Revisiting the Stock Reports at Focused Compounding: Ark Restaurants (ARKR), BWX Technologies (BWXT), and Bank of Hawaii (BOH)

by Geoff Gannon


When someone joins Focused Compounding – use the promo code “BLOG” to save $10 a month – they get immediate access to the Singular Diligence archives. These are found in the “Stocks A-Z” section of Focused Compounding where we alphabetically list every stock write-up on the site. While there are plenty of write-ups on the site not written by me – and plenty of write-ups I’ve done for Focused Compounding that aren’t as long as the Singular Diligence reports – there are enough stock ideas in the Singular Diligence archives that I thought I’d spend a whole blog post just quickly re-visiting every report in there.

Each report is over 10,000 words.

There’s a bunch of past financial data at the front of each report.

And then there’s an “appraisal price” at the back of each report.

Some reports also include a “notes” section which includes quotes, data, and sources I used in writing the report but were too detailed to include in the report itself.

So, here are the stocks we have full reports on at Focused Compounding. Since we order them alphabetically on the site, I’ll order them alphabetically here too.

To keep these posts short enough – I’m just going to do revisit 3 stocks per day.

Come back tomorrow for another 3 stocks.

 

Ark Restaurants (ARKR)

Written up at: $22.20 a share

Now trades at: $23.13 a share

How I originally described it: “Ark Restaurants operates mostly very large restaurants in mostly landmark locations.”

A lot has changed at Ark Restaurants since I wrote it up. The company is a partner in the Meadowlands racetrack (a quarter horse race track in Northern New Jersey) and would have nearly exclusive rights to any food and beverage at a planned casino there. I say “nearly”, because another partner in the racetrack is Hard Rock and Hard Rock has the rights to put in a Hard Rock restaurant there. This is the “lottery ticket” portion of Ark I wrote about in the report. Allowing casino gambling outside of Atlantic City (where it’s long been legal) was put on the ballot in New Jersey. The measure failed. Sports betting became legal. Ark’s interest in the Meadowlands racetrack remains a “lottery ticket”. The company owns about 10% of the equity in that project – though this might be watered down by future dilutions if any project really did materialize. Casino gambling can be put back on the ballot in New Jersey again (just not immediately). I have no idea if it’d ever pass. The value in 10% ownership plus the food and drink concession would be huge for such a small company. But, a Meadowlands casino project remains 100% a lottery ticket – and not something any investor should count on. The company has also shifted its strategy by buying more restaurants outright. Previously, it had only long-term leases. The balance sheet of the company now looks different because it takes debt directly on to the balance sheet and also takes the land on to the balance sheet. Some of the locations the company has bought are pretty valuable. Overall, the stock continues to plod along as generally a pretty safe dividend paying stock with extremely limited growth prospects. I recommend researching this stock if you don’t know it, because there are very few public companies out there that operate non-chain restaurants. It’s an interesting business model to study. Though – as you can see in the stock’s long-term compounding record for the last 25 years or so – it’s not been an especially lucrative one.

What I originally concluded: “it is appropriate to value Ark as a high dividend yield stock. The company should be capable of paying $2 a share in dividends in the future. In normal times, a 6% dividend yield is considered high. That would value Ark at $33 a share.

That certainly hasn’t happened yet. Ark only pays a $1 dividend and only trades for $23 a share. This gives it a dividend yield of 4.3%.  Since I wrote that report, Atlantic City has certainly gotten worse. Some things have changed at the company – like the referendum failing and sports betting becoming legal – but, overall I’d say the stock is both similarly priced and similarly attractive now as when I wrote the report. For the most part, you can read that report and then read the most recent earnings call transcript, 10-K, etc. update some figures and come to your own conclusion about Ark. There hasn’t been a ton of change in either the stock price or business value here. This is still a stock idea it’s fine to research today.

 

Babcock & Wilcox – Now BWX Technologies (BWXT) and B&W Enterprises (BW)

How I originally described it: “The single most important line of business for Babcock…is providing critical nuclear components for nuclear powered military ships…Babcock is completely dependent on the U.S. Navy as its sole customer in this business…(and) the U.S. Navy is completely dependent on Babcock as its sole supplier.”

This is a rare case where I actually bought the stock I wrote about. There’s no reason to do the “written up at” and “now trading at” for this one. The BWXT half surged in value. The BW half plunged to almost nothing. I sold my BW shares and kept my BWXT shares. I also wrote up the BW – “bad Babcock” – half for Focused Compounding. In that write-up, I said I was not interested in the stock at all because it was far too risky. That turned out to be a good choice because the stock fell a lot further.

Should you read this report? To learn about the BWXT side, sure. BWX Technologies does a few things. The most important thing it does is build all of the U.S. Navy’s nuclear reactors for submarines and aircraft carriers. BWXT has long had a monopoly on that. And it has a monopoly, or oligopoly – as part of various consortiums bidding for government work – on just about everything else related to the U.S. government’s use of nuclear power and nuclear weapons. For example, BWXT does all the down blending of U.S. weapons grade uranium into uranium that can be used for other purposes. Since I wrote about the stock, two things have happened. One, BWX Technologies acquired a medical isotopes business called “Nordion”. Here’s a quote from the press release announcing the deal:

“Nordion’s medical radioisotopes business is a leading global manufacturer and supplier of critical medical isotopes and radiopharmaceuticals for research, diagnostic and therapeutic uses. Its customers include radiopharmaceutical companies, hospitals and radiopharmacies.”

And then the other thing that happened is BWXT was awarded a (very small) NASA contract to do work on nuclear propulsion for manned spaceflight (such as a future mission to Mars). You can find information about BWXT’s work on a mission to Mars here:

“BWX Technologies, Inc. (BWXT) is working with NASA in support of the agency’s Nuclear Thermal Propulsion (NTP) Project. BWXT is responsible for initiating conceptual designs of an NTP reactor in hopes of powering a future manned mission to Mars.

NTP possesses numerous advantages over traditional chemical propulsion systems. With NTP technology’s high-energy density and resulting spacecraft thrust, NASA is projecting up to a 50 percent reduction in interplanetary travel times compared to chemical rockets, significantly increasing the crew's safety by reducing exposure to cosmic radiation.

For this latest interplanetary endeavor, BWXT is drawing upon its extensive space nuclear reactor experience. While previous projects utilized high-enriched uranium, the current NTP Project relies on low-enriched uranium.”

So, how much has Babcock & Wilcox changed since I wrote the report?

Well, a huge amount overall. That’s because the company split off into two parts after I wrote that report. The BW part pursued new (non-coal) projects like waste-to-energy in a big way. It had disastrous losses on those engineering projects which may eventually bankrupt the company. Meanwhile, the market quickly valued BWXT – the Navy nuclear reactor business – like some sort of ultra-predictable high ROE, high growth blue-chip type company. BWXT is now pretty expensive. But, I would recommend reading the report to learn about BWXT – because, I believe it has the widest moat of any business I’ve ever seen. I would not recommend paying any attention to the power / coal – BW – part of the business. As soon as it was spun-off, it embraced a really risky strategy of straying from its circle of competence (which is an ultra-risky move for an engineering company) and is not a safe enough stock for investors to even consider right now.

What I originally concluded: “Once the nuclear operations unit is split from the power generation business, it will suddenly be seen as one of the most predictable stocks around.”

That happened. BWXT is still the widest moat business I know. Everyone reading this should learn about the company. You should read the 10-K, the investor presentations, etc. But, should you buy the stock today? It’s not cheap. But, it might be cheap one day in the future. Research it now. Remember it for later.

 

Bank of Hawaii (BOH)

Written up at: $73.99

Now Trades at: $75.57

How I originally described it: “Bank of Hawaii is the second largest bank in the island state of Hawaii...From 1994 through 2015, Bank of Hawaii’s deposit share in that state ranged from 27% to 32% ….Hawaii’s banking industry is much more consolidated than the banking industry in other U.S. states.”

Finally, an immediately “actionable idea”. You can buy this stock today if you want. Bank of Hawaii is one of my favorite bank stocks in the sense that it has one of the two best deposit bases – outside of the giant U.S. banks like Wells Fargo (WFC) – I’ve ever seen. The two regional (really one-state) banks I recommend every investor should learn about are Frost (CFR) in Texas and Bank of Hawaii in Hawaii. These banks always have cheap, sticky, and stable deposits. They have really, really low costs of funding. Part of this is because they have really, really high deposits per branch (so, expenses relative to deposits can be low) and the other part is that they have a lot of deposits – from business customers who are also often borrowers from the bank – who aren’t paid much in interest to keep money at the bank. The interesting thing about BOH and Frost is that things on the deposit side change very, very little over time. But, the stocks bounce all over the place because of the asset / yield side (loan demand, interest rates, etc.). Bank of Hawaii is much more growth constrained by its state than Frost is. So, I like Frost’s odds of compounding intrinsic value per share at a nice rate over a decade or something better than BOH.

But, BOH has a weapon that Frost doesn’t use. BOH buys back its own stock. So, if BOH stock gets cheap and stays cheap for a while when bank stocks are out of favor, you – as a new BOH investor – can get a double boost from the stock coming back into favor and EPS growth coming from cheap share buybacks. Bank of Hawaii stock is down 15% this year. Now is a great time to look at banks – they can be BOH, Frost, or some of the others I’ll write about in the week ahead – because stocks in general are down for economic reasons that aren’t bad for banks. Higher interest rates and higher inflation and things like that are truly bad for some U.S. companies. They’re not bad for banks that have a lot of deposits they pay very, very little on and yet haven’t been able to put to good use on the asset side. I don’t spend a lot of time thinking about big stocks like BOH and Frost. But, if I was looking for big stocks to buy – this month, I’d be looking at U.S. banks. And BOH would be very close to the top for me. This is never a very exciting looking bank stock in terms of upside. But, this is the kind of bank stock I think you should own if you can get in at a decent price. As I write this, the dividend yield on BOH and the 30-year Treasury yield are both about 3.3%. When that happens, you should seriously consider BOH. The coupon on that 30-year is never going to go up no matter what happens with inflation. The cash available to pay out as dividends will go up a little in most years at BOH. And the number of shares outstanding will go down every year. So, that dividend per share is going to grow. You’re getting a 3.3% dividend yield that’ll grow over time. This is a stock where you can go out and read the 10-K, investor presentation, etc. (or my report on the company at Focused Compounding) right now. Put this one on the watch list. I makes little sense for a stock like this to be dragged down in any of the recent market wide volatility we’ve seen. So, down days for the market are good days to look at buying BOH for the long-term.

What I originally concluded: “It’s possible to come up with a scenario where BOH stock returns as little as 7% a year over the next 5 years. It’s also possible to come up with a scenario where BOH stock returns as much as 14% a year over the next 5 years.”

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How Much is Too Much to Pay for a Great Business?

by Geoff Gannon


(FULL ARTICLE AT FOCUSED COMPOUNDING)

 

A Focused Compounding member sent me this email:

 

“I've just become a FC member and I've been listening to the very interesting podcasts from day one. Really enjoying them. Those have convinced me to purchase a membership of 1 year (for now).

 

I have a question that has been spinning my head for a while now.

 

Everybody is looking for this gem of a company with a sustainable competitive advantage and consequently… a high sustainable ROIC or ROIIC.

 

But when you invest in a company at 2 times invested capital doesn't that hurt your compounding effect big time in the long term (ROIC of 20% becomes 10%?)? Or am I pursuing the wrong train of thought here?”

 

Yes, it does hurt your compounding. But, paying more than you normally would – in terms of price-to-book – for a great business may not hurt your long-term compounding quite as much as you think. However, there’s a tendency for investors to focus more on how high the company’s return on capital, growth rate, etc. is right now instead of how long those high rates of return on capital, of sales and EPS growth, etc. can last. What matters a lot – as I’ll show using numbers in a minute – is how long you own a stock and how long it keeps up its above average compounding.

 

Think of it this way. If you buy the stock market as a whole, it tends to return about 10% a year. A great business might be able to compound at 20% a year. So, how much more can you pay for a great business than you would pay for the S&P 500? It might seem the simple answer is that you can pay twice as much for a great business. However, that’s only true if you’re planning to sell the stock in a year. That’s because 20% / 2 = 10%. So, paying 2 times book value gets you the same return right out of the gate in a great business as what you’d have in the S&P 500.

 

When value investors like Warren Buffett, Charlie Munger, and Phi Fisher talk about how it’s fine to pay up for great, durable businesses – they mean if you intend to be a long-term shareholder and if the company continues to compound at high rates far into the future. This makes all the difference in what kind of price-to-book value you can afford to pay.

 

To figure out how much more you can pay for a great business and still beat the market, you can actually just sit down and work out the math.

 

Here's what matters...

 

* Price / Asset (equity, invested capital, etc.)

 

* Amount of earnings reinvested in the business

 

* Return on that reinvestment

 

Over shorter holding periods in stocks reinvesting less of their earnings each year – the price you pay matters more.

 

Over longer holding periods where the stock is reinvesting almost all of their earnings each year – the return on reinvestment matters more.

 

A company's maximum growth rate tends to be set by its return on capital. Of course, they could issue stocks, borrow money, etc. for a time. But, in the long-run the only way a company can really have high EPS growth is by having a high enough return on capital. Otherwise, it wouldn't produce enough earnings to grow by that much each year. The easiest way for a company to compound at a high rate for a long time is simply to produce enough cash to fund its own high growth rate.

 

Okay. So, a company with a high rate of return and a lot of opportunity to grow is the kind of business you can afford to pay a higher multiple of book value for. From now on, let’s talk in terms of rate of compounding instead of just return on capital.

 

So, let’s pretend we’ve found a company with a high compounding rate. Now, we want to figure out what multiple of book value we can afford to pay for this company.

 

Say a stock compounds book value by 20% per year for 20 years (this is equivalent to having a 20% after-tax return on capital and always reinvesting 100% of the earnings back into the business). And let’s say you hold this stock for 20 years.

 

How much does it matter how much you paid?

 

If you pay 1x book value you make 20% a year for 20 years.

 

If you pay 2x book value you make 16% a year for 20 years.

 

If you pay 3x book value you make 14% a year for 20 years.

 

If you pay 4x book value you make 12% a year for 20 years.

 

If you pay 5x book value you make 11% a year for 20 years.

 

If you pay 6x book value you make 10% a year for 20 years.

 

This is what you make for holding a stock for 20 years – not what you make for “flipping” the stock by buying at a lower price-to-book today than it will trade at in the future. In other words, I assumed the same exit price – in terms of price-to-book – for all of those 6 scenarios (you always sell at one times book value).

 

So, thinking purely as a long-term shareholder, if you pay a bargain price (1x book value) for a great company with a really long period of growth ahead of it – you can make much, much more than the stock market overall.

 

But, even if you pay 6 times more for that great business with a really long period of growth ahead of it – you can still do about as well as the stock market overall.

 

So, truly long-term growth investors aren't wrong. If you find Southwest Airlines or Wal-Mart in the 1970s or Amazon in the 1990s or 2000s it will pay off – if you hold the stock long enough.

 

A really simple way to think of it is this:

 

The SHORTER your holding period in a stock, the more important the PRICE YOU BUY AT (P/E, P/B, etc.) and the PRICE YOU SELL AT (P/E, P/B, etc.)

 

The LONGER your holding period in a stock, the more important the RETURN ON CAPITAL / GROWTH RATE of the company you've invested in.

 

Basically, value investing works AND growth investing works. Buying and selling value stocks –  paying a lower P/E, P/B etc. and then selling at a higher P/E, P/B, etc. works. 

 

And HOLDING good, growing businesses also works. 

 

One of the best ways to think about this is to remember this formula.

 

Your "hold" return in a stock is:

 

Free Cash Flow Yield (that’s Free Cash Flow / Market Cap) + Growth = “Hold Return”

 

So, if you buy a stock that pays you out a 4% dividend and is growing at 6% a year – then, you can make 10% a year for as long as you own the stock without having to sell at a higher P/E, P/B, etc. than you bought at.

 

But, then you have the "trade" return in the stock.

 

So, let's say you buy a stock – like a net-net – that doesn't grow. Say the stock trades at 0.6 times NCAV. You'd make 19% over a 3-year holding period even if the stock didn't grow. You'd make 11% a year if you had to hold the stock for 5 years. So, because the “trade return” on a net-net is so higher (greater than 10% a year over more than 5 years, if you buy in at a greater than 40% discount), you can afford to hold a non-growing net-net for a long time and still match the market or even beat it.

 

However, good investments usually combine both aspects. A decent hold return or a decent trade return combined with a really good form of the other kind of return.

 

In other words, great investments are often “growth businesses” bought at “value stock” prices and then sold at “growth stock” prices.

 

For example, let's say I buy a stock with a 15% free cash flow yield and 3% growth. I make 18% a year while I hold it. But, then, say the stock doubles its FCF multiple (so the FCF yield drops to 7.5%) by the time I sell it in 5 years.

 

In that case, you'd make a return of greater than 30% a year (you have a double-digit return from a good free cash flow yield and a double digit return from buying at a really low Price/FCF multiple and selling at a "normal" one within 5 years).

 

That’s obviously a great situation. Many good long-term investments don’t look that good on the face of them. But, they do combine positive contributions from both the “hold return” and the “trade return”.

 

Let’s look at what can go wrong if you pay too much for a stock.

 

We said you could pay 6 times book value for a stock that compounds book value at 20% a year. You’d do okay. Not great. But, okay. You’d match the market. But, what if it turns out the stock only compounds at 10% a year for 20 years? In that case, you’d only make about 1% a year. So, the extra 10% a year in compounding – between 20 years of compounding at 20% a year and 20 years of compounding at 10% a year – is the difference between having a long-term stock performance that matches the market versus one that is a very bad outcome (a stock that does nothing for two full decades).

 

Now, growth investors may argue I’ve been unfair here. If a business is a really great compounder and it stays a really great compounder – it should trade at a higher multiple of book value even when you sell it. This would make a big difference in your long-term return.

 

For example, let’s say you have a stock that you pay 6 times book value for today. It compounds book value per share at 20% a year for the next 20 years. And then, at the end of those 20 years, it still trades at 20 times book value. In that case, you would – of course – make a 20% annual return.

 

This is the argument that investors often make when projecting out their own long-term returns in a great, growing business. They assume the stock will grow at more like 20% a year rather than the market’s normal return of 10% a year – plus they assume that, because the stock keeps growing at an above average rate, it’ll keep having an above-average price-to-book ratio.

 

There’s a logical problem with this argument. The argument isn’t wrong. It’s right. But, it leaves you with no margin of safety. You think you’re going to make 20% a year for 20 years, because you are paying 6 times book value for a stock that will compound its value at 20% a year and then will still trade at 6 times book value.

 

But, what happens if the stock grows at 10% a year instead of 20% a year?

 

Well, your two defenses here – the two reasons you think you’re going to get a good return in this stock – are that you expect an above-average growth rate and then you expect to exit the stock at an above-average price-to-book ratio because the stock will still have an above-average growth rate. Really, you are projecting both the growth rate that happens while you own the stock and the price at which you exit the stock based on a single projected data point: how fast this stock will grow.

 

All you’re doing is going all in with a bet on the stock’s future growth rate.

 

I talked about the “hold return” you can get in a stock (because it’s a great, growing business) while you own it and the “trade return” you can get when you sell a stock (because you sell it for more than you bought it for).

 

Well, if you assume both a high growth rate in a stock while you own it and a high price-to-book ratio when you sell it (because, it’ll still be a growth stock) – then, you’re really only making one bet. You’re betting the stock will still be growing at an above average rate far into the future. That is sometimes a difficult bet to make. And, if you’re wrong, there’s no protection on the downside. But, if you’re right – then, paying a price-to-book ratio of anywhere up to 6 times book value can make sense – if you’re buying the right business. Overall, though, it’s the durability of this growth that matters more than you’d think. Buying a stock that will compound at 30% a year for the next 4 years is nowhere near as good a deal as buying a stock that will compound at 15% a year for the next 40 years.

 

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How Big Can Amazon Get?

by Geoff Gannon


(FULL ARTICLE AT FOCUSED COMPOUNDING)

Someone emailed me this question:

I’ve been looking at Amazon for a little short of a year and because the equity doesn't provide a good price to value ratio and margin of safety, in my view, I’ve held back from investing so far. 

 

There’s a little brainteaser which involves asking people how much sales, as a percentage of total sales, are done online. The numbers people answered were surprisingly high. Right now they make up 10% of total sales in the U.S. and I’m positive that number won’t stop there.

 

Assuming internet sales grow at 8% for the next 10 years (16% right now) one-fifth of sales will be online (also assuming 4% historical growth rate on U.S. retail sales). It would be a $1.8tn industry, x4 the size of today. Is an 8% growth rate overly optimistic given that as the base grows, percentage growth usually slows? Not looking for exact numbers, just rough measures.

 

Amazon has 50% market-share and I would assume that isn’t sustainable and the market’s perception of a winner-takes-all is exaggerated, many businesses could co-exist. I don’t think this is a Facebook/Google “aggregator” situation in which the viability of a new company competing with them decreases as they get more users and advertisers. The viability surely decreases to some extent but not to the extent that it does for the other two advertising companies, the retail industry is also much bigger.  

 

All in all, bigger but perhaps fewer companies will co-exist in the online space, and when it comes to smaller online commerce firms, they'll perhaps cater more to niches as a European pet food company is doing. However, even a 20% market-share comes out to a huge revenue number when we extrapolate what the internet sales number might be in the future. 

 

Very successful U.S. retailers like Walmart have ~6% market share of total retail sales, that’s significantly higher for specific categories. In terms of online though I would apply a higher than average market share for Amazon because the supply chain is significantly harder to build and optimize (e.g. more nodes) and therefore in my view this increases barriers to entry. My second question is: Do you think this is a fair assumption?

 

Anything I say in this post is not a suggestion to buy Amazon as a stock today. This is because of the price. We’ll get to that at the end of my article. For now, let’s just say that Amazon stock is priced high enough that unless it grows faster than a conservative estimate of how fast internet retail would grow, or it expands into other things (which, of course, it already has), or it pays out dividends, buys back stock, makes good acquisitions, etc. on top of the industry’s growth – your return in the stock could be just so-so. In other words, Amazon keeping its current position in a fast growing online retail industry isn’t going to be enough to get you great returns in the stock. This is because of the starting price of your investment.

 

So, that part of my answer is pessimistic.

 

On the other hand, I think in the very long-term you've underestimated Amazon's likely size. There are several reasons for this. 

 

One, I don't think judging sales nationally by category makes much sense. For example, yes, Wal-Mart may have a certain share of Sporting Goods nationwide or something. But, in reality, Wal-Mart has little presence in certain categories - for example, groceries - in some parts of the country (Northern New Jersey, Southern California, etc.) and yet has a very high share of almost all categories in places like rural Oklahoma. Supermarkets are very, very regional in the U.S. And so national market share is misleading. For example, the financial press often talks about Wal-Mart and Kroger as if they have the strongest position in groceries. In reality, companies like Publix (Florida) and HEB (Texas) probably have the strongest competitive position because they have very high market share in specific states and essentially zero presence anywhere else. In an upcoming podcast (it’ll air next Wednesday), a portfolio manager talked to me and Andrew about why he likes Village Supermarket (VLGEA). Village is a member of the Shop-Rite co-cop (called Wakefern) that has high market share in New Jersey but less presence in surrounding states and no presence in other regions of the country. However, within Village’s home state of New Jersey the Shop-Rite branded co-op has higher market share than Wal-Mart. At least as of a couple years ago, I know there were 4-5 more Shop-Rite stores in New Jersey than there were Wal-Marts that carried fresh food. Kroger has no presence in the state. And the new competition that worries New Jersey supermarket operators the most is from Wegman’s entering the state not from a national chain like Wal-Mart or Whole Foods. Wegman’s started as a New York state supermarket and expanded into adjacent states over time. It is basically in “Mid-Atlantic” states only.

This is a good indication of how misleading market share data can be. Kroger is one of the biggest supermarket companies in the country. New Jersey is the 11th most populous state in the United States, and yet Kroger has 0% market share. Wal-Mart is a leader nationally in food retail. Its market share in New Jersey is not big. There are several regional chains that all sell a lot more food in the state than Wal-Mart does. This, of course, means that Kroger and Wal-Mart have much, much higher market share in food retail in those local markets where they are the #1 or #2 chain. There are good reasons why brick-and-mortar retail breaks down so regionally. There are less good reasons why online retail would break down that way. And while Kroger and Wal-Mart are also-rans in plenty of places around the U.S. in plenty of product categories – there are quite a few cities, counties, and even states where the two chains wouldn’t have a #1 or #2 market share rank – Amazon is a leader in online retail everywhere. It’s not like Amazon is well behind other online retailers in certain states. So, the analog you should use for Amazon’s potential market share is more like Wal-Mart’s market share in general retail in the most rural counties in the U.S., or the market share in groceries of HEB in Texas, Publix in Florida, etc.

 

How big is that market share?

 

It depends on how narrowly you define the regions and the markets. If you define Publix’s market as “traditional” grocery sales (this excludes things like deep discounters) you would get a market share of 55% for the company. That 55% is over its entire trading area. It has greater than 60% market share in some local markets. But, let’s say it’s possible for a company to have 50% market share in something like groceries.

 

HEB operates throughout Texas. But, because Texas consists in large part of 4 metro-areas that don’t really interact that much economically – Houston, Dallas, Austin, and San Antonio are all far enough apart that they are different “regions” of the same state – a retailers market share (like a bank’s market share) will vary tremendously by which metro area you are measuring. HEB’s home market is “South Texas” this includes the Austin and San Antonio markets and goes as far North as Waco (but not Dallas). HEB has 60% market share in South Texas. Wal-Mart is second in South Texas with 27%. No other seller of groceries has a meaningful share of the market in South Texas. So, you have two companies with over 85% of the market and then you have the other 15% of the market in the hands of competitors with 2% or less market share. The best market share data I have for South Texas groceries is…HEB 60%, Wal-Mart 27%, Safeway 2%. Now, companies like Whole Foods operate profitable stores in the area. They just operate a small number of stores that have bigger market share in a very local area. Across the whole region they add up to a low market share.

 

But, this again points to the possibility that you are overestimating the likely fragmentation of online retail. Retail in the U.S. is often fragmented because competitors with the most successful models started in different parts of a state, country, etc. and then slowly grew to the point where they came into contact and competition with each other. For example, HEB started in South Texas and Wal-Mart started in Arkansas. HEB tried to expand into Central Texas early in its history and had problems and focused on South Texas and eventually Northern Mexico as well.

 

What I’m saying is that if competition in online retail is largely a local matter – you’ll get very fragmented market share nationally like you do with retailers in the U.S. But, if online retail makes all of the U.S. market more like a single local market in offline retail – then, it’s entirely possible to have market share breakdowns like: #1) 50% market share, #2) 25% market share, #3) 12% market share, #4) 6% market share…everybody else: 7% market share. And that’s very possible. It may be that the leader in online retail has 50% of U.S. online sales and the top 4 together have 90%. I can think of lots of mature local retail markets where the leader having 50% and the top 4 having 90% is not uncommon. So, it may be that when online retail is fully mature Amazon has 50% market share in the “everything store” category.

 

What we’re talking about here is scale. And a lot of these lists potentially mis-measure the scale that matters. For example, does having 30% market share in one town instead of 10% market share in one town really mean the same thing as going from 5% to 15% market share nationally. When buying Heinz ketchup or Budweiser beer or Kingsford charcoal it might. But, when advertising it certainly doesn’t. You can target ads locally. The fact that some people in New Jersey have heard of Kroger doesn’t help Kroger sell to people in New Jersey. So, concentration at a very local level is useful. Having good density in a state overall – moving a lot of volume of stuff that needs to go through warehouses and trucks and such – also helps. That’s one reason why you have things like the Wakefern co-op and why supermarkets always try to cluster themselves enough. In fact, the reason why some otherwise good concepts have run into trouble is often due to the failure to put enough stores close enough together in the same state. If you don’t do that, you need to rely on someone else to warehouse and move all your stuff.

 

Amazon isn’t at a disadvantage to anyone in delivering this to your front door. So, they have already reached the scale needed to have the ability to move stuff to you quickly and cheaply. Now, they don’t really have the last mile thing down yet. And there are certainly categories where it’s lower cost to buy in-store than online and shipped to your door. Amazon is unlikely to make as much money as PetSmart on dog food if Amazon is shipping it to Prime members and PetSmart is selling it in its stores. But, I can’t think of many categories – I can think of a few, and most are kind of unusual like very high value to weight or very low value to weight – where someone else has an advantage over Amazon in cheaply and quickly getting an item to your door (rather than to a store for pickup).

 

So, we have to think of scale more specifically. What specific kind of concentration are we talking about? And how does it benefit the company?

 

When thinking about market share, scale, etc. it helps to breakdown what kind of concentration you are thinking about. Where does this company have bargaining power? What is the actual corporate function that provides it with profit? Is it having a big share of each customer's wallet, a big share of all purchases in a certain product category, or a big share of sales in a certain region? Wal-Mart is big nationally. But, there are plenty of towns where Wal-Mart is a total non-factor. There aren't places where Amazon is a non-factor. 

 

What business is Amazon most similar to?

 

Definitely not Wal-Mart. Amazon's model is much, much closer to Costco's model. How does Costco's model differ from Wal-Mart's model?

 

Costco does not try to be a leading general retailer in specific towns, counties, states, the nation as a whole, etc. What Costco does is focus on getting a very big share of each customer's wallet. Costco also focuses on achieving low costs for the items it does sell by concentrating its buying power on specific products and therefore being one of the biggest volume purchasers of say "Original" flavor Eggo waffles. It sells these waffles in bulk, offers them in one flavor (Wal-Mart might offer five different flavors of that same product) and thereby gets its customer the lowest price. 

 

There's two functions that Costco performs where it might be creating value, gaining a competitive advantage, etc. One is supply side. Costco may get lower costs for the limited selection it offers. In some things it does. In others, it doesn't. The toughest category for Costco to compete in is in fresh food. I shop at Costco and at other supermarkets in the area. The very large format supermarkets built by companies like HEB (here in Texas) can certainly match or beat Costco, Wal-Mart, and Amazon (online and via Whole Foods stores) when it comes to quality, selection, and price for certain fresh items. But, what can Costco do that HEB can't? It can have greater product breadth (offering lots of non-food items) and it can make far, far, far more profit per customer.

 

Let's look at that metric.

 

So, a big mistake that investors make when looking at things like retailers, restaurants, movie theaters, etc. is that they think about the product being sold and never about the customer. Often, investors don't know what the customer economics are for a supermarket, Costco, Amazon, etc.

 

This is dumb.

 

It's like knowing what the net interest margin is for a bank, but not thinking about how likely a customer is to keep their deposits with the bank long-term, add to it each year, make use of all sorts of different financial services, etc. Companies know a lot about customer economics and think a lot about customer economics. Investors don't.

 

Amazon's big, big, big advantage - this is the key to its long-term future - is the company's customer economics. It's completely different than offline retailers. But, first let's give an example of how customer economics might work. 

 

Investors think about supermarkets in terms of total sales and prices in store as if people are checking the price of bananas at Wal-Mart and Kroger and deciding to buy most of their shopping list this week at Kroger but then going across the street to Wal-Mart to buy the super cheap bananas they're being offered this week. That's not how actual shopping works.

 

Supermarket customers in the U.S. might do something like this:

 

- Spend $50 per shopping trip

- Make 2 shopping trips to their primary supermarket each week

 

And supermarket product economics might work like this

 

- 25% gross margin

 

And customer economics might work like this

 

- 75% annual retention rate

 

These are estimates. There are stores where gross margin might be 35%, there are stores (who sell fuel, etc.) where gross margin might be 20%. There are times when customer retention rate might be 50% and other where it might be 75%.

 

But, this is a pretty good estimate. Now, when we think about a retailer we can think in terms of the lifetime value of a customer rather than the annual results of a store. This is a much more sensible approach. After all, when you are buying into a retail stock - you are getting millions of existing customers with your stock purchase. This is totally different than buying 200 supermarkets around the country that are opening their doors for the first time this week. There's no customer base there yet. But, if the stores are run right, in about 5 years they'll be much more valuable because they will have built up a loyal customer base. It's this loyal customer base that creates much of the value in any retail stock you're buying into as an investor.

 

So, $50 a visit times 2 visits equals $100 times 52 weeks equals $5,200 in annual revenue. Let's round that down to $5,000 a year. So, a loyal supermarket customer might be a household spending $5,000 a year at the local supermarket of choice. The gross profit from that household will be 25% of $5,000. That's $1,250 a year. Note that there are 12 months in a year. So, even if we round this down to $1,200 – a loyal supermarket customer is actually equivalent to a subscription business where the subscriber pays $100 a month.

 

Imagine that Netflix charged $100 a month for its service. That's the kind of economics you get with a loyal supermarket customer. Note this is only true up to the point where the store becomes crowded. It's not unusual for a company with 25% gross margins to have 21% to 23% SG&A costs. This leaves operating margins in the 2% to 4% range. And it may make the economics of supermarket customers very different than the economics of a Netflix subscriber. SG&A costs at a store can be high. And there are certain unavoidable costs that work like overhead cost absorption.

 

Basically, a low volume store ends up having a greater labor cost component in everything from cashiers to stockers per order because they need a certain base level of service regardless of volume. For reasons I discussed in my Singular Diligence write-up of Village Supermarket (VLGEA) – you can read that report and two dozen other reports like it by becoming a Focused Compounding member – a bigger store with higher inventory turns and simply greater "busyness" has all sorts of wonderful things going for it on cost, quality, etc. It's an example of a "flywheel" type business. Basically, a supermarket location that is getting more and more crowded has store economics that are spiraling upwards. It can lower total costs, increase freshness of the product, increase the store size through additions to the store. It can - over the years - lower prices, increase quality, and increase selection. Meanwhile, a supermarket location that is getting less and less crowded is in a downward death spiral. It's not just that costs can get higher. The supermarket may end up with slower moving inventory, need to cut back on employee hours, it'll start skimping on investment in the store - it won't just became economically an inferior site for the owner. It'll become less appealing to shoppers too. So, in brick and mortar retail things like return on capital for a supermarket are highly tied to store economics. You'd be surprised at how much better the economics of small, established supermarkets in great locations are versus the biggest chains in the nation. It is not true that Wal-Mart and Kroger have the best economics in the supermarket industry. There are smaller operators with better economics and there always have been. So, nationwide scale is not what drives the best returns on capital in the supermarket business. Maybe it's customer economics. Let's return to that now.

 

So, we said a household that's a loyal shopper at a supermarket might bring in $5,000 in revenue per year and $1,200 in gross profit. This is equivalent to $100 a month in gross profit. But, it might be as low as $8 to $16 per month per loyal customer in EBIT (this is 2% to 4% of the roughly $400 in sales per household per month). In the U.S., there are often both state and federal income taxes. For brick and mortar retailers - the tax code is pretty tough. Companies like Google aggressively avoid taxes. This isn't possible with a chain of supermarkets. You have to pay taxes to both the U.S. government and to the state governments where you have stores. The result is probably like a 25% tax rate. So, $100 in gross profits becomes like $8 to $16 in pre-tax income which becomes $6 to $12 per customer per month in after-tax profit. In reality, a MARGINAL customer can add much, much, MUCH more value to a supermarket than $6 to $12 a month after-tax. Most supermarkets are nowhere near 100% full. And they will operate below breakeven if they are pretty empty. Also, new supermarket locations will lose money at first. They might have negative cash flow for a year or two and not payback the original investment till 3-5 years down the road (and this is in the case of a successful supermarket opening).

 

But, let's pretend that the economics of a supermarket are this simple…

 

Each loyal customer adds:

 

$400 a month in revenue

$100 a month in gross profit

$16 a month in EBIT

AND
$12 a month in after-tax profit / free cash flow / "owner earnings"

 

Basically, shareholders get:

 

Size of Customer Base * $12 = Monthly Free Cash Flow

 

Or in annual terms:

 

Size of Customer Base * $144 ($12 * 12 months = $144/year) = Annual Free Cash Flow 

 

So, we'd assume that a company will make about $150 a year per customer. A company with 10 million customers should make about $1.5 billion a year after-tax (going forward, the tax cut wasn't in effect last year so all U.S. supermarkets paid much higher taxes last year than they will this year). 

 

So, if a supermarket chain has a loyal base of 10 million shopping households (about 8% market share; 10 million customers / 126 million households in the U.S. equals 0.08) it should make something like $1.5 billion a year in "owner earnings" free cash flow, etc. In reality, this would be hard to check because these companies tend to use debt. And some own stores and use debt while others lease stores (instead of using debt). But, we can try to check these numbers roughly against a supermarket that has around 8% market share in the U.S. The closest company to having 8% market share of U.S. groceries is Kroger. It probably has like 7% market share or so.

 

So, let's check Kroger's numbers against our estimates. This is what a company with 10 million customers (8% market share) should theoretically look like based on our per customer model:

 

Revenue: $50 billion

Gross Profit: $12.5 billion

EBIT: $1.9 billion

After-Tax Earnings: $1.4 billion

 

What does Kroger really have?

 

Revenue: $100 billion (supermarket sales only - excludes fuel)

Gross Profit: $27 billion (does NOT exclude fuel)

EBIT: $2 billion

After-Tax Earnings: No meaningful figure (but, if taxed at 25% it would have been $1.5 billion).

 

In other words, our per customer economics and Kroger’s actual after-tax earnings for this year match up. Items further up the income statement don’t.

 

So, if Kroger had 10 million customers last year each customer would contribute

 

Revenue per customer: $10,000

Gross profit per customer: $1,250

EBIT per customer: $190

Earnings per customer: $150 

 

I've found estimates that an average family of 2 (which is almost certainly smaller than the median household size shopping at Kroger, because the median household size in the U.S. is about 2.6 people and I’d assume supermarket customers are on average bigger households than overall U.S. households because single people are the least likely to shop at a supermarket) spends around $5,000 a year on groceries. However, supermarkets - like Kroger - often get 1 to 2 times more revenue from "non-grocery" items than from grocery items. So, if a household spends $5,000 on groceries it may actually spend $10,000 a year at its favorite supermarket. So, again, our per customer model is within the realm of possibility. We might be off by 20% either way. We’re not off by 100%.

 

Okay. Let's just use after-tax earnings of $150 per customer as our estimate. How much is a present day customer worth to a supermarket?

 

Let’s look at what an “owner earnings” stream would look like for a supermarket. What is one household using this supermarket as its primary shopping destination worth to the owners of the supermarket?

 

This is how much the owners would make from that customer each year.

 

At a 50% retention rate

 

Year 0: $150

Year 1: $75

Year 2: $38

Year 3: $19

Year 4: $9

Year 5: $5

 

At a 75% retention rate

 

Year 0: $150

Year 1: $113

Year 2: $84

Year 3: $63

Year 4: $47

Year 5: $36

 

Now, your question was about Amazon. And I want to move the discussion a little closer to Amazon - and further away from supermarkets. But first we need to discuss stock market value. How much value in the stock market does a company have per customer?

 

A company like Kroger - so, a fairly normal U.S. public company – where the market is kind of indifferent to its future prospects will likely be valued at about 15 times after-tax profit / free cash flow etc.

 

So, the market value per present day customer this implies is:

 

Year 0: $150 * 15 multiple = $2,250

 

That may seem like a very strange way of looking at it. But, I want to stress just how highly the market values a supermarket customer. Basically, the "market value" of a supermarket customer is greater than $2,000. That may not be how supermarket shareholders are thinking. Cable investors often think in terms of EV/Subscriber. Supermarket investors may not. But, they’re basically paying more than $2,000 per household shopping at that supermarket when they buy into that stock.

 

Now, an interesting question to ask is what SHOULD determine the market value per customer. Not what does. But, what should? In other words, if we had to do a really, really long-term discounted cash flow calculation – what variables would matter most?

 

If two companies both have 10 million customers which company should be valued higher and why?

 

Two variables matter

 

One: Annual profit per customer

Two: Retention rate 

 

Basically, we're talking about a DCF here. If Company A and Company B both have 10 million customers and both make $150 per customer the company that should have a higher earnings multiple (P/E or P/FCF) should be the one with the higher retention rate.

 

And now we can talk Costco. 

 

Do you want to guess what Costco's retention rate is?

 

Costco's 10-K says:

 

"Our member renewal rate was 90% in the U.S. and Canada and 87% on a worldwide basis in 2017. The majority of members renew within six months following their renewal date. Therefore, our renewal rate is a trailing calculation that captures renewals during the period seven to eighteen months prior to the reporting date."

 

What this means is that if we assume a 90% renewal rate that will be an over-estimate of Costco's true retention rate. Their attrition rate is really greater than 10% a year. But, I'll simplify by assuming it's 10% a year. Now, let's look at what a company with the same exact customer economics I laid out before for supermarkets would look like if it had a customer retention rate like Costco's (90%).

 

Year 0: $150

Year 1: $135

Year 2: $122

Year 3: $109

Year 4: $98

Year 5: $89

 

Costco's earnings stream per customer looks very, very different from our theoretical supermarket example. In fact, a present day Costco customer is likely to be continuing to provide the same amount of FCF to Costco 13 years from now as a customer is likely to be providing a supermarket with a 75% retention rate in just 5 years. It's a totally different business.

 

Costco's customers are more loyal than your average supermarket customers. Therefore, Costco should be worth much, much more PER CUSTOMER than other stocks.

 

TO READ THE SECOND HALF OF THIS ARTICLE, BECOME A FOCUSED COMPOUNDING MEMBER: Use the promo code “BLOG” to take $10 a month off your membership.

 

To learn about our managed accounts, email Andrew at info@focusedcompounding.com or call or text him at 469-207-5844.


The Importance of Talking to Yourself

by Geoff Gannon


In the most recent podcast, I talked about how useful it can be to just talk a stock idea through whether that is with someone a lot smarter than you, a peer of about equal investing skill, or anyone else for that matter.

I talk a lot with people on Skype about stock ideas they choose.

And they often tell me how helpful I was in coming up with some insight – some way of thinking about their stock idea – that they themselves hadn’t seen. It’s a nice compliment. But, it’s entirely undeserved. People often think that ideas they themselves had during a discussion must have been someone else’s ideas because they hadn’t had that insight back when they were analyzing the stock quietly on their own.  Since they thought of this bright idea when they were in the middle of talking a stock through with someone else, that someone else must be the one who prompted the bright idea.

It doesn’t work that way.

The truth is that it’s not the someone else that matters. It’s just talking the idea through that matters. If you weren’t too self-conscious to do it – you could talk to a cubicle wall, that troll doll on your desk, or a bathroom mirror. They’re all good investing partners because they all listen.

If you could go into a quiet room, set a timer for one hour, and then start talking through your stock idea out loud till that timer dinged – you’d have a lot clearer idea of what you think about a stock and why than you get from the way you are probably doing it now.

Obviously, you’re not going to do that. Nothing I can say is going to convince you to talk to yourself out loud for an hour.

But, there are cheats. There are ways to trick yourself into doing functionally the same thing without embarrassment.

What are they?

One, you can write a blog. I write a blog. I get to talk to a lot of great people about interesting stock ideas. But, I also get to put down whatever ideas I have in writing. On this blog, I really only discuss general investing concepts now. My specific stock writing is done at Focused Compounding. Over there: from time to time, I’ve done what I call an “initial interest post” where I will write about some stock and at the end say my interest level is 10% in this stock idea, 90% in that stock idea, etc.

I’d be looking at these stocks anyway. Writing them up like that is a way of recording my own pipeline of ideas. Some subscribers have told me they like those write-ups better than true stock picks. They like reading about all the stocks I don’t like right off the bat and why I don’t like them. So, maybe it is useful to others. But, the reason those articles are formatted like that is because I’m constantly looking at stocks and deciding whether or not to follow up on that idea. What I’m doing in those write-ups is very similar to what I’d do on my own. So, writing about a new stock I’ve come across is a way of talking to myself in print. Typing up an idea doesn’t make you look as crazy as talking through an idea out loud. And it has the same benefits. It clarifies your thinking on the subject.

The podcast episodes we’ve done on specific stocks – NIC (EGOV), Frost (CFR), Cheesecake Factory (CAKE), Omnicom (OMC), NACCO (NC), and Tandy (TLF) – are all examples of me talking to myself about a stock by talking to Andrew about a stock. We recorded the discussion and shared it with listeners. But, I’d say that in 5 of those 6 cases, the reason for picking that specific stock at that specific moment in time was a selfish one. I was thinking about NIC or Frost or Cheesecake or Omnicom at that time and doing a podcast on the stock helped me work through my most up to date thoughts on the company.

I’d say NACCO was an exception. It’s a stock I had owned and written about behind a paywall a while back and we always thought it was something we should share with podcast listeners. We just didn’t think the stock was cheap enough (that is, as cheap as I had bought it for) till it dropped a bit right before that podcast. In that one case, I’d say the catalyst for the podcast wasn’t a selfish one. I wasn’t thinking that stock through myself when we recorded that podcast. I already owned it and I knew I wasn’t going to buy any more shares or sell any shares for many months to come.

So, that’s number two. One, you can write a blog. Two, you can record a podcast. What’s three? You can meet in person. Andrew and I do this every week. We each research a stock on our own. Then, we meet in person and discuss it. We usually talk about one stock for about 3 hours. Sometimes, after that talk – we go back to do our own follow up analysis. Usually it’s tracking down numbers and answering questions we hadn’t addressed the first time around that were then suggested to us by the other person. But, very often, we don’t even do that. We simply do our own solo analysis. And then we meet and talk together about a stock for 3 hours. We compare notes. We ask questions. We each state our case. And we come away from it not just clearer on what the other person thinks but clearer on what we think.

The fourth thing you can do is talk to someone not in person. Use the internet. There are other value investors out there. Most people don’t have people in their life who care as much about the stocks they care about as much as they do. It’s unrealistic to expect you can sit down once a week for three hours and just talk stocks with some local friend. But, it’s not unrealistic when you expand that search from offline friend to online friend. For any stock out there, you should be able to find someone who is as interested in the idea as you are.

What are the rules for talking an idea through?

Be yourself. Talk like yourself. Don’t apologize for having different opinions. And don’t feel you have to defend your opinions. Just state your analysis as fact. If someone disagrees with your analysis – they’ll do exactly that. They’ll disagree with your analysis instead of with you personally. The other things – and this is especially important when meeting with someone who you often agree with – is to remember there’s no such thing as veto power. You are investing your own money. You don’t need to win anyone over to your way of thinking.

I talk with a lot of investors on Skype. I’ve heard a lot of solid ideas. I’m not sure I’ve ever said: “oh, that’s such a good idea I think I should invest in it myself right now”. On some level, that means I “disagreed” with that person’s favorite stock idea. I didn’t think it was a good enough idea for me to drop everything and buy it. Yet they probably did come in thinking exactly that. Does that mean they failed to win me over?

That’s not the point. You’re not trying to win anyone over or impress anyone. You’re trying to think out loud for your own benefit. Don’t think of your stock talk sessions as an arena for arguments. What they are instead is just a place and time for guided thinking.

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Focused Compounding Podcast: All 6 Specific Stock Episodes

by Geoff Gannon


Lately, we haven’t done as many specific stock podcast episodes as I’d like. But, we do have some past ones. I think these are the most useful episodes for people to listen to. In order from oldest to newest they are:

Episode #2: NIC (EGOV)

Episode #5: Frost (CFR)

Episode #7: Cheesecake Factory (CAKE)

Episode #14: Omnicom (OMC)

Episode #21: NACCO (NC)

Episode #22: Tandy (TLF)

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Ekornes (Stressless) to be Acquired for 139 NOK - Here is My Report on the Stock

by Geoff Gannon


Focused Compounding members get access to a "Stocks A-Z" section of the website. This includes about two dozen stock reports I did for Singular Diligence between 2013 and 2016. Recently, Ekornes (the Norwegian maker of Stressless brand furniture) announced that its board had agreed to be taken over for 139 NOK a share in cash.

Last I saw, the stock was trading close to that level. So, this is no longer what I would call an "actionable" stock idea. For that reason, I thought I'd share the Ekornes report on this blog as keeping the report exclusive can't benefit paying members anymore.

So, here's my stock report on Ekornes. It's a good example of what the couple dozen other reports on Focused Compounding look like.

Ekornes Stock Report (PDF)

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You’re Now Getting 3 Podcasts a Week: Mondays, Wednesdays, and Fridays – Here’s an Off-Topic One

by Geoff Gannon


New podcast episodes will now come out 3 times a week: Mondays, Wednesday, and Fridays. For our first podcast on this 3-episodes a week schedule, Andrew and I decided to do an off-topic podcast episode…

Episode #33: Getting to Know Andrew and Geoff

By the way, some people have asked how you can get access to old episodes. iTunes only shows the most recent episodes. You can find them at the podcast’s Podbean page.

As for this Monday’s episode (which is already up now), you’ll get to learn more about me and Andrew than in a normal podcast. I like to keep the podcasts short (the unattainable goal seems to be the 15-minute mark). So, we never talk about ourselves. People know me pretty well. But, most don’t know Andrew. So, you’ll come away from this podcast with a better idea of who that other guy is.

Episode #33: Getting to Know Andrew and Geoff

Don’t worry.

We’re not planning to make a habit of these off-topic podcasts.

But, we didn’t tell people they could Tweet us any questions – no restrictions as to subject matter. So, we will do one and only one podcast where we rapid fire answer every question we get. Andrew and I will probably record again this Friday. So, if you do have a question you want answered tweet it to @GeoffGannon and @FocusedCompound.

This one time: you can ask absolutely anything.

We will answer it.

 

Ask Us Anything

@GeoffGannon

@FocusedCompound

 

Episode #33: Getting to Know Andrew and Geoff

 


Sunday Morning Memo

by Geoff Gannon


Sign up for Geoff’s Sunday Morning Memo

I write a weekly memo now. It goes out as a PDF sent via email. It’s about one page. And I discuss one general investing topic in it. In theory, I don’t discuss specific stock ideas in the memo. In practice, I sometimes cite a recent example (often a stock written up at Focused Compounding). It’s free to get the memo. You just enter your email address. And then the only thing we do with that email address is send you one email sometime every Sunday.

The memos so far have been:

5/13/2018: “Goodness vs. Soundness”

5/06/2018: “The Urgent and the Important”

4/29/2018: “The Second Side of Focus”

4/22/2018: “Patience as a Process”

4/15/2018: “Fear, Greed, and Boredom” 

4/08/2018: “An Illiquid Lunch”

4/01/2018: “Killing Your Horse” 

3/25/2018: “Choose to Choose”

The past memos are archived at Focused Compounding.

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Overlooked Stocks

by Geoff Gannon


In our most recent podcast episode, Andrew and I talked about “overlooked” stocks. I said overlooked stocks were basically synonymous with “oddball” stocks. You can read the Oddball Stocks blog here. I recommend going through every past post there and writing down the names of the stocks covered. It will give you a good list of stocks you might want to research and probably had never heard of before.

The truth, though, is that Oddball Stocks really only covers half of the universe I’d call overlooked stocks. The other half is “special situations”. The best blog to read for special situations is Clark Street Value.

Andrew and I also did a podcast episode about our favorite investing books. I mentioned in that episode – as I often have before – that Joel Greenblatt’s “You Can Be a Stock Market Genius” is my favorite investing book.

If you’re interested in overlooked stocks, I recommend reading both those blogs and that book.

Once you start thinking in terms of overlooked stocks – some otherwise odd stocks choices make sense. Among long-term readers and on-again-off-again readers of this blog: I get a lot of emails from two different types of value investors. One type is the Ben Graham / deep value / quantitative value investor. They remember me as someone who would buy a basket of Japanese net-nets, an OTC insurer trading below book value like Bancinsurance, and U.S. net-nets like George Risk (RSKIA). They ask me why my style changed such that I now invest in things like BWX Technologies (BWXT) that are so expensive and so clearly not value stocks. The other kind of value investor is the Warren Buffett / wide moat / qualitative value investor. They remember me as someone who would buy stocks like IMS Health (back in its previous incarnation as a public company). They ask me why my style changed such that I now invest in things like NACCO (NC) that is in a dying industry like coal.

The truth is that I tend to find the most success fishing in two ponds of stocks. One pond of stocks is what I’d call “overlooked”. These stocks are cheap because they are neglected. I should point out here that I don’t mean that all OTC stocks, illiquid stocks, stocks that don’t file with the SEC, stocks emerging from bankruptcy, spin-offs, the remaining company after a spin-off, etc. are in some sense either cheap or even necessarily neglected. Plenty of these stocks get plenty of attention. However, the argument that Keweenaw Land Association (KEWL) might be more likely to be neglected than General Electric (GE) makes sense. If GE sells for less than the sum of its parts, this should be for some reason other than a lot of people trading the stock aren’t bothering to do their own appraisal of each of the business units and then adding that appraisal together. In the case of GE, you could probably have a pretty efficient market in the stock even if 19 out of 20 buyers and sellers were traders dealing in the stock without any regard to the underlying business. If the other 5% of buyers and sellers were quite diligent business analyst types – the average stock price over any set of months could still incorporate a surprising amount of that information and analysis. Now, if all the trader types had the same sort of knee-jerk attitude about the stock – then you can easily drown out whatever useful analysis the investor types were doing. But, for an average stock in an average month – there’s a mix of optimists and pessimists both among investors and traders and it may all work out to a bunch of random noise.

The other pond of stocks is what I call the “contempt” group. A stock can be cheap enough, safe enough, and good enough that I could figure out it’s a bargain and yet others hadn’t already bid up the price a lot in two scenarios: 1) People haven’t looked at the stock and 2) People have looked at the stock – but, can’t get past their emotions and down to the logical part of their thinking.

I recently had coffee with a hedge fund manager when we got on the subject of whether you could apply the same sort of ideas you do in a personal account, a $100 million value fund, etc. in a $1 billion or $5 billion value fund. There are some very smart investors running funds those sizes on the same principles that value investors run much smaller funds. But, can it really work? Or do people who have success in big stocks need to use different strategies than what works with most stocks (that is, the small ones). We talked a little about our personal experiences – times when we really felt we found a stock trading well over a $1 billion market capitalization that looked as cheap as the stocks we find in the under $100 million market cap group.

I’ve had some good experiences in stocks with a market cap over $1 billion. An old example is IMS Health in 2009. It was eventually bought out. My results in IMS Health – an over $1 billion market cap stock – and Bancinsurance (an under $100 million market cap stock) were pretty similar. And, honestly, I’d group the two stocks together in terms of degree and especially clarity of cheapness. These were clearly stocks trading at less than two-thirds of a conservative estimate of their intrinsic value. There is a difference though. Bancinsurance was in a niche business, it was an illiquid stock, it had de-listed and traded over-the-counter (OTC) for a couple years, and then – finally – a controlling shareholder had made an offer to acquire the whole company. It was already pretty neglected before the offer. But, once a controlling shareholder makes an offer to buy out a company – many investors drop any attempt at analysis right then. The stock goes in the special situations / arbitrage category and no investors who don’t specialize in that area bother analyzing whether the stock is cheap, etc. It gets neglected.

IMS Health was not neglected. Investors were avoiding stocks generally (in early 2009), that area of stocks (healthcare stocks in the run-up to Obamacare), and to some extent IMS Health specifically (there was a Senator or two pushing for bills that were aimed at gutting a lot of what the company’s core business was). That kind of situation – a cheap moment in time, for an otherwise good business – is what’s worked for me with big stocks. Frost (CFR) is a big stock. And if you look at a stock chart to see where I bought all my shares – it was just a blip in time. It wasn’t long at all. People still thought the Fed Funds Rate might stay lower for a while. The increases weren’t quite here yet. And then oil prices had plummeted. Frost is 100% in Texas. And something like 15% of loans were to energy producers (in Texas). So, that worried some people. But, it obviously worried them very, very briefly. The stock wasn’t available that cheaply for long. This is typical of what I’ve seen with big stocks that get as cheap as small stocks often get. They don’t stay cheap for long. And their cheapness is very, very dependent on crowd psychology rather than a lack of interest from investors. It’s not that common for investors to continually overlook, misjudge, etc. a big stock quarter after quarter and year after year. That kind of thing is much more likely in small stocks. In big stocks, as soon as the cloud of fear or greed or whatever clears – the stock rockets upwards or plummets downwards or whatever the appropriate direction is.

Then there are overlooked big stocks. And the only stock I’ve owned recently – I actually still own it – that falls in this category is BWX Technologies. I’ve told this story many times. But, basically, when Quan and I found Babcock & Wilcox (which BWX was then a part of) we were immediately excited by what seemed to be a great, wide-moat business that was part of a public company trading at a normal price. Babcock itself had been spun-off from another company several years before. It had 3 parts. One was a speculative, money losing unit. It was essentially an experimental technology. We expected it to be closed down at some point or at least to be scaled down. Then there was a definitely cyclical and probably declining business (the present-day Babcock & Wilcox Enterprises). And the last part was BWX Technologies – the business we really liked.

I bought ahead of the spin-off. This was a mistake for two reasons. One, you really didn’t have to. You could’ve just bought when the spin-off happened and gotten a similar price on the piece you wanted. And, two, buying ahead of time encouraged me to size the position too small. Normally, I’d make a position 20% to 25% of my portfolio. I did the same thing in this case. But, then when the spin-off happened – the portion of my investment left in BWX Technologies (as opposed to the other newly independent stock) was in the 10% to 15% range instead of 20% to 25% range. I didn’t add more after the spin-off. That was my mistake. But, there are plenty of times where waiting till the actual spin-off can be unhelpful in terms of price. So, I wouldn’t say as a rule you should always wait till spin-off day.

My point with Babcock though is that when people email me about the stock they remember it was a spin-off, that I like Joel Greenblatt’s book “You Can Be a Stock Market Genius”, etc. and assume I bought it because I’m interested in spin-offs.

I bought the stock because it had a wide moat, predictable business in it and yet it was trading at what looked to be a normal price overall. I’d say the pre-spin Babcock was a neglected stock.

A good present-day examples of this sort of thing is KLX (KLXI). This one is a little different for a few reasons. One, Boeing (BA) has said it will buy the aerospace part of the business for $63 in cash. And two, the aerospace business isn’t actually being sold cheap. But, it’s similar to Babcock in that KLXI as a whole was a spin-off from B/E Aerospace. And then when I analyzed KLXI a couple years back, the thing that bothered some investors was the energy business. Well, if all goes to plan – KLX’s aerospace business will convert into cash (provided by Boeing) and the energy business will be its own standalone business. The difference here, of course – is that some people may say Boeing is getting the good business and people who buy KLXI stock today are getting the promise of cash from Boeing and the bad business. Maybe. But, it’s similar to Babcock in the sense that there are some issues of mixing businesses investors do and don’t want together, breaking things up, etc. It’s possible that investors neglected KLXI stock in the past because it mixed an aerospace business and an energy business. Investors won’t overlook the stock once the energy business trades on its own for a while. This is no guarantee the energy business is a good business. It is, however, a guarantee that the energy business will not be overlooked anymore.

This brings us to one of the two things that come up a lot with the special situations side of overlooked stocks.

One of the issues is the idea of a catalyst.

The obvious catalyst is that something that was overlooked won’t be anymore. This is even something I’ve said with a stock I own called NACCO. I’ve said that I wouldn’t be surprised if the business wasn’t well understood, the stock got less liquid over time, etc. for a year or more. But, eventually, a company puts out annual reports and does presentations and so on about the business. Some investors learn about it and post write-ups places describing the business model. Eventually, if some enterprising investors feel there is money to be made in learning about the business model, buying the stock, etc. word will get out. This is basically the classic question posed to Ben Graham about what makes a stock go up? Do you advertise or something? There are incentives for people to find a mispriced stock. It’s harder to overlook something that is now standing alone as just one business unit. It may take time. But, just being less overlooked is catalyst enough for a really cheap stock.

The final issue is the riskiness of these special situation overlooked stocks. Some are definitely quite risky. Greenblatt obviously invested in some really risky ones and benefited from the years he was operating Gotham – just as you have undoubtedly benefited from some risks you maybe shouldn’t have taken these past 9 years. Falling stock multiples, rising interest rates, recessions, etc. can kill stocks with too much leverage – both operating leverage and financial leverage. And investors who buy warrants, LEAPs, etc. are even more leveraged than that. So, yes, some special situation type overlooked stocks can be quite risky.

A really good recent write-up at Focused Compounding is one about Entercom (ETM). This is the minnow that swallowed the whale that is CBS Radio. It’s now the second biggest owner of radio stations in the U.S.

A lot of people have asked me about this stock’s margin of safety. And, honestly, while I think it’s a good stock – I don’t think it has a margin of safety. Allegedly, KLXI’s energy business is going to be the opposite of this. They’ve said it’ll be spun-off with $50 million of cash and no debt. Add to that the fact that they had recently been in a really bad part of the cycle in their industry – and there’s a nice margin of safety. They have cash. They don’t have debt. And you’d expect things should be a bit better this year and the next – not a bit worse.

My point here is that I’d definitely classify both Entercom and KLX as overlooked stocks. Entercom is mostly CBS Radio and it’s mostly held by shareholders of CBS who opted in to taking shares of the radio business. I’m guessing that outside of the people who actually run the company and the company itself (both insiders and the company have been buying Entercom shares lately) the people trading this stock are either shorting it or are special situations types not long-term investors. The situation at KLXI is also unlikely to attract long-term investors. In the case of both Entercom and KLX people are now likely to think of the stocks more as pieces of paper to trade and less as long-term ownership of a business to hold. Whether that qualifies the stocks as overlooked or not generally I don’t know. But, as long as the people – basically value investors willing to hold for a while – who think like me aren’t yet attracted to these stocks, I’m more likely to give them a closer look.

Listen to the Podcast

Read Geoff’s Sunday Morning Memo


Frequently Asked Questions: Managed Accounts

by Geoff Gannon


To set up a meeting by telephone or in person (Geoff and Andrew both live in Plano, TX) contact Andrew by email (info@focusedcompounding.com), phone (469-207-5844), or text (469-207-5844).

Frequently Asked Questions

Who will the account manager be?

Geoff Gannon.

How many stocks will I own?

Between 6 and 8 stocks.

What kind of stocks will I own?

Overlooked stocks. These include: spin-offs, stocks emerging from bankruptcy, net cash stocks, net-nets, near net-nets, illiquid stocks, over-the-counter (OTC) stocks, and stocks that don’t file with the SEC.

What strategy will be used?

The strategy Joel Greenblatt outlines in You Can Be a Stock Market Genius.

How often will I hear from Geoff and Andrew?

You will get a quarterly letter. And you can always email us at info@focusedcompounding.com.

What fees will I pay?

The taxable accounts of qualified clients will pay 1% of assets and 15% of profits. The non-taxable accounts of qualified clients and all accounts of non-qualified clients will pay a flat rate of 2.5% of assets.

How often will I pay these fees?

The flat fee will be automatically withdrawn from your account monthly. The percent of profits will be automatically withdrawn from your account quarterly.

Is it possible you will turn me down?

Yes. We are looking for long-term oriented value investors who don’t mind some volatility.

Where will my account be?

Interactive Brokers. We do not have custody of the assets. We are just the manager of the account.

Can you manage money for people outside the U.S.?

Yes.

Can you manage non-taxable money?

Yes.  

What is the minimum investment size you will consider?

We don’t have a precisely defined minimum investment size. If you think your investment might be too small for us to consider, please call Andrew at 469-207-5844 to discuss your personal situation.

To set up a meeting by telephone or in person (Geoff and Andrew both live in Plano, TX) contact Andrew by email (info@focusedcompounding.com), phone (469-207-5844), or text (469-207-5844)


Managed Accounts

by Geoff Gannon


We are planning to offer managed accounts with Geoff Gannon as the portfolio manager. These accounts will hold 6 to 8 overlooked stocks (spin-offs, net-nets, OTC, etc.) and be managed along the lines of the strategy outlined in Joel Greenblatt’s You Can Be a Stock Market Genius.

To set up a meeting by telephone or in person (Geoff and Andrew both live in Plano, TX) contact Andrew by email (info@focusedcompounding.com), phone (469-207-5844), or text (469-207-5844).

We look forward to meeting with you.

 


Less Theory, More Practice: How to Value a Stock Using a “Sustainable Growth” Model Coupled with Return on Capital

by Geoff Gannon


I get a lot of questions about valuing a company based on estimates of its sustainable growth rate. So, someone will say it seems this company can grow 8% to 10% a year and it has a return on equity of 15% or 20% a year – and they’ll ask me: “how do I determine what this stock is worth?”

 

My answer is usually pretty much the same. Unless you know the business very well, that kind of estimate is starting way too far down the income statement.

 

So what’s a better way of tackling the same sort of valuation problem using simpler math, more explicit assumptions, and better tying your model of this specific company into the way the wider world is likely to shake out over 5, 10, or 20 years?

 

Let’s start with a huge bit of simplifying math – something I encourage every investor to make rule #1 of any growth model.

 

It's much easier to pick a certain point in time: 5 years from now, 10 years from now, 15 years from now, etc. and do a point-to-point calculation instead of a sustainable "CAGR" calculation. Why? Well, you would have to decide on whether things like margins stay the same. So, do gross margins stay the same, expand, or contract over time? Do operating expenses decrease or increase over time? So, does the same gross margin percentage convert into more or less operating margin over time? With a point-to-point calculation you can assume gross profit, EBITDA, net income, etc. will grow faster or slower than sales. You can’t really do that with any kind of permanent projection. I mean, you can – and I’ve seen people do it. But, it makes no sense to say I think this company will “sustainably” grow earnings faster than sales.

 

A surprising number of people ask whether the calculation should be in real or nominal terms. Here’s the thing – for most businesses, inflation makes quite a difference. And investors often aren’t that sensitive to differences between units sold, nominal price per unit, and real price per unit. When I look at the long-term history of a company, I always do some calculations in real terms and some in nominal terms.

 

As far as whether the growth rate is sustainable or real, for many of the companies I like to look at - you could do the calculation in real terms. However, that doesn't work for most companies. Most companies would get worse real returns if inflation was higher. Not all. There are exceptions. It's a timing issue. So, asset light businesses (that don't carry much inventory, that collect bills they are owed before paying the bills they owe, companies that raise prices on customers ahead of price increases from suppliers, etc.) would be more able to grow similar in real terms. Like, NACCO and BWX Technologies and Omnicom and Keweenaw Land Association (a timber company) should all be able to have a sustainable "real" rate of growth. That's not true for most companies. For example, you can see in the period from about 1965-1982 when stock multiples were contracting in the U.S. that more and more large U.S. businesses were producing very bad real returns on equity. Inflation was a problem for them. 

How I model out a company's future sustainable growth is:

 

1. Do a point-to-point calculation. This is a reality check. So, if someone sends me something saying Google can grow earnings per share by 15% a year indefinitely or something - I'd say, let's pick a specific year and model that out. Either earnings have to grow much faster than sales, or sales growth has to come from things that aren't advertising, or the ad industry has to grow much faster than it did in the past, or you have to pick an end point for the year you are measuring to that is very near today - or, you'd end up with Google having a huge share of global advertising spending. This is because your model is basically going to require Google to grow revenue from ads faster than ad spending, so market share will grow year after year. This is the reason you do point-to-point calculations using specific years. If you don't, there are people who don't realize how much of the ad industry Google would have in 2038 if you're really doing a 20 year projection, Booking would have of the travel industry, etc. 

 

2. You want to focus on the number you care about (total return in the stock) and break it down from there. So, for example, it doesn't really matter much if Omnicom gets you a return by paying you a dividend, buying back stock, or acquiring more sales. Organic growth is - because the company is asset light - very cheap (pretty much free). So, that's different. But, you want to model it out sort of like:

 

Ad Spending Growth +/- Market Shares Gains and Losses +/- Shares Outstanding Increase or Decrease +/- Dividend Yield

 

Also, for an investor you always have to pick the ending multiple on the stock. You can pick a multiple that's EV/EBITDA, P/E, P/B, P/FCF, EV/Sales, etc. Whatever you want. But, this is an important part of the calculation because a fast growing business will eventually be a slow grower. So, if Booking or Google grows quickly for 10-20 years, that's certainly possible. But, it can't really have a much above market P/E ratio at the end of 20 years because if it does grow fast for 20 years, there just won't be growth opportunities left. The longer and faster a company grows, the harder it’ll eventually be to have an above market P/E ratio (because the sooner it’ll be 100% mature).

 

I don't do any calculations that involve the "reinvestment" rate or returns on capital.

 

Why not?

 

Isn't that important?

 

Well, it's very important. But, it's possible to work out a simple formula that incorporates reinvestment without doing any sort of actual ROC calculation.

 

Project a certain growth rate. Then, determine how much you think the company will have to retain, spend in the business, etc. to achieve it. The past record is very helpful in this calculation. It’s especially helpful over longer periods of time – like 5 years, or an entire business cycle or something.

 

So, with Omnicom the organic growth rate is free because they have "float". The faster they grow organically this year, the more cash flow they get now. So, if you calculate Omnicom will grow sales by 0%, 1%, 2%, 4%, or anything else - it doesn't really matter. You can simplify your assumptions by just assuming Omnicom always has all of FCF available to issue stock options, make acquisitions, buyback stock, and pay dividends regardless of how fast they grow.

 

Similarly, with banks we said something like Bank of Hawaii can grow 3% a year forever while paying out 100% of earnings (in dividends, buybacks, etc.) If BOH grows much faster than 3%, it then needs to retain earnings to keep its capital levels in line with the historical norm. But, we don't really think BOH will grow fast. So, we can just assume BOH will - at a constant P/E multiple - return earnings yield + 3% as a stock. All of the earnings can be paid in dividends or buybacks.

 

For companies with significant amounts of working capital, PP&E, etc. this changes.

 

But, again, it's possible to incorporate the "incremental return on investment" purely in terms of the "cost of growth". Which is how I always do it.

 

This confuses people. But, there's an excellent reason for why I do it.

 

I'm not purely a value investor or purely a quality investor. I will consider companies with 30%+ after-tax returns on equity and also companies with 5% returns on equity if they are incredibly cheap. Some value investors would never consider a company with a 5% return on equity, but that's not the right decision. Actually, as long as a company with a 5% return on equity isn't going to plow any of its cash flow back into the business - it could be a good investment at the right price.

 

For example, let's say I find a net-net trading at about 2/3 of its NCAV. Historically, the company has returned something like 5% to 10% on NCAV. But, say it has returned 10% on NCAV if you exclude net cash. In other words, it might be earning 10% on just receivables plus inventory less accounts payable, accrued expenses, etc. Assume here that PP&E is unimportant. This isn't a weird example. I won't say the company's name. But, this is basically a "live" example of a net-net that exists today. So, this is the kind of problem an investor would actually face: Should I buy this net-net or not?

 

Is it a good investment?

 

The quality oriented investors would say "no". In the long-run it will return between 5% and 10% a year depending on capital allocation at the company. It's a cigar butt.

 

Actually - it depends. The company is more attractive the more it does two things:

 

1) Returns cash in dividends, buybacks, borrows money, etc. (that is, the more it uses financial engineering)

2) The less it grows

 

The reason here is that a low ROE is really just a high cost of growth. It only becomes a problem if the company tries to grow. The fact past owners of this stock funded a lot of slow, low-return growth doesn’t matter to you – the investor who buys in today. If the company has mostly decided it doesn't want to grow and you can buy it at a nice price relative to cash on hand, free cash flow yield in an average year, etc. - the ROE doesn't really matter.

 

Likewise, how much does the ROE of an amazing company matter?

 

It matters a lot if the company grows. But, less so if it doesn't.

 

My own view is that thinking about ROE in terms of a "return" on your money is the wrong way of doing it. What you get is growth. What it costs to fund growth - from a shareholder's perspective - is an incremental addition to equity. So, I don't really think in terms of ROE or incremental ROE. I think in terms of:

 

1) How much can this company grow?

2) How much owner money has to be put up to fund this growth?

Imagine a timber company. Well, if the amount of timber per acre can grow 4% a year without owners putting in more money – then, that’s an important fact to know regardless of what the company reports in earnings. The economic value of the business grew 4% without you doing anything. But, consider if you grow the amount of timber the company owns by buying 4% more acres this year. Well, you are paying for that. So, the price paid per acre of timberland becomes incredibly important to the analysis if the company is buying more timberland. If the company isn’t buying more timberland, the growth rate of the trees matters – not how much the company once paid for the land. In both cases, it’s “cost of growth” that matters. In one case, cost of growth will look a lot like ROE – if the company is growing through buying more and more timberland each year – but, in the other case the “cost of growth” will have no relation to ROE.

 

Lately, Omnicom has grown at about 2% a year. That's all you get regardless of how high the return on capital is. You could try to calculate it as a re-investment rate (though, in Omnicom's case - the reinvestment rate calculation result would be nonsensical, because incremental capital would sometimes be nil or less than nil so the ROIIC you'd get would be "NMF" or negative). I think it's better to think of Omnicom as: well, does it shrink 1% a year, grow 1% a year, grow 3% a year etc. and then is that growth free.

 

In the case of a low ROE type business - yes, you could do a reinvestment rate calculation too. But, again, I think it's not the best way of thinking about it.

 

Why not?

 

I've said before that I think the things you need to focus on when analyzing a stock are those things that are:

 

- Constant

- Consequential

- Calculable

 

Return on invested capital does fit that bill at some companies at certain phases in their history. So, you could do the calculation for Cheesecake Factory today or Howden Joinery. Basically, it's a calculation on new store openings. It used to matter more at those companies (when they were growing store count faster as a percent of their existing store base). But, it's still a "consequential" number and because it's a repeated store model it's definitely a long-term "constant" number. It's also easily calculable. In fact, I'm sure management at these companies has some sort of payback period or ROI targets (probably in cash terms) for new store openings.

 

But, at a lot of companies the return on incremental invested capital and the reinvestment rate isn't really going to fit the "constant, consequential, and calculable" test. At cyclical companies, manufacturers, companies carrying a lot of working capital, etc. the number will - at least in cash terms - fly all over the place. In fact, capital will sometimes flow out of the business. In fact, in the real world, that's often how a company gets its ROE up. It gets very miserly about using capital in that business, it runs down inventory, it improves receivables collection, etc. 

 

If I created an Excel that used the theoretically correct idea of reinvestment rate and return on incremental capital - it'd be all over the place.

 

But, if I pick a point in time that's 5 years, 10 years, or 15 years in the future and I assume a growth rate in sales, gross profit, EBITDA, etc. of 3% or 6% or 9%, I can often come up with a reasonably good approximation of how much owner money I think would need to be retained to hit that number.

 

Remember, it won't be that useful to know the ROIC if you get the growth number completely wrong. So, if ROIC is 50% and growth comes in at 4% a year over the next 10 years instead of 8% a year as you expected - your ending valuation will be off by quite a bit.

 

I like looking at sales and gross profit most because this can be more easily tied to real world things like population growth, inflation, nominal GDP growth, industry growth relative to the economy, market share, increases in spending per capita on something, etc. Like, you can see if the predictions people are making for this specific company could fit with a likely future reality.

 

Store growth is a good example of that. You can say new stores will grow by 8% a year for the next 15 years. That sounds reasonable. But, for some U.S. restaurants, that would mean more locations than any full service restaurant has now. That seems unlikely. It might not be impossible. But, that's a red flag. So, you can look at what kind of saturation we're talking about.

 

It's also a good idea to focus on numbers that don't move around a lot which are things like store level economics, "turns" of inventory and receivables, and income statement lines that are near the top. So, sales and gross profit. Of course, investors care most about the bottom line. But, for most companies, the bottom line is much harder to predict because of economies and diseconomies of scale, business cycles, etc. 

 

The more constant and predictable numbers to base your decisions on will be:

 

* Typical store level economics

* Number of stores

* Number of customers

* Number of units

* Sales relative to those things

* Gross profits relative to those things

 

And then: cash conversion cycle, asset intensity, etc.

 

Things like operating margins are long-term very difficult to model out without knowing what growth rates will be, because these are the things that can widen out a great deal with scale. It would be difficult to know what the eventual EBITDA margin could be at Facebook or National Cinemedia or something without knowing if the business is already at about 100% of the potential in terms of audience and ads. The numbers lower down the income statement would look very different in the future if Facebook was on a planet with 80 billion people instead of 8 billion people or if National Cinemedia wasn't already in like 50%+ of all movie screens. 

 

Compare Facebook and Twitter for instance.

 

Facebook is a success now. As long as it stays a success, that’s easy to model even if you use the bottom line instead of the factors I suggest. But, what about Twitter? Something like that is more difficult things to model out. But, you'd still do it the same way. You'd still say how big is Twitter's audience? How many ads will that audience see? How much could those ads be sold for? If you don't do it that way - if you just try to project out based on bottom line financials as of today - you'll value a business that isn't yet having financial success like it never could have success. Return on capital comes into when asking how much would it cost to grow audience, grow ads served to that audience, or grow prices paid for those ads? Is it a big number? A very small number? That’s what’s really going to determine future returns on capital. It would be hard to see that looking at today’s results though.

 

That gets back to the net-net type business. I see this all the time with tiny banks selling below book value. Investors assume that because they are earning a 5% ROE today they are worth a huge discount to book value. In reality, if a tiny bank could either have a much higher ROE once they grew scale or once they were bought and plugged into another bank - then they could ALREADY be worth book value to someone who is truly future oriented. Really, what you'd care about is the quantity and quality of the deposits. A one bank branch will never earn a good return on equity as a standalone business - but, one branch is obviously worth book value or more to an acquirer. You could say it’s speculative to assume a business would be worth more to an acquirer. But, it’s also speculative to assume a profitable business will never increase scale. A static ROE assumption for a business with increasing returns to scale doesn’t make sense. Of course, for most industries scale is important to a point and much less important beyond that point. A bank with $100 million in assets is likely to be less efficient than one with $1 billion in assets or $10 billion in assets. There’s much less evidence – at least on the cost side – of $100 billion in assets or $1 trillion in assets getting you even better returns. Yes, I can name some banks with great economics at that size. But, I can also name a couple with similar economics at much smaller size. What they have in common isn’t overall size, it’s the percentages of deposits in each city, it’s the deposits per branch they have, and it’s the type of depositors they have. So, again a “point-to-point” analysis still makes sense. The difference between the economics of 1 branch and 10 branches is big in a way that the difference between 500 and 5,000 isn’t.

 

That's why I would focus on modeling out the sort of basic, easy to connect to the real world, and close to the "top line" numbers like deposits, store count, audience, etc. and work from there instead of trying to say I think the sustainable EBITDA growth rate here is 10% a year. An EBITDA growth rate is always making assumptions about all that stuff I listed above. So, if you are wrong in your assumptions, you will be way off on things like EBITDA growth, return on INCREMENTAL capital, etc. Whereas if you break down your assumptions about the company's future growth into a set of 3 or 5 key factors: number of branches, deposits per branch, cost of deposits, etc. - and you pick a specific point in time (like 2023 when I think the Fed Funds Rate will be "X") then you are on much firmer footing.

 

Often, this kind of analysis will match up nicely with real world common sense. Like, a company doubling the number of stores in the same town is going to grow earnings faster than sales while a company increasing its nationwide store count by 10% through filling in the most rural places it hasn’t yet reached is not going to drive any sort of earnings growth beyond store count growth.

 

Most importantly, I think that kind of point-to-point calculation based on 3-5 key factors for the business will also give you a better understanding of the business, the challenges it faces, etc.

 

For example, it will focus you on the "key constraint", the bottleneck that is most holding the company back. I just did a podcast on Tandy and talked about how I thought the lack of ability to add a lot of good, new store managers meant the key constraint for that company is store growth. So, I needed to see either an increase in store SIZE (which would still only require 1 store manager but would do more sales) and a decrease in SHARE COUNT (which would increase the amount of sales per share for investors without needing to increase the number of managers) to give me confidence in buying the stock.

 

So, when you break a business down that way you can come up with possible solutions. How can Tandy give investors a good total return?

 

1) They can find a way to attract more excellent store managers

2) They can grow sales faster than they grow store managers

3) They can grow sales per share faster than they grow sales

 

And we get to that kind of answer just by breaking the business down by key factors like number of stores, square footage per store, sales per square foot, and number of shares outstanding.

 

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NACCO (NC): Podcast Episode, Book on the Company’s History, Articles on the North Dakota Coal Industry, and Exhibit 99 of the 10-K

by Geoff Gannon


Because it’s my largest position, I get a lot of questions about NACCO (NC). Andrew and I just did a 25-minute podcast on the stock:

Episode #21: NACCO (NC)

I also get some questions from people about what exactly it is NACCO does (what is lignite coal, what is a mine-mouth power plant, will these kind of power plants be replaced by natural gas plants, etc.) that I didn’t go into detail on during the podcast. The single biggest state NACCO operates in is North Dakota. So, here are 3 articles about the North Dakota lignite coal industry (NACCO is the biggest part of that industry) that help answer those questions:

Where Coal is Found

July 2017 article on North Dakota coal industry

August 2016 article on North Dakota coal industry

I mentioned I own a book about the company’s history. Here it is:

Getting the Coal Out

Finally, as I mentioned in the podcast there’s a very important document in NACCO’s 10-K. It’s Exhibit 99.

Exhibit 99 of NACCO’s 10-K

This is a must read. It is the financial statements of the unconsolidated coal mines. These unconsolidated coal mines make up most of NACCO’s value as a company despite not contributing anything to NACCO’s revenue line.

Finally, you can read the Clark Street Value Blog post I mentioned:

Clark Street Value Blog: NACCO Industries / Hamilton Beach Brands

Talk to Geoff about NACCO (NC)


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:

www.FocusedCompounding.com

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:

www.FocusedCompounding.com/podcast

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:

gannononinvesting@gmail.com

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.