How Reading Value Investing Books Made Me a Worse Investor

by Geoff Gannon

A podcast listener emailed me about something I said in a Q&A episode:

“A few podcasts back, you said you read value investing books and then started making mistakes because you read them. Where were the mistakes?”

Focusing too much on statistical things like what the price-to-book ratio was and what the P/E was and those sorts of things. The stuff of back tests and academics and all that. Quantitative value investing stuff. Using less common sense.

This is a topic I tried to talk about in the net-net podcast. Returns in net-nets - both my own and any common sense back test I've run - are really excellent. And the success rate is much, much higher than anyone thinks. Like Andrew has asked a couple times "So, some of the Japanese net-nets must have worked out really well and some went to zero..." and I have to say "no, they all worked out". But, that's common sense. If you don't just buy net-nets but focus on companies with 10+ straight years of profits and cash that's 100% of the market cap or more - those work out well and remarkably consistently. But, it's easy to focus on dumb things like whether something technically is a net-net or whether you should buy at 2/3 of NCAV and whether you should sell at NCAV and all that. Common sense says that shouldn't matter much at all. If it's a decent business, it's cheap at 110% of net cash. Why would you only buy things that were 65% or less of NCAV where net current assets are mostly inventory, where the company lost money in 4 of the last 10 years, etc. You wouldn't if you hadn't read value investing books. You’d only think that way if you’d read a specific rule somewhere. Like, I would have bought George Risk whether I ever read Ben Graham or not. Now, maybe I wouldn't have bought the Japanese net-nets without getting the idea of a "net-net" from Graham. But, in general, there is way too much talking about definitions, rules, etc. in value investing and worrying about what can be tested empirically and so on and not enough talk about common sense. Net-nets and low P/B and all that work because it's a market price for a stock that's often below what a bidder would offer for the entire business. It's boring to put it that way. It's hard to write a whole book boiling it down to that one point. But, it's true. You should buy businesses you like, feel comfortable owning, etc. when they trade in the market at a price below what you'd pay for 100% of the company. Basically, you should think like an acquirer and forget the stock trades day-to-day. That's how I first approached stocks before reading about value investing. And that's the thing I most have to remind myself of every day now. I have to remind myself to only think in those terms and not to think in terms of what statistics I know about returns in stocks, not to think of stocks as "stocks", etc. Not to worry about catalysts, etc. Just to think if I was being offered 100% of Keweenaw Land at $130 million or whatever, would I take that deal. That's literally the only way I thought when I started investing as a teen. It’s the only way I knew how to invest. But, that's the easiest thing to forget once you start learning about value investing. The correct model is really just to imagine you are being offered 100% of the company at the current market cap / enterprise value / etc. and you'll be able to do whatever you want with the company. But, most everything written about value investing - except for stuff written by like Warren Buffett himself - will tend to make you drift away from that. Buffett always has the 100% buyer mindset. But, books about Buffett don’t always have that mindset.

The model that works is the one I had before I read anything about investing. If you’re going to consider whether you should buy Keweenaw Land Association you ask: 1) Do I want to be in the timber business? 2) Is the market cap a good price for all 170,000 acres? If you’re going to consider whether you should buy U.S. Lime (USLM) you ask: 1) Do I want to be in the lime business? 2) Is the market cap a good price for all these deposits? If you’re going to consider whether you should buy Vertu Motors you ask: 1) Do I want to be in the car dealership business? 2) Is the market cap a good price for these dealerships?

In those cases, a “value” price could be one times tangible book value or three times tangible book value. You just appraise the timberland, appraise the lime deposits, appraise the dealerships and ask if you’d buy the whole company on those terms. That’s what I always did before I started reading hundreds of books about investing. And many value investing books do say that’s the basic idea of what you should be doing. But, then they drift off to talking about more generic quantitative approaches and less about common sense.

The closest I came to explaining the problem caused by learning too much about value investing was when I talked about how not buying DreamWorks Animation was my biggest mistake of omission. It wasn’t that DreamWorks Animation – which I could have bought around $17 a share and was later acquired for $41 a share – was some sort of home run. The reason I say that was my worst mistake of omission is because the only reason I passed on that stock is because I had read too many value investing books, thought too much about the right multiples for a stock, wrote about value investing, talked with other value investors, etc. The free cash flow yield and the P/E and the book value of a movie studio – especially a young studio like DreamWorks Animation – is irrelevant. I knew that. I’d never use any of those figures to value the entire business. And yet I allowed myself to look at things like book value when considering the stock. I allowed myself to think of the stock as a stock instead of thinking of the stock as a business with a certain market cap. If I was a billionaire and had been offered 100% of DreamWorks Animation at the equivalent price of $17 a share – I would have bought the whole studio right then and there. So, it’s my worst mistake in terms of process rather than outcome. It’s just idiotic not to buy a stock when you’d buy the whole business at that price. And it’s the kind of idiocy you can only get from a book. A younger, less well-read me would have bought DreamWorks with no hesitation. Whether or not that one outcome would’ve been good isn’t the point. The point is that from a process perspective, passing on DreamWorks was just philosophically wrong. There should never be cases where you’d buy the business but pass on the stock. But, if you get used to thinking in terms of certain multiples, you can convince yourself to do something as dumb as that.

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Taking Net-Net Seriously

by Geoff Gannon

Over at the Focused Compounding Podcast, Andrew and I just did a 24-minute episode on “investing in net-nets”. It’s episode 17. You can get all my thoughts on net-nets in that podcast episode.

Here, I’d like to focus on just one thought: “taking net-nets seriously.”

There are three lines in that podcast that might really surprise some people. One, is where Andrew asks if George Risk (RSKIA) – then a net-net – was a smaller than normal position for me. I said, “No. It was a 20 or 25 percent position.” Two, I mention I held George Risk for over 6 years. And three, Andrew asked if some of the Japanese net-nets I invested in did really well, some went bust, etc. and I said: “No. They all worked out.”

This is typical of the kind of net-net investing I’ve done. I’ve taken bigger positions in individual net-nets than you might imagine: 5% to 10% position in net-nets where I know next to nothing about the business and 20% to 25% in net-nets where I know and like the business.

And they’ve all tended to work out.

But, please note that I’m using worked out in the sense that you made money, got a decent absolute return, etc. It’s very easy for net-nets to perform relatively poorly versus the market, because they have little to do with stocks generally.

“Work out” here doesn’t mean they beat the market. Often, solid net-nets perform pretty similar regardless of what the S&P 500 is doing. So, what I mean is if you hold a stock for 5 years and it returns 10% a year or more – it “worked out”. It didn’t go bust. But, it wasn’t some sort of home run. Most investors I talk to – and most backtests of purely statistical looks at net-nets – present a very different picture of net-nets. They are risky stocks where huge numbers of them go bankrupt or nearly bankrupt and a few winners become double, quadruples, octuples, etc. just as fast. That hasn’t been my experience. And that’s mostly because I don’t buy into those kind of net-nets.

The best blog about net-nets is Oddball Stocks. The author of that blog once asked me to run some net-net back tests for him. You can tell from the screenshot included in that post that those back tests were run on Portfolio123 (which is my favorite screener). I don’t get paid or anything if you click that link. The reason I’m including a link to Portfoio123 is that people always ask if I like this screener or that screener and the answer is really “No. If I run a screen, it’s one I created on Portfolio123 myself.”

Anyway, here is a post where Nate of Oddball Stocks is talking about more of the kind of net-nets I would normally be looking at:

“…market bottoms offer opportunities to buy ‘quality’ net-nets, companies that have long records of profitability and are selling below NCAV.  There's no reason an investor couldn't combine investment styles, purchasing some quality companies cheap as well as quality net-nets in a low market.

Of course the data shows that net-nets purchased in 2002 and 2009 with long strings of profitability rewarded shareholders.  This is an obvious conclusion, buying almost anything at a market bottom had positive returns.”

What’s good about this post is that Nate then goes through the history of each of those companies to explain why something that looked good at the time really did go on to succeed, or why it somehow failed, and so on. For example, one stock was a fraud. And, he explains that’s why it went to zero.

One thing you’ll notice about the net-nets in that back test is typical of any list of consistently profitable net-nets. You lose money if the company basically goes out of existence. Otherwise, you make at least a little money. Because net-nets are so cheap, buying a historically profitable net-net where some profitability continues on into the future almost always results in you not showing a loss when you sell the stock. Losses of 5%, 10%, 20%, and 40% are pretty common in the big stocks many investors buy (this is because P/E multiple contraction is pretty common). Those kinds of mild losses are not common with net-nets chosen on the basis of past profitability. You tend to see either a 100% loss or some gains over time. Now, if you hold the net-nets too long – and especially if you hold them during a bull market – you may underperform the S&P 500. But, you’re unlikely to experience any sort of medium sized losses. In fact, that’s why I encourage people to always focus on the downside with net-nets and never the upside. If you could somehow know that the net-net you’re buying will be profitable in every year you own it – odds are the stock will do well for you. In fact, the odds are overwhelmingly in your favor (because you’re buying the stock so cheap) that just clearing that modest hurdle of “staying profitable” is all you need out of your net-net selections.

In fact, in the 2002 back test in that post at Oddball Stocks you basically had 8 net-nets where the investor wouldn’t lose any money in the stock and 2 net-nets where they’d lose everything. One of the two total losses was a fraud.

The other thing that’s notable about net-nets is that they often stay net-nets – or stay below book value – permanently or intermittently even when they perform as well as the S&P 500. This is especially true of small, illiquid, overcapitalized net-nets. A lot of people who come across a net-net will ask: “Can this stock just stay a net-net forever?”. Sometimes, it can. There are examples of stocks that are almost always net-nets, near net-nets, etc. like George Risk and Micropac Industries that constantly show up on net-net lists and yet increase their stock price over 5, 10, 15, and 20 years at pretty normal rates for a public company. This, of course, means you risk being stuck in a stock that is cheap when you buy it and cheap when you sell it and only returns 8% to 10% a year while you hold it. That’s a very real risk in net-nets. But, earning 8% a year long-term in most assets other than net-nets is just considered a normal outcome.

So, why do investors feel so bad when they buy a net-net and it is “dead money” in the sense it only returns 8% to 10% a year over the 5 or more years while they hold the stock?

The biggest reason is that I think they realize they’re making a special effort to dig up a net-net and imagining the riches that will come from discovering some previously undiscovered stock. So, if Apple returns 8% or 10% a year from here – that’s understandable. You aren’t taking unusual risks, putting in unusual effort, etc. You didn’t buy it thinking it was dirt cheap. But, with a net-net you did. So, you’re waiting for something to happen with the net-net. And what you mean by “something happening” is not chugging along at 8% a year.

So, investors remember their experiences in net-nets differently. They often remember a net-net didn’t do much – but that’s because they’re getting frustrated that the value gap isn’t closing the way they imagined. They imagined making 50% in one year. Instead, they made 50% over 5 years. Of course, that’s par for the course in stock investing generally (and the net-net is still cheap when they sell out). But, you probably go into big caps expecting to hold them as they chug along and yet you go into net-nets expecting to get your “one puff” from the cigar butt.

Why else might investors feel “dead money” experiences in net-nets are more frustrating than getting the same annual returns in bigger stocks.

One, some net-nets have very low volatility. I mean very, very low volatility. I can’t emphasize this enough. It’s something most people aren’t used to at all. I’m used to the experience of ultra-low volatility in some stocks from owning them and from back testing them. If you build a net-net portfolio that matches the market over a 5, 10, 15, or 20 year back test – it’s going to do it with a lot less volatility than the market. I don’t talk about beta on this blog. I don’t think about beta. But, the truth is that any net-net portfolio built on the kind of criteria I care about: long history of profitability, high current assets (especially cash) versus total liabilities, etc. is going to have a very low beta. At the high end, the beta might be about what you’d expect in super defensive mega caps. At the low end, it’s unimaginably low. It’s a number stock pickers aren’t used to ever seeing in a portfolio.

But, I think this is incredibly misleading.

Because, it’s not like low-beta giant stocks. Giant, low beta stocks move with the market they just do it more gently. A net-net portfolio isn’t moving with the stock market at all. There’s some correlation. But, we can find assets that aren’t stocks that are at least as highly correlated with something like the S&P 500. And it may seem odd I’m mentioning the S&P 500 when talking about net-nets. That’s not the right benchmark to use, is it?

Well, the personal portfolios investors who write to me talk about look an awful lot like the S&P 500. So, if they carve out 25% of their portfolio to be a dedicated net-net portfolio – it’s going to look very strange in terms of the red and green arrows they see on their account page. Most investors are used to going into their account on a day when the S&P 500 is up 2% and seeing a sea of green and when the S&P 500 is down 2%, they see a sea of red. The net-nets in your portfolio won’t follow that pattern. That isn’t because they’re net-nets. It’s just because the buying and selling of these stocks is not in any way driven by people’s attitudes about stocks generally.

Net-nets are also usually small stocks. There’s very little news about them. Many consistently profitable net-nets don’t change all that much from year-to-year.

These are the only explanations I have for why someone with a big cap stock that returns 8% to 10% a year over the 5 years they own the stock tends to think that stock wasn’t dead money and yet a net-net that returned 8% to 10% a year over 5 years was dead money. From a news perspective, the net-net was quiet. And from a stock price perspective, it didn’t wiggle up and down that much. Big cap stocks give a much greater sense of action than the safer, higher quality net-nets I advocate seeking out.

I’ve also noticed that any stock where you have to use limit orders and wait hours or days or weeks to get your order filled is seen differently by investors. An illiquid stock literally doesn’t move some days. Now, month-to-month it always moves. So, this shouldn’t matter much (when was the last time you sold a stock within a month of buying it?). But, the presence of day-to-day movements seems to create more of a feeling of movement in a stock even when the month-to-month movement is the same in a liquid stock and an illiquid stock. People check their portfolios more than once a month.

Of course, some net-nets are plenty volatile.

Why haven’t I talked about these low quality, unsafe, not historically profitable net-nets?

I don’t invest in them. So, it doesn’t matter to me if those net-nets make up 90% of all the situations out there. I’m not blindly picking net-nets. I’m not buying a net-net index. I only buy certain kinds of net-nets. And I’ve had enough experience with those net-nets to know they don’t behave like a purely random list of net-nets screened for on the web.

What does a random net-net screen look like?

Some of the companies are frauds. You are going to see a surprising amount of U.S. listed net-nets that are really companies controlled by Chinese citizens doing business in China. Don’t touch those. You’re also going to see a surprising number of companies incorporated in Nevada. I’m not saying those are frauds. But, I am saying that if you pay close attention to the stocks already in your portfolio – those will tend to be incorporated either in Delaware or in the state the company has long been doing business (where it was founded). If you compare your current portfolio to a blind net-net screen, I think you’ll find the results of that screen will have a greater percentage of companies incorporated in Nevada than your portfolio does.

You’re also going to find what I call “data errors”. Some of these are caused by the actual data the website is pulling being bad. But other times, it’s really more like computers lacking human common sense. So, a computer may tell you a homebuilder is a net-net. It’s not. I still think it’s interesting when a homebuilder you know shows up on a net-net screen. But, it’s really not a net-net. If you do find a homebuilder selling for less than its inventory of land (held at cost) less its total liabilities and you know where that land is and how good it is and so on – that could be a good opportunity. But, it’s similar to seeing America’s Car-Mart (CRMT) on a net-net screen. When I wrote a report on Car-Mart, I said it should be valued based on receivables. So, stock price divided by receivables per share is a good way to check how cheap the business is. But, those receivables are very, very low quality debt. They are stated on the balance sheet at well below the amount actually borrowed by the car buyer. Again, America’s Car-Mart can be a really interesting stock when its share price falls below its receivables per share. But, you have to understand the business very well to make a judgment about that. You need to think about where we are in the auto loan cycle, how many months are left on the average loan, what incentives are for the employees who make and collect loans at Car-Mart, whether management is candid, what Car-Mart’s charge-offs have been historically, etc.

A human would see that almost all the net current asset value of a homebuilder is land and almost all the net current asset value of a used car seller is risky loans. A computer won’t notice that.  

I’m always saying you should look for net-nets with a long history of profitable and a lack of liabilities. That means I’m saying you need to cross off about 90% of any net-net screen results you get.

So, when people ask me why I don’t seem to be buying any net-nets lately, it’s because there’s always a lower supply of the kind of net-nets I like. But, remember I had 20% to 25% of my portfolio in net-nets for the 6 years I owned George Risk, I had 50% of my portfolio in net-nets when I held Japanese net-nets, and I just wrote about Pendrell (PCOA) – a stock I don’t own as of now – within the past two weeks.

So, I do invest in net-nets. I’m not done with buying net-nets. I’d like to buy more net-nets sometime in the future. I’m just selective about what net-nets I buy. And it’s because I take net-net investing as seriously as any other kind of investing I do. I’m looking for the same margin of safety, history of profitability, strong solvency, etc. that I look for in billion dollar market cap stocks I buy.

Finally: the question everyone asks?

Does buying net-nets with low liabilities and a long history of profitability really outperform blindly buying all net-nets. The honest answer is that I don’t care. I’m not an empirical investor. If a back test works, but I don’t feel confident in the logical principles on which the back test’s strategy is based – I’m not going to consider that strategy. It may be that buying the most leveraged net-nets that aren’t making money right now is the best approach because a few big winners offset the losers. But, I wouldn’t know how to evaluate that strategy.

Ben Graham said investing is most intelligent when it is most businesslike. I don’t know how to buy more leveraged, less historically profitable net-nets in a businesslike way. Seven years ago, I bought George Risk not just because it was a net-net, but because it seemed like a businesslike investment. If I could buy the whole business for less than net cash – I would’ve. So, why not buy a piece of it in the stock market.

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How Do You Know You Know More Than the Market – And: Does it Matter?

by Geoff Gannon

“…how can I confidently judge that a stock may still be underfollowed and hence price discovery may still be incomplete even with a recent price run up but still within low and tight P/E valuation range? And how do I assure myself (where do I look for clues) that I have an informational edge over the consensus?”


So, I subscribe to a “fish where the fish are” philosophy. I do stress – for everyone reading this blog – that you ought to spend as much time as possible looking at spin-offs, illiquid stocks, nano-caps, micro-caps, etc. rather than Google and Facebook. Now, it can be okay to look at Google and Facebook – because they’re great businesses. And there’s sort of two ways to “fish where the fish are”. You can study what appear on the surface to be great businesses or you can study what appear on the surface to be cheap stocks.


I stress the importance of “fishing where the fish are”, because most people who bring me stock ideas don’t bring a bad idea – they just bring an obviously so-so idea. They bring a $3 billion market cap company trading at 13 times earnings when peers trade at 17 times earnings and yes the outlook for the industry is a little mixed short-term, but…


That’s not a stock idea worth following up on.


A stock idea worth following up on is: the company’s land has been appraised at $13 a share and the stock trades for $10 a share. Or, the stock has a free cash flow yield of 10% and is growing 3%, or 5%, or 8% - or really anything but 0% or negative percent. Or: the customer retention rate is 90% or 95% or 99%. Or, the stock has increased sales and profits every year even during recessions. Or…


Something that would either let you know the stock is clearly an above average business and/or (preferably and) the stock is clearly trading at a below average price.


If you have one – or better, both – of those things to start with you don’t need an “edge”. You don’t need to worry too much about why the stock is cheap. You just need to double-check for yourself it really is cheap. Likewise, if a stock trades at a P/E of 15, but you’re sure it’s an above average business – that’s enough. You don’t need an information edge. You just need to be sure it’s an above average business.


The tricky situations are the ones where it’s clearly an above average business but it’s clearly also trading at an above average price or it’s clearly trading at a really cheap price but it’s also clearly a below average business. That kind of analysis gets into issues of quantification that are tough from a handicapping perspective. And those are 90% of the stock idea people want to talk to me about.


For example: It’s a net-net and it’s been profitable in 8 of the last 15 years. I’d rather see a net-net that’s been profitable in 15 of the last 15 years.


Or: it’s a great stock because it’s growing 20% a year. However, it is now trading at a P/E of 50.


Those situations quickly becomes an analysis about “well, just how bad is this net-net” and “well, just how much of a drag is a P/E of 50”.


In a recent write-up at Focused Compounding, I talked about a stock selling for a bit less than net cash and it has net operating loss carryforwards. That’s a good idea, because you are paying 90 cents for something you know is worth at least $1 and then there’s something else attached that might be worth 10 more cents or 20 or 40  - you’re not sure, but all the math we’re doing is about how big the upside is with no math needed on the downside.


Those are the kind of ideas you should be looking for. Now, a stock that’s growing 20% or 15% a year and seems set to do that for a long time is also the kind of stock you should be looking for. Given enough time, the gap between today’s price and eventual value (discounted back to this moment) can be as big or bigger with these fast-growth companies.


I always stress the handicapping aspect of stock picking.


If you found a high growth company at a decent price that wasn’t going to face much competition, technological disruption, etc. it’d be a great stock. But, companies tend to try to invade big, high growth markets. And investors tend to bid up the prices of fast-growing companies. Unless you know that high growth business well, the business can deteriorate while you own it and investors can become a lot less positive on the stock on top of that. A stock growing at 20% a year with a P/E of 50 sounds like it could work out well, but if competition increases and market-wide P/E multiple contract – all of that business quality can quickly be offset when it comes to your returns in the stock. The idea works if you know competition won’t increase. But, if you’re just guessing competition won’t increase – it’s more of a coin flip than a stock idea.


So, all that matters is whether or not you should buy the stock given how the market is handicapping it. The market has added a lot of weight to Netflix. It hasn’t added any weight to GameStop. It’s easy to predict Netflix’s future as a business will be far better than GameStop’s future as a business. However, it becomes more difficult to have confidence that Netflix as a stock will outperform GameStop as a stock.


That’s why I say you should focus on stocks that don’t seem to be carrying extra weight. You should look at small stocks, illiquid stocks, obscure stocks, spin-offs, etc.


But, I don’t think that means you need to know what the market is thinking and how your thinking is different from what the market is thinking. You need to know that one stock is carrying extra weight and how much and that another stock isn’t carrying any extra weight. But, that doesn’t mean you need to know and agree or disagree with the reasons the market has for putting that weight on the stock.

You don’t need to know why the market loves Netflix. You just need to know you’d have to be very, very sure of that stock’s long-term future to offset the extra weight the stock is carrying. So, you only need to know your beliefs about Netflix as a business long-term and then the price of the stock today.


Really, all you need to know is how the market is handicapping a stock – you don’t need to know why it’s handicapping the stock that way.


You need to know price. You don’t need to know the reason for that price. And you don’t need to know if the stock price used to be higher or lower in the past.


All you need to know to make a decision about a stock is:


1.       Your appraisal value for the stock as of today

2.       The price the stock is selling for in the market as of today


(There’s sort of a third issue. The longer you plan to hold the stock, the more you’d need to know about the rate its compounding business value at).


Those are both static bits of information. They’re snapshots. They’re both unmoving and unemotional. As a vale investor, you don’t really need to know why the market loves or hates a stock. The only input you need from other investors is the price they are asking for a stock you don’t own or the price they are bidding for a stock you do own.


Honestly, I don't worry about price discovery. I don't like to spend much time thinking about what the market does or doesn't see, etc. I don't usually ask: "Why is this stock cheap?" Or: "What do I know that the market doesn't?" Or anything like that. 


Obviously, in super illiquid stocks the market can be very inefficient. For example, when I bought most of my shares of Bancinsurance I did so at an average price of not more than $5.80 a share when there was an offer from the CEO (who owned over 70% of the company) to buy the stock at $6 a share, the company's book value was $8.50 a share, and it was set to grow book value by about $1. So, the stock was trading at:


* 97% of the buyout offer price

* 68% of book value

* Just under 6 times comprehensive income per share


The CEO eventually agreed to buy the company for $8.50 a share. I had very little competition for the shares I bought. I was usually buying all of the available volume on the stock. And, if I'd been a little more aggressive on price (for example, bidding 5 cents more than the CEO's offer) I might have gotten a lot more people to sell to me. 


Why did this happen? I don't know. I don't know who I was buying from and why they were selling out. Many might have been selling out because they figured that a 70% owner of the stock had a bid out there for the whole company and there was only 3% left to be made in this stock. Others, might have seen the stock jump from something like $4.50 a share to $6 a share and feared it would drop back down if the deal fell through. So, they saw they were sitting on a sudden 33% gain and they feared they could now lose 25% yet only make 3%. It's possible they were thinking like merger arbitragers. It’s possible they were thinking they’d gotten a chance at a sudden profit and should take it. It’s also possible the stock was usually illiquid and I was willing to take larger blocks of stock in one gulp and some people were excited they could sell 100% of their position finally instead of like 5% at a time. I really don’t know why anyone sold me shares of that stock.


But, if investors did think that way then they were only worrying about how other people priced the stock and not what the stock should be valued at. They saw the CEO offered a price of $6, they saw the stock had been at a price $4.50, etc. I saw things differently. If the deal fell through, I'd like to own the stock. If the deal got done at the current level I'd break even. And if the deal got done at a higher level (as it did) I'd make a high annualized return, because the deal would likely close within the next year.


To be fair: it’s worth noting that this stock didn’t trade above the $6 offer even though the company only announced that the board had received and was considering an offer from the controlling shareholder / CEO at that level. My guess would be that a large, liquid stock would have jumped at least a little past the initial offer, because a controlling shareholder offer a buyout and the board not accepting it yet does sound like the kind of thing that has a decent chance to go higher. But, that’s only a guess.


Arbitrage stuff is complicated when it comes to illiquid versus liquid stocks – especially today, because many people doing this are using borrowed money and expecting a quick timetable. In other words, the actual raw return on money invested (not annualized) is really low. So, it’s not something they’re going to do in an illiquid stock with any sort of bid/ask spread. You’re not going to try to make 5% to 20% on a stock where it might cost you 5% to get in or out of the stock quickly and where you could put in $10,000 or $100,000 but not $1 million or $10 million. Nonetheless, the proposed takeover of a cheap stock should get your attention – it’s what I would call “where the fish are” – whether that stock is liquid or illiquid. An offer to take an insurer private at 0.7 times book value is interesting in a way an offer to take an insurer private at 1.4 times book value is not.


Are mispricings more common in special situations, complex situations, and with illiquid stocks? Sure. I think illiquid stocks sometimes take a little longer to react to news that is more quickly priced into liquid stocks. But, that's actually quite different than saying I think liquid stocks tend to always be efficiently priced. I think liquid stocks usually incorporate specific news into the stock price quickly. But, that doesn't mean that over a long period of time liquid stocks can diverge further and further from underlying value instead of getting closer. 


In a recent podcast I mentioned a "Fermi problem" to Andrew. I said that's the kind of math I do most often in investing. I walk into a retail store or something and I guess right off the top of my head how many square feet the store is, what the rent per square foot is (based on the tenants around the store whose rent per square foot chain-wide I know), how many employees are in the store, how much these employees are paid per hour, etc. and I got to an estimated number of how much rent and labor there is built into a location like this at a minimum. I may be off in any one of my guesses. But, I have some basis to make a guess in each case. There's something I can use to anchor my ball parking. And then when I go through a series of these kinds of guesses as a group of factors - the product of that group is often more accurate than you'd think, because I'm as likely to be 10% too low on square footage as 10% too high on rent per square foot. If I do my estimate right, there shouldn't be any equation-wide bias toward being too high or being too low. My misses should be as likely to be too high as too low.


In theory, I'd say that's sort of how incorporating news into a liquid common stock should work. Investors will guess wrong to some extent about each piece of news. They will send the stock price up 10% on an earnings release that only changes the intrinsic value by +5%, they will send the stock down 20% when a key customer is lost that really only made up 15% of intrinsic value, etc. But, over a long enough period of time, each of these somewhat incorrect guesses about specific news items should work out to a fairly correct guess for the sum impact of all those incorrectly guessed news items taken together.


With liquid stocks, I find each of these guesses are much more likely to be fast and somewhat more likely to be correct than they are with illiquid stocks. There isn't much money to be made in trying to jump on a news item for a liquid stock. However, I don't always find that the sum product of all these pretty good guesses leads to a pretty good estimate of the stock's value.


I don’t know if we should call it inertia, but there is a problem that affects stocks whether liquid or illiquid. And it’s this: if they trade long enough around a certain level – people start to believe that level makes a lot of sense. I saw this a lot in Japan. When you looked at net-nets over 10 years, there was some logic to where the stock was priced versus what the business was worth 10 years ago. But, 10 years later, the stock was still where the stock was and yet the business was worth a totally different amount. The market just didn’t care. But, this isn’t unique to illiquid stocks. I saw the same thing happen with long-cycle businesses tied to housing. The recovery in housing has been slow. If a stock can’t grow sales much for 5-10 years, people give up on it and they are ready to sell it once it starts moving up. But, sometimes the underlying business is much, much better than it was before the bust. It’s just that once a stock is dead money for 5 or 10 years, investors don’t act on the news that way they perhaps should. Has the market for the stock become less efficient? Even for a liquid stock?


Then, there’s the more sudden kind of change in a stock’s price. This is a 2009 story. So, we’re in the shadow of the 2008 financial crisis and not yet really into any sort of recovery in the economy. Stocks had only just started recovering at this point.


This story is about a big, liquid stock. It was every bit as mispriced (though less conspicuously so) as Bancinsurance.


The stock was IMS Health.


It is now public again as part of a bigger company. But, I bought it back in 2009 at an incredibly low price. The company was then bought out (as was Bancinsurance). People sometimes mention to me that I must be bitter about Bancinsurance, because I thought it was worth at least 1 times book (I thought it was worth more, but I felt reasonable people could disagree about how much more) and yet the board approved a sale of the minority shareholders to the majority shareholder at something like 0.9 times book. People use this as evidence that controlled, illiquid stocks can be bought out from under you. There’s some truth to that. But, liquid stocks have a problem that's different but no less dangerous in certain points in the stock market cycle. IMS Health illustrates this. The stock was bought out under me at as bad a price as I got on Bancinsurance. Why? Because it was a big, liquid stock - so, you can take those over just by offering a nice premium over the market price. If a stock goes from $100 to $20 and then stays at $20 for a few years and then you offer to take it over at $30 - in a big, liquid stock you'll have a very real chance of getting overwhelming shareholder approval from an offer that wouldn't be entertained by a handful of owners of a privately held business. Basically, investors fixate on the quote. They think in terms of price instead of value. Often, it’s the big holders of a stock who ignore the most recent quote and focus on value instead.


I'll use information from IMS Health's merger document. The board got a fairness opinion from an investment bank (it actually used several assessments done by several different investment banks).

These investment banks prepared information on what IMS Health was trading at prior to the takeover offer being publicly known. One of the investment banks said the EV/EBITDA was 7.1 on last year's EBITDA and expected to be 6.7 on next year's EBITDA. The P/E ratio was 10.1 on last year's earnings and expected to be 8.9 on next year's earnings. 


The important bit of information comes here. They give a 3-year EV/EBITDA range for the company. This was done in 2009. So, the range is for 2006-2009. The EV/EBITDA range was 4.7 to 11.6.


That's the problem with a big, liquid stock. A private equity firm can just wait till the EV/EBITDA is 5 instead of 12 and make a bid. If they offer 8 times EBITDA, there's a good chance the deal will get done. That's despite 8 times EBITDA being a completely normal price for non-control shares of the company. Basically, if you time it right, you can take over a company without paying any takeover premium to where it normally trades. You just have to buy in bad times. This works well in liquid stocks.


Now, in the IMS Health case, a big part of explaining why investors might take such a deal is that it offered a nice premium over the recent stock price and they might have been comparing IMS Health to pharmaceutical companies (IMS Health's customers) instead of pharmaceutical services companies (IMS Health's peers). As shown in the same merger document, pharmaceutical services companies tended to be taken over at an EV/EBITDA of 12 and P/E of 23.


The other issue turn up in the section "summary financial forecasts". This is where the target company provides a summary of its best estimate of what the next five years might look like. In the forecast, you can see IMS Health was expecting EBITDA growth of about 8% a year over the next 4 years. That's interesting, because the company was buying back stock and because EBITDA trends can be a better estimate of what really matters - free cash flow - at a company like IMS Health. Based on that 5-year forecast and IMS Health's tendency to buy back stock (and the reasonable price of that stock before the buyout rumor leaked) it seems likely that free cash flow per share would have grown by 10%+ annually if IMS Health had stayed a public company. 


My point is just that I would have been much better off as an investor in IMS Health if there had been no takeover. The IMS Health deal wasn't really any better for me than the Bancinsurance deal. In both cases, if I could have stopped the deal, I would have voted against it. 


So, which stock was more efficiently priced: IMS Health or Bancinsurance?


IMS Health incorporated news quickly and accurately into the share price in a way Bancinsurance did not. It certainly reacted to buyout rumors. However, once the stock was trading out of line with its intrinsic value - due to the financial crisis, concerns about healthcare stocks, the threat of legislative action against companies with the kind of data IMS Health had, etc. - it didn't trade back in line with intrinsic value very quickly at all. 


This is a pattern common to many of the very mispriced liquid and illiquid stocks I've found both in the U.S. and in Japan. It's not that the market has mispriced anything recent. It's that the market has not corrected a long-term divergence between the business and the stock. For example, in the years 2006-2009, IMS Health's stock price moved a lot. But, the change in the thing that should drive the stock price (free cash flow) didn't exactly plunge.

2006 FCF: $244 million

2007 FCF: $302 million

2008 FCF: $307 million


Before speculation on a takeover offer leaked out, the stock was trading at $14.67 a share for a market cap of $2.7 billion. That gives the company a price to 3-year average free cash flow - before news of the takeover discussion - of about 9.5x. 


So, before rumors of a $22 takeover offer leaked, the stock traded at $14.67 a share which gave it a free cash flow yield of 10% and management told its investment banking advisers it expected to grow EBITDA by about 8% a year. In other words, this was roughly a 10% FCF yield stock with 8% growth in that free cash flow coupon. 


It was very cheap. In fact, I'd say that IMS Health was perhaps ever so slightly CHEAPER than Bancinsurance was once the CEO had made his $6 offer. Now, it's true that I think the undisturbed stock price of IMS Health (a $2-$3 billion, listed, liquid stock) was not quite as cheap as the undisturbed stock price of Bancinsurance (a sub $50 million market cap, unlisted, illiquid, and closely held stock). But, the difference wasn't huge. In both cases, you would have guessed that buying before any news of a buyout offer would make you at least 15% a year and might make more like 20% a year in the stock. They were both very, very cheap stocks.


But, was Bancinsurance cheap because it was illiquid?


Was it cheap because it was unlisted?


You could say that IMS Health was cheap because it was liquid and listed.


That’s not normally how we think about stocks. We assume illiquid and unlisted stocks are more likely to be mispriced. I think that’s true. But, wide-moat businesses caught up in a decline in the overall stock market, their industry, etc. may be cheap in part because it’s so easy to dump the shares.


This is why I don't like to think too much about why the market is mispricing something. It's more useful in these two cases to think of what the CEO of Bancinsurance was willing to pay for the 25% to 30% of the company he didn't own and what TPG was willing to pay for the 100% of IMS Health it didn't own. I think those are the two numbers that matter. 


Note here that IMS Health's outside, passive shareholders weren't willing to pay even $15 a share for a stock TPG was willing to pay $22 a share for. In fact, if you look at the background to the merger - the very earliest talks about price (without there even being any access to private information about the company) started quite a bit higher than where non-control buyers and sellers of the stock were trading it at each day.


Basically, a control buyer was willing to pay 50% more for IMS Health than the public was.


And, an already control owner of Bancinsurance was willing to pay 90% more for the small part of the company he didn't already own. 


In both cases, what matters most are two questions:


1) Is the company compounding value at an adequate rate

2) Are you buying into the company at less than a control buyer would pay for it


IMS Health was growing free cash flow each year and planned to continue doing so. Maybe it would grow as much as 8% over the next 4 years. Maybe it wouldn’t. Be the FCF yield was 10%. So, any growth at all would make the stock turn out to have been cheap.


Bancinsurance had historically been growing book value each year and was continuing to do so while the bid was on the table. It seemed capable of growing book value by 10% if it paid no dividends. Historically, it had.


The stock market usually grows at something like 8% on the low end to 10% on the high end. So, as long as you find companies that can grow the value a control buyer would bid for the company by 8% to 10% a year and you get in at a price lower than what such a bidder would offer - you'll get good returns in the stocks you buy.


I don't think the market’s beliefs have anything to do with that. You don't need to know what other buyers and sellers of the stock are thinking. For one thing, they usually aren't taking the matter as seriously as I am. I was trying to put 50% of my investable funds into Bancinsurance and 30% into IMS Health. So, I'm thinking like a control buyer would. Some of the other people in the stock market buying and selling may be professionals for whom this is not even their own money they are investing and they may - even if they like IMS Health - be allocating 3% of someone else's money to that portfolio. If I'm allocating 30% of my own money to the stock and they're allocating 3% of someone else's money to the portfolio - why should I worry about what they think?


Because of the wisdom of crowds.


If you don’t know much about something, the crowd’s guess is better than your guess. But, in the stock market, you are only going to make money when you disagree with the crowd. So, believing the crowd is going to point out good areas for you to focus your analysis which will in turn help you disagree with that same crowd seems like an illogical approach.


It's illogical to worry about what the market thinks about a stock. You will get caught in a logical loop. You want to take advantage of situations where you see things differently and yet more clearly than the market and yet you also want to try to see things the way the market sees things? Is that doable? Well, you could try to see things both ways and then only act on your beliefs. So, you are trying to think like the market but not act like the market. 


But, that kind of complicates things unnecessarily.


For one thing, all of your beliefs about what the market believes are guesses. For another, those guesses are anchored on the stock price. So, if I see the market values IMS Health at a low level I assume it's because investors are concerned about something Senator Dodd said or President Obama said or something like that.


But, is it?


I am reasoning backwards from the low stock price to trying to guess what the cause of that low stock price is. I didn’t conduct a poll of 2,000 buyers and sellers of IMS Health while myself being blinded to the current stock price. That’s the actual way you’d want to gather data on what the market believes.


Worrying about what the market is worrying about has never made sense to me. I don't really have an opinion on whether the market is mostly efficient or mostly inefficient and why. I just read through a lot of 10-Ks and note that most of the time the stock price is somewhere within my "confidence range".


So, I will often find a stock trades at $85 a share and I think it's worth $100 a share. But, usually, if I say a stock is worth $100 a share - I mean I'm pretty confident it's not worth much less than $70 a share or much more than $130 a share. For many stocks, the range is wider than plus or minus 30%. If I just took a random stock - not a predictable one - out of the OTC markets my guess could easily be that a stock is worth either 80% less than what it's trading at or 4 times more than what it's trading at. Usually, my confidence range is pretty wide. So, I'm not sure the market is all that efficient or the business is just not that predictable. I only notice inefficiencies in the market when they relate to stocks where my confidence range would be fairly narrow. So, if a stock is priced at $100 a share and I can come up with the most conservative possible way to value it and that gives me a value of $101 a share and I can come up with the most aggressive way of valuing it and that gives me a value of $150 - well, then, I know the market for that stock is inefficient. I literally can't come up with a reasonable way to appraise the stock equal to or less than the current market price.


That's what happened with Bancinsurance and it's what happened with IMS Health. I couldn't possibly come up with a valuation method that told me Bancinsurance should trade at less than two-thirds of book value or IMS Health should have a free cash flow yield higher than 10%. 


So, how does this relate to Japanese net-nets and the like?


Well, the first thing to say is that I just picked them based quantitatively on whether I thought they were much cheaper than what any control buyer would pay for them. Of the original 5 Japanese net-nets I picked, 2 were bought out pretty quickly. I had been told this never happens in Japan. But, it happened to 40% of my Japanese net-net portfolio in something like 12 months. You see an issue there with worrying about what the market is worrying about. All the U.S. value investors I'd ever talked to about Japanese net-nets said they stay net-nets forever because unlike in the U.S., no one offers to take them over and management doesn't try to take them private and so on. And then 2 out of 5 of them got takeover offers. They weren't very good takeover prices. But, I had bought so cheap that they delivered a good and quick return.


Other Japanese net-nets I owned surged in price for no discernible reason. That could be a result of the ways people in Japan trade stocks (instead of investing in them). But, look what happened to me in Weight Watchers. The stock went from $80 to the $30s where I bought it, to $4 where I held on, to $19 where I sold out, to eventually the $60s where it is now. Sometimes there was news. There were a couple huge turning points. But, day-to-day and week-to-week and even month-to-month it was just a lot of momentum trading and a lot of short-sellers getting either greedy or fearful. 


I now own a stock called NACCO (NC). It's a big part of my portfolio. On any given day, it often moves anywhere from down a couple percent to up a couple percent. It's not unusual for the stock to have a range of minus 2% for the day to up 4% for the day or minus 4% for the day to up 2% for the day on days where absolutely nothing is happening in the overall stock market and, of course, nothing is happening with NACCO. NACCO isn't a peer of any stock I know of. It doesn't generate revenue based on coal prices. So, the only things that should change investor's perception of the stock would be beliefs about whether one of about 3-5 key customer sites (mostly coal power plants run by electric utilities) will continue to operate or will be shut down and whether there are accidents at the mines NACCO operates. Now, you could look at electricity demand nationwide and natural gas prices and things like that and make a bet that this somehow affects NAACO's intrinsic value by plus or minus 2% or 4% or 6% in a day.


Or, you could just ignore the price moves and assume they have nothing to tell you.


I bought the stock in early October 2017 at between $32 and $33 a share. It rose to $47 a share and has since fallen to $39 a share (and not for the first time). I sometimes get questions about these price moves. I've never thought about them. I don't think there's any information value in any of the stock price moves in NACCO. 


Part of the reason why i think that way is because I watched a stock very closely called DreamWorks Animation. It has since been taken private. I never bought it, but I should have. DreamWorks Animation has diversified a bit since I first started looking at it. The company was pretty simple back then. It released 1-2 new movies a year. There would also sometimes be information about DVD sales, etc. of last year's releases in theaters.


What's interesting about a company like DreamWorks is how simple it is. My newsletter co-writer, Quan, and I drew up Excel sheets to model out the profit or loss of a movie over its lifetime. A movie depends on its opening box office, how quickly that opening box office weekend drops off, eventual DVD sales, revenue from pay-TV and free TV rights, foreign box office, etc.


Here's the thing though. Almost all of the information value having to do with a major movie release is known in the first two weekends (so, a period of about 10 days) after it’s released in the U.S. Yes, there will eventually be consumer products and sometimes those are high for something like How to Train Your Dragon but low for other movies. And, yes, sometimes Kung Fu Panda is a big hit in China and other - less China focused movies - aren't. But, 3 data points can be used to model the lifetime value of a blockbuster film pretty accurately:


1) Is this an original film or a sequel?

2) What is the opening weekend box office in the U.S.

3) What is the ratio of 2nd weekend box office to first weekend U.S. box office


In other words, if you know Black Panther is an original movie and made $200 million in its first weekend and made 0.55 times its first weekend in its second weekend (that is, a 45% drop), you have a pretty good idea of what Black Panther is worth now and forever to Disney. It's not exact. But, it's an awfully good guess. And there's very little information that can ever come out about Black Panther outside of its first two weeks of release in the U.S. that can be helpful. For example, you might read an article about consumer product sales. But, that's not very informative because any film with a completely new character (to the moviegoing public) that makes $200 million in the U.S. in its opening weekend is going to sell a ton of consumer products. You also have a pretty good guess at the amount of foreign box office versus U.S. box office, because it’s an original film. Hollywood sequels skew more towards foreign box office than Hollywood originals, because Americans value originality more than moviegoers in some other big box office countries do. This becomes very noticeable if you ever get as deep as the 4th film in a series. If the film was about American politics, or baseball, or was going to be banned in some other countries – you might need to factor that in. But, we didn’t need to know any of that for a DreamWorks release. Everything we needed to know about a film was known to the investing public by the end of the movie’s second weekend in domestic release. My point is that if you know if a film is an original or sequel, you know what it's opening weekend box office was, and you know what it's second weekend drop percentage was - you know enough to appraise the lifetime value of that film more accurately than stock analysts can appraise just about any company in its entirety.


So, DreamWorks Animation released 1-2 films a year when I was looking at it. This means the stock should have traded violently on high volume for a period of about 4 weeks a year (20 trading days) and been pretty quiet the other 90% of the time. Maybe there would be rumors that Katzenberg might leave or some studio might try to buy DreamWorks or something. But, other than that - it shouldn't move like other stocks.


It moved like other stocks.


Generally, DreamWorks seemed to somewhat under-react to opening weekends and second weekends. The moves looked big. But, sometimes they needed to be big.  When “Rise of the Guardians” made just $24 million in its opening weekend – the stock needed to drop a lot on that news, because the lifetime value of that movie was now known to be very low and yet the production costs (long since sunk) had already been known to investors. And DreamWorks way, way over-reacted to irrelevant macroeconomic concerns and things like that. More than that, the stock would sometimes get quite a bit of momentum in its price. This is really weird. The stock should be priced more like a re-insurer that only re-insures hurricane risk in Florida or something like that. It should react violently to the upside when hurricane season passes and there were no hurricanes or violently to the downside when a hurricane is headed right for Florida. It should be less volatile than other stocks - that are economically sensitive, that are tied to industries with constant news flow, etc. - for the rest of the year.


DreamWorks Animation was exactly as volatile as other stocks. It moved like a stock, not like an animation studio. Probably half of all the notable month long or quarter long moves in the company’s stock had nothing to do with any information about any movies it released.


Investors in public markets are really good at imagining news when there's no news. They're really good at looking at a stock price moving up or down and imagining it must mean something.


My advice is to forget about the fact this is a publicly traded stock. In fact, I'd recommend doing everything you can to blind yourself to stock price movements. If a stock is trading for 1,000 Yen, you don't need to know if it traded on the same day last year for 1,500 Yen or 500 Yen or 1,000 Yen. All you need to know is that Mr. Market is valuing it at 1,000 Yen and ask how that compares to your appraisal of the stock.


Now, you mention the P/E ratio. I'd always be a little careful with the P/E ratio. The P/E ratio would tell you Micron Technology (MU) is at 9 to 10 times earnings, which sounds normal. You can check the stock price to see this isn't normal - it went from $10 to $60 in 2 years. However, I don't think you need to check the stock price's history to know the stock is trading at an unusual price level. You can just check the book value. The stock is now at 3 times book value. This is because ROE is now at 40%. Normally, the book value and the ROE would be maybe one-third to one-fourth that level. So, people who are buying Micron now are betting on a change in the company's fortunes compared to what kind of business it has been in most of the last 30 years. This is something like the 3rd of 4th time in the company's history that ROE has gone off the charts because of an industry specific issue. You would need to know the business to know if this is a new normal, or just something that happens every 8-10 years or so.


There's no need to look at the stock price movement to see this. Look at the business itself: ROE has spiked. Or, look at the price as a static snapshot not as a dynamic movie: it's at 3 times book value.


Net-nets and things like that work the same way. Take the price Mr. Market is offering you now. But, take it in isolation from where the price has been in the past. Don't worry about that. Just take the price as a bid you can sell your shares at. It doesn't matter if the bid was 50% higher or lower last month. 


What you want to guard against is envy and regret. People care a lot about stock price movements in the stocks they own and didn't sell or that they should have bought and didn't - because of envy and regret. They regret not buying in at a good price or they regret not selling when the stock spiked.


If you have something better to buy, sell this and buy that. If you're uncomfortable owning this, sell it and buy something else.


But, remember what Ben Graham said...


You should not fall under Mr. Market's influence. You should take advantage of him.


To take advantage of Mr. Market, you only need to know what he is bidding for the stock you own now.


But, to fall under Mr. Market's influence, you often need to know what he is bidding for the stock now versus what he bid for it in the past.


It's best not to think in terms of stock charts or price histories. Instead always think in terms of a static bid from Mr. Market. What is he offering today? What is your appraisal of the stock?


And then, don’t anchor your appraisal value to a specific stock price. Anchor it to a price-to-something ratio.


It helps a lot if you can state your appraisal (and Mr. Market's bid) in terms of something other than price. You need to do this. So, don't appraise Omnicom at a static $98 a share. Instead, appraise Omnicom at 1.5 times sales. Don't value IMS Health at $15 a share or $22 a share. Value it at a 6% FCF yield. Value Bancinsurance at 1 times book value. Value Frost at 0.33 times deposits per share. That's the way to do it. This will help you not anchor on a stock price - but instead anchor on a price-to-something.


For example, appraise Micron Technology in terms of price-to-book if you believe it's a cyclical mean-reverting type company. Or, if you don't think it’ll be cyclical from now on, appraise it on something like price-to-earnings. 


If you buy a net-net, value it in some way relative to earnings, book value, net current assets, or net cash. But, if you don’t know anything about the net-net’s business – valuing based on earnings will be toughest.


I always encourage people to use the metric they are most confident in for this company. So, you shouldn't value a cyclical stock on a P/E. If you're valuing something on a P/E, it means you think it's not a cyclical. By definition, a cyclical is something you have trouble predicting the earnings of. You may be able to value a cyclical in terms of price-to-sales and price-to-book if you think you have an idea of what the full-cycle margin or return on equity is.


If I'm valuing Omnicom on price-to-sales it means I have confidence in the company's long-term average FCF margin.


If I'm valuing Frost on price-to-deposits it means I have confidence in the company's long-term average return on its deposits (related to net interest margin).


Also, it means I think revenues are sticky at Omnicom and deposits are sticky at Frost.


With IMS Health, I think FCF and P/E were stable enough that you could just use those.


But, with a net-net - P/E can be a problem. Do you really think you can predict this company's earnings?


If not, you might want to break out surplus cash and value the operating business separately.


For example, if you have a long-term average of past EBIT numbers for the company - ask yourself: what is today's price for the operating business (that is, backing out the surplus cash) relative to the company's worst earnings in the last 10 years.


If you have a stock with a $10 million market cap and $7 million in cash leaving a $3 million market value for the operating business and the worst EBIT of its last 10 years was $1 million - I'd say hold on to it. That's a business selling for 3 times “bad year” EBIT. The upside might be limited if the $7 million in cash doesn't get used for anything good anytime soon. But, hang on. It's a cheap, safe stock.


What if the worst EBIT of the last 10 years was $300,000. That's up to you. But, if you have something better you might want to sell it.


What if the worst EBIT of the last 10 years was a LOSS of $3 million?


Sell it.


To hold a stock like that you'd need to understand the business as a business. If you can't read Japanese, don't know anything about this company, etc. - you shouldn't hold it on an earnings basis. You should only hold it when it's very cheap versus cash, net current assets, etc. Those are generic measures of value. They should tend to work well enough - if you get an insanely low price - on just about any businesses out there.


Earnings are always a "special" valuation measure. There's no way to value $1 of generic earnings. It's not like cash, land, etc. A dollar of current year earnings at Micron can't be compared to a dollar of current year earnings at Starbucks.


Now, the market knows this and values Starbucks at a much higher P/E than it values Micron. But, my point is that earnings values are only predictable where the microeconomics of the underlying business are predictable. Starbucks has very predictable micro-economics. It's a high frequency, low purchase price habit-based business diversified across a large number of very similar locations. You can value it on earnings. It's a special business, not a generic business.


If you don't know anything about a business - it's generic to you. And I'd never buy a business that was generic to me on an earnings basis.


It's not that a business needs to be good (high ROC, free cash flow generative, etc.) to be valued on earnings. It just has to be predictable. If you find a company earning 7% a year on its equity and not growing very fast, but it's a water company somewhere and trading at 5 times earnings - that's fine.


You said the company you're looking at isn't cyclical. It's a tool accessory business. 


What would I do in that situation?


Personally, if I buy a stock - including a net-net - I don't know much about, I try to let it sit for a year. I re-visit that stock on its one-year anniversary in my portfolio. If I decide it's still cheap, I still like it, etc. I just let it sit for another year.


For Ben Graham stocks, I think re-visiting once every year and making the decision then will leave you saner than following price moves during the year. You might miss out on a chance to sell on a spike. But, you also might miss out on the stock moving with momentum higher and higher.


A lot of cigar butt type investors disagree with me on this one. But, I don't see the harm in only checking back in with a Ben Graham type position once a year. You don't need to know or worry about the fact you once had a chance to sell out at a particularly good time or that you probably would have sold too early if you were checking the stock every month, week, or day.


I think a lot of value investors wouldn't be much worse off if they only got one quote a year on a stock they already own. So, I'd suggest acting like you only get one quote a year. Spend your time focused on finding something new and better to own. Don't worry if you have a paper gain of 50% followed by a drop in the stock to nearly the same level it was at before the pop.


Like I said, I watched NAACO go up about 40% and down about 20% for no reason. It's just a waste of time watching those stock quotes. There are some smart traders who got into NAACO at a better time than me and sold out at a better time. On the other hand, they usually size their position much smaller, so their overall gain on the position relative to their portfolio isn't necessarily going to be better than mine despite all their hard work in trading the position. 


Honestly, my suggestion is to focus on buying the right stock at the right price and then just forgetting about it for a year. I'm not saying you need to be a buy and hold investor - especially not in a Ben Graham type stock - but there's nothing wrong with being a buy and hold investor for a year at a time.

What's Focused Compounding?

by Geoff Gannon

Focused Compounding is my member site. It’s the only place where I do stock specific write-ups. Membership costs $60 a month. But, if you listen to one of our podcast episodes, you’ll hear a promo code you can use.

The best way to learn about Focused Compounding is to go to the homepage:

On the left side of your screen, you’ll see an audio file you can click that will play about 30 minutes of me and Andrew talking about the site, what it is, etc. That’s the best description of the site you’ll ever get.

At the bottom of your screen, you’ll see 6 rotating headlines.

These are the 6 most recent articles on Focused Compounding. These are usually specific stock write-ups. So, despite not being a member you’ll still be able to see the stock name and ticker symbol of whatever I and others have been writing about lately. However, you won’t be able to read any of the actual articles.

There are also detailed stock reports and a stock message board (similar to Value Investors Club). These aren’t included in the rotating headlines. So, they’re there. But, you won’t see what stocks are covered just by looking at the home page.

There’s no free trial. The only free thing is the podcast. That podcast is at the top of my blog. But, it’s also at:

The podcast will always be on the free side of the paywall. Everything else will be on the paid side of the paywall.

Some people have asked me if there’s a way to be a contributing member to the site instead of a paying member. That is, can you write articles on specific stocks instead of paying for membership?

It’s something I’m considering. But, we only need so many contributors. And we do have a lot of people who work as analysts in their day job, who already write their own blogs, etc. and are either already Focused Compounding members or would like to contribute instead of paying a monthly fee.

So, if your small portfolio size makes you feel you can’t justify paying the monthly fee, but you do want to join the site and contribute your best stock ideas – email me:

And we can talk about the possibility. It’s very competitive though. And I’d need to see a complete sample of a specific stock write-up you’ve done based on your very own idea.

Finally, everyone who reads this blog – but is not a Focused Compounding member – should always feel free to write me anytime about anything. There are perks to being a Focused Compounding member. But, access to me is always free. You don’t have to feel bad if you’re not a member but still want to talk stocks with me via email. I’m always open to that.

My partner in everything Focused Compounding is Andrew Kuhn. His Twitter is @FocusedCompound. Mine is @GeoffGannon.

Omnicom, Google, and Facebook: Why All Growth Stocks End up in the Same Place

by Geoff Gannon

About 40 years ago, Warren Buffett said it best:

The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.
— Warren Buffett (1979)

Disintermediation: The End of Ad Agencies?

This past week: a major advertising agency holding company, WPP, announced worse than expected results and lowered its long-term earnings per share growth guidance. The stock dropped a lot. I think it had its worst day in about 20 years. However, unlike some of the other trends we’re talking about here – there wasn’t a big spill-over into other ad agency holding company stocks. For example, Omnicom shares are quite a bit higher than the low they hit of around $65 sometime last year. Following WPP’s poor results, I got a lot of emails about the trend toward “disintermediation” in advertising.

To explain the concept, here is a line from Facebook’s 10-K:

Marketers pay for ad products either directly or through their relationships with advertising agencies, based on the number of impressions delivered or the number of actions, such as clicks, taken by users.”

In the past year, some of the world’s biggest ad agency holding companies have paid billions of dollars to Facebook and Google on behalf of clients. As was the case in the age of classified ads in newspapers, small ad buyers always buy directly while some of the world’s biggest brands buy through ad agencies. While agreements between agencies and clients can vary in terms of how the agency makes money, buying ad space on behalf of clients can do two things for ad agencies: 1) It creates commissions and 2) It creates “float”.

Disintermediation is a fancy term for cutting out the middleman. In the case of brands buying on Facebook and Google properties – this includes things like YouTube and Instagram – it can mean three things. One, the company that owns the brand (for example, McCormick owns French’s mustard) could deal directly with Facebook or Google in a special, privileged way. In other words, people at McCormick could develop a relationship with people at Facebook in some way and this could result in a deal that helps raise awareness of the French’s mustard brand on Facebook. Two, the company that owns the brand could buy ad space directly in a non-privileged way via auctions in which all sorts of bidders participate. This saves the company on commissions and may improve working capital use. And three, the company could in-house certain activities related to running a digital advertising campaign. Digital ad campaigns had historically generated the most dollars of revenue for ad agencies per dollar going to the media outlet showing the ad. In years past, we know the same amount of client spending could generate 2-3 times more revenue for an agency if the money was spent on digital instead of TV.

Based on WPP’s most recent results, this last form of disintermediation is the one we see hitting ad agency results now. Giant corporations that have big brands are doing more digital work in-house. This doesn’t rule out the possibility that bigger and worse forms of disintermediation are coming next. But, it’s the in-housing of labor intensive work related to digital advertising that is showing up in 2017 results.


The Duopolists: Facebook and Google

When you take all of Facebook and Google’s properties together they account for a large share of the U.S. online audience each day. Last year, the two companies may have had 60% of the digital advertising market in the U.S. That’s obviously not as high as what CBS, NBC, and ABC had in the U.S. TV ad market 50 years ago (often 90%+). However, Facebook and Google do have similar positions in many other countries. And you have companies like Tencent with big positions in countries where Google and Facebook are not major factors. Of course, when you move down the list past Google and Facebook – ad share drops off completely with a very fragmented market for the other 35% or so of digital ad spending in the U.S. In fact, the other 35% to 40% of the digital media market that doesn’t go to Google and Facebook is much more fragmented than other forms of media had been. There were never 10 TV stations, radio stations, billboard companies, etc. that had 2% market share in a local area. On the internet there are such small players.

The big difference between advertising on TV 50 years ago and advertising on Google and Facebook is the targeting tools that Google and Facebook provide. These companies are moving toward disintermediation simply by making some of the targeting that was part of an ad agency’s job something anyone can do using a lot of technology to help them. In fact, that seems to be the strategy at Facebook where the company will depend on increasing ad prices (which requires increasing ad effectiveness) rather than increasing users, increasing time spent per user, or increasing ads shown per user per hour.

So, the trend is toward disintermediation. Does that mean an investor should avoid ad agency stocks and buy the shares of Facebook and Google?


Handicapping: Why Betting on the Favorites Often Fails to Pay

For investors: The problem with doing that is price. You can be right that Google and Facebook will increase their share of the digital ad market and digital advertising will increase its share of overall advertising, and yet your bet on the winners out there in the world of business may actually underperform some other investor’s bet on the losing business.


Because, you’re placing your bet in the stock market. And the stock market offers tremendously different odds on ad-related favorites like Google and Facebook versus an ad-related longshot like Omnicom. How much optimism is baked into the stock prices of Google and Facebook? How much pessimism is baked into the stock price of Omnicom?

Let’s see…

Here, we’re talking something like the difference between getting 2 to 1 odds on Facebook and Google versus 8 to 1 odds on Omnicom. There’s no real way to translate a stock market bet into horse racing terms, because over very long time horizons stock market bets pay off differently than horse races. Short-term value bets are easier to think of like a horse race. Long-term growth type bets are hard to think of as a horse race.  

Here, as I’ll show you in a moment – we’re lucky enough to know that Facebook and Google can’t actually grow for very long. For growth stocks: These businesses are actually very, very close to total maturity. We’re analyzing an unusually short race here. This isn’t the Belmont we’re handicapping. It’s a sprint.


Outrunning Multiple Contraction

High growth businesses trade at high multiples of free cash flow. Low growth businesses trade at normal (or lower) multiples of free cash flow. Over time, high growth businesses become slow growth businesses. So, over time growth stocks see their price-to-free-cash-flow multiples contract.

As you can see from the table, if you bet “with the market” on the bright future for Facebook and Google and decide not to bet “against the market” on the bleak future for Omnicom – you have to pay for it. What do you have to pay?

Well, taking the high growth side of the argument forces you to also take a series of positions that tend to do badly in the market. Here, betting on Facebook and Google means betting on stocks that already have market caps of $500 billion to $750 billion. In addition to that, their price-to-free-cash-flow levels are too high for a slow growth stock. So, the dollar amount of revenue growth you’d need at these companies to give you a market beating return in the stock market is especially high. At Facebook and Google, you’re going to need revenue growth that’s even faster than the annual return you want in the stock. You want a 10% stock return? You’ll need more than 10% a year revenue growth to get there. You want a 15% stock return? You’ll need more than 15% a year growth to get that. And so on.

Let’s say a no-growth stock has a price-to-free-cash-flow of 15 (that’s a 6% to 7% free cash flow yield). In reality, the price-to-free-cash-flow you see here is not adjusted for stock option grants to employees. So, that 15 times price isn’t as cheap as it appears at any of these companies (including Omnicom). If these companies give away 1% to 2% of the business to employees each year – that comes right out of your annual return as a shareholder.

So, what size would Facebook and Google have to grow to in 5 years, 10 years, etc. for your investment to work out here? Remember, if we know the price-to-free-cash-flow multiple is going to contract at some point, then we know free cash flow has to grow faster than market cap – and you are only going to make money (unless the company buys back stock or pays a dividend) from market cap growth.

If you want a 15% return in Google and Facebook over the next 5 years, free cash flow at these companies needs to grow at a little over 30% a year. That’s if the companies end up trading at a price-to-free-cash-flow of 15. Many people reading this will believe Google and Facebook will never trade as low as a price-to-free-cash-flow multiple of 15. However, the continued success of these businesses pretty much guarantees they will one day trade at such mature company multiples.

Now, I don’t think investors are actually betting on free cash flow growth of 30% a year at these companies – this would mean, Google and Facebook would have to quadruple their free cash flow in just 5 years. What I think people might be betting on is:

1.       A return lower than 15% a year in these stocks

2.       A holding period longer than 5 years in these stocks

3.       That Google and Facebook will always trade above a price-to-free-cash-flow of 15

Point #3 is wrong. It doesn’t feel wrong now, but it’s wrong. Google and Facebook are very fast growers – so, it feels like they should be fast growers forever. However, unlike something like Amazon – Google and Facebook will run out of fuel pretty fast if they continue to grow. All of the profit at Google and Facebook comes from advertising. The two companies combined have over 60% of the digital ad market and the digital ad market is already over 40% of the worldwide advertising. Historically, ad spending grows at the same rate as nominal GDP. Recently, ad spending has grown slower than GDP.


What Happens After Google and Facebook Eat the Ad World?

What’s undeniable is this: Omnicom, Facebook, and Google get the majority of their money from advertising. In fact, of the three companies, Omnicom gets the most money from non-advertising (but still corporate communications) activities. In the long-run, ad spending won’t grow faster than nominal GDP. Therefore, Omnicom and Google and Facebook are all eating from the same pie and that pie is not growing faster than the overall economy.

It’s easy not to notice this. As investors, we look at the past record rather than future projections. And we compartmentalize our thinking by company, industry, etc. People aren’t putting Google and Facebook in the same compartment as Omnicom. But, in the end: it’s all just ads. You might think that digital advertising is somehow different from overall advertising or that Google and Facebook are somehow different from digital media outlets in general. But, in the long-run they’re not. And the faster the companies grow now – the shorter the long-run gets.

What I mean is this: Google and Facebook may be better than the overall digital ad market now. But, pretty soon they will be the digital ad market. Likewise, digital advertising might be a better space than advertising overall – but, pretty soon, digital advertising will be overall advertising. Facebook and Google are becoming the worldwide ad market. And the worldwide ad market is mature. So, Facebook and Google are becoming mature.

For example, let’s say that over the next 5 years Google and Facebook increase their share of the digital ad market from about 60% to about 80% and digital advertising increases its share of total advertising from about 40% to about 60%. If that happened: Google and Facebook would now be capturing 48% of worldwide ad spending instead of 24% now. Ad spending grows over time. Let’s be optimistic – relative to its recent growth – and say global ad spending grows 5% a year. That would mean Google and Facebook would be eating double their portion of the overall ad pie in 2023 relative to 2018 and that pie would be 28% bigger (in nominal dollars). So, the increase in revenue for Google and Facebook would be a little over 20% a year for the next 5 years. That’s a good result if you’re buying a stock at a price-to-free-cash-flow of 15. It’s even a good result if you buy at a price-to-free-cash flow of 20. You could make 15% a year that way (because, the price multiple collapse as the stock ended its growth phase would only take about 5% a year off your returns). But, if you pay 30 to 35 times free cash flow – a 20% annual growth rate over the next 5 years gives you a return somewhat worse than 10% a year but better than 5% a year. Generally, you don’t want to make the kind of bet where you need 20% annual growth in the underlying business to drive 8% annual returns in the shares you own.

Again, this assumes the share prices of Google and Facebook eventually collapses to a price-to-free-cash-flow of 15.

Will they?

They have to.

Let’s go back to the concept of handicapping to explain this. How will the market handicap Facebook and Google’s prospects after another 5 years of 20% annual growth?

Well, we know Omnicom – which eats from the same pie as Google and Facebook – is a close to no-growth company right now (its share of overall ad spending isn’t increasing) and it’s valued at about 9 times free cash flow even when the market knows the company will pay less taxes in the future than it has in the past. Google and Facebook are priced at about 30 times free cash flow. Those prices are more than justified if past growth continue. But, we know it won’t.

Once Google and Facebook account for nearly all of the digital ad spending pie and digital ad spending accounts for nearly all of worldwide ad spending – they would have a future that looks exactly like Omnicom’s future today. The companies would be unable to grow faster than the market. And, of course, any shift to any other kind of advertising would eat away at their existing free cash flow. That’s the situation Omnicom is in now. It can’t outgrow the ad market. And any disruption to the ad market hurts it. Well, if Google and Facebook keep growing much longer they too will reach the point where they can’t grow any faster than the worldwide ad market and any disruption to the ad industry will take earnings from them.


In 2028: No Ads Run Anywhere but on Google and Facebook – What are the Companies Worth?

Let’s look at a hypothetical 10-year future where that’s exactly what happens. Put Omnicom aside. After all, if disintermediation happens on Facebook and Google and the world starts advertising only on Facebook and Google properties – then, there will be very little need for ad agencies. Maybe Omnicom will be a disaster as a stock. But, does that necessarily mean Google and Facebook will be great stocks?

At some point, Google and Facebook will be no growth companies. What if we reach that point in 2028?

Again, we’ll assume a 5% growth rate in worldwide ad spending. This means the world will be – in nominal dollars – spending 63% more on ads in 2028 than it does now. This time, we’ll be assuming that Facebook and Google go from 60% of all digital ads to 100% of all digital ads. And we’ll be assuming that digital ads go from 40% of all ads to 100% of all ads. This assumption literally means that every ad in the world as of 2028 will appear on either a Google or Facebook property. No other advertising will exist.

Over 10 years, Facebook and Google would grow their revenue by a little over 20% a year at which point they’d have eaten all the world’s advertising pie. Absent dividends and buybacks – a big and unfair assumption – Google and Facebook shares would probably return about 12% a year over those 10 years in which they successfully consumed the entire ad world.


Betting on Global Domination

That looks like a terrible bet to me. Honestly, I’d like to make more than 12% a year in stocks. I’ll take a sure 10% over an iffy 15%. But, how sure is the assumption that two companies with 60% market share go to 100% market share and the market they serve goes from 40% of the industry to 100% of the industry all within 10 years.

Obviously, it can’t literally happen. But, there are powerful network effects here. I’ve seen how addictive these media properties are compared to the media properties of old. An outcome close to total domination could be close to inevitable. Maybe Google and Facebook will never get to 100% of digital and digital will never get to 100% of all ads. But, it might actually be likely that Google and Facebook get to 80% of digital ads and digital ads get to 80% of the total ad market.

I want to stress one thing here. I’m not saying Google and Facebook are bad stocks. But, I am saying that a truly long-term investor can’t make anything approaching a fortune just from growth at these companies. You need good capital allocation. To outperform cheaper stocks (like Omnicom), these stocks will eventually have to buy back share and pay dividends. Even if they do that, their stock earnings multiples will fall. A lot of the growth in the underlying business has to first go to offsetting this multiple contraction before you can start profiting from it.

Of course, margins could expand. At Facebook especially this seems a likely outcome. So, Facebook could grow earnings faster than revenue. But, we still end up at the same place. Either: these companies won’t be ultra-fast growers in the years ahead or they will become slow-growth stocks very quickly.

It’s literally impossible for Facebook and Google to grow at 20% a year – or anything like that – beyond 5 or 10 years. Maybe they’ll find other things to do. But, all they’ve done historically is make money off ad spending. And they won’t be able to extract growth from that business after 5 to 10 years from now. Obviously, they could grow much longer if they grew much slower.

On a recent podcast I said, “It doesn’t matter what a company’s worth when you buy it. It only matters what a company’s worth when you sell it.”

That’s a strange thing for a value investor to say. But, it’s true. You can buy Facebook and Google as growth stocks. But, if you’re a long-term investor, you can’t sell them as growth stocks. By the time you sell these stocks, they’ll be done growing.

The other issue, of course, is that once dominant these two companies will be on the wrong side of any future disruption in the ad industry. If you have anywhere from 25% to 100% of the world’s advertising pie – you’re going to find it very hard to be the one who isn’t losing 25% to 100% of revenue to whatever new thing comes along.

Would I buy Google and Facebook today?

No. The stocks are too big and too expensive to offer good odds. If they were this expensive, but much smaller – they might be good bets. And if they were this size but much cheaper – they might make good bets. But, big and expensive is bad in the stock market.

What about Omnicom?

There’s a real risk of disruption. The stock is definitely cheap versus other public companies. It’s even now a tiny bit cheap (especially when you factor in lower future taxes) compared to where it has traded historically. I bought Omnicom in early 2009. It’s 9 years later and the future looks less certain to me than when I bought it back then. And the stock is actually more expensive now than it was then. I’ve said before that I’d definitely consider Omnicom below $65 a share. As I write this, the stock’s at $75 a share. I have to warn people reading this though – even at $65 a share, Omnicom isn’t as good a bet as when I bought it at $27 in 2009. It looks relatively attractive because most other stocks are so unattractive today.

How about handicapping though?

Let’s look at the odds you’re being given on Omnicom. The stock has a 3% dividend yield. It can lower share count by 2% a year. And then an expansion in the price-to-free-cash-flow ratio from 9 when you buy it to say 15 when you sell it could – if it happens over 5 years – would make you another 10% a year. In other words: it’s possible – I won’t say likely, but I’ll definitely say it’s a real possibility – you could make 15% a year in this stock even if organic revenue growth is awfully close to 0% a year.

The hurdle the underlying business of Omnicom has to clear to get me a 10% to 15% a year return while I own it is much, much lower than the hurdles Facebook and Google have to clear to get me the same 10% to 15% a year return. Facebook and Google are ultra-wide moat businesses. But, at today’s prices, I wouldn’t choose those stocks over Omnicom.

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

How to Decide Which Stock to Research Next

by Geoff Gannon

I haven’t done a good job of finding new ideas.

Before last year, I had never researched NACCO (NC). And then I did research and buy that stock. So, that counts as one new idea. It wasn’t my idea. I didn’t come up with it myself. I read a blog post about it. But, there are no points for originality in investing. A well stolen idea is as good as an idea you found off some custom screen you ran.

Finding new ideas is also a big problem for the people who email me. I get a lot of emails from people who have heard of this stock, might be interested in it, etc. and want my thoughts on it – but, they have yet to sit down and read the 10-K. They’re not sure if reading this particular 10-K is worth their time and effort.

How do you decide if you should spend your limited time on reading this particular stock’s 10-K as opposed to some other 10-K?

Let's talk in terms of 3 things: 1) What do you need to know to value a stock? 2) What can you figure out quickly? and 3) What do you already know about this stock before you even start?

Try to Make Key Simplifying Assumptions

This is a hard one to explain. The best use of your time is something where you can do a quick sanity check. It’s important to simplify – yes, often by just guessing – early on in your research process. There are thousands of stocks out there. Even if you read one 10-K a week like I recommend, you are passing up the chance to research something like 99% of the stocks you could be looking at.

Last week, I wrote an article about General Electric (GE) for my Focused Compounding website. The two most important things I did in that article was say:

1.       I want a 35% margin of safety (if GE is worth $10, I want to pay no more than $6.50 for it)

2.       Historically, Aviation and Power were the business segments that contributed the most to GE’s profits

I looked at the past 5 years of results at GE. I saw that two business units – Aviation and Power – may have contributed something like 60% to 75% of the company’s “industrial” profits in recent years. I only looked at industrial profits, because trying to value GE Capital would take a lot of time and effort and might not even be possible. Healthcare might be worth more than Power for all I know. But, starting off, I can’t make a lot of assumptions about the future. I have to start with the past.

So, what I did is some quick math. I said, if GE’s Aviation and Power businesses add up to something like 65% of the company’s value (we’re being real rough here) and I want a 35% margin of safety – then, I’m basically saying I’d only be interested in GE if the entire market cap of the company as of this moment was below my combined appraisal value of Aviation plus Power. Another way to put this is that I’d be willing to consider the stock if I thought all the other businesses (trains, oil and gas, renewable energy, lightning, etc.) could offset any negative value from a pension deficit, GE Capital, etc. and still leave me with some margin of error. So, I asked what kind of multiple would I have to appraise Aviation and Power at to equal the current market cap. If I got a number that said I needed to use a pre-tax earnings multiple of 20 – then, I’d drop the stock right there. But, if I got a number that said I only needed to use a pre-tax earnings multiple of 10 – well, then, GE was an idea I could follow-up on.

GE is a big, complicated business. It’s not the kind of thing I’d normally look at. But, that’s the way you check to see if an idea is simple enough or not. In this case, the idea might – I stress might – be simple enough. It is true that an investor could – if they were excited enough about Aviation and Power and maybe Healthcare – invest in GE without really needing to calculate the value of the other parts of the company. There’s a price where that would be true.

Contrast this with another stock I glanced at recently: Greenlight Re (GLRE). Greenlight Re is a reinsurance company where David Einhorn handles investments. It trades below book value. Any company that holds investment type assets and trades below book value is potentially interesting. But, here we have two problems that complicate things. One, David Einhorn is a long/short investor. It’s hard for me to know what a long/short investor’s returns will be. It would be easier for me to estimate the company’s likely returns on its investment portfolio if it was simply a long-only portfolio. Two, the company is a reinsurer that often operates at a combined ratio above 100. This means “float” costs the company something. Again, this blocks me from a key simplification. If I was looking at an insurer that usually has a combined ratio below 100, I could easily know that at a price below book value – it’s worth researching. For example, I bought Bancinsurance at under 70% of book value, because I knew it had a combined ratio below 100 in 28 of the last 30 years. It’s a safe bet to assume an insurer with a combined ratio under 100 in almost all years is worth more than book value. It’s not a safe bet to assume that if a company usually has a combined ratio above 100. So, Greenlight Re is a hard situation for me to simplify. It’s obviously more of a value investment than General Electric. But, the key simplifying assumptions I wanted to make – assume an investment return of “X”, assume an underwriting profit of “Y” – are difficult to make here. If I went on to study Greenlight Re closely, I might still find it’s a good stock. But, the situation – as it is now – is the kind of thing that tends to lead you to an inconclusive result as far as initial research goes.


Try to Find Stocks Where Part of the Equation is Fixed and Certain

The toughest stocks to analyze are ones where both the issue of the business value you’re getting and the price you’re paying are a little fuzzy. I wrote about another stock, U.S. Lime (USLM), for Focused Compounding. I wouldn’t say the stock price of U.S. Lime is extraordinarily cheap right now. And I can’t say I know exactly what lime demand will be in 5 years. But, I felt I knew there wouldn’t be more lime producers in 5 years and there might be fewer producers. This is a huge, key simplifying assumption. If the industry is low competition, low change, etc. I can assume returns on capital will be fine. So, that means there’s a price where the stock would be a good buy if the capital allocation was good. For an investment in even a no growth wide moat stock to turn out badly, you’d usually need to either pay too high a price or have poor capital allocation by the company. The presence of a moat simplifies things. You shouldn’t buy a wide moat company just because it has a moat. You should buy it because it’s cheap, will grow, has good capital allocation, etc. The moat isn’t going to give you a good result. The moat is just going to increase the confidence you have in getting the good result you would expect from paying a low price, having fast growth, etc.

So, if you know quality is high and constant in the sense that there’s a moat – it’s an easier stock to analyze. But, a price that’s easy to calculate works well too. For example, a company that owns timberland might not be considered a great business – but, I can check what it’s selling for in terms of enterprise value divided by acres of timberland. If acres of timberland often go for $1,200 and this company trades for a price that’s only $800 per acre – that’s a good stock to research next. Of course, there might be a reason this company should have a big discount per acre. But, it’s an easy thing to research. Stocks that own shares in other public companies work the same way. You can see the discount to NAV. So, now the question becomes: is it justified? Why? What could justify such a discount? Is that what I’m seeing here?

You can either ask the question of what stock to research next from the Warren Buffett side of things or the Ben Graham side of things. Does it have a wide moat? Then, it’s easier to research. Does it have a hard value? Then, it’s easier to research. Stocks that don’t have a moat and are valued on earnings rather than assets are usually the toughest stocks to research. This past year, someone asked me about Micron Technology (MU). I don’t know how to value Micron. That would be a very hard stock to research.


Try to Focus on Evergreen Ideas

Any business that changes a lot is hard to value. Also, if such a business isn’t cheap now – your research is unlikely to pay off later. But, if you research a business that stays pretty much the same over time, you might get to use the research you do now to buy the stock years from now. For example, I bought Bancinsurance several years after I first researched it. When I first researched it, I thought it was a good, fine, understandable business – but it wasn’t shockingly cheap. Later, it looked shockingly cheap and I bought it. In between, the company had problems. But, most of the core of what I’d analyzed before those problems was still important when I came around a second time to analyzing the stock.

Wide moat businesses are often good research candidates, because stock prices change a lot and yet wide moat businesses don’t change a lot. Likewise, a company made up of some key assets like certain real estate holdings doesn’t change that much. In 2017, I researched Howard Hughes (HHC). Much of the value in that stock is in a few key developments that will take many, many years to be fully sold off. If you research Summerlin, Nevada in 2017 – much of what you decide about Summerlin is going to have just as much usefulness in making an investment decision in 2022. So, again, evergreen earnings or evergreen assets both work fine.


On the Other Hand: Look for Stuff that Might Be Actionable

If you can’t imagine yourself buying this stock after it’s dropped 20% from today’s price – just move on. This goes against my point about evergreen ideas. If someone thinks Domino’s (DPZ) is an amazing business – why not spend time researching it now?

Domino’s might be a great business. But, if it’s so expensive that you can’t imagine buying it even after a 20% dip from here, your time is better spent looking at stocks like Howden Joinery, Omnicom (OMC), Vertu Motors, and Hunter Douglas. Those stocks are closer to the price where they might seem like an obvious buy. They’re understandable enough and cheap enough that they’re probably a better use of your time right now. If you’re a growth investor who might pay a P/E of 40 for something – this rule doesn’t apply to you. But, I’ve seen a lot of value investors waste time looking at stocks with P/Es of 30 or 40, when I know this investor isn’t going to touch anything till it hits a P/E under 15.

Sadly for value investors, there are some stocks that are definitely good businesses and might even be good stocks but manage to stay above the price level where you’d be likely to ever buy them. Value investors are biased toward paying low prices. So, even if a value investor liked Starbucks during its big growth phase – the stock tended to always be too expensive to buy. On a recent podcast, Andrew and I mentioned Copart (CPRT). He said Copart was a stock that you wait to get cheap enough to buy and it never does. That’s what being a value investor is. Value investors make the mistake of not paying up enough for some stocks. Growth investors make other mistakes. If you have all the time in the world, it’s good to analyze plenty of stocks that aren’t cheap right now. But, most people who read this blog don’t read many 10-Ks. If you’re already reading one 10-K a week, then you might want to alternate between one “cheap” idea and one “good” but expensive stock. You’d still read about 26 cheap stocks a year. So, I don’t have any problem with that approach for someone who is really doing as I recommend and tackling one 10-K a week. Most of you aren’t. So, you probably want to start by focusing on something you might actually buy at a price not too far from today’s price. If you can’t imagine yourself ever paying even a 20 P/E for a stock – don’t look for stocks that currently have a P/E above 25.


Start with Stocks You Know Something About

This one’s simple and surprisingly useful. It’s the Peter Lynch approach of “buy what you know”. I’d re-phrase it as “research what you know”. My office building is run by Regus which is part of the U.K. workspace company IWG. It’s a good idea for me to research IWG. I have more background knowledge about the company’s operations than many investors do. Likewise, I could ask myself: where do I eat? Have I been to Zoe’s Kitchen (ZOES), Potbelly (PBPB), Dave & Buster’s (PLAY) etc.? If I have, it would make more sense for me to research them. My apartment building is owned by a public company as well. It would make sense for me to research that company.

But, it goes beyond that.

You just have to pay extra attention to investing relevant aspects of your everyday life. For example, I was talking to someone here where I live and they said “Why do they have a Sears Auto Center there, that’s so weird.” The presence of Sears at an otherwise nice mall seemed really out of place. And what I said was, “Oh, that’s a Seritage property.” Seritage (SRG) is a spin-off from Sears that controls some real estate and leases it at far below market rates to Sears. The plan is to eventually shift from having Sears as a tenant to having tenants who pay the going rate. In some cases, this will involve re-development of the property. I’m sure many people know the Seritage story. But, if you actually live the experience of having a normal, non-investing type person say to you, “That makes no sense, why is there a Sears here?”, you may have more of an appreciation for the re-development potential in some of Seritage’s portfolio. Of course, there’s the potential for bias. I might live near a better mall than most of what Seritage is at, I might live in a better apartment building that most of what’s in that company’s portfolio, etc. But, at least you have some information to start from. Knowledge of the local real estate market can increase your confidence in making an investment. Andrew bought stock in Green Brick Partners (GRBK). I don’t think he would have put as much into that stock if he hadn’t lived in the same Dallas area where the company does much of its building. Likewise, I lived in North Jersey and had worked at a Village Supermarket (VLGEA) Shop-Rite location. I was more confident than the market – this is back near the turn of the millennium – that competition wasn’t going to intensify all that much for this company, because I knew locations where you could site a large supermarket were rare in that part of the country.

But, remember: that’s no reason to buy a stock. Just knowing a stock doesn’t help. I bought a cheap stock. Village was really, really cheap when I bought the stock. The only thing my local knowledge gave me was confidence that the stock wasn’t cheap because there was going to be a lot of competition coming in. Green Brick Partners was also cheap when Andrew bought it. He would have had confidence that there was nothing wrong with the local housing market.

Local knowledge often retains its usefulness for a long time. But, even that kind of knowledge does diminish over the years. For example, if you asked me now if Village had as wide a moat around its stores as it did in 1999 – I’d say no. There have been new, smaller store formats introduced by some chains (like The Fresh Market) and then to a much lesser extent there’s been more interest in online groceries. For now, it’s the small format stores that would worry me. But, the basic fact remains: it’s still very hard to put a big format store anywhere near an existing Shop-Rite in that area. That’s local knowledge that’s useful to have. However, it’s a lot more useful when the stock trades at a P/E of 6 than when it trades at a P/E of 16.

Value investors underrate Peter Lynch’s advice. He has really smart things to say about bottom up stock picking. And focusing on companies you already know a little about is excellent advice.

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

Bad 10-Ks vs. Good 10-Ks: 11 Annual Reports I Recommend Reading

by Geoff Gannon

In the most recent podcast episode, Andrew and I were asked what was the easiest thing about investing. I answered: reading 10-Ks and coming up with an appraisal value for the business. I realize that not many people think reading 10-Ks is all that easy.


Well, they might be reading the wrong 10-Ks.   

Some 10-Ks are bad. Andrew and I meet each week to go over a specific stock. He’s a big fan of Apple products. So, this past week, we went over Apple (AAPL). Now, Apple is a company everyone knows. You know how people use their phones – chances are, you have a phone made by Apple or a competitor of Apple. There are analyst reports and news articles trying to guess what the company’s gross margin is on its latest iPhones. You don’t need to read the 10-K to learn about the business. However, I have read Apple’s 10-K and I can tell you it’s bad. It would be difficult for me to ever guess how Apple’s business works, why phone users might or might not be “sticky”, why service revenue would grow over time, etc. just from reading that 10-K.

Contrast this with the annual report of Howden Joinery. Howden Joinery has one of the best annual reports you will ever read. Anyone can read Howden’s 10-K and get something out of it.

The degree of difficulty in analyzing some businesses may be a reason why I’ve had a hard time convincing investors to focus their research on micro cap stocks. With a small stock, there is usually no what I’ll call “silver platter” public information about the business other than what’s in the 10-K. There is still public information about the company, but you’d have to hunt for it. You’d have to act like a reporter preparing to write an article on the company. This is not something most investors want to do. Most investors probably don’t really want to read the 10-K either. But, if you’re reading this blog, you’re at least one of those investors who will admit he should be reading the 10-K.

So, what’s a good 10-K? Someone recently asked me to send him a list of 10-Ks I’d recommend reading. Here’s the reply I sent:

“For educational purposes, here are some 10-Ks I'd suggest reading:

·  Coda Octopus (CODA)

·  Transcat (TRNS)

·  Copart (CPRT)

·  Ball (BLL)

·  Exponent (EXPO)

·  Waters (WAT)

·  iRobot (IRBT)

·  Morningstar (MORN)

You can find all of those on EDGAR.

If you're willing to read annual reports from other countries, I'd also suggest:

·  Bunzl

·  Hilton Foods and

·  Aggreko

Those are all good 10-Ks/annual reports. Most of them have more information about the business model, strategy, etc. than the average 10-K.”

Does this difference between good and bad 10-Ks introduce a bias into my stock picking?

Other things equal, am I more likely to buy the shares of a company with a good 10-K than a bad 10-K?


I’m definitely biased toward investing in companies with good 10-Ks.

And I honestly don’t know how to correct this bias.

I need to know a certain amount before I buy a stock. Depending on the price I’m paying, there are different levels of what I need to know. However, if I’m paying a double-digit P/E for a stock – I need to know it’s a durable enough business and a good enough business. I have to believe it’s going to be competitive in its industry 5 years from now.

So, it can be more difficult to invest in a good business if it’s a micro cap, because the company may not provide information in the 10-K that would help me know why it’s a good business.

With bigger businesses – like Apple – it doesn’t matter what the company says in its 10-K. There’s enough information out there to know why it’s a good business. I have an iPhone, I’ve talked to people with iPhones about what the next phone they buy is going to be, I’ve been in Verizon and AT&T stores that sell iPhones and seen what salesmen play up and play down and how customers think or don’t think during the sales process. So – just by living my life – I’ve done the sort of research that would be my next step after reading the 10-K of a small stock.

Most investors are going to feel more confident investing in Apple than in any small stock. They know Apple’s business well. They don’t know the small stock’s business well. But, if you want to be a good stock picker, you need to learn how to get a lot of the information you’d need just from the 10-K. It’s always good to know whether a business is durable, good, has a wide moat, etc. But, if you can figure out that a business is durable, good, has a wide moat, etc. from something (a 10-K) that most investors don’t even read – that’s even better.

Regardless of whether you’re investing in Apple or Transcat, you don’t just need to be right about the business. You need to be right about the business in a way other investors aren’t.

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

Free Report: Luxottica (LUX)

by Geoff Gannon

Now that the Luxottica-Essilor deal has gotten anti-trust approval in the U.S. and E.U., it looks like the merger will go through. For that reason, I’m just going to give away the Luxottica report from 2016 as a free sample of what’s in our library over at Focused Compounding. Focused Compounding members get access to 26 other reports just like this one.

Luxottica Report (PDF)

“Luxottica is a vertically integrated eyewear company. Although founded in Italy, it now gets much of its sales and profits from the United States. And although founded as a part maker for prescription eyeglass frames…it now gets much of its sales and profits from sunglasses….Luxottica is truly vertically integrated. Last year, 59% of the company’s sales came from its own stores…Quan and I consider Luxottica’s four most important assets to be the sunglass brands Ray-Ban ($2.6 billion in sales), and Oakley ($1.1 billion in sales) plus the retail chains LensCrafters (over $2 billion in sales), and Sunglass Hut (also over $2 billion)… if you are looking for a stock to buy and hold forever – Luxottica is definitely your stock. This is a perfect buy and hold forever stock. Of the stocks we’ve written about for Singular Diligence so far, I think Luxottica and Frost are the two stocks to buy today and hold forever.

Luxottica Report (PDF)

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

8 Episodes of the Podcast Now Available in iTunes – New Episodes Mondays and Thursdays

by Geoff Gannon

Focused Compounding Podcast

The best thing you can do for me and Andrew is spread the news about our podcast by rating and reviewing the show in iTunes.

New episodes of The Focused Compounding Podcast come out on Mondays and Thursdays. There are already 8 episodes out now.

These 8 episodes consist of…


“Actionable Idea” Episodes

Episode 2 is a 19-minute podcast about NIC (EGOV). This company operates about half of all “dot gov” state websites in the U.S. Episode 5 is a 21-minute podcast about Frost (CFR). I have about 25% of my portfolio in this stock. It’s the largest bank headquartered in Texas. Episode 7 is a 16-minute podcast about Cheesecake Factory (CAKE). This company operates large format restaurants that each do about $29,000 a day in sales.


“Question & Answer” Episodes

Episode 1 is a 17-minute podcast tackling the questions “How did Geoff and Andrew meet?”, “What’s the best way to become a better investor?”, “How do you decide which stock to research next?”, and “How did you get into investing?”. Episode 4 is a 21-minute Q&A podcast where the questions answered are: “What are the worst mistakes of omission that you’ve both made during your investing careers?”, “How do you determine your position size?”, “How do you counter the psychological effects of writing about your investments publicly – and has writing added to or detracted from your investment performance?” Episode 6 is another Q&A where Andrew and I answer 3 questions: “In your investing career, do you ever get depressed?”, “What is your research process when it comes to a completely new stock?”, and “What are the best investing books you’ve read?”


“Post-Mortem” Episodes

Episode 8 is a 28-minute podcast where I talk about my something like 3 and a half year long experience owning Weight Watchers (WTW). In the podcast description for this show I called these post-mortems “gorily honest tales of what went right and wrong”. This Weight Watchers episode definitely lives up to that description. These post-mortems will be a regular feature of the podcast along with the actionable idea episodes and Q&A episodes.


Special Episodes

Back in early February: After a few rough days for the stock market, Andrew and I sat down to record a special 40-minute podcast called “Volatility in the Markets”. There will be some one-off episodes like this that don’t fit in the 3 normal episode formats: actionable ideas, post-mortems, and Q&As.

If you have a suggestion about an episode format you’d like to see us try out, email me:

And again: if you’d like to help me and Andrew out, please rate and review the show in iTunes.

Focused Compounding Podcast

Should You Limit Yourself to Only Buying Shares in Businesses with “Market Power”?

by Geoff Gannon

This question comes from a Focused Compounding member. I wrote up a stock called U.S. Lime & Minerals (USLM) on the member site last week. In my write-up (which is behind a paywall), I mentioned that I believe lime producers in the U.S. have “market power” because lime is not shipped far (U.S. Lime’s customers are all within 400 miles), it isn’t kept in inventory, and it’s decently likely there will be fewer lime producing sites in 5, 10, or 15 years than there are today. This last point is key. In many industries, I can’t predict that customer choice will be lower in the future than it is now. Often: I’m afraid it will be higher.


Before we get to this question, I need to repeat my own definition of “market power” which is different from the definition used for anti-trust purposes and things like that. I define market power as:


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


Obviously, no firm has perfect market power. And almost all firms have some power over some subsets of customer and suppliers. However, plenty of readers of this blog have noticed that the stocks I tend to purchase for myself (not just the ones I tend to write about) seem to fall in the high market power group. For example, they usually combine high customer retention rates with prices that don’t fall from year-to-year.


Now that that’s out of the way, let’s get to the question.


“I've been thinking a lot lately about market power after reading your Focused Compounding article on it.


While I have always considered market power as a factor in analyzing potential investments, it has not been the primary factor I look for in a business. I have tended to focus on staying power and durability, ideally coupled with strong economics (ROCs). To some extent, there is a large degree of overlap between these factors (one could argue these are semantic differences), but I would say that market power is a little more comprehensive in tying in durability of the economic model with ability to sustain favorable economics due to the relationship between a business and the other entities in the economic ecosystem.


Basically, this idea of the primacy of market power is really changing the way I think about investing and how to frame my research process. In effect, I can't figure out why I would ever invest in a business without strong market power. In the past, I have included companies on my research list like Dominos that have strong economics. My thought process has been that it makes a lot of sense to include "great" companies like Dominos so that I have a value figure predetermined in the event we see a price meltdown, so that I could quickly act to invest in it. 


Now, however, I'm wondering why would I research a company like Dominos when I could focus on companies like US Lime that enjoy much stronger market power and thus a more reliable investment outcome. In a perfect world, I would research both, and all, companies. In practice, it takes a lot of time to really dig in to a company and I think it makes sense to target research on those companies who appear on the surface most aligned with the type you would invest in. 


What is your thinking on the topic? Do you spend a lot of time analyzing companies that have excellent economics but that are in competitive industries that could erode those economics, or do you try to steer your focus more on businesses with huge market power? It's clear your current portfolio favors businesses with strong market power, but I am curious how you frame your research process, not necessary for your writings on GuruFocus or Focused Compounding, but for actual investment. 


In summary, I'm trying to figure out if I should shift the way I use my research pipeline to only include companies with strong market power, or if it makes sense to include other types of companies, too. For reference, I am a focused investor and have been becoming more so over the past 15 months. I have 8 positions and the top 3 are 60% of my portfolio, so I am the type of investor who likes to invest heavily when I come across ideas I feel strongly about. And as I have been increasing concentration, it has become increasingly important for my ideas to be extremely high conviction, which is more attainable by focusing on businesses with strong market power.”


First, I need to go a little off-topic and discuss Domino's specifically.


One interesting point is that I actually researched Domino’s (DPZ) and talked it over with Andrew offline.


I think Domino’s is one of the best businesses I've ever seen.


And I think it has a lot of little systematic advantages that really add up to something impressive. What got me interested in researching Domino's was actually that I was noticing just how important digital orders (and carryout) was becoming for this business. So, there was a real change in habits in terms of making availability greater. If people don't know what to get for dinner now, they can just decide "what the heck" take out their phone and re-order their "favorite" order in the app and it's very affordable (if picked up instead of delivered). I do Starbucks (SBUX) digital orders when walking to my office and it was actually me thinking about that habit I'd developed that made me take another look at Domino's. And I was very, very impressed with what I saw.


At the right price, I would definitely consider Domino's. I think it does have "market power" in some ways. But, this gets complicated, because the way I like to define market power is a little different from the textbook definition. Basically, I consider something like an ad agency, bank, maybe a cloud computing business, a distributor from which a business customer buys the bulk of its needs in a category, etc. to have market power when it's likely to retain customers and/or suppliers even if its offering starts to slip compared to a revival in terms of price or quality or something like that. As an example, if Grainger wants a supplier to provide it with a 2% lower price this year so it can pass a 2% price decrease on to its customers – Grainger would have market power (in this instance: over suppliers, not customers). The “suppliers” part of my definition often gets overlooked. On balance, a successful business needs to have more bargaining power over its customers than its suppliers have over it.


Once again, here’s my definition of market power:


"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."


That's different than the usual definition of market power, and perhaps I should call it bargaining power. Of course, the greatest bargaining power of all is in situations where a customer or supplier doesn't make much of a conscious effort to bargain with you. This fact gets overlooked a lot when I talk with investors. With my Grainger example, investors immediately get the “bargaining power” idea. If one company buys twice as much from a manufacturer than its nearest rival does, the manufacturer may give them a lower price per unit than the second place player. That’s what we might call “hard” bargaining power. However, it’s very common for a company to have “soft” bargaining power in the sense that a customer simply defaults to using this source for a product/service etc. For example, when researching Breeze-Eastern (now part of Transdigm), Quan and I spoke with some customers who didn’t actually know Goodrich (now part of United Technologies) manufactured a part that could be made to work in place of the Breeze part they had been using. This is an “if a tree falls in the forest” question. If a customer doesn’t really know – or doesn’t really care – that there’s an alternative, does that alternative really exist?


If I have a Domino’s app with my payment information in it, my address, the store I get carryout from, my favorite order etc. already on my phone – does the latest coupon offer from Pizza Hut or Papa John’s matter? It still matters some. But, a pizza company that manages to get an app on your phone has a lot more “soft” bargaining power over you than they would in the same situation 10 years ago, where you were ordering by placing a call each time. I really do consider the “soft” bargaining power of an app on your phone and the “hard” bargaining power of a business-to-business purchasing advantage based on scale to both be sources of market power.


That’s a long tangent to go off on.


But, it’s important, because when I talk to investors they tend to focus on economies of scale in business purchasing decisions and to completely overlook habit, availability, etc. in consumer purchasing decisions. However, the evidence in terms of the predictable, persistent profitability from various industries suggests that either source of market power works. There’s a tendency to assume “rational” sources of market power are more durable than “irrational” sources of market power.


So, I think having a Domino's app, a favorite order, a nearby Domino's location for carryout, etc. really ups the availability of Domino's versus other pizzas and makes this into more of a habitual sort of business. What impressed me with Domino's was the way it has an advantaged system versus others. So, for example, Domino's has the best pipeline of franchisees compared to other pizza companies. It has far more people who came up through being a Domino's driver and then eventually operate a franchise. You also see things like how Papa John's (PZZA) has to offer incentives to new franchisees that Domino's doesn't. This reminds me of what I saw when I did a little digging into the terms that MoneyGram (MGI) gets versus the terms Western Union (WU) gets from agents. To grow its number of agents, MoneyGram has often had to offer both higher signing bonuses and higher commissions than Western Union. That's especially interesting, because the way a payment system like that works is that the economics for agents are basically flat and then the economics for the payment processor goes up with the number of agents (this is why payment systems are deflationary – the number of agent locations being processed through the same system causes cost per transaction declines for the payment processor). So, I was impressed with how Domino's has that kind of system. The economics for a franchisee are good enough (I was pretty focused on answering that question) and there are enough potential franchisees who know the Domino's system and then really the benefits of the system tend to go very much to the public company instead of the franchisees. 


I will just say that the multiple I put on the cash flow from the U.S. franchised business of Domino's was very, very high. I'm sure that my appraisal of that business unit included the highest multiples I have ever awarded a business unit versus this year's EBITDA, EBIT, etc. Other parts of the business: international, owned stores, supply chain, etc. got lower multiples from me for the appraisal. But, you can see that I really do think Domino's U.S. franchised business is an incredible system.


And a lot of that was because I researched Papa John's before I researched Domino's. So, I could see Domino’s had the same system with better results.


And also, I just think digital is very, very good for something like Domino's. If you look at how they've remodeled their locations and how they use that app - everyone is looking at start-up food delivery companies and stuff thinking that something will come out of Silicon Valley to take advantage of digital orders for food. But, really, I think the company that captures the profits from something like that is Domino's. 


Since I haven't written about Domino's and yet I consider it to be very, very high on my list of favorite businesses out there - I felt I had to go on a tangent and discuss it with you there.


But, I realize your question wasn't really about Domino's. You were asking a more theoretical question about "market power" versus just "business quality" in the sense of historically having a higher return on capital.


So, now the question of whether I would feel more comfortable with investing forever in Domino's or in U.S. Lime. Obviously, Domino's has the brighter future. Whatever market power Domino's has comes from having a bigger, better system than competitors. This is more of a "survival of the fattest" business. Growth investors should favor that kind of business. U.S. Lime is limited because its advantage is physical location based (not corporate system based). 


I tend to be biased toward companies with very clear market power and away from companies with competition in their industry. I think that's potentially an error I make. I mean, if you look at the investments I did and didn't make - you could say the biggest mistakes I tend to make are: 1) Selling the stocks I like the most too soon and 2) Not buying into stocks with a big upside but some chance of a downside.


My approach is not the Mohnish Pabrai approach. He’s more of a heads I make 5 times my money, tails I lose all my money investor. And my approach is likely to have worse returns than his I think. There's something to be said for just betting that a Magic Formula type stock will do well even though you know competition is a big risk. 


I really overweight market power compared to how other investors operate. You can see this with NACCO (NC). The Hamilton Beach Brands (HBB) business is obviously durable. Yet, the coal business (the new NACCO) obviously has more market power in the sense that Hamilton Beach is going to have an awfully hard time raising prices on its customers (Amazon, Wal-Mart, etc.) in line with inflation. Whereas I know that as long as the clients NACCO has continue to operate they will continue to use coal provided by NACCO and they'll do it at like a cost-plus type rate. So, NACCO has market power (and it had a low stock price on the day of the spin-off). But, it doesn't have durability. Meanwhile, HBB has durability but I don't think it has a lot of market power. 


I went with the cheap stock with high market power and low durability. A lot of other investors would go with the somewhat more expensive stock with lower market power but higher durability.


You can see there I was more willing to take on the risk of obsolescence (coal power declining as a percent of U.S. electricity production) rather than taking on the risk of having to negotiate with Amazon. That gives you an idea of just how skewed my thinking is towards a focus on market power. I’m more willing to invest in a buggy whip business as long as I know the firm will get a good price for each buggy whip it sells than I am to buy into a business where I know the product will always be demanded but have no clue what price the maker will be able to charge for it.


I try to look for fairly simple situations. The way I summed it up recently was that I'm usually interested in one of two situations:


A. A stock that initially seems to be cheaper than 95% of the stocks out there

B. A business that initially seems to have more market power than 95% of the stocks out there


So, basically my idea is to read 20 annual reports and put 19 of them to one side because they aren't extraordinarily cheap or extraordinarily "wide moat" as Buffett would say.


My logic is that it's not that hard to know what price an "average" public company often fetches. So, if I feel sure that what I'm buying is much cheaper than an average business or has much more market power, I'm fine. Where I get into trouble is when a stock I buy is only a bit cheaper or only has a bit more market power than the average business out there. I’m not a skilled enough analyst to know whether a company should trade at 13 or 19 times earnings or whether one teen retailer has a bit better competitive position than another teen retailer. I know an ad agency is a good business. I know a net-net is cheap. So, I stick to obvious extremes of either business quality or valuation.


The issue with market power - or "moats" - is that they tend to be limited and easily outgrown. That's why I mentioned Domino's as having an unusual amount of upside. It still works well at scale.


Booking Holdings (formerly Priceline) is potentially a much better business than say Omnicom (OMC). Advertising as a percent of GDP isn’t going to go up over time. And then traditional advertising – done through something like Omnicom rather than certain forms of online advertising that don’t go through the kind of businesses Omnicom owns – isn’t going to grow as a percent of total advertising. So, Omnicom’s got market power. But, it can’t grow very fast. Booking Holdings can. Hotel spending can grow nicely worldwide. And then you could probably still double the share of hotel rooms sold through something like rather than more traditional ways. The business isn’t all online yet – but one day, it should be 100% online.


So, if I could be sure of Booking’s market power 5, 10, or 15 years out with the same degree of certainty as I am of Omnicom’s – I’d be better off investing in Booking. That’s true even with Booking’s much higher stock price than Omnicom. It’s not a value stock. But, it’ll still outperform – even if bought at today’s price – if market power holds up. Booking is an idea that can work at tremendous scale. The source of Booking’s market power scales well.


The source of U.S. Lime’s market power doesn’t scale at all. It’s location based. I wrote about Watlington Waterworks (a tiny stock traded on the Bermuda Stock Exchange). It's done fine over the seven years since I wrote about it (stock price up 9% a year plus the dividend yield and yet it still trades a bit below book value). But, it can't expand at all. The economics of a water company somewhere other than Bermuda aren't good. If Watlington was sold to a 100% owner who harvested the business for its dividends and re-invested those dividends elsewhere – it could make that guy pretty rich. For public shareholders, it’s a bit trickier. A company like that tends to either pile up cash or it starts to outgrow its market power. It begins expanding into other stuff that doesn’t have the special advantages the original business did. For shareholders, this means that the market power of the “business” – defined as the original business unit – holds up perfectly forever, but the return on capital of the corporation declines over time. Simply put: the company expands beyond its moat.


I run into this problem constantly. I can find companies with market power and I can even find companies with market power at decent prices. But I can't find companies with market power at decent prices that have good growth prospects.


So, then, it becomes all about capital allocation. In large part, I like Omnicom because I think it'll mostly buy back stock and pay a dividend. I like BWX Technologies because I think it will stick to nuclear technologies unrelated to new-build for civilian power. I like NACCO, because I think it won't buy an underground, consolidated coal mine. If I'm wrong about those things, my investment results could really start to deteriorate, because I'm buying something I know has market power but then the company is taking the free cash flow and allocating all of it to something without market power. And that's how you end up with "reversion to the mean" and all that. 


Remember: all the data we have on profitability and stock returns is at the corporate level. Academics often treat this as if we know that the profitability of businesses are “reverting to the mean”. We don’t know that. These corporations aren’t paying out 100% of earnings in dividends. The original business they were in might be holding up quite well in terms of return on capital – but the corporation’s return on capital will decline if it tries to grow faster than the business unit with high market power.


When Buffett buys a company outright for Berkshire, he doesn't have to worry anywhere near as much about growth. If he's really, really right about both market power and price - he's fine. That's because he allocates the capital. So, Berkshire could easily buy Watlington Waterworks, or U.S. Lime, or Omnicom and it would work out great for Berkshire because he will just re-allocate the free cash flow they can't use inside the business.


Where I really run into problems is with companies like (CARS) and Booking Holdings and things like that. I know they have some advantages (Booking especially). But, the intensity of competition is high. Rivals spend a lot on ads, they can - right now - get private equity, public investors, etc. to fund them even if they are losing money at first. It's seen as a very fast growth, winner takes all sort of mad scramble. And, that's tough for me to evaluate. But, those are the stocks that often work out well. 


Would it make sense to swing for the fences on business with market power that can scale up rather than niches like U.S. Lime where I feel more sure the market power will not be diminished over 5, 10, or 15 years?


I feel more comfortable betting on stocks where I’m more sure of future market power. But, I suspect that having a few really big winners – that is, growing companies with market power – would outperform my own approach.


With lime, it seems especially easy to consider researching a company in the industry because you figure in 5 years, 10 years, 15 years there will be fewer sites producing lime. Generally, if that's true in an industry, your results are going to be pretty good as an investor. I don’t know that there are going to be fewer websites competing with in 5, 10, or 15 years.


If you're a long-term holder, I've found "market power" to be an incredibly helpful tool. It's difficult to quantify. But, it is the most constant feature of the business. The industry structure, the relative position of the company in the industry, etc. is all stuff that gets decided fairly early on in a business’s history and then tends to stay the same much more than things like growth rates, P/E ratios, etc.


Market power tends to be the most useful thing about a business to understand because it tends to be the most constant thing about a business. Big shifts in market power tend to happen more decade by decade than quarter by quarter.  


And then the other advantage is you can just buy a stock with market power whenever you think it gets cheap, hold it till it is expensive looking again, sell it and then you keep buying the same companies more than once. Researching a company with market power tends to have the potential for longer-lasting insights that will help you as an investor. Like, I read about U.S. Lime a long time ago. I owned Omnicom 9 years ago. Companies with market power tend to make good “files” for your archives.


For research purposes, I find stocks with market power have the highest pay-off relative to the time you put in studying them.


However, very cheap stocks are also useful things to research. I’m talking net-nets. I’m talking Nintendo when its market cap got down to about the same level as its net cash. Very cheap stocks are a good use of your research time. Spin-offs are a good use of your research time. A retailer at 13 times earnings is often a bad use of your research time, because it’s unlikely to have absurdly high market power (due to the industry it’s in) and it’s unlikely to be absurdly cheap (13 times earnings is a pretty ho-hum price that most stocks hit at some point in their history as a public company). If you have limited research time, I’d spend it on stocks that seem like they might have extraordinary market power and stocks that seem extraordinarily cheap.


Often, a really cheap stock gives some very obvious quantitative sign of its cheapness right off the bat. Like, right now, Vertu Motors (a U.K. stock) looks cheap to me. The P/E says 6. The price-to-book is less than 1, the price-to-tangible-book is awfully close to 1. Even if you don’t know what car dealerships normally trade at – you know that looks like a cheap stock.


FirstGroup (another U.K. stock) doesn’t have a P/E or P/B that would knock your socks off (P/E is 7 or 9 depending on whether you’re “adjusting” EPS or not, book value’s negative) but it has an EV/EBITDA that would grab your attention (it’s 3). I can’t sit here and tell you to focus only on stocks that seem likely to have strong market power when you have car dealerships trading around book value and bus companies trading around 3 times EBITDA. You probably want to put stocks that cheap in your research pile too.


The tricky thing is learning enough about a company to know it might have market power. When I read what most investors have to say about a company - it could be Domino's, it could be U.S. Lime, etc. - they have too quick, too knee-jerk a reaction to the business. So, they say "lime's a commodity" I don't buy commodity stocks. Or, you know Domino's is just some restaurant stock with a ton of competition. But, using Domino's as an example, profit persistence in restaurants is actually really high. People will convince themselves that patents are a moat for some tech company, but they often don't have as consistently good returns on capital as a restaurant. Obviously, restaurants are just the same local, microeconomic "box" replicated thousands of times across the country. So, it's obvious why things like restaurants or supermarkets should have pretty similar economics for a long time. It's the same concept repeated over and over again. If it's a bad concept at the individual location level it'll be a bad company long-term, but if it's a good concept at the individual location level it'll be a good company.


Of course, GuruFocus can show you things about "predictability" as a screen. I think those are fine. But, that's not really how I get ideas. For example, I own BWX Technologies, Frost, and NACCO. GuruFocus rates those either "Not Rated" or 1-star on predictability. So, I am going totally against a statistical measure of a predictable business. Likewise, U.S. Lime is rated 1-star. 


So, here I am saying I like predictable businesses – and yet I own only stocks GuruFocus says are not predictable. Obviously, there’s a “market power” analysis going on there. I read about the companies and liked something I read enough to feel I could disagree with an automated assessment of their past record’s predictability.


If we’re just talking about assessing market power by reading the 10-K, something like U.S. Lime would be at the top of my research list.


So, let’s look at the issues you can still face investing in a business that seems – from reading the 10-K – to have market power.


Growth is really low at U.S. Lime and they are piling up cash. So, the longer you own it the more potentially you could have real capital allocation problems. It's better if you can find a business with market power like U.S. Lime and then buy it when there's a change in capital allocation. Buffett does that a lot. Like, he bought into Coca-Cola when it changed its capital allocation policies, he encouraged Washington Post to change its capital allocations policies while he owned it, and then he bought General Dynamics when it changed its capital allocation policies. He does this even with failures like his investment in IBM. He liked that they were reducing share count.


I think companies with market power are great. But, you always have to connect it with the idea of capital allocation.


Remember two things:


1) It doesn't matter what a company is worth when you buy it - it matters what it's worth when you sell it

2) It doesn't matter what the return on capital put into the business before you bought it was - it matters what the return on capital put back into the business while you own it is


So, honestly, if U.S. Lime said "We're going to target a Net Debt/EBITDA level of 2 at all times and we're going to use all free cash flow beyond keeping leverage at that level to just buy back stock" - I'd feel totally differently about the stock. If they put out that statement, U.S. Lime would suddenly vault to the top of my investment candidates list.


There are only two reasons why something like U.S. Lime got as low an interest level as 50% from me in that write-up I did (meaning I see only a 50/50 chance I’ll analyze the stock further). One, the stock is reasonably priced - but it's not especially cheap for an "average" business. I think the business is more predictable, durable, better, etc. than an average business. But, it's always nice to buy an above average business at a below average multiple. That's not the case with USLM. It's a normal price for a hopefully better than normal business. And then two - and this is the huge one - what's capital allocation going to be?


I mean, say they buy another lime site. Okay. That's fine, I like the industry. But, what is the seller going to get? A lot. The seller of a lime deposit gets a lot of the value. So, the return on investment (the acquisition) isn't going to be great. If instead, U.S. Lime said it would use a safe amount of leverage (or just never hold excess cash) and then buy back its shares constantly - I'd be very interested in the stock. My interest level would soar from like 50% to 90%. 


In the stock market, you often run into this problem. There are businesses that - if I could buy 100% of them for the then stock price - I could make a lot of money on, but I can't be a control buyer. This issue often becomes more important when looking at stocks with market power. The biggest issue a business with market power faces is usually how to allocate capital. There are times when a business with market power presents problems because it doesn't have great growth prospects and it isn't allocating capital in a way that'll keep the value compounding fast enough.


The advantage that growth stocks have is that there's someplace obvious to put all the cash flow. Basically, you know what capital allocation is at a growth stock - it's funding the growth. 


So, there's always some doubt in my mind about whether I am getting the best returns by focusing so much on market power. Rolling the dice a little more in terms of accepting the idea I'm investing in something that is facing a lot of competition might work well over a diversified portfolio. 


But, investing in stocks with a lot of market power and with market power you think is getting better not worse is a pretty forgiving way to invest. If you pick the right stock in terms of being right about market power, you can stay in it pretty much indefinitely and get an okay outcome. It can run into financial problems, operational problems, etc. and someone will still want to buy it, turn it around, etc. There will be stuff of real, lasting value there. It's durable. And it's unlikely to earn a below average return on capital for too long. Even the "failures" in stocks like these are often situations where you make 10% a year over a long holding period. You’ll underperform in a bull market doing that. But, if you buy at an acceptable price and you’re right about the durability of market power – you’ll get an acceptable outcome in these kind of investments.


Personally, it's my belief that the greatest risk investors face is competitive risk. It's the risk that the business they invest in will generate lower returns on capital, will have its existence imperiled, etc. simply because of the day-to-day risks of a capitalist system. It's just microeconomic business risk that investors take on in the long-run. This is especially true because you can mostly eliminate price risk by timing (unless you buy a lot of stocks in 1999, 2007, etc. you will dollar cost average into a decent enough stock price) and most macroeconomic risks dissipate over a long enough time horizon. So, the big mistake you can make is being wrong about the future competitive position of the business you invest in.


One way to avoid that is to diversify. If you own 15 stocks instead of 5 stocks, you reduce business risk. The other way to avoid this risk is by being selective in what companies you pick, what industries you invest in, etc. Basically, you can only focus on businesses with "market power". 


How well will that work?


I think it can work really well over a really long time horizon for an individual investor who isn't trying to make a career out of this. If your goal in life is to be 100% invested in stocks that return 10% or better while you own them - I think focusing on just researching stocks with market power and then trying to buy them when they get to a reasonable price is a good strategy.


Do I think it'll work in a bull market? I don't know that you'll beat the S&P 500 in bull markets focusing exclusively on stocks with market power. You just won't end up with a lot of high growth stocks this way and high growth stocks tend to get popular at some stage in a bull market.


And then: for professional money managers - is a market power first approach best?


I have my doubts about that. Extremely cheap, somewhat troubled businesses might be a better bet. You'll have more complete losses, but you have more upside than you would sticking to high market power stocks. There are always some micro cap stocks, special situations, and distressed or “deep value” situations out there that are probably going to offer better returns. Professionals might be better off fishing in those ponds than the high market power pond.


Obviously, the real money is always made by finding things that are really one way and yet the market thinks it's another. So, it's about finding a stock with market power that most investors believe doesn't have market power. 


There's no money to be made betting on Coke's moat today. You want to find things that are small, obscure, in weird industries, etc. and yet have a moat. 


Finally, I've found that holding stocks with market power has the nice advantage that things in your portfolio get acquired. They get taken private. Everyone is always focused on when the market will recognize some company they believe in. But, if you buy something with market power it'll get taken private if it stays too cheap for too long. As an example, I owned IMS Health and it went private, combined with other companies, etc. and is now a public, very expensive stock again. I've found that businesses with real market power attract a lot of interest from competitors, control buyers, etc. who are willing to look beyond the stock as a piece of paper and commit to holding it for several years. 


There are other approaches to investing that work too long-term. Like, if you invest in a great "jockey" in an industry you know is really good - even if the company isn't that impressive, that can work too. So far: I haven’t been smart enough to pull that one off.


Picking the right industry is important though.


Honestly, I'd say it's maybe 50/50 at most between the company's position in the industry and just the industry. Value investors tend to think in terms of "competitive advantage". So, they are looking for an advantaged company instead of an advantaged industry. It might be smarter to first look for an advantaged industry. I don't really like the term “competitive advantage”. I mean, I'm sure if you pick the exact right competitively advantaged steel maker and track its stock price along with the exact wrong ad agency, the ad agency will underperform. Airlines have been a bad business. Southwest (LUV) has been a good stock. There's a lot of stories like that.


But, I feel more comfortable fishing in ponds like: ad agencies, MRO distributors, and U.S. banks. I think knowing to focus on those industries instead of semiconductors, insurance, and steelmaking gets you more than half of the way to making a good investment.


So, I guess that's a big part of what I mean when I say "market power". That connects with what you said about the "economic ecosystem". I think probably more than 50% of my task as an investor is just picking the right industries, the right niches, etc. even before I pick a specific company in that niche.


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

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

by Geoff Gannon

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

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


At the Risk of Sounding Heartless…

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

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

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

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

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

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


The Competition Section

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

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


The Standard Passage – High Competition Industries

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

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

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

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

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


The Altered Passage – Lower Competition Industries

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


BWX Technologies (BWXT)

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

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


U.S. Lime (USLM)

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

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

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

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

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

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

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

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

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


Fair Isaac (FICO)

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

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

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


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

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

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

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

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

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

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

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

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


Landauer (LDR) – Recently Acquired

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

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

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

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


Omnicom (OMC)

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

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

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

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


Interpublic (IPG)

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

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


Tandy Leather Factory (TLF)

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

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

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


Breeze-Eastern (BZC) – Recently Acquired

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

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

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

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

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

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

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

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

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

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

Being (Conservatively) Roughly Right

by Geoff Gannon

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

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

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

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


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

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

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

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

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

2013: 61.1 million

2014: 63.0 million

2015: 63.5 million

2016: 63.0 million

2017: 64.7 million

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

2012: 262.0 million

2013: 257.6 million

2014: 246.7 million

2015: 239.7 million

2016: 234.7 million

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

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

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

Here is the email in full:

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

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

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

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

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


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

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

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

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

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

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

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

How do you discount for this kind of timing issue?

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

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

But, how much less?

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

This is what I mean about being roughly right.

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

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

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

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

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

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

What about the charge-off rate assumption itself?

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

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

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

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

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

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

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

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

Is that accurate?


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

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

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

Mistakes of Omission and Failures of Imagination

by Geoff Gannon

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


DreamWorks Animation

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

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

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

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

The key passage in that article is:

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

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

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

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


Weight Watchers (WTW)

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

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

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

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

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

Weight Watchers may be fairly valued.

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

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

Of course, leverage works both ways.”

The stock has since zoomed past $63 a share.

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


Failures of Imagination

I was having two conversations recently where this came up.

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

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

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

1921 – 1929: Stocks get more expensive

1929 – 1942: Stocks get cheaper

1942 - 1965: Stocks get more expensive

1965 - 1982: Stocks get cheaper

1982 - 1999: Stocks get more expensive

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Housekeeping: 7 Questions I Get Asked a Lot

by Geoff Gannon

Why Didn’t I Know You Were Doing “X”?

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


Why Didn’t You Respond to my Comment?

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


Where Can You Find My Old Articles?

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


Can I Subscribe to the Podcast?

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


Is a Focused Compounding Subscription Worth It?

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


Can I Write For Focused Compounding?

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


Do You Manage Money?

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

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

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

by Geoff Gannon

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

Here’s the key quote:

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

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

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

Episode #2: NIC (EGOV)

by Geoff Gannon

Listen to the Focused Compounding Podcast

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Listen to the Focused Compounding Podcast

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

by Geoff Gannon

Listen to Geoff’s Podcast

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

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

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

Those are the two things I’d recommend doing.

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

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

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

Listen to Geoff’s Podcast

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

by Geoff Gannon

Listen to the Focused Compounding Podcast


Questions Asked and Answered

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

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

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

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


Listen to the Focused Compounding Podcast

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

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

2:30 – Geoff’s Twitter is @GeoffGannon

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Listen to the Focused Compounding Podcast

My Return to Podcasting

by Geoff Gannon

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

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

Listen to the Focused Compounding Podcast