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.