How to CLOSELY Read the "Competition" Section of a 10-K

by Geoff Gannon


In the most recent podcast, Andrew said: “There are some people I’ve spoken to who have said you’re not really going to find a lot of gems out of 10-Ks.”

I disagree. Reading a company’s 10-K is the most important thing I do. And once I’ve finished reading a 10-K, I’m usually more than 50% of the way to making an investment decision.

 

At the Risk of Sounding Heartless…

To understand what I get out of a 10-K we need to talk a little bit about my single-minded view of what makes a good business and what makes a bad business.

To me, a good business is a business with market power and a bad business is a business without market power. In what I think is the most important article I ever wrote I defined market power as:

“Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.”

This is similar to the Warren Buffett quote I started that article with:

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

So, when I sit down to read a 10-K I’m focused on one thing above all else: does this business have market power?

 

The Competition Section

The most important section of a 10-K is the part entitled “Competition”. It is a sub-heading under “Item I. Business”. So, it is always close to the beginning of the 10-K.

If you’re only going to read one section of the 10-K it should be “Item I. Business”. And, if you are only going to read one sub-heading it should be “Competition”. The “Competition” section of the 10-K is really short. So, I thought the best way to talk about it is simply to quote from actual 10-Ks and show you how I’d interpret the language these companies use.

 

The Standard Passage – High Competition Industries

Here is an example from the Zoe’s Kitchen (ZOES) 10-K. Zoe’s Kitchen is a fast casual (higher priced fast food) restaurant operator in the U.S. I am quoting the “Competition” section in its entirety:

“We compete in the restaurant industry, primarily in the fast-casual segment but also with restaurants in other segments. We face significant competition from a wide variety of restaurants, grocery stores and other outlets on a national, regional and local level. We believe that we compete primarily based on product quality, restaurant concept, ambiance, service, location, convenience, value perception and price. Our competition continues to intensify as competitors increase the breadth and depth of their product offerings and open new restaurants. Additionally, we compete with local and national fast-casual restaurant concepts, specialty restaurants and other retail concepts for prime restaurant locations.”

Zoe’s Kitchen is missing a line of boilerplate that is common in 10-K’s and looks something like this:

“…many of our competitors have significantly more financial and other resources than we possess”.

That exact line appears in the iRobot (IRBT) 10-K. However, a line very much like it appears in probably most 10-Ks out there.

 

The Altered Passage – Lower Competition Industries

We’ll now look at how far the competition section of some 10-Ks departs from the standard passage (of which Zoe’s Kitchen is a good example).

 

BWX Technologies (BWXT)

“Nuclear Operations. We have specialized technical capabilities that have allowed us to be a valued supplier of nuclear components and fuel for the U.S. Government’s naval nuclear fleet since the 1950s. Because of the technical and regulatory standards required to meet U.S. Government contracting requirements for nuclear components and the barriers to entry present in this type of environment, competition in this segment is limited. The primary bases of limited competition for this segment are price, high capital investment, technical capabilities, high regulatory licensing costs and quality of products and services.”

This company is not subtle about their market leadership (they are the monopoly provider). They come right out and say “competition in this segment is limited”. In fact, that term is repeated. Repetition of the term “limited competition” is incredibly rare in 10-Ks. You almost never see that.

 

U.S. Lime (USLM)

“The lime industry is highly regionalized and competitive, with price, quality, ability to meet customer demands and specifications, proximity to customers, personal relationships and timeliness of deliveries being the prime competitive factors…The lime industry is characterized by high barriers to entry, including: the scarcity of high‑quality limestone deposits on which the required zoning and permitting for extraction can be obtained; the need for lime plants and facilities to be located close to markets, paved roads and railroad networks to enable cost‑effective production and distribution; clean air and anti‑pollution regulations, including those related to greenhouse gas emissions, which make it more difficult to obtain permitting for new sources of emissions, such as lime kilns; and the high capital cost of the plants and facilities. These considerations reinforce the premium value of operations having permitted, long‑term, high‑quality limestone reserves and good locations and transportation relative to markets.”

U.S. Lime is more subtle about the low levels of competition in this industry. However, it does – like BWX Technologies – use the term “barriers to entry” which is often the way a U.S. public company will suggest it operates in a less competitive industry. Note also that BWXT and USLM include items like “high regulatory licensing costs” and “clean air and anti-pollution regulations” along with the word “permitted” to stress the ways that government regulations make it harder for new competitors to catch up to the established players.

It’s also common for a company to present information suggesting competition is limited in a way that sounds unfavorable to the company rather than favorable. For example, later in this competition section, USLM says:

“Consolidation in the lime industry has left the three largest companies accounting for more than two‑thirds of North American production capacity. In addition to the consolidations, and often in conjunction with them, many lime producers have undergone modernization and expansion and development projects to upgrade their processing equipment in an effort to improve operating efficiency.”

You have to read between the lines (micro-economically) to understand just what this means. If, over time, fewer and fewer companies operating fewer and fewer sites are supplying the nation with the same amount of lime – we can guess that two things are happening. One, the economics of each site in terms of cost is getting better (they are producing at greater scale). Two, the rivalry each site faces is decreasing. Obviously, if you decrease the number of points of distribution without increasing the deliverable distance – some customers end up with fewer potential suppliers being within a deliverable distance.

Here, it’s helpful to know that lime doesn’t get shipped very far. All you have to do is read the 10-K to know that. It’s mentioned directly here:

“Lime and limestone products are transported by truck and rail to customers generally within a radius of 400 miles of each of the Company’s plants.”

And then, if you go back and closely read the part of U.S. Lime’s 10-K I already showed you paying special attention to any mention of location, you’ll notice indirect references to a small delivery zone:

“The lime industry is highly regionalized and competitive, with price, quality, ability to meet customer demands and specifications, proximity to customers, personal relationships and timeliness of deliveries being the prime competitive factors…high barriers to entry, including…the need for lime plants and facilities to be located close to markets, paved roads and railroad networks to enable cost‑effective production and distribution…”

 

Fair Isaac (FICO)

“In this segment, we compete with both outside suppliers and in-house analytics departments for scoring business. Primary competitors among outside suppliers of scoring models are the three major credit reporting agencies in the U.S. and Canada, which are also our partners in offering our scoring solutions, Experian, TransUnion and TransUnion International, Equifax, and VantageScore (a joint venture entity established by the major U.S. credit reporting agencies). Additional competitors include CRIF and other credit reporting agencies outside the U.S., and other data providers like LexisNexis and ChoicePoint, some of which also represent FICO partners.”

This is a tough one. FICO scores are the industry standard for credit decisions in the U.S. If Windows was a monopoly in the desktop era, FICO is a monopoly. However, the company is very indirect about this in its 10-K. You can still find some really, really strong hints in the 10-K that FICO doesn’t face much competition. But, you’ll have to read closely to find these.

I’ll break down some of the tricks for doing that now.

 

Trick #1 – FICO is side-stepping a discussion of direct competition with rivals and instead discussing the potential for clients to be rivals in some situations. This is a huge tip-off that the industry is not competitive. When a company tells you competition is generally due to “in-housing”, it’s probably not a competitive industry. Read the passage again, paying special attention to my bolding:

“In this segment, we compete with both outside suppliers and in-house analytics departments for scoring business. Primary competitors among outside suppliers of scoring models are the three major credit reporting agencies in the U.S. and Canada, which are also our partners in offering our scoring solutions, Experian, TransUnion and TransUnion International, Equifax, and VantageScore (a joint venture entity established by the major U.S. credit reporting agencies). Additional competitors include CRIF and other credit reporting agencies outside the U.S., and other data providers like LexisNexis and ChoicePoint, some of which also represent FICO partners.”

Here, we see that FICO dodges the normal question of competition. They are offering an answer that basically consists of: some of the end users of credit scores use in-house analytics instead of paying for outside scores like ours (this is the equivalent of Campbell’s Soup saying they compete with people making soup from scratch) and some of the sellers of our product also compete with us by trying to cut-out the need for our product.

Both of these are legitimate concerns. They reduce FICO’s addressable market. And VantageScore can be considered a real competitor. However, the fact that a competing credit score system was created as a joint-venture by FICO’s biggest customers is a strong hint that FICO doesn’t face direct rivals. What I’m saying is: VantageScore was created because FICO’s customers thought FICO had too much market power.

Trick #2 – FICO does give you little snippets elsewhere in the 10-K – just not in the competition section – that strongly hints it’s a monopoly or something very close to a monopoly:

“Our FICO Scores are used in the majority of U.S. credit decisions, by nearly all of the major banks, credit card organizations, mortgage lenders and auto loan originators.”

So, almost everyone who could be a customer is a customer – and customers use FICO more often than they use something else. While this doesn’t directly tell you much about competition, it does tell you that any competitor has to have less market share than FICO and has to be competing by trying to get organizations that already use FICO scores to shift some of their business to the competitor.

“End users of our products include 98 of the 100 largest financial institutions in the U.S., and two-thirds of the largest 100 banks in the world. Our clients also include more than 700 insurers, including nine of the top ten U.S. property and casualty insurers; more than 400 retailers and general merchandisers, including more than one-third of the top 100 U.S. retailers; more than 150 government or public agencies; and more than 150 healthcare and pharmaceuticals companies, including seven of the world’s top ten pharmaceuticals companies. All of the top ten companies on the 2017 Fortune 500 list use FICO’s solutions. In addition, our consumer services are marketed to an estimated 200 million U.S. consumers whose credit relationships are reported to the three major U.S. credit reporting agencies.”

Again, FICO doesn’t come out and say we are the dominant provider of credit scores in the United States. However, a reader of the 10-K would certainly come to that conclusion.

 

Landauer (LDR) – Recently Acquired

Here’s another example of a company that quickly moves from discussing direct competition from rivals to talking about “in-housing”:

“In the U.S., the Company competes against a number of dosimetry service providers. One of these providers is a division of Mirion Technologies, Inc., a significant competitor with substantial resources. Other competitors in the U.S. that provide dosimetry services tend to be smaller companies, some of which operate on a regional basis. Most government agencies in the U.S., such as the Department of Energy and Department of Defense, have their own in-house radiation measurement services, as do many large private nuclear power plants. Outside of the U.S., radiation measurement activities are conducted by a combination of private entities and government agencies. The Company competes on the basis of advanced technologies, competent execution of these technologies, the quality, reliability and price of its services, and its prompt and responsive performance. The Company’s InLight dosimetry system competes with other dosimetry systems based on the technical advantages of OSL methods combined with an integrated systems approach featuring comprehensive software, automation and value. Changing market demand for combining active and passive dosimetry will be redefining the competition and the opportunities going forward.”

Nothing here suggest Landauer enjoys as much market power as FICO. However, take this passage and put it side-by-side with the Zoe’s Kitchen passage. If you had to guess which company had more market power, you’d guess Landauer.

Now, we move on to a really tough topic. Sometimes, there are good businesses where the 10-K will tell you the industry is highly competitive. Let’s look at advertising.

 

Omnicom (OMC)

“We operate in a highly competitive industry. Key competitive considerations for retaining existing clients and winning new clients include our ability to develop solutions that meet client needs in a rapidly changing environment, the quality and effectiveness of our services and our ability to serve clients efficiently, particularly large multinational clients, on a broad geographic basis. While many of our client relationships are long-standing, from time to time clients put their advertising, marketing and corporate communications business up for competitive review. We have won and lost accounts as a result of these reviews. To the extent that we are not able to remain competitive or retain key clients, our revenue may be adversely affected, which could have a material adverse effect on our business, results of operations and financial position.”

I admit you have to read this one really closely to notice the ways in which an ad agency might actually have market power. You’ve seen a lot of these 10-K quotes on competition by now. So, take a second. Can you guess the three hints I’m going to say suggest advertising might not be as intensely competitive as something like the restaurant industry?

One, Omnicom says: “while many of our client relationships are long-standing”. Two, Omnicom says “…from time to time clients put their advertising, marketing, and corporate communications business up for competitive review.” Note, this means business in this industry is only up for periodic review. And three: when Omnicom lists “key competitive considerations for retaining existing clients” it doesn’t mention the price of its services.

This is a huge hint. When reading the competition section of a 10-K, you want to give special attention to the use of the word “price”. How often is the word “price” used? Where in the order of competitive considerations does it appear? How much emphasis does the company give to the importance of being price competitive?

 

Interpublic (IPG)

“The advertising and marketing communications business is highly competitive. Our agencies and media services compete with other agencies and other providers of creative, marketing or media services, to maintain existing client relationships and to win new business. Our competitors include not only other large multinational advertising and marketing communications companies, but also smaller entities that operate in local or regional markets as well as new forms of market participants. The client’s perception of the quality of our agencies’ creative work and its relationships with key personnel at the Company or our agencies are important factors that affect our competitive position. An agency’s ability to serve clients, particularly large international clients, on a broad geographic basis and across a range of services may also be an important competitive consideration. On the other hand, because an agency’s principal asset is its people, freedom of entry into the industry is almost unlimited, and a small agency is, on occasion, able to take all or some portion of a client’s account from a much larger competitor.”

Note that neither Interpublic nor Omnicom lists price as an important competitive factor. Whenever you find an industry where price is not listed as a competitive factor, you want to explore it further.

 

Tandy Leather Factory (TLF)

Here is a company that mentions price. So, price is important. But, it also makes it clear their relative market share is high:

Most of our competition comes in the form of small, independently-owned retailers who in most cases are also our customers. We estimate that there are a few hundred of these small independent stores in the United States and Canada. We compete on price, availability of merchandise, and delivery time. While there is competition in connection with a number of our products, to our knowledge there is no direct competition affecting our entire product line. Our large size relative to most competitors gives us the advantage of being able to purchase large volumes and stock a full range of products in our stores.”

That’s just a few lines in the 10-K of a micro-cap company. I’d consider it a gem of a research discovery. And it takes 30 seconds of your time to read the competition section of TLF’s 10-K. What I just quoted to you is the entire competition section for the company.

 

Breeze-Eastern (BZC) – Recently Acquired

Interestingly, simple micro-cap companies are often more blunt about their competitive position than big companies. Here is the competition section of Breeze-Eastern in its entirety:

“We compete in some markets with the hoist and winch business unit of the Goodrich Corporation, which was acquired by United Technologies in calendar 2012, and is part of a larger corporation that has substantially greater financial and technical resources than us. United Technologies is also our second-largest customer. We also compete in some markets for cargo hooks with Onboard Systems. Generally, competitive factors include design capabilities, product performance, delivery, and price. Our ability to compete successfully in these markets depends on our ability to develop and apply technological innovations and to expand our customer base and product lines. Technological innovation, development, and application requires significant investment and capital expenditures. While we make each investment with the intent of getting a good financial return, in some cases we may not fully recover the full investment through future sales of products or services.”

By now, you know what parts of that passage I’m going to bold:

“We compete in some markets with the hoist and winch business unit of the Goodrich Corporation, which was acquired by United Technologies in calendar 2012, and is part of a larger corporation that has substantially greater financial and technical resources than us. United Technologies is also our second-largest customer. We also compete in some markets for cargo hooks with Onboard Systems. Generally, competitive factors include design capabilities, product performance, delivery, and price. Our ability to compete successfully in these markets depends on our ability to develop and apply technological innovations and to expand our customer base and product lines. Technological innovation, development, and application requires significant investment and capital expenditures. While we make each investment with the intent of getting a good financial return, in some cases we may not fully recover the full investment through future sales of products or services.”

Also, notice the company did not say the industry was “fragmented”, “highly competitive”, etc. In fact, it names only one competitor in each of the markets it talks about (rescue hoists and cargo hooks). So, it may be telling you it competes in duopoly markets. Note: there is zero mention of “smaller competitors” or anything like that. The only competitors mentioned are mentioned by name. That sometimes suggests a duopoly or oligopoly.

There is one point here that you’d have to read really, really closely to catch. As recently as 2015, United Technologies (UTX) owned a helicopter company (Sikorsky). Those helicopters had traditionally been outfitted with Breeze-Eastern rescue hoists. After United Technologies acquired a competing supplier of rescue hoists (Goodrich), it didn’t stop using Breeze-Eastern hoists. This could mean United Technologies has a policy of having each of its subsidiaries managed separately without any prodding from headquarters to make use of synergies from purchasing inside the same corporate umbrella. Or, it could mean there’s some reason why helicopter models that were already using a particular rescue hoist supplier wouldn’t want to switch suppliers – even if the alternate supplier was an internal corporate source.

That’s the kind of thing you’d want to follow-up on.

But, the 10-K is the starting point. And to get off to the right start you have to read it very closely.

I read a print out of the 10-K. I take notes by writing directly on my printed copy of the 10-K. This helps me read the important section closely. You might want to consider doing the same.

You can learn more about Geoff Gannon by emailing him: gannononinvesting@gmail.com, following him on Twitter: @GeoffGannon, or listening to his podcast. His stock specific write-ups appear on a subscriber supported website: Focused Compounding


Being (Conservatively) Roughly Right

by Geoff Gannon


The latest podcast episode is 20 minutes all about Frost (CFR). Frost is a stock I own. And it’s a stock I wrote something like a 10,000 word report about a few years ago (the report is available on the Focused Compounding member site). I was also interviewed at length about this stock last year. So, you’d think that I would have all my facts exactly straight when Andrew and I recorded the Frost podcast.

Our podcasts are recorded without notes. I don’t know what questions Andrew is going to ask ahead of time. And he doesn’t go back and edit them later. We don’t re-record anything. So, what you hear in that podcast is 20 minutes of me talking “on the spot” about Frost. The only things I’m able to say are things that come immediately to mind. So, the facts you hear me reel off are the ones I’ve repeated in my mind over and over again when thinking about this stock. The stuff I get wrong is the stuff I don’t thinks is very important.

I make several factual errors in that podcast. And I think that’s instructive. I put 25% of my portfolio into this stock a few years ago. And I continue to have about 25% of my portfolio in the stock today.

Yet, I say several things in that podcast that simply aren’t true. For example, I say that Frost doesn’t do consumer lending. If we take a look at the company’s most recent 10-K, we can see I’m wrong about that:

 

The bank makes consumer loans. As you can see, consumer real estate plus “consumer and other” is 12% of the bank’s loan portfolio. This is barely more than energy loans (11.4%) and much less than commercial real estate loans (40.2%). Business loans of some kind are about 88% of the bank’s loan portfolio. Furthermore, the bank’s loan portfolio is only about 40% of its total assets. The securities Frost buys are usually not consumer related – for example, they have just 6% of their bonds in mortgage backed securities. State and local government bonds are 65% of the portfolio and U.S. Treasuries are 29% of the portfolio. The bank has about 40% of its assets in loans and about 40% of its assets in bonds. So, it has maybe 5% of assets in consumer loans (11.4% times 0.4 equals 4.6%) and maybe 3% of its assets in consumer backed mortgages (6% times 0.4 equals 2.4%). In other words, Frost has about 93% of its assets in things tied to businesses and governments rather than households. In my mind this simplified to “Frost doesn’t do consumer lending”. I did, however, remember that what consumer lending the bank did was made up in large part by home equity loans.

Obviously, I didn’t think it was worth spending any time thinking about Frost’s consumer loans or its mortgage backed securities. And, I think I’m right about that. Close to 90% of Frost’s loans are not consumer loans and close to 60% of Frost’s assets are not loans at all. To me, this meant I should focus all my analysis of Frost’s assets on just two categories: business loans and government bonds.

During the podcast, Andrew also asked me if Frost buys back stock. And I said “no”. Here is a passage from the company’s most recent 10-K proving it does buy back stock:

“On October 24, 2017, our board of directors authorized a $150.0 million stock repurchase program, allowing us to repurchase shares of our common stock over a two-year period from time to time at various prices in the open market or through private transactions. No shares were repurchased under this plan during 2017. Under prior plans, we repurchased 1,134,966 shares at a total cost of $100.0 million during 2017 and 1,485,493 shares at a total cost of $100.0 million during 2015.”

So, why did I say Frost doesn’t buy back stock. Here is the company’s shares outstanding at the end of each of the last 5 years.

2013: 61.1 million

2014: 63.0 million

2015: 63.5 million

2016: 63.0 million

2017: 64.7 million

To me, if there’s a trend there it’s a trend toward a rising share count rather than a falling share count. Compare the above trend to the share count at Omnicom (OMC), a company I often use as an example of a constant buyer back of its own shares.

2012: 262.0 million

2013: 257.6 million

2014: 246.7 million

2015: 239.7 million

2016: 234.7 million

To me, Omnicom buys back stock and Frost doesn’t. So, in my analysis of Frost I never really thought about stock buybacks. I did, however, (as I mentioned in the podcast) think a little about Frost using its own shares to acquire other Texas banks.

Finally, let’s talk about valuation in terms of being “roughly right” or not. Near the end of the podcast, you can hear me say that “at a price of about $100 a share, Frost stock is probably trading for about two-thirds of what it’s worth”.

Someone who listened to that podcast about Frost and had done their own updated valuation of the company using the same methodology I did in my original report pointed out that I seemed to be saying Frost now has an intrinsic value of $150 a share – when the numbers (using my own methods) say it has an intrinsic value of $185.

Here is the email in full:

While listening to the Frost podcast you and Andrew put up, I was surprised to hear you say you thought the stock's value was around $150 per share (what you said was that at $100 it is trading at 2/3 of value). 

Did you change your valuation approach from the time you did your Singular Diligence research report? At the time you valued CFR by taking 20x after-tax earnings, which was calculated as 2.65% x earnings asset x .65. 

If I apply that formula now, I take the recent earning assets 29,574 x 0.0265 and get 784 of pre-tax owner earnings. Since the federal tax rate was cut to 21, I think it makes sense to use no higher than a 25% tax rate, which gives us 588 of after tax earnings. Multiply that x 20 and we get a business value of 11,760. Divide that by 63.7m shares and we get a value of $185. 

While not radically different than $150, it is almost 25% higher, which represents a materially higher margin of safety relative to the current price the stock is trading.

Did your change your valuation approach, and if so, what was your thought process?”

 

The answer is that I didn’t change my valuation approach. I was just saying that – looking at the way I look at Frost – you’re still able to get a dollar for 65 cents if you pay the current stock price. Why did I say it this way?

Well, there are several reasons. One, we record the podcast episodes before we air them (obviously). Sometimes, we might be recording an episode a couple weeks before the episode airs. When you’re listening the podcast, a stock I thought was trading at $100 could now be at $90 or $100.

Then we have the discount rate issue. So, when we appraise a stock we have to pick some way of deciding what we mean when we say it’s “worth” such and such an intrinsic value. My approach to being “roughly right” rather than precisely wrong with bank stocks is to assume you always have to value a bank as if the Fed Funds Rate is now normal. When I first appraised Frost, the Fed Funds Rate was between 0% and 0.25%. A “normal” Fed Funds Rate is – in my view – more like 3% to 4%. Now, obviously, if the Fed Funds Rate is 0% when I’m writing the report it’s not going to be 3% or 4% next year.

If rates rose shockingly fast, a stock I bought at $47 a share would probably trade at $200 a share in less than 5 years. My return in the stock would be something like 32% a year.

I knew that was unlikely. If rates rose incredibly slowly, my annual return in the stock could get dragged down to something like 16% a year (if it took rates almost 10 years to get to where I thought they should be).

And then you have the issue that rates might never rise. If rates never rose – the Fed Funds Rate literally stayed at 0.25% or less from the time I first wrote this report – it’s possible my return in the stock could be as low as 8% a year.

So, the timing of rate increases could alter my annual return expectation from 32% a year (fast), to 16% a year (slow), down to 8% a year (never).

How do you discount for this kind of timing issue?

Honestly, it’s almost impossible. For example, earning 8% a year sounds less than stellar. However, what would be a normal “discount” rate if the Fed Funds Rate literally never rose above 0.25% a year. This stock would – in the bad scenario – be returning 7.75% more than idle funds left at the Fed. In a normal year, that’s a perfectly decent return for a stock. Meanwhile, if the Fed Funds Rate rose quickly and ever got as high as 4% a year – well, that could mean that yields on all sorts of securities were a lot more attractive. Stock prices might be falling (earnings yields rising). The correct discount rate to use in adjusting my appraisal value for the stock would then be pretty high.

I don’t do a discounted cash flow analysis when appraising a stock. But, I am aware – and adjusting for – the fact that some economic assets (like a bank’s deposits) won’t be earning a lot of money till later years. Deposits have to be worth somewhat less to the extent you can’t lend them out at decent rates right now.

But, how much less?

It’s very hard to fix these problems. I didn’t try. Instead, I calculated my appraisal value using a normal Fed Funds Rate and then I did math on how much you’d have in capital gains if it took 5 years, 10 years, or 15 years to reach that Fed Funds Rate. I also asked – what if the Fed Funds Rate never rises? The conclusion I came to was that at $47 a share, the stock seemed likely to be priced to return no less than 8% a year even if rates never rose and yet more than 20% a year if rates rose quickly. I didn’t even bother calculating exactly how much more than 20% a year you’d make under the “good” scenario as far as timing. If you calculate a stock might return more than 20% a year while you own it – don’t worry about how much more than 20% a year it might return, instead worry about how realistic that scenario really is. I didn’t think the 20% a year return scenario was any less realistic than the 8% a year return scenario (the one where the Fed Funds Rate never rises). That was good enough for me. A stock where you’re as likely to make more than 20% a year as less than 8% a year is a good bet.

This is what I mean about being roughly right.

Assumptions about the Fed Funds Rate’s eventual “normal” level and how quick it would get there were important. So, are assumptions about the correct discount rate – basically, what your opportunity cost is in the stock. For example, if I really thought my returns would be in the 8% a year to 20% a year range, the next question would be how well did I expect the stock market to do while I held the stock. That’s a quick – though inaccurate, in my case – way of ballparking your opportunity cost. For me, I didn’t expect the market to do even 8% a year long-term. So, the stock looked pretty good on that basis.

But, there are tons of other assumptions that went into the original appraisal price I put in that report. Several of these assumptions are wrong – and a few are intentionally wrong. Take the tax rate. Frost hasn’t always paid a 35% tax rate even before the recent tax bill was passed. Like that email said, the bank probably won’t pay much more than a 25% tax rate in the future. My appraisal used a 35% tax rate even when I knew the bank was more likely to pay less than 35% than more than 35%. I intentionally used too high a tax rate.

I also used questionable – but, I hope conservative – approaches to charge-offs. Frost has recently had maybe something like 45% of interest-bearing assets in loans and 45% in bonds and then another 10% or so parked in some kind of cash (like with the Fed). That was about what the situation looked like when I was calculating Frost’ earning power.

Here’s the thing: I applied the bank’s historical charge-off rates on loans to all of its earning assets. If you read the Frost report carefully, you can see I applied a 0.48% charge-off rate to all “earning assets”. Well, Frost might normally have 45% in loans with a charge-off rate of 0.48%. But, then it might have 30% in Texas state bonds and 15% in U.S. Treasury bonds and maybe 10% in some kind of cash. It’s reasonable to assume the bank will lose $1 a year for every $200 it lends out. But, is it reasonable to assume you will lose $1 a year for every $200 worth of Texas State obligations, U.S. Federal obligations, or money parked at the Fed you have?

Probably not. But, the stock still looked attractive even if you did make those assumptions. And, I could never be sure what the mix of these assets would be in “normal” times. In a huge boom, Frost might eventually lend out 70% of its deposits instead of more like 40%. It’s never going to lend out 100%. But, if you penalize the bank with charge-offs as if it is lending out 100% and the investment case still holds up, that’s a good sign.

So, there we were conservative. I’d say we were wrong to do it that way. But, it would be pretty involved explaining just how wrong we were. The important part is that I know the report erred on the side of conservatism in that case. We assumed more stuff would be subject to charge-offs than really will be.

What about the charge-off rate assumption itself?

This one is super tricky. And it points out why you want to try to be “roughly right” in the sense of a little conservative but still reasonable – instead of precisely wrong. The typical methods for coming up with a charge-off rate assumption would risk not looking far enough back in time.

So, in the 20 years prior to when I wrote the report on Frost the bank averaged a charge-off rate of 0.27%. That’s the charge-off rate from 1994-2014. It would seem reasonable to use that charge-off rate. But, I wasn’t so sure. Yes, 20 years is a long-term average. But, there’s two problems there. One, you only had 2 recessions in those 20 years. One was deep (2008) but the other (2001) was about as shallow a recession as you’re ever going to get. The financial crisis (in 2008) was terrible nationwide. But, it wasn’t that bad for Texas. Texas had a much worse time of it in the late 1980s through the early 1990s. Those problems had been resolved by 1994. This meant that Texas banks – not just Frost – had very low charge-off rates from 1994-2014. I thought this might just be lucky. I could certainly use longer-term FDIC data on all banks around the country to come up with a much higher charge-off rate assumption. But, I knew from studying other banks that this was dishonest. Different banks have very different charge-off rates because of the categories of loans they make and also just how conservative the bank is. For example, from 1996-2014, I had data showing Frost’s charge-off rates were much lower than other banks in the same state. So, what did I do?

I used the mean – rather than median – charge-off rate for as many years as I had data. This allowed me to include the problems Texas banks had in the late 1980s. However, it meant I was assuming a 0.48% charge-off rate when the median charge-off rate for the last 20 years was just 0.23%.

Normally, you want to be careful about that. I don’t like using numbers where extending the length of the series from 20 years to 26 years or using the mean instead of the median makes a big difference in the result you get. Here, by using a 26-year mean instead of a 20-year median we got a charge-off rate more than double the one we’d normally use. Very often, I don’t even have data going back more than 20 years on a stock. Here, I intentionally extended the series further back into the past because I wanted to include the worst financial crisis in Texas’s history (as well as the 2008 financial crisis). Once the series I was averaging included both the late 1980s and 2008, I felt better about the assumption. Now, I was including 3 recessions over 26 years.

But, what’s the right charge-off rate? Is it 0.23%? Is it 0.48%? And then what do you apply that charge-off rate to. Obviously, you should apply it to loans. But, loans might be 35% of Frost’s earning assets at the bottom of a bust and 70% of Frost’s earning assets at the top of a boom. So, do you multiple 0.48% by 0.35 or by 0.70 or by some number in between.

I try to make reasonable assumptions. But, when you get to the point where I’m not sure which of a couple reasonable alternatives to choose for my assumption – I just use the more conservative one.

So, I didn’t worry about whether a 0.48% charge-off rate or a 0.23% charge-off rate was right. I used 0.48%. And then I didn’t worry about whether Frost would be lending out 35% or 70% of its deposits. I just pretended it would lend out everything (for the sake of penalizing the bank’s earning for charge-offs). And finally, I didn’t know if the bank’s tax rate would be 25%, 30%, 35%, etc. With the recent tax bill, we now know 25% is unlikely to be a low assumption. But, a couple years ago, it seemed like it might be. I knew 35% wouldn’t be too low an assumption – so I used 35%.

Your final appraisal value is going to be the sum product of a lot of these smaller assumptions you make. So, if each time you face a choice between the more aggressive and the more conservative assumption you always pick the more conservative assumption, your final appraisal value will have the cumulative conservatism of all these little assumptions built into it.

Is that accurate?

No.

But, it’s better than risking the possibility that your final appraisal value might be the sum product of a lot overly aggressive assumptions.

So, it’s fine to be roughly right. But, always try to be conservatively roughly right.

You can learn more about Geoff Gannon by emailing him: gannononinvesting@gmail.com, following him on Twitter: @GeoffGannon, or listening to his podcast. His stock specific write-ups appear on a subscriber supported website: Focused Compounding.


Mistakes of Omission and Failures of Imagination

by Geoff Gannon


In our most recent Focused Compounding podcast, Andrew and I took questions from Twitter. One of the questions was about what mistakes of omission we’ve made. In the podcast, you can hear me give a few examples. I think I said my biggest mistake of omission – in the sense of not doing an obvious and correct thing based on what I knew then, not in the sense of what turned out to have the biggest upside – was not buying DreamWorks Animation.

 

DreamWorks Animation

This is the animation studio behind the Shrek, Madagascar, Kung Fu Panda, and How to Train Your Dragon movies. The company was eventually taken over by Universal Studios (part of Comcast).

On March 12th, 2012 I wrote a GuruFocus article entitled:

“Why I Like DreamWorks But Don’t Own It”

That article really has all my thinking about the stock in one place. So, I recommend you read it.

The key passage in that article is:

“The stock is trading at $17.21 a share. That’s a 10% premium to book value. Now, I ask myself if DreamWorks’ book value is a reasonable approximation of the value of the company to a private owner? And my answer is: no.”

And that’s really all you need to know. If a stock is trading at 110% of book value and you feel book value seriously understates the key economic assets of the business, you should buy it.

As I said in the podcast, I suspect the reason I didn’t buy DreamWorks is because it wasn’t quite a “statistical” value investment at any point. The P/E was never quite low enough (though P/E is a pretty meaningless number at a movie studio) and the stock price usually managed to trade at a slight premium instead of a slight discount to book value.

I don’t read the comments to my GuruFocus articles. But, I would recommend you read the comments to that article to get some idea of how other people felt about the stock back then. That’s often a useful exercise in any kind of post-mortem on a stock. I think Corner of Berkshire and Fairfax also has a DreamWorks Animation thread and that should give you some idea of how people felt about the stock and why they did or didn’t buy it.

 

Weight Watchers (WTW)

I also mentioned a “mistake of commission” stock – both in the buying and the selling – called Weight Watchers (WTW). I’m sure you could have fun going to someplace like Corner of Berkshire and Fairfax and reading a thread on a stock like that as well. I bought the stock at $37.68 a share and held it while it dropped to $4 a share. I then sold it at $19.40 a share. It now trades at $70 a share. This – by the way – is not the highest point the stock has traded at. In fact – people forget this, but – I actually bought Weight Watchers after it had fallen more than 50% from its high (of over $80 a share). So, I bought a stock that had dropped 50% in price, held it while it fell another 90% in price. Then, I sold it after a nearly 400% rebound. And, of course, it has rebounded another 250% from where I sold it. My original Weight Watchers report is at Focused Compounding. And there’s a good Seeking Alpha write-up by someone who used my Weight Watchers post as part of their research process when deciding to buy the stock at a much lower price than I did.

I would link to that excellent article, but I believe it’s behind a Seeking Alpha paywall.

I did a revisit of Weight Watchers for Focused Compounding. What’s interesting is something I said near the end of that post – when the stock was trading at “just” $44 a share:

I’m not sure I believe Weight Watchers is worth more than $63 a share.

It trades at $44 a share which is 70% of my original appraisal value. For that reason, I would not buy the stock today. To buy a stock, I generally want at least a 35% discount to an appraisal value I still believe in. Here, we have a 30% discount to an appraisal value I don’t have any confidence in.

Weight Watchers may be fairly valued.

I don’t think it’s meaningfully undervalued at today’s price.

It is, however, leveraged. So, if I’m wrong by being too pessimistic this time around – the stock will eventually zoom past $63 a share.

Of course, leverage works both ways.”

The stock has since zoomed past $63 a share.

What’s interesting about re-visiting these old stock ideas and having the benefit of hindsight is seeing how limited people’s imagination – my own included – usually is.

 

Failures of Imagination

I was having two conversations recently where this came up.

One person was talking about a value stock and how – although it faces the risk of its business model slowly eroding to nothing due to societal/technological change over the next 5 years – it has a lot more upside than Omnicom (OMC) which looks “close to fairly valued” even though he likes Omnicom as a company and considers the stock inexpensive. The other person was talking about the Shiller P/E and why it does or doesn’t work these days.

My point about the Shiller P/E was that I’m pretty confident it “works” in the sense it tells you when long-term buy and hold returns from this point will be poor –  for two reasons. One, I did my own historical survey using the same exact principle as Shiller uses but with different methods – Shiller uses the S&P 500, I used the Dow; Shiller adjusts for inflation, I assume a perpetual 6% growth trend in EPS; Shiller uses a 10-year average, I use a 15-year average – and it gets you roughly the same answers at roughly the same times. So, why do people who start out believing in the principle behind the Shiller P/E eventually think it has stopped working this cycle.

The cycles in investor sentiment are too extreme. And they’re too long for you to notice they’re too extreme. For example, in my normalized P/E historical survey, this is what the “valuation undulation” as I called it looked like in the 1900s…

1921 – 1929: Stocks get more expensive

1929 – 1942: Stocks get cheaper

1942 - 1965: Stocks get more expensive

1965 - 1982: Stocks get cheaper

1982 - 1999: Stocks get more expensive

Investors are just too short-term practical to sustain their belief in those kind of incredibly lengthy revaluations. That stocks could be in favor for 8-23 years and then out of favor for 13-17 years isn’t very helpful for someone who is trying to find a stock to buy each week, month, or even year. They need to keep making day-to-day decisions. So, it’s easier to just push any decade-to-decade beliefs to one side to get on with the practical business of picking stocks.

Omnicom also strikes me as a good example of failure of imagination, because it’s the kind of stock at the kind of price that seems very boring and unlikely to move. The stock trades now at maybe something like a reported P/E of 16, though when you consider free cash flow conversion at the company and the likely result of the tax cut in the U.S. – the P/E is probably closer to 13. The interesting point here is that Omnicom is probably trading at about two-thirds of the valuation on the overall market. It’s trading at a discount. There were several time periods where Omnicom traded at something like a 33% premium to the market (instead of a 33% discount). So, you can easily have a P/E expansion on the stock of 100% without any change in the market’s P/E.

I’ll repeat that: the stock could double for no other reason than ad agency stocks are back in favor.

I say that not because I like Omnicom at this exact level – I’ve said before that if it hits $65 a share, I think anyone reading my blog would do fine buying it then and holding it pretty much forever – but because it’s perfectly reasonable for the stock to double because of a change in investor attitudes toward it. And yet: most value investors looking at the stock wouldn’t imagine such a doubling. They might think of the stock as a good buy and hold over a very long time horizon by doing math on the share buybacks, the dividend yield, growth in ad budgets in line with inflation, etc. – but they wouldn’t imagine any sort of 100% profit potential just from a re-valuing of ad agencies by investors.

This kind of swing in investor thinking unrelated to underlying business results is a really big factor – especially with very good, very dominant businesses – that we value investors often fail to imagine. I know I did with FICO (FICO). I bought that stock about 8 years ago at a cheap enough price. It hasn’t grown the actual business or earnings or really anything more than I expected when I bought it. What’s happened is the P/E went from a little under 14 to a little over 40. That kind of multiple expansion alone gives you something like a 15% annual return in a stock over 8 years. The actual return in FICO shares has been awfully close to 30% a year now for 8 years.

Needless to say, I sold it a long, long time ago. I never imagined a credit scoring stock would come back into favor with investors quite that dramatically.

Now, I’m not going to encourage you to buy a stock at a P/E of 14 and keep holding it past a P/E of 40. But, I am going to encourage you to untether your imagination from the recent past. It’s very easy to start believing that a Shiller P/E of 30 is normal or a FICO P/E of 14 was normal (in 2010 or whatever) or a P/E of 16 on Omnicom today is normal. At all sorts of points on Weight Watchers, people would have said that the doubling or quadrupling of the stock meant it was time to “take a profit” or “cut a loss”.

The present-day often forms a bubble around us that our mind’s eye has a hard time seeing through.

Revisiting long ago stock picks – the bull case and the bear case – is often a good way to prick that bubble.

And it’s important to prick that bubble, because I find that a failure of imagination often fuels the urge to gamble in people. If you really can’t imagine that Omnicom’s P/E or FICO’s P/E could double or that an acquirer could offer more than two times book value for DreamWorks  – then you start to focus instead on stocks with a P/E of 5 and a lot of trouble ahead or a growth rate of 30% a year and a P/E no value investor would touch.

How do you keep your expectations about the future imaginative enough and yet realistic enough at the same time?

I think you try to divorce them from the recent past generally and recent stock prices especially. Don’t spend a lot of time looking at the 52-week price range for this stock or the 5-year price range for the stock. Instead, ask yourself: What might Disney, Universal, Sony, or Fox pay for DreamWorks if it was a private company – not a public company.

I have a two-step trick for shaking up my imagination:

1)     Ask yourself what the business will look like in 5 years, not today

2)     Ask yourself what a private buyer would pay for that business, not what the stock market would value it at

Many of the dumb mistakes of omission I’ve made have come from caring too much about exactly what a business looks like now (what it’s reporting in earnings, showing in book value, etc.) rather than what I think it’ll roughly look like in 5 years. And then the dumbest mistake of all – thinking too much about how investors will think about this stock. It doesn’t matter what investors think about the stock. If there’s value there – eventually someone outside the stock market will come in and pay what the company’s worth.

Andrew and I will be taking more Twitter questions in the future. So, feel free to tweet your question at us. We will try to do those episodes as often as possible.

On a related note, I hope to increase the frequency of podcast episodes in the months ahead. We will also get it up on iTunes at some point. Till then you can play the audio files here.

You can learn more about Geoff Gannon by emailing him: gannononinvesting@gmail.com, following him on Twitter: @GeoffGannon, or listening to his podcast. His stock specific write-ups appear on a subscriber supported website: Focused Compounding.


Housekeeping: 7 Questions I Get Asked a Lot

by Geoff Gannon


Why Didn’t I Know You Were Doing “X”?

You don’t follow me on Twitter. The best way to keep up to date with what I’m doing is to follow me on Twitter. My Twitter handle is @GeoffGannon. I post links to everything I write, record, etc. pretty much the second the content is out.

 

Why Didn’t You Respond to my Comment?

I’ve never read a comment to any GuruFocus article. If you have a comment you want answered, email me: gannononinvesting@gmail.com. As a writer, I just have an ironclad rule not to read public comments.  I am a prolific responder to emails though. So, ask me absolutely anything via email and the odds are I’ll respond to it with a longer reply than you’d expect.

 

Where Can You Find My Old Articles?

The best way to read what I’m writing is to click the “Articles” link above. That link will take you to a page on GuruFocus with literally every article I have written for that site. There are hundreds of thousands of words of content that’s “new to you” in those archives. My articles tend not to be very “newsworthy” so reading something I wrote in 2012 is about as useful as reading what I’m writing now.

 

Can I Subscribe to the Podcast?

The Focused Compounding Podcast will become a true podcast (be subscribe-able on iTunes) eventually. Also, the podcast will eventually go behind a paywall in some way. The most likely way we do that is to have recent shows always available for free – like the most recent month or two – and keep the “back catalog” solely for Focused Compounding subscribers.

 

Is a Focused Compounding Subscription Worth It?

A lot of people ask what Focused Compounding is. What do you “get” as a subscriber? Basically, you get 24 old stock reports (the Singular Diligence archives), a message board where subscribers share stock ideas, and occasional stock write-ups by me or someone I’ve asked to write-up a specific idea for the site. In the future, there will also be a very brief, breezy weekly email from me telling you what I’m reading, looking at, etc. investment-wise. Basically, it’s the site where I put any stock specific content I create. I hope Andrew and I will soon record introduction videos explaining the site better and make that our landing page. It’s $60 a month. Listen to the podcast to hear about a $10 off promo code. We don’t do refunds or free trials. But we also don’t do longer-term subscriptions. Everyone’s month-to-month.

 

Can I Write For Focused Compounding?

Maybe. We only have one “editor” (me). And our budget for content is small. But, send me an exclusive stock write-up (that is, one you have not yet published anywhere – including your blog) and I can usually give you a “yes” or “no” answer in 24 hours. If I like your writing, we can hook you up with a free subscription to the site. We also pay for articles. The pay’s not great. But, I think we can match or exceed any “base” rates you’d get at other sites. If discussing your stock idea with me is a plus – I can give you as many hours of my time as you’d like to talk through any stock idea you have, give you advice on your article, etc. You can write about any stock of any size traded anywhere in the world. And I’m happy to work with non-native English speakers.

 

Do You Manage Money?

I don’t manage money. And I don’t have plans to start managing money. I’m not temperamentally well-suited to selling myself or dealing with clients. So, I really don’t see this as something that will ever happen.  A lot of people have tried to convince me to do this. I remain unconvinced.

You can learn more about Geoff Gannon by emailing him: gannononinvesting@gmail.com, following him on Twitter: @GeoffGannon, or listening to his podcast. His stock specific write-ups appear on a subscriber supported website: Focused Compounding.


1914: Assassination of the Archduke “Will Tend to Lessen” Political Strife

by Geoff Gannon


In the latest podcast episode (on this week’s bumpy market), I mentioned a 1914 New York Times article.

Here’s the key quote:

The assassination of the heir to the Austrian throne was an event whose consequences were closely considered by the markets abroad, but the calmness which they showed indicated clearly that political complications were not feared as a result of this incident. Indeed, the view that it would tend to lessen rather than to increase political strife in Southeastern Europe found wide acceptance.

In a bit of more timely news, I also mentioned this Wealthtrack interview with Jeremy Granthem discussing the risk of a "melt-up" followed by a "melt-down"

You can learn more about Geoff Gannon by emailing him: gannononinvesting@gmail.com, following him on Twitter: @GeoffGannon, or listening to his podcast. His stock specific write-ups appear on a subscriber supported website: Focused Compounding.


Episode #2: NIC (EGOV)

by Geoff Gannon


Listen to the Focused Compounding Podcast

1:00 – Geoff’s (members only) articles on NIC are “NIC (EGOV): A Far Above Average Business at an Utterly Average Price” (January 15th, 2018) and NIC (EGOV): Loses its Biggest Customer (Texas) – Stock Drops 20% Instantly” (February 1st, 2018).

2:40 – NIC is headquartered in Olathe, Kansas.

3:10 – Tyler Technologies (TYL) has a market cap of $5 billion (vs. less than a $1 billion market cap for NIC). It is headquartered in Plano, Texas.

4:35 – NIC’s three most recently lost state contracts are: Texas (will expire in August of 2018), Tennessee (expired March of 2017), and Iowa (expired November of 2016).

5:10 – NIC has 15 state contracts that can be terminated without cause. Those 15 agreements account for 63% of NIC’s total revenue.

6:10 – Geoff’s estimate for the least possible harm the loss of Texas could do to NIC’s earnings is presented in the comments thread to the article “NIC (EGOV) Loses its Biggest Customer (Texas) – Stock Drops 20% Instantly (February 1st, 2018)

9:00 – Geoff meant to say “it’s a very safe company” not “it’s a very safe stock”. The stock might drop a lot in price. But, there is no financial risk of insolvency, bankruptcy, etc. here at all.

9:35 – The ad agency stock Geoff invested in was Omnicom (OMC). It lost the Chrysler account in 2009.

10:10 – In 2001 (so 17 years ago), NIC had 17 state contracts which is about one-third of all states versus today when they have about half of all states.

10:25 – Same-state interactive government services revenue grew 11% last year.

10:30 –NIC has half of all U.S. states as clients and is valued at an enterprise value of $700 million (after losing the Texas contract). So, the stock market is valuing the entire addressable market of 50 “dot gov” portals at no more than $1.4 billion in market value and about $600 million in revenue (NIC has $300 million in revenue from state portals and a little over half of all “dot gov” portals in the U.S.).

12:00 – EGOV shares are now down 42% in the last twelve months. The market is up 20%+.

13:40 – NIC had paid a tax rate between 35% and 40% in 13 of the last 15 years.

15:30 – Geoff means that the quick and widespread adoption of driverless cars in the U.S. should not lower NIC’s revenue growth rate by more than 2% a year versus a scenario where no driverless cars are on the road (the status quo). He goes into the arithmetic behind this assumption in the comments section of his article “NIC (EGOV): A Far Above Average Business at an Utterly Average Price” (January 15th, 2018)

17:10 – NIC stock has a 2.5% dividend yield on its current price of $12.90 a share.

Listen to the Focused Compounding Podcast


NIC (EGOV) Loses Its Biggest Customer (Texas) – Stock Down 20% Today

by Geoff Gannon


Listen to Geoff’s Podcast

NIC (EGOV) lost its biggest customer, the State of Texas, yesterday. The stock is down 20% today. A lot of people have emailed me asking for my thoughts about this stock and this development.

I just posted an article to Focused Compounding on the loss of the Texas business and whether the 20% stock price decline is too much, too little, about right, etc.

For free, you can read the company’s earnings call transcript at Seeking Alpha. And you can read the company’s earnings release.

Those are the two things I’d recommend doing.

Of course, you can read my thoughts on the company at Focused Compounding if you become a member. However, I’m not going to write anything about the company over here. From now on, all my company specific thoughts go to Focused Compounding. This blog will not be about specific companies. It will be about general investing ideas.

We might discuss EGOV on a future podcast. Andrew and I will be taking old ideas off Focused Compounding and discussing them on the podcast. So, you may be able to hear my thoughts about EGOV via the podcast. As far as in writing, that’ll only be at Focused Compounding – never here.

I'm sorry to draw that line in the sand. But, Focused Compounding is a member supported website that pays me and Andrew and the other people who write there. This is a free blog.

Listen to Geoff’s Podcast


Focused Compounding Podcast Episode #1 (1/29/2018): Notes

by Geoff Gannon


Listen to the Focused Compounding Podcast

 

Questions Asked and Answered

Question #1: “How did Andrew and Geoff meet?” (2:05)

Question #2: “What’s the best way to become a better investor?” (5:50)

Questions #3: “How do you decide which stock to research next?” (9:55)

Question #4: “How did you get into investing?” (12:35)

 

Listen to the Focused Compounding Podcast

0:15 – The promo code to get $10 a month off Focused Compounding is “PODCAST” (all one word).

2:05 – Question #1: “How did Andrew and Geoff meet?”

2:30 – Geoff’s Twitter is @GeoffGannon

2:55 – Plano, Texas has a population of over 285,000. GuruFocus is also headquartered here.

5:50 – Question #2: “What’s the best way to become a better investor?”

6:45 – If you want to write for the site, email gannononinvesting@gmail.com with a stock ticker in the subject line.

8:25Green Brick Partners (GRKB) is a Plano, Texas based homebuilder. David Einhorn is a big shareholder.

9:55 – Question #3: “How do you decide which stock to research next?”

10:30 – You can screen for “Magic Formula” stocks at magicformulainvesting.com.

10:55 – GuruFocus has a “summary” page with price ratios like EV/EBITDA.

11:30NACCO Industries (NC) is a cost-plus contract coal miner. Geoff owns the stock.

11:35 – The blog post on NACCO Geoff’s talking about is this one at Clark Street Value

12:10Hamilton Beach Brands (HBB) was spun-off from NACCO at the end of September 2017.

12:35 – Question #4: “How did you get into investing?”

12:45 –  Geoff got into investing in 1999. That year was the peak of the dot com bubble.

13:40EDGAR, the SEC filing website, dates back to around 1996.

14:25Activision (ATVI) has a market cap of over $53 billion today. In 1999, it had a market cap of just $300 million.

14:30 – The supermarket stock Geoff mentions is Village (VLGEA). The snack food stock is J&J Snack Foods (JJSF).

17:05 – Again, the promo code to get $10 a month off Focused Compounding is “PODCAST” (all one word).

Listen to the Focused Compounding Podcast


My Return to Podcasting

by Geoff Gannon


The first ever episode of the Focused Compounding podcast is up now. You can listen to me and my co-host (and Focused Compounding co-founder) Andrew Kuhn answer 3 of your questions. This week is a Q&A episode. We hope to alternate that format with episodes dedicated to a single stock idea (taken from a Focused Compounding write-up).

The podcast will be hosted at the Focused Compounding website. So, you may want to bookmark this page.

Listen to the Focused Compounding Podcast


Great Businesses + Seriously Mispriced Stocks = What to Research

by Geoff Gannon


One of the most common questions I get from really good investors – not beginners, but people who are dedicating many hours a week to this – is how they can find the next stock to research. Usually, their approach is pretty haphazard.

I’ve mentioned before that I keep a sort of research “pipeline”. I started doing this explicitly when I was writing the newsletter. Quan and I always had 11 stocks on a white board (the one we were researching now plus the next 10 we planned to research).

I think that’s a good approach. But, it’s not the answer most people are looking for. They want something more like “how do you create a watchlist in the first place?”

Today, I wrote a couple articles at GuruFocus discussing the two filters I think are most effective at screening for stocks to research next.

I’ll give you the boiled down version here.

Research the stocks that at first glance seem especially likely to be:

A)      Great businesses

B)      Seriously mispriced stocks

Usually, they’re not the same thing. So, on the member site we’ve recently had write-ups about Dunkin Donuts (DNKN), NIC (EGOV), etc. Those are what I’d call “great business” ideas not “mispriced stocks” ideas.

A great business idea is usually something that appears to be non-cyclical, highly predictable, doesn’t require capital to grow, faces little competition, and seems easy enough for you to understand its durability.

What’s a “seriously mispriced stock” idea? It’s something messy, complicated, cyclical, small, unfollowed, boring, opaque, etc.

I’m very selective about which stocks I buy. And – if I’m being honest – I tend to really want to pounce when I see a little of “A” plus a little of “B”. In other words, I don’t just want to buy a great business that is recognized as such. And, I don’t just want to buy a special situation. I want to buy a special situation involving a great business.

For a list of potentially mispriced stocks, I recommend bookmarking these two pages:

Clark Street Value (A Special Situations Blog)

And

Insider Arbitrage: Upcoming Spin-offs

The last point I’d make about looking for “seriously mispriced stocks” is to avoid what the super investors, gurus, etc. own. Although we think of value investors as standing apart from the flock – most of the stock ideas people bring me are actually already popular with value investors as a group.

In fact, many people bring me ideas they first learned about from some well-known value investor’s presentation.

Value investing shouldn’t be crowd following of just a different sort of crowd. In great enough numbers, value investors become a sort of crowd of their own. And it’s often more comforting to crowd into the same investments as the people you look up to.

Is that a good idea or a bad idea?

I’d say if one value investor you know likes the stock – that’s great. Go for it: ride his coat tails.

But…

If five of them are all owning it at the same time – in my book, that’s a minus rather than a plus.

Join Geoff's Member Site: use promo code "GANNON" and get $10 off a month


All About Edge

by Geoff Gannon


Richard Beddard recently wrote a blog post about company strategy. And Nate Tobik recently wrote one about how you – as a stock picker – have no edge. I’d like you to read both those posts first. Then, come back here. Because I have something to say that combines these two ideas. It’ll be 3,000 words before our two storylines intersect, but I promise it’ll be worth it.

 

Stock Picking is Like Playing the Ponies – Only Better

Horse races use a pari-mutuel betting system. That is, a mutual betting system where the bets of all the gamblers are pooled, the odds adjust according to the bets these gamblers place, and the track takes a cut regardless of the outcome.

At the race track, a person placing a bet has a negative edge. He places a bet of $100. However, after the track takes its cut, it may be as if he now “owns” a bet of just $83.

At the stock exchange, a person placing a buy order has a positive edge. He places a bet of $100. However, after a year has passed, it may be as if he now “owns” a bet of $108.

All bets placed at a race track are generically negative edge bets. All buy orders placed at a stock exchange are generically positive edge bets.

In horse racing, the track generally has an edge over bettors. In stock picking, the buyer generally has an edge over the seller.

 

In the Long Run: The Buyers Win

The Kelly Criterion is a formula for maximizing the growth of your wealth over time. Any such formula works on three principles: 1) Never bet unless you have an edge, 2) The bigger your edge, the more you bet and 3) Don’t go broke.

In theory, the best way to grow your bankroll over time is to make the series of bets with the highest geometric mean. Math can prove the theory. But, only in theory. In practice, the best way to prove whether a system for growing your bankroll works over time is to back test the strategy. Pretend you made bets in the past you really didn’t. And see how your bankroll grows or shrinks as you move further and further into the back test’s future (which is, of course, still your past).

Try this with the two “genres” of stock bets:

1)      The 100% buy order genre

2)      And the 100% sell order genre

Okay. You’ve run multiple back tests. Now ask yourself…

Just how big was your best back test able to grow your bankroll over time by only placing buy orders – that is, never selling a stock. And just how long did it to take for your worst back test to go broke only placing buy orders.

Now compare this to back tests in the sell order genre.

Just how big was your best back test able to grow your bankroll over time by only placing sell orders –  that is, never closing a short position. And just how long did it take for your worst back test to go broke only placing sell orders.

What you’ll find is that generally a 100% buy order approach compounds wealth faster and bankrupts you less often than a 100% sell order approach.

Why?

Over a long series of bets, one generic strategy can outperform another generic strategy by: 1) Placing more bets with an edge, 2) Making bigger bets when your edge is bigger, and/or 3) Making smaller bets when your edge is smaller.

Here, the reason a stock buying strategy outperforms a stock selling strategy is because the buy strategy bets with an edge more often than the sell strategy.

 

Why All Stock Buyers Have an Edge

In stock markets: sellers generally have a negative edge and buyers generally have a positive edge, because the asset being given up by sellers (a part interest in a business) is of higher quality than the asset being given up by buyers (cash).

This is not a unique feature of stock markets.

We can see the same concept illustrated by a hypothetical barter trade involving two commodities. Party A wants to be rid of his holdings of aluminum; Party T wants to be rid of his holdings of timberland. Like cash and stocks, aluminum and timberland are both assets. And like cash and stocks, aluminum and timberland are assets of differing quality.

Generally, swaps of cash for shares favor the side getting shares and giving cash. And, generally, swaps of aluminum for timberland would favor the side getting timberland and giving aluminum.

Some specific sales and specific systems for the sale of stock for cash favor the seller and some specific trades and specific systems for the trading of timberland for aluminum would certainly favor the party trading away his high quality timberland for low quality aluminum. However, the special edge the trader of timberland for aluminum would need to juice his returns on any one deal to the point it was a net profitable trade for him would be big. Likewise, the special edge a seller of shares would need to juice his returns over a buyer of shares to make any one sale a net profitable trade for him would also have to be quite big.

Excellent selection and timing of which stocks to sell when and which timberland to sell when could allow you to make a trading profit. However, in the real-world excellent selection of which races to bet on, which horses to bet on, and how much to bet on those horses in those races really does allow some bettors to profit at a race track even though the generic strategy of betting on horses is still a bad one.

You can make money betting on a horse race. And you can make money selling a stock. But, a generic strategy of not betting on horse races outperforms a generic strategy of betting on horse races. And a generic strategy of buying stocks outperforms a generic strategy of either selling stocks or neither buying nor selling stocks.

Generally, buying stocks works. As a result: stock buyers have a “dumb money” edge.

 

The 3 Levels of “Edge”

At a stock exchange, there are 3 levels of edge:

1.       Generic edge: The “dumb money’s” edge. Since buying stocks generally works better than selling stocks or not owning stocks, a constant buyer of stocks – such as an investor in an index fund – has an edge over other kinds of operators (non-investors, investors who hold mixed portfolios with bonds, market timers who sometimes hold cash, and long/short investors).

2.       Special edge: the “factor investor’s” edge. Since buying certain kinds of stocks (high quality businesses, cheap stocks, and stocks rising in price) works better than buying other kinds of stocks (low quality businesses, expensive stocks, and stocks falling in price) an investor who systematically bets in order to maximize certain factors (like high quality, good value, and positive momentum) has an edge over both operators who systematically bet in order to maximize other factors (low quality, poor value, and negative momentum) and operators who don’t bet systematically.

3.       Unique edge: the “stock picker’s” edge. This is the kind of edge Nate is talking about when he says “You have no edge. Get over it.”

 

Does the Stock Picker’s Edge Exist?

There is no debate over whether the generic edge an index fund has and the special edge a factor based fund has exists.

Both exist.

A generic strategy that bets in favor of stocks is a better generic strategy than one that bets against stocks. And a special strategy that systematically bets in favor of quality, value, and momentum is better than a special strategy that systematically bets against quality, value, and momentum.

For example: a “dumb money” stock index fund outperforms a “dumb money” bond index fund. This is due to the generic edge that buying stocks has over not buying stocks.

And: A semi-smart system like Toby Carlisle’s (low EV/EBITDA) “The Acquirer’s Multiple” outperforms a “dumb money” strategy like putting everything in an S&P 500 index fund.

 

How to Win a Coin Flipping Contest – Play Against Humans

Of course, the dumb money approach will outperform the semi-smart money approach over some series of years. That’s irrelevant. Picking heads 0% of the time at better than even money odds will outperform picking heads 100% of the time at worse than even money odds over some series of coin flips.  As a rule: bad bets sometimes outperform good bets. This has nothing to do with the stock market. It has everything to do with betting.

So, is the dumb money approach to winning a coin flipping contest – that is, not betting because I have no edge – neither better nor worse than the semi-smart strategy? The semi-smart strategy would be accepting even money odds on coin flips and then just trying to make the best bets you can.

I know what you’re thinking: not betting and betting the best you can on coin flips will tend toward the same outcome.

That’s true if you’re playing against the house and the house is offering even money odds.

But, what if you were participating in a pari-mutuel coin flipping contest. Remember, there is no “house” in stock picking. There is no “vig”. It’s like playing the ponies – only better. The stock market isn’t like a coin flipping contest. A coin flipping contest is usually modeled as having fixed even money odds.

There’s actually a really big assumption in coin flipping models. The assumption is that whoever is giving you odds on coin flipping consistently applies his best available strategy on every flip.

It’s true you can’t win a fixed even money odds coin flipping game even if you use your best available strategy for betting. But, that’s only because the other player is also using his best strategy available. He’s “selling” you coin flips at even money odds on both heads and tails. That’s literally the only move he can make that guarantees you can’t take advantage of him. If he ever makes any other move, you can beat him.

 

Real Games Don’t Really Work This Way – Real Players Don’t Really Play This Way

This is an ideal opponent fallacy. It’s a fallacy in the “begging the question” sense. The question is: “Can you profit from a coin flipping contest?” And the unstated argument is: “You can’t profit from a coin flipping contest, because your opponent in a coin flipping contest must always make the best available move.”

A coin flipping game is so simple that we tend not to realize we’re assuming the argument “because your opponent in a coin flipping contest must always make the best available move.”

Is that really how a large group of humans would play a coin flipping game?

Let’s simplify it down to one guy. You and an opponent. Would your opponent always offer you even money odds on both heads and tails?

What if he doesn’t? What if he makes a mistake?

 

You’re Always Playing the Player

Why do I have a negative edge when I sit down to play blackjack at a casino?

It’s not just because I’m playing blackjack. It’s because I’m playing against the casino’s dealer at fixed odds set by the casino. The casino’s dealer has to employ a strategy that is, in practical terms, close enough to ideal. No, it’s not quite the best strategy. But, it’s very easy to apply consistently and very hard to beat with out a lot of extra effort.

Now, replace the casino’s dealer with a third grader and replace the casino’s fixed odds with variable odds – shouted out before each hand – by a sixth grader.

I now have an edge. And it has nothing to do with counting cards. The third grader will not employ a strategy as good as the casino’s dealer was forced to and he will not apply any strategy as consistently. Meanwhile, the sixth grader will get bored and sometimes shout out odds that are more favorable for one hand and then less favorable for the next.

That’s all I need. I don’t need an ideal strategy. I just need a sound strategy that takes advantage of my opponent’s occasional mistakes. If the odds are set inconsistently, I can now profit at the blackjack table without applying any effort. I only need two skills. One: the mental ability to recognize mistakes in my opponent’s play. And two: the patience coupled with courage to bet big when my opponent errs and only when my opponent errs.

In the stock market: you are not playing against the house. You are not facing the ideal opponent. And the odds are not fixed.

So, if other bettors use a negative edge strategy and you use what should (against an ideal opponent) be a zero edge strategy – you’ll win. In a mutual betting system, the presence of losers creates winners. If some bettors bet badly, then bets that should yield you no advantage will instead yield you an advantage.

 

So: Should You Bet on Coin Flips?

A while back, I asked which of two strategies works better. Strategy A: Never bet on coin flips.

Or...

Strategy B: Bet on coin flips in such a way that you’d expect to have very close to zero gain and zero loss after a long series of flips of a perfectly fair coin.

If the odds are fixed, it’s safer and easier to just not play.

But: If the odds aren’t fixed, it’s potentially profitable to play.

If you apply a consistently sound strategy and your opponent’s strategy is either unsound or inconsistently applied – you can profit from a coin flipping contest.

Why?

 

Short Stupidity

The semi-smart approach of assuming you know there is an equal likelihood of a coin flip coming up heads or tails but you don’t know which particular flips will come up which outperforms the truly idiotic approach of assuming you don’t know what the likelihood of a coin coming up heads vs. tails is and so you just guess (it could be 50/50, it could be 90/10, who knows?).

I know what you’re thinking. No one would bet that way.

But, consider this…

 

In the Real World: There is No House – And There are Idiots

If you were given a $25 bankroll (free) and the chance to bet heads or tails on a series of flips of a coin that comes up heads 60% of the time and tails 40% of the time, how much money would you bet on each flip? And, would you bet heads every time, tails every time, or some mix of the two?

My last question sounds absurd.

In theory, it is.

But, the real-world experiment – using mostly people who were either currently studying finance or economics at college or who were currently working at a finance firm – resulted in 65% of the participants betting tails on at least one toss. These people had been told the coin was biased to come up heads 60% of the time and tails 40% of the time. And they were eligible to walk away from this experiment with up to $250.

The results?

Most people (65%) made at least one negative edge bet (picking tails) during the experiment.

And nearly 30% of the participants ended up with zero dollars. That’s most likely because 30% of the participants bet everything on a single coin toss.

The study wasn’t perfect. The participants knew it was an experiment and knew they had been told the coin would come up heads 60% of the time and tails 40% of the time. This is a pretty close to fatal flaw in the design of the experiment. The way the experiment was designed would certainly prime many participants to suspect they were being lied to.

But, even if that is what happened here (and I suspect it is), that still raises an interesting question. Were some people so afraid of looking foolish that they lost $25 in actual cash and lost $225 in potential cash just to avoid a loss of face.

The result of this study does seem to suggest it’s either one or the other. Either, people believed the experimenters when they were told the likelihood was 60% heads and yet they still made idiotic bets like picking tails or betting their entire bankroll on a single coin toss – or, they thought there was a chance the experimenters were trying to fool them, so they avoided believing a lie at the cost of free cash.

 

In Practice: The World is Not Like it is in Theory

We often model approaches to asset allocation, position sizing, stock picking, etc. using unrealistic assumptions. For example, we benchmark different investment approaches against an index. However, this assumes an average investor not employing this strategy will get the same result as the index (most likely: he won’t, he’ll get a worse result).

Likewise, we frame the concept of edge in terms of special edges (factors) and unique edges (stock picking) without thinking about just how odd it is that stocks have enjoyed a generic edge over other assets even in periods when the investing public knew stocks had historically had this generic edge.

So, what if we discard theory?

What if we put aside a logic based approach (like the one Nate uses in his post about the non-existence of edges) and instead use an entirely empirical (that is, observation based) approach.

To do this, I want to consider one and only one kind of edge.

In his post “Getting Serious About Strategy”, Richard Beddard says:

“…how many investors, people who depend on a company making the right choices actually take the trouble to work out what a company actually does?”

The most valuable edge you can have as a stock picker is to better understand what a company actually does than the person on the other side of the trade from you.

We know stock buying is a better generic strategy than stock selling. So, I’d suggest the best decision you can make as an investor is one in which you – as a stock buyer – know more about what a company actually does than the fellow selling his shares to you.

 

What Does NACCO Actually Do?

I’m not cherry picking here. NACCO (NC) is my biggest (50%) and most recently added (October 2017) position. Here is an excerpt – courtesy of Seeking Alpha – from the company’s latest earnings call (its first after it spun-off a big division):

Investor: I want to thank you…for completing the spin-off. This has probably been one of the best investments I have made in years. But I have a question about it, even though I have sold almost all of my position, I have a small position left. The value of this stub, which was the parent company less the value of the when issued, spin-off of Hamilton was trading around $20 per share before the confirmation of the spin-off. And then in the brief period since the spin-off, the value of the stub which now is no longer technically a stub, it's a…stand-alone and its symbol NC (has) gone close to $40 and even $44 which, again, (I’m) very thankful of, because I made lots of sales during that period. Do you have an explanation why the value has gone up over…100% despite the fact that the outlook for 2018 does not appear to be salubrious and that coal prices have been stable to down slightly and (royalties) and production from the mines at North American Coal does not appear to have skyrocketed or has done anything exceptional?

CEO: …why the stock trades up, why it trades down is often a mystery. Your comment about the coal prices, our business model really doesn't have us with any exposure whatsoever to coal prices. Our unconsolidated mines really operate as a service business and our one consolidated mine has a formula price for the coal it sold. So it's not like any of this is driven by coal prices.

Investor: …But don't you agree that the higher coal prices might lead to higher production at the associated mines?

CEO: I don't know that it's really connected. Our mines are individually dedicated to a single customer. And it's really just that customer's demand for electricity that determines how much coal we sell to them.

I don’t know for sure if I bought shares of NACCO that this caller was selling (though his comments make it sound like we might have been on opposite sides of a trade). And I don’t know for sure if I have an edge in understanding NACCO’s strategy better than this caller.  

However, I do know 3 things:

1)      NACCO’s strategy is to sell coal at a fixed (rather than a market) price so that its earnings do not fluctuate with the price of coal.

2)      If NACCO’s earnings did fluctuate based on the market price of coal, I would not have bought the stock.

3)      This caller clearly would have bought the stock even if NACCO’s earning fluctuated with the price of coal.

So, we know that I had one understanding of NACCO’s business strategy and this caller had a different understanding of NACCO’s business strategy. I was a buyer of the stock while he was a seller of the stock. And we know that my buying was based on my understanding of NACCO’s business strategy while his selling wasn’t (it might have been based on his understanding of NACCO’s business strategy, but it certainly wasn’t based on our shared understanding of NACCO’s strategy – because this call makes it clear we don’t share any understanding of what the company’s strategy is.)

Does this constitute an edge?

Who knows.

But, this is the kind of situation I want you guys to focus on.

 

I Was Cherry Picking - You Should Too

I said I wasn’t cherry picking. But, I was. In most stocks: most big buyers and big sellers of the stock know how the company makes money. In NACCO: some big buyers and some big sellers of the stock don’t know how the company makes money.

There are two things I want you to take away from this post:

1.       Generally, stock buyers have an edge over stock sellers. And...

2.       Stock buyers have a unique edge in cases where they understand “what a company actually does” better than the person they are buying their shares from.

Therefore, focus most of your attention – and most of your bankroll – on buying stocks where you think you know what the company actually does better than sellers of that stock.

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Is Negative Shareholder Equity a Good Thing or a Bad Thing? - No, It's an Interesting Thing

by Geoff Gannon


Someone emailed me this question:

“…how do you consider negative shareholder equity? Is this good, bad or other?”

Before I give my answer, I apologize to the roughly 60% of my audience that I know is made up of non-Americans. I’m about to use a baseball analogy.

Like Warren Buffett has said: the best businesses in the world can be run with no equity now.

I've invested in companies with negative equity. Most notably, IMS Health in 2009.

I would always notice negative shareholder equity. It would make me more likely to want to learn about the stock - because it's odd.

Remember, you are looking for extraordinary investment opportunities.

We can break that search into two parts: “extra”+”ordinary”.

Sometimes, we know whether something is a "plus" or a "minus". Other times, we only know it's an anomaly without knowing whether it's "good odd" or "bad odd".

As an investor, you always want to investigate anomalies. However, you don't always want to invest in anomalies. There's a difference. 

Say we're searching for a good or even a "great" stock. The first thing we know for sure about this hypothetical good or great stock we haven’t yet found is that it's not ordinary.

Negative shareholder equity is very not ordinary.

In the past, I've compared negative shareholder equity to the number of strikeouts a Major League batter has. 

We know high strikeout rates are good for a pitcher

However, there is considerable debate about whether high strikeout rates are good or bad for a batter.

Theoretically, it's better to have positive equity than negative equity. For example: if IMS Health looked exactly like it did when I found it plus it had billions in extra cash on the balance sheet - that'd be better. 

But, that’s like saying it’s better to have a stock with a 17% growth rate and a P/E of 7 rather than just a P/E of 7. In the real world: a P/E of 7 is plenty interesting all on its own.

And, using our baseball analogy: Theoretically, it's always better to have not struck out rather than struck out (excluding the possibility of double-plays).

Yes, if Babe Ruth had the same number of home runs plus some of his strike outs were instead balls he put into play - he'd be an even better batter. But, let’s face it: if your job was picking the right guy to have on your team – identifying the next Babe Ruth is all you need to do.

So, let's forget theory for a second. Let's look at the cold, hard facts. 

What does the data say?

The data actually says that some of the best batters in Major League history had unusually high strike out rates.

And the data says that some of the best stocks around have unusually low shareholder's equity.

So, if I'm a general manager who sees a batter with an absurd number of strike outs, I know I want to learn more. I don't know I want to trade for this player. But, I know my eye is drawn to this statistical anomaly.

And, if I'm a value investor who sees a stock with an absurdly low amount of shareholder equity, I know I want to learn more. I don't know I want to buy the stock though.

Why?

Because a batter with a high strikeout rate could just be an absurdly bad batter. It's unlikely he'd get this far if he was - but it's possible.

And a public company with a low amount of shareholder equity could just be a distressed company. 

So, when you see a stock with negative shareholder equity, imagine it's shouting "Research me! Research me!". Don't imagine it's shouting "Buy me! Buy me!"

I can't say negative shareholder equity is always good or always bad. I can say it's always worth investigating.

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Are We in a Bubble? – Honestly: Yes

by Geoff Gannon


"Are we in a bubble?"

Right now: This is the most common question I get. For a long time, my answer to this question has been: “yes, stocks are overvalued but that does not mean the stock market has to drop.”

This exact phrasing has been my way of hiding behind a technicality. Technically, logic allows me to argue that just because stocks are overvalued does not mean they have to drop – after all, stock prices could just go nowhere for a long time.

And history does show that the combination of a sideways stock market in nominal dollars and high rates of inflation can “cure” an expensive stock market (see the late 1960s stock market Warren Buffett quit by winding down his partnership).

Unfortunately, the question asked was “are we in a bubble” not “do all bubbles pop with a crash”.

So, as of today: I will stop hiding behind that technicality.

 

What Today’s Bubble Looks Like

To get some idea of how expensive U.S. stocks are check out GuruFocus’s Shiller P/E page.

For a discussion of the psychological aspects of whether or not we are in a bubble, read two 2017 memos by Howard Marks: “There They Go Again…Again?” and “Yet Again?”

I don’t have much to say about the psychology of bubbles other than:

1.       When we’re in a bubble: I tend to get emails asking about the price of stocks rather than any risks to the economy or fears of a permanently bleak future.

2.       When we’re in a bubble: the emails I get tend to acknowledge that prices are high but then assert that there is no catalyst to cause them to come down.

3.       When we’re in a bubble: people tend to talk about their expectation for permanently lower long-term rates of return rather than the risk of a near-term price drop.

4.       And finally: when we’re in a bubble, people ask more about assets that are difficult to value.

This last point is the one historical lesson about the psychology of bubbles I want to underline for you.

Eventually, manic and euphoric feelings have to lead investors to focus on assets that are difficult to value.  

It’s easier to bid up the prices of homes (which don’t have rental income) than apartment buildings (which do have rental income). It’s easier to bid up the price of gold (which doesn’t have much use in the real economy) than lime (which is mined for immediate use).

Generally, assets which are immediately useful are the most difficult to bid up in price.

Stocks without earnings are easier to bid up than stocks with earnings.

And stocks in developing industries are easier to bid up than stocks in developed industries.

The less present day earnings and less of a present day business plan a company has – the more a manic or euphoric investor can project on to the stock. The asset takes on a Rorschach test quality.

 The 3 topics I get asked about the most are:

1.       Online groceries

2.       Electric cars

3.       Bitcoin

What’s notable about these 3 subjects is that they have investor adoption without consumer adoption.

Online groceries have the most consumer adoption at about 2% of U.S. grocery sales. Electric cars have less than 1% market share in the U.S. And bitcoin has no meaningful adoption as a medium of exchange.

Online groceries and electric cars have failed in the past. That doesn’t mean they will fail again now. However, it does mean that they are probably being attempted now at greater scale because funding is available for these ventures due to investor adoption running ahead of consumer adoption.

I’m an American who was born in 1985. So, I have only lived through two stock bubbles: the 1990s internet bubble and the 2000s housing bubble.

I said everything that needed saying about high stock prices in two posts written in 2006 and 2008 respectively. They are:

“In Defense of Extraordinary Claims” – December 29th, 2006: A post in which I argued that returns in U.S. stocks from that point in time forward would be below average, because “(the) great returns of the 20th century occurred under special circumstances – namely, low normalized P/E ratios. Today's normalized P/E ratios are much, much higher. In other words, the special circumstances that allowed for great returns in equities during the 20th century no longer exist.”

And…

On a Return to Normalcy” – October 10th, 2008: A post in which I argued that returns in U.S. stocks from that point in time forward would not be below average, because “at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.”

I ended the second of those two posts with the same postscript I’ll end this one with:

“All this brings up an interesting question – and I know a lot of people may not agree with my strict either/or dichotomy between a price drop or a stock market that does nothing for many years – but assuming the Dow’s normalized P/E had to revert to the mean for it to offer its historical returns once again…Which would you rather lose: Forty percent or eight and a half years?”

Because, either: the market will go nowhere between now and 2026 or it will drop by 40%.

That is what I believe.

Other investors believe differently. For example, there is a post called “Beyond All Expectations" by Of Dollars and Data.

That post is representative of the arguments used against declaring U.S. stocks in a bubble at year-end 2017.

I disagree with that argument.

So, I will declare us officially “in a bubble”.

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Looking for Cases of Over-Amortization and Over-Depreciation

by Geoff Gannon


A blog I read did a post on goodwill. The discussion there was about economic goodwill. I’d like to talk today about accounting goodwill – that is, intangibles. Technically: accounting goodwill applies only to intangible assets that can’t be separately identified. In other words, “goodwill” is just the catch-all bucket accountants put what’s left of the premium paid over book value that they can’t put somewhere else.

For our purposes though, accounting for specific intangible items is often more interesting than accounting for general goodwill. That’s because specific intangibles can be amortized. And amortization can cause reported earnings to come in lower than cash earnings.

 

Unequal Treatment

The first thing to do when confronting a “non-cash” charge is to figure out if it is being treated equally or unequally with other economically equivalent items.

I’ll use a stock I own, NACCO (NC), as an example. As of last quarter, NACCO had a $44 million intangible asset on the books called “coal supply agreement”.

The description of this item (appearing as a footnote in the 10-K) reads:

Coal Supply Agreement: The coal supply agreement represents a long-term supply agreement with a NACoal customer and was recorded based on the fair value at the date of acquisition. The coal supply agreement is amortized based on units of production over the terms of the agreement, which is estimated to be 30 years.”

All of NACCO’s customers are supplied under long-term coal supply agreements which often had an initial term of 30 years. These agreements are economically equivalent. However, one of the agreements is being treated differently from the rest.

The amortization of this coal supply agreement is probably meaningless.

Why?

Because: if NACCO acquired a company that had a 29-year coal supply agreement in place, it would record this item on its books as an intangible asset and it would amortize it over the life of the contract. But, if NACCO itself simply signed a coal supply agreement with a new customer – no intangible asset would be placed on the books. And there would be no amortization. What’s the difference between creating a contract and acquiring a contract?

There is none.

Now, that doesn’t mean the economic reality is that NACCO’s earnings never need to be replaced. Many of the contracts NACCO has in place only run for about 13-28 years now. And, far more importantly, the power plants NACCO supplies with coal might close down long before their contracts expire. So, earnings really will “expire” and need to be replaced. But, this has nothing to do with whether a certain coal supply agreement is or is not being amortized. The amortization charge is irrelevant. But, the limited remaining economic lifespan of NACCO’s customers – which isn’t shown anywhere on NACCO’s books – is relevant.

Therefore, two adjustments need to be made. One, amortization has to be “added back” to reported EPS to get the true EPS for this year. And, two, that EPS number has to be considered impermanent.

 

Depreciation (Unlike Amortization) is Usually a “True” Expense

A depreciation charge is used to smooth out the expensing of an initial cash outlay (the purchase of a long-lived asset) so that the timing of expenses and revenues match.

Depreciation charges are not used to pre-expense the purchase of a replacement asset.

Depreciation charges are only used to post-expense the purchase of an asset now in use.

Because of inflation, a replacement asset will almost always cost more than the original asset.

Therefore, depreciation expenses – unlike the amortization expense above – are not only economically necessary, they are also almost always insufficient to fund the replacement.

As a rule, the annual depreciation expense you see at a company – like the Carnival (CCL) example I will give below – “underfunds” the amount needed to replace the asset. In other words, the more depreciable assets appear on a company’s balance sheet – the more that company’s earnings are likely to be overstated.

 

Usual Assumptions

A change in the assumptions a company uses to calculate depreciation will change reported earnings. Here is a cruise line, Carnival, explaining how a small change in depreciation assumptions can cause a large change in reported earnings:

“Our 2015 ship depreciation expense would have increased by approximately $40 million assuming we had reduced our estimated 30-year ship useful life estimate by one year at the time we took delivery or acquired each of our ships. In addition, our 2015 ship depreciation expense would have increased by approximately $210 million assuming we had estimated our ships to have no residual value at the time of their delivery or acquisition.”

Carnival’s depreciation assumptions are generally reasonable. The company always overstates its economic earnings, but only because of inflation. Management is not gaming either the estimated useful life of a cruise ship to Carnival (30 years) or the fact that cruise ships have residual value after the initial owner is done with them. There really are buyers for retired Carnival cruise ships. So, each ship has a residual value. There is nothing unusual about these assumptions.

 

Can Depreciation Ever Be an Exaggerated Expense?

There are, however, company’s that make unusual assumptions. Gencor (GENC) is one such company.

In the company’s 10-K, “Note #4” reads:

“Property and equipment includes approximately $10,645,000….of fully depreciated assets, which remained in service during fiscal 2017…”

This is significant, because the total amount of “property and equipment, net” is shown to be $5.7 million.

 

Move Up the Income Statement

Distortions caused by accounting assumptions usually appear lower down in the income statement. So, an investor who is worried about misleading expenses can use an item like EBITDA instead of net income. This takes out the complications of assumptions and one-time items related to interest, taxes, depreciation, and amortization. If EBITDA seems high and net income seems low – you want to investigate where that EBITDA is disappearing to. Are these real depreciation charges? Are these irrelevant amortization charges?

 

The Earnings You Care About Come in the Form of Cash

The key question to ask about any accounting item is whether it will eventually become a cash charge.

To an accountant: whether a company paid cash for the asset in the past matters. For an investor: only whether a company will ever have to pay cash again in the future matters.

Carnival is going to buy more ships each year. It spends billions doing that. So, while you own the stock, cash is going to be headed out the door and ships headed in the door.

The same thing would be true if NACCO’s business really consisted of buying existing coal supply contracts. If, while you owned the stock, your expectation was that NACCO would be using cash to purchase intangibles – then, that amortization charge would make a lot more sense as an ongoing expense.

In reality, the company probably isn’t going to be buying more intangibles while you own the stock. And: earnings from supplying coal to existing customers will “expire”, but it’ll be the shut down of the power plants – not the expiration of the contracts – that causes this.

You always want to focus on economic reality rather than the accounting treatment. So, you want to think in terms of how much cash Carnival will spend buying ships rather than how much depreciation expense it will report.

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Insider Buying vs. Insider Incentives

by Geoff Gannon


A blog reader sent me this email:

Do you ever pay attention to insider transactions when analyzing a company?”

I do read through lists of insider buys from time-to-time. I follow a blog that covers these kind of transactions. But, I can't think of any situation where I incorporated insider buying or selling into my analysis.

 

 

Learn How Executives are Compensated

I can, however, think of situations where a change in how insiders were compensated was included in my analysis. For example, years ago, I was looking at a stock called Copart (CPRT). It had a high enough return on capital and generated good enough cash flow that it was going to have more cash on hand than it could re-invest in the business pretty soon. Up to that point, it had been able to plow a lot of the operating cash flow back into expanding the business. However, it seemed like they had gotten too big to keep that up. So, they were going to have to buy back stock, pay a dividend, do an acquisition, or let cash pile up on the balance sheet.

I saw that the Chairman and the CEO (two different people, the CEO is the Chairman's son-in-law) were now going to be compensated in a form that meant the share price a few years down the road is what mattered (if I remember right: compensation would now be a big block of five-year stock options combined with an elimination of essentially all other forms of compensation for those next 5 years). I had also read an interview with the Chairman (it was an old interview I think) where he didn't strike me as the kind of person who was going to venture out beyond his circle of competence if and when he had too much cash.

So, I felt the likelihood of big stock buybacks happening soon was high.

To answer your question: no, I don't really pay attention to insider buying and selling. But, yes, I do pay attention to whether insiders own a lot of stock, how they are compensated (what targets the company has for calculating bonuses), etc.

I can think of one situation where both the company and the CEO were buying a lot of stock at the same time. And, I should have bought that stock. If I had, I would've made a ton of money. However, to be honest, even if the CEO wasn't buying shares and the company wasn't buying back stock I should've seen this was a stock to bet big on.

It was trading for less than the parts would've fetched in sales to private owners. It was an obvious value investment. And that’s probably why insiders were buying.

 

 

Insiders Are Like You – Only Confident

Insiders tend to be value investors in their own companies. So, I think outside investors assume that insiders are acting more on inside information and less on just pure confidence than is really the case. To me, insider buying often just looks like how an especially confident value investor would behave. It’s not that the insider has all this information you don’t – it’s more that (unlike you) the insider doesn’t assume the market knows something he doesn’t.

Part of what I’m basing this on is discussions with insiders about transactions in their own companies. I know some people who have worked at public companies and bought and sold shares of those companies while they were there. Generally, they’ve explained why they bought stock in their company’s shares by saying that the market price moved a lot while nothing inside the company seemed to be changing. Almost always: they’ve described the purchase of shares in the company they worked at as the most “obvious” investment decision they ever made. That’s the word they tend to use: “obvious”.

 

 

Read the 14A

I always read the 14A. The 14A is a proxy document that includes a list of major shareholders, shows how much top executive are paid, discusses the bonus plan (if there is one), etc.

So, I am aware of whether management is paid in cash or stock and what the targets are in the bonus plan. I’m also aware of who the major shareholders are. If I don’t recognize names on that major shareholder list, I’ll try to track down who they are. Sometimes, I also do a little research into when major shareholders bought their stake and whether they’ve ever talked about the business.

I wrote a report on Breeze-Eastern (now part of Transdigm). And, in that case, the major shareholder list made me think the company was more likely than most to sell itself within the next couple years.

That’s not inside information. Who the shareholders were, what they had said publicly, etc. was all out there for anyone to look at.

On the other hand: I have gotten information about a possible sale other folks did not have in two cases. In both cases, someone who interacted with the CEO from time-to-time was sure the company would soon be sold. In both cases, I received that “information” – I’d call it pure rumor – years ago. And, in both cases, the company has still not been sold and the stock does not trade at a higher price now than it did then.

So, the information “everyone knew” was worth more than the information only I knew. The fact of the shareholder list was more useful than the gossip out of headquarters.

All of this research is much easier to do than it sounds. Like I said, facts everyone knows are at least as valuable – I find them more valuable – than gossip only a few people have heard. And the 14A includes sufficient detail to do internet searches on every executive and every major shareholder.

Like 10-Ks, you get better at reading 14As the more you’ve seen. I’ve certainly read hundreds by now.

When I look at any stock: I always read the 10-K and I always read the 14A. Other things like the latest 10-Q, the company’s investor presentation, a recent earnings call transcript, etc. are more optional.

The two documents I consider mandatory reading in all cases are the 10-K and the 14A.

Also, if there’s a “going public” document of some kind (either an IPO or spin-off) that is mandatory reading as well.

 

Read the Merger Document

I’ll take this opportunity to mention that the two documents every investor should be reading (but probably isn’t) are both 14As. By “both” I mean the 14A that is filed in regard to the upcoming annual meeting and the 14A that is filed after the announcement of a merger, going private transaction, etc. looks ready to end the company’s time as a public company.

Generally, the press and analysts and investors basically stop following a public company once it agrees to a merger everyone knows is going to go through.

I want you to be the exception to that rule. Keep following a company till after it is no longer publicly traded.

There will be a wonderful document you want to read that provides:

1.       A “fairness opinion” which will likely include a list of past transactions in the industry and what multiples they were done at.

2.       A “background of the merger” section that will provide a sort of narrative timeline of board decisions, negotiations, etc. from the time someone first considered selling the company to the time the deal went through.

The best source of information about what a public company in an industry is worth is usually this document explaining how a once public peer of the company sold itself.

Here is an example of the merger document Harris Teeter filed in connection with its sale to Kroger (KR). Note here that Harris Teeter actually filed some of the most important parts of this document as a later amendment. For example, the table of EV/EBITDA ratios of past transactions in the supermarket industry was filed in a later amendment.

So, when I say “read the document”, I mean dig through all the amendments too.

This is one of those times where I’m telling you there’s an important piece of information that is very easy to obtain and read – and yet most people aren’t doing it.

It’s public information. But, most investors who could benefit from reading these documents have never read them. So, it might as well be private information.

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Why I Spend 95% of My Time Thinking About New Stocks

by Geoff Gannon


I’ve done a couple posts recently that have too many “rules” type statements in them. As investors: it’s less important what we tell ourselves we’re doing and more important what we’re actually – habitually – doing.

So, how do I spend my day?

If I told you I spend 95% of my time thinking about new stock ideas and 5% of my time thinking about the stocks I already own – I’d be exaggerating how much time I spend thinking about the stocks I already own.

I’m on a constant quest to find new stocks. That might not be obvious judging by how rarely I buy something new. But, that’s how I spend my days. I’m always looking to buy something new.

I don’t really think about what I own. And I don’t really think about “selling right”.

I just think about “buying right”.

Which really consists of:

1)      Picking the right business to be in

2)      Paying the right price

Using NACCO as an example, I decided early on in my research on that spin-off that the coal business was the business I wanted to be in and the small appliance business was the business I didn’t want to be in. It then became a question of the price I was willing to pay.

In very rough terms, I’d decided that I wanted to pay less than $40 a share for the coal business. When I first looked at the price after the spin-off, the coal business was selling for about $32.50. So, I bought it.

The truth is: I’m not really going to re-visit NACCO at all – except sometimes to write a little about it – till the end of 2018.

Someone asked me recently if writing about stocks made me a better investor or a worse investor. I’ll answer that question on the first Q&A episode of my new podcast (reminder: read this post, and send us a question if you get a chance).

It certainly makes me a different investor. The investor part of me spent all my time thinking about NACCO before buying it. The writer has spent all his time thinking about NACCO after buying it.

If I wasn’t writing about the stock, I would’ve bought it in October 2017 and then only checked in again with it around December 2018.

I’ve always thought my attention is best spent focused 100% on finding new ideas. And I know from past experience that thinking a lot about what you own is as likely to hurt your returns as to help those returns.

I know that a lot of attention and effort spent on a stock in the research phase generates better returns. I’m not sure that extra attention and effort spent on a stock you already own generates better returns.

For some people, I think it leads to worse returns.

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So: Am I Keeping Stocks Forever Now – Or Not?

by Geoff Gannon


There is a discrepancy between two posts I wrote. One is this post at Focused Compounding. Another is yesterday’s post here on this blog. A reader pointed this out:

 

In your post on NACCO from 15 December 2017, you state: “I don’t trade around a position. I buy all my shares at one point and sell all my shares at another.”

 

However in your post from 29 May 2017, your verdict is: “Geoff will never voluntarily exit a position entirely. Once he owns a stock, he’ll keep owning at least some of that stock forever unless that company is taken over or goes bankrupt. He will simplify things down to a true “buy and hold” approach. No thought will be given to selling a stock ever again.”

 

Don’t you think that these two statements are contradictory? Do you have a true “buy and hold” approach?

 

I don't have a true buy and hold approach. I'm not a buy and hold investor. I'm always 100% open to selling a stock because I no longer like something about the business, the balance sheet, the management, the capital allocation, etc.

 

However, I'm not really open to selling a stock because it's gotten too expensive.

 

Keep in mind: I find new stocks to buy over time. There are dry spells. Recently, I went almost two years without buying anything. But, my tendency to feed new ideas into the portfolio - in big initial position sizes - means that old ideas tend to become a smaller part of my portfolio over time.

 

So, even if a stock does become more expensive, I'd still be selling some shares of that stock over time just to fund new purchases. The stock could rise as a percent of my portfolio, but I'd still have sold shares in it. Two good examples are Frost and BWXT. Frost is a more than 25% position now (so, it's slightly bigger in percentage terms than when I first bought it even though I've sold shares) and BWXT is close to a 15% position now while it was only originally part of a 20% position that got broke up (I bought Babcock & Wilcox stock pre-spinoff). I've sold about a third of BWXT and Frost, and yet they're both just about the same percentage of my portfolio as when I first bought them. 

 

Having said that, it should tend to be the case the the "stale" ideas in my portfolio will tend to get sold down and the "fresh" ideas in my portfolio will tend to be the biggest positions. The one exception to this would be if something in my portfolio was rising in price at a really unusual - probably very momentum driven - way.

 

It'll be an interesting test of my resolve not to sell based on price if and when that ever happens.

 

So, I'm always open to selling a stock because I no longer like that stock (however, this has historically been a very rare reason for me selling). What has changed in my approach is that I no longer like to choose which stock to sell when buying a new stock.

 

As far as how I'll eventually exit NACCO: I don't know if it'll be a sale of all of the position at once or a gradual reduction of something like one-third of the position each year (as I buy new stuff) along the lines of: 2017: 50% position, 2018: 34%, 2019: 22%, 2020: 15%, 2021: 10%, 2022: 7%, 2023: 5%, 2024: 3%, etc...

 

I'd prefer that my exit from the stock looks like that percentage position size series above. However, that will only happen if I never decide that NACCO - as a business - is too risky to hold on to. If I keep liking the stock, that gradual sell-down is what you'll see. If I decide I made a mistake buying the stock, or something unexpected happens with capital allocation, management, etc. that really bothers me - you'll see the position go to zero overnight.

 

I don't know which I'll do. My preference would certainly be to sell a stock only to replace it with another stock. 

 

So, say my portfolio is now:

 

NACCO: 50%

Frost: 28%

BWXT: 14%

Natoco: 7%

 

And I decide - hypothetically, that I would like to have a new position in Howden Joinery. At a minimum, I would probably want that position to be 20% (as if it was part of a five stock portfolio) and at maximum I would probably want that stock to be a 33% position (as if it was part of a 3 stock portfolio).

 

In the minimum position size (20%) case, the resulting portfolio might look like:

 

NACCO: 40%

Frost: 22%

Howden: 20%

BWXT: 11%

Natoco: 6%

 

And, in the maximum position size (33%) case, the resulting portfolio might look like:

 

NACCO: 34%

Howden: 33%

Frost: 19%

BWXT: 9%

Natoco: 5%

 

However, there are 2 reasons why this literal application of the rule I laid out in the Focused Compounding post - that is, that I'd sell my existing positions down in in exact fractional proportion to my new position to fund that new position - would not be implemented.

 

One, this would be difficult to apply with illiquid and very small positions. So, at some point, I'd just eliminate a small position. To fund my NACCO purchase (in October) I sold about a third of Frost and a third of BWXT to have a position that was half my portfolio (the rest came from cash). However, I didn't touch Natoco, because that stock was too difficult to trade quickly enough to fund a new purchase.

 

So, Natoco is likely to just be sold off from 7% of my portfolio to 0% at some point. 

 

The other reason I wouldn't implement this rule is if I decided I wanted to sell a specific stock for some reason having to do with that old position other than buying a new position. In other words, I still might make a sell decision instead of a buy decision.

 

Let's say I decide that - after about a year of owning it - I re-consider NACCO and decide I don't like the capital allocation, I don't like what the management is doing, I'm more concerned about the future of the company's customers than I was at first, etc. Then, I'd just sell it down from 50% to 0% in one decision.

 

What I was talking about in that post about being a "collector" of stocks is something different.

 

In the past, if my portfolio looked like this:

 

NACCO: 50%

Frost: 28%

BWXT: 14%

Natoco: 7%

 

And I wanted a new 20% position, I'd decide between selling either BWXT and Natoco or just all of Frost or something like that. I'd make a decision about which stock to sell to fund a new purchase.

 

I'm not going to do that anymore. So, if you see my sell NACCO and just NACCO - it'll mean I wanted to get out of NACCO for some reason.

 

If I decide to buy a new stock, I will fund it - as best as I think is practical - through selling down all the stocks I already own in equal proportion.

 

Now, what about the language I just used "as best as I think is practical". There are 2 reasons why selling a position as part of a proportional sale of my existing portfolio would be impractical:

 

1) I've owned the stock for less than one year (in other words, it is impractical to sell from a tax perspective)

2) The stock is illiquid (in other words, it is impractical to sell from a trading perspective)

 

Finally, there is one reason why it would be impractical to keep a position:

 

1) Below a certain portion of my portfolio - it might start to become expensive to sell pieces of a position.

 

I don't use a discount broker. Now, if you look at my actual trading behavior, although I use a very high fee, high commission, etc. broker - I don't have high fees/commissions etc. as a percentage of my portfolio compared to people who use discount brokers. This is because I trade much, much less than they do. 

 

One, I sometimes have lower portfolio turnover than people who use discount brokers. And two: I place much bigger orders - as a percent of my portfolio - than people who use discount brokers. I will place single buy or sell orders that are 20% to 50% of my portfolio. So, the actual number of trades that are executed each year on my behalf is very, very small. 

 

But, this kind of approach would break down if I slowly sold off a very small position into oblivion. So, if I had a 5% position this year that became a 4% position next year a 3% position in 2019, a 2% position in 2020, a 1.5% position in 2021, a 1% position in 2022, a 0.67% position in 2023, etc. That would eventually become wasteful. If I had a $1 billion portfolio, trading a stock exponentially downward by like 0.80 or 0.75 or 0.67 a year forever wouldn't create trading costs that mattered. But, I don't have a $1 billion portfolio. So, eventually that would create meaningful trading costs relative to the position for me.

 

It certainly won't at 5% of the portfolio or above (and honestly, I could go a lot lower without worrying about this).

 

But, as a rule, I'd say that you're right in thinking that positions which are about 5% or higher will be sold down proportionately to fund new positions - as I discussed in the post on "collecting" stocks.

 

Once a stock gets to about 5% or below - I might eliminate it at some point. I haven't had to face this situation yet. Other than Natoco, it could be years before this becomes an issue for me.

 

As far as never selling a stock...

 

I never intended that to mean I wouldn't sell a stock because I no longer liked that stock. I am still retaining the power to sell a stock as a sell decision. What I am doing away with is my power to pick between which stocks to sell to fund a new position.

 

So, in the past, if I owned both FICO (FICO) and Omnicom (OMC) and wanted a new position - I'd choose to either sell all of FICO or all of Omnicom.

 

In the future, I'd just sell a fifth of my FICO position and a fifth of my Omnicom position to create a new position that was a fifth of my portfolio.

 

Like I said in my post on whether I'd sell NACCO - I'll re-consider that stock in about a year. If I don't like that stock for some reason, I'll sell all of it.

 

But, if I just want to buy a new position, I'm not going to sell all of NACCO to do that.

 

I was unclear in my post on NACCO. I said I'd sell all of the position. I didn't mean I'd sell all of it to fund a new purchase. I meant only that if I disliked the stock for some reason - I'd sell it all at once.

 

Whenever I make a new purchase, I'll fund it through selling all of the stocks in my portfolio in the same fractional terms as the new position I want is stated relative to the total portfolio. So, for a 20% position, I'd sell one-fifth of everything I currently own.

 

Finally, I don't know if I mentioned this before or not - but, I've always though of Natoco (the Japanese net-net) as being separate from this new approach. Natoco is an old, leftover position that is more difficult to trade and which I've long said (it's been years now) is slated for the chopping block. When I see a moment where I'd like to exit Natoco, I'll probably exit Natoco in full.

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Was There Ever Any Chance I Was Going to Sell NACCO (NC)?

by Geoff Gannon


I’ve gotten this question a couple times in recent weeks. So, I thought I should address it. First, let’s cover why people have been asking me if I’d sell NACCO. Paying members of the Focused Compounding site have known since October 2nd, that I had 50% of my portfolio in NACCO (NC) bought at an average cost of $32.50 a share. So, the fact this was 50% of my portfolio is probably a big reason people asked whether I’d sell. What were the other reasons?

As the stock went up it got to be a bigger part of my portfolio – reaching nearly 60% of my portfolio about six weeks after I bought the stock – and some people assumed I’d sell to get it back down to 50% or below. Then, two, some people assumed I’d want to “take profits” on a stock that was – at its peak – up almost 40% in something like 6 weeks.

So, let’s look at a chart of NACCO’s stock price since I bought it:

I got a lot of emails about selling NACCO when it first hit the $40 to $42 range and then again when it was in the $44 to $48 range. The stock is now below $40. So, the people asking these questions might make pretty good traders.

However, I think some of the emails I got asking if I’d sell NACCO had more to do with the relative performance of NACCO stock and Hamilton Beach Brands stock once the two were trading separately. Many of the emails mentioned that Hamilton Beach – not NACCO – was the spin-off, so why did I focus on just buying NACCO? After all, I could have bought the “old NACCO” before the spin and then just kept my shares of both NC and HBB. In fact, some people asked if I’d sell my NACCO stock and put some of the proceeds into Hamilton Beach.

If you look at this chart, you can see why they might suggest this:

The truth is: I never considered selling NACCO. There are probably 4 reasons for this:

1)      I don’t trade around a position. I buy all my shares at one point and sell all my shares at another.

2)      I don’t trim positions as they get to be a bigger part of my portfolio.

3)      I don’t “take profits”.

4)      I don’t sell a stock within the first year of buying it.

If something happened to the company that made the stock a lot riskier – I’d considered selling it. But, I would never consider selling a stock within the first year of buying it just because it had gone up 20%, 40%, 80%, or even 160% in price.

I bought NACCO in early October of 2017. I’ll probably first re-consider the position around year-end 2018.

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A U.S. Corporate Tax Cut is Not Priced into Stocks

by Geoff Gannon


I’ve noticed that in a lot of the emails I’ve been getting recently, the emailer says something along the lines of “of course a U.S. corporate tax cut in 2018 is probably already priced into stocks”.

It’s not.

 

The Stock Market is Expensive

Stocks markets around the world – and in the U.S. especially – are very expensive right now. They’re overvalued. And no corporate tax cut being discussed would get close to increasing after-tax earnings enough to bring the normalized P/E on the overall market down to a normal level.

So, stocks generally are overpriced now before any tax cut and will still be overpriced after any corporate tax cut.

However, that’s not what matters to a stock picker. A stock picker chooses individual stocks. Factors like the price level of the stock market or the effective tax rate of the S&P 500 are irrelevant to a stock picker.

To a stock picker: it’s the prices of individual stocks and the taxes paid by those individual stocks that matter.

 

U.S. Stocks that Pay Higher Taxes Than Foreign Peers Aren’t Rising Faster Than Those Peers

The easiest comparison to make is between the big 5 advertising agency holding companies: Omnicom (U.S.), Interpublic (also U.S.), WPP (not U.S.), Publicis (not U.S.), and Dentsu (not U.S.). This is the easiest comparison because the 5 companies are comparable businesses and they are headquartered in different countries – yet they are all “multi-national” in the sense of where their profits come from.

If the market has already priced in a U.S. corporate tax cut – the EV/EBITDA (“DA” is rarely anything more substantial than an accounting charge at advertising companies) – of the U.S. ad agency stocks (that’s Omnicom and Interpublic) should have been rising versus the EV/EBITDA ratios of WPP, Publicis, and Dentsu as a U.S. corporate tax cut looked more and more likely.

What actually happened this year?

Shares in the big 5 global ad companies moved as if these were identical securities. Investors showed no preference for one stock over another. They certainly didn’t start preferring the U.S. ad stocks – Omnicom and Interpublic – over ad stocks elsewhere in the world as we approached year-end.

In fact, I got several emails from people asking whether they should buy WPP instead of Omnicom because WPP is cheaper. None of those emails mentioned that – since the financial crisis – Omnicom has paid much more in taxes than WPP. This may indicate investors are not focused on future tax rates when considering which stock to buy in an industry.

 

The Highest Taxed U.S. Stocks Aren’t Rising Faster Than Other Stocks

Because investors often think in terms of P/E ratios and other after-tax measures (like EPS), another way a U.S. corporate tax cut could be “priced in” to stocks is for those stocks paying the highest tax rates (that is, those converting the least amount of EBIT into EPS) to rise the most in price. These are the stock where EPS will jump the most.

The best example of a high taxed stock is probably Village Supermarket (VLGEA). This company makes all of its profits from supermarkets in the high-tax country of the U.S. and basically all of its profit from supermarkets in the high-tax state of New Jersey (I don’t believe the couple stores outside New Jersey are money makers – though the company doesn’t explicitly break this out).

Village has paid a tax rate of 41% in 13 of the last 15 years. In the other two years, a tax dispute was resolved (against the company) in a way that caused it to book an 83% tax rate in one year and a 26% tax rate in the following year. Altogether, this means the company has been paying a 41% tax rate for at least 15 years.

Because Village is subject to both U.S. and New Jersey taxes on all its profits – it’s an extreme example. But, U.S. supermarkets as a group are highly taxed versus peers. Here is a comparison of how two U.S. supermarket stocks (Village and Kroger) have performed versus two U.K. supermarket stocks (Tesco and Morrison’s). The U.S. supermarkets pay high taxes (that might soon be lower). The U.K. supermarkets pay lower taxes that will presumably stay the same.

How have these stocks traded this year?

Here, it’s notable that these stocks seem to trade more on national – or even international headlines – than on factors that are more determinative of near future earnings per share (like what tax rate they will pay).

The sudden moves are in Kroger and Tesco and probably relate more to Amazon than to taxes.

How likely is it that Amazon buying Whole Foods will have a bigger impact on the financial results of Kroger than what the U.S. corporate tax rate is?

It’s also notable that, in a given month, the two more famous stocks – Kroger and Tesco – sometimes show at least as much similarity with each other as they do with the same-country peer I’ve matched them off with. For example, it’s Tesco and Kroger that have been racing up in price as we approach year-end. Only one of these stocks (Kroger) may be on the verge of getting a big tax break.

Finally, it’s worth noting there is a theoretical difference in how tax cuts should affect firms in different industries. In the long-run, a corporate tax cut may benefit supermarket owners only partially and the rest will go to shoppers. In the ad business – this won’t be true. When an ad agency pays lower corporate taxes this benefits no one but the ad agency.

 

How Messy Would a Corporate Tax Cut Make the Statements of U.S. Public Companies?

This is an email question I got a couple times this year. The long answer is technical. The short answer is…

Pretty messy.

U.S. public companies show both tax assets and tax liabilities on their balance sheet. The valuations put on these lines use the current tax rate as an input. The exact guideline is as follows:

“…using the enacted tax rate expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.”

Therefore, a change in U.S. tax rates will change both the amount shown for tax assets and tax liabilities. The tax assets will be reduced and the tax liabilities will also be reduced (in other words: the balance sheet will shrink). For many companies, the net result will be small.

However, almost every public company in the U.S. has some net tax asset or net tax liability on its books (they don’t cancel out). And how much of a deferred tax asset compared to a deferred tax liability a company has is not evenly distributed by industry. For example, capital intensive industries (like utilities) tend to have large deferred tax liabilities. Meanwhile, firms with large deferred tax assets aren’t really industry specific – instead they come in two flavors:

1)      Companies with large net loss carryforwards

2)      And companies with large employee benefit obligations

Of interest to value investors: it’s possible that some companies that now show up as net-nets may drop off the net-net list – if and when there is a change to the U.S. corporate tax rate.

And of interest to all investors: changes to tax assets and liabilities pass through the net income statement rather than just the comprehensive income statement.

This means that any company that wants to present its EPS to you as if the tax rate was the same in 2018 as it had been in 2017 will have to present you with two “adjustments” to reported earnings:

1)      They will have to tell you that the tax rate was “X” this year and “X plus Y” last year. In other words, they will have to tell you how much they benefited purely from paying less taxes. This, of course, is expected to be a benefit they keep enjoying in the years to come.

2)      More confusingly: they would also have to discuss changes in balance sheet items that pass through the income statement. So, they will have to say something like “our change in the assumed tax rate decreased our tax assets by $1.7 million and decreased our tax liabilities by $1.3 million which, on a net basis, caused a $0.4 million reduction in our reported net income for the quarter.”

Public companies that do investor days, earnings calls, press releases, etc. will likely be very explicit about all this. They will pretty much hold analysts’ hands and tell them what EPS number to use – and it won’t be the reported EPS number.

But, there are other public companies that just dump all this in disclosures. There are U.S. companies – often smaller and sometimes family controlled – that disclose everything but explain nothing.

It’s these less well-covered stocks you should be focusing on in the wake of any U.S. corporate tax cut. Watch those stocks whenever they first release quarterly results that include the impact of any changes in the corporate tax rate. In the hours and days right after they report that quarterly result – the stock may be temporarily oddly priced.

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