I had no business background before I started studying value investing. So, I usually start my research with no idea about the business of a company. Even worse, whenever I look at a company that I think I’m familiar with and have some preconception of, that preconception turns out to be a misconception. Peter Lynch would give me an F for how well I apply what I know to investing. So, in this post, I’ll share some misconceptions I had about some stocks when I started researching them.
#1 Nutrisystem (NTRI)
I thought this business doesn’t require a lot of tangible investment. There’s no customer loyalty. Customers use their product for only 10-12 weeks. So, the barrier to entry is low. Medifast (MED) was growing fast. Is that an indicator of low barrier to entry? And Nutrisystem has a much bigger competitor Weight Watcher (WTW).
It turns out that while the product economics of Nutrisystem is bad in the sense that customers do often stop dieting once they hit their goals – only to need to diet again – there actually is certain level of customer loyalty. Brand image is important in this business. And it’s hard for someone to replicate Nutrisystem. And I overestimated how similar each diet company’s business model was. Nutrisystem’s competitors have different modesl. Medifast has a direct selling model. Weight Watcher’s business model is based on group meetings.
Nutrisystem and Weight Watcher might not necessarily target the same customers. Nutrisystem is actually a big fish in its pool. The question is whether the pool is big enough to justify its stock price.
I didn’t understand any of this before I started researching the company.
#2 DreamWorks Animation (DWA)
I read The Curse of the Mogul and had a bad impression of movie studios. I thought DreamWorks is in a hit-or-miss business. I later found out that DreamWorks’s movies are much more consistent than I expected. They produce big movies through a development and production process that can take as long as 4-5 years. They spend a lot of time to develop a great story before actually spending money in animating the story. They usually pay voice actors contingent compensation instead of star sized guaranteed pay. Above all, DreamWorks is in a franchise business. While live-action movies are usually watched only once, children watch animated movies again and again. And there’re more opportunities to monetize their franchise than live-action movies. That means despite the inherent risk in movie producing business, DreamWorks’ value is more sustainable than I expected.
The graph below shows the worldwide box office of all DreamWorks’s in house produced computer animated movies. I also include a dash line showing the average of the 3 most recent movies at any point in time. The graph below is for worldwide box office. It's in millions of dollars - so yes, that's a billion dollars at the top there.
As you can see, the worldwide box office on the combination of the three most recent DreamWorks movies at any time is incredibly stable. Right now, DreamWorks make 2.5 movies a year so the average line is an idea of their performance in the new releases business (comparable to the underwriting part of an insurance company business). DreamWorks has a library that’s similar to the investment portfolio of an insurance company. In both cases, it helps to smooth the results. What you see above excludes this library portion of the business.
#3 Carnival (CCL)
The first thought came to my head when I look at Carnival was the analogy to airlines. However, there’s huge difference between cruise and airline business. Geoff and I talked about this in some previous posts:
- Carnival (CCL): No Pricing Power – But Plenty of Value Created Over Time
- 10 Bad Years at Carnival (CCL): Oil and the Economy Changed – The Business Didn’t
I won’t repeat those points.
Instead, I’ll just show a graph comparing the EBITDA/NTA (Net Tangible Asset) of Carnival and Southwest Airlines (LUV) for the years 1997 through 2011:
#4 Nintendo (NTDOY)
I knew the Nintendo DS and Wii. I thought Nintendo was a high tech company. And I thought because they are a Japanese company, they don’t care about their shareholders. Japanese companies have a reputation for caring more about product market share than making enough profit on every sale.
Everything I thought about Nintendo turned out to be false. They have a clear dividend policy. They care more about making profit from the first console they sell than their two competitors – Microsoft (MSFT) and Sony (SNE). And they want to use low tech to produce fun games. They are the least cutting edge console maker.
#5 International Speedway (ISCA)
I thought NASCAR was boring and only popular in the South. And I thought International Speedway earns a low return on capital because of high fixed costs. I was surprised to learn that NASCAR was the second most popular sport in the U.S. There is also as many tactics in NASCAR as in any other sports. The noise and smell of racing fuel and burning rubber along with the danger and excitement make up the attractions of the sport. I hadn’t thought about any of these things before studying the company.
More surprisingly, ISCA earns extremely high returns on invested capital. The company’s 9-year average return on invested capital is 24%. Unlike railroads, ISCA doesn’t have to spend a lot on maintenance capital expenditure. While railroads have to spend on thousands of miles of railroads maintenance, ISCA maintains only 1- mile of racetracks. And no one is stupid enough to build a racetrack close to ISCA’s.
This makes it similar to a franchise business where a single company owns a territory.
#6 Corticeira Amorim (COR:PL)
This is a hidden champion. Amorim produces the most cork stoppers in the world. The vast majority of the world’s cork is grown in Portugal. I thought that Amorim was simply a manufacturer and anyone near the cork forest can produce cork stoppers and compete with them. I thought the key to competition in the cork business was manufacturing skill.
It turns out that Amorim is more like a supply chain management company than a manufacturer. They have distribution offices all around the world. They keep ready inventories to deliver to customers whenever customers want. Their advantage is in the distribution network.
So I was wrong about Amorim’s margins (they are higher than I thought they would be). And I was wrong about Amorim’s capital turns (they are lower than I thought they would be).
Because my preconceived notions were focused on Amortim’s manufacturing rather than its materials handling – I didn’t give much thought to the importance of reusing the “waste” produced when you punch wine stoppers from cork.
Overall, I was too focused on what I thought Amorim was (a manufacturer) and too little focused on what they actually were – a company built around a single material: cork.
Amorim taught me an important lesson. A company is not an arbitrary industry designation. A company is what it’s built around.
#7 Ambassador Group (EPAX)
Reading the business description, I thought brand image and word-of-mouth might be important. But EPAX’s profitability is actually the result of their effective/misleading direct selling tactics. I never imagined that the sales tactic can have such a big impact on earnings. That helped me understand why Medifast still grows while Nutrisystem is slumping. Marketing matters. I’ve read Charlie Munger’s favorite book: Influence. So I should have known that. But my mind jumped immediately to brands instead of salespeople.
So, I actually don’t know a lot of things that I think I know. I learnt to get rid of preconception when studying a company. I always keep an open mind when it comes to investing. And I know one thing: there’s a lot of interesting surprises in learning about.