Stock Write-Up On Demand

by Geoff Gannon

I’m trying something new here. It will be first come, first served. And there’s only going to be room for a couple people this week.

Request a private write-up on a specific stock.

This write-up can be for the use of you, your family, your firm, etc. You can buy stock in the company, short it, etc. based on my write-up or you can ignore my write-up. The choice is yours.

There is, however, one thing you can’t do.

The one thing you can’t do is share what I write for you anywhere on the internet.

Here’s how it works:

·         Pick a stock

·         I’ll research the stock for you

·         I’ll send you a short write-up summarizing my analysis

·         You’ll send me $100 via PayPal if you’re satisfied with the write-up

Request a Stock Write-Up

4 Great Blog Posts

by Geoff Gannon

In this post, I’m going to combine ideas from two recent posts – “The Chains of Habit” and “My 4 Favorite Blogs” – to show how the four blogs I like best do the kind of work you should be doing as an investor.


Richard Beddard: Howden Joinery

First up, Richard Beddard’s piece on Howden Joinery. He summarizes the company’s business model beautifully right here:

You can almost parse that description phrase by phrase to come up with the bullet points you need to research Howden Joinery:

·         How much capital does Howdens tie up in inventory to “keep everything…in stock”?

·         What are credit losses like at Howdens?

·         What if the public learns about the mark-up tradesmen are adding on the stuff they buy from Howdens?

·         What if Howdens depots had a different incentive pay system?

I’ve researched Howden Joinery myself and those are 4 of the maybe 6 or so questions I wrote down on my yellow notepad.


Value and Opportunity: Topdanmark

Next up, Value and Opportunity wrote a terrifically simple post about Topdanmark. Reading this post felt like reading a case study out of Joel Greenblatt’s “You Can Be a Stock Market Genius.” The idea here is that a company had been buying back stock for almost 18 straight years – there was a little blip during the financial crisis – and now it was going to switch to paying a dividend instead. The market would have to go from valuing Topdanmark as a “cannibal” that eats up its own shares to a dividend yield stock. What would happen?

My favorite part of this post was that such a simple idea was backed up with so much historical evidence:

Clark Street Value: NACCO Industries (NC)

This is a great example of “doing the work”. A lot of the stock write-ups I read don’t show much evidence that the author has actually read the SEC filings (a primary source) rather than relying solely on secondary sources (media reports, other blogs, etc.).

On the surface, what I’m about to quote from Clark Street Value looks like it’s just a business description. But, in reality, you had to read NACCO’s notes on how it prepares its financial statements to be able to lay things out as accurately as Clark Street Value did here:

Now that Hamilton Beach (HBB) has been split off from NACCO (NC), this will be obvious to everyone. NACCO has already released pro-forma numbers for the first 6 months of 2017. But, before the spin off, you had to do some close reading of the 10-K to be able to prepare a write-up like this one.


Kenkyo Investing: Weathernews

Here’s an example of the kind of company I wouldn’t have even known existed unless I read blogs like Kenkyo Investing:

The Chains of Habit

by Geoff Gannon

In my last post, I mentioned Twitter is a distraction most investors are better off keeping themselves clear of. I got some responses like:

“Agree (Twitter) can be (a) distraction. I'm careful who I follow, restrict my usage, save leads for later like you!”

But also:

“…if it’s a distraction for him I get it. But you can literally pick who you follow, don’t have to tweet, connect (with) other investors...”


“…get Geoff’s (point) here, but Twitter has led me to some great ideas, resources, convos. Great tool if used correctly.”

All of these responses are right, of course.

Some people I’ve gone on to meet in real life have mentioned the first place they saw my name was on Twitter. It helps that my Twitter profile says I live in Plano, Texas. This has encouraged investors who live in Texas or are passing through one of Dallas’s airports to reach out to me for a face-to-face meeting. In a couple cases, good things have come from that. And I have Twitter to thank for it.

So, why don’t I think Twitter’s so great?


Part the First: Wherein Geoff Complains All the Good Playwrights have Gone to Hollywood

I started blogging on Christmas Eve 2005. Back then, I used to read a lot of value blogs. Most of them don’t exist anymore. And not enough good ones have been stared up since. Why? Twitter. Some of the best “would-be” value bloggers spend their time on Twitter instead of blogging.

I talk stock ideas with a lot of people via email, Skype, etc. You wouldn’t know the names of anyone I talk with. But some of them are good. Very good. And they know small, obscure stocks in their home regions – Benelux, Nordic countries, India, Southeast Asia, Hong Kong, Latin America, wherever – so much better than I do or likely ever could. In the past, I’d tell them “you should start a blog.” And sometimes, they would. Now, I tell them “you should start a blog”. And they say: “If I have something to say, I can put it on Twitter.”

And they can. And in terms of visibility, I think they’ll get more out of Twitter. They’ll reach a bigger audience. But, if I can be selfish here for a second…

They are robbing me of depth.


Part the Second: Wherein Geoff Complains that All Music Ought Not to be Pop Music

They are robbing me of a considered, potentially contrarian take. Because Twitter is many things. But the one thing it is above all else is: “catchphrase”. To appear on Twitter, an investment idea has to be distilled into a single phrase. And that phrase – if it’s to be re-tweeted widely – has to be catchy.

I’m writing this post in a noisy environment. There are other people here doing other things. And they’re a distraction. So, I have on some good headphones and I have a piano version of “Pachelbel’s Canon in D Major” playing loud on loop. It’s a catchy tune. If you’re not sure if you’ve heard it, you have. If you’ve been on planet Earth any time in the last 30 years, I promise you you’ve heard this song. Parts of it – especially one particular part – crop up in all sorts of music that worms its way into your ears as you go about life (listening to your car radio, shopping in stores, watching TV, going to weddings, etc.)

Here’s the thing. If you search online for Pachelbel’s Canon right now and play it – I’m pretty sure it won’t sound novel to you. I can promise that. You won’t be 100% certain this is the first time you’ve heard this song. None of you will. For some of you, you’ll know exactly where you’ve heard it before. Congrats. But, for others, you’ll know only that you have heard it before – but you won’t remember where.

And then there will be some of you for which this will happen…

You will hit that chord progression (or whatever the famous part is, I don’t know music) and you’ll know only that you are sort of nodding your head on the inside: “Yes, yes this is familiar and catchy and that’s really all I know and really all that matters in this second.”

That’s Twitter. Twitter is Pachelbel’s Canon.

Now, there’s nothing wrong with that if you use it the right way. I’m looping a bit of piano to create a musical cocoon I can write in. If I had a workspace all my own at this moment – I wouldn’t need a piano playing on loop. Likewise, If you’re using Twitter the way investors of old used to start their day with The Wall Street Journal, The Financial Times, etc. and a cup of coffee to ease into the day – that’s fine.

But, Twitter is – like skimming a newspaper – shallow work with a low return on your attentional investment.

I’ve said before that Cal Newport’s “Deep Work” isn’t a great book. But, it is a great idea. Let me plug it again here.


Part the Third: Wherein Geoff Complains that Writers Can’t Ever Be Just Readers Again

You don’t know this about me, but I sometimes write fiction to relax. And I sometimes hang out with real fiction writers – novelists who make a living making stuff up. And when you ask these novelists a question you think is really clever – “what’s the one thing about being a professional writer no one ever told you to expect?” – they all pretty much give you the same 3 answers:

1.        It’s physically demanding. At some point, you’re 100% certain to majorly mess up your back.

2.       You read less.

3.       It changes the way you read.

As someone who managed to mess up his back writing before he reached the age of 30, I’d prefer not to dwell on #1. So: why do writers read less once they become professionals?

Writers, not surprisingly, spend a lot of time writing. And writing and reading exercise the same mental muscles. Writing often feels enough like reading that it ends up taking its place.

Amateurs can write or not write. Professionals don’t have that luxury. They have to write. So, they end up cutting reading from their life. No editor or agent has ever called them up saying “so, how’s the reading coming along?” Any prodding they get from others pushes them toward writing – not reading.

What does this have to do with Twitter? I fear that an hour spent skimming stock related Tweets feels a lot like an hour spent reading a 10-K. We all know our time is better spent actively reading 10-Ks, taking notes, doing our own calculations, etc. And yet, what are we being prodded to do?

Twitter prods us to:

·         Quickly agree/disagree (make a knee-jerk logical judgment)

·         Get outraged about something (make a knee-jerk moral judgment)

·         Click that link (I started this post with a link).

·         Read that book (I told you to go out and get “Deep Work”).

·         Watch that interview.

·         Etc.

No one is prodding you to read a 10-K. A terrific investment for a stock picker to make would be to buy a parrot and teach him only those two words: “10” and “K”.  I doubt I could ever give you a morsel of advice that would do as much to improve your actual stock picking as that kind of constant nagging.

Finally, professional writers report that they can’t read the way they used to. They can’t read “just for fun” anymore. They watch a magic trick, and they see the magician at work. Reading for them becomes more about analyzing the artifice of good storytelling than simply surrendering themselves to the tale.

This, honestly, is where you (the reader of this post) and me (the writer of the post) diverge in terms of our attitudes toward Twitter. A writer is more likely to be changed by Twitter than a reader.

A huge problem with Twitter is that I can clearly see which posts of mine “work” and which “don’t work” in terms of the immediate response of new followers, re-tweets, reactions from people, etc.

My goal isn’t really to get a lot of followers, re-tweets, etc. It’s to write stuff that resonates. More than anything, I want to write stuff that translates into some practical improvement for my readers. I don’t want them to agree with what I write. I want them to incorporate something I wrote into their investment process. I want them to get better because of me.

It’s fine to say that. But, our actions aren’t driven by what we claim to believe. Beliefs simmer on the back burner. Actions are determined by more immediate front burner stuff. They’re driven by things like a nagging parrot that squawks “10-K, 10-K, 10-K”. Our actions are driven by reminders. Our actions are driven by habits. Our actions are driven by the stuff we choose to measure.

If I want to lose weight – I don’t actually have to change my beliefs about what food I should be eating. All I have to do is start recording everything I eat throughout the day. That simple act of monitoring my diet will change my diet. Buy a journal, buy a scale, get someone to nag you to exercise – and that’s all it takes. You’re going to lose some weight. Will this “new me” prove durable without the right principles, motivation, etc. to back it up? Maybe not. But it’ll get you started faster than thinking the right thoughts. It’ll get you actually doing the right things. The act of monitoring followers, re-tweets, likes, etc. can change behavior. If you want your behavior to be changed in the same direction as the stuff Twitter measures and notifies you about – that’s great. Your interests and Twitter’s metrics are aligned.

But, if your preferred metrics for success are different from Twitter’s – that’s a problem. Because you’re going to do what you’re reminded to do – not what you believe in but don’t measure.


Part the Fourth: Wherein Geoff Tells Investors to Eat Their Vegetables

I told you I know some professional novelists. I’ve read one of the earliest works (unpublished of course) by one of these writers. It’s terrible. I don’t just mean it’s unpublishable. I mean, it would quite likely not make it into the top few slots of your average high school writing class. There isn’t anything there that would give you the slightest whiff of innate ability. No teacher would encourage this writer to write more because they saw something good in what the kid was already doing. The only reason they’d encourage him is because they saw passion and they saw some serious work ethic. In fact, this writer went on to write more completed books – before ever getting published – than some successful novelists write in an entire career. He willed himself to become good. And he did.

I’ve talked to a ton of investors over the 12 years I’ve been blogging. Intelligence is not what separates the successful ones from the unsuccessful ones. Having the “best” investment philosophy isn’t what does it either. The ones with initiative succeed. The lazy ones don’t. The difference between those who made it and those who didn’t comes down to what I’d call “intellectual assertiveness”. I’ve been doing this 12 years – so, I’ve now met people who were in high school or college at first and now have several years of really solid investing behind them. All the good ones today are people who from the moment I first met them were willing and eager to go off and do their own work and come to their own conclusions. They were all people who’d rather spend time with a 10-K than with Twitter.

Does that mean a little Twitter is so bad?


But, I want you to be very honest with yourself here when I ask you this. If you are presented with two next actions to take and one is “quick” and “easy” and one is “slow” and “hard” – what’s your next action going to be?


Conclusion: Wherein Geoff Presents Two Expensive, Irrational Habits He Has

I read 10-Ks in a little office I rent about a ten-minute walk from my apartment. It costs me money to rent an office. So, why do I do it?

I use a full service broker I have to call up on the phone to place a trade with. It costs me money to use a full service broker instead of an online broker where I’d enter the trades myself. So, why do I do it?

Twitter is a great tool if you use it right. Online brokers save you a lot of money if you use them right.

I have a lot less confidence in my ability to consistently tackle the slow, hard things when I could instead tackle the quick, easy things than most people do.

Most people judge a tool by how useful it is when put to its best use.

There is a tendency to think all future decisions will be made in the clear light of day.

I try to imagine all future decisions will be made when it’s 2 a.m. – I’m a little sleepy, a little hungry, I’ve had a drink or two. What could go wrong?

Ask Geoff a Question

My 4 Favorite Blogs

by Geoff Gannon

I get asked a lot what my favorite blogs are. I started blogging in 2005. Most of my favorite blogs are no longer active.

However, the four blogs I’d recommend right now are:

1.       Anything by Richard Beddard

2.       Value and Opportunity

3.       Clark Street Value

4.       Kenkyo Investing

You can also follow some of these authors on Twitter (but, you shouldn’t). I’m on Twitter. But, again, you shouldn’t be on Twitter.


I just wrote a post about how you need to go into a room alone with just a 10-K and sit still there for several hours.

You’re not going to do that if you can check your Twitter feed instead.

So, I have three pieces of advice about learning from bloggers:

1.       Read: Richard Beddard, Value and Opportunity, Clark Street Value, and Kenkyo Investing.

2.       Don’t follow any bloggers on Twitter (because you should delete your Twitter account if you’re serious about investing).

3.       Whenever you come across a potentially interesting blog post, print that post out and put it in a folder somewhere that you read all the way through like once a week. Don’t “browse” from one post to another and one blog to another. The way to get a lot out of any reading material is to focus on it and read it closely (like with a pen and calculator). Don’t skim.

Ask Geoff a Question

Roam Free From the Value Investing Herd

by Geoff Gannon

Although allegedly a value investor, my own portfolio is usually idiosyncratic in two respects:

1.       The position sizes I take (right now they’re 50% / 28% / 15% / 7%) are not the position sizes well-known value investors use.

2.       The stocks I own are not owned by well-known value investors.

A lot of readers comment on point #1 (my level of portfolio concentration is by far the topic I get the most emails about). No one ever comments on point #2.

To prove to you that almost none of the stocks I own are owned by well-known value investors, I’ll use Dataroma.

Dataroma tracks the portfolios of about 60 investors. I would call most of them “value investors” and some of them “famous” in the sense that the sort of folks who read this blog would have heard of them.

Here’s my portfolio’s popularity according to Dataroma:

·         Undisclosed Position (50%): One of the investors tracked at Dataroma owns this stock. He has less than 1% of his portfolio in it.

·         Frost (28%): No investor tracked at Dataroma owns this stock.

·         BWX Technologies (15%): No investor tracked at Dataroma owns this stock.

·         Natoco (7%): This is a Japanese stock that Dataroma doesn’t track.

Basically, no famous value investor has a meaningful amount of his portfolio in any stock I own.

This is very different from almost all the stocks I get emails about. People want to talk to me about stocks that a lot of value investors own. They want to talk about stocks that you can find in portfolios over at Dataroma or GuruFocus and that you can read threads about on Corner of Berkshire and Fairfax or read write-ups about at Value Investors Club.

My favorite investing book is Joel Greenblatt’s “You Can Be a Stock Market Genius”. If I can cheat a bit, I’d say my second favorite investing book is the section of “The Snowball” that details Warren Buffett’s career from about 1950-1970.

Both books teach you the importance of doing your own work. In fact, my favorite Ben Graham quote is:

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

The key word here is “your” data and “your” reasoning. At some point, you have to go into a room alone with just the 10-K. And when you come out of that room you need an appraisal value for that stock that’s yours and yours alone.

I would say that 90% of the investors I talk to never get this far. They pick their own stocks. But, they don’t do their own work.

Nothing is going to make you a better investor faster than just picking the 10-K of a stock that’s not well-covered and coming up with an appraisal value for that stock on your own. Repeat this every week. And you’ll be a better investor in no time.

To get you started, here are some stocks that aren’t well-covered but are worth learning about:

·         George Risk (RSKIA)

·         ATN International (ATNI)

·         Ark Restaurants (ARKR)

·         Transcat (TRNS)

·         Tandy Leather (TLF)

·         U.S. Lime (USLM)

·         Green Brick Partners (GRBK)

·         Seaboard (SEB)

·         Hostess Brands Warrants (TWNKW) – Not a stock but worth doing your own homework on

I intentionally limited this list to U.S. listed stocks and tried to find some names that have market caps over $100 million (in fact, a couple there have market caps over $1 billion). The easiest way to find things other value investors don’t own is by focusing on stocks under $100 million and including stocks listed outside the U.S.

Let’s talk small caps.

There’s no perfect relationship between market cap and popularity of a stock. But, going in sort of “order of magnitude” intervals, we could say:

·         Under $300 million market cap: Unknown to investors who don’t do their own work

·         $300 million to $3 billion: Known to professionals and serious stock pickers

·         $3 billion to $30 billion: Known to investors generally

·         $30 billion to $300 billion: Known even to people who don’t invest any of their own money

If you look at the portfolio I have now, at the time I bought shares in these companies:

·         Two of the four stocks had market caps of about $300 million or under

·         Two of the four stocks had market caps of about $3 billion or under

So, about 50% of my ideas were in the $0 to $300 million market cap category and 50% of my ideas were in the $300 million to $3 billion market cap category. None were really in the $3 billion to $30 billion or $30 billion to $300 billion categories.

This isn’t a bad rule for you to follow. Certainly, in the U.S.: at least half of all the good ideas out there have a market cap under $300 million. So, at least half of your portfolio should probably be in stocks with a market cap under $300 million.

Ask Geoff a Question

Hostess Brands (TWNK) Warrants

by Geoff Gannon

Note: Hostess stock is down about 8% as I write this; the warrants are down 10%. Make sure you check for an updated quote on both.

My Focused Compounding co-founder, Andrew Kuhn, recently wrote up Hostess Brands (TWNK) common stock on the member site. Today, I put up a link on my Twitter noting that the company’s CEO is leaving and the Executive Chairman (billionaire Dean Metropoulos) will assume additional duties in the interim. From these two facts, you can probably guess Andrew and I have been looking at Hostess.

That’s true. But, this post isn’t going to be a write-up of Hostess stock. It’s a good business with very strong brands (most famously Twinkies). But, it’s also highly leveraged. Hostess Brands is essentially a publicly traded LBO. And, in the past, Metropoulos has flipped the food companies he’s turned around (example: Pabst Blue Ribbon 2010-2014) fairly quickly.

The above suggests there may be two important limitations on Hostess Brands common stock:

1.       The company is so leveraged the stock may be unsafe even if the brands are safe

2.       The company may be sold within 5 years, limiting the stock’s long-term potential

Downside protection and unlimited time for your idea to work out are usually two of the biggest advantages a common stock holder has over an option holder. If, in this case, the common stock itself is a very leveraged bet and is less likely to be public in 5 years than is normal – you might want to consider buying options instead.

Or better yet: long-term warrants.

Hostess has publicly traded warrants (they trade under the ticker TWNKW – that’s TWNK with an extra “W”) that expire on November 4, 2021 (so, just over 4 years from now).

You need two warrants to get one share of common stock. So, I’ll simplify things by talking in terms of a “pair” of warrants. A pair of warrants are exercisable at $11.50 a share. However, they really must be exercised once the stock exceeds $24 a share, as you can see from this quote taken from the prospectus:

“Once the Public Warrants become exercisable, we may call the Public Warrants for redemption: 

in whole and not in part;

at a price of $0.01 per warrant;

upon not less than 30 days’ prior written notice of redemption to each warrant holder; and

if, and only if, the last reported sale price of the Class A Common Stock equals or exceeds $24.00 per share for any 20 trading days within a 30 trading day period ending on the third trading day prior to the date we send the notice of redemption to the warrant holder.”

So, if you buy 2 warrants today, what you get is: 1) 4 years during which you only need to put down the price of 2 warrants instead of the price of the common stock (as of yesterday, the common stock was over $13 a share and two warrants were priced under $4 a share) and 2) the 4-year possibility of upside limited to movements in the stock price between $11.50 and $24.

So, am I recommending you buy Hostess warrants?

No. But that’s because I’m not ready to recommend you buy Hostess stock.

What I am recommending is that you look at Hostess Brands in general and the warrants in particular.


I was talking to someone who had analyzed Hostess Brands stock recently and asked him: 1) Okay. That’s your appraisal of the stock. Now, what’s your appraisal price for the warrants? 2) If you were going to invest in Hostess, would you do it through the common stock or the warrants?

He didn’t have an answer to those questions. Why? Because, he hadn’t really looked at the warrants at all. Looking at the stock just seemed simpler. 

In my last post, I said “As a stock picker: Your job is to find a great business no one thinks is a great business yet.”

Well, looking at a security that some people aren’t thinking about at all is always a good idea. Other things equal, if you know more people are analyzing the common stock than the warrants – you should start by analyzing the warrants.

Ready to get started? Here is the prospectus for those warrants. And here is Hostess’s 10-K.


Ask Geoff a Question

The Dangers of Holding on to Great Stocks

by Geoff Gannon

Someone emailed me a question about Activision (ATVI), a stock I put 100% of my portfolio into a little over 16 years ago (the stock went on to return 22% a year – but, of course, I didn’t hold on to it these last 16 years):

“Would it be fair to say that your returns would have been much better had you just put all your money into Activision at the time you initially bought it… and just sat on your butt until now? Let's assume that this is a fair assessment for now.

So if we brought ourselves back to the year you bought it, early 2000s was it? If we looked at it with the models you currently possess but likely did not possess back then, could you have made a better allocation based on those models alone?”

The only “model” I can think of that would have improved my performance is not letting myself make any conscious sell decisions. In other words, just selling pieces of all the stocks I own in proportionately equal amounts to fund new purchases, never selling just to hold cash, etc.

I wrote an article discussing some of this. Overall, my sell decisions haven’t added much (if any) value to my investing record. My investment results are primarily a result of taking larger than normal positions in some stocks and then secondarily in picking the right stocks more often than I pick the wrong stocks.

With hindsight, I would have done as good or better while doing far less work if I’d just stuck with a stock like Activision that I once (16 years ago) had the conviction to put 100% of my net worth into it.

However, I think there is both: 1) A valuable truth and 2) A dangerous falsehood in this kind of thinking. Basically, what you’ve uncovered here is a good idea. But, a good idea can be taken to a bad extreme. And, I think the combination of 1) abusing hindsight and 2) going off the stock performance rather than the business performance can skew just how good and certain an idea Activision really was in September of 2001 (when I allocated 100% of my portfolio to it).

I couldn't have foreseen that Activision would return something like 20% to 25% a year for the next 15-20 years. At the time, I thought I was able to foresee Activision could return 10% to 15% a year for the next 10-15 years though. Now, it’s true I thought this thought with enough “certainty” that I was willing to put 100% of my portfolio into the stock. But, I didn’t go “all in” on Activision believing I could make 20% to 25% a year. I did it believing I could make 10% to 15% a year (with greater confidence than I had in any other stocks).

Since 2001, Activision’s capital allocation has turned out to very good, or very lucky - or some combination of the two. Should I have known that would happen? To some extent, yeah. A key reason – really, the key reason – for me buying Activision instead of something like EA is that I liked Activision's management and capital allocation a lot better. In fact, I disliked EA’s management so much I’d never consider buying the stock as long as that management team was there. And I really liked Activision’s management a lot. It’s not like I was neutral on the top people there. I thought they were saying the right things about capital allocation at a time (around the turn of the millennium) when no one was saying the right things about capital allocation. I knew that in a business like video game publishing, book publishing, movies, etc. you bet the “jockey” if by “jockey” we mean best capital allocator. That’s because these businesses produce tons of free cash flow, so your return is largely going to be the return on re-invested cash. There’s no requirement to put the cash back into the franchise that earned in. In fact, you often can’t do that. A hit media franchise can never come close to re-soaking up all the free cash flow it gushes.

Okay. So, I should have held Activision longer. Is this part of a bigger pattern for me?

In general, I haven't been much better off selling a stock I bought to buy another. Certainly, of the stocks I sold within about 10-15 months - where things were going well and the price was rising - I would have been better holding for 10-15 years.

You can see this even more recently. For example, I bought FICO about 7 years ago. The stock has returned over 25% a year since then. I didn't hold it from then till now. 

What you have to be careful about here though is multiple expansion. When you buy something like Activision, J&J Snack Foods, FICO, or Village Supermarket (these are all stocks I bought a lot of when they were really cheap) at a low multiple of sales, book value, earnings, etc. you can consider the substantial annual return bonus you get in the stock from multiple expansion to be one-time but fully justified (and therefore not going to be reversed in future years) up to a point

I’m going to spend the rest of this post explaining what “up to a point” means. It’s one of the most important concepts to long-term, buy and hold investors. This idea that you are – if you buy only cheap stocks – entitled to getting one and only one multiple expansion “bump” to your returns is something buy and hold investors need drilled into their heads during the last stages of a bull market. Since we may now be in the last stages of a bull market, let’s talk about how a justified initial multiple expansion in a stock can quickly morph into a totally unjustified subsequent multiple expansion.

Let me give you some examples.

Activision: I bought this stock at something like an EV/Revenue of 1. It now trades at an EV/Revenue of more than 6. This multiple expansion counts for over 10% of the annual return in the stock. How much of it is justified? Activision shouldn't trade at an EV/Revenue of 1, but I'm not sure it should trade at an EV/Revenue of 6 either. Today, the stock would have to fall more than 50% before I'd say it was clearly "cheap".

FICO: I bought this stock at something like an EV/Revenue of 2. It now trades at an EV/Revenue of more like 5. This multiple expansion counts for over 22% of the annual return in the stock. FICO might have to fall close to 70% before I'd say it was clearly "cheap". 

You want to be careful about this, especially as we are now in one of the longest lasting bull markets ever. It's often better to look at your returns in terms of the business results than the stock results. So, judge your returns by the increase in per share sales, free cash flow, etc.

Having said that, you must also take justified multiple expansion into account to some extent if you're a value investor. I bought Village Supermarket (VLGEA) at a P/E of let's say less than 7 and an EV/Revenue of around 0.1. It was reasonable I think to believe that because the business was a perfectly decent one it would eventually deserve a P/E of about 15 and an EV/Sales of about 0.2 or 0.25. Beyond that, you are starting to get speculative. I often think in terms of what I think I can get as a return over the next 5 years if the company's stock takes that long to get valued at what I think is the "right" multiple. For me (a value investor) this means I am usually buying below the market's "normal" P/E and expecting the stock to at least rise to that level. So, I’m buying Village at a P/E of 7 and expecting it to one day trade at a P/E of 15. For some exceptional businesses – like Omnicom, FICO, and BWX Technologies – I may be buying at a P/E of 15 and expecting the stock to one day trade at a P/E of 25. What I’m not doing though is buying at a P/E of 20 and expecting the stock to one day trade at a P/E of 40 – even though, I know, there may come a time where Mr. Market gets overexcited with this kind of wonderful business and really does give it a P/E of 40.

So, does that mean I should sell when it reaches that level? If I expect a multiple expansion from a P/E of 7 to a P/E of 15 for an average business or from a P/E of 15 to 25 for an above average business, should I sell the second a stock I own hits my P/E “target”?


But, even if you look at someone like Buffett's returns - you can see two features. One, he often did fine if he never sold. This is true even of stocks he did sell. For example, Buffett bought General Dynamics (GD) shares in the early 1990s. He sold the stock. But, he would've done very well if he'd hung on to General Dynamics for the last 25 years. Why? Probably because Buffett analyzed the business and saw it was a good one and he saw that capital allocation was going to be good and then the CEO then in place followed through with that kind of capital allocation and the CEOs that followed him copied those practices. So, the two things Buffett saw that he liked: good economics and good capital allocation proved to be durable.

As an example of what’s durable here – the industry structure of defense contractors and the market power they have with respect to their customer (the U.S. government) and their suppliers (often companies who do not deal directly with the U.S. government the same way they do on big projects) is going to tend to stay the same. If market power and capital allocation don’t change – the right business to own in the 1990s will often stay the right business to own in the 2000s, the 2010s, etc.

This is why it's often a bad idea to ever sell a stock you've bought. In a sense, you are making a very tough bet to get right. You're saying that you correctly judged the quality of the company to be high, its future to be bright, etc. but now you are correctly judging that the company's quality, future prospects, moat etc. are not high enough to overcome the current elevated price. That's a tough bet to ever win. The more certain you were of this business in the first place, the more you should doubt ever selling it. This is if you did the sort of in-depth look at moat, etc. that someone like Buffett does or that I often do. If I think WTW has a moat (like its relative size versus competitors), it's hard to later be right in saying the moat has been breached.  If I think BWXT’s industry structure (it’s a monopolist in some areas and an oligopolist in others) and product economics (it rarely has to tie up much capital ahead of time in anything it does) are so favorable it’s the right stock to buy at a P/E of 15 – then, it’s much harder than you might think for me to reverse myself correctly at a P/E of 30 from a handicapping perspective. This requires an ability in precise quantification that I probably lack. How much is the right product economics and the right industry structure worth? It’s hard to say. What I know is I researched these questions in-depth and liked the answers when I first bought the stock. To do what is probably a more superficial (and biased towards “recency”) analysis later that overturns my initial decision – that’s hard to do. Common law legal systems operate on a principle of precedent. If you believe you made a correct precedent setting decision years ago, leave that decision undisturbed now. A lot of investors are making decisions based on beliefs they might have 50% to 75% confidence in. Don’t do that. You want every decision you make – including overturning a prior decision you made – to be decisions you make with 90% to 100% confidence. The likelihood that you’ll ever have 90%+ confidence in a decision that overturns a previous decision you made is extremely low. Who can reverse themselves with 90% confidence?

Okay. So, whenever possible, leave your stocks undisturbed and your prior decisions in place.

But, I did say there were two features you see with the buy and hold practices of someone like Buffett.

The other feature is that while it's true that if you measure from the time he bought a stock till the time he is still holding it decades later, the return is still often good despite him not selling out at an earlier date - the annual returns is often not as good as it once was. This isn't always true. For example, General Dynamics did worse over the first 10 years from the time Buffett bought it versus the subsequent 15 years. However, if we break down the returns in some of Buffett's favorite stocks into two time periods: the first 10 years and then all the other years - we can see the first 10 years sometimes had really amazing results.

Based on information in Berkshire's annual letters, I estimate Buffett's Washington Post stock returned about 32% a year for the first 10 years he owned it. The stock still did fine as an investment for Buffett once you include the next 20-25 (taking it through the 2000s). But, the returns were very strong in those first 10 years.

Coke shows a similar pattern. The return in that stock was something like 25% a year for the first 10 years. That stock hasn't done well over the last 18 years. A lot of people will blame changes in consumer tastes for that. But, really it was Coke's P/E. The company experienced multiple expansion for the first 10 years Buffett owned it that was very extreme. 

This is why people should be careful about the FANG stocks. Not because they aren't great businesses, but because their stock prices have been growing faster than the underlying business value.

Facebook: Over the last 5 years, there's been a 5% boost to the annual return in FB stock due to multiple expansion (EV/S).

Apple: Over the last 5 years, none of AAPL's annual return has been due to multiple expansion.

Amazon: Over the last 5 years, there's been a 12% annual return boost in AMZN stock due to multiple expansion.

Netflix: Over the last 5 years, there's been a 43% annual return boost in NFLX stock due to multiple expansion.

Google: Over the last 5 years, there's been a 7% annual return boost in GOOGL stock due to multiple expansion.

I based all those multiples on sales, which is usually the safest way to do it. Investors often use the P/E multiple. That can be risky though. Because you are then assuming that both higher sales and higher margins (today vs. the past) are normal. Unless you have very strong evidence about the long-term structure of this business as it scales, I would strongly suggest using growth in sales per share or maybe growth in gross profit per share rather than growth in EPS as your guide to intrinsic value growth.

I actually looked pretty hard at Netflix about 5 years ago and couldn't bring myself to buy it because I'm too much of a value investor who focuses on certain multiples you get accustomed to paying in terms of earnings and things like that. But, Quan and I both knew Netflix was cheap and it was going to have a wider moat in 5 years than it did in 2012. 

Should I blame myself for not having the flexibility to break free from some of that value investing dogma that fills my mind and buying Netflix?

Sure. Probably.

But, should I blame myself for missing out on an 80% annual return in the stock?

No. Netflix has only grown its revenue per share by something like 20% a year. 

Two things have happened to expand Netflix's share price result far beyond this. One, it grew debt. Two, investors valued each dollar of sales higher (even when it came attached with more debt). 

A re-rating of Netflix from having an EV/Sales of 1 to having an EV/Sales of 2 or even 2.5 might make sense based on the company's own past history. Knowledge of the historical economics of similar media companies (cable networks, TV stations, etc.) might even get you to a belief that if Netflix would become both dominant and mature it might even deserve a EV/Sales of 4 at that time. However, no analysis I'd be able to come up with would ever tell me that Netflix deserved an EV/Sales anywhere near 8 unless it was still growing phenomenally fast.

The danger here is always that because of the combination of a strong business performance and then a strong stock performance on top of that (due to multiple expansion) we may become more sure of Facebook, Amazon, Netflix, and Google or of Activision or FICO or whatever long-term winner we own in our portfolio. And the truth is that while some of those businesses are certainly on more stable ground today than when I first analyzed them - other aren't. FICO isn't a wider moat, better company today than when I looked at it. FICO should have been priced at the exact same multiple of sales in 2010 and 2017. Instead, Mr. Market is willing to pay 2.5 times more per dollar of FICO’s sales in 2017 than he was in 2010. FICO was too cheap in 2010. And it’s too expensive now. I could’ve gotten a tremendous return – something like 25% a year – in FICO by holding all the way from when I bought it (knowing it was way too cheap) in 2010 and holding it till today (when I know it’s way too expensive).

But: Is that smart? Is it safe?

Nothing happened with FICO that I didn’t pretty much expect to happen over the next 7 years – except for one thing: I never expected the stock to end up with a P/E of 40.

Let’s look at Netflix over the last 5 years. I'm not sure I'd say Netflix's competitive position today is different from where I expected it to be at this point in time. However, the stock is probably 4 times higher than where I would've told you it should be. In other words, I could have correctly – in very rough terms – guessed where Netflix might be in terms of its number of subscribers, how much it was charging, and how much competition it was facing for the acquisition of content (this was always my biggest concern). Now, I was nowhere near 100% certain of my guess as to where Netflix would be in 5 years. Otherwise, I would have bought the stock. But whether I was 51% certain or was I 75% certain of where the business would be – I still never would have guessed where the stock would be today. I’d have guessed that if Netflix hit all the expectations I had for it (as a business) the stock might return 20% to 30% a year over the next 5 years – not 80% a year.

If you look at Buffett's investment in Coke, the P/E on that stock expanded by about 13% a year in the first 10 years he owned the stock. And I'm sure Buffett would say the quality of those earnings deteriorated as well. Now, I don't mean to say that Buffett was wrong buying Coke at a P/E of 15-17 or whatever he bought it at and believing it deserved a P/E of 25 sometime down the road. We can see from the stock's subsequent history that outside of moments of real financial stress in the market - Coke hasn't really had a P/E of 15-17 since Buffett bought it almost 30 years ago. So, he was justified in the belief (if he had any such belief) that Coke deserved an expansion of its P/E ratio. But, Buffett wouldn't be justified in believing Coke deserved a re-rating in the P/E from 15-17 to say 45-51 (3 times expansion). And yet, at times, Coke actually traded at such a P/E and the stock's long-term performance would have looked amazingly good during those periods. 

That brings us to the classic question: Should Warren Buffett have sold Coke in the late 1990s?

He has a different calculus than the rest of us. Berkshire brings in a lot more new cash to invest all the time. So, I think by not buying more of stocks he already owns he is watering them down in much the same way an individual investor would be when he sells all the stocks he owns in equal proportions.

This is the approach I've chosen to take.

You can see that with my latest purchase. At the start of October, I put 50% of my portfolio into one stock. However, I only had about 30% of my portfolio in cash at the time. So, I had to sell something. Instead of selling all of BWXT (the most expensive stock I owned) I sold about one-third of BWXT and one-third of Frost which means I express no preference when it comes to selling. Now, actually I prefer Frost over BWXT at today’s prices. But, I forced myself to ignore that. I’m trying to only express my preferences in buy decisions – not sell decisions, from now on. Basically, I’m trying to “buy right” and then just forget about what I own.

If I continue to apply this rule, it means I will slowly sell down stocks I own over several years making them a smaller and smaller part of my portfolio as they age.

For example, I took a 50% just now. If I buy a new 20% in 2018 and another new 20% in 2019 and then another new 20% position in 2020, and so on…

That would hypothetically (if the 50% position had the same performance as my other stocks) result in the stock I just bought being 50% of my portfolio in 2017, 40% of my portfolio in 2018, 32% of my portfolio in 2019, 26% of my portfolio in 2020, 20% of my portfolio in 2021, and so on.

That’s not a true “buy and hold” approach. But, it both relieves me of having to make sell decisions and yet also gradually clears out my old ideas (which have presumably risen closer to their intrinsic value) and replaces them with my new (and hopefully cheaper) ideas.

This is the approach I think makes the most sense. I think buy and hold makes a tremendous amount of sense and I recommend it to people who have a constant influx of cash into their savings and don't have a ton of time to ferret out new stock ideas.

In fact, for the average stock picker my advice is:

·         Take everything you saved this year

·         Buy just one stock with all those savings

·         Never sell that stock

·         Repeat every year

That might lead you into situations like Activision and lead you to hold them forever. It would certainly cause you to be focused on what I think matters most: your highest conviction buys. 

Superficially, it would also seem that this approach should lead to wide diversification. However, in practice, this is unlikely to happen. Your winners will become much bigger than your losers if you truly never sell the winners.

I think it's important - especially as I write this in October of 2017 - to consider how with hindsight the results of buying and holding the right stocks through a bull market look better than we should perhaps expect we can do in the future. There are stocks that may have looked like Activision and didn't work out. And then there are periods (like 1965-1982) where multiples simply do not expand on stocks. 

However, have I often sold too soon?

Yes. There are definitely chances I missed to buy and or simply hold a business I knew well and liked. But, I'd also say that much of the subsequent return in these stocks is something I couldn't have counted on (an expanding multiple beyond the historical norm).

I think it's reasonable to buy an undiscovered or misunderstood stock at a low multiple and expect a one-time re-rating of the correct price multiple as that stock is discovered and better understood by the public. However, this is a one time and one time only bump in the stock that may take 3, 5, or even 10 years. A multiple expansion from an EV/EBITDA of 6 to 12 may be justified in cases where you know just how great a business is and the market doesn't yet. An expansion from an EV/EBITDA of 12 to 24 won't be justified ever. But, it will still happen to some stocks you own and while you own it this second expansion may not feel that different from the first (fully justified one).

The thing about bull markets both in the overall market and in specific stocks you own too is that a good idea is first latched on to by a few very smart people and then over time some less and less intelligent people doing less and less in-depth work of their own on that stock take this good idea and they take it way too far. 

When I tell the story of BWX Technologies (BWXT) it makes a great deal of sense at half of today's price (about where I bought it). But, that same story makes a lot less sense as a reason to buy the stock today. The story is the same: BWX Technologies is still a high return, monopoly business that can pass inflation along to its customer (the U.S. Navy). It's clear that you should buy such a business at a P/E of 15. At a P/E of 30, it's less clear. And yet it seems more certain (because of the stock's multiple expansion) to people looking at the stock today than when I first wrote about it.

That's the fear I have when talking about some of these businesses. What you want is to buy an above average business at a multiple below what will be justified in the future when the stock is still undiscovered or misunderstood. 

When I ask for examples of great businesses from people, they bring me examples of businesses that are already recognized by the market as being great.

If you read what I write about the stocks I own – Frost, BWXT, etc. – or stocks I would seriously consider buying (Omnicom, Howden Joinery, etc.) you’ll notice that I’m saying both:

1)      I think this is a great business AND

2)      I don’t think the market fully appreciates this is a great business

So, with BWXT I’ll say that unlike with other stocks you have greater visibility into the long-range buying plans of BWXT’s customer in real terms. With the stock at a P/E of 30, this may now be recognized. At a P/E of 15, it wasn’t. With Frost, I always say that this is a far above average bank at a normal Fed Funds Rate. With a Fed Funds Rate at 0% to 1%, I don’t think the market recognizes this. With a Fed Funds Rate at 3% to 4%, it will recognize it.

It’s nice to talk about stocks I bought 15-20 years ago that have worked out well. But, the market recognizes the quality of those businesses today. When I bought J&J Snack Foods (JJSF) like 17 years ago, it wasn’t recognized as being anything other than a mediocre small-cap stock (the P/E was 12). Over the following 17 years, the business changed far less than the stock did. The stock became recognized.

It’s not worth spending even a second thinking about businesses the market already recognizes as great. The problem with FANG stocks isn’t that they aren’t great businesses. It’s that everyone knows they are great businesses.

As a stock picker: Your job is to find a great business no one thinks is a great business yet.

Ask Geoff a Question

Bought a New Stock: 50% Position

by Geoff Gannon

I bought a new stock today. This is the first buy order I’ve placed in about 2 years.

As of this moment, the new stock is just under 50% of my portfolio.

To fund this purchase, I had to:

·         Use my 30% cash balance

·         Sell one-third of my position in Frost (CFR)

·         Sell one-third of my position in BWX Technologies (BWXT).

I’ll reveal the name of this new position on the blog sometime within the next 30 days. 

Ask Geoff a Question

NACCO (NC) Spin Off Article

by Geoff Gannon

You can read a new article over at GuruFocus that I wrote discussing the lignite coal mining business (NACoal) that will be left over once NACCO spins off its Hamilton Beach brand of small appliances.

NACCO: Why NACoal Is Inside My Circle of Competence and Hamilton Beach Is Outside It

"The company is involved in operating lignite (again that’s “brown”) coal mines for a few major customers. These customers are usually power plants of some kind. They sit very, very near (in some cases, basically on top of) the coal deposit that NACoal is working. I was able to confirm this to my satisfaction by going online and getting satellite images of NACoal’s five biggest mines. Using those images, I can see where the customer’s plant is in relation to the surface mining activity.

I’ve never researched a coal miner before. However, I have researched two companies related to coal mining..."

NACCO: Why NACoal Is Inside My Circle of Competence and Hamilton Beach Is Outside It

Cheesecake Factory vs. The Restaurant Group

by Geoff Gannon

A blog reader emailed me these questions:

“With respect to CAKE and its same-restaurant sales decline, do you have any thoughts on the following:

1.       The strength / source of its economic moat?

2.       Will the cost spread between eating at home and eating away from home narrow, and if so, what will cause it to do so?

3.       Are you worried about declining foot traffic at malls, and brick and mortar stores in general, as it pertains to CAKE?

I’m also wondering if you still feel The Restaurant Group is a potentially attractive idea?”

First, an aside: For those who don’t know, what he’s talking about in #2 is the fact that food prices in U.S. supermarkets have been falling for about 2 years even while food prices in U.S. restaurants have been rising. That’s historically rare. In fact, the recent rate of change in the relative price of food in supermarkets versus food in restaurants may be historically unprecedented.  Other things equal, such a relative price change obviously causes restaurant traffic to fall and supermarket traffic to rise.

Back to the questions…

1) I don't think Cheesecake Factory (CAKE) has a moat. Everyone goes to multiple restaurants. The most successful restaurant chains do a good job of compounding wealth for shareholders and earning high returns on capital. But, no restaurant is insulated from competition with others. So: no moat.

2) Yes. At some point, prices of food in supermarkets will rise faster than prices of food in restaurants. Several publicly traded supermarkets had EPS declines of 10% to 20% this year. That won't continue indefinitely. At some point, they will have to open fewer new stores, close some existing stores, and raise prices. Food at home prices have fallen because retailers have accepted pricing that earns them less money. What's happened is not that food costs are down. It's that supermarket profits are down. The cycle will get worse as long as rivalry in food retail gets more intense and then it will get better only once rivalry in food retail gets less intense. Right now, food retailers are more intense rivals than restaurants. I haven't seen anything that changes costs in food. I've just seen supermarkets and other retailers lowering prices without lowering costs - and thereby lowering profits for themselves and their competitors.

3) Yes. Declining traffic to malls is the biggest risk for Cheesecake Factory. Management thinks it can grow from about 200 locations in the U.S. to about 300 locations. That means finding another 100 good locations for a Cheesecake Factory where there isn't already a Cheesecake Factory. If there is a societal shift away from visiting malls, I'm not sure it'll ever be possible to add 100 more Cheesecake locations in the U.S. It's true that Cheesecake is in better malls and what I've seen anecdotally is the very best malls I've been to in New Jersey and Texas show no signs of any traffic decline while the very worst malls I've been to in New Jersey and Texas show signs that they are on the verge of being totally abandoned.

I don't like The Restaurant Group as much as Cheesecake Factory. The Restaurant Group is a fairly typical operator of fairly typical casual dining restaurants in the U.K. Basically, The Restaurant Group does in the U.K. today what plenty of U.S. casual dining operators started doing a couple decades ago. The problem is that the U.K. is behind the U.S. in terms of the development of casual dining restaurant chains. Chains have been expanding faster over there. This means that the pace of expansion of casual dining concepts and the starting of new casual dining concepts in the U.K. is intense compared to the U.S. I don't like investing in an "unsettled" industry. In the next 5 years, I believe more competing restaurants are going to open near a Restaurant Group location (Franky & Benny's, Chiquito, etc.) than are going to open near a Cheesecake Factory location. 

Cheesecake is a more differentiated concept (it can go in places that make sense for Cheesecake, Maggiano's, or a higher end restaurant but don't make sense for your average Chili's, Olive Garden, Texas Roadhouse, etc.) Cheesecake has a well-known brand (the mindshare is abnormally high for a casual dining restaurant chain). And then Cheesecake is just in places (the U.S., "A" malls, etc.) that aren't going to add as many restaurants within a drivable radius as what you're going to see with The Restaurant Group in the U.K.

I'm not saying The Cheesecake Factory stock is better priced probabilistically versus The Restaurant Group stock. Cheesecake may not be a better investment. I'm just saying Cheesecake Factory has a more certain future. And I'm the kind of investor who prefers to put my money into the business with the more certain future. 

Just as one indicator of what I mean: The Restaurant Group closed something like 30 locations in just one year recently. By comparison, Cheesecake Factory has rarely ever closed a location with the exceptions of: A) moving to a different nearby location or B) Not renewing a lease after there's been a change to the mall in some way. In fact, I think they still opened one net new store in 2008-2009. 

I am speaking only about The Cheesecake Factory concept. I have no opinion on Grand Lux and Rock Sugar. In my appraisal of the stock, I assume those concepts are worthless and only the company's namesake concept has value.

For those who don’t know The Restaurant Group, it’s a collection of U.K. casual dining restaurant chains. I wrote a 10,000+ word report on the stock maybe a year or so ago (it’s up on the member site). The company has had problems recently. For a description of what those problems are and what management is doing to fix them, I recommend reading the latest Interim Results press release.  

Ask Geoff a Question

An Email from a Weight Watchers (WTW) Investor

by Geoff Gannon


I know you already published your WTW post-mortem post but I have been an intermittent reader and after WTW's recent run, decided to check in on your blog.


I first heard about WTW as an investment thesis from your blog. I got the free sample of Avid Hog recommending WTW. I bought my first shares on 9/9/13 and in less than six months, my WTW position occupied 30% of my retirement portfolio. I proceeded to keep buying sporadically and even had the courage to pick up 300 more shares when it hit $6.18 on 5/26/15 - my only purchase of WTW that year. My holdings had an average purchase price of $24.52.


I believe in what WTW is about. Obesity is a systems problem. It is complex…I'm a pastor and I work with substance abuse addicts. Besides behavioral modification, a huge part of recovery is community support, peer reinforcement, and mindset change - all elements of what WTW groups do. Obesity has elements of addiction and disease. I view WTW as a kind of 12-step recovery for obesity. Because of the nature of obesity and addiction, WTW's program will not be successful for even a majority of people but it will be successful for many. Oprah's first ad was also incredible…


I sold 14% of my shares in November and December of 2015 after the Oprah announcement. I wanted to free up some capital for other purposes and re-coup some losses. I sold another 38% in gradual increments this year. I made a modest 5% total gain on all the sales (FIFO). I still have just under 50% of what I originally purchased, at a paper gain of 146%. 


My total return (paper + actual) from 12/6/13 to 9/22/17 is 52.67%, besting the S&P500's 38.53% rise for the same period.


I often felt terrible about pouring more money into WTW as I watched it decline in 2014 and 2015. It was rough. I kicked myself for not considering the impact of debt. I told my wife about my decision and she shook her head. Those were difficult times but I quickly learned not to base my mood off WTW swings. Many days, I would look at the stock price, shake my head, and just laugh. There was no rhyme or reason for the price changes. 


I definitely hated your advice but was reassured that you had skin in the game. I also thought the market was undervaluing everything about the company. It was kind of ridiculous. I stopped reading your blog this past year and I'm glad I didn't read about you selling. It might have influenced me to do the same.


Lessons learned: 


1) I won't make any company 30% of my portfolio again. WTW is currently 20% and I'm gradually taking that down.


2) I'll take a company's debt more seriously before jumping in.


3) Belief in the underlying premise of the company is what drove me not to sell completely. I had hope this company would turn around. (I also hate taking losses at any point and am holding on to worthless shares of…a company that went bankrupt two years ago)


4) I was/am extremely lucky but was also fortunate that I did not panic. I just kept believing that it might come back. 


I'm actually not sure what other lessons there are except that this experience was humbling although perhaps not as humbling as it should have been, due to the happy (thus far) ending. I would love to hear your thoughts. Your post about selling as value subtraction resonates with me and is true of my investing history.”

Talk to Geoff about Weight Watchers (WTW)




He Who Has the Highest Opportunity Cost Wins (CAKE, NC, GRBK)

by Geoff Gannon

Someone who reads the blog emailed me about Cheesecake Factory (CAKE):

Why are you not buying CAKE - it is around 66 cents on the dollar - at 40 dollars (a share)?”

When I answered that to his satisfaction, he asked:

“…So your options right now are most likely OMC, Howden and CAKE? You said in your OMC (stock report) that it was the best business you've ever analyzed. Is that still the case, especially compared to CAKE etc.?”

Omnicom is a better business than Cheesecake. However, Cheesecake may have more room to deploy capital within the business for the next 5, 10, 15 years. Apparently, Cheesecake management still thinks they can grow the concept from 200 locations to 300 locations. It’s not unheard of for them to open 8 new restaurants a year. So, that’s probably equivalent to 3% compound annual growth in the number of Cheesecake locations over a period of 10-15 years. Each location may be capable of earning a 10% to 15% after-tax return on the company’s cash investment of say $8 million to $12 million (they also sign a lease, but this does not tie up any shareholder money). Let’s call it $10 million per location in cash the company puts in and they can repeat that same $10 million bet at each of another 100 new locations – that’s $1 billion more in reinvestment done at rates of 10% plus.

To put this in perspective: Cheesecake may be able to re-invest 50% of its current market cap over the next 10 years at rates of return equal to or greater than 10% a year. It can also buy back its own stock. Both companies can do that and I expect both will do that aggressively. But, Cheesecake may have this additional opportunity to invest about 50% of its market cap over the next 10 years in the actual business at good rates of return. For Omnicom to reinvest 50% of its market cap on those same terms, there would need to be something in the $8 billion to $9 billion price range that will earn a year one 10% plus cash return on your investment.

I don’t see how Omnicom can find something like that. Right now, Omnicom can only compete with that kind of value creating capital allocation by buying back its own stock. Omnicom’s stock would have to stay cheap for a long time while the company gobbled up its own shares for OMC’s capital allocation to add as much value as Cheesecake’s capital allocation. So, Cheesecake may grow intrinsic value per share faster than Omnicom. Omnicom’s still the safer bet if you had to own one stock forever. But, if you have to own one stock for the next 10 years – I can’t promise that OMC has a way to deploy as much cash as profitably as Cheesecake might. Again, I stress might (CAKE needs to find good mall type locations to do this).

My options other than Cheesecake are not limited to Omnicom and Howden Joinery.

I look at a lot of stocks.

Yes. The ones recently that stand out as the kind of businesses I would normally buy at the kind of price I normally like are: Cheesecake Factory, Howden Joinery, and Omnicom. Those are the most stereotypical me type stocks.

However, there are other stocks I look at that also seem potentially attractive. I just may not be done researching them enough to know them as well as I know things like Cheesecake, Howden, and Omnicom (all of which I originally researched at least a year ago and in one case - Omnicom - more than 8 years ago.)

Right now, two stocks that stand out as deserving a lot more study are: NAACO (NC) and Greenbrick Partners (GRBK)

NAACO is splitting into what should be a pretty capital light, non-cyclical, and non-competitive coal mining business and the Hamilton Beach small appliances business. 

Green Brick Partners is a homebuilder that is split close to evenly between Dallas Fort-Worth (it builds homes in places like Frisco, which is right by where I live in Plano) and Atlanta. I don't know the Atlanta housing market. But, I do know the Dallas housing market. The stock trades at about 1.1 times book value. However, in the homebuilding industry, land is usually held for 2-5 years from the time a homebuilder buys it to the time they sell the finished house on that land. Land prices in Dallas Fort-Worth have risen, so the fair value of their holdings would actually somewhat exceed 110% of book value - meaning, the market value of the company's assets is slightly greater than the market cap of the company. They have enough net operating loss carryforwards to not pay taxes for another 3-5 years depending on how much they grow earnings. The decision maker (Jim Brickman) is a good homebuilding guy and has a meaningful personal stake in the company. Together with David Einhorn's Greenlight capital (about a 50% owner) and Dan Loeb's Third Point (about a 17% owner) people who are insiders/long-term investors of some kind hold about 75% of Green Brick Partners. So, the float is probably no more than $125 million. The stock was, in recent memory, a speculative ethanol type company that was used as the public entity to take this Einhorn/Brickman homebuilding entity public. In investors’ minds, the company is probably not “seasoned” as much as it’s going to get in the sense that if I say “Green Brick Partners” today – you may not have recognized the name and if you did you may not have immediately remembered it’s a homebuilder and even if you did remember that you still might not have remembered where it builds home (Dallas and Atlanta). It’s underrecognized. If you buy the stock in 2017 and plan to sell it in 2022, you'll probably be selling a bigger, more recognized stock with a higher price-to-book multiple that is then starting to pay taxes.

A homebuilder is not the kind of stock I'd usually buy. Green Brick isn’t a capital light pure homebuilder like NVR (NVR). Nor is it more of a marketing machine like LGI Homes (LGIH). It’s something that buys up land, holds it for up to five years, puts a house on it, and then sells the land plus the house. There’s no cash flow that doesn’t go back into buying up more land. Everything it does is tied to residential land values where it operates. So, this is purely an investment in residential land in Dallas and Atlanta. However, the combination of UNTAXED (for now) cash flow from homebuilding activities going back into buying additional land plus the annual appreciation of land while it’s on the balance sheet gets you to a good growth in Market Value of Land Per Share which is what the intrinsic value of the company obviously is.

Green Brick Partners is clearly very attractive relative to the market. The S&P 500 is trading at probably twice what it normally does. One times book is not above normal for a homebuilder that operates only in good metro areas. And then I feel sure that on a per share basis Green Brick Partners will grow its book value faster over the next 5 years than the S&P 500 will grow its EPS. So, Green Brick definitely has higher growth and a lower price multiple than the overall market.

It's an attractive potential investment. And I'd have to compare something like Green Brick to something like Cheesecake to something like Omnicom to decide which to buy.

Most investors would just buy Howden and buy Omnicom and buy Cheesecake Factory and buy Green Brick Partners and buy AutoZone if they felt the way about those stocks that I do. 

But then they'd eventually end up with a portfolio of like 20 stocks with 5% in each instead of a portfolio with 5 stocks and 20% in each like I want. 

If you've read “The Snowball” and looked carefully at how Warren Buffett sized positions in his own portfolio and the partnership in the 1950s and 1960s - that's more how I operate. 

Right now, my portfolio is basically:

40% Frost (CFR)

25% BWX Technologies (BWXT)

35% Cash

I'm very concentrated and very patient. I'm so slow to buy a stock. I mention my high selectivity / concentration in posts all the time, but I don't think readers really understand how different that makes my decision making from their decision making.

I haven't bought a stock in 2 years.

Chances are that if I do buy Omnicom, Howden, Cheesecake, AutoZone, Green Brick Partners, or NAACO it will only be one of those stocks. It could be two if I like one best now and then another one absolutely plummets in price.

But, because I buy so few stocks and buy them so rarely – my hurdle is very high. If you see me buy Cheesecake, it means that ultimately I decided I felt more comfortable with Cheesecake as a business and at this price than I did with EACH AND EVERY ONE OF: Omnicom, Howden, AutoZone, Green Brick, NAACO, etc. That's a high hurdle to clear. 

One of the best ways to improve your investment returns is simply to raise your opportunity cost.

If the best idea you DON'T buy is better than most the ideas other investors DO buy – then, you'll win over time.

Talk to Geoff about Raising Your Opportunity Costs


5 Stocks Ben Graham Would Buy

by Geoff Gannon

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

Here are 5 of those retailers:

(All numbers are taken from GuruFocus)

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

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

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

What do I consider the spirit of Ben Graham?

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

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

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

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

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

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


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

I do.

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

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

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

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

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

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


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

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


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

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


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

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


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

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


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

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

Those assets include:

·         155 existing supermarkets

·         18 undeveloped sites suitable for a new supermarket

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

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

·         A 1.65 million square foot distribution center / headquarters

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

·         A 139,000 square foot warehouse

·         The 21 acres on which that warehouse is located

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

·         The 20 acres on which those buildings are located

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

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

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

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

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

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

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

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

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

Talk to Geoff about 5 Stocks Ben Graham Would Buy

Are You Buying Anything Now?

by Geoff Gannon

A blog reader emailed me this question:

“Are you buying anything now?”

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

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

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

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

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

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

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

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

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

Talk to Geoff about Whether He’s Buying Anything Now

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

by Geoff Gannon

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

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

“Hi Geoff,

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

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

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

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

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

The formula:

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

That's only the cash interest rate though.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Full Report on Frost (CFR)

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

·         Frost’s deposits per share

·         The Fed Funds Rate

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

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

Talk to Geoff about Frost


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

by Geoff Gannon

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

Read my interview with Punch Card Research about Frost

Read the report I did on Frost

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

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

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

Talk to Geoff about Frost (CFR)


Why Ad Agencies Should Always Buy Back Their Own Stock

by Geoff Gannon

(Excerpt from today's Focused Compounding article)

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

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

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

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

How would the market efficiently price ad agency stocks?

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

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

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

Focused Compounding