All Supermarket Moats are Local

by Geoff Gannon


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

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

Read the Full Report on Village Supermarket (VLGEA)

In the Grocery Industry: All Moats are Local

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

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

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

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

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

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

Read the Full Report on Village Supermarket (VLGEA)


Can Howdens Joinery Expand to the European Mainland?

by Geoff Gannon


Richard Beddard has added Howdens Joinery to his Share Sleuth portfolio. I mention this because I’ve written a little about Howdens Joinery in the past. And some of you know Howdens is the stock I like best that I don’t yet own.

This raises the question:

Why haven’t I bought Howdens yet?

There are two reasons:

1.       I try to buy stocks I’m confident I’d be willing to hold for more than 5 years if necessary

2.       I try to simply hold cash till I’m confident a stock will return at least 10% a year while I hold it

I believe Howdens may – in about five years from now – have fully covered the U.K. with about as many depots as it ever will have in that country. I’m not 100% sure this is true. I’ve seen companies raise their estimates of the size of their chain’s footprint that their home country can support. So, Howdens may have more years of depot growth ahead of it beyond 2022.

But, there will eventually be a limit to how many depots Howdens can build in the U.K. So, the next question is:

Can Howdens expand to other countries?

Richard Beddard writes:

“The other risk is Howdens might fill the UK with depots within my 10-year scenario, in which case it would need to find some other way to grow. Due to its entrepreneurial culture and decade long experimentation with European stores, I think it probably will be able to adapt its business model and establish profitable stores abroad.”

I don’t doubt Howdens’s entrepreneurial culture. But, at the risk of ethnocentrism here (I am an American writing about a British company), I am not 100% certain that Howdens’s entrepreneurial culture will – at the depot level – be easily exportable to non-English speaking countries. I’ve researched a few organizations in the past – notably Tandy Leather (TLF) and Car-Mart (CRMT) – where scuttlebutt taught me the importance of delegation and incentivization of the branch managers.

I believe Howdens’s model depends heavily on good management at the depot level.

As a rule, English speaking countries tend to be among the most “flexible” when it comes to labor in the sense employers can easily fire workers with little cost. And, as a rule, continental European countries tend to be among the least flexible when it comes to labor.

In its 2015 annual report, the company said:

“Managers hire their own staff locally and develop relationships with local builders. They do their own marketing to existing and potential customers. They adjust their pricing to suit local conditions. Managers manage their own stock. They work out where to put everything they can sell – old favourites and new introductions. Every day, they balance the needs of builders, end-users, staff and everyone in their local area who has an interest in the success of their depot...Managers are in charge of their own margin, and effectively of their own business. Both managers and staff are strongly incentivised on a share of their local profit less any stock loss, which results in a common aim to improve service, and consequently profit, with virtually no stock loss.”

Howdens’s most recent annual report included this statement:

“We continue to investigate the opportunities for Howdens in Europe. At the end of 2016, we had twenty four depots outside the UK: twenty in France, two in Belgium, one in the Netherlands and one in Germany. We have been in mainland Europe for eleven years and continue to learn. We intend to thoroughly understand these markets before any decision is made to expand in them.”

The emphasis is mine. But, I think it’s reasonable to assume - from this statement and other little bits you can find in past annual reports - that the depot level economics are not as good in France as in the U.K.

Finally, the most recent annual report includes this passage:

“We give staff the opportunity to get substantial bonuses for exceptional performance. This has always been part of the Howdens business model and culture. Our people share in the profitability of their local site, as well as in the profitability of Howdens as a whole. In the words of some of our staff, the bonuses that they can achieve for exceptional performance in our peak trading period can be ‘life-changing’.”

As an American, I don’t know much about the differences between the U.K. and countries like France and Germany in regard to how low guaranteed pay can be and how big bonuses can be – nor how easy it is to fire people who don’t fit with your company’s “entrepreneurial” culture.

I’m not sure Howdens’s depot level culture can spread to other countries that easily. If I believed the model was easily repeatable in other countries – this might be my favorite stock of all (ahead of even the two I already own: BWX Technologies and Frost).

Instead, Howdens is on the bubble for me. I like the at least five year future I see in the U.K. And I can imagine the stock returning 10% a year for the next 5 years. I am less certain of the repeatability of growth beyond five years.

Does this mean I like Howdens less than Richard Beddard?

Actually, no.

His Share Sleuth portfolio has a “meaningful position” definition of about 3% to 4% of the portfolio. For my personal portfolio, a normal position would start at around 20% of the portfolio. If I was considering whether or not to put something like 3% or 4% or 5% of my portfolio into Howdens – I’d have already made the decision to buy. Because I’m considering putting 20% of my portfolio into Howdens, I still haven’t made a decision.

Read Richard Beddard's Post About Howdens Joinery

Talk to Geoff about Howdens Joinery


Do Supermarket Stocks Have Long-Term Staying Power?

by Geoff Gannon


Read the Free Report on Village Supermarket

Check Out Focused Compounding

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

Today’s re-post is a roughly 1,300 word excerpt from the Village Supermarket (VLGEA) stock report Quan and I wrote back in 2014. This section focuses on whether or not a supermarket can be a durable investment. The full 10,000+ word report on Village – along with 26 other reports of similar depth – are now available at my new site, Focused Compounding.

Some facts have changed since this report was written. For example, Amazon’s companywide sales figure is much, much higher than it was in 2013 (the last year for which we had data when we wrote this report).

And – more relevant to the grocery industry – Amazon Fresh has gone from a $300 a year add-on to Amazon Prime to a $15 a month add-on to Amazon Prime (so 40% cheaper).

 

Durability (From the 2014 Report on Village Supermarket)

High Volume Supermarkets are Durable Local Market Leaders

Demand for food is stable. Most grocers do not experience meaningful changes in real sales per square foot over time. Changes in real sales numbers almost always reflect changes in local market share. There will be online competition in the grocery business. However, in Village’s home market of New Jersey, direct to your door delivery of groceries has been available for 18 years. Peapod started offering online grocery shopping in 1996. The company was later bought by Royal Ahold. Royal Ahold owns Stop & Shop. Peapod has 4 locations in Somerset, Toms River, Wanaque, and Watchung. These locations offer grocery delivery in Village’s markets. They are direct competition and have been for years. Peapod does not require a $300 annual fee like Amazon Fresh. Instead, Peapod simply adds a delivery charge. Customers also tip the driver. Since the driver normally carries the bags into the customer’s home and puts them on the kitchen counter for the customer – the tip is usually a generous one.  Peapod charges $6.95 for orders over $100. The charge for orders under $100 is $9.95. The minimum order size is $60. Customers can also order online and then drive to one of the 4 Stop & Shops mentioned above (Peapod often uses the second floor of a building where the ground level is Stop & Shop’s retail store) and pick up their own order. Pick-up is free. However, a Peapod employee still collects the groceries and brings them to the customer’s car. So, a tip is still expected. Common tips are probably $5 to $10. So, the total cost of a Peapod home delivery order is probably anywhere from $12 to $20 higher than a trip to a Stop & Shop grocery store. Even a pick-up is probably $5 higher than a normal Stop & Shop visit – and the customer still has to drive to a store to make the pick-up.

Wakefern is a large co-op with similar scale to Stop & Shop nationally and more scale than Stop & Shop in New Jersey. Creating a retail website is easier now than it was in 1996. Therefore, it is no surprise that 87 of Shop-Rite’s 480 locations offer online shopping. In fact, online shopping is available from both Shop-Rite and Peapod in certain towns like Somerset.

This is important, because the average supermarket customer in the U.S. does not drive far to visit a location. Kroger uses a 2 to 2.5 mile radius to define its local market. Research on the opening of a new Wal-Mart found that supermarkets further than 3 miles from a new Wal-Mart saw no meaningful impact to their sales. This suggests that Wal-Mart Supercenter’s do not draw grocery customers from more than 3 miles away. So, a 2-3 mile radius is a reasonable definition of a supermarket’s local market. Convenience is the biggest hurdle for online grocery providers to clear. Amazon Fresh requires a $300 annual fee from its customers. Peapod requires a $60 minimum order.

The average grocery store visit results in a checkout of less than $60. At Shop-Rite, the average customer pays $52 at checkout. So, online grocery shopping tends to be more expensive and require larger orders than traditional brick and mortar supermarkets. Furthermore, online selection is usually inferior to the largest traditional supermarkets. For example, Peapod has a narrower selection of items on its website than it does at its retail stores – even though its online business is literally housed in actual supermarkets. This is a logistical problem caused by the difference between running a delivery business, an employee collected pick-up order, and a customer’s self-selected in store order.

Costs tend to be lowest and selection widest when a customer is forced to put their own items in their own cart by going through the store aisles themselves. Another problem with online ordering is the need for scheduling. Online grocery orders require the customer to be home at a specific time. The customer is usually given a window that can be as long as 2-3 hours during which they must be home to answer the door. Meanwhile, in store visits are always at the customer’s options. Traditional supermarkets are often open from roughly 10 a.m. to 8 p.m. seven days a week. Customers can drop into their local store at their convenience – including on the way home from work – and pick-up an order of any size. There is no scheduled time, no delivery fee, no tip, and no minimum order size. The selection is usually as wide as the company can provide.

For example, Village’s largest new store is 77,000 square feet. It includes plenty of fresh foods and prepared foods that are not sold online. So, online competition is not new to the New Jersey grocery market. And groceries are an especially tough business for online retailers to compete in.

One problem for online retailers is that all of their offline competitors have local scale. There is no such thing as a “Mom and Pop” grocery store in the U.S. Unlike hardware stores, pet stores, and book stores – the supermarket business is very locally consolidated. It would take an online retailer a long time to have scale locally. However, it would be possible for online retailers to develop bargaining power with suppliers. This is why Shop-Rite is run as a co-op.

Online retailers will continue to enter the grocery business. It is a huge market. The opportunity for growth is enormous. For example, the U.S. grocery business is probably about $600 billion a year while Amazon’s entire companywide sales are just $75 billion. Amazon could more than double its sales with just a 13% share of the nation’s grocery business. The size of the opportunity in groceries will continue to attract online and non-traditional competitors.

Non-traditional competitors are the biggest threat to Village. In the industry, “non-traditional” refers to both deep discount and high end (especially fresh and/or organic) grocery stores. In New Jersey, the high end is the area of greatest concern. The non-traditional supermarket with the store model best suited for entering New Jersey is The Fresh Market.

Local competitors that segment the market are a risk for existing supermarkets. The one-year customer retention rate in American supermarkets is probably around 70%. About 30% of customers may switch to a local competitor each year. In a Consumer Reports survey, the top reasons giving for switching were: “lower prices” and “better selection”. Shop-Rite generally has the lowest prices and widest selection in its local market. The only exception is in towns with a Wegman’s. Wegman’s has larger stores and wider selection than even the biggest Shop-Rites. As a result, Wegman’s is usually ranked #1 in customer satisfaction.

Supermarkets tend to be durable. However, there is a constant churn of locations at most companies – closing failed stores and relocating stores to better locations – that can be costly. Since a restructuring in the early 1990s, Village has not experienced any store failures. Nor has it relocated a store for any reason other than wanting to increase its size. Over the last 17 years, Village has spent just 1.7% of sales on cap-ex. Meanwhile, Kroger spent 2.7%, Safeway spent 3.0%, and Weis Markets spent 3.2%. Village’s low cap-ex advantage is entirely due to not closing stores. Because Village – as a Shop-Rite operator – has the highest sales per store of any supermarket, it also tends to be able to renew leases. Supermarkets are the “anchor” tenant at strip malls. In the last 17 years, there was only one example – in 2003 – of Village failing to sign a new lease. Village has the most durable portfolio of supermarkets of any publicly traded company. For example, in just the last 12 years, Kroger closed 21% of its starting store base. Village owns 4 stores (with 335,000 square feet of selling space) and leases 24 stores (with 1.3 million square feet of selling space). The initial term of a lease is usually 20-30 years. Many have multiple renewal options after those first 20-30 years.   

Read the Free Report on Village Supermarket

Check Out Focused Compounding


Supermarket Stocks Down: Start Your Industry Research with a Free Report on Village Supermarket (VLGEA)

by Geoff Gannon


Read the Free Report on Village Supermarket

Check Out Focused Compounding

Kroger (KR) is down 11% today. The stock’s P/E is now about 11.

Kroger is guiding for same store sales of flat to up just 1% this year. This guidance – combined with Amazon’s purchase of Whole Foods – is probably why the stock is down.

Supermarket stocks are a good area for value investors to research now.  One way to learn about the supermarket industry in the U.S. is to read the report Quan and I wrote on Village Supermarket (VLGEA) back in 2014.

That stock is now at roughly the same price – $25 a share – it was when we wrote about it.

A membership to my new site, Focused Compounding, gives you access to this report on Village Supermarket as well as 26 other stock reports just like it.

A membership to Focused Compounding costs $60 a month. If you enter the promo code “GANNON” at sign-up, you will save $10 a month forever.

Check Out Focused Compounding

Read the Full Report on Village Supermarket


The 3 Ways an Investor Can Compromise

by Geoff Gannon


GuruFocus: Pick the Winners First – Worry About Price Second

“There are 3 ways an investor can compromise:

1.    He can compromise by paying a higher price than he’d like to

2.    He can compromise by buying a lesser quality business than he’d like to

3.    He can compromise by not buying anything when he’d rather own something

You could use these 3 compromises as a test of what kind of investor you are.

A growth investor – like Phil Fisher – compromises by paying a higher price than he’d like. He won’t compromise on quality. So, he has to compromise on price. A value investor – like Ben Graham – compromises by purchasing a lower quality business than he’d like. He won’t compromise on price. So, he has to comprise on quality. Finally, a focus investor – like me – compromises by not owning any stock when he’d much rather be 100% invested.”

GuruFocus: Pick the Winners First – Worry About Price Second


I’ve Decided to Stop Deciding Which Stocks to Sell

by Geoff Gannon


Over the Last 17 Years: Have My Sell Decisions Really Added Anything?

“The stocks I pick don’t benefit much from well-timed sales. There’s usually little harm in holding on to them much, much longer than I do.

So, I’ve decided to hold the stocks I own indefinitely. When I find a really, really good stock idea – which might happen once a year – I will need to sell pieces of the stocks I already own to raise cash for that purpose. I’ll do that. So, if I’m fully invested and want to put 20% of my money into a new stock – I’ll have to sell 20% of each stock I now own. But, I’m not going to eliminate my entire position in a stock anymore. Those decisions to completely exit a specific stock haven’t added value for me. So, I’m not going to try to make them anymore.

From now on, I’m going to be a collector of stocks.”

Over the Last 17 Years: Have My Sell Decisions Really Added Anything?


Quan's Reflections on Writing the Newsletter

by Geoff Gannon


(Email)

(Focused Compounding)

Many of you may remember Quan Hoang. He wrote some blog posts here. And he co-wrote a monthly stock newsletter called The Avid Hog (later renamed Singular Diligence) with me from 2013 to 2016. During those years, Quan was my investing partner. There wasn’t a single stock idea either of us considered without discussing it with the other person. Quan stopped writing about investing to pursue an MBA in the U.S. (he’s from Vietnam). And he’s now focused on studying artificial intelligence – specifically deep learning. Quan is the clearest thinker on investing I know. Here are his “reflections” on writing a newsletter with me for 3 years:

Reflections on the Newsletter

Like I said, he’s the clearest thinker on investing I know. So, it’s a good idea to read what he writes.

(Email)

(Focused Compounding)


Get Geoff’s Take on a Stock You’re Interested In

by Geoff Gannon


(Focused Compounding)

Note: You have to be a member of the Focused Compounding community to take me up on this offer.

New Feature: Request for Research

Focused Compounding is adding a “Request for Research” feature to the site. Any member of the Focused Compounding community can now send Geoff a stock idea they’d like him to look at. Geoff will pick one stock from this idea pile each week. He will research the stock and do a full write. Geoff’s analysis will be viewable by the whole Focused Compounding community.

The stock you want to get Geoff’s thoughts on can be any size and traded anywhere in the world. There are no restrictions.

So, please send your best current stock idea to:

gannononinvesting@gmail.com

With the subject line:

Focused Compounding: Request for Research

Geoff will respond to all emails, even if time doesn’t permit him to do a full write-up of your idea.

(Focused Compounding)


The First 8 Things to Look at When Researching a Stock

by Geoff Gannon


(Focused Compounding)

The other day, someone I talk stocks with on Skype asked how I normally go about starting my initial research into a stock. What documents do I gather?

Here’s what I said:

“Basically, I start by finding the longest series of financial data I can (GuruFocus, Morningstar, whatever) and then look at that along with reading the newest 10-K and the oldest 10-K in detail. So, 10-year+ financial data summary, 20 year old 10-K (or whatever), this year's 10-K, and then the investor presentation if they have one, and the going public/spin-off documents if that's online. Also, I read the latest proxy statement and the latest 10-Q as needed for info on management, share ownership, the balance sheet etc.”

I also check the very long-term performance of the stock. So, I will chart the stock – at someplace like Google Finance – against the market over a period of 20, 30, or 40 years.

So, here’s a full list of my usual sources:

1.       Check long-term stock performance (what is the compound annual return in the stock over 20, 30, or 40 years?)

2.       Find the longest series of historical financial data possible (search for a Value Line sheet, a GuruFocus page, or go to Morningstar or QuickFS.net to see the long-term financial results)

3.       Read, highlight, and take notes on the latest 10-K (so 2016)

4.       Read, highlight, and take notes on the oldest 10-K (On EDGAR, this is usually around the year 1995)

5.       Read, highlight, and take notes on the company’s own investor presentation

6.       Read, highlight, and take notes on the IPO or spin-off documents (On EDGAR, this will be something like an S-1 or 424B1)

7.       Read, highlight, and take notes on the latest proxy statement (On EDGAR, this will be something like a DEF14A)

8.       Read, highlight, and take notes on the latest 10-Q.

 

Why Check the Long-Term Stock Performance?

This is something a lot of value investors wouldn’t think of. But, I find it very useful. Any time you are looking at a stock’s performance your choice of start date and end date are important. The good news is that your start date will be fairly arbitrary if you just look as far back as possible. So, if the stock has 27 years of history as a public company – and you look back 27 years – you probably aren’t picking a price near an unusual low point in the stock’s history. In fact, you’re probably picking the IPO price, which will rarely have seemed a “value” price at the time. The other good news is that – as a value investor – you’re probably attracted to stocks that seem cheap now. They trade at low or at least reasonable multiples of earnings, EBITDA, sales, tangible book value, etc. This means that any stock you are looking at as a possible purchase is unlikely to be benefiting right now from a particularly good choice of an end point.

Here’s an example.

If we go to Google Finance, we can see that Fossil (FOSL) has a stock price performance from 1994 through 2017 (so about 23 years) that’s a bit better than the S&P 500. You can use the data in Google Finance and combine that with a compound annual growth calculator to find the stock’s annual return was about 9% a year over the last 23 years. Does that mean Fossil created value over 23 years? Did it compound its intrinsic value faster than the average stock? That would be hard to tell if Fossil had started the period trading at a low price and now traded at a high price. However, the stock now trades at an EV/Sales ratio of 0.3. Historically, it traded around 1.5 times sales. It’s rare for a company in this kind of business to trade much below sales. So, if Fossil survives its current crisis and investors eventually warm to the stock’s future prospects – you’d expect the share price to jump at least 3 to 5 times. The stock’s $12 now. But, you’d expect it to be in the $35 to $60 range the moment investors felt sales had stopped plunging. That sounds like a big prediction to the upside – but this stock once traded at $120 a share. So, that’s still only a slight recovery of what Fossil’s market value had been.

Now, if Fossil stock was at a price 3-5 times higher than it is now, the 23 year return wouldn’t be 9% a year it’d be in the 14% a year to 17% a year range over more than 20 years. That’s a lot of value creation. In fact, if the end point had been the start of 2015 (when Fossil’s current problems hadn’t yet devastated its sales and earnings) instead of the middle of 2017, Fossil would have returned about 22% a year over more than 20 years.

So, the exact start point and end point you pick matters a lot when judging a stock’s past long-term compounding power. But, if you are looking at something that appears to be a value stock now and yet it still had returns of about 10% a year in its share price over 20, 30, 40 years or more – you’re fine. This is a business that didn’t destroy value over time. It compounded its intrinsic value as well or better than the stock market. If the stock’s future is as good as its past – and you’re buying it at a below average price – you’ll do well.

Those are two big ifs.

But, this check of the stock price performance compared with the more usual approach of looking at return on equity, return on capital, etc. over the past few decades will give you a good idea of what kind of quality business you’re dealing with. The stock performance check is especially important with conglomerates, cyclical companies, companies that issue and/or buyback a lot of stock, serial acquirers, and other corporations that are involved in a lot of financial engineering at the corporate level.

I strongly suggest checking the long-term stock performance when you’re looking at companies like: Baker Hughes (BHI) which is cyclical, Omnicom (OMC) which buys back its own stock, Textron (TXT) which is a conglomerate, and UniFirst (UNF) which acquires companies in the uniform industry.

Although it is easy to find the return on equity for these companies in any one year – it can be difficult to know what the return on investment of their various acquisitions, stock buybacks, etc. has been over a full cycle without using the long-term stock price performance as a guide.

It’s still not a perfect guide.

Remember, depending on exactly when in the last 2-3 years you checked Fossil’s stock price, you’d see long-term compound annual returns of anywhere from 9% to 22% in the stock. The important point is that you wouldn’t get a long-term compound annual return figure much below the S&P 500. So, you’d be able to assume Fossil had – historically – been an average or even an above average business. What you’re looking for here is any discrepancies where a company that seems to have an above average return on capital manages to always barely keep pace with – or even lag – the S&P 500 over the decades.

 

Why Use the Longest Series of Financial Data Possible?

The simplest reason here is that most investors don’t do this – so you should. There are figures that might be useful – like knowing what a company is expected to report in EPS next year, that have their usefulness diminished by the fact everyone else buying and selling the stock knows this figure. There are other numbers that might also be useful – which other investors aren’t looking at. You want to focus on figures that matter but are ignored by most people.

Let’s stick with the Fossil example. Knowing that Fossil’s pre-tax earnings dropped 22% in 1995, 18% in 2001, and 23% in 2005 might be useful when looking at the stock in 2015 because earnings had never declined from 2006-2014. So, at the end of 2014, a lot of investors might have only been looking at Fossil’s results from 2006-2014 (since that gives you the 5-10 years of history that many investors feel they needn’t look past). Investors may have also been looking at analyst estimates and the company’s guidance for the year ahead. I have nothing against you looking at near-term future projections. But, you should know, that probably 99% of investors are looking at projections for next year’s earnings while maybe 1% of investors are looking at historical data from further than 10 years in the past. That means the old historical data is more likely to give you an unorthodox insight into a company. And that’s what you need to be right when others are wrong.

 

Why Read the Most Recent 10-K?

As a serious value investor you know you’re supposed to do this. Everyone tells you you’re supposed to do this. You read the most recent 10-K to learn about the company as it exists today. I’m not going to waste words pushing this particular practice. If you aren’t reading 10-Ks, you should try it. They’re the most useful documents out there.

 

Why Read the Oldest 10-K?

Again, part of the reason for doing this is the same reason a lefty can have an advantage playing baseball. In absolute terms, it makes no difference if you’re left handed or right handed. Left handedness doesn’t make you a better baseball player. But, if 90% of the world is naturally right handed – being left handed makes you different. It makes you the opposite of what your opponent (the pitcher or the batter) normally faces. If trying to bat left handed makes you a worse hitter – there’s a point where you shouldn’t invest the effort in learning to do it. Likewise, if it’s a complete waste of your time to read the oldest 10-K, you shouldn’t read it. But, I don’t think it’s a waste of your time. And I know almost no one else does it. So, here’s something you can do that’s both useful and different.

Reading the oldest and newest 10-Ks one right after the other is a shortcut to understanding how the business developed and how the industry developed. You could work on studying the company’s entire history. But, that’s a huge investment of time for a stock you’re not sure you’re interested in yet. By reading the oldest annual report and the newest annual report, you get the quickest overview possible of the truly long-term history of the company. I think it’s sometimes useful. And I know it’s very rare for other investors to do this. So, if you’ve never read the oldest 10-K you can find on a company, try adding this to your regular routine.

 

Why Read the Company’s Own Investor Presentation?

This one is a bit more of a mixed bag.

There are aspects to reading this report that probably aren’t good for your understanding of the stock. One, everything in the presentation is well known by people buying and selling the stock. Two, this pitch is being made directly by the company’s management and aimed directly at people like you (potential investors).

So, it can be dangerously biased.

Those are the negatives. And they’re big negatives.

The positives are that, frankly, the investor presentation can give you the most background on a company and an industry in the shortest amount of time. If, for example, you have no idea how the frozen potato industry in the U.S. works, reading the Lamb Weston (LW) investor presentation is the quickest way to get an overview of the industry, the company’s rivals, and the company’s customers.

This is especially true for obscure industries – like frozen potatoes – where nobody writes books about the industry, none of the companies in the industry have ever had much cultural impact, and the companies just aren’t that well known by the public.

For example, you really need to read an investor presentation by Grainger (GWW), Fastenal (FAST), or MSC Industrial (MSM) to start your research into the MRO industry – because most people don’t know what the MRO industry is or how it works. It’s an invisible part of the economy.

If you don’t have much time to spend researching a stock before deciding whether or not to cross it off your list – I’d say skim at least 10 years of financial data (at someplace like GuruFocus) and read the investor presentation (on the company’s own website). That’ll take you a matter of minutes, not hours. And it’ll give you the background you need to look for the names of competitors, suppliers, and customers and to know what to look for in the 10-K. So, the investor presentation is often the best place to start your research into a company.

 

Why Read the IPO or Spin-Off Document?

This is often a very detailed report. It will have a lot of information on the industry. It is probably the single longest document on this list. Take your time. If you can work your way through a 10-K, you can work your way through an S-1, etc. Finding this document on EDGAR can sometimes be inconvenient because the company will often file a bare bones version initially and then keep amending it. Sometimes companies keep their original going public roadshow presentation on their website many years after actually going public. The same is true for spin-offs. For example, I own BWX Technologies (BWXT). Even though it is now 2017, that company keeps a 60 or so page presentation on its website that dates back to the 2015 analyst day which discussed the spin-off. Like a lot of IPO / spin-off presentations, that one takes a longer term view of the company. So, it has some discussion of how Babcock’s nuclear business evolved from the early 1990s through 2015. That’s the kind of historical information that is rarely discussed in quarterly earnings results. You’ll only find it in company presentations. Historical discussions that take a longer term view are especially common when a company goes public or is spun-off. So, an IPO or spin-off document is kind of the opposite of a quarterly earnings call transcript.

 

Why Read the Proxy Statement?

This will be the DEF14A on EDGAR. I read this just for background information on management, to understand how much control big shareholders have over the company, and to see how management is compensated.

So, I’m looking for: 1) Who the managers are 2) Who the owners are and 3) How the owners choose to compensate the managers. Incentives are part of what I’m looking for here.

For example, Grainger (GWW) has a passage in the latest DEF14A that reads:

“The 2016 Company Management Incentive Program (MIP) payout was calculated at 75% of target for all eligible employees as the Company fell short of the 2016 sales growth goal of 5.5% and the ROIC goal of 26.6%.”

So, we see that Grainger incentivizes management to hit two targets: 1) A sales growth goal and 2) A return on capital goal. The sales growth goal is modest. In a normal year, nominal GDP growth in the U.S. might be in the 4% to 6% range. So, a 5.5% sales growth target is close to a GDP type growth rate. And then the return on capital goal is aggressive. A 26.6% return on capital before taxes translates into about a 17% unleveraged return on equity. A business like Grainger can use some leverage. So, this return on capital target – if achieved – would tend to deliver a 20% or better after-tax return on equity for Grainger shareholders. There are more details about how incentive compensation is paid (in what form and when) as well as if it’s capped at some level. But, what I’ve discussed above is one of the most important parts of the proxy statement. Look for the metrics management is judged on for compensation purposes. And also look at what the specific target levels are for those metrics.

Finally, you also want to look at the ownership structure of the company. For example, the Under Armour (UA) proxy statement – this is the DEF14A – tells you that the CEO, Kevin Plank, is also the company’s founder. It tells you he has a 15% economic interest in the company and a 65% voting interest. It also tells you he’s 44 years old. Founders often make it to a retirement age of 65 or beyond. So, you this tells you that – since he has voting control of the company – Under Armour’s founder might lead the company for another 20 years or more. Minority shareholders have no say in the company, because the CEO has more than 50% of all votes. Also, we know the CEO owns about 15% of the company and UA has a market cap of around $8 billion. So, he has maybe $1.2 billion or so of his net worth in the company’s stock. His total compensation was usually in the $2 million to $4 million range over each of the last 3 years (that kind of information can be found in this same proxy). So, the performance of Under Armour stock is something like 300 times more important to Plank than his own pay. So, the proxy statement has told us: 1) This is a controlled company – your votes don’t matter 2) The company may have another 20 years to go in its founder led era and 3) The CEO’s overriding incentive is getting the best possible growth in the stock price over time.

A lot of people skip the proxy statement. But, the points I just made about Under Armour are huge. You could have another 20 years of the company being run by a founder who is something like 99% compensated as a permanent owner.

And that founder has voting control – so your votes don’t matter. Under Armour has 3 classes of stock. You can buy two of those classes. The two classes you can buy have identical economic rights but one comes with voting power and one comes with no votes. The shares with the “UAA” ticker cost $19.10 and have one vote each. The shares with the “UA” ticker cost $17.86 and have zero votes each. The proxy tells us your vote can’t matter in either case. So, you should buy “UA” shares not “UAA” shares and save yourself more than 6% of the purchase price. See, reading that proxy just made you 6% smarter. That’s why you should always read the proxy statement. You want to know: who the owners are, who the managers are, how everyone is compensated, and which class of stock is the better buy.

 

Why Read the 10-Q?

The more you know about accounting, the more you’ll get out of the 10-Q. The 10-Q is useful because it has the exact number of shares outstanding on the front of it (and, of course, this figure will be more recent than the 10-K in 3 out of 4 quarters of the year). You will want to study the balance sheet. And you’ll want to read the footnotes to the financial statements. A lot of the value in the 10-K and 10-Q comes from reading about how the company accounts for everything in the financial statements. What is amortization made up of? How quickly are they depreciating various assets? How long have they had certain assets – like land – on the books? Do they lease or own all their property? If you’re more of a Ben Graham type investor than Phil Fisher type investor – you’ll get more out of the 10-Q. Honestly, a long-term growth investor isn’t going to find anything in the last quarter to change his mind about a company. As far as sales and earnings go, it’s not necessary to check in more than once a year with the stocks you own. I’ll look at a 10-Q or even read an earnings call transcript or two if there’s been a big drop in the stock and I want to understand if the reaction from investors is appropriate given some change in the company. For example, Under Armour’s stock dropped a lot after an earnings report. The company’s sales growth has decelerated from more than 20% a year to closer to 10% a year (which is about what management is now guiding for in fiscal 2017). Recently, sales actually dropped about 1% in the U.S. So, you can read the 10-Q for Under Armour along with checking the 10-Qs of competitors like Nike (NKE) and key customers like Dick’s Sporting Goods (DKS) to try to understand exactly why sales and earnings disappointed investors, what the problem is, and whether or not it’s temporary. Other than that kind of analysis of a very recent event – the 10-Q is most useful for giving you an up to date balance sheet.

So, those are the first 8 things I look at when researching a stock. They aren’t necessarily the most important 8 things to look at. But, they are easy enough to find and important enough to give you a good foundation for understanding the business even if you never read anything else.

(Focused Compounding)


Constantly Concentrating: Why I Sold George Risk (RSKIA) and Weight Watchers (WTW)

by Geoff Gannon


I’ve gotten a lot of questions regarding my sales of Weight Watchers (WTW) and George Risk (RSKIA).

 

Interestingly, literally no one emailed me about selling Babcock & Wilcox Enterprises (BW).  

 

I’ve picked out two questions as representatives of the larger group.

 

 

Question #1: George Risk

 

“Really interested in why you decided to suddenly sell RSKIA.

 

I mean it's still obviously undervalued. You could have sold it in the beginning of 2014 for a better price than $8.40. Stocks in general were obviously cheaper at that time than they are now.

 

So logically it means you've found a better opportunity now than you could find in 2014 relative to the current price of RSKIA. That just seems really surprising to me.

 

The only logical conclusions are that you either lost patience with RSKIA, now have a different view on the risk of the markets, or really did find something better than what you could in 2013/2014.

 

If it's the latter, I can't wait to hear what it is when you decide to post it...”

 

 

 

I sold George Risk, because I am planning to buy Howden Joinery.

 

I don’t like to take positions that are smaller than 20% of my portfolio. The total amount I had available in cash, Natoco, and Weight Watchers combined was less than 20% of my portfolio. So, I sold George Risk to make room for Howden Joinery.

 

I try to only sell one stock to make room for another. The reason I hadn’t sold George Risk before is that I hadn’t found a stock I liked better than George Risk. I’ve now decided I like Howden Joinery better than George Risk.

 

Yes, I could have and should have realized this a couple years ago. I’ve known about Howden for years. Howden shares were cheaper in the past than they are now. George Risk shares were more expensive in the past than they are now. I’d have been better off if I made the swap sooner. But, it took me a while to come to this decision. I don’t own Howden yet. But, I expect to buy it soon.

 

 

Question #2: Weight Watchers

 

“With regards to your long term stake in WTW, I am just curious about the WTW sale, since WTW has announced growing subscription numbers and has Oprah as a Board Member, so things look rosier than last year.”

 

Yes. Weight Watchers is doing better now than it was in the past. Oprah Winfrey is a great spokeswoman and a good board member for WTW.

 

I didn’t sell my shares in Weight Watchers because I like the stock less now than I did last year. I sold my shares of Weight Watchers because I looked at what percent of my portfolio the stock made up and then considered whether or not I’d like to buy more.

 

Here’s what I said in a previous post:

 

“Weight Watchers, B&W Enterprises, and Natoco combined were now only about 10% of my portfolio. I had no intention of buying more of these stocks. I like individual positions to be about 20% of my portfolio. So, both Weight Watchers and B&W Enterprises had become distractions I wanted to eliminate at some point.”

 

Honestly, once I come to the realization that I’m never going to buy enough of a stock to get it up to 20% of my portfolio – I start thinking about selling that stock. I still own Natoco. It’s only about 5% of my portfolio. And I plan to sell it at some point. When I do sell Natoco, it won’t be because I don’t like the stock. It’ll be because I don’t like the stock enough to bring it up to 20% of my portfolio.

 

That’s really just how I think. If I wouldn’t want a stock to be 20% of my portfolio – then why would I want it to be any percent of my portfolio?

 

From time to time, I do own stocks that are less than 20% of my portfolio. Natoco was bought as part of a roughly 25% to 50% of my portfolio basket of Japanese stocks. When I sold out of those Japanese net-nets, nobody was willing to take the price I was asking for some of my Natoco shares. So, I kept the leftover shares rather than compromise on price. Later on, I kept holding Natoco, because I didn’t have anything I wanted to buy more of at the moment. So, it was a choice between either doing nothing and staying in Natoco or doing something and adding 5% of my portfolio to my cash balance. My bias is usually toward: 1) Inaction and 2) Holding stocks instead of cash. So, I just stayed with Natoco.

 

Once I decided I was probably going to buy Howden Joinery, I started thinking about selling George Risk, Weight Watchers, Babcock & Wilcox Enterprises, and Natoco because these positions combined were about 30% of my portfolio. I knew I’d want to put at least 20% of my portfolio into a new stock idea like Howden.

 

And I knew I don’t like holding “distractions”. I consider any stock that makes up less than 10% of my portfolio to be a distraction. When I look at a distraction, I ask myself a simple question. Would I rather have 20% of my portfolio in this stock or 0% of my portfolio in this stock? And then, I either buy more to get the stock up to 20%. Or (much more likely) I eliminate the position entirely.

 

This is something I really do. With both Weight Watchers and Babcock & Wilcox Enterprises – which are two stocks that dropped 50% or more at one point to become small positions for me – I really did ask myself whether I wanted to more than “double down” on these positions. In both case, I decided I’d rather buy a completely new stock than take positions like these from less than 10% of my portfolio up to more like 20% of my portfolio.

 

So, I sold George Risk because I decided I liked Howden Joinery more than George Risk. And I sold Weight Watchers and Babcock & Wilcox Enterprises because – in both cases – I decided I’d rather have 0% of my portfolio in each of those stocks than 20% of my portfolio in each of those stocks.

 

I could have kept them at 10% or less. But, that always feels to me like a half measure that doesn’t make much sense. I never want to “water down” a future good idea I’ll have – like Howden – because I’m still holding some ideas I maybe half-like and half-don’t like so much anymore. I’d rather ask myself: do you really want to buy more of this stock to bring it up to 20% of your portfolio? No. Then why own it at all?

 

I know that’s an unorthodox approach. I’ll also admit that on a strictly rational single case basis, it’s an incorrect approach. It’s not rational to sell something just because you aren’t willing to make it 20% of your portfolio. However, I’m always trying to find the strategy that works best for me over the long-term. And I think a habit of focusing all my efforts on holding no more than 5 ideas is one that makes sense. If I’m going to implement that policy long-term, I need to constantly eliminate positions of less than 20% in the short-term.

Talk to Geoff About Why He Sold George Risk and Weight Watchers


Sold George Risk (RSKIA)

by Geoff Gannon


Last week, I eliminated my entire position in George Risk (RSKIA).

This position was about 20% of my portfolio. It is now 0%.

My average sale price was $8.40 a share.

My average purchase price had been $4.66 a share (back in 2010).

I held the stock for about 6.5 years. So, the stock price compounded at about 9.5% a year while I held it.

George Risk also paid a dividend. The yield was rarely less than 4% a year. So, my total return in the stock was about 13% a year over my entire holding period.

My return in George Risk was not better than the return I could have gotten by simply holding the S&P 500 for the same 6.5 years.

However, the stock was cheaper than the S&P 500 when I bought it. I believe it remains cheaper than the S&P 500 today.

Right now, George Risk’s dividend yield is about 4.2%. And the stock has $6.36 a share in cash and investments versus a share price of $8.40 a share.

I didn’t sell George Risk because I no longer like the stock. Rather, I sold George Risk to make room in my portfolio for a totally new position.

I try to only buy one new stock a year. So, when I do finally buy this new position – it’ll be a big moment for me.

I’ll let you know once I’ve added the new position.

Talk to Geoff about George Risk (RSKIA)


Some Books and Websites That Have Been Taking Up My Time

by Geoff Gannon


I get a lot of questions from readers about what investing sites I use, what books I’m reading, etc.

So, here are two sites and four books I’ve been spending time with lately.

 

Websites

 

GuruFocus: Buffett/Munger Screener

I write articles for GuruFocus (click the “Articles” link at the top of the page to see all of them). So, it’s a conflict of interest to recommend premium membership to the site. What I will say is that if you are a premium member – I think the most useful part of the premium membership is the various predictable companies screens. There’s a Buffett/Munger screen, an undervalued predictable companies screen, and you can also just filter companies by predictability score (GuruFocus assigns companies 1-5 stars of predictability in 0.5 star increments). I think the best thing GuruFocus ever developed is the predictability score. And it’s a good use of your time to type in some ticker symbols and see which of those companies are high predictability, which are low, etc. Do I personally invest based on predictability? No. GuruFocus doesn’t rate BWX Technologies (BWXT) and it assigns predictability scores of 1 (the minimum) to both Frost (CFR) and George Risk (RSKIA). I have about 85% of my portfolio in those 3 companies. So, I have almost all my money in non-predictable companies according to GuruFocus. The predictability score isn’t perfect. But, for non-cyclical and non-financial stocks that have been public for 10 years or more – I think it’s a pretty good indicator. Use it like you would the Z-Score, F-Score, etc. It’s just a vital sign to check. Don’t just buy a stock because it’s predictable or eliminate it because it’s unpredictable according to GuruFocus’s automated formula.

 

Quickfs.net

I can’t vouch for the accuracy of the data on this site. But, that’s true for summary financial statements at all websites. Once I’m actually researching a stock, I do my own calculations using the company’s financial statements as shown in their past 10-Ks on EDGAR (the SEC website). What I like about Quickfs.net is that it’s simple and clean. Most websites that show you historical financial data give you way too much to look at. When you’re just typing in a ticker you heard of for the first time – which is what I use these sites for mainly – what you need is a “Value Line” type summary of the last 10 years. It shouldn’t be something you need to scroll down to see. As sites age, they get more and more complicated showing more and more financial info. You don’t need more than what Quickfs.net shows you. If you like what you see of a company at Quickfs.net then you should go to EDGAR yourself and do the work. Quickfs.net is for the first 5 minutes of research. The next hours should be done manually by you – not relying on secondary sources like Quickfs.net, GuruFocus, Morningstar, etc. None of them are a substitute for EDGAR.

 

Books

 

Deep Work: Rules for Success in a Distracted World

This is a great concept. It’s not a great book though. I recommend reading the book only because focus is probably the most important concept in all of investing. If you can focus the way the author of this book talks about – you can become an above average investor. If you can’t focus the way this author talks about – I’m not sure you can ever become an above average investor. In fact, I actually think you can’t. Focus is the foundational skill for an investor. You can teach most everything else. I’m not sure you can teach focus. But, this book tries to teach focus. So, I do recommend it. Value and Opportunity reviewed this book last year.

By the way, Value and Opportunity is a great blog. You should read it.

 

Tao of Charlie Munger

I just said “Deep Work” wasn’t a great book. That’s true. But, it’s not a bad book. This book is really, really not a good book. However, it has some great quotes from Charlie Munger in it. And, although I was disappointed by the book as I read it – I did find myself quoting the book quoting Munger in the weeks after I read it. So, the author did actually imprint some of Munger’s quotes on my psyche. I guess it’s worth $12 on Kindle for that. Don’t expect much out of this book though. Just think of it as a collection of quotes from Charlie Munger.

 

The Founder’s Mentality

This is a Chris Zook book. You might know that I’ve read all of Zook’s books. They’re basically about profitable growth. How can a business grow for a long time in a way that compounds wealth for the business’s owners at an above average rate? I’m sure that’s not how Zook would phrase it exactly. But, that’s how I approach his books. This is a good book. It’s probably my least favorite Zook book so far. But, I do recommend it to all value investors. This kind of book is very useful for buy and hold investors. For example, I was just talking to someone about Howden Joinery and I mentioned that in about 6 years the company will have fully saturated the U.K. with its namesake concept (the concept is a chain of depots for local, small builders who are renovating kitchens). The founder/CEO is also about 61 now. So, I told this person I was talking to that while I thought Howden would likely return something like 12% a year as a stock – I was only interested in viewing the stock as a 6-year commitment. In 6 years, the founder would be about retirement age and the company would be producing a lot of free cash flow it could no longer put back into its core concept (Howden depots) in its core country (the U.K.). So, I just felt that it’s possible the company’s phase of value creating growth would be over at that point. I think it’ll continue to be a durable business. But, most companies start to stray once their original concept is mature and once they move on to the second generation, third generation, etc. of management. When I invest in a growth company, I want it to be run by the founder and to still have room to roll out its core concept in its core country. I think Howden has about 6 more years of that period left in it. I’m not sure I would be able to so clearly explain my thinking on Howden if I hadn’t read this book and Zook’s other books. So, I recommend them all.

 

Global Shocks: An Investment Guide for Turbulent Markets

Now, this is actually a great book. Though I’m not sure it’s a great topic. And it’s a topic I’d recommend most value investors avoid. Full disclosure, a member of my extended family knows the author of this book. So, I actually heard about the book before it came out. It’s not a topic I would have found searching through Amazon. The topic is basically financial crises. However, it’s really focused on financial crises through the lens of monetary policy meaning especially foreign exchange and asset bubbles. It’s very useful for value investors to hunt in countries that have been devastated by these sorts of crises. It’s also useful to avoid countries that may be in bubbles. I would recommend this book with a caveat. Most value investors I talk to are already way too worried about things like the overall price of the stock market, whether a country is in an asset bubble, foreign exchange rate levels, etc. I started investing as a teenager in the late 1990s. So, I went through years like 1999-2001 and 2007-2009. Even when the stock market is overvalued, you can find stuff to do. The market is clearly overvalued now. And yet I hope to add a new stock to my portfolio later this year. I think it’s good to understand these things. But, I also think it’s good to be practical about it. If you’re a value investor and a stock picker – you should be capable of both believing that a market is overvalued and also believing that it isn’t pointless to keep reading 10-Ks, looking through spin-offs, etc. day after day. Hope is having something to do. And there’s always something for a stock picker to do. So, I recommend the book. But, I also recommend staying focused on individual stocks rather than macro-concerns. If you know you’re the kind of person who tends to get overwhelmed – don’t read this book. For everyone else, it’s an interesting read. Some people think it’s dry. I don’t. It helps if you’re interested in financial history. There’s a lot of (recent) financial history in this book.

Ask Geoff a question.

 

 

 

 

 

 


When Picking Stocks: Can Snap Decisions Ever Be Good Decisions?

by Geoff Gannon


"...if you’re an experienced investor, you’re going to be instantly attracted to the best ideas you have within the first hour of hearing about them. That’s just how it happens. Good ideas are simple. They’re obvious. You know them when you see them. It happens really fast. That doesn’t sound prudent and full of the kind of due diligence we’re told we’re supposed to practice, but it’s the truth. A great investment is usually something you fall in love with the day you first find it."


The Difference Between “Moat” and “Durability”

by Geoff Gannon


Someone emailed me this question:

"Am I correct in assuming that when you discuss durability, you are referring to the ongoing need or want for an industry’s products or services, whereas when you discuss moat, you are referring to the competitive positioning of an individual company within its industry?"

Yes. Exactly. Durability is about the product and the product economics of the industry. Moat is the ability of the specific company to sell more of the product and have better product economics than competitors.

In Michael Porter's approach: moat limits rivalry between firms.

And durability is about the relationship between the customers and the firm we are looking at.

So, Corticeira Amorim (Amorim Cork) in Portugal may have low durability and a wide moat at the same time, because it has advantages in the production and especially the distribution of cork compared to other firms. However, there are substitutes for cork including synthetic products and screw tops. Societal shifts in the acceptance of these ways of enclosing a wine bottle would mean that Amorim might not have very good durability.

On the other hand, a company like McCormick (MKC) has perfect durability. McCormick sells a variety of spices. Spices have been part of the food that even households that aren't very rich have used for well over 2,000 years and they have been used all over the world. It isn't anything cultural that determines the desire for spices. The spices used may change a little but people all over the world will always want to add spices to their meals. Whether McCormick will always be a leader in spices is a different question. But, 2,000 years from today people will be spicing the food they eat. I'm not a hundred percent sure people will be corking wine even just 20 years from now.

Sanderson Farms (SAFM) is another good example of the distinction between durability and moat. The durability of chicken is excellent. There are only a handful of domesticated animals that have been as selectively bred and extensively used as meat - mainly cattle and pigs - throughout human history. The product economics of processing chicken are also fine, you can earn a decent ROE doing it. I also think chicken should continue to be a cheaper protein than other alternatives. So, while I can't guarantee humans will be eating chicken in 2,000 years - I'm sure they'll be eating about as much or more chicken in 20 years. And I wouldn't be surprised if people are still eating more chicken than almost any other meat even 50, 100, or 200 years from now. So, I think the durability of SAFM's product and the business model - the things the firm actually does day-to-day - are both durable in terms of providing value for customers. The question is rivalry between firms. Fifteen years from today, someone will be doing what Sanderson is doing. But, how much profit will the firms that process chicken actually make? That's why I compare it to airlines. Airlines will be around in 20 years. It's not hard to guess how many passengers will be flying in 2037 within the United States. It may, however, be hard to know how much the major carriers will make in profit per passenger.

From a discounted cash flow perspective, it isn't very important what earnings will be far into the future. If you are buying a tradeable, liquid asset like a stock and you are expecting a fairly high return on your money (I try to stay in cash till I find something I expect to compound at 10% a year) you don't really need to worry about 50 or 100 years. I'd say that the clarity with which you can see the next 5-15 years is what matters. A lot of investors and analysts are looking out at years 1-4. But, if you can find situations where the durability 5-15 years out and the moat 5-15 years out looks good - you'll do fine. So, from an intrinsic value perspective - I'd say that both McCormick and Sanderson have high enough durability (in spices and chicken) that risks to durability don't need to factor into your investment analysis at all. I would say that Amorim Cork has enough risks to durability that you should factor those risks to the durability of cork as a product and the cork industry in general into your calculation of the price you’d be willing to pay for Amorim stock.

Here are some examples of how I'd classify durability.

 

ZERO RISK TO DURABILITY (nothing about the product is going to change in the next 15 years)

* Sanderson Farms (SAFM) - Chicken

* McCormick (MKC) - Spices

* Omnicom (OMC) – Advertising

 

SOME RISK TO DURABILITY (something about the product may change in the next 5-15 years)

* Progressive (PGR) - Car insurance

* Corticeira Amorim - Wine corks

* Village Supermarket (VLGEA) - Offline groceries

 

BIG RISK TO DURABILITY (something about the product may change in the next 5 years)

* Fossil (FOSL) - Watches

* Teradata (TDC) - Data warehouses

* Wal-Mart (WMT) - Offline general retail

 

What I said above doesn't deal with moat. For example, I would put Costco (COST) in the "low durability" category and yet also in the "wide moat" category. Costco has a strong competitive position. However, offline retail has serious risks to durability within even just the next 5 years. On the other hand, there are plenty of commodity type products (like steel) that have high durability as a product and yet no moat at all for many of the individual firms.

I think you can keep this fairly simple.

Durability: Will customers still value this product as much in 5 years, 15 years?

Moat: Will the company’s competitive position versus its rivals be as strong in 5 years, 15 years?

If you aren’t sure about either of these statements over the next 5 years, don’t buy the stock.

If you aren’t sure about either of these statements over the next 5-15 years, you need to seriously consider whether this is the kind of business you want to own and how cheaply you need the stock to be selling for.

If are sure about both of these statements over the next 15 years, you’re fine. To buy Apple (AAPL), you need to be sure of the durability of smartphones generally and the Apple iPhone specifically through 2032. Beyond that, it’s okay if you don’t know what the future will be. But, if you have any uncertainty about the durability of smartphones or the moat around the iPhone between now and 2022 – you really can’t buy the stock. Risks to moat or durability that could manifest themselves within the next 5 years are what cause losses in a stock.

Ask Geoff a question.