Mistakes of Omission and Failures of Imagination

by Geoff Gannon


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

 

DreamWorks Animation

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

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

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

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

The key passage in that article is:

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

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

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

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

 

Weight Watchers (WTW)

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

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

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

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

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

Weight Watchers may be fairly valued.

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

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

Of course, leverage works both ways.”

The stock has since zoomed past $63 a share.

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

 

Failures of Imagination

I was having two conversations recently where this came up.

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

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

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

1921 – 1929: Stocks get more expensive

1929 – 1942: Stocks get cheaper

1942 - 1965: Stocks get more expensive

1965 - 1982: Stocks get cheaper

1982 - 1999: Stocks get more expensive

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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