neglected than General Electric (GE) makes sense. If GE sells for less than the sum of its parts, this should be for some reason other than a lot of people trading the stock aren’t bothering to do their own appraisal of each of the business units and then adding that appraisal together. In the case of GE, you could probably have a pretty efficient market in the stock even if 19 out of 20 buyers and sellers were traders dealing in the stock without any regard to the underlying business. If the other 5% of buyers and sellers were quite diligent business analyst types – the average stock price over any set of months could still incorporate a surprising amount of that information and analysis. Now, if all the trader types had the same sort of knee-jerk attitude about the stock – then you can easily drown out whatever useful analysis the investor types were doing. But, for an average stock in an average month – there’s a mix of optimists and pessimists both among investors and traders and it may all work out to a bunch of random noise.

The other pond of stocks is what I call the “contempt” group. A stock can be cheap enough, safe enough, and good enough that I could figure out it’s a bargain and yet others hadn’t already bid up the price a lot in two scenarios: 1) People haven’t looked at the stock and 2) People have looked at the stock – but, can’t get past their emotions and down to the logical part of their thinking.

I recently had coffee with a hedge fund manager when we got on the subject of whether you could apply the same sort of ideas you do in a personal account, a $100 million value fund, etc. in a $1 billion or $5 billion value fund. There are some very smart investors running funds those sizes on the same principles that value investors run much smaller funds. But, can it really work? Or do people who have success in big stocks need to use different strategies than what works with most stocks (that is, the small ones). We talked a little about our personal experiences – times when we really felt we found a stock trading well over a $1 billion market capitalization that looked as cheap as the stocks we find in the under $100 million market cap group.

I’ve had some good experiences in stocks with a market cap over $1 billion. An old example is IMS Health in 2009. It was eventually bought out. My results in IMS Health – an over $1 billion market cap stock – and Bancinsurance (an under $100 million market cap stock) were pretty similar. And, honestly, I’d group the two stocks together in terms of degree and especially clarity of cheapness. These were clearly stocks trading at less than two-thirds of a conservative estimate of their intrinsic value. There is a difference though. Bancinsurance was in a niche business, it was an illiquid stock, it had de-listed and traded over-the-counter (OTC) for a couple years, and then – finally – a controlling shareholder had made an offer to acquire the whole company. It was already pretty neglected before the offer. But, once a controlling shareholder makes an offer to buy out a company – many investors drop any attempt at analysis right then. The stock goes in the special situations / arbitrage category and no investors who don’t specialize in that area bother analyzing whether the stock is cheap, etc. It gets neglected.

IMS Health was not neglected. Investors were avoiding stocks generally (in early 2009), that area of stocks (healthcare stocks in the run-up to Obamacare), and to some extent IMS Health specifically (there was a Senator or two pushing for bills that were aimed at gutting a lot of what the company’s core business was). That kind of situation – a cheap moment in time, for an otherwise good business – is what’s worked for me with big stocks. Frost (CFR) is a big stock. And if you look at a stock chart to see where I bought all my shares – it was just a blip in time. It wasn’t long at all. People still thought the Fed Funds Rate might stay lower for a while. The increases weren’t quite here yet. And then oil prices had plummeted. Frost is 100% in Texas. And something like 15% of loans were to energy producers (in Texas). So, that worried some people. But, it obviously worried them very, very briefly. The stock wasn’t available that cheaply for long. This is typical of what I’ve seen with big stocks that get as cheap as small stocks often get. They don’t stay cheap for long. And their cheapness is very, very dependent on crowd psychology rather than a lack of interest from investors. It’s not that common for investors to continually overlook, misjudge, etc. a big stock quarter after quarter and year after year. That kind of thing is much more likely in small stocks. In big stocks, as soon as the cloud of fear or greed or whatever clears – the stock rockets upwards or plummets downwards or whatever the appropriate direction is.

Then there are overlooked big stocks. And the only stock I’ve owned recently – I actually still own it – that falls in this category is BWX Technologies. I’ve told this story many times. But, basically, when Quan and I found Babcock & Wilcox (which BWX was then a part of) we were immediately excited by what seemed to be a great, wide-moat business that was part of a public company trading at a normal price. Babcock itself had been spun-off from another company several years before. It had 3 parts. One was a speculative, money losing unit. It was essentially an experimental technology. We expected it to be closed down at some point or at least to be scaled down. Then there was a definitely cyclical and probably declining business (the present-day Babcock & Wilcox Enterprises). And the last part was BWX Technologies – the business we really liked.

I bought ahead of the spin-off. This was a mistake for two reasons. One, you really didn’t have to. You could’ve just bought when the spin-off happened and gotten a similar price on the piece you wanted. And, two, buying ahead of time encouraged me to size the position too small. Normally, I’d make a position 20% to 25% of my portfolio. I did the same thing in this case. But, then when the spin-off happened – the portion of my investment left in BWX Technologies (as opposed to the other newly independent stock) was in the 10% to 15% range instead of 20% to 25% range. I didn’t add more after the spin-off. That was my mistake. But, there are plenty of times where waiting till the actual spin-off can be unhelpful in terms of price. So, I wouldn’t say as a rule you should always wait till spin-off day.

My point with Babcock though is that when people email me about the stock they remember it was a spin-off, that I like Joel Greenblatt’s book “You Can Be a Stock Market Genius”, etc. and assume I bought it because I’m interested in spin-offs.

I bought the stock because it had a wide moat, predictable business in it and yet it was trading at what looked to be a normal price overall. I’d say the pre-spin Babcock was a neglected stock.

A good present-day examples of this sort of thing is KLX (KLXI). This one is a little different for a few reasons. One, Boeing (BA) has said it will buy the aerospace part of the business for $63 in cash. And two, the aerospace business isn’t actually being sold cheap. But, it’s similar to Babcock in that KLXI as a whole was a spin-off from B/E Aerospace. And then when I analyzed KLXI a couple years back, the thing that bothered some investors was the energy business. Well, if all goes to plan – KLX’s aerospace business will convert into cash (provided by Boeing) and the energy business will be its own standalone business. The difference here, of course – is that some people may say Boeing is getting the good business and people who buy KLXI stock today are getting the promise of cash from Boeing and the bad business. Maybe. But, it’s similar to Babcock in the sense that there are some issues of mixing businesses investors do and don’t want together, breaking things up, etc. It’s possible that investors neglected KLXI stock in the past because it mixed an aerospace business and an energy business. Investors won’t overlook the stock once the energy business trades on its own for a while. This is no guarantee the energy business is a good business. It is, however, a guarantee that the energy business will not be overlooked anymore.

This brings us to one of the two things that come up a lot with the special situations side of overlooked stocks.

One of the issues is the idea of a catalyst.

The obvious catalyst is that something that was overlooked won’t be anymore. This is even something I’ve said with a stock I own called NACCO. I’ve said that I wouldn’t be surprised if the business wasn’t well understood, the stock got less liquid over time, etc. for a year or more. But, eventually, a company puts out annual reports and does presentations and so on about the business. Some investors learn about it and post write-ups places describing the business model. Eventually, if some enterprising investors feel there is money to be made in learning about the business model, buying the stock, etc. word will get out. This is basically the classic question posed to Ben Graham about what makes a stock go up? Do you advertise or something? There are incentives for people to find a mispriced stock. It’s harder to overlook something that is now standing alone as just one business unit. It may take time. But, just being less overlooked is catalyst enough for a really cheap stock.

The final issue is the riskiness of these special situation overlooked stocks. Some are definitely quite risky. Greenblatt obviously invested in some really risky ones and benefited from the years he was operating Gotham – just as you have undoubtedly benefited from some risks you maybe shouldn’t have taken these past 9 years. Falling stock multiples, rising interest rates, recessions, etc. can kill stocks with too much leverage – both operating leverage and financial leverage. And investors who buy warrants, LEAPs, etc. are even more leveraged than that. So, yes, some special situation type overlooked stocks can be quite risky.

A really good recent write-up at Focused Compounding is one about Entercom (ETM). This is the minnow that swallowed the whale that is CBS Radio. It’s now the second biggest owner of radio stations in the U.S.

A lot of people have asked me about this stock’s margin of safety. And, honestly, while I think it’s a good stock – I don’t think it has a margin of safety. Allegedly, KLXI’s energy business is going to be the opposite of this. They’ve said it’ll be spun-off with $50 million of cash and no debt. Add to that the fact that they had recently been in a really bad part of the cycle in their industry – and there’s a nice margin of safety. They have cash. They don’t have debt. And you’d expect things should be a bit better this year and the next – not a bit worse.

My point here is that I’d definitely classify both Entercom and KLX as overlooked stocks. Entercom is mostly CBS Radio and it’s mostly held by shareholders of CBS who opted in to taking shares of the radio business. I’m guessing that outside of the people who actually run the company and the company itself (both insiders and the company have been buying Entercom shares lately) the people trading this stock are either shorting it or are special situations types not long-term investors. The situation at KLXI is also unlikely to attract long-term investors. In the case of both Entercom and KLX people are now likely to think of the stocks more as pieces of paper to trade and less as long-term ownership of a business to hold. Whether that qualifies the stocks as overlooked or not generally I don’t know. But, as long as the people – basically value investors willing to hold for a while – who think like me aren’t yet attracted to these stocks, I’m more likely to give them a closer look.

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Frequently Asked Questions: Managed Accounts

by Geoff Gannon


To set up a meeting by telephone or in person (Geoff and Andrew both live in Plano, TX) contact Andrew by email (info@focusedcompounding.com), phone (469-207-5844), or text (469-207-5844).

Frequently Asked Questions

Who will the account manager be?

Geoff Gannon.

How many stocks will I own?

Between 6 and 8 stocks.

What kind of stocks will I own?

Overlooked stocks. These include: spin-offs, stocks emerging from bankruptcy, net cash stocks, net-nets, near net-nets, illiquid stocks, over-the-counter (OTC) stocks, and stocks that don’t file with the SEC.

What strategy will be used?

The strategy Joel Greenblatt outlines in You Can Be a Stock Market Genius.

How often will I hear from Geoff and Andrew?

You will get a quarterly letter. And you can always email us at info@focusedcompounding.com.

What fees will I pay?

The taxable accounts of qualified clients will pay 1% of assets and 15% of profits. The non-taxable accounts of qualified clients and all accounts of non-qualified clients will pay a flat rate of 2.5% of assets.

How often will I pay these fees?

The flat fee will be automatically withdrawn from your account monthly. The percent of profits will be automatically withdrawn from your account quarterly.

Is it possible you will turn me down?

Yes. We are looking for long-term oriented value investors who don’t mind some volatility.

Where will my account be?

Interactive Brokers. We do not have custody of the assets. We are just the manager of the account.

Can you manage money for people outside the U.S.?

Yes.

Can you manage non-taxable money?

Yes.  

What is the minimum investment size you will consider?

We don’t have a precisely defined minimum investment size. If you think your investment might be too small for us to consider, please call Andrew at 469-207-5844 to discuss your personal situation.

To set up a meeting by telephone or in person (Geoff and Andrew both live in Plano, TX) contact Andrew by email (info@focusedcompounding.com), phone (469-207-5844), or text (469-207-5844)


Managed Accounts

by Geoff Gannon


We are planning to offer managed accounts with Geoff Gannon as the portfolio manager. These accounts will hold 6 to 8 overlooked stocks (spin-offs, net-nets, OTC, etc.) and be managed along the lines of the strategy outlined in Joel Greenblatt’s You Can Be a Stock Market Genius.

To set up a meeting by telephone or in person (Geoff and Andrew both live in Plano, TX) contact Andrew by email (info@focusedcompounding.com), phone (469-207-5844), or text (469-207-5844).

We look forward to meeting with you.

 


Less Theory, More Practice: How to Value a Stock Using a “Sustainable Growth” Model Coupled with Return on Capital

by Geoff Gannon


I get a lot of questions about valuing a company based on estimates of its sustainable growth rate. So, someone will say it seems this company can grow 8% to 10% a year and it has a return on equity of 15% or 20% a year – and they’ll ask me: “how do I determine what this stock is worth?”

 

My answer is usually pretty much the same. Unless you know the business very well, that kind of estimate is starting way too far down the income statement.

 

So what’s a better way of tackling the same sort of valuation problem using simpler math, more explicit assumptions, and better tying your model of this specific company into the way the wider world is likely to shake out over 5, 10, or 20 years?

 

Let’s start with a huge bit of simplifying math – something I encourage every investor to make rule #1 of any growth model.

 

It's much easier to pick a certain point in time: 5 years from now, 10 years from now, 15 years from now, etc. and do a point-to-point calculation instead of a sustainable "CAGR" calculation. Why? Well, you would have to decide on whether things like margins stay the same. So, do gross margins stay the same, expand, or contract over time? Do operating expenses decrease or increase over time? So, does the same gross margin percentage convert into more or less operating margin over time? With a point-to-point calculation you can assume gross profit, EBITDA, net income, etc. will grow faster or slower than sales. You can’t really do that with any kind of permanent projection. I mean, you can – and I’ve seen people do it. But, it makes no sense to say I think this company will “sustainably” grow earnings faster than sales.

 

A surprising number of people ask whether the calculation should be in real or nominal terms. Here’s the thing – for most businesses, inflation makes quite a difference. And investors often aren’t that sensitive to differences between units sold, nominal price per unit, and real price per unit. When I look at the long-term history of a company, I always do some calculations in real terms and some in nominal terms.

 

As far as whether the growth rate is sustainable or real, for many of the companies I like to look at - you could do the calculation in real terms. However, that doesn't work for most companies. Most companies would get worse real returns if inflation was higher. Not all. There are exceptions. It's a timing issue. So, asset light businesses (that don't carry much inventory, that collect bills they are owed before paying the bills they owe, companies that raise prices on customers ahead of price increases from suppliers, etc.) would be more able to grow similar in real terms. Like, NACCO and BWX Technologies and Omnicom and Keweenaw Land Association (a timber company) should all be able to have a sustainable "real" rate of growth. That's not true for most companies. For example, you can see in the period from about 1965-1982 when stock multiples were contracting in the U.S. that more and more large U.S. businesses were producing very bad real returns on equity. Inflation was a problem for them. 

How I model out a company's future sustainable growth is:

 

1. Do a point-to-point calculation. This is a reality check. So, if someone sends me something saying Google can grow earnings per share by 15% a year indefinitely or something - I'd say, let's pick a specific year and model that out. Either earnings have to grow much faster than sales, or sales growth has to come from things that aren't advertising, or the ad industry has to grow much faster than it did in the past, or you have to pick an end point for the year you are measuring to that is very near today - or, you'd end up with Google having a huge share of global advertising spending. This is because your model is basically going to require Google to grow revenue from ads faster than ad spending, so market share will grow year after year. This is the reason you do point-to-point calculations using specific years. If you don't, there are people who don't realize how much of the ad industry Google would have in 2038 if you're really doing a 20 year projection, Booking would have of the travel industry, etc. 

 

2. You want to focus on the number you care about (total return in the stock) and break it down from there. So, for example, it doesn't really matter much if Omnicom gets you a return by paying you a dividend, buying back stock, or acquiring more sales. Organic growth is - because the company is asset light - very cheap (pretty much free). So, that's different. But, you want to model it out sort of like:

 

Ad Spending Growth +/- Market Shares Gains and Losses +/- Shares Outstanding Increase or Decrease +/- Dividend Yield

 

Also, for an investor you always have to pick the ending multiple on the stock. You can pick a multiple that's EV/EBITDA, P/E, P/B, P/FCF, EV/Sales, etc. Whatever you want. But, this is an important part of the calculation because a fast growing business will eventually be a slow grower. So, if Booking or Google grows quickly for 10-20 years, that's certainly possible. But, it can't really have a much above market P/E ratio at the end of 20 years because if it does grow fast for 20 years, there just won't be growth opportunities left. The longer and faster a company grows, the harder it’ll eventually be to have an above market P/E ratio (because the sooner it’ll be 100% mature).

 

I don't do any calculations that involve the "reinvestment" rate or returns on capital.

 

Why not?

 

Isn't that important?

 

Well, it's very important. But, it's possible to work out a simple formula that incorporates reinvestment without doing any sort of actual ROC calculation.

 

Project a certain growth rate. Then, determine how much you think the company will have to retain, spend in the business, etc. to achieve it. The past record is very helpful in this calculation. It’s especially helpful over longer periods of time – like 5 years, or an entire business cycle or something.

 

So, with Omnicom the organic growth rate is free because they have "float". The faster they grow organically this year, the more cash flow they get now. So, if you calculate Omnicom will grow sales by 0%, 1%, 2%, 4%, or anything else - it doesn't really matter. You can simplify your assumptions by just assuming Omnicom always has all of FCF available to issue stock options, make acquisitions, buyback stock, and pay dividends regardless of how fast they grow.

 

Similarly, with banks we said something like Bank of Hawaii can grow 3% a year forever while paying out 100% of earnings (in dividends, buybacks, etc.) If BOH grows much faster than 3%, it then needs to retain earnings to keep its capital levels in line with the historical norm. But, we don't really think BOH will grow fast. So, we can just assume BOH will - at a constant P/E multiple - return earnings yield + 3% as a stock. All of the earnings can be paid in dividends or buybacks.

 

For companies with significant amounts of working capital, PP&E, etc. this changes.

 

But, again, it's possible to incorporate the "incremental return on investment" purely in terms of the "cost of growth". Which is how I always do it.

 

This confuses people. But, there's an excellent reason for why I do it.

 

I'm not purely a value investor or purely a quality investor. I will consider companies with 30%+ after-tax returns on equity and also companies with 5% returns on equity if they are incredibly cheap. Some value investors would never consider a company with a 5% return on equity, but that's not the right decision. Actually, as long as a company with a 5% return on equity isn't going to plow any of its cash flow back into the business - it could be a good investment at the right price.

 

For example, let's say I find a net-net trading at about 2/3 of its NCAV. Historically, the company has returned something like 5% to 10% on NCAV. But, say it has returned 10% on NCAV if you exclude net cash. In other words, it might be earning 10% on just receivables plus inventory less accounts payable, accrued expenses, etc. Assume here that PP&E is unimportant. This isn't a weird example. I won't say the company's name. But, this is basically a "live" example of a net-net that exists today. So, this is the kind of problem an investor would actually face: Should I buy this net-net or not?

 

Is it a good investment?

 

The quality oriented investors would say "no". In the long-run it will return between 5% and 10% a year depending on capital allocation at the company. It's a cigar butt.

 

Actually - it depends. The company is more attractive the more it does two things:

 

1) Returns cash in dividends, buybacks, borrows money, etc. (that is, the more it uses financial engineering)

2) The less it grows

 

The reason here is that a low ROE is really just a high cost of growth. It only becomes a problem if the company tries to grow. The fact past owners of this stock funded a lot of slow, low-return growth doesn’t matter to you – the investor who buys in today. If the company has mostly decided it doesn't want to grow and you can buy it at a nice price relative to cash on hand, free cash flow yield in an average year, etc. - the ROE doesn't really matter.

 

Likewise, how much does the ROE of an amazing company matter?

 

It matters a lot if the company grows. But, less so if it doesn't.

 

My own view is that thinking about ROE in terms of a "return" on your money is the wrong way of doing it. What you get is growth. What it costs to fund growth - from a shareholder's perspective - is an incremental addition to equity. So, I don't really think in terms of ROE or incremental ROE. I think in terms of:

 

1) How much can this company grow?

2) How much owner money has to be put up to fund this growth?

Imagine a timber company. Well, if the amount of timber per acre can grow 4% a year without owners putting in more money – then, that’s an important fact to know regardless of what the company reports in earnings. The economic value of the business grew 4% without you doing anything. But, consider if you grow the amount of timber the company owns by buying 4% more acres this year. Well, you are paying for that. So, the price paid per acre of timberland becomes incredibly important to the analysis if the company is buying more timberland. If the company isn’t buying more timberland, the growth rate of the trees matters – not how much the company once paid for the land. In both cases, it’s “cost of growth” that matters. In one case, cost of growth will look a lot like ROE – if the company is growing through buying more and more timberland each year – but, in the other case the “cost of growth” will have no relation to ROE.

 

Lately, Omnicom has grown at about 2% a year. That's all you get regardless of how high the return on capital is. You could try to calculate it as a re-investment rate (though, in Omnicom's case - the reinvestment rate calculation result would be nonsensical, because incremental capital would sometimes be nil or less than nil so the ROIIC you'd get would be "NMF" or negative). I think it's better to think of Omnicom as: well, does it shrink 1% a year, grow 1% a year, grow 3% a year etc. and then is that growth free.

 

In the case of a low ROE type business - yes, you could do a reinvestment rate calculation too. But, again, I think it's not the best way of thinking about it.

 

Why not?

 

I've said before that I think the things you need to focus on when analyzing a stock are those things that are:

 

- Constant

- Consequential

- Calculable

 

Return on invested capital does fit that bill at some companies at certain phases in their history. So, you could do the calculation for Cheesecake Factory today or Howden Joinery. Basically, it's a calculation on new store openings. It used to matter more at those companies (when they were growing store count faster as a percent of their existing store base). But, it's still a "consequential" number and because it's a repeated store model it's definitely a long-term "constant" number. It's also easily calculable. In fact, I'm sure management at these companies has some sort of payback period or ROI targets (probably in cash terms) for new store openings.

 

But, at a lot of companies the return on incremental invested capital and the reinvestment rate isn't really going to fit the "constant, consequential, and calculable" test. At cyclical companies, manufacturers, companies carrying a lot of working capital, etc. the number will - at least in cash terms - fly all over the place. In fact, capital will sometimes flow out of the business. In fact, in the real world, that's often how a company gets its ROE up. It gets very miserly about using capital in that business, it runs down inventory, it improves receivables collection, etc. 

 

If I created an Excel that used the theoretically correct idea of reinvestment rate and return on incremental capital - it'd be all over the place.

 

But, if I pick a point in time that's 5 years, 10 years, or 15 years in the future and I assume a growth rate in sales, gross profit, EBITDA, etc. of 3% or 6% or 9%, I can often come up with a reasonably good approximation of how much owner money I think would need to be retained to hit that number.

 

Remember, it won't be that useful to know the ROIC if you get the growth number completely wrong. So, if ROIC is 50% and growth comes in at 4% a year over the next 10 years instead of 8% a year as you expected - your ending valuation will be off by quite a bit.

 

I like looking at sales and gross profit most because this can be more easily tied to real world things like population growth, inflation, nominal GDP growth, industry growth relative to the economy, market share, increases in spending per capita on something, etc. Like, you can see if the predictions people are making for this specific company could fit with a likely future reality.

 

Store growth is a good example of that. You can say new stores will grow by 8% a year for the next 15 years. That sounds reasonable. But, for some U.S. restaurants, that would mean more locations than any full service restaurant has now. That seems unlikely. It might not be impossible. But, that's a red flag. So, you can look at what kind of saturation we're talking about.

 

It's also a good idea to focus on numbers that don't move around a lot which are things like store level economics, "turns" of inventory and receivables, and income statement lines that are near the top. So, sales and gross profit. Of course, investors care most about the bottom line. But, for most companies, the bottom line is much harder to predict because of economies and diseconomies of scale, business cycles, etc. 

 

The more constant and predictable numbers to base your decisions on will be:

 

* Typical store level economics

* Number of stores

* Number of customers

* Number of units

* Sales relative to those things

* Gross profits relative to those things

 

And then: cash conversion cycle, asset intensity, etc.

 

Things like operating margins are long-term very difficult to model out without knowing what growth rates will be, because these are the things that can widen out a great deal with scale. It would be difficult to know what the eventual EBITDA margin could be at Facebook or National Cinemedia or something without knowing if the business is already at about 100% of the potential in terms of audience and ads. The numbers lower down the income statement would look very different in the future if Facebook was on a planet with 80 billion people instead of 8 billion people or if National Cinemedia wasn't already in like 50%+ of all movie screens. 

 

Compare Facebook and Twitter for instance.

 

Facebook is a success now. As long as it stays a success, that’s easy to model even if you use the bottom line instead of the factors I suggest. But, what about Twitter? Something like that is more difficult things to model out. But, you'd still do it the same way. You'd still say how big is Twitter's audience? How many ads will that audience see? How much could those ads be sold for? If you don't do it that way - if you just try to project out based on bottom line financials as of today - you'll value a business that isn't yet having financial success like it never could have success. Return on capital comes into when asking how much would it cost to grow audience, grow ads served to that audience, or grow prices paid for those ads? Is it a big number? A very small number? That’s what’s really going to determine future returns on capital. It would be hard to see that looking at today’s results though.

 

That gets back to the net-net type business. I see this all the time with tiny banks selling below book value. Investors assume that because they are earning a 5% ROE today they are worth a huge discount to book value. In reality, if a tiny bank could either have a much higher ROE once they grew scale or once they were bought and plugged into another bank - then they could ALREADY be worth book value to someone who is truly future oriented. Really, what you'd care about is the quantity and quality of the deposits. A one bank branch will never earn a good return on equity as a standalone business - but, one branch is obviously worth book value or more to an acquirer. You could say it’s speculative to assume a business would be worth more to an acquirer. But, it’s also speculative to assume a profitable business will never increase scale. A static ROE assumption for a business with increasing returns to scale doesn’t make sense. Of course, for most industries scale is important to a point and much less important beyond that point. A bank with $100 million in assets is likely to be less efficient than one with $1 billion in assets or $10 billion in assets. There’s much less evidence – at least on the cost side – of $100 billion in assets or $1 trillion in assets getting you even better returns. Yes, I can name some banks with great economics at that size. But, I can also name a couple with similar economics at much smaller size. What they have in common isn’t overall size, it’s the percentages of deposits in each city, it’s the deposits per branch they have, and it’s the type of depositors they have. So, again a “point-to-point” analysis still makes sense. The difference between the economics of 1 branch and 10 branches is big in a way that the difference between 500 and 5,000 isn’t.

 

That's why I would focus on modeling out the sort of basic, easy to connect to the real world, and close to the "top line" numbers like deposits, store count, audience, etc. and work from there instead of trying to say I think the sustainable EBITDA growth rate here is 10% a year. An EBITDA growth rate is always making assumptions about all that stuff I listed above. So, if you are wrong in your assumptions, you will be way off on things like EBITDA growth, return on INCREMENTAL capital, etc. Whereas if you break down your assumptions about the company's future growth into a set of 3 or 5 key factors: number of branches, deposits per branch, cost of deposits, etc. - and you pick a specific point in time (like 2023 when I think the Fed Funds Rate will be "X") then you are on much firmer footing.

 

Often, this kind of analysis will match up nicely with real world common sense. Like, a company doubling the number of stores in the same town is going to grow earnings faster than sales while a company increasing its nationwide store count by 10% through filling in the most rural places it hasn’t yet reached is not going to drive any sort of earnings growth beyond store count growth.

 

Most importantly, I think that kind of point-to-point calculation based on 3-5 key factors for the business will also give you a better understanding of the business, the challenges it faces, etc.

 

For example, it will focus you on the "key constraint", the bottleneck that is most holding the company back. I just did a podcast on Tandy and talked about how I thought the lack of ability to add a lot of good, new store managers meant the key constraint for that company is store growth. So, I needed to see either an increase in store SIZE (which would still only require 1 store manager but would do more sales) and a decrease in SHARE COUNT (which would increase the amount of sales per share for investors without needing to increase the number of managers) to give me confidence in buying the stock.

 

So, when you break a business down that way you can come up with possible solutions. How can Tandy give investors a good total return?

 

1) They can find a way to attract more excellent store managers

2) They can grow sales faster than they grow store managers

3) They can grow sales per share faster than they grow sales

 

And we get to that kind of answer just by breaking the business down by key factors like number of stores, square footage per store, sales per square foot, and number of shares outstanding.

 

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