Insider Buying vs. Insider Incentives

by Geoff Gannon

A blog reader sent me this email:

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

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



Learn How Executives are Compensated

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

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

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

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

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

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



Insiders Are Like You – Only Confident

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

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



Read the 14A

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

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

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

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

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

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

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

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

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

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

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


Read the Merger Document

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

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

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

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

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

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

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

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

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

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

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

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

by Geoff Gannon

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

So, how do I spend my day?

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

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

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

I just think about “buying right”.

Which really consists of:

1)      Picking the right business to be in

2)      Paying the right price

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

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

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

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

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

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

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

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

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

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

by Geoff Gannon

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


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


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


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


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


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


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


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


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


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


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


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


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


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


So, say my portfolio is now:


NACCO: 50%

Frost: 28%

BWXT: 14%

Natoco: 7%


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


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


NACCO: 40%

Frost: 22%

Howden: 20%

BWXT: 11%

Natoco: 6%


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


NACCO: 34%

Howden: 33%

Frost: 19%

BWXT: 9%

Natoco: 5%


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


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


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


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


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


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


In the past, if my portfolio looked like this:


NACCO: 50%

Frost: 28%

BWXT: 14%

Natoco: 7%


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


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


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


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


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

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


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


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


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


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


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


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


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


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


As far as never selling a stock...


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


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


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


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


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


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


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


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

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

by Geoff Gannon

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

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

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

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

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

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

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

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

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

3)      I don’t “take profits”.

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

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

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

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

by Geoff Gannon

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

It’s not.


The Stock Market is Expensive

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

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

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

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


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

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

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

What actually happened this year?

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

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


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

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

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

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

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

How have these stocks traded this year?

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

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

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

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

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


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

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

Pretty messy.

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

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

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

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

1)      Companies with large net loss carryforwards

2)      And companies with large employee benefit obligations

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

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

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

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

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

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

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

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

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Why I Don’t Use WACC

by Geoff Gannon

A blog reader emailed me this question about why I appraise stocks using a pure enterprise value approach – as if debt and equity had the same “cost of capital” – instead of using a Weighted Average Cost of Capital (WACC) approach:


“…debt and equity have different costs. In businesses with a (large) amount of the capital provided by debt at low rates, this would distort the business value. In essence I am asking why do you not determine the value of the business using a WACC, similar to how Professor Greenwald proposes in Value Investing: From Graham to Buffett and Beyond. The Earnings Power Value model seems theoretically correct, but of course determining WACC is complicated and subject to changes in the future. Nevertheless, your approach of capitalizing MSC at 5% is basically capitalizing the entire business value, including the amount financed by debt, at what is presumably your cost of equity for a business with MSC's ROIC and growth characteristics. Perhaps I am coming at this from a different angle than you, but it seems a little inconsistent from the way I am thinking about it, and for businesses with more debt this would lead to bigger distortions. AutoNation would be a good example of a business with meaningful…debt that this approach would distort the valuation on.”


When I’m doing my appraisal of the stock – this is my judgment on what the stock is worth not whether or not I’d buy the stock knowing it’s worth this amount – I’m judging the business as a business rather than the business as a corporation with a certain capital allocator at the helm. Capital allocation makes a huge difference in the long-term returns of stocks. You can find proof of that by reading “The Outsiders”. Financial engineering makes a difference in the long-term returns of a stock. You can read any book about John Malone or Warren Buffett to see that point illustrated.


But, for me…


My appraisal of Berkshire Hathaway is my appraisal of the business independent of Warren Buffett. Now, knowing Warren Buffett controls Berkshire Hathaway would make me more likely to buy the stock and to hold the stock. So, it’s an investment consideration. But, it’s not an appraisal consideration for me. When I appraise Berkshire Hathaway, I appraise the businesses without considering who is allocating capital. Otherwise, I’d value Berkshire at one price today and a different price if Warren died tomorrow. I don’t think that’s a logical way to appraise an asset. Although I do think that buying an asset that’s managed by the right person is a good way to invest.


A good example of this is DreamWorks Animation (now part of Comcast). Quan and I valued DreamWorks Animation at a level that was sometimes more than double the stock’s price.


There was a point where we could have bought the stock at probably 45% of what we thought the business was worth.


However, we asked each other: “If you bought this stock today and then Jeffrey Katzenberg died tomorrow, would you hold the stock?” Both of us said no.

That didn’t change our appraisal of the stock.


It did change whether we’d buy the stock or not.


We thought that – with or without Katzenberg running the company – the business of DreamWorks Animation (its distribution deals, the library it had, the characters it had the rights to, the systems it had in place, etc.) meant it was worth more than the stock market was then valuing it at. We just weren’t comfortable investing in a movie studio – even at a discount to our appraisal of that movie studio as a movie studio – without being sure we liked the guy running the place. What I mean is that if I was a private buyer and I was offered DreamWorks stock at $18 or whatever the low on that stock was at one point – I would’ve said “does it come with Katzenberg or not?” And if the answer was “No, he’s retiring”, my answer would be “Thanks. But we’ll pass on this deal”. I don’t want to own a movie studio without knowing who is going to run it.


I can value a movie studio without knowing anything about the head of that studio. But, I can’t invest in it.


When I appraise the business – I just appraise the business like I’m being asked by a private buyer and a private seller to arbitrate the case of how much cash should pass between the buyer and seller for this asset.


So, questions of how a business is organized as a corporation – where it is incorporated, how much debt it uses, how aggressively it avoids taxes, etc. – can be part of my thought process when it comes to a “go or no go” call on investing in the stock. But, these considerations don’t change how much I appraise the stock for. I would never arbitrate a dispute between a buyer and seller differently because of those considerations.


Honestly, I always value a stock – that is, a single piece of equity in the company – by first valuing the entire enterprise as if it was being sold to a 100% private buyer. Although I’m looking at a public company – I always think of it as if it’s about to become a private company.


I always use capitalization independent measures of value (an enterprise value based approach) when valuing a business. I understand the logic of valuing a business controlled by a certain capital allocator - Warren Buffett, John Malone, Robert Keane (head of Cimpress / "Vistaprint") etc. – using a mix where debt and equity are valued differently. However, when valuing a business, I am trying to appraise the day-to-day operations of the business in the sense of what is inherent to the operation – not the current corporate structure, current capital allocation policies, etc. which can all change if the company's management changes. 


Sometimes, there are long-term financing advantages in place at a company. For example, among U.S. supermarket: Village Supermarkets (VLGEA) has long-term leases (often running 20-40 years) that allow it to occupy good locations in New Jersey at reasonable rental rates and Kroger (KR) has effectively financed the supermarkets it owns outright (about half of everything it occupies) using long-term fixed rate bonds that mostly pay low after-tax interest rates. When considering whether or not to invest in these businesses, I certainly consider the fact these leases don’t run just 5 years and these bonds aren’t due in just 5 years.


But, normally, I try to value businesses using multiples of EBIT, EBITDA, etc. that are independent of how the business is capitalized (whether it is using debt or equity) and even often how the business is taxed (if it is incorporated in the U.S. or Swizterland for example).


When writing Singular Diligence, Quan and I disagreed a bit about this. And so, sometimes we applied a higher EBIT multiple for European companies than we did for U.S. companies. I am not sure I agree with that kind of thinking. Over time, corporate tax rates in a European country could rise and corporate tax rates in the U.S., Japan, etc. could fall. It is probably unwise to assume a 100% probability of the same corporate tax rate everywhere in the world. However, I have always also felt that it's actually wrong to assume a 100% probability that the current corporate tax rate in a country will remain the current corporate tax rate.


Within a year, the U.S. corporate tax rate could be about 40% of what it was 50 years ago. I’m not sure that – 25 years ago – your ability to guess whether the U.S. corporate tax rate would stay the same, double, or halve over the next 25 years would have been very good.


Taxes from country to country – and state to state within the U.S. – vary quite a lot. Countries and states can change their tax rates. And corporations can change where they do business to avoid taxes.


Often, the difference a change in tax rates would make is not taken into account by investors.


For example, Village Supermarket (VLGEA) hasn’t really paid less than 41% in taxes at any point in the last 15 years (there’s one exception that’s too complicated to get into here), and would – under some proposed tax plans in Congress – have made about $1.90 to $2 in EPS last year instead of $1.60 if rates had been different.


If you just take the most recent tax rate as being the tax a company will always pay – you’d be changing your appraisal of Village by something like $6 a share depending on whether the federal tax rate was what it is now or what it might be soon. It’s only a $23 stock. So, a $6 adjustment in your appraisal price is about 25% of the market price.


The stock’s EV/EBIT of less than 7 looks low. The stock’s P/E over 14 doesn’t looks so low. If I could only use one measure: I’d always favor EV/EBIT over P/E. So, I’d say that stock looked cheap to me. Other folks – looking at the P/E of 14 – don’t see anything noteworthy there.


It sounds like a small point when I warn someone that Village might be worth $5 to $6 more per share if corporate tax rates were cut or Apple might be worth $15 less a share if top management decided to be less aggressive about avoiding taxes.


But, this becomes an issue in some cases that the market doesn’t pay enough attention to. I can see some industries right now (like ad agencies) where global peers inside and outside the U.S. have tracked each other nearly perfectly in terms of stock price movements this year but which – if the U.S. cuts its corporate tax rates – will see very different movements in their P/E ratios in the years ahead. The U.S. headquartered companies are going to grow their after-tax earnings a lot faster than the non-U.S. headquartered companies. And this isn’t because they are doing business in different countries – it’s just because of where they’re headquarters is.


Now, you can certainly use an approach where you value debt and equity differently and still be aware of these things. But, that’s a lot to think about. And you’re likely to default to just assuming that whatever the market now values stocks at is what tells you the correct cost of equity, whatever tax rates now are goes into your model, etc.


I’d rather move up the income statement and think in terms of how much pre-tax income (in cash form) the company is producing versus the amount of total capital it’s using (not what is equity and what is debt in that mix).


I find the approach that works best for me is to try to value whatever company I am looking at – Village Supermarket, Apple, etc. – as if I’m appraising the business independent of the corporate tax policy, corporate debt policy, etc.  


Then I just take the amount of debt the company has and give the bondholders the first portion of EV (up to the face value of the debt) and the appraised business value that’s left over is what I assign to the equity holders.




This gets into the issue of what I'm trying to accomplish by using an appraisal method of Enterprise Value (not just market cap) that uses EBIT (earnings before interest and taxes).


A business model does not have an inherent and immutable interest rate it pays, it does not have an inherent and immutable tax rate that it pays, and it does not have an inherent and immutable mix of debt and equity. These things will change over time. They are really "corporate" issues - that is, issues of financial engineering - rather than business issues. 


When I appraise a company I generally want to use a "highest and best use" type approach like one would use with real estate. So, if a company is - like Village Supermarket (VLGEA) is - paying a 41% tax rate (between U.S. Federal and New Jersey state taxes) I don't want to make the mistake of assuming that's entirely a result of business decisions rather than financial engineering (corporate) decisions. The same is true - in the opposite direction - of something like Cimpress. Cimpress would be difficult to engineer in a way where it would pay less in taxes. The same is true for many of the big tech and drug stocks in the U.S. It would be hard to engineer these companies in a way where they would pay less in taxes than they already are. We need to dock them for that relative to company’s that can be financially engineered to pay less in taxes, carry more debt, etc. than they are now.


I want to be careful not to overvalue Apple and undervalue Village. The EV/EBIT ratio is helpful in avoiding this. The P/E ratio is not.


We could assume that we should treat things like debt-to-equity ratios, tax rates, interest rates, etc. as givens that won't change.


Or: we could assume that these things should tend to be leveled off much the way they would be in a 100% buyer's mind.


I think that’s the best approach. Instead of always thinking about what tax rates might change, how the cost of debt and equity might change, etc. we try to think in terms of what a private buyer would pay for 100% of the business if he could organize the business under any corporate umbrella he wanted to.


Let's use Village Supermarket as an example. Imagine it was for sale. Now, Village is - I think - the second biggest member of Wakefern. There are limitations on a non-Wakefern member being an owner. So, you can't really own supermarkets inside and outside the Wakefern (Shop-Rite) system. This means Kroger can never acquire Village. However, there is nothing stopping someone like a private equity owner from buying both the #1 and #2 biggest Wakefern members, firing the family members who work at those companies, leveraging up the combined (and now more synergistic) Shop-Rite operator and thereby paying less in corporate expenses, paying less in taxes, and tying up less capital relative to sales than is currently done at Village. In fact, if I had hundreds of millions or $1 billion on hand that is exactly how I would consider buying 100% of Village in a negotiated transaction. And ultimately it is this figure - what a company would be worth to a private control buyer - that I want to nail down. It’s important that - if I'm going to come to a conclusion that's independent of the stock market - I think in terms of a transaction for the whole company instead of asking myself what a passive, minority shareholder would pay for a share of the stock. 


I don't want to ask: what would the stock market pay for Village?


I want to ask: what would a knowledgeable, private owner/operator of supermarkets pay for Village.


I find treating debt and equity the same useful when making that calculation.


Using Cimpress as an example takes us the other way. Cimpress may be valued more highly in the stock market than it would be valued by a private owner, because the person who controls Cimpress is running it in a way to maximize how much he can report in "adjusted" earnings and how little the company pays in taxes and so on. This isn’t necessarily the wrong way to run the business to maximize intrinsic value over time. It might be the right way. But, what I’m saying is that – if I was analyzing the acquisition of Cimpress as a 100% control buyer intending to take the company private, I’d have a hard time figuring out what I could do to end up with more after-tax cash in my pocket than the company is producing now. Likewise, I’d have a hard time figuring out how I could keep less of my own capital in the business (Cimpress has debt, capital leases, etc.) when I owned it than shareholders are now keeping in Cimpress.


If you have the time, go look at what Cimpress has paid over the last 15 years or so in taxes and what Omnicom has paid over the last 15 years or so in taxes. Then try to figure out how much of each company’s earnings have come from high tax countries like the U.S., lower tax countries, etc. I can’t come up with a business explanation for the tax differences. I can, however come up with theories on how you could do that through corporate level decisions.


That’s what financial engineering looks like. Based on that, I don’t think it would be a good idea to award as high a P/E ratio to Cimpress as you would to Omnicom. You can level this by looking at measures like EV/EBITDA and EV/EBIT.


Overall: I really want to discourage investors from ever using the P/E multiple in place of the EV/EBIT multiple.


In some cases, like Berkshire Hathaway (BRK.B) and Village Supermarket (VLGEA) there are steps the companies could take immediately to report higher earnings after-taxes than they now report. The stock market often does not see this or does not care about this. However, a potential buyer of the entire business always thinks in these terms. He thinks about how he could use debt instead of equity, how he could pay less in taxes, how he could combine one company with another, what he could do with excess cash on the balance sheet, etc.

The concept of weighted average cost of capital (WACC) is popular with academics. Bruce Greenwald is an academic. And so he used WACC in the book he wrote on value investing. If I ever wrote a book on value investing, I'd never once mention WACC.


And I don't think Buffett or Munger would either.


Now, that isn't to say that "cost of capital" doesn't matter. But, the way WACC is used by academics is problematic. Here's why. One, it's unnecessarily complicated. There is no need for the board of directors, the CEO, etc. to know what the cost of equity capital is. Their job is to maximize the return on equity. This means they may want to take on debt to the extent they can safely increase the after-tax earning power of the equity. It also means they may want to buy back stock if it increases the after-tax earning power of the equity. And, they may even want to issue stock if it increases the after-tax earning power of the equity. So, they need to think in terms of earning power. But, it's not actually necessary for any capital allocator to know what the market is going to value their equity at. John Malone is a good example. John Malone does not need to think in terms of Discovery Communications having a higher cost of capital when it uses equity, because investors are likely - since Discovery owns cable channels - to assign a lower earnings multiple to Discovery's equity than to the equity in other Malone holdings.


First of all, they could be wrong. In fact, I suspect John Malone and passive, minority investors differ in their appraisal of Discovery Communications equity. 


And honestly, it is John Malone's appraisal of Discovery Communications stock that probably matters more than passive, minority investors' appraisal of the stock. That's because the value in Discovery Communications can always come from a transaction done outside of the stock market (taking it private, combining it with another company for cash, combining it with another company for stock, etc.). 


Or, we could take the Disney and Fox negotiations. Murdoch has to consider whether he wants to be paid in stock or cash. He might also prefer one buyer over another, because he prefers one stock over another. Murdoch doesn’t need to think in terms of WACC to make this decision. He just needs to think of the price he is being offered in terms of the intrinsic value of Disney shares rather than the market price of Disney shares. If you’re locking yourself into a stock for any reason, the market price of that stock isn’t what matters to you. What matters to you is your appraisal of the intrinsic value of that stock.


I just don't see how thinking in terms of WACC makes sense when you are talking about equity. Now, what the cost of a company's liabilities are does matter. And we can get into that discussion in a second. But, the cost of equity is not something you need to figure out. It's an unnecessary complication in determining value. It's overly academic.


Very often, when you believe one company’s equity is worth a low multiple of book value and another company’s equity is worth a high multiple of book value – what you’re really saying is that one company (the high book value company) has ample access to stable, long-term, and low-cost funding as part of its day-to-day business. Examples would be: Berkshire Hathaway (BRK.B), Frost (CFR), Progressive (PGR), Omnicom (OMC), and Dun & Bradstreet (DNB).


In all those cases though, the low-cost funding comes from the basic business model. It is not the result of commodity type liabilities like issuing bonds. For example, Omnicom – and actually Berkshire long ago in its history (about 1989 I think) – did engage in some financial engineering to get low cost funding where they issued zero-coupon bonds. In a sense, issuing zero coupon bonds – the Omnicom zeroes were convertible into the stock – was a long-term speculation on interest rates (and because the bonds were convertible, the stock’s P/E ratio). Basically, Omnicom tried to lower its cost of capital (its WACC) through a pure financing play of trying to take the other side of a speculation from the market.


Omnicom was – this was in 2003 just after the millennium bubble years – betting that long-term interest rates were low and the stock’s own P/E was high. The imputed interest – interest you owe each year but don’t actually pay yet – also has tax implications that a financial engineer might be interested in.


Basically, these are bets. To the extent Berkshire and Omnicom were able to lower their cost of capital via these deals it’s really just because they were smarter than the people on the other side of the table from them. You too can find ways to bet P/E multiples won’t expand from a certain point, interest rates won’t rise from a certain point, etc. If WACC got lowered by these deals, that’s because management was smart and opportunistic not because it was an inherent characteristic of the business model.


I’m only interested in things that lower WACC that are a constant feature of the business itself.


I have written a ton about a company's cost of liabilities. But, I've done it specifically about what I consider day-to-day cost of liabilities concerns rather than financial engineering concerns. If I was a control investor - or at least an "influence" investor - like John Malone often is, then I might worry about financial engineering. But, I can't buy Village Supermarket with the idea of getting them to make changes to their cash, debt, owned buildings, leased buildings, etc. in order to reduce the amount of equity capital in the business while also reducing the amount of taxes paid. John Malone can do that in some cases.


So, what companies have a low cost of liabilities?


One, insurers have a low cost of liabilities if they are able to operate at a combined ratio below 100. This is what Berkshire Hathaway's insurers do. Berkshire owns a ton of niche insurers that have very low combined ratios (but aren't big enough to get individually discussed in Buffett's annual letters). Berkshire also owns GEICO. Progressive is a good comparable for GEICO. Progressive has been able to achieve high returns on equity (and grow intrinsic value per share) because it has a lower cost of liabilities than a life insurer like MetLife. In the long-run, MetLife is going to have trouble compounding shareholder value the way Progressive does because MetLife is paying more for its liabilities than Progressive is.


Other companies I have written about also have ample day-to-day business access to liabilities that have a cost of 0%. These include database / subscription type businesses like John Wiley, Dun & Bradstreet, IMS Health, etc. These companies can operate with negative book value if they want to. Basically, they can use all their profits to buy back their stock at above book value. And - over time - they've tended to outperform companies with business models that require them to pay more for liabilities.


Who pays more for their liabilities?


Any company that needs to borrow long-term to finance some kind of specialized capital like a steel plant, a race track, a copper mine, a stretch of railroad, a stretch of cable, a cruise ship, an airplane, etc. runs into this problem.


Some of these businesses can be good enough - because they may have monopoly like characteristics - to offset a high cost of liabilities. Examples would be: Hilton Food, Ball (BLL), U.S. Lime (USLM), etc. The business model requires capital. But, once you’ve built what you needed the financing for – you usually have zero local competition.


A low cost of liabilities is a feature in many - probably most - of the stocks I’ve bought recently.


Frost has a low cost of liabilities. In general, Frost can fund about 90% of itself at a cost that is no more than the Fed Funds Rate. Here, I am including both the actual interest cost Frost pays and the net non-interest cost it pays. What I mean is that - in a normal year - the Federal Reserve and Frost are paying similar amounts for their funding. That's really the key element of my analysis of Frost. 


I get emails all the time about banks that trade at lower price-to-book ratios than Frost. However, the price-to-book ratio only works well when you are comparing two firms with the same cost of liabilities.


So, say MetLife trades at 1.2 times tangible book and Progressive trades at 3.8 times tangible book. Is MetLife stock really cheaper than Progressive stock?


Well, Progressive should trade at a very high price-to-book ratio because it normally has a negative cost of liabilities. The company is "paid" to make use of other people's money.


Many bank investors think Frost is expensive at 2.5 times tangible book. However, I disagree. The book value you are judging the expensiveness or cheapness of is only the equity portion of the company. A bank's value resides not in its equity but in its deposits. So, you can only decide whether Frost is expensive or not once you've done your best to determine how much or how little it pays for its liabilities.


Ad agencies pay nothing for their liabilities. This has been critical to their outperformance of other public companies over time.


So, if you want to talk about WACC in the sense of comparing the fundamental elements of a business model between industries, firms in an industry, etc. - I'm right there with you.


In the long-run, I want to own ad agencies rather than railroads. People forget this, but Omnicom stock has (even now when it's cheap) outperformed Union Pacific stock (even now when it's expensive) over these past 30 years - and not by a small margin. Over the last 30 years, the economics of railroads have improved a lot more than the economics of ad agencies have improved. But, advertising is still such a better business because it pays 0% on its liabilities (client money) while Union Pacific pays anywhere between 2% and 8% (pre-tax) on the bonds it uses to finance itself. In addition, Union Pacific's financing needs constantly increase in nominal dollars (because assets must always be replaced in real dollars) while Omnicom's financing needs constantly decrease in nominal dollars (it gets more float as client billings rise each year).


So, I do think of a company's cost of liabilities - whether it needs capital on top of the equity it has outstanding and how much that will cost. This is a key part of assessing the quality of the basic business model.


A great example of this is NACCO (NC).


NACCO has one consolidated mine. Other than that…


NACCO's customers finance the mines NACCO operates to supply those customers with coal. These economic liabilities - they don't show up as accounting liabilities, because under GAAP you don't consolidate an enterprise you are incapable of financing yourself - are non-recourse to NACCO but the economic benefits (the free cash flow) is paid out 100% to NACCO each and every year (it's not held at the unconsolidated subsidiary level where the liabilities are).


If NACCO was the company funding the mining operations – as it does with the one consolidated mine it has – there’s no way I would buy the stock at any price. So, the way the company’s business model works – in the sense of what liabilities cost the company – determined whether or not I’d invest. The company’s business model – not corporate level financial engineering – also gives it a lower tax rate (since it operates the mines that take the coal out of the ground – it gets the depletion benefit for tax purposes even though it isn’t financing those mines).


But, these liabilities come from the day-to-day operations of the business.


So, when Bruce Greenwald talks about something like the negative working capital cycle at Dell, I'm in agreement with his thinking. But, when he talks about using WACC to value a business - I'm not on board with his thinking.


The simple answer is that I never use WACC.


The more complicated answer is that I appraise a business in terms of what it would be worth to a 100% buyer who put those assets to their highest and best use.


And then the honest answer is: I focus heavily on stocks with access to low cost, no cost, or negative cost liabilities. These are the best businesses in the world. But, all my thinking goes into how the business model provides these valuable liabilities. None of my thinking goes into financial engineering.


One reason for this is that a business model seldom changes while financial engineering changes dramatically all the time at many public companies.

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Call for Questions: A New Weekly Focused Compounding Podcast to be Hosted by Me and Andrew

by Geoff Gannon

Within the next month: my Focused Compounding co-founder, Andrew Kuhn, and I will launch a free weekly podcast.

Each episode will be 20 minutes or less.

And each episode will cover one and only one stock idea.

Each week’s stock idea will be taken from a write-up over at Focused Compounding.

This written germ of an idea could be a an old newsletter issue I wrote (we have a little over two dozen at the member site), a guest write-up (we usually have one a week over at the member site), a forum post on our members’ “Idea Exchange” (there are now a dozen ideas on that board), or one of the write-ups Andrew and I did ourselves (like my write-up of my NACCO investment or Andrew’s write-up of his investment in Hostess Brands shares and warrants).

What does this have to do with you?

Once a month: the podcast will change formats and answer email questions “rapid fire” one right after another.

Normally, these email questions will come only from Focused Compounding members (these are the folks who pay us a monthly fee).

However – just this once – we’re going to open up the field entirely and take questions from my blog, my Twitter, Andrew’s Twitter, and Focused Compounding members.

So, if you want to hear my answer and Andrew’s answer to your question – and yes, it can be on absolutely any topic at all – simply email that question to me before Andrew and I record our first monthly Q&A episode.

You can also Tweet at us.

Geoff’s Twitter

Andrew’s Twitter

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Stocks You Can’t Buy

by Geoff Gannon

The always interesting Japanese stock blog (it’s written in English), Kenkyo Investing, has a post on a negative enterprise value stock called Hokuyaku Takeyama. The reason this stock is cheap is because it trades on the Sapporo Stock Exchange – not one of the more popular exchanges like Tokyo or Osaka. Very few stocks only trade on the Sapporo Stock Exchange. So, very few investors make the special effort to do business with a broker who will give them access to this exchange.


Watlington Waterworks (Bermuda Stock Exchange)

I wrote about a similar situation in March of 2011. That stock was called Watlington Waterworks. It’s a water company on the island of Bermuda. Because it’s on the island of Bermuda – a rich, densely populated remote island with no fresh water – the economics of Watlington Waterworks are generally superior to all other water companies around the world. And yet – in March of 2011 – the stock traded for lower multiples of earnings, book value, etc. than other water companies. In the 7 years since I wrote about Watlington Waterworks, the stock has risen in price by about 9% a year. It also paid a dividend. So, holders of the stock got 10%+ owning something that was a true diversifier in their portfolio (Watlington’s price doesn’t move based on how the Dow Jones, Nasdaq, or S&P 500 are doing). In fact, on many days, it doesn’t move. What’s more impressive is that Watlington returned more than 10% a year over 7 years while finishing that period with a P/E ratio less than 12, a price-to-book ratio less than 1, and a rock solid balance sheet.

Many stocks have returned more than 10% a year over the last 7 years. However, very few stocks that returned more than 10% a year now have a P/E under 12, a P/B under 1, and a solid balance sheet. Meanwhile, many companies that now have a P/E under 12 and a P/B under 1 have returned far worse than 10% a year over the last 7 years. In other words: Watlington is rare in the sense it combines a 7-year total return performance that has been adequate with a stock price that has always remained at an investment level rather than straying into speculative levels like most stocks. Basically, it’s been a decent “set it and forget it” investment. The business has never really performed badly. And the stock’s price has never really been anything but cheap.

Also worth mentioning is the way I presented Watlington Waterworks. I showed the company’s recent financial results on this blog – but didn’t give out the company’s name or business description. Readers then guessed where the stock traded. Back in 2011, almost everyone came up with a guess in the $20 to $30 price range. At the time, the stock traded at $14.


What Ben Graham Would Really Be Buying Today

These are the kinds of stocks you want to find – stocks like Hokuyaku Takeyama and Watlington Waterworks. They are stocks that just about everyone – if shown the company’s financials but not told the obscure exchange the stock trades on – would value at a price higher than where the stock actually trades.

In the U.S., these are usually OTC stocks. You can read blogs like Oddball Stocks to learn about some of these kinds of companies.

When people ask what would Ben Graham buy – this is it. He wouldn’t be buying the net-nets that turn up on screens (like Chinese reverse mergers). He would be opening an account in Japan, an account in Bermuda, etc. and putting 1%, 2%, or 3% into becoming a collector of little, illiquid, but clearly incorrectly priced stocks like these.



I’ve written about my experience in Bancinsurance many times before. Back in 2010, I bought into this stock. It was traded over-the-counter at the time. However, I was familiar with the company from years before when it was a listed stock. If you look at the second letter I wrote to the board of directors of Bancinsurance, you can see a graph showing that after the company de-listed, the stock started to consistently trade below book value even though (when it had been listed) the stock often traded above book value.

This is what we – as value investors – want to look for. The stock is priced differently because of factors like who owns it, what exchange it trades on, how it is categorized by investors, etc. rather than whether the balance sheet, the industry, the company, and the management team are solid or not.

In the case of Bancinsurance, it was priced differently than a “normal” stock in two ways:

1.       It was an insurance stock with a history of underwriting profits (the combined ratio was less than 100 in 28 of the last 30 years) and yet it traded at a discount to book value

2.       There was a $6 a share offer to take the company private from the CEO (and majority shareholder) and yet the stock consistently traded below the going-private offer

In other words: because of its obscurity, this stock wasn’t getting the attention of investors who specialized in insurance stocks or arbitrageurs who specialized in speculating on higher takeover offers. In this case, the deal was eventually done at $8.50 instead of $6. Normally, a deal that ends up being done at a 40% higher price within about six months to a year would attract special situations speculators. That didn’t happen here. Between the time the original $6 offer was made and the time the board accepted the $8.50 offer, I had very little competition buying as much of this stock as I could get my hands on. Honestly, I was my own competition for this stock. And it was only my reluctance to bid up the stock on myself that kept the price in check (and the number of shares I ended up getting lower than what I would have wished).

Here again we see what we – as value investors – should be looking for in a stock: a good asset traded in an inefficient market.

After all: how efficient is a market likely to be when there are days with no serious second bidder?


Warren Buffett (The Snowball): National American Fire Insurance and Blue Chip Stamps

In Warren Buffett’s pre-Berkshire investing days, he came across several stocks where the market for those stocks was inefficient for historical reasons.

Let’s talk about two.

The first is National American Fire Insurance. This was the holding company in which the Ahmanson family stashed some of their best assets. However, it was built out of an unrelated company that had done badly as a stock for many people in the local Omaha area.

You can read the full story in Alice Schroeder’s “The Snowball”. This is what I wrote in an article called “How Warren Buffett Made His First $100,000”:

“…it was a super illiquid stock that had once been worth a lot more. The shares ended up spread thinly across a lot of different individual investors. They remembered when the stock was worth $100 a share. That’s where a lot of them bought. And many of them didn’t want to sell until the stock got back to $100 and made them whole. But, because the stock had burned them so bad, they also had no interest in buying more shares. They just clung to what they had.

Now, what’s really fascinating about this story is what Warren Buffett did. So, the stock was last selling for about $27 a share. At first, he tried buying around $30 a share. Then he went to $35. He went to towns where he knew people owned the stock. He talked in person to people to try to get them to sell to him. 

Eventually, he offered some people $100 a share. Now, think about this for a minute. That’s still a very, very low price for this stock. At $100 a share, Buffett was paying 3.5 times earnings. And he was still only paying about 75% of book value for what he thought were some of the best insurance companies in America.”

Warren Buffett – and Charlie Munger – also bought into a company called Blue Chip Stamps. What attracted them to this business was its “float”. But, what attracted me to discussing it here in this post is the odd way that shares of Blue Chip stock had been distributed.

Blue Chip Stamps was a trading stamps company. It ran a multi-retailer loyalty program. A shopper would make purchases at participating grocery stores, gas stations, drug stores, etc. and would receive a certain number of Blue Chip Stamps in return. These stamps could then be exchanged for merchandise. This kind of loyalty alliance between a participating group of retailers encouraged households that already shopped at say a grocery store giving out Blue Chip Stamps to also seek out a gas station, a drug store, etc. that gave out Blue Chip Stamps instead of a competing location that gave out nothing, or gave out competing Sperry & Hutchison Green Stamps. Basically, it encouraged locking shoppers into a loop of retailers and encouraged locking retailers into that loop as well. The bigger the loop got in terms of attracting shoppers – the more it could attract retailers. And the bigger the loop got in terms of attracting retailers – the more it could attract shoppers. The company’s business would decline in the years after Buffett bought in (eventually disappearing altogether). But, it obviously had similarities to payment processing companies like American Express (AXP) charge cards.

What’s important for our purposes here is not how attractive Blue Chip Stamps was as a business. What we’re discussing here is the odd way that shares of the stock were allocated.

In 1963, the United States government opened an anti-trust case against Blue Chip Stamps. Four years later, Blue Chip Stamps settled with the U.S. government via a “consent decree”. (I’m simplifying here. In reality: first, it seemed like there was an agreement, then there wasn’t, then there was again, then there was one last court case, etc. – but the end result was that Blue Chip Stamps and the government came to an agreement over anti-trust issues).

You may have heard of “consent decrees” before. One of the most famous is the 1948 Paramount consent decree that spelled the beginning of the end for the “Hollywood System”. Consent decrees are of interest to investors because they often involve a company settling an anti-trust issue with the U.S. government.

Usually, this means two things.

One: the company has a lot of “market power”. It has some sort of monopoly, market dominance, etc. Otherwise, it wouldn’t sign a consent decree.

And two: the company is often agreeing to take some sort of extraordinary action – like separating a movie theater chain from a studio that makes movies (the Paramount case) or breaking up the various stages (or geographic regions) of oil distribution in the United States (the Standard Oil case) that may unlock the potential for investors to suddenly invest in pieces of a once dominant business. These pieces may be mispriced, they may end up in the hands of owners who didn’t originally intend to invest in just that one part of the parent alone, etc.


A Brief Aside: Northern Pipeline

Ben Graham invested in Northern Pipeline. Northern Pipeline was a stock that had a more valuable investment portfolio than it did a stock price. Northern Pipeline was part of the Standard Oil system broken up by that anti-trust case.  

For more details on Ben Graham’s investment in Northern Pipeline, read my 2007 GuruFocus article on the subject.


Back to Blue Chip

In the case of Blue Chip Stamps, the participating retailers (actually, past participating retailers) ended up with a little over half the shares of Blue Chip Stamps stock.

To give you some idea of the inefficiency likely to result from this kind of distribution, I will quote from a later (mid-1970s) case involving Blue Chip Stamps where a U.S. court (actually the Supreme Court) included a description of the consent decree as background in that court’s opinion:

“…Old Blue Chip was to be merged into a newly formed corporation, Blue Chip Stamps (New Blue Chip). The holdings of the majority shareholders of Old Blue Chip were to be reduced, and New Blue Chip…was required under the plan to offer a substantial number of its shares of common stock to retailers who had used the stamp service in the past but who were not shareholders in the old company. Under the terms of the plan, the offering to non-shareholder users was to be proportional to past stamp usage, and the shares were to be offered in units consisting of common stock and debentures. The reorganization plan was carried out…Somewhat more than 50% of the offered units were actually purchased. In 1970, two years after the offering…a former user of the stamp service and therefore an offeree of the 1968 offering, filed this suit in the United States District Court for the Central District of California…(alleging, among other things) that the prospectus prepared and distributed by Blue Chip in connection with the offering was materially misleading in its overly pessimistic appraisal of Blue Chip's status and future prospects. It alleged that Blue Chip intentionally made the prospectus overly pessimistic in order to discourage (the) respondent and other members of the allegedly large class whom it represents from accepting what was intended to be a bargain offer, so that the rejected shares might later be offered to the public at a higher price. The complaint alleged that class members, because of and in reliance on the false and misleading prospectus, failed to purchase the offered units.”

Think of all the ways that distributing Blue Chip Stamps shares in this manner was likely to lead to an inefficient market in the stock (a mispriced stock). One, Blue Chip – which knew the most about its own business – had incentives to discourage people from buying the stock. Two, the stock was offered in proportion to past stamp usage and specifically to past stamp users who were retailers but not investors in Blue Chip. In other words, the stock was being offered specifically to entities that were likely to be businesses but not investors. So, the well-informed entity here (Blue Chip) had incentives to make itself look bad when offering to sell itself to what were essentially potential investors who had no experience investing in anything (these were businesses not investors). Furthermore, Blue Chip was offering combined units of both stocks and bonds to retailers who had no experience dealing in either stocks or bonds. So, you’re asking someone who has never been a buyer of stocks or bonds – only sometimes an issuer of their own stocks and bonds – to suddenly make a decision about the attractiveness of units that combine both stocks and bonds.  

Think about this for a second. For value investors: the Blue Chip Stamps consent decree resulted in something even better than a spin-off.


Why Spin-Offs Can Sometimes Be Unusually Attractive to Value Investors

In a spin-off, a group of investors – both institutions and individuals – is given stock in a company that might not be related to their original reason for buying into the parent. For example, I bought into a company called NACCO (NC) the day after it spun-off Hamilton Beach Brands (HBB). Hamilton Beach is a maker of small appliances like crockpots, slow cookers, microwaves, toasters, etc. The remaining business at NACCO – NACoal – is a cost-plus miner of lignite (brown) coal for power plants sited very near the mine. The two businesses have nothing in common. So, some investors may have originally bought NACCO stock because they liked Hamilton Beach Brands. Other investors may have originally bought the stock precisely because it was a “special situation”. Once Hamilton Beach was spun-off from NACCO, these investors were no longer invested in a conglomerate/special situation type investment. So, the folks who just wanted Hamilton Beach might want to unload NACCO. And the folks who were just invested in the combined company as a special situation might want to unload NACCO too, because now it was just a pure play coal company (there was no longer anything special about the situation). That’s usually how a spin-off works. Investors might not be interested in one of the two parts post break-up.

But – even in a spin-off – all these supposedly lazy investors are still investors who are used to analyzing public companies, deciding whether or not to hold a stock, etc. So, while they may not want a coal company – they certainly don’t mind holding a share of stock in something. Even if the people selling to me didn’t want to own a standalone coal company at (almost) any price – they were still investors who knew full well how to analyze NC stock as a stock. Even in the strangest of spin-offs, you usually still have to buy the stock you want from investors who have spent years analyzing stocks.

The Blue Chip Stamps case involved the creation of shareholders – the participating retailers – who didn’t want to own stocks at all. They weren’t investors. They were retailers. So, naturally, they were going to be too eager to unload as much stock as possible as quickly as possible without much regard to what that stock was worth.

You can compare this to situations where a government owns some stock in a public company and is now showing a profit on that position. If the government has political reasons why it might rather not own the stock – as soon as it shows the slightest profit, it’s going to be very tempted to sell that stock and just wash its hands of the matter.

In the case of Blue Chip Stamps: Warren Buffett obviously saw the potential to get a lot of shares from unusually motivated sellers. In fact, he even started buying the shares of publicly traded retailers that received Blue Chip Stamps shares – not because he was interested in these retailers as businesses, but purely because he believed he could get the retailers to agree to swap their shares in Blue Chip Stamps for his shares in them. Basically, he was betting he could get a company to give him Blue Chip Stamps to make him go away (as a shareholder).



Dealing in Illiquid Stocks: You Can’t Know Till You Try – George Risk and NACCO

Finally, I need to discuss the two ways in which something may be thought of as “a stock you can’t buy”.

Really, there are 3 ways. However, one is so odd most of you will never come across it.

So, reason #1 is legitimate but extremely rare. There are a few stocks around the world that have special rules which may literally prohibit you from buying the stock purely for investment purposes. These are often some kind of club that needed capital (a town, a housing development, etc.) and so issued stock to raise capital but never really intended to be operated purely for profit-seeking purposes. This is so rare you’re likely to never come across such a case. They do exist though. And in such cases, it may literally be true that you “can’t buy the stock”.

What are the other two cases?

The two cases you’ll actually run into are: 1) Your current broker won’t buy the stock for you or 2) You think the stock is too illiquid.

In reality, #2 is almost never a real problem for a small investor. But, I stress both those words: small and investor. Illiquid stocks are obviously un-buyable for a big trader. But, for a small investor – these stocks aren’t really “stocks you can’t buy”.

One, your portfolio must be small: thousands, tens of thousands, hundreds of thousands, or millions. But, not tens of millions or hundreds of millions. However, provided you are investing less than $10 million total – it will almost never be the case that you literally can’t get enough shares of a publicly traded company to matter to you. For example, say you are managing $10 million. A 5% position would be $500,000. Assume you buy one-third of the volume of a stock (I’ve bought more) for a period of six months. If the stock trades about $15,000 worth of stock per day – you’ll have no problem buying into it. And a lot of people reading this are managing less than $1 million. Buying illiquid stocks will be more than 10 times easier for you. That means many people reading this blog can invest in stocks trading as little as $1,000 to $2,000 a day. And some of you can invest in stocks trading much less than that.

So, illiquidity is almost never an excuse in terms of getting in.

Illiquidity may be an excuse in terms of getting in quickly or getting out quickly – or feeling you can get out at a price reasonably close to the last trade price. However, those are all trading concerns. Not investing concerns.

I know that sounds glib of me. But, the ability to get out of a stock at a price close to the last trade price is 100% a trading concern and 0% an investing concern. It has become so conventional to think in terms of liquidity that many people who consider themselves investors assume that the ability to get out of a stock at near the last trade price is some kind of necessity.

That’s not even a legitimate concern for an investor to have.

When you invest in a house, a small business, a farm, etc. you don’t have any expectation you can get out either 1) quickly or 2) at a price similar to some “last trade”. All you are betting on – as an investor – is that you’ll be able to eventually unload the asset in a way that gets you an adequate annual return over the period you owned it. There are many stocks out there that promise adequate annual returns without promising the ability to get out reasonably quickly or reasonably close to the last price someone else paid for the stock.

Now, let’s move from the theoretical argument of why illiquid stocks are worth your attention to a couple practical examples of the difficulties involved in buying enough of these stocks to move the needle in your portfolio.

As an example: I bought stock in George Risk (RSKIA). The stock supposedly averages a little over $5,000 in daily volume. I owned the stock for about 6.5 years. When entering the stock, I put in a lot more than $5,000 and I did most of it in a single trade. When exiting the stock, I sold a lot more than $5,000 and I again did most of it in a single trade. In neither case did I bid for stock or offer stock at a price that was less advantageous to me than simply using the last trade price (what most people used to dealing in liquid stocks simply call the “market” price). As it turned out, the illiquidity of this stock never mattered to me. Both going into this stock and going out of it – I was prepared to wait a month or more and get a price that was a lot different than the last trade. It didn’t turn out that way. It turned out to be way easier to get in and out of George Risk than I ever would have dreamt.

NACCO was a different story. So far, I’ve only gone into this stock. I still have 50% of my portfolio in the stock. I planned to buy once it was trading separately from Hamilton Beach Brands. Because the stock’s market cap – as a combined company – had been several hundred million dollars and because my buying was to be done on the day the two stocks started trading separately (thus attracting a lot of attention including from special situations folks, etc.) I expected it to be very easy to get all the shares I wanted in this stock right away at very close to the last trade price.

It didn’t work out that way. I only checked the stock price several hours after the open – I don’t place orders when the market first opens – and by that point in the late morning there was a lot of volume. But, there was no one interested in doing one big trade near the last trade price. So, I had to make the decision to accept dozens of smaller trades – each of which might move the price a little – to fill my order rather than insisting on one all-or-nothing deal. Like I said, there was a lot of volume. So, I don’t think it made much difference to the average price I got over the entire day. You could have bought any time in the late morning through to the close of that day and probably gotten a very similar average cost for your shares whether you did it in one trade, ten trades, or a hundred trades.

But, it definitely wasn’t easier for me to get into NACCO than it had been to get into George Risk. And you wouldn’t have predicted that from looking at the average daily volume in those two stocks.

So, never assume you can’t get a stock just because it hasn’t traded a lot of shares in the past. Always make an effort. Put a bid out there and see what you can get.


Inconvenience Yourself

The other reason you might not buy a stock is because your broker doesn’t offer you access to the exchange on which that stock trades. This is a very common reason for why individual investors don’t buy some stocks. In fact, I’ve written several newsletters, did a report on Japanese net-nets, etc. and this is the most common complaint given whenever you mention foreign stocks to someone. They’d need to open another brokerage account with someone else.

I’ve gotten a lot of emails from investors saying they’d love to buy some specific stock but they can’t.


Can’t or won’t?

They could open another brokerage account. They just won’t.

Do it.

This is a good illustration of how the concept of “switching costs” doesn’t mean what it appears to mean. It’s not expensive to find a broker to buy the stock you want to buy. What is it?

It’s inconvenient.

When we say “switching costs” we often just mean “inconvenience”.

All I can say about the cost of this kind of inconvenience is to consider how much you’d put into the stock and how much more you’d likely make on this stock rather than something your broker will buy for you.

If you’re the kind of person who would choose to fly coach rather than first class when crossing the Atlantic but won’t open a brokerage account to buy that stock you want so badly in Japan – you’re probably doing something wrong.

It may feel like it’s reasonable to prefer coach over first class for financial reasons but unreasonable to open another brokerage account just to buy some obscure stock.

From your net worth’s perspective though: those are equally reasonable actions.

It’s very likely that giving up on buying some obscure stock because your broker says he can’t buy it for you is costing you more than a first class plane ticket would.

So, you’re actually spending thousands on avoiding an inconvenience.


I Don’t Use an Online Broker

To be fair, most people reading this use an online discount broker of some kind.

I don’t.

My reason for not using something like Interactive Brokers isn’t that I want access to more exchanges around the world than that broker would give me.

My reason for not using an online broker is that I specifically don’t want the ability to place trades myself.

If you want to focus on investing – the first thing to do is prevent yourself from having the ability to trade. So, I leave trading to someone else entirely. This works very well for me.

But, I understand it is potentially more expensive and certainly less convenient than the approach others take.

Personally, I think it’s much easier on the mind and potentially more profitable in the long-run to go the old fashioned route and call your broker on the phone instead of placing a trade with your mouse.

I promise you you’ll make less trades this way.

But, I know I’m not going to win any converts to my side here.  

In fact, nothing I say is going to get you to switch brokers. This is what we really mean when we say “switching costs”. I can change people’s minds about a lot of things. But, it’s very hard to convince someone to do anything that’s both: 1) inconvenient and 2) a break from their established habits.

In some sense that’s probably why there will always be some oddly mispriced stocks out there. We’d have to break our habits and put in some extra effort to track them down and buy them.

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Why You Might Want to Stop Measuring Your Portfolio’s Performance Against the S&P 500

by Geoff Gannon

Someone emailed me this question about tracking portfolio performance:

“All investors are comparing their portfolio performance with the S&P 500 or DAX (depends were they live). I have asked a value investor why he compared the S&P 500 performance with his portfolio performance…for me as a value investor it makes no sense. A value investor holds individual assets with each of them having a different risk…it's like comparing apples and oranges.

The value investor told me that…Warren Buffett compares his performance with the S&P 500. But I believe he did it, because other investors…expect it or ask for such a comparison.

How do you measure your portfolio success? Do you calculate your average entry P/E and compare it with S&P500 or Dow P/E to show how much you (over)paid for your assets? Or do you avoid such a comparison and calculate only the NAV of your portfolio?”

I don’t discuss my portfolio performance on this blog.

And I think it’s generally a good idea not to track your portfolio performance versus a benchmark.

It’s certainly a bad idea to monitor your performance versus the S&P 500 on something as short as a year-by-year basis.


Well, simply monitoring something affects behavior. So, while you might think “what’s the harm in weighing myself twice a day – that’s not the same thing as going on a diet” – in reality, weighing yourself twice a day is a lot like going on a diet. If you really wanted to make decisions about how much to eat, how much to exercise, etc. completely independent of your weight – there’s only one way to do that: never weigh yourself. Once you weigh yourself, your decisions about eating and exercising and such will no longer be independent of your weight.

Knowing how much the S&P 500 has returned this quarter, this year, this decade, etc. is a curse. You aren’t investing in the S&P 500. So, tethering your expectations to the S&P 500 – both on the upside and on the downside – isn’t helpful. The incorrect assumption here is that the S&P 500 is a useful gauge of opportunity cost. It’s not.

Let me give you an example using my own performance. Because of when the 2008 financial crisis hit, we can conveniently break my investing career into two parts: 1999-2007 and 2009-2017.

Does knowing what the S&P 500 did from 1999-2007 and 2009-2017 help me or hurt me?

It hurts me. A lot.

Because – as a value investor – the opportunities for me to make money were actually very similar in 1999-2007 and 2009-2017. In both periods, I outperformed the S&P. However, my outperformance in 2009-2017 was small while my outperformance in 1999-2007 was big. In absolute terms, my annual returns were fairly similar for the period from 1999-2007 and 2009-2017. It is the performance of the S&P 500 that changed.

Many value investors have a goal to outperform the S&P 500. But, is this a useful goal?

I don’t think so. Let’s look at the 1999-2007 period to see why it’s not a good goal. The S&P 500 returned very little from 1999-2007. However, a value investor – like me – who was looking to own only 3-5 specific stocks at a time could have made 15% a year. It’s this number – something like 15% a year – that’s the rabbit you should have been chasing in 1999-2007, not the 5% or so the S&P 500 did.

Let’s assume the S&P 500 returned about 5% a year from 1999 through 2007. And then let’s assume that some value investor returned 8% a year during the same time period. This value investor is very proud of himself.

Should he be?

No. He blew it.

If you were an individual investor who made 8% a year from 1999-2007, you missed a lot of opportunities you should have taken advantage of. It was possible to make 15% a year without taking a ton of risk. And, so, you left something like 7% a year on the table over a period of 8 full years.

That kind of underperformance versus your potential rate of compounding has – when it occurs over a period as long as 8 full years – a significant (really permanent) influence on your lifetime investment outcome. If you had been making 15% a year from 1999-2007 you’d have $1.72 for every $1 you’d have if you were making 8% a year from 1999-2007. And yet, because you outperformed the S&P 500 – you chalked this period up as a win for you.

When we look at the period 2009 through 2017, we see the opposite problem. We especially see it in the last couple years. But, let’s look at the full period. Let’s say that from 2009 through 2017 you again made 15% a year.

This time you’d say you just about tied the S&P 500. You certainly didn’t beat it. And so, if you did 15% a year from 2009 through today, you’d say you don’t deserve any accolades at all.

Is that right?

Well, it depends on how you achieved it. The argument that people make about why you should track your results against the S&P 500 is that the S&P 500 is always a viable alternative. So, if you didn’t do much better than 15% a year from 2009 through 2017 – you didn’t add value.

Your effort was wasted.

There’s a logical problem here. As an investor, you don’t control outcomes. You only control process. Any benchmarking against historical performance is limited in the sense that it starts at one exact beginning point and finishes at one exact end point.

Basically, we are assuming clairvoyance on your part. I don’t just mean that we’re assuming you knew everything that could be known in 2009 and reasoned everything out correctly from there. I’m not just saying you were omniscient and infallible. I’m saying you could actually foresee the future free from uncertainty.

That’s no way to measure results.

I’m now going to take you on a very involved philosophical detour. But, it’s an important side trip to take if we’re going to understand that what we want to judge is always our process not our outcome even though the most readily available tool for measuring our process (indirectly) is reasoning backwards from our outcome.

Just remember this: we have no control over outcomes. We control only process. So, going forward, our goal is to fix our process – not our outcome.

In the long run: outcomes will follow process.


The Past is Only Fixed in Retrospect

People intuitively understand that the future is not fixed. However, they don’t always make the (correct) logical leap that the present we are now living was never a 100% certainty at any point in the past. In other words, even when you are able to correctly predict the future – you should never make a 100% bet on that future. Retrospectively, this means that while the particular past that got us to today’s present is mostly informative of what we should have done in the past – it is never fully informative. The moment we are in now is somewhere near the average of moments that might have been. It is not – all by itself – ever a perfectly precise measure of what the likely future was at any point in the past.

This is very important when considering something like the performance of the S&P 500 over the past year. Let’s say the S&P 500 returned 20% in 2017. How correct was a bet made in January 1st of this year that the S&P 500 would be 20% higher on December 31st? I’d say such a bet was a bad bet even though the outcome was positive. What I mean is this: rolling one die and betting 1-to-1 odds that it will come up 3 is a bad bet even if it does come up 3. A bet that the S&P 500 might return 10% this year could be an okay bet. But, a bet that the S&P 500 would return 20% a year – which turned out to be the truth – is still a bad bet. This isn’t obvious because you lived only one 2017. But, if you could live 1,000 2017s in a row one-after-another in some sort of set of parallel experiences – it’s not likely that the central tendency of those 1,000 different last years would work out anything like the last year we all just lived.


Why It’s Better Not to Know EXACTLY What the Dow Really Earned Last Year

About 11 years ago now, I took a look at returns in the Dow based on a smudged history approach. Instead of assuming that the EPS reported for the Dow in any one year was the inevitably “correct” EPS for that year (as if you could have foreseen that it always had to work out that way), I assumed that the best way to think of the Dow’s earnings in any one year was to look at the 15 years preceding it and then draw 15 lines – moving at 6% a year – forward in time till they reached the current year. You then – metaphorically – took your finger and smudged those 15 endpoints.

That’s the normal earnings for the Dow.

It’s the central tendency suggested by 15 points from the past rather than the actual observed point we’re at now (the present). As it turns out, using the central tendency suggested by 15 past points works much better than relying on one present-day point.


Never Measure One Point In Time

This sounds strange, counterintuitive, and overly complex. But, it’s actually a much more logical way to look at the historical level of anything. If I was shooting a pistol at a target and sometimes hit the left shoulder and sometimes the right and then maybe the head and once or twice the abdomen and then finally – with my very last bullet – I hit the target right in the heart…

Should we award you any points for guessing that I’d hit the heart with that last shot? In what way does it even make sense to say I hit the heart? I mean, I also hit both shoulders and the head and the gut.

So, what would constitute a good guess on your part?

If you correctly guessed the central tendency of my shots to cluster in some particular part of the target over 5 attempts, 50 attempts, 500 attempts, or 5,000 attempts – that would be something worth giving you credit for.

So, history is certain and precise. But, the certainty and precision with which we can measure the past is not necessarily useful. Over very long periods of time – for example, from 1999 all the way through 2017 – a comparison of your results versus the S&P 500 might tell you something.


What’s Easiest to Measure vs. What Matters Most

But, even then: does it tell you what you care most about?

Should the average person really be aiming to get a better performance than the S&P 500?

In terms of building wealth, it’s the long-term rate of compounding that matters.

I once broke this down as follows…

If you string together back-to-back-to-back 15-year periods of 5% annual returns: you aren’t going to achieve any of your long-term financial goals.

If you string together back-to-back-to-back 15-year periods of 10% annual returns: you may achieve most of your long-term financial goals if you make enough, are frugal enough, etc.

And finally…

If you string together back-to-back-to-back 15-year periods of 15% annual returns: you will achieve all your long-term financial goals.

Now, I’ve brushed over the issue of inflation there. But – aside from differences in the rate of inflation over your investment lifetime – what I’ve said is true.

What matters is getting a good absolute rate of compounding over 40-50 years. Getting a good relative rate of compounding over 4-5 years isn’t important.

Because some financial cycles – like interest rates, P/E ratios, bull markets, etc. – are so long: I suggest measuring your annual returns over 15-year intervals.

And – because you can’t eat relative returns – I suggest you think in terms of absolute returns.

If, over the last 15 years, you’ve done 5% a year: that’s not good enough.

If, over the last 15 years, you’ve done 10% a year: that’s fine.

And if, over the last 15 years, you’ve done 15% a year: that is good enough.

As an individual investor, your goal should be to try to do 2 things:

1)      Avoid doing anything that might get you returns as low as 5% a year for as long as 15 years

2)      Seize any opportunities that come along that seem likely to get you returns as high as 15% a year for as long as 15 years

When I say that: I’m talking about individual stock picks, strategies you can adopt, process improvements – everything. If you think it can get you to 15% a year over 15 years – go chase it down.

Okay. So far I’ve said:

1.       Measure your absolute returns

2.       Think in terms of 15-year intervals

Is that all you can measure?

No. You can measure the performance of individual stock picks.


Measure Your Individual Forced Outcomes

In fact, you will find that several of the picks you make will resolve themselves permanently in less than 15 years. Some stocks you pick will suffer a permanent impairment of intrinsic value – they may even end up in bankruptcy. Others will be acquired at a price higher than you paid for them.

For example, I bought a stock called IMS Health in 2009. That company went private. It’s public again. But, my investment was permanently resolved – by that private equity buyout – in the sense that I had no choice of whether or not to take a profit. I was forced to take a profit.

Likewise, in 2010, I bought a stock called Bancinsurance. About 9 months later, that stock was taken private. Again, I had no choice of whether or not to take a profit. I was forced to take a profit.

Before the financial crisis, Warren Buffett invested in some Irish bank stocks. They ended up being basically worthless. So, Buffett didn’t choose to take a loss in that stock. He was forced to take a loss.

You can always measure your performance in stock picks that permanently resolve themselves irrespective of your actions. You can look at the annual returns in those stocks.

For example, my return in Bancinsurance was about 40% in about a year. Do I spend time thinking: what was the return in the S&P 500 during the period when I held Bancinsurance stock?


I just think that any time you can find something that makes you about 40% a year – that’s a win. Now, there was obviously a chance that Bancinsurance could have ended up much, much worse. I couldn’t have foreseen a 100% probability of a 40% profit ahead of time. But, when you look back at what I knew when I made my decision to invest – you could imagine that, based on the probabilities of the situation, a return of 20% a year was a good guess. At the time I made the investment, the most likely outcome seemed to be a return of no less than 3% but no more than 60% in perhaps less than a year. The important thing was this: it seemed a good enough bet in the sense it was likely to return 15% or better annualized.

And, as an individual investor, that’s what you’re looking for. You’re looking for absolute returns. You’re looking to avoid anything – like an S&P 500 index fund today – that seems more likely to return 5% a year over the next 15 years rather than 10% a year over the next 15 years. And you’re looking to jump on any opportunities that seem more likely to return 15% a year rather than 10% a year.

So, for individual investors, I think benchmarking your results against an index is bad for two reasons: 1) The time period you care about is long-term (1-year results, 3-year results, even 5-year results aren’t going to be informative much of the time) and 2) The returns you care about are absolute returns not relative returns.

If you’re picking stocks for yourself and only yourself – your long-term, absolute rate of compounding is all that matters.


Why Individual Investors Have It Easy

Who should use benchmarking then?


Professionals are looking to attract and retain clients. Clients care about relative returns. Should clients care about relative returns? That’s a question for another day. But, they do. And they often care about short-term results. For example, I just read a blog post that said Bill Ackman’s results were “mixed” because:

At Pershing Square he significantly underperformed from 2015 to 2017 and outperformed from 2004 to 2014.”

Now, the period 2004-2014 is a lot longer than 2015-2017. And, more importantly, this blog post showed results from 2004-2016. Ackman’s cumulative results from 2004-2016 were a lot better than the S&P 500 (his benchmark). And yet, the general feeling is that Ackman’s track record is mixed. When people say “mixed” they mean his long-term results are good but his short-term results are bad. For an individual investor, that’s not a mixed track record. That’s simply a good track record. But, for a professional – that kind of track record means clients are going to pull their money.

So, professionals track performance versus a benchmark, because: 1) Clients care about short-term performance and 2) Clients care about relative performance.

There is one other reason why benchmarking makes sense for most professionals and yet doesn’t make sense for many individual investors.

This reason doesn’t apply to Bill Ackman (a concentrated investor). But it does apply to most money managers (diversified investors).

I try to own 3-5 stocks at a time. There are 500 stocks in the S&P 500. And there are more like 5,000 stocks that are investable for me. So, at any moment in time – I only need to say “yes” to something like 1% to 0.1% of all potential investments. Professionals who are diversified may – depending on how big the pile of assets they manage is – need to say “yes” to more like 1% to 10% of all stocks they learn about.

Let’s take an extreme case. Imagine someone is managing $10 billion in a diversified way. This manager will often need to stick to S&P 500 type stocks. And he will often need to hold 30-50 stocks. In reality, holding 50 stocks instead of 20 stocks isn’t going to add much diversification in terms of the resulting volatility versus the benchmark. But, the convention among professional money managers is often to hold up to 50 stocks for the purpose of diversification whether or not this can be shown to make a meaningful difference in the ups and downs of the portfolio or not.

A money manager who holds 30-50 stocks of S&P 500 sized companies needs to say “yes” about 6% to 10% of the time. This is 6 to 100 times more frequently than I have to say “yes”. As a result, the performance of such a money manager’s portfolio – whether he wants this to be the outcome or not – is going to be a lot closer to his benchmark from year-to-year.

Now, this is a position number / position size issue (that is, lack of selectivity issue) not a professional versus individual investor issue. A professional money manager who runs $10 million by allocating that portfolio to just 3-5 stocks would be in the same boat at the individual investor rather than the worst case professional (a big, diversified fund) I showed here.

In reality, a professional money manager who has to invest $10 million or maybe even $100 million and is willing to keep that in as few as 3-5 stocks is in the same position as an individual investor except for the fact that he has an unstable source of funding (his clients) who may pull money the second his short-term relative performance weakens.

So, benchmarking makes more sense for people who:

1.       Rely on other people’s money

2.       Own a lot of different stocks and

3.       Manage a lot of money

Benchmarking makes less sense for people who:

1.       Invest only their own money

2.       Own very few stocks and

3.       Manage a small amount of money

Most readers of this blog fall more into the second group (as I certainly do) than the first group.

Therefore, benchmarking is something you are probably better off eliminating from your investing process.

Personally, I don’t care what the S&P 500 does. I only care what I do. So, I do my best to ignore all benchmarks.

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The Risk of Regret: NACCO (NC)

by Geoff Gannon

Someone emailed me this question about NACCO (NC):

“If you don't mind me asking, why do you so strongly recommend other people not buy the stock given your obvious high conviction? It seems like a classic value situation where a company in a hated industry (coal) with a long-term bleak outlook has an individual player (NC) where the cash flow characteristics are more than enough to justify the current stock price. If you prefer not to answer because your answer is embedded in your member-only site, I totally understand, but I am quite intrigued. For what it's worth, I am not at a point where I am seriously considering NC for potential investment - I am more interested in Frost (CFR), although I would prefer it to come down more. I am just trying to understand the business and what a fair price for it is. It seems to me that if we had 100% certainty that all the contracts would remain viable for a couple of decades, then NC is easily worth say double where it trades now, but the name of the game is in handicapping the risks of the mines closing, and I would be interested in your thoughts about doing that. It's obvious that you view this risk as worth the price paid, but I am curious why you do not think others should take the same risk.”

I'll quote from the write-up I did on the Focused Compounding member site. I had sub-titled sections in this write-up. So, let's just bullet point the headlines that appeared in the article.


They were:


* All value comes from the unconsolidated mines

* There are risks

* NACCO's business model

* Each share of NACCO is backed by 5 tons of annual coal production

* NACCO makes anywhere from 57 cents to $1.75 per ton of coal it supplies

* Side not: amortization of coal supply contracts

* NACCO vs. NACoal

* Quality of earnings

* Risk of catastrophic loss

* How I "frame" NACCO

* Why I don't recommend NACCO shares


You asked about "why I don't recommend NACCO shares" and that's one of the section headers. So, let's look at that part:


"I put 50% of my portfolio into NACCO. But, I think people reading this should put 0% of their portfolio into NACCO. As long as electricity demand in the U.S. is declining and natural gas production is rising, coal power plants will shut down. As a shareholder of NACCO, you could wake up any morning to the news that the company has lost 35% of its earnings overnight. I don’t think this is a risk most investors can handle.

Therefore, I don’t recommend anyone invests in NACCO even though it’s now my biggest position.

Let me be clear: I’m not just saying this is a ‘perceived’ risk you may want to avoid.

It’s a real risk.

NACCO is a risky stock.

I absolutely can’t prove that all of the power plants NACCO supplies won’t shut down real soon. This means I can’t prove NACCO won’t lose literally all of its business in the very near future.”


I wasn't joking when I wrote any of that. I talk a lot to investors. And I feel certain they shouldn't put any money into NACCO. That kind of business specific risk - that a stock you picked could lose 35% of its earnings overnight - has the potential to make them feel so stupid, that they shouldn't invest.

It's not just that I think differently about stock picking than other people. It's that I feel differently about stock picking. If I lose a lot of money in NACCO, I'll lose a lot of money - same as anyone else. But, losing a lot of money in NACCO won't crush my psyche. That kind of loss will do a number on most other investors' heads. 

To have success in investing, you have to stay in it long-term. That - more than anything else - is the key. You can have the optimal system picked out, but if you quit after just 8 years of investing instead of sticking it out for 50 - you lose. The real risk to investors is not the risk shown in something like the Kelly Criterion where you will end up with a zero dollar bankroll at some point. The real risk is that you'll stop picking stocks. And the reason you'll do that is because your mind gets broken - not your bankroll. 


Losing a lot of money in an obscure stock like NC that I picked out for myself vs. losing a lot of money in the S&P 500 doesn't feel any different to me. It feels different to the average person out there. So, when I say: you might lose 35% overnight in NC because of a single event that hasn't happened - that's disturbing to most investors. But, the way I look at it - you might lose 35% in NC because of an event that hasn't happened yet. But, you will lose 35% in the S&P 500 because of an event that has already happened (it's more than 50% overpriced right now). 


That sounds wrong to most people.


But, it's right.


The fact that all investors are aware of the S&P 500 and almost all of them don't believe it's overvalued by at least 50% doesn't change the fact that it is overvalued by at least 50%. Likewise, the fact that almost no investors are aware of NACCO doesn't change the fact that there is some price level below which it should not sell.


I looked at the stock before the spin-off. And I came to the conclusion that the stock shouldn't sell for less than about $45 a share. I didn't value it at $45 a share. I just said: "it'd be really weird for this stock to ever trade below $45 a share" and then the stock was trading at around $32.50 a share when I first checked the price on October 2nd (the day of the spin-off). So, I bought it.


I wrote the article at Focused Compounding in which I discussed NC after the spin-off had happened. So, I used $32.50 as the price I discussed in that article. 


Basically, what I said was something like this:


Over the last 5 years prior to NC's expansion into (and now exit from) the very different business of owning and operating an underground bituminous coal mine (Centennial), NACoal reported an after-tax profit of over 90 cents per ton of coal mined if we assume all "corporate" losses stay with NC and none go to HBB. NACCO is now producing more than 5 tons of coal per share of NC stock. So, 90 cents times 5 tons = $4.50 per share in earnings. Furthermore, NACCO is taking a non-cash charge in the form of amortization of its coal supply contracts with every ton of coal it mines. This causes NACCO's reported profit per ton of coal mined to come in well below its cash received per ton of coal mined. 

Then, I knew that HBB was supposed to pay NACCO a $35 million cash dividend just prior to the spin-off. And, knowing that, I could see that this would leave NACCO with a balance sheet that was basically free of meaningful net debt or net cash. NACCO has long-term liabilities. But, these don't require much in the way of immediate funding (they aren't things like bank loans). And the company has cash on hand right now. So, I assumed the net result – in my quest to simplify the situation – was that the asset and liability situation came close enough to being a wash that I could just value the stock as if it was nothing but an annual stream of free cash flow.


So, for the sake of simplicity, you have a stream of free cash flow that's about $4.50 a year and costs you about $32.50 (with no meaningful cash or debt attached).


Normally, free cash flow is capitalized in the stock market at a rate no higher than 6% (that is, 16-17 times free cash flow). So, a stock priced at $32.50 a share with neither meaningful debt nor cash attached to it is priced like it is expected to deliver an annual stream of free cash flow of $1.95. In other words, NACCO looked like it would normally have about $4.50 a share in free cash flow and yet it was priced like it would normally have about $2 a share in free cash flow.

This meant that NC's free cash flow could end up being (more than) 50% lower than what I calculated without the stock price needing to decline to reach fair value. 


The way NACCO's unconsolidated mines are set up - where the customer takes all the capital risk - made me feel that NACCO was better situated to lose a big chunk of revenue without necessarily losing a much bigger chunk of free cash flow. At many businesses, a decline of say 35% of revenue could cause a 100% decline in earnings. Here, I didn't think that - after the initial year or so following the contract loss - a loss of 35% of revenue would cause much more than a loss of 50% of free cash flow. 


So, I looked at the stock and said that NACCO at $32.50 a share is already priced like it has lost its biggest customer. That's your margin of safety. It's priced like it's lost its biggest customer. And yet it hasn't yet lost its biggest customer yet. And - while you own the stock and wait for it to lose that biggest customer - cash will pile up on the balance sheet at a rate of about 10% to 15% of your original purchase price, or you'll get a dividend (right now, it's about 2% of my cost in the stock), or the company will buy back stock, or the company will - as it did in the past - acquire businesses unrelated to coal mining. 


This looked like a good deal to me. So, I bought the stock. However, I don't recommend anyone else buys the stock, because they will have such tremendous regret if they buy NACCO and then coal power plant after coal power plant after coal power plant closes and the company's stock drops nearly to zero.


The regret they feel losing money in NACCO will be much greater than the regret they'd feel losing the same amount of money in something like an S&P 500 index fund, because in the case of NACCO their loss will be their fault. In the case of the S&P 500, they can take solace in the knowledge that everyone they know also lost money the same way.


Unlike most people, I don't really feel regret. And so: one loss feels just like another loss to me. 


For example, I lost a lot of money in Weight Watchers (WTW).


That doesn't really bother me. I know some other people who followed me into that stock, lost less money than me (or pretty much broke even) and yet are still bothered by the experience.


This is why I warn everyone away from NACCO even while owning the stock myself. You may really regret owning NACCO in a way I won't. 


For me, if I look back on a stock purchase I made and can say "knowing what I knew then it seemed like a good bet at the time" - I won't regret that purchase no matter how much I lose. 


Also, if I do something like keep money in cash that could go into the S&P 500 and then the S&P 500 goes up 20% or so (like it did this year) despite already being expensive - I won't regret not being in the market. Because, yes, it went up 20%. But, looking back a year ago - it certainly didn't look like a good bet at the time. So, I don't think anyone who has made 20% in stocks this year should give themselves credit for being lucky a little longer than it probably was safe to be. 


This may or may not be how most investors think. But, I know it's not how most investors feel. So, there are just certain stocks the average investor should avoid for purely psychological reasons. And I think NACCO is one of those stocks.


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Do I Think About Macro? Sometimes. Do I Write About Macro? Never.

by Geoff Gannon

When writing about a stock, it’s always easier to use a more conventional estimate so you don’t have to argue with people about your “model”. This is one way in which writing about investing – showing your work publicly – is bad for your own investment process.


Regarding macroeconomic variables – the expected rate of nominal GDP growth, the Fed Funds Rate, the price of oil, etc. – the conventional assumption is usually the most recent reading modified by the recent trend. So, if the price of oil was “x” over the last 3-5 years, some people think 0.75x is reasonable and some think 1.25x is reasonable. But, estimates of 0.5x and 1.5x and beyond are considered unreasonable.


This “recency” issue makes it hard to have macroeconomic discussions. The level and trend of the recent past becomes the conventionally accepted answer for future estimates. The problem for you as an investor is that any application of conventional wisdom is useless. If the conventional wisdom is that the Fed Funds Rate will be 1.5% fairly soon – and you also believe the Fed Funds Rate will be 1.5% fairly soon – you may be correct, but your correctness will do you no good. Stocks are already “handicapped” according to the conventional wisdom.


The only macro assumption that can do you any good as an investor is a belief that is both:


1)      Correct and

2)      Out of step with conventional wisdom


Sometimes, I do have such beliefs. But, they’re never any fun to write about. So, I try not to write about them. However, in terms of my actual investing behavior – I can’t help myself from buying something I believe to be incorrectly “handicapped”. So, you will sometimes see indications of macro assumptions in my actual investments even though they don’t appear in my writing.



Fed Funds Rate


When doing my own (private) work on Frost, I can assume a normal Fed Funds Rate of 3% to 4% without any problem. But, when writing about Frost for others – I have to spend a ton of time justifying something I think seems obvious. A lot of my Frost report was wasted on discussing the Fed Funds Rate instead of discussing Frost. In my own head: I spent very little time worrying about where the Fed Funds Rate would be and when.



Oil Prices


In some cases, the mental toll writing and defending such justifications takes on you just isn’t worth it. So, you don’t write about that topic. For example, people who discussed stocks with me privately – like Quan – long knew that I was using assumptions of $30 to $70 a barrel for oil even when Brent was trading at $110 a barrel. In fact, since I started this blog 11 years ago, my assumptions for the price of oil have never changed. My process has always been “plug in $30 a barrel” and see what you get and then “plug in $70 a barrel” and see what you get. Assume the worst for the stock you’re looking at (so $70 for an oil consumer and $30 for an oil producer) and see if there’s any margin of safety left in the stock at that price per barrel for oil. So, now you know why I’ve never bought an oil producer and why I wrote about a cruise line – Carnival (CCL) – on this blog. I was only putting $30 a barrel into my assumptions for oil producers. And I was only charging Carnival $70 a barrel even in years when it was spending the equivalent of $110 a barrel for its fuel.





This is one where you may notice a difference between what I practice and what I preach. If you look at what I preach – I don’t talk much about inflation. And when I do, I say something like: “inflation may be 2% to 4% a year, let’s take the low-end of that for our assumptions about this stock’s growth rate.”


Now, what do I “practice” though?


Well, over 50% of my portfolio is in NACCO (NC). All of that stock’s earnings are indexed to inflation (they are cost plus coal supply contracts). I have about 15% of my portfolio in BWX Technologies (BWXT). A lot of that stock’s earnings are indexed to inflation (they are cost plus shipboard nuclear reactor contracts – among other things). So, that’s at least 65% of my portfolio that’s “cost plus”. Finally, I have 28% of my portfolio in Frost (CFR). Frost’s earnings are basically tied to nominal interest rates. So, that’s about 93% of my portfolio – all U.S. – that is in businesses that don’t put in much tangible capital up front and do insist their customers pay them more (as inflation happens). Finally, the remainder of my portfolio is in a company in Japan. So, although I never really write about inflation in the U.S. – you’ll notice that I’ve invested in things where I won’t be hurt by inflation in the U.S. Most U.S. stocks will do worse in periods of inflation than NACCO, BWXT, and Frost will.


Does this mean I’m predicting higher inflation in the future?


No. But, a lot of investors are putting 2% type inflation numbers into their assumptions about stocks when I’m not sure that – 10 years from now – 2% inflation is any more likely than 6% inflation in the U.S. Right now, the rate of inflation is not much different from where it was in the early 2000s or the mid-1960s. Ten years after the early 2000s, the inflation rate hadn’t really moved much. And ten years after the mid-1960s, it had gone from less than 2% to about 11%.


I’m not sure knowing what the inflation rate is today or what the Fed Funds Rate is today is helpful in predicting where either will be 10 years from now.



P/E Multiples


The same is true for P/E multiples. I’m not sure that knowing what the average P/E multiple – or Shiller P/E multiple – is today will help you predict what the average P/E multiple will be in 10 years. Maybe 50% of the time today’s average P/E multiple and the average P/E multiple 10 years from now are about the same. But, the other 50% of the time – today’s average P/E multiple and the average P/E multiple 10 years from now are completely different (just as a 2% inflation rate and an 11% inflation rate are completely different – yet in U.S. history those two readings were separated by just 10 years of time).





The only times I can think of where I’ve incorporated some sort of macro assumption into my investment decision making is where I’ve assumed that some macro variable will tend to be more like its long-term past (that is, the last 30-50 years) rather than its recent past (that is, the last 3-5 years). In other words: I can only make useful macro assumptions when some macro variable has been quite different over the last 3-5 years than the last 30-50 years and the conventional wisdom is that the recent past – rather than the long-term past – is right.



P.S. – China


Some of you who read this blog religiously know “I don’t invest in China”. That’s a rare hard and fast rule for me. Another hard and fast rule for me is: “I don’t write about why I don’t invest in China.”

I’m willing to be more controversial in my investment decisions than my writing.


I don’t see a point in writing about why I don’t invest in China. I’m not an expert on China. Anything I write on the topic would be controversial. And, more importantly: anything I write on the topic would be unlikely to change your mind about whether you should invest in China. So, it’s just not a topic I’m going to touch.

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What Most Investors Are Trying to Do

by Geoff Gannon

John Huber, who writes the Base Hit Investing blog and also runs the excellent BHI Member site, did an interview over at In that interview, Huber says:

“(My) strategy is very simply to make meaningful investments in good companies when their stocks are undervalued.

This is obviously what most investors are trying to do…”

Like John, I used to think that this is what most investors were trying to do. However, the thousands of email exchanges I’ve had over the 12 years I’ve been writing this blog have taught me that most investors are not trying to “make meaningful investments in good companies when their stocks are undervalued.”

Let’s break this statement down to see what I mean:

1.       Make meaningful investments

2.       In good companies

3.       When their stocks are undervalued

We have 3 key words there:

1.       Meaningful

2.       Good

3.       Undervalued


Make Meaningful Investments

What is a meaningful investment?


“Meaningful Investments” According to Me

My minimum position size is around 20%. My maximum position size is around 50%. I usually own 3-5 stocks. I often have some cash.

At the start of this quarter, my portfolio was more concentrated than usual. I had 50% of my portfolio in my top stock alone, 78% in my top 2 stocks combined, and 92% in my top 3 stocks combined.


“Meaningful Investments” According to Joel Greenblatt

Quote: “After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to reduce risk is small.”

Answer: A meaningful investment is 13% to 17% of your portfolio (1/8 = 12.5%; 1/6 = 16.67%).


“Meaningful Investments” According to Warren Buffett

Quote: Charlie and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.”

Answer: A meaningful investment is 16% to 25% (80%/5 = 16%).


“Meaningful Investments” According to Charlie Munger

Quote:If you are going to operate for 30 years and only own 3 securities but you had an expectancy of outperforming averages of say 4 points a year or something like that on each of those 3 securities, how much of a chance are you taking when you get a wildly worse result on the average? I’d work that out mathematically, and assuming you’d stay for 30 years, you’d have a more volatile record but the long-term expectancy was, in terms of disaster prevention, plenty good enough for 3 securities.”

Answer: A meaningful investment is 33% (1/3 = 33.33%).


So, the above value investors (jointly) define a “meaningful investment” to be in the range of 13% to 33% of your total portfolio.

Over the last 12 years, I’ve discussed position size with dozens of individual investors. Maybe five of them take “normal” positions of 13% to 33% of their portfolio. I would estimate that at least 85% of investors do not try to make meaningful investments.


In Good Companies

What is a good company?


Good Companies According to Me

Quote: “A business with market power is a good business. A business without market power is a bad business…Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.”

Answer: A good company is a player in markets (both those it buys from and those it sells into) where competition is extraordinarily imperfect.


Good Companies According to Warren Buffett

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

Answer: A good company faces extraordinarily mild price competition.


Do Most Investors Look for Good Companies?

Most public companies don’t have highly persistent profitability. They experience mean reversion. This is because either: 1) They operate in markets (both those they buy from and those they sell into) where competition is not extraordinarily imperfect and therefore tends toward the “mean reversion” of profitability common in more perfectly competitive markets or 2) They expand the corporation by taking the profits earned in an extraordinarily imperfectly competitive market (one in which they have a “moat”) and re-invest them in a more perfectly competitive market (where they don’t have a moat).

Is it possible to identify imperfectly competitive industries ahead of time?


They’re less cyclical.

Let me explain.

A perfectly competitive market is made up of a large number of price takers. An imperfectly competitive market is made up of a small number of price setters. A large number of price takers – each believing they have no influence on the market they operate in – act irresponsibly in the literal sense of believing their individual actions are not responsible for the outcome the group experiences. A small number of price setters – each believing they have some influence on the market they operate in – act responsibly in the literal sense of believing their individual actions are responsible for the outcome the group experiences.

In other words…

Players in a perfectly competitive market act like humans do when wearing masks, among strangers, etc.

Players in an imperfectly competitive market act like humans do when showing their face, among peers, etc.

As a result, perfectly competitive markets are driven by more self-destructive decision making. Self-destructive decision-making leads to cyclicality.

This is because a cycle is only possible if a decision is made now that is regretted later. An industry free of regrets would be an industry free of cyclicality.

A decision may be regretted later because it was based on information that proved to be false or…

A  decision may be regretted later, because – despite having the correct information – a player in the market made a decision they knew was against the group’s long-term interest because they believed it might be in their own short-term interest.

Economists, investors, etc. tend to focus on bad information as an explanation for behavior that is later regretted. However, anecdotally, I think many of us would have to say that the regrets we observe in our day-to-day lives are at least as frequently due to the decision maker having all the necessary information to make a correct decision but still giving into a short-term impulse simply because the ill effects of the decision were known to be felt only in the long-term.

The classic quote here is, of course, from Citigroup CEO Chuck Prince in July 2007:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Note the focus on time as opposed to risk. This is something you hear in cyclical industries but never in non-cyclical industries. He said: “in terms of liquidity, things will be complicated.” That’s all you need to know to know you shouldn’t be dancing. That’s the risk. But, he prefaced the bit about risk with “When the music stops” and added the afterword: “But as long as the music is playing…” This kind of quote is common – though rarely as direct – in cyclical industries. The justification for self-destructive behavior is that “yes, we’re doing something risky” but “no, now’s not the time we’ll have to pay for the risks we’re taking”.

Credit Suisse did a study of how persistent profitability was by industry. (You can Google the title “Do Wonderful Companies Stay Wonderful” to find a discussion of this report).

The extreme results – the industries listed as those where firms had the most persistent profitability and the industries listed as those where the firms had the least persistent profitability – were not surprising.

The 3 industries where firms had the most persistent profitability were: 1) Household and Personal Products, 2) Food and Beverage, and 3) Hotels and Restaurants. All non-cyclical industries.

The 3 industries where firms had the least persistent profitability were: 1) Insurance, 2) Semiconductors, and 3) Real Estate. All cyclical industries.

Let’s take a look at Berkshire Hathaway’s 5 largest stock positions shown in the 2009 shareholder letter:

(This is the last year where Warren Buffett was the only person at Berkshire making investment decisions.)

#1) Coca-Cola (KO): Soft drinks

#2) Wells Fargo (WFC): Banking

#3) American Express (AXP): Credit cards

#4) Procter & Gamble (PG): Toiletries

#5) Kraft (KFT): Food

Coke and Kraft are in the food and beverage industry. That’s the #2 industry in terms of most persistent profitability among firms. Procter & Gamble is in the household and personal products industry. That’s the #1 industry in terms of most persistent profitability among firms. There were 24 industries listed in that Credit Suisse report. So, 60% of Buffett’s top 5 stocks in 2009 were in the top 8% of industries by persistence of profitability at the firm level. Almost without exception, Buffett’s 2009 stock investments were in companies that were either in non-cyclical industries or in financial services.

(The exceptions are Posco and ConocoPhillips. Berkshire also owned BYD; however, this investment was probably made by Charlie Munger – not Warren Buffett).

Berkshire’s investment portfolio skews heavily towards the very least cyclical industries around.

Do most investors look for good companies?

When I put out a call for readers to request I research specific stocks for them (I’ve since cancelled this project), I got as many requests for companies in cyclical industries as in non-cyclical industries.

In fact, after getting a flood of requests from readers – I wrote this on the blog:

“Finally, a suggestion. I will certainly try to do my best to research any stock you ask about. However, I have gotten a lot of requests to research companies that are speculative in the sense that:

·         They are in bankruptcy right now

·         They are losing money right now

·         They have never made money in the past

·         Statistical measures like Z-Score and F-Score suggest they are very poor credit risks

I can research these stocks. But, common stock is junior to the company’s obligations. So, in cases like this, my write-up is likely to focus on the company’s weak financial position and the possibility that the stock will be worthless.”

These requests were not for good companies.

Conclusion: I would estimate that investors spend about 50% of their time looking at good, non-cyclical companies and about 50% of their time looking at bad, cyclical companies. Except among a very small subset of readers I exchange emails with – I have not detected any tendency for investors to focus on good, non-cyclical companies to the exclusion of bad, cyclical companies.


When the Stocks are Undervalued

I write a value investing blog. And I have to say that my readers do tend to ask about cheap stocks. They tend to own the stock that has the lowest P/E, EV/EBITDA, etc. in an industry. They are much more interested in stocks hitting 52-week lows than 52-week highs.

Conclusion: In my experience, value investors really do like to buy stocks that have fallen in price, stocks that are cheaper than peers, and stocks with low price-to-book ratios, price-to-earnings ratios, and especially low EV/EBITDA ratios.


One Out of Three

My experience is limited to talking with readers of the blog over the last 12 years. These readers (or at least the ones who email me) are maybe 40% American and 60% from other countries. They almost all identify as value investors. A very slight majority are individual investors who don’t work in the investment industry. Most of the remaining minority are professionals in the sense they work in the investment industry – often as analysts – but do not have ultimate responsibility for a portfolio. A much smaller minority – probably no more than 5% – are fund managers. The funds they are running are usually small: anywhere from tens of millions to hundreds of millions of dollars – not billions.

So, the population I’ve interacted with skews entirely to the “value” side. It is more individual investors than institutional. A lot of money is run by big institutions which may not be value oriented. I can’t talk about them.

For those investors I can talk about: how do they score on John Huber’s 3-point strategy?


#1: Make Meaningful Investments

False. Overwhelmingly, the investors I know prefer to make non-meaningful investments. They prefer taking a 5% position over a 15% position and a 3% position over a 33% position.


#2: In Good Companies

Neither true nor false. At the same price, I get the impression they’d prefer investing in a good, non-cyclical company over a bad, cyclical company. But – give the prices at which stocks typically trade – they seem as interested in bad, cyclical companies as good, non-cyclical companies. When a reader asks me about a stock unprompted – that stock is as likely to be a bad, cyclical company as a good, non-cyclical company.


#3: When Their Stocks are Undervalued

True. The value investors who read my blog like stocks that have dropped in price. They like stocks with low EV/EBITDA multiples, low P/E ratios, and sometimes even low price-to-book ratios. They like stocks that are cheaper than their peers.


Conclusion: The value investors who read my blog don’t really follow John Huber’s approach of seeking to “make meaningful investments in good companies when their shares are undervalued”. Instead, they seek to make less than meaningful investments in companies regardless of their quality when those stocks are cheap.

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Risk Habituation and Creeping Speculation

by Geoff Gannon

In response to an email a reader sent about some of my recent posts on the difference between investment and speculation, I entered lecture mode…


I am especially worried about the tendency among readers to speculate using the logic that value investors (like me) are sometimes wrong (like in WTW) and these "investments" turn out to be speculations. Therefore, how is buying at 8 times EBITDA in what has historically been a fairly predictable company different from buying at 16 times EBITDA in a company that hasn't historically been predictable? Aren’t they both speculations since you are always ultimately going to make money or lose money based on how right you are about the future?


Are You Better Off Than You Were 8 Years Ago? – Are You a Better Investor?

I feel this is an issue with the length of the latest bull market. Whether or not stocks are very expensive (and I do find them expensive generally, but this point still stands if I'm wrong about that), most readers of the blog have seen mostly good results from the stocks they've chosen to hold over the last 8 years now. Eight years is a long time. Many people have not even been following the same investment strategy for more than 8 years.

Their current approach has never been battle tested.

So, now I hear a lot from people who are more into paying up for higher quality, holding longer, etc. There are ways of implementing a strategy like that which work. But, I think the experience of the "recent" past is what gets them thinking in these directions.

Although I'm "only" 32, I was investing seriously (in terms of how much time I spent thinking about the subject) in 1999-2002 and in 2007-2009. Now, most years are not like 1999-2002 or 2007-2009. But neither are they like the run from the second half of 2009 through to today (the end of 2017). That kind of run is rarely this smooth. And so, when you have not seen a period with P/E multiples of even good stocks contracting 30% or 50% or more – you are less worried about the distinction between investment and speculation.

When you look at something I own like BWX Technologies (BWXT), which has performed well both as a business and as a stock, you see that it is now trading at 31 times earnings. It’s a great business. But, even if it is always recognized as a great business by the market – it may yet be assigned a P/E of 20 instead of 31. Great businesses sometimes trade at a P/E of 20. So, right there, you have the potential for a 35% decline in the price of this stock.

I still own the stock. And I’ll keep owning it till I know for sure that whatever new stock I want to buy is better than holding on to this stock. But, what is always foremost in my mind when I look at BWXT is the potential of this 35% decline in the price – absent any decline in the underlying business – simply because there will come a time when the P/E does contract from 31 to 20.

This is my bigger concern. Not that the Shiller P/E is high (though it is). But, that things have gone so well for so many investors even when their stock picking has been rather sloppy in terms of risk avoidance that they no longer think first about risk avoidance.


Risk Habituation

I’ve always believed that errors in investing which lead to excessive risk taking are the result of habituation. Wikipedia has a fairly good description of habituation which I quote here:

“It is obvious that an animal needs to respond quickly to the sudden appearance of a predator. What may be less obvious is the importance of defensive responses to the sudden appearance of any new, unfamiliar stimulus, whether it is dangerous or not. An initial defensive response to a new stimulus is important because if an animal fails to respond to a potentially dangerous unknown stimulus, the results could be deadly. Despite this initial, innate defensive response to an unfamiliar stimulus, the response becomes habituated if the stimulus repeatedly occurs but causes no harm. An example of this is the prairie dog habituating to humans. Prairie dogs give alarm calls when they detect a potentially dangerous stimulus. This defensive call occurs when any mammal, snake, or large bird approaches them. However, they habituate to noises, such as human footsteps, that occur repeatedly but result in no harm to them.”

In other words: investors should always be scanning their own thinking for risks they’ve taken but haven’t yet harmed them. It’s the risks you’ve gotten used to taking that kill you.

Prairie dogs can’t employ reason. Humans can. Even if the P/E ratios of stocks I’ve owned have done nothing but go up, up, up for the last eight years – I can reason out that multiple expansion is ultimately a self-defeating rather than a self-reinforcing trend.  

I think the distinction between investment and speculation is the most important concept in value investing.

When people say they are a value investor, they often stress that first word "value" and forget the second word "investor" is just as important.

An investor looks to the downside first, insists on a margin of safety, and only then thinks about how he might profit from a brighter future than the market now imagines.

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You Don’t Need to Know What a Stock’s Worth to Know It’s Cheap

by Geoff Gannon

Someone emailed me asking what sources they needed to study to get better at valuing stocks.

My answer was that the ability to come up with accurate valuations for public companies is overrated.

Why? Because…

It's rarely important to know how to value a company. What's important is the ability to recognize when a company is clearly selling for less than it's worth and then acting on that knowledge.

For example, in a write-up I did on my member site (Focused Compounding) explaining why I put 50% of my portfolio into NACCO (NC) when it completed the spin-off of Hamilton Beach (HBB), I said that:

"I think of each share of NACCO as an inflation adjusted stream of free cash flow. As I’ve shown, I think the stream has a ‘coupon’ of greater than $3.25 and I bought it at $32.50. So, the yield is 10% or more and that’s effectively a ‘real’ yield.

The average U.S. stock has a free cash flow yield in the 4% to 5% range and that yield is not as well protected against inflation.

It’s true that NACCO’s yield will eventually decline as coal power plants shut down (although, in recent years, the tons of coal supplied has risen rather than fallen). However, I think of my ‘margin of safety’ as being the fact that it isn’t 100% certain these plants will shut down and they haven’t shut down yet. Till they do, cash will build up on the balance sheet of NACCO (the parent company) or it will pay out dividends, buy back stock, or acquire businesses unrelated to coal mining (as it did in the past)."

It's important to note that:

1) I never said that NACCO's cash earning power is $3.25 a share. I said it's at least $3.25.

2) I never said that the right multiple for NACCO is 10 times FCF. I just said that a normal stock trades for 20-25 times FCF (a 4% to 5% FCF yield) and NACCO trades for no more than 10 times FCF.

In fact, in that same article, I walk through ways of estimating what cash earnings would be in a normal year for NACCO (now that's it just the coal business). The range of earnings estimates these different methods give you actually cluster around $4.75 to $5.50 a share (not the $3.25 figure I cite). However, I didn't think those numbers were important when the stock was at $32.50.

Why? Because…

Earnings of $4.75 to $5.50 on a $32.50 stock are overkill. You don't need to know if a stock has a P/E of 6 to 7. What you need to know is how certain it is that a stock doesn't have a P/E any higher than 10 to 11.

So, I spent more time focusing on the fact that the method of estimating earnings that was most conservative - using this year's tons of production and multiplying it by the lowest ever profit per ton the company achieved in the last 25 years - still gives you about $3 a share in cash earnings. The thing I thought was a lot more important than correctly valuing the stock was proving that the stock was almost certainly priced at 11 times cash earnings or less when I bought it. If the average stock trades for at least 20 times cash earnings and I am buying something at no more than 11 times cash earnings, I'm getting a 45% discount.

When buying a stock: the important thing isn't whether you’re getting a 45% discount or a 75% discount. It's establishing how certain you are that you really are getting a 45% discount. 

The relevant Ben Graham quote here is:

"You don't have to know a man's exact weight to know that he's fat."

It's not that important to know the exact value of anything in the stock market. What's important is knowing there's a big gap between some value you think it's highly probable a stock's worth more than and the value you're paying.

So, say the average stock trades for 25 times its after-tax free cash flow (when it's unleveraged). And then you find a stock that you think is equal to or better than the average public company in terms of quality, durability, safety, etc. Fine. What you do then is you say: well if the average stock is worth 25 times cash earnings right now and I think this stock is probably a bit better than the average stock - then I can be very sure it's worth at least 15 times earnings. So, you build a 40% discount right into your initial assumptions about the stock.

And then, what you try to do is force yourself to wait till the stock is trading not at 15 times earnings (where you feel certain it's not expensive) but at more like 10 times earnings (where you know it's cheap). You take your initial conservative assumption that forms your belief about the stock and then you insist on an extra margin of safety before you turn that belief into action.

So, now you've taken your initial 40% discount in terms of how conservative you were in valuing the company. And then you've built an extra 35% discount of inaction into your investment. 

Honestly, that's how you'll make money in the stock market. It's not by knowing exactly what anything's most likely worth that matters. It's knowing what something is almost certainly worth more than that matters. 

In value investing: technique isn't very important. Discipline is.

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Why Smart Speculations Still Aren’t Investments

by Geoff Gannon

I got an email in response to my earlier post about the line between investment and speculation. It’s a good email, so I want to quote it in full:


Really interesting post today, but I was wondering how you would evaluate the Weight Watchers (WTW) situation. 


It seems like an investment that turned into a speculative situation.


I think there are a couple of cases like this where a seemingly safe investment turns into a very speculative situation. Fossil (FOSL) is another one that comes to mind. Even though it had some debt, nobody would think that it would have an existential crisis at some point due to changes in business and the weight of its debt. I don't think anybody would have called it a speculation 3 years ago at over $100 a share. But on the other hand, it's speculative now at under $7 a share.


On the other hand you have situations like Facebook (FB) which IPO’d at an extremely speculative price but the business turned out to be so strong that even at that price, it morphed into an excellent investment had the margins not expanded so much.


I'm not saying that's the case for Amazon or Netflix today, but maybe it's not so easy to distinguish between investment and speculation in some cases because there are factors that we cannot foresee or do not yet understand. If you have the knowledge that it's almost certain the company will grow into and beyond the current valuation, then perhaps it would be a good investment at what others may consider to be a speculative price. 


If you know that a business could potentially come under hard times and the modest amount of debt it has could compound the problem, then a company with a very modest valuation may morph into a speculative stock at even 1/10th the original price a few years down the road.


In the end, a lot of it depends on what you really know I think.”


George Orwell wrote an essay called “Politics and the English Language”. One passage from that essay is helpful to quote here:


The word Fascism has now no meaning except in so far as it signifies ‘something not desirable’. The words democracy, socialism, freedom, patriotic, realistic, justice have each of them several different meanings which cannot be reconciled with one another. In the case of a word like democracy, not only is there no agreed definition, but the attempt to make one is resisted from all sides. It is almost universally felt that when we call a country democratic we are praising it: consequently the defenders of every kind of regime claim that it is a democracy, and fear that they might have to stop using that word if it were tied down to any one meaning.”


The word “democracy” has an actual definition, etymology, and history we can trace. The etymology is Greek. It means literally something like “people-power” or “people-rule” in the sense of “the people” as a group and not “people” as individuals (persons). The history is Athenian. The term “democracy” is first used to describe the government of Classical Athens specifically in opposition to monarchies, tyrannies, and “mixed” governments (what we’d now call “republics”) like Sparta, Carthage, and Rome.


In the modern, Western world the term “democracy” is almost universally considered positive. And two of the most commonly copied systems of government, those of the U.K. and the U.S., like to refer to themselves as democracies. But neither has much in common with the government of Classical Athens. And when being precise, we modify the “democracy” of the U.K. by saying it is a parliamentary democracy and we modify the “democracy” of the U.S. by saying it is a federal, democratic-republic.


The knee-jerk definition of democracy is “good”. The sloppy definition is “like the U.S., U.K., etc.”. The precise definition is “like the government of Classical Athens, only those elements of the U.K. government which are not specifically parliamentary, only those elements of the U.S. government which are neither specifically federal nor republican.”


In other words: we are capable of thinking about democracy very quickly and fuzzily (all heart no head), somewhat quickly and fuzzily, or very slowly and sharply.


We can think about investment and speculation the same three ways.


As value investors, our knee jerk definition of investment is “good, right, sound, what I do, etc.” and our knee jerk definition of speculation is “bad, wrong, risky, what everybody else does, etc.”


We equate speculation with gambling. But, true gambling is different from speculation just as true speculation is different from investing.


Let’s think slowly and sharply about “investing” and “speculation”. What is the definition, etymology, and history of these two terms?


In my last post on the line between investment and speculation I cited a post by Richard Beddard which in turn cited “The New Speculation in Common Stocks” by Ben Graham. You can google “The New Speculation in Common Stocks” and find a PDF of Graham’s speech.


Graham’s point was that investors had bid up the price of some common stocks enough that though the firms themselves had been investments, they became speculations at this higher price. In that talk, Graham introduces the term speculation by saying:


“The dictionary says that ‘speculate’ comes from the Latin ‘specula’, a look-out or watch-tower. Thus it was the speculator who looked out from his elevated watch-tower and saw future developments coming before other people did.”


Graham had earlier defined investment and speculation in his 1934 book, Security Analysis:


“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”


The other definition that I would offer is that if investment is in some sense an antonym of speculation – if speculation is rooted in the future, then investment must be rooted in the present and the past.


In other words, an investment is a stock purchase that can be fully justified on the evidence provided by the current financial position (balance sheet) and past earnings record (income statements and statements of cash flows) of the business.


A speculation is an operation that can’t be fully justified on the evidence provided by the current financial position and past earnings record of the business.


I am not making a distinction between quantitative and qualitative factors here. I am making a distinction between a business’s recorded history and its projected future.


Let me quote from another email I received about the line between investment and speculation:


“…this was the worst (post) I ever read from Geoff…I don’t think he understands Amazon at all…and it is obvious that he has not tried to objectively analyze Amazon. I think there is a real chance that OMC is more speculative than Amazon…I actually think Amazon looks cheap and I consider myself a hardcore value investor. You probably think I’m crazy so I’ll stop right here.


I don’t think the person who wrote that email is crazy. And if he had said “I think there is a real chance that Amazon stock outperforms Omnicom stocks” instead of “I think there is a real chance that OMC is more speculative than Amazon” I’d agree with him. There is a real chance Amazon will outperform Omnicom. But, that doesn’t make Amazon an investment. And it’s possible for Amazon to “look cheap” and still be a speculation.


Let’s look at why I called Amazon a speculation. First, here’s what I wrote about Amazon in that earlier post:


And we would also say that Amazon (AMZN) and Netflix (NFLX) are speculations. The enterprises themselves aren’t speculative. They are proven money makers. But, the prices investors now put on these stocks make them speculative. There is no measure – P/E, P/B, EV/EBITDA, etc. – by which either Amazon or Netflix are within spitting distance of an average price. So, a buyer of either Amazon or Netflix stock is not just betting that these businesses are above average. He is betting that they are better enough to offset paying a higher than average price for the stock.”


The last two sentences are what defines Amazon as a speculation for me: “a buyer of Amazon stock is not just betting that the business is above average. He is betting that the business is better enough to offset paying a higher than average price for the stock.”


Buying Amazon stock is an exercise in handicapping. Let’s look at how much extra weight this horse is carrying.


I will take data from GuruFocus. Amazon shares now trade at $1,130. Revenue per share is $328. EBITDA per share is $29 a share. However, “cash flow from operations” is 16% higher. That’s not “free cash flow”. Just “cash flow from operations” before any cap-ex. As the email writer said, I haven’t tried to objectively analyze Amazon. So, it is possible “cash flow from operations” is a more accurate gauge of Amazon’s cash generating ability than EBITDA. Note that it is very difficult for a company’s “owner earnings” to be higher than both EBITDA and cash flow from operations. And also note I am starting by using a figure that is 8 times Amazon’s reported earnings for this last year. I know it is not appropriate to use Amazon’s reported earnings. I’m not using that number at all here.


So, we will start with Amazon’s “cash flow from operations” per share of $33 as the maximum possible proxy for current earning power. Let’s assume Amazon grows this $33 per share in “cash flow from operations” at a rate of 20% a year for the next 20 years. That gives you cash flow from operations per share of $1,265 at the end of 2037. Assume this is equivalent to EBITDA per share (it’s not, it’s lower). And apply a normal EBITDA multiple of about 8 times (an EBITDA of 8 times tends to roughly equal a P/E of 15 for an unleveraged company paying a 35% U.S. tax rate). This gives you a future share price of $10,121 at the end of 2037. The compound annual growth rate needed to get you from a share price of $1,130 today to $10,121 is 11.6% a year. So, Amazon stock would return something like 12% a year over 20 years if it grew its earning power per share by about 20% a year for the next 20 years.


How difficult is that to do?


Amazon would have to grow its size relative to the economy by about 12 times if the economy grew at about 6% a year for the next 20 years while Amazon grew 20% a year. So, however much clout Amazon has today – imagine it has 12 times more clout.


The path I’ve laid out here is difficult for Amazon to accomplish. The company is too big already to easily achieve that. Once a company has meaningful market share in an industry, it becomes more and more difficult to grow faster than that industry. Within 20 years, things like online retail and probably cloud computing as well will be mature industries. They won’t be growing much faster than the economy.


Are there other ways Amazon stock can return something like 12% a year over the next 20 years?


Yes. It can buy back stock to allow it to grow slower companywide – but the stock is too expensive for that to work right now. In fact, Amazon has historically diluted its share count. So, I’ve actually underestimated the necessary increase in the size of the overall enterprise in my example above. To achieve a 20% annual growth in earning power per share – companywide earnings would have to grow even faster. Maybe all of the company’s spending on research and development is really profit. It’s necessary to spend $42 a share on research and development right now – but maybe in 20 years, Amazon will no longer have to spend a penny on R&D if it’s done growing.


The stock could also pay less in taxes, trade at a higher EBITDA multiple in 2037, etc. These are all possible.


But they’re speculative. The only potentially non-speculative argument here is that Amazon is expensing items which are actually profits that are being re-invested in future growth. So, for example, what if all of the company’s R&D was treated more like growth cap-ex on the cash flow statement.


If you count all of the company’s cap-ex and all of the company’s research and development as being purely for the purpose of further growth – none of it is needed to maintain the current sales level – you can get to a price on the company today that is about 15 times this adjusted free cash flow figure. That’s a leveraged number. But, the number including debt wouldn’t be much higher.


So, the stock could actually be trading at about 15 times (heavily adjusted) owner earnings right now?


There’s a problem with that assumption. The company is spending on research and development. So, it has to grow at the sorts of rates I laid out to justify the investment in R&D for as long as it keeps making those investments. As long as you are spending $15 billion a year on cap-ex and $21 billion a year on R&D, you have to grow sales by $36 billion a year.

Let me explain why this is.


For an “investment” in R&D or cap-ex to be worth as much as profit you have in cash today, you would need to get something like a 10% after-tax return on that money. Otherwise, shareholders would be better off receiving a dividend and finding another stock that can return 10% a year. Even if you add back Amazon’s R&D expense, you still only get an adjusted operating margin of about 15% which works out to about 10% after-tax. For Amazon to grow its earnings – before R&D expense – by about $3.6 billion a year, it needs to grow sales by about $36 billion a year. That’s because $36 billion of added sales creates $3.6 billion of added profit (before any R&D expense but after taxes), which is about 10% of the $36 billion Amazon is investing in cap-ex and R&D right now. The company has $161 billion in revenue right now. So, adding $36 billion to that would be an increase of about 22%.


Once again, we come to about the same conclusion. To guarantee a 10%+ return in the stock, Amazon has to grow at about 20% a year.


Of course, that’s only if the company keeps investing in R&D and capital spending. It could stop investing in those things and slow its growth considerably and generate similar returns for shareholders. But, it either has to reduce investment in R&D and cap-ex and grow slower or grow at 20% a year or so and keep investing. It can’t keep investing and grow slower while delivering adequate returns for shareholders. That’s the one combination it’s not allowed.


Let’s compare this to the example I gave of an investment: Omnicom (OMC) at $68 a share. Right now, the stock has a P/E of 13, a 3.25% dividend yield, and a 2.25% annual rate of reduction in shares outstanding. A P/E of 13 is a smidge below the long-term historical average of around 15 for U.S. stocks. A 3.25% dividend yield and a 2.25% share buyback rate combined give you a 5.5% annual return if the company itself neither grows nor shrinks and the P/E multiple neither expands nor contracts. If you consider a 10% annual return adequate, the math works out as follows: 10% - 5.5% = 4.5%. The stock can deliver a 10% annual return if the company itself grows at 4.5% a year. The economy is likely to grow – in nominal terms – at something like 4% to 5% a year. So, if Omnicom as a company grows at the same rate as the economy and the stock becomes neither more or less expensive over time – investors who buy the stock today should expect a 10% annual return for as long as they hold it.


This is why I call Omnicom an investment. The most common-sense way of looking at the company based on the present situation and the past record suggests the stock will return about 10% a year.


The Amazon case is trickier. It assumes that large amounts of money spent on research and development and cap-ex will continually generate after-tax returns in excess of 10% a year. That’s a speculation. Is it a good speculation?


Up to a point, I think it is. I don’t think it’s an unreasonable speculation to say that Amazon can commit $20 to $40 billion a year on projects that will generate 10%+ after-tax rates of return in 2018 or 2019.


The problem is the 18 years after that. I don’t know of any historical examples of R&D on that scale that have generated adequate returns for the company doing them. At the rate Amazon is going, it would be spending $50 billion a year on R&D in 5 years and $120 billion a year on R&D in 10 years. Or…


Or, it would stop.


And here is the other part of the speculation: Jeff Bezos.


You could speculate that management is focused on return on capital rather than just growth. Amazon spends on growth now because it gets good returns on capital by doing so. But, it’ll stop spending in the future when it stops getting good returns on that spending.


I wouldn’t bet against that kind of management-based speculation. I wouldn’t bet against Amazon either as a company or even as a stock (and even at this price level).


But, I would call Amazon a speculation. Amazon can be a good enough speculation and Omnicom can be a bad enough investment that Amazon outperforms Omnicom. But, that doesn’t mean in hindsight that Amazon was an investment.


Let me return to the email I started this all with:


“…but maybe it's not so easy to distinguish between investment and speculation in some cases because there are factors that we cannot foresee or do not yet understand….”


If we cannot foresee or do not yet understand factors, those are speculative factors. They’re important factors to consider if you’re speculating. And I’m not saying people shouldn’t speculate. If you think you have really sound reasons for believing the world will be different in the future than it is now – you can make such a speculation.


For example, several years ago – when Brent was at about $110 a barrel – I was interested in researching companies that used fuel as a commodity input but were otherwise pretty stable, understandable businesses. I looked at oil prices and couldn’t come up with good reasons for why oil should be at $110 a barrel instead of $70 or less per barrel. So, there was a speculation here on my part that might uncover a potential investment.


Likewise, there is a speculative element any time you are considering an investment with a “catalyst”. So, when I was researching Barnes & Noble (BKS) in 2010, the investment case was the high free cash flow from the stores versus the low market cap of the company. The speculative element was the proxy battle between Ron Burkle and Len Riggio that might serve as a catalyst which would re-direct the free cash flow to uses that I favored. I was wrong on that speculation. Riggio stayed in control of the company. And Barnes & Noble directed the free cash flow from the stores into the Nook. I sold out once I saw the profit from the stores would not come in the form of cash but rather would come in the form of R&D and start-up losses on the Nook. I could evaluate what cash was worth. I couldn’t evaluate what the Nook was worth.


And then there is the point about investments turning into speculations:


If you know that a business could potentially come under hard times and the modest amount of debt it has could compound the problem, then a company with a very modest valuation may morph into a speculative stock at even 1/10th the original price a few years down the road.”


This is the “fallen angel” concept. And it relates to Graham’s talk on “The New Speculation in Common Stocks”. There have always been high yield bonds. But, during Ben Graham’s career high yield bonds were “fallen angels”. The bonds had good credit ratings at one time, adequate interest coverage, and could be considered “investments”. But then the enterprises who issued these bonds fell on hard times and the bonds fell in price. In hindsight, the bonds were bad investments when initially issued but could often be good speculations when bought when the company was distressed and the bonds sold at pennies, dimes, or quarters on the dollar. Later, after Ben Graham retired from investing, bonds began to be issued as high yields from the start. This was speculative grade stuff. Not because the company issuing the bonds was distressed, but because the amount of debt issued made the situation speculative. Bond investors were willing to speculate as long as the potential returns were greater (the yield was higher).


The potential upside in Amazon stock is much, much greater than the potential upside in Omnicom stock. But, the likelihood of an adequate return in Omnicom stock is higher than the likelihood of an adequate return in Amazon stock. This is not because Omnicom is a safer business than Amazon. It’s because Omnicom is trading at a much lower price relative to actual free cash flow – cash that will (this year) be used to buy back stock and pay dividends – than the price Amazon trades at.


Amazon may be reasonably priced versus some form of adjusted earnings. But consider the form these adjusted earnings come in. They are R&D and capital spending. The certainty that $1 of money spent on additional R&D and capital spending is worth at least $1 in market value is much less than the certainty

that $1 of cash spent on buybacks and dividends is worth at least $1 in market value.


Graham speculated.


He bought – as a group operation – into a variety of arbitrage situations and other “workouts”. Some of the workouts were investments in inherently cheap businesses. But, some weren’t. Sometimes he was buying into a stock purely on the odds that an acquirer would successfully close the deal at the announced price. That’s speculation. It’s smart speculation with a calculable “edge”. But it’s still speculation.


Warren Buffett has speculated too. In his 1988 Letter to Berkshire Hathaway Shareholders he described his arbitrage operation in Arcata:


Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and turns of the business. On September 28, 1981 the directors of Arcata agreed in principle to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), then and now a major leveraged-buy out firm.  Arcata was in the

printing and forest products businesses and had one other thing going for it: In 1978 the U.S. Government had taken title to 10,700 acres of Arcata timber, primarily old-growth redwood, to

expand Redwood National Park.  The government had paid $97.9 million, in several installments, for this acreage, a sum Arcata was contesting as grossly inadequate.  The parties also disputed the interest rate that should apply to the period between the taking of the property and final payment for it.  The enabling legislation stipulated 6% simple interest; Arcata argued for a much higher and compounded rate.


Buying a company with a highly-speculative, large-sized claim in litigation creates a negotiating problem, whether the claim is on behalf of or against the company.  To solve this problem, KKR offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the government for the redwood lands.


Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate the transaction since, among other things, its offer was contingent upon its obtaining “satisfactory financing.” A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage.  However, we were not particularly worried about this possibility because KKR’s past record for closing had been good.


We also had to ask ourselves what would happen if the KKR deal did fall through, and here we also felt reasonably comfortable: Arcata’s management and directors had been shopping the company for some time and were clearly determined to sell. If KKR went away, Arcata would likely find another buyer, though of course, the price might be lower.


Finally, we had to ask ourselves what the redwood claim might be worth.  Your Chairman, who can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.


We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks purchased about 400,000 shares, or 5% of the company.  The initial announcement said that the $37.00 would be paid in January, 1982.  Therefore, if everything had gone perfectly, we would have achieved an annual rate of return of about 40% - not counting the redwood claim, which would have been frosting…”


I have also made speculations. Years ago, there was a case in which a state government took land belonging to a publicly traded company. The issue went to trial. And I started following the story. At that point: it was possible to figure out what other pieces of land in the same area sold for per acre, it was possible to see what compensation the company was seeking for the land, etc. But, I didn’t have faith in my ability to predict an outcome at trial. It was just too hard to tell if the company had a 45% chance of winning or a 95% chance of winning. Once the company won the trial, the stock jumped a great deal. But, it didn’t jump to anywhere near the actual level of cash the company would eventually be awarded once the state had exhausted its appeals. At that point – although the potential upside was now much lower – it was possible to see the company’s chance of winning the appeal was much closer to 95% than 45%. So, I was now ready to buy the stock.


That purchase was a speculation – not an investment. It was purely based on my belief that I could more correctly judge the odds of a decision being upheld on appeal than other investors could. I think it was a sound speculation. I read the decision, I talked to lawyers, I looked for examples of similar decisions being overturned on appeal, etc.


This was not gambling. But, it was speculating.


To understand the difference, we have to think about: subjectivity and edge.


If I play a hand of blackjack at a casino, I am gambling because I’m certain the house has an edge. It’s a small edge – but it’s against me. As long as I knowingly put money down in which I know the edge is against me – not with me – I’m gambling, not speculating.


Speculating is when I believe I have an edge. However, I believe that edge has to do with a future event. When Buffett thought the redwood claim could be worth somewhere between “zero and a whole lot” he thought he had an edge about a future event: a court decision. Likewise, when I bought stock – after the trial but before the appeal – in the company that had land seized, I thought I had an edge about a future event: the appellate court decision. If I had believed that Ron Burkle would win the proxy fight with Len Riggio at Barnes & Noble, I would have been betting on an edge I thought I had in predicting a proxy election. If I had invested in a company that was now trading at 20 times earnings when oil was at $110 a barrel but would be trading at 10 times earnings when oil was at $65 a barrel, I’d be betting on an edge I thought I had in predicting a future event: at some point oil prices would fall.


Subjectivity means that – in judging whether an action would be a gamble, a speculation, or an investment – I am not omniscient. I am limited by my lack of knowledge of future events. I am limited by only being able to consider information that is accessible to me at the time.


It may be that Amazon is – today – an investment from God’s perspective. However, it’s still a speculation from my perspective. An investment is an action that I (the subject) take. We can’t consider whether something is gambling, speculating, or investing apart from when I’m making the decision and what I’m capable of knowing. In hindsight, it may be that I will know things about Amazon that weren’t possible for me to know now but which – had I known them now – would have made me realize Amazon was an investment rather than a speculation. Those things don’t count. If they did, we’d simply call all decisions that were right in hindsight “investments” and all decisions that were wrong in hindsight “speculations”. By this logic, hitting on 17 could be an “investment” if we later learned the next card was a 4.


You can judge whether something is an investment or a speculation by keeping those two concepts in mind: edge and subjectivity.


What do I (the subject) believe my edge comes from? Do I have a positive edge? If I have a positive edge: I’m not gambling. If my edge comes from predicting a future event: I’m not investing. I’m speculating.


Now, some people reading this will be saying “wait: isn’t every stock purchase a speculation? Aren’t you always betting on future events?”


The outcome always depends on future events. However, saying that the outcome depends on the future is very different from saying your edge in an investment comes from a future event.


There’s a simple way to think of this: “invert”. Flip your analysis. Don’t ask: what has to happen for this investment to work out for me? Ask: what has to happen for this investment not to work out for me?


Are the risks “investment” risks or “speculative” risks?


The risks in Omnicom at today’s price are all speculative. For you to be wrong, we have to speculate that Omnicom will grow slower than the overall economy.


The risks in Amazon at today’s price are all investment risks. For you to be wrong buying Amazon, you simply have to be wrong about the long-term return on the company’s spending on R&D and cap-ex. If Amazon was to grow at the same rate as the overall economy, you’d lose a lot of money. If Amazon was to get the same returns on its R&D and cap-ex as other companies do, you’d also lose money.


Now, you could say this is the wrong way of looking at it. All Amazon needs to do is to continue its present trend.


This is usually the argument made for why speculative stocks are really investments. If they continue at the current rate of growth, they will justify today’s prices. If they continue generating the same returns on capital, they will justify today’s prices. It’s possible for returns on capital to be persistently high. It’s also possible for growth rates to be persistently high (though only for a time). But, it’s very hard to maintain high returns on capital at high rates of growth for long periods of time.


No high growth trend can continue indefinitely.


Assumptions about stocks maintaining a certain dividend level, stock buyback rate, and growth in line with the economy can, in fact, continue indefinitely. There’s nothing about those assumptions that isn’t infinitely repeatable.


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In 2017: What is the Line Between Investment and Speculation?

by Geoff Gannon

In a recent post, Richard Beddard mentions Ben Graham’s speech “The New Speculation in Common Stocks” and particularly how it ends with a quote from the Roman poet Ovid:

“You will go safest in the middle course.”

At the end of that talk, Graham adds: “I think this principle holds good for investors and their security-analyst advisors.”

What Graham is saying is that investors should avoid both stocks that are speculative because the underlying enterprise is speculative and stocks that are speculative because the price is speculative.

I agree with Graham on this one. And I think it helps clear up some confusion that readers have with my own approach to investing. I get a lot of questions from investors – each coming from one of the two opposing philosophical camps – that go something like this: “When I look at the stocks you own, I wonder are you really 100% a value investor?” That’s the question from the Ben Graham value camp. And then the other question goes something like: “When I look at the stocks you own, I wonder are you really 100% a wide moat investor?”

My answer to these questions tends to go something like this:

If you look back at all the stocks I’ve bought, how many times in my life have I ever really paid more than about a P/E of 15?

And, if you look back at all the stocks I’ve bought, how many times in my life have I ever really bought into a company with a weak competitive position?

Those – to me – are the two speculations the average investor slides right into without much thought.

1.       He speculates that this business he likes is not just better than other businesses but better enough to more than offset paying a higher than average price for the stock (that is, a P/E over 15).

2.       And he speculates that this business he likes will withstand the ravages of competition that are an ever-present part of capitalism.

Now, there are other kinds of speculations you can make. Readers are quick to point out that I own NACCO (NC) which is basically a speculation that no more than one of the coal power plants the company supplies will be shut down in the truly near-term future. I also own BWX Technologies (BWXT) which is a speculation that the U.S. Navy will continue to use aircraft carriers, ballistic missile submarines, and attack submarines – and that those 3 classes will be nuclear powered. I own Frost (CFR) which is a speculation on higher interest rates in the sense that if the Fed Funds Rate was never to rise from the level it is at today, my returns in Frost would be middling.

But when you stretch the word “speculation” that far, you demolish any distinction between investment and speculation in the way Graham used those words. The future is always uncertain. But, we have to be able to define the words “investment” and “speculation” in such a way that we can all agree lottery tickets are speculations and savings bonds are investments; that stock options are speculations and investment grade corporate bonds are investments.

How would we apply this distinction between investment and speculation to stocks today?

Well, we would say that Tesla (TSLA) and Twitter (TWTR) are speculations, because the enterprises themselves are speculative (they have yet to make money). These stocks would be speculative at any price. It is – as yet – impossible to make an “investment” in them.

And we would also say that Amazon (AMZN) and Netflix (NFLX) are speculations. The enterprises themselves aren’t speculative. They are proven money makers. But, the prices investors now put on these stocks make them speculative. There is no measure – P/E, P/B, EV/EBITDA, etc. – by which either Amazon or Netflix are within spitting distance of an average price. So, a buyer of either Amazon or Netflix stock is not just betting that these businesses are above average. He is betting that they are better enough to offset paying a higher than average price for the stock.

What then is an investment?

I would say Omnicom (OMC) at $67 a share is an investment. The competitive position is not speculative. And the stock’s price – at 13 times earnings – is not speculative. So, it is an investment. I would also say The Cheesecake Factory (CAKE) at $44 a share is an investment. The competitive position is not speculative. And the stock’s price – at 16 times earnings – is not speculative.

What wouldn’t I say?

I wouldn’t say that Omnicom and the Cheesecake Factory at $67 and $44 a share respectively are better stocks than Amazon and Twitter at $1,120 and $19 respectively. Amazon and Twitter may be good speculations. And Omnicom and Cheesecake Factory may be bad investments. Reasonable people can disagree about that. The future is always uncertain. But that does not mean the line between investment and speculation is invisible.

Amazon and Twitter are speculations. Omnicom and Cheesecake Factory are investments.

There is a real danger some of us will forget that. Amazon’s future may be brighter than Omnicom’s. But, when we make a statement like that – we are comparing two entirely different classes of financial assets. Amazon’s future needs to be many, many times brighter than Omnicom’s to preserve even a fraction of the capital you put into it today. Just because society has several hundred billion dollars riding on a certain stock doesn’t make that stock any less of a speculation.

Is it wrong to speculate?

Should you ever speculate?

My own investment process is based on finding investments not speculations. So, my answer would be that you should train yourself to distinguish between good and bad investments and ignore speculations all together.

Having said that, I wrote about Hostess Brands warrants (TWNKW). At today’s price of $2.66 for a pair of warrants (owning a pair of warrants gives you the right to buy one share of TWNK common stock at $11.50 in late 2021), I think they might be a good speculation.

They aren’t an investment.

And I think it’s important to remember that. No matter how good a speculation those warrants are – a Hostess Brands warrant at $1.33 is a speculation and Omnicom stock at $67 is an investment. The Hostess warrants can outperform the Omnicom stock. But that should never fool us into thinking a speculation has become an investment.

Words have meaning.

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Buy Unrecognized Wonder; Sell Recognized Wonder

by Geoff Gannon

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

-          Warren Buffett

Richard Beddard has an excellent post worrying about whether the stocks in his Share Sleuth portfolio are becoming too popular.

I want to use his post as an opportunity to talk about how an investor – or, at least an investor like me – needs to cycle out of stocks that are getting recognized for what I believe them to be and into stocks that aren’t getting recognized for what I believe them to be.

I like “wide moat”, predictable businesses. But, I can’t afford to pay the kind of prices that stocks with recognized moats and recognized predictability trade for. So, I need to find unrecognized moats and unrecognized predictability.  

The top three stocks I own are: NACCO (NC), Frost (CFR), and BWX Technologies (BWXT). The best performer among that group is BWX Technologies. That good performance is the result of increased recognition of what BWX Technologies is. When I bought Babcock & Wilcox pre-spinoff (and then later sold my BW shares but kept my BWXT shares) I was seeing the company differently than the market was. Today, the market sees BWXT the same way I do.

Let’s look at this in chart form.

Today, the market values BWX Technologies about 120% higher than it valued the combined Babcock & Wilcox. The stock you are seeing here spun something off (so it disposed of value) and yet it still more than doubled its market price.

The stock now has a P/E of 32. The return here is due to multiple expansion. BWX Technologies – as part of Babcock & Wilcox – went from being valued as an average company (a P/E around 15) to being valued as a wide-moat, predictable company (a P/E around 30). BWXT’s biggest business is being a monopoly provider to the U.S. government under cost plus contracts indexed to inflation. That’s not new information. The market just sees the same old information differently now that BWXT is reporting its own clean, independent EPS and giving long-term guidance for EPS growth as far as 3-5 years out.

The price on this stock (a P/E of 30+) indicates the market sees this business much the way I see this business. If we have the same understanding of the business – it’s time for me to consider selling.

Now, I don’t sell a stock just to have cash. But, if I want to buy anything new – I should buy something that’s a wide-moat, predictable business that has yet be recognized for being that and fund the purchase by selling BWXT which is also a wide-moat, predictable business but is now recognized as such.

The next chart is Frost. You can read an explanation of how I see the stock here.

The stock has about doubled. Here, though, it is not appropriate to use the P/E ratio for Frost (because earnings rise faster than deposits as interest rates rise). The better way to value Frost is price-to-deposits. So, that’s share price divided by deposits per share. For Frost we use “earning assets” – which are loans, bonds, and money left at the Federal Reserve – as a proxy for deposit funded assets. At Frost, these assets are about 93% funded by deposits (the rest is funded by shareholder equity). When I bought Frost, it had about $25.91 billion in earning assets and 63.18 million shares outstanding. So, it had $410 a share in earning assets. I bought at a price just under $50 a share. So, I paid 0.12 times earning assets ($50 / $410 = 0.12). Today, the bank has $28.34 billion in earning assets and 63.16 million shares outstanding. So, it has $449 in earning assets per share. The stock price is just under $98 a share. So, the market now values Frost at 0.22 times its earning assets ($98 / $449 = 0.22).

Again, the rise in the stock price is due to multiple expansion. Frost’s stock price is now 96% higher than when I bought it. However, the amount of earning assets per share is just 10% higher. Where did the other 86% increase in market value come from? The market now values Frost at 0.22 times its earning assets instead of 0.12 times its earning assets.

So, has the market fully recognized what I saw in Frost about two years ago?

Not fully, no. In the report I wrote on Frost, I said that a valuation of 0.35 times earning assets (not 0.22 times like today) would be appropriate for Frost in “a normal interest rate environment”.

That phrase is key. Frost trades at a P/E of 19. So, it is fully recognized as a good bank given today’s interest rates. However, I believe a “normal” Fed Funds rate is about 3 times today’s Fed Funds Rate. I see a 3% to 4% Fed Funds Rate as normal. The market does not. So, the market doesn’t yet see Frost quite the same way I see Frost.

Since the market doesn’t fully recognize everything I see in Frost – the way it does with BWXT – I should cling harder to my Frost shares than I would to my BWXT shares.

What would cause me to sell Frost?

Well, we have a good example of that. About a month ago, I got the chance to buy NACCO at $32.50 a share. I sold one-third of my Frost shares to help fund that new position.

What does this mean?

It means I think I see something in NACCO that is not as recognized by the market as what I see in Frost.

Do I like NACCO better than Frost?

That’s not the right way to ask the question. The market operates on a handicapping system. Everyone thinks Netflix has a brighter future than Viacom – they “like” Netflix better as a business. But, Netflix stock is saddled with an incredibly high price (its enterprise value is more than 8.2 times sales) while Viacom isn’t carrying much weight at all (its enterprise value is 1.5 times sales). The question is whether Netflix can outrun Viacom when Netflix is carrying more than 5 times as much weight.

So, what’s the right question to ask?

You can ask – at the same price – would I prefer BWXT over Frost and Frost over NACCO?


But they’re not at the same price.

NACCO is my biggest position, Frost is my second biggest position, and BWX Technologies is my third biggest position – because I think the market recognizes all of what I like about BWXT but only recognizes some of what I like about Frost and doesn’t recognize any of what I like about NACCO.

It’s a great goal to own the best businesses you can. But, you can’t afford to pay the price everyone else pays for wonderful businesses and still hope to do better than everyone else.

Don’t just look for wonderful businesses. Instead, look for businesses where you see something wonderful about them that the market doesn’t yet recognize.

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My New 50% Stock Position is NACCO (NC)

by Geoff Gannon

Someone on Twitter mentioned it’s been 32 days since I put 50% of my portfolio into a new stock and said: “I’ll reveal the name of this new position on the blog sometime within the next 30 days”. Since, I promised 30 days this time, I’ll reveal the name now. In the future, I think I’m going to wait a full quarter (3 months) between the time I mention a stock on my member site (Focused Compounding) and on the blog. I want to be open with blog readers. But, I also want the people who provide me financial support through their monthly subscriptions to get real value for their money. The only reason I can afford to spend time writing content on this blog for free is because there are subscribers on the member site. So, the member site will always hear about my new stock ideas first.


On the morning of October 2nd, I put 50% of my portfolio into NACCO (NC) at an average cost of $32.50. That was the first day the North American Coal Company was trading separately from Hamilton Beach Brands (HBB).

NACCO operates unconsolidated (their debt is non-recourse to NACCO) surface coal mines that supply “mine-mouth” coal power plants under long-term cost-plus contracts that are indexed to inflation.

You can learn more about NACCO by reading:

The company’s investor presentation

Clark Street Value’s post on NACCO

NACCO’s first earnings report as a standalone company

You can also listen to the company’s earnings call here

Finally, you can buy a book that provides a complete corporate history of NACCO from 1913 through 2013. The title is “Getting the Coal Out”. The author is Diana Tittle. It’s available used at places like Amazon.  You may also be able to order it from the company. I’m not sure about that.

Yes, I do own a copy.

My NACCO position was posted immediately on the member site. I’ve written several articles about it there over the last month, mostly in response to questions from Focused Compounding members.

So, as of October 2nd, my portfolio was:

NACCO (NC): 50%

Frost (CFR): 28%

BWX Technologies (BWXT): 14%

Natoco: 7%

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The Best Investing Books for a Budding Value Investor to Read

by Geoff Gannon

Value and Opportunity just reviewed a book “100 Baggers” that I’ve read (and didn’t particularly like) which is basically an update of another book I own called “100 to 1 In the Stock Market” (which is outdated, not available on Kindle, but I probably like better). The fact that I’ve read both these books reminded me that I actually do read a lot of investing books and yet I don’t write much about books on this blog.

There’s a reason for that.

I get a lot of questions about what investing books people should read. My advice to most is to stop reading books and start doing the practical work of slogging your way through 10-Ks, annual reports, etc. There seems to be a tremendous appetite for passive reading among those who email me and no appetite for active research. It’s better to read a 10-K a day than an investing book a day.

But, there are good investing books out there. And, yes, I read a lot of books. Still, I’m going to give you a simple test to apply to yourself: if you’re reading more investing books than 10-Ks, you’re doing something wrong.

Assume you’re reading your fair share of 10-Ks. Then you can read some investing books on the side. Which should you read?

Practical ones.


How to Read a Book

A book is only as good as what you get out of it. And there’s no rule that says you have to get out of a book what the author intended. The best investing books give you plenty of case studies, examples, histories, and above all else – names of public companies. While you read a book, highlight company names, names of other investors, and the dates of any case studies. You can look into these more on your own later. Also, always read the “works cited” or “bibliography” at the back of any book you read. This will give you a list of related books you can read next. Since I was a teen, I’ve always read the works cited or bibliography to come up with a list of related titles. And I’ve realized talking to other people as an adult, that most people ignore those pages. They’re very useful. Read them.



My Personal Favorite: “You Can Be a Stock Market Genius”

If you follow my Twitter, you know I re-tweeted a picture of ”You Can Be a Stock Market Genius” that my website co-founder, Andrew Kuhn, posted. It’s one of his favorite books. And it’s my favorite. If you’re only going to read one book on investing – read “You Can Be a Stock Market Genius”. The subject is special situations. So, spin-offs, stub stocks, rights offering, companies coming out of bankruptcy, merger arbitrage (as a warning), warrants, corporate restructurings, etc. The real appeal of this book is the case studies. It’s a book that tells you to look where others aren’t looking and to do your own work. It’s maybe the most practical book on investing I’ve ever read.


My Partial Favorite: “The Snowball” – The 1950 through 1970 Chapters

I said “You Can Be a Stock Market Genius” was my favorite book. If we’re counting books in their entirety, that’s true. I like “You Can Be a Stock Market Genius” better than the Warren Buffet biography “The Snowball”. However, I might actually like some chapters of “The Snowball” more than any other investing book out there. The key period is from the time Warren Buffett reads “The Intelligent Investor” till the time he closes down his partnership. So, this period covers Buffett’s time in Ben Graham’s class at Columbia, his time investing his personal money while a stockbroker in Omaha, his time working as an analyst at Graham-Newman, and then his time running the Buffett Partnership. These chapters give you more detailed insights into the actual process through which he researched companies, tracked down shares, etc. than you normally find in case studies. That’s because this is a biography. The whole book is good. But, I’d say if you had to choose: just re-read these chapters 5 times instead of reading the whole book once. Following Buffett’s behavior from the time he read The Intelligent Investor till the time he took over Berkshire Hathaway is an amazing education for an individual investor to have.


Often Overlooked: John Neff on Investing

I’m going to mention this book because it’s a solid example of the kind of investing book people should be reading. And yet, I don’t see it mentioned as much as other books. John Neff ran a mutual fund for over 3 decades and outperformed the market by over 3 percent a year. That’s a good record. And this book is mostly an investment diary of sorts. You’re given the names of companies he bought, the year he bought them, the price he bought them at (and the P/E, because Neff was a low P/E investor), and then when he sold and for what gain. This kind of book can be tedious to some. But, it’s the kind of book that offers variable returns for its readers. Passive readers will get next to nothing out of it. But, active readers who are really thinking about what each situation looked like, what they might have done in that situation, what the market might have been thinking valuing a stock like that, what analogs they can see between that stock then and some stock today, etc. can get a ton out of a book like this. Remember: highlight the names of companies, the years Neff bought and sold them, and the P/E or price he bought and sold at. You can find stock charts at Google Finance that go back to the 1980s. You can find Wikipedia pages on these companies and their histories. A book like this can be a launching point into market history.


A More Modern Example: Investing Against the Tide (Anthony Bolton)

There are fewer examples in Bolton’s book than in Neff’s book. But, when I read Bolton’s book, it reminded me of Neff’s. A lot of Neff’s examples are a little older. Younger value investors will read some of the P/E ratios and dividend yields Neff gives in his 1970s and 1980s examples and say “Not fair. I’ll never get a chance to buy bargains like that.” As an example, Neff had a chance to buy TV networks and ad agencies at a P/E of 5, 6, or 7 more than once. They were probably somewhat better businesses 30-40 years ago and yet their P/Es are a lot higher today than they were back then. Bolton’s book is more recent. You get more talk of the 1990s and early 2000s in it. So, it might be more palatable than Neff’s book. But, this is another example of the kind of book I recommend.


Best Title: There’s Always Something to Do (Peter Cundill)

This is one of two books about Peter Cundill that are based on the journals he wrote during his life. The other book is “Routines and Orgies”. That book is about Cundill’s personal life much more so than his investing life. This book (“There’s Always Something to Do”) is the one that will appeal to value investors. It’s literally an investment diary in sections, because the author quotes Cundill’s journal directly where possible. Neff was an earnings based investor (low P/E). Cundill was an assets based investor (low P/B). He was also very international in his approach. This is one of my favorites. But, again, it’s a book you should read actively. When you come across the name of a public company, another investor, etc. note that in some way and look into the ones that interest you. Use each book you read as a node in a web that you can spin out from along different strands to different books, case studies, famous investors, periods of market history, etc.


You’re Never Too Advanced for Peter Lynch: One Up On Wall Street and Beating the Street

Peter Lynch had a great track record as a fund manager. And he worked harder than just about anyone else. He also retired sooner. Those two facts might be related. But if the two themes I keep harping on are finding stocks other people aren’t looking at and doing your own work – how can I not recommend Peter Lynch. He’s all about turning over more rocks than the other guy. And he’s all about visiting the companies, calling people up on the phone, hoping for a scoop Wall Street doesn’t have yet. The odd thing about Peter Lynch’s books is that most people I talk to think these books are too basic for their needs. Whenever I re-read Lynch’s books, I’m surprised at how much practical advice is in there for even really advanced stock pickers. These are not personal finance books. These are books written by a stock picker for other stock pickers. The categories he breaks investment opportunities into, the little earnings vs. price graphs he uses, and the stories he tells are all practical, useful stuff that isn’t below anyone’s expertise levels. These books try to be simple and accessible. They aren’t academic in the way something like “Value Investing from Graham to Buffett and Beyond” is. But, even for the most advanced investor, I would definitely recommend Peter Lynch’s books over Bruce Greenwald’s books.


An Investing Book That’s Not an Investing Book: Hidden Champions of the 21st Century

I’m going to recommend this book for the simple reason that the two sort of categories I’ve read about in books that have actually helped me as an investor are “special situations” (from “You Can Be a Stock Market Genius”) and “Hidden Champions” (from “Hidden Champions of the 21st Century”). It’s rare for a book to put a name to a category and then for me to find that category out there in my own investing and find it a useful tool for categorization. But, that’s true for hidden champions. There are tons of books that use great, big blue-chip stocks as their examples for “wonderful companies” of the kind Buffett likes. This book uses examples of “wonderful companies” you haven’t heard of. In the stock market, it’s the wonderful companies you haven’t heard of that make you money. Not because they’re better than the wonderful companies you have heard of. But, because they are sometimes available at a bargain price. As an example, Corticeira Amorim (Amorim Cork) was available at 1.50 Euros just 5 years ago (in 2012). That was 3 years after this second edition of the book was published. Amorim is now at 11.50 Euros. So, it’s a “seven-bagger” in 5 years. More importantly, if you go back to look at Amorim’s price about 5 years ago versus things like earnings, book value, dividend yield, etc. – it was truly cheap. And yet it was a global leader in cork wine stoppers. Amorim is not as great a business as Coca-Cola. It doesn’t earn amazing returns on equity. But, it’s a decent enough business with a strong competitive position. And it was being valued like a buggy whip business. That’s why learning about “hidden champions” and thinking in terms of “hidden champions” can be so useful. There are stocks out there that are leaders in their little niches and yet sometimes get priced like laggards. As an investor, those are the kinds of companies you want to have listed on a yellow pad on your desk.


The Canon: Security Analysis (1940) and The Intelligent Investor (1949)

Do you have to read Ben Graham’s books? No. If you’re reading this blog, visiting value investing forums, etc. you’re sick and tired of hearing about Mr. Market and margin of safety. Those concepts were original and useful when Ben Graham coined them. I’ve read all the editions of these books. People always ask me my favorite. So, for the record: I like the 1940 edition of Security Analysis best and the 1949 edition of The Intelligent Investor. I recommend reading Graham’s other work as well. Fewer people have read “The Interpretation of Financial Statements” and collections of Graham’s journal articles that can be found in titles like “Benjamin Graham on Investing: Enduring Lessons from the Father of Value Investing”. Don’t read any books about Ben Graham but not written by him. Instead look for any collections of his writing on any topics you can find. He was a very good teacher. I especially like his side-by-side comparative technique of presenting one stock not in isolation but compared to another stock which is either a peer, a stock trading at the same price, or even something taken simply because it is alphabetically next in line. It’s a beautiful way of teaching about “Mr. Market’s” moods.


Out of Print: Ben Graham’s Memoirs, “Distant Force” (A Book About Teledyne), and 100 to 1

I own all these books and like all these books. Do I recommend them? Not really. You have to buy them in print. The price on some of them (even heavily used) is not cheap. And they aren’t as good as the books I’ve mentioned above which you can get cheaper (and on your Kindle).

Still, if you don’t own these books, you’re probably wondering: what am I missing?


You can replace 100 to 1 with “100 Baggers”. That’s probably why “100 Baggers” was published in the first place.

Ben Graham’s memoirs include only a few discussions of investing limited to a couple chapters. I found them interesting, especially when I combined the information Graham gives in his memoirs with historical newspaper articles I dug up. Some of the main stories he tells relate to operations he did in: 1) the Missouri, Kansas, and Texas railroad, 2) Guggenheim Exploration, 3) DuPont / General Motors, and 4) Northern Pipeline. The Northern Pipeline story has been told elsewhere. In some cases, I’ve seen borderline plagiarizing of Graham’s account in his memoirs. But, if you’ve ever read a detailed description of Graham’s proxy battle at Northern Pipeline, it was probably lifted from this book.

What about “Distant Force”? Some people find this book extraordinarily boring. I found it interesting more as a “source” for putting together a picture of how Teledyne worked rather than just a book to be read in isolation. There are old business magazine articles you can find on Teledyne and there’s a chapter length description of Teledyne in “The Outsiders”.

Although I’m not going to recommend you dig up expensive, out of print, used, and often boring books – I am going to warn you about the “copy of a copy of a copy” syndrome. A lot of value investors will cite something about habits, or checklists, or Ben Graham, or Teledyne that is from a more popular / more recent book. That book is “popularizing” a primary (or in some cases actually a secondary) source. Like popular science, the author is making certain tweaks to the presentation of the idea to better fit the concept their book is about and to simplify the ideas they present. Some authors do this in a way that shows they probably understand the original material really well but are just presenting it simplified for your benefit. Other authors give some hints that they may not really understand the primary source that well. Something like “The Snowball” simplifies certain ideas because it’s not an investing book. It’s a biography. However, the simplification in that book is done really well. Sure, I’d love to have more detail. Alice Schroeder gave a talk about Mid-Continent Tab Card Company that would’ve been a great addition to the book. But, I’m not worried that Alice Schroeder is really garbling what she’s reporting even when she’s presenting it for a general audience whose main interest might not even be value investing.

I’m not going to name names. But, there are value investing books out there that aren’t as good. Wherever possible, try to read the primary sources.

If you find a book with good concepts in it, but find the detail lacking – read through the works cited for the sources that book is using.

And if you really want to know what Ben Graham thought, read the 1940 edition of Security Analysis and the 1949 Edition of The Intelligent Investor. Don’t read a modern book that just has Ben Graham’s name in the title.

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